Are Tax Exemptions Subsidies?

The drive to penalize private schools that discriminate on the basis of race by denying them tax exemption poses some serious problems of “bleed-through.” If the penalty could be limited to racial segregation, few except segregationists would object. But the rationale advanced for tax penalization is not now limited to racial segregation or even to violation of rights guaranteed by the Constitution. It relies on either or both of two elements that are lately supposed to be qualifications for tax exemption: public benefit and public policy.

To qualify for tax exemption, it is now contended, an organization must benefit the public and must not violate public policy. Schools that discriminate are excluding or disadvantaging a portion of the public and therefore do not truly benefit the (whole) public, and they also violate the federal public policy against racial discrimination. These two criteria were not applied to federal income tax exemption until 1969, when the IRS, under Randolph Thrower, borrowed them from the law of charitable trusts and applied them to the Internal Revenue Code’s section on exempt organizations -- Section 501(c), as applied in Treas. Reg. 1.501(c)(3) -- 1(d)(2).

Prior to that time, tax “exemption” had simply been a formal recognition that nonprofit organizations normally have no net income and so are not appropriate objects of income taxation. As Cordell Hull, author of the Revenue Act of 1913, said: “Of course any kind of society or corporation that is not doing business for profit and not acquiring profit would not come within the meaning of the taxing clause.” There were no tests of public benefit or conformity to public policy applied. Indeed, in 1966 the Supreme Court observed that even criminal activities were not punished by the tax code.

. . . the federal income tax is a tax on net income, not a sanction against wrongdoing. That principle has been firmly embedded in the tax statute from the beginning. One familiar facet of the principle is the truism that the statute does not concern itself with the lawfulness of the income that it taxes. Income from a criminal enterprise is taxed at a rate no higher and no lower than income from more conventional sources [Commissioner v. Tellier, 383 U.S. 687, 1966].

If the tax code is to be used to penalize conduct that is not criminal but is only contrary to public policy or renders no public benefit, then it is important to notice the assumption underlying that innovation and its implications for all voluntary organizations, particularly churches.

The underlying assumption is that tax exemption is a public subsidy, a form of federal financial assistance, and that other taxpayers must make up the taxes not exacted from an exempt entity. (This assumption is shared by virtually all persons quoted in the press on this issue: members of Congress, leaders of civil rights organizations, church leaders, experts on constitutional law, etc. Reagan administration officials do not deny this assumption but insist only that Congress, not the IRS, should determine who is entitled to the supposed subsidy.) From this assumption arises the corollary that to qualify for that “subsidy,” an organization must be of benefit to the public and must not violate “public policy” -- whatever that may be.

The consequences of that rationale, however, are ominous for democracy, for freedom of association, and for religious liberty. If the legislature -- or the IRS -- can give or withhold tax exemption from nonprofit organizations on the basis of its interpretation of what serves the public benefit or violates public policy, then we are all in trouble. For instance, organizations trying to assist Haitian and Salvadoran refugees to avoid repatriation, or organizations urging boycott of banks doing business with South Africa, or organizations counseling young people not to register for the draft, or organizations protesting increased military expenditures, or organizations demonstrating against nuclear power or against mineral exploration in wilderness areas, are all in danger of losing their tax exemptions for violating “public policy.”

But it is fallacious to equate tax exemption with subsidy. Boris Bittker, in an important 1976 Yale Law Journal article, “The Exemption of Nonprofit Organizations from Federal Income Taxation,” states the correct concept: “The exemption of nonprofit organizations from federal income taxation is neither a special privilege nor a hidden subsidy. Rather, It reflects the application of established principles of income taxation to organizations which, unlike the typical business corporation, do not seek a profit.”

A tax exemption simply does not function as a subsidy does. The U.S. Supreme Court, in upholding the constitutionality of church property tax exemptions, has recognized this difference:

Obviously a direct money subsidy would be a relationship pregnant with involvement and, as with most governmental grant programs, could encompass sustained and detailed administrative relationships for enforcement of statutory or administrative standards, but that is not this case. . . . The government does not transfer part of its revenue to churches but simply abstains from demanding that the church support the state. No one has ever suggested that tax exemption has converted libraries, art galleries or hospitals into arms of ~he state or employees “on the public payroll” [Walz v. Tax Commission, 397 U.S. 644, 1970].

In a tax exemption, no money changes hands between government and the organization. The organization cannot buy a thing with a tax exemption. Without contributions from its supporters, it has nothing to spend. Government cannot create or sustain by tax exemption any organization which does not attract donations on its own merits.

There is no specified amount to a tax exemption, as there is to a subsidy; it is “open-ended”; the organization’s income is determined by its contributors, each of whom decides individually how much to give.

Likewise, there is no periodic legislative or administrative struggle to obtain, renew, maintain or increase the amount, as there would be with a subsidy. The organization does not have to expend its energies applying for, defending, reporting, qualifying, undergoing audits and evaluations; nor does the government have to devote its resources to administering these tests and scrutinies.

A subsidy is not voluntary in the way that tax-exempt donations are. The individual citizen has little or no choice in the matter when the legislature taxes the citizenry and appropriates a portion of the revenues as subsidies to private organizations for purposes it deems appropriate (and of course it could not properly give any such subsidies to churches).

Finally, a tax exemption does not convert the organization into an agency of “State action,” whose activities are thus sponsored and endorsed by government, whereas a subsidy may do so. (“No one has ever suggested that tax exemption has converted libraries, art galleries, or hospitals into arms of the state or employees ‘on the public payroll,’” said the court in 1970. Well, perhaps someone has suggested so now.)

A Senate Concurrent Resolution introduced in January by Senators Gary Hart (D., Colo.) and Daniel Patrick Moynihan (D., N.Y.) asserts that Congress intended to deny tax exemption to segregated private schools when it adopted the Civil Rights Act of 1964, which contains in Title VI a prohibition of “federal financial assistance” to any segregated institutions. It is instructive to note, however, that in the debates of 1964, proponents and opponents of the proposed Civil Rights Act both listed all of the forms of federal financial assistance that would be cut off if the act passed, and neither side mentioned tax exemption. So if, in reconstructive hindsight, tax exemption is now claimed to be federal financial assistance, then, of course, churches are not entitled to it at all!

But if the assumption is wrong, if tax exemption is not a subsidy or a form of federal financial assistance, then the tests applied to charitable trusts are not appropriate to tax exemption, and exempt entities need not be required to render what the legislature or IRS considers public benefit or to conform to what they construe to be public policy.

The earlier rationale for tax exemption was that nonprofit organizations are simply not part of the tax base to begin with because their members already pay their own share of the costs of government as taxpayers in their own right. If any taxes were to be collected from the nonprofit organizations which they have formed to achieve their shared purposes, those taxes would have to be paid by the members, supporters, contributors to such organizations. They would in effect be taxed again for organizing themselves into groups for activities from which they derive no monetary gain and which indeed might also benefit the community.

This issue is complicated by the fact that “tax exemption” refers to a bundle of things. Organizations so designated are exempt not only from federal taxation of their net income but also from payment of social security taxes, federal unemployment insurance, various sales and excise taxes, and taxes on real property. “Tax exemption” also refers to deductibility: of charitable bequests from federal inheritance taxes, of charitable gifts from the federal gift tax and of charitable contributions from the donor’s gross income.

The rationale is not the same for all of these. It is not easy to justify as a matter of “right” the exemptions from taxes paid by most employers, and one could contend that if nonprofit organizations employ people, they should pay the appropriate employers’ share of social security and unemployment taxes just as any other employers do.

The tax-base rationale applies only to the exemptions from income, sales and real-estate taxes. The remaining items refer to deductibility of charitable contributions, gifts and bequests, which are otherwise taxable -- deductibility not to the recipient nonprofit organization, but to the donor, on the rationale that what the donor gives away to a charitable organization should not be treated as income for purposes of taxation since, unlike taxable income, it does not represent the consumption or accumulation of income for the donor’s personal aggrandizement.

The criteria of charitable trusts could and I should properly apply only to the area of deductibility, which also represents the principal area of impact of the federal exemptions. That is, it would normally not have any great effect on a nonprofit organization to be taxed on its net income, since it seldom has any. Loss of deductibility of contributions would have a much greater effect, and it is the only area to which the criteria of charitable trusts should apply. In other words, an organization that does not serve the public benefit or which violates public policy might properly be deprived of deductibility of charitable contributions, but not of exemption from income taxation.

The difference might seem only technical in income taxation, but it is more practical with regard to sales, excise and property taxation, where nonprofit organizations enjoy important insulation from governmental imposts and oversight by virtue of their not being a legitimate part of the tax base. This is not just a logical nicety but an important protection of the freedom of association -- a freedom that has been safeguarded in decisions like NAACP v. Alabama (357 U.S. 449, 1958), which held that a state may not compel a voluntary association of citizens to turn over its list of members because that might subject them to governmental penalties. Similar considerations should apply with respect to the powers of government to tax such organizations, since “the power to tax can become the power to destroy.”

When groups of citizens get together to accomplish purposes of mutual interest (from which they derive no profit), it should not be the responsibility of government to inspect, evaluate and approve their endeavors on the basis of supposed conformity to the prevailing notion of “public benefit” or “public policy” of the moment. It is the responsibility not of government to formulate and perpetuate public policy but of the citizenry, who can do so wisely, creatively and effectively only by organizing themselves in voluntary groups around their various shared interests and concerns. Precisely because the public policy they envision may be different from that currently in effect, their voluntary organizations need to be as free as possible from governmental surveillance, scrutiny and supervision.

Tax “exemption” -- meaning exclusion from the tax base -- is one mode of insulating such groups from the tides of popular opinion and the caprice of incumbent governors. It should be something legislatures cannot turn on or shut off at will, something that is anchored in the essential right of freedom of association protected by the First Amendment.

But even if that bastion were, regrettably, to fall, a further protection should be maintained to safeguard the free exercise of religion on the part of organizations seeking to carry out what members believe to be the duties of conscience required by their religious obligations; i.e.. those involving “duties superior to those arising from any human relation” (Chief Justice Hughes dissenting in U.S. v. MacIntosh, 283 U.S. 605 1931, an opinion which has become a keystone of the conscientious-objector exemption from Selective Service requirements).

Religious bodies should seek to reclaim the original rationale of nontaxation of nonprofit organizations in general for the sake of freedom of association for everyone. But if that cannot now be done, they should not surrender any defensible safeguard of the autonomy of religious organizations to embody the free exercise of religion of their members. To characterize that nontaxation as a governmental “subsidy” or as “federal financial assistance” is needlessly and fallaciously to give away an important protection of religious liberty.