New Pennsylvania Law and Court Ruling Specify Standards for Tax Exemptions

After years of debate, the State of Pennsylvania has enacted a law that redefines what non-profit organizations must do to qualify as charities and gain exemptions from property and sales taxes. The House and Senate passed the legislation and Gov. Tom Ridge signed it into law last month.

Many non-profit organizations in Pennsylvania — including colleges, hospitals, and smaller groups — lobbied for the statute and praised the new law.

But some observers worry that the complex law could cause some problems for charities later on. Among other things, the statute offers incentives to encourage large charities to enter into voluntary agreements with local governments to make payments in lieu of property taxes and strictly limits charity business ventures.

In a strange coincidence, the law was enacted just as the Pennsylvania Supreme Court issued a long-awaited ruling on a college property-tax case that, if issued months earlier, might have made passage of the new statute less urgent or even unnecessary, some say, although others argue that the new law was essential. The court’s 2-to-1 opinion said that the private Washington and Jefferson College qualified as a charity under the old state law and, therefore, did not owe property tax. A lower court ruling in 1994 against Washington and Jefferson shocked many colleges and spurred some to join efforts already under way by non-profit groups to seek a new law that would guarantee their charity status.

The developments in Pennsylvania have national implications because the large state is closely watched by state legislatures and charities across the country. What’s more, many local governments in Pennsylvania have been leaders in efforts to press charities to help pay for local services.

The turmoil over tax exemptions began in 1985 when the Pennsylvania Supreme Court tried to clarify the existing law, which gave tax exemptions to “purely public charities.” The court said that to qualify, organizations must:

* Advance a charitable purpose.

* Operate with no intention of making a profit.

* Offer a substantial portion of its services free.

* Perform services that would otherwise have to be provided by government.

* Provide services to people who are legitimate subjects of charity.

Because the Pennsylvania Supreme Court did not spell out in detail what each standard meant, some local governments viewed its ruling as a tightening of legal requirements for tax exemptions and began to challenge the status of charities. When the city of Washington, Pa., sued Washington and Jefferson College, the local court ruled that the college flunked four of the five criteria developed by the state Supreme Court.

The new law incorporates the court’s five standards and provides the missing details that explain how charities can meet each criterion.

For example, to show that it offers a substantial portion of its services free, a non-profit organization must meet any one of seven tests. One test would require that an institution have a written policy, publicized in a reasonable manner, that it turns no one away because of an inability to pay. Under that test, an organization would have to provide uncompensated goods or services equal to the greater of 75 per cent of its net operating income or 3 per cent of its total operating expenses.

Another important part of the law is intended to help small charities fight off local government attempts to make them pay property taxes.

A non-profit organization with annual program-service revenues of under $10-million and a state sales-tax exemption is presumed to be in compliance with the five criteria. That means a local government would have to prove that a non-profit organization did not qualify as a charity, rather than the organization’s having to prove that it did qualify.

But groups with program-service revenues of $10-million or above are pressured by the law to make voluntary payments. Such organizations are not presumed to be in compliance with the five criteria unless they have entered into voluntary agreements with local governments to pay money in lieu of taxes.

Another incentive for charities to make voluntary payments: They have a better chance of proving that they offer a substantial portion of their services free — the third of the five standards.

The statute’s provisions that encourage large charities to pay money in lieu of taxes were designed to help cities and towns with substantial amounts of tax-exempt land — including Philadelphia — that have voluntary agreements in place or want to set them up.

The Pennsylvania law also takes aim at non-profit organizations that engage in “unfair competition” with small businesses. The statute prohibits charities from carrying on “a commercial business that is unrelated to the institution’s charitable purpose as stated in the institution’s charter or governing legal documents.” A commercial business is defined as the sale of products or services that are principally the same as those offered by an existing small business in the community.

The law hands out several exceptions. One goes to any charity business already in operation 120 days after the law was enacted, as long as the charity does not expand the enterprise in the future. Another exception is provided to charity businesses that are intended only for the use of the organization’s employees, clients, volunteers, patients, residents, members, alumni, faculty, or students.

Small businesses that feel “aggrieved” by a charity business must file a complaint with Pennsylvania’s Secretary of State, who then will name an arbitrator to resolve the dispute. If the arbitration failed, the dispute would head to court, which could shut down a charity business that the court found had failed to comply with the law.

The new law was hailed by many non-profit organizations. “It will help to define and clarify what is a charity in Pennsylvania,” said Brian C. Mitchell, president of the Association of Independent Colleges and Universities of Pennsylvania. “The law was absolutely critical, whether you’re the Y.M.C.A., or the local hospital, or the private college.”

Mr. Mitchell added: “There was a lot at stake, and it has implications for the non-profit community across the country.”

But some others see some problems with the law.

“It provides substantial protection to state charities, but it does so at a high cost,” said Janne G. Gallagher, a Washington lawyer who represents charities and is the editor of the national newsletter State Tax Trends for Nonprofits.

One drawback, she said: The law’s descriptions of the five criteria are sometimes ambiguous. A charity under future fire from a local government might be forced to challenge one or more of the standards in order to nail down its exact meaning, she said. The criteria could also draw an attack from Pennsylvania school districts that are unhappy with parts of the law, she said.

Pennsylvania charities could chafe under the law’s provisions on unfair business competition, Ms. Gallagher said. “As charities expand and change their services, they will face challenges from small businesses under the law,” she said. That could lead charities to challenge the state’s right to bar a charity from carrying on an otherwise lawful activity: running a business.

Ms. Gallagher said she also sees a problem with the law’s incentives for large charities to enter into voluntary agreements with local governments. Few states have statutes that deal directly with payments in lieu of taxes by charities, she said, and those that do generally confine the laws to narrow areas such as federally financed housing projects. “I fear this part of the Pennsylvania law further legitimizes the concept of payments in lieu of taxes,” said Ms. Gallagher. “It strengthens the position of local governments in other states that are seeking similar payments or similar laws.”