Second Thoughts on Tax Treatment of American Philanthropy

The essays by William Dennis and Robert Atkinson suggest possible reforms of the tax treatment of American philanthropy. In this commentary I review and critique their proposals and identify some further problems these potential tax code changes would cause.

As things currently stand, nonprofit entities enjoy two kinds of tax advantages over for-profit entities. These roughly correspond to the expense and revenue sides of the nonprofit balance sheet. Nonprofit corporations need not pay income tax, need not pay property tax on the land and buildings they work in, and often need not pay sales tax. Regarding income (and donated capital) for nonprofits, donations to nonprofits enjoy tax-deductible status. These arrangements have grown up over a number of years through a variety of motivations—a classic camel as a horse put together by a committee.

Not So Different After All

One problem with this differential tax treatment is that nonprofit entities may not be quite as distinct from their for-profit counterparts in real life as they seem to be in the tax code. The distinction between nonprofits and for-profits is based on a combination of their purposes and the disposition of remaining funds after costs are paid out of revenues. Essentially, if the IRS deems the mission of a corporation to be a charitable one, broadly defined, and the residual claimant to any profits is the enterprise itself, the entity may be registered as a nonprofit. It makes little difference that some activities of a nonprofit might be more or less identical to those of a for-profit. Art museums operate small restaurants that can compete with nearby commercial restaurants. Goodwill Industries solicits donations of used cars that they refurbish and auction, much like any other used car dealer. The primary mission of such nonprofits, though, is supposed to be something in the public interest: to display great art to the public or to provide job training to the handicapped, for example. In addition to business activities, the financial strategies of for- and nonprofit firms also bear a close resemblance. Reinvestment of non-distributed profits is a common strategy of private, for-profit firms as well as nonprofits. The nonprofit’s goal is not to earn profits for its owners, but it cannot run in “the red” consistently over a long period either, so striving for income to regularly exceed expenses is a necessity.

Further muddling the picture are situations in which for-profits and nonprofits are in direct competition with each other. As Dennis notes, art, science, and history museums often operate bookstores that sell titles related to the museum’s exhibits. The impact of such competition is complex. On the one hand, tax-exempt status helps nonprofits compete against other bookstores; on the other, it was not museum bookstores living on impulse purchases that killed Borders. A thornier case in the same industry, however, involves university and privately operated stores that sell expensive textbooks to students. Why the university operation should not be taxed while the private firm next door pays taxes has no clear rationale.

In some industries for-profits and nonprofits contribute to more or less the same production process, but with no clear a priori rationale for the profit-making status of each component. Consider the health care industry. Not only do for-profit hospitals compete directly with nonprofits, but it is unclear why nonprofit hospitals enjoy tax-exempt status while closely related pharmaceutical and equipment manufacturers, physician practices, and health insurers bear the usual tax liabilities. Whatever a hospital does to contribute to public health and well-being, it could do little of it without surgical equipment, drugs, doctors, and money.

The point of these observations is to note that whether an enterprise is by some standard primarily philanthropic or primarily profit-making is a judgment call. In our polity we have left this judgment to the IRS. The papers presented here raise the question of whether that is the best we can do. Both authors, but particularly Atkinson, emphasize that there are two kinds of charitable activity. One promotes excellence in human creative activities, a good example of which would be an art museum; the other promotes the well-being of the poor and unfortunate, such as a soup kitchen. A vigorous civil society provides for both, and as things stand in the United States, both types of enterprises receive the same tax treatment, which is to say for the most part they are exempted from payment of most taxes (through the corporate tax-exemption), and gifts reduce their donors’ tax liabilities (through the personal charitable deduction). In the end, however, Dennis and Atkinson present two very different alternative reforms.

Dennis proposes that the preferential treatment of nonprofits is unneeded and that they should receive identical tax treatment as for-profits. Atkinson proposes that tax exemptions be narrowed to the types of philanthropic activities that promote “neoclassical republican” ideals. I suggest that Atkinson’s proposed reforms are poorly supported in argument, unclear in intent and operation, and overall a complete nonstarter. On the other hand, Dennis’ proposals seem well-grounded in argument and at least worth considering in part.

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