'First Bite' and the Private Benefit Doctrine: A Comment on Temporary and Proposed Regulation 53.4958-4t(A)(3)

Abstract

Temporary and Proposed Regulation 53.4958-4T(a)(3), promulgated in 2001, allows an eventual insider to collect profits earned by a charitable organization. As long as profit taking is accomplished via a contract entered into before the recipient is an insider - even when the recipient becomes an insider by virtue of the very contract allowing for the profit distribution - the fundamental requirement that no person may earn a profit from the operation of a charity will not be violated. If, indeed, the recipient becomes an insider by virtue of the contract or arrangement by which profit is first collected, any subsequent profit taking via an unrelated contract or other arrangement will constitute a violation. Hence, the latter day insider is allowed a "first bite" at the charity's profit. Although the Service opposed the first bite rule in the first set of regulations proposed under IRC 4958, it later conceded the rule after its loss in United Cancer Council, Inc. v. Commissioner, 165 F.3d 1173 (7th Cir. 1999). In that case, Judge Posner reasoned that there was no private inurement when an outside fundraiser took (as commission and reimbursement for expenses) 95% of the contributions made to a charitable organization. The Service agreed that the fundraiser was not an insider prior to becoming the charity's exclusive fundraiser. The Service argued, not without factual support, that the fundraiser became an insider by virtue of the fundraising contract, since the contract ceded significant control over the charity's operations to the fundraiser. Judge Posner, adopting a rather literalist approach, noted that the prohibition against private inurement applies only to those who are insiders. The implication was that the right to the profit (rather than the actual taking of the profit) must occur after the recipient is an insider if a violation of the profit-taking prohibition is to be found. Instead of continuing its opposition to the first bite rule, the Service adopted it in 53.4958-4T(a)(3). Judge Posner's opinion, however, cannot be viewed as condoning profit taking. Instead, the opinion asserts that the prohibition against private inurement was the wrong theory. The prohibition against private benefit, according to Posner, is the correct theory. But the private benefit doctrine, as presently articulated in the regulations, will not prohibit first bite profit taking in most instances. Judge Posner assumed otherwise. In any event, once the Service decided to adopt the first bite rule, it should also have re-stated the private benefit doctrine in a manner necessary to effectuate Judge Posner's assumption that profit taking may be addressed under that theory. The Service did not do so. This article contains a proposal for restating the private benefit doctrine in a manner that will close the loophole created by the first bite rule. The substance of the proposal was presented to the Service at a July 31, 2001 public hearing concerning the IRC 4958 regulations.