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Taxation of investment income of section 501 organizations – c – 6

Taxation of investment income of section 501 organizations – c – 6 – tax exempt professional associations

February 25, 1999

On February 25, 1999, Tax Executives Institute filed the following comments with the congressional tax-writing committees, opposing the Clinton Administration’s proposal to tax the investment income of organization qualifying for exemption under section 501(c)(6) of the Internal Revenue Code. The Institute’s comments, which took the form of a letter from TEI President Lester D. Ezrati to the Honorable William V. Roth, Jr., Chairman of the Senate Committee on Finance, and the Honorable Bill Archer, Chairman of the House Committee on Ways and Means. Note: The Administration’s proposal would directly affect TEI’s own liability under the income tax laws.

On behalf of Tax Executives Institute, I am writing in opposition to the Clinton Administration’s proposal to tax the investment income of organizations that are otherwise exempt from income tax pursuant to section 501(c)(6) of the Internal Revenue Code. The proposal proceeds from a false premise — that the exemption from tax derives somehow from the level of the tax benefits enjoyed by members of the organization — as well as a misapprehension about the purposes underlying current exceptions to the exemption (the unrelated business income tax provisions of the Code). TEI strongly recommends that it be rejected.

Tax Executives Institute is the preeminent association of corporate tax professionals in North America. TEI has 5,000 individual members who represent more than 2,800 of the leading corporations in the United States and Canada. As a professional association, TEI is dedicated to the development and implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of both government and taxpayers. The companies represented by TEI members belong (either directly or through their employees) to numerous associations that would be subject to the Administration’s proposal, including the Institute itself.

Background

Section 501(c)(6) of the Internal Revenue Code provides an exemption from income tax for nonprofit business leagues, chambers of commerce, and professional and trade associations. Such organizations are not taxed on the revenues derived from membership dues and exempt purpose activities. Income derived from unrelated business activities, however, is taxed under section 511 at the regular corporate rate, but an exclusion is provided for investment income derived from interest, dividends, rents, and royalties.

On February 1, 1999, President Clinton submitted his fiscal year 2000 budget proposals to Congress. Included in the package is a provision to eliminate the current exclusion from unrelated business income tax (UBIT) in respect of investment income in excess of $10,000 earned by section 501(c)(6) organizations (such as TEI). The Administration explained the rationale for the proposal, as follows:

The current-law exclusion from the UBIT for certain investment income of a

trade association allows the organization’s members to obtain an immediate

deduction for dues or similar payments to the organization in excess of the

amounts needed for current operations, while avoiding tax on a

proportionate share of the earnings from investing such surplus amounts. If

the trade association member instead had retained its proportionate share

of the surplus and itself had invested that amount, the earnings thereon

would have been taxed in the year received by the member. Although in some

instances investment income earned tax-free by a trade association may be

used to reduce member payments in later years, and hence reduce deductions

claimed by members in such years, the member still has gained a benefit

under current law through tax deferral. Thus, under current-law rules,

trade association members may be able to claim current deductions for

future expenses. Even assuming that dues and similar payments would be

deductible by the member if made in a later year, to the extent that

investment income is earned by the trade association in one year and spent

in a later year, the current-law exclusion effectively provides the benefit

of a deduction before the expenditure actually is made.

U.S. Department of Treasury, General Explanations of the Administration’s Revenue Proposals 160 (Feb. 1999). The Administration’s proposal wholly misapprehends the basis of the tax exemption for organizations specified in section 501(c)(6) and the reasons for the UBIT provisions under which certain income of such organizations are currently subject to tax.

The Administration’s Proposal Should Be Rejected

More than a century and a half ago, Alexis de Tocqueville observed that one of America’s unique qualities was the manner in which so many of its citizens join together in associations to advance the public good. Although the success of these cooperative efforts may not be dependent on exempting associations from income tax, the Administration oversimplifies the issue by essentially tying the exemption from tax of investment income to whether an association’s members deduct their dues. The Administration contends that since members of a trade association can generally deduct dues payments, exempting investment income earned on “excess” dues payments would constitute an untoward double tax benefit. The Administration’s argument, however, suffers several flaws.

First, not everyone paying dues to section 501(c)(6) organizations necessarily realizes a tax benefit from those payments. For example, many (though concededly not most) TEI members pay their dues personally (rather than have their dues paid or reimbursed by their corporate employer). Because of the limitations on deducting employee business expenses, those members may not enjoy a tax benefit associated with their dues.

Second, members of organizations exempt under other provisions of the Internal Revenue Code — associations the Administration does not propose to subject to the tax on investment income — may enjoy comparable tax benefit for their dues or other payments to the association. Members of labor unions (which are exempt under section 501(c)(5)), for example, are entitled to deduct their dues as employee business expenses. The Administration, however, does not propose to tax the investment earnings of those organizations, presumably because the availability or nonavailability of a deduction for dues is irrelevant to the purpose of which the exemption from tax was granted: such organizations advance socially laudable ends. The same is true of organizations exempt under section 501(c)(6).

Most fundamentally, the Administration errs in linking the exemption from tax to whether and when the members of the exempt organization may deduct their dues. Indeed, the UBIT provisions currently in the Code were motivated not by the connection between an exempt organization’s investment income and its members’ dues payments but rather to primarily eliminate a source of unfair competition by placing the unrelated business activities of a tax-exempt organization on the same tax basis as for-profit activities. Hence, when the tax was enacted as part of the Revenue Act of 1950, Congress explained its intent, as follows:

The problem at which the tax on unrelated business income is directed here

is primarily that of unfair competition. The tax-free status of [section

501] organizations enables them to use their profits tax-free to expand

operations, while their competitors expand only with the profits remaining

after taxes.

H.R. Rep. No. 81-2319, 81st Cong., 2d Sess. 36-37 (1950); S. Rep. No. 81-2375, 81st Cong., 2d Sess. 28-29 (1950).(1) Congress recognized, however, that, in the absence of unfair competition, investment income was an important source of revenue for tax-exempt organizations; it therefore excluded interest, dividends, rents, and royalties from the UBIT “because they are `passive’ in character and are not likely to result in serious competition for taxable businesses having similar income.” H.R. Rep. No. 81-2139 at 36-38; S. Rep. No. 81-2375 at 30-31.

An organization qualifies for exemption under section 501(c)(6) only if its activities are aimed at improving the business conditions generally of a line of business. Where the revenues to fund those activities derive from is not the key issue. Hence, while dues and other exempt purpose revenues (e.g., fees from educational programs) may be used to fund an organization’s exempt purposes, investment income is also an important source of revenue. The use of passive investments promotes economic stability and permits organizations to maintain operating funds in accordance with legitimate cash management policies. Without alternative forms of revenues, membership organizations may be forced to raise their dues — an action that would generate a currently deductible business expense and certainly diminish any revenue-raising purpose behind the proposal.(2)

In an organization such as TEI, revenues are used to fund educational programs, cooperate in joint projects with the Internal Revenue Service and other government taxing authorities, comment on specific tax issues, and facilitate better communication between tax officials and its own members — all of which further the Institute’s exempt purposes and its ongoing commitment to maintaining a tax system that works. Passive investment income permits the organization to provide public service on tax administrative matters to the benefit of both corporate taxpayers and the government. Other section 501(c)(6) organizations serve similarly salutary purposes. The reason for exempting such investment income from UBIT is just as valid today as it was half a century ago. The Administration’s proposal to tax such income should be rejected.

(1) This position was reaffirmed in 1976 when the Senate Finance Committee noted that one of the major purposes of the UBIT is “to make certain that an exempt organization does not commercially exploit its exempt status for the purpose of unfairly competing with taxpaying organizations.” S. Rep. No. 94-938, 94th Cong., 2d Sess. 601 (1976).

(2) The Administration recognizes this but contends its proposal is nevertheless meritorious because current law “effectively provides the benefit of a [dues] deduction before the expenditure actually is made.” We suggest that such a “matching” rationale betrays a compulsion toward theoretical purity that is neither achievable in practice, uniform in application, nor justified in terms of the administrative burden and complexity it would spawn.

COPYRIGHT 1999 Tax Executives Institute, Inc.

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