Should charities still be tax-exempt?

Here’s a word association game: I say tax-exempt public charity. You say house of worship, soup kitchen, or university. You probably don’t think about secret back-room political operations or multi-billion dollar businesses. But you should.

Increasingly, these organizations are straying from the charitable work that drove Congress to grant them tax-exempt status in the first place. Instead, they are using the law to avoid tax on business profits or mask the identities of big-bucks campaign donors who finance increasingly nasty, but entirely anonymous, political ads.          

Yesterday, while most tax wonks were focused on the Senate’s largely symbolic votes on the fate of the 2001-2010 tax cuts, the House Ways & Means Oversight subcommittee was holding an important hearing on the arcana of tax-exempt public charities. And the panel heard, in great, sad detail, how charities are abusing the spirit, if not the letter, of the law.

Let’s take two examples:

The first is the growing commercial activity of charities. As University of Illinois Law Professor John D. Colombo told the subcommittee, such business is booming. “It is increasingly common,” Colombo said, “to find charities engaged in a variety of economic activities through for-profit subsidiaries, joint-venture partnerships, and contractual arrangements.”

In theory, charities are required to pay tax, called the unrelated business income tax, on this revenue. They can even lose their tax-exemption for such aggressive business activities.  But they almost never lose their exemption and they rarely pay the tax.

Once, this issue applied to income from college bookstores. Now, it is big business. Colombo described one non-profit Pennsylvania health system that controlled eight tax-exempt entities and three for-profit corporations. Then, there are non-profits such as the National Football League and the U.S. Olympic Committee that arguably exist only as commercial enterprises.

Colombo argued that this trend raises many important concerns, including unfair competition between non-profits and for-profits, the erosion of the corporate tax base, and the loss of focus by charity management.  

The second issue, and one that is getting lots of attention in this heated election season, is the aggressive use of the public charity law by political operatives. Through a chain of immensely complex arrangements, these groups have been able to organize themselves in a way that allows their funders to make unlimited, entirely anonymous contributions to political campaigns.

The thread is mind-numbing. But Ohio State University Law Professor Donald B. Tobin walked the committee through the maze. First, keep in mind that the tax laws prohibit public charities from engaging in political advocacy. However, the IRS does allow tax-exempt social welfare organizations—organized under a different section of the Tax Code–to lobby or advocate for issues. Unlike charities, donors can’t deduct their contributions to these groups. However the organizations themselves do not have to pay tax on their income.

These social welfare groups can even create separate funds to engage in political activities. However,   they must disclose the names of their contributors—exactly what the political operatives want to avoid. So, smart lawyers figured out a way to keep contributors’ names secret by laundering funds directly through the social welfare organizations themselves. This requires them to claim they are engaged in issue advocacy and not politics, and assertion that would surprise anyone who watches the ads they fund.

Tax-exempt organizations won’t be immune from the debate over tax reform, and their special treatment may be jeopardized as Congress looks for ways to broaden the tax base. The more public charities use their tax-exemption to avoid tax on regular business income or mask political operations, the more they will put that special treatment at risk.