Ethan G. Stone, Adhering to the Old Line: Uncovering the History and Political Function of the Unrelated Business Income Tax

• Publication year: 2005

EMORY LAW JOURNAL

Volume 54 FALL 2005 Number 4

ARTICLES

ADHERING TO THE OLD LINE: UNCOVERING THE HISTORY AND POLITICAL FUNCTION OF THE UNRELATED BUSINESS INCOME TAX

Ethan G. Stone^*

INTRODUCTION ............................................................................................. 1478

I. BACKGROUND ................................................................................... 1481

A. The Charitable Tax Exemption.................................................. 1481

B. The Unrelated Business Income Tax (UBIT)............................. 1483

C. Standard History of the UBIT.................................................... 1484

D. Explanations of the UBIT .......................................................... 1488

1. Unfair Competition.............................................................. 1488

2. Revenue Protection.............................................................. 1491

3. New Explanations................................................................ 1492

II. LIMITATIONS OF PRIOR EXPLANATIONS ............................................ 1494

A. Logical Inconsistencies with the Unfair Competition

Argument ................................................................................... 1495

1. The Arguments..................................................................... 1495

2. Evidence Policymakers Were Aware of the Arguments....... 1499

B. The Historical Incongruity of the Unfair Competition

Explanation: The Absence of Complaining Taxpayers ............. 1502

1. The Dog Barks: The Fight Against Cooperatives and Beyond ................................................................................. 1503 a. An Introduction to Cooperative Taxation in the

1940s ............................................................................. 1503

b. The Rise of the NTEA and the Fight Against

Cooperatives .................................................................. 1505

c. Taxpayer Campaigns Against Unfair Competition

After the UBIT ............................................................... 1508

2. The Absence of Taxpayer Protest over the Charitable

Exemption............................................................................ 1510

C. Problems with the Revenue Explanation ................................... 1513

1. The Threat to Revenue: Why the Dog Did Not Bark ........... 1513 a. Leasebacks .................................................................... 1515 b. Bootstraps...................................................................... 1517 c. Charities Were Incidental and Interchangeable

Participants .................................................................. 1519

2. UBIT's Incongruous Response to the Threat ...................... 1520

D. The Paranoid Delusion Theory ................................................. 1526

III. THE POLITICAL FUNCTION OF THE UBIT .......................................... 1528

A. The Increased Importance of the Exemption.............................. 1529

1. Prior to World War II: The Unexamined Subsidy ............... 1529

2. The Transformation of the Income Tax and Charitable

Exemption During World War II ......................................... 1530

3. Sensing the Change Without Seeing It................................. 1532

B. Problems with the Charitable Exemption as Subsidy................. 1533

C. Justifying the Transformed Exemption....................................... 1536

1. Perceptions of Continuity .................................................... 1538

2. The Role of the Nondistribution and Exempt Purpose

Requirements ....................................................................... 1539

3. Nontraditional Activities as Threats to Perceptions of the

Exemption ............................................................................. 1542

D. Political Function of the UBIT ................................................... 1544

1. Inconsistent Coverage of the UBIT ..................................... 1545

2. Absence of Complaining Taxpayers .................................... 1547

3. Anomalous Legislative Focus on Facilitator Rather than

Tax Evader .......................................................................... 1552

CONCLUSION................................................................................................. 1553

ABSTRACT

This Article examines the history of the building pressure during the

1940s to tax charities' business income and finds that the traditional explanations hide an underlying political function. As the charitable exemption became more important with the expansion of the income tax in the 1940s, it attracted new attention from both policymakers and a growing tax-shelter industry. Charities and sympathetic policymakers tried to justify a suddenly important blanket subsidy to charity on the basis of the charities' exclusive dedication to good works. Tax-shelter promoters made the effort more difficult by featuring charities in roles, such as buying and leasing commercial real estate and operating businesses, distinctly incompatible with traditional perceptions of charitable activities. The "unrelated business income tax" (UBIT) prevents this cognitive dissonance. It discourages activities that make charities look uncomfortably uncharitable by taxing them, while simultaneously leaving exempt the "old line" of passive investment and business activities related to an exempt purpose.

"The action taken is so extraordinary and so revolutionary . . . that it occurs to me probably the whole system of tax exemption for educational and charitable organizations might seriously be threatened if this precedent is allowed to spread. I think that the trustees of your alumni fund ought to look over the situation very carefully to see whether . . . it is not better for you to adhere to the old line rather than to go out into the competitive business field the way you have done." Congressman Walter A. Lynch, 1947.¹

"Noncompliance involving tax-exempt entities is especially disturbing because it involves organizations that are supposed to be carrying out some special or beneficial public purpose." Mark Everson, Commissioner of Internal Revenue, 2004.²

INTRODUCTION

As the above quotes illustrate, policymakers can get emotional when they find tax-exempt charities³acting in ways that do not fit their perceptions of what charities do. Policymakers and the public alike have a perception that "charity" means selfless dedication to the public good. When that perception is shaken, a political reaction to stop the unseemly behavior and resolve the cognitive dissonance is likely. Such sentiment has been running high again lately. In June 2004, the Senate Finance Committee held hearings on self- dealing and tax shelter facilitation at nonprofits and the staff released a white paper, which proposed a broad-based crackdown on charities.⁴In April 2005, the Senate Finance Committee and the House Ways and Means Committee both held hearings on problems with charities.⁵The following month, the House Ways and Means Committee held further hearings on nonprofit hospitals.⁶The American Jobs Creation Act of 2004 included provisions aimed at certain well-publicized tax shelters involving the purported sale- leasebacks of government infrastructure,⁷as well as abuses involving non-cash charitable donations.⁸The broader proposals regarding the regulation of charities and their governance are under consideration, and it appears that further legislation may be in the offing.⁹

As the above quotes also indicate, this dynamic is not new. In this Article, however, I argue that that it was new in the 1940s. Before World War II, those who bothered to explain the charitable exemption from the federal income tax described it as a subsidy to charity, but very few bothered to explain it. It was a traditional exception to a relatively minor tax, and no one gave it much thought. This changed with the vast expansion of the income tax during World War II. As the tax expanded, tax exemptions became newly valuable and attracted new attention.

In particular, the charitable tax exemption attracted the attention of tax shelter promoters, who realized for the first time that a person who does not pay taxes is handy for facilitating tax avoidance by persons who do. The first two waves of this perennial form of tax shelter-the sale-leaseback and the bootstrap purchase-arose in the mid-1940s. In each case, an exempt party "bought" income-producing property from a taxable seller and then "leased" it back to the seller (or close affiliate), leaving the seller with a tax-advantaged income stream and the charity with a small fee for the use of its exemption.

With new importance came new attention. The attention, however, did not result from a technical analysis of the new tax shelters, nor did it cause a fundamental rethinking of the policy of subsidizing charities with an income- tax exemption. To the contrary, it arose from nonanalytical discomfort with charities' strange new activities-buying commercial real estate and businesses-that challenged public perceptions of the kind of activity the exemption subsidized. In focusing on these uncharity-like activities, policymakers and the press largely ignored the tax shelters. Instead of aiming their anger and legislative efforts at taxable people avoiding taxes, they became incensed at the inappropriate activities of charities and looked for ways to stop those activities.

The denouement of this confrontation between perceptions of the charitable exemption and its reality was the passage of the "unrelated business income tax" (UBIT) in 1950. The original UBIT taxed the income of certain tax- exempt charities to the extent the income derived from the active conduct of a business unrelated to the charity's exempt purpose. The UBIT was justified then and has been justified since as a measure to protect taxable businesses from unfair tax-exempt competition and to...