News and analysis
March 04, 2012

Think Tank in Koch Brothers Dispute Could Find Its Tax Status at Risk

By Debra E. Blum

Charles and David Koch, the billionaire brothers active in Tea Party politics, last week sued the libertarian Cato Institute, which Charles Koch helped found more than 30 years ago, in a move that would ensure their control over the institution.

But in filing the lawsuit, the brothers may well have tipped off the Internal Revenue Service to concerns that the organization has never deserved to be a charitable institution eligible to receive tax-deductible contributions or other benefits of tax exemption, says a former head of the tax agency’s charity division.

Marcus Owens, a Washington lawyer, says the lawsuit filed in Kansas state court reveals a “fatal flaw” in Cato’s structure. The lawsuit and other documents about Cato’s legal status show that the think tank gave ownership shares to its founders, including, it appears, the right to sell the organization. That goes against federal law, which has strict rules that forbid any one person or group from having ownership rights.

The penalty, says Mr. Owens, could be as severe as the IRS revoking the think tank’s tax-exempt status going back to Cato’s founding in the 1970s. That would require it to file corporate tax returns for the revoked years and pay federal and state taxes on income for some years, where appropriate. Cato has an annual operating budget of about $20-million. Last year, the group raised nearly $40-million in private contributions, about half of it for a capital campaign.

A Cato spokesman said the organization’s lawyers are preparing comments on the lawsuit, but its longtime lawyer, Bruce Hopkins, said he did not expect that the structure, albeit unusual, would ultimately cause the Internal Revenue Service to declare it problematic.

In the meantime, Cato’s president and co-founder, Ed Crane, released a short written statement saying that he sees the lawsuit as “an attempt at a hostile takeover” by Charles Koch and an effort to “transform Cato from an independent, nonpartisan research organization into a political entity that might better support his partisan agenda.”

The Kochs, owners of the privately held megabusiness Koch Industries, in Wichita, Kan., have long been major donors to conservative and libertarian causes and are now also prominent backers of the Tea Party movement. (They are also major charitable donors, as demonstrated by their appearance over the years on The Chronicle’s Philanthropy 50 list of America’s most generous donors.)

Lawyers for the Kochs did not respond to The Chronicle’s request for comment.

Money and Politics

The lawsuit, which seeks to ensure that the Kochs gain majority control to select Cato’s board members, has sparked renewed debate about the creeping influence of politics into all corners of the nonprofit world. Observers say that think tanks, considered powerful thought leaders, are especially vulnerable to manipulation by activists with a political viewpoint.

“We are suffering now from way too much politicization in the policy research space,” says William Schambra, director of the Bradley Center for Philanthropy and Civic Renewal at the Hudson Institute, a conservative think tank. But that politicization is not limited to think tanks, he says: “The entire spectrum of organizations from foundations right down to (c)3s and (c)4s, the entire apparatus is shifting dramatically closer to the realm of activism.”

Board Selection

Politics aside, the Cato case raises other thorny questions about who controls nonprofit groups and how. The lawsuit reveals that Cato was long ago incorporated in Kansas as a nonprofit owned by shareholders—an unusual arrangement allowed in very few states.

Unlike for-profit corporations, these types of nonprofit entities do not issue capital stock or give shareholders rights to dividends or any distributions of profits or assets. Instead, shareholders get to elect the nonprofit’s board.

According to Cato’s Form 990 informational tax return, its shareholders elect the board and have the right to remove board members by a majority vote.

Until last year, Cato had four shareholders: both Koch brothers, Mr. Crane, and William Niskanen, a former Cato chairman.

The lawsuit centers on the fate of the shares owned by Mr. Niskanen, who died in October. The Koch brothers maintain that under a shareholder agreement, originated in 1977, first the corporation, then the remaining shareholders must be given the option to buy Mr. Niskanen’s shares. The court papers say, however, that Mr. Niskanen’s widow, Kathryn Washburn, has not offered to sell them.

Whether the corporation or its three remaining equity partners get the shares, the Koch brothers, who already hold a 50-percent stake, stand to gain majority control of the organization.

Mr. Hopkins, who has represented Cato on tax issues but is not involved in the Koch lawsuit, acknowledged that the set-up is unusual and might prompt the IRS to ask questions.

“The IRS is suspicious of anything they don’t see regularly or where they sense or feel some kind of private benefit or inurement.”

But he noted that “the stock in this context is a way for the entity to be controlled. There is no money flowing through it. It’s more of a control mechanism than an economic benefit.”

Control by Board Members

Other nonprofit legal experts say that while Cato’s incorporation arrangement has cleared the way for a small number of shareholders to acquire majority control, it is not unusual for such voting rights to be up for grabs at more traditionally structured charities, too.

Evelyn Brody, a professor at Chicago-Kent College of Law, says, for example, that at many organizations governing boards are self-perpetuating, meaning the trustees themselves vote for their successors. If the group has a small number of trustees, she says, it might be easy for them to keep tight control. Similarly, she says, nonprofits that have members who elect trustees could be subject to a sort of takeover of the board, especially if the group limits itself to having only a handful of members.

Whatever the details, Ms. Brody says, the IRS would want to ensure that shareholders, trustees, or members are not gaining personal benefits, be it money or power, from their control of a nonprofit.

Mr. Owens says that with Cato, the IRS would probably have more-serious concerns than the perks for people who lead the nonprofit. He says even though Cato’s shareholders do not earn dividends, Kansas law would allow them to sell the charity.

“They don’t take money from Cato Institute’s bank account, but they can sell that account to someone else,” Mr. Owens says. “It is the control and the ability to sell that asset that is the fatal flaw for federal tax exemption.”

Noelle Barton contributed to this article.