Many charities that generate income through businesslike activities such as magazine publishing and retail sales are taking advantage of vague rules and specific exemptions built into statutes to avoid paying federal tax on this income, according to a Chronicle review of previously unavailable tax forms and other tax returns.
The Chronicle study of the business practices of 91 of the nation’s largest charities finds that more than half of the groups list zero or negative taxable income for activities that are unrelated to their core missions.
The finding, which mirrors a just-released analysis by the Internal Revenue Service, comes at a time when the IRS and some lawmakers are questioning whether Congress needs to revisit the laws governing the collection of the so-called “unrelated business income tax,” a tax that was created to put charities and businesses on a more level playing field.
Newly Public Forms
For its study, The Chronicle reviewed the most recent 990-T tax forms of dozens of prominent charities — a cross-section of nonprofit organizations like Harvard University, the American Red Cross, the Salvation Army, the National Geographic Society, the Christian Broadcasting Network, and the Metropolitan Museum of Art. The 990-T forms are available to the public for the first time, thanks to a change in federal law.
Of the 91 large nonprofit organizations analyzed, 46 — or 51 percent — listed zero or negative taxable income after taking deductions and making other calculations.
In all, the 91 groups in the Chronicle’s review generated $419.1-million in income through such activities as publishing magazines and operating museum shops, bookstores, parking facilities, and restaurants.
Once these organizations calculated their taxes, that $419.1-million figure was reduced to a collective loss of $3-million.
The finding does not mean the nonprofit organizations have run afoul of tax laws. In fact, legal experts say charities are merely following federal rules that have been on the books for years that allow them to take deductions for myriad operating expenses and shield much of their income from tax through exemptions.
But the finding may verify concerns voiced by a top IRS official to Congress that current rules on unrelated business-income tax — known as UBIT — may allow “excess flexibility” for charities in some cases when they calculate the amount of their unrelated business taxable income.
The IRS’s own studies of unrelated business income reporting finds that each year, roughly two-thirds of the public charities that generate unrelated business income pay nothing in tax, a trend that dates back to the beginning of its reporting on unrelated-business income in the 1992 tax year.
Under federal law, nonprofit organizations must pay tax on income generated from business activities that are not “substantially related” to their charitable mission.
The government levies the tax to prevent nonprofit groups from enjoying an unfair competitive edge over private companies.
But The Chronicle’s findings have some lawmakers worried that existing rules are giving charities an unfair tax advantage over businesses.
There are also questions over whether some charities are being too aggressive in how they account for these activities to avoid taxes.
Sen. Charles E. Grassley, of Iowa, the senior Republican on the Senate Finance Committee, says the information “raises a significant number of questions that need to be looked at more closely by charity boards, Congress, and the Treasury Department.”
Of the 91 organizations that provided their most recent Forms 990-T to The Chronicle for review, 45 calculated that they owed unrelated-business income tax.
Collectively, those payments totaled nearly $21.4-million. Payments from just five of the 45 groups accounted for $16.2-million, or 76 percent, of the total tax paid: the Metropolitan Museum of Art, Stanford University, United Jewish Appeal/Federation of Jewish Philanthropies of New York, Emory University, and New York Community Trust.
The remaining 46 organizations reviewed by The Chronicle paid no tax. Seventeen of these groups, after taking deductions and making other calculations, listed $0 as their taxable income. Another 29 of these organizations reported a loss for their taxable income, meaning that their unrelated-business activities cost more money than they generated.
For some organizations, the declared losses totaled millions of dollars.
The Christian Broadcasting Network, in Virginia Beach, Va., generated more than $4.7-million in unrelated-business income, largely through broadcasting and advertising. After taking its deductions and making other calculations, the organization reported a loss on its unrelated-business-income activities of more than $15.3-million.
Another group, National Public Radio, in Washington, reported a loss of nearly $9.5-million after reporting income of more than $4.4-million for activities like sponsorships and the sale of excess satellite capacity.
Senator Grassley says that The Chronicle’s review raises “key questions” for government regulators. “One is whether a charity should be engaged in a loss-making enterprise that may take funds away from their charitable mission,” Mr. Grassley said. “Another is whether charities are inappropriately lowering their tax bills by assigning costs from the charitable activities to the business activities, allowing them to avoid tax and compete unfairly with for-profit businesses.”
Some organizations know in advance that they will lose money each year but do so intentionally through activities that help the public or potential donors, like visitors to a restaurant run by a nonprofit organization for the charity’s patrons. Also, many groups have set up for-profit subsidiaries on which they do pay taxes.
IRS Raises Concerns
Last summer, Steven T. Miller, commissioner of the IRS’s tax- exempt and government-entities division, told a Congressional hearing that his agency was concerned that roughly half of nonprofit organizations that file the unrelated-business tax return report “zero income or a loss in the conduct of their unrelated-business activities.”
Among charities (excluding other types of tax-exempt groups), that figure is even higher. Figures released by the IRS last month show that only 37.7 percent of the nearly 12,400 charities that reported unrelated-business income paid tax on those earnings during the 2004 tax year.
Those organizations reported a collective gross income of more than $5.5-billion, yet paid only $192.5-million in tax — meaning that for every dollar in unrelated-business income, these groups paid about 3.5 cents in federal taxes.
During the 2003 tax year, that figure was even lower. Charities paid about $102.6-million in federal taxes on more than $4.8-billion in unrelated business income or 2.1 cents for every dollar earned.
While the figures suggest to some observers that charities are able to write off millions in otherwise taxable income, some experts say the system is working as it was intended.
“The UBIT rules serve more as a boundary than as an actual source of revenue to the government,” says Marc Owens, a lawyer specializing in nonprofit issues in Washington and the former chief of the IRS’s tax-exempt division. “It’s a barometer that charities use to make sure they are keeping true to their mission.”
He adds, “If there was no boundary on the commercialization of the assets, it would be awfully easy to operate commercial businesses willy-nilly. The UBIT rule serves as a check on that.”
How Rules Work
Just how do the rules governing nonprofit business activities work in practice?
One common way that nonprofit groups reduce their income-tax liabilities is to take deductions for operating expenses, then apply those deductions to their tax bills the same method that commercial businesses use.
But because of the way the rules are written, charities often have significant leeway in how they calculate those deductions.
Suzanne Ross McDowell, a lawyer in Washington and a former Treasury Department official, says that “when you determine what losses or expenses you are going to allocate to unrelated-business income, the regulations leave a lot of room to determine what you think is a reasonable allocation, and these are questions on which reasonable people could come to different conclusions.”
“There is not a lot of guidance out there, so organizations may come to the reasonable conclusions that help their bottom line,” she says.
Nonprofit groups, for example, are allowed to write off some of the salaries and wages of employees who work on business activities. But there are no hard-and-fast rules for determining how much they can deduct for these expenses.
On its most recent Form 990-T, the American Red Cross deducted $334,777 in salaries and wages related to “charitable gaming” events.
The Red Cross told The Chronicle that only one chapter engaged in such events — which were mainly pull-tab games — and has since stopped its participation because “management has determined that it is in the long-term interest of the Red Cross to rely on fund-raising activity that is directly related to service delivery.” The Red Cross declined to identify the chapter involved.
Another group, the Trinity Christian Center of Santa Ana, in California, told the IRS on its most recent Form 990-T that its primary unrelated-business activity is operating gift shops and restaurants. The organization, which operates the Trinity Broadcasting Network, said it owed no income tax after calculating a loss of $378,377. Its deductions included $306,989 for salaries and wages.
Colby M. May, a lawyer for the Trinity Christian Center, said in an e-mail message that the gift shops and restaurants “are not set up price-wise to generate an actual profit after taking into account the overhead and direct costs.”
Mr. May said the facilities “are there for the convenience of visitors, to assist them in having the most enjoyable experience that can be provided when they visit. The actual costs necessary to offer such conveniences, however, cannot be recouped without pricing the activities out of reach of the average visitor. Hence, these activities virtually always operate at a loss when applying all direct and overhead expenses.”
While the federal law states that some forms of charities’ commercial income are taxable like advertising revenue from magazines and journals that nonprofit groups regularly publish, as well as income from insurance policies that they offer the law also includes more than two dozen separate exemptions that allow organizations to shelter such income.
Some of these exemptions are in wide use, including those for capital gains from the sale of stock or property; dividends and interest from investments; and certain royalty and rental income.
As organizations have gotten more sophisticated, said Ms. McDowell, increasingly “exempt organizations may be seeking advice from tax advisers and structuring business activities to take advantage of the royalty exclusion, which is absolutely fine. It’s good tax planning.”
The Chronicle review also found that healthy deductions were common for organizations that rely heavily on advertising revenue and income from renting their facilities for private parties and other uses.
In 2006 the National Geographic Society, in Washington, earned $89-million in taxable advertising revenue from its magazines. After deducting the costs of magazine paper, printing, postage, editorial salaries, distribution, and selling expenses, and taking into account other items and expenses, the organization calculated its taxable income at $3.2-million.
When the society then took a $3.2-million deduction for a “net operating loss” — a sum that charities (as well as taxable entities) are allowed to carry over from previous years and frequently do — the organization’s taxable income dropped to zero.
The society wound up calculating that it owed $64,357 in alternative minimum tax, which applies to some organizations that would otherwise owe little or no tax.
Crista Ministries, in Seattle, reported unrelated-business income of $8.6-million for its 2007 fiscal year, which ended in June, mostly in the form of advertising revenue from three commercial radio stations it operates in the Puget Sound area.
The organization reported taxable income of more than $2.2-million after taking deductions that included $55,476 for compensation of officers, directors, and trustees, and $2.3-million for salaries and wages.
For example, Crista figured that its president, Bob Lonac, spent about 10 percent of his time — or $25,128— involved with broadcast operations unrelated to the group’s mission and deducted this portion of his salary, according to John Jordan, the organization’s vice president and controller.
In the end, Crista calculated that it owed $767,758 in unrelated-business income tax.
Debates over the scope of charities’ business dealings and whether they should be taxed stretch back to the early decades of the 20th century.
Under pressure from business executives, Congress decided in 1950 to tax charities’ unrelated-business activities in hopes of preventing nonprofit groups from enjoying an unfair competitive edge over private companies.
But the law was riddled with loopholes, and in the ensuing years Congress and the courts have added more.
Intense Congressional interest in the issue surfaced in the 1980s, when the Internal Revenue Service, the House Ways and Means Committee, advocates of small commercial businesses, and other people questioned the appropriateness of nonprofit organizations’ generating millions of dollars of tax-free income from activities outside the scope of their charitable missions.
Those questions continue today, as the line between related and unrelated business-income remains blurred, says the IRS’s Mr. Miller.
“This problem is becoming more critical as tax-exempt entities provide goods or services that are similar to or in some cases virtually indistinguishable from those offered by the tax-paying commercial sector,” Mr. Miller said in testimony to the House Ways and Means Committee in July. “This movement raises a number of concerns, including the erosion of the nation’s tax base, unfair competition with the commercial sector, and potential damage to the public’s support of the charitable sector.”
Noelle Barton and Sonya Behnke contributed to this report.