A Brief History of The Tax-Exempt Sector

A Brief History of The Tax-Exempt Sector

A Brief History of The Tax-Exempt Sector

Its tax season once again, and that probably comes with a great deal of stress for your nonprofit. But have you ever wondered where your tax-exempt status comes from?

Believe it or not, the tax-exempt sector in the U.S. actually predates the republic. Since the early settlers lacked any real governmental framework, they created charitable organizations and other types of “voluntary” associations. From these, there came two main types of organizations: public-serving and member-serving. Early public-serving organizations included schools, and churches. While member-serving charities included fraternal societies, as well as labor and agricultural organizations. Despite their early popularity, voluntary associations are still very prevalent in the U.S. and have developed a long-standing relationship with the government. According to the Statistics of Income Bulletin, “a significant component of this relationship is Government’s recognition of the importance of the charitable and voluntary sector, and the support of its organizations in the form of an exemption from income and certain other taxes.”

The 75 years between 1894-1969 were pivotal for the nonprofit sector. This time period was characterized by major legislation regarding the structure of tax-exemption through the U.S. Tax Code. During these years, Congress passed many pieces of legislation establishing the basic requirements of tax exemption, identifying the business activities that are subject to taxation, and regulating private foundations as subsets of these tax-exempt organizations.

In the earlier years, tax-exemption regulations were created around three main principles:

  1. Organizations that were dedicated to charitable purposes were not required to pay the federal income tax.
    • The Wilson-Gorman Tariff Act of 1894: established the requirements for the tax-exempt status for charitable organizations.
      • Although this law was declared unconstitutional the year after it was created, the language regarding tax-exemption has become the cornerstone for tax-legislation to this day.
  2. Tax-exempt organizations were not permitted to allot any of their income to benefit an individual within or related to the organization.
    • The Revenue Act of 1909: granted tax exemption 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 would ensure that private inurement should not be a part of any tax-exempt organization.
  3. Individuals could receive an income tax deduction for charitable giving
    • The Revenue Act of 1917: This was the first law that established an individual income tax deduction for any contributions made to tax-exempt organizations.
      • This was done to encourage more charitable giving while income tax rates were rising to fund WWI.

Prior to 1950, tax-exempt organizations were not solely exempt from the income earned from their mission-based activities, but also from their commercial business activities unrelated to the organization’s overall purpose. The only factor that came into play was whether or not their net profits were used for exempt purposes. This was changed in the 1940’s due to Congress’ growing concern that tax-exempt organizations were given an unfair competitive advantage over most for-profit, taxable corporations. This concern resulted in The Revenue Act of 1950. This established the “unrelated business income tax,” which was imposed on the “unrelated business income” of charities (except churches).

“Unrelated Business Income” includes any income produced from a regular activity that was deemed a “trade or business,” but not hugely related to the organizations exempt purpose. This income is taxed regardless of whether or not the profits from these activities go towards the organization’s mission.

Due to the rising concern in the 1960s that private foundations were not as accountable to the public as most traditional charities, The Tax Reform Act of 1969 introduced significant reforms to the nonprofit sector as well. This piece of legislation introduced the first explicit definition of private foundations, as well as established their strict requirements, and outlined their “prohibited activities.” Some of these new rules included an annual excise tax on their investment income,  and a requirement to distribute a minimum amount of money for charitable purposes each year. Any private foundation that failed to meet these requirements, or that engaged in any “prohibited activities” were penalized with taxes or other sanctions.

“Prohibited activities” include anything that could be considered contrary to the interest of the public.

Additionally, this law increased the existing charitable deduction limits for individual donors from 30% to 50% of an adjusted gross income.

Since the passage of The Tax Reform Act of 1969, the basic structure of tax exemption for charities in the United States has stayed relatively stagnant. However, a few modifications to the rules governing private foundations have been introduced in recent history. These changes include adjustments to their net investment income tax rates, and the tax rates for foundations that engage in “prohibited activities.” Also, there have been exceptions added to what constitutes the “unrelated business income” of charities, and new legislation requiring that 501(c)(3) organizations make their “unrelated business income” tax returns available to the public.

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Source: here

By: Emily Dietz, Business Development Strategist