The Business of Charity

Nonprofit groups reap billions in tax-free income annually

Over the past five years, the Sesame Workshop, the nonprofit group

that created the “Sesame Street” television program, has made $286-million from business dealings. The money has included fees paid by advertisers in Sesame’s children’s magazines, revenue from sales of Big Bird and Elmo stuffed toys, and royalties from a private company that operates three Sesame Street theme parks, one of them in Japan.

And yet, unlike many commercial businesses that profit from royalties, advertising, and toys, the Sesame Workshop has paid very little in federal income taxes, according to its president, Gary Knell. Under Internal Revenue Service rules, money from the toys and theme parks is tax-free, and Sesame has been able to slash its tax bill on the advertising income by writing off operating expenses against it.

Sesame Workshop is one of thousands of nonprofit groups that have found ways to profit from ancillary business ventures and avoid paying tax on much of the income such activities produce.

A Chronicle study of the informational tax returns filed by nearly 14,000 of the nation’s largest charities in 1998 found that at least $61-billion in income from outside business dealings — what the IRS calls “unrelated business” activities — was shielded from federal taxes by exemptions that Congress has built into the federal tax code.

A separate study by the IRS shows that in 1997, even after subtracting all exempted income, charities still received $4.2-billion from outside business dealings — more than double the total in 1990. What’s more, only $337-million — about 8 percent — of the 1997 total was taxed because charities were able to claim deductions for operating expenses to shelter the income.

The IRS also found that an estimated 10,614 charities reported outside income, but that fewer than half — 4,008 — owed taxes after claiming deductions for operating expenses. The total payment to the federal treasury was $103-million — about two-tenths of a cent for every dollar in unrelated-business income, the IRS found.

Charity executives and nonprofit tax experts generally view the growth in outside income as a benign trend. The ability to generate business income — and to do it without a heavy tax burden — helps nonprofit groups make up shortfalls in donations, weather economic hard times like those that charities currently face, and enhance the ability of groups to carry out their tax-exempt missions, many observers contend.

“I’m loath to suggest in a time of dwindling public commitment that nonprofits ought not to have the ability to earn money in other ways without being taxed on it,” says Mark Rosenman, a professor of public service at the Union Institute in Washington.

Still, even supporters of the trend see potential hazards in the rapid growth of unrelated-business income and the ability of charities to shelter it from taxes.

Burton A. Weisbrod, an economics professor at Northwestern University, in Evanston, Ill., who has studied the finances of thousands of nonprofit groups, says that outside income can help an organization like Sesame Workshop pay for expensive technology and improve the scope and quality of its offerings. “If you make it harder [for charities] to raise revenue,” says Mr. Weisbrod, “you’re keeping them cleaner but you’re also undermining their ability to conduct their missions.”

But Mr. Weisbrod warns that an overreliance by nonprofit groups on outside commercial revenue can undermine their charitable missions and lead them to focus too much on profits. “These unrelated activities could be dangerous to the integrity of the exempt organization,” he declares.

Other experts fear that if charities continue to generate growing amounts of commercial income, they could become easy targets for federal lawmakers looking to find new sources of revenue, especially in a weak economy.

“Who do legislators want to get the next dollar from — the guy making $30,000 a year or a very wealthy charity?” says Evelyn Brody, a professor at Chicago-Kent College of Law, in Chicago, who specializes in nonprofit tax law.

Decades of Debate

Fewer and fewer charities seem to be heeding such cautions, however, partly because the opportunity to generate ancillary revenue — much or all of it tax-free — can make a huge difference to a nonprofit group’s future.

Sesame Workshop had an operating loss of $6.5-million in fiscal 2000 and sold stock to make up the loss, according to the group’s Form 990 informational tax return. Without the tax-free income from toy sales and theme-park royalties, and the ability to write off expenses against the taxes on its advertising revenue, Sesame’s financial outlook would have been considerably worse, says Mr. Knell. “We need the resources to continue going forward,” he says of the group’s unrelated-business income.

Debates over the scope of charities’ business dealings and whether they should be taxed stretch back to the early decades of the 20th century. Under pressure from business executives, Congress decided in 1950 to tax charities’ unrelated-business activities in hopes of preventing nonprofit groups from enjoying an unfair competitive edge against private companies. But the law was riddled with loopholes, and in the ensuing years Congress and the courts have added more.

Intense congressional interest in the issue surfaced in the 1980s, when the IRS, House Ways and Means Committee, advocates of small commercial businesses, and others questioned the appropriateness of nonprofit groups’ generating millions of dollars of tax-free income from activities outside the scope of their charitable missions. But in a series of cases, federal courts rebuffed the government’s attempts to curb the trend. Among the few types of ancillary income that the courts said are taxable: advertising revenue from magazines and journals that nonprofit groups regularly publish, and income from insurance policies that they offer.

41 Exemptions

But many forms of outside revenue escape taxes, and the federal tax code now has 41 separate exemptions for nonprofit organizations, 29 of which charities use to shelter commercial income.

Some of those exemptions are in wide use. Stock sales and other investment income account for $45.5-billion, or about 75 percent of the total revenue that was excluded from taxation in 1998, according to the Chronicle study, which used computerized data provided by the National Center for Charitable Statistics at the Urban Institute, in Washington. The data are from informational tax returns that nonprofit groups registered under Section 501(c)(3) of the tax code filed in 1998 and are the most recent available.

The Howard Hughes Medical Institute, in Chevy Chase, Md., which conducts biomedical research and education, traded $149-billion worth of securities in fiscal 1999, reaping a tax-free capital gain of $1.02-billion. In 1999 Harvard University received $3.9-billion in tax-free gains from securities sales. Greg Poppe, a tax lawyer for Harvard, said those profits were used to help build the school’s endowment, which currently totals $22.7-billion.

Unlike the investment exemptions, however, other tax breaks are tailor-made for a narrow segment of the nonprofit world. One allows nonprofit groups in North Dakota to avoid taxes on income from gambling activities offered to the public. Another allows religious orders that operated a business, such as a television station, under a federal license before May 27, 1959, to escape taxes on income produced by that enterprise.

Universities, generally among the wealthiest nonprofit groups in the nation, get tax breaks that are not available to private businesses. For instance, the California Institute of Technology, in Pasadena, earned $1.3-billion under a contract to operate the federal government’s Jet Propulsion Laboratory. But Caltech owed no taxes on that money. While commercial companies are subject to taxes on income from research for the federal government, universities are not. In fact, all nonprofit organizations are exempt from paying tax on any kind of federal research revenues.

Failed Efforts

Efforts to tax universities on a bigger share of their outside incomes have met with especially strong resistance. Marc Owens, a lawyer in Washington who in the 1990s directed the IRS unit that oversees tax-exempt groups, says that as a government official he announced a plan to tax revenue that colleges received from corporate sponsorships of football and basketball games. But, he says, officials of the Treasury Department, which oversees the IRS, decided that Congress intended for college athletics to be treated as educational activities — and thus not subject to income taxes.

During Mr. Owens’s tenure at the IRS, from 1990 to 2000, the service did tighten rules defining when charities can collect tax-free income from travel tours that they offered to the public. Commercial-tour operators contend, nonetheless, that nonprofit groups continue to benefit from an unfair tax advantage. “The IRS rules helped, but the problem is still there,” says Hank Phillips, president of the National Tour Association.

Taking Deductions

One common way that nonprofit groups reduce their income-tax liabilities is to take deductions for operating expenses, then apply those deductions to their tax bills — the same method that commercial businesses use. In its study, the IRS found that in 1997 nonprofit groups reduced the total amount of revenue on which they paid tax by more than 99 percent through the combined use of congressionally enacted exemptions and deductions for operating expenses, to about $337-million.

Many charitable groups have become quite sophisticated at the approach. In 1998, for example, the National Geographic Society, in Washington, earned $60.7-million in taxable advertising revenue from its magazines. But Terry Adamson, executive vice president of the society, says that once the costs of magazine paper, printing, postage, and editorial salaries were deducted, the tax bill shrank substantially. He declines to provide exact figures, and the IRS does not make information on income-tax payments by nonprofit groups publicly available.

“It seems relatively easy to use enough accounting finesse to avoid paying any tax,” Mr. Weisbrod says. “Having found something you think is going to be profitable, what you do is find as many existing expenses as you can to write off against it. The building’s going to depreciate anyway, but you can claim some of it against the tax bill.”

Robert J. Yetman, an assistant professor of accounting at the University of Iowa who recently published a study of charities’ income-tax returns, says he believes that nonprofit groups are making appropriate use of the law on unrelated-business income, and he notes that private businesses have enjoyed a wide range of tax breaks for decades. Still, Mr. Yetman says that if nonprofit groups become overly aggressive in claiming expenses as tax deductions, Congress could begin to tighten the law.

“The purpose of the unrelated-business income tax was to prevent unfair competition of nonprofit groups with private businesses,” Mr. Yetman says. “If nonprofits don’t pay taxes, the tax can’t do its job. I would urge nonprofits to review their position and be careful not to invoke the anger of Congress.”

Complex Rules

Another reason that nonprofit groups might seek to review their stance on unrelated-business income is that obeying the tax law — and its wide array of exclusions — can be confusing and time-consuming.

Donald Ruhl, national tax director for the Kaiser Foundation Health Plan, a nonprofit insurance company in Oakland, Calif., notes that parking money that a nonprofit group receives from the general public is subject to income taxes, but that parking fees paid by members, clients, or employees of the organization are not. When Kaiser found it difficult to properly account for revenue it received from its parking lots, it resorted to a low-tech way of sorting things out: Over time, it counted the proportion of motorists who did not belong to the Kaiser plan but used its parking lots. Then it applied that figure to its overall parking revenue to calculate its tax liability. “It’s hard to tell where people are going once they park the car and walk away,” Mr. Ruhl says.

Over the years, rather than having to untangle the tax law on other kinds of business dealings, he adds, “We’ve actually tried to stay away from things that generate revenue.”