Friday, July 24, 2015

Nonprofit Tax Exemption: Post-Obergefell


As described in our law firm’s preceding blog article, nonprofits’ tax-exempt privileges are increasingly being questioned.  It thus may be helpful to understand not only the underlying rationales for income and property tax exemptions, but also to consider what may lie ahead in the aftermath of the U.S. Supreme Court’s recent Obergefell same-sex marriage decision.

During oral argument in Obergefell, U.S. Solicitor General Verrilli indicated that religious colleges’ tax-exempt status could become an issue for colleges that prohibit same-sex relationships.  Post Obergefell, questions have now been raised as to whether this prediction will become a reality, not only for religious colleges but also for churches and other faith-based organizations.  

Such debate inevitably harkens back to the historic Bob Jones[1] decision, in which the U.S. Supreme Court approved the IRS’s rejection of a university’s tax-exempt status based on the school’s racially discriminatory policies.  In that case, the IRS claimed the power to withhold tax-exempt status for any organization that participates in any activity “contrary to a fundamental public policy.”  In siding with the IRS, a seven-justice majority rested its decision on the government’s “compelling . . . interest in eradicating racial discrimination in education.”[2]  In so ruling, the Court noted that it was dealing only with schools, not churches or other purely religious institutions.[3]  Two justices expressed great concern that the “public policy” authority accorded to the IRS strays dangerously from Section 501(c)(3)’s confines and is too heavy-handed.[4]

Fast forward to 2015.  Will Obergefell lead to new application of Bob Jones, within the context of same-sex marriage issues, such as religious colleges’ housing policies? Will the decision, in combination with anti-discrimination laws protecting sexual identity and gender orientation, mean that churches and other nonprofits’ tax-exempt status will be in jeopardy as being contrary to “public policy”?  The answers are unknown.  Neither the IRS nor the courts have applied the public policy doctrine to religious institutions, and the doctrine has not been developed further regarding nonprofits generally.

Fifteen state Attorneys General recently warned against extension of the public policy doctrine, specifically with respect to religious organizations but also with more broadly applicable language.  They urged Congressional action against such IRS overreaching:

[S]tripping tax-exempt status from religious organizations in this way – a severe consequence that could force groups to exit the public square – would be an unprecedented assertion of governmental power over religious exercise.  The public policy exception has never applied beyond educational organizations or the Government’s interest in “eradicating racial discrimination in education.”  To allow the IRS to proceed in this way would suggest that the IRS has the power to target disfavored beliefs in any religious organization, to effectively decide the truth or correctness of a religious belief, and to penalize as a matter of “policy” a mainstream belief held by groups that long have received tax-exempt status.  This would go beyond the common law public policy, beyond the text of the Internal Revenue Code, and beyond the strictures of the First Amendment and [the Religious Freedom Restoration Act].[5]

Perhaps in response, the IRS reportedly issued a short statement on July 16, 2015, as follows: “The IRS does not intended to change the standards that it applies to section 501(c)(3) organizations by reason of the Obergefell decision.” 

Time will tell if the IRS stays this course, or if Congress makes any overriding adjustments.   For further guidance on legal issues affecting tax-exempt organizations, please contact an attorney in our office


[1] Bob Jones University v. United States, 461 U.S. 574 (1983).
[2] Id. at 604.
[3] Id. at FN 29.
[4] Id. at 606-623.
[5] Letter to Hon. M. McConnell (R.KY) and Hon. J. Boehner (R.OH) re Tax-Exempt Status for Religious Organizations (July 2, 2015). 

Tuesday, July 21, 2015

Rationales for Nonprofit Tax Exemption


Nonprofits face recurring political pressure to justify their tax-exempt privileges.  In the wake of the U.S. Supreme Court’s Obergefell[1] ruling that a fundamental right to marry exists for same-sex couples, some religious organizations have questioned whether their Section 501(c)(3) tax-exempt status may come under attack, to the extent that they object to sexual orientation civil rights protections and notwithstanding their religious beliefs regarding human sexuality.  Property tax exemption for nonprofits is a related area under increasing opposition, as noted in our law firm’s article on “PILOTs.”  Both income and property tax exemptions are extremely well grounded in history, tax law, and underlying rationales, as follows.

Historical Rationale

Religious tax exemption has a lengthy historical precedent:  ancient regimes ranging from Sumer to Babylon, Egypt, Israel, Persia, and India provided tax exemption for the property of churches and priests.[2]  American theories of tax exemption are derived from English law, which recognized exemption for both religious and charitable institutions and identified religion as benefitting an indefinite charitable class. 

These concepts have likewise permeated American society.  As the U.S. Supreme Court observed in the landmark case of Walz v. Tax Commission, specifically with respect to religious institutions’ unquestioned tax-exempt status:

Few concepts are more deeply embedded in the fabric of our national life, beginning with pre-revolutionary colonial times, than for the government to exercise at the very least this kind of benevolent neutrality toward churches and religious exercise generally, so long as none was favored over others and none suffered interference.[3]

This kind of benevolent neutrality is also embedded in state law – all fifty states and the District of Columbia currently provide for religious tax exemption through statutory or constitutional provisions.[4]  Other faith-based, charitable, and educational nonprofits enjoy similar tax exemptions.  While historical tradition alone cannot suffice as the sole rationale, the long-standing and long-reaching history of tax exemption – particularly for religious organizations – provides a persuasive argument for its continuation.

Tax Base Definition Rationale

The second rationale for tax exemption is based upon definition.  Proponents argue that the tax base, by definition, does not include religious, educational, and charitable activities.  Therefore, such nonprofits must be exempt from taxation.  In other words, the income of such organizations cannot be measured in profit-seeking terms because their “income” is distributed for charitable purposes rather than to shareholders.  Any tax imposed on a nonprofit’s revenues would thus be borne by the organization’s beneficiaries and donors, which is inconsistent with such organizations’ overall charitable nature.[5]  This analysis is particularly true for churches and other religious institutions, which typically do not charge any fees for admission or other benefits offered.

Subsidy Rationale

Tax exemption sometimes has been framed as a subsidy, or incentive, for qualified charitable activities.  Also known as the quid pro quo theory, this reasoning suggests that nonprofits gain tax exemption – along with the significant benefit of receiving tax-deductible contributions – in exchange for lessening the burdens of government by providing charitable services.  This burden reduction may be common for strictly charitable and educational nonprofits, but more as a hallmark of such activities rather than as a qualification for tax-exemption. 

The theory’s application to religious institutions gets more complicated because distinctly religious functions (worship, prayer, religious teaching, etc.) cannot necessarily be construed in this manner.  Furthermore, such approach could be problematic under the First Amendment’s Establishment Clause, which prohibits the state from sponsoring or supporting a particular religion.  A blanket tax exemption avoids the possibility of any unequal or selective tax treatment on the basis of an organization’s religious beliefs. 

On the other hand, religious institutions long have provided extensive societal benefits that reduce government burdens by, essentially, fostering good citizenship.  As a Georgia court once explained, they include:

[B]enevolence, charity, generosity, love of our fellow men, deference to rank, to age and sex, tenderness to the young, active sympathy for those in trouble or distress, beneficence to the destitute and poor, [which] constitute not only the “cheap defence of nations,” but furnish a sure basis on which the fabric of civil society can rest, and without which it could not endure.  Take from it these supports, and it would tumble into chaos and ruin.[6] 

Such qualities, even if not readily quantifiable, continue today and justify the inherent economic benefits of religious institutions.  Religion’s societal benefits also are much cheaper and more effective for maintaining order than governmental alternatives such as welfare programs and costly police powers.

Sovereignty Rationale

Sovereignty theory posits that nonprofit organizations occupy a sphere completely separate from the state.  This theory particularly provides a powerful rationale for tax exemption for religious institutions due to their First Amendment freedom from governmental interference.  Instead of considering whether the state is allowed to exempt religious organizations, sovereignty theory asks if the state has any power to tax such entities at all.[7]

Two critical tax principles are essential to understand sovereignty theory.  First, as Justice Marshall famously pointed out long ago, “the power to tax involves the power to destroy.”[8]  Second, the power to tax is held by a sovereign government.  The sovereignty theory recognizes that it would be quite problematic if the government could control religious organizations – directly or in more subtle ways – through potentially onerous taxes, intrusive reporting requirements, consequent penalties for compliance failures, and other tax-based regulations.  Accordingly, while religious institutions may be subject to the sovereign in limited ways (e.g., payroll taxes, health and safety regulations), courts have required that government intrusions into the religious sphere be strictly scrutinized to guard against overreaching.  This safeguard is a matter of our country’s constitutional protections, grounded in the sovereignty rationale.[9]

Concluding Remarks

To be equipped for future challenges, religious organizations and other nonprofits may wish to better understand the multiple rationales for their tax exemptions.  Our upcoming blog will address what lies ahead, in the wake of the U.S. Supreme Court’s  recent Obergefell same-sex marriage ruling.   For further guidance on legal issues affecting tax-exempt organizations, please contact an attorney in our office at info@wagenmakerlaw.com or 312-626-1600.



[1] Obergefell v. Hodges, No. 14-556, 2015 WL 2473451 (U.S. June 26, 2015).
[2] Deirdre Dessingue, “The Special Case of Churches,” in Property Tax Exemption for Charities, 173 (Evelyn Brody ed., 2002).
[3] 397 U.S. 664, 676 (1970).
[4] Dessingue at 174.
[5] See Evelyn Brody, “Legal Theories of Tax Exemption:  A Sovereignty Perspective,” in Property Tax Exemption for Charities, 147-148 (Evelyn Brody ed., 2002).
[6] Trustees of the First Methodist Episcopal Church, South v. City of Atlanta, 76 Ga. 181, 192 (1886).  See also Founding Church of Scientology v. United States, 412 F.2d 1197, 1199 (Ct. Cl. 1969) (tax exemptions exist for religious, charitable, and educational groups because these “institutions and organizations exist and function for [many] purposes which Congress deems beneficial to society as a whole.”).
[7] See Dessingue at 176-177.
[8] McCulloch v. Maryland, 17 U.S. 316, 431 (1819).  See also Murdock v. Pennsylvania, 319 U.S. 105, 112 (1943) (“The power to tax the exercise of a privilege is the power to control or suppress its enjoyment.”).
[9] See Kenneth C. Halcom, Taxing God, 38 McGeorge L. Rev. 729, 765-66, 772-73 (2007); Glenn Goodwin, Would Caesar Tax God?  The Constitutionality of Governmental Taxation of Churches, 35 Drake L. Rev. 383, 384 (1986).  See also, Walz, 397 U.S. at 676 (“All of the 50 states provide for tax exemption of places of worship, most of them doing so by constitutional guarantees.  For so long as federal income taxes have had any potential impact on churches - over 75 years - religious organizations have been expressly exempt from the tax.”).

Wednesday, July 15, 2015

PILOT Programs – The Nonprofit Property Tax


           If it walks like a duck and quacks like a duck…    

In an era of waning revenue streams and increasing demand for government services, some cash-strapped municipalities cast a longing eye at nonprofits’ real property as a missed source of revenue.  Through Payment in Lieu of Taxation (“PILOT”) programs, states and municipalities encourage – and sometimes require – nonprofits to pay what they consider the nonprofit’s “fair share.”   PILOT programs, however nicely packaged, are still essentially property taxes.  The trend toward PILOT programs in the last fifteen years should concern the nonprofit sector because of the potential for substantial financial implications, as explained herein. 

Background

PILOT programs have long been used to compensate localities for lost property tax revenues.  Historically, both state and federal governments have utilized PILOTs to reimburse municipalities containing exempt state- and federally-owned land.[1] In addition, some large educational nonprofits for decades have made voluntary PILOT payments to municipalities to help offset their considerable use of municipal services.  For example, Harvard and MIT have made voluntary payments to the City of Cambridge, Massachusetts since 1928.[2]   

Recently, use of PILOT programs has increased dramatically.  From 2000 to 2010, eighteen states implemented PILOT programs affecting nonprofits.[3]  However, these programs have not gained universal approval; some states have expressly declined to implement PILOT programs.  Florida, for example, determined its PILOT program statute violates Florida’s constitution.[4]  The overall trend, however, favors PILOT programs for nonprofits.  Municipalities continue to pressure state legislatures to assist local communities facing tough economic realities.

Voluntary PILOT or Mandatory Tax?

Are PILOT programs truly “voluntary” or in practice a mandatory tax?  As some authors have put it, “Unhappy governments can make life difficult for nonprofits by limiting access to local public services, failing to relieve burdensome local regulation, or challenging tax exemptions on the basis of whether nonprofits properly pursue their exempt purposes. In such environments nonprofits may feel considerable pressure to accede to local requests for PILOTs.”[5]

Some states simply drop any pretense of choice and make PILOT requirements mandatory under state and municipal law.  For example, the Massachusetts legislature is presently considering a bill (HB 2584) that would give municipalities the right to require nonprofits like schools and hospitals to pay 25% of the property tax they would owe if they were not tax-exempt entities.  If adopted, the bill could significantly affect nonprofits.  For example, one local school that paid the town $858.89 in 2014 anticipates an increase to nearly $150,000 per year.[6]  Another nonprofit school with substantial land holdings estimates its PILOT payment to cost an additional $462,000 per year.[7]
                                                                                          
Supporters of the Massachusetts bill laud its flexibility and argue that municipalities will have the ability to exclude certain nonprofits, such as small charitable organizations.  Such assurances, however, ring hollow.  Any exceptions made by localities would be completely discretionary.  The bill thus contains no inherent protections for smaller nonprofits facing the threat of localities ravenous for new revenues.  The lack of such protections and the substantial financial impact make the Massachusetts bill and other similar PILOT programs all the more problematic.

The Massachusetts example is not unique.  Some studies estimate that “for the more than 150,000 U.S. nonprofits with greater than $500,000 of real property… annual tax exemption was worth an average of 19 percent of their total revenues.”[8]  Such PILOT programs will likely stifle nonprofit activities, particularly with regard to activities requiring real property ownership.[9] 

Nonprofit organizations should remain aware of this new trend and alert to legislative efforts to enact PILOT programs in their states.   Nonprofit leaders should be ready to challenge PILOT programs where possible.  For further information about PILOT programs and other property tax issues, please contact one of our attorneys at 312.626.1600 or info@wagenmakerlaw.com, or visit us on the web at www.wagenmakerlaw.com.


[1] For an example of a state-provided PILOT program, see e.g., Connecticut, http://www.ct.gov/opm/cwp/view.asp?A=2985&Q=383162.
[2] Fan Fei, James Hines, Jill Horwitz, Are PILOTS Property Taxes for Nonprofits?  The National Bureau of Economic Research at 3, available at http://www.nber.org/papers/w21088.
[3] Daphne A. Kenyon and Adam H. Langley.  Payments in Lieu of Texas: Balancing Municipal and Nonprofit Interests.  Lincoln Institute of Land Policy (2010), available at http://www.lincolninst.edu/subcenters/significant-features-property-tax/upload/sources/ContentPages/documents/PILOTs%20PFR%20final.pdf .
[4] See AHF-Bay Fund, LLC v. City of Largo, No. 2D14-408, 2015 WL 1809577 (Fla. Dist. Ct. App. Apr. 22, 2015) (holding that PILOT program affecting a nonprofit was ad valorem taxation and unconstitutional as applied to the tax exempt entity under Florida law).
[5] See supra Fei et al.  at 3. 
[6] See Tom Relihan, How could Kulik’s PILOT bill affect private schools? Available at:  http://www.recorder.com/home/17297539-95/how-could-kuliks-pilot-bill-affect-private-schools
[7] Id.
[8] See supra Fei et al. at 5.
[9] See supra Fei et al. at 20.

Tuesday, July 7, 2015

End of IRS’s Health Insurance Reprieve?


Since the Affordable Care Act (ACA)’s enactment, the IRS and the U.S. Department of Labor have delivered a rather unpleasant surprise to many, namely, that it now treats employers’ reimbursement or payment of employees’ individual health insurance premiums as taxable income to such employees (also known as health reimbursement arrangements or “HRAs”).  This new rule, which essentially is an interpretation of “plan” under the ACA’s so-called market reforms, applies to small employers that are otherwise exempt under the ACA.  The interpretation constitutes an about-face from the longstanding treatment of HRAs as a pre-tax employee benefit.

Transitional relief was granted when the IRS issued a notice in early 2015, providing that employers who provided such pre-tax benefit would not owe any penalties or be required to include such benefit as taxable income – at least through June 30, 2015.  Such relief was extremely helpful (even though quite late), since the penalty for noncompliance is extreme: $100 fine per employee, per day (!).  

At this point, no further tax relief for HRAs is on the horizon.  Legislative rumblings of relief developed earlier this year but failed to produce any helpful result.  Now that the U.S. Supreme Court upheld the ACA’s federal subsidy programs in its recent King v. Burwell ruling (and therefore its core elements), perhaps legislators will focus again on modifying such ACA aspects as this HRA issue.   Instituting such relief would be both consistent with the fervent opposition of many politicians and greatly welcomed by many. 

In the meantime, employers are essentially left with two choices with respect to reimbursement (or payment) of their employees’ individual health insurance premiums:

1.         Start complying with current legal requirements (e.g., by “grossing up" employees' wages so that they can pay such insurance costs with after-tax dollars, or ceasing such employee benefit entirely), as of July 2015 payroll; OR

2.         Face the possibility of severe tax penalties for non-compliance ($100 per day, per non-compliant employee reimbursement).

Please note that this newly enforceable tax regime applies for all employers that reimburse at least two employees’ health insurance premiums.  A significant exception applies for one-participant-only reimbursement plans, which applies even if the employer has multiple employees.

Our law firm will closely follow further ACA developments and keep you posted regarding taxability of employers’ health insurance premium reimbursements.  For further guidance on specific application to your organization or for other legal counsel, please contact an attorney in our office at info@wagenmakerlaw.com or 312-626-1600.