Lapham Foundation v. CIR ( 2004 )

RECOMMENDED FOR FULL-TEXT PUBLICATION
Pursuant to Sixth Circuit Rule 206
File Name: 04a0401p.06
UNITED STATES COURT OF APPEALS
FOR THE SIXTH CIRCUIT
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Petitioner-Appellant, -
LAPHAM FOUNDATION, INC.,
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No. 03-1229
v.
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COMMISSIONER OF INTERNAL REVENUE, -
Respondent-Appellee. -
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On Appeal from the United States Tax Court.
No. 01-03881.
Argued: June 15, 2004
Decided and Filed: November 18, 2004
Before: DAUGHTREY and SUTTON, Circuit Judges; COOK, District Judge.*
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COUNSEL
ARGUED: James C. Thomas III, HUSCH & EPPENBERGER, Kansas City, Missouri, for Appellant.
Francesca Ugolini, UNITED STATES DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee.
ON BRIEF: James C. Thomas III, HUSCH & EPPENBERGER, Kansas City, Missouri, for Appellant.
Francesca Ugolini, Kenneth L. Greene, UNITED STATES DEPARTMENT OF JUSTICE, Washington,
D.C., for Appellee.
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OPINION
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MARTHA CRAIG DAUGHTREY, Circuit Judge. The petitioner, Lapham Foundation, Inc., appeals
from a Tax Court judgment classifying it as a private foundation under 26 U.S.C. § 509(a)(3). The Tax
Court based its decision on a finding that the Foundation did not meet the “integral part” test set forth in
26 C.F.R. § 1.509(a)-4(i)(3). On appeal, the Foundation argues that it does meet the requisite test and is
therefore a supporting organization, rather than a private organization. The Commissioner of Internal
Revenue, in response, claims that the Tax Court was correct in holding that the Foundation did not meet the
“integral part” test and that, even if the Foundation does meet that test, the Tax Court’s decision should be
affirmed because the Foundation has not shown that it is not controlled by disqualified persons, as required
by 26 U.S.C. § 509(a)(3)(C) in order to be classified as a supporting organization. The Tax Court did not
address the latter question and, because we conclude that the Tax Court’s ruling on the Foundation’s failure
*
The Honorable Julian A. Cook, Jr., United States District Judge for the Eastern District of Michigan, sitting by designation.
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No. 03-1229 Lapham Foundation v. Comm’r Page 2
to meet the integral part test was correct, we likewise find it unnecessary to address the issue raised under
§ 509(a)(3)(C).
FACTUAL AND PROCEDURAL BACKGROUND
Lapham Foundation, Inc. (the Foundation), is a Michigan non-profit corporation, organized under
its articles “to operate exclusively for the benefit of the American Endowment Foundation” in a manner
intended to “enable [it] to qualify as a supporting organization of the American Endowment Foundation
within the meaning of Section 509(a)(3) of the Code.” In turn, the American Endowment Foundation (AEF)
is an Ohio non-profit corporation that the IRS has recognized both as tax-exempt as an organization
described in § 501(c)(3) and as a publicly supported entity under § 509(a)(1). AEF runs a donor-advised
fund program through which the donors have the right to advise AEF on how they wish their contributions
to be distributed, but AEF is not obligated to follow the recommendations and retains control over the
timing, manner, and recipients of the distributions.
The Foundation’s sole asset was a promissory note, payable to Charles and Maxine Lapham, in a
face amount of $1,554,244. The maker of the note was Estate Storage Co., a corporation owned by the
Laphams, and it was collateralized with real estate owned by Estate Storage. The principal amount was
due in full no later than December 30, 2013. The interest rate on the note was 7.75%, to be paid in equal
quarterly payments of $30,113.48. In exchange for the note, the Laphams received a gift annuity, under
which the Foundation agreed to pay them $116,568 annually over their joint lives.
In July 1999, the Foundation filed Form 1023 with the IRS, seeking to be recognized as a tax-exempt
organization under § 501(c)(3) and as a supporting organization under § 509(a)(3). The application
indicated that the Foundation would support AEF “by receiving and administering funds for the benefit of
[AEF]” and listed its sources of financial support as “[d]onations from the Lapham family and its friends,
including individuals and businesses,” and interest on investments. On a financial disclosure form, the
Foundation noted that it had received $1,554,244 in 1998 (the promissory note) and that it expected to
receive $5,000 a year in gifts, grants, and contributions in 1999 and 2000. The form also noted that the entity
anticipated receipt of $120,454 in gross investment income in 1999 and in 2000, and that it had a gift
annuity obligation of $116,568 per year. The Foundation thus expected an excess of revenue over expenses
of $8,886 per year for 1999 and 2000. Because it intended to give at least 85 percent of its income to the
supported organization, the application estimated a donation of $7,600 annually to AEF.
During the administrative process, the Foundation reported that it would receive outright
testamentary gifts of approximately $693,000 at the death of the Laphams, which it estimated would occur
in 25.5 years, and that it was the beneficiary of a charitable lead trust under the revocable living trusts of
Charles and Maxine Lapham, which, if certain assumptions proved to be true, would distribute $355,834
annually for 17 years after the Laphams’ deaths. The report also indicated that the Laphams had pledged
an additional $207,733 to the Foundation contingent upon the approval of its status under § 501(c)(3) and
§ 509(a)(3).
In a later communication to the IRS, the Foundation stated that it would recommend that AEF use
one-third of the support provided through the donor-advised fund to expand its representation in
Southeastern Michigan, and the remaining two-thirds to support charities in Northville, Michigan. It also
estimated that AEF’s total annual income was $7,997,910, although the Tax Court later determined that,
in 1998, AEF received total contributions in the amount of $7,350,000 but had income of only $650,000.
On April 19, 2000, the IRS recognized the Foundation as exempt from taxation as a § 501(c)(3)
organization but determined that it was a private foundation, rather than a supporting organization under
§ 509(a)(3). In response, the Foundation offered to make various changes in its organizational structure in
order to achieve supporting organization status. The Tax Court found it unclear from the administrative
record whether any of the proposed changes were actually made, although it appears that the Foundation
No. 03-1229 Lapham Foundation v. Comm’r Page 3
did amend its by-laws concerning the make-up of the board of directors. The Foundation nonetheless
received an adverse ruling as to its request for a supporting organization classification under § 509(a)(3).
The IRS explained that the Foundation had failed to meet the “attentiveness” test under the “integral part”
test found in section 1.509(a)-4(i)(3)(iii) of the Income Tax Regulations, and that it had also failed to meet
the test for control by disqualified persons set forth in section 1.509(a)-4(j)(1) of the Regulations. The IRS
further explained, as to the control test, that the Foundation’s primary asset was a promissory note payable
by a corporation controlled by disqualified persons and secured by assets of that corporation. It found,
therefore, that “[d]isqualified persons are in a position to control [the Foundation] by means of the power
they exercise, through their corporation, with respect to [the Foundation’s] primary asset.”
Dissatisfied with this ruling, the Foundation filed a petition for declaratory judgment in the Tax
Court, seeking a determination that it was a supporting organization as described in § 509(a)(3), rather than
a private foundation. The case was submitted for a decision on the basis of the pleadings and the
administrative record. The Tax Court found that the Foundation did not meet the “integral part” test and,
because that decision was fatal to the Foundation’s claim that it was a supporting organization, did not reach
the issue of whether the Foundation was controlled by disqualified persons.
The Foundation now appeals the Tax Court’s determination. In response, the Commissioner argues
that if the Tax Court’s decision is not upheld on the ground that the Foundation does not meet the “integral
part” test, it should be upheld on the ground that the Foundation has not shown that it is not controlled by
disqualified persons.
ANALYSIS
I. Standard of Review
Under well-settled rules, we review the Tax Court’s factual findings for clear error and legal
questions de novo. See Kenco Rests., Inc. v. Comm’r, 206 F.3d 588, 593 (6th Cir. 2000). The line between
the two is not always obvious, however. In this case, for example, the parties dispute whether the issues
to be resolved are factual or legal in nature. The Foundation asserts that the facts are undisputed and that
the case therefore presents a pure question of law, whereas the Commissioner contends that whether the
Foundation is operated “in connection” with AEF, a dispositive question in this case, is a question of fact.
We have held that the determination that an organization is not “organized and operated exclusively
for” exempt purposes, for purposes of § 501(c)(3), is a question of fact. See Ohio Teamsters Educ. and
Safety Training Trust Fund v. Comm’r, 692 F.2d 432, 435 (6th Cir. 1982). It could be argued that the
question of whether an organization is operated “in connection” with another organization is similar in kind
to the question of whether it is operated exclusively for certain purposes. On the other hand, what is being
reviewed here is not actually the existence of a fact, but the application of the law to the facts, a situation
requiring de novo review. See Sherwin-Williams Co. Employee Health Plan Trust v. Comm’r, 330 F.3d 449,
453-54 (6th Cir. 2003). Although the question is an interesting one, in the end we conclude that we need
not decide it here, because the standard of review is not outcome-determinative in this case. Regardless of
which standard is employed, the decision of the Tax Court must be affirmed for the reasons detailed below.
II. Qualification under § 509(a)(3)
Under 26 U.S.C. § 509(a), a § 501(c)(3) organization is a “private foundation” unless it meets one
of the exemptions specified in § 509(a)(1)-(4). Private foundations are subject to various taxes, such as an
excise tax based on investment income and taxes on self-dealing and failure to distribute income. See
26 U.S.C. §§4940-4948. “Public charities [are] excepted from private foundation status on the theory that
their exposure to public scrutiny and their dependence on public support [will] keep them from the abuses
[of the tax-exempt status] to which private foundations [are] subject.” Quarrie v. Comm’r, 603 F.2d 1274,
1277 (7th Cir. 1979). The Foundation claims that it should not be classified as a private foundation because
it is a supporting organization, as described in § 509(a)(3). Supporting organizations are exempt from
No. 03-1229 Lapham Foundation v. Comm’r Page 4
private foundation status “in so far as they are subject to the scrutiny of a public charity.” Quarrie, 603
F.2d at 1278. “The Treasury Regulations therefore provide that the supporting organization must be
responsive to the needs of the public charity and intimately involved in its operations.” Id.
Under § 509(a)(3), an organization is exempt from private foundation status if it:
(A) is organized, and at all times thereafter is operated, exclusively for the benefit of, to
perform the functions of, or to carry out the purposes of one or more specified organization
described in paragraph (1) or (2),
(B) is operated, supervised, or controlled by or in connection with one or more organizations
described in paragraph (1) or (2), and
(C) is not controlled directly or indirectly by one or more disqualified persons (as defined
in section 4946) other than foundation managers and other than one or more organizations
described in paragraph (1) or (2); . . . .
The Commissioner contends that Lapham fails to meet the criteria of subsections (B) and (C); subsection
(A) is not at issue in this case.
In order to qualify under §509(a)(3)(B), an organization must be “(i) [o]perated, supervised, or
controlled by, (ii) [s]upervised or controlled in connection with, or (iii) [o]perated in connection with, one
or more publicly supported organizations.” 26 C.F.R. 1.509(a)-4(f)(2). The Foundation claims that it is
operated in connection with AEF and therefore fulfills the third of these relationships. However, the
Treasury Regulations further elaborate that an organization will only be considered to be operated “in
connection with” a publicly supported organization if it meets a “responsiveness test” and an “integral part
test.” See 26 C.F.R. § 1.509(a)-4(i)(1). The Tax Court found that the Foundation’s structure satisfied the
responsiveness test, and the Commissioner does not challenge that finding on appeal. Thus, the only
question that remains with regard to § 509(a)(3)(B) is whether the Foundation meets the “integral part” test.
That test “is designed to insure that the publicly supported organization will be attentive to the
supporting organization.” Cockerline Mem’l Fund v. Comm’r, 86 T.C. 53, 61 (1986). A supporting
organization meets the integral part test if “it maintains a significant involvement in the operations of one
or more publicly supported organizations and such publicly supported organizations are in turn dependent
upon the supporting organization for the type of support which it provides.” 26 C.F.R. 1.509(a)-4(i)(3)(i).
There are two ways in which an organization can fulfill the integral part test: by meeting either the “but for”
test set out in 26 C.F.R. 1.509(a)-4(i)(3)(ii) or the “attentiveness” test described in 26 C.F.R. 1.509(a)-
4(i)(3)(iii).
A. The Attentiveness Test
The “attentiveness” test focuses on whether the supported organization will be attentive to the
supporting operation. In order to satisfy this test, the supporting organization must donate substantially all
of its income to the supported organization, and the amount of support received by the supported
organization must be “sufficient to insure the attentiveness of such organization[] to the operations of the
supporting organization.” 26 C.F.R. 1.509(a)-4(i)(3)(iii)(a). In order for the amount of support received
to be considered sufficient, either the amount of support must “represent a sufficient part of the [supported]
organization’s total support so as to insure such attentiveness,” id., or it must be demonstrated that “in order
to avoid the interruption of the carrying on of a particular function or activity, the beneficiary organization
will be sufficiently attentive to the operations of the supporting organization.” 26 C.F.R. 1.509(a)-
4(i)(3)(iii)(b). “This may be the case where either the supporting organization or the beneficiary
organization earmarks the support received from the supporting organization for a particular program or
activity, even if such program or activity is not the beneficiary organization’s primary program or activity
so long as such program or activity is a substantial one.” Id. In determining whether the amount of support
No. 03-1229 Lapham Foundation v. Comm’r Page 5
received is sufficient, “[a]ll pertinent factors, including the number of beneficiaries, the length and nature
of the relationship between the beneficiary and supporting organization and the purpose to which the funds
are put” will be considered. 26 C.F.R. 1.509(a)-4(i)(3)(iii)(d). “[E]vidence of actual attentiveness by the
beneficiary organization is of almost equal importance” with the substantiality of the amount involved in
determining the attentiveness of the supported organization. Id.
With regard to the first way of satisfying “attentiveness,” the Tax Court pointed out that the
Foundation anticipated giving only $7,600 per year to AEF in the near future and concluded that such a
small contribution was insufficient to ensure AEF’s attentiveness. The Foundation argues that the Tax
Court erred by over-emphasizing the amount AEF would be receiving in the Foundation’s first two years
of operation, while failing to take into consideration the nearly $7 million the Laphams had pledged to the
Foundation on a long-term basis, at least 85 percent of which the Foundation intended to donate to AEF.
It points out that taxpayers often establish charitable-giving programs that are modest during their lifetimes
but significant after death, and that such programs are beneficial in that they allow taxpayers to teach a
charitable philosophy to their children and help to avoid post-mortem litigation by enabling taxpayers to
address potential IRS objections during their lifetimes. The Foundation contends that we should follow the
analysis used in National Foundations, Inc. v. United States, 13 Cl. Ct. 486 (1987), a case in which a
foundation was given § 501(c)(3) status based on proposed activities, and that we allow a “declaratory
judgment based upon proposed activities before substantial time and resources have been committed toward
actual operations.” Id. at 495.
Although the Laphams have pledged significant funds to the Foundation, and although the
Foundation has indicated that it will distribute at least 85 percent of its future income to AEF, we agree
with the Tax Court’s determination that the future contributions are not sufficient to fulfill the
“attentiveness” test, given how far in the future AEF anticipates receiving them. It is difficult to
believe that AEF will give the Foundation the sort of regular oversight contemplated by the test when
it will not be receiving substantial support from the organization for another two decades. Furthermore,
although the relevant documents recording the various trusts set up by the Laphams are not in the
record, it appears that the trust through which the Foundation will supposedly receive $355,834 a year
for 17 years is, in fact, revocable. If this is the case, there is no assurance that the Foundation, and
through it AEF, will ever receive those contributions. Finally, as the Commissioner has pointed out,
once AEF actually receives enough support to ensure its attentiveness, i.e., once the Laphams have died
and the Foundation begins to receive their funds and make donations to AEF, then the Foundation can
petition, under 26 U.S.C. § 507(b)(1)(B), to convert from a private organization into a supporting
organization.
With regard to the second method of fulfilling the “attentiveness” test, the Foundation asserts
that AEF intends to place contributions from the Foundation in a special account for making grants to
support charitable activities in southeastern Michigan in general and in Northville, Michigan, in
particular. Without its support, the Foundation argues, the donations in those areas would likely cease.
In other words, it is arguing that, without its support, the “particular function or activity” of giving
charitable donations in southeastern Michigan would be “interrupted.” As the Tax Court points out,
however, the regulations specify that the program or activity to which the Foundation has earmarked
its funds must be a “substantial” one; it must be important enough to the supported organization that
the fear of its loss will cause the supported organization to be properly attentive to the supporting
organization. Supporting charitable organizations in Michigan is not a substantial part of AEF’s work.
In 1998, for example, of $1,300,000 it distributed to organizations similar to those the Foundation
proposes to recommend, AEF distributed only $5,500 in Michigan. Furthermore, the Foundation’s
contributions can hardly be said to be earmarked for a specific program or activity when the Foundation
has simply named a geographic area in which it wants the funds to be spent, rather than naming specific
charities to which it wants the funds distributed and when, in any case, AEF does not have to abide by
the Foundation’s recommendations.
No. 03-1229 Lapham Foundation v. Comm’r Page 6
Finally, the Foundation claims that it has demonstrated actual attentiveness on the part of AEF.
In particular, it points out that AEF appointed one of the Foundation’s directors, that this director has
access to all of the Foundation’s financial information, that the Foundation sends financial reports to
AEF, and that the Foundation and AEF have had ongoing communications. Although 26 C.F.R.
1.509(a)-4(i)(3)(iii)(d) uses the imposition of the requirement that the supporting organization furnish
reports to the supported organization as an example of evidence of actual attentiveness, there is no
evidence here that AEF requires the Foundation to furnish such reports, nor that the requirement is in
the Foundation’s by-laws or articles of incorporation. Absent more specific evidence about the
communications between the Foundation and AEF, we, like the Tax Court, “remain unconvinced that
the [] features highlighted portend the type of ongoing monitoring and attentiveness envisaged in the
regulation.”
For all these many reasons, we conclude that the Tax Court was correct in finding that the
Foundation does not meet the “attentiveness” test.
B. The But-For Test
The “integral part” test is also fulfilled if “[t]he activities engaged in for or on behalf of the
publicly supported organizations are activities to perform the functions of, or to carry out the purposes
of, such organizations, and, but for the involvement of the supporting organization, would normally
be engaged in by the publicly supported organizations themselves.” 26 C.F.R. 1.509(a)-4(i)(3)(ii). We
conclude that the Foundation does not meet this test any more than it meets the “attentiveness” test.
To begin with, it is unclear that the Foundation is engaging in any activity “for or on behalf” of AEF,
given that its only activity is contributing money to AEF. Even if donating money to AEF was
considered an activity “for” AEF, it is not an activity AEF itself would be doing but for the Foundation.
The Foundation similarly fails the but-for test if its activity is viewed as giving grants to charitable
organizations, which it does by giving money to its donor-advised fund at AEF. As the Tax Court
pointed out, “such grant-making activities cannot properly be characterized as something in which AEF
would be engaged but for petitioner’s support. Rather, distributing grant moneys is something in which
AEF is and will continue to be engaged regardless of support from petitioner.” If the Foundation’s
activity is construed as giving grants within Southeastern Michigan, it still cannot be said that but for
the Foundation’s involvement, AEF would engage in the activity itself. As described above, absent
significant funding from the Foundation, AEF distributes very little money in Michigan.
CONCLUSION
Because we agree with the Tax Court’s determination that the Foundation fails to qualify as a
supporting organization under 26 U.S.C. § 509(a)(3)(B), we also conclude that it is unnecessary to
address the contention that the Foundation also fails to qualify under subsection (C). The failure to
meet the requirements of any one of the three subsections of § 509(a)(3) is a sufficient basis on which
to deny the petitioner status as a supporting organization. For the reasons set out above, we AFFIRM
the judgment of the Tax Court in all respects.