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Giving Thanks for Charitable Tax Exemption

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Have you ever wondered why charities enjoy special tax exemption privileges? Or on a deeper level, how the word “charity” came to be defined by the IRS, for Section 501(c)(3) purposes? This article provides a short historical primer on the evolution of the term “charity,” special aspects for exempt religious organizations, and related tax theories in brief.[1]

The Code

Let’s start with the Internal Revenue Code itself. Section 501(c)(3) provides an exemption from federal income tax to organizations “organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports compensation or for the prevention of cruelty to children or animals,” provided that certain other conditions are met. Correspondingly, Section 170 of the Code provides that donations to such tax-exempt organizations qualify for tax deductibility, which is a unique benefit among the Section 501(c) categories. These types of organizations enjoy this privilege because they engage in activities that benefit the general public and promote the general welfare. Commonly, but not always, they also offset government burdens like educating children, providing for the poor, and fostering community well-being.

Charity – Before the IRS and Today

Moving on to the historical question: where did these significant benefits come from? The U.S. system is based on the English Statute of Charitable Uses of 1601, which simplified conveyance rules for charities and codified the term “charitable.” This statute extended the European tradition of exempting churches from property tax to charitable and educational institutions. When the United States was formed, our country’s citizens continued this tradition, with remarkably beneficial effects. As Alexis de Tocqueville famously observed:

Americans of all ages, conditions and dispositions constantly unite together. Not only do they have commercial and industrial associations to which all belong but also a thousand other kinds, religious, moral, serious, futile. . . Americans group together to hold fetes, found seminaries, build inns, construct churches, distribute books. . . They establish prisons, schools by the same method. . . I have frequently admired the endless skill which the inhabitants of the U.S. manage to set a common aim to the efforts of a great number of men and to pursue it voluntarily.[2]

Fast-forward to the turn of the twentieth century: Congress imposed, for the first time, income tax on corporate entities. In doing so, Congress specifically exempted “corporations, companies, or associations organized and conducted solely for charitable, religious, or educational purposes.” Following the 1909 Revenue Act and the ratification of the Sixteenth Amendment, such exemption was maintained in the Revenue Act of 1913. The tax laws were furthered developed over time, and Section 501(c)(3) eventually became the tax classification that we know today for exempt organizations qualifying for tax-deductible contributions. 

Bringing it all together, the term “charitable” under Section 501(c)(3) is derived from and associated with common law standards of charity and charitable trusts, based on the general concept that such organizations hold charitable assets in trust. This term is generally applicable to all three major categories identified separately in Section 501(c)(3) as religious, educational, and charitable. More specifically, Section 1.501(c)(3)-1(d)(2) of the Code of Federal Regulations provides:

The term charitable is used in section 501(c)(3) in its generally accepted legal sense and is, therefore, not to be construed as limited by the separate enumeration in section 501(c)(3) of other tax-exempt purposes which may fall within the broad outlines of charity as developed by judicial decisions. 

The term thus includes, but is not limited to, governmentally themed purposes like “lessening the burden of government,” erection of public buildings, promotion of social welfare, relief of the poor, and combatting juvenile delinquency. As exemplified in IRS Revenue Ruling 75-384, with trust law as the “main source” of the “general law of charity,” no tax-exempt organization may be created for illegal purposes.

Public Benefit and Tax Subsidy Theory Dimensions, Briefly

An underlying meta-narrative is the “tax subsidy” concept as applied to religious organizations, particularly in light of related “public benefit” aspects of Section 510(c)(3) tax exemption. Is the charitable deduction available through Section 501(c)(3) and its Section 170 counterpart effectively a tax subsidy, allowing money to be taken out of government coffers and used instead for charitable, religious, and educational purposes? Or do these Tax Code provisions merely encourage people to act – and spend – philanthropically, as our country has long encouraged through such favorable tax treatments and other incentives?

In Walz, the U.S. Supreme Court noted that public charities are granted exemption in recognition of their “beneficial and stabilizing influences in community life.” In the much earlier 1924 case of Trinidad v. Sagrada, the Court similarly observed that tax exemptions are given “in recognition of the benefit which the public derives.” These cases underscore the importance of keeping the definition of public benefit necessarily broad, which is especially significant for historical religious exemptions and the related principle that the government should not demand that the church support the state. 

Such broad interpretation further comports with the tax law thesis that “[c]haritable entities should be tax-exempt because there are not individual owners.”

Further, tax law is fundamentally incompatible with nonprofit organizations, because corporate tax is – in essence – aimed at taxing owners (i.e., taxing something of value to shareholders), but nonprofits do not have owners.[3] And as the charitable deduction’s legislative history shows regarding the question of whether deductions should be viewed as exclusions from income or a government subsidy, a general recognition exists for the great public benefits generally from charity – and thus the tax system intentionally promotes charitable giving. 

Constitutional Freedoms for Religious Organizations

Within Section 501(c)(3)’s taxonomy, are religious organizations special? Yes, they enjoy an especially important tax exemption foundation, in addition to charitable trust principles underlying Section 501(c)(3) organizations generally, and are consistent with worldwide historical treatment of religious institutions as exempt. As the U.S. Supreme Court observed in the landmark 1970 case of Walz v. Tax Commission:

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.

As U.S. Supreme Court Justice O’Connor further observed, the early American leaders “accorded religious exercise a special constitutional status,” with all agreeing that “government interference in religious practice was not to be lightly countenanced.” (City of Boerne v. Flores, 521 U.S. 507, 564 (1997). Critical constitutional principles are implicated here in two key ways.

First, the Free Exercise Clause of the First Amendment protects religious liberty by prohibiting invasions thereof by the government. Consequently, a law may offend constitutional neutrality if it unduly burdens the free exercise of religion. The relevant inquiry is thus whether the government has placed a substantial burden on religious belief or practice and, if so, whether a compelling governmental interest justifies the burden. Such a government/religious liberty balancing test is exemplified in the federal Religious Freedom Restoration Act and comparable state versions. These RFRA laws require a claimant to show (1) a sincerely held religious belief that (2) has been substantially burdened by government action.

Second, the Establishment Clause of the First Amendment acts as restraint on government power of matters “respecting an establishment of religion,” thus making tax exemption consistent with separation of church and state. Indeed, as rooted in the Establishment Clause, whereby the government is to respect religious organization and leave them alone, tax exemption actually furthers separation rather than contradicting it.

Religious organizations’ special tax-exempt treatment reflects a foundational aspect of our civic structures with respect to the authority of the state over religious institution.[4] In addition, it recognizes that maintaining religious institutions’ independence from requiring the imprimatur of state approval is a vital aspect of a flourishing society, much less a liberal democracy. These historically recognized justifications, as codified in the First Amendment, thus protect the tax-exempt status of religious organizations on separate grounds from other types of charitable organizations.[5]

Giving Thanks

Our country’s recognition of tax exemption for Section 501(c)(3) organizations is based on a rich tradition of favoring and encouraging charitable activities generally, as well as a steadfast and constitutionally based concern for religious organizations’ autonomy. These are key legal dynamics for which we can all be thankful, in season and out!

[1] These subjects are in treated in much more extensive detail in a forthcoming article to be published by the Taxation of Exempts Journal (Thomson Reuters/Checkpoint), entitled Digging Deeper on Tax-Exempt Status the Public Policy Doctrine, Post-Obergefell.

[2] Alexis de Tocqueville, Democracy in America, Book II, Ch. 5 (Henry Reeve trans.) (1840).

[3] See B. Bittker, Charitable Contributions: Tax Deductions or Matching Grants? 28 Tax L. Rev. 37 (1972).

[4] As one commentator has explained, “the First Amendment’s commitment to religious freedom provides the greatest legal justifications” for religious tax exemption, particularly since the power to tax is that of a sovereign. See M. Martin, Should the Government Be in the Business of Taxing Churches, Regent Univ. L. Rev. 309, 315 (2017).

[5] “Churches have been wholly or partially exempt from secular taxes since the time of Constantine at least; only the most rigorous ideologues feel that such exemption violates state or federal constitutional provisions.” See R. Rodes, Jr., The Last Days of Erastianism: Forms in the American Church-State Nexus, 62 Harv. Theo. Rev. 301, 317 (1969). See also S. Diamond, Efficiency and Benevolence: Philanthropic Tax Exemptions in 19th Century America; E. Brody, Legal Theories of Tax Exemption: A Sovereignty Perspective; D. Dessingue, The Special Case of Churches, all collected in Property Tax Exemption for Charities (E. Brody, ed.) (2002). 

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