December 19, 2008
More Excise Tax Fodder From Madoff Scandal
Seems pretty clear, at least by one case, that the Bernie Madoff (pictured below) ponzi scheme ought to generate some excise tax scrutiny. According to Bloomberg.com, Yeshiva University lost about $110 million in investments:
Most of the lost money was invested through hedge funds controlled by J. Ezra Merkin (pictured at top, second from left), who was a Yeshiva trustee and chairman of the investment committee, the spokesman, Bill Anderson, said today in a telephone interview. The losses left Yeshiva, a 122-year-old private school that combines academic and religious education, with an endowment of about $1.2 billion.
So let's see here. An influential member of the board of directors -- who serves as a member of the 501(c)(3)'s investment committee -- causes the charity to invest more than $100 million in that member's own investment firm. Let's just assume that the obviously lucrative fees paid by Yeshiva to its own board member's firms were reasonable. Still, I have argued elsewhere that tax law ought to recognize something called "joint venture private inurement."
One might legitimately conclude that the universe of private inurement violations is divided solely between strict accounting and incorporated pocketbook private inurement. Strict accounting private inurement, representing the literal form, is closest to the statutory language, and even incorporated pocketbook private inurement can be made to fit within the literal prohibition if one thinks of unrelated transactions benefiting insiders as distributions of earnings in kind, rather than of cash. Those two forms of private inurement seem to exhaust the means by which an insider might violate the prohibition. The universe, though, includes a third form of private inurement not contingent upon an unfair or unnecessary transaction. This final category, which I call "joint venture private inurement," can occur even though the entity pays or charges an appropriate amount and even though the transactions are entirely appropriate and necessary to the accomplishment of the tax-exempt purpose. Instead, the violation occurs because the operations of the tax-exempt entity and an insider-controlled taxable entity are so closely related that the insider, by virtue of his interest in the taxable entity, financially benefits from the exempt entity's invariable consumer power. The taxable and tax-exempt entities are engaged in an implicit joint venture. As such, the exempt entity purchases all of its necessary commodities solely from the insider's for-profit entities or otherwise conducts its affairs through an insider's profit-making apparatus. Although serving an exempt purpose, the entity necessarily subsidizes individual profit making. Through the use of his taxable entity as an intermediary, the insider manifests himself as a parasite draining a portion of the entity's tax-exempt lifeblood whenever the entity receives a tax-free infusion. There occurs a synonymity of wealth such that private inurement is justifiably found even in the absence of a bad quantitative transaction or a systematic looting of the entity's assets.
The Scintilla of Individual Profit: In Search of Private Inurement and Excess Benefit, 19 Va. Tax Rev. 620 - 622 2000). Here we have not just a member of a public charity's board, but the dadgum chair of the investment committee, investing a large portion of the tax exempt monies in his own investment firm! I am aware, of course, that traditional analysis prevents the occurrence of a private inurement or excess benefit transaction unless an insider is "skimming profits" and that the reasonableness of a payment logically precludes that conclusion. I am also aware of the argument that the private benefit doctrine might be the better rationale to apply in this case. The problem, of course, is that nobody knows what "private benefit" means. The historical articulation requires that the benefit to a noncharitable person be so large relative to the organization's benefit to charitable beneficiaries that we can conclude that the charity is not really achieving a charitable purpose at all. But that understanding is sufficient only when we are dealing with a contract between the organization and a stranger. When we are dealing with an organization and one of its fiduciaries, the doctrine is insufficient. When the organization deals with a stranger, the natural order of things means that there is little chance that some of the organization's funds will be skimmed off -- there is an opposing force (the charity itself) that limits the possibility. When the organization is engaged with its own fiduciary, the idea that a little private benefit is ok morphs into an almost inevitability. The insider who deals with himself on behalf of the organization ought to take a cut for himself (even if it is in the form of preferential award of an otherwise reasonable vendor or service contract) because the private benefit doctrine (as articulated above) allows it. What is to stop the insider from investing in his own investment firm at fair market rates?
The private inurement doctrine -- joint venture private inurement -- is better because it recognizes the inevitability of the conflict and eliminates the idea that we should balance the relatively insignificant harm to charitable beneficiaries (in this case $110 million) with the greater benefit to the charitable beneficiaries (however many billions Yeshiva spends on education and research). It also recognizes that the insider has ultimately skimmed just like any other vendor who might have more blatantly overcharged the organization. In this case, for example, an investment firm unrelated to the chairperson of the organization's investment comittee might very well have divested a long time ago when people started asking questions about the Madoff firm. We need a legal doctrine that prevents (or at least imposes certain process on) even fair market value transactions between a public charity and its own insider. I don't think the Exces Benefit Excise tax presently applies, but as we get out of the financial mess we are in, no doubt a whole host of regulaltions (or de-regulations) will be reconsidered. We ought to more precisely define private inurement and excess benefit to take into account this sort of self dealing in the public charity sector.
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