October 18, 2001 | Read Time: 5 minutes
The Internal Revenue Service and most states do a poor job of policing tax-exempt groups, and much of the reason can be traced to a lack of adequate funds. But the money to fix the problem is readily available. It should come from the federal excise tax that is levied annually on the net investment income of private foundations.
Currently, the excise tax is imposed under a two-tiered system that neither provides an adequate incentive for increased grant making nor makes much economic sense. About two-thirds of foundations pay a tax of 2 percent. The rest pay only 1 percent because they spend more than the minimum legal requirement of 5 percent of their net assets each year.
The formula for determining which foundations receive this reward is complex, based on a grant maker’s average distribution of assets over five years. But because the payout includes not only grants but all costs associated with running the foundation, including employees’ salaries and real-estate payments, it is unlikely that groups that receive a 1-percentage-point reduction in the excise tax have much of an incentive to increase their grant making.
The excise tax should be cut from 2 percent to 1 percent for all private foundations, and the income from the tax should be used to support a greatly expanded effort by the Internal Revenue Service and state attorneys general to oversee nonprofit organizations. What’s more, foundations should be required to use the savings solely for additional grant making.
Right now, foundations that pay only 1 percent in excise taxes use much of the savings for administrative and operational costs. Even with a lower excise tax, many large foundations still pay out only 3.8 percent to 4 percent of their net assets in grants to nonprofit organizations. The only way that foundations will substantially increase the amount of money they spend on grants is if the minimum-distribution requirement is raised.
When Congress levied the excise tax on foundations in 1969 as part of the Tax Reform Act, it wanted the federal government to use the income to regulate tax-exempt organizations and handle the myriad administrative tasks associated with them. But things didn’t work out that way. That income has gone into the general treasury.
The tax generates far more money than is being spent now on oversight of the nonprofit world.
In 1999 the excise tax raised $499-million, approximately eight times the amount that the IRS spent on supervising nonprofit groups. Were the excise tax reduced to 1 percent for all private foundations, the annual revenue from the tax would still generate nearly $300-million in 2003. It is difficult to justify the enormous disparity between revenue from the tax and the paltry resources allocated to the oversight of philanthropy.
Because of the federal government’s lackluster support of the IRS division that oversees nonprofit groups, the service has been roundly, and justifiably, criticized by both charities and foundations for poorly regulating and policing charities and foundations. As the number of financial scandals and episodes of mismanagement of nonprofit groups have grown in recent years, that criticism has intensified.
Moreover, the IRS’s authority to punish nonprofit groups that pay overly generous salaries to their executives has, unfortunately, not been accompanied by added enforcement capacity. Nor is the service equipped to evaluate the tens of thousands of applications for tax-exempt status that come its way each year.
The IRS simply does not have the employees and money to do its job effectively.
Changing the excise tax would provide Congress with an excellent opportunity to remedy the situation. It should earmark most, if not all, of the excise-tax revenue for the regulation and supervision of nonprofit organizations. Doing so would entail a vast expansion of the tax-exempt–organization division of the IRS, including substantial growth in the number of auditors, investigators, researchers, and other personnel.
As part of this expanded role, the IRS should finance efforts to make the data it collects from Form 990 annual reports of charities and foundations more readily available to the public. Philanthropic Research, a nonprofit group in Williamsburg, Va., that operates the Guidestar Web site, and the Urban Institute, a Washington think tank, have worked together to digitize and put information from Forms 990 online. Yet they have struggled each year to raise money from foundations to do it. Money for this activity, which is so essential to public accountability, should come from the government, not foundations.
To ensure even more oversight of nonprofit groups, a portion of the excise tax revenue should be allocated, either directly or through the IRS, to the state attorneys general, possibly with the states required to match new federal grants. State attorneys general have responsibility within their respective jurisdictions to oversee charities and foundations, but in almost all states, the divisions that regulate tax-exempt groups are small and understaffed, when they exist at all.
Legislation to reduce and redirect the excise tax could be an important mechanism to increase the public accountability of nonprofit groups, greatly expand the capacity of the IRS and states to oversee nonprofit organizations, and channel additional foundation money to needy charities.
If charities and foundations truly want to serve the public, they should support such a measure. And if Congress fails to act, lawmakers will have lost a golden opportunity to make both economic and regulatory sense out of the current, haphazard system of managing the nonprofit world.
Pablo Eisenberg is senior fellow at the Georgetown University Public Policy Institute and a member of the executive committee of the National Committee for Responsive Philanthropy. He is a regular contributor to these pages. His e-mail address is pseisenberg@erols.com
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