The attack on nonprofit status: a charitable assessment.

• Author: Hines, James R., Jr.

American nonprofit organizations receive favorable tax treatment, including tax exemptions and tax-deductibility of contributions, in return for their devotion to charitable purposes and restrictions not to distribute profits. Recent efforts to extend some or all of these tax benefits to for-profit companies making social investments, including the creation of the new hybrid nonprofit/for-profit company form known as the Low-Profit Limited Liability Company, threaten to undermine the vitality of the nonprofit sector and the integrity of the tax system.

Reform advocates maintain that the ability to compensate executives based on performance and to distribute profits when attractive investment opportunities are scarce makes for-profit entities more efficient than nonprofit counterparts. Offering more favorable tax treatment to for-profits engaging in charity would encourage greater charitable entrepreneurship, the argument goes, and provide worthwhile competition for the nonprofit sector. As matters stand, however, nonprofits can and occasionally do reward executives with performance-based compensation, and their nondistribution rules impose no obligation to make subpar investments. The existing nonprofit sector is extremely competitive, and the charitable activities of for-profits already receive favorable tax treatment. Going further and offering socially active for-profits the tax benefits equivalent to those available currently to nonprofits would create opportunities for tax arbitrage by providing tax deductions to high-bracket donors and taxable income for lightly taxed recipients. The difficulty of policing lines between nonprofit and for-profit activities of the same business entities would entail significant administrative complexity and is unlikely ultimately to succeed. And even should it succeed, the costs of offering new tax benefits to for-profit charities include not only foregone tax revenues, but also spillover effects on the charitable activities of nonprofits.

TABLE OF CONTENTS INTRODUCTION I. THE NONPROFIT FIRM II. FOR-PROFIT CHARITIES: RECENT EXAMPLES AND THE CASE FOR EXPANSION A. Existing For-Profit Charities and New Hybrid Form B. For-Profit Charities III. INVESTIGATING THE ASSUMPTIONS: EFFICIENCY AND COMPENSATION A. Efficiency and Compensation B. Bringing Competition into the Picture IV. TAKING NONPROFIT CHARITIES SERIOUSLY A. Public Goods and Positive Externalities B. Agency Theory C. Altruists D. Imperfect Consumers V. TAKING FOR-PROFIT CHARITIES SERIOUSLY: UNINTENDED TAX CONSEQUENCES CONCLUSIONS INTRODUCTION

Nonprofits are under attack. Tax authorities have increasingly challenged the income tax exemptions and the (often more valuable) property tax exemptions available to many nonprofits. (1) Some policymakers and scholars would weaken nonprofits further, diluting their tax privileges by offering them to for-profit organizations engaging in charitable activities. In this Article, we argue that nonprofit tax treatment should be reserved for nonprofit organizations.

Many observers believe that, despite the good work of nonprofits, they benefit unfairly from an incongruity in the system used to identify eligibility for tax exemptions. Nonprofits qualify for favorable tax treatment by satisfying various criteria, most notably that they do not have shareholders to whom they can distribute profits. This requirement means that for-profits are ineligible for nonprofit tax exemptions. Yet this distinction between non profit and for-profit organizational form seems over-strong to some advocates. (2) The requirements for nonprofit federal tax exemption--nonprofits must be both organized and operated for specified charitable purposes (3)--are surprisingly spare. Further, American charities law "is a relatively weak force in the realm of charity operations," offering little guidance to nonprofits regarding how to provide charity. (4) Moreover, nonprofit organizations are far from perfect, at times deploying their resources in ways that fail to advance the public good, and for-profit firms are occasionally willing to operate in ways that advance social welfare at the expense of their own profits.

It is tempting, therefore, to contemplate a radical policy reform in which charitable operations alone define which organizations might receive the benefits of favorable policy treatment. With such a reform, the provision of charitable services, regardless of organizational status, would be the sole criterion for tax and other benefits. The reform, therefore, would permit for-profit firms to receive tax deductions to the extent that they use funds for specified charitable purposes, and deny tax deductions to nonprofit organizations to the extent that they do not. (5)

These same issues are often cast as a different set of policy questions-whether nonprofit organizations merit their special tax status and, if they do, whether specific charitable acts should be required of organizations that enjoy tax benefits. (6) Once tax benefits are contingent on particular acts, it is a short step to contemplate permitting entities that do not qualify as nonprofit organizations nonetheless to enjoy the benefits available to nonprofits, at least insofar as they engage in charitable activities.

There is considerable appeal to these proposals. Rather than toss a tax exemption into an undifferentiated sea of nonprofits and hope for the best, the government can act like a megaconsumer, using its vast purchasing power to buy the public goods that it wants. (7) And, according to proponents, (8) if the government is wise enough to contract with for-profit organizations, it can harness private sector incentives and market competition--which, at least until recently, seemed to have desirable effects.

State and federal government actors have found at least some of these ideas persuasive, perhaps in part because of recent political concerns about the insufficiency of charitable activity by nonprofit organizations. As a result of these concerns, the Internal Revenue Service ("IRS") and state tax agencies are once more tweaking exemption requirements for nonprofits to better monitor their provision of charity. The United States is hardly alone in this endeavor; the United Kingdom recently implemented major reforms to its charity laws, adding specificity to the public benefit requirement that likely predates the Statute of Elizabeth (1601). (10) (One might think that after hundreds of years of study and practice, Western governments would have answers to questions about the extent to which organizations should be favored based on their charitable status, but easy answers have been elusive.)

Some state governments have taken reform one step further toward the creation of for-profit charities, embracing what is known as "social entrepreneurship," the blending of for-profit incentives with charitable ends." A prominent example is the creation of a new corporate form, the Low-Profit Limited Liability Company ("L3C"). As we explain below, this example highlights some of the risks associated with diluting the significance of nonprofit status and, properly interpreted, points to ways in which the nonprofit form may be more amenable to the use of incentives than is often assumed.

Another recent development is scholarship endorsing new legal forms to ease the provision of for-profit charity. Of particular note is the publication of Professors Anup Malani and Eric Posner's provocatively entitled article "The Case for For-Profit Charities." (12) The article promises a break from the familiar debate about the merits of conditioning charitable tax exemption on charitable status or contracts for charitable behavior. Instead, following a path taken by other analysts who assume that for-profit organizations are more efficient than nonprofits, (13) Malani and Posner argue that "there is no reason to condition the tax subsidy for charitable activities on organizational form." (14) They offer a litany of benefits of for-profit ownership and, by implication, the costs of nonprofit ownership. Although appealing on first reading, careful examination of the arguments raises questions about their economic foundations, and helps illuminate why the article's policy recommendation-making subsidies available to organizations of any type that provide desirable and measurable public benefits--is considerably less sound than the current regime of restricting tax benefits to organizations with nonprofit status.

Why deny for-profits the opportunity to compete with nonprofits on equal terms? What if both pursue (at least in part) the same goals? One reason is that, as a realistic matter, it is almost impossible to administer a system that ties tax benefits to public benefit provision levels. Leaving aside whether a practical system could be designed, however, such a system would create significant tax avoidance opportunities for self-interested taxpayers. Symmetric treatment of nonprofits and for-profits requires permitting tax deductible contributions to for-profit entities undertaking charitable activity. This, in turn, permits taxpayers to claim deductions for indirect gifts to owners of companies with charitable impulses, thereby undercutting the current nondeductibility of gifts and creating tax arbitrage opportunities whenever donors are in higher tax brackets than donees. Consequently, symmetric treatment of nonprofits and for-profits would be accompanied by significant tax planning opportunities and tax base erosion.

Even so, might the costs of tax avoidance be worth the benefits of conditioning charitable exemption on behavior, regardless of ownership? Since the potential benefits are so modest, we think that they would not. First, the relevant compensation structures and other methods that for-profit firms use to create productivity incentives are already available to nonprofit organizations. However, on the whole they appear less valuable for...