In May of 2008, the New York Times’s Stephanie Strom took note of “the growing confusion over what constitutes a charity.” As “nonprofit groups look more like businesses, charging fees and selling products and services to raise money, and state and local governments are under financial pressure because of lower tax revenues,” the courts, legislators, and tax authorities are questioning whether entities designated as charities under federal law really merit the privileges they claim.
The Internal Revenue Service, which regulates charities under federal law, has compounded the confusion.
The Form 990, the annual non-tax filing required of all charities over a certain size, was recently amended to require that exempt organizations provide a detailed “Statement of Program Service Accomplishments” reporting revenues from their three most significant program services, as well as an evaluation of what they deem to be their most significant program service accomplishments for the year. At the same time, the Senate Finance Committee has expressed concerns about excessive accumulation of endowments by elite private universities, threatening to impose on them payout requirements and excise similar to those levied on private foundations. The failure of nonprofit hospitals to provide charity care has led some states to revoke their tax exemptions and has rekindled efforts to write such a requirement into the IRS Code. Executive compensation at certain large charities has also aroused public and legislative outrage.
While the requirement that U.S. charities report their “program service accomplishments” is far from the kind of rigorous public benefit standards adopted recently by Great Britain’s Charities Commission, under which, for example, the government is threatening to terminate the exemptions of the country’s elite endowed “public” schools for failing to provide sufficient financial aid for middle class students, changes in the Form 990 may constitute a basis for this kind of substantive accountability.
On the other hand, the IRS appears to be growing more lax in applying even the most general kind of public benefit considerations in granting charitable status. The Yale Daily News recently reported that Mory’s, the private eating club whose membership is restricted to Yale alumni, faculty, students, and administrators had received 501(c)(3) status as a tax exempt charity.
While it is certainly true, as legal scholar Evelyn Brody has noted, that federal charities law is notable for its willingness to give this status for any purpose not “illegal, impossible, or impracticable,” it has generally required that exempted entities benefit a “substantial and indefinite class of persons” and that it provide some sort of service to the general public. As an exclusive members-only social club financed by commercial activities (earned revenues from food and liquor sales and rental of its premises), the award of charitable tax-exempt status seems to be pushing the envelope in a variety of ways — and doing so at a time when public concern over the often unwarranted privileges enjoyed by charities is intensifying.
SO WHAT IS A CHARITY?
Questions about what constitutes a charity have been argued for almost as long as there have been charities. The Statute of Charitable Uses, enacted by the British Parliament and signed into law by Good Queen Bess (Elizabeth I) in 1601, was an effort to clarify the question by identifying as charitable certain designated purposes. These included the relief of the poor and disabled, caring for sick and maimed soldiers and sailors, supporting schools and scholars, repairing public works, caring for orphans, maintaining houses of correction, providing dowries for “poor maides,” aiding young tradesmen and artisans, redeeming prisoners and captives, and relieving “poore inhabitants” of their tax burdens.
Until the mid-eighteenth century, British and American courts debated whether charitable status was restricted to the “uses” enumerated in the statute or whether other institutions and activities might be awarded the special treatment that charities enjoyed. In 1767, Lord Camden defined a charity as “a gift for general public use which extends to the poor as well as the rich.” In 1804, ruling in a case on the validity of a charitable trust for an unenumerated purpose, Sir William Grant expanded the definition of charity to include “those purposes which are considered charitable, which that statute enumerates, or which by analogies are deemed within its spirit and intentment” (Morice v. Bishop of Durham 1804).
In 1844, in a landmark case involving the validity of charitable trusts established by Philadelphia millionaire Stephen Girard, the United States Supreme Court embraced the statement of plaintiff’s lawyer Horace Binney that charity is “whatever is given for the love of God or for the love of your neighbor in the Catholic and universal sense — that it is given from these motives and to these ends — free from the stain or taint of every consideration that is personal, private, or selfish” (Vidal v. Girard 1844).
Gradually, at least in federal law, jurists were broadening the definition of charity by differentiating the body of the Statute of Charitable Uses that both enshrined obsolete uses and overlooked new ones from its spirit. By the end of the nineteenth century, jurists like U.S. Supreme Court Justice Noah Haynes Swayne were enunciating sweepingly broad definitions: “A charitable use, where neither law nor public policy forbids,” Swayne declared, “may be applied to anything to promote the well-doing and well-being of social man” (Ould v. Washington Hospital 1877).
While some states, like Massachusetts, embraced liberal constructions of charity, awarding tax exempt status to virtually every form of non-commercial association, including social and athletic organizations, others remained staunchly conservative. Pennsylvania, Minnesota, and several other states limited charitable exemptions to organizations that advanced a charitable purpose, donated or rendered gratuitously a substantial portion of its services, benefited a substantial and indefinite class of persons who are legitimate subjects of charity, relieved government of some of its burden, and operated entirely free from private profit motive. Other states restricted exemption to organizations devoted to purposes enumerated in their charities statutes.
Following the revision of the Internal Revenue Code in the early 1950s and the creation of Section 501(c), a classification which included all types of organizations exempt from federal corporate income taxation, the agency moved rapidly towards a definition of charity based not on designated purposes or activities, but on such formal and fiduciary criteria relating to private benefit and the destination of surplus revenues. In effect, all an entity applying for charitable tax-exempt status needed to demonstrate was that its proposed purposes were legal and that its revenues would not be distributed in the form of dividends. Without examining their own charities laws, the states fell into line, granting exemption from corporate income, sales, real estate, and other taxation on the basis of federal designation.
In the meantime, the number, wealth, and centrality of nonprofits grew rapidly. In 1950, only 50,000 organizations were registered with the IRS as charitable tax-exempt. By the mid-1960s, when the government first began systematically counting them, the umber had grown to a quarter million. Today, there are more than two million and their growth continues unabated.
More significantly, as legal criteria for charitable tax-exempt status became more relaxed, nonprofits increasingly competed with tax-paying for-profit firms in industries (like broadcasting, publishing, educational testing, and recreation) from which they had been largely absent. At the same time, the IRS became more permissive about charities earning revenues from commercial activities and more liberal in its construction of what constituted tax-exempt “related income” from those activities. By the turn of the twenty-first century, nearly 90% of the revenues of secular nonprofits was earned income rather than the donations and bequests that had traditionally sustained charities.
Even more significantly, in many cities, nonprofit service providers largely replaced commercial and industrial enterprises as economic leaders. (In New Haven, Connecticut, for example, four large nonprofits — Yale University, Yale-New Haven Hospital, St. Raphael’s Hospital, and the Knight of Columbus — employed more people than all the other enterprises in the city combined). The displacement of tax-paying for-profit enterprises by tax-exempt non-profits had predictable adverse impact on their tax base. (In New Haven by the 1970s, 70% of the value of properties on the Grand List were tax-exempt).
Under the circumstances, it was hardly surprising that political leaders and tax payers began to question the wisdom of unlimited expansion of the charitable domain!
The first major challenge to the federal government’s non-substantive definition of charity came in the mid-1980s in Pennsylvania, when Allegheny County tax assessors denied the Hospital Utilization Project’s application for tax exemption. The HUP was a charitable tax-exempt entity that charged fees to hospitals for coordinating information flows between participating health care providers. It was a commercial enterprise that provided no direct services to individuals.
The case prompted the state’s Supreme Court to take a close look at the Commonwealth’s charities laws — only to discover that Pennsylvania held organizations seeking exemption to a far higher and more substantive “purely public charity” standard than the federal government did. The court upheld the local tax authorities denial of charitable status and eventually the legislature codified the ruling in the state’s Purely Public Charity statute, enacted in 2000.
Stephanie Strom’s 2008 article on the debate over defining charity was prompted by a similar case in Minnesota — this one involving a child day care center which charged all clients the same fees, regardless of ability to pay (in other words, it offered no charity care). The state’s Supreme Court discovered that Minnesota, like Pennsylvania, also had a purely public charity standard written into its charities law. The day care center lost its exemption from state and local taxes and Minnesota’s entire nonprofit community was thrown into a panic.
CHARITIES: CAUGHT BETWEEN A ROCK AND A HARD PLACE?
Ironically, as Strom points out, these court rulings and the increasingly hostile tone of the press, politicians, and the public towards charities, come at a time when declining giving, government austerity, and increasing demands for services have left them little choice but to pursue commercial income and to manage themselves in a more business-like way. But this inevitably raises the question of whether entities run like commercial enterprises deserve the tax and other privileges granted charities when they were genuinely donative, voluntary, and public-serving.
Assuming it is not an anomaly or oversight, the grant of charitable tax-exempt status to Mory’s offers an uncheering glimpse into the IRS’s current thinking about how charity should be defined. Because Mory’s itself has not responded to requests for copies of its Form 1023 (Application for Exempt Status), exemption letter, or related correspondence, we don’t really know what representations it made to the agency about what might constitute its “Program Service Accomplishments” or how it managed to equate its exclusively Yale-affiliated members as a “substantial and indefinite class of persons.” Nor is it clear how an entity whose revenues will be almost entirely derived from restaurant services could pass either of the tests for public charity status. None of the public statements by the club’s president and board chair, the latter a prominent New Haven lawyer associated with a host of high-profile local nonprofits, suggests that Mory’s intends to change or expand its services to include anything that could, by any conventional standard, be considered charitable.
According to a September 11th posting on the Nonprofit Law Professor’s Blog (http://lawprofessors.typepad.com/nonprofit/), it is not the club that is the charity,
but a separate trust designed to support the certified historic structure
within which the club operates. Contributions to Mory’s Trust would be
tax deductible as ‘qualified conservation contributions’ under section
170(h) of the Code; note that among the conservation purposes
provided in subsection (4)(A) of that section is “(iv) the preservation of
an historically important land area or a certified historic structure. The
arrangement utilized by Mory’s is not at all unusual, and numerous
clubs with historic structures have acted likewise. The result is often
the reconstruction and renovation of historic structures which, in many
cases, were deteriorating.”
While this certainly satisfies what the law requires, it may not pass public muster — particularly among New Haven tax-payers. As a parade of press reports have reminded us, it was not the historic building housing the club that was endangered, but the club itself, which had mismanaged its way into near-bankruptcy. The tax-exempt trust, rather than serving as a subsidy for historic preservation, actually serves as a subsidy for the social organization that occupies the building by relieving it of the necessity of attracting investors or soliciting non-deductible contributions.
The IRS’s political insensitivity not only ignores the national debate outcry about charities, but also the particular circumstances of charities in New Haven, a financially-troubled city where seventy percent of the value of properties on the Grand List are exempt, either because they are owned by nonprofits or by government, and where taxpayers pay some of the highest levies in the state (the current mill rate is 42.21 properties that are reassessed annually). Granting charitable status to Mory’s not only removes another valuable property from the tax rolls, but also subsidizes a food service business that competes with the city’s tax-paying restaurants, many of which are struggling to survive the current recession.
Most of all, decisions of this kind, which seem at odds with the IRS’s hesitant steps towards a public benefit standard, serve to fuel the increasing divergence between public expectations about charity and what the law allows. In the long run, if the experience of nonprofits in Pennsylvania and Minnesota is any indication, the political consequences of this widening gap between expectation and the law are likely to be adverse.
Nonprofit executive and boards would do well to remember that, for decades before the enactment of the 1969 Tax Reform Act, foundations resisted accountability to government and citizens. As a result of their arrogance, foundations publicly humiliated in congressional hearings and were compelled to submit to unprecedented oversight and regulation of their business holdings, payout rates, investment policies, governance, and political activities.
Peter Dobkin Hall
Hauser Center for Nonprofit Organizations
Harvard University
and School of Public Affairs,
Baruch College, CUNY
I’ve been involved in taxes for longer then I care to admit, both on the individual side (all my working life-time!!) and from a legal stand since satisfying the bar and pursuing tax law. I’ve furnished a lot of advice and rectified a lot of wrongs, and I must say that what you’ve put up makes impeccable sense. Please persist in the good work – the more people know the better they’ll be equipped to comprehend with the tax man, and that’s what it’s all about.