FEDERAL ENCOME TAXATION 0F UNRELATED BUSWESS ENCOME AND FEEDER COMPANY ENCDME OF NON-PROF” EDUCATIQNAL INSTiTUTIONS Thesis for the Degree of Ph. D. MICHIGAN STATE UNIVERSITY Wayne E. Vanda Vere 1987 55.615 C. LIBRAR Y b!“ xte V...- ‘J 1;. “t ‘r-‘y‘ Y llllHHllHllllllflHHllHHIIHMllhllthllthlllHl 3 1293 10575 3051 This is to certify that the thesis entitled Federal Income Taxation of Unrelated Business Income and Feeder Company Income of Non-Profit Educational Institutions presented by wayne E. VandeVere has been accepted towards fulfillment of the requirements for Ph.D. degree in Business Administration [2L 4&4? ’ Major files r Dana/Z 09/: /7[ 0-169 ABSTRACT FEDERAL INCOME TAXATION OF UNRELATED BUSINESS INCOME AND FEEDER COMPANY INCOME OF NON— PROFIT EDUCATIONAL INSTITUTIONS. by Wayne E. VandeVere Purpose The 1950 amendments to the Internal Revenue Code marked a change in_the status of tax—exempt organizations. To halt the use of tax-free feeder companies--particularly by educational institutions-—Congress initiated taxes on feeder companies and on unrelated business income of most tax—exempt.institutions. Claims of dire consequences were made by opponents and advocates of the legislation and with the increasing need for funds by colleges and universities, the effects of these tax amendments are significant. The purposes of this study are to investigate the Judicial and legislative background of these taxes, delineate Congres— sional objectives, attempt to verify opposing arguments, test the effects of the new taxes, and develop criteria for appropriate action by educational administrators. Methods of Study Research was accomplished in four steps. First, the literature, including Congressional Committee Hearing reports and Judicial decisions, were investigated. Second, Wayne E. VandeVere the appropriate sections of the Internal Revenue Cose were analyzed along with the regulations and rulings of the Internal Revenue Service. Third, a questionnaire was mailed to college financial administrators to survey cur— rent practices and opinions with respect to these taxes. Fourth, a detailed case history was made of one educational institution which has been involved with these taxes and is currently paying federal income taxes. Summary of Results The major reasons for Congressional action in taxing feeder companies and unrelated business income of tax- exempt institutions were to equalize competition and to clarify what it felt was the original intentions of Con- gress when the tax-exempt privilege was granted. In spite of Internal Revenue Service's protest, the courts had' generally ruled destination of income and not its source determined its tax status under prior law. Tax—free feeder companies were the logical result and to eliminate this abuse of the tax-exempt privilege it was also necessary to tax unrelated business income of non-profit organizations. The source and not the use of income became the deciding factor. The opponents claims of unreasonable governmental interference, excessive financial hardship, and unequal treatment between exempt organizations as well as the governments claims of a potentially large tax loophole and Wayne E. VandeVere unfair competition, the survey revealed to be less serious than envisioned. The relatively few schools engaging in such activities and the even smaller number which indicated the new law had affected their schools policy decisions indicate the problem to be minor in its total effect but significant for a few isolated institutions. The majority still concur with the 1950 testimony favoring taxation of feeder companies but not of unrelated business income where an activity of the exempt organization itself is taxed. The major unsolved problem is how to differentiate between related and unrelated activities. To meet the requirements of the Code, emphasis must be on unrelated business and not on unrelated income in making this decision. Educational leaders must plan school activities and make investments wisely. They must become better acquainted with the law, should consult with the Internal Revenue Ser— vice, and should carefully compare their school objectives with the objectives of each of their commercial activities. The need for income must not preclude other considerations when business operations are contemplated. The size and risks involved in owning and operating a business firm may in the long-run make traditional investments in securities and real estate the most appropriate for educational endowment funds. The Internal Revenue Service needs expanded regulations respective to the relatedness of various educational activi— ties and Congress should reconsider its position taxing "business leases." Room for improvement exists. FEDERAL INCOME TAXATION OF UNRELATED BUSINESS INCOME AND FEEDER COMPANY INCOME OF NON- PROFIT EDUCATIONAL INSTITUTIONS By i W“ Wayne E. VandeVere A THESIS Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Accounting and Financial Administration 1967 @ Copyright by WAYNE ELMER VANDEVERE 1967 ACKNOWLEDGMENTS The author is indebted to many individuals for help in the completion of this research project. Foremost was Professor Charles J. Gaa, chairman of my dissertation committee. His many hours of precious time, his helpful suggestions, and his constant encouragement have been greatly appreciated. The other members of the committee, Professors Charles Lawrence and Denzel Cline also gave valuable assistance and the help and encouragement of Professor James D. Edwards has been invaluable. The help provided by Southern Missionary College both financially and in supplying the information needed for its case history has been greatly appreciated. Dr. C. N. Rees, Mr. Charles Fleming, Mr. Robert Merchant, and Miss Louesa Peters were especially helpful in this regard. To all the college and university financial adminis- trators who took.time to answer the questionnaire and thereby helped to make the survey a success goes a special word of thanks. Without the constant patience, help, and encouragement of my family this dissertation would not have been possible. Special thanks to my wife, Evelyn, and children, Rhonda, Robert, Jolinda, and David. . iii TABLE OF CONTENTS Page ACKNOWLEDGMENTS . . . . . . . . . . . . 111 LIST OF TABLES o o c o o c s o o o o o ‘ 1X Chapter I. INTRODUCTION AND OBJECTIVES. . . . . . 1 Introduction Limitations of study Federal income tax Educational.institutions. Unrelated business income and feeder company income Historical tax-exempt position of edu- cational institutions Reasons for tax—exemption Opposition to tax-exemption Importance of study- To society To educational institutions Objectives of study Delineate legislative objectives Investigate Validity of legislative objectives Investigate financial implications Investigate unrelated income concept Develop criteria for educational institutions II. HISTORICAL DEVELOPMENTS UP TO THE PASSAGE Philanthropy encouraged by government Legislative developments favoring tax-exemption Early income.tax laws 1913 income tax law 1913 to 1950 income tax laws iv Chapter Page Organizations added to exempt classification Limitation of activities by exempt institutions Judicial developments Trends in the position held by the courts Meaning of the term "operated exclusively" Competition factor Feeder company and size of operation Courts final position before 1950 tax law Summary of courts position Congressional committee hearings in 1950 House Ways and Means Committee Testimony favoring new legislation President's message Secretary of the Treasury Treasury department counsel Chairman-of House Ways and Means Committee Testimony in opposition to new legislation Limited in amount Representative Boggs dis- cussion Senate Finance Committee Testimony favoring new legislation Secretary of the Treasury National Association of Manu- facturers American Federation of Labor. U. S. Chamber of Commerce N. M. Mason, Illinois repre— sentative Testimony in opposition to new legislation J. R. Killan, Massachusetts Institute of Technology H. E. Stassen, University of Pennsylvania Carter Davidson, American Council on Education Mr. Brown, Union College Clarence Schock, 8100 Company Summary of testimony before the committees Chapter Page III. THE CURRENT LAW AND ITS INTERPRETATION . . A9 Current provisions of the 195A Internal Revenue Code Section 501, exempt organizations Section 502, feeder organizations. Section 503, prohibited transactions Sections 511-513, unrelated business income Taxation of state organizations Definition of-unrelated business income Section 514,-business leases Internal Revenue regulations and rulings Reg. #l.501 organizational and oper- ational test Reg. #l.501 definition of "educational" Reg. #l.501 definition of "exclusive" Reg. #l.511 unrelated business income Reg. #1.512 rental income Reg. #l.513 related and unrelated activities Internal Revenue rulings Related and unrelated activities Exempt Organization Council Scholarly opinion of current law Opposing views Favorableeviews Opinions of educational financial leaders Regarding feeder company income Regarding unrelated business income Conclusions IV. THE CONCEPT OF UNRELATED BUSINESS INCOME . 80 Introduction-~New terms in 1950 tax law Concept of Income Concept of unrelatedness Dictionary definition Internal Revenue Code definition Accounting theory--entity concept Position of minor revenues on statements Reasons for consolidated state- ments Summary of when income is unrelated Need for income by educational institutions Purpose of income tax law vi Chapter. Page- V. CURRENT PRACTICE OF EDUCATIONAL INSTITUTIONS WITH FEEDER COMPANIES AND UNRELATED BUSINESS ACTIVITIES . . . . . . . 92 Introduction Survey made Description of questionnaire Selection of sample Description of returns Type of institutions Size of institutions Location of institutions Feeder companies Institutions receiving feeder company income Effect of law on school policies Taxes paid on feeder company income Opinion of tax on feeder company income. Use of feeder company income Summary Unrelated business income Type of.activities Related Unrelated Taxes paid on unrelated business income Effect of law on school policies Opinion of tax on unrelated business income. Use of unrelated business income, Summary Endowment funds Types of investments Taxes paid on income of endowment funds Opinion of tax on endowment fund income Summary Contingency Funds Summary Limited occurrence of feeder company income and unrelated business income Opinion agrees with 1950 testimony Prevention of unfair competition appro- priate goal Difficulty in determination of related- ness of a business activity vii Chapter Page VI. SOUTHERN MISSIONARY COLLEGE AN EMPIRICAL STUDY . . . . . . . . . . . . 127 Description of Southern Missionary College Purposes and objectives of Southern MissionarysCollege vacational objectives :Industries operated by Southern Missionary College College Industries, Inc. Collegedale Enterprises, Inc. Collegedale Distributors, Inc. Southern Missionary College Net income of College industries Student part-time labor provided Rate of return on investment 'Source of operating and expansion funds Taxation of unrelated business income Collegedale Enterprises, Inc. Internal Revenue investigates Reorganization of Collegedale. Enterprises, Inc. Final ruling Taxes paid.196A-l966 Purpose of operation determines taxation College InduStries, Inc. Unprofitable Operations Taxes anticipated for 1967 Summary VII. SUMMARY AND CONCLUSIONS . . . . . . . 145 APPENDIX BIBLIOGRAPHY . . . . . . Legislative objectives Validity of arguments for and against the 1950 tax amendments Financial implications Reasonableness of the unrelated income concept Criteria for educational institutions Other recommendations . . . . . . . . . . . . . . 157 . . . . . . . 164 viii Table V—10 V—ll LIST OF TABLES Summary of Questionnaires Sent to 352 Colleges and Universities (Number of Questionnaires). . . . . . . . Analysis of 192 Questionnaire Returns By Type and Size of Institution (Number Received). . . . . . . . . Analysis of Questionnaires Sent and Re- ceived by Size of Institution . . . Analysis of 192 Questionnaire Returns By Geographic Location (Number Sent and Received). . . . . . . . . . Number of Institutions Receiving Income From a Feeder Organization . . . . Effect of the 1950 Tax Law on the School's Page 9“. 96 99 Policies Regarding Feeder Organizations. 100 Number of Feeder Companies Which Paid Federal Income Taxes or Filed a Tax Return. . . . . . . . . . . Financial Administrator's Opinions Regard- ing the Principle of Federal Taxation of Feeder Company Income (Agree It Should be TaXed = Yes) . . . . Types of Operations Not Strictly Related to the Educational Process (Number of SChOOlS) o o o o o ‘ o o ‘ o 0 Types of Unrelated Operations (Number of Schools) . . . . . . . . . Number of Schools Out of 192 Which Paid Federal Income Taxes or Filed a Tax Return on Unrelated Business Income . ix . 102 . 104 109 112 113 Table V—12 V-l3 V-IA V-lS V—16 V—l7 VI-l VI-2 VI-3 VI-A VI-S ~0- Effect of the 1950 Tax Laws on the School's Policies Regarding Unrelated Business Income 0 O O O O O O 0 O O O 0 Financial Administrator's Opinions Regard- ing the Principle of Federal Taxation of Unrelated Business Income (Agree it Should be Taxed 3 Yes) . . . . . . How the Unrelated Business Income Was: Used in A7 Educational-Institutions (Number of Schools) . . . . . Types of Investments of Endowment Funds (Number of Schools) Financial Administrator's Opinions Regard- ing the Principle of Federal Taxation of Endowment Fund Income Invested in Feeder or Unrelated Business Concerns (Agree it Should be Taxed = Yes) . Contingency Funds at 170 Universities and Colleges (Number of Schools) . . . Net Income for Industries Owned and Oper- ated by Southern Missionary College for Years Ended June 30, 19A7-1966. Student Labor at Southern Missionary College 19A7-l966 . . Net Worth, Net Income, and Rate of Return for Industries Owned and Operated by Southern Missionary College for Years Ended June 30, 1947-1966. . . . . Source of Funds for Southern Missionary College 19A7-l966 Income Taxes Paid by Collegedale Distri- butors and Mercantile Division, College— ,dale Enterprises for Years Ended June 30, 196A, 1965, 1966 Page 11A 116 117 120 123 124 132 133 134 137 IMO CHAPTER I INTRODUCTION AND OBJECTIVES Since the beginning of the Federal Income Tax in the United States, charitable, religious, and educational in- stitutions have received special consideration. However, in 1950, Congress passed amendments to the Internal Revenue Code which limited the tax-exempt activities of these insti- tutions in certain areas. Prior to this date, the only major restrictions had been that private individuals were not to profit from the activities of the institution and they were not to operate in the field of propaganda and politics. With the 1950 amendments, limitations were imposed on the business activities of these institutions. Profits from "feeder" com— panies, the receipt of "unrelated business income," and in- come from certain "business leases" were no longer tax-free. These limitations marked an abrupt change from the past. As ruled by the courts, the prior law had made the destination of income the deciding factor. Thus income, regardless of source, had been tax free if it inured to a tax-exempt insti- tution. Under the new law after 1950, the source of the in- come became the important factor and if the income was pro— duced by competitive business operations which were not related to the tax—exempt purposes of the institution save for the purpose of producing income, the income was taxable. The terms "feeder company" and "unrelated business in- come" were new to the Internal Revenue Code. A feeder com- pany is an organization operated primarily to carry on a trade or business for profit; which profit is payable in its entirety to an exempt organization. On the other hand, unrelated business income is earned by a division of the tax-exempt organization itself. The unrelated trade or business is one that is not-substantially related to the exercise or performance of the purpose or function consti— tuting the basis for which the organization receives its tax-exempt status. At the time when the amendments were passed, Congress particularly had educational institutions in mind. The Mueller Macaroni Company, operated as a feeder by the New York University Law School, was the leading example which brought the problem to the attention of the public. On the one hand, the government claimed that the abuse by the tax- free institutions of their tax-exempt privilege must be stopped to prevent unfair competition with normal business firms and also the loss of tax revenue must be stopped by closing this tax loophole. On the other hand, the edu— cational institutions insisted that their time honored tax— exempt privilege must not be violated and nothing should be done to hinder the progress of education at a time when the costs of education were rising rapidly. The purpose of this study is to investigate the problems and consequences raised by the above changes in the Internal Revenue Code. First, the study-is limited to the federal income tax. It in no way attempts to delve into the problems of state and local property taxes as. they affect non-profit institutions. The multitude of local.taxing authorities and the variations in their tax statutes prohibit their inclusion. Neither does it di- rectly relate to state income taxes, however, in at least ten states, their income tax laws indicate that the pro- visions of the federal law also apply in their state-laws.l Second, the study is primarily limited to colleges and universities. Other types of non-profit institutions such as churches, hospitals, charitable foundations, etc. are of necessity brought into the study when court cases and legislative provisions applying directly to them also apply to educational organizations. This frequently occurs because the same section of the Internal Revenue Code ap- plies to these same institutions. The reasons for limi- tation of this study are (l) the 1950 tax amendments in this area were aimed primarily at colleges and universities, 1In answer to an.inquiry by the author to all fifty states in 1965, it was found that (1) 16 states reported no corporate income tax, (2) 10 states had provisions similar to the federal law, (3) 18 states had no special provisions regarding feeder companies or unrelated business income, (A) 1 state, Louisiana, had a tax on feeder companies but no special provisions for unrelated business income, and (S) 5 states did not reply. (2) these.institutions raised most of the objections to the law in 1950, and (3) the research project had to be kept within manageable limits. Third, the study is limited in the main, to the pro- visions of the Internal Revenue Code relating to feeder company income and unrelated business income. These two types of operations combine to make a unitt The Treasury Department and Congress were first interested in the feeder company situation, but they soon realized that it would in many cases be~a simple matter for the tax-exempt organization to transfer the feeder company to an operating department of itself. If the tax were only on feeder companies, the tax would thus be avoided. The tax on.unrelated business income of non-profit institutions is consequently a companion mea— sure to the tax on feeder companies. Historically, there have been centuries of precedent which have made charitable and educational institutions tax-exempt. In Europe and particularly France, taxpayers had a most heavy burden because so much of the land was owned by the Church and tax-exempt. This left a relatively small portion of the country to carry the entire tax load. Also in China a public law in 172A said, "The exempt lands are those which are used as sites for the buildings or are rented in order to augment the revenue for public worship, "2‘ public education, and public charity. Thus it is not 2Shao-Kwan Chen, "The System of Taxation in China in the Tsing Dynasty, 16AA-l9ll," Studies in‘HistoryLEconomicsL surprising that in the United States, the same principles of tax—exemption have been adopted. All of our income tax laws have made these institutions themselves tax—exempt in most areas. To further encourage these charitable, re- ligious, and educational institutions, contributions made to them have been made deductible in calculating taxable income for individuals since 1917 and for corporations since 1935.3 There are several reasons which justify this favored treatment. Since most of these institutions do not earn any true profit, they are without taxpaying ability. In addition, their services are of great social value to the community, and to compel them to curtail these services for the sake of a small amount of tax revenue would be unrea- sonable, it is argued. Furthermore, these institutions perform services which state and local governments would otherwise have to undertake. If they were taxed, the govern- ment would be putting money into one pocket and taking it out of the other.“ President Eliot of Harvard in 1874 made this classic statement in this regard: and Public Law, #143 (New York: Columbia University, Long- mans, Green and Co., 191A), p. 55. 3Revenue Act of 1917, sec 120(2); Revenue Act of 1935, sec 102(c). ”William J. Shults, American Public Finance (3rd ed.; New York: Prentice Hall, Inc., 19A2), p. 295. To tax lands, buildings, or funds which have been devoted to religious or educational purposes, would be to direct money from the highest public use,--the promotion of learning and virtue,--to some lower public use like the maintenance of roads, prisons, or courts.5 One other point favoring tax exemption is that free— dom from governmental restrainst is necessary. It is con- tended that while the importance of such freedom is most obvious in connection with religious organizations, it should be equally clear that educational and scientific institutions, which are intended to stimulate learning and creativity for the benefit of the public, will make the most progress without governmental restraint.6 However, the policy of liberal tax exemptions has not been without criticism. Particularly in connection with churches and church related colleges, the objection has been raised that a tax exemption is in effect a subsidy to churches. This it is said, violates the principles of separation of church and state and therefore the subsidy is forbidden by the Bill of Rights and by many state consti- tutions. Exemption of profit—producing property owned by religious, charitable, and educational institutions has 5L. W. Killough, "Exemptions to Educational, Philan- thropic and Religious Organizations," Tax Exemptions, Tax Policy LeagueLADec. 28-30, 1938 (New York: Tax Policy League, Inc., 1939), p. 31. 6Norman A. Sugarman, "Business Income of Exempt organizations," Tax Revision Compendium, Nov. 16, 1959, Vol. III, House Ways and Means Committee Hearings (Waghington, D. C.: Government Printing Office), p. 211 . also been protested. It is argued that since the property is employed as an economic asset, it should contribute its quota to the upkeep of the government which makes its economic use possible.7 The tax question under investigation is important both in~a general way to society and to educational insti— tutions and in its specific application to the individual college or university. In principle, society must decide to what extent it wishes to aid education and to what extent it wishes to allow educational institutions to chart their own course and develop their own financial policies without government interference. The problem is made more compli- cated by the diversity of types of educational institutions. There are state supported institutions, private church re— lated institutions, and private non-church related insti- tutions; society may not wish to extend the same aid or the same degree of freedom to each type. On the other hand, if they are not treated in a similar manner, the cry of favor- itism will be raised by the less fortunate group of insti- tutions. The specific question in this study is what balance should be maintained between freedom for colleges and universities to plan their own financial policies and what restraint is necessary to insure equal competition between normal business firms and those owned and operated by these educational institutions. 7Shults, op. cit., p. 295. To the individual institution the tax on feeder income and unrelated business income has a direct effect on their source of funds. Operating and expansion funds usually come from tuition and fees, subsidies--from the state for public institutions and from church organizations for church related institutions--and from gifts and grants usually placed in endowment funds. The amount of income received from endowment funds and other investments is directly related to this tax question. Of course, to generate as much income as possible and thereby be able to offer as many educational services as feasible, the edu- cational institution will make these investments where the highest return can be expected compatible with a reasonable degree of risk. The income tax on feeder companies and on unrelated business income reduces this return and, therefore, may be the deciding factor in the type of investments made and the amount of return received. With the social and practical importance of these taxes, the objectives of this research project are as follows: 1. To delineate the legislative objectives in levying the income tax on feeder company income. and on unrelated business income of educational institutions. 2. To investigate the validity of these legislative objectives in changing the Internal Revenue Code in this area and to investigate the validity of the claims made by each side of the question in 1950, when these taxes were enacted. To investigate the financial implications of these taxes to educational institutions. To investigate the reasonableness of the un- related income concept. To develop a set of criteria to help educational institutions relate themselves in an enlightened manner to the federal income tax on their feeder and unrelated business income, not just to try to minimize these taxes but also to react in a way which will best meet the needs of society. CHAPTER II HISTORICAL DEVELOPMENTS UP TO THE PASSAGE OF THE 1950 AMENDMENTS To clearly appreciate the current position of edu- cational institutions relative to the federal income tax law, it is necessary to understand the historical back- ground of their tax-exempt status. This background is made up of two distinct phases; first, the legislative developments and second, the judicial interpretation of these laws by the courts. It is well nigh impossible to determine which area played the leading role, In some cases and at certain times, the judicial branch of govern— ment led in the process of change, while at other times it was the legislative branch. There has been a long—honored tradition in the United States to encourage philanthropy. The trend in the laws enacted by the Congress was for many years to enlarge the provisions of the law so as to give impetus to people to exercise their generosity. Encouragement was accomplished by first making certain organizations tax—exempt and second, by making contributions to these same organizations de- ductible, within prescribed limits, in the determination of the donor's taxable income. However, beginning in the 10 11 late 1940's, the current of thought changed. Hedges were placed about the area of non-profit, charitable organ- izations.l The major shift came in 1950 when certain seg- ments of their income were made subject to the federal income tax. Since that time, the tax code has had little or no change in its content regarding non—profit insti- tutions, and the differences of openion and the interpre- tations of the law have been considered primarily by the tax courts and by the Internal Revenue Service in its rul- ings. Legislative Developments The first federal income tax law was actually enacted in August of 1861. It was strictly a personal income tax and did not tax the income of corporations of any kind. Although several additional income tax laws were passed in the interim, it was not until 189“, that business concerns were first included as taxable entities.2 Section 32 of the 1894 law stated, "There shall be assessed and levied, and collected, except as herein otherwise provided, a tax of two per centum annually on the net profits or income above actual operating and business expenses . . . but not lLouis H. Powell, "Problems of the Tax Exempt Organ- ization," Proceedings of New York University Thirteenth Annual Institute on Federal Taxation (New York: Matthew Bender & Co., 1955), p. 807. 2J. s. Seidman, Seidman's Legislative History of Federal Income Tax Laws 1938-1861 (New York: Prentice- Hall, 1938), p. 1016. 12 including partnerships." Later in the same section in regard to exempt institutions it said: Nothing herein contained shall apply to States, counties, or municipalities nor to corporations, com- panies, or associations organized and conducted solely for charitable, religious, or educational purposes, including fraternal beneficiary societies, orders, or associations operating upon the lodge system and pro- viding for the payment of life, sick, accident, and other benefits to the members of such societies, orders or associations and the dependents of such members; nor to the stocks, shares, funds, or securities held by any fiduciary or trustee for charitable, religious, or edu- cational purposes; nor to building and loan associations, or companies which make loans only to their share- holders.3 Thus, in the very first federal income tax law on busi— ness concerns, the principle was established that certain organizations, including educational institutions, were com— pletely tax-exempt. This same principle was reiterated in the act of 1909, and in addition the 1909 law made an attempt to clarify the circumstances under which the listed organ- izations would be tax-exempt. This was accomplished by add- ing the phrase, "no part of the income of which inures to the benefit of any private stockholder or individual."u The exemption principle was intended to protect and encour- age those activities which benefited the general public but to tax as ordinary income those activities which were of benefit primarily to private individuals. 3Aug. 27, 189A, H. R. A86“, Public No. 227, 53d Cong. 2d Session, Ch. 349, 28 Stat. 509. “Aug. 5, 1909, H. R. 1u38, Public No. 5, 61st Cong. lst Session, Ch. 6, 36 Stat. 11. 13 During this period, however, the constitutionality of income tax laws was in doubt. The 189A law was declared unconstitutional in 1895 because the Supreme Court felt it was a direct tax and not apportioned among the states in conformity with the Constitution.5 The 1909 act, on the other hand, was upheld since it was a corporate excise tax rather than a tax on property and individuals and thus not a direct tax.6 With the passage of the 16th Amendment to the Constitution in 1913, the income tax, as we know it today, was enacted that same year. The 1913 act continued the policy to tax exemption for certain organizations. The pertinent section II (G)(a) said, Provided, however, that nothing in this section shall apply to . . . any corporation or association organ- ized and operated exclusively for religious, charita- ble, scientific, or educational purposes, no part of the net income of which inures to the benefit of any private stockholders or individual; nor to any civic league or organization not operated for profit, but Operated exclusively for the promotion of social wel- fare. The new law of 1913, added several new categories to the list of exempt organizations. The additions included: 5Pollock v. Farmers Loan & Trust Co., (157 U. S. A29; 158 U. S. 601), 1895. 6 Flint v. Stone Tracy Co., (220 U. S. 107), 1911. 7Seidman, o . cit., p. 1002. (Oct. 3, 1913, H. R. 3321, Public No. 15, 63rd Cong. lst Session, Ch. 16, 38 Stat. 114). 14 labor, agricultural, and horticultural organizations; mutual savings banks, cemetary companies organized for the sole benefit of their members; civic leagues and scientific organizations.8 Congress clearly intended to encourage the develOpment of many types of non-profit organizations, and where private individuals as owners were not the main bene- ficiaries of the organization, tax exemption was granted. With one minor exception, from 1913 up until 1950, the only changes in the law regarding tax-exempt insti- tutions were to add more types of organizations to the list and to systematize the list so it could be more readily understood. The additions were as follows: 1918, organ- izations for the prevention of cruelty to children and ani- mals; 1921, community chests, funds, or foundations, if they met the other tests, and literary organizations; and 1936, religious or apostolic associations under certain circum- stances. The one exception came in 1934. At that time the tax—exempt organizations were limited in their activities in that they were not to carry on propaganda or otherwise attempt to influence legislation. To do so would result in the loss of the tax-exemptlprivilege.9 8Ibid., p. 1002. 9"Legislative History of I. R. C., Section 501(C)(3)," Ninth Tax Institute, University of Southern California Law School (New York: Matthew Bender & Co., 1957), pp. 699- 703. 15 Legislative developments until 1950, then, can be summarized into two categories. From the beginning it was unquestioned that certain organizations would be tax- exempt. The first type of changes continually enlarged the number and types of institutions that were to be tax- exempt. These changes brought the number of such specified organizations from seven to seventeen or more. Some list- ings were specific such as community chests, whereas, other groupings were general in nature, only specifying the ac- tivity to be carried on. Scientific, literary, and edu- cational organizations are examples of this latter group. The second category of legislative change during this period was clarification of the scope of activities in which tax—exempt institutions could engage. Primarily these ac- tivities were to be of benefit to the general public and not to private individuals. In most cases the argument was that government should encourage private organizations to engage in these activities so that the government itself would be relieved from carrying on many of these necessary functions or at least it would decrease to a considerable extent the governmental expenditures for such activities. In other cases it was the social benefit received and not the cost saving that prompted Congress to grant tax-exempt status to the organization. 16 Judicial Development Concurrently with the above legislative changes were developments in the courtS-regarding the tax-exempt status of certain organizations. The arguments in the courts re- volved primarily around the nature of the term "organized and Operated exclusively" for the prescribed purposes stated in the law. The trend in the court decisions during the period 1913 to 1950 was from a quite liberal interpre— tation to a more strict reading of the law. The climax was reached in the C. F. Mueller Macaroni case. The original concept was that the ultimate use to which funds were applied was the ruling factor in determining if income was taxable or not. This concept held for several years, but by the early 1940's, the courts had switched their position; the new rule to be applied was that the source of the income and not the use of such funds determined the taxability of such income. This was a profound change in the application of the law. Then by 1950, the courts held it could be either position depending on the individual circumstances. The first prominent case was that of Trinidad v. Sagrada Orden de Predicadores in 1924.10 The plaintiff in this case brought an action to recover taxes paid under protest. It was a corporation in the Philippine Islands and was organized and operated for religious, benevolent, scientific, and educational purposes in the Philippine loTrinidad v. Sagrada Orden de Predicadores, (263 U. S. 578-582), January 14, 1924. l7 Islands and in its missions in China, Co-chinchina and Japan. None of its net income or part of its rents was applied to the benefit of any particular stockholder or individual and no part of its temporal properties belonged to any of its members, even in case of dissolution of the corporation. The plaintiff had large properties consist- ing of real estate, stocks in private corporations, and money loaned at interest, all of which were held and used as sources from which to obtain funds or revenue for carry- ing on its religious, charitable, and educational work. The bulk of its income consisted of rents, dividents, and interest derived from these properties; the rest of its in- come, though relatively small, came from alms for mass and profits from occasional sales, in excess of cost, of wine, chocolate, and other articles purchased and supplied for use in its churches, missions, parsonages, schools, and other subordinate agencies. The taxing authority (defendant) conceded that the plaintiff was organized and operated for religious, charita- ble and educational purposes but it contended that it was not "operated exclusively" for these purposes and therefore was not within the exemption of the taxing act. In effect, it was asserted that the plaintiff was also operated for business and commercial purposes in that it used its proper- ties to produce income by trading in wine, chocolate, and other articles. The contention put aside as immaterial the 18 fact that the income from the properties was devoted ex— clusively to religious, charitable and educational pur- poses. In commenting on the meaning of the excepting clause the court said: Two matters apparent on the face of the clause go far towards setting its meaning. First it recognizes that a corporation may be organized and operated ex- clusively for religious, charitable, scientific or educational purposes, and yet have a net income. Next it says nothing about the source of the income, but makes the destination the ultimate test of ex- emption. . . . Making such properties productive to the end that the income may be thus used does not alter or enlarge the purposes for which the corporation is created and conducted.ll The opinion went on to refer to the decision in Uni- versity v. People. In that case the court had said, . . . the purpose of a college or university is to give youth an education. The money which comes from the sale or rent of land dedicated to that object aids this purpose, land so held and leased is held for school purposes in the fullest and clearest sense.12 The conclusion of the court was that the plaintiff was organized and operated exclusively for religious, charitable and educational purposes within the meaning of the exempting clause. That the transactions yielded some profit was-in the circumstances a negligible factor. Financial gain was not the end to which they were directed. This early case thus clearly shows that in the begin— ning the Supreme Court placed the emphasis on the use of llIbid. 12University v. People, (99 U. s. 309, 324). l9 funds by a tax-exempt institution and not on the source of these funds. The court concluded that to be operated exclusively for exempt purposes meant that the ultimate use of funds was the deciding factor and the fact that some of these funds were obtained from business type ventures was immaterial so long as the business venture, per se, did not become the primary activity of the organization. Two years later in 1926, a similar case was decided by the Board of Tax Appeals. In the Unity School of 13 Christianity case the main difference from the preceding one was that the tax commissioner insisted that several departments.of the corporation such as an inn and publi- cations were conducted in competition with purely commercial business firms. This it was said, deprived the corporation of an exclusively religious, charitable or educational character. The concept of competition had not been intro- duced in the Trinidad case. The Board of Tax Appeals said: there is nothing in the statute which justifies the government's emphasis upon the competitive aspects of its selling. The inquiry must always be whether all of the activities of the organization in question are devoted to furthering its predominent religious, charitable, scientific or educational purposes. The congressional purpose of exemption, made in recognition of the benefit which the public derives, should not be defeated because its incidental fea— tures are to some extent profitable. It is only when such profits or net income are used for private 13Appeal of Unity School of Christianity, (u BTA, 61-70), April 23, 1926. 20 rather than public benefit that congress has taxed them. . . . Congress left open the door of tax exemption to all corporations meeting the test, the restriction being not as to the species of religion, charity, science, or education under which they might operate, but as to the use of its rofits and the exclusive purpose of its existence.1 The Board of Tax Appeals was emphatic again the next 15 year in the Sand Springs Home case. "The test here is not the source of the income but its ultimate destination" it was stated. These three cases, then, conclusively demonstrate the thinking of the courts in the 1920's. However, a decade later the courts appeared to be less definite in their opinion. In the next significant case in the area, Roche's Beach Inc. v. Commissioner of Internal Revenue,16 the Court of Appeals ruled against the taxpayer. This case was different from the preceding cases in that it involved what is now known as a "feeder" com- pany, whereas, the former cases had been concerned with tax-exempt organizations having income producing depart- ments, which in current terminology is called "unrelated business income." Roche's Beach Corporation was organized by a testator to operate his property, collect the income from it, and luIbid. 15Sand Springs Home, Petitioner v. Commissioner of Internal Revenue, Respondent, (6 BTA, 198—217), February 18, 1927. 16 Roche's Beach, Inc. v. Commissioner of Internal Revenue, (96 Fed (2d) 776, Second Circuit), May 9, 1938. 21 then turn the income over to a charitable foundation created by his will. A bathing beach, real estate and equipment rentals, and concessions were the primary sources of income, which in one year amounted to around $85,000. It was not disputed that the income was turned over to the charitable foundation as required by the will. On the one hand, the petitioner claimed that it was merely a company "organized for the exclusive purpose of holding title to property, collecting income therefrom, and turning over the entire amount thereof, less expenses" to an exempt organization. The Board of Tax Appeals, on the other hand, held the corporation was not tax—exempt because its certificate of incorporation gave it broad powers related to carrying on various kinds of business and said nothing of the charitable purposes which it was to serve. The Federal Second Circuit Court of Appeals in its decision did not agree with the position of either side. Since the operation of the bathing beach was extensive, the court felt this was more than just holding title to property and collecting rents. The primary purpose of the corporation was operating a business and hence, was not tax—exempt. The court then discussed the position held by the Board of Tax Appeals. They felt the concept that the corporation's charter must state the charitable pur— poses of the organization was too narrow a view. They said, 22 This does not mean that to come within the_ exemption a corporation may-not conduct business activities for profit. The destination of the in- come is more significant than its source. . . . Exemptions of income devoted to charity are begotten from motives of public policy and are not to be narrowly construed. . . . No reason is apparent to us why Congress should wish to deny exemption to a corporation organized and operated exclusively to feed a charitable purpose when it undoubtedly grants it if the corporation itself administers the charity.1 At this time the court, it seems, was not completely clear in its position. It recognized that there was a difference between a feeder corporation and a non-profit company operating a business type venture of its own. The court held in this case that both situations were tax- exempt unless, as it was in the Roche's Beach situation, the business venture was the major operation and not merely incidental to either holding property and receiving passive income or operating a non-profit organization. The size of the business operation was again con- sidered a deciding factor in the Better Business Bureau of Washington, D. C. case in 1945. The Supreme Court con- cluded, "an organization must be devoted to educational purposes exclusively and the presence of a single non- educational purpose, if substantial in nature, will destroy the exemption regardless of number or importance of truely educational purposes."18 l71pm. 18Better Business Bureau of Washington, D. C. v. United States, (326 U. S. 279), November 13, 1945. 23, One more case early in 1941, clearly showed the court's wavering position when compared to the comments made in the Roche's Beach case. The Regents of the Univer- sity of California owned the entire stock of a corporation organized for the purpose of acquiring land and water rights, construct canals, ditches, reservoirs, and pipe lines, and operate a water distributing system. The university was not served with water by the corporation but its income con- sisted solely Of receipts from sale of water to private consumers. As the only owner, of course, the entire pro— fits Of the company would go to the University of California. The Court of Appeals decided the corporation was not tax- exempt. It was held that it was not Operated "exclusively for educational purposes." The separate legal status of the water company appeared to be an important factor to the court, which said: . during the years involved corporation did not declare any dividends, and hence no income was re- ceived by the university, since, although the univer- sity was sole stockholder, corporation's income was not the university's income and did not accrue to the university until a dividend payable therefrom was declared by corporation.l9 Here the court definitely held a "feeder" to be taxable, whereas, in the Roche's Beach case it had said a "feeder" was tax exempt-unless the business operations became the primary activity of the organization. 19Bear Gulch Water CO. v. Commissioner of Internal Revenue,fi(ll6 F(2d) 975, 9th Cir.), January 13, 1941. 24 By 1950 the entire question came to a head. The courts had shown where the problems lay because of the ambiguity of the law. In the opinion of many, a tax loop- hole needed to be closed, and Congress in 1950, moved to clarify their intentions regarding appropriate activities in which tax—exempt institutions might engage. The two cases which clarified the judicial position were United States v. Community Services20 and C. F. Mueller CO. v. Commissioner of Internal Revenue.2l- The Court of Appeal decisions were handed down in 1951 after the passage of the 1950 tax amendments but both cases referred to tax years prior to 1950 and the arguments were well known prior to the advent of the new tax law since the cases had pre— viously been in the Tax Courts. The Mueller Macaroni case was the one which particularly attracted national and Con- gressional attention. The Community Services case involved a corporation which operated a canteen refreshment service, a coal and wood yard, a filling station, and an electric appliance store for the convenience of employees of a textile company. NO sales were made to the general public. The interesting fact was that all profits of the company were to be turned over to a charitable organization. Because of this latter provision the company claimed to be tax-exempt. 20United States v. Community Services, (189 Fed (2d) 421, 4th Cir.), May 5, 1951. 21C. F. Mueller CO. v. Commissioner of Internal Revenue, (190 F (2d) 120, 3rd Cir.), June 20, 1951. 25 In considering this case the Court made two impor- tant decisions. First, this company was not tax-exempt because it was not organized and Operated exclusively for charitable purposes. The major activities were the supply- ing of services to the textile company's employees and the charitable nature of the company was secondary. Second, the Court said, "Tax exemptions are matters Of legislative grace which must be strictly construed against the tax- payer." In twelve years the Courts had gone from "not to be narrowly construed" in the Roche's Beach case to "strictly construed" in the Community Services case. This constituted quite a change by the Courts. The change in position, of course, was brought about to a large extent by the abuses of the tax-exemption privilege by non-profit organizations. In this case the Court also discussed the important matter of competition. Competition was the prime factor in 1950, leading to the change in public, judicial, and legis- lative sentiment towards the tax-exempt status Of the non- profit organizations. The Court said concerning the problem; Manifestly, a corporation engaged in commercial activities, if exempt from federal taxes, would have a tremendous economic advantage over competitors in the same field. Such a corporation could effectively eliminate competitors, actual and potential, since it could undersell corporations, whose earnings are sub— ject to diminution by federal taxation. It is diffi- cult tO believe that Congress intended to continue such a situation. . . . Had Congress intended to accord tax exempt status to a corporation, regardless of the nature of its own activities, solely because its pro— fits are distributed to exempt organizations, it would have been an easy matter to say this, simply and clearly. . . . these provisions, and these opinions, 26 lend color to the view that tax exemption for a corporation is based on its own activities and pur— poses rather than those of the ultimate recipients Of its income.22‘ Each side in this case had cited many other cases in support Of its position.23 The Court agreed that both had precedent on their side. There had not been consistency in the past. The Court said, "Both the decisions reached on the facts and the views expressed in the opinions are so varied and so divergent, that they cannot readily be reconciled." NO wonder Congress moved to clarify the law in 1950. 22United States v. Community Services, (189 Fed (2nd) 921, 4th Cir.), May 5, 1951. 23Cases cited by taxpayer showing a feeder to be tax- exempt: (1) Trinidad v. Sagrada Orden, 263 U. S. 578; (2) Roche's Beach Inc. v. Commissioner, 2 Cir, 96 F(2d) 776; (8)—Willingham v. Home Oil Mill, 5 Cir, 181 F(2d) 9; (4) Commissioner of I. R. v. Orton, 6 Cir, 173 F(2d) 483; (5) Debs Memorial Radio Fund v. Commissioner, 2 Cir, 148 F(2d) 948; (6) Bohemian Gymnastic Ass'n. v. Higgins, 2 Cir, 147 F(2d) 774; (7) Commissioner v. Battle Creek, Inc., 5 Cir, 126 F(2d) 405; (8) Gimbel v. Commissioner, 3 Cir, 42 F(2d) 616; (9) Southeastern Fair Ass'n. v. United States, 52 F. Supp..2l9; (10) Sand Springs Home v. Commissioner, 6 BTA 198; (ll) Unity School of Christianity v. Commissioner, 4 BTA 21; (12) Estate of Louise V. Simpson v. Commissioner, 2 TC 9 3. Cases cited by government showing a feeder to be taxable: (1) Better Business Bureau of Washington, D. C. v. United States, 326’U. S. 279, 285; (2) National Carbide 933p, v. Commissioner, 336 U. S. 422; (3) Moline Properties v. Commissioner, 319 U. S. 436; (4) Burnett v. Commonwealth Improvement CO. 287 U. S. 415; (5) Bear Gulch Water CO. v. Commissioner, 9 Cir, 116 F(2d) 975; (6) Gagne v. Hanover Water Works CO. 1 Cir, 92 F(2d) 659; (7) C. F. Mueller Co. v. Commissioner, 14 TC 922-Pending; (8) Sun-Herald Corp. v. Duggan, 2 Cir, 160 F(2d) 475; (9) New York v. U. S., 326 U. S. 572; (10) Allen v. Regents of University System Of Georgia, 304 U. S. 439; (ll) Chattanooga Auto Club v. Commissioner, 6 Cir, 182 F(2d) 551; (12) Universal Oil Pro- ducts v. Campbell, 7 Cir, 181 F(2d) 451; (13) Smythe v. 27 Beyond a doubt, the Mueller Macaroni case was the most publicized situation which involved the problems of "feeder income" and "unrelated business income." The Tax Court ruled the income was taxable,2u whereas, the Court of Appeals held that under the extraordinary circumstances of the case, "ambiguity of provisions of the Internal Revenue Code exempting from income taxes a corporation organized for charitable purposes, would be resolved against taxation."25 In 1947, a group of individuals organized a Delaware chartered corporation. The sole purpose of the company was to be charitable in nature in that it was to turn all profits over to New York University for the exclusive benefit of its School of Law. Then the company, with borrowed funds, pur- chased all the outstanding stock of the C. F. Mueller Co., a taxable New Jersey corporation. Next, the shares of the old New Jersey company were cancelled and the two companies were merged together, with the charitable Delaware corpor— ation the remaining organization. NO stockholder was Calif. State Auto Ass'n., 9 Cir, 175 F(2d) 752; (14) Davenport Foundation v. Commissioner, 9 Cir, 170 F(2d) 70; (15) Underwriters Labortories v. Commissioner, 7 Cir, 135 F(2d) 371; (16) Scholarship Endowment Foundation v. Nichols, 10 Cir, 106 F(2d))552; (17) Stanford University Book Store v. Helvering, 65 App D. C. 364, 83 F(2d) 710. 2“C. F. Meuller Co., Petitioner v. Commissioner of Internal Revenue, (14 T.C. 922), May 25, 1950. 250. F. Mueller CO. v. Commissioner of Internal Revenue, (190 F(2d) 120, 3rd Cir.) June 20, 1951. 28 entitled to dividends, profits, or assets of the new company. Finally, no director of the company could receive compen— sation for his services as a director. These were truly involved and unusual circumstances. The Tax Court ruled a tax liability present because it did not meet the test of being "organized and operated exclu— sively for religious, charitable, scientific, literary, or educational purposes." The Court of Appeals, however, ruled no tax liability prior to 1950. The exclusive purpose required by the statute is met when the only Object of the organization involved originally was and continues to be religious, scien- tific, charitable or educational, without regard to the method of procuring2ghe funds necessary to ef- fectuate the Objective, the Court said. Indeed, the Court stated this this had been the predominant point of view for over thirty years. Only with the passage of the 1950 tax law, did the Court feel this type Of income could be held to be taxable. Thus it is not surprising that Congress in 1950, moved to rewrite the sections Of the tax code in regard to tax- exempt institutions. Regardless of what other motives may have prompted their action, it was necessary to clarify their intentions regarding appropriate activities in which a tax-exempt institution might engage. The courts had by this time demonstrated where the problems lay. First, and foremost, it was necessary to define what was meant by the 26Ibid. 29 term "organized and Operated exclusively" for charitable purposes. It had been shown that there was a difference between a "feeder" company, a separate legal entity pro- ducing income for a non-profit institution, and an insti- tution itself engaging in a commercial enterprise for the production Of income. The courts had tried to draw a fine line between situations that were taxable and those which were not, depending on the individual circumstances, but in the end, had admitted that the present law was ambiguous and in the Mueller Macaroni case felt relieved that Congress had finally tried to clarify the situation.27 The courts had also shown, that Congress must decide as a matter of general policy, how much, to whom, and what type of aid in the form of tax-exemption they intended to extend to non-profit organizations. In the Community Ser- viggg case the competition factor had been discussed as an important item to consider. We have seen how the courts developed the issues, it is now necessary to investigate what Congress did to alleviate the situation. The next section includes a study of the hearings of the House Ways and Means Committee and the Senate Finance Committee. The reports of these hearings shed light on the thinking of Congress relative to the tax amendments passed in 1950. 271pm. 30 1950 House Ways and Means Committee Hearings In the process of presenting the new 1950 legis- lation, President Truman sent in part the following message to the Committee on Ways and Means Of the House of Repre- sentatives: Some tax loopholes have also been developed through the abuse Of the tax exemption accorded educational and charitable organizations. It has properly been the policy Of the Federal Government since the begin- ning of the income tax to encourage the development of these organizations. That policy should not be changed. But the few glaring abuses Of the tax- exempt privilege should be stopped. Responsible educational leaders share in the con- cern about the fact that an exemption intended to protect educational activities has been misused in a few instances to gain competitive advantage over private enterprise through the conduct of business and industrial Operations entirely unrelated to edu- cational activities. . . . These and other unintended advantages can and should be removed without jeopardizing the basic purposes of these organizatéons which should rightly be aided by tax exemption.2 The Government's position was presented by J. W. Snyder, Secretary Of the Treasury, and by Vance Kirby, tax legislative counsel of the Treasury Department. Secretary Snyder stressed that the proposed tax changes were neces- sary (1) because the courts continued to interpret the law in such a manner as to make the ultimate destination of income the test of tax exemption, and (2) because of the unfair competition which these institutions enjoyed in their commercial activities. He said, "The correction of 28Revenue Revision of 1950, Hearings, Committee on Ways and Means, House of Representatives, 81st Congress, 2nd Session, Vol. 1, Item 294 (L. C. 50-60569) Y4. W36: 8 32/55/V.l, p. 4. 31 present abuses, which shift additional burdens to the rest Of the population, becomes essential for reasons of equity."29 The activities which he mentioned were busi- ness undertakings, including the production of automobile parts, chinaware, and food products, and the Operation of~ theaters, oil wells, and cotton gins. He also particularly stressed the sale—and-lease—back type of Operation where the exempt institution with borrowed funds would purchase real estate and then rent it back to the former owner. TO meet the above problems he recommended that all such in- come which was, as he felt, clearly-unrelated to the pri- mary function of the tax-exempt organization, should be taxed at regular corporation income tax rates. Mr. Vance Kirby in his testimony gave in brief the historical background Of the problem. He felt that Congress had granted tax exemption to charitable and educational institutions to encourage their particular altruistic or group-interest activities, which generally were not con- ducted for profit. However, nowhere did it appear to him, that Congress contemplated that such organizations would engage in the active conduct Of a business. The real aim was to protect these charitable and educational institutions. He stated; If such activities are conducted by the exempt organ- ization itself, the exemption Of the organization would not be disturbed, but such business income would be segregated and subject to tax. . . . Moreover, 29Ibid., p. 19. 32 only business income which is not incident or related to the exempt purposes would be taxed. . . . There is no intent to reverse the long-standing policy of giv— ing preferred treatment to such organizations; the only purpose is to terminate the abuses. Robert L. Doughton, chairman Of the Committee on Ways and Means, summed up the committee's reaction to the pro- posals submitted by the Treasury Department when he said: "You see, we not only have the purpose, as I understand it, Of closing lOOphOles and Of receiving additional revenue, but at the same time, as far as we can, equalizing compe- tition among business people."31 In the end the prevention of unfair competition became the prime reason for the com- mittee's approval of this section of the new tax law. In obvious reference to the Mueller case, committee member Dignell of Michigan stated, "Eventually all the noodles in this country will be produced by corporations held or created by universities."32 Most Of the testimony before the committee on this particular part of the proposed tax amendments was in agree- ment with the Government's position; the members of the educational community did not have time to prepare their objections. However, as will be discussed later, they did present their side Of the question to the Finance 3OIbid., pp. 165—167. 31Ibid., p. 11A. 32"Colleges, Charities, and the Revenue Act of 1950," Yale Law Review, LX (May, 1951), p. 851. 33 Committee Of the Senate. There were three exceptions. Paul Cabot, Treasurer of Harvard University,33 J. R. Killian, President of the Massachusetts Institute of 34 Technology, and K. E. Fauver, attorney for Oberlin College35 testified that they were particularly opposed to the section which taxed the "unrelated business income" Of educational institutions. They were not Opposed, how- ever, to the taxation of "feeder" type companies. A most interesting discussion took place during the hearings between Representative Boggs, a committee member, and Mr. T. J. Lynch, another representative Of the Treasury Department. Representative Boggs asked questions concerning the definition of unrelated business, and he was most inter- ested in the effect the tax proposals would have on the operation of educational institutions. For example, he asked, Is it not also true that if the net effect Of this proposal is to adversely.affect private educational institutions, that the result will be a greater con- centration in tax-supported institutions, State insti- tutions; is that not logical to assume? Again he asked, As a matter of policy, should Congress do anything that will adversely affect the private educational institutions in the United States at this time? 33Revenue Revision of 1950, Hearings, Committee on Ways and Means, House of Representatives, 81st Congress, 2nd Session, Vol. 1, Item 294 (L. C. 50+60569)Y4. W36: R 32/557V.1, p. 494. 3uIbid., p. 500. 35Ibid., p. 554. 34 Mr. Lynch found these questions debatable. He did not deny that the new tax proposals would diminish the revenue received by educational institutions from these commercial activities. However, he saw two problems. On the one hand, was the interest in educational and charita- ble organizations and the protection of their usual activi- ties. On the other hand, he felt, was the whole question of unrelated business activities and competition with tax- paying business firms. Representative Boggs ended the exchange of views by saying that it seemed to him that if the government started taxing unrelated business income, the next logical step would be the taxation of normal investments Of colleges and universities, such as real estate, and stocks and bonds. He was afraid the definition of unrelated income could be easily changed in the future and the current bill opened the door to such possibilities.36' 1950 Senate Finance Committee Hearings The House of Representatives passed the tax measure relative to tax-exempt institutions substantially as it had been presented by the Treasury Department.37 It then came before the Senate Finance Committee. In contrast with 36Ibid., pp. 174—176. 37See Chapter III for the exact provisions of the act relative to the tax-exempt sections. 35 the Ways and Means Committee hearings, the majority of the testimony before the Senate Finance Committee was Opposed to at least part of the proposed new legislation. Secretary of the Treasury Snyder was again first to testify in favor of the proposed tax changes. He insisted that he was thoroughly in sympathy with the_policy of en- couraging charitable and educational institutions with a favored tax policy, but he feared they were in danger of being discredited because a minority abused their tax privileges. The new tax measures, he felt, would protect the majority of these institutions from being so discredited, would prevent unfair competition, and would close a tax loophole which he feared would grow larger. He admitted. the present revenue loss was not large, but in the future he could see a prospective annual loss of $100,000,000 if effective remedies were not promptly adopted. Of special concern to Secretary Snyder were the sale- and-lease-back operations. Whereas, the proposed tax law would continue to leave most rental income tax free for non—profit institutions, he did not think this should be true Of the sale-and-lease—back transactions where the pur- chase was made with borrowed funds. He called this "trading on their tax exemption." It was not only profitable to the tax-exempt organization but was also profitable to the leasees because it enabled them also to share indirectly in the non-profit organization's tax exemption. With the rental income being tax—free to the lessor, they would be 36 in a position to pass on part of the savings to the leases. This unfair competition to other investors he felt should be corrected.38 Three other individuals representing large organ- izations also testified in favor of the tax bill. First was Charles R. Sligh, chairman of the taxation committee of the National Association of Manufacturers, who said, "The Federal income-tax exemption privilege should be eliminated with respect to that part of their net income which is derived from the actual Operation or management "39 Of business enterprises. Second, was a statement by the American Federation of Labor. In part their statement said, In general, we are thoroughly in accord with the pro— posal for closing up loopholes in existing tax laws. Any and all exemptions or loopholes that confer special privileges or benefits on certain groups of citizens or organizations should be eliminated. Tax exemption for nonprofit educational, charitable, fraternal, religious, or labor organizations should not extend to income or property not employed by such organizations in the carrying out of their primary functions. The third individual was John Dane, Jr., representing the United States Chamber of Commerce. "We favor the closing Of any real loopholes which exist in connection with section 101 organizations, particularly where they Offer 38Hearings Before the Committee on Finance, U. S. Senate, Blst Congress, 2nd Session, on H. R. 8920, 1950 (Washington, D. C.: U. S. Government Printing Office, 1950), pp. 6-7. 4O 391bid., p. 421. Ibid., p. A82. 37 unfair competition to taxable institutions," he said. However, Mr. Dane recommended that perhaps some changes were needed in the proposed legislation in order that no hardships would come to bona fide undertakings which were in the public interest. He cautioned Congress to move slowly in this direction, stating that the implications of the tax on "unrelated business income" were enormous, going to the very heart of the American system of charita— ble contributions!ll Finally, Noah M. Mason, Representative from the State of Illinois and member of the House Committee on Ways and Means, had an article, which he had authored for the Reader's Digest, inserted in the Official records of the Senate Fi— nance Committee's procedings. This article named five widely used devices to escape taxes: the charity trust, the edu- cation, the religious, the co-operative, and the labor union. In discussing the educational device he listed eight schools who he.knew were dealing in business activities.“2 One Of these, New York University, he said, had admitted they would have had to pay $1,500,000 in taxes each year if their “libid., p. 8u8. u2Ibid., pp. 828-829. The eight were: University of Michigan, Willow Run Airport; Wittenberg College, a super- market; Girard College, coal mines; Oberlin College, 5 and 10 cent store; Washington University Of St. Louis, business buildings and railroad freight yard; University of Louis- ville, horse racing business; Yale University, sale and lease back of department store to R. H. Macy & Co.; and New York University, macaroni factory, piston ring factory, pottery factory, and a leather goods company. 38 business activities had not been under the University's protective wing. Mr. Mason was adamant that such activi- ties should not be permitted to continue tax free. By the time the tax measure came before the Senate Finance Committee the colleges and universities had organ- ized their forces against the proposed taxation of their "unrelated business income." James R. Killian, Jr., President of Massachusetts Institute of Technology, repre- sented the Association of American Universities, Harold E. Stassen, then President of the University Of Pennsylvania, represented the American Association of Colleges, and Carter Davidson, chairman of the committee on taxation and financial reporting to the Federal Government, represented the American Council on Education. President Killian was the first to testify. He. stated that any change in the revenue laws should be aimed not at the university but at the separate entity. Any ef- fort to tax the university or some part of it would violate the historic principle of tax—exemption. His organization felt strongly that unrelated business enterprises held by separate entities should be taxed, but the direct taxation of the educational institution for several reasons should never be taxed. First, the breach in the tax-exemption principle would be the initial step towards a gradual destruction of the principle. Second, the problem of try— ing to discriminate between the types of income received by a university would arise. Hair line decisions would 39 have to be made to distinguish between taxable and non- taxable income and would involve the schools with adminis- trative uncertainties and the expense Of litigation which might ensue. Third, colleges should be treated on the same basis as churches, as their status was similar and both needed the same protection. Fourth, the valuable national service performed by universities in war and peace should be encouraged to continue as in the past. The national policy should be to help maintain the strength and growth of these institutions and even to help them to help themselves. "Neither they (the Government) nor the public institutions should be handicapped by impairment Of their tax exemption, particularly when they are struggling to keep their heads above water at the present time," he said.“3 When Senator Kerr asked about the situation in which a business was operated by a university, President Killian said he thought the university should still be tax-exempt. President Killian hoped that this situation could be handled by allowing the universities to police themselves. The Association of American Universities which he repre- sented, had taken a firm stand that it was improper for a college or university to undertake to own or Operate an unrelated business enterprise. Great influence could be brought to bear on association members he was sure. “3Senate Finance Committee--l950 Tax Revision, Blst angress, 2d Session on H. R. 8920 (Washington, D. C.: U. S. Government Printing Office, 1950), pp. 375-385. 40 By far the most vocal individual to appear before the Senate Finance Committee was Harold E. Stassen. The proposed tax on the "unrelated business income" he con— tended was a thinly veiled attempt to weaken the colleges and universities, as a prelude to bringing them under Federal control. It would immediately give the Treasury Officials the authority to tell the schools what activities they might enter, through the device of passing upon activi— ties as related or unrelated. The effect would be govern- ment censorship, which would be very serious to the academic and scientific freedom of the educational institutions. In a strong statement he said, I believe that the objective of the men in the Trea— sury who drew this bill without consultation with the American Colleges and Universities was to bring the American Colleges and Universities under the control of the Federal Government. And I am against that ob- jective. . . . My position is that no one from the exterior can wisely define what is a related or an unrelated activity of a university or a college; and therefore you should not attempt to define and tax unrelated activities of universities and colleges. President Stassen stated that both he and the associ- ation which he represented agreed that the feeder type organ- ization should be taxed. The dividend income from the feeder company should be treated in the same manner as dividend income from any other domestic corporation. The fact that feeders were wholly owned by the tax—exempt organization should make no difference. A separate entity organized under the laws of a state, not chartered for educational purposes, that is, not having a faculty and a student body, can engage in any business whatsoever under the laws Of that state 41 and then also can be taxed under the present laws. . . . And I immediately draw the line between what the university and college does itself, under its own Charter, as compared to what might be done by some special foundation or special corporation. If then, an educational institution did itself engage in commercial activities, he felt the proper action was to bring an ultra vires suit against the institution rather than to breach the traditional principle of tax—exemption Of educational institutions. The Government should en- courage these institutions rather than attack them in this "reprehensible manner," he stated. In conclusion he said, "1 respectively submit that this committee and the Senate should insist that educational institutions should keep their rightful place alongside of the churches as tax exempt uncontrolled institutions serv— ing the higher ideals of mankind."uu In addition to the points brought out by presidents Killian and Stassen, Carter Davidson reminded the Senate Finance Committee "that colleges are not, and never have been, profit-making, that every cent Of income merely in- 45 creases our public service." He reported that his Com- mittee on Taxation and Financial Reporting to the Federal Government for the American Council on Education had two years previously made a survey Of the sources Of college income and their best estimate was that a maximum of $10,000,000 might be subject to the proposed new taxes. 1M1bid., pp. 498—514. uSIbid., p. 526. 42. They had found total endowment funds to be approximately two billion dollars, which invested at 5% would bring a return Of $100,000,000. The Committee had then calculated that at most 10% Of this would be Of the type covered by the proposed taxes. The plugging up of such a small "loophole" would be of little help to the Federal budget, he asserted. NO one on the Senate Finance Committee questioned his estimates. Several other educators either sent letters to com- mittee members which were put into the official record.“6 or appeared before the committee in opposition to the pro— posed tax changes. For instance, Stuart Hedden, trustee of Wesleyan University of Middletown, Connecticut, stated the new law "will introduce the revenue collector into the front Office of every college in America.”7 One final subject which brought considerable comment, was that of the proposed tax on sale-and-lease—back income where the purchase was made with borrowed funds by the tax- exempt organization. The only loophole that Mr. Hedden could discern was in the case where the rent deduction for the lessee was greater than the presale depreciation charge or there had been a reportable tax loss on the sale. He u6Letters inserted in the record were from: Ibid. 3 p. 577, P. C. Cabot, Treasurer, Harvard University; p. 583, J. F. Meek, Treasurer, Dartmouth College; p. 585, A. W. Griswald, President, Yale University; p. 587, R. P. Briggs, Financial Vice President, University of Michigan; and p. 680, C. Barton, President of the Board, Johns Hopkins University. u7Ibid., p. 567. ————-—- 43 thought that in these cases the tax should be applied to the lessee in order to close the supposed tax loophole.48 Carter Davidson had held a similar position in his testi- mony. His comments on the subject covered most Of the points. Investment of college funds in real estate (sec 423) is the Oldest and most respectable of all forms Of in— vestments. Colleges have been invested in such invest- ments because of long-range values. The fact that in some cases the property is subject to heavy mortgages should not alter the principle of tax exemption on the rent to a college owner, for the college must pay interest on the mortgage, and the holder of the mort- gage pays the tax. . . . The principle Of taxation of borrowed funds is a new and potentially dangerous one. Again there seems to be no reason why the former owner of a building should not have the right to lease the prOperty. He may be the only possible renter. If the sales price and the rental are fairly arrived at, and if there is no agreement for later repurchase at a fixed low price, we can see nothing unfair in the so- called-lease-back. Only colleges and insurance com— panies can be in a position to make such long-term frozen investments. . . . In any case, the Commissioner of Internal Revenue has adequate legal means to deal with this problem, through taxes on the seller-lessee. It should be remembered that the seller is seeking fluid funds from the sale to expand his business; the result should be, and has been in every case known to us, an increase in the corpprate income and in the Federal tax on that income. 9 In case the sales price and the rental were not fairly arrived at, the legal means available to the Internal Revenue Service to which he referred were (1) in the case where the rental charge was higher than previous depreci— ation, the excess could be disallowed as a deductible ex— pense; and (2) in the case where the rental fee is small because the property had been sold at a low price to the “81bid-. p. 567. ugIbid., p. 527. 44 tax—exempt organization, the loss.on the sale could be disallowed for tax purposes. In either case there would be no tax loss and hence no tax loophole. In both cases, however, the seller-lessee is the one who pays the tax. Mr. Brown, a trustee and lawyer for Union College at Schenectady, New York, cited a most unusual and actual case where his institution had purchased seven Allied Stores and then leased them back. The store buildings had a book value of $16,000,000, a 50% mortgage, and an ap- praised value Of $24,000,000. They had been purchased by a separate legal organization on behalf of Union College for $16,750,000 with $12,000,000 borrowed from an insurance company and $4,750,000 borrowed from a bank. In his testi— mony Mr. Brown attempted to show that even though the rental income was tax free, the government had-not lost any tax revenue. Prior to the sale, Allied had annual depreciation of about $259,000 and paid interest of $330,000 on the mortgage, giving a total deductible expense of $589,000. Their rental payments for the first year were $1,141,000. It would appear then that the government had lost taxes on the difference of $552,000. However, Mr. Brown pointed out that the Union College subsidiary had paid out a total of $523,500 in interest on the mortgages, consequently, came close to off-setting the additional deduction available to Allied. Finally, since during the past five years Allied had made an average of a 30% return on current assets, the additional $8,000,000 in working capital received from 45 the sale of the building would add another $2,400,000 to taxable income. This, Mr. Brown felt, showed that the government had gained tax revenue rather than losing it. In a lively discussion between Mr. Brown, Senator Kerr, Senator Milliken, and Senator Taft, it was brought out that the large loans to the Union College subsidiary had been made possible because Of the good record made by Allied and also because the rent to Union College was tax free. In fact it was shown that Union College would net almost nothing for the first thirty years; the entire rent income going to pay the interest and principal of the loan. Senator Taft felt this to be a very unbusiness-like, shoe- string transaction for a school to become involved in. Mr. Brown, however, said it was the only way a "poor" school like Union could get ahead. The point being that at no present cost to the college, they would own after thirty years assets which they figured would still have a value Of at least $5,000,000 and would receive the income from the prOperty to be used for operations. The Senators also argued that just because Allied had been profitable in the past, that was no guarantee that they would continue to be in the future. On this assumption, they felt, rested the case that the government would not lose any taxes in the lease—back transaction. It is interesting, that in his presentation, Mr. Brown failed to include the fact that the $330,000 interest paid by Allied prior to the sale had been taxable income to 46 their creditors. Also, he passed over quickly the point that the interest paid after the transaction to the in- surance company was tax free since the insurance company was also a tax-exempt organization. His basic argument seemed, however, to be quite correct and in the end the committee's main disapproval of such a transaction was due to the fact that the large loans, up to 100% of the pur- chase price, were only possible because the rent income was tax free. This was unfair competition to other in- vestors they felt.50 The Committee on Financial Support and Taxation Of the Association of American Universities also sent a report to the Senate Finance Committee in which they reiterated the same points as had been brought out in the previous testimony. They also could see no more objection to a university than to anyone else becoming the owner of fixed assets through sale-and-lease—back operations. They could not understand how the rental income from this type of transaction differed from the rentals from other real estate investments which were tax-exempt.51 The testimony of Clarence Schock, president of SICO Co., was different from the others in that he did not repre- sent an educational institution but a non-profit corpor- ation designed to promote public education in the State of Pennsylvania by marketing petroleum products and turning the profits over to public educational institutions. In 5°ibid., pp. 550-566. 51Ibid., pp. 573-57u. 47 effect he represented a feeder type organization and felt it should be tax-exempt. His argument was the SICO taxed itself 100% to aid public education. If Congress were to tax them, it would be the same as taxing the State Of Pennsylvania which he did not believe Congress aimed to do either directly or indirectly.52 His assumption that since his organization aided public education, and conse— quently should be considered as a state organization, ap- pears to really stretch the point. A private company can hardly be considered a state organization. His best argu- ment would have been that his foundation performed a public service and no profit was to go to private individuals. In the end, the position of the two sides can be con- densed as follows. On the one hand, the government wanted to close a tax loophole and also to prevent unfair compe- tition between tax-exempt institutions and commercial busi- ness firms. On the other hand, educators urged that their tax-exempt status be left untouched and feared a step to- wards government control would result from the proposed legislation. The tax bill as finally passed attempted to satisfy both groups as far as possible. A tax was levied on both "feeder" companies and on the "unrelated business income" of educational and charitable institutions to cor— rect the unfair competition; however, the bill contained provisions exempting all activities which could possibly 52Ibid., p. 537. 48 be considered as related to the Operation of a college or university, save only the one of producing income for the institution. In Chapter III the provisions of the law regarding the status of these organizations will be examined in detail. CHAPTER III THE CURRENT LAW AND ITS INTERPRETATION Current Provisions of the InternaI‘Revenue COde General Sections 501 to 514 of the 1954 Internal Revenue Code are the sections primarily involved with the tax-exempt status of educational institutions. With only minor techni- cal changes these sections are the same as those which had been in the previous 1939 Code as amended in 1950. Section 501(0) lists seventeen classifications of tax-exempt organ- izations. The third class which covers educational insti— tutions says the following are exempt: (3) Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or for the prevention of cruelty to children or animals, no part of the net earnings of which enures to the benefit Of any private shareholder or individual, no substantial part of the activities of which is carrying on propa- ganda, or otherwise attempting, to influence legis- lation, and which does not participate in, or inter- vene in (including the publishing or distributing of statements), any political campaign on behalf Of any candidate for public office.1 Four points stand out. To be tax—exempt the organ— ization (1) must be organized and Operated exclusively for O 1Internal Revenue Code, 1954, Sec. 501(c)(3). 49 50 the exempt purposes, (2) must have none of its earnings inure to private individuals, (3) must not carry on propa- ganda or try to influence legislation as a substantial part of its activities, and (4) must not participate in political campaigns. Feeder Organizations In the sections subsequent to Section 501, Congress put hedges about the activities of these organizations to insure that they would not abuse their tax—exempt privi- leges. The first hedge is the denial of exemption to a feeder organization (Section 502). The Code describes such an organization as one Operated primarily to carry on a trade or business for profit; which profit is payable in its entirety to an exempt organization. However, the Code brings out that the term "trade or business" does not in— clude the mere rental of real property or personal property leased with the real property. Organizations which only hold title to property, collect the rent, and turn the rent less expenses over to an exempt institution are specifically listed as tax-exempt in Section 501(c)(2). As brought out in Chapter II, Congress denied exemption to feeder organ— izations, not so much as a tax policy, but more as an economic principle of promoting equal competition with ordinary business firms. 51 Prohibited Transactions The second hedge is that of denying exemption if the organization engages in certain prohibited transactions (Section 503). This section of the law does not apply to religious, medical, or educational institutions having a regular faculty, curriculum, and enrolled student body, so is of only passing interest to this study. Of the six 'categories of prohibited transactions, five are specific and one is a catch-all provision. The five have in common the feature of prohibiting transactions between the organ- ization and its creator or large contributor where the indi- vidual receives some advantage from the transaction. The prohibited activities are loans, payment for services, rendering services, purchases, and sales between the exempt organization and a substantial contributor where it can be demonstrated that the transaction was not at arm's length and the individual received preferential treatment. The sixth prohibition denys exemption if a substantial portion Of the income or corpus of the organization is diverted to the creator or major contributor. In addition section 504 of the Code prohibits the accumulation Of unreasonable amounts Of income and the misuse Of these earnings in a manner detrimental to the exempt purposes of the organization. Unrelated Business Income Sections 511—513 deal with the problem of unrelated business income of otherwise tax—exempt organizations. 52 This third hedge is the companion measure to the one which taxes feeder organizations and is again directed primarily at the problem of unfair competition. Section 511 levies regular corporate income tax rates against the unrelated business taxable income Of all 501(c)(3) organizations ex- cept churches and conventions or associations Of churches, and also on a few of the other seventeen classifications of exempt organizations listed in section 501(c). However, most Of the tax-exempt mutual type institutions such as social clubs, civic leagues, fraternal associations, and voluntary employees beneficiary associations are not in- cluded.2 Of particular interest is the fact that this section of the Code includes taxation of the unrelated business in- come Of state colleges and universities. They were added to the Code in 1951 as a specific item. This caused a considerable amount of discussion since it involved inter- governmental taxation. Governments have usually refrained from taxing the operations of another level Of government 2The organizations subject to the tax are: Sec. 501 (c)(2) Corporations merely holding title to and collecting rent from real estate for another tax-exempt organization; Sec. 501(c)(3) Charitable, scientific, literary, and edu- cational corporations and foundations; Sec. 501(c)(5) Labor, agricultural or horticultural organizations; Sec. 501(c)(6) Business leagues, chambers of commerce, real estate boards, and boards of trade; Sec. 501(c)(14, B&C) Mutuals: building & loan associations, cooperative banks, and mutual savings banks; Sec. 501(c)(l7) Trusts providing employee supplemental unemployment compensation benefits. 53 as a type of subsidy to assist the public interest, and because the constitutionality of such taxation has Often been in doubt. This section still stands in the Code with- out interpretation by any major court case decisions probably because very few state educational institutions have become involved in operations which produce unrelated business income.3 The Code attempts to carefully define the taxable un- related business income to which the tax rates apply. In the first place, an unrelated trade or business is one that is not substantially related to the exercise or performance Of the purpose or function constituting the basis for which the organization receives its tax-exempt status. There are three specific cases listed in the Code where the trade or business is considered as related and therefore exempt. They are (l).where the work in carrying on the operation is performed without compensation, (2) where the Operation is carried on by the organization primarily for the con- venience of its members, students, patients, Officers, or employees, and (3) where the Operation is the selling of merchandise, substantially all of which has been received by the organization as gifts or contributions. In the second place, the trade or business must be regularly carried on by the tax-exempt-organization to be subject to the tax. For example, if a charitable 3See Chapter V for information from a recent survey on the degree of involvement by these schools in this area. 54 organization gives an occasional dance to which the public is admitted for a charge, hiring an orchestra and enter- tainers for this purpose, it is not regularly carrying on a trade or business. Likewise, a sandwich stand operated during the week of an annual county fair is not regularly carrying on a trade or business. However, if an organ— ization operates a public parking lot one day each week, it will be considered as regularly carrying on a trade or business.“ The Code in section 512(b) also lists several items which are excluded in calculating unrelated business tax— able income. They are: l. Dividends, interest, annunity, royalty, and most rental income. Rental income from a "business lease," however, is part of the unrelated busi— ness income. See the next section, page 56 for a discussion of the "business lease." 2. Gains and losses on the sale Of property other than stock in trade which is held primarily for sale to customers in the ordinary course of business. 3. Income from research performed for Federal, State and local governments; income from all research performed by colleges, universities, and hospitals; and income from any fundamental research the results of which are freely avail- able to the public. 4. A deduction as a charitable contribution of up to 5% of the net income without regard to this section. 5. A specific deduction of $1,000. “U. S. Code Congressional Service, 8lst Congress, 2d Session, 1950, p. 3165. 55 It appears quite evident from the above provisions that Congress made a real attempt to leave the normal operations and normal investments of educational insti- tutions tax free. For example, a wheat farm operated by an exempt agricultural college as part Of its educational program would be considered a related business, and so would be income from football games Operated as part Of athletic activities of the school. In addition, dining halls and restaurants Operated for students and staff are exempt, but it is not clear what the consequences are if one—half or more Of the business came from the general public. In 1958, a ruling by the Internal Revenue Service stated that a corporation organized to Operate a book and supply store and a cafeteria on the campus of a state uni- versity is tax-exempt. In this case the operations were primarily for the convenience of the students and faculty, no part Of the earnings inured to the benefit of any private individual, and thus the organization was found to be an integral part of the educational institution.5 With the emphasis in this ruling on the word primarily, it seems to give the implication that if over half Of the business was with the general public, then its income would be taxable as unrelated business income. However, even in this situ- ation it could be easily argued that the primary purpose 5Rev. Rul. 58—199, IRB 1958. 56 of the operation is for the convenience of the students and staff. The question seems to revolve around the in- tent and major purpose of the operations. To date, this is one Of the_controversial, unsolved problems. On the other hand, the manufacture and sale of automobile tires by a college would be considered unrelated and it would not become substantially related even though some students as part Of their educational program performed some minor 6 clerical or bookkeeping functions. Business Lease Income As a fourth hedge, rental income from property which is purchased with borrowed funds is subject to taxation. The Code, section 514, calls this a "business lease" and its definition has two basic parts. First, there must be a long term lease—-of more than five years. Second, the leased property must be subject to a business lease indebted— ness. This includes any indebtedness incurred in acquiring or improving the property, whether incurred before, at the time Of, or after, acquiring or improving the property, if the indebtedness is demonstrably incurred in connection with the acquisition or improvement of the property. The same percentage Of the rental income must be included as unrelated business income as the business lease indebted- ness is to the adjusted basis of the property at the end 6U. S. Code Congressional Service, 81st Congress, 2d Session, 1950, pp. 3165-3166. 57 Of the year. Thus from property with a basis of $100,000 and indebtedness of $75,000 at the end of the year, the Code requires that 75% Of the gross rental income be in- cluded as an item of gross income derived from an unrelated trade or business. The same percentage is used in calcu— lating expense deductions allowed in computing the unre- lated business taxable income. Summary To summarize, as the Internal Revenue Code now stands, educational institutions are tax-exempt although an organ- ization which is educational in nature and purpose but is not in the regular sense a school with a faculty and student body may lose its exempt status by engaging in certain pro- hibited transactions. In addition, the exemption privilege does not include "feeder" organizations which merely pro- vide income for the tax-exempt educational institution. Finally, while not losing their tax-exempt status, edu- cational institutions are required to pay income taxes on "unrelated business income" and on rental income from a "business lease" even when these activities are owned and operated by the educational organization itself. Internal Revenue Regulations and Rulings Recent regulations and rulings are relatively few in the area of educational institutions and their activities. Primarily the rulings that have been issued are concerned 58 with the determination Of which activities are related and which are unrelated to the exempt purposes of the tax— exempt organization. While the regulations issued by the Internal Revenue Service clarify to a degree the interpre- tation Of the Code, they in most cases add nothing new to what is said in the Code itself. There are a fex exceptions, Of course. As one author said, To determine, in a particular instance, whether a commercial activity is substantially related to the exempt purposes of the organization obviously is a difficult task. The only delineation of the loose term "unrelated" appears in a few examples cited in the 1950 Committee Reports which are in turn re- peated in the Regulations.7 Internal Revenue Regulations In a general way, the Regulations stress that in order for an organization to be tax-exempt, it must pass the organ— izational test and the operational test. Organizationally, the articles or charter Of the organization must limit its purposes to one or more exempt purposes and must not ex- pressly empower the organization to engage, other than as an insubstantial part of its activities, in activities which in themselves are not in furtherance of one or more exempt purposes. The operational test states that the organization must engage primarily in activities which accomplish one or more exempt purposes, must not have its net earnings in 7Maurice C. Greenbaum, "Business Dealings by Chari- ties," New York University Fourteenth Annual Institute on Federal Taxation (New York: Matthew Bender & Co., 1956), p- 133- 59 whole or in part inure to the benefit of private share— holders or individuals, and must not be an "action" organ- ization. An action organization is one that attempts to influence legislation or participates in political cam- paigns.8 The Regulations do attempt to carefully define the word "educational" as used in this section of the Code. They say: (i) In General. The term "educational," as used in section 501(c)(3), related to - (a) the instruction or training Of the individual for the purpose of im- proving Or developing his capabilities; or (b) the instruction of the public on subjects useful to the individual and beneficial to the community. An organ- ization may be educational even though it advocates a particular position or vieWpOint so long as it pre- sents a sufficiently full and fair exposition of the pertinent facts as to permit an individual or the public to form an independent Opinion or conclusion. On the other hand, an organization is not educational if its principal function is the mere presentation of unsupported opinion. (ii) Examples. (1) An organization, such as a pri- mary or secondary school, a college, or a professional or trade school, which has a regularly scheduled cur- riculum, a regular faculty, and a regularly enrolled body of students in attendance at a place where the educational activities are regularly carried on. (2) An organization whose activities consist of presenting public discussion groups, forums, panels, lectures, or other similar programs. Such programs may be on radio or television. (3) An organization which presents a course of instruction by means of correspondence or through the utilization of television or radio. (4) Museums, zoos, planetariums, symphony orchestras, and similar organizations.9 8Reg. #l.501(c)(3)-l(b & c), Standard Federal Tax Re orts, Vol. 3, #3032 (New York: Commerce Clearing House, 1986), pp. 36,025-36,028. 9Reg. #1.501(c)(3)-l(d), Standard Federal Tax Re- orts, Vol. 3, #3032 (New York: Commerce Clearing House, 19 , p. 36,029. 60 Thus it is clear that "educational" means consider- able more than just schools on the primary, secondary, and collegiate level. However, this study is concerned pri— marily with the type given in-example (1) above. In addition the Regulations give a liberal interpre- tation to the word "exclusive" in the Code. An organization is considered to have met the requirements of section 501 (c)(3) even if it operates a trade or business as a sub- stantial part of its activities, if the operation of the trade or business is in furtherance of the organization's exempt purposes and if the trade or business is not the pri- mary purpose of the organization. The Regulations state in several places that all the circumstances must be considered, including the size and extent of both the trade or business and the exempt activities, in determining the primary pur— poses of the organization. In other words, each case has to be decided on its own merits.10 The Regulations, with one exception, add little to the Code in the area of feeder organizations. They do ex— plain, however, that if a subsidiary of an exempt organ- ization is itself exempt as an integral part Of the exempt activities Of the parent organization, the exemption would not be lost because, asla matter of accounting, the subsi- diary derives a profit from its dealings with its parent 10Reg. #l.501(c)(3)—l(e), Standard Federal Tax Reports, Vol. 3, #3032 (New York: Commerce Clearing House, 1965). p. 36,031. 61- organization. As an example, if a subsidiary furnishes electric power exclusively to its parent organization, the subsidiary would not be subject to taxation. However, if the primary purpose of the subsidiary is to provide electric power to outside consumers and only incidentally to the parent organization, it would be subject to taxation.ll- In expanding sections 511—513 of the Code relative to the taxation Of unrelated business income, the Regulations add several points not clearly stated in the Code. First, the Regulations explain that the section which includes, schools operated by state and local governments as subject to this tax does not include elementary and secondary schools operated by such governmental units. Only colleges and uni- versities are subject to the tax on unrelated business in- come.12 In discussing the exception granted churches from the tax on unrelated business income, the Regulations carefully limit the meaning of the word church as used in the Code in this connection. The organization must be a church or an association or convention of churches which actually carries on religious services as its primary activity. Religious llReg. #l.502-l, Standard Federal Tax Reports, Vol. 3é #3203 (New York: Commerce Clearing House, 1966), p. 3 ,0 0. 12Reg. #l.511-2(a), Standard Federal Tax Reports, Vol.63, #3236 (New York: Commerce Clearing House, 1966), p. 3 115. 62 organizations, including religious orders, if not them- selves churches or conventions of churches, and all other organizations which are operated under church auspices, are subject to the unrelated business income tax, whether or not they engage in religious, educational or charitable activities approved by the church.13 Church related col- leges would clearly be in this group subject to the tax. A recent court case in this area involved the Christian Brothers Winery of California. The organization is'a membership, non-profit educational corporation, all of whose members are members of a religious order. The Tax Court and the District Court both ruled that since the pri- mary purpose of the organization was educational and the organization itself was not a church, even though operated by a religious order, the corporation would have to report all income derived from the Operation of the winery as an unrelated business income.1u Another point explained in the Regulations is the meaning of rental income received from investments in real estate which basically is not subject to the unrelated business income tax. If, in addition to renting space to an occupant, a service is also rendered to the occupant, then the operation will be considered as a trade or business 13Ibid., p. 36,115. 1“De La Salle Institute v. U. S. (D. C. Cal) 7/24/61, and (195 F. Supp. 891.). 63. subject to taxation and not merely the collection of rent from a real estate investment, which is not taxable. Conse- quently the operation of hotels, boarding houses, and apart- ment houses furnishing hotel services or tourist camps, tourist homes, motels, parking lots, warehouses, and stor- age garages, do not constitute rentals from real estate in- vestments. Generally services are considered rendered to the occupant if they are primarily for his convenience and are other than those usually or customarily rendered in con- nection with the rental of rooms or other space for occu- pancy only. For example, supplying maid service constitutes such service; but the furnishing of heat and light, the. cleaning Of public entrances, lobbies, etc., are not con- sidered as services rendered to the occupant. Payment for the entire use of a private residence or living quarters in a duplex or apartment, and office space-in an Office build- ing is considered as rental income from real estate in- vestments.15 In Regulation 1.513 some.examples are given as to how to distinguish between those activities which are related to the exempt purposes of the organization and those which are not. Again, it is stressed, that in each case the nature and size of the trade or business must be compared with.the nature and extent of the activities for which the organization is granted exemption. 15Reg. #1.512(b)-1, Standard Federal Tax Reports, Vol. 3, #3246 (New York: Commerce Clearing House, 1966), p. 36,123. 64 For example, the operation of a wheat farm is substantially related to the exempt activity of an agricultural college if the wheat farm is operated as a part of the educational program of the college and is not operated on a scale disproportionately large when compared with the educational program of the college. Similarly, a university radio station or press is considered a related trade or business if Operated primarily as an integral part of the educational program of the university, but is con- sidered an unrelated trade or business if operated in substantially the same manner as a commercial radio station or publishing house.15' Aside from the above points, the Regulations do not clarify the Code relative to educational institutions. The sections of the Code still open to the most differences Of opinion are Sections 511-513 which cover the area of unrelated business income. The general concept of compar- ing the size, nature, and extent of the trade or business with the same characteristics of the tax-exempt activities of the exempt educational organization is only a general guide and does not settle the issue. Consequently, several rulings have been made by the Internal Revenue Service in this area, and more can be expected in the future. Internal Revenue Rulings One of the earliest rulings was made in 1955. In- volved were a radio station, a cinder block plant, and the school laundry, all operated by the educational institution. The radio station was affiliated with a national net work and the greatest portion of its time was devoted to the l6Reg. #l.513-l(a), Standard Federal Tax Reports, Vol. 3, #3256 (New York: Commerce Clearing House, 1966), pp. 36,129-36,l30. 65 activities of a regular commercial station, although it also was used to some extent in the educational program as a laboratory for training students in radio. The cinder block plant was Operated primarily to provide cinder blocks to the general public. In both of these departments, since the Operations were conducted in a manner similar to commercial undertakings operated for profit, the Commissioner of Internal Revenue ruled their net income to be taxable as unrelated business income. The laundry, however, was found to be operated primarily for the convenience of the students and employees and thus was not taxable, coming under the exception listed in Section 513(a)(2) Of the Internal Revenue Code.l7‘ More recently a ruling has been issued in another case involving a radio station. A non-commercial educational FM broadcasting station presenting educational, cultural, and public interest programs was ruled to be organized and Operated exclusively for educational purposes and consequently was found to be tax-exempt under Section 501(c)(3) of the Code.18 The distinction, of course, being that in the for- mer case the radio station was operated like a regular commercial enterprise and in the latter case it was not. Other activities that have been ruled as related or educational in nature are: (1) an alumni association 17Rev. Rul. 55-676, IRB 1955 - 46,7. 18 Rev. Rul. 66-220, IRB 1966 - 32. 66 controlled by a university and operated as an important- part of the institution;19 (2) a non-profit interscholastic 20 and (3) an organization formed to 21 athletic association; provide a school district with a stadium. Another interesting situation is where oil and gas production payments have been purchased with borrowed funds by tax-exempt institutions. There is no ownership or work- ing interests in the oil and gas properties but only the production payments are acquired. There is a 1/4 to 1/2 per cent return to the purchaser of these production pay- ments. It has-been ruled that this income is tax-free, not coming under the business lease provisions or unrelated business activities, rather it is considered acceptable in- vestment income.22 In 1963, the Internal Revenue Service began a new program in its relationship to non-profit, tax-exempt organ- izations. This program dealt to a large extent with tax- exempt foundations but indirectly involves educational institutions as well. Mitchell Rogovin, assistant to the Commissioner and chairman of the Exempt Organization Council, stated the new procedures as follows: (1) the audit program of tax-exempt organizations is to be expanded; (2) the 19Rev. Rul. 56-u86, IRB 1956 - 40,11. 2ORev. Rul. 55-587, IRB 1955 - 38,11. 21Rev. Rul. 57-493, IRB 1957 - M3,28. 22Rev. Rul. 66-295, IRB 1966 41, and Rev. Rul. 66—296, IRB 1966 - 41. 67 ruling letter granting exemption to_a particular organ- ization remains effective unless specifically cancelled by the Internal Revenue Service; (3) the rule that an organization must operate for twelve months in a manner satisfactory to the law as a tax—exempt organization has been waived; preliminary exemption is granted upon notice of intent by the organization; (4) most tax-exempt organ— izations must now file an annual informational return; (5) the Commissioner will make more use Of advisory letters in trying to help organizations to keep their tax-exempt status by warning them against activities which might cause them to lose this status; and (6) the Commissioner appointed an advisory committee, The Exempt Organization Council, to study the problems in the area.23 Later in commenting on the work of the Council, Mr. Rogovin said, The work of the Exempt Organization Council should be heartening to those who have found Subchapter F a troubled area in the past. Guided by the Commission- er's request for "reasonable, workable, and enforce- able rules of construction," the journey has begun. While the working out of cohesive principles will not be done overnight, something considerably more.than the first step has been taken.24 23Mitchell Rogovin, "Exempt Organizations: New Pro- cedures and Current Policies Within the IRS," The Journal of Taxation, XX (January, 1964), pp. 28-30. 2“Mitchell Rogovin, "Tax Exemption: Current Think- ing Within the Service," New York University Twenty-second Annual Institute on Federal Taxation, 1964 (New York: Matthew Bender & Co., 1964), p. 964. 68 However, by December of 1966, these principles still had not been worked out. A letter from the Technical Ser- vices Branch of the Internal Revenue Service stated, "The Internal Revenue Service has neither published a report or proposal in respect of the Exempt Organization Council nor does it contemplate doing so in the very near future."25 It is evident that the Internal Revenue Service is well aware that more detail and explanation is needed in its regulations to clarify the position of tax-exempt‘organ- izations, but is not sure how to proceed. Educational institutions will do well to watch for these.new principles if and when they are developed to determine the effect that they will have on their activities. Scholarly Opinion Of Current Law As in most situations, those who are opposed to some- thing are much more vocal than those who are in agreement with the current practice. This has been true regarding the sections of the amendments to the Internal Revenue Code passed in 1950 which pertain to the taxation of feeder com— pany income and unrelated business income of otherwise tax- exempt organizations. Authors have generally been opposed to one or more of these new tax provisions. Soon after passage of the 1950 tax amendments comment arose against them. One author called them the "latest 25Letter from A. L. O'Connell, Chief, Technical Services Branch, Internal Revenue Service, December 28, 1966. 69 monstrous off-spring of the legislative mind."26 Another, William A. Cruikshank, Jr., lecturer at the University of Southern California School of Law, said that Congress did not close the lOOphOles referred to by President Truman, but merely created a number of smaller ones. "The social and economic-effects of the legislation were not adequately considered in the crusade against unfair competition and tax avoidance," he stated.27 Both of these individuals thought that the tax on unrelated business income was un- necessary. They felt that if adequate measures were adopted to prevent the accumulation of surplus, the Objectionable factors, which this section of the law was intended to correct, would be corrected by themselves. By requiring that all the earnings be expended on tax-exempt activities, the advantages of tax-exemption would go to only those pur- poses which Congress intended tO aid by granting tax exemption. In addition, the point was raised by others that tax- exempt organizations should not have to pay taxes merely because of the presence of competition between a normal business firm and a department of a tax-exempt institution. Such a view would permit commercial enterprises to set the 26Berrien C. Eaton, Jr., "Charitable Foundations and Related Matters Under the 1950 Revenue Act," Virginia Law Review, 37, Nos. 1 & 2, p. 296. 27. William A. Cruikshank, Jr., "Taxation Of Charitable.Organizations," Proceedings of the Tax Insti- tute, University Of Southern California School of Law (New York: Matthew Bender & Co., 1952), p. 451. 7O limits on the proper activities of educational insti- tutions merely by occupying the field. Less concern should be paid to the fact that commercial enterprises may be active and competing in the same field occupied by activities Of exempt organizations; it should be recognized that such activities may well be within legitimate spheres of charitable and educational functions. Essenti- ally, the test should simply be whether the general welfare is being served by the questioned activity.28 Norman A. Sugarman, attorney of Cleveland, Ohio, gave two reasons why he agreed with this point of view. First, since tax exemption is granted as a matter of public policy tO encourage activities which are in the public interest, the mere fact that someone else may seek a profit by enter- ing the same or related field of endeavor should not de- tract from the over all public policy. Second, he felt Congress should not surrender its responsibility in deter- mining which areas of activities are to be tax—exempt.29 Both of these individuals, H. K. Mansfield and N. A. Sugarman, felt that as amended in 1950, the Code was basi- cally sound in this area. They recognized the major problem was a matter of defining which activities are related to the purposes of the exempt institution. Mr. Sugarman 28Harry K. Mansfield, "Some Aspects of Taxation of Business Income of Exempt Organizations," Tax Revision Compendium, Nov. 16,1959, Vol. III, House Ways and Means Committee Hearings((Washington, D. C.: Government Print- ing Office, 1959), p. 2075. 29Norman A. Sugarman, "Business Income Of Exempt Organizations," Tax Revision Compendium, Nov. 16,,1959, Vol. 111, House Ways and Means Committee Hearings (Washington, D. C.: Government Printing Office, 1959), pp. 2115-2125. 71 particularly, however, felt that both Congress and the Internal Revenue Service should be extremely careful not to restrict the freedom necessary in the conduct of charitable, educational, and scientific activities by seeking to substitute their judgment for that Of the pro- fessional heads of such organizations. In many areas the motives for carrying on a particular Operation would deter- mine whether that operation was related or not to the tax- exempt purpose of the institution. He did not think Con- gress could possibly write laws which would encourage the necessary functions of the social worker, educator, and the scientist in the public interest and at the same time arm revenue agents with authority to place limitations on their professional activities.30 Another objection raised to the 1950 amendments of the law involved the question of taxing income received from a "business lease." It was said that this would give an unfair advantage to the rich, well-endowed institution. With relatively large sums available, these institutions would be able to invest in real estate and lease—back trans- actions with their own money and thus not be subject to the tax because no debt was involved. 0n the other hand, the only way for the less-endowed institutions, although equally worthy, to deal in such investments would be to incur at least a partial mortgage debt, which would then make them subject to the tax. If trading on the tax 30Ibid., p. 2124. 72 exemption was the real loophole to be closed in this case, as stated in the Congressional Committee Hearings, it would seem that the tax should be placed on income re— ceived from all lease-back transactions. The tax-exempt institution would have a competitive advantage regardless of how the purchase of the property was financed. As W. A. Cruikshank, Jr., said, "The misuse of a tax exemption is no more evil in transactions financed with borrowed money than insothers."31 He then quoted the famous state- ment of Oscar Wilde, "charity creates a multitude of sins." One last criticism that often arises is the apparent inconsistencies in the law. There are some provisions which tax certain entities and do not tax others, even though the character of the transaction or income may be the same. The prime example, of course, is the exemption of churches from the provisions relative to unrelated business income. This has been called the "gap" in the statute. Then, as George D. Webster in the Journal of Taxation said, "This situation has been compounded by the Internal Revenue Service. Through the years, and without regard to political administrations, the Service has per- mitted further inconsistencies to arise in the adminis- tration Of the statute." Social clubs were covered in the proposal sent to Congress by the Treasury Department 31William A. Cruikshank, Jr., "Taxation of Charita- ble Organizations," Proceedings of the Tax Institute, University of Southern California School of Law (New York: Matthew Bender & Co., 1952), p. 451. 73 in 1950, but they were deleted by the House Of Represent- atives. Mr. Webster also disagrees with the decision not to tax the unrelated business income of so-called mutual organizations, because he feels that in a sense most all 501 organizations are "mutual."32 The problem of unfair competition and its social ramifications are the main reasons why many individuals agree with the current provisions of the law. Harry Mans- field said, "To permit a tax-exempt organization to engage in business without restraint would undoubtedly have ad- verse economic and psychological effects in the community which would probably outweigh any advantages derived from their favored treatment."33 Others felt it would be to the interest of all legitimate tax-exempt organizations to support an enlightened and forceful application of the current tax principles. This would help to assure a social and economic rather than a purely technical basis for tax- 34 exemption. 32George D. Webster, "Current Inconsistencies and Discrimination in the Taxation of Exempt Organizations," The Journal of Taxation, XXI (August, 1964), p. 102. 33Harry K. Mansfield, "Some Aspects of Taxation of Business Income of Exempt Organizations," Tax Revision Compendium, Nov.,rl959, Vol. III, House Ways and Means Committee Hearings (Washington, D. C.: Government Print- ing Office, 1959), p. 2068. 3”Robert S. Thompson, "Family Charitable Foundations --Administration," Ninth Tax Institute, University of Southern California School of Law (New York: Matthew Bender & Co., 1957), p. 667. 74 In a survey made by the author in 196535 it was found that the financial executives of educational institutions do not agree in their Opinions Of the current tax provi— sions. In answer to the question whether or not they felt "feeder organizations" should pay income taxes, out of 135 who answered the question, 66% said yes and 34% said no. It is evident that a good majority Of these school Officials agree with the current provisions of the law which taxes feeder companies. Those who commented on this question gave unfair competition and abuse of the privilege of tax exemption as the main reasons for favoring taxation. Ex- amples of comments given relative to the competition reason were: "I believe that it is unfair to other business enter— prises tO have a feeder organization escape the income tax"; "To exempt such organizations lays them (and, in the public mind, us) Open to a justifiable charge Of unfair competition"; "These organizations are directly competitive with tax-pay- ing businesses. There is danger that the tax advantage would cause pricing of product below fair levels"; and "I believe for such organizations not to be taxed places them in a preferred position competitively and therefore is un— fair to other businesses." Those who gave abuse of the tax privilege as their reason for agreeing with the tax provisions made comments like, "Otherwise there would be a tendency and inclination 35See Chapter V for complete details regarding the survey and its results. 75 to abuse the exempt privilege"; "Otherwise this would or could be used to evade taxes"; and "Any business operating for profit should bear an equal load in my Opinion regard- less Of the disposition of the profits." One other inter- esting comment was that "The possibility that such vio- lations may bring about legislation which might wipe away our tax advantages, which in the past have been given for good purposes, and expected that they would be used with proper intent." Of course, all of the comments did not favor taxation of feeders. Some were either against it altogether or they were not sure about the question. Typical answers were: "Not if 311 profits are distributed to non-profit insti- tutions"; "If it is sound to have a tax exemption in one area of income it should be equally sound in others"; and "This provides the only satisfactory return on endowment funds and should be considered as an auxiliary income oper- ation." Of those who were undecided, they said, "Probably not"; "Depends on what is considered a feeder organization"; and "Undecided--feeder organizations may be an effective means of providing support of higher education--on the other hand, there is danger of abuse and unfair competition for the non-feeder enterprise." The comments are most interesting. While the majority do favor taxation of feeders, there were one-third who did not. In the minds of these Officials, then, it is not a settled question. However, only a little over two per cent 76 of the financial executives indicated that their decisions on school policies regarding investments had been affected by the current law taxing feeder companies. Quite a different result was Obtained when these same school officials were asked their Opinion regarding the taxation of the unrelated business income of their institutions. Of the 150 who responded, 91 or 61 per cent answered no and only 59 or 39 per cent answered yes to the question whether or not they agreed with the current prO- visions of the law which taxes the unrelated business in- come of educational institutions. In this case the majority did not favor taxation. Just as their representatives had testified in 1950 before the Congressional Committee Hear- ings, they still evidently favor taxation of feeders but not the direct taxation of educational institutions even when they carry on an unrelated business activity. Again the comments made by these financial adminis- trators are most interesting, showing their varied feelings in the matter. A few of those favorable to taxation said, "But only if there is no connection, direct or indirect, to an educational purpose"; "Yes, if truly unrelated and Open to the general public"; "I believe that tax exemption is a precious privilege to education and we should lean oven backwards not to abuse this privilege"; "From a broad policy standpoint there is no valid reason for any charita- ble institution to be permitted to Operate an unrelated business for profit without paying income tax"; "In the 77 face of rising governmental costs, I feel that this must be conceded. Abuse could arise that would jeopardize pre— sent privileges"; and "As a matter of general policy this institution, though tax-exempt, has felt that where in— come has been generated from non-educational activities, the institution should pay its fair share of support to the common good through the channels Of taxation." Those opposed gave a variety of reasons in their com- ments. The need for public support and the difficulty of determining the correct tax base were predominent. Ex- amples are: "Tax supported institutions should also be tax-exempt"; "It is by all standards difficult-to finance any education system. Those Of us in private education need every possible assistance"; "We would qualify this answer to say that such income should be used to further educational or research Objectives"; "If all profits are used to assist the non-profit institution to expand and/or more effectively accomplish its purposes"; "The operation of auxiliary enter— prises is so intimately related to the program of the insti— tution that it would be impossible to determine the basis Of taxation"; and "In our case, we feel that all such in- come is related to basic institutional Objectives." One other most interesting comment came from a large univer- sity which previously had had a disagreement with the In- ternal Revenue Service. Its spokesman said, "Depends on interpretation of 'unrelated.' When volume Of business 78 is sole basis for determining unrelatedness, (as was ruled in our case by the Internal Revenue Bureau), we dis- agree." The use of endowment funds to purchase the stock Of corporations, even when a majority interest was involved, was thought by a large majority to be acceptable in the survey, if the corporations themselves paid income taxes. The endowment fund dividend income then should definitely not be taxed, it was felt. Dividend income is currently tax free to tax-exempt institutions when only a minority interest is involved and they could see no reason why the same rule should not apply regardless of the per cent of ownership. Comments like, "Tax should be on the business-- not on the endowment income received"; "The business con- cerns themselves pay taxes and therefore enjoy no competi- tive advantage"; "No objection to taxing the corporation, object to taxation of dividends received by institution", and "If the business concern itself pays federal income tax, answer is no. Majority ownership is then irrelevant so far as taxation is concerned" were made. A very few felt it most inapprOpriate for a school to become a majority stockholder in a business. One institution in commenting on the 1950 tax law said, "It convinced us more firmly that our policy was correct and that non-profit educational in- stitutions should not Operate businesses or control corpor- ations thru majority stockholdings." 79 In conclusion, as might be expected, there is no agreement of opinion regarding the provisions which tax the business activities of educational institutions. These differences of Opinion are both philosophical as to the propriety of taxing these institutions and practical as to the application of these tax provisions. The differ- ences Of opinion seem to be much the same now as they were in 1950. However, in actual practice, there probably has not been as much hardship or erosion of the tax-exempt principle as had been envisioned by the opponents of the 1950 tax amendments. The cost Of preventing undue abuse of the exemption privilege may well have been worth the price. CHAPTER IV THE CONCEPT OF UNRELATED BUSINESS INCOME With the passage of the 1950 tax amendments the two terms, "feeder company" and "unrelated business income" became part of the Internal Revenue Code. As previously defined a feeder company is a legally separate commercial enterprise owned by a tax-exempt organization. The pri- mary purpose of the feeder company is to provide income for the parent organization. Unrelated business income, on the other hand, is produced by a commercial operation owned and Operated as a department of the tax-exempt insti- tution, and its operations are not sufficiently related to the purposes for which the institution receives its tax- exempt status to be tax exempt as defined in the Code. Little objection has been raised to the taxation Of feeder companies, and it has not been difficult to determine when a company is Of the feeder type. The major problems have arisen when the attempt is made to isolate unrelated busi- ness income. Therefore, a brief analysis of the concept of unrelated business income is appropriate at this point. The term has two parts--income and unrelated business. While the concept of income is not simple and many defi- nitions with different shades Of meaning are found in the 80 81 economic and accounting literature, in the context of the section of the Internal Revenue Code under study, "unre- lated business" is the part of the term which causes the most controversy. However, a very brief look at the con- cept of income will help in the analysis. First, the concept of income involves a time period. Income is said to be a certain amount for a week, a month, a year, or for some other period of time. Second, the idea of a flow of economic resources is involved for the given time period. Income may have several qualifications such as gross income, net Operating income, and net income. These terms are primarily found in accounting reports and tend to confuse the understanding of the income concept. For tax purposes we also have the terms gross income, ad- justed gross income, and taxable income. Also complicating the issue is the fact that there may be a different conno- tation between personal income and the income Of a business firm. In trying to understand the income concept, Erwin N. Griswald quotes the following from economic literature: R. M. Haig - "Income is the money value of the net accretion to one's economic power between two points of time." W. W. Hewett - "Net individual income is the flow of commodities and services accruing to an individual through a period of time and available for disposition after deducting the necessary cost of acquisition." H. C. Simons - "Income may be defined as the algebraic sum of (l) the market value of rights exercised in consumption and (2) the change in the 82 value of the store Of property rights between the beginning and end of the period in question."1 From accounting we find the following generally ac- cepted definition: The terms net income or net profit refer to the results of operations after deducting from revenues all related costs and expenses and all other charges and losses assigned to the period. These deductions do not include dividends or comparable withdrawals.2 And from the tax literature we have: Gross income means all income from whatever source derived, unless excluded by law. Gross income includes income realized in any form, whether in money, property, meals, accommodations, stock, or other property, as well as in cash.3 Income, in the broad sense, means all wealth which flows into the taxpayer, other than as a mere return of capital or as unrealized appreci- ation in value.4 Taxable income means gross income, minus the deductions allowed.5 The terms having the most similarity seem to be in- come, net income, and taxable income from the areas of economics, accounting, and taxes respectively. While lErwin N. Griswald, Cases and Materials on Federal Taxation (New York: The Foundation Press, 1960), p. 141. 2Accounting Research and Terminology Bulletins, Terminology Bulletin #2, final edition (New York: American Institute of Certified Public Accountants, 1961), P. 35. 3Reg. #l.6l--l(a), Commerce Clearing House Standard Federal Tax Reports, I, No. 630 (New York: Commerce Clearing House, 1966), p. 17,005. ”Commerce Clearing House Explanation, Standard Federal Tax Reports, I, NO. 631 (New York: Commerce Clearing House, 1966), p. 17,006. 5Internal Revenue Code of 1954, Sec. 63(a) 83 economics stresses the theoretical concept of what income is and says it is the increase of wealth which is either spent on consumption goods or saved, the other two areas deal more in the practical side of calculating the amount of income. However, all three appear to agree that in- come involves a time period, a flow of resources, and the deduction of acquisition costs from a gross revenue figure. The exact amount will vary because each discipline may assign different items to the gross revenue figure and to the deductions which it allows as the costs of acquiring that gross revenue. When is income unrelated? This is the prime question to be answered. Unrelated according to the dictionary means not related or not having relationship; not-connected by reason of an established or discoverable relation.6 Unrelated income would be this definition by income not having a relationship or not connected by reason Of-an established relation to the central organization--the col- lege or university in this study. Since the operation Of educational institutions requires large amounts of funds, it is difficult to agree that income from whatever source does not have a relationship to the institution. The simple dictionary definition seems to indicate that the production of income is related and not unrelated to the operation of a school. 6Webster's Third International Dictionary-—Una- bridged (Springfield, Mass.: G. & C. Merriam Co., 1964). 84 As shown in Chapter III, the Internal Revenue Code defines income as unrelated when it is produced by a trade or business, regularly carried on, and not substantially related to the purposes or functions for which the organ- ization receives its tax-exempt status. The point stressed is that the tax-exempt institution may have income from a commercial activity not connected or necessary to the Oper- ation Of that institution. The need for income is not con- sidered a sufficient reason for such income to be called related income. In addition to furthering education by granting tax-exempt privileges, it must be recognized that the tax law has other purposes to promote. The raising Of tax revenue and the prevention Of unfair competition between normal business firms and those Operated by tax-exempt insti— tutions are significant in this situation. However, to in- sure the success Of these purposes, Congress in the Internal Revenue Code has found it necessary to consider the need for income as unrelated when it comes from certain sources. Other activities connected with the business world in the form of investments in stocks, bonds, and most real estate have been considered acceptable. The Internal Revenue Code, then, places its own unique meaning on the concept of being unrelated in this one instance. The need for income does not in itself determine relatedness; the character of the operation producing the income does. There are two areas in accounting theory and practice which relate to the problem of relatedness. One is the 85 importance of and hence the location Of other and extra- ordinary income items on the income statement, and the other is the theory which supports the preparation of consolidated statements. The basic concept in both cases is that of the business entity. "A business entity is a formal or informal unit of enterprise—-a collection of economic goods and services and a group of persons-— organized to accomplish certain express or implied pur- poses."7 All phases Of the organization which contribute in any way towards the objectives of the firm are con- sidered as part of this business entity; they are considered as being related to its Objectives. The minor revenues are typically placed near the end of the income statement in a section labeled other and/or extraordinary items. The rationalization being that they are in addition to the normal Operations Of the firm. How- ever, one important accounting scholar does not agree with this approach. He recommends that for two reasons, minor revenue items should be placed directly after the major revenue items. First, it is unreasonable to assume that any revenue elements, however minor or incidental, are completely free Of cost, . . . and second, the side-line revenues --even if appearing somewhat irregularly--are a part of business getivity in a broad sense and should be so reported. 7"Accounting and Reporting Standards for Corporate Financial Statements, 1957 Revision," Accounting Review, (October, 1957), p. 537. 8William A. Paton and William A. Paton, Jr., Cor— poration Accounts and Statements (New York: The Macmillan 00-. 1955). pp. 365-366. 86 In either case there is no question whether the minor revenue or income items should be on the income statement or not. A strong case is made for a prominent location and thus gives weight to the idea that such items should definitely be considered as being related to the Operations of the firm. Even when shown near the end of the state— ment, these items appear before Net Income and are there- fore still considered as related to the business entity and its results but perhaps not to the same degree as in the other procedure. Consolidated statements rest on the premise that it is more useful to show the financial reports Of a parent company and its subsidiaries as a single unit than to show each one separately following their legal basis. The legal separateness of each unit is disregarded, the fiction of separate corporate entities is ignored and legal lines of cleavage are replaced by the more useful but less definite boundaries of "economic unity."9 The decision to prepare consolidated statements has traditionally rested on three prime factors. First, the fundamental basis is control supported by ownership and if that ownership equals 100 per cent, the subsidiaries are in effect incorporated departments of the main company.lo 9Maurice Moonitz, "The Entity Approach to Consolidated Statements," Accounting Review, XVII (July, 1942), p. 237. 10Paton, Op. cit., p. 576. 87 This ownership basis may be stated as the need for a financial unit to exist. Second, not only must control be possible (100 per cent ownership is not necessary) but it must be exercised. The group of legally separate entities must be operated as a single Operating unit, all working towards the same goal. The subsidiaries are looked upon as related departments under the control of one manage— ment. Third, it has usually been argued that operations of the various consolidated companies should be similar or at least operationally related. However, with the increased emphasis placed on the business entity concept, this third prerequisite for consolidation has been relaxed to a cer- tain extent. For example, for many years financial subsi- diaries of predominately manufacturing type firms were not consolidated, but now there is considerable argument for consolidation in this case.11 From the standpoint Of the parent company and its stockholders all resources are com- mitted to the purpose Of producing income and all Operations regardless of type that are Operated with this objective are related and should be shown as a unit on consolidated statements. llVictor L. Andrews, "Should Parent and Captive Finance Companies be Consolidated?," The Journal of Accountancy, CXXII, NO. 2 (August, 1966), pp. 48:56. 88 There is support for the propriety Of consolidated income in the Internal Revenue Code as it allows the con- solidated group to file a single tax return.l2- In regard to the basis for assessing the income tax on such a group, Senator Simmons, then chairman of the Senate Finance Committee, spoke as follows: "The committee recommends its adoption not primarily because it Operates to prevent evasion Of taxes or because of its effect upon the revenue, but because the principle of taxing as a business unit what in reality is a business unit is sound and equitable and convenient to the taxpayer and the government."13 The major hypothesis of consolidated statements is that economic unity and singleness of purpose is more im— portant than legal considerations. Where this unity is made evident by related financial control and by oper— ational control, the reporting Of the results of Operations as a unit is deemed appropriate and perhaps necessary for accurate appraisal of Operations. Each subsidiary company contributes towards the goal of producing income for the stockholders Of the parent company and by so doing is con- sidered an important element of the total economic unit. In both areas of accounting that have been considered, the importance Of minor revenue items and the supporting theory for consolidated statements, the fact that each sub— division Of a business firm contributes toward the major objective of profit making has made each part related to 12Internal Revenue Code Of 1954, Sec. 1501. 13William H. Childs, Consolidated Financial State- ments, Principles and Procedures—(Ithaca, New York: Cornell University Press, 1949), p. 35. 89 the whole. The purpose and Objective of each section and not the type of operation involved has been the major consideration in the determination of relatedness. This may be classified as the total managerial concept. This brings us back to the original question, when is income unrelated business income? The purpose Of colleges and universities is to provide an education to its students and to be a service to the community and society in which it is located. TO provide these services these institutions must have funds. While most of these funds come from tuition charged to the students, from grants appropriated by government and church organizations, and from private gifts, these have not been sufficient to pro— vide all the services demanded from the modern educational institution. To supplement these sources of income, in- vestments have been made in the world of business. The traditional investments in stocks, bonds, and real estate where borrowed funds are not significantly involved have been allowed by the Internal Revenue Code, but the Operation Of a commercial enterprise either as a feeder company or as a department producing unrelated business income has been disallowed. However, with the extreme need for funds from all sources it is difficult to understand why the income from one group is related to the Operation of educational institutions and the income from the other group is not. Both the dictionary definition Of the word unrelated and the arguments from accounting support the concept that 90 the need for income and its use in the educational pro- cess makes the acquisition of income related to the oper- ation of educational institutions. They support the long-standing approach prior to 1950, that the destination of income and not the source determine the status Of that income. The acquisition of needed income from all sources is related to the educational process and indeed is of great concern to and consumes a large amount of the time of the top financial officers of colleges and universities. Into this picture, the Congress through its amend— ments to the Internal Revenue Code in 1950, arbitrarily said that income received from certain commercial activities is unrelated and therefore taxable. Granted Congress had the right and authority to do so and was motivated by con- siderations Of unfair competition which it felt was more important than encouraging education by granting tax- exemption in this area. Perhaps the word unrelated was poorly chosen. If the emphasis is placed on unrelated busi— ness rather than on unrelated income, it appears to be much more plausible. At any rate, the income from certain types of business Operations is currently subject to the federal income tax whether one feels it is related or not. The wide variety of activities required of the modern college and university in todays educational process does make it extremely difficult to decide which activities produce in- come falling within this arbitrary group called "unrelated business income." Since the logical use Of the word 91 unrelated cannot be used in this decision. the occasional disagreement between the Internal Revenue Service and educational administrators will continue. CHAPTER V CURRENT PRACTICE OF EDUCATIONAL INSTITUTIONS WITH FEEDER COMPANIES AND UNRELATED BUSINESS ACTIVITIES Around 1950 when Congress was investigating and finally passing the amendments to the Internal Revenue Code relative to feeder companies and the unrelated busi- ness income of tax-exempt institutions, many claims were made by each side. The government urged that a tax lOOp- hole must be closed because the abuse of the tax-exempt privilege was increasing at an alarming rate. It was felt that if something were not done to correct the situ- ation, whole blocks Of business activities and real estate investments would be owned by these institutions. This situation would both produce a loss in tax revenue and bring about unfair competition with regular business firms. Of particular interest were educational institutions be— cause Of the publicity Of the Mueller Macaroni Case1 and others. These institutions were thought to be the primary offenders. On the other hand, the educational institutions in- sisted that there was no major problem, the loophole was 1See Chapter II for a discussion of this case. 92 93 not large, and most reputable colleges and universities would not become involved in these activities. Moreover, if they did, the schools had their own organizations which they felt could police their own members. A some- what divergent argument was advanced by other educational leaders to the effect that government should not encroach upon the time honored privilege of tax exemption granted to educational institutions. With rising costs and short— ages Of funds, they felt the Government should do every- thing possible tO encourage their operations and not place these additional burdens on their financial activities. Survenyade In order to study the validity of these claims and also to determine the current practices of educational institutions, a survey was made by the author in July of 1965. The survey was in the form of a questionnaire sent to the chief financial Officer of each of 352 educational institutions in all fifty states of the United States.2 With the exception of three questions, the questions were of a factual nature concerning the degree and type of in— volvement by these institutions with feeder organizations and with unrelated business activities. The questions were divided into five groups concerning: (1) general information, (2) feeder organizations, (3) unrelated business income, (4) investment of endowment funds, 2See Appendix A for a copy of the questionnaire. 94 and (5) contingency funds. The questions were designed so most of the responses could be made by a check-mark indicating a yes or no type Of answer. Space was also provided for optional additional comment. Table V-l indicates the number of questionnaires sent and the number of replies received from each type of institution to which they were sent. The colleges and TABLE V—I SUMMARY OF QUESTIONNAIRES SENT TO 352 COLLEGES AND UNIVERSITIES (NUMBER OF QUESTIONNAIRES) Private Non- Church Public Church Related Related Total Institutions Institutions Institutions Sent 119 109 124 352 Received 71 48 73 192 % Return 59.7% 44.0% 58.9% 54.5% universities were divided into three groups; public, state supported institutions; private, non—church related insti- tutions; and private, church related colleges. The choice Of institutions to which the questionnaires were sent was made by arbitrary groups as described below making it a stratified sample, however, the institutions were selected randomly within each group. First it was determined that each state should be represented so as to get a good geo- graphic distribution. More were selected from states with 95 a large number of colleges and universities located within their boundries than from those with fewer schools. Second, it was decided that each of the three types of institutions should have approximately the same number. Church related institutions outnumber each Of the other groups but state supported institutions have the largest total enrollment and carry on the greatest number of educational activities. Finally, the selection was made so that there would be a representative group from the various sizes of institutions within the three basic groups. The sample is relatively large compared to the total number Of colleges and univer- sities, and the returns received represent a good cross section Of the different types, sizes, and locations of educational institutions. Tables V—l, V-2, V-3, and V-4 show the distribution of returns according to these cate— gories. It is interesting to note that almost a 60 per cent return was received from both public and church related institutions, whereas only a 44 per cent return was received from private, non-church related schools, making an over- all return Of 54.5 per cent. The length of the question- naire, six pages, and the number of such questionnaires received by busy administrators may account for keeping the return percentage from being higher. However, the return is good since in most samples using nailed 96 TABLE V-2 ANALYSIS OF 192 QUESTIONNAIRE RETURNS BY TYPE AND SIZE OF INSTITUTION (NUMBER RECEIVED) 4..) CI (1) E m m m 15 m H 0 IE 43! C Lim IQ H rid O curio O4JrlO H om HpH >PH snow m LN .0014.) wimp :3pr p de 3:23 nc35 .CGJQI3 0 mm 04H» Q—cHJ-J £2me E Under 1,000 0 4 28 32 17% 1,001 — 5,000 17 27 32 76 39% 5,001 - 10,000 22 6 8 36 19% Over 10,000 3g 11 _§ 48 25% Totals 71 48 73 192 100% Percentage 37% 25% ' 38% 100% questionnaires with voluntary responses, the return is usually from 10 to 30 per cent.3 Table V-2 shows the number Of returns received from the three basic types of institutions. Public and church related institutions have almost equal representation, 37 per cent and 38 per cent respectively of the total responses received. Private, non—church related school returns are somewhat less, only 25 per cent Of the total received, because Of two factors. First, a slightly smaller number 3Samuel B. Richmond, Statistical Analysis, 2nd Edition (New York: The Ronald Press Co., 1964), p. 15.; Edward E. Lewis, Methods Of Statistical Analysis in Economics and Business, 2nd Edition (Boston, Mass.: Houghton Mifflin Co., 1963), p. 15. 97 of questionnaires were sent to this type Of institution, and second, the percentage return was not as large for this group (see lable V-l). TABLE V-3 ANALYSIS OF QUESTIONNAIRES SENT AND RECEIVED BY SIZE OF INSTITUTION Percent Enrollment Sent Received Return Under — 1,000 62 18% 32 17% 52% 1,001 - 5,000 159 45% 76 39% 48% 5,001 - 10,000 60 17% 36 19% 60% Over 10,000 _11 _g9% _38 _35% §§% Totals 352 100% 192 100% 54.5% When the returns are analyzed according to the size Of the institutions, Table V-3, the returns are found to be about what one would expect when compared to the number Of questionnaires sent out. The returns from the one to five—thousand enrollment size institutions show the largest number, 39 per cent Of all returns, but there is also the largest number Of colleges and universities in this size group as 45 per cent Of the questionnaires were sent to them. The other sizes of institutions have smaller per- centages of the total replies received, with the largest schools receiving 25 per cent and 17 and 19 per cent for the other two groups. The variation in the percentage 98 return, 48 to 68 per cent, accounts for the more equal representation in the replies received from each group. Geographically, Table V-A indicates that the largest number of returns were from the Northeastern and Midwest- ern sections of the country, where also the largest number of educational institutions are located. Most noteworthy is the fact that the percentage return for each section of the country was very similar, 51 per cent to 55 per cent, except for the Midwestern schools, where the return was ' TABLE v—u ANALYSIS OF 192 QUESTIONNAIRE RETURNS BY GEOGRAPHIC LOCATION (NUMBER SENT AND RECEIVED) Percent Location Sent Received Return Northeast 94 27% U8 25% 51% Midwest 93 26% 58 30% 62% South 80 23% Al 22% 51% Southwest 42 12% 23 12% 55% West _£; 12% 22 11% 51% Totals 352 100% 192 100% 5U.5% considerably higher, 62 per cent. This correlates with the higher percentage return received from state supported and church related institutions because these types of schools appear to predominate in the Midwest. Sixty-nine 99 of the 93 Questionnaires sent to Midwestern schools were to these institutions. However, the return percentage is quite uniform and does not seem to indicate any geographic bias in the results. Feeder Organizations In 1950, when Congress passed the new sections of the Internal Revenue Code taxing the business activities of non-profit institutions, it was feeder organizations that had caused the most interest and controversy, finally lead- ing to the new legislation. This fact makes the results of the survey in this area most interesting. Table V—5 shows that 187 replies were received in answer to the question if the school received income from a feeder company. Before 1950 and between 1950 and 1960 only seven institutions or 3.7 per cent indicated that they received such income. Since, 1960, the number increased to 12 or 6.U per cent of those who answered this question. TABLE V-5 NUMBER OF INSTITUTIONS RECEIVING INCOME FROM A FEEDER ORGANIZATION Church Public Private Related Totals Yes No Yes No Yes No Yes No Before 1950 5 62 0 H7 2 71 7—3.7% l80—96.3% 1950 - 1960 5 62 0 47 2 71 7-3.7% 180—96.3% 1960-- 1965 8 59 2 U5 2 71 12-6.“% 175-93.6% 100 In conjunction with this question, the financial adminis- trators were also asked if the 1950 tax amendments had had any effect on the school's policies regarding feeder com— panies. Only four or 2% per cent out of the 163 who answered this question, said that the law had affected the school's plans. In commenting on this question, each of the four indicated that with the passing of these tax amendments, their institution had decided against acquiring a feeder company. In addition these decisions were made soon after 1950 and not within the recent five year period. Table V-6 shows the distribution of these replies by type of institution; one for public supported schools and three for church related institutions. TABLE V-6 EFFECT OF THE 1950 TAX LAW ON THE SCHOOL'S POLICIES REGARDING FEEDER ORGANIZATIONS Yes No Public Institutions 1 59 Private Institutions 0 A2 Church Related Institutions 3 _58 Totals 4 159 Percentage 2.5% 97.5% The results of these two questions seem to indicate that the problem of feeder organizations was not as large 101 as had been envisioned in 1950. Neither the claim by government supporters that educational institutions would soon operate tax-free large sections of business enter- prises nor the claim by some educators that the tax on feeder companies would be a hardship to many institutions is borne out by these results. The small number of schools owning such organizations and the even smaller number who said the law had an effect on their policy decisions sub- stantiates the idea voiced by some in 1950 that the tax loophole in this area was indeed quite small. Secretary of the Treasury, John W. Snyder, in 1950 before the Senate Finance Committee admitted the loss at that time to not be large, but stated that he felt in the absence of effective remedies, the prospective annual loss would rise to around $100,000,000.“ The survey results do not substantiate his fears. The amount of annual income received from feeder companies varied widely from $180,000 down to $375. One institution also indicated that to date there had been no taxable income produced by its feeder company since de- pletion allowances had been greater than the net income from its operations in oil and gas properties. Factors other than income taxation evidently deter- mine whether an educational institution owns a feeder com— pany or not. Probably, the most important is that most “Hearings before the Committee on Finance, United States Senate, 8ISt Cong., 2d Session, on H. R. 8920, 1950 (Washington, D. C.: U. S. Government Printing Office, 1950), p. 7. 102 institutions do not want to invest sufficient funds to become the sole owner of a single business enterprise. They do not wish to subject endowment or other funds to such a high degree of risk. Rather most institutions are content to receive income from the more traditional in- vestments in marketable securities and real estate. See Table V-15 for more details on the subject of endowment fund investments. Of the twelve institutions which indicated that they received income from a feeder company, only eight answered the question concerning the payment of income taxes on this income. Six indicated that they either paid taxes or filed a tax return but had no taxable income, however, two schools indicated without explanation that they had not- paid income taxes. Both of these schools were publicly supported institutions. Neither of the church related schools answered this question. See Table V-7. TABLE V-7 NUMBER OF FEEDER COMPANIES WHICH PAID FEDERAL INCOME TAXES OR FILED A TAX RETURN Church Public Private Related Total Yes No Yes No Yes No Yes No Before 1950 l 2 - _ _ _ 1950 — 1960 l 2 — _ _ _ 1961 - 1965 A 2 2 - - - 6 103 It is regretable that four schools did not respond to this question on the payment of taxes, but the results showing that six out of eight did pay taxes indicates that most institutions have complied with the law and have paid the taxes. Most interesting is that a good majority of the financial officers agreed that feeder companies should pay Federal income taxes even though prior to 1950, the courts had ruled in most cases that they were tax- exempt. As a matter of ethics in order to equalize competition with regular business firms, the majority felt taxation to be justifiable. See Table V-8. For each type of institution the results are much the same. Those agreeing that feeders should be subject to taxation ranged from 64 per cent for church related insti- tutions to 69 per cent for private institutions, with an overall average of 66 per cent for the 135 who answered this question. however, when analyzed by the size of the institutions involved, quite a varied response was received. For the smaller schools, particularly the church related institutions, only a little over 50 per cent agreed to the taxation principle. This percentage rose to 79 per cent for the institutions with enrollments from five to ten- thousand. No doubt the low percentage of financial officers from small, church related institutions who agreed with the principle that feeder companies should be taxed came more from practical rather than ethical reasons. 10A OHM HOO HOm H3O HHm ROO Hmm HHO O: OO Om mm OH mm OH mm OHOOOB HOm ma HON mm m1 m1 M! ml mu mm OO0.0H hO>O HHm m HON OH O A H m H O OO0.0H I OOO.m Hmm Om HNO mm OH mH A mH m H OOO.m : OOO.H HO: OH Hmm NH OH HH O H O O OOO.H HOOOO 02 wow oz wow 02 wow 02 wow Hoozom HOOOO OOOOHOm OOOOHHO OHHOOO HO ONHm OOOOOO A mmw u me<9 mm 0430mm EH mmmw¢v MZOOZH w2¢mzoo mmammm mo ZOHB mqmONO OH HH O O O O N m N O O O OOHHOOch OOOO HO O: O: NH OH O HH OH NH ON ON ON mmmpm OOHOOHON HOH OOH OOH OO OO OO NO NO HO OO OO OO mmhoum xoom O: O: :: OH OH OH O O O NN NN HN OOHOOOOOH OOH HOH OOH OO :O mm mm mm mm mm NO HO 3:333 ON NO OO OH NH OH OH OH :H :O O: O: OOOOOOON mchsom OOH NOH OOH OO OO OO :m :m :m OO mO NO OOHNOOHEOOO mmmmmmmm HOOOOO OHmmHszm OOOH OOOH OOOH OOOH OOOH OOOH OOOH OOOH OOOH OOOH OOOH OOOH on on who“ on on whom on on whom on on whom HOOH OOOH -Om HOOH OOOH -mm HOOH OOOH umm HOOH OOOH -Om OHOOOO OOOOHOO nohsno OOO>HHN OHHOOO HmHOOmOm mo mmszzO mmmoomm AdonB mqm¢B 110 mm ma OH mm #1 mm ma ma mm mm ma :H om MHQ N am OH ma ma mm OH MH ma mm OH HH 2H Hmpom pp0mmm Emmpm mo mamm mmu O HHO HOOHOOOO .oo mpHHHpD OHOpm homeopo >9 O oaumm mpmopom ”OOQOO mammocoo .wmz mmHOpm mpfima a .pm< mpflofinxm oaansm mHoom wcfisefizm mmmpsoo maoc 111 farming operations and the lack of student labor in recent years probably accounts for the decrease in agricultural sales, particularly in the smaller schools where most of the decrease took place. One of the two schools which dropped their manufacturing operations also stated the rea- son as being the lack of available student labor. In isolated cases the financial administrators listed other miscellaneous operations in which their institution was engaged. These included a forest, a utility company, radio and T.V. operated similarly to a private station, a grocery store, oil and gas operations, sale of excess steam, and a resort hotel. Each of these was operated primarily as an unrelated business activity. For analysis purposes it is helpful to divide the activities which involve the public into three groups; real estate, services partially to the public, and manufacturing and other operations. From this grouping we find that the number of institutions engaging in real estate operations has steadily increased over the years while the number pro— viding services partly to the public and engaging in manu- facturing and other operations has remained quite constant. Prior to 1950, “1 per cent of the schools engaged in real estate operations and this increased to A8 per cent in the 1961-1965 period. Approximately one-third of the insti— tutions engaged in services benefiting the public and only about 5 per cent had manufacturing and other operations. See Table V-lO. While the totals remained quite constant 112 OO O OOO OO OO: NO NOH OHOOOB mm m OOH mm OOO mm OO OOOOHOO OOpOOO OO O OON HH ONO ON O: OOO>HON OO O OOO H: OOO ON HO OHHOOO OOOH I HOOH OO O OOO OO OO: OO OOH OHOOOO Wm M ONN Om OOO mm OO OOOOHOO zOpOOO OO O OON NH ONO ON O: OOO>HON O : OOO O: OOO :N HO OHHOON OOOH . OOOH O: O OOO OO OH: OO NOH OHOOOO Om m OOH mm OO: mm O OOOOHOO OOwOOO OO O OON OH ONO ON O: OOO>HHN OO N OOO O OON ON HO OHHOOO OOOH Op OOHON OOOOO OcO OHHOOO OO OOOOOO OHOOOOO mcfipzuommscmz adamfippmm Hmmm mo mmoa>pmm mmnEsz AOHOOOOO mo Ommzszv OZOHBOOOOO OOBOHOOZO OO OOOOO OHI> mqm<8 113 in sales and services to the public, this was not true individually for the different types of institutions. The larger public institutions showed an increase in these activities while the smaller private and church related colleges showed a decrease. This decrease was almost en- tirely in the area of farm and dairy products. Most all of the activities of the 192 colleges and universities were evidently related enough to the educational purposes of the institutions so as to avoid the need to pay federal income taxes. From 1950 to 1960 only five schools indicated that they had filed a tax return and from 1961 to 1965 this increased to seven. See Table V—ll. The maximum reported tax paid was approximately $9,000 and the minimum TABLE V-ll NUMBER OF SCHOOLS OUT OF 192 WHICH PAID FEDERAL INCOME TAXES OR FILED A TAX RETURN ON UNRELATED BUSINESS INCOME 1950-1960 1961-1965 Public Institutions 1 1 Private Institutions 1 2 Church Related Institutions 3 3 Totals 5 7 was zero as two schools stated that their operations as yet had not been profitable although they had filed tax returns. In addition, of the 153 institutions which 114 answered the question, only five or 3.3 per cent indicated that the tax amendments of 1950 had had any effect on the school's decisions to engage in such activities. See Table V-12. In four of these cases, it was stated that the law had discouraged them from going into a business venture and in the fifth case, their accounting procedures TABLE V-12 EFFECT OF THE 1950 TAX LAWS ON THE SCHOOL'S POLICIES REGARDING UNRELATED BUSINESS INCOME Yes- No Public Institutions 1 56 Private Institutions 1 37 Church Related Institutions 3 _55 Totals 5 148 Percentage 3.3% 96.7% had been affected so that realistic rent and overhead had been charged to the business activity minimizing the re— ported income compared to that of earlier periods. The above figures would seem to indicate that rela- tively few schools have been affected by the tax on un- related business income, and very few have had to pay any income taxes on such income. Evidently the fears expressed just prior to 1950 were based on isolated cases and not on a general trend towards unfair competitive practices by 115 educational institutions in the business world. Also, the way in which the law is currently written does not appear to create much of a hardship on the vast majority of colleges and universities, with only seven out of 192 finding it necessary to pay income taxes or even to file a tax return. In their opinions of the income tax on unrelated business income, the majority of the financial adminis- trators still supported the same position that they ex— pressed before Congress in 1950. Of the 150 who gave their opinions, 59 or 39 per cent said they agreed that unrelated business income should be taxed and 91 or 61 per cent dis— agreed. See Table V-l3. It is interesting to note that more--44 per cent—-of the private, non-church related schools agreed in principle to the tax while fewer——36 per cent--of the public supported schools agreed. The church related institutions showed results very similar to the total of all reporting institutions. When size of institution is considered, we find that the very small, less than 1,000 enrollment, and the very large, over 10,000 enrollment, have similar opinions, 44 per cent agreeing to the tax. However, only 36 per cent agree from the middle size institutions. There does not seem to be any apparent reason for this variation. Of the seven schools which paid taxes, or at least filed a tax return on unrelated business income, six gave their opinion of the tax. Only one, a church related institution, said 116 OOO Omm OOO OOO Omm OOO OOO OOm HO OO OO ON NN OH OO OH OHOOOB OOO mm OOO mm Al w: mu «1 Om ma OO0.0H OOOO OOO OH OOO OH : O O N HH O OO0.0H . OO0.0 OOO OO OOO HN OH O :H OH O O OO0.0 : OOO.H OOO :H OOO HH :H OH O H O O OOO.H NOOOO 02 mm» oz mm» 02 wow oz mow Hoozom OO ONHO HOOOO OOOOHOO OOO>HON OHHOON gopOcO OOO» u OOOOB mm OHOOOO 9H OOOOOO OZOOzH OOOzHOOO OOBOHOOZO mo onOOOOO HOOOOOO OO OHOHOZHOO NOB OzHOOOOmm OonzHNO m.mOOOmBOHszOO HOHOZOZHO mal> mqm<8 117 it agreed with the tax. The other five disagreed. This would seem to indicate either one of two things, (1) the inherent dislike of paying taxes, or (2) more probably the fact that the schools felt their activities to be related to their educational purposes while the Internal Revenue Service did not consider them to be so related. Most of the income from unrelated business activities, it was reported, was used for general operations and capital expenditures. The difficulty in determining what is un- related business income is again pointed out in that while only seven institutions paid income taxes on such income, 47 schools reported how they made use of their unrelated business income. Many evidently felt some of their income to be at least to a degree unrelated to educational pur- poses even though it was tax-exempt according to the Internal Revenue Code. Table V—l4 shows that in addition to general Operations and capital expenditures, the income was used for TABLE V-l4 HOW THE UNRELATED BUSINESS INCOME WAS USED IN 47 EDUCATIONAL INSTITUTIONS (NUMBER OF SCHOOLS) I ,c: I CH I H Hor-I 0 S4 OH 42 cu m «5'0 :4 (U 0 HS: S—«lc: 43:22!) «5 H0) :4 (DO CUO 0:40 H00) (D on. (D 0.x: and) CCU-H 0.0.9 m .CH .C :50 06):: 0044-3 «mu: m 0.12 4) EU) Bum-H com um» 0:: mm 0 Public 14 7 7 2 5 3 Private 7 2 O O 0 Church Related 25 21 _4 g 4 1 Totals 47 35 13 2 9 4 118 research, scholarships and other items which included student activities, library support, bond service cost, and amortization of investment. Of the seven taxpaying institutions, six reported the use of their funds--four for general operations and three for capital expenditures. One school used its income for both of these purposes. In summary, it appears that most schools carry on functions which in theory might be considered by some as unrelated business activities but only a very few of these activities are considered as unrelated to the operation of a modern college or university and thus subject to income taxes under the current law. In addition, only a few insti- tutions indicated that the law has had any effect on their policy decisions. In contrast to their opinions regarding the taxation of feeder income, the majority of the financial administrators felt that unrelated business income should not be taxed, and this was particularly so when their insti— titution had been subject to the tax. Endowment Funds One of the possible uses to which a college or univer— sity can put its endowment funds is in the total ownership of a business concern in the hope of receiving a greater return than can be secured by the usual types of invest- ments. This can be accomplished by either organizing a new firm or purchasing all the stock of an existing firm. However, this use of endowment funds would subject their 119 income to the federal income tax. Total ownership would constitute in effect the operation of a feeder company. As shown in Chapter III, investment in stocks and bonds is considered by the Code.as acceptable and tax-exempt income is received when less than total ownership is in— volved. The typical investment involves the purchase of marketable governmental and corporate securities. On the surface, taxation then appears to be a matter of degree; partial ownership is acceptable, and 100 per cent ownership is not. But there is one significant difference. In the partial ownership case, taxes have already been paid by the 114k? business firm. It is only the dividend distribution that is tax-free to the educational institution. A wholly owned tax-paying feeder company is in the same situation. In order to determine the relevance of this problem to the actual practices of educational institutions, the survey contained questions concerning the types of invest— ments made with endowment funds. One-hundred—fifty-three of the 192 total questionnaires received, replied to this series of questions. See Table V—15 for the results. Clearly the most frequent investments were in the form of stocks and bonds, ranging from 93 per cent of the schools which had such investments prior to 1950 to 97 per cent during the period 1961 to 1965. However, these investments were of the partial ownership variety. In sharp contrast, none of the reporting schools indicated total ownership of a business firm with endowment funds prior to 1950, and 120 OON OO OH N OOO OO OOO OOH OOH OHOOOO OON mm OOH m OOH mm: mmm mm: mm: OOOOHOO cohzgo OHN O I O OOO ON OOO OO OO OOO>HHN OON NH ON H OOO NN OOO O: O: OHHOOO OOOH . HOOH OON OO OO. H OOO OO OOO OOH HOH OHOOOB OOO Hm OOH O ONO HO: OOO OOI OO OOOOHOO OoOOOO OOH O n O OOO ON OOO OO OO OHO>HHN Omm ma 0 0 ON: om OOm O: m: oaanzm OOOH n OOOH OON OO . O OHO OO OOO OOH OOH OHOOOO OHM mm ”1. ml OON Owl mww mm: MOI OOOOHOO OohOcO OmH O I 0 OOO mm Omm mm Om mpm>flpm OON HH n O OOO OH OOO H: O: OHHOOO OOOH Op OOHHN Leave .00 mmmchsm mpmuwm mucom mHoonom no dazmpmczo Hmmm a mxoopm mo Hopesz HOHOOOOO OO mmmsszv mQZDm Bzmz3omzm mo mBzmzemm>ZH mo mmmwfi mHI> mqmde 121 there was only one from 1950 to 1960 and two from 1961 to 1965. This very small number does not seem to result from the fact that such income would be taxable. Only four institutions stated that the law had any effect on invest- ment decisions. Of the four, one indicated that legal counsel had cautioned them against becoming involved in this area and another said the law convinced them more firmly that their policy was correct that non-profit edu- cational institutions should not operate businesses or control corporations through majority stockholdings. The results also show that real estate and rental property are frequent places in which schools invest endow- ment funds. About two—thirds of the reporting institutions had such investments and in addition, most of the invest- ments in the "other" category were indirectly in the real estate area. Almost all of them were either saving and loan accounts or mortgages. During 1950 to 1960, two schools indicated that they had paid income taxes or filed a tax return on earnings from endowment funds. This number increased to three after 1961. This would indicate that one of the investments marked "other" produced taxable income. The amounts were quite small; $800 being the maximum average annual tax paid and one having operated at a loss up to 1965. The opinions of school officials regarding taxation of endowment fund income were very much the same as those expressed concerning the taxation of unrelated business 122 income. In total, 41 per cent agreed in principle with the tax and 59 per cent did not. See Table V-l6. The type of institution seemed to make little difference; 39 per cent agreeing from public supported schools and up to 43 per cent for the private, non-church related insti- tutions. The size, however, did have an effect going from 35 per cent agreement for the small schools up to 50 per cent agreement for the largest institutions. The officers from the larger schools in all probability were more knowledgeable of the situation and had a better understand- ing of the competitive advantage that could arise if such income were tax-exempt. To summarize, the traditional investments in market- able securities and real estate have and continue to pre- dominate in the use of endowment funds. Few financial administrators admitted that taxation had anything to do with their investment decisions, although from the one or two comments made they were nevertheless aware of the situ— ation and probably were influenced to a small degree by tax considerations. To a much larger degree, they probably refrained from total ownership of a business concern for other reasons; (1) it would be unethical for an educational institution to become involved in the operation of a busi- ness firm, (2) it would be taking an unwarrented risk to invest the necessary funds in one enterprise, and (3) it would violate the institution's charter and basic operating 123 Omm OOO OOO OH: OOO Om: OHO Omm OO OO OO ON ON OH OO OH OHOOOO OOO mm OOO mm mu ml MI MI mm mm OO0.0H OO>O OOO OH ON: HH O O N N OH O OOO.OH : OOO.O OOO OO OOO ON OH NH OH O O O OOO.O : OOO.H OOO OH OOO O OH O O H O O OOO.H HOOOO oz mow 02 wow 02 mm» oz mow HOOOOO HOOOO OOOOHOO OOOOHON OHHOON HO ONHO cohOOO OOO» u omOOB mm OHOOOO 9H mmOOOO OZOOOZOO mmmszOm OOBOHOOZO mo OOOOOO 2H OOODO>2H OEOOZH ozom ezngoozm mo ZOHOOOOO HOOOOOO NO OHOHOZHON OOO OzHOOOOmm OZOHZHNO O.OOBOOOOH2H2OO HOHOZOZHO OHI> mqm¢B 124 policies to operate a business with income as its primary purpose. Contingency Funds One final question involved contingency funds held by the educational institutions for unforeseen expenditures. Sixty-five of 170 institutions indicated that they made plans for such funds in their annual budgets. See Table V-l7. The use of these funds, however, has not been questioned by the Internal Revenue Service to any extent. TABLE V-17 CONTINGENCY FUNDS AT 170 UNIVERSITIES AND COLLEGES (NUMBER OF SCHOOLS) School V Internal Budgets Revenue Average Contingency Questioned Annual Funds Use Amount Yes No Public 23 40 0 $171,000 Private 18 20 0 129,000 Church Related 24 45 2 85,000 Totals 65 105 2 $126,000 In all only two church related institutions indicated that there had been any question and they added no additional comment. While some of these funds ran high, up to $700,000 making an average of $126,000 the median was only 125 $62,000. In the comments given on this question, it was stated that most all of these funds were eventually used for educational purposes. Thus, what might become a tax question had been avoided by these institutions. Summary Overall the survey brought out several important points. First, and perhaps the most striking, was that a very small percentage of the institutions have in the past or are presently engaged in business activities which have made them subject to the federal income tax. The misuse of endowment funds, the existence of feeder companies, and the Operation of unrelated business activities have all had limited use. Not only have these activities been few in number, but they have remained so without the tax law being a major factor in deciding school policies. Second, the survey indicated that while there is some difference of opinion, the majority of the financial adminis- trators continue to agree with the testimony of their leaders before the Congressional Committees in 1950. They feel that separate legal business entities should be taxed but that the educational institutions themselves should be tax— exempt in all of their activities. With the high cost of education they feel government should continue to aid edu- cation by granting tax exemption, but at the same time, many express the opinion that educational institutions must be careful not to abuse this privilege. 126 Third, the majority appear to agree that the primary goal in the tax law of preventing unfair competition in business by educational institutions is appropriate. While they may disagree with some of the technical aspects of the Internal Revenue Code, in general they find it accept- able. The fears expressed in 1950 that the new tax amend- ments were just the beginning of more government control of education and that every college business office would swarm with revenue agents as yet do not seem to have materi- alized. Fourth and last, the major problem continues to be in the determination of which activities are related to the tax-exempt purposes of educational institutions and which are not. The difficulty arises when general rules and principles are applied to individual cases. The need for an enlightened Tax Court will continue. CHAPTER VI SOUTHERN MISSIONARY COLLEGE AN EMPIRICAL STUDY In order to understand the application of the Internal Revenue Code in respect to the taxation of unrelated busi- ness income of educational institutions, it will be helpful to examine a particular case. Southern Missionary College, a church related, coeducational, liberal arts institution, has been involved in this tax question. Organized first as a Christian training school in 1891 at Graysville, Tennessee, the school was moved in 1916 to its present location at Collegedale, Tennessee, near Chattanooga, Tennessee. The institution operated as a junior college until 1944 and was granted its full senior liberal arts college accreditation by the Southern Association of Colleges and Universities in 1950.1 Enrollment during the 1965-1966 school yeas was approximately twelve hundred. In addition to the usual intellectual, ethical, social, aesthetic, and civic objectives of educational institutions, Southern Missionary College, as a church related institution 1A Self-Study Report of Southern Missionary College (Collegedale, Tennessee, 19627: pp. 6—9. 127 128 operated by the Seventh—day Adventist denomination, has spiritual and vocational objectives in the training of its students. The vocational objective and its appli- cation has caused the school to become involved in the tax problem under study. Specifically this objective is stated as: The college provides opportunity for work experi— ence and vocational training as an integral part of the total educational program in order to teach that labor is God—given, dignified, and an aid to charac- ter development as well as a means of financial sup- port.2 This objective has three purposes: (1) to develop voca- tional skills as a supplement to the professional and liberal arts training received in college, (2) to develop discipline and character growth, and (3) to aid the stu- dent in meeting his school expenses. This vocational objective is not unique to Southern Missionary College. John Dewey, the famous educator, held work activities to be valuable. One author in discussing Dewey's theory of work in education said: For these work activities in the school contribute both to the understanding of moral values and the actual nurture of ethical fiber. . . . Work projects are uniquely significant because they are embryonic recapitulations of social life. They serve, there- fore, as an introduction to that cooperative activity which is the most powerful educator of character. . . It is rather the function of work, Dewey wrote, first to sustain life and then to supply it with some margin and thereby "to provide a permanent home in which all the higher and more spiritual interests may center."3 21bid., p. 14. 3John W. Donohue, Work and Study (Chicago: Loyola University Press, 1959), pp. 93-94. 129 Similar approval for student work experience con— nected with the educational program is given in a report. concerning work-study college programs. ‘Some of the ad- vantages listed are theory and practice are more closely related, student motivation is increased, greater sense of responsibility is developed, students are oriented to the world of work, and students for financial reasons who would not otherwise go to college are enabled to receive the advantages of higher education.“ In addition to the usual student work opportunities on a college campus as secretaries, janitors, maintenance workers and library workers, Southern Missionary College has over the years operated industrial and commercial enter- prises to provide additional part-time work for its stu- dents. Some of these are required because of the rural location of the school for the convenience of the students and staff, while others have been operated purely to pro- vide additional work opportunities. While the primary pur— pose has been to meet the school's vocational objectives for its students and to provide needed services, the enter— prises have in most cases provided profits which have been used either for capital expenditures or for the general Operations of the institution. In cases where one of the industries has consistently operated at a loss, its oper- ations have usually been discontinued. “James W. Wilson and Edward H. Lyons, Work—Study College Programs-~Appraisal and Report of the Study of Cooperative Education (New York, Harper and Brothers, 1961), pp._6—7. 130 During the 20 year period, 1947—1966, these industries have been legally organized as College Indystries, Inc., Collegedale Enterprises, Inc., Collegedale Distributors, Inc., and also in a few cases as departments of Southern Missionary College. Each corporation has included the following activities with their dates of operation: College Industries, Inc. Furniture Factory 1947-1956 Laundry 1949— College Press 1947— Broom Shop 1947- Book Bindery 1962- Misc. Assemblies 1965 only College Enterprises, Inc. College Market 1952- Southern Mercantile 1952- Garage & Service Center 1952—1965 Campus Kitchen 1952-1965 Music House 1961-1965 Distributors 1952-1963 College Creamery 1952-1961 Auto Expeditor 1952-1956 Collegedale Distributors, Inc. 1964- Southern Missionary College College Store 1947-1951 College Garage 1947—1951 Farm and Dairy 1947-1957 Laundry 1947-1948 The separate legal organizations are necessary be- cause Tennessee State law prohibits educational institutions from operating commercial enterprises even when they further the non-profit objectives of the institution and Collegedale Distributors, Inc., was organized as a direct result of questions concerning the federal income taxation of the 131 income from some of the industries. (To be discussed later in the chapter.) However, they have all been oper— ated as departments of the college even though legally separate and the school prepares combined financial state- ments showing them as auxiliaries of the institution. College Industries, Inc., was organized in 1933, College Enterprises, Inc., in 1952, and Collegedale Distributors, Inc., in 1964. The most significant changes have been (1) the closing of the unprofitable furniture factory in 1956 after a fire destroyed most of the buildings, which were not rebuilt; (2) the opening of the book bindery in 1962, which showed a profit for the first time in 1966; (3) the leasing of the garage and service center and Campus Kitchen to private individuals in 1965; (4) the closing of unprofitable farming operations in 1957 and creamery in 1961; and (5) the separating of Collegedale Distributors, a health food dealer and distributor for Southeastern United States, into a separate corporation. Table VI-l shows the earnings of these organizations. Total earnings during the 1947-57 period were adversely affected by the farming operations and in certain years by large losses sustained by the furniture factory. In addition, 1962 marked the beginning of the development stage of the book bindery, which finally became profitable in 1966. In 1963 new enlarged facilities were constructed for Collegedale Enterprises, bringing sharply increased rent and overhead expenses. The broom shop, laundry, college 2 3 l .wOOmn mEoocO ampm mqmO O.O OOO.HOO.O: O0.000,000 0.0 ,NO.O:O.ON ON.OHO.OOO OOOH H.O H:.NOO.OO OH.N:H.HNO O.H O:.OHO.NH H0.000.000 OOOH N.O OO.NOO.O: OO.:O:.O:O HH.HO HOO.OON.O O OO.OON.OOO :OOH 0.0 ::.OON.NN O:.:OO.:OO HO.HO HOO.NOO.OHO OO.OOO.OOO OOOH H.ON OO.OOO.NO ON.OOO.OOO 0.0 ON.OH:.NO OH.NO:.OOO NOOH N.O O:.OOH.ON ,ON.HOO.OOO O.OH ON.OHO.H: HO.OOO.NOO HOOH O.NH OO.NNO.H: HO.OOO.ONO 0.0 ON.OOO.:O NO.OH:.OOO OOOH O.O OO.OOO.ON H:.OOO.:ON O.HN OO.O:H.OO :O.NOO.OOO OOOH O.O :O.:OO.NH NN.N:O.OON O.OH OO.NOO.OO OO.HOO.NON OOOH N.O OH.NOO.O :N.OOO.OON O.O ON.OOO.:H OO.NOO.HHN OOOH 0.0 OO.OOO.ON OO.O:O.NON .N.HH ON.OOO.OO HO.OOO.OON OOOH O.HH OO.OOO.ON :0.000.:ON H:.:NO HOO.OOO.OOO O:.OOO.:HO OOOH O.OH OO.OOH.ON OO.NOO.OON H0.0HO HOO.ONN.OOO OH.ONO.OOO :OOH O.OH OH.OO:.ON OO.ONN.HOH O.O VOO.OOO.OH O:.NON.OOO OOOH oO.O HO.ONO.OHO OO.OOO.OOHO 0.0 OO.OOO.ON NO.H:O.NOO NOOH I I I 0.0 OO.OOO.OO ON.OOO.OOO HOOH I I I 0.0 NH.OOO.ON :O.OOO.OON OOOH I I I 0.0 O0.0H0.0H OO.:H:.HON OOOH I I I 0.0 OO.OOO.O OO.HOO.NON OOOH I I I HON.ONV HOO.HOO.OOOO HO.OOO.OOHO OOOH Chapom oEoocH pmz supoz poz Gazpom oEoocH poz appoz poz go mpmm mo mumm pmom muonsnfihpmfim a momfiadpmpcm mamomwmaaoo moanpmSUCH mmeHoo OOOHIOOOH .OO OZOO omozm OOOOO OOO OOOHHOO OOOZOHOOHE zmmmesom Om OOOOOOOO OZO Omzzo OOHOOOOOZH OOO szeOm mo OBOO OZO .szOzH Bmz .OOOOO emz mIH> mqm<8 135 amounted to $2,775,510.94 or an average of $138,775 per year. This total was almost equal to the $2,823,208.07 of student labor provided by the non-industrial areas of the campus. The peak amount, $238,197 was reached in 1953 when the furniture factory was operating at its highest volume of business. While it true that the amount of labor pro- vided by college owned industries decreased after-the fire and closing of the furniture factory, student labor actually increased on the campus but in another way. The college used the fire insurance money and other funds to build facilities for a cabinet shop and a bakery. These buildings were leased to private individuals with the agreement that they would employ student labor as much as possible. Thus the college receives only-rent from rental property which is tax free and the private tax-paying organ- izations, Collegedale Cabinets and McKee Bakery, provide the student labor. It is also most interesting to note the decrease in student labor in 1966. This was caused to a small extent by the leasing of the Campus Kitchen and the College Garage and Service Station to private individuals in a manner similar to the above, but the decrease was caused to a much larger extent by the increase in federal funds available to students for educational purposes. In many cases availability of federal funds decreased the amount of part—time work needed for a student to remain in school. In fact, for the first time, during the 1965-66 school year there were not enough students to fill all the positions available. 136 For the 20-year period under study the rate of return on investment averaged 3.1 per cent for College Industries and 8.0 per cent for Collegedale Enterprises and Distributors. See Table VI-3. Together they averaged 5.5 per cent. While not exceptional, the return was as large as many types of traditional investments for colleges, and since profits are secondary to providing student labor as the main objective of these organizations, the return has been quite acceptable. Southern Missionary College receives funds from tuition; subsidies from its church related organization both for operating and for expansion purposes; donations from private individuals and funds; profits from aux- iliaries such as dormitories, married students apartments, and cafeterias; leasehold income; and profits generated by its industries. See Table VI-4. Tuition and church sub- sidies have by far accounted for most of the funds, 88.9 per cent, while industrial profits amounted to only 4.5 per cent of the total. While not large when compared to the total funds used in the college operation, in recent years the industrial profits have usually been sufficient to cover the operating deficit in the instructional division of the college. The profits have thus been used for general operations and for increased working capital and equipment for the commercial enterprises themselves. As might be expected, the Internal Revenue Service has questioned the operation of these commercial activities. 137 OO.: OO.N O:.H OO.N O0.0N ON.NH ON.HO Osmosom ON.OOH.NNOO OO.OOO.OOOO OO.ONO.OOHO OH.OOO.:OOO OO.NHO.OOO.OO :O.NHO.OOO.HO O:.OO0.00H.OO HOOOO OO.NOO_OO H:.HNO4OO HO.OOO4OOH OO.OOH~OOH OO.OOWONOO OO.OOO4HNH NO.NNO.OOO OOOH OO.NO0.0: OO.:OO.OO OO.OOO.ON OH.OOO.OOH HO.HOO.OOO NO.NH:.ONH OH.:O:.OHO OOOH OH.OOO.NO OO.OO:.OO HO.OOO.ON OO.:O0.0: OO.OOO.OOO O0.000.:OH OO.NHO.OOO :OOH OO.ONO.HH :O.OOO.OO HON.:O0.00 OH.OON.O OO.OOO.OON OO.OON.NOH OO.OON.OOO OOOH HO.OO:.:OH OO.OHO.N: OO.OOO.OH O:.OO:.O OO.OOO.O:N OO.OOO.OOH OO.N:H.OOO NOOH HO.OOO.OO OO.OOO.OO OH.OOO.N OO.OOH.O OO.OOO.OON O0.000.0HH OO.HOO.HO: HOOH OO.HOO.OO OO.OOO.OO HOH.O::.OO O0.0H0.0 OO.OOO.OOH OO.OOO.ONH OO.OOH.HOO OOOH O0.0NO.HO OO.OOO.O HOO.:OO.OHO O0.0HH.O HO.OO:.OON OO.OON.OHH OO.:O0.000 OOOH OO.OOO.HO O0.000.: HOO.OOO.HO :O.OOO.H OO.ONO.OHN OO.OON.OHH OO.OOH.NON OOOH OO.OON.O I HOO.OOO.:HO NO.OO:.OH OO.OOO.ONH OO.OON.OO OO.ONH.OON OOOH O:.OO0.0: I HNO.HOO.NO OO.HON.O OO.OOO.OO OO.OON.OO HO.OHO.O:N OOOH HO0.000.HOO I HO.NNO.OH I NO.OHO.HHH O0.00N.OO O:.OO:.ONN OOOH HOH.:OO.NOV I OO.OOH.O I OO.OOO.NHH O0.000.0: OH.OON.HON :OOH HN.OOO.OO I OH.OOO.OH I OO.OO:.NON O0.000.:: HO.O:O.ONN OOOH OO.OOO.OO I OO.OON I HO.OOO.OO OO.OOO.H: :H.OO:.:ON NOOH OH.OOO.O: I ON.ONO.: I OO.NOH.HO O0.000.0: O0.0H0.00H HOOH :O.OHO.O: I O:.:ON.O I OO.OOO.OOH O0.000.H: OO.O:O.OOH OOOH OO.OOO.O I HOO.OHO.HO I OO.:OO.OO OO.OOH.OO NO.OOO.OOH O:OH HO:.OOH.O O I :O.HOO.: I OO.OO:.NO OO.OOO.O: N:.OOO.O:H O:OH HNO.OOO.OOOO I OO.OO:.O O I OO.NOO.NOH OO.OOO.OO O OO.:OO.OHH O O:OH oeooCH moaonommoq wofipmfiflfixs< mcofipmcoo mcfimozm cofim zofimnsm wcfium coapfise Hmmw HmfippmsocH Izmdxm cognac Inwdo nopzco OOOHIOOOH mcmqqoo Mm¢ZOHmmHE zmmmebom mom mmzam mo mombom :IH> mqm United States v. Community Services, 189 F(2d) 421. University v. People, 99 U. S. 309. Other Sources Accounting Research and Terminology Bulletins. Final edition. New York: American Institute of Certified Public Accountants, 1961. O'Connell, A. L. Letter from Chief Technical Services Branch, Internal Revenue Service, December 28, 1966. Reg #1.501-(c)(3). Standard Federal Tax Reports, Vol. 3. New York: Commerce Clearing House, 1966. Reg #1.502-1. Standard Federal Tax Reports, Vol. 3. New York: Commerce Clearing House, 1966. Reg #1.511-2(a). Standard Federal Tax Reports, Vol. 3. New York: Commerce Clearing House, 1966. Reg #1.512. Standard Federal Tax Reports, Vol. 3. New York: Commerce Clearing House, 1966. Reg #1.513-1. Standard Federal Tax Reports, Vol. 3. New York: Commerce Clearing House, 1966. 171 Reg #1.61-l(a). Standard Federa1ATax Reports, Vol. 3. New York: Commerce Clearing House, 1966. A Self-Study Report of Southern Missionary College, Collegedale, Tennessee, 1962. Annual Reports of Southern Missionary College, 1947-1966. {Amt -. A i 4.. .' J I'IICHIGRN STRTE UNIV. LIBRRRIES lHIIllllllllllllllllIlllIlllllllllllllllllll 31293105753051