Court Opinion

ID: 9472086
Source: CourtListenerOpinion
Date Created: 2023-08-05 03:49:00.116156+00
Date Added: 2024-06-11T17:42:44.292039
License: Public Domain

*1063MANSFIELD, Circuit Judge
(dissenting):
I respectfully dissent.
Rensselaer Polytechnic Institute (“RPI”) is a tax-exempt institution only because it has dedicated itself and its property in perpetuity to “charitable” and “educational purposes.” 26 U.S.C. § 501(c).1 Its unrelated business income less “deductions ... which are directly connected with the carrying on of such trade or business” is taxable. 26 U.S.C. §§ 501(b), 512(a). We are here asked to permit the college to deduct from its commercial business income fixed expenses that would normally be allocated on a time basis to periods when the college’s property is not being used for trade or business but for its educational purposes.
In my view such expenses are not “directly connected” with the institution’s commercial business activities within the meaning of § 512(a) and are therefore not deductible from its business income. On the contrary, they are attributable to time when the facilities exist for educational purposes. Indeed, it could reasonably be argued that since RPI would, absent part-time use of its fixed assets for commercial purposes, be required to absorb all depreciation of such assets, no such depreciation is “directly connected” with its commercial business operations. See Pittsburgh Press Club v. United States, 579 F.2d 751, 761 (3d Cir.1978). RPI represented in its petition to the Tax Court that “[t]he main function of the fieldhouse is to provide a suitable facility necessary to allow petitioner to carry out its total educational responsibilities.” (Emphasis added). Although some allocation may be permissible, I do not believe RPI should be allowed to give its commercial use any credit for time when its facilities exist for educational use. To do so would give a tax-exempt institution an unfair tax advantage over commercial institutions. The majority reaches this result only by what appears to be a misinterpretation of the governing statute and regulations.
In my view the fundamental error underlying the majority’s decision is its assumption that tax-exempt institutions are governed for tax deduction purposes by the same standards as those governing taxable businesses. That assumption conflicts with legislative intent, economic reality, and the express wording of the pertinent statute and regulations. When Congress in 1950 passed legislation subjecting tax-exempt organizations to income tax on unrelated business income, it was concerned both with removing the unfair competitive advantage enjoyed by tax-exempt institutions and with assuring that the unrelated business income would produce a fair amount of revenue for the public fisc.2 However, it was confronted with inherent differences between a regular taxable business and a non-profit university engaged *1064mainly in educational activity and only partially in income-producing commercial activities. These differences precluded a wholesale transfer and application to a university of the same deduction principles as those governing regular commercial businesses.
In the case of a commercial business devoted solely to making a profit, its entire operation is subject to a tax on its income. Regardless how it chooses to allocate its business expenses between divisions, the net income from all divisions is taxable. The IRS therefore has no quarrel with any “reasonable” allocation of deductible expenses between branches of the operation. The tax-exempt university, on the other hand, is fundamentally different in that one of its “divisions” — the educational function — is not subject to taxation. The university will therefore always have an incentive to minimize the allocation of expenses attributed to the educational function, and correspondingly to maximize the deduction for unrelated business activity. This incentive, which is not present in the ordinary business setting, requires a stricter standard of deductibility for tax-exempt organizations than for purely profit-seeking firms. The government cannot, in the case of an educational institution engaged in unrelated commercial business activity, afford to take the same relaxed approach as with wholly-taxable businesses and to accept any allocation the taxpayer may deem “reasonable.”
Thus, the majority achieves parity only in the most superficial sense. The identical rule of deductibility is imposed, but it is imposed on organizations that have different characteristics and are therefore affected differently by the same rule. To whatever extent Congress sought to place wholly taxable and exempt organizations on the same footing, it was concerned not with such technical legal tests but with the real after-tax situations of the two different types of organization. Yet the majority’s approach, which claims to provide equal treatment, actually leaves the tax-exempt organizations with the very advantage that the majority claims Congress was trying to eliminate.
That Congress adopted a narrower test of deductibility for the tax-exempt organization is clearly reflected in the statute. 26 U.S.C. § 512 allows such an organization to take those “deductions allowed by this chapter which are directly connected with” its unrelated business income (emphasis added). The italicized language is imposed as an additional requirement for tax-exempt institutions not faced by purely profit-oriented businesses.
If there were any doubt after reading the language of the statute that disparate standards have been prescribed by Congress, one needs only to look at the pertinent regulations. The regulation governing business deductions for the profit-seeking corporation, 26 C.F.R. § 1.162-l(a), is stated in the disjunctive: “Business expenses deductible from gross income include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer’s trade or business.” (Emphasis added). In stark contrast to this relatively broad test, the regulation concerning the tax on unrelated business income provides:
“§ 1.512(a)-l Definition.
(a) In general. Except as otherwise provided ... section 512(a)(1) defines ‘unrelated business taxable income’ as the gross income derived from any unrelated trade or business regularly carried on, less those deductions allowed by chapter 1 of the Code which are directly connected with the carrying on of such trade or business____ To be deductible in computing unrelated business taxable income, therefore, expenses, depreciation, and similar items not only must qualify as deductions allowed by chapter 1 of the Code, but also must be directly connected with the carrying on of unrelated trade or business____to be ‘directly connected with’ the conduct of unrelated business for the purposes of section 512, an item of deduction must have proximate and primary relationship to the carrying on of that business.” (Emphasis added).
*1065Thus, the regulation does not merely reiterate the statutory language; it goes on to expressly state that the “directly connected with” language is an additional requirement imposed on tax-exempt organizations that is not imposed on organizations subject only to Chapter One of the Internal Revenue Code. The status of the requirement as an additional one is reinforced by its definition of the deduction as one that must have a “proximate and primary” relationship, which is a far cry from being merely “pertinent to” the business operation. I find no such direct proximate connection between the expense and the conduct of the unrelated commercial business at issue in the present case where the depreciation is incurred for a period of idle time when the commercial activity is not being conducted on the premises being depreciated.3
The provision in Treas.Reg. § 1.512(a)-1(c) permitting allocation of expenses on a “reasonable basis,” upon which the majority heavily relies, nowhere appears in the statute itself. It obviously must be read in light of subsection (a), which bears the caption “in general” and which explains the language of the statute. I can see no justification for reading subsection (c) in isolation from the more general provision of the regulation and from the controlling dictates of the statute. When subsection (c) is read together with subsection (a) it is clear that allocation betweeri “two uses on a reasonable basis” requires that depreciation allocated to the unrelated business use, as subsection (c) expressly states, be “proximately and primarily related to that business activity.” Thus even subsection (e) is not satisfied in the present case.
The majority’s reliance on Tax Court home-office, dual-use cases (Maj.Op. -) is clearly misplaced. It is true that the home-office situation is somewhat comparable to that of a tax-exempt institution engaged in taxable unrelated business activities. When a home is used as an office there is an incentive, as with tax-exempt institutions partially engaged in profit-making business, to allocate as large a percentage of all expenses as possible to the taxable activity. However, the analogy is seriously flawed because the homeowner is free to use his home for any purpose he chooses, while the university, in order to gain the tax-exempt treatment it enjoys, must dedicate its facilities to exempt purposes. Thus, while it might reasonably be argued that a home office’s “idle time” is equally available for exempt and non-exempt purposes, and thus that depreciation accruing during that time should be divided in proportion to the periods used for business and living respectively, it is clearly not reasonable to make the same assumption with respect to a university’s “idle time.” If that idle time were equally available for unrelated business activity, the university would not have obtained its exemption in the first place.
Even if the home-office deduction were a useful point of comparison, there is another serious problem with the majority’s position. Although the Tax Court has taken the position that depreciation of a home-office can be allocated on the basis of actual use rather than on total hours in the day, the Ninth Circuit has reached the opposite conclusion and has reversed the Tax Court on this issue. See Gino v. Commissioner, *1066538 F.2d 833 (9th Cir.), cert. denied, 429 U.S. 979, 97 S.Ct. 490, 50 L.Ed.2d 587 (1976); see also, Lewis v. Commissioner, 560 F.2d 973, 978 (9th Cir.1977). Under these circumstances the Tax Court decisions on this issue can hardly be viewed as authoritative.
Pittsburgh Press Club v. United States, 579 F.2d 751, 761 (3d Cir.), on remand, 462 F.Supp. 322 (W.D.Pa.1978), rev’d, 615 F.2d 600 (3d Cir.1980), is a more reliable precedent. In that case, the Third Circuit held that in determining a social club’s taxable unrelated business income for the purpose of deciding whether to revoke its tax exemption, only those expenses which would not have been incurred but for the unrelated taxable activity could be deducted from gross unrelated business income.4 Under this marginal expense test, exempt institutions could not deduct depreciation, since it accrues over time at a constant rate, regardless of the use to which the facility is put. See Davidson, Handbook of Modern Accounting 18-9,18-10 (1970). The majority attempts to distinguish Pittsburgh Press on the ground that exempt social clubs are not permitted to earn any outside income, while universities are permitted to do so. However, that is not the case. The language of 26 U.S.C. § 501(c)(7), which creates a tax exemption for social clubs “no part of the net earnings of which inures to the benefit of any private shareholder,” is identical to that of § 501(c)(3), which creates the same tax exemption for educational institutions. In both cases, the amount of unrelated business income that will be tolerated is a matter of degree. See Pittsburgh Press, supra, 615 F.2d at 603.
In short, Pittsburgh Press is not distinguishable, and the Commissioner would have been justified in denying RPI any depreciation deduction at all. That he did not do so, and instead adopted regulations which permit the college to take a limited deduction, ought not be grounds for this court to undermine a statutory and regulatory scheme that makes far more legal and economic sense than the superficially appealing solution adopted by the majority. Sympathetic as I am to the financial needs of hard-pressed private educational institutions seeking to cope with ever-mounting costs, Congress remains the only body that can change the law governing allocation of expenses between exempt and non-exempt uses.
For these reasons, I would reverse the Tax Court’s decision.

. Section 2 of the Act of the New York Legislature incorporating RPI (Chapter 151, Laws 1861, as amended by Chapter 229, Laws 1866, Chapter 277, Laws 1887, and Chapter 14, Laws 1907), provides:
"Sec. 2, Rensselaer Polytechnic Institute is hereby incorporated for the purpose of continuing and maintaining in the city of Troy and county of Rensselaer, a school for instruction in mathematics, civil engineering, chemistry, mineralogy, geology, botany, literature and the arts and their application to agriculture, domestic economy and manufacturing, as the trustees shall direct; and for the delivery of lectures on such subjects connected therewith as may be deemed necessary by said Board of Trustees.”

. The statute’s dual purpose was emphasized by the Fifth Circuit in Louisiana Credit Union League v. United States, 693 F.2d 525, 540 (5th Cir.1982):
“Clearly, Congress was concerned that commercial businesses operated by tax-exempt organizations would enjoy a competitive advantage. But other weighty considerations influenced passage of the unrelated business income tax as well. Revenue objectives played a major role in shaping that statutory design____ Furthermore, Congress also sought to eliminate an inherent inequity in the overall scheme of taxation by closing the loophole that allowed tax-exempt institutions to operate commercial businesses at no tax cost. Thus, although Congress enacted the predecessors of section 511-513 to eliminate a perceived form of unfair competition, that aim existed as a corollary to the larger goals of producing revenue and achieving equity in the tax system.” (Footnotes omitted).

. The result of the majority decision is to permit a tax-exempt institution, which owns and operates a field house and rink in order "to carry out its total educational responsibilities,” to deduct from unrelated business income depreciation attributable to periods of time when the facility is not being used for such commercial activities. "Depreciation accounting is a system ... which aims to distribute the cost ... of tangible capital assets ... over the estimated useful life of the unit ... in a systematic and rational manner.” Research Study No. 7, Generally Accepted Accounting Principles for Business Enterprises, Ch. 11, 55-56, by Paul Grady, American Institute of Certified Public Accountants, Inc. (1965). Rensselaer did not depreciate its rink according to use but according to time, using the widely accepted "straight-line” method under which the expense accrues at a uniform rate over the projected life of the asset being depreciated, whether it is actively used or idle. See Davidson, Handbook of Modern Accounting 18-9, 18-10 (1970). The expense, like interest or taxes, must therefore be allocated strictly on a time basis. Rensselaer cannot now retroactively change to a use method.

. “It was improper ... to charge against outside banquet income those costs which were not incurred directly as a result of the outside banquet, but were rather fixed costs which the Club’s members would have to bear in the absence of the nonmember income." Pittsburgh Press Club v. United States, 579 F.2d 571, 761 (3d Cir.1978).