                       109 T.C. No. 17



                UNITED STATES TAX COURT



      UNITED CANCER COUNCIL, INC., Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 2008-91X.               Filed December 2, 1997.



      Petitioner was organized in 1963. In a ruling letter
dated Mar. 31, 1969, respondent ruled that petitioner was
exempt from Federal income tax and was an eligible
charitable donee. Secs. 501(a), 501(c)(3), 170(c), I.R.C.
1954.

     On June 11, 1984, petitioner entered into a 5-year
fundraising contract (the Contract) with a professional
fundraiser (W&H). During 1984 through 1989, W&H helped
petitioner conduct a nationwide direct mail fundraising
campaign. Petitioner received a total of about $2¼ million
in net fundraising revenue under the Contract. W&H received
more than $4 million in fees from petitioner, and in
addition derived substantial income from exploiting the co-
ownership rights in petitioner’s mailing list, which rights
had been granted to W&H under the Contract.

     On Nov. 2, 1990, respondent revoked the favorable
ruling letter retroactively to June 11, 1984. Petitioner
initiated the instant action under sec. 7428, I.R.C. 1986,
for a declaratory judgment that it qualifies as an exempt
organization and as an eligible charitable donee.
                               - 2 -


          1. Held: W&H was an “insider” for purposes of the
     inurement provisions of secs. 501(c)(3), 170(c)(2)(C),
     I.R.C. 1954 and 1986.

          2. Held, further, there was an inurement of net
     earnings to W&H; petitioner fails to qualify as an exempt
     organization or as an eligible charitable donee.

          3. Held, further, respondent’s retroactive revocation
     of the favorable ruling letter back to June 11, 1984, was
     not an abuse of discretion.



     Leonard J. Henzke, Jr., James W. Curtis, Jr., MacKenzie

Canter III, Theodore R. Weckel, Jr., and Joseph Greif, for

petitioner.*

     Dianne I. Crosby, Deidre A. James, Sandra M. Jefferson, and

Chalmers W. Poston, Jr., for respondent.


                         TABLE OF CONTENTS
                                                                Page

Introduction and Statement of Issues   ......................     4

Findings of Fact   ..........................................     5

    Background and Summary..................................      6

    Direct Mail Fundraising.................................     14


*
      After the trial was held and opening briefs were filed, but
before the parties filed their answering briefs, Theodore R.
Weckel, Jr., was given permission to withdraw from the instant
case.

     Briefs amici curiae were filed by Thomas A. Troyer, Albert
G. Lauber, Jr., and Catherine E. Livingston, as attorneys for
American Heart Association, American Lung Association, American
Cancer Society, and Independent Sector (hereinafter sometimes
collectively referred to as American/Sector), and by Roger Warin
as attorney for Non-Profit Mailers Federation (hereinafter
sometimes referred to as Mailers).
                              - 3 -


    W&H; AICR...............................................   21

    The Contract; Related Agreements .......................   25
       A. The Contract (June 11, 1984) .....................   25
       B. The Escrow Agreement .............................   29
       C. Petitioner's “Draw” Arrangement...................   32
       D. Agreement To Continue At 50 Percent The Percentage
          Of Net Housefile Mailing Income The Fundraising
          Contract Required To Be Retained In The Escrow
          Account To Reimburse W&H..........................   36
       E. April 1987 Addendum to the Contract...............   36

    Direct Mail Fundraising Campaign: 1984--1989............   40
       A. In General........................................   40
       B. W&H’s Advances Of The Initial
          Capital To Conduct The Direct Mail
          Fundraising Campaign..............................   44
       C. Vendors Who Furnished Goods Or Services...........   45
       D. Rentals Of Mailing Lists..........................   46
       E. Sweepstakes Mailings..............................   53
       F. Adverse Publicity ................................   60
       G. Petitioner's Escrow Account-Related Problems......   64
          1. Draws and Petitioner's Dispute with W&H
             Over the Calculation of Cumulative
             Net Mailing Campaign Revenue...................   64
          2. W&H’s Purchase And Invoice Control
             Procedures.....................................   68
       H. Petitioner's Attempt To Obtain A Copy of
          Its Housefile.....................................   76

    Petitioner's and W&H’s Respective Accounting
    Treatments Of The Direct Mail Campaign's
    Revenue And Expenses....................................   78

    Petitioner's Allocation Of Expenses Between
    Fundraising And Public Education........................   80

Opinion.....................................................   85

    I. Status Under Sections 501(c)(3) And 170(c)(2)........   85
       A. W&H As Insider ...................................   90
       B. Did Any Of Petitioner’s Net Earnings
          Inure To W&H?.....................................   98

   II. Retroactivity Of Respondent's Revocation Of The Prior
       Favorable Ruling Letter Issued To Petitioner......... 111
                                 - 4 -

     CHABOT, Judge:     Petitioner initiated this action pursuant to

section 74281 for a declaratory judgment that for all periods

beginning on or after June 11, 1984, it qualifies as an

organization described in section 501(c)(3) which is exempt from

tax under section 501(a) and that it qualifies as an organization

described in section 170(c)(2).    The action was initiated after

respondent revoked a favorable ruling letter which had been

issued to petitioner.    The revocation is retroactive to June 11,

1984.    Petitioner has exhausted its administrative remedies and

satisfied the other statutory predicates (sec. 7428(b); Rule

210(c))2.

     The issues for decision are as follows:3

            (1) Whether petitioner is operated exclusively for

     charitable, educational, scientific, or other exempt

     purposes under sections 501(c)(3) and 170(c)(2)(B).

            (2) Whether any part of petitioner’s net earnings

     inured to the benefit of private shareholders or


     1
          Unless indicated otherwise, all section references are
to sections of the Internal Revenue Code of 1954 or the Internal
Revenue Code of 1986, as in effect for the period of time
referred to.
     2
          Unless indicated otherwise, all Rule references are to
the Tax Court Rules of Practice and Procedure.
     3
          In United Cancer Council, Inc. v. Commissioner, 100
T.C. 162 (1993), we denied petitioner’s motion for summary
judgment, holding that the due process clause of the Fifth
Amendment to the Constitution does not require respondent to
initiate judicial review before revoking the ruling letter issued
to petitioner.
                               - 5 -

     individuals, within the meaning of sections 501(c)(3) and

     170(c)(2)(C).

          (3) If the answer to issue (1) is “no”, or the answer

     to issue (2) is “yes”, then whether the retroactive

     revocation of the favorable ruling letter was an abuse of

     discretion.

     The parties have also raised ancillary issues, including the

following:   (1) whether petitioner’s direct mail fundraising

arrangement with Watson and Hughey Company (hereinafter sometimes

referred to as W&H) constitutes a joint venture; (2) whether a

portion of the direct mail campaign expenses petitioner incurred

are properly allocable to public education; and (3) whether the

mailings made under petitioner’s nonprofit mail permits violate

United States Postal Service regulations as cooperative mailings

due to the nature of the fundraising arrangement between

petitioner and W&H, and to W&H’s co-ownership rights in

petitioner’s mailing list.

                         FINDINGS OF FACT

     Some of the facts have been stipulated; the stipulations and

the stipulated exhibits are incorporated herein by this

reference.

     On June 1, 1990, petitioner filed for bankruptcy under

chapter 7 of the Bankruptcy Code in the U.S. Bankruptcy Court for

the Southern District of Indiana, Indianapolis Division.   On

January 28, 1991, the bankruptcy court granted petitioner’s
                               - 6 -

motion to lift the automatic stay and permit petitions to be

filed in the Tax Court for purposes of initiating the instant

declaratory judgment action and a related deficiency proceeding.4

     When the petition was filed in the instant case, petitioner

was a not-for-profit corporation in bankruptcy in Indiana.

Gregory Fehribach, the trustee in bankruptcy, maintained an

office in Indianapolis, Indiana.

                      Background and Summary

     Petitioner was organized in 1963 as a Delaware not-for-

profit corporation.   Petitioner is a membership organization.

Its members consist of local cancer agencies throughout the

country.   By letter dated March 31, 1969, respondent ruled that

petitioner was exempt from Federal income tax under section

501(c)(3) and that donors may deduct contributions to petitioner

under sections 170, 2055, 2106, and 2522.

     Petitioner’s founding members had previously been local

chapters of the American Cancer Society (hereinafter sometimes

referred to as the ACS).   These founding members separated from

the ACS because (1) they wanted to participate in United Way

fundraising campaigns, which ACS prohibited at that time; and (2)

they wanted to concentrate on cancer prevention and alleviation

of pain and suffering of cancer victims, rather than research to

develop a cure for cancer.

     4
          The related deficiency proceeding, docket No. 2009-91,
involves deficiencies determined for 1986 and 1987. The parties
have agreed to hold that case in abeyance until after the
resolution of the instant case.
                               - 7 -

     From 1963 until 1984, petitioner acted as a support

organization for its “affiliate member agencies”.   It published a

quarterly newsletter, offered access to cancer educational

materials, and held an annual meeting of its membership each

fall.   Petitioner was an umbrella organization, coordinating its

affiliate member agencies which met the direct needs of cancer

patients through the providing of medical supplies, cancer

research, and public education about cancer prevention,

detection, and treatment.   Petitioner was supported primarily by

the membership dues paid by its affiliate member agencies.

Petitioner also received contributions in small amounts as a

result of direct solicitations of individuals who were members of

petitioner’s board of directors or of the boards of directors of

petitioner’s affiliate member agencies.    Until 1984, petitioner’s

annual budget never exceeded $50,000.

     In 1983, some affiliate member agencies indicated they

intended to withdraw from petitioner.   This precipitated a budget

crisis for petitioner.   Its board of directors realized that

petitioner might have to be dissolved unless other sources of

funding could be secured for petitioner.   The board directed

petitioner’s executive director to conduct a search for a

professional fundraiser that could assist petitioner in

conducting fundraising to meet its increased need for funds,

without the necessity of petitioner’s contributing initial

capital for the fundraising effort.
                                 - 8 -

     As a result, during 1983 and 1984, petitioner and W&H

discussed their possible entry into a fundraising contract.    As

of March 12, 1984, petitioner estimated it would have an

operating deficit for 1984 of $13,000, without additional

fundraising income.   In addition to providing the initial capital

to conduct petitioner’s direct mail fundraising campaign, W&H

offered to furnish funds with which petitioner could continue to

operate.

     On June 11, 1984, petitioner and W&H entered into a “Full

Service Direct Response Fundraising Agreement” (hereinafter

sometimes referred to as the Contract) for a term ending May 30,

1989.   As of the date the Contract was entered into, petitioner

was on the verge of insolvency; petitioner did not have money to

start a direct mail or other fundraising program on its own.    The

Contract was amended by an addendum on April 8-9, 1987.    Unless

the context indicates otherwise, references to the Contract are

to be taken as including both the Contract entered into in 1984

and the 1987 amendment.   The Contract expired in May 1989, and

was not renewed.

     In conjunction with the formation of the Contract, W&H

agreed to advance money to petitioner in order to cover the

initial costs of the mailings.    W&H also agreed to give to

petitioner an immediate advance, or “draw”, against petitioner’s

projected future earnings from the Contract.
                                - 9 -

     From 1984 until its bankruptcy in 1990, petitioner

maintained its principal office in either Carmel or Indianapolis,

Indiana.   As part of the direct mail fundraising campaign

petitioner conducted from 1984 through 1989 pursuant to the

Contract, a Washington, D.C., office mailing address was

maintained for petitioner.    Contributors were directed to send

their donations to the Washington, D.C., office mailing address.

     During 1984 through 1989, about 79.6 million fundraising

letters were mailed under the Contract.     Of the 79.6 million

letters, about 51.8 million were “prospect letters” and 27.8

million were “housefile letters”.    The terms “prospect letter”

and “housefile letter” are discussed more fully infra.        The

Contract provided that W&H was to receive as compensation, among

other things, mailing fees of $.05 per prospect letter mailed and

$.10 per housefile letter mailed.    However, the Contract was a

“no-risk” contract for petitioner, in that petitioner was liable

to pay fundraising expenses only to the extent proceeds were

raised.    If insufficient proceeds were raised to cover the

fundraising expenses, then W&H was liable to pay the excess

fundraising expenses.    During the term of the Contract, W&H

advanced funds to conduct petitioner’s direct mail fundraising

campaign and, generally, was paid its fees only after other

fundraising expenses had been paid.     Under the Contract,

petitioner was further guaranteed that, for the first 2 years of
                              - 10 -

the Contract, petitioner would receive at least 50 percent of the

cumulative net income produced from its housefile mailings; after

the first 2 years, petitioner would receive at least 70 percent.

In April 1986 petitioner agreed to keep the guarantee at 50

percent in exchange for W&H’s reducing its “creative” package fee

on housefile mailings and capping its mailing fee on any

housefile mailing of more than 500,000.

     Petitioner generally maintained its books under an accrual

method of accounting.   For 1984 through 1989, petitioner received

the amounts of total annual contributions set forth in table 1.

                              Table 1

               Year            Total Contributions

               1984                   $240,380
               1985                  5,087,453
               1986                  7,869,015
               1987                 10,740,045
               1988                  3,883,352
                                      1
               1989                     943,142

                Total               28,763,387
1
  An analysis of petitioner’s financial statements, prepared by
petitioner’s counsel and assumed to be true by petitioner’s
expert witness Richard S. Steinberg, indicates that $644,627 of
the 1989 contributions were produced under the Contract.

     For 1984 through 1989, petitioner incurred at least the

amounts of total annual expenses in fundraising and in its

mailing campaign set forth in table 2.
                             - 11 -

                             Table 2

               Year                Total Expenses

               1984                  $241,251
               1985                 4,980,949
               1986                 7,255,744
               1987                 9,734,233
               1988                 3,229,425
               1989                 1,082,315

                Total               26,523,917

The amounts in table 2 include mailing campaign expenses from

petitioner’s “Donor Development Fund” that petitioner concluded

were allocable to its public education activities, as

distinguished from its fundraising activities.      The amounts in

table 2 do not include other management and general expenses that

petitioner incurred as a result of carrying out its fundraising

activities and mailing campaign.

     Petitioner received a total of about $2¼ million in net

fundraising revenue under the Contract.   In 1984 through 1989,

petitioner paid to W&H the amounts for fundraising shown in table

3.
                                - 12 -

                                Table 3

               Year                   Amounts Paid

                1984                        $43,965
                1985                        143,196
                1986                        842,219
                1987                      1,974,247
                1988                        999,527
                1989                        115,406

                 Total                    4,118,560

The amounts in table 3 do not include list rental fees and

commissions paid to Washington Lists, a division of W&H, or

income derived by W&H from exploiting its rights in petitioner’s

housefile.

     For 1984 through 1989, petitioner paid to Washington Lists

the amounts for mailing list rentals shown in table 4.




                                Table 4

                Year                  Amounts Paid

                1984                    $39,813
                1985                    907,594
                1986                    868,763
                1987                  1,756,964
                1988                    328,070

                 Total                3,901,204

     After the end of the term of the Contract, petitioner

entered into a fundraising contract with another fundraising

consultant.   Under this second contract, petitioner was liable

for all fundraising expenses.    However, when petitioner was not

able to pay certain debts to vendors, the new fundraiser paid
                                  - 13 -

those debts.   The fundraising efforts conducted under the new

contract were not successful, and petitioner suffered a

substantial financial loss on the mailings done, and was unable

to pay all of the fundraising expenses.

     On November 2, 1990, respondent issued to petitioner a final

notice of revocation of the favorable ruling letter retroactive

to June 11, 1984.    The notice of revocation states, in pertinent

part, as follows:5

     We have completed our review of your activities, and
     examination of your Forms 990 for the years ending December
     31, 1986 and December 31, 1987.

     By a determination letter dated March 31, 1969, we
     recognized your exemption from Federal Income tax under
     section 501(c)(3) * * *.

     As a result of the examination of your activities and
     financial records for the years noted above, we had
     unresolved questions concerning your mailings and your
     exempt status. On July 12, 1989, we requested technical
     advice from our National Office in order to resolve these
     questions.

     In response to the request for technical advice, our
     National Office ruled that your exemption from income tax
     should be revoked effective June 11, 1984.

                      *   *   *     *      *   *   *

     This letter constitutes formal notification of revocation of
     your exemption from Federal income tax effective June 11,
     1984.

                      *   *   *     *      *   *   *

     5
          There are some slight differences between the notice of
revocation letter identified by both sides in the pleadings, and
the one that the parties have stipulated in the administrative
record; these differences appear to be irrelevant to any matter
in dispute. In these findings we have used the letter that is in
the administrative record.
                                - 14 -

     Contributions to you are no longer deductible as provided in
     section 170 * * * .

On November 2, 1990, respondent also issued a notice of

deficiency to petitioner, determining income tax deficiencies for

1986 and 1987.

     On January 30, 1991, after the bankruptcy court lifted the

automatic stay, petitioner filed its petition initiating the

instant declaratory judgment action pursuant to section 7428.    On

January 30, 1991, petitioner also filed its petition initiating a

proceeding for review of the notice of deficiency issued to it

for 1986 and 1987, United Cancer Council, Inc. v. Commissioner,

docket No. 2009-91.   The parties have agreed that the deficiency

proceeding should be held in abeyance pending the resolution of

the instant declaratory judgment action.



                      Direct Mail Fundraising

     W&H operated with the understanding that direct mail

solicitation allows an organization’s marketing and solicitation

efforts to directly focus on and target specific individuals.    In

W&H’s view, in comparison to direct mail solicitation,

solicitations conducted through the print media or radio will

generally reach a nonspecific and less targeted audience.    W&H’s

advice to petitioner and actions under the Contract were based in

part on these understandings.

     In a direct mail fundraising campaign, a “prospect letter”

is a letter mailed to an individual who has not previously
                               - 15 -

contributed, or otherwise responded, to the mailing organization.

A “housefile letter” is a letter mailed to an individual who has

contributed to the organization or has responded favorably to a

communication, typically as the result of a prospect letter.    An

organization’s housefile mailing is a mailing sent strictly to

that organization’s housefile.

     An organization’s housefile, containing the names,

addresses, and other pertinent information with respect to that

organization’s previous contributors, can be a valuable asset in

that organization’s present and future fundraising efforts.

Typically, in a direct mail fundraising campaign, practically all

of an organization’s net mailing revenue will be generated from

its housefile mailings.   As a result, a usual primary goal of a

direct mail fundraising campaign is to develop a productive

housefile of contributors for use in the organization’s

fundraising efforts.

     In contrast to housefile mailings, an organization will

usually lose money or, at best, break even in conducting prospect

mailings.   However, an organization typically first develops and

establishes a productive housefile through conducting prospect

mailings.   Moreover, over the course of time, a housefile will

suffer from attrition.    Not all previous contributors will

continue to contribute to the organization.    As a result, even

after an organization has built up a productive housefile, the

organization will periodically conduct prospect mailings to
                               - 16 -

refresh and add new names to its housefile.

     An organization’s housefile can also be of considerable

value to other organizations in their fundraising or solicitation

efforts.    Accordingly, an organization may be able to profit

economically from its housefile by using its housefile to produce

rental income or by exchanging its housefile for another

organization’s housefile, thereby reducing its fundraising

expenses.    Before the late 1970's there were few mailing lists on

the market, and most that were available were exchanged list for

list, rather than rented for a fee.     By the late 1970's and early

1980's a rental market for mailing lists had developed.    The

rental market has expanded since the mid-1980's because there are

more lists being made available for rent and more list rental

brokers.    However, some organization that have mailing lists did

not rent or exchange their lists.

     It is common practice to use monitoring or “dummy” names

(sometimes called “seed names”) in a housefile, to guard against

unauthorized use of the housefile and to monitor the patterns of

mail drops across the United States.    Both petitioner and W&H

maintained their own, separate, monitoring names with regard to

the mailing lists developed under the Contract.    The parties have

not presented us with illustrations of how this dummy name

monitoring works in practice, or how much effort or funds are

expended in such monitoring programs generally, or were expended

under the Contract.
                              - 17 -

     By industry custom, if a rented name responds favorably to

the mailing made by the lessee of the mailing list (i.e., by

sending a contribution, making a purchase, or entering a

sweepstakes contest), then the lessee is entitled to add that

name to its own housefile.   The lessee thereafter may use the

name as its own and will not have to pay a further rental fee.

     W&H had Wiland Associates (described infra as a services

vendor) provide management information reports to petitioner.

Among these reports was one that evaluated individual

contributors on mailing lists, based on an analysis of the

following three factors:   (1) recency (i.e., how recently the

last donation by that contributor was made), (2) frequency (i.e.,

how frequently that contributor has made donations to the

organization), and (3) size of the gift.   All other things being

equal, a contributor who made a donation within the past 6 months

is considered more valuable than a contributor who last made a

donation 3 years ago.   Similarly, all other things being equal, a

contributor who made 10 donations is considered more valuable

than a contributor who made just one donation.   Lastly, all other

things being equal, a contributor who made a $100 gift is

considered more valuable than a contributor who made a $5 gift.

     In the 1960's and the 1970's, the use of computers

revolutionized the operation of the direct mail fundraising

industry.   Using the electronic data processing capability of

computers, mailing lists could be analyzed, compiled, and
                              - 18 -

utilized much more efficiently than previously was possible.

Before the use of computers, mailing lists were maintained on 3-

by-5 cards or on metal plates.

      Richard Viguerie (hereinafter sometimes referred to as

Viguerie) was an early pioneer in the contemporary direct mail

fundraising industry.   By the late 1970's, Viguerie and his

company, Richard Viguerie and Associates (hereinafter sometimes

referred to as the Viguerie Company), had received considerable

press and publicity as a result of their ability to successfully

conduct direct mail fundraising campaigns for “conservative”

political candidates and causes.    The Viguerie Company reportedly

had a master mailing list comprising the names and addresses of

millions of contributors.   The Viguerie Company also conducted

nonpolitical direct mail fundraising campaigns for charitable

organizations exempt under section 501(c)(3).

     As of the early 1980's, Viguerie and the Viguerie Company,

which maintained offices in the Washington, D.C., area, had

several competitors who offered similar fundraising services.

Some of these competitors were former employees of the Viguerie

Company.

     By the 1980's, many States enacted charitable solicitation

statutes.   Generally, such statutes require most charitable

organizations to register with a State governmental regulatory

agency before soliciting contributions from members of the

general public within that State.   Some State charitable
                              - 19 -

solicitation statutes further prohibited or restricted charitable

organizations from soliciting contributions, unless a prescribed

minimum percentage of the proceeds raised would be expended in

the charitable organization’s charitable program, thereby

limiting the percentage of the proceeds to be used by the

charitable organization to pay fundraising expenses.6

     The Council of Better Business Bureaus (hereinafter

sometimes referred to as the CBBB) and the National Charities

Information Bureau (hereinafter sometimes referred to as the

NCIB) established certain guidelines for organizations that

solicit charitable contributions from the public.   The objectives

of the CBBB as to these matters are to (1) encourage self-

regulation of charities and (2) assist potential donors by

helping them to make better-informed gift-giving decisions.    The

objective of the NCIB is to promote informed giving by providing

to the public information that will help potential donors to

evaluate charities.   The CBBB is exempt under section 501(c)(6)

as a business league; its activities in the charitable area are

conducted by a division called the Philanthropic Advisory


     6
          Ultimately, the United States Supreme Court held
unconstitutional, on First Amendment grounds, several State
charitable solicitation statutes that limited the amount or
percentage of the proceeds raised that could be expended by
charitable organizations to pay fundraising expenses. See Riley
v. National Federation of Blind, 487 U.S. 781 (1988); Secretary
of State of Md. v. J.H. Munson Co., 467 U.S. 947 (1984);
Schaumburg v. Citizens for Better Environ., 444 U.S. 620 (1980);
see also, United Cancer Council, Inc. v. Commissioner, 100 T.C.
at 174-177.
                               - 20 -

Service.   The CBBB and the Philanthropic Advisory Service were

formed in 1971, as the successors to the National Better Business

Bureau and its Solicitations Control Division, respectively.    The

NCIB is exempt under section 501(c)(3) as a charity; it was

founded in 1918.   CBBB and NCIB also prepared and issued reports

on whether particular charitable organizations met CBBB’s and

NCIB’s respective fundraising and operational guidelines.

Typically, a report on a particular charitable organization was

prepared as a result of CBBB’s or NCIB’s receipt of inquiries

with respect to that charitable organization.

     Among its guidelines, CBBB generally recommends that (1) a

charitable organization’s fundraising costs not exceed 35 percent

of related contributions, and (2) total fundraising and

administrative expenses not exceed 50 percent of its total

income.    However, CBBB recognizes that a charitable organization

that does not meet these percentage limitations may provide

evidence demonstrating that its use of funds is reasonable.    In

particular the CBBB pamphlet on standards states as follows:

     The higher fundraising and administrative costs of a newly
     created organization, donor restrictions on the use of
     funds, exceptional bequests, a stigma associated with a
     cause, and environmental or political events beyond an
     organization’s control are among the factors which may
     result in costs that are reasonable although they do not
     meet these percentage limitations.

The overwhelming majority of the charities that the CBBB reviews

meet all 22 of the CBBB’s guidelines.

     Similarly, among its guidelines, NCIB generally recommends
                              - 21 -

that not more than 30 percent of the contributions, grants, and

bequests a charitable organization receives should be spent on

fundraising.   NCIB suggests that, where more than 30 percent was

spent on fundraising, then the prospective contributor should

further analyze the charitable organization’s operations and ask

the charitable organization for an explanation regarding the

percentage of proceeds spent in fundraising.   In particular,

NCIB’s contributor’s checklist pamphlet states as follows:

     Some fund-raising practices are always expensive--
     acquisition of new donors through direct mail or
     telemarketing, for example--and yet they may be the
     only methods available to an organization if it hopes
     to reach the general public. Some charities which rely
     heavily on bequests will have fundraising costs that
     vary considerably from year to year. New
     organizations, organizations with causes that are
     little known or controversial, organizations with a
     contributor base made up of many smaller contributions
     rather than a few large grants--are all likely to have
     relatively high fund-raising costs, and yet they may be
     quite well managed.

                             W&H; AICR

     W&H began business in late 1981 as a two-person partnership

owned 50 percent each by Jerry Carroll Watson (hereinafter

sometimes referred to as Watson) and Byron Chatworth Hughey

(hereinafter sometimes referred to as Hughey).   As of the time of

the trial in the instant case, Watson and Hughey have been W&H’s

only two partners.   Before forming W&H, Hughey was employed at

the Viguerie Company from 1978 to 1981.   From 1983 through the

time of the trial in the instant case, W&H maintained its offices

in the Washington, D.C., area, in Alexandria, Virginia.   (In July
                                - 22 -

1992, W&H changed its name to Direct Response Consulting

Services; herein we continue to refer to it as W&H.)

     W&H is engaged in the direct mail and fundraising services

business and has had up to about 20 to 22 employees.      Its clients

primarily have been nonprofit organizations.      Over the years, W&H

began to specialize in offering direct mail fundraising services

to nonprofit health organizations.       In 1984, W&H had one or two

clients in addition to petitioner which were nonprofit health

organizations.    Over the years, more and more of W&H’s clients

were in health-related areas.    In 1987, W&H received 65 percent

of its income from three major clients and petitioner accounted

for 26 percent of W&H’s gross income for that year.      In 1987, W&H

had a total of 12 clients.

      American Institute For Cancer Research (hereinafter

sometimes referred to as AICR), which has been recognized by

respondent as tax-exempt under section 501(c)(3) since its

incorporation in September 1981, was one of W&H’s first nonprofit

health clients.    Watson and Hughey are the two sole “founding

members” of AICR.    AICR’s articles of incorporation provide that

only its founding members have the right to vote.      The articles

also provide that no changes may be made with respect to the

founding members who were designated at AICR’s initial board

meeting and that no other founding members may be added, unless

all the founding members are dead.

     AICR and W&H entered into successive fundraising contracts
                                - 23 -

that covered the period from AICR’s inception through December

31, 1989.7   When W&H did its first mailings for AICR, Watson and

Hughey consulted an attorney.    The attorney advised them that

they and AICR would have to be careful that section 501(c)(3)’s

prohibition against inurement was not violated, in light of

Watson’s and Hughey’s status as founding members of AICR.    As a

result, W&H reduced its fees “drastically”, W&H relinquished all

ownership in AICR’s mailing lists, and other changes were made.

Table 5 summarizes certain features of W&H’s fundraising

contracts with AICR.




     7
          Petitioner does not object to respondent’s proposed
finding of fact to this effect. We note that the first of the
contracts that respondent listed in support of this finding was
executed on Jan. 20, 1983; this contract states that it “is
effective the 1st day of June 1982”; but AICR had been
incorporated in September 1981. Similarly, the last of the
contracts that respondent listed states that “The term of this
Agreement is two (2) years beginning Jan. 1, 1987”; thus, the
last contract appears to have expired 1 year before the date
specified in the agreed-to proposed finding. We have treated the
agreed-to proposed finding as, in effect, an additional
stipulation between the parties.
                                                       - 24 -
                                                        Table 5

                                                    Mailing Fees
    Effective                           Prospect--cents         Housefile--cents
    Date of     No-Risk     Term of      per letter,             per letter,
    Contract    Provision   Contract    letter per year         letters per mailing     Retainer1    List Ownership

    6/1/82      Yes         1 yr.      4 cents                    8 cents               $3,000/mo.   Capital List--
                                                                                                     forever

    2/4/83      Yes         1 yr.      4 cents                    8 cents                1,500/mo.   Joint--W&H, AICR

    2/4/832      No         1 yr.      2 cents                    4 cents 1st 250,000
                                                                  2 cents thereafter     1,500/mo.   Sole property
                                                                                                      of AICR

    1/1/84      No          1 yr.      2 cents 1st 10 mil.        4 cents 1st 250,000
                                       1 cent next 5 mil.         1 cent next 250,000
                                       0.5 cents next 3 mil.      Free after 500,000
                                       Free after 18 mil.                                1,500/mo.   Sole property
                                                                                                      of AICR

    1/1/85      No          1 yr.      1.8 cents 1st 10 mil.      3 cents 1st 250,000
                                       0.9 cents next 5 mil.      1 cent next 250,000
                                       0.45 cents next 3 mil.     Free after 500,000
                                       Free after 18 mil.                                    No      Sole property
                                                                                                      of AICR

    1/1/86      No          1 yr.      1.8 cents 1st 10 mil.
                                       0.9 cent next 5 mil.
                                       0.45 cents next 9 mil.     3 cents 1st 250,000
                                       Add’l. letters--price      1 cent next 250,000
                                       to be arranged             Free after 500,000         No      Sole property
                                                                                                       of AICR
    1/1/87      No          2 yrs.     1.8 cents 1st 10 mil.      3 cents 1st 400,000
                                       0.9 cent next 5 mil.       1 cent next 400,000        No      Sole property
                                       0.45 cents next 9 mil.                                         of AICR
                                       Add’l. letters--price
                                       to be arranged

1
      Payment to be applied to AICR’s debt to W&H, not a separate “package fee”.
2
      Contract signed Aug. 10, 1983, retroactive to Feb. 4, 1983.
                                - 25 -

      Later, as a result of advice by another attorney, changes

were made regarding Watson’s and Hughey’s control over AICR.

Under AICR’s original articles of incorporation, directors are

elected by, and may be removed without cause by, AICR’s founding

members, Watson and Hughey.   Under amendments filed May 4, 1984,

any founding member is forbidden to elect or remove directors

“during any period in which such founding member has a commercial

relationship with the Corporation [AICR] and for a period of three

years thereafter.”    For these purposes “the term `founding member’

shall be deemed to include any * * * partnership * * * in which a

founding member has a material interest.”   These amendments also

provide as follows:

      During any period that all founding members are
      prohibited, or are abstaining, from exercising their
      rights with respect to the election and removal of
      Directors, Directors shall be elected and removed by the
      affirmative vote of a majority of the entire Board of
      Directors.

                  The Contract; Related Agreements

A.   The Contract (June 11, 1984)

      The Contract provides that, during its 5-year term, ending

May 30, 1989, W&H would be petitioner’s exclusive fundraising

consultant and adviser in petitioner’s conduct of its direct mail

fundraising solicitations.    Petitioner agrees not to “retain or

use the services of any other person or company to provide counsel

and advice to [petitioner] in conducting its direct mail

solicitations.”   W&H agrees to furnish its services and to advise,
                                - 26 -

counsel, and make recommendations concerning all aspects of

preparing petitioner’s direct mail fundraising and membership

solicitations, and to be responsible for implementing all of the

work required, either directly or through affiliates or other

suppliers, “subject to the approval of CLIENT [petitioner].”     W&H

further agrees to maintain petitioner’s housefile and to perform

all follow-up correspondence.

     The Contract further provides that all mailing campaign

materials prepared and recommended by W&H, including the proposed

numbers of letters to be mailed, would be subject to petitioner’s

approval “and no such material shall be mailed or made available

to the public without such approval.”

     The Contract additionally provides that a bank or “caging

company” (described below) would be hired to act as cashier and

escrow agent for the funds generated under the Contract.   The bank

or caging company would process receipts and disburse payments

under an agreement to be entered into by it, petitioner, and W&H.

     The Contract requires W&H to promptly furnish to petitioner

copies of invoices received from suppliers of goods and services

used in fulfilling W&H’s obligations under the Contract.   The

Contract also requires W&H to make reasonable efforts, where

market conditions and time permit, to obtain competitive bids or

rates for work subcontracted to suppliers.   W&H affiliates would

be allowed to perform such subcontract work, subject to this

competitive bid and rate requirement.    No markup was to be added
                                - 27 -

by W&H on the supplier or subcontractor invoices billed to

petitioner.

     The Contract provides that W&H would be paid, as compensation

for its services, mailing fees of $.05 per prospect letter mailed

and $.10 per housefile letter mailed, as well as certain creative

fees for each housefile mailing package mailed.    On a housefile

package mailed to under 50,000 previous contributors, W&H would be

entitled to a $2,500 creative fee.    On a housefile package mailed

to 50,000 or more previous contributors, W&H’s creative fee would

be $5,000.    Petitioner would pay a retainer of $1,500 per month to

W&H as a draw against these fees.    During the term of the

Contract, all materials, packages, and ideas developed by W&H on

behalf of petitioner would remain the sole property of W&H, and

all such material could be used by petitioner only with W&H’s

written consent.

     With respect to petitioner’s mailing list, the Contract

provides that W&H and petitioner would have respective co-

ownership rights as follows:

          Section 14. List Ownership. It is expressly
     understood, covenanted and agreed upon * * * that any
     and all names and addresses and amounts contributed, if
     any, of persons, firms, associations or corporations
     which are obtained, developed, compiled or otherwise
     acquired for CLIENT by or through the direct or indirect
     efforts of W&H in connection with any services rendered
     by W&H to CLIENT pursuant to the terms hereof shall at
     all times be and constitute the property solely and
     exclusively of W&H and CLIENT. These names and
     addresses and the amounts of contributions, if any, can
     be used at any time by CLIENT in any manner, for any
     purpose for its own account. CLIENT shall use these
                              - 28 -

     names and addresses developed by W&H for no purpose
     other than in direct connection with CLIENT’S own
     projects. CLIENT shall not at any time during the life
     of this Agreement or any time thereafter rent, exchange,
     lease, sell or give away these names and addresses
     developed as the result of the efforts of W&H to any
     other parties for any purpose whatsoever. However, W&H
     shall be free to use the names and addresses referred to
     in Section 14 in any way it so desires and for any
     purpose it may so determine.

The Contract also states that “It is expressly understood and

agreed upon that * * * Section 14 [the list ownership rights

provision] shall survive” the termination of the Contract.   The

Contract also requires that, during the Contract’s term, any

computer work that petitioner wants to have done with respect to

the names developed as a result of the Contract “must be done at

W&H or at a company designated by W&H.”

     The Contract provides as follows with respect to its “no-

risk” nature:

          Section 9. Payments to W&H and Suppliers. W&H
     assumes full obligation and responsibility for the
     payment of all vendor, suppliers and W&H invoices
     arising out of the fulfillment of W&H’s obligations
     hereunder, said invoices to be subsequently reimbursed
     by CLIENT only under the terms and conditions set forth
     in this Section. CLIENT shall reimburse W&H only to the
     extent that W&H has raised such funds. W&H shall have
     no right or claim upon any other funds or accounts of
     CLIENT. W&H shall be reimbursed for money owed to it
     only out of funds obtained as a result of W&H’s efforts.
     However, if CLIENT raises additional funds through their
     own efforts from names that W&H has generated, these
     funds shall be considered in the same category as funds
     raised by W&H. People who are members of UCC or prior
     donors to UCC are excluded from the provisions of this
     section. In other words, W&H is liable for all expenses
     connected with this contract to the extent that W&H has
     not raised funds to cover those costs. This section
     applies throughout this agreement.
                                 - 29 -

           CLIENT shall make monthly payments to W&H to the
      full extent that W&H has raised funds to pay the costs
      incurred by W&H in carrying out its obligations under
      this Agreement.

           For the first two years of this Agreement, up to
      50% of net income from * * * [house] file mailings may
      be applied to the cost of * * * [prospect] mailings.
      After two years and for the remainder of this Agreement,
      up to 30% of net income from * * * [house] file mailings
      may be applied to the cost of * * * [prospect] mailings.
      CLIENT will only utilize * * * [house] file net income
      for its projects under the terms and conditions set
      forth in this Section.

           For purposes hereof, net income received pursuant
      to this Agreement by CLIENT shall hereby be defined as
      all contributions received, less all expenses incurred,
      pursuant to the terms hereof, including supplier
      invoices, postage, W&H charges and all other items
      described in this Agreement.

      The Contract provides that it “is automatically renewable for

Five (5) Years if either Party does not in writing specify the

canceling of this Agreement at least Three (3) Months prior to the

expiration of this Agreement.”    Apparently this provision was

intended to give each party to the Contract a veto over the

Contract’s automatic renewal.    However the Contract does not

include a provision permitting termination for cause.

B.   The Escrow Agreement

      On June 19, 1984, petitioner, W&H, and Washington

Intelligence Bureau (hereinafter sometimes referred to as WIB)

entered into an escrow agreement (hereinafter sometime referred to

as the Escrow Agreement), whereby WIB would provide escrow

services in connection with the Contract.    The Escrow Agreement,

which W&H provided to petitioner and WIB, is essentially the same
                               - 30 -

agreement that W&H uses in all of the escrow arrangements that W&H

has with WIB.   During the term of the Contract, WIB was at all

times the escrow agent and did most of the caging.8

     WIB began to deal with W&H in 1982 or 1983.   WIB has been the

escrow agent for most of W&H’s clients.   WIB’s first W&H-related

client was AICR.   In 1984, about 15-20 percent of WIB’s business

pertained to W&H’s clients.   By 1989, this had grown to 30-35

percent.   Thereafter, the percentage dropped to about 25 percent.

WIB has always been unrelated to W&H in ownership.

     The Escrow Agreement provides, in pertinent part, as follows:

          WHEREAS, the Client [petitioner] agrees to pay all
     costs for direct mail fund raising services as well as
     cost for others providing services and supplies for the
     direct mail fund raising program.

           IT IS, THEREFORE, agreed:

     1. ESCROW FUND. The Agency [W&H] and the Client hereby
     agree that returns from the direct mail fund raising
     programs shall be received by the Escrowee [WIB] and the
     sum so received shall be known as the Escrow Fund.

     2. PAYMENT OF CREDITORS. The Escrow Fund shall be held
     by The Escrowee separate and apart from the other funds
     of the Escrowee. The Agency shall present the Escrowee
     with invoices of creditors, including invoices of the
     Escrowee, which the Escrowee shall pay from said Escrow
     Fund. All invoices paid from said Escrow Fund shall be

     8
          Caging involves receiving, opening, and processing the
return mail generated by a direct mail campaign. A caging
company generally performs such functions as depositing the
return mail receipts with a bank, providing to the client an
account of these receipts, verifying and correcting name and
address information with respect to contributors, recording
pertinent information with respect to contributors, and relaying
such contributor information to a computer company selected by
the client.
                               - 31 -

     approved by the Agency and submitted to the Escrowee
     promptly for payment.

     3. MAIL CHARGES. The Escrowee may transfer all sums
     necessary to pay charges by the United States Postal
     Service for the Client’s Business Reply Mail without
     approval of the Agency or Client.[9]

     4. ESCROWEE’S COMPENSATION. The compensation of the
     Escrowee shall be established by the Agency, the Client,
     and Escrowee. The Escrowee shall render billings for
     Escrowee services to the Client, in care of the Agency,
     and shall be paid on a priority basis. If approved
     invoice is not received from the Agency by the Escrowee
     within 30 days from the date of invoice, the Escrowee
     shall be authorized to pay such billing without the
     approval of the Agency.

                 *    *    *     *      *   *   *

     6. ACCOUNTING. The Escrowee shall provide the Client
     and Agency an accounting as to each payment or
     disbursement made from the Escrow Fund. Those
     disbursements shall only be upon the written approval of
     the Agency. The Escrowee shall be provided compensation
     for these services.

     7. DISPUTES. In the event of any dispute with respect
     to disposition of all or part of the Escrow Fund, The
     Escrowee shall not be obligated to disburse the disputed
     portion thereof nor shall the Escrowee be required
     affirmatively to commence any action against the Client
     or Agency, or defend any action that a creditor might
     bring. In his [sic] sole discretion, the Escrowee may,
     in the event of a dispute as to the disposition of all
     or part of the Escrow Fund, commence an action in the
     nature of interpleader and seek to deposit the disputed
     portion in a Court of Competent Jurisdiction.

     9
          The Business Reply Mail postage referred to represented
postage on the return mailing envelopes provided to the persons
solicited in the direct mail fundraising campaign for purposes of
making contributions to petitioner or otherwise responding.
Unlike the outgoing fundraising letters and materials which were
mailed under petitioner’s nonprofit mail permits at the lower
nonprofit mailing rate, postage at the regular United States
Postal Service rate was required on the return letters mailed by
recipients of the fundraising letters.
                                - 32 -

     Pursuant to the Escrow Agreement, WIB opened a bank account

(hereinafter sometimes referred to as the Escrow Account) in which

to maintain the escrow fund.    Only authorized employees of WIB

could withdraw funds from the Escrow Account.    The money deposited

into the Escrow Account came primarily from the following sources:

(1) The money W&H advanced to pay for petitioner’s fundraising

expenses and operational expenses, and (2) the contributions made

by the general public in response to the fundraising letters

mailed under the Contract.   All of the revenues from petitioner’s

direct mail campaign, not merely the profits from the mailings,

went into the Escrow Account.

C. Petitioner’s “Draw” Arrangement

     As indicated above, during its discussions with petitioner

about entering a possible fundraising contract, W&H offered to

provide funds with which petitioner could continue to operate.

W&H furnished such funds to petitioner after the Contract was

executed.

     A December 17, 1984, letter agreement between petitioner and

W&H provides, in pertinent part, as follows:

          In order to meet your cash flow needs for administration
     and program, you [petitioner] plan to transfer funds from the
     escrow account that were generated from * * * [prospect
     letter mailings]. To date $5,000 was transferred on November
     1, $5,000 was transferred on December 1, and you plan to
     transfer another $5,000 on January 1, 1985.

          This letter acknowledges the fact that these transfers *
     * * are made in such a manner from * * * [prospect letter
     mailing] revenues will be replenished from UCC’s income from
     * * * [housefile letter] mailings within six months of
                               - 33 -

     making such a transfer.

     Contrary to what is suggested in the above letter agreement,

as of December 1984, no net mailing revenues had yet been produced

from either the prospect letter mailings or housefile letter

mailings conducted.   Only losses or relatively small amounts of

net mailing revenues were produced by the housefile letter

mailings up until June or July 1985.    It was not until about July

1985, that the cumulative net revenue produced from housefile

letter mailings began to somewhat approach the cumulative amount

of funds W&H provided to meet petitioner’s operating expenses.

Initially, some of the funds used to meet petitioner’s operating

expenses were advanced by W&H to the Escrow Account.    Also, W&H

deferred receiving payment of its fees.

     Later, as the net revenue produced from mailings began to

increase, W&H authorized and permitted petitioner to “draw”

increasingly larger monthly amounts of funds from the Escrow

Account to finance petitioner’s larger annual operating budgets.

Up until about the execution on April 8-9, 1987, of an addendum to

the Contract, petitioner was fully liable to repay the draws it

had taken, to the extent the draws exceeded the 50 percent of

cumulative housefile income guaranteed to petitioner under the

Contract.   The draws petitioner received were to be repaid within

6 months, regardless of the direct mailing campaign’s

profitability.   The events leading up to and culminating in the

execution of the April 1987 addendum to the Contract are discussed
                               - 34 -

more fully infra.

     Once the mailings had become sufficiently more profitable, in

deciding the amount of petitioner’s monthly draws, W&H considered

petitioner’s budget plans and the future net mailing revenues

expected to be produced.   W&H based its decisions, in large part,

on its calculation of the current monthly net housefile mailing

revenue being produced and the 50 percent of the cumulative

housefile income that petitioner, in all events, was guaranteed

under the Contract.

     Monthly draws from the Escrow Account were taken by

petitioner over the period from October 1984 through May 1989, as

shown in table 6.

                               Table 6

                            Monthly           Cumulative
     Month                   Draws              Draws

     10/84                   $5,000            $5,000
     11/84                     --               5,000
     12/84                    5,000            10,000
      1/85                   10,000            20,000
      2/85                      --             20,000
      3/85                    6,000            26,000
      4/85                   14,000            40,000
      5/85                   10,000            50,000
      6/85                   10,000            60,000
      7/85                   18,000            78,000
      8/85                   20,000            98,000
      9/85                     --              98,000
     10/85                   22,000           120,000
     11/85                   33,000           153,000
     12/85                   25,000           178,000
      1/86                   40,000           218,000
      2/86                   40,000           258,000
      3/86                   40,000           298,000
                           (Cont.) Table 6
                             - 35 -

                          Monthly         Cumulative
    Month                  Draws            Draws

     4/86                 40,000             338,000
     5/86                 40,000             378,000
     6/86                 40,000             418,000
                                           1
     7/86                 40,000             453,000
     8/86                 40,000             493,000
     9/86                 40,000             533,000
    10/86                 40,000             573,000
    11/86                 40,000             613,000
    12/86                 40,000             653,000
     1/87                 50,000             703,000
     2/87                 50,000             753,000
     3/87                 50,000             803,000
     4/87                 50,000             853,000
     5/87                 50,000             903,000
     6/87                 50,000             953,000
     7/87                 50,000          1,003,000
     8/87                 50,000          1,053,000
     9/87                 50,000          1,103,000
    10/87                 50,000          1,153,000
    11/87                 50,000          1,203,000
    12/87                 50,000          1,253,000
     1/88                 60,000          1,313,000
     2/88                 60,000          1,373,000
     3/88                 60,000          1,433,000
     4/88                 60,000          1,493,000
     5/88                 60,000          1,553,000
     6/88                 60,000          1,613,000
     7/88                 60,000          1,673,000
     8/88                 60,000          1,733,000
     9/88                 60,000          1,793,000
    10/88                 60,000          1,853,000
    11/88                 60,000          1,913,000
    12/88                 60,000          1,973,000
     1/89                 60,000          2,033,000
     2/89                 60,000          2,093,000
     3/89                 60,000          2,153,000
     4/89                 60,000          2,213,000
1
  So shown in the stipulated exhibit. Evidently, there is a
$5,000 error in either the July 1986 monthly draw amount or the
cumulative draws. This discrepancy does not affect our analysis
or conclusions.
                                 - 36 -

D. Agreement to Continue at 50 Percent the Percentage
   of Net Housefile Mailing Income the Fundraising
   Contract Required to be Retained in the Escrow
   Account to Reimburse W&H

     As indicated above, the Contract originally provided that,

after 2 years, the percentage of net housefile mailing income that

petitioner was required to retain in the Escrow Account be lowered

from 50 percent to 30 percent.    In March and April 1986, Watson

proposed to petitioner that this percentage remain at 50 percent,

rather than be lowered, because of higher prospect mailing

expenses resulting from an increase in postal rates.    In exchange

for petitioner’s agreement to this, W&H would reduce its creative

fee on housefile package mailings from $5,000 to $2,500 and cap

its mailing fee at $50,000 for any housefile mailing done in

excess of 500,000 letters.   On April 26, 1986, petitioner’s board

of directors accepted Watson’s proposal.

E. April 1987 Addendum to the Contract

     The certified public accounting firm that examined

petitioner’s annual financial statements issued a qualified

opinion, dated April 18, 1986, as to petitioner’s 1985 financial

statement.   The certified public accounting firm elaborated on its

concerns in a management letter dated May 23, 1986, to the

executive committee of petitioner’s board of directors.    This

management letter states, in pertinent part, as follows:

     General Fund

       1. Continued Existence of the Agency [petitioner].
          Our gravest concern is the viability of the
                               - 37 -

          organization. It is our understanding that the
          1986 budget totals $520,000 including grant
          commitments of $100,000. You expect to fund this
          ambitious budget with the excess of revenues over
          expenses from the direct-mail campaign. What will
          the Council [petitioner] do if the excess of
          revenues over expenses does not materialize at the
          level expected?

          The General Fund must borrow heavily from the
          Donor Development Fund [Escrow Account] to finance
          the budget, and if required to repay such
          borrowings it is doubtful the General Fund would
          have the ability to make the repayments.

     Over a 7- to 8-month period beginning in or about July 1986,

petitioner discussed with W&H its concerns regarding petitioner’s

full recourse liability to repay the excess draws taken and

petitioner’s inability to receive unqualified opinions from the

certified public accounting firm with respect to petitioner’s

future annual financial statements.        On October 23, 1986, Watson

sent a letter to petitioner’s executive director stating W&H’s

position with respect to petitioner’s repayment of the excess

draw liability, stating in pertinent part, as follows:

          This letter is to confirm our discussion relating
     to program draws from the UCC escrow account.

                       *   *   *   *   *    *   *

          As we understand it, UCC’s concerns surround the
     procedure by which this [50 percent of] net income
     [from housefile mailings] is transferred to your
     regular operating account.

          Rather than receiving the exact amount as
     determined by the 50% formula, UCC, with W&Hs
     knowledge, is taking a fixed amount each month. When
     the final net income figure becomes known some months
     later, UCCs draw from the escrow account can be greater
     than it should be.
                              - 38 -

          Your question is Will UCC be required to pay the
     escrow account back for this excess draw?
          According to the terms of the agreement, I suppose
     that technically you would have to do this.

          However, since W&H does have knowledge that these
     transfers are taking place, we currently have no
     objection to this in light of our hope that we can
     overcome the deficits. W&H would not request UCC to
     repay any overdraws unless we objected to a specific
     draw at the time it was taken or in the event that UCC
     would unreasonably interfere with W&H’s efforts to
     continue the mailing campaign to recover the deficits.

          The worst thing that could happen is that should
     the deficits continue to grow or can not be reduced,
     and if UCC substantially overdraws its 50% program
     allocation, it could become necessary to reduce the
     draws to bring them back into balance.

          Should we determine this situation to be
     developing, I would like for us to sit down well in
     advance of such time and create plans so that a
     reduction would not adversely impact UCC’s operation.

After reviewing Watson’s October 23, 1986, letter, petitioner’s

executive committee and executive director concluded that the

letter was not satisfactory for petitioner’s purposes and did not

relieve petitioner from having full recourse liability with

respect to excess draws.

     Petitioner’s executive committee asked petitioner’s

executive director “to contact * * * Watson to ask that he

rewrite it [i.e., the October 23, 1986, letter] in time for our

auditors review.”

     Watson sent a new letter to petitioner’s executive director

on November 19, 1986.   The November 19, 1986, letter is

substantially the same as the October 23, 1986, letter, except as
                              - 39 -

follows:   (1) The November 19 letter omits the October 23, 1986,

paragraph that states “According to the terms of the agreement, I

suppose that technically you would have to do this [i.e., repay

the excess draw]”; and (2) the November 19 letter replaces the

phrase “the draws” by the phrase “future draws” after “reduce” in

the October 23 letter clause “it could become necessary to reduce

the draws to bring them back into balance.”

     On December 12, 1986, petitioners executive director sent a

letter to Watson about the treatment of general and

administrative costs under the Contract.   In the course of this

letter, he pointed out that the auditors “were in the office to

begin preliminary work on the 1986 Financial Statements.”

     Petitioner and W&H executed an addendum to the Contract on

April 8-9, 1987.   The addendum provides that, beginning with

1986, petitioner would not have to repay draws taken in excess of

its 50 percent of its housefile income, to the extent sufficient

net fundraising revenue was not raised.    The addendum states that

such excess draws would be treated in the same manner as prospect

mailing debts for purposes of the Contract.   The addendum further

provides that petitioner’s monthly draws would be agreed to in

writing by W&H and petitioner, and requires W&H to give 90 days’

prior written notice to petitioner in order to effectuate any

reduction in the monthly draws.   Petitioner’s then-chairman

believed that W&H agreed to the April 1987 addendum--especially

the nonrefundability of the draws--because W&H hoped that it
                              - 40 -

would improve relations with petitioner’s board of directors and

increase the likelihood that the Contract would be renewed.

     As a result of the addendum provision regarding monthly

draws, petitioner received an unqualified opinion for 1986.    That

is, the certified public accounting firm’s report no longer

included qualifications or reservations about petitioner’s

practices or potential liabilities.

           Direct Mail Fundraising Campaign:   1984-1989

A. In General

     From June 1984 through May 1989, W&H conducted a nationwide

direct mail fundraising campaign for petitioner.    Mailings were

eventually sent throughout all 50 States.   However, petitioner

directed W&H not to make mailings to areas serviced by certain of

petitioner’s member agencies, as those member agencies received

annual funding from the United Way campaign and a condition of

their receipt of such funding was that they not be involved in

competing fundraising efforts.

     W&H created and developed direct mail fundraising packages

with petitioner’s assistance and input.   Before each direct mail

package was mailed, petitioner received from W&H all materials to

be included in the package, as well as the names of all mailing

lists to which W&H proposed to send the package and the estimated

numbers of names from each mailing list to be used in the

mailing.   Petitioner, through its staff and a committee of its

board, reviewed and revised the package and the mailing list and
                             - 41 -

gave instructions as to the mailing list numbers, the copy, the

dates of mailing, and the total number of letters to be sent.

     Petitioner received from W&H a monthly status report of the

cumulative costs and revenues of each direct mail package mailing

and a proposed schedule of future mailings.   Petitioner was also

advised with regard to test mailings, typically of 5,000 letters,

that W&H had done of proposed mailing packages.   If a test

mailing was successful, then W&H generally recommended that more

mailings of that package be “rolled out” in greater quantities.

     W&H issued purchase orders on behalf of petitioner with

respect to all of the goods, services, and other expenditures

required for the various mailings.    This was done on an on-going

basis and involved such items as computer work, mailing house

expenses, mailing list rentals, and printing.   When petitioner

approved the making of a mailing, W&H and petitioner considered

petitioner to have authorized W&H to order and arrange for all of

the related goods, services, and other expenditures required to

effectuate the mailing.

     Petitioner accrued the amounts shown in table 7 as its

expenses for (1) postage and shipping, (2) printing and

publishing, (3) fundraising fees,10 and (4) mailing list rentals.

     10
          Compare the accruals shown on the fundraising fees
column in table 7, with the payments shown supra table 3. When
adjusted for the W&H reimbursements pursuant to the Contract, the
net accrual amounts are fairly close to the actual payment
amounts, except for 1986, where the difference is about $275,000.
                                                   (continued...)
                             - 42 -

Petitioner allocated about 45 percent of each of these categories

of expenditures--other than fundraising fees--to “program

services”, rather than “donor development and fundraising”.




     10
          (...continued)
                                                  - 43 -


                                                  Table 7




           Postage       Printing     Professional    (Reimbursable)    Net Professional   Mailing
             and          and          Fundraising       or Not          Fundraising        List
Year       Shipping    Publications      Fees          Reimbursable1         Fees          Rentals

1984        $60,171     $74,224         $30,092              --             $30,092         $50,201

1985      1,480,719    1,445,431        798,092         $(641,920)          156,172        1,034,711

1986      2,079,059    1,513,599      1,521,101             (403,772)     1,117,329        1,133,254

1987      2,678,137    1,824,517      1,259,798             730,228       1,990,026        1,475,299

1988        936,627     675,605         659,179             237,444         896,623         229,684

1889        263,514     439,479         115,406              65,890         181,296          14,529

    Totals 7,498,227   5,972,855      4,383,668             (12,130)      4,371,538        3,937,678




1
   Expenses (reimbursable), or no longer reimbursable, by W&H under the Contract. The
amounts are taken from petitioner’s Forms 990. The parties have not explained why these
amounts net to ($12,130), rather than -0-.
                              - 44 -

B. W&H’s Advances of the Initial Capital to
   Conduct the Direct Mail Fundraising Campaign

     As indicated above, the Contract was a “no-risk” contract

with respect to petitioner’s payment of fundraising expenses.

     For the first 2 years or so under the Contract, W&H advanced

money to the Escrow Account to pay for postage.   Postage was an

“upfront” expense, while other expenses generally were billed

“after the fact”, when petitioner had already received the

revenue generated by the mailing.    For a while, W&H continued to

advance money to pay for postage even when there were substantial

amounts in the Escrow Account.   W&H did this because its people

believed that there was not enough money in the Escrow Account to

pay both the postage and the other vendors, and because of the

draws that W&H paid to petitioner.

     W&H’s last advance of funds to petitioner for postage

occurred on March 9, 1987.   Thereafter, petitioner earned

sufficient profits from its mailings to cover its postage

expense.

     The Contract does not specify how much capital W&H would

provide to fund petitioner’s direct mail fundraising campaign.

W&H’s decisions to advance additional capital were based, in

substantial part, on its evaluation of the results from the

mailings that had already been done and on its conclusions about

the mailing campaign’s profits prospects.   Where W&H and its

clients entered into no-risk fundraising contracts similar to the
                                - 45 -

Contract, W&H’s practice was to stop advancing funds to finance a

client’s direct mail fundraising campaign if the initial mailings

were unsuccessful and W&H concluded that reasonable prospects for

conducting a profitable mailing campaign did not exist.   If W&H

decided to stop advancing funds, W&H then advised that client its

mailings would be curtailed, unless that client paid the expenses

of the further mailings that the client wanted to do.   On the

other hand, if W&H concluded that strong prospects for conducting

a profitable mailing campaign existed, W&H then might

substantially increase its advancements of funds in order to

finance larger mailings for that client.

     In this manner W&H effectively limited the risk that it had

apparently assumed in any no-risk fundraising contracts similar

to the Contract

C. Vendors Who Furnished Goods or Services

     In the course of petitioner’s direct mail fundraising

campaign, goods and services were obtained from a number of

vendors.   As indicated above, WIB was the escrow agent and

provided most of the caging services with respect to the return

mail received in response to petitioner’s mailings.   Wiland

Associates (hereinafter sometimes referred to as Wiland) was

retained by W&H and performed the computer services required in

connection with the Contract.

     Several other vendors at various times furnished goods or

services in connection with petitioner’s direct mail campaign.
                               - 46 -

W&H did not own or have any interest in the vendors who furnished

printing, mailing, telemarketing, or data processing services

under the Contract, nor did W&H own or have any interest in WIB

or Wiland.

     The Art Department Company, a corporation owned by Watson

and Hughey, prepared mock-ups and layouts and performed other art

work-related services for W&H’s clients and for other customers.

Petitioner was billed at the rate of $25 per hour for the Art

Department Company services.

     Washington Lists, a division of W&H, performed list

brokerage services for petitioner.11    A list broker represents an

organization that wants to rent a mailing list from another

organization.    One of Washington Lists’ functions as a list

broker was to arrange for petitioner to use as lessee certain

mailing lists.    Washington Lists arranged these mailing list

rental transactions for petitioner through standard industry

channels for such transactions.

D. Rentals of Mailing Lists

     As indicated above, Wiland was retained by W&H to perform

the computer services required in connection with the Contract,

including maintenance of a computer list of petitioner’s

housefile.   Wiland also maintained computer lists which W&H owned


     11
          In 1986, Washington Lists changed its name to Capitol
List. Hereinafter, use of the term Washington Lists includes,
where applicable, reference to Capitol List.
                                - 47 -

or co-owned with its other clients.      Wiland, as instructed by

W&H, automatically merged and added to W&H’s masterfile on a

monthly basis all new names and donor information that had been

added to petitioner’s housefile.    W&H’s masterfile included the

names and donor information that was owned by W&H or was jointly

owned by W&H and its clients.    W&H had joint ownership rights in

most of the client housefile mailing lists developed under the

fundraising contracts it entered into with its nonprofit clients;

W&H did not have such an arrangement with respect to AICR.

     In conducting petitioner’s prospect mailings, prospect

mailing packages were mailed to the following categories of names

and addresses (hereinafter for convenience referred to as names):

(1) Names that W&H, as lessor, rented to petitioner from the W&H

masterfile, (2) names that Washington Lists arranged for

petitioner to rent as lessee from outside list owners unrelated

to W&H, (3) names that W&H, as lessor, rented to petitioner

through Washington Lists which names W&H obtained from outside

list owners in exchange for petitioner names, and (4) names that

W&H, as lessor, through Washington Lists rented to petitioner

which names W&H obtained from outside list owners in exchange for

non-petitioner names on W&H’s masterfile.

     The Contract forbids petitioner to exchange or to rent as

lessor its housefile list names.    When petitioner as lessee used

names from W&H’s masterfile, W&H charged petitioner W&H’s

advertised rental rate for the names published in the current
                              - 48 -

“Standard Rate and Data” publication (hereinafter sometimes

referred to as SRD).   SRD is a direct mail industry advertising

publication that sets forth the characteristics of a number of

mailing lists available for rental, the rental rates, and the

name and telephone number of the particular list owner or list

owner’s agent to contact.   When petitioner as lessee used names

that W&H obtained from outside list owners either through

exchanges of petitioner’s housefile list names or exchanges of

non-petitioner names on the W&H masterfile, W&H charged

petitioner the outside list owner’s currently advertised SRD-

published rental rate for the names furnished to petitioner or,

if no current SRD-published rental rate existed for the names

furnished to petitioner, W&H’s currently advertised SRD-published

rental rate for the names W&H gave up in the exchange

transaction.

     Generally, by engaging in an exchange transaction, a list

owner is able to obtain additional names at a significantly

cheaper cost than it would otherwise incur to use the names as a

lessee in a rental transaction.   For instance, in a typical

exchange transaction, the two list owners involved might agree

that each would furnish to the other 10,000 of their respective

housefile list names that meet certain prescribed specifications.

The two owners would not pay one another any cash fee; the only

costs an owner would incur include computer-related production

costs for a computer tape or mailing labels containing the 10,000
                               - 49 -

names that owner furnishes, postage to ship the tape or labels,

and a list broker’s fee or list manager’s fee12 for arranging the

exchange transaction.

     When W&H exchanged for petitioner names it owned jointly

with petitioner, the cost to W&H of acquiring the third party’s

names included charges for computer processing, postage, and a

list broker’s or list manager’s fee.     W&H did not pay a rental

fee to the owner of the third-party names in these situations,

because W&H was providing names to the third party that normally

rented for $60 per thousand names.

     Table 8 shows the amounts petitioner as lessee paid to

Washington Lists by way of mailing list rental fees for renting

mailing lists which W&H owned or mailing lists to which W&H

claimed mailing list rights.   The payments petitioner made to W&H

include payments for names that W&H acquired by exchanging

petitioner’s names for names owned by unrelated third parties.

                               Table 8

                                           Payments for Names W&H
                    Payments for W&H       Obtained by Exchanging
     Year           Masterfile Names       Petitioner Names

     1984                 -0-                         $1,450
     1985                $6,448                       57,349
     1986                44,645                      119,436
     1987               122,747                      219,896
     1988                32,408                       24,660


     12
          In the direct mail industry, a list manager functions
as a sales agent who represents a list owner in marketing the
list owner’s mailing list to others. The list manager promotes
the mailing list and arranges for rentals and/or exchanges of the
mailing list to other parties.
                                 - 50 -

     1989                  -0-                       -0-


      Totals             206,248                   422,791

     When W&H obtained names for petitioner to use as lessee,

including non-petitioner names from W&H’s masterfile and third-

party names for which W&H exchanged petitioner names, W&H charged

or passed on any direct out-of-pocket costs of obtaining those

names to petitioner.   These out-of-pocket costs included

computer-processing charges and mailing charges.

     W&H’s masterfile had numerous subparts or discrete “list

selects” that could be selected via computer processing.     For

example, list selects of all donors to sweepstakes contest

appeals, all donors to health causes, all donors to cancer-

related health causes, or all donors to a particular W&H client,

could be obtained through computer selection.

     During 1984 through 1989, W&H exchanged segments of

petitioner’s housefile list between 200 and 300 times.     These

exchange transactions involved as few as 5,000 petitioner names

or as many as 300,000 petitioner names.

     For each of these exchanges, W&H charged petitioner the

published SRD rental fee of the names received in the exchange;

if no published SRD rate existed, then W&H charged petitioner the

published SRD rental fee of petitioner’s names that were given up

in the exchange.   UCC’s payments to W&H on account of these

charges constituted income to W&H.
                               - 51 -

     W&H also rented as lessor the names on its masterfile to

third parties, including other W&H clients and W&H-controlled

entities.   Petitioner’s names could be separately selected from

the W&H masterfile and were occasionally rented by W&H to third

parties as a discrete, separate list of petitioner names.

Petitioner’s names were also contained in lists rented by W&H to

third parties mixed together with non-petitioner names.   On the

record in the instant case, it is virtually impossible to

determine how often any particular petitioner name was rented as

part of a mixed list.

     From 1984 through the time of the trial in the instant case,

W&H as lessor rented discrete segments of petitioner’s housefile

names about 50 to 80 times.   These rental transactions may have

involved as few as 5,000 petitioner names or as many as 300,000

petitioner names.13   From 1984 through the time of the trial, in

the instant case, W&H as lessor rented segments of the W&H

masterfile more than 2,000 times.   Any such rental may have

involved no petitioner names, one petitioner name, or a

substantial number of petitioner names.   On at least one occasion

as many as 300,000 petitioner names were contained on a rented

     13
          For example, a list rental order dated Jan. 1, 1990,
submitted on behalf of the Norris Hospital at the University of
Southern California to W&H, reflects that an 8,500-name
“representative cross section” of certain petitioner names was
being ordered. The order indicates that the segment of
petitioner names selected consisted of donors who had made a
donation of $5 or more to petitioner within the past 24 months.
Note that the Contract had expired more than 7 months earlier.
                              - 52 -

segment of the W&H masterfile.

     W&H as lessor rented petitioner names at rates that were

common in the list rental market.   A typical rate was $60 per

thousand names.

     The Contract did not require W&H to, and W&H did not, notify

petitioner before renting parts of the W&H masterfile including

petitioner’s names to third parties.   Pursuant to the Contract,

W&H retained all rights to approve a mailing sample of what would

be mailed by the third parties renting parts of W&H’s masterfile.

W&H also retained all rights to control the mailing dates when

these third parties using parts of W&H’s masterfile would make

their mailings to the rented list names.

     During the term of the Contract, some of petitioner’s

directors and staff became aware that W&H was exchanging

petitioner housefile names for other names, and then charging

petitioner full regular rental rates for the use of the other

names.   Some of petitioner’s directors and staff also became

aware that other W&H clients, including certain nonprofit cancer

organizations, were mailing fundraising packages similar to

petitioner’s.   They were further aware that W&H possibly could be

renting or otherwise providing petitioner housefile names to the

W&H clients that were mailing fundraising packages which were

similar to petitioner’s.   In fact, W&H did so use petitioner’s

housefiles and did mail similar sweepstakes packages for

petitioner’s “competitors”.   Petitioner did not try to have W&H
                              - 53 -

stop such activities, as petitioner concluded that W&H was acting

within its rights under the Contract.

     Under the Contract, it would have been improper for W&H to

impose a markup on charges made by suppliers.   Thus, if W&H

secured a desired mailing list for petitioner as lessee, and the

lessor charged $55 per thousand, then it would have been improper

for W&H to pass a cost of $60 per thousand on to petitioner.    W&H

and petitioner operated in accordance with the Contract.

However, when W&H “paid for” the desired mailing list by

exchanging one of petitioner’s mailing lists for it, so that the

lessor imposed no monetary rental fee, then, as petitioner’s

staff understood the Contract, it was appropriate for W&H to pass

on to petitioner a rental fee in the amount that the lessor would

have charged for the desired mailing list if the lessor had not

instead received petitioner’s mailing list in exchange.    In

exchange situations, then, W&H received as its own revenue the

“as if” rental that the lessor had not in fact charged, as well

as W&H’s regular fees under the Contract.

     The bar against petitioner’s exchanging its own names

extended past the term of the Contract.   Because petitioner could

not exchange its own names, petitioner had to pay the greater

costs associated with renting names from others.

E. Sweepstakes Mailings

     The first sweepstakes contest mailing that W&H conducted was

done under the Contract.   W&H then used sweepstakes contest
                              - 54 -

mailings extensively with most of its other clients.    Before they

formed W&H, both Watson and Hughey had experience with the use of

sweepstakes contests on behalf of either their employers or their

clients.

     As part of its initial program of prospect mailings for

petitioner, W&H tested various packages.   A “check” package

performed best and became petitioner’s “control” package--a

package that is mailed until a later package can net more money.

In November 1984 a sweepstakes (sweeps) package was tested and

also performed well.   As Watson put it in an October 15, 1985,

memorandum to several of petitioner’s directors and its executive

director, “At this point UCC had two control packages, the check

package which could be mailed to the traditional donor market;

and a sweepstakes offer which could be mailed to markets that

respond to sweepstakes.”

     A January 1985 major prospect mailing was planned using the

check package.   However, although the package had been approved

by petitioner, petitioner’s board of directors then urged that

the check package be replaced by a different package.   That

different package then lost $110,000.14

     14
          The record reflects that petitioner’s directors
directed the check package not be used, because they believed
certain representations contained in the package were inaccurate.
Recipients of the package were informed that if they made a
contribution, petitioner then essentially would receive a
matching donation from another party. In actuality, at the time
the solicitation was made, petitioner had not yet secured a
                                                   (continued...)
                              - 55 -

     In August 1985 an “annual fund” package was successfully

tested.   As a result, petitioner again had two control packages.

An annual fund package was first mailed out in substantial volume

(almost 500,000 letters) in December 1985.

     Apart from the foregoing, for petitioner every substantial

volume prospect mailing and almost every test prospect mailing in

1985 was a sweeps package.   Five of these 1985 sweeps prospect

mailings each lost more than $100,000; one lost $228,569.

     However, from mid-1986 to mid-1987, sweeps packages produced


     14
      (...continued)
commitment from another party to make matching contributions.

     In his letter dated Feb. 19, 1985, to petitioner’s executive
director, Watson complained that the projected $70,000 loss on
the Jan. 1985 poll package mailing (excluding at least another
$45,000 due W&H in fees) done at petitioner’ directors’ urging
was the largest single loss W&H ever experienced. He stated that
it was essential that what happened not occur again and formally
requested that once petitioner approved a mailing package that
petitioner be committed to the package’s use, unless it was
“obvious and conclusive” that the package’s continued use would
result in irrevocable harm to petitioner. His letter concluded,
in pertinent part, as follows:

          I’m sure you are disappointed in what has happened in
     regard to this Poll package mailing. But, I assure you, no
     one is as concerned as I am. I hope it has been a lesson
     for us all.

          I had the hope, and still have the dream, that UCC
     could be made financially strong within a relatively short
     time. And, I pray this setback doesn’t postpone that day
     too long into the future.

Copies of this letter to the executive director were also sent by
Watson to three of petitioner’s directors.
                                 - 56 -

the greatest percentages of responses to prospect mailings.

Also, contrary to the usual experience with prospect mailings,

some sweeps packages produced substantial profits.

     Although the sweeps packages were often profitable for

petitioner, they had their drawbacks.         Sweeps packages generally

worked on individuals who were primarily interested in playing

the contest, as opposed to being interested in supporting

petitioner.   In his memorandum dated July 9, 1986, to

petitioner’s executive director, Watson, in generally commenting

on petitioner’s direct mail campaign, made the following

observations about the sweeps package donors who contributed to

petitioner:

     UCC basically has two donor files--one being sweepstakes
     donors and the other being regular or straight donors.

     The Sweepstakes file makes up 80% of all donor names and the
     straight file has the balance of 20%.

     Although sweeps names have a higher conversion rate into
     second and third donations, the life span of these donors is
     less than straight donors.

     We are continuing to try to expand the straight file which
     is a true donor base and is the one that can be tapped for
     future major gifts. * * *

                     *   *   *     *      *    *   *

          In summary, it appears that the UCC direct mail
     fundraising program is healthy and shows signs of continued
     improvement. As the straight donor file expands, it should
     lend stability to the monthly income for UCC. The
     sweepstakes housefile mailings should continue to provide
     the buffer needed to provide the minimum revenues to help
     UCC make its monthly budgetary commitments.

In addition to the problem that Watson noted, some of the
                              - 57 -

sweepstakes contest mailings generated adverse publicity for

petitioner, because some individuals who received the mailings

believed the solicitations were misleading.   The adverse

publicity petitioner experienced in conducting its direct mail

campaign is discussed more fully infra.

     Although W&H attempted to convert some of petitioner’s

sweepstakes donors into straight donors by sending them non-

sweepstakes mailing packages, the conversion efforts were not

successful.   W&H concluded that the only way to obtain further

contributions from sweepstakes donors was to continue to send

them sweepstakes contest mailing packages.

     During 1985 through May 1989, sweepstakes contests mailings

were used heavily in petitioner’s direct mail fundraising

campaign.   Beginning in late 1987 or early 1988, petitioner

sharply reduced the numbers of sweepstakes contest prospect

letters it mailed, because petitioner realized the sweepstakes

contest prospect mailings were not helping petitioner to develop

a strong housefile.   In his letter dated January 28, 1988, to the

W&H executive who handled petitioner’s account on a daily basis,

petitioner’s executive director responded as follows to the W&H

executive’s prior argument that petitioner should not reduce the

level of its 1988 prospect mailings so greatly below the level of

the 1987 prospect mailings, because the 1987 prospect mailings,

the W&H executive claimed, had added 1 million new names to

petitioner’s housefile:
                                - 58 -

     Your reference to the 1 million names added in 1987
     housefile is interesting. Why were we continuing to
     mail to only 300+ thousand with housefile packages
     given this million “new” names? My opinion is that we
     both knew those names wouldn’t produce due to their
     acquisition from sweeps. And if they did work, their
     lifespan was a matter of weeks, not months. We wish to
     see greater cultivation of housefile names with new
     packages and straight packages. If we only get 180,000
     names or less, but they have been generated via quality
     straight packages, we will be better off than adding
     another 1 million sweeps players.

     In November 1988 petitioner stopped conducting prospect

mailings.     During 1984 through 1988, a total of 90 prospect

mailings were done in petitioner’s direct mail fundraising

campaign.     Of the 90 prospect mailings, 71 involved the use of

sweepstakes contest mailing packages.     The total number of

prospect letters mailed in petitioner’s mailing campaign was

51,771,026, of which 37,546,124 involved the use of sweepstakes

contests.15

     15
          So stipulated. The parties stipulated as an exhibit
W&H’s July 1, 1989, status report to petitioner. In that
exhibit, the listing of the 90 prospect mailings occupies three
pages. The stipulated number of letters is the total of the
prospect mailings listed on the first two pages of this portion
of the exhibit. The total for the prospect mailings listed on
all three pages is 57,758,533. Only 48 of the prospect mailings
are identified in the status report with the word “sweeps”; these
48 involve 32,671,489 letters. We cannot clearly identify which
23 of the 42 other prospect mailings are among the 71 stipulated
sweeps prospect mailings. Based on the descriptive terms used in
the status report, our best estimate is that the status report
shows that the 71 stipulated sweeps prospect mailings involved
about 41-43 million letters.

     Similarly, the parties have stipulated that the status
report shows 75 housefile mailings, of which 47 were sweeps
letters, and a total of 27,849,216 housefile mailings letters of
                                                   (continued...)
                               - 59 -

     As of May 19, 1989, near the end of the term of the

Contract, petitioner’s housefile contained a total of 2,084,019

donor names, of which 1,165,153 were “active names” and 918,866

were “inactive names”.16   As of May 8, 1989, petitioner’s

housefile contained 1,164,698 “active donor names”, which had

been produced from the sources indicated in table 9.

                              Table 9

                 Source                  Number of Names

          Sweepstakes Mailings                810,411

     15
      (...continued)
which 19,915,212 were sweeps letters. The stipulated status
report shows 75 housefile mailings, but a total of only
21,849,216 letters. The 47 sweeps housefile mailings that we
were able to identify involved 17,313,153 letters.

     It may be that the status report misidentified mailings
totaling about 6,000,000 names. Although the discrepancy between
the stipulation and the stipulated exhibit is substantial (more
than 10 percent of the total), it does not affect our ultimate
conclusions.
     16
          The parties stipulated to these numbers of “active
names” and “inactive names”. An invoice dated May 19, 1989, to
petitioner from Wiland, the computer company that maintained
petitioner’s housefile, reflects that Wiland had prepared a
computer tape of petitioner’s housefile that contained 1,165,153
“active names” and 918,866 “inactive names”. According to Dan
Wells, an employee of Wiland who testified at trial, “active
names” were the names that petitioner had mailed most recently.
Interestingly, Watson, during his testimony, estimated that
petitioner’s housefile, as of the May 30, 1989, date petitioner’s
contract with W&H ended, contained approximately 250,000 to
300,000 “active names” and another 1 million “inactive names”.
Watson, however, defined “active names” to be names which, at
that point, would produce a profit if mailed to, and “inactive
names” to be names which, at that point, would not produce a
profit if mailed to. He elaborated that the actual
categorization of a particular name as “active” or “inactive”
results from applying a complex statistical aging formula.
                             - 60 -

          Non-Sweepstakes Mailings             279,084
          Miscellaneous                         75,203

           Total                              1,164,698


F. Adverse Publicity

     As a result of its direct mail fundraising campaign and its

association with W&H, petitioner received adverse publicity.

This adverse publicity began in or about November 1984 and

persisted through the term of the Contract.

     In late 1984, some of petitioner’s directors and staff began

receiving complaints and inquiries about the direct mail

fundraising campaign petitioner was conducting.    Adverse

newspaper articles concerning petitioner had been published.   The

negative press came from all parts of the country to which

petitioner was mailing fund-raising letters.    The areas of

concern raised in the complaints or inquiries included (1) W&H’s

control of another cancer charity, AICR, (2) the mailing packages

petitioner employed, (3) the adverse impact of mailings done in

certain areas covered by petitioner’s member agencies, and (4)

whether petitioner was spending a sufficient portion of its

receipts for charitable purposes, as distinguished from spending

for fundraising and administration.

     At petitioner’s board of directors meeting on November 17,

1985, the board members viewed and discussed a videotape of an

unfavorable Dayton, Ohio, television news story about

petitioner’s direct-mail fundraising.   The news story focussed on
                               - 61 -

petitioner’s asserted high-pressure fundraising tactics and

sweepstakes contests.

     Petitioner’s directors were divided concerning the course of

action petitioner should pursue as a result of the above adverse

publicity petitioner experienced.    Some directors wanted

petitioner to discontinue its direct mail fundraising campaign

entirely.   However, a majority of the directors decided that

petitioner’s direct mail fundraising campaign should be continued

and that the adverse publicity was a problem which could be

managed.    Financial considerations were a controlling factor in

the majority’s decision to continue the direct mail campaign.

The fundraising arrangement with W&H accounted for substantially

all of petitioner’s operating funds.    Additionally, at this time,

petitioner was fully liable on a recourse basis to W&H for the

excess draws petitioner had obtained from the Escrow Account.

Although petitioner had tried, at various times, to develop other

sources of funds, these efforts were not successful and

petitioner remained heavily financially dependent on its direct

mail fundraising campaign revenues throughout the term of the

Contract.

     In early 1987, NCIB issued a report on petitioner that,

among other things, concluded petitioner’s fundraising expenses

for 1985 equaled about 97.7 percent of the related contributions
                                - 62 -

petitioner received.17    The NCIB report resulted in further

adverse publicity for petitioner.

        In or about September 1986, petitioner began using a

sweepstakes prospect mailing package known as the Instant Cash

package.     The Instant Cash package mailings were highly

profitable for petitioner--especially unusual for prospect

mailings.     However, petitioner’s use of this sweeps package

resulted in adverse publicity for petitioner.     After receiving

complaints from contributors who received the Instant Cash

Package,18 petitioner stopped using the package by about June

1987.

     At petitioner’s board of directors meeting on June 13, 1987,

its executive director proposed that petitioner establish a

cancer patient assistance fund which it would fund with $2,000

per month.     In discussing the proposed patient assistance fund,

        17
          As is discussed infra, table 10 and the text following,
NCIB did not accept petitioner’s allocation of a portion of its
direct mail campaign expenses to public education.
        18
          Recipients of the package were informed that they were
winners in a contest with a prize of $5,000, if they would enter
the contest. As applicable State laws generally prescribed that
the recipients of such sweepstakes contest solicitations be
allowed to enter the contest without making a contribution, they
were also asked, but not required, to make a contribution to
petitioner. Although the solicitation letter also indicated that
the actual amount won by a recipient would be decided in a later
drawing, the individuals who complained to petitioner believed
the package was deceptive. In actuality, the $5,000 prize money
awarded in the contest would be split evenly among all the
contestants who entered the contest, and these contestants
typically received about $.09. In some instances, petitioner
refunded the contributions it received from the complainants.
                              - 63 -

petitioner’s executive director stated that the direct mail

campaign is a form of public relations, some viewing it as a

negative form, but with a cancer patient assistance fund in place

it could be turned around to a positive form in the future.

     In April 1988, petitioner retained a consultant to assist

petitioner in soliciting donations and grants from corporations

and foundations.   The consultant reported to petitioner on the

May 6, 1988, meeting that took place between the consultant and

an executive with the Lilly Endowment, a large foundation in

Indianapolis.

     The consultant advised that the Lilly Endowment’s

executive’s unfavorable reaction to petitioner during the meeting

indicated that petitioner’s continuance of its fundraising

contract with W&H would jeopardize petitioner’s efforts to obtain

funding from corporations and foundations.   The consultant

advised that “It is doubtful that Lilly will ever fund UCC * * *.

Perhaps a case could be built three or four years after the

termination of the direct mail consultant contract.”

     The consultant’s report was given to petitioner’s

Administrative Fundraising Committee, and mentioned by this

committee in its May 11, 1988, report to petitioner’s Executive

Committee.

     Several of petitioner’s affiliate member agencies withdrew

from petitioner as a result of the adverse publicity petitioner

experienced.
                              - 64 -

     In addition, investigative inquiries with respect to

petitioner’s direct-mail fundraising activities were begun by

various State attorneys general, including the attorneys general

for Alabama, Illinois, Maryland, Massachusetts, New York, and

Pennsylvania.   Later, lawsuits were begun by some of the State

attorneys general, including the attorneys general for New York

and Pennsylvania.

G. Petitioner’s Escrow Account-Related Problems

     1. Draws and Petitioner’s Dispute With W&H Over the
Calculation of Cumulative Net Mailing Campaign Revenue

      Pursuant to its draw arrangement with W&H, petitioner

received monthly draws from the Escrow Account maintained by WIB.

See supra table 6 & preceding text.    In late 1984 these draws

were $5,000 per month.   W&H exercised final authority with

respect to approving and directing WIB to release the funds

petitioner sought.   Even though the Escrow Account was in

petitioner’s name and WIB considered that the funds in the Escrow

Account belonged to petitioner, WIB paid money out of the Escrow

Account only in response to check requests submitted by W&H.

This was so whether the payments were (1) to vendors in

connection with petitioner’s fundraising activities (in which

events WIB also required the vendors’ invoices), (2) to W&H, or

(3) directly to petitioner.

     Petitioner could not have obtained immediate possession of

the funds that WIB held in the Escrow Account by unilaterally
                              - 65 -

revoking the Escrow Agreement between petitioner, WIB, and W&H.

If a dispute between petitioner and W&H had arisen with respect

to the disposition of the funds held in the Escrow Account, then

WIB would have frozen the account.

     At petitioner’s executive committee meeting on July 19,

1986, the committee members directed petitioner’s staff to ask

W&H to increase petitioner’s monthly draw from $40,000 to

$64,000, beginning August 1, 1986.     During the meeting,

petitioner’s executive director expressed his reservations about

petitioner’s increasing the amount of its monthly draws, unless

W&H provided written assurance that petitioner would not have to

repay the excess draws it received.     However, the executive

committee member who proposed that petitioner should seek to

increase its monthly draw, responded that he wanted to have those

funds in UCC’s control and accounts despite the possible future

need to repay W&H.   This member’s proposal was further supported

by another of the committee members.

     At petitioner’s executive committee meeting held on

September 25, 1986, a W&H executive who attended a part of the

meeting advised the committee members that W&H was of the opinion

that petitioner should not increase its monthly draw beyond the

then-current $40,000, because of a decrease in petitioner’s

housefile mailing income.   W&H suggested that petitioner wait

until January 1987 before increasing its monthly draw to $50,000.

Petitioner’s monthly draw was increased to $50,000 beginning in
                              - 66 -

January 1987, and was again increased, to $60,000, beginning in

January 1988.

     In his letter dated November 4, 1988, to Watson,

petitioner’s executive director advised Watson that there was a

substantial discrepancy between W&H’s calculation of petitioner’s

Escrow Account balance and what petitioner calculated its Escrow

Account balance to be.   The executive director asked that W&H

authorize transfer from the Escrow Account of the entire

remaining $90,000 of petitioner’s draws for 1988.

     In his letter dated November 23, 1988, to Watson,

petitioner’s executive director acknowledged petitioner’s receipt

of its mid-November, semimonthly draw of $30,000 from the Escrow

Account, and stated that he assumed petitioner would be receiving

its draws for 1988 as originally scheduled, rather than in the

lump sum he had asked for in his November 4, 1988, letter.   He

further asked that W&H immediately transfer to petitioner half of

the proposed $300,000 it would draw from the Escrow Account for

the period January through May 1989.

     In his letter dated December 28, 1988, to Watson,

petitioner’s executive director advised that petitioner’s

Executive Committee had decided petitioner should stop receiving

monthly draws of $60,000 from the Escrow Account, and instead

receive 50 percent of the housefile mailing income, based on

petitioner’s calculation of the net housefile mailing income.

Petitioner’s executive director stated that these transfers are
                              - 67 -

to be made within 10 working days of petitioner’s calculations.

     In her letter dated February 15, 1989, to Watson,

petitioner’s chief financial officer enclosed a copy of

petitioner’s tentative calculation reflecting, as of January

1989, a $92,358.03 positive balance of cumulative net income from

the direct mail campaign.   As petitioner had not received all

invoices of mailing expenses in connection with the January 1989

mailings, petitioner’s chief financial officer asked that

petitioner be paid $75,000, which would leave another $17,000 to

cover any additional mailing expenses.    Her letter stated that if

W&H had any questions regarding any of this, petitioner should be

contacted, otherwise petitioner would expect to receive its

requested check for $75,000 no later than February 21, 1989.

     In her letter dated May 9, 1989, to a W&H executive,

petitioner’s chief financial officer noted that there was a

substantial discrepancy between petitioner’s and W&H’s respective

computations of cumulative housefile net income, as of December

31, 1988.   Petitioner’s chief financial officer stressed that

petitioner’s figures were audited.     Petitioner computed that, as

of December 31, 1988, its cumulative housefile income was

$1,930,909, its cumulative transfers from the Escrow Account

amounted to $2,078,200, and there was a resulting deficit of

$147,291. In contrast, W&H computed that the cumulative transfers

were only $1,973,000, but there was a deficit of $540,711. W&H

prepared a status report dated July 1, 1989, in which it took the
                               - 68 -

position that, as of April 30, 1989, the cumulative transfers had

grown to $2,213,000 and the deficit had risen to $687,712.

     In order to wind up the fundraising arrangement between

petitioner and W&H, the Escrow Account was kept open until at

least September 30, 1989, as petitioner’s last housefile mailing

under the Contract was sent out in early May of 1989.     Petitioner

expected that W&H would render a final accounting to it on

September 30, 1989.   However, no final accounting was ever made

or agreed to by petitioner and W&H.

     Petitioner’s position is that all debts incurred for

prospect mailings had been paid for by the revenues produced from

the mailing campaign, and that petitioner did not owe any money

to W&H.

     2. W&H’s Purchase and Invoice Control Procedures

     Similar to the authority it exercised with respect to the

funds petitioner sought from the Escrow Account, up until about

1987, W&H generally exercised final authority with respect to

approving and directing WIB to release funds to pay the direct

mail campaign’s expenses.   As indicated above in discussing the

Escrow Agreement, the sole exceptions to W&H’s authority

concerned WIB’s transfer of Escrow Account funds to pay “Business

Reply” postage and invoices for WIB’s own services.     Beginning

about 1987, W&H generally obtained petitioner’s approval with

respect to the payment of certain vendor invoices, before issuing

payment instructions to WIB.
                              - 69 -

     During 1984 through 1989, W&H generally furnished WIB with

copies of all vendor invoices along with check requests and

payment instructions.   WIB relied on W&H to tell WIB that

petitioner had approved the check requests.   When WIB paid an

invoice, it promptly sent to petitioner a copy of the invoice,

the check request, and payment information.   Any time that

petitioner called WIB to ask questions about an invoice, WIB

referred petitioner to W&H, because WIB did not review the

correctness or appropriateness of the invoices to petitioner.

Petitioner never asked WIB not to pay a vendor invoice.   However,

on at least one occasion W&H authorized a payment without

petitioner’s approval; W&H finally agreed that it would pay that

bill.

     In a memorandum dated October 15, 1985, Watson addressed and

discussed a number of matters raised during an October 8, 1985,

meeting between himself, two of petitioner’s directors, and

petitioner’s executive director.   Among the matters dealt with in

the memorandum are W&H’s procedures with respect to its issuance

of purchase orders, processing of invoices, and issuance of check

requests to WIB to pay invoices.   W&H’s asserted practice was to

send to petitioner copies of purchase orders for all goods or

work contracted by W&H.   After completion of the work or delivery

of the goods and W&H’s receipt of an invoice from the vendor, the

W&H account executive reviewed the invoice for accuracy and

returned it to W&H’s accounting department.   A check request was
                               - 70 -

then prepared and sent to WIB, and a copy of that check request

was also sent to petitioner.    In his memorandum, Watson stated

that “Should UCC wish to raise a question concerning any bill,

all they need to do is pick up the telephone and call the escrow

agent [WIB] and request that payment be held up until UCC is

satisfied.”

     In his October 15, 1985, memorandum Watson also responded to

petitioner’s concern that W&H, as required by the Contract, make

reasonable efforts to solicit competitive bids from vendors,

where time and market conditions permitted.     Watson explained

that W&H’s executives, in soliciting bids, prepared

specifications for the various goods and services needed on a

standardized 7-part purchase order form.     The executives then

contacted prospective vendors, advised them of the specifications

for the goods and services sought, and requested bids.     The bids

submitted typically were given to the executives over the

telephone, rather than in writing.      However, the W&H executives

who received these bids recorded the bid, the name of the company

making it, and the date the bid was submitted, on the last page

of the purchase order.   Watson maintained that requiring W&H to

obtain written bids, as petitioner wanted, would be too

cumbersome a procedure and might deter prospective bidders from

submitting bids.    If petitioner wanted to audit a bid, Watson

suggested, then petitioner could contact various vendors and ask

them for their internal documentation on the bids they had

submitted to W&H.
                             - 71 -

     Among the concerns raised by petitioner’s certified public

accounting firm in its later management letter dated May 23,

1986, to petitioner’s board of directors and executive committee,

are the following:

     2. W&H Responsibility for Documentation.

     It is our understanding that certain procedures in the areas
     of purchasing and cash disbursements are executed by W&H
     personnel. We performed a limited test of such procedures
     and have the following observations:

     a.   We could not locate a check request for each cash
          disbursement. It was our understanding that at the
          very minimum, each check issued is to have a
          corresponding check request identified with it. The
          check request is the only document which indicates W&H
          approval of the cash disbursement.

     b.   During our testing, there were several instances where
          we could not locate the invoice(s) associated with
          specific checks. We recommend that Council personnel
          perform a timely limited review of all cash
          disbursements to insure that the proper supporting
          documentation exists. One area that needs special
          attention is postage. Although invoices are not issued
          for postage disbursements, receipts are given to W&H
          upon payment. We strongly recommend that the Council
          request that the original postage receipt be sent to
          the Council and if W&H requires the receipts for their
          files, they could retain a copy of the receipt.
          Although our testing did not indicate that any of the
          checks written for postage were used for items other
          than postage, the receipts would provide verification
          of these substantial expenditures. [See supra table 7,
          which shows that postage and shipping was petitioner’s
          largest category of expenses for 1985, 1986, 1987, and
          1988.]

     c.   W&H appears to be decidedly lacking in its adherence to
          the stated procedures regarding obtaining competitive
          bids on behalf of the Council. A number of the goods
          and services are paid for on a contractual basis so
          that the main items subject to purchase using
          competitive bids are printing and mailhouse costs. Of
          the items we examined on a test basis which should have
          been subject to competitive bids, we could find
          documentation that bids had been obtained only
                                 - 72 -

          approximately 50% of the time. It is possible that
          bids were obtained over the phone, but not documented.
          In some instances, the documentation we reviewed stated
          that a bid could not be obtained due to time
          constraints. We do not understand how this could occur
          as the mailing schedule is determined months in
          advance. Another possibility which exists is that
          competitive bids are not obtained but documentation is
          provided that states bids were obtained to pacify
          council personnel requesting adherence to the stated
          procedures regarding obtaining bids. True compliance
          testing of the procedures can only be achieved through
          independent verification with the vendors involved.

     3.   Lack of Timely Information.

          The final major item we would like to discuss concerns
          the lack of adequate, timely financial information
          summarizing the activities of the direct mail campaign.
          It is our understanding that management decisions are
          often based on financial information obtained from
          reports generated by W&H and the modified cash-basis
          monthly financial statements prepared by the Council’s
          accountant. This could be a dangerous course. We have
          made two attempts to reconcile financial information in
          the W&H reports to the Council’s financial records and
          have been unable to do so. We were then informed by
          * * * Watson that these reports were not complete,
          contain several estimates, and would probably not agree
          with the Council’s books. Therefore, we strongly
          recommend that the Board not rely quite so heavily on
          the reports generated by W&H. The best course of
          action would be for Council personnel to prepare the
          monthly financial statements in the same manner as they
          have been prepared at December 31, 1985. However,
          given current circumstances, it would be impossible to
          do this on a timely basis. One problem is that W&H can
          take up to four months to record an invoice in accounts
          payable, particularly W&H’s own invoices. With that
          kind of time lag, the Council cannot determine the true
          accounts payable at month-end until four months later.
          * * *

     Petitioner’s concern about W&H’s use of reasonable efforts

to obtain competitive bids from vendors continued throughout the

term of the Contract.   During 1986 and 1987, petitioner further

discussed with W&H petitioner’s desire to exercise more control
                              - 73 -

over the payment of its direct mail campaign expenses.    However,

petitioner’s efforts to obtain full control over disbursements

from the Escrow Account ultimately were unsuccessful.

     In his letter dated July 31, 1986, to Watson, petitioner’s

executive director confirmed that he and petitioner’s chief

financial officer would be attending a meeting at W&H’s offices

on August 12, 1986.   As part of the agenda for their meeting, the

executive director enclosed for Watson a list of petitioner’s

“staff concerns”.   Among the listed staff concerns, was one which

stated that the “EXECUTIVE COMMITTEE MOVED TO BRING ALL

ACCOUNTING FUNCTIONS IN-HOUSE EFFECTIVE JANUARY 1, 1987.

Approval of all invoices and check requests shall come from the

UCC Headquarters, as well as the actual writing and

reconciliation procedures.”

     In his letter dated August 21, 1986, to Watson, petitioner’s

executive director stated his understanding that, at the August

12, 1986, meeting with Watson, “It was agreed that when UCC

demonstrates the capability of assuming escrow authority and the

escrow account debt level is significantly reduced, then UCC will

become the escrow agent.”

     In her letter dated January 14, 1987, to petitioner’s chief

financial officer, preparatory to a meeting scheduled for January

28, 1987, a W&H executive stated as follows concerning

petitioner’s previously expressed desire to take over management

of disbursements from the Escrow Account, beginning in early

1987:
                               - 74 -

          Concerning moving the Escrow Account Payable management
     to the [petitioner’s] Carmel office early in 1987, you are
     probably referring to the discussion we had concerning this
     matter during the last visit by you and * * * [petitioner’s
     executive director] to our offices in Alexandria. At that
     time, we mentioned that only one of W&H’s clients handles
     this function in that way. That organization maintains a
     surplus cash balance in their accounts in excess of $2
     million and a positive fund balance of over $400,000. It is
     our policy that once a client is able to develop a positive
     fund balance or the outstanding deficit can otherwise be
     reduced to a reasonable level, we would be supportive of
     such a move as we have been in the past.

          Frankly, with nearly $500,000 in outstanding postage
     loans to UCC on the books as of last week, it makes us
     somewhat nervous to hear mention of this again for the
     reasons outlined in your letter. Certainly those areas that
     were brought up can easily be overcome. If, on the other
     hand, there has been any serious discussion within your
     organization which is outside the scope of what we have
     already stated, I would appreciate your advising me so that
     we can review this with * * * [Watson] and * * * [the W&H
     executive who handled petitioner’s account on a daily
     basis].

     In her letter dated January 30, 1987, to Watson,

petitioner’s chief financial officer discussed her understanding,

from her meeting and discussions with Watson and two W&H

executives on January 28, 1987, of some actions W&H would take to

address petitioner’s concerns with respect to the conduct of its

direct mail campaign and the accounting for and disbursement of

funds to pay the mailing campaign expenses.     Among these actions

to be taken by W&H, the letter states that Watson “will write an

addendum to the   * * *   [Escrow Agreement] which would allow   the

Council to approve invoices paid by the Escrow Agent [WIB]. The

Council would be able to provide written requests for payment of

invoices without the approval of    * * *   [W&H].”   With respect to
                              - 75 -

petitioner’s desire to control the funds held in the Escrow

Account, the chief financial officer’s letter states as follows:

     11. Again, the Council desires to obtain control of
     Accounts Payable through a separate bank account which
     would be funded by the current Escrow Account. Our
     reason is the lack of control we currently have over
     Escrow Account Funds. While I appreciate * * * [the
     W&H executive who handled petitioner’s account on a
     daily basis’] wish to shield us from the aggrevations
     [sic] associated with Accounts Payable, I feel the
     Council is quite capable of shouldering the
     responsibility. If the other changes requested
     previously in this letter occur within the next few
     months, we will be willing to delay the transfer for a
     period of time. Ultimately, the Council wants to
     control all of its accounts.

     In her letter dated March 10, 1987, to a W&H executive,

petitioner’s chief financial officer objected that the January

31, 1987, listing of accounts payable submitted by W&H that were

to be paid, contained invoices previously disapproved by

petitioner.   Petitioner’s chief financial officer complained that

it appeared to her that W&H intended to circumvent the invoice

approval procedure that had been established.   Her letter further

stated as follows:

     This scenario only emphasizes the lack of control the
     Council [petitioner] exerts over its own funds. * * *
     [W&H] previously has expressed that the Council is incapable
     of managing the Escrow Account, yet the recent activity has
     been unacceptable to us and goes against standard accounting
     principles. Just as * * * [W&H] insists on administering
     the Council’s Accounts Payable, so will we insist that
     standard accounting policy be followed, which includes
     maintaining vendor correspondence and reviewing invoice
     costs.

     The proposed addendum to the Escrow Agreement discussed in

petitioner’s financial officer’s above letter dated January 30,
                             - 76 -

1987, to Watson, was never executed by petitioner, W&H, and WIB.

In his letter dated June 1, 1987, to petitioner’s executive

director, Watson offered to revise the Escrow Agreement to

provide that petitioner would have the right to approve the

payment of all invoices, if petitioner agreed to an early renewal

of the Contract and entered the proposed new fundraising contract

he enclosed.

     Petitioner eventually abandoned its efforts to obtain full

control over disbursements from the Escrow Account.   In his

letter dated June 16, 1988, to petitioner’s certified public

accounting firm, petitioner’s executive director stated as

follows:

     The Council [petitioner] chose not to bring all of the
     record keeping for accounts payable and cash
     disbursements in-house. W&H insisted that it would no
     longer be responsible for the prospecting debt if such
     action were taken. Mr. Watson explained that he did
     not want his firm to be responsible for the debt, in
     the event that the Council spent all of the proceeds of
     the campaign on programs and did not pay the fund
     raising expenses. Although we all agree that it would
     be considerably easier and more efficient for the
     Council to exercise direct control of the record
     keeping, the decision was made not to jeopardize the
     Council’s financial health by incurring a large
     prospecting debt.

     We hope these explanations help you understand the
     Council’s position and actions during the past year.

H. Petitioner’s Attempt To Obtain A Copy Of Its Housefile

     In July 1988, petitioner asked Wiland, the computer services

company that maintained petitioner’s housefile, to provide to

petitioner a complete computer tape of its housefile, as of June
                               - 77 -

30, 1988.    Petitioner stated that it would pay for the file.

Petitioner’s stated reason was that, “At the urging of our legal

counsel,” it wanted to have a copy of the housefile “to maintain

a ‘file copy’ * * * in the event some disaster strikes Wiland”.

Watson responded that Wiland has a file copy in the vault of a

bank in Fredericksburg, Va., and the safety procedures are

standard in the industry.    Watson also pointed to the Contract

provision that “‘any computer work client desires to have done

with any names developed as a result of this contract with W&H

must be done at W&H or at a company designated by W&H during the

term of the agreement’”.

     In September 1988, Watson told petitioner that petitioner

would receive a copy of its housefile after the Contract ended,

in May 1989.

     Petitioner’s general counsel, James W. Curtis (hereinafter

sometimes referred to as Curtis), tried to get for petitioner a

copy of its housefile.   Curtis was not successful in persuading

W&H to provide to petitioner a copy of its housefile.    On January

19, 1989, Curtis formally notified Watson that petitioner was

invoking the arbitration provisions of the Contract and was going

to begin an arbitration action in order to obtain the copy of its

housefile.   After an unsatisfactory response from W&H’s counsel,

on February 3, 1989, Curtis authorized another attorney to

prepare an arbitration petition for filing on petitioner’s

behalf.   On February 9, 1989, Curtis spoke with Watson by
                              - 78 -

telephone, concluded that Watson appeared to be cooperative, and

instructed the other attorney “to put the arbitration matter on

hold”.   On February 16, 1989, Curtis followed up the February 9

telephone call, asked for the housefile tape and certain other

material needed to understand and use the housefile tape, and

assured that petitioner would respect W&H’s right to designate

the company that would do any computer work with the housefile

during the term of the Contract.   On February 24, 1989, W&H

responded that it would direct Wiland to provide to petitioner a

sample tape containing donor information on 10,000 names from

petitioner’s housefile, together with the other material that

Curtis had asked for that was needed to understand and use the

housefile sample tape.   W&H also agreed that “as soon as the

entire housefile is needed by whoever ends up working on it, we

can request that it be sent to them by Wiland.”

     On February 27, 1989, W&H advised Wiland that petitioner

would transfer its housefile to another computer company after

the Contract ended in May 1989.    W&H instructed Wiland to prepare

a sample tape containing donor information on 10,000 contributors

from petitioner’s housefile and to provide certain other

information about the housefile that would be useful to any other

company in deciding whether to become petitioner’s computer

house.

     Petitioner’s and W&H’s Respective Accounting Treatments
        of the Direct Mail Campaign’s Revenue And Expenses

     On its financial statement and Form 990 for 1984, petitioner
                              - 79 -

failed to treat the direct mail campaign’s expenses that exceeded

the direct mail campaign’s gross revenue as being its expenses.

     In his letter dated December 20, 1985, to petitioner’s

executive director, Watson advised that petitioner’s accounting

treatment of the direct mail campaign’s 1984 expenses was

incorrect.   Watson’s December 20, 1985, letter stated, in

pertinent part, as follows:

     The proper way to account for all your funds and
     expenses is to account for all of the income generated
     from UCC mailings as UCC income and all of the expenses
     related to all of the mailings must be recorded as UCC
     expenses. If * * * [W&H], through its direct mail
     assistance, raises $1,000,000 for UCC and spends
     $900,000 doing it, then the financial statements must
     reflect a gross income of $1,000,000 and $900,000 in
     expenses. * * * If your accountants are overly
     concerned about the * * * [Contract], I would recommend
     that they list the contract as a contractual obligation
     in the footnotes to the financial statement. And, they
     may want to even indicate that * * * [W&H] is
     potentially liable for any losses incurred in the
     fundraising efforts. But most importantly, and I have
     said this over and over again, * * * [W&H] is not the
     keeper of UCC funds. * * * [W&H] does not dole out net
     proceeds of fundraising campaigns to UCC.

     On its 1985 through 1989 financial statements and Forms 990,

petitioner treated all of the direct mail campaign’s revenue and

expenses as its revenue and expenses.

     On its partnership returns, W&H included in “cost of goods

sold” the postage advances it made and included in income the

subsequent reimbursements it received for these advances.
                                 - 80 -

     Petitioner’s Allocation of Expenses Between Fundraising
                       and Public Education

     On its financial statements for 1985 through 1988,

petitioner concluded that substantially all of its direct mail

campaign expenses were “joint expenses” allocable to public

education and fundraising.      Its 1985 through 1988 financial

statements reflected that petitioner received total annual

contributions, and incurred joint expenses that it allocated to

public education and fundraising, as shown in table 10.

                                Table 10

                      1985          1986         1987          1988

Contributions      $5,087,453    $7,869,015   $10,740,045   $3,883,352

Joint Expenses--
  Education         2,301,260     3,843,907     4,306,377   1,463,432
  Fundraising       2,647,470     3,390,012     5,399,344   1,693,333

     Petitioner’s certified public accounting firm advised it of

certain factors to be considered in allocating its direct mail

campaign expenses between public education and fundraising.       The

Accounting Standards Division of the American Institute of

Certified Public Accountants issued two Statements of Position

(hereinafter sometimes referred to as SOP), SOP 78-10 and SOP 87-

2, concerning the appropriateness of allocating fundraising

appeal expenses to a charitable organization’s exempt purpose

function.   SOP 87-219 amended the earlier-issued SOP 78-10,


     19
            SOP 87-2, states in pertinent part, as follows:
                                                     (continued...)
                               - 81 -

primarily by providing additional matters to be considered, and

had an effective date which made it applicable to petitioner’s

1988 financial statement.20   As petitioner’s chief financial

officer interpreted SOP 87-2, if the considerations set forth in

that SOP were applied--

     to 1986 or 1987, we would have to show all expenses of the
     Donor Development Fund as fund raising. This means that 96%


     19
          (...continued)

          15. All joint costs of informational materials or
     activities that include a fund-raising appeal should be
     reported as fund-raising expense if it cannot be
     demonstrated that a program or management and general
     function has been conducted in conjunction with the
     appeal for funds. However, if it can be demonstrated
     that a bona fide program or management and general
     function has been conducted in conjunction with the
     appeal for funds, joint costs should be allocated
     between fund-raising and the appropriate program or
     management and general function.

          16. Demonstrating that a bona fide program or
     management and general function has been conducted in
     conjunction with an appeal for funds requires
     verifiable indications of the reasons for conducting
     the activity. Such indications include the content of
     the non-fund-raising portion of the activity; the
     audience targeted; the action, if any, requested of the
     recipients; and other corroborating evidence, such as
     written instructions to parties outside the
     organization who produce the activity, or documentation
     in minutes of the organization’s board of the
     organization’s reasons for the activity.

     20
          SOP 78-10 and SOP 87-2 address only whether allocation
of a charitable organization’s fundraising appeal expenses is
appropriate. SOP 87-2 states that “this statement of position
does not address the issue of how to allocate joint costs. A
number of cost accounting techniques are available for that
purpose.”
                              - 82 -

     of our total expenses (General Fund and Donor Development
     Fund), would be allocated to Supporting Services.
     Obviously, we cannot afford such a devastating report at the
     end of 1988, and must correct any deficiencies in the direct
     mail program immediately.

     During 1984 through 1989, petitioner was well aware of the

guidelines CBBB and NCIB established for members of the general

public to use in evaluating charitable organizations that

solicited contributions.   Petitioner planned and endeavored to

meet eventually all of the CBBB and NCIB guidelines, as

petitioner believed that doing so would enable it to gain more

support from corporations, foundations, and the general public.

     Although petitioner, during 1984 through 1989, was never

able to meet all of the CBBB and NCIB guidelines, petitioner

concluded that it was in its interest to allocate as much of the

direct mail campaign’s expenses to public education as possible.

All of the mailing packages petitioner utilized during 1984

through 1989 contained some educational material.   A list of the

“Nine Warning Signals of Cancer” was included with almost all the

housefile and prospect letters petitioner mailed.   As its mailing

campaign progressed, petitioner tried to increase the educational

content of its mailings.

     Petitioner’s 1986 financial statements, published as part of

petitioner’s Annual Report for 1986, contain the following

explanation of petitioner’s allocations of its 1985 and 1986

mailing campaign “joint expenses” between public education and

fundraising:
                             - 83 -

     NOTE 4--ALLOCATION OF JOINT COSTS OF MAILINGS:

     Expenses related to both * * * [prospect mailings and
     housefile mailings] are allocated to public education
     and fundraising based on the relative content and
     intent of all mailings. The content of each and every
     mailing is evaluated to determine what percentage of
     the mailing satisfies the goal of educating the public
     and what percentage of the mailing deals with
     fundraising. Public education includes any information
     about cancer, its treatment and cures as well as
     discussion of the Council’s [petitioner’s] programs in
     research and cancer patient services. Fundraising
     includes direct requests for money as well as emotional
     appeals intended to solicit funds. The relative
     content of individual * * * [prospect mailings and
     housefile mailings] are summarized and a composite
     percentage is determined which is then applied to total
     costs. Since the goals of the direct mail campaign are
     to educate the public and to raise funds, none of the
     costs directly associated with the mailings are
     allocated to management and general [expenses?].

Petitioner’s 1988 financial statement, published as part of

petitioner’s Annual Report for 1988, contain the following

explanation of petitioner’s allocations of its 1987 and 1988

mailing campaign “joint expenses” between public education and

fundraising:

     NOTE 5--ALLOCATION OF JOINT COSTS OF MAILINGS:

     In 1988, the Council [petitioner] incurred joint costs
     of $3,156,765 for informational materials and
     activities that included fundraising appeals. These
     joint costs are expenses related to both * * *
     [prospect mailings and housefile mailings] and have
     been allocated as follows: $1,463,432 to public
     education and $1,693,333 to fundraising. In allocating
     the joint costs between public education and
     fundraising, the Counsel evaluates the content or
     message of the mailing and the intended audience. If
     the content is information about cancer, its
     treatments, cures and prevention and requests for the
     reader to take some action other than sending a
     contribution, then the public education function has
                             - 84 -

     been fulfilled. An audience selected because of its
     interest in cancer and other health related issues also
     indicates the reason for the mailing is public
     education. Conversely, if the message is a direct
     appeal for funds and sent to individuals based on their
     ability to contribute money, then the fundraising
     function has been fulfilled. All circumstances
     surrounding a mailing with regard to content and
     audience are examined together to arrive at the joint
     allocation of costs for each mailing between public
     education and fundraising.

     In 1987, the Council incurred joint costs of $9,705,721
     for informational materials and activities that
     included fundraising appeals. Of those costs,
     $4,306,377 was allocated to public education and
     $5,399,344 was allocated to fundraising. Expenses
     related to both * * * [prospect mailings and housefile
     mailings] were allocated to public education and
     fundraising based on the relative content and intent of
     each mailing without regard to intended audience.

     NCIB did not accept petitioner’s allocations of its 1985,

1986, and 1987 mailing campaign expenses to public education.     In

preparing its reports on various charitable organizations, NCIB

generally accepted the financial information contained in a

charitable organization’s financial statements, except for the

charitable organization’s allocation of its fundraising appeal

expenses to exempt purpose activity.   While aware of SOP 78-10

and SOP 87-2, NCIB examined the reasonableness of the allocations

made by the charitable organization.   For example, as indicated

above, in a report it issued on petitioner, NCIB concluded that

petitioner’s fundraising expenses for 1985 equaled about 97.7

percent of the related contributions petitioner received.

     With respect to petitioner’s 1988 mailing campaign “joint

expenses”, petitioner’s certified public accounting firm
                               - 85 -

experienced considerable difficulty in applying SOP 87-2 and was

unable to conclude what portion of the 1988 direct mail campaign

expenses qualified as joint expenses.   The accounting firm

essentially let petitioner itself decide how to categorize and

allocate the expenses.



     The compensation that W&H received under the Contract by way

of direct payment by petitioner and by way of the value of W&H’s

use of the names generated by petitioner’s fundraising efforts,

exceeded reasonable compensation.

     Respondent’s revocation of petitioner’s favorable letter

ruling retroactively to the start of the Contract was not an

abuse of discretion.

                              OPINION

           I. Status Under Secs. 501(c)(3) and 170(c)(2)

     Section 501(a) provides that “An organization described in

subsection (c) * * * shall be exempt from taxation under this

subtitle”.21

     In order to be described in section 501(c)(3),22 an


     21
          Exceptions from this broad rule because of secs. 502
(relating to feeder organization), 503 (relating to prohibited
transactions by certain categories of transactions), 501(b)
(relating to unrelated business income), and various other
provisions of the Code do not appear to be issues in the instant
case.
     22
          Sec. 501(c)(3) provides, in pertinent part, as follows:

                                                    (continued...)
                               - 86 -

organization must meet all of the following criteria:   (1) it

must be both (a) organized and (b) operated, exclusively23 for

certain specified exempt purposes, including charitable,

educational, and scientific purposes; (2) no part of its net

earnings may inure to the benefit of any private shareholder or



     22
      (...continued)
     SEC. 501. EXEMPTION FROM TAX ON CORPORATIONS, CERTAIN
     TRUSTS, ETC.

                   *   *   *    *   *   *   *

          (c) List Of Exempt Organizations.--The following
     organizations are referred to in subsection (a):

                   *   *   *    *   *   *   *

               (3) Corporations * * * organized and operated
          exclusively for * * * charitable, scientific, * * * or
          educational purposes * * *, no part of the net earnings
          of which inures to the benefit of any private
          shareholder or individual, no substantial part of the
          activities of which is carrying on propaganda, or
          otherwise attempting, to influence legislation, * * *
          and which does not participate in, or intervene in
          (including the publishing or distribution of
          statements), any political campaign on behalf of (or in
          opposition to) any candidate for public office.

The text includes an amendment made by sec. 10711(a)(2) of the
Omnibus Budget Reconciliation Act of 1987 (OBRA 87), Pub. L. 100-
203, 101 Stat. 1330, 1330-464. This amendment applies to
activities after Dec. 22, 1987, the date of the enactment of the
Act. This amendment relates only to political campaigns, and so
does not affect the instant case.
     23
          “Exclusively”, in this context, means that there is no
nonexempt purpose that is “substantial in nature”. Better
Business Bureau v. United States, 326 U.S. 279, 283 (1945);
Living Faith, Inc. v. Commissioner, 950 F.2d 365, 370 (7th Cir.
1991), affg. T.C. Memo. 1990-484; Stevens Bros. Foundation, Inc.
v. Commissioner, 324 F.2d 633, 638 (8th Cir. 1963), affg. on this
issue 39 T.C. 93, 109 n.10 (1962).
                                  - 87 -

individual; (3) no substantial part of its activities may consist

of lobbying efforts; (4) no part of its activities may constitute

intervention or participation in any political campaign on behalf

of, or in opposition to, any candidate for public office (sec.

501(c)(3)); and (5) its purpose must not be “contrary to a

fundamental public policy”.       Bob Jones University v. United

States, 461 U.S. 574, 592 (1983).       See generally, American

Campaign Academy v. Commissioner, 92 T.C. 1053, 1062-1063 (1989).

These requirements are stated in the conjunctive.        Petitioner’s

failure to satisfy any of these requirements would be fatal to

its qualification under section 501(c)(3).         American Campaign

Academy v. Commissioner, 92 T.C. at 1062; Stevens Bros.

Foundation, Inc. v. Commissioner, 39 T.C. 93, 109-110 (1962),

affd. on this issue 324 F.2d 633, 637-640 (8th Cir. 1963).

     Donations to section 501(c)(3) organizations generally are

deductible for income tax purposes under section 170.        Secs.

170(a), 170(c); Bob Jones University v. Simon, 416 U.S. 725, 727-

728 (1974).   Section 170(c)24 defines the term “charitable


     24
          Sec. 170(c)(2) provides, in pertinent part, as follows:

     SEC. 170. CHARITABLE, ETC., CONTRIBUTIONS AND GIFTS.

                     *   *    *     *      *   *   *

          (c) Charitable Contribution Defined.--For purposes of
     this section, the term “charitable contribution” means a
     contribution or gift to or for the use of--

                     *   *    *     *      *   *   *
                                                          (continued...)
                                 - 88 -

contribution” to mean a contribution or gift to or for the use of

certain types of organizations enumerated thereunder.     With a few

minor differences, the organizations and requirements listed in

section 170(c)(2) are virtually identical to those described in

section 501(c)(3).     In view of the nearly identical statutory

language, the courts have applied many of the same standards in

interpreting section 170(c)(2) and section 501(c)(3).     See Bob

Jones University v. United States, 461 U.S. at 586-587.     For


     24
          (...continued)
                   (2) A corporation * * *--


                       (A) created or organized in the United States
                  or in any possession thereof, or under the law of
                  the United States, any State, the District of
                  Columbia, or any possession of the United States;

                       (B) organized and operated exclusively for *
                  * * charitable, scientific, * * * or educational
                  purposes * * * ;

                       (C) no part of the net earnings of which
                  inures to the benefit of any private shareholder
                  or individual; and

                       (D) which is not disqualified for tax
                  exemption under section 501(c)(3) by reason of
                  attempting to influence legislation, and which
                  does not participate in, or intervene in
                  (including the publishing or distributing of
                  statements), any political campaign on behalf of
                  (or in opposition to) any candidate for public
                  office.

The text includes an amendment made by sec. 10711(a)(1) of OBRA
87, Pub. L. 100-203, 101 Stat. 1330, 1330-464. This amendment
applies to activities after Dec. 22, 1987, the date of the
enactment of the Act. This amendment relates only to political
campaigns and so does not affect the instant case.
                              - 89 -

convenience, we shall refer to section 501(c)(3), but our

analysis and conclusions, in the context of the instant case,

will apply equally to section 170(c)(2).

     In the instant case, respondent contends only that (1)

petitioner was not operated exclusively for exempt purposes

because its “activities served private commercial purposes;”     (2)

petitioner “operated in large part for the private benefit of

W&H;” and (3) petitioner’s net earnings inured to the benefit of

private shareholders or individuals.   Respondent does not contend

that petitioner is an “action” organization (sec. 1.501(c)(3)-

1(c)(3), Income Tax Regs.), has not raised any contention that

petitioner has failed to satisfy any of the other requirements

discussed above for exemption under section 501(c)(3), and does

not dispute petitioner’s organization exclusively for exempt

purposes.   Respondent further acknowledges that respondent bears

the burden of proof in establishing inurement, because

respondent’s notice of revocation did not indicate that inurement

was a ground for the revocation.   Rule 217(c)(2)(B); Dumaine

Farms v. Commissioner, 73 T.C. 650, 659-660 (1980).

     We note that while the inurement prohibition and the private

benefit analysis under the operational test of the Treasury

regulations may substantially overlap, the two are distinct

requirements which must independently be satisfied.   American

Campaign Academy v. Commissioner, 92 T.C. at 1068-1069.     However,

it is not clear that the first two of respondent’s contentions--
                                - 90 -

activities serving private commercial purposes, and operation for

the private benefit of W&H--are meaningfully different

requirements, at least in the context of the instant case.

     We consider first the issue of inurement.

     In order for an organization to qualify for exemption under

section 501(c)(3), no part of the organization’s net earnings may

inure to the benefit of any private shareholder or individual.

Sec. 501(c)(3); sec. 1.501(c)(3)-1(c)(2), Income Tax Regs.

     A “private shareholder or individual” is broadly defined as

any person having a personal and private interest in the

activities of the organization.     Sec. 1.501(a)-1(c), Income Tax

Regs.     Such private shareholders or individuals are sometimes

referred to for convenience as “insiders”.     See American Campaign

Academy v. Commissioner, 92 T.C. at 1066; Sound Health

Association v. Commissioner, 71 T.C. 158, 185-186 (1978).

     We consider first whether W&H was an insider with respect to

petitioner, and then whether there was an inurement of

petitioner’s net earnings to W&H.25

A. W&H As Insider



     25
          Petitioner does not make the argument that W&H cannot
be an insider under the statutory language because W&H is not a
shareholder in petitioner and is not an individual. Accordingly,
we do not consider that question. See Estate of Fusz v.
Commissioner, 46 T.C. 214, 215 n.2 (1966). In any event, sec.
501(c)(3) deals with whether there is an inurement “to the
benefit of any * * * individual”. If there were an inurement to
W&H, then it may well be that any such inurement would be “to the
benefit of” W&H’s owners--the individuals Watson and Hughey.
                               - 91 -

     Petitioner maintains that (1) “the inurement doctrine

applies only to insiders who receive an impermissible benefit

from the organization, not to third parties with whom the exempt

organization contracts for services” (emphasis in original); (2)

petitioner was independent of W&H, and the two entities “had no

common directors, officers or employees;” and (3) petitioner--and

not W&H--had “control” in that (a) petitioner directed its

charitable program, (b) petitioner “renegotiated the contract

with W&H in mid-stream, gaining an important financial

advantage,” (c) petitioner “diligently exercised its right of

review over all proposed mail copy, mailing lists, vendor’s

invoices, and volume and frequency of mailings”, and (d)

petitioner “exercised ultimate ‘control’ by terminating its

relationship with W&H.”

     Respondent contends that “an ‘insider’s’ control consists of

a meaningful opportunity to influence any portion of the

organization’s activities that could readily be manipulated to

the benefit of the insider.”   Respondent asserts that in the

instant case “the record clearly shows that W&H controlled most

of * * * [petitioner’s] income and assets, including controlling

most uses of (and all rental income from) * * * [petitioner’s]

donor and non-donor names, even after the five-year term of the

contract.”

     Petitioner rejoins that its board of directors retained

ultimate control, and, to the extent that any control over any
                              - 92 -

assets or activities was delegated to W&H, petitioner’s board of

directors exercised due diligence in supervising W&H’s actions.

     Mailers contends that, if a charity and an “outsider”

negotiate a contract at arm’s length, then the contract does not

make that person an insider for inurement purposes with respect

to that contract.   The contract between petitioner and W&H was

negotiated at arm’s length and was “market rate”, Mailers

asserts, and so W&H was not an insider and there was no inurement

to W&H.

     American-Sector contends that “the case law often labors to

craft metaphysical distinctions between these requirements”--the

ban on “private inurement”, the ban on “private benefit”, and the

general requirement that a charity be organized and operated

“exclusively for an exempt purpose”.

     We agree with respondent’s conclusion.

     The term “private shareholder or individual” appears at

present in sections 170(c) (three places), 501(c) (eight places),

528(c)(1)(D), 833(c)(3)(A)(vi), 2055(a), 2522 (four places), and

4421(2)(B).   This term has been unchanged since the Revenue Act

of 1924, Pub. L. 176, 68th Cong., 1st. Sess., ch. 234, 43 Stat.

253, 271, 282.   The Revenue Act of 1921, Pub. L. 98, 67th Cong.,

1st Sess., ch. 136, 42 Stat. 227, 241, 253, used the term

“private stockholder or individual”, as did the prior Revenue

Acts back to the Tariff Act of 1913, Pub. L. 16, 63d Cong., 1st.

Sess., ch. 16, 38 Stat. 114, 172.   The term “private stockholder
                              - 93 -

or individual” also appears in section 38 of the Tariff Act of

1909, commonly called the Corporation Excise Tax Act of 1909,

Pub. L. 5, 61st. Cong., 1st Sess., ch. 6, 36 Stat. 11, 113.

Neither the parties nor the amici have directed our attention to,

and we have not found, any statutory explanation of any of these

terms.   Our examination of the legislative history of the Revenue

Act of 1924 has not turned up any explanation of the shift from

“stockholder” to “shareholder”.   We note that the

Administration’s proposed bill leading to the Revenue Act of 1924

retained the word “stockholder”, while the bill as reported by

the House Ways and Means Committee used the word “shareholder”.

We note also that the term “private stockholder or individual”

appears in paragraph (2) of section 2055(a) (and its 1939 Code

predecessor, section 812(d)), while the term “private shareholder

or individual” appears in paragraph (4) of the same section

2055(a).   We have not found any explanation of the intended

difference between “stockholder” and “shareholder”, nor any

reason why “stockholder” was replaced by “shareholder” in the

Revenue Act of 1924.   See Western Natl. Mut. Ins. Co. v.

Commissioner, 102 T.C. 338, 354 (1994), affd. 65 F.3d 90 (8th

Cir. 1995).

     Section 1.501(a)-1(c), Income Tax Regs., provides as

follows:

          (c) “Private shareholder or individual” defined. The
     words “private shareholder or individual” in section 501
     refer to persons having a personal and private interest in
                              - 94 -

     the activities of the organization.

     See sec. 1.501(c)(3)-1(c)(2), Income Tax Regs.

This definition is unchanged from Regs. 65, art. 517 (1924),

except that the older regulations use “individuals” and

“corporation”, instead of “persons” and “organization”,

respectively.   Art. 517 of Regs. 65 is essentially similar to

Regs. 45, art. 517 (1920).   In general, the case law appears to

have drawn a line between those who have significant control over

the organization’s activities and those who are unrelated third

parties.   People of God Community v. Commissioner, 75 T.C. 127,

133 (1980).

     We proceed to consider whether, and if so then to what

extent, W&H controlled petitioner’s activities.

     On the one hand, neither W&H nor Watson nor Hughey was a

director or officer of petitioner, nor did any of them have a

formal voice in the selection of any director or officer of

petitioner.

     On the other hand, in exchange for (a) funds to keep

petitioner operational and get it past its 1984 financial crisis

and (b) fundraising services, W&H received (1) compensation, (2)

effectively exclusive control over petitioner’s fundraising

activities, including supposedly separate computer activities,

and (3) substantial control over petitioner’s finances.   The

amounts that W&H would advance for petitioner’s operational costs

and as capital for petitioner’s fundraising costs were not
                              - 95 -

specifically contracted for, but were essentially discretionary

with W&H.

     Moreover, up until the execution of the April 1987 addendum

to the Contract, petitioner was fully liable on a recourse basis

to repay W&H for the excess draws petitioner received.   This

repayment liability caused petitioner’s certified public

accounting firm to express serious concern about petitioner’s

continued existence and economic viability, in the accounting

firm’s management letter dated May 23, 1986, to petitioner’s

board of directors and Executive Committee.

     Although petitioner had a longstanding existence before its

involvement with W&H, the position W&H occupied in relation to

petitioner, during 1984 and 1985, was in many ways analogous to

that of a founder and major contributor to a new organization.

Petitioner, which was on the brink of insolvency, was being

heavily financed and kept in existence by W&H pursuant to the

fundraising arrangement that petitioner and W&H entered.

     Petitioner became dissatisfied with its lack of control over

the Escrow Account funds.   In 1986 and 1987, petitioner made a

number of concerted efforts to obtain more control over the

Escrow Account.   However, its efforts were unsuccessful as a

result of W&H’s refusal to give up control over the account.    W&H

continued to retain control over the Escrow Account long after it

and petitioner knew the direct mail fundraising campaign was

financially successful.
                               - 96 -

     W&H’s control over petitioner’s fundraising campaign is

further manifested by petitioner’s unsuccessful efforts to obtain

a copy of its own housefile in July 1988, about 11 months before

the contract ended.    W&H refused to provide to petitioner a copy

of its housefile until the contract was over.    It instructed

Wiland, the computer company W&H selected to maintain

petitioner’s housefile, not to comply with petitioner’s July 1988

request.    Despite the extensive efforts of its attorney,

petitioner was unable to obtain its complete housefile until

after the Contract ended.

     From a practical standpoint, W&H exercised substantial

control over petitioner’s finances and direct mail fundraising

campaigns during the period from 1984 through 1989.    In light of

W&H’s extensive control over petitioner and petitioner’s near-

insolvent financial condition when the fundraising arrangement

was entered into in June 1984, we conclude that W&H was an

“insider” with respect to petitioner.

     Petitioner and Mailers contend that one cannot become an

insider merely by entering into an arm’s-length negotiated

contract.    We are not aware of any such “one-free-bite” principle

in this part of the law.    Whether the control thus transferred,

or shared, makes the transferee an insider depends on the

circumstances.    The arrangement authorized by the Contract in the

instant case was not a “one-shot deal”, but a 5-year

relationship, involving many transactions during its term.     The
                             - 97 -

arm’s-length negotiations may have a significant bearing on the

fairness of the Contract, but they do not inoculate W&H against

insider status.

     Mailers makes a further argument along this line by pointing

out that--

     even the definition of self-dealing provides that the term
     does not include ‘a transaction between a private foundation
     and a disqualified person where the disqualified person
     status arises only as a result of such transaction.’ Treas.
     Reg. §53.4941(d)-1(a).

     However, the cited regulation explains this rule in the very

next sentence, as follows:

     For example, the bargain sale of property to a private
     foundation is not a direct act of self-dealing if the seller
     becomes a disqualified person only by reason of his becoming
     a substantial contributor as a result of the bargain element
     of the sale.

Thus, the cited regulation (which does not apply to public

charities anyway) focuses on the “one-shot deal” and does not

appear to immunize a substantial course of dealing merely because

the substantial course of dealing is pursuant to one contract

(and its amendments and extensions).

     We conclude that the cited regulation, fashioned in an

environment of “disqualified persons” and “prohibited

transactions”, is distinguishable from what we face in the

instant case, viz, “insiders” and “inurement”.

     We hold, for respondent, that W&H was an insider with regard

to petitioner.
                              - 98 -

B. Did Any of Petitioner’s Net Earnings Inure to W&H?

     Petitioner points out that respondent has the burden of

proof, and contends that respondent has failed to carry this

burden.

     Respondent acknowledges having the burden of proof, but

contends that this burden has been carried because it was shown

that W&H received “excessive and unreasonable compensation (and

other private benefit)” from petitioner.

     Mailers argues that private inurement does not result from a

third-party contract for fair market value and contends that the

Contract was at “Market Rate”, especially in light of all the

facts and circumstances when the Contract was executed.

     We agree with respondent’s conclusion.

     An organization’s payment of reasonable compensation to an

insider for services performed for the organization would not

constitute inurement of net earnings,26 but payment of excessive

compensation would.   United States v. Dykema, 666 F.2d 1096, 1101

(7th Cir. 1981); Unitary Mission Church v. Commissioner, 74 T.C.

507, 514 (1980), affd. without published opinion 647 F.2d 163 (2d

Cir. 1981).   Whether the compensation in question is reasonable

     26
          Neither side suggests that we should examine the
statutory term “net earnings”, and so we do not. See People of
God Community v. Commissioner, 75 T.C. 127, 132 n.5 (1980); Alive
Fellowship of Harmonious Living v. Commissioner, T.C. Memo. 1984-
87 n.21; see also discussion in B. Hopkins, The Law of Tax-Exempt
Organizations, sec. 13.4 (6th ed. 1992).
                                - 99 -

is a question of fact.   Founding Church of Scientology v. United

States, 188 Ct. Cl. 490, 412 F.2d 1197, 1200 (1969).      Factors

similar to those considered in determining reasonable

compensation under section 162(a)(1) are examined.       Founding

Church of Scientology v. United States, supra; B.H.W. Anesthesia

Foundation v. Commissioner, 72 T.C. 681, 686 (1979).       In

determining whether there has been an inurement of net earnings

we are to consider all forms of compensation, and not merely

direct payments from the organization to the insider.       Founding

Church of Scientology v. United States, supra; Unitary Mission

Church v. Commissioner, 74 T.C. at 512-513.

     A cap or limit on the contingent compensation that may be

earned under a particular incentive formula, can be considered a

factor supporting the reasonableness of that contingent

compensation arrangement.   See People of God Community v.

Commissioner, 75 T.C. at 132.

     At trial, petitioner and respondent offered the testimony of

several expert witnesses on the issue of whether W&H received

more than reasonable compensation.       As trier of fact, we are not

bound by the opinion of any expert witness and will accept or

reject expert testimony, in whole or in part, in the exercise of

sound judgment.   Helvering v. Nat. Grocery Co., 304 U.S. 282, 295

(1938); Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir.

1976), and cases there cited, affg. T.C. Memo 1974-285.
                             - 100 -

     Petitioner offered the testimony of three expert witnesses:

(1) James Feldman (hereinafter sometimes referred to as Feldman),

a professional direct mail marketing and fundraising consultant;

(2) J. Curtis Herge (hereinafter sometimes referred to as Herge),

an attorney practicing in the Washington, D.C., area, who has

advised nonprofit organizations and professional fundraisers

about fundraising contracts and represented such clients in the

negotiation of their fundraising contracts; and (3) Richard S.

Steinberg (hereinafter sometimes referred to as Steinberg), an

economist who has specialized in the economics of nonprofit

organizations.

     Respondent offered the testimony of four expert witnesses:

(1) Nora Carrol (hereinafter sometimes referred to as Carrol), a

professional fundraising and marketing consultant, (2) John Kehoe

(hereinafter sometimes referred to as Kehoe), a professional

fundraiser who at the time of the trial specialized in mailing

list brokerage services, (3) William C. McGinly (hereinafter

sometimes referred to as McGinly), president of the Association

for Healthcare Philanthropy, a professional organization of

health care facility and hospital executives concerned with

fundraising, marketing, and public relations, for nonprofit

health care facilities and hospitals, and (4) Robert S. Tigner

(hereinafter sometimes referred to as Tigner), general counsel

for the Association of Direct Response Fundraising Counsel
                              - 101 -

(hereinafter sometimes referred to as ADRFCO), a professional

organization of professional fundraising companies that provide

direct response consulting services to nonprofit organizations.

     Herge attached to his expert report copies of 21 fundraising

agreements for various nonprofit organizations filed with

Virginia’s Office of Registrations, Division of Consumer Affairs.

Herge asked the Virginia Office of Registrations to provide him

with copies of all fundraising agreements filed with it by up to

10 to 12 professional fundraisers during a specified time period.

From the agreements thus provided, Herge selected agreements

which he believed were representative and typical of the

agreements similar to petitioner’s found in the market place.

     These 21 fundraising agreements were entered into during the

period from 1984 through 1992.   They involve various professional

fundraisers and client organizations.   Nineteen of the 21 client

organizations involved in these agreements have been recognized

by respondent as being exempt from Federal income tax either

under section 501(c)(3), 501(c)(4), or 501(c)(5).   Four of the 21

agreements essentially provide that the nonprofit organization

client is fully liable on a recourse basis for the fundraising

expenses.   The remaining 17 agreements are essentially “no-risk”

contracts for the nonprofit organization.   However, a few of the

essentially “no-risk” agreements require the nonprofit

organization client to either contribute a specified amount of
                               - 102 -

the initial capital to conduct the mailing campaign or bear

financial responsibility for certain specified types of expenses.

     Without going into an analysis of each of these expert

witness’ testimony, we draw the following overall conclusions

from their testimony:

     1.   Contingent-fee charitable fundraising arrangements occur

with modest frequency.   Although some in the fundraising field

regard such arrangements as being improper, others treat such

arrangements as an ordinary part of the fundraising landscape.

It is expected that a fundraising arrangement with a contingent-

fee element would present opportunities for greater total

compensation for the fundraiser than a similar fundraising

arrangement that does not have a contingent-fee element.

     2.   No-risk charitable fundraising arrangements occur with

less frequency.   They may take various forms, most of which may

more appropriately be labeled as “limited risk”, rather than “no-

risk”.    It is expected that a fundraising arrangement with a no-

risk or limited-risk element would involve greater total

compensation for the fundraiser than a similar fundraising

arrangement that does not have a no-risk or limited-risk element.

     3.   As petitioner’s experts Feldman and Herge point out, co-

ownership of mailing lists is typical in no-risk charitable

fundraising arrangements and is regarded as a method of enhancing

compensation to the fundraiser without requiring the charitable
                              - 103 -

organization client to actually write checks.   Although such co-

ownership is understood to be an element of compensation, it has

the side effect of making it more difficult to determine what is

the total compensation to the fundraiser.   Note that petitioner’s

Form 990 did not report this as an element of compensation paid,

and respondent does not suggest that petitioner should have tried

to find out how much W&H earned as a result of this feature of

the fundraising agreement.   In the instant case, the co-ownership

had features that significantly restricted petitioner’s use of

its own mailing list.27   Under section 18 of the Contract, all of

these restrictions even survive the term of the Contract.    In

addition, W&H and petitioner interpreted the Contract to permit

W&H to exchange petitioner’s mailing list for another

organization’s mailing list and then require petitioner to

“reimburse” W&H for the expense that W&H did not in fact incur

because of the exchange of mailing lists.   A side effect of this

feature is that in such a situation a payment by petitioner to

W&H which appeared to be a simple reimbursement of W&H’s out-of-

pocket expenses would in fact have been additional compensation

by petitioner to W&H.

     27
          See sec. 14 of the Contract, set forth supra. The
Contract expressly forbids petitioner to “rent, exchange, lease,
sell or give away” the names and addresses that W&H develops “to
any other parties for any purpose whatsoever.” On the other
hand, the Contract expressly permits W&H to use these names and
addresses “in any way it so desires and for any purpose it may so
determine.”
                               - 104 -

     4.   Petitioner’s mailing fees under the Contract--$0.05 per

prospect letter and $.10 per housefile letter--were within, but

about the high end of the range of charges in what Herge

described as a representative group of fundraising contracts.

Petitioner was charged package fees for housefile mailings under

the Contract.   In Herge’s group of contracts, package fees were

ordinarily found only in conjunction with lower mailing fees; in

only one instance in this group (The Viguerie Co.’s contract with

The Solidarity Endowment) was there both a package fee and a high

mailing fee.    As Tigner points out, it is difficult to evaluate

the reasonableness of a particular mailing fee unless one

understands the volume of mailings that are anticipated.    In

general, the greater the volume of mailings anticipated, the

smaller the mailing fees.   This relationship was clearly

recognized in five of the fundraising contracts in Herge’s group

of contracts, involving four different fundraisers, which

provided graduated mailing fees, depending on the volume of

mailings actually sent.   Thus, when the parties to a fundraising

contract do not have a basis for confidently estimating the

volume of mailings to be sent, a graduated mailing fee schedule

is a device that may be used to protect both sides.   In April

1986 petitioner and W&H agreed to a cap on housefile mailing fees

in exchange for a reduction, from 70 to 50 percent, in the

cumulative net income from housefile mailings that petitioner was
                                - 105 -

guaranteed to receive.     The $50,000 cap applied to any single

housefile mailing of more than 500,000.

     5.    In almost all of Herge’s group of contracts the exempt

organization could terminate the fundraising contract with some

form of advance notice.     The longest notice so required is 120

days and the shortest is 30 days.     Often these contracts provide

that an exempt organization that terminates its fundraising

contract becomes liable for mail campaign losses.     In contrast,

the Contract does not make any provision for petitioner to

terminate it by giving notice or for cause.     On the contrary, the

Contract provides that, during its entire 5-year term, W&H would

be petitioner’s exclusive fundraiser, and specifically forbids

petitioner to “retain or use the services of any other person or

company to provide counsel or advice to [petitioner] in

conducting its direct mail solicitations.”

     Thus, W&H had an effective way to limit its risk if the

Contract did not prove to be productive--W&H could reduce or

eliminate the monthly draws that it allows petitioner to take and

it could end the advances used to fund future mailings for

petitioner.     Once petitioner had grown accustomed to this

lifeline, petitioner could not remain viable without continued

infusions; W&H could figuratively pull petitioner’s plug and

thereby effectively rid itself of future losses or insufficiently

profitable obligations.     Petitioner, on the other hand, had no

exit.     Presumably, petitioner could have refused to authorize
                              - 106 -

more mailings, but petitioner could not use another fundraiser no

matter how unhappy it was with how the Contract was working out.

This suggests that the uncertainties normally attendant on a no-

risk contingent fee arrangement warranted less of a premium to

W&H under the circumstances of the Contract than might be

appropriate in the usual run of no-risk contingent fee cases.

     The dollar amounts in some of the tables set forth supra in

our Findings of Fact in many instances do not properly match the

dollar amounts in other tables.   This results from the

inconsistent and usually unreconciled exhibits that the parties

introduced in the extensive record in the instant case.

Nevertheless, the following conclusions may fairly be drawn from

the information we have:

          1. W&H’s services under the Contract netted petitioner

     about $2¼ million for its own uses unrelated to the

     Contract.   Tables 1, 2, and 10.

          2. This net is less than 10 percent of what donors

     contributed to petitioner in the fundraising campaign.

     Tables 1 and 10.

          3. Petitioner directly paid more than $4 million to W&H

     as fundraising fees.   Tables 3 and 7.

          4. In addition, petitioner paid almost $4 million to

     Washington Lists, a division of W&H, for list rental fees

     and commissions.   Tables 4 and 7.

          5. More than 10 percent of petitioner’s payments to
                                - 107 -

     Washington Lists were for rentals of lists that W&H or

     Washington Lists had obtained at little or no cost by

     exchanging petitioner names.    Table 8.

           6. Although the record does not show how much W&H or

     Washington Lists profited from being able to use petitioner

     names for mailing list exchanges on behalf of W&H’s other

     clients, it does show that about 5 percent of petitioner’s

     payments to Washington Lists were for rentals of lists that

     W&H or Washington Lists had obtained at little or no cost by

     exchanging W&H masterfile names.     Table 8.

     At trial, Watson testified that the mailing fee rates that

W&H charged to petitioner under the Contract were equal to the

highest rates that he understood professional fundraisers in the

Washington, D.C., area charged their nonprofit organization

clients in no-risk fundraising contracts.     In his letter dated

June 1, 1987, to petitioner’s executive director, Watson proposed

that petitioner and W&H agree to an early renewal of the Contract

and enter into a new proposed contract that would replace and

supersede the Contract.    Under the proposed contract Watson

enclosed, W&H’s mailing fees would be reduced from $.05 to $.03

per prospect letter and from $.10 to $.07 per housefile letter.

     When W&H entered into contracts with AICR on a no-risk

basis, AICR’s mailing fees were 20 percent less than what

petitioner had to pay, and AICR did not also have to pay package

fees.   Supra table 5.    The second 1983 AICR contract and the 1984
                                - 108 -

AICR contract, both of which were entered into before the

Contract, showed W&H’s understanding of the uses of graduated

mailing fees.

     The market, as exemplified by Herge’s sample of fundraising

contracts, provided two significant checks on excessive

compensation in no-risk situations--early termination rights for

the exempt organization (almost all the contracts) and graduated

mailing fee (five contracts).    Until the April 1986 agreement,

the Contract did not provide either of these checks on the effect

of high mailing fees, thereby reducing the market justification

for charging what Watson acknowledged to be equal to the highest

rates in the Washington, D.C. area.

     Although our inquiry in the instant case is to some extent

similar to that in section 162(a)(1) cases, this inquiry is

easier in one important respect--if we determine that there is

excess compensation in a section 162(a)(1) case, then we must set

a dollar amount on that excess, while in the instant case we

merely have to determine whether there is excess compensation and

need not then set a dollar amount.        Airlie Foundation, Inc. v.

United States, 75 AFTR 2d 95-2068, 95-2070, 95-1 USTC par. 50279

(D.C. Cir. 1995); Orange County Agr. Soc., Inc. v. Commissioner,

893 F.2d 529, 534 (2d Cir. 1990), affg. T.C. Memo. 1988-380; see

Church of Scientology of California v. Commissioner, 823 F.2d

1310, 1316 (9th Cir. 1987), affg. 83 T.C. 381, 491-492 (1984);

Founding Church of Scientology v. United States, 412 F.2d at
                              - 109 -

1202; Unitary Mission Church v. Commissioner, 74 T.C. at 513.

But see Carter v. United States, 973 F.2d 1479, 1486 n.5

(majority opinion), 1489-1490 (Tang, J., concurring in part and

dissenting in part) (9th Cir. 1992).

     The instant case does not involve an insider’s embezzlement

or any other kind of theft or use of assets unbeknownst to the

other insiders.   What we conclude to be excessive compensation

resulted from what petitioner and W&H apparently believed the

Contract permitted or required.   The fact that the Contract was

bargained for is a significant factor pointing toward

reasonableness.   Sec. 1.162-7(b)(2), Income Tax Regs.   However,

even under the standards of section 162(a)(1) the bargaining

factor does not by itself conclusively protect an arrangement

from a determination that the compensation was unreasonable; we

are required to consider all the circumstances.   Sec. 1.162-

7(b)(3), Income Tax Regs.

     Our examination of the other contracts provided by Herge, of

the multiplicity of compensation sources that W&H had under the

Contract, of the open-ended nature of W&H’s charges under the

Contract even though graduated fees were already being used in

the industry--and specifically by W&H in connection with AICR--

convinces us that the initial risk that W&H bore did not justify

so high a level of compensation. We are not holding that an

arm's-length arrangement that produces a poor result for an

organization necessarily would cause the organization to lose its
                               - 110 -

tax-exempt status.   We conclude, and we have found, that the

compensation that W&H received under the Contract by way of

direct payment by petitioner and by way of the value of W&H’s use

of names generated by the fundraising efforts that petitioner

already paid for, exceeded reasonable compensation.

     As a result, we conclude that, as of the June 11, 1984, date

on which the Contract started, the Contract was not a reasonable

contingent compensation arrangement, that W&H’s compensation

under the Contract exceeded reasonable compensation, and that

thus there was an inurement to an insider, in violation of the

restrictions in sections 501(c)(3) and 170(c)(2)(C).

     It is suggested that the $2¼ million that petitioner cleared

during the course of the Contract may justify such high

compensation.   However:   (1) The $2¼ million is so small in

comparison to the amounts of contributions, of W&H compensation,

of postage and shipping costs, of printing and publications

costs, and of mailing list rental costs, as to be almost an

incidental product of the fundraising campaign; and (2) W&H was

supposed to provide a substantial asset to petitioner--a

housefile that petitioner could exploit in future fundraising

(see supra findings under Direct Mail Fundraising)--but W&H’s

services were a practical failure in this regard.    Thus, the

magnitude of W&H’s compensation is not justified by adequacy of

results.

     We hold for respondent on this issue.
                                  - 111 -

           II. Retroactivity of Respondent’s Revocation of
             the Prior Favorable Ruling Letter Issued to Petitioner

     Petitioner contends that it was improper for respondent to

revoke the prior favorable ruling letter retroactively to June

11, 1984, the date on which petitioner entered into the Contract.

Petitioner contends that the retroactivity of the revocation (1)

violates its Fifth Amendment due process rights and (2)

constitutes an abuse of respondent’s discretion under section

7805(b).    Petitioner’s constitutional arguments were considered

and dealt with in United Cancer Council, Inc. v. Commissioner,

100 T.C. 162 (1993), and in the hearing that preceded that

opinion.    Petitioner asks the Court “to reconsider our previously

detailed arguments, and we also note our preservation of the

issues in the event of an appeal.”      We believe that our earlier

rulings in this matter were correct and that there is no need to

restate them.    We proceed to consider the abuse-of-discretion

issue under section 7805(b).28

     28
           Sec. 7805(b) provides as follows:

     SEC. 7805. RULES AND REGULATIONS.

                      *   *   *     *   *   *   *

          (b) Retroactivity of Regulations or Rulings.--The
     Secretary may prescribe the extent, if any, to which any
     ruling or regulation, relating to the internal revenue laws,
     shall be applied without retroactive effect.

This provision was extensively revised by sec. 1101(a) of the
Taxpayer Bill of Rights 2, Pub. L. 104-168, 110 Stat. 1452,
1468 (1996), effective for regulations which relate to statutory
                                                   (continued...)
                                 - 112 -

     The Supreme Court has held that respondent has broad

discretion under section 7805(b) and its predecessor, in deciding

to revoke a ruling retroactively, and that such a determination

is reviewable by the courts only for abuse of that discretion.

Automobile Club v. Commissioner, 353 U.S. 180, 184 (1957); see

Dixon v. United States, 381 U.S. 68 (1965).        See generally,

Virginia Education Fund v. Commissioner, 85 T.C. 743 (1985),

affd. 799 F.2d 903 (4th Cir. 1986).

     More recently, in a different but analogous setting, we

described review of exercise of discretion as follows:

          Whether the Commissioner has abused his discretion is a
     question of fact. Buzzetta Construction Corp. v.
     Commissioner, 92 T.C. 641, 649 (1989); Estate of Gardner v.
     Commissioner, 82 T.C. 989, 1000 (1984). In reviewing the
     Commissioner’s actions, however, we do not substitute our
     judgment for the Commissioner’s, nor do we permit taxpayers
     to carry their burden of proof by a mere preponderance of
     the evidence. Buzzetta Construction Corp. v. Commissioner,

     28
      (...continued)
provisions enacted after July 30, 1996, and so does not affect
the instant case. We note that present sec. 7805(b)(8) provides
as follows:

     SEC. 7805. RULES AND REGULATIONS.

                     *   *   *     *   *   *   *

          (b)   Retroactivity of Regulations.--

                     (8) Application to rulings.--The Secretary
                may prescribe the extent, if any, to which any
                ruling (including any judicial decision or any
                administrative determination other than by
                regulation) relating to the internal revenue laws
                shall be applied without retroactive effect.
                              - 113 -

     92 T.C. at 648; Mailman v. Commissioner, 91 T.C. 1079, 1084
     (1988); Pulver Roofing Co. v. Commissioner, 70 T.C. 1001,
     1011 (1978). Taxpayers are required to clearly show that
     the Commissioner’s action was arbitrary, capricious, or
     without sound basis in fact. Knight-Ridder Newspapers v.
     United States, 743 F.2d 781, 788 (11th Cir. 1984); Mailman
     v. Commissioner, 91 T.C. at 1084; Drazen v. Commissioner, 34
     T.C. 1070, 1076 (1960). [Capital Federal Savings & Loan v.
     Commissioner, 96 T.C. 204, 213 (1991).]

     The Contract caused the inurement violation.   It is not

“arbitrary, capricious, or without sound basis in fact” for

respondent to determine that the revocation of the favorable

ruling letter should relate back to the start of the Contract.

     Neither the parties nor the amici refer to section

601.201(n)(6), Statement of Procedural Rules, nor to Rev. Proc.

90-27, 1990-1 C.B. 514, both of which provide, in pertinent part,

that “The revocation [of an exemption ruling] * * * may be

retroactive if the organization * * * operated in a manner

materially different from that originally represented”.   The

start of the Contract marked a substantial change in petitioner’s

operations.   This change was material with respect to inurement.

Petitioner has not suggested that there was any event after the

start of the Contract which marked a change in W&H’s actions, or

W&H’s rights under the Contract, such that there was an inurement

after that event or change but not before that event or change.

If the revocation, which occurred after the Contract expired, had

been made prospective only, then the revocation would have been a

meaningless act.

     We conclude that (1) the retroactivity of the revocation to
                             - 114 -

the start of the Contract is not an abuse of discretion when

tested by the usual standards, (2) petitioner does not maintain

that these standards have been modified as a result of section

601.201(n)(6), Statement of Procedural Rules, or Rev. Proc. 90-

27, and (3) the retroactivity would not be an abuse of discretion

even if the usual standards were so modified.    See Capital

Federal Savings & Loan v. Commissioner, 96 T.C. at 217-219, 223.

     We hold that respondent’s determination, that the revocation

be retroactive to the start of the Contract, was not an abuse of

discretion.



     In light of our holdings for respondent, we do not consider

whether petitioner should be denied tax-exempt status for other

reasons, whether anyone’s actions violated postal regulations and

if so what effect that should have on petitioner’s exempt status,

whether petitioner and W&H engaged in a joint venture, whether a

portion of petitioner’s expenses is properly allocable to public

education, or whether any particular feature of the Contract

constituted a “per se” violation of any of the requirements of

sections 501(c)(3) and 170(c)(2).   Finally, section 4958,

imposing an excise tax on “excess benefit transactions”, applies

only to transactions occurring on or after September 14, 1995,

and so does not apply to the instant case.
                                   Decision will be entered

                               for respondent.
- 115 -
