Tangled Up in Tax: The Nonprofit Sector and the Federal Tax System
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Description
Exemption is the term most often used by scholars, practitioners, and policy makers to describe the relationship between nonprofit organizations and the federal tax system in the United States. But although the term is useful as shorthand to characterize the complicated connections between the nonprofit sector and federal tax law, it also should be recognized as the misnomer that it largely is. The nonprofit sector is subject to a wide range of federal taxes—some of which apply broadly to nonprofit and for-profit entities alike, others of which fall almost exclusively on organizations that are ostensibly “exempt.” Insofar as nonprofit entities are excused from payment of federal income tax, exemption comes with a heavy load of compliance burdens, disclosure obligations, and other behavioral restrictions that dictate the day-to-day lives of these organizations. Rather than existing at several steps’ remove from the federal tax system, nonprofit entities are, in fact, tangled up in tax. Indeed, if the relationship between the nonprofit sector and the federal tax system were to be summarized in a single word, entanglement rather than exemption would be the more appropriate term. Nonprofit organizations in the United States are caught in a complex web of nonprofit-specific code provisions, the most significant of which are summarized and evaluated in previous editions of this book upon which this chapter builds. Even seemingly unrelated tax statutes often tie back to the nonprofit sector in winding ways. There is, moreover, no non-entangling option; even total exemption would result in interactions between tax authorities and nonprofit organizations at exemption’s boundaries. Some interactions between the federal tax system and the nonprofit sector are probably desirable. Insofar as the federal tax system seeks to support nonprofit organizations, such support almost inevitably involves a considerable degree of contact. The dominant dilemma in the design of the federal tax rules for non-profit organizations is how to manage entanglement without releasing all strings. Before proceeding further, it may help to clarify what exactly “entanglement” entails. The dictionary definition of entanglement is straightforward—“the condition of being deeply involved”—but that single definition elides entanglement’s many manifestations. Courts and commentators have drawn a helpful distinction between administrative entanglement and political entanglement. Administrative entanglement refers to the involvement of tax authorities in the lives of nonprofit organizations; political entanglement refers to the involvement of nonprofit organizations in the political sphere. Each category can be subdivided further. The clearest form of administrative entanglement is enforcement entanglement, which occurs when tax authorities audit the returns of nonprofit organizations or seek to collect taxes from them (e.g., through liens, levies, and foreclosures). Enforcement entanglement can be avoided if nonprofit organizations are exempt from tax, but exemption leads to a second form of administrative entanglement: borderline entanglement (i.e., interactions between nonprofit organizations and tax authorities policing exemption’s boundaries). Meanwhile, political entanglement can occur when nonprofit organizations are subjects of political controversy or when they are participants in political conflict. The two categories sometimes overlap, as when issues of taxation tug nonprofit organizations into the political sphere. Likewise, the efforts of tax authorities to prevent nonprofit organizations from becoming involved in political conflicts may themselves be a source of administrative entanglement. Administrative entanglement and political entanglement both refer to the entanglement of the nonprofit sector and the organs of government; a different type of entanglement occurs when nonprofit organizations become involved in the market—for example, by operating profit-seeking enterprises. Market entanglement raises several potential concerns. One is a worry about unfair competition between nonprofit organizations that enjoy the benefits of tax exemption and for-profit firms that pay full freight. A second concern is that excessive entanglement between the nonprofit sector and the market will divert nonprofit organizations from their core missions. A third is that nonprofit managers will prove ill-equipped to succeed in commercial ventures and that they will squander their organizations’ resources when they try. The weight of these concerns is discussed at greater length in other chapters of this book. The key point for purposes of this chapter is that market entanglement is an additional dimension of entanglement between the nonprofit sector and other sectors of society that the tax system seeks to control. This chapter approaches the phenomenon of entanglement in four sections. The first section sets out the central dilemma in the tax treatment of nonprofit organizations: how to support the nonprofit sector through the tax system while managing administrative, political, and market entanglement. The second section explores the key provisions of the Internal Revenue Code affecting the nonprofit sector and explains how these provisions balance a set of seemingly irreconcilable policy objectives with varying degrees of success. The third section considers recent legislative changes that significantly reduce the tax system’s support for the nonprofit sector while generating greater entanglement along several dimensions, and also raising the possibility that some nonprofit entities will opt out of tax-exempt status altogether. A final section offers tentative thoughts on entanglement’s future and reflections on possible reforms.
Source Publication
The Nonprofit Sector: A Research Handbook
Source Editors/Authors
Walter W. Powell, Patricia Bromley
Publication Date
2020
Edition
3
Recommended Citation
Hemel, Daniel J., "Tangled Up in Tax: The Nonprofit Sector and the Federal Tax System" (2020). Faculty Chapters. 762.
https://gretchen.law.nyu.edu/fac-chapt/762
