Statement of John Colombo, Professor, University of Illinois College of Law, Urbana-Champaign, Illinois

Testimony Before the Full Committee
of the House Committee on Ways and Means

April 20, 2005

Mr. Chairman, Members of the Committee:

My name is John Colombo.   I am a professor of law at the University of Illinois College of Law in Urbana-Champaign, and I have taught about and written on issues of tax-exempt organizations for the past 18 years.   I think my job today is to give you some background and context regarding tax exemption rules, particularly as they apply to private foundations and trade associations.

Charitable Exemption vs. Other Exemption

Let me start with two very basic and very useful distinctions to keep in mind when assessing policies regarding nonprofits and tax exemption.   The first distinction is that when it comes to tax exemption, there are charities exempt under Code Section 501(c)(3) and then there is everything else.  Section 501(c) grants exemption to 28 different kinds of organizations, but the “charities vs. everything else” distinction is a very useful way to think about this for several reasons.  First, in general only charities exempt under 501(c)(3) are eligible to receive additional major tax benefits like tax-deductible contributions.   Other exempt entities, like trade associations (which are exempt under § 501(c)(6), rather than § 501(c)(3)), get exemption from having to pay the corporate income tax on their earnings, but are not permitted to receive deductible contributions.

Second, the underlying rationales for exemption vary between charitable organizations and everything else.   Although we academics carry on a lively debate about the rationale for charitable tax exemption, all of us would agree, I think, that at some level exemption for charities is tied to a concept that they are improving general public welfare in some way.  For non-charitable entities, however, the rationale tends to be much more entity-specific. 

For example, trade associations are exempt if they carry on activities designed to promote a common business interest of its members; such organizations must not “engage in a regular business of a kind ordinarily carried on for profit.”[1] These organizations are exempt because they represent simply a pooling of resources by people with a common interest to conduct activities that, if conducted by the members themselves, would not be profit-making businesses.   Hence we believe that creating an “association” for members to pool their resources in this manner should not result in taxation of those pooled resources.  But if a trade association does conduct regular business activities or provides specific services for members, then the organization should not be exempt because it no longer represents this nontaxable collective pooling of resources, but rather is now engaging in a for-profit business.

Third, charities constitute the bulk of exempt organizations under 501(c).  Data complied in 2002 indicated that there were in excess of 900,000 exempt charitable organizations in the IRS’s master file, constituting well over half the total number of all exempt organizations.[2]  Trade associations under 501(c)(6) were the next most numerous category, with approximately 84,000 organizations, but still less than a tenth of the number of charitable organizations.

Public Charities vs. Private Foundations

The second major distinction in tax-exemption law occurs within the charitable sector itself.   This distinction is between public charities and private foundations.   People often get confused about the tax-exempt status of private foundations; so the first thing to remember is that private foundations are charitable organizations eligible for exemption under Section 501(c)(3) just as much as a church or a private school.   The IRS has long recognized that making monetary grants to other charities is itself a charitable activity, and that’s largely what private foundations do – make grants to other charitable organizations.  Historically, in fact, private foundations preceded the income tax.   The wealthy industrialists of the 19^th century, such as Andrew Carnegie, for example, created trusts to benefit charitable organizations long before we had a functioning income tax.   As a result, prior to 1969, private foundations and public charities were treated pretty much the same for tax purposes.

In the 1969 Tax Reform Act, however, Congress decided to subject private foundations to more specific regulation designed to prevent abuses of the private foundation form.   The best way to understand why we have this heightened regulation of private foundations is to focus on two main differences between private foundations and public charities: accountability and continuing control.

Public charities are organizations that are accountable to the general public because they get their money in one way or another from a broad cross-section of the public.   Private foundations, however, generally receive their funding from a single individual or family, and therefore are accountable to and controlled by that primary donor.

These two distinctions are the basis for our different regulation of public charities and private foundations.   When you have true public accountability and “public control” over assets, then you have some reason to believe that the managers of the charity will be careful about their mission and the execution of that mission, because a publicized misstep will have significant adverse effects on the public funding of that organization.  Think back to the adverse publicity for the United Way a couple of years ago when its CEO’s salary and perks were disclosed in the national media, or the outcry that happened when the Red Cross decided to divert some money donated for 9/11 victims to other needs – I believe, in fact, that this Committee held hearings about the Red Cross’s decision and was instrumental in bringing the weight of public accountability to bear on that. 

When you do not have this public accountability, however, and you have significant continuing control by one person or family over donated wealth, then there is enormous room for abuse, which is why we have the much tighter regulatory scheme for private foundations.   This tighter regulatory scheme generally is set forth in Sections 4940-4946 of the Code, and includes a requirement that a foundation pay out a certain amount of its assets each year to other charities, a prohibition on self-dealing transactions of any kind, limits on the kinds and size of certain business holdings of a foundation, limits on certain kinds of investments that a foundation can make, more stringent limits on lobbying, and so forth.  In addition, in 1969 Congress also tightened the rules with respect to charitable donations to private foundations, again to avoid abuse situations in which individuals could eliminate tax liability by making gifts of certain kinds of property, like stock of a privately-held corporation, that could still be controlled for by the donor after the gift.  So while individuals can make deductible donations of up to 50% of their adjusted gross income to public charities, and in many cases can take a deduction for the full fair market value of donated property to public charities, deductions to private foundations are limited to 30% of AGI and deductions for property gifts generally are limited to the taxpayer’s tax basis in the property, not its market value.

Defining “Charitable” Organizations for Tax Exemption

While I think this short summary gives a useful overview of the two main distinctions in our tax exemption laws (charities vs. everything else, and within the “charity” category, public charities vs. private foundations), I would like to close with an additional thought about tax exemption, particularly as it applies to charitable organizations.

One of the core problems with tax exemption for charities over the years has been that exemption more or less “just happened” without a great deal of thought regarding why we hand out tax exemption.   Many organizations, such as churches and private schools, for example, were already exempt from state property taxes when Congress passed the first corporate income tax law in 1894; these organizations were not businesses in any sense of the word, and hence exemptions were incorporated into the “new” income tax law without much debate.  

As a result, while we have this vague notion that we grant exemption to charities because they “do good things” for society, there has never been a specifically-articulated rationale that allows us to tie down exactly what good behavior should be rewarded with exemption.   Currently, the IRS relies on the 400-years of legal precedent in the law of charitable trusts to define charitable organizations.   As the operation of nonprofit organizations has changed over time, however, difficult questions have come up regarding tax exemption for certain nonprofits.   For example, in the 1800’s private nonprofit hospitals were essentially shelters for the poor.  Today, most of them are very large fee-for-service businesses. So why are modern private nonprofit hospitals still exempt?   Is it because they “do good things” for society?   There is no question that nonprofit hospitals in fact do good things for their communities, but one could argue that many for-profit businesses do good things for their communities, as well.   Is it because they provide free care for the uninsured poor in some cases?   Maybe so, but that is not currently required by law and the empirical evidence on whether nonprofit hospitals provide significant charity care is mixed.[3]   So in some cases we have ended up with a sort of disconnect between our traditional views of charities and the way they operate in the real world today.

Over a decade ago, my colleague Mark Hall and I suggested a system in which tax exemption under Section 501(c)(3) would be limited to entities that were substantially dependent on donations for their operating revenues each year.[4]   There is a reason why limiting exemption to donative organizations makes sense – in brief, donations are the signal that people believe an organization is doing something worthwhile, and is not otherwise being sufficiently funded by the private market or by the government.  People donate to organizations because they see the needs these organizations serve and see a lack of resources to meet those needs. In contrast, organizations that do not get significant donations either aren’t doing anything the public thinks is worthwhile, or the public sees that they have ample resources without donations.   In either case, such organizations do not need tax exemption.   Using donative status, therefore, seems to be a pretty good way to distinguish organizations that do the things that ought to warrant tax exemption from those organizations that do not.   In fact, if I asked all of you to name your paradigm charities, I suspect that most of you would name donative entities – your church, the Salvation Army, the Red Cross, the United Way, maybe certain arts organizations.

I think that any discussion of reforming the rules for tax exemption ought to include some thought about the overall system for granting tax exemption, particularly for charitable entities under 501(c)(3), and whether you agree with my suggestion about using donations as this core rationale or not, I would urge the Committee to give some thought to this general point as it deliberates on these issues.

 Thank you.

[1] Treas. Regs. 1.501(c)(6)-1.

[2] Marion Fremont-Smith, Governing Nonprofit Organizations 6-7 (Belknap Press 2003).   This number is likely significantly higher than what is reported, because churches do not have to file with the IRS for recognition of exemption under   Section 501(c)(3) and therefore are not included in the IRS Master File.

[3]  Under the “community benefit” test of exemption promulgated by the IRS in 1969, free care for the uninsured is not a requirement for a hospital to receive exemption under Section 501(c)(3).  See Rev. Rul. 69-545, 1969-2 C.B. 117; John D. Colombo, The Role of Access in Charitable Tax Exemption, 82 Wash. U.L.Q. 343, 347 (2004).  For a review of the empirical evidence, see John D. Colombo, The Failure of Community Benefit, 15 Health Matrix 29 (forthcoming 2005).

[4] John D. Colombo and Mark A. Hall, The Charitable Tax Exemption (Westview Press, 1995); Mark A. Hall and John D. Colombo, The Donative Theory of the Charitable Tax Exemption, 52 Ohio St. L.J. 1379 (1991).