DATELINE: December 11, 2007, Chicago
We noticed that Harvard University announced on Monday a plan to make more financial aid available to middle-class and upper-middle class students. Jane J. Kim, Harvard Trims Tuition Bills for Families, Wall Street Journal, Dec. 11, 2007. For these students, tuition will equal 10% of the family's household income. As a consequence, a family making $120,000 a year would pay $12,000 per year in tuition, compared to $19,000 in tuition under the existing policy. Harvard also plans to do away with the loan portion of its financial package, substituting a grant instead. As per the existing policy, those with under $60,000 of family income pay no tution, with those with slightly higher family incomes required to pay a relatively small percentage of the sticker price.
None of this should come as a surprise, with the federal government and Harvard critics eyeing Harvard's...
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$35 billion endowment. People are asking whether hoarding money is a charitable activity. More generally, the question of what constitutes a charity seems to be on everybody's mind these days. So far the House and the Senate have made a lot of noise, but have accomplished nothing in terms of arriving at a new of set of rules that redefine the basis for tax-exemption.
The state courts, on the hand, have been very active in defining what constitutes a charity for purposes of property tax exemption. Although those decisions don't affect federal tax policy, they are another sign that there is widespread interest in defining exactly what a charity is for purposes of government subsidy. Although the Minnesota Supreme Court's decision in Under the Rainbow Child Care Center v. Goodhue County (December 6, 2007) has no direct effect on Harvard, the majority opinion nicely summarizes the issues facing policymakers in deciding what activities should be subsidized through various tax-exemptions, be the subsidy a property tax exemption, income tax exemption, or the right to receive tax deductible charitable contributions. In the long run, the answer to that question has a great deal of significance to Harvard and many other tax-exempt organizations.
The Minnesota case involved a state-licensed child care facility that was initially established as a sole proprietorship in 1994 and subsequently incorporated in 1995. Its mission is "to provide [for] children away from their homes" and it was organized "exclusively for charitable, scientific, literary, or educational purposes."
Like many states, Minnesota has a multi-factor test to determine whether an organization qualified as a charity for purposes of property tax exemption. The six factors are: (1) whether the stated purpose of the undertaking is to be helpful to others without immediate expectation of material reward; (2) whether the entity involved is supported by donations and gifts in whole or in part; (3) whether the recipients of the "charity" are required to pay for the assistance received in whole or in part; (4) whether the income received from gift and donations and charges to users produces a profit to the charitable institution; (5) whether the beneficiaries of the "charity" are restricted or unrestricted and, if restricted, whether the class of persons to whom the charity is made available is one having a reasonable relationship to the charitable objectives; (6) whether dividends, in form or substance, or assets upon dissolution are available to private interests.
The first portion of the court's opinion focuses on this test, declaring that these are not necessarily the only factors that are relevant, but in all cases, the third factor must be present—the recipients of the "charity" must receive the services on a subsidized basis. This factor turned out to be a significant problem for Rainbow. As it turned out, Rainbow charged market rates to all who sent their children to the day care facility. The court relied on a survey to show that Rainbow's rates were "generally higher than the rates of the other Red Wing child care centers." According to the court,
Rainbow's weekly rates were higher than both of the other child care centers in Red Wing for infants, toddlers, and preschool children, who constituted 55 of Rainbow's 70-child licensed capacity. For school age children, Rainbow's weekly rates were lower than those of one center, but higher than those of the other. But school age children occupied only 15 of Rainbow's 70 licensed spots. Thus, when Rainbow's rates are compared to actual market rates, the tax court's finding that Rainbow's rates were "at or just below market rates" during the years in question is not supported by the evidence. Rather, Rainbow's weekly rates were for the most part above market rates.
The dissenting opinion notes that the market is comprised of only nonprofits and that Rainbow had operated at a loss each year. But the majority rejects this line of reasoning, pointing out that just because an organization operates at a loss does not mean it is charging rates below market. It also points out,
even if we were to accept that Rainbow's rates are below cost, precedent requires Rainbow's rates to be "considerably less" than cost "as a means of proving that [rates] were established for the stated charitable purpose rather than for purely business reasons."
The majority then turns to the Rainbow's Form 990, and the following schedule:
|
2003 |
2004 |
2005 |
Program Service Revenue |
$415,627 |
$488,457 |
$513,821 |
Total Expenses |
$430,390 |
$480,930 |
$525,211 |
Excess (Deficit) for the Year |
($14,763) |
$7,527 |
($11,390) |
Excess (Deficit) as a Percentage of Program Service Revenue |
(3.55%) |
1.54% |
(2.29%) |
It then points out that Rainbow's results are consistent with an organization that is a nonprofit, but not one that is "so organized and operated that its commercial activities are subordinate to or incidental to any possible charitable activities."
In the greater scheme of things, the majority is troubled by the fact that all those attending Rainbow's program pay the full rate. Also troubling to the majority was Rainbow's failure to provide "scholarships" to needy families. Rainbow argued that the some families effectively receive a 20% discount because government funding covers 20% of the fee, but the court rejected this argument, essentially concluding that Rainbow cannot count the government's "charity" as its own.
In sum, the majority wants any organization that is claiming charity status for purpose of Minnesota property tax exemption to fund the subsidized or free services it provides to the charitable class. The majority will not permit the organization to count government subsidies for this purpose, which means the organization must receive what would seem to be significant levels of charitable contributions or investment income from an endowment before the organization will be entitled to property tax exemption.
The reason we facetiously say Harvard must have received an advance copy of the opinion is because the changes in its financial aid program seem to anticipate the requirement of true subsidy that the Minnesota Supreme Court is looking for.
More relevant to Harvard and federal tax policy is an earlier portion of the majority's opinion that addresses two distinct theories for tax exemption. The court wrote,
This point illuminates the fundamental difference between our analysis and that of the dissent. The dissent believes that "the essence of a charity lies in the nature of the service provided" and therefore, "the question of whether an organization is a charity depends primarily on the nature of the service it provides." In contrast, we understand the essence of charity, as defined in our cases, to be the provision of the service as a gift to the recipient. The dissent instead sees the extent to which the recipients are charged for the service simply as a matter of the mechanism for funding the service, which "has limited materiality to the question of whether the organization is a charity." This primary emphasis on purpose and the concomitant marginalization of the gift factor allow the dissent to conclude that Rainbow could be deemed a purely public charity based simply on finding that (a) Rainbow's objectives "qualify as traditionally charitable," (b) it is "organized so that no individual can profit from ownership of its assets," and (c) it does not offer its services only to "a select and favored few."[1] This analysis would, in essence, hold that serving a worthwhile purpose and operating on a nonprofit basis is sufficient to exempt an organization from taxation as a "purely public charity." This interpretation of charity would expand the tax exemption far too broadly, for several reasons.
This language puts in sharp focus the policy debate facing members of the congressional tax writing committees who currently are focused on the basis for tax-exemption. In Harvard's case, is tax exemption to be granted because of the nature of its activity—we like education so it should be subsidized through tax-exemption—or because that activity is provided to the charitable class on a significantly subsidized basis? Harvard's change in its financial aid package is a step toward a significant subsidy, but is it a large enough step? Time will tell, but we suspect part of that answer will depend on the size of Harvard's endowment the corresponding spending rate.
Now we don't mean to pick on Harvard. College athletic programs, nonprofit hospitals, and cultural institutions more than likely will need to address this question as policymakers focus on the basis for tax-exemption. One thing is for sure: We would not want to be a nonprofit hospital in Minnesota right now.
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