I don’t carry a cell phone for a variety of idiosyncratic reasons. My accommodating wife lets me keep our home phone, a land-line we got 20 years ago. She no longer answers it, however, because we get a lot of spam calls. Sure, it’s on the FTC’s Do Not Call Registry, but that does not protect us from certain types of spam, particularly charity spam and polling spam.
This charity loophole in the Do Not Call system is the basis for today’s lesson in substance over form. In Giving Hearts, Inc. v. Commissioner, T.C. Memo 2019-94 (July 29, 2019), Judge Guy teaches how the operational test in tax exempt entity taxation looks through formal agreements to focus on function. Thus, a charity created to provide cover for a replacement windows telemarketing business was not really a charity.
This is not the typical case of a taxpayer using a charity to cheat the IRS. We’ve seen those lessons before here (pastor mis-characterizing income as gifts) and here (item 5: taxpayer creating charity to pay family expenses). No, the taxpayer’s scheme here was to create a charity to work around the FTC Do Not Call restrictions. The tax benefits were just a side effect. This is a cool opportunity to see the interplay of two different statutory schemes.
The Law: Exempt Organizations and the FTC
Congress empowered the Federal Trade Commission (FTC) to write regulations that create a Do Not Call registry. 15 U.S.C. §§ 6151-6155. The regulations were to implement the Congressional requirement that “telemarketers may not undertake a pattern of unsolicited telephone calls which the reasonable consumer would consider coercive or abusive of such consumer’s right to privacy.” 15 U.S.C. 6102(a)(3)(A).
On the basis of that authority, the FTC created the Do Not Call registry and regulations in 2003. Congress ratified those regulations in the Do-Not-Call Implementation Act, P. L. 108–82, 117 Stat. 557. The FTC regulations generally prohibit telemarketers from calling phone numbers listed on the Do Not Call registry. 16 CFR 310.4(b).
The FTC regulations do not generally apply, however, to non-profit organizations. That is because the FTC organic act—the legislation giving it existence---only gives the FTC power over “corporations” which are defined as entities "organized to carry on business for its own profit or that of its members." 15 U.S.C.§44. Thus, corporate entities organized for non-profit purposes are not within the FTC’s jurisdiction to regulate. The FTC website explains that: “Because of the limits to FTC’s authority, the Registry does not apply to political calls or calls from non-profits and charities.” That means non-profit organizations can access the Registry and can call the numbers on it. But if non-profits use for-profit corporations (“telefunders”) to raise money for them, the telefunders are subject to restrictions, just nowhere near as onerous as straight-up telemarketers. You can see the very interesting reasons for this in National Federation of The Blind v. FTC, 420 F.3d 331 (4th Cir. 2005).
The FTC nowhere defines what kind of organizations qualify for the non-profit exception. What is important for today’s lesson is to understand that the non-profit exception to the Do Not Call restrictions may or may not match up with being a non-profit entity for tax purposes. This FTC FAQ webpage emphasizes that tax exempt status is not the test for FTC purposes. Just because your organization may be tax exempt does not take it outside the FTC jurisdiction. As examples, the website references a couple of tax-exempt entities that the FTC busted some 15 years ago for violating the Do Not Call Registry.
The bottom line, the FTC website says, is that “whether your organization is exempt is a decision that requires an understanding of the FTC's and FCC's requirements, as well as your specific business practices. Therefore, whether you should subscribe as an Exempt Organization is a decision you must make. In making this decision, you may wish to consult with an attorney.”
The Law: Exempt Organizations in Tax Law
An organization can be exempt from tax on its gross income if it fits into one of the categories in §501(c). Everyone wants to be in the §501(c)(3) category because that allows donors to take deductions under §170. However, since Congress almost doubled the standard deduction, §170 deductions may not be as important. The empiricists are working on that.
An entity receives §501(c)(3) status when it is “organized and operated exclusively for” a bunch of do-good purposes, which, collectively, we call charitable purposes. The key words for this lesson, however, are “organized” and “operated.” The word “exclusively” modifies both.
Treas. Reg. 1.501(c)(3)-1 tells us that to be “organized exclusively” as a charity, the entity must have the proper paperwork---charter or trust or other entity-creating documents. For example, the paperwork must keep the entity from “attempting to influence legislation by propaganda or otherwise” by more than an insubstantial amount. Nor can the paperwork authorize the entity to touch the third rail of tax-exempt law: participation in an election.
The same regulation tells us that an entity will be found to be “operated exclusively” as a charity “only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3).” An organization fails this operational test “if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.”
Mr. Carrier ran a home improvement business called Window Plus, a multi-generational family operation. During the period at issue it appears the company was run by Mr. Carrier and his cousin Don Carrier. The company depended heavily on telemarketing to obtain customers. After the Do Not Call registry went into operation in the early 2000’s, that business model became harder to sustain.
Mr. Carrier believed that if he had access to a charity then he could gain access to the Do Not Call registry. The result was Giving Hearts, Inc., incorporated in 2009 by the wives of Mr. Carrier and his cousin, and an apparently unrelated CPA acting as Treasurer.
Giving Hearts applied for tax exempt status in 2009 and the IRS initially declined to grant it because the formal documents were deficient. Eventually Giving Hearts fixed the formal documents to provide that its charitable purpose was to raise money to give away to other charities. The IRS approved tax exempt status. Giving Hearts was in business! Oh...er...I meant it was now operational.
To raise the money it was supposed to give away, Giving Hearts sold its access to the Do Not Call Registry. It did this through a scheme where Giving Hearts would authorize a for-profit company to make telemarketing calls to raise funds for Giving Hearts. But the calls were not straightforward solicitations for donations. Nope. The solicitation was to attend a sales meeting! And only if the customer agreed to a sales meeting would money flow to the charity. And it would not flow from the consumer, but from the for-profit company. A quid for the access quo.
The only for-profit company to take advantage of this wonderful opportunity was---surprise, surprise---Window Plus. Window Plus telemarketers used a script where they would call the forbidden telephone number and say they were calling to raise money for Giving Hearts. Judge Guy tells us that the script then pivoted to this: “For every home owner that accepts a product demonstration and free estimate, our charity will receive a donation from Window Plus.” The telemarketers would then launch into a sales pitch for replacement windows.
As you might imagine, these calls did not go over well. Folks complained. In 2011 the Michigan AG wrote the IRA about complaints that Giving Hearts was “a front for a window sales operation.” In 2012 the IRS opened an examination and in 2016 revoked Giving Hearts tax exempt status. Giving Hearts petitioned the Tax Court to review the revocation decision.
Lesson: Gotta Walk Like a Charity to Be a Charity
If the organizational test were the only consideration, Giving Hearts would have won. That is truly a formal test, depending as it does on the correctness of the language used in the formal articles of operation. While Giving Hearts initially had some problems, it eventually talked the right talk. Raising money to give to other charities is, apparently, in and of itself a charitable purpose.
The problem was on the operational side: the method Giving Hearts used to raise that money. It did not walk the right walk. The telemarketers did not solicit donations for Giving Hearts. They were not telefunders. Instead, they solicited sales appointments. The customer was not asked to give money. It was Window Plus, the for-profit company, that paid Giving Hearts a commission for each successful appointment made. Thus, Window Plus was paying, not just for access, but for successful access.
On these facts Judge Guy had no difficulty concluding that Giving Hearts was not “exclusively operated” for a charitable purpose. Instead, it “was primarily engaged in generating sales leads (and ultimately revenues) to advance a commercial enterprise, with charitable donations arising only as a function of the [business'] success in securing in-home product demonstrations and presenting project estimates to potential customers.”
Comment 1: The Corporate Sponsorship Issue
Giving Hearts was not tax exempt. That meant the payments made by Window Plus to Giving Hearts were gross income to Giving Hearts. Even if Giving Hearts was a charity, however, the payments might still be income, called Unrelated Business Income (UBI). In his blog post on this case, Pete Reilly reports that some commentators have dinged Judge Guy’s analysis as ignoring the fact that corporate sponsorships, by themselves, can be legit.
Corporate sponsorships of charities is a pretty well-established practice. You can find some good information on this webpage and on this IRS webpage. Apparently, legit corporate sponsorship arrangements can include payment arrangements that are contingent on sales by the for-profit business. For example, if I am in the business of selling hats, a charity might agree to let me put their brand on a hat if I donate some percentage of each hat sales to the charity. That agreement does not affect the charity’s charitable purpose.
If a corporate sponsorship go too far, however, it can result in UBI to the charity. Those rules are set out in §513. As relevant here, §513(i)(1) provides that UBI does not include “qualified sponsorship payments.” That means, of course, that non-qualified payments DO count as UBI. Section 513(i)(1)(A) says that what makes a payment “qualified” is when “there is no arrangement or expectation that such person will receive any substantial return benefit other than the use or acknowledgement of the name or logo (or product lines) of such person’s trade or business in connection with the activities of the [charity].” Going back to my hat example, I would be making qualified sponsorship payments because the only benefit I am receiving from the charity is the use of its name or logo.
I am no expert, but I would think the corporate sponsorship arrangement here involved a return benefit far greater than “the use...of the name or logo.” Giving Hearts was selling more than its good name. It was selling access to the Do Not Call Registry. If I am right that such access would make the resulting payments from Window Plus to Giving Hearts UBI, then 100% of Giving Hearts’ income was UBI. That would be true even if it had entered into similar arrangements with other telemarketing-dependent companies.
I recognize that the UBI question is not the same as the operational test. But I would think it could affect the operational test. My friends who are expert in EO tell me that the extent to which UBI impacts the operational test for any charity is a subject of robust debate and inconsistent IRS guidance. So yes, I understand that the existence of UBI may not determine the question of whether a charity meets the operational test to be a charity. But gosh, I simply cannot see how a charity funded 100% by UBI can say it operates for a charitable purpose.
Comment 2: Why Did the IRS Audit Giving Hearts?
In his blog post, Pete Reilly knocks the IRS for opening an examination in the first place. In his view, the IRS should have responded to the Michigan IG’s complaint by pointing the bureaucratic finger at the FTC and telling the Michigan IG: “not our job.” Pete writes: “if you look at the 990s what you see is a few thousand dollars coming in and most of it going out to other charities after some administrative expenses. Nobody is getting away with anything when it comes to federal income tax...” For Pete, the de minimis nature of the subterfuge means the IRS should have just ignored it.
I have two reactions to Pete’s comment.
First, I don't see that the IRS is doing the FTC’s work. Remember, the set of organizations exempt from federal taxation is not co-terminus with the set of organizations exempt from the Do Not Call restrictions. Overlapping, sure. But not the same. Here, Giving Hearts may still well be a non-profit entity under state law. It may still well be exempt from the Do Not Call registry. I do not know. That’s a matter for FTC enforcement. The IRS was doing its own work, enforcing the tax exemption rules.
Second, it about more than dollars. The IRS function that handles charities, the Tax Exempt and Government Entities Operating Division (TE/GE)---has a mission statement that goes beyond protecting the federal fisc. IRM 22.214.171.124 says: “The purpose of TE/GE is to provide top quality service and comply with applicable tax law and protect the public interest by applying the tax law with integrity and fairness to all.”
The reason it’s about more than dollars is that taxpayers try to set up tax-exempt organizations for a whole host of non-tax purposes. Pete himself makes the point. He writes: “you might find it surprising that many, possibly most, organizations go after 501(c)(3) status for reasons unrelated to federal taxation.”
Approved tax-exempt organizations like to tell people they have been blessed by the IRS. In this case, for example, Mr. Carrier responded to a complaint about the fake charity on Google reviews by writing: “Giving Hearts was established in 2010 by the Department of Treasury.” You can find this by Googling "Window Plus Michigan Reviews" and then looking at the right hand part of the results page and clicking on the "14 Google reviews." Most readers of this blog will recognize the absurdity of Mr. Carrier's statement. Giving Hearts was established by Mr. Carrier's wife! But normal folks are not at all sensitive to that nuance. Mr. Carrier, and others, like to use the IRS blessing as a halo.
Pete is essentially critiquing the IRS for its workload selection, saying there were better ways to use the resources spent on auditing Giving Hearts. He may well be right. But he may well also be wrong. It's not his job, nor mine, to make workload allocation decisions. Workload decisions is a discretionary function that involves a variety of variables beyond dollars. IRM 126.96.36.199.5 list a bunch of objectives such as “selecting cases or compliance strategies that will have the highest positive impact on voluntary compliance and tax administration” and “protecting the confidentiality of the criteria used to select work so taxpayers cannot easily avoid detection.” So selecting a low-dollar entity for examination may help other low-dollar entities understand they may be audited.
More importantly, when the AG of a state complains to the IRS, it is not a de minimis matter, by definition. When I was in Chief Counsel’s office we would frequently get picayune requests from members of Congress and other politicians. The IRS policy is to take such requests seriously and respond to them substantively. See IRM 188.8.131.52.5(2) (requiring response to all congressional inquiries within 20 days). I can well imagine why the IRS would follow a similar policy for state AG requests: the IRS often works with state authorities and depends on state authorities to help it do its mission.
So, yes, the IRS should be policing the legitimacy of tax exempt organizations through ex-post audits as part of the “public interest” aspect of ensuring the integrity of the ex-ante approval process. Focusing merely on the dollars is short-sighted. It was no more unfair for the IRS to audit Giving Hearts than for it to audit any other taxpayer.
Coda: Giving Hearts may have just been unlucky in timing. Notice that the audit here was started in 2012, back before the TE/GE division was decimated by the BOLO scandal. As the National Taxpayer Advocate explained in 2015, TE/GE then started almost automatically approving tax exemption applications. That caused increased workload on TE/GE’s diminished audit resources. The workload selection criteria after 2013 may not have favored auditing Giving Hearts.
Coda 2: As we saw in this 2017 Lesson From The Tax Court, the downside of easy exemption is retroactive revocation of tax exempt status with interest running on any gross income from the date of revocation. For Giving Hearts, that may not matter if they can show that the payments from Window Plus were excludible from gross income because they were made from disinterested generosity. Commissioner v. Duberstein, 363 U.S. 278 (1960). Yeah, right.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School Thereof