Why Are Charities Tax-Exempt?

Charitable organizations are eligible to be tax-exempt under section 501(c)(3) of the Internal Revenue Code. This is based on a common belief that giving to charities is good for society. However, with ever increasing reports of corruption and fraud, very large amounts of monies tied up in endowment funds of universities and foundations, and cries of unfair competition by taxable for-profits, some people are questioning whether or not all charitable organizations should be tax-exempt?

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With over 1.1 million tax-exempt charitable organizations, the first question is whether the requirements for being a 501(c)(3) organization are appropriate and sufficient for tax-exemption and for being a recipient of tax-deductible contributions*. The next question is whether governmental authorities are appropriately enforcing those requirements.

* Ed. Eligibility for receiving deductible charitable contributions is described under Section 170 of the Internal Revenue Code but generally covers the vast majority of domestic 501(c)(3) organizations.

501(c)(3) organizations:

  • must be organized exclusively and operated primarily for a 501(c)(3) exempt purpose – religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals;
  • must not allow net earnings to inure to the benefit of any private shareholder or individual (including any director);
  • must not engage in substantial lobbying (though a relatively generous amount of lobbying is permissible to most public charities, particularly those making the 501(h) election;
  • must not engage in electioneering.

What does it mean to be charitable?

Treasury Regulations describe “charitable” to include but not be limited to:

  • relief of the poor and distressed or of the underprivileged
  • advancement of religion, education, or science
  • defense of human and civil rights secured by law
  • action to combat community deterioration and juvenile delinquency

What does it mean to be educational?

Treasury Regulations describe “educational” as relating to:

  • the instruction or training of the individual for the purpose of improving or developing his capabilities; or
  • the instruction of the public on subjects useful to the individual and beneficial to the community.

Criticisms:

Some critics assert that it’s too easy to pass the requirements for furthering a “charitable” or “educational” purpose. This has only been made worse by the new Form 1023-EZ made available last year by the Internal Revenue Service for use by applicants for 501(c)(3) status.

Conclusion:

With unclear guidance about what it means to be operating for “charitable” and/or “educational” purposes, there are likely thousands of charitable organizations that are operating with purposes that many critics believe are not worthy of tax-exemption. But are we okay with lawmakers determining that a symphony deserves to be tax-exempt but a small animal rescue group does not or vice versa? Or that educating students on the sciences is an exempt activity but educating them on starting a business is not?

What is clear is that the charitable sector provides valuable services to communities and great value to society. Better guidance on what types of organizations qualify and do not qualify as exempt may be helpful, but lawmakers must be careful in making decisions that in the broader scheme harm the general good only to prevent a very small percentage of organizations from operating in a manner that may not have obvious public benefit or that many may believe are undeserving of exemption. What is important is for the IRS and state agencies to consistently and fairly enforce laws to help prevent organizations from operating inconsistent with 501(c)(3).

 

By Hana and Gene Takagi, NEO Law Group. Reprinted with authorization from Nonprofit Law Blog: “Nonprofit Limited Liability Company.”

 

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