[Legislative Update] Tax Treatment of Charities; Foundation Excise Tax

The federal tax code treats public charities equally with regard to charitable deductions. A dollar given to an art museum qualifies for the same tax deduction as a dollar given to a food bank, animal rescue group, or environmental advocacy organization.

Should all charities be treated equally? Some proposals for differential treatment might appear noncontroversial, such as when special deductions are allowed for disaster relief. But legislators have also wondered whether charitable institutions not dedicated to helping disadvantaged citizens deserve the same tax treatment as those that do. Or whether a million dollar gift with a tax deduction of $350,000 deserves more oversight than a $100 gift the donor chooses not to declare.

This line of questioning has accelerated during the economic downturn, as Congress feels pressure to provide more assistance while its revenues decline. The questions will be raised more intensely as the Bush tax cuts sunset and our tax laws come under review.

Tax Treatment of Charities

At a recent public forum hosted by Catholic University of America’s Columbus School of Law, academics and policymakers wrestled with the notion of equal treatment of charities under the tax law.

• Would it serve the public interest to preferentially incent donations to human services organizations, especially during economic downturns when donations decline and demand for services increases?
• Because itemizing deductions creates an incentive for wealthy donors to make major gifts, does the tax code favor large charities? Small charities receive most of their donations from middle income donors who do not itemize and therefore have less incentive to give.
• Tax extensions that encourage giving to disaster relief and recovery can simply displace donations rather than encourage additional gifts. What can be done to encourage more philanthropy?
• Should Congress penalize large universities with big endowments? More broadly, should charities that build up reserves be penalized?
• Is it fair that charities in rural areas, or those that serve minority populations, have fewer connections to wealthy donors?

ASF is cautious of unequal treatment of charities. On one hand, we believe donors’ flexibility to direct gifts as they desire is critical for vitality of the charitable sector. On the other hand, we want to see tax incentives for charitable giving protected, even enhanced, and sometimes the best way to incentivize giving is one step at a time, such as when special deductions were allowed for giving in the aftermath of Hurricane Katrina.

Flattening the Excise Tax

A proposal to flatten the foundation excise tax is also under serious discussion in Washington. The proposal may be included in legislation prior to the Fourth of July recess.

It calls for a 5-year study period during which the excise tax would be set at a flat rate of 1.39%, replacing the current 1%–2% structure that allows foundations to qualify for the lower rate if, generally speaking, current expenditures exceed the foundation’s 5-year average by a set percentage.

The current two-tiered structure creates a disincentive for giving in times of great need, as higher rates of giving in a particular year make it difficult to qualify for the lower tax rate during the next 5 years.

The proposal represents a slight tax increase for the country’s largest foundations. Whereas the Joint Committee on Taxation determined the revenueneutral tax rate to be 1.39%, the largest foundations have historically paid lower rates. Smaller foundations with assets below $25 million, which account for more than 95% of foundations, have historically paid a slightly higher rate than 1.39%.

Smaller foundations also incur a relatively larger administrative burden to calculate the tax. A 2008 poll of more than 100 ASF members found all but one to support flattening the rate—in my opinion, a pragmatic nod in favor of simplification.

The ASF board is seriously weighing the interest of the minority of members who desire to pay only 1%. It is likely to take a position that flattening the tax is only a simplification measure, albeit one that will eliminate disincentives for generosity in times of great need, but that policymakers should hear loudly that the tax should be eliminated altogether or collected only in the amount needed to provide oversight of the nonprofit sector.

-By Tim Walter, CEO, Association of Small Foundations