House Ways and Means Subcommittee on Oversight Hearing
Federal Information & News Dispatch, Inc. |
I. Introduction
In a 2002 article,
Charities are not just conducting more commercial activities themselves, however. It is increasingly common to find charities engaged in a variety of economic activities through for-profit subsidiaries, joint-venture partnerships and contractual arrangements. The health care sector is perhaps the most visible in its use of complex structures, but they are also found in education and other traditionally-charitable activities. n7
Commercial activity by charities, therefore, seems to be an entrenched and growing phenomenon. Yet the income tax rules surrounding commercial activity are confused and contradictory, based on regulations issued in 1959 that no longer serve either tax policy or the exempt organizations community.
II. The Current Tax Rules n8
Federal tax rules regarding commercial activity involve two main issues and two subsidiary ones. n9 The first main issue is whether the activity jeopardizes the charity's tax exemption under Section 501(c)(3) of the Internal Revenue Code ("Code"). Commentators have referred to this first issue as the "commerciality doctrine" or "commerciality limitation" on exempt status. n10 The second main issue is whether, if commercial activity does not jeopardize exemption, it nevertheless should be taxed. This issue is covered by the Unrelated Business Income Tax (UBIT) in sections 511-514 of the Code that has been with us since 1950.
To illustrate these main issues, suppose that I start a charity whose purpose is to run a soup kitchen for the homeless. The revenue for this charity comes exclusively from donations. Provided that this organization complies with other requirements of exemption, there is no question it qualifies as an exempt charity under 501(c)(3), with both a primary purpose and activity dedicated to relief of the poor. Now suppose that I decide that I could expand my soup kitchen operation if I had more revenue. So I finance the acquisition of a small manufacturing facility to manufacture and can chicken soup that I then sell through commercial channels with the intent of using the profits generated to expand my soup kitchen operation. Two questions arise: does the "commercial" soup manufacturing/sales operation cause my organization to lose its exempt status? If not, must I nevertheless pay tax on the profits from the soup sales?
The two subsidiary issues are (1) whether commercial activity undertaken by entities related to a charity (e.g., a subsidiary of a charitable parent, a sibling for-profit corporation or a partnership in which a charity is a partner) will be "imputed" to the exempt entity for purposes of determining their tax-exempt status and (2) how the
A. The Commerciality Limitation vs. the UBIT
Though Section 501(c)(3) states that an organization will qualify for exemption only if it is "organized and operated exclusively" for a charitable purpose, the statute has almost never been interpreted literally. As early as 1924, the
The destination of income test was overruled by
The final regulations adopted by the
With respect to the exempt status issue, Regulations [Sec.]1.501(c)(3)-1(b)(1)(i) states that an exempt charity's organizational document (e.g., articles of incorporation or trust agreement) may not empower it to "engage, other than as an insubstantial part of its activities, in activities which in themselves are not in furtherance of one or more exempt purposes." n19 A couple of paragraphs later, the regulations warn that an organization will fail to qualify for exemption "if more than an insubstantial part of its activities is not in furtherance of an exempt purpose." n20 But an even later part of the regulations (1.501(c)(3)-1(e)) states that an organization may qualify for exemption even if "it operates a trade or business as a substantial part of its activities, if the operation of such trade or business is in furtherance of the organization's exempt purpose and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business . . . ." n21 It appears from these regulations, therefore, that the two key concepts in determining the effect of commercial activity on exempt status (as opposed to whether the commercial activity is taxable under the UBIT) is when an activity is "substantial" and when an activity can be said to be "in furtherance of" an exempt purpose. The regulations, particularly Regulations [Sec.]1.501(c)(3)-1(e), seem to say that unrelated business activities that are "in furtherance of" can be substantial without endangering exempt status; activities that are not "in furtherance of," however, must be insubstantial in order to retain exemption.
The regulations, therefore, seem to set forth a fairly straightforward linear analysis regarding the effect of commercial activity on exempt status. This three-step analysis is as follows. First, one must identify the organization's charitable purpose (if any). Second, one must analyze whether a particular noncharitable activity (e.g., a commercial activity) is "substantial" in comparison to other activities of the organization in question. Third, if the commercial activity is substantial, then one must analyze whether that substantial commercial activity is "in furtherance of" the organization's charitable purpose.
The problem is that the regulations under 501(c)(3) do not tell us anything about when a commercial activity is "substantial" or when it is or is not considered "in furtherance of" an exempt purpose. With respect to the former issue, a number of questions arise. Is "substantial" measured quantitatively or qualitatively? If the former, what quantitative measures are relevant, and are they measured absolutely or relative to charitable activity? If absolute, how much activity is "substantial"? If relative, do we compare the gross expenditures on the commercial activity vs. the charitable activities? Gross revenues for each? Number of employees (or volunteers) in each activity? The amount of time spent by the employees/volunteers on each activity? The regulations say nothing about this. n22
With respect to the interpretation of "in furtherance of," the regulations and case law are also completely silent. One possible interpretation of the regulations is that "in furtherance of" is equivalent to "substantially related" under the UBIT. Or put the opposite way, one might conclude that any "unrelated" activity under the UBIT is not "in furtherance of," and any "substantial" amount of unrelated commercial activity therefore creates exemption problems. n23 Certainly, one cannot see "related" activity as creating exemption problems; if an activity is related for UBIT purposes, then by definition it must functionally advance the organization's exempt purpose, and hence must be viewed as being "in furtherance of" that purpose. But the contrary proposition (that "unrelated" activity automatically is not "in furtherance of") is not necessarily true. In fact, if this proposition were correct, then the statement in Regulations [Sec.] 1.501(c)(3)-1(e) quoted above that an organization may operate a business as long as the "primary purpose" is not carrying on an unrelated business makes no sense. If any "unrelated" business were viewed as not being "in furtherance of," then any unrelated business that was "substantial" would cause an organization to lose exempt status. A "substantial" business is presumably well short of one that is a "primary purpose"; therefore, the reference in Regulations [Sec.] 1.501(c)(3)-1(e) to an organization losing exemption when an unrelated business becomes its primary purpose would be completely meaningless, because any "substantial" unrelated business would cause loss of exemption even if that business was not the "primary purpose."
The only sensible harmonization of these regulations, therefore, is that in enacting the UBIT,
Early interpretations of the regulations by the
The background to the 1964 revenue ruling, however, is more revealing than the ruling itself in interpreting the "commensurate-in-scope" language. Prior to approving the 1964 revenue ruling, the General Counsel's office referred the issue in the proposed ruling to the
A later
[A]side from express statutory limitations on business activity, such as section 502 and the newly enacted provisions relating to private foundations, there is no quantitative limitation on the "amount" of unrelated business an organization may engage in under section 501(c)(3), other than that implicit in the fundamental requirement of charity law that charity properties must be administered exclusively in the beneficial interest of the charitable purpose to which the property is dedicated.
[F]or some time now it has been increasingly apparent that our earlier approach to the problem of permissibility or nonpermissibility of business activities of charities has been based on a misconception that somehow in the enactment of the provisions for exemptions of charities from income tax,
Exhaustive research of legislative history from the earliest enactment of the charitable provisions of our income tax laws fails to provide support for such proposition. To the contrary, the evidence is clear that the first provision for exemption of charities from imposition of tax under the Corporation Excise Tax of 1909, from which the present income tax exemption provisions derive, was accompanied not by any intention to limit exemption to charities not engaged in business, but an intention to assure exemption of certain charities that were engaged in business. n31
The memo also addressed the issue regarding what should happen in cases in which the operation of an unrelated business either produced no profit to subsidize charitable activities or in which the profit was purposely reinvested to grow the unrelated business, as opposed to dedicated to expanding charitable outputs. As to the former case, the memo agreed with the original position of the Council that "the better logic in cases in which the business activity does not in fact provide any significant funds for charitable use is that the organization is not being operated exclusively for charitable purposes." n32 With respect to the latter case, the memo observed,
We think that if an organization devotes its resources to business use which produces a reasonable return on the investment, but refuses to apply any significant part of its profits or resources to any charitable program and the condition prevailed for an unwarranted long time, a prima facie case could be made out that the organization is not administering its properties exclusively in the beneficial interest of charity since it is neither accomplishing any short range or any long range charitable purpose in respect to the beneficial use of its properties. n33
The memo cautioned, however, that each such case would need to be resolved on its particular facts and circumstances.
Despite what seems to be the clear linear analysis mandated by the regulations, the
For example, in
As a result of
This analysis, however, is not consistent with the
On the other side of the ledger, in 1984 the Third Circuit reversed the revocation of exempt status for a religious publisher in Presbyterian & Reformed
Publishing v. Commissioner, n44 a case substantially similar to
Similarly, the Tax Court itself approved exemption in several "resale shop" cases -situations in which a nonprofit enterprise primarily operated a business selling crafts produced by a particular group. In the late 1970's, for example, the Tax Court approved exemption for an organization that imported, purchased and sold artist's crafts, n47 an organization that purchased and sold products manufactured by blind individuals, n48 and an organization that operated two public art galleries. n49 A Federal appellate court also reversed a lower court ruling upholding a revocation of exemption on commerciality grounds when the taxpayer, a publishing company, showed that it had no "operational profits." n50
Even the
In short, the Treasury Regulations,
B. Complex Structures
The conflict between "relatedness" and "in furtherance of" is not the only inconsistency in the commercial activity realm.
In one sense, therefore, the
A subsidiary corporation of an exempt parent can sometimes claim tax exemption as an "integral part" of the parent's exempt activities. In general, the
In post-audit years, it appears that the subsidiary grew rapidly --perhaps beyond X's expectations. It is now worth several times X's investment in the subsidiary, although it apparently had not earned an operating profit through * * *. This growth presents a continuing obligation on X to translate this valuable asset into funds, and use those funds for the expansion of its charitable religious activities. For example, X may have to give consideration to selling some of the subsidiary's assets, or selling a portion of the stock of the subsidiary, to an unrelated party. The proceeds of such transactions must be used to fund or expand X's charitable or religious activities. The subsidiary should give highest enterprise via a partnership would place its exempt status at risk under the current version of the commerciality doctrine described above. n60 At the same time, an exempt organization that isolated a particular business activity in a corporate container for regulatory or liability reasons would lose any possibility of arguing that the business was "related" to the exempt organization's charitable purpose, since the parent's charitable activities could not be attributed "downstream" to the subsidiary corporation. n61 At one time, even the Treasury itself questioned the wisdom of these rules, n62 although there are no current legislative proposals to change them.
C. Private Benefit
The final issue that comes up repeatedly in the commercial-activity sphere is the private benefit doctrine. Even trying to summarize the private benefit doctrine is hazardous, but from a variety of
An organization is not described in section 501(c)(3) if it serves a private interest more than incidentally. . .
A private benefit is considered incidental only if it is incidental in both a qualitative and a quantitative sense. In order to be incidental in a qualitative sense, the benefit must be a necessary concomitant of the activity which benefits the public at large, i.e., the activity can be accomplished only by benefiting certain private individuals. . . . To be incidental in a quantitative sense, the private benefit must not be substantial after considering the overall public benefit conferred by the activity. n63
Although the
III. Making Tax Law Coherent
A. A Taxonomy of Commercial Activity and the Policy Objectives of Regulating It
Part II. above recounts the inconsistent positions the
In some prior writing, I identified several policy concerns with charities conducting commercial activities. Those concerns are (1) avoiding unfair competition between exempt and for-profit entities, (2) limiting erosion of the corporate tax base by having charitable organizations buy taxable activities that become non-taxable in the charity's hands, (3) limiting the extent to which the attention of management is "diverted" from charitable activities into running for-profit businesses, (4) promoting economic efficiency, (5) guarding against "over-subsidizing" charitable activities by letting charities "self-subsidize" through the acquisition of commercial businesses and (6) limiting the business risk exposure of charitable assets that might accompany running a business from the same "container" (corporation or trust) that houses charitable assets. n69 Some of these policy concerns are more significant than others. For example, economists have almost uniformly rejected the notion that charities engage in unfair competition, at least if that phrase is limited to predatory pricing techniques or inappropriately using exempt revenues to subsidize commercial activity. n70 Similarly, exposing charitable assets to business risk can best be handled through insurance and proper diversification; tax law should have little to say about this policy issue. n71 On the other hand, protecting the corporate tax base, limiting managerial diversion, promoting economic efficiency and limiting possible over-subsidization of charitable activities (which could be viewed as simply a subset of promoting economic efficiency) do seem to be significant concerns.
Say Recent Joint Venture Ruling Doesn't
Commercial activity also has its benefits, however. The obvious benefit is that it permits charitable organizations to expand (or maintain) their outputs in an environment in which the availability of direct government grants may be shrinking and competition for both the available government money and private donations is increasing exponentially along with the sheer numbers of exempt charities. n72 In some cases, moreover, commercial activity may permit a charity to earn a return on capital investments made primarily for charitable purposes, but which by their nature may be under-utilized for purely charitable outputs. Thus a conclusion that commercial activity by exempt charities is uniformly "bad" is not correct.
Instead, it may be useful to try to categorize the kinds of commercial activities charities engage in and analyze whether the concerns with commercial activity outweigh the potential benefits. In general, one can separate commercial activity into five categories:
* Category 1: commercial activity that is also the primary exempt activity;
* Category 2: commercial activity that is functionally related to the organization's exempt purpose (e.g., "substantially related" activity under the UBIT);
* Category 3: "unrelated" commercial activity that exploits excess capacity;
* Category 4: "unrelated" commercial activity that does not exploit excess capacity but the revenues from the activity are directed to charitable outputs, and
* Category 5: "unrelated" commercial activity that becomes "empire building" for its own sake. n73
Categories 2-5 involve inherently different circumstances. In each of these categories, the charity has a substantial charitable activity of some kind that exists alongside the commercial activity. In Category 2, the commercial activity is one that is functionally related to the charity's exempt purpose - activity which would be "substantially related" under the current UBIT. Such related activities may be a concern for tax-base erosion, but little else. Since the activities are functionally related to the exempt purpose they bear little risk of managerial diversion (after all, management is engaging in these activities as an integral part of their exempt activities). Moreover, as Professor
For example, one would expect that the music school that puts on concerts by by for-profit groups already has personnel experienced in concert planning and execution. There may be some risk of undue "self-subsidization" by charities if these related activities are financially successful, but given that these activities are by definition a functional part of the charitable program, the chances of these activities becoming serious money-makers likely are small.
In Category 3, charities undertake "unrelated" commercial activities because they have excess capacity from capital investments made for charitable purposes. The classic example here is a university that rents its stadium facilities to a professional football team for the summer or that leases unused supercomputer time to for-profit research groups. n77 Commercial activities falling within this category also should not raise exemption problems. In this kind of case, we should positively encourage charities to avoid letting assets simply lie fallow. Doing so is a waste of invested capital. There may be some concern that we not encourage charities to consciously "over-invest" in capital facilities or in employees simply to use them in commercial businesses, but to the extent that investments are made at a level necessary to conduct charitable activities, earning a profit through maximum utilization of that investment would seem to be a desirable and efficient outcome. Moreover, if the capital investment is made in the first instance to pursue charitable activities, there is little reason to think that there is much risk to the corporate tax base (since the activities for which the investment was made likely would not have been undertaken by the private market). Managerial diversion also would be limited, because if the capital assets used in the commercial activity were primarily meant for charitable purposes, any commercial activity by definition will be subordinate to commercial use. For example, the empty athletic stadium is only available to rent when the university's teams are not using it - generally, this means the summer only. Ditto for the unused supercomputer time - commercial use will by necessity be subordinate to academic use.
In Category 4, charities undertake commercial activities that do not exploit economies of scope, but generate returns above the market rate on stocks and bonds that in turn will be used to expand charitable outputs. The church that opens a
These Category 4 activities raise mixed issues. On the one hand, it seems that we should not impede the ability of charities to develop alternative resources to expand charitable outputs. Other commentators have noted the modern pressures on funding sources for charities; n78 if investing wisely in certain commercial activities produces a premium rate of return for charities to expand charitable outputs, that seems as though it would be a generally good thing. Engaging in these activities, therefore, likely should not affect exempt status as long as the revenues from the commercial activity are used to subsidize charitable outputs. Yet there are some countervailing concerns. Unlike category 2 or 3 activities, those in category 4 are far more likely to result in managerial diversion, since the commercial activity is not subordinate to any charitable use of the underlying assets. The church that runs a
Finally, in Category 5, charities become involved in commercial activities that take on a life of their own, where revenues are largely reinvested in the activity itself, instead of being used to subsidize expanding charitable outputs. In a 2004 Technical Advice Memorandum dealing with an exempt church that owned a for-profit subsidiary, the
B. Suggested Reforms
The above analysis suggests some reforms that may be worthy of consideration. First, the problem with Category 1 cases is really a problem with defining appropriate charitable activities, not a problem of the relationship between charitable activities and commercial ones. What is necessary here is that the
Of course, this approach would create a few problems with some existing organizations. If publishing religious texts in a manner similar to commercial publishers is not charitable, then one wonders why operating a hospital in a manner similar to for-profit hospitals justifies exemption. I certainly have no problem with the
Catgories 2, 3, 4, and 5, on the other hand, all presuppose that the organization in question has some charitable activities apart from its commercial activity. Of these, only Category 5 activity should result in loss of tax exemption. These "empire building" cases present the greatest threat of managerial diversion and of nonprofits becoming for-profits in disguise. Accordingly, exemption should be at risk only in cases in which the commercial activity is not functionally related to the organization's exempt purpose and revenues from commercial activity are not used to substantially cross-subsidize charitable outputs. Put another way, the
A second suggested reform, therefore, is for either
A third reform would be to jettison the relatedness test for the UBIT and impose tax on all commercial activities by charities, whether related or not. n85
There are several reasons for this approach. First, the analysis in Part III.A. indicates that while commercial activity in categories 2, 3 and 4 should not affect exemption, such activities (particularly those in category 4) do present some significant risks to the corporate tax base, of managerial diversion, and of economic inefficiency and excessive self-subsidization. Taxing all commercial activities obviously would more completely protect the corporate tax base than the current system, since no commercial activity (even if it is "related") would escape taxation. Second, taxing all commercial activity would promote economic efficiency, because charities could not earn a premium rate of return on a particular activity simply by avoiding the income tax that would otherwise be due. Under this proposed system, a charity presumably would choose to invest in a direct commercial activity only if the after-tax rate of return it could earn would be greater than the market rate on a diversified portfolio of investment assets - that is, the charity would have to make a decision that it could earn a premium rate of return by efficient operation of the commercial enterprise, and not just by avoiding taxes. n86 It is likely, therefore, that if all commercial activity were taxed, charities would concentrate on commercial activities for which they enjoy some economies of scope with respect to either capital investments or employees or which had some other kind of synergy with their charitable programs, which in turn would also help curb empire-building tendencies and avoid managerial diversion issues. n87 Finally, this approach would actually simplify the law - we would no longer rely on tortured interpretations of the phrase "substantially related" to determine if a commercial activity is taxable or not; and if all such activities are taxable, the "container" used to conduct them would be irrelevant.
The fourth potential reform follows from the second and third. If commercial activity is essentially unlimited provided that it is used by the exempt organization as a source of funding for charitable outputs and if all commercial activity is community, really meant "any competition." As noted in the text, several other policy concerns present better rationales for taking this step. taxed, then there is no tax reason to distinguish between the activities of different pieces of a complex enterprise for tax exemption purposes. That is, whether a specific nonprofit within a related group of organizations meets the "primary purpose" test for exemption should be tested based upon the aggregate activities of a complex group, not on an entity-by-entity basis. n88 Either the group as a whole would have a "primary" charitable purpose (and operating commercial businesses to fund this primary purpose would be perfectly OK under my proposals) or it does not. Exemption should follow this group analysis, and not rest upon arbitrary distinctions regarding the kind of economic container in which specific activities are carried out. Note, however, that if the first and second reforms suggested above are adopted, then the
Finally, the
The reforms suggested here, however, are dependent on a final issue: being able to distinguish revenue-producing charitable activities from commercial ones. If a nonprofit theater sells tickets to the public, is the ticket revenue from a "commercial activity"? How about sales of drinks and food to theater patrons? For the answer, we should turn back to the main policy issues surrounding commercial activity, including protecting the corporate tax base, managerial diversion and economic efficiency. In particular, it seems that if these are the main problems with charities engaging in commercial activity, then an activity should not be labeled "commercial" unless it is competing with substantially similar for-profit goods or services. An activity that would not be conducted in the for-profit market is not a worry for the corporate tax base, because no tax would be collected on that activity in any event. Nor would such an activity seem to be a managerial diversion concern - in fact, it seems that nonprofits should be providing exactly those services not part of the for-profit market. Finally, if the for-profit market can't or won't produce a particular good or service, then by definition there is no more efficient way to produce it than through the government or the nonprofit sector, and if the government won't do it, that leaves only the nonprofit sector. Thus whether the theater's ticket sales are a "commercial activity" or not should depend on whether the theater is producing the same kinds of plays as for-profit theaters and hence is competing in the for-profit theater market. Food and drink sales, on the other hand, are easy to classify as "commercial" since all sorts of for-profit restaurants, vending machine companies and so forth are in that same business. n91 For cases in the middle, the "commercial hue" analysis developed by the courts and the
IV. Summary
As a policy matter, how the law regulates commercial activity by charities goes to the very heart of what the charitable sector will look like in the future.
Unfortunately, the current provisions of the I.R.C. regarding commercial activity by charities and the
*
n1
n2
n3 "
n4
n5 TO PROFIT OR NOT TO PROFIT (
n6
n7 One of the more famous recent cases illustrating a complex structure was
nv. Comm'r, 100 T.C. 394 (1993). As explained by the Tax Court:
Petitioner [GHP] owned and operated a health maintenance organization (HMO) under the Pennsylvania Health Maintenance Organization Act, Pa.
The foundation controlled petitioner and the other entities in the Geisinger system, as well as three for-profit corporations. The foundation had the power, under the articles of incorporation and bylaws of petitioner, GMC, GWV, GSS, the clinic, and
Id. at 395-96.
Although a large percentage of complex structures come from the health care sector, they exist in other sectors as well. See, e.g., Priv. Ltr. Rul. 95-06-046 (
n8 Parts of this section are copied or adapted from
n9 See generally, Colombo, Commercial Activity, supra note 8, at 491 (2002); JAMES J. FISHMAN AND STEPHEN SCHWARZ, NONPROFIT ORGANIZATIONS 567-72 (4th ed. 2010).
n10 Colombo, Commercial Activity, supra note 7, at 491; FISHMAN AND SCHWARZ, supra note 7, at 572;
n11 Trinidad v. Sagrada Orden de Predicadores de la Provincia del Santissimo Rosario de Filipinas,
n12 Colombo, Commercial Activity, supra note 8, at 498-99; FISHMAN &
n13 E.g.,
n14 I.R.C. [Subsec.] 502, 511-514. A "feeder" is an entity that operates a commercial business but is obligated to pay the net revenues of that business over to an exempt charity. See FISHMAN AND SCHWARZ, supra note 9, at 588-589.
n15 Colombo, Commercial Activity, supra note 8, at 500; FISHMAN &
n16 Indeed, Professor
n17 I.R.C. [Sec.] 513(a). For a more extensive discussion of the UBIT rules, see HILL AND MANCINO, supra note 7 at chapter 22; HOPKINS, supra note 10 at chapter 23
n18 Treas. Reg. [Sec.] 1.513-2(a)(4).
n19 Treas. Reg. [Sec.]1.501(c)(3)-1(b)(1)(i).
n20 Treas. Reg. [Sec.]1.501(c)(3)-1(c)(1).
n21 Treas. Reg. [Sec.]1.501(c)(3)-1(e).
n22 Case law is equally useless. The closest we have to a definition of "substantial" is a case that dealt with the concept under the lobbying limitation ("no substantial part" of an exempt organization's activities may be lobbying). In
n23
n24
n25 Rev. Rul. 64-182, 1964-2 C.B. 186.
n26 Id.
n27
n28 Id.
n29 Id.
n30 As summarized by the Counsel's office in GCM 34682, 1971
n31
n32 Id. at *18.
n33 Id. at *23-24.
n34 285 F.2d
n35 Id. at 803.
n36 Id. at 804.
n37 Id. at 804-05.
n38 Id.
n39 Id. at 806.
n40 Fides Publishers Ass'n v.
nv.
n41
n42 Living Faith , Inc. v. Commissioner, 950 F.2d 365, 367 (7th Cir. 1991) ("According to its articles of incorporation, Living Faith was established for the purpose of keeping with the doctrines of the
n43 Id. at 373-75. An even more recent case (decided literally weeks ago) is
nv. Commissioner, No. 11-1553 (6th Cir. 2012). In this case, the Sixth Circuit used a "commercial hue" analysis to conclude that an organization which provided consulting services to farms and agribusinesses on a fee-for-service basis was not an exempt charity under 501(c)(3). The court's one-page analysis of the commercial activity issue (on page 10 of the slip opinion) completely ignores the three-step analysis set forth above. While I suspect the result in the case is correct, it would be nice if courts and the
n44 743 F.2d 148 (3d Cir. 1984)
n45 79 T.C. 1070 (1982).
n46 Id. at 158.
n47 Aid to
n48 Industrial Aid for the Blind v. Comm'r 73 T.C. 96 (1979). The charitable purpose was to provide employment for the blind and thus came within the regulations' statement that a charitable purpose includes "relief of the poor and distressed or underprivileged." Id. at 100-101.
n49
n50
n51 See generally,
n52 Tech. Adv. Mem. 9636001, 1996 PLR LEXIS 1026 (
n53 Tech. Adv. Mem. 9711003 (
n628. In the ruling, the
n54 Priv. Ltr. Rul. 200021056, 2000 PRL LEXIS 562 at *33 (
n55 E.g.,
n56 E.g., Priv. Ltr. Rul. 200704041, 2006 PLR LEXIS 2448 (
n57
n58 See, e.g., Rev. Rul. 98-15, 1998-1 C.B. 718, 720-721.
n59 One private ruling issued in 2004 suggests (in the mode of the "commensurate in scope" doctrine discussed above) that an exempt parent must somehow use revenues or assets of its for-profit subsidiaries to further its charitable purpose, or else it may run afoul of the primary purpose test. In TAM 200437040, the
nThe fact that the assets are being accumulated in a for-profit company under the formal legal control of X does not excuse X from using such assets for charitable religious purposes.
Tech. Adv. Mem. 200437040, 2004 PLR LEXIS 612, *25-*26 (
n60 See text at notes 19-56, supra.
n61 For example, we know from recent case law that a contract-model health maintenance organization (HMO) will find it difficult to obtain exemption under 501(c)(3) if the HMO business is in a separate corporation. See, e.g., IHC Health Plans v. Comm'r, 325 F.3d 1188 (10th Cir. 2003). It is not clear, however, whether revenues from an HMO that was operated as a "division" of a nonprofit corporation that operated an exempt acute-care hospital would be taxable or not; one could certainly argue that such revenues are "substantially related" to the hospital's exempt purpose of providing health care for the general benefit of the community, although some older
n62 As part of hearings on the UBIT in the late 1980's (hereafter, "the Pickle hearings") the Oversight Subcommittee of the
n63
n64 E.g.,
n65 See, e.g.,
n66 E.g., Rev. Rul. 2006-27, 2006-21 I.R.B. 915.
n67 See generally,
n68 In 2004, the
n69 Colombo, Commercial Activity, supra note 8, at 529-546.
n70 Id. at 530. See also,
n71 Id. at 544-46.
n72
n73
n74 See, e.g.,
n75 This category is one where confusion over the difference between charitable purpose and charitable activities is most problematic. One might argue, for example, that a nonprofit pharmacy has a charitable purpose to promote health; see, e.g., Rev. Rul. 69-545, 1969-2 Cum.
In PLR 200818023 (released
n76
n77
n78
n79 Corporations pay entity-level tax on their earnings at a maximum rate of 35%, whereas proprietorships and partnerships (or LLC's that choose to be taxed as partnerships) pay no entity-level tax. That means that in theory, a corporation must earn a higher pre-tax return on equity to compete with other investments in the market on an after-tax basis. If a charity could acquire a corporate business and avoid the corporate-level tax, it would be able to capture this higher pre-tax rate of return for itself simply as a result of the ownership change.
n80 Tech. Adv. Mem. 200437040, 2004 PLR LEXIS 612, *25-*26 (
n81 See,
n82 Of course, if one believes that big-time college football and basketball programs are themselves charitable activities, then this example is really a Category 1 case, not a Category 5 case. An issue that arises with the analysis in the text is exactly how one distinguishes between a "commercial" activity and a "charitable" activity that produces revenue. For a discussion of this issue, see text at notes 91-92, infra.
n83 I have in the past suggested that tax exemption is appropriate only in cases of combined market failure and government failure; if a "charity" is engaged in an activity that is simply participating in a private market, there is no market failure and no need for exemption. See generally, JOHN D. COLOMBO AND MARK A. HALL, THE CHARITABLE TAX EXEMPTION (1995).
n84 Colombo, Commensurate-in-Scope, supra note 8, at 351.
n85 This proposal is not new. The idea of replacing the "substantially related" test with a "commerciality" test stretches back at least to the Pickle hearings by the Oversight Subcommittee of the
n86
n87 Making all commercial activities subject to taxation, rather than just "unrelated" activities, might also reduce the ability of charities to "game the system" by allocating costs from charitable and related businesses to "unrelated businesses," thereby reducing (often eliminating) any tax liability for unrelated activities. See, e.g.,
n88 Once again, this proposal is not new and harkens back to the Pickle hearings of the late 1980's. The Treasury proposal at that time suggested aggregation for 80%-owned subsidiaries; see note 62, supra. I have suggested a far broader test of aggregation based upon the "supporting organization" tests in I.R.C. [Sec.] 509(a)(3). Colombo, Commercial Activity, supra note 8, at 565.
n89 I do not mean to suggest here that for-profit entities in a complex structure would somehow be converted for tax purposes to nonprofit status. Rather, I mean only that any nonprofit organizations in a complex structure would be tested for its "primary purpose" based upon the activities of the group as a whole, and not on their individual activities.
n90
n91 Of course, as with all other legal tests, there will be inevitable disagreement at the edges. For example, are Division I college football and basketball "commercial" under this test? They certainly produce substantial revenues for their schools, but whether they compete with "substantially similar" for-profit goods and services (e.g., professional for-profit sports) is an open question.
n92 See text at notes 41-43, supra.
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