DATELINE: November 26, 2007, Chicago
During the last year or so, the big question for policymakers has been the basis for tax-exemption. Hospitals, college athletic programs, and cultural institutions have been asked in one way or another to justify their tax-exempt status. That isn't all that surprising following Hurricane Katrina, an event that opened many people's eyes. Given the federal government's woefully inadequate response, it also is not surprising that policymakers are looking to the Independent Sector as a possible alternative source for addressing major social problems.
On Monday, November 12, 2007, we received a glimpse of what is likely to be the next phase...
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of the inquiry. In the lead article in the New York Times' annual Giving section, Stephanie Strom penned a lengthy piece entitled How Long Should Gifts Grow? Strom highlighted the new effort on the part of some policymakers to push for minimum payouts by public charities such as museums, universities, and large grantmaking organizations. Her article nicely summarizes the debate.
H. Art Taylor of the BBB Wise Giving Alliance pointed out that good business practice dictates reserve funds. A number of nonprofit leaders pointed to the desirability of rainy day funds, which permit nonprofits to maintain program levels when a downturn in the economy hinders fundraising efforts. On the other side of the coin, Senator Charles Grassley, the ranking member of the Senate Finance Committee, argued that large college endowments are troubling in light of soaring tuition costs.
Warren Buffet and the Gates Foundation also chimed in, but we think it is time to start discounting their comments. We say that not because we have any axe to grind, but because they are outliers. Gates and Buffet find themselves facing an entirely different set of problems caused by what could be termed an overabundance of resources. Those are problems that most nonprofits, be they hospitals, museums, colleges, or social services agencies, simply do not face. We would also lump Harvard University and several similarly-situated institutions in with Gates and Buffett.
What we suspect is precipitating this push by some for mandatory payouts/spending rates is government deficits and debt accumulation. To the extent that we are correct, the call for minimum payouts/spending rates is really a call to tax the endowments of charitable institutions. Unable for whatever reason to raise taxes to meet the public's unabated demand for services, government officials and those who support government solutions to problems are eyeing big pools of capital. In short, they want to make the Independent Sector less independent.
Probably the most telling quote in the article came from H. Peter Karoff, who recounted a story about a donor who wanted to give $100 million to help kids in the city. The donor acknowledged that he knew how to give $100 million to his Ivy League school, but not to social services agencies. Karoff told Strom, "We told him he would have to hire 20 people to do that well, and he wrote his check to the Ivy League school. Many of these huge gifts are what I call default gifts."
To us the answer lies in the free-market, not a minimum payout/spending rate requirement. What Karoff really was saying is that those agencies that address social problems are not viewed as the best stewards of money. That obviously isn't true in all cases, and certainly there are many incidents of abysmal stewardship by colleges and cultural institutions. But rather than demanding that the government enact laws to force those exempt entities holding large pools of capital to make greater distributions or increase spending on mission, the institutions without endowments might want to do some serious thinking about why they are not attractive to donors and grantmakers and how they might go about improving perceptions. In our view, the solution is quite simple. There should be a series of mergers so that five nonprofits are not providing essentially the same services within a two or three mile area of each other, with the attendant duplication of overhead costs. But that is only a start. Those organizations that want to be attractive need to better measure the long-term outcomes from their efforts. Finally, many organizations must stop paying lip service to good governance, transparency, and financial accountability and control.
Our headline today uses the word "confluence." That is in part a reference to a second article we read two weeks ago. This one appeared in the Chronicle of Philanthropy and provided a summary of a speech given by IRS EO/EP Commissioner Steven Miller, to the Philanthropy Roundtable. Ben Gose, IRS Official Says Tax Agency May Step Up Efforts to Identify Ineffective Charities, Nov. 12, 2007. Commissioner Miller asked some rather pointed questions, including: "Is providing a peppercorn of public benefit enough for a tax exemption?; How much savings is too much savings?; and Should we insist on behalf of the public that the charity provide a public benefit that is commensurate with the charity's financial resources and with the tax subsidy it receives?" Something must be in the air, because those are largely the same questions that are being posed in the Strom article.
Legislators like Senator Grassley are certainly in a position to push for higher levels of spending. They can extend the minimum payout provision applicable to private foundations to public charities or develop some other mechanism to force more current spending. However, we have serious doubts whether the IRS, on its own accord, is in a position to force higher payouts/spending from public charities. The very fact that Section 4942 exists to force private foundations to distribute a minimum amount of income is clear evidence that there is no statutory requirement applicable to public charities.
In our view, there is no statutory basis for a separate "commensurate benefit" test as referred to by Commissioner Miller. The test's roots go back to Revenue Ruling 64-182, 1964-1 CB 186, and are most charitably viewed as part of the operational test. As noted commentator Bruce Hopkins points out in his treatise, the test laid largely dormant for the 25 years until 1990. As enunciated by the Service, the test doesn't reduce itself to requiring the expenditure of some minimum percentage of income or assets. According to the Service, the test requires that the charity "have a charitable program that is both real and,taking the organization's circumstances and financial resources into account, substantial."
We have a great deal of trouble seeing the test applied to most mainstream charities. We suspect that any cases brought by the Service would look quite similar to cases brought under the now largely dormant accumulated earnings tax found in Section 531 of the Code. Charities would attempt to demonstrate why their accumulation of assets are for reasonable purposes. Given existing practices and the current landscape, we also have some trouble seeing a court mandating that Harvard University or some other large charity begin spending surplus, particularly when much of that surplus has been restricted by donors.
But Commissioner Miller's speech and sentiments are notable because they underscore much of the thinking reported in Strom's article. If nothing else, charities have a public relations issue to the extent they are viewed as hording assets. What will prove difficult for Commissioner Miller, policymakers, and advocates of more spending will be the fact that most charities are struggling to make ends meet. In other words, any serious discussion of changes to existing laws should be preceded by a thorough analysis of the true extent of the problem rather than reliance on anecdotal evidence.
We can expect much more discussion about the appropriate levels of endowment in the months to come. In the end, we prefer a free-market solution rather than litigation or legislation. Donors and charities are in the best position to address wasteful hording. Harvard's alumni should begin asking why Harvard requires a $35 billion endowment. Nobody is making them contribute to never ending fundraising campaigns. Those charities who lack resources need make better pitches to Harvard's alumni, but those pitches need to be supported by improved practices.
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