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Tax-Exempt Firm Gets $600 Million Profit Flying First Class

November 14, 2012

The IRS

The U.S. Internal Revenue Service requires annual filings by all nonprofits, while allowing trade associations to self-declare their tax-exempt status. The porous rules allow a ship inspection company to make hundreds of millions of dollars and reward its executives with lavish pay and travel perks. Photographer: Andrew Harrer/Bloomberg

Since 1862, an obscure company called American Bureau of Shipping has been approving oceangoing vessels as seaworthy. The Houston-based firm reported $3.17 billion in revenue and just less than $600 million in profits from ship inspections from 2004 to 2010 and paid no U.S. income taxes on those earnings.

The Internal Revenue Service hasn’t had any complaints. That’s because the company has been registered as a nonprofit for 150 years, Bloomberg Markets magazine reports in its December issue.

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ABS routinely inspects independently owned ships on behalf of the U.S. Coast Guard, and one of its customers is the U.S. Navy. The company employs 3,028 people in 70 countries. ABS paid Robert Somerville, then its chief executive officer, $21.7 million from 2004 to 2010.

ABS shows how an organization that isn’t a charity, a school, a religious institution, a hospital or any other kind of body that commonly has nonprofit status can earn millions of dollars and legally avoid paying U.S. taxes.

Another such outfit is the U.S. Polo Association, which tells the IRS its tax-exempt status is allowed because its purpose is to govern the sport of polo in America.

In 1982, more than five years after clothing designer Ralph Lauren featured a player with a mallet on horseback for his Polo brand logo, the Polo Association began licensing its own line of merchandise -- with a similar image.

Top 50

Today, the association’s brand, U.S. Polo Assn., has annual retail sales of $1 billion, placing it in the top 50 of all licensed brands. The association pays no income tax on its licensing income, its filings show.

At a time when the U.S. is struggling with a gaping budget deficit, nonprofit companies such as ABS and the Polo Association operate large-scale, profit-making commercial enterprises tax-free.

“This showcases a massive problem of tax-exempt companies that walk, talk and quack like tax-paying businesses but benefit from very favorable treatment under the tax code,” says Dean Zerbe, a lawyer who was senior counsel and tax counsel for the Senate Finance Committee until 2010. “Taxpayers are subsidizing them. It’s wild.”

Anyone can start a nonprofit. It’s as simple as incorporating in any state and correctly filling out an IRS application. Once that’s done, a company is tax-exempt.

‘Rubber Stamping’

“It’s complete rubber-stamping,” says Ken Berger, CEO of Charity Navigator, a watchdog group based in Glen Rock, New Jersey, which is itself a nonprofit. “The IRS and the states are tremendously understaffed.”

For a company to get tax-exempt status, the IRS requires it to qualify in one of 28 categories, including charities, religious organizations and schools. The IRS says that some kinds of groups -- such as trade associations, unions, agricultural organizations and social welfare groups -- don’t even have to apply for nonprofit status.

Such groups, which include ABS and the Polo Association, can self-declare their tax-exempt status, the IRS says. Federal law on tax-exempt companies is so lax and vague that organizations can legally skip taxes on hundreds of millions of dollars of profits, Zerbe says.

“The problem is growing because there is so little enforcement, and the laws are so loosey-goosey,” he says.

The roster of tax-exempt trade associations includes the National Football League and the National Hockey League. The NFL -- which in 2011 negotiated $27.9 billion in television contracts over nine years for its 32 member teams -- paid Commissioner Roger Goodell $11.6 million in fiscal 2011. It reported a loss of $52.2 million.

Reported Losses

The NHL paid Commissioner Gary Bettman $4.6 million in fiscal 2011 and reported a $14.8 million loss. Broadcast and ticket revenue go to the teams, which are required to pay taxes on profits.

It wasn’t always so simple to start a nonprofit. In a bizarre twist of jurisprudence, a 1961 New York State Court of Appeals ruling involving a white supremacist group known as the Association for the Preservation of Freedom of Choice made it much easier for all sorts of organizations to become tax-exempt.

Until that point, would-be nonprofits had to get a state judge to approve their tax-exempt status. The supremacist group’s application was at first rejected by a New York trial level judge.

The appeals court reversed that decision, saying the right to form a nonprofit was guaranteed by the freedom of expression allowed in the Constitution.

‘National Trend’

Incorporating a nonprofit soon became a right, not a privilege, in states across the country, says Norman Silber, a professor who specializes in nonprofits at Hofstra University’s Maurice A. Deane School of Law in Hempstead, New York.

“That case reflected a national trend,” he says.

There are 1.63 million tax-exempt organizations in the U.S., according to the Urban Institute. Nonprofit charities reported revenue of $1.51 trillion in 2010 from donations, government grants and contracts. Zerbe says that the U.S. Treasury could collect tens of billions of dollars annually in taxes from nonprofits that make money essentially as for-profit companies.

One of the most profitable nonprofits is American Bureau of Shipping -- a company whose members are the ship owners who use its services. ABS inspects 11,898 vessels annually. The IRS asks companies in its standard filing form to say why they are nonprofits.

‘Promote Security’

ABS answers that question every year with the following phrase: “To promote the security of life & property on the seas.”

ABS’s headquarters occupies an entire eight-story office building on the north side of Houston. Its reception area displays scale models of a schooner, an oil tanker and an offshore oil-drilling ship.

The nonprofit company has earned hundreds of millions of dollars in profits in the past decade; lavished its executives with multimillion-dollar pay packages and perks; and purchased an offshore hedge fund, its IRS filings show.

“ABS’s status as a nonprofit organization allows it to achieve the necessary impartiality to fulfill its mission,” ABS spokeswoman Jean Gould says. She declined to make any company executives available for interviews.

ABS has a particularly close relationship with the Coast Guard. On Oct. 11, at a fundraising event in New York, the Coast Guard Foundation, a nonprofit organization that supports the Coast Guard, honored ABS and its Chairman Somerville, who stepped down as CEO in 2011.

Hiring Admirals

He was presented with a 10-inch (25-centimeter) engraved glass obelisk. The foundation said Somerville had supported its sailing and scholarship programs.

Since 1998, ABS has hired four former Coast Guard admirals as executives. They include retired Admiral Robert Kramek, who led the Coast Guard as commandant from 1994 to 1998. It was Kramek who signed an agreement with ABS in 1995 that expanded the nonprofit’s powers to inspect independently owned ships on the Coast Guard’s behalf.

In June 1998, three years after Kramek signed that inspection agreement, ABS hired him as president of its Americas division.

Jack Devanney, a retired executive of companies that own ships that used ABS services, says this revolving door is bad for ship safety.

‘Second Career’

“When you give Kramek a nice job, you’re sending a message to all the Coast Guard guys that they’ve got a second career at ABS,” says Devanney, who has a Ph.D. in management science from the Massachusetts Institute of Technology. “If you rock the boat, that opportunity’s not going to be available to you.”

In a written response to questions, ABS says, “The U.S. Coast Guard and ABS share a common mission to promote maritime safety.”

ABS has also hired executives from its private-sector clients, most notably Frank Iarossi, a former Coast Guard officer who joined ABS after working for Exxon Mobil Corp. (XOM) Iarossi was president of the oil giant’s Exxon Shipping Co. from 1982 to 1990. During his last year in that job, the Exxon Valdez oil tanker struck a reef in Alaska, causing what was then the largest oil spill in U.S. history.

The following year, a federal grand jury indicted Exxon and Exxon Shipping for allowing an incompetent crew to run the ship. Two days after the indictment, which didn’t name any Exxon executives, ABS announced it was hiring the Exxon executive as its chairman and CEO.

Retirement Payout

He also became chairman and CEO of ABS Group of Cos., a for-profit subsidiary owned by ABS. Exxon eventually settled government criminal and civil cases, paying $1 billion.

Iarossi took a $2 million lump sum retirement payout in 1999, at age 62, without retiring, according to ABS’s federal filings. He stepped down as chairman and CEO of ABS in 2004, receiving $1.4 million in compensation from the nonprofit that year, the company reported.

But he still wasn’t retired. He stayed on as CEO of ABS Group, a for-profit subsidiary, until 2006. ABS didn’t disclose his salary there. Iarossi, who lives in Naples, Florida, says his compensation wasn’t excessive.

“When you hire an executive out of Exxon, you’ve got to cover their lost stock options,” he says. “That’s how executives get hired out of big companies.” ABS says in its written response that its executive compensation is reasonable and conforms with IRS standards.

Unrelated Business

ABS paid no U.S. income taxes from 2004 to 2010 on just less than $600 million in profits it reported for what the company refers to as ship classification. Its filings show that it may have paid taxes on profits from less than 0.3 percent of revenue during that period on sales the IRS calls unrelated business revenue -- any income not from ship classification.

ABS didn’t make public details on that revenue. The tax-exempt company earns income from writing rules for ship construction, inspecting vessels and certifying offshore oil rigs.

Its net assets soared to $787.3 million at the end of 2010 from $292.7 million six years earlier. In 2010, the company’s holdings included $241.7 million in cash, $349.9 million in publicly traded securities and $144.8 million invested in subsidiaries.

“A strong financial reserve is prudent given ABS is subject to unlimited liability,” ABS says in its response.

Hedge Fund

ABS reported in its 2010 IRS filing that it had shifted some of its profits into Cayman Islands-based AIP Custom Hedge Fund Solutions. It transferred $61.8 million of its $152.7 million in profit in 2010 to AIP, a fund of hedge funds. That gave the nonprofit 41.8 percent ownership of AIP.

ABS’s board has been generous with perks for its officers, directors and highly paid employees. The company checked off boxes on its 2010 tax return showing it had provided some of them with first-class or charter air service, travel for companions, health or social club dues and personal services such as chauffeurs, chefs and maids.

In its filing, ABS wrote that those expenses were within company policy. The company declines to say who got which perks.

“Generally, some of these benefits are provided to employees on overseas assignments in foreign countries where company-provided services of this nature are typically standard business practice,” ABS says in its written response.

‘Eyes Popped’

“My eyes popped out when I saw how many boxes were checked and their lack of explanation,” Hofstra’s Silber says. “It’s extremely opaque and cries out for explanation. If their answer satisfies regulators, we have a problem.”

IRS spokesman Dean Patterson declined to comment for this story.

One explanation for such lavish spending is that nonprofits sometimes have more money than they know what to do with -- and one thing they don’t have to do is pay taxes.

“The problem with a nonprofit is, when you start grinding out money, what do you do with it?” Devanney says. “There are only so many fancy cars you can buy your top executives.”

Many other countries don’t recognize ABS’s tax-exempt status. In 2010, China’s State Administration of Taxation rescinded ABS’s tax exemption, retroactive to the beginning of 2008.

China ordered ABS to pay $12.9 million in back income taxes, $4.7 million in current income taxes and $2.5 million in business tax, according to ABS’s 2010 filing with the IRS. The South African Income Tax Court denied ABS’s application for tax-exempt status in 1997. The company lost an appeal in 2008.

‘Not Qualify’

“The appellant simply does not qualify,” ruled High Court Judge Eberhard Bertelsmann.

European authorities take a similar view. ABS Europe Ltd. paid 3.3 million British pounds ($5.3 million) of taxes in Europe on profits of 12.6 million pounds in 2010, the company’s annual report says.

“The recognition of this type of entity as tax-exempt is somewhat unique to the United States,” ABS says in its response.

Rare details of ABS’s operations emerged following a disaster on the high seas. On Nov. 19, 2002, an oil tanker that had passed a recent ABS inspection split in half during a storm in the Atlantic Ocean and sank. The nonprofit company had approved the 26-year-old single-hulled Prestige, registered in the Bahamas, in May 2002.

The wreck of the Prestige, 130 miles (225 kilometers) off the coast of Spain, spread more than 50,000 tons of fuel oil along hundreds of miles of Spanish and French beaches and disrupted fishing and tourism, causing damage estimated at more than $1 billion by the Spanish government.

Spain Sues

The Kingdom of Spain sued ABS in U.S. District Court in New York in 2003, claiming the company had behaved recklessly. In a sworn statement in that case, former Prestige Captain Efstratios Kostazos said he informed the tanker owner and ABS that he was leaving the ship two months before it sank.

“During my almost 40 years of going to sea, I have never seen a vessel in this poor condition that was still in actual service,” he wrote.

Former ABS surveyor John Lee said in a sworn statement that he had inspected the Prestige on Dec. 13, 2000, and had refused to certify it.

“I was shocked and horrified by the general level of deterioration and condition of the vessel,” he wrote. Lee wrote that ABS allowed the ship to go to sea, despite his objections.

ABS Wins

ABS denied having any obligation to Spain. A New York federal judge threw out Spain’s lawsuit in 2010, agreeing with the company’s argument. In September, the U.S. Court of Appeals for the Second Circuit in New York turned down Spain’s request for reconsideration.

ABS vetted the Deepwater Horizon oil rig used by BP Plc (BP), which exploded on April 20, 2010. The disaster killed 11 workers and triggered a massive spill that soiled beaches along the shores of the Gulf of Mexico. A Coast Guard investigation wrote that ABS inspectors failed to report that critical safety systems aboard the rig had not been properly maintained.

In its written response, ABS says the Coast Guard made no findings against the company.

Like ABS, the U.S. Polo Association has used its nonprofit status to earn money from around the world. Founded in 1890, the Lexington, Kentucky-based company, with 14 employees, governs polo in the U.S.

Although its 3,500 members pay annual dues of $150, 90 percent of its income comes from investments and the licensing of more than 900 polo-related trademarks, according to IRS and court filings.

Polo Image

With those trademarks, the association can use its name and the image of a polo player on everything from umbrellas to swimwear to handbags and deodorants. Such items are sold at Sears, J.C. Penney and stores in 130 countries.

The association collected more than $30 million in royalties from retail sales since 2006, according to IRS filings and CEO Peter Rizzo.

“Getting millions of dollars tax-free for licensing these polo ponies helps undermine confidence in the tax system,” Zerbe says. “You’ve got to put them on the same playing field with other businesses.”

The tax-exempt group has increased profits in the past seven years, according to its filings. Annual earnings rose sevenfold to $7.9 million in 2010 from 2004. Its net assets, including unspecified publicly traded securities and cash, increased sixfold to $37.3 million.

Royalties, Investments

The USPA spent just 13 percent in 2010 -- $1.3 million of the $9.9 million it earned from royalties and investments -- on delivering polo program services. It gained $6.8 million from royalties and $3.1 million on investment income in 2010, its IRS filing shows.

The association also used $1.1 million from membership dues and fees for polo purposes.

Rizzo says his organization is increasing its spending on polo to 40 percent. Most of the money the group earns on invested profits will eventually be used to support polo, says Rizzo, interviewed in the association’s rented suite at the Museum of Polo and Hall of Fame in Lake Worth, Florida.

The Polo Association provides the museum with no financial support.

“It’s a business decision,” Rizzo says.

Ralph Lauren Corp (RL)., which reported $6.93 billion in revenue in fiscal 2012, has sued the Polo Association at least twice in the past three decades. Lauren argued that the nonprofit was infringing on the trademarks for its Polo line, which Lauren registered in 1974.

Some Restrictions

Courts have found that the association could market products with some restrictions. In 2011, a federal judge in New York issued an injunction forbidding the association from competing with Lauren’s Polo fragrances. The USPA filed an appeal in July, which is pending.

Rizzo says he sees no issue with brand confusion.

“We are the legitimate connection to the sport,” he says. “There was an opportunity out there to license trademarks. We seized it.”

Both the USPA and Lauren have shops at the Ontario Mills factory outlet mall an hour east of Los Angeles. The similarities and proximity can cause confusion among consumers.

Ferial Sharifi, a 28-year-old fashion consultant visiting from Toronto, shopped at both stores in early October. She bought a $99 jacket at the Polo Ralph Lauren store and then entered the Polo Assn. boutique, which sells polo shirts for $15. When asked, she says both shops are owned by Lauren.

Shopper Surprised

She says the second one sells less expensive shirts of lower quality, sporting a variation of a polo player logo. She’s surprised to learn the Polo Association isn’t owned by Ralph Lauren and receives tax-exempt royalty payments.

“Why does a nonprofit sports group have a commercial store in a mall?” she asks.

Reviewing the filings of hundreds of tax-exempt companies leads to similar questions. Entities that look and smell like for-profits are permitted to pay no taxes on tens of billions of dollars of income, Zerbe says.

As the U.S. struggles to deal with its growing budget deficit, legislators may want to re-examine an oxymoron: nonprofit companies swimming in profit.

To contact the editor responsible for this story: Jonathan Neumann at jneumann2@bloomberg.net.

The U.S. Internal Revenue Service requires annual filings by all nonprofits, while allowing trade associations to self-declare their tax-exempt status. The porous rules allow a ship inspection company to make hundreds of millions of dollars and reward its executives with lavish pay and travel perks. Photographer: Andrew Harrer/Bloomberg The U.S. Polo Association tells the IRS its tax-exempt status is allowed because its purpose is to govern the sport of polo in America. Here, the 3rd annual Veuve Clicquot Polo Classic on Governors Island in New York City. Photographer: Stephen Lovekin/PA Wire via AP Images Robert Somerville, chairman of ABS, was honored in October by the Coast Guard Foundation at a New York fundraising dinner. Photographer: Ian Allen/ Bloomberg Markets via Bloomberg. Fuel tanker Prestige split apart during a storm after ABS inspected the ship and allowed it to go to sea. Photographer: Douanes Francaise/Avion Polmar II/ AP American Bureau of Shipping routinely inspects independently owned ships on behalf of the U.S. Coast Guard, and one of its customers is the U.S. Navy. Photographer: Tim Rue/Bloomberg

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