The Charitable Tax Exemption

John D Colombo, Mark A Hall

• Publisher: Routledge
• Year: 2019
• ISBN:
  9781000315325
• Edition: 1
• Topic: Law
• Subtopic: Tax Law
• Index: Law

The tradition of tax-exempt status for nonprofit "charitable" organizations is well established, and few would argue with the principle. But the tax-exempt sector of the economy is vast and rapidly growing, resulting in the loss of billions of dollars of tax revenue. At the same time, we have no consensus on what purpose the charitable tax exemption serves, let alone agreement on what constitutes a charity. In this important addition to the theory of tax law, Colombo and Hall develop an original "donative" theory that links the charitable tax exemption to the ability of an organization to derive donative support from the community. Their theory not only makes intuitive sense but also receives support from economic, political, and moral theory. Its implications would rationalize the charitable tax exemption, comport with legal precedent, and simplify the administration of the law. The Charitable Tax Exemption is a major contribution to the theory of tax law and should be essential reading for a wide range of lawyers dealing with taxes. It will also be enlightening for anyone involved in the operation of a nonprofit organization

Part One
Conventional Theories of Exemption

1
The Charitable Tax Exemption: An Introduction

The Structure and Significance of Exempt Status

The History and Rationale of the Charitable Exemption

Exempting charities from various forms of taxation is a practice that appears as old as western civilization itself. In the words of one scholar, "real property taxation, and exemption therefrom, seems to be about as old as history. . . . One historian reports that the 'economic equilibrium of the state was endangered' by the fact that the tax exempt temples owned fifteen percent of the cultivable land and vast amounts of slaves and other personal property during the reign of Ramses III about 1200 B.C."¹ Ezra 7:24 commands that "it shall not be lawful to impose toll, tribute, or custom upon . . . priests ... or ministers of the house of God," and Genesis 47:24 declares that "Joseph made it a law over the land of Egypt unto this day, that Pharaoh should have the fifth part; except the land of the priests only, which became not Pharaoh's." England has had a charitable exemption in its income tax law since it was enacted in 1799 and reintroduced in 1842.² In the United States, federal tax law has relieved charitable organizations from income tax since the law's inception in 1894.³ And, in both countries, charities have enjoyed exemption from state and local property taxes for centuries longer.⁴

The universal character of the charitable exemption extends internationally. A survey of ten other countries, both eastern and western (Austria, Belgium, Hungary, Israel, Italy, Spain, Taiwan, Thailand, United Kingdom, and West Germany) found that all conferred an exemption from corporate income tax and from some form of ad valorem taxation on nonprofit entities that we would classify as charitable, although the particular listings and descriptions varied.⁵

The long history of the charitable exemption has made it a virtually immutable part of the tax laws—so much so that the thought of taxing charitable organizations on the same basis as profit-making enterprises seems contrary to nature. As early as the nineteenth century, the custom of exempting education, religion, and care of the poor was "so grounded in the nature of our Government as to represent a practically irrevocable law."⁶ Even those most critical of the exemption suggest its repeal in only the most tentative tones, preferring a reformulation instead.⁷

Given this universal status and ancient lineage, it is extraordinary that no generally accepted rationale exists for the charitable tax exemption. In searching for a coherent theoretical or public policy rationale in modern times, various commentators have conceded: "despite th[e] long history of the tax [laws], or perhaps because of this long history, there is very little logic, or reason, or legislative history to support... the tax exemption";⁸ "the statutory phrases 'exclusively used for charitable purposes' [and] 'purely public charity' seem to mean less than nothing";⁹ "we do not have any careful and comprehensive rationale for the scope and operation of the tax exemption. We do not have any satisfactory theory, legal or economic, to apply in making judgments about it";¹⁰ "a comprehensive review of the standards and the rationale for tax exemption has never been undertaken";¹¹ and "think[ing] more seriously about what is meant by the concept of charity [is] a task that is about four hundred years overdue."¹²

Scholars have a murky idea of the basis for the exemption in prior ages, but these historical rationales no longer remain relevant. In ancient Egypt, Greece and Rome, temples and other religious institutions were not taxed because it was thought they were owned by the gods themselves and were thus beyond the reach of mortal taxing authorities. In medieval England, churches, monasteries and the like were not taxed, at first because in feudal times there was no centralized government capable of imposing such a tax; indeed, the churches themselves were a sort of taxing authority, collecting tithes from feudal lords. This power distribution changed dramatically later in England's history when churches were not only taxed but confiscated as part of the suppression of clerical power during the Reformation. The charitable exemption survived during this time by expanding its reach to secular charities as a way of further undermining the church's influence.

In the American colonies, the initial pattern was much more haphazard. Systems of taxation were inconsistent and incomplete because these newformed governments lacked uniform methods for identifying taxable property or even an annual tax collection system.¹³ Exemptions arose simply by virtue of these incomplete systems of taxation and therefore carried no rationale. As taxation become more systematized, exemptions typically were incorporated in corporate charters on an ad hoc basis, as a matter of legislative grace. The primary example of a uniform exemption in colonial America was for orthodox churches, which were not taxed because the colonies were established as theocracies and no government taxes itself. The religious exemption continued in the states even after the constitutional adoption of the separation principle, largely for reasons of historical Anglo-American tradition. Thus, it was expanded to cover education and other secular charitable purposes in early state statutes and often in state constitutions, because that was the pattern that prevailed in England at the time. The present form of charitable exemption in state property law is essentially unchanged from this time, when its political rationales disappeared.¹⁴

At the federal level, tax exemption was simply not an issue until the passage of the first income tax act in 1894. Prior to this, federal revenues came mostly from import duties and excise taxes, which did not affect the charitable organizations of that time. The first federal income tax law adopted in 1894, however, contained a broad exemption for "corporations, companies or associations organized and conducted solely for charitable, religious or educational purposes."¹⁵ The legislative history is largely silent regarding the origins of this provision. It appears to have been completely uncontroversial, and not debated. As a result, most commentators have concluded that the federal exemption merely recognized the universality of the exemption at the state and local level, as well as the fact that a tax on profits should not include "nonprofit" organizations.¹⁶ This recognition was then incorporated into subsequent tax acts: while the 1894 law was declared unconstitutional in 1895, every subsequent federal income tax law has contained a similar exemption.

In summary, the charitable exemption arose in earlier centuries as a consequence of the prevailing patterns of taxation. Classic charities such as churches were not taxed because they did not fit within the existing tax bases, not out of any sense of explicit social policy justification. As the structure of taxing systems evolved, however, the categories of non-taxed activities were retained, despite the change in rationale. As a consequence, we are left with a pattern of exemption defined largely by history and accident. The absence of a coherent rationale founded on the structure of our modern taxing systems gave rise to a subsidy theory of the exemption, one that generalizes the exemption as an attempt to help those entities that "do good" for society. This subsidy rationale differs sharply from the earlier tax-based theories in that it attempts a normative justification for excusing certain entities otherwise subject to tax from contributing their social share, whereas the earlier tax-base theories are a largely descriptive exercise of explaining why certain entities or activities do not fall within the prevailing system of taxation. In Chapter 2, we elaborate further on this distinction.

Turning briefly to the modern subsidy rationale, while our society superficially agrees that certain "good activities" are entitled to tax exemption, this superficial agreement masks considerable confusion over precisely what good activities qualify as charitable and why they are deserving of tax exemption. Part of the problem is the vast array of activities to which the exemption has been applied. While one intuitively thinks of classic charitable entities as those serving the poor or distressed, such as the Salvation Army or the Red Cross, in fact charitable exemption status extends to entities that have little to do with the poor—for example, symphony societies, opera houses, museums and any number of private schools and universities. Moreover, even those exempt entities that we might classify as unquestionably "doing good" are often replicated to a degree by nonexempt entities that perform the same functions. Health care, for example, is an area in which exempt and nonexempt institutions exist side-by-side in the same market in the form of nonprofit and for-profit hospitals, which provide virtually identical services to paying customers.¹⁷ Likewise, while no one denies that the greatest research universities in the United States are nonprofit exempt organizations, there is certainly no lack of for-profit educational institutions, either.¹⁸ The same is true in virtually all other sectors of exempt activity: while we know of no officially for-profit churches, certainly the music industry is dominated by for-profit record companies and recording groups existing alongside exempt opera companies and symphony societies; for-profit art galleries ply their wares amidst nonprofit museums, and exempt scientific organizations report on the research work done at Intel or Motorola.

This generality and nonspecificity of the modern subsidy theory, which society has adopted by default as a result of the disappearance of earlier political and tax-base rationales, forms the central problem of this book. In order for the charitable exemption to have a firm social and theoretical foundation, and in order to provide some guidance for its administration, it is necessary to search for the particular concept of "doing good" that makes sense of the actual universe of charitable activities that has been handed down through history, and that makes sense of why a subsidy should be administered through a tax exemption rather than more directly. To explain why this is an important undertaking, we next describe the vast scope of the exempt sector.

The Size of the Exempt Sector

Why should one care about the theory underlying exempt charitable organizations? The answer, in a word, is money. To that one, we might add power and influence, as well. The exempt sector as a whole (of which charitable organizations are a subset) is very large and growing rapidly. Burton Weisbrod notes that nonprofits "engage in hundreds of distinct activities; they are growing at the rate of thousands per year; they employ millions of workers; and they have hundreds of billions of dollars of annual revenues and assets."¹⁹ The number of categories of federally exempt activities has grown from 90 to 260 since 1965.²⁰ Correspondingly, the number of federally exempt entities has nearly tripled over the last 25 years: at the end of 1993, there were 1,440,265 exempt organizations.²¹ Alfred Balk summarizes without exaggeration that our society provides "cradle-to-grave" exemptions: "by careful planning, one now can live much of his life on tax-exempt property . . . [starting] with birth in a tax-exempt hospital, followed by baptism in an untaxed church and education in tax-immune public schools. . . . [H]e then could be interred in a tax-exempt cemetery beneath a gravestone that had been displayed in and engraved at a tax-exempt showroom."²²

According to 1990 data, nonprofit organizations controlled property, cash and investments worth some $850 billion, not including churches and smaller nonprofit groups that do not have to report such holdings.²³ If one factors in churches, the figure likely exceeds $1 trillion. Recent estimates are that 10 percent of all private properly in the United States is tax-exempt; if one includes government property, as much as one-third of all property in the country is exempt.²⁴ Revenues and expenditures are equally staggering. Nonprofits garnered some $400 billion in revenues in 1989, and expended some $327 billion.²⁵ In some local areas, the expenditures of charitable organizations actually exceed those of local government. Lester Salamon reports that one study of Baltimore, Maryland found that nonprofit expenditures in the Baltimore metropolitan area exceeded the total expenditures of the city of Baltimore and the five surrounding counties.²⁶

Organizations exempt because of their charitable status constitute by far the largest component of the private exempt sec...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Dedication
• Contents
• Preface
• PART ONE CONVENTIONAL THEORIES OF EXEMPTION
• PART TWO THE DONATIVE THEORY
• Index
• About the Book and Authors