Legislative History of the Tax-Exempt Sector

Legislative History of the Tax-Exempt Sector in the United States

The structure of tax exemption granted to the charitable and voluntary sector outlined in the United States Tax Code was developed through legislation enacted between 1894 and 1969. Over that 75-year period, Congress established the basic principles and requirements of tax exemption, identified business activities of tax-exempt organizations that were subject to taxation, and defined and regulated private foundations as a subset of tax-exempt organizations.

The privileged tax treatment that the Government grants to charitable and member-serving organizations can be traced to the earliest versions of United States tax law. Early tax-exemption regulations developed around three major principles. First, organizations that operated for charitable purposes were granted exemption from the Federal income tax. Second, charitable organizations were required to be free of private inurement—that is, a charitable organization’s income could not be used to benefit an individual related to the organization. Finally, an income tax deduction for contributions, designed to encourage charitable giving, was developed. The Wilson-Gorman Tariff Act of 1894, one of the earliest statutory references to the tax-exempt status enjoyed by charitable organizations, established the requirement that tax-exempt, charitable organizations operate for charitable purposes. While establishing a flat 2-percent tax on corporate income, the act stated “nothing herein contained shall apply to… corporations, companies, or associations organized and conducted solely for charitable, religious, or educational purposes, including fraternal beneficiary associations.”

Though the law was declared unconstitutional by the Supreme Court in 1895, the exemption language contained in the act would provide the cornerstone for tax legislation involving charitable organizations for the next century. The Revenue Act of 1909 mirrored and expanded the language from the 1894 act. Under this statute, tax exemption was granted to “any corporation or association organized and operated exclusively for religious, charitable, or educational purposes, no part of the net income of which inures to the benefit of any private stockholder or individual.” This important addition set forth the idea that tax-exempt charitable organizations should be free of private inurement—in other words, nonprofit. Ratification of the Sixteenth Amendment granted Congress the power to levy income tax. The subsequent Revenue Act of 1913 established the modern Federal income tax system.

For charitable organizations, the act used identical language as that found in the Tariff Acts of 1894 and 1909 with regard to charitable purpose and private inurement. The Revenue Act of 1917 established, for the first time, an individual income tax deduction for contributions made to tax-exempt charitable organizations. This deduction was conceived as a way to encourage charitable contributions at a time when income tax rates were rising in order to fund World War I. One year later, the Revenue Act of 1918 provided that charitable bequests were entitled to a similar deduction on estate tax returns. Finally, corporations were able to claim the charitable deduction beginning in 1936.

The Revenue Act of 1950

Before the 1950s, tax-exempt organizations could earn tax-free income from both mission-related activities and commercial business activities that were unrelated to the purpose for which they were exempt, as long as they used the net profits for exempt purposes. However, in the 1940s, concerns grew in Congress over the perception that tax-exempt organizations were permitted an unfair competitive advantage over taxable entities. As a result, Congress established the “unrelated business income tax” (UBIT) as part of the Revenue Act of 1950. For tax years beginning after December 31, 1950, unrelated business income tax was imposed on the “unrelated business income” (UBI) of charitable organizations (except churches); labor and agricultural organizations; chambers of commerce, business leagues, and real estate boards; certain trusts; and certain title holding companies. In 1951, Congress extended the unrelated business income tax to the unrelated business income of State and municipally owned colleges and universities, to correct for an omission from the 1950 act.

Income was considered unrelated business income if it was produced from an activity deemed a “trade or business” that was “regularly carried on” and was not “substantially related” to the organization’s exempt purpose(s), regardless of whether or not the profits from the unrelated trade or business were used solely for exempt purposes. Passive income and certain gains and losses from the disposition of property were not subject to tax. The Revenue Act of 1950 addressed several other issues regarding the unrelated activities of tax exempt organizations. Tax exemption was no longer permitted to “feeder” organizations, which did not conduct any charitable activities, but rather operated commercial enterprises from which they passed income to a charitable organization.

In addition, income from debt-financed real estate sale-leaseback activities was subject to unrelated business income tax. In these cases, tax-exempt organizations purchased real estate with borrowed funds, leased the property back to the owner, and used the tax-free rental income to pay off the debt. (Staff report of the Joint Committee on Taxation, “Historical Development and Present Law of Federal Tax Exemption for Charities and Other Tax-Exempt Organizations” (JCX-29-05) (April 19, 2005)). The Revenue Act of 1950, and additional changes made under the Tax Reform Act of 1969, discussed in the following section, formed the contemporary structure for the unrelated business taxation of tax-exempt organizations.

Tax Reform Act of 1969

By the 1960s, there was a growing perception among lawmakers that private foundations, with their small networks of financers and administrators, were less accountable to the public than traditional charities. These concerns were addressed with the Tax Reform Act of 1969 (TRA69), which introduced sweeping reforms to the charitable sector. TRA69 also significantly expanded the rules governing unrelated business income taxation of tax-exempt entities.

Main issues:

  • TRA69 introduced the first definition of private foundations, for tax purposes, expanded filing requirements for these newly defined organizations, and established the “private foundation rules.” Foundations were required to pay an annual excise tax equaling 4 percent of their net investment income. With certain exceptions, taxes were imposed on a nonoperating foundation that failed to distribute, for charitable purposes, the greater of its adjusted net income, excluding long-term capital gains, or its minimum investment return, defined as 6 percent of investment assets, annually. The legislation also prohibited self-dealing, defined as conducting activities that benefit foundation managers, officers, substantial contributors, and other foundation “insiders,” and imposed taxes on individuals who engaged in self-dealing activities. Further, in cases of “willful repeated acts or a willful and flagrant act” of self-dealing, a foundation could be subject to termination.
  • TRA69 also imposed sanctions on foundations that engaged in a variety of other activities, such as holding excess interests in a business enterprise or investments that jeopardized the foundation’s charitable purpose, making taxable expenditures, or violating other requirements.
  • TRA69 expanded the tax on unrelated business income, extending the tax to all tax-exempt organizations described in IRC sections 501(c) and 401(a) (except United States instrumentalities), and including churches for the first time.
  • The legislation expanded the filing requirements for many tax-exempt organizations. Under the new requirements, all tax-exempt organizations were required to complete annual returns; however, TRA69 exempted certain organizations and activities from this requirement. Churches and their integrated auxiliary organizations were not subject to the new filing requirements. Organizations that normally had gross receipts of $5,000 or less and that previously were not required to file Form 990 were also exempted. Additionally, the “exclusively religious activities of any religious order” were not subject to the reporting requirements, although certain religious organizations were required to report activities that were not religious in nature.
  • Finally, TRA69 permitted additional exclusions to the reporting requirement, to be determined at the discretion of the Treasury Department.
  • TRA69 also increased the individual charitable income tax deduction limitation from 30 percent to 50 percent of AGI for contributions made to most charitable organizations. Contributions to nonoperating private foundations generally remained subject to the 20-percent limitation.
  • Additionally, TRA69 introduced two important concepts regarding unrelated business taxation of tax-exempt organizations. First, a trade or business activity does not lose its identity as a trade or business merely because it was carried on within a larger aggregate of similar activities or within a larger complex of other endeavors that are related to the exempt purposes of the organization (called the “fragmentation” rule). Second, in order to be considered “related,” there had to be a causal relationship between an organization’s engaging in a trade or business activity and the performance of the organization’s exempt functions. This relationship had to be substantial, and the activities that generated the income must have contributed importantly to the accomplishment of the organization’s exempt purpose(s).
  • Under TRA69, certain payments of interest, annuities, royalties, and rents from taxable subsidiaries to a tax-exempt parent were subject to UBIT. These types of payments from tax-exempt subsidiaries were taxed to the extent that the subsidiaries’ payments were generated from unrelated business income.

For more information on Tax Reform Act of 1969, see here.

Other legislation from 1970

While the underlying structure of tax exemption for the charitable and voluntary sector has changed little since the passage of TRA69, subsequent legislation has introduced a number of modifications. These include adjustments to the private foundation net investment income tax rates and to the excise tax rates on charitable organizations that engage in prohibited activities. Further changes have provided new exceptions to unrelated business income tax (taxation) for specified activities, tightened the rules pertaining to the taxation of payments received from subsidiaries, and required unrelated business income tax returns filed by IRC section 501(c)(3) organizations to be made publicly available.

The Deficit Reduction Act of 1984 (DEFRA)

This Act raised the limit on individual deductions for contributions to nonoperating private foundations from 20 percent to 30 percent of AGI; gifts of capital gain property to nonoperating private foundations remained subject to the 20-percent limitation. DEFRA included a provision to permit nonoperating foundations’ donors to carry over contributions that exceeded the 20- or 30-percent limitation for up to 5 years. For a 10-year period ending December 31, 1994, contributors were permitted to deduct the full fair market, rather than a reduced value, for donations of certain appreciated stock to private nonoperating foundations.

Additionally, operating foundations that met certain additional criteria were exempted from the excise tax on net investment income. To encourage foundations to make charitable distributions at levels above the minimum required amount, DEFRA included a provision that allowed foundations that showed improvement in the amount of charitable distributions made over a 5-year period to be eligible for a 1-percent reduction in the excise tax. Additionally, DEFRA set an upper limit on the amount of administrative expenditures incurred for grantmaking activities that private foundations could count toward the minimum charitable distribution.

This limitation was effective for a 5-year period to allow the Treasury Department to study its effects on foundations’ charitable distributions. Subsequent research showed that the limitation had little effect on charitable distributions, and the regulation expired at the end of Tax Year 1990.

The Taxpayer Relief Act of 1997 (TRA97)

terminated exceptions granted to specific organizations under a Tax Reform Act of 1986 provision that revoked the tax-exempt status of any organization if a substantial part of its activities consisted of providing commercial-type insurance. Under TRA97, tax exemption for the two largest public charities at the time was revoked: the Teachers Insurance Annuity Association and the College Retirement Equities Fund (collectively known as TIAA-CREF).

Additionally, TRA97 amended UBIT rules, effective after December 31, 1997, to exempt from unrelated business taxation certain “qualified” sponsorship payments solicited or received by tax-exempt organizations, and to allow charitable organizations and pension, profit-sharing, and stock-bonus plans exempt from tax under section 501(a) to hold shares in an S corporation without the S corporation losing its status as such.

Legislation of Note from 1894

  • The Wilson-Gorman Tariff Act of 1894 established a flat, 2-percent tax on corporate income, but excluded “. . . corporations, companies, or associations organized and conducted solely for charitable, religious, or educational purposes, including fraternal beneficiary associations.” The law was declared unconstitutional by the Supreme Court in 1896.
  • The Revenue Act of 1909 established an excise tax on corporate income and included tax exemption in language similar to that introduced in the 1894 act. The 1909 act included the important concept of private inurement, meaning that a charitable organization’s income could not be used to benefit an individual related to the organization.
  • The Revenue Act of 1913 established the modern income tax system and included tax exemption and private inurement in language similar to that in the 1909 act.
  • The Revenue Act of 1917 included the introduction of the charitable income tax deduction for individual donors.
  • The Revenue Act of 1918 added organizations operated “for the prevention of cruelty to children or animals” to the list of tax-exempt public charities and added the estate tax charitable deduction for charitable bequests.
  • The Revenue Act of 1921 added both “literary” groups and “any community chest, fund, or foundation” to the list of tax-exempt organizations.
  • The Revenue Act of 1934 set forth limits on lobbying by charitable organizations, stating that “no substantial part” of the organizations’ activities can involve “propaganda” or attempts “to influence legislation.”
  • The Revenue Act of 1936 expanded the charitable income tax deduction to corporate donors.
  • The Revenue Act of 1943 required certain tax-exempt organizations to file the Form 990 information return with the IRS. A number of organizations, including religious organizations, most schools, and publicly supported charitable organizations, were exempt from this filing requirement.
  • The Revenue Act of 1950 introduced the unrelated business income taxation of tax-exempt organizations.
  • The Revenue Code of 1954 introduced a number of changes to the tax-exempt organization tax law. Most notably, the current structure of the Internal Revenue Code was developed, with section 501(c) describing tax-exempt organizations. Charitable organizations were described under section 501(c)(3) and now included organizations operated for the purpose of “testing for public safety.” Following passage of the Revenue Code of 1954, charities were not allowed to “participate in, or intervene in (including the publishing or distributing of statements), a political campaign on behalf of any candidate for public office.”
  • The Revenue Act of 1964 increased the charitable income tax deduction for contributions made to publicly supported organizations to 30 percent of adjusted gross income (AGI). Previously, the charitable income tax deduction had been limited to 20 percent of AGI for publicly supported organizations. Prior to the 1964 act, only specific organizations, including churches and many schools, were subject to the 30percent limitation.
  • The Tax Reform Act of 1969 (TRA69) included significant legislation regarding charitable organizations.
  • The Tax Reform Act of 1976 redefined the minimum investment return calculation for private foundations to 5 percent of investment assets.
  • The Revenue Act of 1978 reduced the net investment income tax rate for private foundations to 2 percent.
  • The Economic Recovery Tax Act of 1981 changed the basis for the minimum charitable distribution required of nonoperating foundations from the greater of adjusted net income or minimum investment return to minimum investment return only.
  • The Deficit Reduction Act of 1984 (DEFRA) (see above)
  • The Revenue Reconciliation Act of 1993 imposed a tax on certain nondeductible lobbying and political expenditures made by membership organizations tax-exempt under IRC sections 501(c)(4), (5), and (6). These organizations were liable for the tax if they did not notify members of the shares of their dues allocated to the nondeductible lobbying expenditures or if they failed to include in the notice the entire amount of dues allocated to the expenditures.
  • The Taxpayer Bill of Rights 2, enacted for 1996, added “intermediate sanctions” as an alternative to the revocation of an organization’s tax-exempt status in instances when a person with substantial influence over the affairs of the organization was found to have engaged in an excess benefit transaction. The rules, which apply to organizations exempt under IRC sections 501(c)(3) and 501(c)(4), require reimbursement of the excess benefit to the organization and payment of excise taxes and interest penalties by disqualified persons and/or organization managers.
  • The Taxpayer Relief Act of 1997 (TRA97) (see above)
  • The Tax and Trade Relief Extension Act of 1998 made permanent the provision that permitted contributors to deduct the full fair market, rather than a reduced value, for donations of certain appreciated stock to nonoperating private foundations.
  • The Pension Protection Act of 2006 introduced a number of regulatory changes. IRC section 501(c)(3) public charities and private foundations reporting unrelated business income were required to make their Forms 990-T, Exempt Organization Business Income Tax Returns, available for public inspection. Organizations with gross receipts less than $25,000 (the Form 990/990-EZ filing threshold) were required to file the Form 990-N, an annual electronic notice also known as the “e-Postcard.” Additional filing requirements were placed on supporting organizations, donor-advised funds, and credit counseling organizations. The legislation also doubled excise tax rates on the prohibited activities of private foundations and public charities.
  • Tax Technical Corrections Act of 2007 required the Internal Revenue Service to make available for public inspection all Forms 990-T filed by IRC section 501(c)(3) public charities and private foundations after August 17, 2006, the date the Pension Protection Act of 2006 was enacted. The Pension Act required section 501(c)(3) organizations to publicly disclose their Forms 990-T, but it failed to include language authorizing IRS to do so.

Note: based on a document for the IRS authored by by Paul Arnsberger, Melissa Ludlum, Margaret Riley, and Mark Stanton.


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