Commercial activity and charitable tax exemption.

• Author: Colombo, John D.

TABLE OF CONTENTS INTRODUCTION I. BACKGROUND: CURRENT LAW & DOCTRINE A. The Effect of Direct Commercial Activity on Charitable Status B. The Relationship of the Commerciality Doctrine to the UBIT and the Commensurate-In-Scope Test C. The Effects of Indirect Commercial Activity in Complex Structures 1. The Corporate Separate-Identity Rule and the Integral-Part Test 2. The Partnership Attribution Rule D. Summary II. WHY DO WE CARE? PUBLIC POLICY CONCERNS REGARDING COMMERCIAL ACTIVITY A. Why Do Exempt Charities Engage in Commercial Activities? B. Policy Concerns with Commercial Activities 1. Traditional Policy Concerns: Unfair Competition and Erosion of the Corporate Tax Base 2. Other Policy Concerns a. The Diversion Problem b. Economic Efficiency c. Assessing Worth and Need for Indirect Government Subsidies d. Liability Insulation III. RECONSTRUCTING THE RULES TO ADDRESS THE POLICY CONCERNS A. Controlling the Economic Incentive B. Eliminating the Incentive for Direct Commercial Activity by Expanding the UBIT CONCLUSION INTRODUCTION

In 1998, Professor Burton Weisbrod and several of his colleagues published a book that chronicled the expanding tendency of nonprofit organizations to engage in commercial activity. (1) In his concluding chapter, Professor Weisbrod offered two striking examples of this trend. Chicago's Art Institute, Shedd Aquarium, and Field Museum began holding after-hours cocktail parties as a sort of upscale bar; and Baptist Hospital, the largest nonprofit hospital in Nashville, built a $15 million office and training complex to rent to the Tennessee Titans professional football team, partly for the revenue it would generate, but also for the marketing opportunities it offered. (2) Meanwhile, an article in the Wall Street Journal in August 2001 noted that churches from Jacksonville, Florida, to Seattle, Washington are opening restaurants, private gyms, and even Starbucks coffee franchises. (3) Underscoring the current trend, the Yale School of Management announced in early 2002 that it had secured grants totaling $4.5 million from the Pew Charitable Trusts and the Goldman Sachs Foundation to establish a program to help charities develop business plans for entry into commercial markets. (4)

Commercial activity by charities, however, goes even further in scope. While individual charitable organizations still exist in our world, it is now common to find charities engaged in numerous economic activities through a variety of business arrangements including subsidiary corporations, joint ventures, and contractual agreements. The health care sector, in particular, epitomizes the modern charitable organization in a complex structure. The entity that started as a single nonprofit corporation operating a local hospital likely has mushroomed into a multilayered health care delivery system, often consisting of a parent holding company with myriad for-profit or nonprofit subsidiaries, contractual agreements with doctors and other service providers, and joint venture participation with other nonprofit and for-profit entities. (5)

Tax policy with respect to commercial activity by charitable organizations leaves much to be desired. The rules on the subject involve three separate but intimately related tax issues. The first is whether commercial activity should adversely affect tax exemption for an organization directly conducting such activity. Commentators in the tax-exemption field generally refer to this issue as the "commerciality" doctrine, which holds that charities engaged in commercial business enterprises can risk their tax-exempt status if their business activities grow too large in relation to their charitable activities. (6) The second issue is whether, if such activity is consistent with underlying tax-exempt status, the commercial activity itself nevertheless should be taxed. This issue has been the province of the unrelated business income tax (UBIT) adopted in 1950. (7) The third issue, which relates more to the first than the second, concerns whether and how commercial activities undertaken by one organization in a complex structure should be "imputed" to related entities in that structure for purposes of judging the related entities' exempt status and conversely whether the charitable activities of related corporations should be "imputed" to the corporation conducting the commercial activity in order to make it tax exempt. (8)

The relationship between these three broad issues has produced some very odd administrative rulings and conflicting court decisions. For example, on the tax-exemption side, the Third Circuit and the Claims Court disagreed on the exempt status of virtually identical nondenominational religious publishers. (9) Meanwhile, because it relies on a "relatedness" concept, the UBIT taxes some (e.g., "unrelated") commercial activity by charitable organizations, but not other (e.g., "related") commercial activity. The UBIT itself, however, provides no guidance on whether commercial activity, even if taxed, should threaten exempt status. On the final issue, the Internal Revenue Service (IRS or Service) has adopted the position that individual corporations "stand alone" with respect to charitable status--that is, the activities carried on in a separate corporate entity will not be imputed to corporate parents or siblings and vice-versa. (10) In contrast, the IRS position with respect to partnership and other joint venture arrangements is that each partner is deemed to be in the underlying business of the partnership. (11) These positions create a curious dichotomy in which business activities segregated in a wholly-owned subsidiary corporation do not jeopardize a related entity's exempt status, whereas that status is threatened by the same activities carried on directly or in a joint venture or partnership. At the same time, because the UBIT applies only to "unrelated" business activity, commercial activities carried on by a subsidiary corporation as stand-alone operations might well escape taxation if conducted by a parent as a part of the parent's overall activities if such activity is "related" to the parent's charitable purpose. (12)

Legal academics and economists, like the courts and the Service, have tended to focus only on the individual pieces of these related rules, primarily on the UBIT, (13) without considering how the pieces fit together as a whole. The purpose of this Article is to take a broader view: to look at how the various tax rules regulating commercial activity by charitable organizations relate or fail to relate, to review how the current rules address the various public policy concerns with commercial activity, and finally to suggest how we might restructure our approach to commercial activity to simplify the doctrinal issues and address the policy concerns at the same time.

The Article proceeds in three separate parts. Part I traces the current doctrinal status of the commerciality doctrine, the relationship of that doctrine to the UBIT, and the tax rules regarding the effects of commercial activity by related corporations or partnerships. This Part concludes that current doctrine is largely a mess, due to the lack of clear rules regarding when commercial activity endangers exemption or when it is taxable even if it does not endanger exempt status, and due to the presence of conflicting rules on how commercial activities within a complex structure should affect tax exemption overall.

Part II builds on this foundation, sorting through the various policy issues raised by commercial activity conducted by charities. This Part begins with an overview of the reasons charities might conduct direct commercial activity as opposed to passively investing in stocks and bonds. It then identifies six potential public policy concerns. The first two are traditional concerns underlying the UBIT: unfair competition and protecting the corporate tax base. The other four are broader policy concerns. First is the possibility that commercial activity diverts the attention of charitable managers from their core charitable mission and, at the extreme, will turn exempt charities into "for-profits in disguise." Second, rules regarding commercial activity should promote economic efficiency. Third, these rules should also provide adequate checks to determine whether an organization is both worthy and in need of the additional indirect government subsidies that direct commercial activities may offer. The final concern is that commercial activity places charitable assets at the risk of liabilities incurred in noncharitable pursuits.

In this Part, the Article observes that the current rules on commercial activity address each of these issues in a limited way. For example, the rules help protect the tax base and limit charitable asset risk by pressuring charities to use separate corporate containers for commercial activities. These rules, in conjunction with the corporate separate-identity rule, almost always result in those separate containers not being eligible for exemption and therefore subject to taxation. (14) At the same time, these separate containers help isolate charitable assets from the liabilities of noncharitable activities and make it more difficult for charities to minimize the taxable income of these separate organizations by cross-allocating expenses of running the charitable organization to the taxable business.

Part III then examines alternative approaches to dealing with commercial activity. The Article notes that there are two general policy paths one might take. The first path is to permit charities to capture premium financial returns on direct commercial activity as a means for providing an additional indirect government subsidy to these organizations. This Article suggests three different approaches to commercial activity along this general path: (1) clarifying the doctrinal structure of current law; (2) enacting new rules overlaying the current ones...