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.

Tax Base Definition Rationale

The second rationale for tax exemption is based upon definition. Proponents argue that the tax base, by definition, does not include religious, educational, and charitable activities.  Therefore, such nonprofits must be exempt from taxation.  In other words, the income of such organizations cannot be measured in profit-seeking terms because their “income” is distributed for charitable purposes rather than to shareholders. Any tax imposed on a nonprofit’s revenues would thus be borne by the organization’s beneficiaries and donors, which is inconsistent with such organizations’ overall charitable nature.[5]  This analysis is particularly true for churches and other religious institutions, which typically do not charge any fees for admission or other benefits offered.

Subsidy Rationale

Tax exemption sometimes has been framed as a subsidy, or incentive, for qualified charitable activities.  Also known as the quid pro quo theory, this reasoning suggests that nonprofits gain tax exemption – along with the significant benefit of receiving tax-deductible contributions – in exchange for lessening the burdens of government by providing charitable services. This burden reduction may be common for strictly charitable and educational nonprofits, but more as a hallmark of such activities rather than as a qualification for tax-exemption. 

The theory’s application to religious institutions gets more complicated because distinctly religious functions (worship, prayer, religious teaching, etc.) cannot necessarily be construed in this manner.  Furthermore, such approach could be problematic under the First Amendment’s Establishment Clause, which prohibits the state from sponsoring or supporting a particular religion.  A blanket tax exemption avoids the possibility of any unequal or selective tax treatment on the basis of an organization’s religious beliefs. 

On the other hand, religious institutions long have provided extensive societal benefits that reduce government burdens by, essentially, fostering good citizenship.  As a Georgia court once explained, they include:

[B]enevolence, charity, generosity, love of our fellow men, deference to rank, to age and sex, tenderness to the young, active sympathy for those in trouble or distress, beneficence to the destitute and poor, [which] constitute not only the “cheap defence of nations,” but furnish a sure basis on which the fabric of civil society can rest, and without which it could not endure.  Take from it these supports, and it would tumble into chaos and ruin.[6] 

Such qualities, even if not readily quantifiable, continue today and justify the inherent economic benefits of religious institutions.  Religion’s societal benefits also are much cheaper and more effective for maintaining order than governmental alternatives such as welfare programs and costly police powers.

Sovereignty Rationale

Sovereignty theory posits that nonprofit organizations occupy a sphere completely separate from the state.  This theory particularly provides a powerful rationale for tax exemption for religious institutions due to their First Amendment freedom from governmental interference.  Instead of considering whether the state is allowed to exempt religious organizations, sovereignty theory asks if the state has any power to tax such entities at all.[7]

Two critical tax principles are essential to understand sovereignty theory. First, as Justice Marshall famously pointed out long ago, “the power to tax involves the power to destroy.”[8]  Second, the power to tax is held by a sovereign government.  The sovereignty theory recognizes that it would be quite problematic if the government could control religious organizations – directly or in more subtle ways – through potentially onerous taxes, intrusive reporting requirements, consequent penalties for compliance failures, and other tax-based regulations.  Accordingly, while religious institutions may be subject to the sovereign in limited ways (e.g., payroll taxes, health and safety regulations), courts have required that government intrusions into the religious sphere be strictly scrutinized to guard against overreaching.  This safeguard is a matter of our country’s constitutional protections, grounded in the sovereignty rationale.[9]

Concluding Remarks

To be equipped for future challenges, religious organizations and other nonprofits may wish to better understand the multiple rationales for their tax exemptions.  Our upcoming blog will address what lies ahead, in the wake of the U.S. Supreme Court’s  recent Obergefell same-sex marriage ruling.