Testing the Limits

When Michelle Finholdt applied for a property-tax exemption for the nonprofit child-care center that she built in Red Wing, Minn., in 2003, she had no idea she would create a huge stir. She believed her operation, Under the Rainbow Child Care Center, qualified for the exemption, and she dreamed of how she could use the money she saved on taxes to buy educational materials for the children in her care. But her application set off a chain of events that drew in the Minnesota Supreme Court, followed by nonprofit leaders, lawyers, tax officials, county officials, and state legislators.

The debate that her case sparked: How do you define an “institution of purely public charity,” a category that under state law qualifies for a property-tax exemption? The supreme court gave its answer in December 2007, ruling that Under the Rainbow did not meet the test since it always charged full price for its services, offering no discounts or free care for people with limited incomes. Therefore, it was ineligible for a property-tax exemption.

Legislative Fix

But far from resolving the issue, the ruling galvanized the state’s nonprofit leaders, who believed the court had severely narrowed the definition of a charity. The Minnesota Council of Nonprofits, a coalition of nonprofit groups, organized a campaign to persuade the state Legislature to dampen its impact.

Now, after months of complex talks between the nonprofit council, the state Department of Revenue, the Minnesota Association of Assessing Officers, and legislative aides, a bill is before the Legislature that would for the first time set out the legal criteria to determine which groups are eligible for charitable property-tax exemptions.

“We’ve worked so closely, we’re going to celebrate passage of the bill together,” says Marcia Avner, the council’s public-policy director.

While the legislation would apply only to Minnesota, other states and cities are struggling with similar issues, especially as they look for revenue during economic hard times. But there is no uniform definition of a charity, and state laws are in many case ambiguous, says Evelyn Brody, a professor of law at Chicago-Kent College of Law. “People will definitely be watching to see if this helps,” she says.

But the Minnesota talks highlight how hard it can be to come up with a definition of charity that applies to such a diverse set of organizations.

The legislation, introduced last week by Sen. Tarryl Clark and Rep. Paul Marquart, both Democrats, says organizations generally must meet six criteria that the state supreme court has laid down to determine when a property-tax exemption is warranted — including a requirement to offer “a material number of people” goods or services free or at reduced prices.

But it attempts to clarify some questions those criteria raise — for example, how to treat charities that rely heavily on government payments. Even if they don’t offer price breaks, charity advocates said, shouldn’t it count that they are providing help to people on behalf of the government? The new bill says yes.

One test to determine whether an organization is a charity, it says, is whether it offers services to the public “that alleviate burdens or responsibilities that would otherwise be borne by the government.”

The Minnesota Council of Nonprofits says that language is critical to protect the tax exemptions of groups like Residential Services of Northeastern Minnesota, which provides services to people with developmental disabilities and owns 28 homes that provide foster care to clients.

“I really felt we were at risk because of how the supreme court decision was worded,” says Jon Nelson, the group’s executive director. Almost all of his organization’s $12-million budget comes from government contracts, mostly for Medicaid payments, he says, and they specify that the charity must charge fixed rates. That means no free or discounted care.

Donations vs. Payments

Another thorny question was how to treat government grants. One factor the supreme court uses to determine whether an organization is a charity is whether it is supported by donations and gifts. The court ruled in the Under the Rainbow case that government payments did not count.

The new legislation says assessors can consider government grants, along with money from private sources, when weighing that factor — although defining “grant” proved to be challenging. The six-line definition in essence says a grant involves a transaction designed to “support a public purpose authorized by law.” That wording was crafted to ensure that contractors who perform services to help government agencies, rather than the public, are not granted tax exemptions.

But Mr. Nelson is worried that it could be interpreted to exclude his charity as well, since he considers the government money it receives fees for services, rather than grants. He is hoping the Legislature will tweak the language.

While the Minnesota Council of Nonprofits has focused on working out nitty-gritty details like that, it has also been mobilizing its members in a campaign to persuade lawmakers, and the general public, that property-tax exemptions are good public policy.

“If nonprofits lose their tax exemptions, the money is directed away from programs,” Ms. Avner says. “That means somebody has to pick up the slack or some need in the community is not being met.”

The nonprofit council says surveys show wide public support for that view in Minnesota. But Carol Lee, assistant attorney for Goodhue County, who brought the Under the Rainbow case to the supreme court, has a slightly different take: “The outlook of the government is, If you’re not paying the tax, somebody else is going to have to, so we need to make it equal.”

Subsidy Sought

Ironically, Under the Rainbow, the child-care center that brought the issue into the public arena, is not likely to benefit from the legislative effort. The new language still requires charities to offer free or discounted services — something Ms. Finholdt says she cannot now afford to do.

“Without getting some kind of subsidy to allow us to do that, it’s just not reality with our budget that we have,” she says. Her center, which serves about 120 children six weeks to 12 years old, charges from $122 to $154 a week for full-time enrollment.

Ms. Finholdt, who studied child-care education in junior college, fulfilled a longtime dream when she started Under the Rainbow in 1994. She began as a sole proprietor after her proposal to run a center at a local technical college was accepted, draining her savings to buy toys and equipment.

A year later, she decided to convert the operation to a nonprofit corporation, both to limit her liability and to become eligible for money from foundations and a state food-and-nutrition program. She opened a second location in 1996, but decided to build a new center, on 1.7 acres of land, after the technical college notified her that it was expanding and needed its space back.

That’s when she started dealing with Goodhue County assessors about property taxes — and, she says, “It was just a constant struggle.” When the county denied her an exemption, Ms. Finholdt got a lawyer and decided to fight it — and she won the first round. The Minnesota Tax Court ruled that Under the Rainbow was an “institution of purely public charity,” applying six criteria that had been set out in a 1975 state supreme court case, North Star Research Institute v. County of Hennepin.

Those criteria, which are at the crux of the Minnesota debate, ask tax assessors to examine whether an organization:

• Seeks to help others without immediate expectation of material reward.
• Is supported partly or entirely by donations and gifts.
• Requires recipients of the charity to pay for the aid, in whole or in part.
• Earns a profit from the income from gifts, donations, or fees.
• Restricts who benefits from the charity.
• Makes dividends or assets available to private interests if the organization dissolves.

The tax court said Under the Rainbow met all those standards except the third one, and granted a property-tax exemption. But Goodhue County decided to fight the ruling. Minnesota law specifically exempts some organizations from property taxes — for example, colleges and universities, public hospitals, public cemeteries, seminaries, and churches.

But an organization that applies as an “institution of purely public charity” has the burden of proof, says Ms. Lee, the assistant county attorney — and she found it hard to distinguish Under the Rainbow from a business.

In addition to not offering any scholarships or grants to needy children, the center did only minimal fund raising, thus failing to meet the requirement to be supported by donations and gifts, the county argued.

The case then moved to the state supreme court, which ruled in Under the Rainbow Childhood Center vs. County of Goodhue that an organization does not necessarily have to meet all six North Star criteria to earn a tax exemption, but that it must absolutely meet the third standard — by offering goods or services free or at “considerably reduced rates.”

“It is not sufficient that an organization serves a worthwhile purpose, or even that it does so on a nonprofit basis,” it said. “There must be a substantial charitable, or gift, component to an organization’s operation in order to qualify as an institution of purely public charity.”

Fees for Services

The court also, in 4-3 decision, offered guidance on how to apply the requirement on gifts and donations. It rejected the tax court’s ruling that payments made to Under the Rainbow from county and tribal governments for families unable to pay full price — which represented more than 20 percent of its fees — were “public donations.” Those payments, it said, “were made for services rendered.”

The Minnesota Council of Nonprofits learned of the supreme court decision on a Thursday, when a local newspaper reporter called to ask about it.

The following Monday, more than 50 nonprofit and philanthropic leaders gathered in the council’s conference room to discuss how to respond.

They agreed to focus their attention on the state Legislature, persuading it to adopt a moratorium last spring that barred tax assessors from changing the way they evaluated charities for taxes payable in 2009. The legislation also asked the Department of Revenue to survey county assessors and prepare a report on how they determine which groups qualify as charities.

That report, which was issued this month, found that practices in 84 counties and the city of Minneapolis varied widely. More than half said they used the North Star criteria, while others said they looked at factors like whether the applicant competes with a taxable entity, provides a service the government would normally provide, or lessens the burden of government. Some said they required groups to provide benefits free or at below-market prices, or considered government payments donations, but others did not.

When it comes to defining concepts like charity, market competition, or government burdens, the report concluded, “it is clear that many of the guidelines used are ‘feeling-based’ as opposed to ‘fact-based.’” The revenue department agreed that legislation was needed to bring some uniformity to the assessments, and endorsed the language that was introduced last week. But it noted that negotiations were difficult because none of the parties wanted to use words that would either expand or narrow the types of groups that are eligible for an exemption.

To ensure the legislation passes, the Minnesota Council of Nonprofits has organized a sophisticated campaign, appointing captains in each Senate district who are working to mobilize charities in their region to contact lawmakers.

More than 200 nonprofit leaders, board members, and volunteers showed up for “Nonprofit Day at the Capitol” in St. Paul this month and lobbied their representatives.

Of 68 reports submitted by people who attended, all but two or three said their legislators supported the council’s efforts, says Rinal Ray, coordinator of the group’s Preserve Charitable Tax Exemptions Campaign.

‘Reasonable’ Test

But even if the legislation passes, some murkiness will remain. The bill allows some charities that do not meet certain criteria to earn exemptions if they can offer a “reasonable justification.” A three-person panel (two nonprofit representatives, one assessor) would be set up to offer a nonbinding recommendation in such cases.

Furthermore, the revenue department says separate legislation may be needed to preserve the tax exemptions for nonprofit nursing homes, as long as they do not discharge patients who can’t pay, because they often do not raise substantial donations.

Meanwhile, Ms. Finholdt of Under the Rainbow is contemplating how to change the way she operates if the new legislation indeed requires her to offer free or discounted services, and to solicit gifts or donations, to win a tax exemption.

With revenues of about $540,000, according to the group’s 2007 informational tax return, she says she pays about $16,000 a year in property taxes and has racked up $55,000 in legal fees to press her case.

The center holds two fund-raising events a year that raise a total of $3,000 to $4,000, mainly from parents of youngsters at the center, but Ms. Finholdt says she has been reluctant to organize more because they take time that she would rather spend on the center’s mission.

She says she is exploring other avenues, like applying for foundation grants, though so far has had no luck.

“If there’s something that we can be doing here to fit how the new law’s going to read,” she says, “absolutely, we’ll give it our best shot.”