Non Profit versus For Profit

["Leo Smith" <barter@ntplx.net>]

For those interested in distinction between For Profit versus Non Profit
the following paper is  ©Villanova Center for Information Law and Policy.
It is available at
http://www.law.vill.edu/vill.tax.l.compen/files/student_papers/tax2.htm
and is titled: 

FOR-PROFIT AND NON-PROFIT ORGANIZATIONS:
IS IT TIME TO START TAXING "LIKE" ENTITIES ALIKE?

INTRODUCTION: The Revenue Reconciliation Act of 1993 has caused a
re-examination of the Federal Income Tax Code. Politicians in both the
House Ways and Means Committee and the Senate Finance Committee are again
concerned with the issues of fairness, equity, efficiency and
simplification regarding taxation policies. Yet when discussing equitable
policies within the tax code, one sector, the non-profit organization,
appears to bear less of a tax burden than its comparable neighbor, the
for-profit organization. Lawmakers are aware of discrepancies between the
taxation policies applied to non-profit as opposed to for-profit
organizations and see fit to maintain them. However, in this time of
deficit reduction and a stalled economy, lawmakers have considered
modifying taxation policies toward non- profit organizations in order to
keep non-profit organizations from unfairly competing with for-profit
organizations and to create more horizontal equity between non-profit
organizations and for-profit corporations. This article explains the
differences between non-profit and for-profit organizations and how
non-profit organizations obtain and retain their tax- exempt status. The
article goes on to discuss recent legislative developments and the
rationales behind the tests which distinguish a non-profit organization
from a for-profit organization. Finally, this article reviews both federal
and state legislation designed to tighten tax rules and provide more
equitable treatment of for-profit and non-profit organizations.



BASIC DEFINITIONS

In order to understand the differential tax policies between for-profit and
non-profit organizations, a few basic misconceptions regarding these
organizations must be dispelled from the start. A for-profit organization
is incorporated using a legal form called the Articles of Incorporation. A
for- profit organization will also have a Board of directors and officers,
pay compensation, make investments, produce goods or services and
hopefully, turn a profit. A non-profit organization is also formed using
Articles of Incorporation. Similarly, a non-profit organization is run by
an Administrative Board and officers, produces goods or services and makes
investments. A non-profit organization will also, hopefully, turn a profit,
unlike its name suggests. The dividing line between for-profit
organizations and non-profit organizations concerns questions of ownership
and profit distribution. For-profit organizations function under the
"private inurement doctrine". 1 This doctrine arises because for-profit
organizations have owners, namely private stockholders. Profits earned by a
for-profit organization ultimately are passed through, or inured, to the
stockholders, usually by dividends on shares of stock. 2 Non- profit
organizations are not permitted to function using the private inurement
doctrine. The owners or administrators of a non-profit organization do not
receive any portion of the organization's profits, as is specified in the
Articles of Incorporation. 3 Any profits earned must inure back to a
non-profit activity sponsored by the organization itself or must be donated
to other non-profit organizations. By not permitting non-profit
organizations to distribute their profits according to the private
inurement doctrine, it is thought that non- profit organizations will
observe their pledges to serve the public interests and provide charity to
the surrounding community. 4 

Another difference between for-profit organizations and non-profit
organizations concerns tax-exempt status. Generally, tax-exempt status is
not conferred to for-profit organizations and similarly, not all non-profit
organizations are tax exempt. Tax- exempt organizations are a subset of
non-profit organizations. For a non-profit organization to attain
tax-exempt status, it must have the following three characteristics. 

First, the organization's Articles of Incorporation must outline tax exempt
activities at the time the corporation is started. A pre-existing
corporation will not be permitted to attain tax-exempt status, even if the
activities that they are performing would be considered charitable, unless
its Articles of Incorporation are amended or modified to include tax exempt
activities. 5 

Second, a "substantial" portion of a non-profit organization must consist
of tax exempt activities or a substantial portion of the corporation's
money must go towards tax exempt activities. Attaining tax-exempt status
does not mean that the non-profit organization cannot turn a profit. It
does mean, however, that the profits are used only for tax exempt
activities and are not distributed among shareholders. 6 

Finally, upon the dissolution of the non-profit corporation, all assets
must be distributed to other tax-exempt organizations. Again, tax exemption
for a non-profit organization means that a substantial portion of the
monies are used for charitable purposes. The money is not to be used by
individuals for their own gains. 7 



DEFINING A 501(C) ORGANIZATION

As one might guess, many of the non-profit, tax- exempt organizations that
exist today were not always conferred with this special status. Nor should
it come as any surprise that non-profit, tax-exempt organizations were not
the result of extensive legislative planning. Prior to 1894, any
organization not mentioned in the Federal Income Tax Code was considered
tax-exempt. In 1894, a two percent flat tax was imposed on corporate income
which forced lawmakers to define which entities would remain tax-exempt. 8
Lawmakers used three basic considerations to determine which types of
organizations would be designated tax-exempt:



The first of these considerations was "heritage"; ...the "history of
mankind reflects that ... early legislators were not setting precedent by
exempting religious or charitable organizations." The second of these
considerations was "morality"; ..."[l]egislative history clearly indicates,
for example, that Congress [was] generally ... willing to exempt the income
of organizations formed for the mutual benefit of members so long as they
[were] primarily financed by such members..." [Finally], "special interest
legislation [was determined to be] the... underlying ... concept of
exemption. 9 



Employing the above criteria, lawmakers determined that non-profit
charitable, religious, and educational organizations, fraternal beneficiary
societies, certain mutual savings bonds, and certain mutual insurance
companies would remain tax-exempt. These provisions were set forth in
section 32 of the Tariff Act of 1894. 10 Although, the Tariff Act of 1894
was later repealed due to Constitutional challenges, the Tariff Act of 1913
permanently established tax exemptions for those organizations. 11 

Today, Subchapter F of the Federal Income Taxation Code defines what
entities are considered exempt organizations. Specifically, I.R.C. section
501(c)(3), which was originally enacted as part of the 1954 Code, 12
permits tax exemptions for



corporations, and any community chest, fund, or foundation, organized and
operated exclusively for religious, charitable, scientific, testing for
public safety, literary, or educational purposes, or to foster national or
international amateur sports competition ... or for the prevention of
cruelty to children or animals...,



as long as,



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 ... any
political campaign on behalf of (or in opposition to) any candidate for
public office. 13



Like their counterparts in 1894, lawmakers in 1954 used history and
cultural trends to define which groups would attain tax-exempt status under
I.R.C. section 501. Another consideration used by lawmakers in determining
what organizations would be designated as I.R.C. section 501(c)
organizations may have been the First Amendment. In light of several court
decisions, 



[t]ax exemption for non-profit membership organizations [could] be viewed
as a manifestation of the constitutionally protected rights of association
accorded the members of these organizations. 14



Regardless of the legislators' reasoning, I.R.C. section 501(c) clearly
reaffirms the fact that citizens rely on a wide array of community groups,
instead of government, to provide for certain types of necessities. 15 

With I.R.C. section 501(c) in place, it has been up to the I.R.S. and the
Treasury to determine which organizations are truly 501(c) organizations.
Specifically, the I.R.S. distinguishes between for- profit corporations and
non-profit, tax-exempt corporations using both an organizational and
operational test. Under the organizational test 16 , the I.R.S. determines
that a non-profit corporation is tax exempt if it's organized in such a
manner 



that the Articles of Incorporation outline tax exempt activities; that a
substantial part of business profits go towards tax exempt activities; and
that the assets, upon dissolution, go to other tax exempt organizations. 17



The I.R.S. does not use the operational test as frequently as the
organizational test because it is not as definitive. 



Under the operational test, the purpose towards which an organization's
activities are directed, and not the nature of the activities themselves,
is ultimately dispositive of the organization's right to be classified as a
section 501(c)(3) organization exempt from tax under section
501(a)...Rather, the critical inquiry is whether...[an organization's]
primary purpose for engaging in its ... activity is an exempt purpose, or
whether its primary purpose is the nonexempt one of operating a commercial
business producing net profits for...[the organization]...Factors such as
the particular manner in which an organization's activities are conducted,
the commercial hue of those activities and the existence and amount of
annual or accumulated profits are relevant evidence of a forbidden
predominant purpose. 18 





THE EXPANSION OF 501(C) ORGANIZATIONS

There have been little or no legislative changes made to the definition of
what denotes a tax-exempt organization since 1913. However, Congress has
added specific provisions to I.R.C. section 501(c) in an attempt to respond
to special interest groups and to expand the types of organizations which
should be included under the "tax-exempt organization" heading. An
excellent example of this expansion is I.R.C. section 501(c)(6) pertaining
to the tax-exempt status of 



[b]usiness leagues, chambers of commerce, real- estate boards, boards of
trade, or professional football leagues... 19



Entities like those above were probably not the types of organizations that
lawmakers first envisioned as appropriate for tax-exempt status. Yet it was
during this legislative period, while Congress continued to expand the
tax-exempt category, that for-profit organizations increasingly expressed
concerns regarding non-profit, tax-exempt organizations' abilities to
expand and unfairly compete in for-profit markets. Specifically, for-profit
corporations were critical of non-profit corporations for their ability to
use non- taxed profits for capital improvements. Similarly, for- profit
corporations worried that tax-exempt organizations undercut their
businesses by virtue of lower costs. 20 

Today, for-profit organizations' concerns regarding unfair competition seem
reasonable. Non- profit, tax-exempt organizations are losing federal funds
and are being forced to seek revenue by competing in markets which were
used exclusively by for-profit businesses. Statistics support for-profit
concerns about competition and smaller market share as approximately 29,000
new organizations a year are declared to be non-profit, tax-exempt
organizations. 21 



[W]hile the real GDP 22 grew by 50 percent in the period from 1974 to 1990,
...[t]he total gross receipts of other charitable organizations exempt from
income tax under IRC 501(c)(3)...grew by 275 percent from 1975 to 1990,
while the total receipts of all exempt organizations under 501(c) grew by
206.1 percent. 23 



The staggering figures continue with total gross receipts for all
organizations exempt under 501(c) reaching $807 billion for 1990 and total
assets reaching a little over one trillion dollars. 24 



UNRELATED BUSINESS INCOME

In an attempt to control unfair competition from non-profit organizations,
for-profit organizations in the 1950's began pressuring members of Congress
with horizontal equity arguments. For-profit organizations felt that
non-profit, tax-exempt organizations were performing similar functions and
providing similar services, and as such, should bear the same tax burden.
Rather than attempting to address for-profit corporate concerns directly by
rescinding 501(c) status for certain entities, legislators created the
Unrelated Business Income Tax, better known as UBIT. 25 The UBIT test was
designed to replace the "destination of income" test which provided that
funds raised through unrelated business activities were held to be tax
exempt as long as the funds ultimately went to a charitable purpose. 26
Current UBIT provisions are contained in sections 511 through 515 of the
Federal Income Taxation Code. 27 

Under I.R.C. section 512(a)(1),



the term "unrelated business taxable income" means the gross income derived
by any organization from any unrelated trade or business...regularly
carried on by it, less the deductions...which are directly connected with
the carrying on of such trade or business. 28



Legislators further designate under I.R.C. section 513(a) that,



the term "unrelated trade or business" means,...,any trade or business the
conduct of which is not substantially related...to the exercise or
performance by such organization of its charitable, educational, or other
purpose or function constituting the basis for its exemption under section
510...except that such term does not include any trade or business-

(1) in which substantially all the work in carrying on such trade or
business is performed for the organization without compensation; or

(2) which is carried on, in the case of an organization described in
section 501(c)(3) or in the case of a college or university described in
section 511(a)(2)(B), by the organization primarily for the convenience of
its members, students, patients, officer, or employees...which is the
selling by the organization of items of work-related clothes and equipment
and items normally sold through vending machines, through food dispensing
facilities, or by snack bars, for the convenience of its members at their
usual places of employment; or

(3) which is the selling of merchandise, substantially all of which has
been received by the organization as gifts or contributions. 29 



UBIT is applied using corporate or trust tax rates, depending on the form
of the organization.

UBIT provisions were first expanded by Congress in the Tax Reform Act of
1969. 30 Congress broadened the applicability of UBIT because



[i]n recent years many of the exempt organizations not subject to the
unrelated business income tax - such as churches, social clubs,fraternal
beneficiary societies, etc.-began to engage in substantial commercial
activity....Some churches ... engaged in operating publishing houses,
hotels, factories, radio and TV stations, parking lots, newspapers,
bakeries, restaurants, etc. Furthermore, it is difficult to justify taxing
a university or hospital which runs a public restaurant or hotel or other
business and not tax a country club or lodge engaged in similar activity.
31 



Yet, the applicability of UBIT provisions has not remained constant.
Legislators appeared to narrow UBIT provisions in the Tax Reform Acts of
1976 and 1986. 32 Within these acts, further exclusions from UBIT were
provided for borderline commercial activities, like income from trade shows
or state fairs 33 , certain hospital services 34 , bingo games 35 , or
distribution of low cost articles. 36 



STUDIES BY THE WAYS AND MEANS OVERSIGHT SUBCOMMITTEE

Even with UBIT provisions in place, for-profit organizations remained
adamant in their beliefs that more was needed to keep non-profit tax-exempt
organizations from engaging in commercial activities and providing market
competition. In 1987 and 1988, the House Ways and Means Committee responded
by appointing their Oversight Subcommittee to study the current UBIT rules
and 



the policies underlying the tax treatment of income-producing activities of
tax-exempt organizations, the impact of present-law rules on both
tax-exempt organizations and for-profit business, as well as the Internal
Revenue Service (IRS) administration of, and taxpayer compliance with, the
law. 37



Specifically, the Oversight Subcommittee focused its investigation on what
types of income-producing activities were carried on by tax-exempt
organizations and to what extent tax-exempt organizations were engaging in
commercial activities with for-profit businesses through joint ventures and
partnerships. 38 The Oversight Subcommittee continued by reviewing the
purposes of the unrelated business income tax and whether the rationales
underlying the "relatedness" and "trade or business" tests were still
appropriate. 39 Finally, the Oversight Subcommittee studied compliance with
the UBIT rules and whether the IRS had an adequate enforcement program in
place. 40 

It is again interesting to note that in the late 1980's, for-profit
concerns regarding the expansion of non-profit, tax-exempt organizations
were not unfounded.



Unrelated business gross income and deductions both almost doubled from
1987 to 1988, with deductions exceeding receipts by over $600 million for
1988....[F]or 1988, unrelated business gross income as a percent of total
receipts for all [501(c)] organizations was less than one percent. And much
of this unrelated gross income was eliminated by deductions. 41



Equipped with knowledge of UBIT provision abuses, suggested by the
statistics above, hearings were held by the Oversight Subcommittee in June
of 1987 42 and preliminary discussions were held in March of 1988. 43 The
Ways and Means Oversight Subcommittee submitted their recommendations on
June 23, 1988 to the Chairman of the Committee on Ways and Means, Dan
Rostenkowski. 44 

The Oversight Subcommittee began its recommendations by noting that



[a]s current budgetary constraints have necessitated reduced Federal
support of social, educational, and scientific programs, exempt
organizations have felt compelled to look for additional funding
alternatives. Many exempt organizations have come to derive the primary
portion of their income from income-producing or commercial activities
rather than from the traditional source of contributions. 45 



Yet even with this acknowledgement of non-profit, tax- exempt organizations
participating in commercial ventures, the Oversight Subcommittee had few
suggestions in its Report to keep non-profit organizations from attaining
unfair advantages over for-profit organizations. 46 

The Oversight Subcommittee's Report started with a comprehensive history of
I.R.C. section 511. 47 To reiterate, current UBIT provisions provide that 



income derived by tax-exempt organizations from any trade or business that
is regularly carried on by the organization and that is not substantially
related to the performance by the organization of its exempt
purpose....This unrelated business income tax is applied at the corporate
or trust tax rates, depending on the form of the organization. 48



The Report continued by making several observations regarding the current
UBIT rules. 49 First, the Oversight Subcommittee concluded that the
"substantially related" test, while imperfect, offer[ed] the best available
standard." 50 The Oversight Subcommittee remained concerned, however, that



the current relatedness test, which turns on the facts and circumstances of
each case, provides inadequate guidance to exempt organizations, the IRS
and the courts. 51



In their Report, the Oversight Subcommittee did consider other proposals as
replacements for the "substantially related" test. At the time, however,
the Oversight Subcommittee felt that 



[t]he substitution of a new standard of general applicability under UBIT
... could generate uncertainty as to the continued validity of these
interpretations under any new standard that itself constituted a facts and
circumstances test. 52



It is worth noting that the proposals mentioned in the Oversight
Subcommittee's 1988 Report as alternatives to the "substantially related"
test have been revisited in recent articles as solutions to the problems of
hospitals diversifying into joint partnerships with for-profit
organizations and facing possible revocation of their licenses. 53 The
problems arising from joint venture activities were touched upon during the
Oversight Subcommittee Hearings. 54 The Oversight Subcommittee questioned
then, as others do now, whether "an exempt organization can pursue its
charitable purpose rather than act for the benefit of the taxable partners"
55 when involved in a joint partnership.

In order to avoid jeopardizing a facility's tax- exempt status, some
proposed to the Oversight Subcommittee that a revenue producing activity
should be "directly related" to the organizations performance of tax-exempt
functions instead of "substantially related". 56 Others suggested an
extension of the "fragmentation rule". Under I.R.C. section 513(c), 



an activity does not lose identity as a trade or business merely because it
is carried on within a larger aggregate of similar activities or within a
larger complex of other endeavors which may, or may not, be related to the
exempt purpose of the organization. Where an activity carried on for profit
constitutes an unrelated trade or business, no part of such trade or
business shall be excluded from such classification merely because it does
not result in profit. 57



In an extension of the above rule, an organization would be granted
tax-exempt status only if their activities (or possibly, a subsidiary's
activities), each standing alone, would come under the definition of their
tax exempt purpose.

The 1988 Oversight Subcommittee Report then reviewed the "regularly carried
on" test and determined that it should be retained. The "regularly carried
on" test is frequently relied upon to determine if an activity is
substantially related to the trade or business of a non-profit organization
since the "unrelated trade or business" definition is broad and difficult
to apply. Whether a business is regularly carried on, and therefore subject
to UBIT, is determined by the following factors: (a) the frequency and
continuity of income producing operations; (b) the manner in which
activities are conducted; and (c) are the activities comparable/similar to
commercial activities of non-exempt organizations. 58 

After thoroughly reviewing the rationales applied to identify unrelated
business income, the Oversight Subcommittee discussed a few concrete
recommendations for restructuring UBIT provisions in the Code. The
Oversight Subcommittee did suggest that the scope of the "convenience
exception", found in I.R.C. section 513(a)(2), should be re-examined. As
previously mentioned, income earned via a trade or business subject to UBIT
under the general rules may be exempt from UBIT if the trade or business is
primarily conducted for the "convenience of its members". 59 The Oversight
Subcommittee found "[t]he lack of limits to the convenience exception,
which applies without regard to the exempt purpose of the organization" 60
to be troublesome. The Oversight Subcommittee 



concluded that there is no continued justification for generally exempting
from the UBIT other unrelated business activities that are regularly
carried on merely on the ground of 'convenience' to the organizations,
members, employees, officers, patients, or students. 61 



Likewise, the Oversight Subcommittee did suggest that UBIT provisions could
be strengthened by broadening the definition of a "controlled
organization". I.R.C. section 512(b)(13) provides that amounts of interest,
annuities, royalties and rents from a controlled organization are to be
included in gross income in an amount which bears the same ratio as-



(ii) in the case of a controlled organization which is exempt from taxation
under section 501(a), the amount of such organization's taxable income of
the controlled organization, bears to 

(B) the taxable income of the controlled organization...both amounts
computed without regard to amounts paid directly or indirectly to the
controlling organization. 62 



To be "controlled" means



ownership by an exempt organization of stock possessing at least 80 percent
of the total combined voting power of all classes of stock entitled to vote
and at least 80 percent of the total number of shares of all other classes
of stock of such corporation....In the case of a non- stock organization,
the term "control" means that at least 80 percent of the directors or
trustees of such organization are either representatives of or directly or
indirectly controlled by an exempt organization...A trustee or director is
controlled by an exempt organization if such organizations has the power to
remove such trustee or director and designate a new trustee or director."
63



The Oversight Subcommittee determined that the "controlled organization"
definition was being easily circumvented and therefore, UBIT income was not
being collected properly.



[T]he Subcommittee concluded that (1) control should be measured by the
tax-exempt organization's share of total voting power or value of a
subsidiary; (2) ownership attribution rules should be adopted; and (3) the
ownership interest of two or more tax-exempt organizations acting together
should be aggregated for purposes of this rule. 64 



To help attain their recommendations, the Oversight Subcommittee suggested
that the "control" requirement be lowered from 80 percent to 50 percent
because an ownership interest of more than 50 percent is considered a
majority interest in the for-profit community. 65 

The above recommendations made by the Oversight Subcommittee were never
acted upon by the House Ways and Means Committee or other congressional
members. The Oversight Subcommittee itself concluded that "[f]urther
studies, based on better reporting and meaningful data, [were] needed
before a major overhaul of the UBIT statutory framework can be undertaken."
66 

Yet, while no legislation was created, the Oversight Subcommittee's
findings clearly reflect the trend of non-profit, tax-exempt organizations
to participate in commercial endeavors with for-profit organizations and
legislative concern that current law may not be adequate to control such
endeavors.



H.R. 11

H.R. 11, a/k/a "The Revenue Act of 1992" was introduced in the House Ways
and Means Committee on January 3, 1991. 67 It began as a simple piece of
legislation regarding the implementation of federally funded "Enterprise
Zones"; a program proposed by then President George Bush to help jump start
the economy. 68 After going through both the House and Senate and
undergoing eight revisions, H.R. 11 resembled a Christmas tree, with the
original program, "Enterprise Zones" making up less than 5% of the bill. 69
However, while H.R. 11 seemed to be a typical piece of legislation, in
midst of its pork barrel provisions appeared the most recent attempt to
impose some reporting requirements upon non-profit, tax-exempt
organizations while at the same time providing more areas of potential
revenue for non- profit, tax-exempt organizations.

The reporting requirements for non-profit, tax- exempt organizations under
H.R. 11 seemed to reflect the 1988 Oversight Subcommittee's concern that



lapses in reporting, record-keeping deficiencies and limitations in current
IRS examination practices inhibit proper administration and enforcement of
the law, and aggravate the unfair competition concerns of small businesses.
70 



Yet, even the reporting requirements suggested in H.R. 11 which were
supposed to control non-profit, tax- exempt organizations did not restrict
their behavior effectively.

Section 7202 of H.R. 11, version eight, provided that as of January 1,
1994, no deduction was to be allowed under I.R.C. section 170(f) for any
contribution of $750.00 or more unless the taxpayer substantiated the
contribution by a written acknowledgement from the non-profit, tax-exempt
organization. 71 Under section 7202, however, the donee organization was
not required to provide separate documentation regarding contributions of
$750.00 or more if their tax return reflected such information. 72 

Another reporting requirement was set forth in section 7204 of H.R. 11,
version eight. 73 Section 7204 was designed to amend I.R.C. section 6115
and required non- profit organizations to place in advertisements or
solicitations 



an express statement (in a conspicuous and easily recognizable format) that
such organization [was] not exempt from Federal income taxes. 74 



The reporting requirement of section 7204 carried a heavy penalty of
$1000.00 a day with a maximum of $10,000.00 per year. 75 Section 7205 of
H.R. 11, version eight, went hand in hand with the disclosure requirements
of tax status under section 7204. 76 Under section 7205, which was designed
to amend I.R.C. section 6104(e)(1), a copy of the exempt organization's tax
return would be made available to any member of the public for inspection.
77 Fines were to be imposed for non- compliance.

Yet while legislators appeared to be controlling some activities of
non-profit, tax-exempt organizations in H.R. 11 by requiring more accurate
reporting, they actually were providing these organizations with more
avenues to attain revenues. Section 7201 of H.R. 11, version eight, 78 was
to amend subsection (A) of I.R.C. section 57 and provide for the removal of
the appreciated property charitable deduction under the Alternative Minimum
Tax (AMT) provisions. AMT significantly impaired a donor's tax benefit by
reducing the amount deductible under I.R.C. sections 170 or 642(c) if all
capital gain property were taken into account at adjusted basis. 79
Moreover, a year after section 7201 of H.R. 11 was to take effect, a
provision was to be implemented under which



taxpayers [could] elect to seek an agreement with the Secretary as to the
value of tangible personal property prior to the donation of such property
to a qualifying charitable organization.... 80 



Currently under I.R.C. section 57, capital gain property does not include
any tangible personal property. 81 

The major revenue producing provision for non- profit, tax-exempt
organizations was contained in section 7303 of H.R.11, version eight, which
excluded certain sponsorship payments from UBIT consideration. Under
section 7303, I.R.C. section 513 was to be amended to reflect that the term
"unrelated trade or business"



[did] not include the activity of soliciting and receiving qualified
sponsorship payments with respect to any qualified public event. 82



Specifically, a "qualified sponsorship payment" is



any payment by any person engaged in a trade or business with respect to
which there is no arrangement of expectation that such person will receive
any substantial return benefit other than -...

(A) the use of the name or logo of such person's trade or business in
connection with any qualified public event... 83 A qualified public event
may be sponsored by any 501(c)(3),(4), (5) or (6) organization if
substantially related to the organizations tax-exempt purpose. 84 



The above exclusion was written into H.R. 11 because of an earlier IRS
Technical Advice Memorandum, TAM 9147007, which interpreted the visual and
verbal onslaught of a corporate sponsor's name during a New Year's Day
football game to create advertising revenue for the charity putting on the
game. The I.R.S. determined that this advertising revenue would result in
UBIT being assessed to the charity. Charities and other tax-exempt
organizations criticized the I.R.S. for it's position. The I.R.S. responded
by opening up the issue for comments by releasing audit guidelines in
Announcement 92-15 on January 17, 1992. 85 Three days of public hearings
were held in July of 1992 and the definitions worked out in those hearings
were adopted into section 7303 of H.R. 11. 86 

Since the revenue producing elements of H.R. 11 far outweighed the
reporting requirements for non- profit, tax-exempt organizations, H.R. 11
was considered a dream come true. Unfortunately, H.R. 11 was pocket vetoed
by President George Bush on November 5, 1992. 87 In President Bush's
Memorandum of Disapproval, he denounced H.R. 11 as 



includ[ing] numerous tax increases, violat[ing] fiscal discipline and ...
destroy[ing] jobs and undermin[ing] small business. The urban aid
provisions that were once the centerpiece of the bill have been submerged
by billions of dollars in giveaways to special interests. 88 



It appeared, from President Bush's Memorandum, that he vetoed H.R. 11
because it encompassed too many incidental revenue provisions and did not
focus on his economic proposals. He did not veto H.R. 11 because of the
non-profit, tax-exempt provisions per se.



ATTEMPTS AT "TAXING" NON- PROFIT TAX-EXEMPT ORGANIZATIONS

Future policies toward non-profit, tax-exempt organizations are uncertain.
However, one thing is clear, as each citizen and for-profit organization is
called upon by the Clinton Administration to pay even higher taxes,
government is going to come under more criticism for its preferential tax
treatment towards non-profit, tax-exempt organizations. Current estimates
provide that tax exemptions 



are costing more than $36.5 billion a year in lost tax revenue...the
equivalent of the income taxes paid by 25 million taxpayers. 89 







Clearly..., the exemption for charitable organizations is a derivative of
the concept that they perform functions which, in the organizations'
absence, government would have to perform; therefore, government is willing
to forego the otherwise tax revenues in return for the public services
rendered. 90



Yet it appears that legislators under tight budget constraints are wanting
to have their cake and eat it too. They not only want tax-exempt
organizations to keep providing services so that the government itself will
not have to provide these services, but also, legislators want non-profit,
tax-exempt organizations to begin paying for the revenues their
accumulating through commercial activities.

As illustrated by the 1988 Oversight Subcommittee's Report and H.R. 11
above, many proposals have been advanced concerning how the government
should restructure the Federal Income Tax Code itself in order to keep
non-profit organizations from taking advantage of their tax-exempt status.



Contemporary tax reform proposals are focusing with more particularity on
the restructuring or repeal of tax exemptions, reflecting two recurrent
basic themes: (1) the rationale that gave rise to the particular tax
exemption under review is no longer valid today and (2) tax-exempt
organizations are unfairly competing with for- profit businesses. 91



Proposals for tightening up existing Code provisions are also gaining
popularity because they appear "fair". As non-profit, tax-exempt
organizations act more like for-profit organizations, from a horizontal
equity standard, it appears that they should be required to pay like taxes.
As previously mentioned, the Oversight Subcommittee's 1988 Report set forth
several proposals for restructuring the Code. These proposals are revisited
below because they would be simple to impose, administratively speaking,
and would provide government with some new revenue without causing
non-profit, tax- exempt organizations to be forced out of business. 

The Oversight Subcommittee recommended in their 1988 Report that the Code
provisions concerning "controlled organizations" be tightened by lowering
the percentage required to control an organization from 80 to 50 percent.
92 This would cause an increase in UBIT as more rents, royalties, etc.
would have to be included in calculations of unrelated business income.

Another proposal made by the Oversight Subcommittee was the repeal of the
"convenience exception". I.R.C. section 513(a)(2) currently provides that



income earned by a tax-exempt organization...from a trade or business that
is not related to its tax-exempt function and that is regularly carried on
nonetheless is exempt from the UBIT if the trade or business is conducted
by the organization primarily for the convenience of its members.... 93 



The provision mainly applies to entities, like hospitals or colleges, who
run cafeterias or bookstores for the convenience of their staff and
students. The "convenience exception" 



has had the effect of significantly broadening the range of activities
exempt from the UBIT, and has freed exempt organizations from the
responsibility for deciding whether particular activities are in fact
substantially related to the organization's exempt function. 94



The "convenience exception", if not repealed totally, could be easily
narrowed to exclude items sold by the non-profit institution which could be
found by employees or students at other nearby for-profit places of
business. For example, cards or felt tip pens at the college bookstore
could be subject to UBIT as such items are readily purchased at nearby
for-profit stationary stores or drug stores.

Rather than restructure the Code, others have suggested that current Code
provisions need to be more strictly enforced.



IRS's Exempt Organizations Technical Division, which is responsible for
approving new exempt organizations and policing existing ones, in 1991 had
486 employees to watch over an estimated 1.1 million organizations - or one
worker for 2,279 exempt groups. And that gap is widening. 95



The I.R.S. itself complains that the depth of their audits of non-profit,
tax-exempt organizations are often confined to what the organization
reports themselves via their 990-T return. 96 Moreover, the I.R.S.'s budget
for policing non-profit organizations has not kept up with the non-profit
boom.



In 1980, the agency spent $27.6 million to oversee exempt groups, or an
average of $32.61 per organization. 

In 1992, IRS spent $35.7 million, an average of $29.75 per organization.

Taking inflation into account, that meant IRS spending to supervise
non-profits declined by nearly 25 percent. 97



The Oversight Subcommittee of the House Ways and Means acknowledged these
administrative problems in their 1988 Report.



The Subcommittee agrees and finds that lapses in reporting, record-keeping
deficiencies and limitations in current IRS examination practices inhibit
proper administration and enforcement of the law, and aggravate the unfair
competition concerns of small businesses. 98 



Congress, however, has not had any success in passing any budget proposals
or regulations to rectify this situation.

The federal government is not the only entity attempting to restructure
their tax laws to control and attain revenues from non-profit, tax-exempt
organizations. State and local governments have come up with proposals
which will permit them to attain new sources of revenue from
non-profit,tax-exempt entities. The key to a state's ability to "tax" a
non-profit, tax-exempt organization lies in the granting of tax- exempt
status. Once the federal government grants tax- exempt status to an entity,
state and local governments have granted exempt status to the entity as
well. However, "states are under no obligation to 



grant tax exemptions just because the federal government 



has" 99 and many state governments and large cities are using this loophole
to re-evaluate which organizations do not pay taxes and why.

A policy implemented by the Virginia legislature appears quite equitable
and is being looked at by other states as a new way to generate revenue.



Virginia lawmakers... passed HB 1115, which provides that any non-profit
organizations that are exempt from local property taxes and that generate
unrelated business taxable income (UBTI) under section 512 of the Internal
Revenue Code will become liable for local property taxes to the extent that
the exempt property has generated UBTI. 100 



A simple example of how the above policy operates appears below. A
non-profit organization acquires a property whose current property tax is
$100.00. On it's latest tax return, the non-profit organization claims
$1000.00 in revenues of which $300.00 is UBIT. HB 1115 would require the
non-profit organization to pay 30 percent (300/1000) of the property tax
rate on their building. Therefore, the non-profit organization would owe
$30.00 of property taxes to the state. 101 

It should be noted that the Virginia plan does contain a de minimis
exception. If the property owner generates UBIT in an amount less than the
amount of property taxes due on the property then no property tax liability
would result. 102 HB 1115 also contains a provision which requires the
Virginia Department of Taxation to compile information on their program and
present it to the Chairmen of the Senate Finance Committee and the House
Finance Committee on or before December 1, 1993. The information will
probably be used to generate future legislation regarding local real estate
taxes involving tax-exempt entities. 103 

Nearby, in Pittsburgh, Pennsylvania, another program aimed at "taxing"
non-profit, tax-exempt organizations has also been successful. Pittsburgh's
solicitor instigated a PILOT program, (Payments in lieu of Taxes). 104
Rather than make payments to state and local authorities based on a
percentage of UBIT generated, non-profit, tax-exempt organizations are
required to pay set amounts or "taxes" to state and local governments. 



In Pittsburgh, 10 nonprofit organizations now make payments totaling nearly
$3.5 million for city services. Five hospitals have signed up following
pressure from local taxing authorities. 105



Due to its fiscal difficulties, Philadelphia, Pennsylvania is one of many
large cities which is now contemplating adoption of a PILOT or SILOT
(Services in lieu of Taxes) program. Should Mayor Rendell instigate a PILOT
or SILOT program, about 12 percent of Philadelphia's property owned by
tax-exempt organizations would be susceptible to the tax. The current
market value of this property totals $3.6 billion. 106 

Some non-profit, tax-exempt organizations may resist such a proposal by
moving their headquarters out of Philadelphia, but it seems as if most
organizations, specifically hospitals, religious institutions and colleges,
will have no choice but to participate due to their extensive facilities
within the city limits. Moreover, moving to the suburbs may not be easy as
more counties pass zoning ordinances to keep their tax base from further
erosion. For example, 



[i]n Langhorne Borough, Bucks County, officials amended the township's
zoning ordinance in 1991 to limit "property devoted to tax-exempt or
nontaxable uses" to 25 percent of the borough's total acreage. 107 





CONCLUSION

As more and more non-profit, tax-exempt organizations are forced to enter
the commercial marketplace in search of funding, the government is forced
to defend its' preferential treatment towards these entities. For-profit
organizations are lobbying governments to instigate horizontal equity
policies, while at the same time, non-profit, tax-exempt organizations are
struggling to maintain their special status.

The balance is precarious. If government imposes more taxes on non-profit,
tax-exempt organizations, these organizations may no longer be able to
function, and thereby, would force the government to use the revenue it
collects to put into place its own programs. There is some question,
however, whether the government even has the necessary structure in place
to implement such diverse services.



[S]ociety is regarded as benefiting not only from the application of
private wealth to specific purposes in the public interest but also from
the variety of choices made by individual philanthropists as to which
activities to further. This decentralized choice-making is arguably more
efficient and responsive to public needs than the cumbersome and less
flexible allocation process of government administration. 108





Even if the government did take over certain kinds of community services,
it may not attain the appropriate results. It has been shown that 



consumers have a greater basis for trusting tax- exempt organizations to
provide the services - a restatement, in a way, of the fiduciary concept.
Thus, the consumer "needs an organization that he can trust, and the
non-profit, because of the legal constraints under which it must operate,
is likely to serve that function better than its for- profit [or
governmental] counterpart. 109 



Yet there is no denying that by promoting preferential tax policies for
I.R.C. section 501(c) organizations, governments are limiting the size of
their tax base and the amount of revenues collected. With the economy in
its current depressed state and with a rising federal deficit, it appears
that legislative action towards non-profit, tax-exempt organizations is
inevitable.

As suggested by H.R. 11, Congress is likely to pass legislation aimed at
more stringent reporting requirements for non-profit, tax-exempt
organizations who generate UBIT. Federal legislators are also likely to
restructure current Code provisions in an attempt to promote equity and
fairness between for-profit and non- profit, tax-exempt organizations.
States and large cities are likely to revoke or review non-profit, tax-
exempt organization's status. More state revenues will be generated through
PILOT or SILOT programs or programs aimed at collecting a percentage of
property taxes based on reported UBIT. These changes appear justified as
citizens and small businesses are no longer able to support federal or
state services via their tax dollars alone.









Footnotes

1 Treas. Reg. sec. 1.501(c)(3)-1(c)(2). 

2 B. Hopkins, The Law of Tax-Exempt Organizations, 4 (6th ed. 1992) 

3 Id. at 4, (6th ed. 1992) 

4 Id. at 5, (6th ed. 1992) 

5 Treas. Reg. sec. 1.501(c)(1)-1(b)(1). 

6 Treas. Reg. sec. 1.501(c)(3)-1(b)(1). 

7 Treas. Reg. sec. 1.501(c)(3)-1(b)(4). 

8 28 Stat. 556 (Act ch. 349) See also Hopkins at 7, (6th ed. 1992). 

9 Hopkins at 7, (6th ed. 1992) 

10 28 Stat. 556 (Act ch. 349). 

11 38 Stat. 114, 166 (Act ch. 16, sec. II(G)(a)) 

12 68 A Stat. 163 (ch.736). 

13 I.R.C. sec. 501(c)(3)(P-H 1988). 

14 B. Hopkins, The Law of Tax Exempt Organizations, 14 (5th ed. 1987). 

15 Giving in America - Toward A Stronger Voluntary Sector (1975), the
Commission of Private Philanthropy and Public Needs quote used with
permission in Hopkins at 11-12, (6th ed. 1992). 

16Treas. Reg. 1.501(c)(3)-l(b)(1). 

17 Treas. Reg. 1.501(c)(3)-1(c)(l). 

18 B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352, 356-257 (1978). Also
Ohio Teamsters Education and Safety Training Fund v. Commissioner, 77 T.C.
189 (1981), aff'd 692 F.2d 432 (6th Cir. 1982). See Hopkins at 88-89, (5th
ed. 1987). 

19 I.R.C. sec. 501(c)(6)(P-H 1988). 

20 Contest, "Unfair Competition or Fundraising? A Proposal to Modify the
Regularly Carried On Test of the Unrelated Business Income Tax", 10 Am Jrnl
of Tax Pol, 73, 74-75 (Spring 1992, No. 1) (authored by Mary E. Monahan). 

21 The Philadelphia Inquirer, April 18, 1993, at A1, col. 1. 

22GDP stands for Gross Domestic Product which is the sum total of all the
goods and services produced in the United States. 

23 Bergin, New IRS Statistics on Nonprofits and Charitable Giving, 5 Exempt
Org. Tax Rev. 973, 974 (June 1992). 

24 Bergin at 974 (June 1992). 

25 Rev. Act of 1950,Pub L. No. 81-814, sec. 301(a), 64 Stat. 906, 947-52. 

26 Contest, "Unfair Competition or Fundraising? A Proposal to Modify the
Regularly Carried On Test of the Unrelated Business Income Tax" 10 Am Jrnl
of Tax Pol 73, 74 (Spring 1992, No. 1) (authored by Mary E. Monahan). 

27 I.R.C. secs. 511-515 (P-H 1987). 

28 I.R.C. sec. 512(a)(1)(P-H 1987). 

29 I.R.C. sec. 513(d)(3)(P-H 1988). 

30 I.R.C. sec. 511(a)(2)(A). See also Hopkins at 851 (6th ed. 1992). 

31 Joint Committee on Internal Revenue Taxation, "General Explanation of
Tax Reform Act of 1969", 91st Cong., 2d Sess. (1970), at 66-67. 

32 P.L. 99-514, 99th Cong., 2d Sess. (1986). 

33 I.R.C. sec. 513(d)(3)(P-H 1987). 

34 I.R.C. sec. 513(e)(P-H 1987). 

35 I.R.C. sec. 513(f)(P-H 1987). 

36 I.R.C. sec. 513(h)(P-H 1987). 

37 Ways and Means Oversight Subcommittee UBIT Recommendations (Section 511
- Unrelated Business Income Tax), printout p. 5 (June 23, 1988)
[hereinafter Ways and Means Oversight Subcommittee] (LEXIS, Fedtax library,
TNT file) (Doc. 88-5664) Note that author was able to locate all original
hearing transcripts but was unable to locate this particular Summary and
Recommendation Report on any other medium. 

38 Id. at printout pp. 5-6. 

39 Id. at printout p. 6. 

40 Id. at printout pp. 6-7. 

41 Bergin at 975-976 (June 1992). 

42 Unrelated Business Income Tax Part 1, Part 2, and Part 3, 100th Cong.,
1st Sess. 100-26, 100-27, 100-28(1987)(Y4W36:100-26, 100-27, 100-28). 

43 Discussion Options on the Unrelated Business Income Tax, 100th Cong., 2d
Sess., 100-74 (1988)(Y4W36:100-74). 

44 Ways and Means Oversight Subcommittee, supra, at printout p. 1. 

45 Id. at printout p. 23. 

46Id. at printout pp. 25-27. 

47 Id. at printout pp. 12-14. 

48 Id. at printout p. 4. 

49 Id. at printout pp. 25-27. 

50 Id. at printout p. 25. 

51 Id. at printout p. 26. 

52Id. at printout p. 30. 

53 The Philadelphia Inquirer, April 19, 1992, at A12, col. 2. 

54 Unrelated Business Income Tax Part 1, 100th Cong., 1st Sess. 100-26,
(June 22, 1987) (Testimony of the Honorable O. Donaldson Chapoton, Deputy
Assistant Secretary (Tax Policy - Department of the Treasury)(Y4W36:100-26,
pp. 11-89). 

55 Ways and Means Oversight Subcommittee, supra at printout p. 26. 

56 Id. at printout p. 29. 

57 I.R.C. sec. 513(c) (P-H 1987). 

58 Treas. Reg. 1.513-1(c)(1)(P-H 1983). 

59 I.R.C. sec. 513(a)(2)(P-H 1988). 

60 Ways and Means Oversight Subcommittee, supra at printout p. 26. 

61 Id. at printout p. 39. 

62 I.R.C. sec. 512(b)(13)(P-H 1988). 

63Treas. Reg. 1.512(b)-(1)(l)(4)(P-H 1983). 

64 Ways and Means Oversight Subcommittee, supra, at printout pp. 42-43. 

65 Id. at printout p. 42. 

66 Id. at printout p. 25. 

67 H.R. 11, "The Revenue Act of 1992", 1 Congressional Index -102nd
Congress (1991-1992)(CCH). 

68 Entin and Schuyler, H.R.11 - R.I.P., Congressional Advisory No. 10, IRET
Briefing, (Section 1202 - Deduction for Capital Gains(R)) (September 18,
1992)(LEXIS, Fedtax library, TNT file)(Doc. 92-8780) printout p. 2. 

69 Id. at printout p. 3. 

70 Ways and Means Oversight Subcommittee, supra, at printout p. 27 

71 H.R. 11, "The Revenue Act of 1992", version 8, 102nd Cong., 2d Sess.,
sec. 7202(a) (November 17, 1992)(LEXIS, Legis library, BTX102
file)[hereinafter H.R. 11] Note that author was only able to find
microfiche original for H.R. 11, version 3 at Y1.4/6:102- 2(nos.)00310 and
microfiche original for H.R. 11, version 4 at Y1.4/6:102-2(nos.)00358 using
the most recent February 12, 1993 House/Senate Bill Cumulative Index. 

72 Id. at 7202(a). 

73Id. at 7204(a). 

74 Id. at 7204(a). 

75 Id. at sec. 7204(b). 

76 Id. at sec. 7205(a). 

77 Id. at sec. 7205(a). 

78 Id. at sec. 7201(a). 

79 I.R.C. sec. 57(a)(6)(A)(CCH 1992-1993). 

80 H.R. 11, supra, at sec. 7201(d) 

81 I.R.C. sec. 57(a)(6)(B)(CCH 1992-1993). 

82 H.R. 11, supra, at sec. 7303(a). 

83 Id at sec. 7303(a). 

84 Id. at sec. 7303(a). 

85 Announcement 92-15, 1992-5 I.R.B. 51 (February 3, 1992). 

86 Spirtos and Streckfus, Year in Review: Tax Exempts Stood to Gain From
H.R.11; Hill Help Expected in '93, 57 Tax Notes 1740 (December 28, 1992,
No. 14). 

87 H.R. 11, "The Revenue Act of 1992", 1 Congressional Index -102nd
Congress (1991-1992)(CCH). 

88 Bush, George, Bush Statement on Veto of H.R. 11, p. 1,
(Miscellaneous)(Release Date: November 4, 1992)(LEXIS, Fedtax library, TNT
file)(Doc. 92-10152). 

89 The Philadelphia Inquirer, April 18, 1993 at A1, col. 3. 

90 Hopkins at 5 (5th ed. 1987). 

91 Id. at 26-27 (5th ed. 1987). 

92 Ways and Means Oversight Committee, supra at printout p. 42. 

93 Id. at printout p. 39. 

94 Id. at printout p. 39. 

95 The Philadelphia Inquirer, April 21, 1993, at A10, col. 1. 

96 Id., April 21, 1993, at A10, col. 2. 

97 Id., April 21, 1993, at A10, col. 1. 

98 Ways and Means Oversight Committee, supra, at printout p. 27. 

99The Philadelphia Inquirer, April 21, 1993 at A12, col. 1. 

100Bell, Craig D., Lawmakers Pass Bill on Nonprofits' Property Tax
Liability, 5 Exempt Org. Tax Rev. 771 (April 1992). 

101 Id. at 771. 

102 Id. at 771. 

103Id. at 771. 

104The Philadelphia Inquirer, April 18, 1993, at A11, col. 5. 

105 The Philadelphia Inquirer, April 18, 1993, at A11, col. 5. 

106 Id., April 18, 1993, at A11, col. 5. 

107 The Philadelphia Inquirer, April 18, 1993, at A11, col. 1. 

108 Hopkins at 10, (6th ed. 1992). 

109 Id. at 17 (5th ed. 1987). 


------------------------------------------------------------------------
This document is made available by VCILP as a part of its ongoing
commitment to make information available to the world community. VCILP does
not evaluate the substantive accuracy of materials created by persons
beyond its control or supervision. This document is made available with the
understanding that VCILP is not engaged in rendering legal, accounting,
computing, or other professional service. If legal advice or other expert
assistance is required, the services of a competent professional person
should be sought. 
------------------------------------------------------------------------
http://www.law.vill.edu/vill.tax.l.compen/files/student_papers/tax2.htm
©Villanova Center for Information Law and Policy