Charity and Taxes (Background)

The Senate version of the 2005 tax bill now being considered in Congress includes significant reforms to the way the tax code governs charities. This is a big deal for the non-profit community because the tax code is the principal way that non-profits are regulated. Most states give the state attorney general the right to shut down charities that don’t actually live up to their charters, but hat almost never happens and is complaint driven. The tax provisions targeted at charities, in contrast, are relatively vigorously enforced by the Internal Revenue Service.

None of these reforms make sense in a larger policy context, however, without some background. Today, I'll start today by looking at the biggest questions at all, which are what non-profits status gives a charity and why there are increasing doubts about whether this scheme is a good one.

There are a variety of kind of charities, but the most well known is the domestic 501(c)(3), typically, in the form of a non-profit corporation incorporated under a state law specific to non-profits. While these charities are often called “tax exempt” which means that they don’t owe corporate income taxes on their profits, this benefit turns out to be the least important of the benefits of 501(c)(3) status. The reality is that most tax exempt 501(c)(3) organizations spend virtually all of the money they receive each year on purposes which would be tax deductions if the organizations were taxable.

Moreover, 501(c)(3)s aren’t really truly tax exempt either. They still have to pay FICA and FUTA payroll taxes for their employees, and still have to withhold income taxes at the state and federal level from wages paid to their employees. And, if a non-profit engages in an active business activity unrelated to its charitable purpose, e.g. a church that also ran a chain of ordinary gas stations, the profits from the unrelated business activities is taxable as if the business was a for profit corporation and if the activities are substantial and continuing, the charity’s entire non-profit status could be lost. Investment income, on the other hand (even dividends from a for profit corporation owned entirely by a non-profit corporation, or rents actively managed rental real estate), is tax free.

Most states do permit non-profits to escape paying sales taxes on their purchases (although typically only medium and large non-profits figure out how to do this and even in those organizations, small purchases are often made without exercising this privilege). Most states also permit non-profits to escape paying property taxes on real estate which they own, although this generally only impacts the fairly small cross-section of non-profits (largely hospitals, schools and churches) which own real estate.

The real big financial advantage to non-profit status, however, comes from the charitable deduction from income taxes (Internal Revenue Code 170), the charitable deduction from estate taxes (Internal Revenue Code 2055, and similar provisions for gift and generation skipping transfer taxes), and eligibility to receive grants reserved for non-profits, such as distributions from a kind of charity known as a private foundation.

The income tax charitable deduction is one of the biggest “tax expenditures” in the tax code. It costs the federal government hundreds of billions of dollars a year, is generally speaking, regressive in terms of how it impacts tax bills relative to income (non-itemizers, who tend to be lower income, can’t take it at all, and wealthier people can generally afford to give away a larger percentage of their incomes), and is one of the biggest sources of complexity in the tax code for the average taxpayer because the number of transactions which an individual must keep records regarding and summarize for a tax return once a year to claim the charitable deduction far exceeds that of other common itemized deductions like the mortgage interest deduction and state and local taxes deduction.

The charitable deduction also is the source of a great deal of governmental interference in the affairs of non-profit organizations. Organizations that claim this lucrative financial benefit are forbidden from engaging in substantially lobbying and can not endorse political candidates – in effect, they up the freedom to engage in political speech, despite the fact that political action may be a local way to further the organization’s non-profit purposes (more subtle political influence through education and advocacy on certain political issues is permitted). They must file tax returns on a regular basis if they are large operations, even though generally nothing will be owed, and must register with tax authorities to obtain an identifying employer identification number. They also put the IRS in the position of deciding whether or not the organization is really engaging in charitable activities.

Progressives have, never the less, historically supported the charitable deduction. This is because the non-profits that benefit from the charitable deduction have historically been an important progressive force in our society. Charitable organizations heal the poor, educate people, provide human services, and further arts and science which often promote progressive messages. Until relatively recently, religious organizations, which backed the civil rights movement, the abolition of slavery, improved treatment of working women and children, peace, opposition to the death penalty, and the narrowing or abolition of the death penalty, was also seen as a generally progressive force in society.

More recently, considerable skepticism has developed regarding the degree to which charities are really selfless gifts that governments should subsidize with tax breaks, or whether they are more like personal expenditures. Going to the movies or buying a CD advances the arts, but we don’t give you a charitable deduction for those. Hospitals do provide charity care, but it is rarely more than 3% of revenues, and is usually far less. Churches similarly spend a far greater proportion of their revenues on operating expenses like rent and furnishings and a pastor and secretary’s salary, in most cases, than they do on human services targeted at the poor. Secular private schools and colleges typically primarily serve the upper middle class who pay a healthy price for the privilege, and while many do provide financial aid to needy students, donations don’t have to be limited to that purpose to obtain tax breaks. A donation to establish a cushy lounge at an elite law school where the average student will make $90,000 a year upon graduation gets just as much of a tax break as a scholarship fund for first time college students. Yet, a personal gift to help a particular needy student whom the donor knows attend college, without a formal scholarship process, doesn’t qualify for a charitable deduction at all. Art museums, operas, and theater companies are routinely classified as non-profit and entitled to charitable deductions, despite the fact that these institutions often charge healthy admissions charges to see their artistic offerings and cater to a decidedly middle to upper middle class audience, while professional sports teams, which provide entertainment to a much more plebian audience, often made available to the public for free through broadcast television subsidized with advertisements, are routinely operated as for profit ventures. National Public Radio, and Public Television, which routinely note in an effort to generate advertisements called “underwriting” that they have audiences with a socially and economically elite demographic. Credit unions, which receive a tax exemption, increasingly look very much like their for profit cousins, but with better deals made possible, in part, by a lack of a need to pay dividends to shareholders or to pay taxes on profits.

In short, the rough justice understanding that the tax benefit that the rich receive from making charitable donations is matched by the public benefit that accrues from those donations is an assumption which is increasingly being challenged.

(The skepticism is less stark in the case of the gift and estate tax charitable deductions. While these taxes are structured as taxes on donors, the policy justification for these taxes is as a tax in lieu of an income tax on inheritors and gift recipients. These taxes are felt primarily by the Paris Hilton's of the world. Rather than tax the amounts received to the recipient, as we do with lottery winners whom inheritors of great wealth resemble, it is more practicable to tax the individual who has the funds and gives them away. But, when a gift is made to a charity, which wouldn't pay income taxes on what it received in any case, this justification for the gift and estate taxes breaks down.)