Taxing Nonprofits out of Business

I. IntroductionImagine a not-for-profit organization, such as a law school, organized to engage in the charitable purpose of providing education for students. Assume that, under federal tax law, neither tuition revenues nor contributions to the school are taxed to the school. What if that school also was to run an unrelated commercial business, such as a macaroni factory? If it was not taxed on the revenue from that company, the law school's macaroni company would have a competitive advantage over other similar companies, shrinking their profit margins and perhaps driving them out of business.This hypothetical may seem unrealistic, but it is grounded in reality. In the 1940s, a group of individuals wished to benefit New York University, which had a small endowment, a large enrollment, and needed additional funds to cover its costs.1 These benefactors donated the stock of the C.F. Mueller Co. to New York University.2 At the time, C.F. Mueller was the country's largest manufacturer of macaroni.3In addition to the C.F. Mueller Co., New York University acquired three other companies: Howes Leather Company; American Limoges China, Inc.; and the Ramsey Corporation, a piston ring manufacturer.4 New York University was not alone. After World War II, a number of colleges acquired commercial real estate that included department stores, warehouses, office buildings, and apartment buildings.5 Frequently, these colleges acquired the real estate by borrowing the purchase price and then repaying the loan with the tax-free rental income.6By 1950, the public outcry over nonprofit organizations' commercial activities galvanized Congress to take action.7 New York University's activities were particularly troubling to certain members of Congress, causing Representative John Dingell to warn that unless action was taken, "the macaroni monopoly will be in the hands of the universities .... Eventually all the noodles produced in this country will be produced by corporations held or created by universities."8While the Revenue Act of 1950, containing the proposed unrelated business income tax provisions,9 was pending, Congress held hearings and heard testimony from both the business community and representatives from colleges and universities.10 Subsequently, the provisions were enacted and are still a part of the Internal Revenue Code (I.R.C. or Code). ' ' Thus, today, a law school that started or acquired a macaroni company would have to pay tax on the pasta profits, much as a commercial enterprise would.Since then, nonprofit organizations have engaged in other activities that are harder to classify as "business" in the sense the drafters of the 1950s' legislation conceived it. In recent years some nonprofits have availed themselves of two increasingly popular means for raising funds: (1) renting their donor mailing lists to commercial and other nonprofit organizations and (2) licensing the organization's name and logo to banks that issue credit cards bearing that name and logo (affinity cards).12This is not an insignificant or unimportant issue. Within the last twenty years, the number of nonprofit organizations has burgeoned. As of 1995, there were approximately 1.2 million groups registered with the Internal Revenue Service.13 Their numbers include the Salvation Army, the United Ancient Order of Druids, Toastmasters, the oilfield Chili Appreciation Society, Alcoholics Anonymous, the Assembly of Wicca, Cleveland Clinic Hospital, the Red Cross, and the Columbia Ultimate Frisbee Association.14 In 1995, the 307,384 exempt organizations that filed tax returns reported $1.6 trillion in assets and more than $8 billion in revenues.15 In 1997, only 19.9% of the nonprofit sector's funds came from private contributions; fees for servicesj government grants, and profits from sales and investments accounted for the balance of the revenue.16For years, small businesses in particular have complained about the increasingly commercial activities of nonprofits. …