The Case Against Income Tax Exemption for Nonprofits

St. John's Law Review Volume 89, Winter 2015, Number 4 Article 3 The Case Against Income Tax Exemption for Nonprofits Michael Fricke Follow this and additional works at: https://scholarship.law.stjohns.edu/lawreview Part of the Tax Law Commons Recommended Citation Michael Fricke (2015) "The Case Against Income Tax Exemption for Nonprofits," St. John's Law Review: Vol. 89 : No. 4 , Article 3. Available at: https://scholarship.law.stjohns.edu/lawreview/vol89/iss4/3 This Article is brought to you for free and open access by the Journals at St. John's Law Scholarship Repository. It has been accepted for inclusion in St. John's Law Review by an authorized editor of St. John's Law Scholarship Repository. For more information, please contact . FINAL_FRICKE 6/28/2016 2:36 PM THE CASE AGAINST INCOME TAX EXEMPTION FOR NONPROFITS MICHAEL FRICKE† INTRODUCTION ............................................................................ 1130 I. BACKGROUND ........................................................................ 1134 A. How the Tax Code Treats Nonprofit Organizations ............................................................. 1134 B. Historical Development of the Income Tax Exemption ................................................................... 1138 C. Theories Justifying Income Tax Exemption for Nonprofits ................................................................... 1140 1. The Public Good Theory........................................ 1140 2. The Income Measurement Theory ....................... 1142 3. The Capital Formation Theory............................. 1145 4. The Donative Theory ............................................ 1147 5. Other Theories ...................................................... 1151 6. Conclusions from Current Theories of Income Tax Exemption ...................................................... 1152 II. THE PROBLEM ...................................................................... 1153 Table 1: Ten Largest Educational Nonprofits by Total Assets .......................................................................... 1155 Table 2: Ten Largest Health Care Nonprofits by Total Assets .......................................................................... 1155 Table 3: Ten Largest Arts Nonprofits by Total Assets ... 1156 III.  OTHER PROPOSED REFORMS.............................................. 1162 A. Mandatory Distributions for University Endowments ............................................................... 1162 B. The Addition of a “Nondiversion” Constraint for Nonprofits ................................................................... 1163 C. Elimination of Barriers Between Nonprofit and For-Profit Enterprises ................................................ 1164   † Lecturer of Business Administration, University of Illinois College of Business. Special thanks to Paul Lansing for his helpful insight during the writing of this Article. 1129 FINAL_FRICKE 1130 6/28/2016 2:36 PM ST. JOHN’S LAW REVIEW [Vol. 89:1129 IV.  THE PROPOSED SOLUTION ................................................. 1166 A. A Framework for Evaluating Any Proposed Change to the Tax Code........................................................... 1166 B. A Proposal for Reforming Nonprofit Income Taxation ...................................................................... 1167 C. Evaluating the Proposal Against the Framework .... 1170 D. So What Value Remains in Nonprofit Status? ......... 1172 E. Convergence with Other Theories of Exemption ...... 1174 F. What of the UBIT? ..................................................... 1176 V. CHALLENGES TO THE PROPOSED SOLUTION........................ 1176 A. Is the Proposal Even Possible, Given the Entrenched Nature of the Income Tax Exemption for Nonprofits? ............................................................ 1177 B. Would the Proposal Encourage Wasteful Spending To Avoid Taxation?..................................................... 1180 C. Other Objections......................................................... 1182 CONCLUSION................................................................................ 1183 INTRODUCTION Imagine that “the big one” finally strikes Southern California—a major earthquake destroys buildings and leaves thousands homeless and without power, water, and other basic necessities. Immediately, Hollywood springs into action and marshals every A-list entertainer available to perform for a concert benefiting earthquake relief. As George Clooney, Kanye West, and Taylor Swift plead with television viewers to help the people of Los Angeles, they reassure the public that one-hundred percent of all their donations will go directly to the American Red Cross for relief of those affected by the disaster. Swayed by this guarantee, the American people step up and provide millions of dollars to help their west coast neighbors recover. Now, consider what might have happened had the celebrities instead informed the viewers that the Red Cross already had plenty of money in its coffers to handle the crisis, but that it would appreciate more donations so the Red Cross would not have to dip into its savings. Not quite as compelling of a marketing pitch, is it? FINAL_FRICKE 2015] 6/28/2016 2:36 PM INCOME TAX EXEMPTION FOR NONPROFITS 1131 As a society, we have come to expect certain things. Politicians will say anything to get your vote; the Chicago Cubs will always be a group of lovable losers; and when we donate money to a nonprofit1 organization, that money will, in some way, aid in making our society better. But with regard to the latter, what we do not expect is for the nonprofit organization to accept our donation and then fail to use it to further its charitable purposes,2 or worse, to never use the money for anything at all. Yet, as the nonprofit segment of the marketplace continues to grow,3 a nonprofit’s failure to use donations for charitable purposes occurs more and more frequently. Most of us have an ingrained image of nonprofit organizations as perpetually scraping the bottom of the barrel for pennies to cover its operating expenses, while its staff happily lives below the poverty level because they believe in “the cause.” Then we write that year-end check to take advantage of tax deductions and imagine balloons falling from the sky at whatever ramshackle hut that passes for the organization’s headquarters. Our generosity has enabled the organization to fight the good fight for yet another day! Romanticism aside, many exempt organizations defy these traditional notions of the nonprofit world. While the food pantry in town probably does use every spare penny to feed the homeless, there are quite a few organizations that would happily  1 The terms “nonprofit,” “not-for-profit,” and “non-profit” are each bandied about with varying degrees of frequency in both academic and popul (...truncated)