Reforming Nonprofit Exemption Requirements

Fordham Journal of Corporate & Financial Law Volume 17, Number 2 2012 Article 4 Reforming Nonprofit Exemption Requirements Peter Molk∗ ∗ Copyright c 2012 by the authors. Fordham Journal of Corporate & Financial Law is produced by The Berkeley Electronic Press (bepress). http://ir.lawnet.fordham.edu/jcfl Reforming Nonprofit Exemption Requirements∗ Peter Molk Abstract This Article proposes a reform for nonprofit exemption and unrelated business income tax. Current tax law provides unclear guidance and requires exempt organizations to risk their entire exemptions on this guidance, leading them to make the socially inefficient choice to use for-profit subsidiaries to preserve their exemptions. Reforming the tax law will solve this inefficiency while providing exempt nonprofits with the desirable option to undertake efficient nonexempt activities to augment their operating budgets. This reform is particularly timely in light of changes to the healthcare field; reform will enable exempt healthcare organizations to offset rising health costs and decreased reimbursements with other revenue opportunities. KEYWORDS: Nonprofits ∗ J.D., Yale Law School; M.A., Yale (economics). Thanks to Tom Aageson, Howard Abrams, John Colombo, Miranda Fleischer, Henry Hansmann, Jeffrey Kahn, and John Morley for insightful comments and discussions. VOLUME XVII 2012 NUMBER 2 FORDHAM JOURNAL OF CORPORATE & FINANCIAL LAW REFORMING NONPROFIT EXEMPTION REQUIREMENTS Peter Molk REFORMING NONPROFIT EXEMPTION REQUIREMENTS Peter Molk* ABSTRACT This Article proposes a reform for nonprofit exemption and unrelated business income tax. Current tax law provides unclear guidance and requires exempt organizations to risk their entire exemptions on this guidance, leading them to make the socially inefficient choice to use for-profit subsidiaries to preserve their exemptions. Reforming the tax law will solve this inefficiency while providing exempt nonprofits with the desirable option to undertake efficient nonexempt activities to augment their operating budgets. This reform is particularly timely in light of changes to the healthcare field; reform will enable exempt healthcare organizations to offset rising health costs and decreased reimbursements with other revenue opportunities. TABLE OF CONTENTS INTRODUCTION .................................................................................... 476 I. JUSTIFICATIONS FOR THE NONPROFIT FORM ............................. 480 A. PUBLIC GOODS THEORY .......................................................... 480 B. INFORMATION ASYMMETRIES THEORY.................................... 482 II. REQUIREMENTS FOR FEDERAL TAX EXEMPTION ....................... 486 A. ACTIVITIES RELATED TO EXEMPT PURPOSES ........................... 491 B. INSUBSTANTIALITY DETERMINATION ...................................... 492 C. WHAT IS AT STAKE ................................................................. 493 D. SUMMARY ............................................................................... 494 III. THE UBIT .................................................................................... 494 A. UNRELATED TRADE OR BUSINESS ........................................... 495 B. REGULARLY CARRIED ON ....................................................... 499 C. STATUTORILY EXCLUDED ACTIVITIES ..................................... 500 * J.D., Yale Law School; M.A., Yale (economics). Thanks to Tom Aageson, Howard Abrams, John Colombo, Miranda Fleischer, Henry Hansmann, Jeffrey Kahn, and John Morley for insightful comments and discussions. 475 476 FORDHAM JOURNAL OF CORPORATE & FINANCIAL LAW [Vol. XVII D. SUMMARY ............................................................................... 501 IV. USE OF FOR-PROFIT SUBSIDIARIES BY EXEMPT NONPROFIT ORGANIZATIONS .......................................................................... 502 A. INCOME STRIPPING .................................................................. 503 B. COMPLETELY NONEXEMPT ACTIVITY ..................................... 504 C. MIXED ACTIVITIES .................................................................. 506 1. When For-Profit Subsidiaries are Efficient ..................... 507 2. When For-Profit Subsidiaries are Inefficient but are Used Nevertheless ............................................................ 509 D. SUMMARY ............................................................................... 512 V. REFORMING EXEMPTION AND UBIT LAW .................................. 512 A. REFORM 1: EXEMPTION AS GATEKEEPER................................. 513 B. REFORM 2: POLICING THROUGH UBIT .................................... 515 1. Broadening the UBIT’s Scope ......................................... 515 a. Intermittent Activity .................................................. 517 b. Statutorily-Enumerated Exceptions ........................... 518 c. Related Activity ......................................................... 526 2. Relaxing Exemption Requirements .................................. 529 3. Potential Concerns .......................................................... 532 4. Exemptions for For-Profit Organizations?...................... 539 CONCLUSION ........................................................................................ 540 APPENDIX ............................................................................................. 541 INTRODUCTION Healthcare costs have risen significantly over the past several years. Health expenditures per capita have increased by more than five thousand percent from 1960 to 2008.1 Government support of exempt activity2 and private donations3 have dropped. Yet exempt healthcare 1. See National Health Expenditures Aggregate, U.S. DEP’T OF HEALTH AND HUMAN SERVS., CTRS. FOR MEDICARE AND MEDICAID SERVS., http://www.cms.gov/ NationalHealthExpendData/downloads/tables.pdf (last visited May 25, 2011). National expenditures have risen from $147 per capita in 1960 to $7,845 per capita in 2008. Id. Amounts are adjusted to current dollars. Id. 2. See MICHAEL I. SANDERS, JOINT VENTURES INVOLVING TAX-EXEMPT ORGANIZATIONS 1-2, 5 (3d ed. 2007). 3. See id. at 1-2; see also Shelly Banjo, Donations Slip Amid Anxiety, WALL ST. J., June 9, 2010, at A2 (documenting decreases in support of nonprofits). Private charitable giving fell in 2008 and again in 2009. Id. at A2. Until 2008, charitable giving had fallen only once since 1956. Id. 2012] REFORMING NONPROFIT EXEMPTION REQUIREMENTS 477 organizations are frustrated by an unclear IRS tax policy that often leads to a high-stakes gamble when they attempt to offset price increases with profitable activity. Other exempt organizations are also faced with the same problem, and are similarly dissuaded from engaging in nonexempt activity that might raise revenue to counter the diminished government and private support. Tax law, which threatens to revoke exemptions if organizations undertak (...truncated)