Rationales for Nonprofit Tax Exemption

Nonprofits face recurring political pressure to justify their tax-exempt privileges.  In the wake of the U.S. Supreme Court’s Obergefell[1] ruling that a fundamental right to marry exists for same-sex couples, some religious organizations have questioned whether their Section 501(c)(3) tax-exempt status may come under attack, to the extent that they object to sexual orientation civil rights protections and notwithstanding their religious beliefs regarding human sexuality.  Property tax exemption for nonprofits is a related area under increasing opposition, as noted in our law firm’s article on “PILOTs.”  Both income and property tax exemptions are extremely well grounded in history, tax law, and underlying rationales, as follows.

Historical Rationale

Religious tax exemption has a lengthy historical precedent:  ancient regimes ranging from Sumer to Babylon, Egypt, Israel, Persia, and India provided tax exemption for the property of churches and priests.[2] American theories of tax exemption are derived from English law, which recognized exemption for both religious and charitable institutions and identified religion as benefitting an indefinite charitable class. 

These concepts have likewise permeated American society.  As the U.S. Supreme Court observed in the landmark case of Walz v. Tax Commission, specifically with respect to religious institutions’ unquestioned tax-exempt status:

Few concepts are more deeply embedded in the fabric of our national life, beginning with pre-revolutionary colonial times, than for the government to exercise at the very least this kind of benevolent neutrality toward churches and religious exercise generally, so long as none was favored over others and none suffered interference.[3]

This kind of benevolent neutrality is also embedded in state law – all fifty states and the District of Columbia currently provide for religious tax exemption through statutory or constitutional provisions.[4]  Other faith-based, charitable, and educational nonprofits enjoy similar tax exemptions. While historical tradition alone cannot suffice as the sole rationale, the long-standing and long-reaching history of tax exemption – particularly for religious organizations – provides a persuasive argument for its continuation.

PILOT Programs – The Nonprofit Property Tax

    If it walks like a duck and quacks like a duck…    

In an era of waning revenue streams and increasing demand for government services, some cash-strapped municipalities cast a longing eye at nonprofits’ real property as a missed source of revenue.  Through Payment in Lieu of Taxation (“PILOT”) programs, states and municipalities encourage – and sometimes require – nonprofits to pay what they consider the nonprofit’s “fair share.”   PILOT programs, however nicely packaged, are still essentially property taxes.  The trend toward PILOT programs in the last fifteen years should concern the nonprofit sector because of the potential for substantial financial implications, as explained herein. 

Background

PILOT programs have long been used to compensate localities for lost property tax revenues.  Historically, both state and federal governments have utilized PILOTs to reimburse municipalities containing exempt state- and federally-owned land.[1] In addition, some large educational nonprofits for decades have made voluntary PILOT payments to municipalities to help offset their considerable use of municipal services.  For example, Harvard and MIT have made voluntary payments to the City of Cambridge, Massachusetts since 1928.[2]   

Recently, use of PILOT programs has increased dramatically.  From 2000 to 2010, eighteen states implemented PILOT programs affecting nonprofits.[3]  However, these programs have not gained universal approval; some states have expressly declined to implement PILOT programs.  Florida, for example, determined its PILOT program statute violates Florida’s constitution.[4]  The overall trend, however, favors PILOT programs for nonprofits.  Municipalities continue to pressure state legislatures to assist local communities facing tough economic realities.

End of IRS’s Health Insurance Reprieve?

Since the Affordable Care Act (ACA)’s enactment, the IRS and the U.S. Department of Labor have delivered a rather unpleasant surprise to many, namely, that it now treats employers’ reimbursement or payment of employees’ individual health insurance premiums as taxable income to such employees (also known as health reimbursement arrangements or “HRAs”).  This new rule, which essentially is an interpretation of “plan” under the ACA’s so-called market reforms, applies to small employers that are otherwise exempt under the ACA.  The interpretation constitutes an about-face from the longstanding treatment of HRAs as a pre-tax employee benefit.

Transitional relief was granted when the IRS issued a notice in early 2015, providing that employers who provided such pre-tax benefit would not owe any penalties or be required to include such benefit as taxable income – at least through June 30, 2015. Such relief was extremely helpful (even though quite late), since the penalty for noncompliance is extreme: $100 fine per employee, per day (!).  

At this point, no further tax relief for HRAs is on the horizon.  Legislative rumblings of relief developed earlier this year but failed to produce any helpful result.  Now that the U.S. Supreme Court upheld the ACA’s federal subsidy programs in its recent King v. Burwell ruling (and therefore its core elements), perhaps legislators will focus again on modifying such ACA aspects as this HRA issue.   Instituting such relief would be both consistent with the fervent opposition of many politicians and greatly welcomed by many.