Knowing an 'educational institution' when you see one: applying the commercially approach to tax exemptions for universities under s. 501(c) (3).

AuthorRubin, Eric
  1. INTRODUCTION

    Beginning with the earliest colonial schools, educational institutions have had a consistent presence in America, challenging both their students' intellects and the federal government, which must implement laws to define and monitor the roles of educational institutions. (1) As colleges and universities have proliferated, particularly over the last century, they have "changed from small, regionalized educational schools to large, government-funded institutions with multi million-dollar budgets and endowments." (2) In many cases, these monolithic schools can impact how a community limctions or governs itself, often by serving as the primary interest group or employer in their towns. (3) Yet, even before the colossal growth and expansion of contemporary universities occurred, when schools were smaller entities, the federal government recognized the value of higher education (4) and sought to support it with the hope of encouraging academic endeavors within the populace. (5)

    Over time, these efforts culminated in the creation of Internal Revenue Code [section] 501(c)(3), (6) which outlines the parameters for determining tax exemptions for non-profit organizations, including educational institutions. (7) Given the tremendous size and scope of contemporary universities, however, this statute appears to be overly generous in its applications and definitions. (8) Colleges, in an increasing number of facets, are beginning to more closely resemble businesses than educational entities driven solely by academic pursuits. (9) As a result, numerous frameworks have been created for determining whether an educational institution is actually educational in nature because the line between a business and a school has been blurred. (10) Essentially, modern universities have evolved to the point where they can no longer be considered purely educational institutions as defined by federal law. Instead, as they exist today, universities function more like businesses, which should preclude them from receiving the tax exemptions that the government affords to charitable institutions.

    This Note will examine the appropriateness of allowing tax exemptions for educational institutions to universities and argue that modern colleges have begun to more resemble businesses rather than schools given their tremendous scope, size, and profit-making capabilities. Part II provides a historical survey and genesis of tax exemption legislation to understand the basic principles, justifications, and goals behind the creation of these laws. Part III outlines four frameworks that have been created to determine if an entity, specifically a university, is an educational institution. This Part will enumerate multiple components and criteria that are used to evaluate organizations, concluding that the use of quantifiable measurements under the commerciality approach makes it the most useful and appropriate framework for the government to employ. Part IV analyzes the applicability of using the commerciality approach by demonstrating the multiple profitable business ventures that contemporary universities are involved in. Finally, Part V offers comprehensive proposals for adopting the commerciality approach and addresses problems that may arise during their implementation.

  2. BACKGROUND

    The concept of university tax exemption precedes American history, dating back to medieval Europe." Though colleges were originally "no more than relatively spontaneous, informal, and unstructured associations of teachers and students who combined into communities ... analogous to the trade guilds," their positive contributions to society gained significant appreciation and recognition over time. (12) For example, in the Preamble to the Statute of Charitable Uses Act of 1601, which enumerates purposes and activities that the British Crown believed were beneficial to society and deserving of private contributions, "Schooles of Learninge, Free Schooles and Schollers in Univsities" (13) are included, demonstrating that the English government understood the importance of educating the populace and wanted to foster the growth of the developing concept of a university. (14) Consequently, the English government, as well as other governments throughout Europe, (15) recognized that the expansion of these institutions could be expediently accomplished by offering them tax exemptions. (16) By being free of the requirement to contribute to the government's maintenance via taxation, the universities could instead use the money for the education of students. (17)

    The United States, on the other hand, would not codify tax exemptions for schools in federal law (18) until centuries later in 1894, when Congress passed the first corporate income tax law. (19) This legislation contained a broad exemption for "corporations, companies, or associations organized and conducted solely for charitable, religious, or educational purposes." (20) Furthermore, it appears that this segment of the law pertaining to tax exemption was passed without much controversy or debate, emphasizing the universality of its congressional approval. (21) At the time, this law was predominantly viewed as confirmation of the framework of university tax exemptions that had already been in place "at the state and local level" of government. (22)

    Since then, Congress has continued down the path of exemptions for universities, utilizing its powers under the Taxing Clause (23) and enabling the proliferation of legislation that gives tax benefits to universities. (24) Initially, educational activities that fell within tax-exempt status were loosely defined and widely applicable, such that assorted broad or eclectic academic pursuits would be included within the law. (25) This extremely generous labeling, however, has been significantly modified and narrowed over time. (26) In particular, one of the most important landmarks in the genesis of tax exemptions was [section] 501(c)(3), (27) which was "introduced in its current form in 1954." (28) This law has been the paradigmatic piece of legislation for guiding the government's allowance of university tax exemptions, outlining the contours and requirements that institutions must meet to qualify for these benefits. (29) Yet, even with the guidelines it articulates, there is still a tremendous amount of debate surrounding what constitutes "education" and who is allowed to claim that they are "educating" others via their services. (30)

    Therefore, Congress has attempted to remedy some of the problems caused by the ambiguity with even more legislation. (31) As a result, unlike during the late 19th and early 20th centuries, there is now no longer immense, unrestrained freedom in defining what constitutes an educational institution because the government recognized the dangers of unchecked organizations. (32) In particular, the government did not want tax-exempt groups to gain unfair competitive advantages in the market, which has led to the taxation of unrelated business activities. (33) Essentially, the relevant laws establish that charitable organizations that would be "exempt from federal income taxation pursuant to Section 501(c) of the Internal Revenue Code are, nevertheless, subject to taxation on income derived from any trade or business regularly carried on by them which is unrelated to their exempt purposes." (34) This law reflects the congressional desire to allow tax-exempt organizations to pursue commercial ventures while limiting them with the same competitive restrictions that their tax-paying counterparts in the market face. (35)

    For example, when an esteemed tax-exempt scientific organization exploits its reputation by selling endorsements of laboratory equipment to aid manufacturers, the income derived from that transaction does not

    "contribute importantly to the accomplishment of' its exempt purpose, which is research and development. (36) Thus, the income derived from the endorsement would be taxed as unrelated business income under the law. (37) Furthermore, the courts have attempted to support congressional efforts to define and maintain these tax exemptions. (38) "[C]ase law has slowly shifted in favor of the taxpayers because courts have begun to scrutinize the composition and the operations of exempt institutions," minimizing the ambiguity present in the statutes. (39) Essentially, courts are attempting to resolve loopholes in the tax exemptions afforded to universities to prevent systematic abuse. (40)

    Yet, despite the government's considerable efforts, there is still tremendous disagreement regarding the vagueness presented by undefined terms in the law. (41) As a result, scholars have created multiple frameworks to aid in the evaluation and definition of an "educational institution" (42) that can be applied to universities. (43)

  3. STANDARDS FOR EVALUATING [SECTION] 501(C)(3)

    To qualify as tax-exempt, there are a few basic bureaucratic hurdles that an organization must surpass. (44) Satisfying these conditions is rarely a challenge though, as most entities meet these requirements in the course of their daily operations. (45) Instead, most litigation pertains to having a court decide whether an educational institution is barred from a tax exemption because its activities are not legitimately educational in practice. (46) Not surprisingly, both the Internal Revenue Service and the courts have had trouble creating a definition that can be uniformly applied. (47) This ambiguity has led to the creation of four different frameworks for analyzing whether an "educational institution" is eligible for a tax exemption. (48)

    1. Inurement/Private Benefit Approach

      The inurement/private benefit standard is a two-part scheme that stems from the language "no part of [an educational institution's] net earnings of which inures to the benefit of any private shareholder or individual" (49) in [section] 501(c)(3). (50) The first facet of the test, inurement...

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