Of Sovereignty and Subsidy: Conceptualizing the Charity Tax Exemption

Evelyn Brody* I. INTRODUCTION Why are charities tax exempt? This question has been discussed in general theoretical terms of whether the exemption is, on the one hand, a "subsidy" or, on the other, an acknowledgment that charitable activity falls outside the "right" tax base.1 Consider other tax exemptions. Congress from time to time grants exemption to infant industries to spur economic investment. By contrast, household production goes untaxed because it has never occurred to Congress to impose tax on our imputed income when we clean our house or care for our children. Uniquely, exemption for charitable activity has been justified on both subsidy grounds and "base-defining" grounds. These opposing theories of the tax treatment of charity, however, share a common perspective. This Article proposes that a "sovereignty" view of the charitable sector underlies the tax exemption. Clearly, a sovereignty view is easier to see in a base-defining approach: Charities go untaxed because Caesar should not tax God (or the modern secular equivalent). But a sovereignty view also explains why a subsidy would take the form of tax exemption rather than the more logical form of direct grants: For all its imprecision, tax exemption keeps government out of the charities' day-to-day businesses, and keeps charities out of the business of petitioning government for subvention. Moreover, current tax exemption is not absolute. A sovereignty perspective illuminates those rules in the tax scheme that operate to curtail rather than enhance the economic strength of the charitable sector. After all, rival sovereigns rarely feel comfortable letting the other grow too powerful.2 Indeed, John Simon uses the sovereign-sounding term "border patrol" to describe the function of statutory provisions that limit charities' political and lobbying activities, and that tax income from commercial activities.3 Thus, thinking of charity as a co-sovereign to the state explains not just blanket exemptions based on organizational form, but also those seemingly peculiar tax rules that, paradoxically, reduce the reach and effectiveness of tax exemption. To identify subsidy and base-defining explanations for the current tax exemption is not to suggest that such theories consciously motivated legislators. Indeed, for a variety of historical and political reasons, we find that subsidy and base-definition theoriesinfluenced to a greater or lesser degree by sovereignty concerns-have operated simultaneously to produce the American federal and state exemption schemes. Part II of this Article contrasts the subsidy and base-defining theories, and the influence of a sovereignty perspective on each. To illustrate the tension between these theories, Part III turns to an old American tax regime: the state property tax. Property-tax exemption also raises a true sovereignty concern: The exemption is granted at the state level, while the burden falls on local municipalities. Accordingly, we examine the municipalities' response: to demand that exempt charities make "voluntary" payments in lieu of taxes (PILOTs). Part IV looks at the federal corporate income-tax exemption. Here we see the schizophrenic impact of a sovereignty view most clearly: Seemingly technical provisions operate both to limit and to promote the growth of charities in ways explainable only by government's view of charity as a parallel sovereign. Specifically, we examine longstanding rules that subject debt-financed investments to the unrelated business income tax ("UBIT"), even though a leveraged investment produces no tax advantage to a taxexempt investor if it borrows at market interest rates. Surprisingly, then, in 1997 Congress granted charities the right to issue unlimited amounts of tax-exempt bonds for constructing exempt-function facilities;4 the ability to issue cheap debt does provide charities a tax-arbitrage opportunity, and it has the greatest advantage precisely to those charities with the largest endowments. …