What should be an allowable non-profit?

by on May 26, 2008 at 8:25 am in Law | Permalink

In a ruling last December that sent tremors through the not-for-profit world, the Minnesota Supreme Court said a small nonprofit day care agency here had to pay propery taxes because, in essence, it gave nothing away. 

…Almost 88 percent of overall nonprofit revenues in 2005, the most
recent year for which figures are available, came from fees for
services, sales and sources other than charitable contributions…Nonprofit
health care providers, day care centers and retirement homes, among
others, are often difficult to distinguish from their tax-paying
competitors.

…the Mall of America, a major tourist attraction, was seeking tax
exemptions as part of its plans to expand, arguing that it aids the
state economy by drawing visitors.

Here is the full story, interesting throughout.  I would say the Mall of America no, hospitals no (any subsidy to care should be more selective), the AAA club no, universities yes (ideas are public goods), and charities yes.  And here are important new developments in the world of Harvard philanthropy.

1 AO May 26, 2008 at 8:43 am

shouldn’t subsidies to ideas also be more selective as well?

2 Matt May 26, 2008 at 9:18 am

” universities yes (ideas are public goods), ..” ???

Please unlock jstor then.

3 Paul Hsieh May 26, 2008 at 9:36 am

The whole system of tax-exempt status for non-profit organizations and/or causes inevitably leads to this kind of political wrangling. Plus, it puts the government in a position of creating inappropriate incentives that distort how people choose to allocate their money/resources in a fashion that is biased towards someone’s political agenda.

A few weeks ago, Yaron Brook wrote a great column in Forbes.com on the perils of tax-exempt status and “social engineering” at:

“Life and Taxes”
http://www.forbes.com/opinions/2008/04/16/yaron-taxes-campaign-oped-cx_ybr_0417yaron.html

4 David R. Henderson May 26, 2008 at 10:56 am

Tyler,

I think everyone should be exempt from property taxes. That would solve the problem.

Best,

David

5 jorod May 26, 2008 at 11:40 am

In Europe they have a wealth tax. Maybe we should adopt this. Then people won’t be putting so much money into nonproductive assets like real estate. Be careful what you wish for…

What about credit unions? Do they pay property taxes?

6 Patrick Fitzsimmons May 26, 2008 at 11:59 am

So all the non-profits should be taxed, except for the one you work for … nice. I absolutely think universities should not be exempt. It’s obvious that univerisities are revenuing maxmizing. The only difference is that universities do not have equity investors, so they distribute the profits to their employees. Imagine if Harvard was for profit. Instead of sinking all their extra money into ridiculous luxury, they would open up a dozen branches and education ten times the number of students. Non-profits are usually the last type of business you want to subsidize with the tax structure, since they are the most ineffcient and least scalable business structure.

7 John Thacker May 26, 2008 at 1:51 pm

Non profits that “give nothing away” are still very different from for profit institutions. Think nonprofit food coops vs whole foods.

Aren’t most food cooperatives for-profit but owned by the consumers? The consumers prefer making a small profit generally, but they do sometimes send out checks, just like mutual insurance companies.

8 Bob Murphy May 26, 2008 at 1:59 pm

I agree with David Henderson; there is no objectively correct answer on this. Whenever government gets involved, you can’t be “fair” since it’s not fair to take people’s money at gunpoint (i.e. taxman).

I think the objections to Tyler’s position are good ones. What about bookstores? What about creative writing seminars? What about music lessons, so long as the students agree to keep any new songs in the public domain?

And the person who gives tech support to non-profits: I’m not disagreeing with your principle, but notice that then the McDonald’s down the street from the hospital could also claim at least partial exemption, since it “provides food to the non-profit sector” when the hospital employees eat there. And then GM when it sells a car to a pastor shouldn’t be taxed on those revenues…

9 azer May 26, 2008 at 2:44 pm

See that is where you are incorrect. Non Profits do make accounting profits or else they would have no need for non profit status. Non-profit status just means they do not pay Taxes on the profits unlike the rest of companies who have to pay taxes on profits AND oftentimes revenue.

“The idea of not taxing non-profit firms is quite simple. Since they don’t make an accounting profit, there is no profit to tax. A for-profit firm that makes no taxable profit also is untaxed.”

10 Alan Gunn May 26, 2008 at 6:16 pm

Patrick Fitzsimmons: “The only difference is that universities do not have equity investors, so they distribute the profits to their employees.”

Yes, with one qualification: a lot of their “profits” (from their fund-raising activities) are just added to their endowments, which keep growing. A for-profit corporation can’t do that, partly for tax reasons and partly because there are residual claimants who wouldn’t stand for it. Universities are piling up billions in assets that will never be spent for any educational purpose–the endowments will just grow forever or until the government can no longer resist the urge to take some. Why people give them money is a mystery; there are lots of truly deserving, and poor, charities around.

11 Michael Kelly May 26, 2008 at 7:01 pm

azer, you are completely correct; however, I think that I have a point to make. Let’s find out if I do and see what words appropriately describe it.

The way I look at a non-profit operating “properly” is that even if they make money in one period, they will tend to make investments so that they lose that money in another period. For instance, suppose a non-profit hospital makes money from a transaction. That money is then used to buy a piece of equipment (an MRI machine). A non-profit that should be getting a tax holiday is one where that the services of that machine will be priced so that the internal rate of return from that investment is less than or equal to zero.

Let me give you another example that is closer to my experience. Suppose a non-profit raises money to preserve a historic site. The fund-raising can be thought of as a positive accounting profit event; however, the money goes into an investment that has an internal rate of return of zero. (The buy and preserve the site and building, perhaps renting the building out to a local arts group, but the endeavor merely meets operating costs.) I think most people would agree that no “profits” are made here, or, perhaps, that no “profits” are made here that “should” be taxed. All of the “profits” are tied up in the zero IRR historic site, not in a pile of cash or securities at the bank.

The problem in my mind comes about when the non-profit starts to price its products such that it has money left over and winds up with an endowment. (I believe that very few non-profits [on a percentage basis] have endowments, but, as we’ve seen in education, they can get quite large.) In this case, the non-profit has positive internal rate of return projects that dwarf any zero or negative IRR projects. Ultimately, money is being funneled primarily into market return securities and we can question whether that is worthwhile for society.

So, in my mind, Harvard is a hedge fund that has a relatively small, money-losing education business on the side. I can see a justification for an endowment in a world of uncertainty when there are “bankruptcy costs” associated with the failure of a non-profit. However, large endowments are disturbing and are possibly evidence that a non-profit has not followed a zero or negative IRR strategy.

I don’t think we should penalize the charities that truly funnel their “profits” into zero and negative internal rate of return projects that help the public good.

azer, is there anything reasonable in the above statements?

12 LZ May 26, 2008 at 9:54 pm

The article is talking about tax exemption for the purposes of property taxes. Property taxes do not depend on whether the entity is making a profit or not. In other words, hospital A that makes 0 profit has to pay more property taxes than “non-profit” hospital B that makes $1m profit which is added to the endowment.

I say get rid of exemptions on profits while keeping the charitable deduction for donors. Why should Harvard be tax-exempt on the dividends it receives from Microsoft or IBM stock, when everyone else is taxed on that dividend?

13 GIdoc May 26, 2008 at 10:40 pm

I disagree with Azer’s statement that for profit hospitals have worse outcomes. In fact scientific studies failed to show such is the case. By the way, all hospitals in the US regardless of profit status are required by federal law to care for everyone that is admitted whether they have insurance or not (and whether they are legal residents of the US or not).
The community not for profit hospital I work at charges the same fees as any for profit hospital and goes after defaulters as aggressively as any other entity using collection agencies and such. Not for profit entities just like religious entities want to be treated as sacred cows (- no critical look at their executive salary structure, equipment purchases and hiring practices, etc). The community is actually a net loser with not for profit hospital because of loss of huge property tax revenue and income tax. Just because there is no stock holder dividend does not make not-for-profit entities efficient or better at delivery of health care services. Often these entities have religious affiliations and indeed I suspect have a subtle bias in hiring and caring. In some places not for profits are magnates to hire family and friends of the administrators and board members. Actually, for profits are under greater scrutiny because of the stock holders.
What we need is a free market in health care with government getting out of provision of health care and letting customers choose the best and most affordable service they can find. I would also think the providers should be able to compete on fees based on their knowledge, skill, customer service metrics (and the market value of their service).

14 Andrew May 27, 2008 at 10:51 am

Professors at my school often make $100 large plus.

To bank that in the for-profit sector you’d have to do more than run off 20% of your underlings per year.

So, when I hear the word(s?) non-profit I chuckle inwardly.

15 taxlawyer May 28, 2008 at 12:24 pm

The basis of exemption from federal income taxation is that an organization is organized and operated exclusively for exempt purposes. It doesn’t mean an organization will not have revenue, just that such revenue will be used exclusively for the organization’s exempt purposes and not inure to the benefit of any private individuals. In the case of a college, the exempt purpose is education. Note that if the college received revenue from operating in a manner that was essentially the same as a private business, it would generally be subject to tax on that income (its called Unrelated Business Income Tax).

This is not inconsistent with a professor receiving a salary for her services, since a school cannot further its exempt purposes without teachers. And, as one commentator noted above, that salary will be taxable. If the professor is compensated at other than an arm’s length rate, there are penalty and other provisions that come into play. The system actually works pretty well at targetting abuse, provided there is enough auditing to put the fear of God in tax exempt organizations.

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