Nonprofit Organizations Update Fall 2007

ARNSTEIN & LEHR LLP Attorneys at Law

Nonprofit Organizations Update About our Nonprofit Practice Group Arnstein & Lehr LLP provides legal services to trade associations, professional societies, public charities, private foundations, fraternal organizations, group insurance trusts, political action committees, schools, hospitals, medical staffs, "captive" insurance companies, and other organizations exempt from federal income tax under Section 501(c) of the Internal Revenue Code. The Firm's attorneys help such clients deal with a wide array of issues, including: •

Corporate and trust formation and maintenance

•

Development of bylaws

•

Obtaining and maintaining federal and state tax exemptions

•

Avoiding and minimizing unrelated business income taxes

•

Registrations and annual filings with attorneys general and other government officials

•

Proper conduct of organization elections

•

Avoiding antitrust problems

•

Fund raising campaigns, including use of professional fundraisers

•

Self-dealing, inurement and intermediate sanctions

•

Relations with subsidiary groups, including group tax exemptions

•

Protection of intellectual property

•

Charitable gaming

•

Limitations on political and legislative activity

•

Professional ethics matters

•

Public and member disclosure requirements

•

Deductions for donors

•

Nonprofit mailing permits

•

Partnerships and joint ventures with forprofits

•

Employment issues

•

Insurance issues

IRS Announces Compliance Initiative Directed at Use of Tax-Exempt Bond Financing by Charities The Internal Revenue Service has announced a new compliance initiative directed at use of tax-exempt bond financing by charities. The initiative will involve the Service's sending surveys to all types of charities using proceeds of tax-exempt bonds issued by governments on behalf of institutions. Of concern to the IRS is organization compliance with government requirements relating to the cost of issuance, public notice and hearings, and record retention. Problems were found in these areas after a previous, more limited initiative conducted in 2006 in an effort to determine the level of compliance with post-bond issuance private use rules.

IRS Notifies Small Exempt Organizations Regarding Form 990-N Reporting Requirements The Internal Revenue Service announced that it would be mailing educational letters to 650,000 small tax-exempt organizations before the end of 2007, notifying them of their need to file Form 990-N with the Service. Filing of the form is required by the Pension Protection Act of 2006 for tax-exempt organizations with gross receipts of $25,000 or less, which, prior to the enactment of the PPA, were not required to submit Form 990 information returns to the federal government. The first Form 990-Ns are to be filed during calendar year 2008. The form requires small organizations to provide a legal name and mailing address, any other names used, a Web address if one exists, the name and the address of a principal officer, and a statement confirming that the organization's annual gross receipts are normally $25,000 or less. The Service calls the new form an e-Postcard because it is intended to be short, easy and electronic. But failure to follow the return will have harsh consequences that are intended to encourage compliance. Any organization failing to file the return for three consecutive years will automatically lose its tax-exempt status and be required to reapply.

Supreme Court Rejects Challenge to President's Faith-Based and Community Initiatives Program for Lack of Standing The Supreme Court of the United States, reversing a lower court, has rejected a constitutional challenge to President Bush's Faith-Based and Community Initiatives program, finding that the plaintiffs did not have standing to claim that the program violated the Establishment Clause of the First Amendment simply because they paid

Continued on Page 2 Nonprofit Organizations Update | Fall 2007

federal taxes. The plaintiff taxpayers claimed that conferences held as part of the program violated the Establishment Clause because, among other things, President Bush and former Secretary of Education Paige gave speeches at the conferences using "religious imagery" and praising the efficacy of faithbased programs in delivering social services. The program in question was established by Presidential Executive Order directed to federal agencies and departments, which were given the job of ensuring that faith-based community groups would be eligible to compete for federal financial support without impairing their independence or autonomy, as long as they did "not use direct federal financial assistance to support any inherently religious activities, such as worship, religious discussion, or proselytization." In furtherance of the program, certain federal officials had organized conferences at which faith-based organizations allegedly were "singled out as being particularly worthy of federal funding…, and the belief in God [was] extolled as distinguishing the claimed effectiveness of faith-based social services." Taxpayers challenging the constitutionality of the program further argued that the content of the conferences sent a message to religious believers "that they are insiders and favored members of the political community" and that the conferences sent a message to non-believers "that they are outsiders" and "not full members of the political community." The only alleged basis for the taxpayers' standing to challenge the program was their status as federal taxpayers who were "opposed to the use of Congressional taxpayer appropriations to advance and promote religion." A district court dismissed the taxpayers' claims for lack of standing, but the U.S. Court of Appeals for the Seventh Circuit reversed that decision, reading a prior decision by the Supreme Court, in Flast v. Cohen, as granting federal taxpayers standing to challenge Executive Branch programs on Establishment Clause grounds so long as the activities are "financed by a congressional appropriation." On appeal of the decision by the Seventh Circuit, the Supreme Court found that the Court of Appeals incorrectly invoked Flast as granting standing to the taxpayers in this case. The Supreme Court noted that Flast was an exception to a longstanding generally recognized rule that the payment of taxes alone was not enough to establish standing to challenge action taken by the federal government. As the Court read the Flast decision in this case, it created a narrow exception to the general rule, which allowed taxpayers standing to challenge a law passed by Congress to authorize the use of federal funds in a way that allegedly violates the Establishment Clause. But, in this case, Congress did not specifically authorize the use of federal funds to pay for the conferences or speeches to which

Nonprofit Organizations Update | Fall 2007 | Page 2

the taxpayers objected, though the conferences were paid for with money appropriated by Congress. Rather, the conferences were paid for out of general Executive Branch appropriations. The unwillingness of the Supreme Court to expand or read broadly the Flast decision can be explained by the statement of Justice Alito, in announcing the Supreme Court's judgment, that, in light of the size of the federal budget, "it is a complete fiction to argue that an unconstitutional federal expenditure causes an individual federal taxpayer any measurable economic harm. And if every federal taxpayer could sue to challenge any Government expenditure, the federal courts would cease to function as courts of law and would be cast in the role of general complaint bureaus."

Provena Covenant Medical Center's Charitable Exemption from Property Tax Restored Updating a report previously published in this newsletter, the Circuit Court of Sangamon County has reversed a decision by the Illinois Department of Revenue to remove the charitable exemption from property tax enjoyed by Provena Covenant Medical Center. In a case that generated national attention, the Department had found that the hospital could not be considered charitable because its financial figures for one year fell short of proving that its primary purpose was charitable care. But that decision has now been overturned in a oneparagraph docket entry by the circuit court, which merely says that the court is reversing the decision of the Department and granting an exemption for charitable use and religious use.

IRS Announces Intention Not to Treat as Impermissible Private Benefit or Inurement Specific Financial Assistance Provided by Hospitals to Staff Physicians The Director of Exempt Organizations for the Internal Revenue Service has issued a memorandum stating that the IRS will not treat as impermissible private benefit or inurement any financial assistance provided by hospitals exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code to staff physicians in order to facilitate their acquiring and implementing software used predominantly for creating, maintaining, transmitting or receiving electronic health records for their patients. However, the assistance must be permissible for hospitals under regulations issued by the U.S. Department of Health and Human Services under the federal Anti-Kickback Law, 42 U.S.C. Section 1320a-7b, and Physicians Self-Referral Law, 42 U.S.C. Section 1395nn, and the hospitals must operate in a manner described by the memorandum.

In order to qualify for the treatment as described in the memorandum, assistance provided by a hospital must be in accordance with arrangements requiring both the hospital and the participating physicians to comply with the Department of Health and Human Services regulations on a continuing basis, and, to the extent otherwise permitted by law, the hospital must be able to access all of the electronic medical records created by a physician with the assistance provided by the hospital. In addition, the hospital must ensure that software and technical support services benefiting the staff physicians under these arrangements are available to all medical staff physicians at the hospital, and the hospital must provide the same level of subsidy to all of its medical staff physicians or vary the level of subsidy by applying criteria related to meeting healthcare needs of the community.

Formation of Parent 501(c)(6) Entity by Charitable Organization Will Not Affect Charity's Tax-Exempt Status Under Internal Revenue Code Section 501(c)(3) The Internal Revenue Service has held that a charity exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code would not jeopardize its tax-exempt status by forming a parent trade association/business league to which it would transfer certain of its activities that were similar to those of a business league. The charity was a membership organization that conducted activities such as continuing medical education programs and produced products focusing on the latest scientific and professional information, as well as reports on diagnosis, treatment and research relating to certain medical conditions, and it hosted a large international gathering of physicians, researchers and academics in a certain field. The charity proposed to form the trade association/business league to conduct activities such as collection and processing of dues, as well as public affairs activities and membership advocacy through lobbying at the state and federal levels. A purpose of creating that entity was to allow the charity to concentrate on its purely educational and charitable activities. Accordingly, the parent organization was formed and recognized as tax-exempt by the Internal Revenue Service under Section 501(c)(6) of the Code. The parent was created to serve as the charity's sole corporate member, which would have the right to appoint and remove the charity's board of trustees. The former members of the charity became the members of the new trade association/business league, and the boards of the two entities were reorganized so that they would not be identical, but there would be substantial overlap in their membership.

After reorganization, it was anticipated that the charity would provide some employees to the new parent pursuant to an administrative services agreement and on a cost basis. The new parent was planning to lease space from an independent party, and the charity appointed a committee to review all proposed transactions between the organizations from the standpoint of fairness to the charity, charging that committee with protecting the charity's assets. Under this set of facts, the Internal Revenue Service ruled that creation of the new parent organization exempt under Section 501(c)(6) of the Code would not adversely affect the exempt status of the charity under Code Section 501(c)(3), because the charity had not given up control of its charitable and educational purposes or activities to the Section 501(c)(6) parent. The IRS noted that activities being transferred to the parent, namely, membership services including collecting and processing of dues, member advocacy through lobbying, and a public affairs committee, would not constitute, in and of themselves, purposes or activities of the Section 501(c)(3) entity.

Sale of Merchandise by Breast Cancer Awareness Organization Not Subject to UBIT The Internal Revenue Service has held that the sale of merchandise by a nonprofit organization exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code, because of its involvement in public education with regard to breast cancer and the need for early detection, would not be subject to unrelated business income tax. The IRS noted that the organization sold certain merchandise bearing the pink ribbon symbol commonly associated with breast cancer awareness, as well as other items not bearing the symbol, but nevertheless having the signature pink color and being easily recognizable as related to the breast cancer awareness cause. Analyzing the organization's claim to an exemption from UBIT for the sales, the IRS said that much of the merchandise was inherently educational, providing information on breast cancer, related topics and resources, so that its sale was clearly related to the exempt purposes of the organization and was not an unrelated business income activity producing taxation. With regard to other merchandise, however, the IRS concluded that the pink ribbon symbol in itself was a reminder of the need for positive breast health practices and early detection, and even the sale of items not bearing the symbol, but having the signature pink color associated with the cause, furthered the purpose of the organization by reminding and encouraging those who wore, displayed or saw them that early detection of breast cancer and positive breast health practices save lives. Therefore,

Nonprofit Organizations Update | Fall 2007 | Page 3

the sale of all merchandise in question was related to the organization's exempt purpose and not subject to tax.

Association Name Denied Protection as Descriptive Mark The U. S. District Court for the Western District of Arkansas, faced with a dispute between two rival non-profit organizations, each of which was using the name Arkansas Trophy Hunters Association, has ruled that both of the nonprofits can use the name in Arkansas because the name is too highly descriptive to deserve any protection under federal or state law, especially in the absence of any evidence that consumers were misled by the two organizations' use of the same name. Accordingly, claims and counterclaims filed by each of the organizations against the other were all dismissed. The first organization to use the disputed name was incorporated in Arkansas in 2003 as the Arkansas Trophy Hunters Association by several hunters whose goals centered on various hunting and fishing activities. This corporation never had more than a few members, held a few fish fries, sponsored and filmed a few hunts, established a website that was sometimes and sometimes not operational, and adopted a logo that was included on some shirts, hats and window decals used by its members. In the fall of 2005, meanwhile, a nonprofit based in Texas for over 30 years, which was called the Texas Trophy Hunters Association, decided to set up an Arkansas group using the name Arkansas Trophy Hunters Association, apparently without any knowledge that there was an entity incorporated in Arkansas by that name. They launched a large and well-funded marketing effort, including production of logobearing hats, shirts and other give-aways, mailed out solicitations of membership, and planned for a trade show to be held in Fayetteville, Arkansas during 2006. Before the trade show was held, the Texas organization became aware of the Arkansas corporation, and some discussions ensued between the groups, apparently amicably, about the possibility of making arrangements with regard to the name they were both using. No conclusions were reached, and the Arkansas corporation eventually filed suit in federal court to enjoin the Texas entity's trade show, prompting counterclaims by the Texas group. Both organizations based their claims on federal and state law provisions, including federal trademark infringement, false advertising and trademark dilution, as well as Arkansas unfair competition, trademark infringement and trademark dilution laws.

The district court, however, dismissed all charges in the case, finding that the name Arkansas Trophy Hunters Association was so highly descriptive of the activities of both groups that it was not entitled to any protection under the federal and state laws cited by the parties, because the mark would not be closely associated, in the minds of the public, with the services rendered by either party. The court also concluded that the name Arkansas Trophy Hunters Association did not appear to be causing any mistake, confusion or deception among the members of the public, and, because of the name's descriptive nature, the court ruled, as a matter of law, that it could not cause such mistake, confusion, or deception, resulting in liability for either group, under any of the theories advanced by the parties.

Business League Found Not Subject to UBIT for Providing Services to For-Profit Conducting Trade Show The Internal Revenue Service has held that a business league exempt from federal income tax under Section 501(c)(6) of the Internal Revenue Code did not receive unrelated business taxable income from services it provided to a for-profit entity that owned and conducted trade shows for the members of the business league's industry. Under an agreement between the business league and the for-profit, the league actively promoted the trade shows, shared exhibit space at the trade shows with the for-profit, provided staffing for the trade shows, cosponsored a lounge at the trade shows with the for-profit, provided management assistance for the trade shows, and assisted the for-profit in publication of a periodical for the industry. In return, the for-profit paid the business league a fixed percentage of income derived by the for-profit from various show-related revenue streams, including exhibit space, catalog advertising, sponsorships and conferences. Considering that the business league was actively involved in providing services for the for-profit, the Internal Revenue Service ruled that payments received by the business league from the for-profit in return for such services could not be considered "passive" royalty payments generally exempted from unrelated business income taxation under Internal Revenue Code Section 512(b)(2). But the IRS ruled that the payments were exempt because the services performed by the business league for the for-profit constituted the conduct of a qualified convention or trade show by a qualifying organization, which would be tax-exempt under Code Section 513(b)(3). The IRS found that the business league was a "qualifying organization" within the meaning of Code Section 513(d)(3)(c), and the trade shows were qualified convention or trade shows

Nonprofit Organizations Update | Fall 2007 | Page 4

regularly conducted with a purpose of stimulating interest in and demand for the products and services of the league's industry through exhibits and display of industry products. Furthermore, the activities engaged in by the business league furthered its exempt purposes, and the fact that it conducted its trade show activities through sponsoring and participating in trade shows with a for-profit entity did not change their nature as qualified trade show activities.

Nonprofit Seeking Supporting Organization Status Denied Federal Income Tax Exemption In a private letter ruling, the Internal Revenue Service has denied a federal income tax exemption under Section 501(c)(3) of the Internal Revenue Code for an organization formed to provide financial support for another exempt organization described under the same Code subsection. The IRS cited numerous reasons for denying the exemption, including the fact that the applicant's attorney had advised the Service that the organization to be supported would be closed before the end of the calendar year. The Service found the applicant organization was not organized for tax-exempt purposes because the organizing documents permitted the manager of the organization to substitute other Section 501(c)(3) organizations for the organization allegedly to be supported, at any time and for any reason. In addition, the IRS noted that the organizational documents allowed distribution of the applicant's assets to other than specified publicly supported organizations upon termination of the applicant entity, or even to the family of the individuals who founded the applicant. The IRS also determined that the applicant was not operated for tax-exempt purposes because the applicant failed to demonstrate that amounts distributed to the organization intended to be supported by the applicant were actually spent for tax-exempt charitable purposes. Furthermore, the IRS noted that the applicant had made loans to its founders, who were also serving as directors of the applicant, and the making of such loans was, in fact, the primary purpose of the applicant. Finally, as the founders were substantial contributors and disqualified persons with respect to the applicant under Internal Revenue Code Section 4946, the applicant had not established that disqualified persons did not control it. Rather, the loans indicated that such persons did control the applicant.

Nonprofit Organizations Update | Fall 2007 | Page 5

For all of the above reasons, the IRS concluded that the applicant organization was not qualified for a tax-exemption under Section 501(c)(3) or to be considered a publicly supported organization under Section 509(a) of the Code.

Unincorporated Organization Denied Charitable Use Property Tax Exemption The Massachusetts Appellate Tax Board has denied a charitable use property tax exemption for an organization that was operating a nursing home facility, finding that the property owner was not organized in the manner required by Massachusetts statutes for a charitable use exemption. The court noted that the applicable statutes required that a charitable organization eligible for the property tax exemption must be "incorporated," whereas the taxpayer was an unincorporated entity.

Court Finds Store Operated by Nonprofit for Members Entitled to Property Tax Exemption The Ohio Supreme Court has held that a nonprofit organization's store, which was operated for the benefit of its members, and which did not advertise to the general public, was entitled to a property tax exemption, even if the store made a profit. Merchandise offered at the store was branded specifically for the organization. The store in question had been operating for eleven years without making a profit, but in 2003 had made a profit of $2,363. Thereupon, the Ohio Tax Commissioner listed the property for tax purposes, denying it the charitable use property tax exemption that had previously been extended to the facility. When the Commissioner's action was appealed to the state supreme court, the Commissioner argued that the property was taxable because the store, after making a profit in 2003, was being operated with a view towards profit, and it was in competition with other commercial enterprises. However, the Supreme Court rejected the Commissioner's arguments, finding that the mere generation of revenue was not grounds for revocation of a charitable use property tax exemption, the store existed for the benefit of the organization, and the prices charged there were intended to cover only the store's operating costs, even if it had made a profit in one year. Furthermore, because the store's merchandise was not marketed to the general public, the court held that it was not competing with commercial for-profit enterprises.

Fund-Raising Organization Loses Tax Exemption The Internal Revenue Service has revoked the federal income tax exemption previously recognized under Section 501(c)(3) of the Internal Revenue Code for an organization created to provide support and assistance for those in need of, and those providing, education. After an IRS audit of the organization was instituted due to media reports portraying the nonprofit in a poor light, the IRS found that the organization's board had decided to lay off all of its employees due to a poor economy and had decided not to hold any more meetings until the organization had raised funds. Consequently, the only activities of the organization in recent years had been to conduct fundraising events and to act as a conduit for loans made to the organization by its president, which were used, in part, to make political contributions at the president's direction.

Reviewing that record, the IRS revoked the exemption because it determined that the organization had failed to establish that it was operated exclusively for public and charitable purposes. The IRS found that the organization conducted no charitable activities, because fundraising is not a charitable activity and that was the primary activity the entity had conducted in recent years.

If you would like further information about any of the topics mentioned in this publication, please contact James F. Gossett at [email protected] or 312.876.7833.

ARNSTEIN & LEHR LLP Chicago, Illinois 120 South Riverside Plaza, Suite 1200 Chicago, IL 60606 phone 312.876.7100 fax 312.876.0288

Hoffman Estates, Illinois 2800 West Higgins Road, Suite 425 Hoffman Estates, IL 60169 phone 847.843.2900 fax 847.843.3355

Springfield, Illinois 808 South Second Street Springfield, IL 62704 phone 217.789.7959 fax 312.876.6215

Boca Raton, Florida 2424 North Federal Highway, Suite 462 Boca Raton, FL 33431 phone 561.322.6900 fax 561.322.6940

Fort Lauderdale, Florida 200 East Las Olas Boulevard, Suite 1700 Fort Lauderdale, Florida 33301 phone 954.713.7600 fax 954.713.7700

Miami, Florida 200 South Biscayne Boulevard, Suite 3600 Miami, FL 33131 phone 305.374.3330 fax 305.374.4744

Tampa, Florida Two Harbour Place 302 Knights Run Avenue, Suite 1100 Tampa, Florida 33602 phone 813.254.1400 fax 813.254.5324

West Palm Beach, Florida 515 North Flagler Drive, Suite 600 West Palm Beach, FL 33401 phone 561.833.9800 fax 561.655.5551

Milwaukee, Wisconsin 7161 North Port Washington Road Milwaukee, WI 53217 phone 414.351.2440 fax 414.352.6901

www.arnstein.com © 2007 ARNSTEIN & LEHR LLP

Nonprofit Organizations Update | Fall 2007 | Page 6