[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]



 
                   OVERVIEW OF THE TAX-EXEMPT SECTOR

=======================================================================

                                HEARING

                               before the

                      COMMITTEE ON WAYS AND MEANS
                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                               __________

                             APRIL 20, 2005

                               __________

                            Serial No. 109-6

                               __________

         Printed for the use of the Committee on Ways and Means



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                      COMMITTEE ON WAYS AND MEANS

                   BILL THOMAS, California, Chairman

E. CLAY SHAW, JR., Florida           CHARLES B. RANGEL, New York
NANCY L. JOHNSON, Connecticut        FORTNEY PETE STARK, California
WALLY HERGER, California             SANDER M. LEVIN, Michigan
JIM MCCRERY, Louisiana               BENJAMIN L. CARDIN, Maryland
DAVE CAMP, Michigan                  JIM MCDERMOTT, Washington
JIM RAMSTAD, Minnesota               JOHN LEWIS, Georgia
JIM NUSSLE, Iowa                     RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas                   MICHAEL R. MCNULTY, New York
ROB PORTMAN, Ohio                    WILLIAM J. JEFFERSON, Louisiana
PHIL ENGLISH, Pennsylvania           JOHN S. TANNER, Tennessee
J.D. HAYWORTH, Arizona               XAVIER BECERRA, California
JERRY WELLER, Illinois               LLOYD DOGGETT, Texas
KENNY C. HULSHOF, Missouri           EARL POMEROY, North Dakota
SCOTT MCINNIS, Colorado              STEPHANIE TUBBS JONES, Ohio
RON LEWIS, Kentucky                  MIKE THOMPSON, California
MARK FOLEY, Florida                  JOHN B. LARSON, Connecticut
KEVIN BRADY, Texas                   RAHM EMANUEL, Illinois
THOMAS M. REYNOLDS, New York
PAUL RYAN, Wisconsin
ERIC CANTOR, Virginia
JOHN LINDER, Georgia
BOB BEAUPREZ, Colorado
MELISSA A. HART, Pennsylvania
CHRIS CHOCOLA, Indiana

                    Allison H. Giles, Chief of Staff

                  Janice Mays, Minority Chief Counsel

Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.


                            C O N T E N T S

                               __________

                                                                   Page

Advisory of April 13, 2005 announcing the hearing................     2

                                WITNESS

U.S. government Accountability Office, Hon. David M. Walker, 
  Comptroller General............................................     6
Joint Committee on Taxation, George Yin, Chief of Staff..........    39
Congressional Budget Office, Douglas Holtz-Eakin, Ph.D., Director    50
University of Illinois College of Law, Urbana-Champaign, 
  Illinois, John Colombo.........................................    57
University of Miami School of Law, Miami, Florida, Frances R. 
  Hill...........................................................    61
Morgan, Lewis and Bockius, and Commissioner, Internal Revenue 
  Service, 1965-1969, Hon. Sheldon S. Cohen......................    69
Polsinelli Shalton Welte Suelthaus, P.C., Kansas City, Missouri, 
  Bruce Hopkins..................................................    75

                       SUBMISSIONS FOR THE RECORD

America's Community Bankers, Ike Jones, statement................   111
American Association of Debt Management Organizations, Mark 
  Guimond, statement.............................................   116
American Bankers Association, Floyd Stoner, statement............   127
American Society of Association Executives, John H. Graham IV, 
  statement......................................................   133
Association of Fundraising Professionals Greater Cleveland 
  Chapter, Cleveland, OH, Deborah S. Miller, letter..............   136
Association of Independent Consumer Credit Counseling Agencies, 
  Poinciana, FL, David Charles Jones, statement..................   137
Berns, Peter V., Standards for Excellence Institute, Baltimore, 
  MD, letter.....................................................   166
Castle, James R., Ohio Hospital Association, Columbus, OH, letter   161
Cates-Ortega, Tina J., Read ``Write'' Adult Literacy Program, 
  Moriarty, NM, joint letter.....................................   163
Central Arkansas Area Agency on Aging, Inc., North Little Rock, 
  AR, Ann C. Leek, letter........................................   140
Cohen, Rick, National Committee for Responsive Philanthropy, 
  statement......................................................   151
Credit Union National Association, Gary Kohn, statement..........   141
Droegemueller, Heidi Ann, Phoenix Children's Hospital, Phoenix, 
  AZ, letter.....................................................   162
Fair Housing Center, Toledo, OH, Michael Peter Marsh, letter.....   145
Fortney, Mary Martha, National Association of State Credit Union 
  Supervisors, Arlington, VA, statement..........................   150
Graham IV, John H., American Society of Association Executives, 
  statement......................................................   133
Guimond, Mark, American Association of Debt Management 
  Organizations, statement.......................................   116
Hayes, David, Independent Community Bankers of America, statement   124
Hazen, Paul, National Cooperative Business Association, statement   158
Hilinski, Keith, San Diego County Veterinary Medical Association, 
  San Diego, CA, letter..........................................   165
.................................................................
Independent Community Bankers of America, David Hayes, statement.   124
International Community Foundation, San Diego, CA, Richard Kiy, 
  letter.........................................................   146
International Health, Racquet and Sportsclub Association, Boston, 
  MA, John McCarthy, letter......................................   146
Jones, David Charles, Association of Independent Consumer Credit 
  Counseling Agencies, Poinciana, FL, statement..................   137
Jones, Ike, America's Community Bankers, statement...............   111
Kiy, Richard, International Community Foundation, San Diego, CA, 
  letter and attachment..........................................   146
Kohn, Gary, Credit Union National Association, statement and 
  attachment.....................................................   141
Krehely, Jeff, National Committee for Responsive Philanthropy, 
  statement......................................................   151
Leek, Ann C., Central Arkansas Area Agency on Aging, Inc., North 
  Little Rock, AR, letter and attachment.........................   140
Levy, Barbara R., Tucson, AZ, statement..........................   147
Maehara, Paulette, The Association of Fundraising Professionals, 
  Alexandria, VA, letter.........................................   134
Marsh, Michael Peter, Fair Housing Center, Toledo, OH, letter....   145
McCarthy, John, International Health, Racquet and Sportsclub 
  Association, Boston, MA, letter................................   146
Miller, Betty, Read ``Write'' Adult Literacy Program, Moriarty, 
  NM, joint letter...............................................   163
Miller, Deborah S., Association of Fundraising Professionals 
  Greater Cleveland Chapter, Cleveland, OH, letter...............   136
National Association of Federal Credit Unions, Arlington, VA, 
  Brad Thaler, statement.........................................   148
National Association of State Credit Union Supervisors, 
  Arlington, VA, Mary Martha Fortney, letter.....................   150
National Committee for Responsive Philanthropy, Rick Cohen, Jeff 
  Krehely, joint statement.......................................   151
National Cooperative Business Association, Paul Hazen, statement.   158
Ohio Hospital Association, Columbus, OH, James R. Castle, letter.   161
Phoenix Children's Hospital, Phoenix, AZ, Heidi Ann 
  Droegemueller, letter..........................................   162
Read ``Write'' Adult Literacy Program, Moriarty, NM, Tina J. 
  Cates-Ortega, Betty Miller, joint letter.......................   163
Rose, Steven M., Walpole, MA, letter.............................   164
San Diego County Veterinary Medical Association, San Diego, CA, 
  Keith Hilinski, letter.........................................   165
Standards for Excellence Institute, Baltimore, MD, Peter V. 
  Berns, letter..................................................   166
Stoner, Floyd, American Bankers Association, statement...........   127
Thaler, Brad, National Association of Federal Credit Unions, 
  Arlington, VA, statement.......................................   148


                   OVERVIEW OF THE TAX-EXEMPT SECTOR

                              ----------                              


                        WEDNESDAY, APRIL 20, 2005

                     U.S. House of Representatives,
                               Committee on Ways and Means,
                                                    Washington, DC.

    The Committee met, pursuant to notice, at 10:40 a.m., in 
Room 1100, Longworth House Office Building, Hon. William M. 
Thomas (Chairman of the Committee) presiding.
    [The advisory announcing the hearing follows:]

ADVISORY

FROM THE 
COMMITTEE
 ON WAYS 
AND 
MEANS

                                                CONTACT: (202) 225-1721
FOR IMMEDIATE RELEASE
April 13, 2005
No. FC-7

                     Thomas Announces Hearing on an

                   Overview of the Tax-Exempt Sector

    Congressman Bill Thomas (R-CA), Chairman of the Committee on Ways 
and Means, today announced that the Committee will hold a hearing 
titled ``An Overview of the Tax-Exempt Sector.'' The hearing will take 
place on Wednesday, April 20, 2005, in the main Committee hearing room, 
1100 Longworth House Office Building, beginning at 10:30 a.m.
      
    In view of the limited time available to hear witnesses, oral 
testimony at this hearing will be from invited witnesses only. Invited 
witnesses will include Honorable David Walker of the U.S. Government 
Accountability Office, Douglas Holtz-Eakin of the Congressional Budget 
Office, George Yin of the Joint Committee on Taxation, and several 
legal experts. However, any individual or organization not scheduled 
for an oral appearance may submit a written statement for consideration 
by the Committee and for inclusion in the printed record of the 
hearing.
      

BACKGROUND:

      
    According to the Internal Revenue Service (IRS), there are over 1.8 
million tax-exempt organizations under Sec. 501(c), not including 
churches and religious organizations. Between 1998 and 2002, the assets 
of tax-exempt organizations grew from $2 trillion to more than $3 
trillion.
      
    Congress first defined the exemption for charitable organizations 
and allowed the first deductions for charitable contributions 
approximately 100 years ago. Over time, Congress has vastly expanded 
eligibility to include a wide array of entities. Since 1954, there have 
been some 35 changes made to Sec. 501(c). There are now 28 tax-exempt 
categories under Sec. 501(c) covering organizations ranging from public 
charities and religious organizations to labor unions, trade 
associations, social clubs, fraternal societies, credit unions, 
cemetery companies and cooperatives.
      
    In announcing the hearing, Chairman Thomas stated, ``This continues 
the series of hearings we held last year examining the tax-exempt 
sector. Congress needs a better understanding of how vast and diverse 
this sector is today. Tax-exemption is an important benefit and the 
Congress has a responsibility to oversee and assure the American 
taxpayer that the tax-exempt sector is living up to its legal 
responsibilities.''
      

FOCUS OF THE HEARING:

      
    The hearing will examine the legal history of the tax-exempt 
sector; its size, scope and impact on the economy; the need for 
congressional oversight; IRS oversight of the sector; and what the IRS 
is doing to improve compliance with the law.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
    Please Note: Any person(s) and/or organization(s) wishing to submit 
for the hearing record must follow the appropriate link on the hearing 
page of the Committee website and complete the informational forms. 
From the Committee homepage, http://waysandmeans.house.gov, select 
``109th Congress'' from the menu entitled, ``Hearing Archives'' (http:/
/waysandmeans.house.gov/Hearings.asp?congress=17). Select the hearing 
for which you would like to submit, and click on the link entitled, 
``Click here to provide a submission for the record.'' Once you have 
followed the online instructions, completing all informational forms 
and clicking ``submit'' on the final page, an email will be sent to the 
address which you supply confirming your interest in providing a 
submission for the record. You MUST REPLY to the email and ATTACH your 
submission as a Word or WordPerfect document, in compliance with the 
formatting requirements listed below, by close of business Wednesday, 
May 4, 2005. Finally, please note that due to the change in House mail 
policy, the U.S. Capitol Police will refuse sealed-package deliveries 
to all House Office Buildings. For questions, or if you encounter 
technical problems, please call (202) 225-1721.
      

FORMATTING REQUIREMENTS:

      
    The Committee relies on electronic submissions for printing the 
official hearing record. As always, submissions will be included in the 
record according to the discretion of the Committee. The Committee will 
not alter the content of your submission, but we reserve the right to 
format it according to our guidelines. Any submission provided to the 
Committee by a witness, any supplementary materials submitted for the 
printed record, and any written comments in response to a request for 
written comments must conform to the guidelines listed below. Any 
submission or supplementary item not in compliance with these 
guidelines will not be printed, but will be maintained in the Committee 
files for review and use by the Committee.
      
    1. All submissions and supplementary materials must be provided in 
Word or WordPerfect format and MUST NOT exceed a total of 10 pages, 
including attachments. Witnesses and submitters are advised that the 
Committee relies on electronic submissions for printing the official 
hearing record.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. All submissions must include a list of all clients, persons, 
and/or organizations on whose behalf the witness appears. A 
supplemental sheet must accompany each submission listing the name, 
company, address, telephone and fax numbers of each witness.
      
    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.

                                 

    Chairman THOMAS. Good morning. This is the Committee's 
second in a series of hearings on the tax-exempt sector. Last 
year, the Oversight Subcommittee in a narrow, purposeful 
hearing focused on the hospital pricing system and its 
relationship to tax-exempt status, but that focus was primarily 
on hospitals and their pricing system given profit and not-for-
profit in the hospital area. Today's hearing really is the 
fundamental hearing to provide a broad overview of the tax-
exempt sector. Our government witnesses will provide 
information about the laws governing tax-exempt organizations, 
how they are administered, and their economic effects. We have 
an exceptionally qualified panel of legal experts who will 
discuss how a patchwork of laws has evolved, leading one of our 
witnesses to describe it as disparate, irregular, unbalanced, 
and uneven. The tax-exempt sector has grown significantly since 
its creation more than 100 years ago. A growth in any area 
isn't in and of itself bad, but revenue reported by tax-exempt 
organizations has grown from about $3 billion in 1975 to $1.2 
trillion in 2001, according to the Joint Committee on Taxation. 
In 2001, this amount represented 12.2 percent of the gross 
domestic product. According to the government Accountability 
Office, the tax-exempt sector employs at least 9 percent of the 
civilian workforce.
    Despite the significant size, scope, and economic impact of 
tax-exempt organizations, there has been no comprehensive 
oversight by Congress in nearly two decades, and I hesitate to 
call what occurred two decades ago a comprehensive oversight 
because I was on the Committee and the Subcommittee. The 
Committee conducted examinations in hearings on the question of 
business activities of tax-exempt organizations and whether 
they should be subject to an Unrelated Business Income Tax. 
Many charitable organizations provide critical social services 
to those in need. These organizations benefit greatly from 
their legal status because they do not pay taxes and because 
donors can deduct contributions they make to charitable 
organizations. However, many goods and services provided by 
tax-exempt organizations are similar, if not identical, to 
goods and services provided by tax-paying entities. This raises 
a fairly fundamental question of what makes these organizations 
unique and, hence, deserving of a tax-exempt status. It is also 
worth comparing Congressional interest in tax-exempt 
organizations to its interest of traditional for-profit 
corporations. When reports of abuse in the corporate world 
emerged, there was a swift and comprehensive response. Tax-
exempt organizations should not be immune from similar 
scrutiny. The Senate Finance Committee recently held a hearing 
in which they reviewed abuses in the tax-exempt sector and 
discussed potential reforms. Our hearing is not intended and 
will not duplicate their work by examining specific proposals. 
Instead, it establishes a foundation from which Members can 
systematically begin to examine the tax-exempt sector and 
determine what remedies, if any, are needed to provide greater 
clarity, transparency, and enforcement. Now I recognize the 
gentleman from New York, Mr. Rangel, for any comments he may 
wish to make.
    Mr. RANGEL. Thank you, Mr. Chairman. I am glad that you 
shared with me the reason for this hearing. I think the subject 
matter is very important, especially in view of the explosion 
of the number of not-for-profits and the amounts of moneys that 
are involved. I can't for the life of me see how this panel, as 
distinguished as they are, can help me to deal with some of the 
problems that it appears as though we are having from 
organizations, from the Heritage Foundation to the audit of the 
National Association for the Advancement of Colored People. 
These are real problems as to whether or not lobbyists are 
laundering money into these not-for-profits with trips for 
Members of Congress. There are a lot of things that I would 
have hoped that the Internal Revenue Service, who has oversight 
jurisdiction, might help and guide the Congress, but as you 
indicated, this is going to be an overview of the history of 
not-for-profits and people who don't pay taxes, so I would hope 
that some wealthy people would be included, because they don't 
pay taxes, either, and I don't know what contribution they are 
making. At a time where there are severe cutbacks in Federal 
programs and more and more of the majority are saying that 
people should rely on charitable organizations, I would hope 
that the testimony we hear today is how we can more effectively 
support these organizations that tend to provide services for 
the lower-income people and the poor people that the for-
profits don't have as a priority. May I ask the Chair, do you 
intend to do oversight of religious organizations, as well?
    Chairman THOMAS. I will tell the gentleman that one of the 
questions that I would begin with is do these people have a 
constitutional right to tax-exempt status. The answer is for 
most of them in the area that we are looking at, no. Pretty 
obviously, religion has another location in the Constitution 
which gives them a position different than most of these other 
organizations. That obviously is the First amendment.
    Mr. RANGEL. Would not the Internal Revenue Service 
determine what is a religious organization?
    Chairman THOMAS. I will tell the gentleman that is 
eventually something that could be looked at, because as is 
commonly known, a number of churches have activities which 
border on--that don't border on, they are in competition with 
tax-paying entities. This has been examined in the past. It is, 
I think, worthy of an examination. The problem is, until you 
understand the abject failure of Congress to provide adequate 
statutory direction and oversight of IRS and other agencies is 
to not understand how we reached the point that the gentleman 
indicated in his opening statement was of concern to him. Once 
we establish and understand that, we can then go in and examine 
various areas. Without this initial understanding of how little 
has been done in the past and how much needs to be done to 
create a structure and definitions and transparency, we either 
go into the knot with a sword and cut it or we learn how to 
untie it, and the Chair believes that learning how to untie it 
is the way we ought to go and that is what we are going to 
begin.
    Mr. RANGEL. So, they----
    Chairman THOMAS. This will be ``Un-Knot-Tying 101.''
    Mr. RANGEL. They will share with us how a religious 
organization, what do you have to do to be entitled to be 
considered a religious organization, since they are giving this 
broad background, because we have a whole lot of groups out 
there that call themselves religious and they are nuts, but we 
will see where we go with this.
    Chairman THOMAS. I tell the gentleman that is exactly the 
problem, because there are people who call themselves 
charitable. There are people who call themselves--so 
terminology----
    Mr. RANGEL. --religious organizations. I just wanted to----
    Chairman THOMAS. Eventually, we will.
    Mr. RANGEL. This panel is broad, so they will, too.
    Chairman THOMAS. This panel could briefly touch on that. In 
fact, if the gentleman has, and I know he has, looked at the 
written testimony, there are offerings of definitions for what 
should be allowed under this section, which certainly would 
circumscribe today's activities. Frankly, regulations issued by 
the IRS have caused additional groups to be qualified as 
nonprofits when there is no direct relationship in the law that 
allows them. That is part of the problem.
    Mr. RANGEL. IRS is not here----
    Chairman THOMAS. No, no.
    Mr. RANGEL. This group is. I just hope they venture and 
give me some guidelines as to what should be a religious 
organization's exemptions, Islamic and Muslims and other groups 
and communities should be given tax exemption.
    Chairman THOMAS. The gentleman will have ample time to ask 
the IRS why they have done what they have done in the past. 
Without an understanding and structure of what has occurred in 
the past, it probably would be not as worthwhile an exchange. 
As we look at the theory and practice of tax-exemption and you 
begin to get a structure which you believe is appropriate, we 
can then examine past behavior, and the Chair believes most of 
the Members of the Committee will be quite surprised at the 
failure of Congress to exercise its legitimate oversight 
function in this area. The problem is, without the structure, 
it is difficult to oversee.
    Mr. RANGEL. I thank the Chairman for his generosity, but 
could I ask, is the IRS in the house? Okay. Thank you.
    Chairman THOMAS. That doesn't mean they aren't in the 
house.
    Mr. RANGEL. Well, they can't speak up.
    Chairman THOMAS. That just means they don't want to be 
identified.
    [Laughter.]
    Mr. RANGEL. Officially, they are not here.
    Chairman THOMAS. No, because we aren't going to go into 
that level of detail. The Chair hopes--in fact, this hearing is 
for the purpose of a broad outline of the concept, the theory, 
and the practice of charity and tax exemption.
    Mr. RANGEL. Let the games begin.
    [Laughter.]
    Chairman THOMAS. First at bat----
    [Laughter.]
    Chairman THOMAS. Welcome back, David Walker, the 
Comptroller General of the U.S. GAO. Thank you. As I will 
indicate to all the witnesses, the written testimony that you 
have in front of you will be made a part of the record and you 
may address this Committee as you see fit in an appropriate 
period of time. The Chair wants to underscore, I have no 
interest in limiting the panel members to a narrow, confined 5 
minutes. I would hope that they try to sum up their position 
and not repeat what others have said to try to create a broad, 
immediate record in front of the Members as we begin this 
investigation. Mr. Walker?
    [The opening statement of Mr. Larson follows:]

    STATEMENT OF DAVID M. WALKER, COMPTROLLER GENERAL, U.S. 
GOVERNMENT ACCOUNTABILITY OFFICE; ACCOMPANIED BY MIKE BROSTEK, 
             U.S. GOVERNMENT ACCOUNTABILITY OFFICE

    Mr. WALKER. Thank you, Chairman Thomas, Ranking Member 
Rangel, other Members of the Ways and Means Committee. It is a 
pleasure to be back before you today to speak about the tax-
exempt sector and related oversight activities. As many of you 
know, under section 501(c) of the Internal Revenue Code, it 
covers a diverse number of entities currently estimated to be 
in excess of 1.5 million entities, varying in size and purpose. 
Before addressing the topics that the Committee asked, I think 
it is important to note that in many ways, this sector is 
indicative of the need for a fundamental review and 
reassessment of the entire Federal Government that is mentioned 
in the document that I mentioned before this Committee before 
called ``Reexamining the Base of the Federal Government,'' the 
21st century Challenges booklet, because what has happened is 
over many decades, there has been a layering and layering of 
new tax-exempt entities, new different types of requirements, a 
significant change in the nature and composition of the tax-
exempt portion of the economy, and there is a need to step back 
and engage in a fundamental review and reexamination of this 
sector, just as there is in connection with many others. In 
that regard, I would respectfully commend to each of the 
Members some of the key questions that are noted on page two of 
my testimony as an example of some of the broader type of 
questions that ultimately, hopefully, the Congress will get 
into at some point down the road with regard to this sector.
    Specifically, the Chair has asked that I briefly address 
the growth of the tax-exempt sector, certain governance 
practices and transparency mechanisms, related IRS oversight 
activities, and then what are some issues that the States are 
involved in. You have the typical very thick GAO testimony that 
has been provided. I will give you an executive summary. With 
regard to the size, it is estimated that there are currently 
over 1.5 million tax-exempt entities and that the reported 
assets, revenues, and expenses for these entities have grown 
significantly over the years. For example, between 1998 and 
2002, which is the most recent year that we have data 
available, the reported assets grew by 15 percent to over $2.5 
trillion. Accordingly, the tax-exempt sector represents an 
increasingly significant part of the Nation's economy and work 
force, and as the Chairman mentioned, 11 to 12 percent of the 
economy. With regard to work force, if I can show the first 
slide, which is on page ten of my testimony, you will see that 
the tax-exempt sector as of the year 2002 was estimated to 
employ about 9 percent of the civilian work force. So, not only 
with regard to the size of the economy, but also the size of 
the work force.
    Clearly, good governance and transparency mechanisms are 
essential elements to assure that tax-exempt entities operate 
with integrity and effectiveness and to prevent potential 
abuse. All of us are aware of recent concerns about certain 
abuses in the tax-exempt sector and, therefore, renewed 
attention to good governance practices and to enhancing 
transparency and improving oversight is called for. At the same 
time, I think we all can recognize a vast majority of these 
entities and the individuals who comprise them try to do their 
jobs in accordance with laws and to the best of their ability 
every day. With regard to staffing trends, you will see that 
based upon this first slide, that there has been a decline in 
the overall exam rate within the IRS, but that actually, while 
the overall exam rate has started to increase, the increase 
started earlier in the tax-exempt sector than it did overall. 
Yet, the tax-exempt exam rate is still far below average, and 
as one might expect, far below for-profit entities.
    In addition to that, you will see that for fiscal year 
2005, the number of full-time equivalents, or employees, who 
are being assigned to the examination process in the tax-exempt 
area is increasing for the first time in the last several 
years. So, there is a marked increase in 2005. Furthermore, you 
will note that the number of ``no changes'' that result in 
exams as a review of the Form 990, which is the annual report 
that these tax-exempt entities have to file, has declined. 
Stated differently, the number of changes has increased in the 
last year, as can be demonstrated by this particular graphic. 
With regard to activities by the States, in addition to the 
Internal Revenue Service focusing on this sector to the extent 
of its ability, the information that it has and the resources 
that have been allocated to it, the States also often oversee 
tax-exempt entities, frequently focusing on trying to protect 
the public from fraudulent activities and guarding against 
misuse of charitable assets. The States and the IRS believe 
that it would be in the public interest to enhance data sharing 
between the Internal Revenue Service and the States in order to 
be able to share more information on their respective 
enforcement activities. GAO has recommended in the past that 
steps be taken to increase this data sharing while protecting 
certain sensitive information from public disclosure.
    In summary, because I am trying to make sure that everybody 
else has an opportunity to speak, tax-exempt entities provide 
an incredibly diverse set of services to our equally diverse 
population. They enrich our lives and improve our country. Yet, 
like all organizations, they are run by human beings. As a 
result, tax-exempt entities can sometimes engage in 
inappropriate and unlawful practices. Ensuring that tax-exempt 
entities run as effectively and efficiently as possible and in 
line with the purposes of Congress, the reason that they 
receive their tax-exemption, can be enhanced through 
strengthening sound governance practices; number two, improving 
transparency over certain of their operations; and number 
three, enhanced oversight by the IRS, the States, as well as 
the U.S. Congress. Regarding oversight by the States and IRS, 
as I mentioned, additional data sharing would be desirable in 
order to target enforcement efforts, minimize necessary 
overlap, and enhance the effectiveness of both parties' 
respective activities. Ultimately, the Congress is going to 
have to decide what activities should benefit from a tax-
exemption and what organizations must do in exchange for this 
tax advantage. As I have testified before this Committee 
before, it is important to keep in mind that in many years, the 
tax preferences under the Internal Revenue Code, the total 
value of those tax preferences, including tax exemptions, 
exceed total discretionary spending. So, this is a large and 
growing part of our economy, a large and growing part of our 
work force, and it is important not to let it be off the radar 
screen. It is important to relook at this area and reexamine it 
in light of 21st century changes and challenges. Periodic 
Congressional oversight is, therefore, critical to ensuring 
that the tax-exempt sector remains a vibrant contributor to the 
quality of life in America, at the same point in time while 
operating with integrity and making sure that entities that are 
granted tax-favored status, in fact, are serving a public 
purpose above and beyond entities that have not been granted 
that status, and as we know, there are many sectors of the 
economy where you have both not-for-profit and for-profit 
entities in the same business, health care and education being 
two examples. There should be some meaningful distinction 
between those two in order for one to be able to be granted 
tax-exempt status and another not. As always, the GAO stands 
ready to help the Congress in reviewing this area, in examining 
this area, and we look forward to answering any questions you 
may have, Mr. Chairman. Thank you.
    Chairman THOMAS. Thank you very much, Mr. Walker.
    [The prepared statement of Mr. Walker follows:]
 Statement of The Honorable David M. Walker, Comptroller General, U.S. 
                    Government Accountability Office

Chairman Thomas and Members of the Committee:

    I am pleased to participate in today's hearing about the tax-exempt 
sector and oversight of it. The sector recognized under section 501(c) 
of the Internal Revenue Code (IRC) covers a diverse group of over 1.5 
million entities with varying sizes and exempt purposes (see app. I for 
types of section 501(c) exempt entities). The breadth and diversity of 
the tax-exempt sector allows it to address the specific needs of many 
of our citizens and the general needs of society. The exempt sector, 
and those that volunteer to assist, also supplements government 
programs to meet various needs. For example, charities can supplement 
programs by providing comfort to the aging, health care to the 
uninsured, and education to the uneducated.
    As the nation's tax administrator, the Internal Revenue Service 
(IRS) has a key role in overseeing the tax-exempt sector. Oversight can 
help sustain public faith in the sector and ensure that exempt entities 
stay true to the purposes that justify their tax exemption. It also can 
help protect the entire sector from potential abuses initiated by a 
small minority.
    Before discussing the work we did for the Committee, I want to 
frame today's hearing within a broader context. GAO recently issued a 
report entitled, 21st Century Challenges: Reexamining the Base of the 
Federal Government.\1\ This report provides examples of a number of key 
questions that need to be explored in light of our current and 
projected fiscal imbalances as well as other changes and challenges. It 
highlights the need for a re-examination of all major federal policies 
and programs in light of 21st century realities. Although that report 
did not specifically cover the tax-exempt sector, the sector is a 
microcosm of the issues raised in the report. While the provisions 
granting federally recognized tax-exempt status and associated policies 
have been layered upon one another to respond to challenges at the 
time, a comprehensive re-examination of the tax-exempt sector has not 
been done in recent times. On a broad scale, a comprehensive re-
examination could help address whether exempt entities are providing 
services to our citizens commensurate with their favored tax status, 
whether the current number and nature of exemptions continue to make 
sense, whether restrictions on the activities of tax-exempt entities 
remain relevant, and whether the framework for ensuring that exempt 
entities adhere to the requirements attendant to their status is 
satisfactory.
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    \1\ GAO-05-325SP.
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    Today's hearing provides an excellent forum to launch such a re-
examination. Some of the more specific issues that may merit re-
examination for the tax-exempt sector include:

      Should the criteria for granting exempt status be 
reconsidered and do we need as many types of tax-exempt entities?
      Do we need to modify the model used in overseeing tax-
exempt entities to ensure that the tax--exempt purpose is met and that 
fraud or other misuse is deterred?
      What governance standards should apply to the tax-exempt 
sector, and should particular types of exempt entities have more 
specific standards?
      Are the operations and activities of tax-exempt 
organizations sufficiently transparent to support oversight by the 
public, news media, and federal, state, and local governmental 
agencies?
      Beyond revoking tax-exempt status and various currently 
available intermediate sanctions, do we need more intermediate 
sanctions to deter abuse and enhance accountability while minimizing 
any damage to those served by the exempt entity?
      Should certain federal audit and internal control 
requirements apply to tax-exempt entities, and if so, how should the 
requirements vary according to entities' size or other characteristics?
      Is there sufficient transparency over the total 
compensation package and its justification for executives and other 
officials at tax-exempt entities?
      What should be the allowable ``lobbying and political'' 
activities in which different types of tax-exempt entities can engage 
and how should such activities be reported?
      What are the differences between nonprofit and for-profit 
entities that perform similar missions, such as nonprofit and for-
profit hospitals, and do the nonprofit entities provide sufficiently 
different services to justify their exemption?
      Based on your request, I will discuss
      The growth of the tax-exempt sector, focusing on those 
entities whose tax-exempt status falls under section 501(c) of the IRC.
      The role of sound governance practices and transparency 
in ensuring that tax-exempt entities function with integrity and 
perform their missions effectively.
      IRS's capacity for overseeing those exempt from taxation 
under section 501(c), results of its oversight activities, and efforts 
to address critical compliance problems.
      The states' role in overseeing tax-exempt entities and 
their relationship with IRS in conducting oversight.

    To summarize the growth of the tax-exempt sector, we analyzed data 
filed annually with IRS by section 501(c) entities. To summarize 
governance practices and transparency in the tax-exempt sector, we 
reviewed documents published by IRS and others, and official statements 
made in testimony before Congress. To summarize IRS's oversight 
capacity, results, and efforts to deal with critical compliance 
problems, we reviewed IRS's data and interviewed IRS officials. To 
summarize the role of states and their relationship with IRS, we 
reviewed our previous reports \2\ and outside articles and reports. To 
the extent possible, we sought data from 1998 through the most recent 
year available for all descriptive statistics. We reviewed the 
reliability of the data used and found them reliable for our purposes. 
We did our work from December 2004 through March 2005 in accordance 
with generally accepted government auditing standards.
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    \2\ See Tax-Exempt Organizations: Improvements Possible in Public, 
IRS, and State Oversight of Charities, GAO-02-526 (Apr. 30, 2002); 
Political Organizations: Data Disclosure and IRS's Oversight of 
Organizations Should Be Improved, GAO-02-444 (July 17, 2002); and 
Vehicle Donations: Benefits to Charities and Donors, but Limited 
Program Oversight, GAO-04-73 (Nov. 14, 2003).
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    Let me begin by highlighting key points I will make.

      The 501(c) tax-exempt sector has grown steadily in 
reported assets, revenues, and expenses. For example, between 1998 and 
2002 (the most recent year of available data), their reported assets 
grew 15 percent to over $2.5 trillion. Accordingly, the tax-exempt 
sector comprises a significant part of the nation's economy and 
workforce. For example, spending in the tax-exempt sector appears to be 
about one-tenth of our economy and the paid exempt workforce appears to 
be comparable in size to some of the largest sectors of the U.S. 
civilian workforce, such as food and lodging. The sector's significance 
in the economy might be greater because the asset, revenue, and expense 
data are likely understated to some unknown amount. For example, the 
data do not include all tax-exempt entities under section 501(c) 
because not all entities are required to file, such as religious 
entities, and some entities do not file required Form 990.
      Good governance and transparency are essential elements 
to ensure that tax-exempt entities operate with integrity and 
effectiveness in carrying out their missions. Governance facilitates 
well-run operations that dissuade abusive behavior. Transparency sheds 
light on entities' practices, which enhances incentives for ethical, 
efficient, and effective operations and facilitates oversight by the 
public and others. With recent concerns about abuses within the tax-
exempt sector, renewed attention is being given to improving governance 
practices and expanding and increasing the transparency of the sector's 
operations.
      Staffing trends and insufficient data have contributed to 
IRS being challenged in executing its oversight role. IRS has begun to 
increase staffing during 2005, which results in 467 FTE to examine the 
compliance of about a half million section 501(c) entities that file 
Forms 990. However, IRS does not know the extent to which these 
entities comply. Recognizing this, IRS started efforts in 2002 to 
obtain compliance data for various segments of the exempt sector but 
had to suspend most of these efforts to use those resources on higher 
priorities such as pursuing known types of noncompliance. For example, 
IRS has ongoing special compliance initiatives dealing with critical 
issues such as excessive compensation and abusive tax transactions 
involving exempt entities. IRS is also seeking ways to access and 
better analyze existing data at IRS or elsewhere on exempt entities.
      States often oversee tax-exempt entities, frequently 
focusing on protecting the public from fraudulent activities and 
guarding against misuse of charitable assets. States and IRS believe 
that more data sharing would make their oversight more efficient and 
effective. Consistent with our earlier recommendations, IRS has 
improved its processes for sharing data and Congress has been 
considering a legislative proposal to expanded IRS's authority to share 
data with specified state officials under appropriate restrictions and 
protections related to using the data.

    My statement today will address each of these topics in turn. 
Before that, I will provide some background on the tax-exempt sector 
and IRS's oversight of it.
BACKGROUND
    Internal Revenue Code (IRC) section 501(c) specifies 28 types of 
entities that are eligible for tax-exempt status and over 1.5 million 
entities have been recognized as exempt as of 2003.\3\ Section 501(c) 
entities are involved in a variety of activities and exempt purposes. 
Congress authorized the tax exemption for each type of entity to meet 
specific purposes, such as health care for the uninsured.
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    \3\ Other types of tax-exempt entities are authorized under other 
Section 501 subsections such as for cooperative hospital service or 
educational investment organizations or under other sections such as 
Section 521 (farmer cooperatives) and Section 527 (political 
organizations), among others.
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    Almost two-thirds of these entities--over 960,000 in 2003--were 
classified as 501(c)(3) charities, which have exempt purposes such as 
serving the poor; advancing religious, educational and scientific 
endeavors; protecting human rights; and addressing various other social 
problems.\4\ About another 20 percent of exempt entities were social 
welfare organizations, labor unions, and business associations--501(c) 
(4 through 6), respectively. The remainder covered an array of types of 
exempt entities with varying purposes and numbers. In 2003, such types 
included 15 teacher retirement funds, over 10,000 cemetery companies, 
over 4,000 state-chartered credit unions, an employee-funded pension 
trust, 20 corporations to finance crop operations, and over 35,000 
veteran organizations.
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    \4\ Taxpayers may deduct from their taxable income the value of 
donations to charities, unlike for almost all other types of tax-exempt 
entities.
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    An entity that believes it meets the requirements set by Congress 
must apply to IRS to obtain tax-exempt recognition by submitting the 
following: \5\
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    \5\ Entities that are not required to apply include those that are 
not private foundations and that have gross receipts of less than 
$5,000 as well as churches and church-affiliated entities.

      Form 1023 (Application for Recognition of Exemption under 
Section 501(c) (3) of the Internal Revenue Code) or Form 1024 
(Application for Recognition of Exemption under 501(a));
      organizing documents, such as the Articles of 
Incorporation, Articles of Association, Trust Indenture, Constitution, 
or other enabling documents;
      4 years of financial data; \6\ and
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    \6\ If the entity has operated for less than a year or has not 
begun operations, a proposed budget for two full accounting periods and 
a current statement of assets and liabilities will be acceptable. 
Otherwise, entities that have operated for less than four years should 
report data for those years.
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      a full description of the purposes and the activities of 
the entity.

    After receiving tax-exempt recognition, many entities must annually 
file a Form 990 to report their financial transactions and activities 
for a ``tax year'' (see app. II for a copy of Form 990) if annual gross 
receipts are normally more the $25,000. Those that have less than 
$100,000 in gross receipts and year-end assets of less than $250,000 
may use Form 990-EZ. Generally, entities with gross receipts below 
$25,000 are not required to file. Certain types of entities such as 
churches and religious organizations also are not required to file. 
Form 990 has information on revenues, expenses, and assets. For 2003, 
the form had 105 line items on 6 pages as well as 46 pages of 
instructions plus two schedules. Schedule A covers several areas such 
as compensation, lobbying, and revenue sources. Schedule B covers the 
source of contributions to charities and certain other exempt entities, 
such as IRC Section 527 political organizations.
    IRS oversight relies on two activities. First, IRS reviews 
applications for tax-exempt status to determine whether a tax-exempt 
purpose is envisioned. IRS can approve or deny the application. Once an 
application is properly completed, the criterion for approving or 
denying the exemption is whether the applicant provides sufficient 
evidence that its operations will match an allowable exempt purpose. 
Second, IRS annually examines some Forms 990 to determine whether 
selected exempt entities meet various requirements (such as 
restrictions on political activities). In general, IRS attempts to 
select entities that it believes are likely to have violated 
requirements. IRS can accept the Form 990 as filed or change the status 
of the entity, impose excise taxes for certain types of violations, or 
revoke the exempt status if the violations are serious enough. IRS can 
also assess taxes if an entity has not fully paid employment taxes or 
taxes on unrelated business income.
    Given concerns about the tax-exempt sector, the Senate Committee on 
Finance asked that a panel of experts make recommendations to Congress 
to improve oversight, transparency, and governance in the sector. To do 
so, the Independent Sector \7\ convened a Nonprofit Sector Panel in 
October 2004, which includes 24 nonprofit and philanthropic leaders.\8\ 
It provided an interim report of findings and recommendations in March 
2005 and plans to issue a final report in June 2005.
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    \7\ The Independent Sector is a national coalition of nonprofit 
organizations, private foundations, and corporate-giving programs that 
is to support the tax-exempt sector.
    \8\ The Panel is assisted by over 100 nonprofit executives and 
other experts on five work groups.
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TAX-EXEMPT ASSETS, REVENUES, AND EXPENSES HAVE GROWN, MAKING IT A 
        SIGNIFICANT SECTOR IN THE NATION'S ECONOMY
    The tax-exempt sector is growing. During 1998 through 2002, more 
entities have been filing Forms 990 and reporting higher amounts of 
assets, revenues, and expenses. These reported amounts indicate that 
the tax-exempt sector is a significant part of the economy and the 
civilian workforce.
    The data on the growth in assets, revenues, and expenses reported 
on the annual Form 990 are likely to be understated because not all 
tax-exempt entities under section 501(c) are included. Entities below 
certain asset or gross receipt tolerances are not required to file. Nor 
are various types of religious entities. Further, an unknown number of 
tax-exempt entities do not file the required Form 990. The number and 
finances of those not included are unknown.
Tax-exempt Entities Have Reported Increased Assets, Revenues, and 
        Expenses
    For tax years 1998 through 2002, the number of section 501(c) 
exempt entities filing a Form 990 grew from about 450,000 to 465,000--
about 3 percent (see table 1 in app. III). These Forms 990--of which 
between 63 and 65 percent are filed by charities--have been reporting 
higher asset amounts. Figure 1 shows the growth in reported assets for 
tax years 1998 to 2002 (the most recent year of data). The reported 
assets grew 15 percent to over $2.5 trillion--about 12 percent growth 
for section 501(c)(3) charities and about 22 percent growth for the 
other 27 types of noncharities covered under section 501(c). (See table 
2 in app. III.)

 Figure 1: Assets Reported by Section 501(c) Entities in 2004 Constant 
                      Dollars, Tax Years 1998-2002
[GRAPHIC] [TIFF OMITTED] 23916A.001

    The reported revenue and expense amounts also grew from tax years 
1998 through 2002 (see tables 3 and 4 in app. III). However, the amount 
by which reported revenues exceeded expenses has been closing for 
exempt entities filing Forms 990--from about 9 percentage points in 
1998 to 2 percentage points in 2002 (see figure 2).

 Figure 2: Revenue and Expenses Reported by Section 501(c) Entities in 
               2004 Constant Dollars, Tax Years 1998-2002
[GRAPHIC] [TIFF OMITTED] 23916A.002

  Tax-exempt Sector Is a Significant Part of the Economy and Civilian 
                               Workforce

    The growth in the tax-exempt sector indicates that it has become a 
major part of our economy and workforce. From 1975 to 1995, the real 
assets of entities filing Forms 990 more than tripled while the economy 
grew 74 percent during the same 20-year period, according to an IRS 
study.\9\ More recently, based on data reported on Forms 990 during 
1998 through 2002, spending by tax-exempt entities was roughly 11 to 12 
percent of the United States' gross domestic product (GDP).\10\ (See 
table 5 in app. III.) Because the tax-exempt sector is not measured as 
a specified GDP sector, its percentage of GDP cannot be compared to 
official GDP sectors such as medical care or housing, which likely 
include spending by tax-exempt entities. Even so, no single sector 
accounted for more than 15 percent of the GDP in 2002.
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    \9\ A 20-Year Review of the Nonprofit Sector, 1975-1995, Compendium 
of Studies of Tax-exempt Organizations, Volume 3, IRS Statistics of 
Income.
    \10\ Gross domestic product is the market value of all goods and 
services produced within a country during a given time period.
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    Figure 3 indicates that tax-exempt entities appear to account for a 
major portion of the civilian workforce. Data from the U.S. Census 
indicates that over 9.6 million employees in the tax-exempt sector 
accounted for about 9 percent of the civilian workforce in 2002. 
Although generally aligned with section 501(c), the Census definition 
of a tax-exempt entity excluded certain types of entities (such as 
universities, labor unions, religious organizations, and public 
administration), which means that the number of tax-exempt employees is 
understated.

   Figure 3: Paid Employees by Economic Sector as Percentage of U.S. 
                            Workforce, 2002
[GRAPHIC] [TIFF OMITTED] 23916A.003

Note: ``Other'' category includes 13 economic sectors that individually 
 accounted for less than 8 percent of the workforce in 2002, including 
educational services such as technical, driving, and other specialized 
  training schools; mining; utilities; construction; and real estate.

    In addition to paid workers, one study \11\ suggests that the 
number of volunteers at certain tax-exempt entities (which account for 
at least 60 percent of the sector)grew about 27 percent from 4.5 
million in 1982 to 5.7 million volunteers in 1998.
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    \11\ IRS does not transcribe data on the numbers of paid workers 
and volunteers. The Independent Sector issued a nonprofit almanac with 
data through 1998 on volunteers at entities classified as 501(c) (3) 
charities, 501(c) (4) social welfare and civic organizations, and 
religious congregations.
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STRONG SELF-GOVERNANCE AND TRANSPARENCY ARE ESSENTIAL ELEMENTS FOR A 
        THRIVING AND EFFECTIVE EXEMPT SECTOR
    Strong self-governance and transparency are essential elements to 
help provide assurance that tax-exempt entities operate with integrity 
and effectiveness in meeting their missions while maintaining public 
trust. A number of requirements help establish governing structures 
while required public disclosure of information about exempt entities 
enhances transparency. However, recent concerns about abuses in the 
tax-exempt sector have prompted consideration of and support for 
enhanced governance and transparency.
Good Governance Helps Provide Assurance that a Tax-exempt Entity 
        Effectively Manages Funding and Programs
    Governance can be viewed as the collective policies and oversight 
mechanisms in place to establish and maintain sustainable and 
accountable organizations that achieve their missions while 
demonstrating stewardship over resources. Good governance helps ensure 
that tax-exempt entities are well run and that abusive behavior is 
minimized. Generally, an organization's board of directors has a key 
role in governance through its oversight of executive management, 
corporate strategy, risk management and audit processes, and 
communications with external stakeholders. This is implicitly 
recognized in some of the statutory and regulatory requirements for the 
tax-exempt sector.
    For example, to obtain federal tax-exempt recognition, applying 
entities must include charters and bylaws with their application. The 
states in which they are established specify what must be included in 
the charters and/or bylaws and the states' requirements help create a 
basic governance structure for exempt entities. Some states, for 
instance, have requirements for audited financial statements of tax-
exempt entities. For example, in one state, charities with gross 
revenue in excess of $100,000 and not more than $250,000 are required 
to file financial statements accompanied by a report from a licensed 
certified public accountant. If gross revenues exceed $250,000, the 
state requires an audited financial statement with an independent 
auditor's report.
    In addition, Congress and IRS have various requirements to help 
ensure that tax-exempt entities do not engage in activities that are 
inconsistent with their exempt purpose and to promote stewardship over 
the use of the funds. For instance, to ensure that tax-exempt assets 
are for public rather than private benefit, IRS has issued regulations 
affecting tax-exempt entities on ``excessive compensation'' to 
officers, directors, or other employees. IRS requires market 
comparability studies and a review of compensation by boards of 
directors. If excessive compensation is found, excise taxes under 
section 4958 for charities and section 4941 for private foundations can 
be levied against the overpaid individual and certain managers who 
knowingly approved the payments. (See app. V for an explanation of such 
excise taxes imposed against private foundations and other tax-exempt 
entities.)
    The federal government also has certain accountability requirements 
that affect some tax-exempt entities. OMB Circular A-133, for instance, 
requires those entities, including tax-exempt entities that receive 
federal awards of $500,000 or more per year to perform an audit of 
federal funds received and expended and ofthe programs for which the 
funds were received.
Transparency complements good governance
    While strong governance practices can help ensure that tax-exempt 
entities operate effectively and with integrity, public availability of 
key information about the entities--i.e., transparency--can both 
enhance incentives for ethical and effective operations and support 
public oversight of tax-exempt entities, while helping to achieve and 
maintain public trust. Recognizing the importance of transparency for 
tax-exempt entities, Congress provided for substantial transparency 
regarding tax-exempt entities by making their Forms 990 publicly 
available documents. This is in stark contrast to the strong 
protections for the privacy of individuals' tax returns.
    Since tax exemptions are granted to entities so that they can carry 
out particular missions or activities that Congress judged to be of 
special value, the public availability of the entities' Forms 990 is 
one means to help ensure that the public has information to judge 
whether those missions are carried out properly. Presumably, when 
``sunshine'' is let in, inappropriate activities are less likely to 
occur. In the particular case of charitable organizations, the 
availability of their Forms 990 provides some information for 
individuals to use in judging whether to make a donation. Thus, 
publicly available information helps establish a ``free market'' in 
which charities compete for donations, which should encourage 
efficiency and effectiveness.
    At various times, Congress has reinforced the commitment to 
transparency over the operations of tax-exempt entities. For instance, 
when some exempt entities were found to be imposing inappropriate fees 
or other requirements on those seeking to obtain a copy of their Form 
990, Congress modified the law to provide that copies must be provided 
without charge to the individual other than a reasonable fee for any 
reproduction and mailing costs.\12\
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    \12\ See IRC Section 6104(d) and changes made by the Tax and Trade 
Relief Extension Act of 1998, P.L. 105-277.
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Recent Concerns about Abuses Have Led to Support for Enhanced 
        Governance Processes and Transparency
    With recent concerns about abuses in the tax-exempt sector, 
attention has been renewed on improving the sector's governance and 
transparency. Among the proposals being considered for improved 
governance are enhancing the controls and processes for determining 
executive compensation, guarding against other misuse of charitable 
assets, and forestalling tax-exempt entities' participation in tax 
avoidance schemes. Proposals for enhanced transparency include 
requiring more information in a more timely and user-friendly fashion 
on the Form 990.
    In recent years, media accounts have publicized certain alleged 
abuses in the tax-exempt sector that speak to failures in tax-exempt 
entities' governance. For example, a series of articles in 2003 
highlighted possible misuse of foundations and trusts, citing numerous 
cases of excess compensation, insider loans, self-dealing, extravagant 
perks, and other questionable activities.\13\ The articles cited, for 
instance, alleged abuses such as:
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    \13\ The Boston Globe ran a series of articles between October and 
December of 2003 that uncovered questionable practices among 
foundations and trusts.

      A foundation in New York more than tripled its 
president's compensation to over $900,000 between 1997 and 2001.
      A family-based foundation in Chicago paid two family 
members over $1 million during a 5-year stretch and donated only 
$175,000 to charities.

    Another series of articles pointed to the apparent misuse of 
easements.\14\ An easement is when an owner voluntarily restricts 
changes to real property, such as to preserve historic buildings and 
the environment. Donation of the easement to an exempt entity provides 
an income-tax break to the donor. In some cases, insiders at the 
charities charged with policing the restrictions imposed by the 
easements on development may have benefited the most. In other cases, 
individuals may have claimed tax deductions for easement donations even 
though local or other laws already required preservation of the 
property.
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    \14\ The Washington Post has been running periodic articles about 
alleged abuses within the tax-exempt sector. The most recent series, in 
December 2004, concerned the alleged donation of historic facade 
easements to obtain inflated charitable contributions.
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    Concerns about excessive compensation and whether some tax-exempt 
entities provide sufficient services to justify their exempt status 
have surfaced regarding nonprofit hospitals. An example of concerns in 
these areas has been offered by the Minnesota Attorney General who 
recently testified on such abuses.\15\ Among other things, his office 
found that certain tax-exempt health care systems paid for trips to 
vacation resorts by executives and board members without a clear 
business purpose, and that some nonprofit hospitals provided inadequate 
levels of ``charity'' care to patients without the resources to pay. 
Across the United States, little is known about the extent to which 
these potential abuses involving excess compensation and the level of 
services provided by nonprofit hospitals occur. More information about 
the practices employed by exempt entities to compensate executives and 
others, and by nonprofit hospitals to serve their patients, would be 
valuable.
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    \15\ Testimony of Mike Hatch, Attorney General for State of 
Minnesota, before the Senate Committee on Finance, April 5, 2005.
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    Even as these abuses were surfacing, some organizations within the 
tax-exempt sector were seeking to improve the governance and 
transparency within the sector. For example, in recent years, the 
National Association of State Charity Officials (NASCO), the 
Independent Sector, and the National Committee for Responsive 
Philanthropy, among others, have called for revisions to the Form 990.
    Others have taken the initiative to establish self-regulatory 
standards independent of those set by IRS. For example, the Better 
Business Bureau has established a seal of approval program to help 
donors make informed decisions and foster public confidence in 
charities. Charities participating in the program are to provide 
documentation that the bureau uses to determine whether its 20 
standards have been met. These standards address governance and 
oversight, effectiveness, finances, and public information materials. 
For example, 5 standards are used to measure governance and oversight 
such as through an active and independent governing board, and 7 
standards are used to ensure that spending is honest, prudent, and in 
accordance with fund-raising appeals.
    Concerns about abuses in the tax-exempt sector also have spurred 
congressional interests. This House Committee on Ways and Means' 
hearing exemplifies that interest. In June 2004, the Senate Committee 
on Finance released a discussion draft of proposals for tax-exempt 
reforms. The draft discussed more than three-dozen proposals to 
generate comments about possible legislation. The proposals addressed 
conflict of interest, federal-state coordination, transparency, 
governance, best practices, funding for enforcement, among many others. 
Such proposals mirror similar types of recent requirements to increase 
accountability and oversight of other types of large public and private 
organizations, such as corporations, in which ethical, financial, and 
other abuses have occurred.
    The Panel on the Nonprofit Sector responded to such proposals in 
its March 2005 interim report. In discussing governance and ethical 
conduct, the report pointed to the need for best practices, accepted 
standards, self-regulation, and education. To improve governance, the 
report recommended that charities enforce a conflict-of-interest 
policy, select board members with some financial literacy, and 
encourage disclosure of illegal practices. The report also advocated 
more transparency to enable public oversight and confidence in tax-
exempt entities. It concluded that IRS should promote transparency 
while recognizing the burdens that reporting more data can place on 
exempt entities that are small and lack resources. The report supported 
revising the Form 990, mandating electronic filing in coordination with 
the states for the Forms 990 and 1023, and increasing the sanctions for 
not filing an accurate or timely Form 990. The report acknowledged that 
these steps would not fully dissuade those who want to violate 
standards, and concluded that some government oversight is necessary.
    More specifically, among the proposals being considered to improve 
governance and transparency are:

      Governance Proposals:

        Require that compensation for all management positions 
at a charity must be approved annually and in advance, and must be 
justified in a manner that can be understood by those with a basic 
business background.
        Require the board of directors of a charity to 
establish a conflict-of-interest policy, a compliance program to 
address regulatory and liability concerns, and program objectives and 
performance measures, among other duties.
        Prohibit board membership to those not permitted to 
serve on the board of a publicly traded company.
        Establish a prudent investor rule for the investment 
activities of charities.

      Transparency Proposals:

        Require the chief executive officer of a tax-exempt 
entity to sign under penalty of perjury that the Form 990 and other 
forms filed comply with the Internal Revenue Code and that reasonable 
assurances were given of the accuracy and completeness of the 
information reported.
        Require disclosure of relationships of a tax-exempt 
entity with other exempt and nonexempt entities, including the 
formation of taxable subsidiaries and transactions with these other 
entities.
        Require disclosure of annual performance goals and 
measures by charities with over $250,000 in gross receipts.
        Require disclosure of investments by public charities.
IRS HAS BEEN CHALLENGED TO OVERSEE TAX-EXEMPTS AND IS BEGINNING STEPS 
        TO ENCHANCE ITS OVERSIGHT CAPACITY
    Staffing and insufficient data have constrained IRS's oversight of 
the tax-exempt sector. IRS is in the midst of increasing tax-exempt 
staffing in fiscal year 2005 and improving its data on tax-exempt 
entities as well as enhancing its ability to analyze data to help in 
targeting compliance efforts. IRS has identified compliance problems it 
deems critical and is taking actions to address them.
IRS Oversight Resources Have Been Relatively Flat Until Recently
    Based on a 1997 IRS memorandum and more recent data, it is apparent 
that the staffing level for the functions that are now within the Tax 
Exempt and Governmental Entities (TE/GE) division has been essentially 
flat since 1974--2,075 in 1974 versus 2,122 in 2004. These are total 
staffing levels for all of the work done within the current TE/GE, 
which includes reviewing employee pension plan issues and certain other 
matters. Although we did not obtain a measure of the overall change in 
TE/GE workload from 1974 to 2004, the number of 501(c) tax-exempt 
entities increased from around 670,000 to over 1.5 million.
    From fiscal year 2000 through 2004, IRS staffing for overseeing 
tax-exempt entities stayed relatively flat as measured by the number of 
full-time equivalent (FTE) staff assigned to oversee tax-exempt 
entities.\16\ For fiscal year 2005, IRS increased the number of FTEs 
assigned for such work. The assigned FTEsdropped about 4 percent from 
fiscal years 2000 through 2004 but increased about 11 percent for 
fiscal year2005, resulting in a 7 percent increase in assigned FTEs 
overall (see fig. 4). This 2005 increase is due to the FTEs assigned to 
do examinations since the FTEs assigned to do determinations of exempt 
status stayed relatively flat. As of 2005, IRS assigned 467 FTEs to 
examine the hundreds of thousands of entities who generally file Forms 
990 (see table 6 in app. IV).
---------------------------------------------------------------------------
    \16\ An FTE equals 2,087 hours in a year. IRS did not have 
comparable FTE data for its exempt activities back to 1998 due to its 
reorganization in 2000. FTEs assigned are what IRS budgets for this 
work. We were unable to obtain reliable data on the FTEs used for tax-
exempt oversight in time for this testimony. However, because IRS may 
not use the FTEs assigned to examination or determinations for those 
purposes, the number of hours that staff charge to these oversight 
tasks may be a better indicator of the level of effort.
---------------------------------------------------------------------------

Figure 4: Assigned FTEs by Type of IRS Activity, Fiscal Years 2000-2005
[GRAPHIC] [TIFF OMITTED] 23916A.004

  Note: ``Other FTE'' includes technical staff who issue rulings, the 
             Director's staff, and education and outreach.

    Competition within IRS for resources helps explain why resources 
for tax-exempt oversight have not increased much until fiscal year 
2005. IRS has many other priorities in collecting the proper amount of 
tax from tens of millions of individuals and businesses. IRS's budget 
emphasizes areas that produce tax revenue rather than areas that are 
regulatory. IRS oversight of the exempt sector is primarily regulatory 
rather than revenue producing. IRS exempt officials also said that an 
ongoing issue is the proper mix of resources budgeted for oversight 
versus other activities such as providing guidance or education. Beyond 
tax-exempt entities, TE/GE must also budget resources to deal with 
pension plans, Indian tribal governments, and other types of government 
entities.
    Congressional tax-writing committees have attempted to provide 
dedicated funding for exempt oversight. For example, in 1969, Congress 
added section 4940 to the Internal Revenue Code, which imposes an 
excise tax on the net investment income of private foundations (see 
app. V for an explanation of this tax and tax rates). The legislative 
history indicates that the tax committees intended for the amounts 
collected from the excise taxes would operate as user fees to fund IRS 
oversight of exempt entities. To date, congressional appropriation 
committees, which have jurisdiction over annual funding, have not 
earmarked these tax collections for this purpose.\17\
---------------------------------------------------------------------------
    \17\ The Nonprofit Sector Panel interim report concluded that 
Congress should increase resources, and earmark some penalty, fee, and 
excise tax amounts for IRS exempt oversight and education.
---------------------------------------------------------------------------
    IRS has not maintained data on how much excise tax it has assessed 
or collected under Section 4940 (or any other excise tax that can be 
assessed against tax-exempt entities either overall or by type of 
excise tax). However, IRS did have data that showed tax-exempt entities 
reported owing (i.e., self-assessed), in 2004 constant dollars, at 
least $247 million in this excise tax annually (about $1.5 billion 
overall) for 2000 through 2003 (see table 10 in app. V). For 
comparison, the fiscal year 2003 budget for all of TE/GE (i.e., not 
just tax-exempt oversight functions) was around $205 million.
IRS's Oversight Caseload Has Been Increasing in Recent Years and IRS 
        Has Had Difficulties Sustaining Its Oversight
    For section 501(c) entities, IRS's oversight caseload has been 
increasing. In its determinations' work involving applications for tax-
exempt status, in fiscal years 1998 through 2004, applications 
increased about 17 percent from 78,358 to 87,080, with some annual 
fluctuations (see table 7 in app. IV). IRS officials said that IRS must 
review each application to make a determination of exempt status. IRS's 
potential tax-exempt examination universe has grown more slowly. As 
mentioned earlier, the number of exempt entities filing a Form 990 grew 
from about 450,000 to 465,000 during tax years 1998 through 2002--or 
about 3 percent.
    IRS has had difficulty sustaining a consistent examination rate for 
tax-exempt entities. As figure 5 shows, the rate at which IRS examined 
filed Forms 990 fell from 1.8 percent in 1998 to 1.1 percent in 2002 
before rising to 1.3 percent in 2003 (see table 8 in app. IV).

  Figure 5: IRS Examination Rates for Section 501(c) Entities, Fiscal 
                            Years 1998-2003
[GRAPHIC] [TIFF OMITTED] 23916A.005

    IRS officials said that the declining examination rates primarily 
resulted from a decline in FTEs for examinations and an increase in the 
average hours spent per examination. The number of tax-exempt entities 
that IRS examined decreased from 8,290 in fiscal year 1998 to 5,889 in 
2004, or about 29 percent, after dropping as low as 5,423 examinations 
in 2002. IRS officials said that they have examined more returns since 
2002 because they used more of their examiners to examine Forms 990 
rather than help elsewhere such as with determinations, and expedited 
examinations, such as by limiting their scope and depth.
    In terms of determinations' results, during fiscal years 1998 
through 2004, IRS annuallydenied about 1 percent of the applications 
while the approval rate was 74-80 percent (see table 7 in app. IV).\18\ 
Denials occur when IRS determines that an applicant has not met the 
statutory requirements for exemption. In accordance with the statutory 
guidance on qualifying for tax-exempt status, IRS is not likely to deny 
the recognition of tax-exempt status as long as the applicant provides 
all required documents, files a complete Form 1023, and provides an 
appropriate statement about its intent to serve an approved exempt 
purpose.
---------------------------------------------------------------------------
    \18\ The rest of the applications included those for which IRS had 
not made a determination for reasons such as applications that were 
withdrawn or incomplete.
---------------------------------------------------------------------------
    Regarding examination results,during fiscal years 1998 through 
2003, IRS revoked exempt status in 1.2 percent of its examinations. 
Revocations occur when IRS determines that the entity omitted or 
misstated a material fact, operated materially different from its 
stated exempt purpose, or engaged in a prohibited transaction in 
conflict with its exempt purpose. IRS does not often revoke tax-exempt 
status because the need for revocation often does not arise and when it 
does, IRS focuses more on getting the tax-exempt entity to comply with 
federal laws rather than on taking away its exempt status.
    Beyond revocations, IRS examinations can produce one or more other 
changes \19\ such as in the section 501(c) paragraph,\20\ foundation 
status of a 501(c)(3) entity,\21\ and assessed tax.\22\ Changes in 
paragraph are important because of rules governing permissible 
activities. For example, a tax-exempt entity classified as a charity 
under 501(c)(3) can accept donations that are tax deductible for the 
donor unlike those classified as a social welfare entity under Section 
501(c)(4). However, such charities are more restricted in their ability 
to lobby and engage in political activity compared to social welfare 
entities. Changes in foundation status are important because 
foundations generally are subjected to more requirements than public 
charities, such as in the requirement to annually distribute a minimum 
amount of income towards its exempt purpose.
---------------------------------------------------------------------------
    \19\ IRS examiners can make 12 ``other'' types of changes such as 
those involving related returns, delinquent returns, appeals, closing 
agreements, referrals to other IRS divisions, and claims.
    \20\ ``Paragraph'' refers to the types of 501(c) entities such as 
(c)(3) or (c)(4). When an entity applies for exempt status, it must 
tell IRS the section 501(c) paragraph under which it qualifies.
    \21\ An entity that qualifies under section 501(c)(3) is a private 
foundation unless it meets the criteria for a public charity, such as 
having broad public support. Beyond an examination, status can be 
changed when (a) an entity requests an IRS determination letter on its 
status, and (b) 5 years have elapsed for an entity that has been 
permitted to be a public charity for its first 5 years.
    \22\ Tax-exempt entities could owe employment taxes, various types 
of excise taxes, or income taxes if they operate a business activity 
not related to their exempt purpose.
---------------------------------------------------------------------------
    Figure 6 shows that the percentage of examinations that produced no 
change rose from 31 percent in fiscal year 1998 to 39 percent in 2004, 
with higher rates in 2002 and 2003 (see table 9 in app. IV). In 
general, IRS is not likely to find a change in every examination given 
the focus on getting exempt entities into compliance and the need for 
better data to select the most noncompliant entities for examination. 
Higher no-change rates mean that IRS spends resources examining 
compliant entities. IRS officials said that they are working to reduce 
the no-change rate to or below the 1998 level.

 Figure 6: No-Change Rate for Examinations of Forms 990, Fiscal Years 
                               1998-2004
[GRAPHIC] [TIFF OMITTED] 23916A.006

IRS Has Had Insufficient Reliable Information to Guide Oversight 
        Efforts but Is Working to Obtain Better Information
    IRS has acknowledged that it lacks sufficient data to effectively 
find and address noncompliance among tax-exempt entities. At the same 
time, IRS is aware that improvement to the Form 990 data made available 
to the public could better support public, media, and others' oversight 
of tax-exempt entities. To better enable it to collect and analyze such 
data, IRS is taking a number of steps. IRS is also trying different 
actions to enhance its ability to address critical and other types of 
noncompliance.
    To help identify noncompliance, IRS is revising the data requested 
on the Form 990. IRS has determined that the Form 990 does not provide 
sufficient data to identify tax-exempt entities that merit an 
examination due to noncompliance. Nor can IRS easily compare Form 990 
data with data reported on the Form 1023.\23\ For example, the current 
Form 1023 requests data on hospitals and low-income housing that are 
not captured in the Form 990. Being able to compare similar data on 
both forms would better enable IRS to see whether the stated exempt 
purpose is being pursued and met.
---------------------------------------------------------------------------
    \23\ IRS revised Form 1023 in 2004 to provide information that 
helps identify potential problems early in the application process, 
including potentially abusive situations involving tax-exempt entities 
such as those claiming to provide credit counseling.
---------------------------------------------------------------------------
    To enhance the usefulness and ease of preparation of the Form 990, 
IRS officials stated that the IRS is undertaking a large-scale 
revision. IRS officials said that the revision process has key steps to 
be taken before IRS shares the specific changes. However, IRS officials 
identified some general changes being developed. To ease preparation, 
IRS is attempting to write all questions in plain English and group 
questions related to an issue. Further, IRS officials explained that 
the revised Form 990 is to consist of one form applicable to all tax-
exempt entities and a series of organization and activity schedules. 
The organization schedules would be tailored to filers such as 
hospitals or veteran's organizations while the activity schedules would 
be tailored to issues such as compensation packages and grant making 
that may be financing terrorism.
    An IRS team completed a first draft of the revised Form 990 in 
December 2004. Before setting milestones for publishing the Form 990, 
IRS wants to allow for review by various parties inside and outside 
IRS. IRS also plans to consider recommendations on the Form 990 of the 
Nonprofit Sector Panel to be presented in its final report in June 
2005. Finally, IRS plans to make the revised Form 990 suitable for 
electronic filing in a cost-effective manner.
    IRS has also recognized that it has insufficient data on the extent 
or causes of noncompliance for segments of the tax-exempt sector. IRS 
has done a few studies to measure the compliance of exempt entities 
filing Forms 990 and reporting items such as the unrelated business 
income tax owed. IRS did these studies in the 1970s, except for a 
smaller compliance study done during the 1980s.
    To alleviate such data shortcomings, in 2002, IRS began over 30 
studies of ``market segments,'' which are homogeneous groups of tax-
exempt entities such as charities, social clubs, and business leagues, 
or of exempt issues such as business income unrelated to an exempt 
purpose. These studies were to develop reliable data on the types and 
extent of compliance problems. IRS planned to use the data to refine 
selection criteria for identifying noncompliant returns for examination 
as well as help identify other strategies to improve compliance such as 
through improved guidance or instructions. However, IRS has had to 
delay most of these studies due to higher priorities (such as dealing 
with abusive tax transactions).
    Given its concern about insufficient data, IRS also is taking steps 
in fiscal year 2005 to improve its capabilities to analyze data. IRS 
has been establishing a Data Analysis Unit to provide trend analysis 
intended to improve the selection of tax-exempt entities for 
examination and the identification of compliance issues to pursue. The 
unit is to make better use of internal and external databases.\24\ A 
driving force in creating the unit was the lack of research tools and 
staff trained in using data. As described below, IRS has several other 
efforts underway or planned to improve the use of electronic data on 
the tax-exempt sector.
---------------------------------------------------------------------------
    \24\ The Data Analysis Unit plans to use data-mining techniques to 
identify patterns and establish relationships to uncover compliance 
issues. For example, by comparing state bingo databases to IRS files, 
IRS could identify entities with gross receipts in excess of the 
$25,000 filing threshold that failed to file a required Form 990.

      IRS plans to expand electronic filing of returns, which 
could help IRS to more quickly identify noncompliance and improve 
public access to Form 990 data.\25\ IRS began accepting the Form 990 
\26\ electronically on a voluntary basis in 2004, and plans to expand 
voluntary electronic filing to Form 990-PF filed by private foundations 
in 2005 and to create a single point for electronic filing of federal 
and state returns in 2006. IRS plans to require electronic Form 990 
filing for exempt organizations with assets in excess of $100 million 
for 2006 and in excess of $10 million for 2007. Private foundations 
would be required to file electronically for 2007 regardless of the 
amount of their assets.\27\
---------------------------------------------------------------------------
    \25\ IRS has a network to image the paper Forms 990 filed by 
charities. The imaged forms, minus sensitive data such as social 
security numbers and donor names, are sold to groups that want such 
data. Due to resource limitations, IRS transcribes little data from 
Forms 990 into electronic databases. To have more electronic data from 
Forms 990, IRS has a contract to have the imaged Form 990 data 
keypunched.
    \26\ IRS is developing electronic filing for Form 1023, which is 
used to apply for tax-exempt status. IRS hopes to begin accepting the 
electronic Form 1023 by 2007.
    \27\ Consistent with IRC section 6011(e), only large organizations, 
including exempt organizations and private foundations, that are 
required to file 250 or more returns with IRS will be required to file 
their Form 990 electronically. Such returns include Forms 990, annual 
employee wage and tax statements (Form W-2), quarterly payroll tax 
returns (Form 941), and annual information returns, such as payments to 
vendors for services (Form 1099 MISC).
---------------------------------------------------------------------------
      IRS's Exempt Organizations Electronic Initiatives Office 
\28\ is developing a ``Better Data Initiative'' intended to synthesize 
IRS's electronic data for compliance purposes, such as examination 
selection and compliance trend analysis. The goal is to have an 
effective database management infrastructure in place by 2007. This 
office also is to help find and use electronic data sources that would 
be useful for trend analysis.
---------------------------------------------------------------------------
    \28\ The Electronic Initiatives Office manages the development and 
implementation of automation efforts on exempt organizations in support 
of the strategic plan.
---------------------------------------------------------------------------
IRS Has Identified Priority Compliance Issues and Is Working to Address 
        Them
    Because of increasing concerns about specific types of 
noncompliance, IRS has created initiatives to address specific abuses 
across the tax-exempt sector. IRS also is attempting to build a 
stronger enforcement presence during 2005 through new processes to 
supplement examinations of compliance among exempt entities.
    IRS has identified four critical compliance problems, which it 
plans to address through enforcement during fiscal year 2005, as 
follows.

      Anti-terrorism--examine a sample of exempt entities that 
make foreign grants to ensure that the funds are used for the 
charitable purpose and not for terrorist activity.
      Credit counseling--examine credit counseling and consumer 
credit organizations that appear to operate as businesses rather than 
provide the educational or charitable services required under tax-
exempt status.
      Excessive compensation--conduct compliance checks and 
examinations of charities and private foundations to identify potential 
excessive compensation paid to insiders.
      Abusive tax avoidance transactions--focus on four types 
of transactions that are intended to exploit tax-exempt status for 
personal gains, including:

        using non-life mutual insurance companies \29\ and 
producer-owned reinsurance companies \30\ to earn tax-free profits.
---------------------------------------------------------------------------
    \29\ Insurance companies or associations that provide other than 
life insurance are generally tax exempt under IRC section 501(c)(15) if 
their gross receipts do not exceed $600,000 and more than 50 percent of 
their receipts consist of premiums.
    \30\ A producer-owned reinsurance company provides reinsurance for 
a producer group's business; reinsurance transfers part or all of the 
risk from one insurer to another.
---------------------------------------------------------------------------
        establishing donor-advised funds \31\ to generate 
questionable deductions, benefits to donors, or management fees for 
promoters.
---------------------------------------------------------------------------
    \31\ Donor-advised funds allow donors to advise how the charitable 
contribution is to be used.
---------------------------------------------------------------------------
        misusing tax-exempt entities that are to support other 
exempt entities by, for example, making large loans to the founder of 
the supported entity or by not providing the required tax-exempt 
support.
        abusing Department of Housing and Urban Development 
programs such as through personal use of program property.

    IRS plans to address other compliance problems as well. The 
problems to be addressed involve charitable gaming, disaster relief 
organizations whose distributions result in private benefit or fraud, 
tax-exempt political organizations that fail to annually report all 
required information, and prohibited political intervention by 
charities.\32\ In addition, IRS is addressing excess deductions for 
conservation easements, vehicle donations and other noncash 
contributions, as well as abuses involving charitable trusts, and a 
``corporation sole''.\33\
---------------------------------------------------------------------------
    \32\ IRS plans to contact over 100 charities identified as having 
potentially violated the prohibition, to educate the organizations and 
prevent future violations of the law.
    \33\ A corporation sole is an entity authorized under state law to 
allow religious leaders to hold property and conduct business for the 
benefit of a religious entity.
---------------------------------------------------------------------------
    To enhance enforcement overall, IRS has been developing new units 
or processes. For example, IRS created the Exempt Organization 
Compliance Unit in 2004 to help deal with growth in the number of tax-
exempt entities coupled with the limited examination resources. It is 
to check exempt entities' compliance with record-keeping and 
information-reporting requirements via correspondence rather than a 
review of books and records in an examination. During fiscal year 2004, 
the unit sent over 2,000 letters to check compliance and over 8,000 
letters to educate the entities about how to comply. If an entity does 
not respond or has questionable activity identified in the compliance 
check, IRS could initiate an examination.
    IRS also is developing a Financial Investigations Unit to 
specialize in complex fraud and tax-avoidance schemes involving the 
exempt sector. IRS recognized that it lacked staff in its tax-exempt 
unit trained to trace funds through complex transactions but was being 
asked to ensure that charitable assets are not diverted for illegal 
purposes. IRS plans to hire specialists that can identify fraud and 
track foreign grants. Furthermore, IRS has established a group to 
review exempt applications for names of individuals that appear on a 
Department of the Treasury Office of Foreign Assets Control listing of 
suspected terrorists or that IRS knows to be tax-scheme promoters as 
well as for types of entities with a history of noncompliance, such as 
in credit counseling. The presence of such names or entities would 
likely result in a referral to the examination group, or for a 
suspected terrorist, to IRS Criminal Investigation group.
STATES PLAY AN IMPORTANT ROLE IN OVERSEEING TAX-EXEMPT ENTITIES AND MAY 
        BENEFIT FROM ADDITIONAL COORDINATION WITH IRS
    In addition to IRS oversight, states oversee tax-exempt entities, 
often focusing on potential fund-raising fraud and misuse of charitable 
assets. The states believe that their oversight could be more effective 
if IRS were able to share additional information with them. We have 
previously recommended that IRS work with states on data-sharing 
proposals that Congress could consider.
States Provide Critical Oversight
    Many states oversee some aspects of the tax-exempt sector through 
their attorney general and/or state charity offices. Although some 
overlap in responsibility with IRS exists, state oversight differs. IRS 
focuses on whether the tax-exempt entities meet tax-exempt requirements 
and comply with federal laws. States have an interest in whether tax-
exempt charities' fund-raising is fraudulent and whether the entity is 
meeting the purpose for which it was created.
    In general, exempt entities are to incorporate in a state or the 
District of Columbia. State attorneys general have broad power to 
regulate the charities that are established or operate in their states. 
States monitor charities for compliance with statutory and common-law 
standards, and can correct noncompliance through litigation and other 
means.
    States can impose requirements on tax-exempt entities incorporated 
or operating in their jurisdictions that specifically affect governance 
or transparency. For example, some states require fund-raisers to 
register and file information regarding fund-raising or monitor charity 
solicitations through their consumer protection bureaus to protect 
against fraud. Through its Nonprofit Integrity Act of 2004, California 
established governance requirements for financial audits, audit 
committees, disclosure of audited statements, and review and approval 
by the board of directors of compensation paid to the chief executive 
officer and chief financial officer. The act also established 
requirements related to fundraising.
Coordination between IRS and the States in Sharing Data About Tax-
        Exempt Entities Could Enhance Oversight and the Use of Limited 
        Resources
    State officials believe, and IRS officials agree, that state 
oversight of tax-exempt entities could benefit if IRS and states 
coordinated on sharing IRS's data. IRS is working on improved data 
sharing consistent with recommendations we made in 2002.\34\ First, we 
recommended that IRS consult with state charity officials on how to 
regularly share IRS data that federal law allowed to be shared (e.g., 
data on denials or revocations of tax-exempt status). State charity 
officials told us that IRS has implemented this recommendation and has 
been open to input from the states on how to better share the data on a 
regular basis.
---------------------------------------------------------------------------
    \34\ See GAO-02-526.
---------------------------------------------------------------------------
    Second, we recommended that IRS work with state charity officials 
and the Department of the Treasury to identify other types of IRS data 
that states would find useful and provisions to protect the data from 
improper disclosure or misuse, and to develop a legislative proposal 
that would expand state access to such IRS data. State and IRS 
officials believe that revising statutes to allow IRS to share more 
data, such as about ongoing and closed examinations of charities, would 
help IRS and states to better use limited resources and the states to 
more quickly respond to noncompliance. Congress is now considering a 
proposal to allow IRS to share more information with the states, 
including their charity regulators.
CONCLUDING OBSERVATIONS
    Tax-exempt entities provide an incredibly diverse set of services 
to our equally diverse population. Our lives are enriched and improved 
through the work of this sector. In sum, the tax-exempt sector has 
become an indispensable part of American life. Yet, like all 
organizations run by human beings, tax-exempt entities' operations can 
at times be flawed.
    Ensuring that tax-exempt entities run as effectively and 
efficiently as possible, and in line with the purposes for which 
Congress established their tax exemption, can best be accomplished 
through a series of complementary controls. At the organization level, 
a sound governance structure can establish the set of checks and 
balances that help steer an entity towards result-oriented outcomes 
consistent with their purposes while also guarding against abuses. 
Transparency over the operations of the exempt entity provides an 
incentive to help ensure the governance practices function as intended 
and when they do not, transparency helps increase the chances that 
inappropriate behavior will be detected and corrected. Oversight by IRS 
and the states brings to bear the powers of government to investigate 
errors made among tax-exempt entities, to change the rules when 
necessary, and to provide consequences when rules are not followed.
    Regarding oversight by states, IRS and states believe greater 
sharing of federal data would help states target their enforcement 
efforts and minimize unnecessary overlap with federal oversight of 
exempt organizations. As we recommended, we look forward to IRS, the 
Department of the Treasury, and states identifying the specific 
information that should be shared and procedures for sharing it 
consistent with taxpayer privacy rights, to help Congress in 
deliberating changes to current restrictions on IRS sharing such data 
with the states.
    Ultimately, Congress determines what activities should benefit from 
tax exemption and what organizations must do in exchange for that 
advantage. Periodic congressional oversight is therefore critical to 
ensuring that the exempt sector remains a vibrant contributor to the 
quality of American lives and operates with integrity in achieving 
results commensurate with the tax-favored status it has been granted. 
As noted earlier, the hearing today provides an excellent forum from 
which to launch a comprehensive re-examination of this vital sector as 
we work to address the challenges arising in the 21st century. We stand 
ready to assist Congress as it considers such a re-examination and 
continues its oversight of this critical sector of our national 
economy.
                                 ______
                                 
    Mr. Chairman, this concludes my prepared statement. I would be 
happy to respond to any questions you or other Members of the committee 
may have.
    For further information on this testimony, please contact Michael 
Brostek at (202 512-9110) or [[email protected]]. Individuals making key 
contributions to this testimony include Perry Datwyler, George Guttman, 
Shirley Jones, Bob McKay, John Mingus, Jeff Schmerling, and Tom Short.
Appendix I: Types of Tax-Exempt Entities under Section 501(c)
    The following lists the 28 types of tax-exempt entities under the 
subsections of section 501(c) of the Internal Revenue Code.

     (1)  Corporations organized by Act of Congress; Central Liquidity 
Facility for Federal Credit Unions; Resolution Trust Corporation; 
Resolution Funding Corporation
     (2)  Title-holding corporations
     (3)  Public charities, private foundations, religious, charitable, 
scientific, testing for public safety, literary, or educational, 
fostering national or international amateur sports competition, 
prevention of cruelty to children or animals
     (4)  Civic leagues, social welfare organizations, local 
associations of employees dedicated to charitable, educational, or 
recreational purposes
     (5)  Labor unions, agricultural, or horticultural organizations
     (6)  Trade associations, professional football leagues
     (7)  Social and recreational clubs
     (8)  Fraternal benefit societies providing payment of certain 
benefits to members
     (9)  Voluntary employees' beneficiary associations providing 
payment of certain employee benefits
    (10)  Domestic fraternal societies whose net earnings are devoted 
to religious, charitable, scientific, literary, educational, and 
fraternal purposes, which do not provide benefits to members
    (11)  Teachers' retirement fund associations
    (12)  Benevolent life insurance associations, mutual ditch or 
irrigation companies, mutual or cooperative telephone, electric, or 
water companies
    (13)  Cemetery companies
    (14)  Credit unions
    (15)  Small mutual insurance companies
    (16)  Corporations to finance crop operations
    (17)  Supplemental unemployment benefit trusts
    (18)  Pre-June 25, 1959 trusts to fund pension benefits
    (19)  Veterans' groups
    (20)  Group legal service organizations
    (21)  Black lung benefit trusts
    (22)  Multi-employer pension plan trusts
    (23)  Armed Forces insurance organizations established before 1880
    (24)  ERISA trusts for certain terminated plans
    (25)  Multi-parent holding companies
    (26)  State-sponsored, high-risk insurance organizations
    (27)  State-sponsored worker compensation reinsurance organizations
    (28)  National railroad retirement investment trust
Appendix II: Copy of Form 990
[GRAPHIC] [TIFF OMITTED] 23916A.007

[GRAPHIC] [TIFF OMITTED] 23916A.008

[GRAPHIC] [TIFF OMITTED] 23916A.009

[GRAPHIC] [TIFF OMITTED] 23916A.010

[GRAPHIC] [TIFF OMITTED] 23916A.011

[GRAPHIC] [TIFF OMITTED] 23916A.012

Appendix III: Form 990 Data
    The following tables summarize data reported on the annual Form 990 
by tax-exempt entities under section 501(c) of the Internal Revenue 
Code. The tables cover reported assets, revenues, and expenses overall 
and, where appropriate, broken out by charities and the rest of the 
section 501(c) entities (i.e., noncharities).

                 Table 1: Form 990 Returns Filed by Section 501(c) Entities, Tax Years 1998-2002
----------------------------------------------------------------------------------------------------------------
                                                                        Number of returns filed
                      Tax year                       -----------------------------------------------------------
                                                           Charities         Noncharities        All entities
----------------------------------------------------------------------------------------------------------------
1998                                                            281,228             168,309             449,537
----------------------------------------------------------------------------------------------------------------
1999                                                            299,204             173,239             472,443
----------------------------------------------------------------------------------------------------------------
2000                                                            301,612             168,963             470,575
----------------------------------------------------------------------------------------------------------------
2001                                                            301,359             171,006             472,365
----------------------------------------------------------------------------------------------------------------
2002                                                            302,464             162,134             464,598
----------------------------------------------------------------------------------------------------------------
Source: Tabulation of data from IRS's Return Inventory Classification System, 1998-2002.


        Table 2: Assets Reported by Section 501(c) Entities in 2004 Constant Dollars, Tax Years 1998-2002
----------------------------------------------------------------------------------------------------------------
                                          All entities                Charities               Noncharities
                                   -----------------------------------------------------------------------------
             Tax year                Assets (in     Percent    Assets (in     Percent    Assets (in     Percent
                                      millions)     change      millions)     change      millions)     change
----------------------------------------------------------------------------------------------------------------
1998                                 $2,208,676         N/A    $1,509,209         N/A      $699,467         N/A
----------------------------------------------------------------------------------------------------------------
1999                                 $2,413,917        9.3%    $1,664,857       10.3%      $749,059        7.1%
----------------------------------------------------------------------------------------------------------------
2000                                 $2,474,471        2.5%    $1,696,064        1.9%      $778,407        3.9%
----------------------------------------------------------------------------------------------------------------
2001                                 $2,552,606        3.2%    $1,733,734        2.2%      $818,872        5.2%
----------------------------------------------------------------------------------------------------------------
2002                                 $2,545,189       -0.3%    $1,694,435       -2.3%      $850,754        3.9%
----------------------------------------------------------------------------------------------------------------
Source: Tabulation of data from IRS's Return Inventory Classification System, 1998-2002.


       Table 3: Revenues Reported by Section 501(c) Entities in 2004 Constant Dollars, Tax Years 1998-2002
----------------------------------------------------------------------------------------------------------------
                                          All entities                Charities               Noncharities
                                   -----------------------------------------------------------------------------
             Tax year               Revenues (in    Percent   Revenues (in    Percent   Revenues (in    Percent
                                      millions)     change      millions)     change      millions)     change
----------------------------------------------------------------------------------------------------------------
1998                                 $1,121,387         N/A       844,224         N/A       277,163         N/A
----------------------------------------------------------------------------------------------------------------
1999                                 $1,214,807        8.3%       925,849        9.7%       288,958        4.3%
----------------------------------------------------------------------------------------------------------------
2000                                 $1,240,216        2.1%       944,131        2.0%       296,085        2.5%
----------------------------------------------------------------------------------------------------------------
2001                                 $1,258,046        1.4%       953,841        1.0%       304,205        2.7%
----------------------------------------------------------------------------------------------------------------
2002                                 $1,250,914       -0.6%       941,197       -1.3%       309,718        1.8%
----------------------------------------------------------------------------------------------------------------
Source: Tabulation of data from IRS's Return Inventory Classification System, 1998-2002.


       Table 4: Expenses Reported by Section 501(c) Entities in 2004 Constant Dollars, Tax Years 1998-2002
----------------------------------------------------------------------------------------------------------------
                                          All entities                Charities               Noncharities
                                   -----------------------------------------------------------------------------
             Tax year               Expenses (in    Percent   Expenses (in    Percent   Expenses (in    Percent
                                      millions)     change      millions)     change      millions)     change
----------------------------------------------------------------------------------------------------------------
1998                                 $1,017,582         N/A      $768,280         N/A      $249,303         N/A
----------------------------------------------------------------------------------------------------------------
1999                                 $1,091,788        7.3%      $826,572        7.6%      $265,215        6.4%
----------------------------------------------------------------------------------------------------------------
2000                                 $1,145,280        4.9%      $867,063        4.9%      $278,217        4.9%
----------------------------------------------------------------------------------------------------------------
2001                                 $1,210,670        5.7%      $912,200        5.2%      $298,470        7.2%
----------------------------------------------------------------------------------------------------------------
2002                                 $1,221,859        0.9%      $917,528        0.6%      $304,330        2.0%
----------------------------------------------------------------------------------------------------------------
Source: Tabulation of data from IRS's Return Inventory Classification System, 1998-2002.


  Table 5: Section 501(c) Entities' Reported Expenses as a Percentage of U.S. Gross Domestic Product, 1998-2002
----------------------------------------------------------------------------------------------------------------
                                                                                                Section 501(c)
                                                         U.S. GDP (in       Section 501(c)    Entities' Expenses
                        Year                               Millions)      Entities' Expenses  as a Percentage of
                                                                             (in Millions)          U.S GDP
----------------------------------------------------------------------------------------------------------------
1998                                                          8,747,000          $1,017,582               11.6%
----------------------------------------------------------------------------------------------------------------
1999                                                          9,268,000          $1,091,788               11.8%
----------------------------------------------------------------------------------------------------------------
2000                                                          9,817,000          $1,145,280               11.7%
----------------------------------------------------------------------------------------------------------------
2001                                                         10,128,000          $1,210,670               12.0%
----------------------------------------------------------------------------------------------------------------
2002                                                         10,487,000          $1,221,859               11.7%
----------------------------------------------------------------------------------------------------------------
Source: Tabulation of data from IRS's Return Inventory Classification System, 1998-2002 and U.S. Department of
  Commerce figures.

Appendix IV: IRS Data on Its Tax-Exempt Oversight
    The following tables summarize data provided by IRS on its 
oversight activities involving tax-exempt entities under section 501(c) 
of the Internal Revenue Code. The tables cover resources, applications, 
examinations, and examination results.

              Table 6: Assigned FTEs as IRS Budgeted for Exempt Activities, Fiscal Years 2000-2005
----------------------------------------------------------------------------------------------------------------
                                                                Determination
                 Fiscal year                  Examination FTE        FTE           Other FTE        Total FTE
----------------------------------------------------------------------------------------------------------------
2000                                                     424              342               32              798
----------------------------------------------------------------------------------------------------------------
2001                                                     432              347               33              812
----------------------------------------------------------------------------------------------------------------
2002                                                     421              351               44              816
----------------------------------------------------------------------------------------------------------------
2003                                                     394              370               38              802
----------------------------------------------------------------------------------------------------------------
2004                                                     378              348               43              769
----------------------------------------------------------------------------------------------------------------
2005                                                     467              347               42              856
----------------------------------------------------------------------------------------------------------------
Source: IRS Exempt Organization officials.
Note: ``Other FTE'' include technical staff who issue rulings, director's staff, and education and outreach.
  FTEs assigned are what IRS budgets for this work.


              Table 7: Actions Taken on Applications for Tax-Exempt Status, Fiscal Years 1998-2003
----------------------------------------------------------------------------------------------------------------
                                        Total                          Percent
           Fiscal year              applications      Approved        approved         Denied          Other
----------------------------------------------------------------------------------------------------------------
1998                                      78,358          58,162           74.2%        593              19,603
----------------------------------------------------------------------------------------------------------------
1999                                      73,605          59,264           80.5%        585              13,756
----------------------------------------------------------------------------------------------------------------
2000                                      82,707          67,267           81.3%        482              14,938
----------------------------------------------------------------------------------------------------------------
2001                                      81,636          65,409           80.1%        646              15,581
----------------------------------------------------------------------------------------------------------------
2002                                      87,342          70,214           80.4%        557              16,571
----------------------------------------------------------------------------------------------------------------
2003                                      91,439          72,092           78.8%      1,192              18,155
----------------------------------------------------------------------------------------------------------------
2004                                      87,080          69,315           79.6%      1,050              16,715
----------------------------------------------------------------------------------------------------------------
Source: GAO Analysis of IRS's Exempt Determination System, 1998-2004.
Note: The ``Other'' category includes applications withdrawn; applications that did not provide the required
  information; incomplete applications; IRS refusals to rule on applications because the information submitted
  was insufficient to conclude whether to approve the exemption request; and applications forwarded to other
  than the IRS National Office.


                         Table 8: Examination Rate of Section 501(c) Entities, 1998-2003
----------------------------------------------------------------------------------------------------------------
                                                  Returns filed in     Returns examined in
                  Fiscal year                       previous year          fiscal year        Examination rate
----------------------------------------------------------------------------------------------------------------
1998                                                        458,014                 8,290                  1.8%
----------------------------------------------------------------------------------------------------------------
1999                                                        449,537                 8,780                  2.0%
----------------------------------------------------------------------------------------------------------------
2000                                                        472,443                 6,866                  1.5%
----------------------------------------------------------------------------------------------------------------
2001                                                        470,575                 5,471                  1.2%
----------------------------------------------------------------------------------------------------------------
2002                                                        472,365                 5,423                  1.1%
----------------------------------------------------------------------------------------------------------------
2003                                                        464,598                 5,964                  1.3%
----------------------------------------------------------------------------------------------------------------
Source: GAO Tabulation of IRS's Audit Information Management System and IRS's Return Inventory Classification
  System, 1997-2002.


 Table 9: Examinations Resulting in No Change to Forms 990 Filed by Section 501(c) Entities, Fiscal Years 1998--
                                                      2004
----------------------------------------------------------------------------------------------------------------
                                                                          Examinations
                  Fiscal Year                       Examinations         resulting in no       No-change rate
                                                                             change
----------------------------------------------------------------------------------------------------------------
1998                                                          8,290                 2,552                 30.8%
----------------------------------------------------------------------------------------------------------------
1999                                                          8,780                 3,191                 36.3%
----------------------------------------------------------------------------------------------------------------
2000                                                          6,866                 2,431                 35.4%
----------------------------------------------------------------------------------------------------------------
2001                                                          5,471                 2,112                 38.6%
----------------------------------------------------------------------------------------------------------------
2002                                                          5,423                 2,445                 45.1%
----------------------------------------------------------------------------------------------------------------
2003                                                          5,964                 2,965                 49.7%
----------------------------------------------------------------------------------------------------------------
2004                                                          5,889                 2,299                 39.0%
----------------------------------------------------------------------------------------------------------------
Source: GAO analysis of IRS's Audit Information Management System, 1998-2004.

Appendix V: Tax-Exempt Excise Taxes by Code Sections
    Over the years, Congress has imposed various excise taxes that 
affect tax-exempt entities, particularly private foundations under 
Section 501(c)(3). Private foundations differ in several ways from 
public charities. Public charities have broad public support and tend 
to provide charitable services directly to beneficiaries. Private 
foundations are often tightly controlled and receive a significant 
portion of their funds from a small number of donors, and tend to make 
grants directly to other entities rather than directly provide 
charitable services. Since these differences create the potential for 
self-dealing or abuse by a small group, private foundations are subject 
to anti-abuse rules not applicable to public charities. In addition, 
public charities and private foundations generally are prohibited from 
engaging in certain types of transactions. Excise taxes are to be 
levied on public charities and private foundations, as well as a few 
other types of tax-exempt entities, who violate the rules. Details on 
these rules and excise taxes follow.
Section 4940 Excise Tax on Private Foundation Investment Income

    Section 4940 was added by the Tax Reform Act of 1969, P.L. 91-172. 
The related Senate Report \35\ described the excise tax as an ``audit 
fee tax'' that was believed to be necessary to cover IRS's costs for 
increased supervision over private foundations under the act. Section 
4940 imposes a 2 percent excise tax on the net investment income of 
tax-exempt private foundations. Net investment income includes income 
from interest, dividends, and net capital gains that is reduced by the 
expenses incurred to earn it. This tax is 1 percent if a private 
foundation meets certain distribution requirements. Private foundations 
that meet the requirements to be an ``exempt operating foundation'' are 
not subject to this excise tax. Among these requirements are 
stipulations that the foundation be publicly supported for at least 10 
years and that it have a governing body that is broadly representative 
of the general public. Private foundations that are not exempt from 
taxation are subject to this excise tax and unrelated business income 
tax.
---------------------------------------------------------------------------
    \35\ S. Rep. No. 91-552 (1969).
---------------------------------------------------------------------------
Section 4941 Excise Tax on Private Foundation Acts of Self-Dealing

    Because a tax-exempt entity cannot operate to confer a benefit on 
private parties,Section 4941 was enacted by the Tax Reform Act of 1969. 
According to the Senate Report, generally prohibiting self-dealing 
transactions would minimize the need to apply the subjective arm's-
length standard that was used for loans, payments of compensation, and 
preferential availability of services under the 1950 amendments. 
Section 4941 imposes a 5 percent excise tax on acts of self-dealing 
between a private foundation and disqualified persons. This tax is to 
be paid by the disqualified person who participated in the self-
dealing. An additional tax equal to 200 percent of the amount involved 
is to be imposed if the self-dealing is not corrected during the 
taxation period. A separate tax equal to 2 = percent of the amount 
involved is to be imposed on the foundation's manager if that manager 
knowingly participated in the act of self-dealing. If this additional 
tax has been imposed on the foundation manager and that manager refuses 
to agree to part or all of the correction, an additional tax equal to 
50 percent of the amount is to be imposed. Acts of self-dealing include 
sales, exchanges, or leases of property; lending of money or other 
extensions of credit; and payment of compensation. Disqualified persons 
include substantial contributors to the foundation, foundation 
managers, an owner of more than 20 percent of a business enterprise 
that is a substantial contributor, and certain government officials.
Section 4942 Excise Tax on Private Foundation Failure to Distribute 
        Income

    Section 4942 was enacted by the Tax Reform Act of 1969. Prior to 
it, a private foundation could lose its exemption if it failed to make 
distributions towards its charitable purposes instead of just 
accumulating income. According to the Senate report, the committee 
believed that loss of exempt status as the only sanction was often 
ineffective or harsh, and that substantial improvement could be 
achieved by providing a graduation of sanctions if income is not 
distributed. Section 4942 imposes a 15 percent excise tax on the 
undistributed income of a private foundation for any taxable year in 
which the required amount has not been distributed before the first day 
of the next taxable year. If an initial tax has been imposed under 
section 4942 and the income remains undistributed at the end of the 
taxable period, a tax equal to 100 percent of the remaining 
undistributed amount is to be imposed. This excise tax does not apply 
to private operating foundations that meet distribution requirements or 
to the extent that the failure to distribute is due solely to an 
incorrect valuation of assets as long as other requirements are met.
Excise Tax on Private Foundation Excess Business Holdings (Section 
        4943)

    Section 4943 was enacted by the Tax Reform Act of 1969. According 
to its Senate Report, the use of foundations to maintain control of a 
business appeared to be increasing, and some who wished to use a 
foundation's stock holdings to control a business were relatively 
unconcerned about producing income for charitable purposes. Where the 
charitable ownership predominated, the business could unfairly compete 
with businesses whose owners were required to pay taxes on their 
business income. The committee concluded that a limit on the extent to 
which a private foundation may control a business was needed. Section 
4943 imposes a 5 percent excise tax on certain excess business holdings 
of a private foundation. Permitted holdings generally include up to 20 
percent of the voting stock of an incorporated business enterprise 
(reduced by the percentage of the voting stock owned by all 
disqualified persons). Similar holdings are also permitted in 
partnerships and other unincorporated enterprises (except sole 
proprietorships). If the excise tax has been imposed, foundations that 
fail to make the required divestiture of excess holdings above the 
permitted amounts are subject to an additional tax equal to 200 percent 
of the excess holdings. In certain cases, foundations are allowed a 5-
year period to dispose of the excess holdings and may receive an 
additional 5-year extension.
Excise Tax on Private Foundation Investments which Jeopardize 
        Charitable
Purpose (Section 4944)

    Section 4944 was enacted by the Tax Reform Act of 1969. Under prior 
law, a private foundation could lose its exemption if it invested in a 
manner that jeopardized its exempt purpose. In the Senate Report, the 
committee concluded that limited sanctions were preferable to the loss 
of exemption. Section 4944 imposes an initial 5 percent excise tax on 
the amount involved if a private foundation invests in a manner that 
jeopardizes its exempt purpose (e.g., investing with the purpose of 
income production or property appreciation). If such a tax is imposed 
on the foundation, a separate 5 percent excise tax is to be imposed on 
the foundation manager if that manager knew that making the investment 
would jeopardize the foundation's exempt purpose. If an initial tax is 
imposed, an additional tax equal to 25 percent of the amount of the 
investment is to be imposed on the foundation if the investment is not 
withdrawn within the taxable period. An additional tax equal to 5 
percent of the amount of the investment is to be imposed on the 
foundation manager if the investment is not withdrawn.
Excise Tax on Private Foundation Taxable Expenditures (Section 4945)

    Section 4945 was enacted by the Tax Reform Act of 1969. Under prior 
law, the only sanction against prohibited political activity by a 
foundation was loss of exemption. The Senate committee report noted 
that the standards for determining the permissible level of political 
activity were so vague as to encourage subjective application of the 
sanction. As a result, section 4945 was added to clarify the types of 
impermissible activities and provide more limited sanctions. Section 
4945 imposes an initial 10 percent excise tax on each taxable 
expenditure made by the foundation. An additional 2\1/2\ percent excise 
tax is to be imposed on the foundation manager if that manager 
knowingly participated in the taxable expenditure. Taxable expenditures 
include amounts paid to carry on propaganda or otherwise influence 
legislation or the outcome of a public election, or to directly or 
indirectly carry on a voter registration drive. If the expenditure is 
not corrected within the taxable period, an additional tax equal to 100 
percent of the amount of the expenditure is to be imposed on the 
foundation and additional tax equal to 50 percent of the amount of the 
expenditure is to be imposed on the foundation manager.
Excise Tax on Section 501(C) (3) Political Expenditures (Section 4955)

    Section 4955 was added by the Revenue Act of 1987, P.L. 100-203. 
According to the House Report \36\ for the act, the committee believed 
that the excise tax applicable to private foundations for making 
prohibited political expenditures (section 4945) should also apply to a 
public charity. Section 4955 imposes an initial 10 percent excise tax 
on each political expenditure of a section 501(c) (3) organization. An 
additional 2\1/2\ percent excise tax is imposed on the organization's 
manager if the manager knew that it was a political expenditure. 
Political expenditures include any amounts paid or incurred by the 
organization in any participation or intervention in any political 
campaign on behalf of any candidate for public office. If an initial 
tax has been imposed regarding a political expenditure and that 
expenditure is not corrected, an additional tax equal to 100 percent of 
the amount is to be imposed on the organization. An additional tax 
equal to 50 percent of the amount of the expenditure is to be imposed 
on the organization's manager if that manager refuses to agree to part 
or all of the correction.
---------------------------------------------------------------------------
    \36\ H. Rep. No. 100-391 (1987).
---------------------------------------------------------------------------
Excise Tax on Section 501(C) (3) and (4) Excess Benefit Transactions 
        (Section 4958)

    Section 4958 was added in 1996 by the Taxpayer Bill of Rights 2, 
P.L. 104-168. According to the related House Report,\37\ this excise 
tax was added to ensure that the advantages of tax-exempt status 
benefit the community and not private individuals. The act provided for 
this intermediate sanction (i.e., something short of a loss of tax 
exemption) to be imposed when nonprofit organizations engage in 
transactions with certain insiders that result in private inurement. 
Section 4958 imposes an initial tax of 25 percent on each excess 
benefit transaction entered into between a disqualified person and tax-
exempt organizations under sections 501(c)(3) and (4). The initial tax 
is to be paid by this disqualified person, including any person who at 
any time during the 5-year period ending on the date of the transaction 
was in a position to exercise substantial influence over the 
organization, a member of such person's family, and a 35 percent 
controlled entity. Such an entity exists when a disqualified person 
owns more than 35 percent of the voting power of a corporation, more 
than 35 percent of the profit interest of a partnership, or more than 
35 percent of the beneficial interest of a trust or estate. If an 
initial tax is imposed on the disqualified persons, an additional tax 
of 10 percent is to be imposed on the organization's manager if that 
manager participated knowing that it was an excess benefit transaction. 
If the excess benefit transaction is not corrected within the taxable 
period, a tax equal to 200 percent of the excess benefit transaction 
will be imposed on the disqualified person. Private foundations are not 
subject to this excise tax.
---------------------------------------------------------------------------
    \37\ H. Rep. No. 104-506 (1996).
---------------------------------------------------------------------------
Abatement of Taxes When Corrective Action Taken (Sections 4961-4963

    Sections 4961-4963 provide for abating the various excise taxes 
described above. Section 4961 stipulates that additional taxes shall 
not be assessed if corrective action is taken within the applicable 
correction period. Similarly, it stipulates that if the additional tax 
is already assessed, it will be abated if corrective action is taken. 
For example, the additional tax of 200 percent for self-dealing shall 
not be assessed if corrective action is taken within the applicable 
period. Section 4962 provides that excise taxes shall not be assessed 
if the event that gave rise to the excise tax was (1) due to reasonable 
cause, (2) not due to willful neglect, and (3) corrected within the 
applicable period. If already assessed under these circumstances, the 
excise tax shall be abated. Section 4963 sets out the instances in 
which the abatement provisions apply.
Excise Taxes Owed for IRC Violations

    IRS did not maintain data on how much excise tax involving tax-
exempt entities was ultimately assessed or collected either overall or 
by the various types of violations. These assessments can result from 
IRS examinations but IRS's system did not maintain information on these 
types of assessments. These assessments may also arise from tax-exempt 
entities ``self-assessing'' excise taxes by reporting the violations to 
IRS. IRS did record excise taxes owed for certain types of IRC section 
violations as reported by tax-exempt entities on Form 4720, Return of 
Certain Taxes on Charities and Other Persons Under Chapters 41 and 42 
of the Internal Revenue Code and on Form 990-PF, Return of Private 
Foundation or Section 4947(a) (1) Nonexempt Charitable Trust Treated as 
a Private Foundation.
    As table 10 shows, tax-exempt entities reported self-assessments of 
at least $247 million in 2004 constant dollars each year or about $1.5 
billion in 2004 constant dollars for tax years 2000 through 2003.

 Table 10: Excise Tax Amounts That Tax-exempt Entities Self Assessed on
   Forms 4720a and 990-PFb by Code Section, Tax Years 2000-2003 (2004
                     Constant Dollars in Thousands)
------------------------------------------------------------------------
                                           Tax year
    Code section     ---------------------------------------------------
                        2000      2001      2002      2003       Total
------------------------------------------------------------------------
                         Taxes on organizations
------------------------------------------------------------------------
Section 4942--          $2,196    $4,608    $3,802    $2,421     $13,027
 Undistributed
 income
------------------------------------------------------------------------
Section 4943--Excess       385       178       196        35         794
 business holdings;
 Section 4944--
 Investments that
 jeopardize, other c
------------------------------------------------------------------------
Section 4945--           1,112       702       408       316       2,538
 Taxable
 expenditures
------------------------------------------------------------------------
Section 4955--               1         4         8         0          13
 Political
 expenditures
------------------------------------------------------------------------
    Subtotal             3,694     5,492     4,414     2,772      16,372
------------------------------------------------------------------------
                          Taxes on individuals
------------------------------------------------------------------------
Section 4941--Self-        438       665       415       204       1,722
 dealing
------------------------------------------------------------------------
Sections 4944, 4945,        70        46        35        46         197
 4955, and Section
 4958--Excess
 benefits
------------------------------------------------------------------------
    Subtotal               508       711       450       250       1,919
------------------------------------------------------------------------
Tax on net investment income
------------------------------------------------------------------------
Section 4940--         683,767   320,811   242,187   244,627   1,491,392
 Investment Income
------------------------------------------------------------------------
    Total              687,969   327,014   247,051   247,649   1,509,683
------------------------------------------------------------------------
Source: GAO analysis of IRS data.
a Return of Certain Excise Taxes on Charities and Other Persons Under
  Chapters 41 and 42 of the Internal Revenue Code.
b Return of Private Foundation or Section 4947(a)(1) Nonexempt
  Charitable Trust Treated as a Private Foundation.
c Includes Section 4911--Excess Lobbying Expenditures and 4912--
  Disqualifying Lobbying Expenditures.
(450383)


                                 

    Chairman THOMAS. Mr. Yin is obviously the Chief of Staff of 
the Joint Committee on Taxation, and thank you.

STATEMENT OF GEORGE K. YIN, CHIEF OF STAFF, JOINT COMMITTEE ON 
                            TAXATION

    Mr. YIN. Mr. Chairman, Mr. Rangel, Members of the 
Committee, thank you very much for asking me to testify today. 
In my brief comments, I am going to cover just three areas. One 
is to provide some highlights about the sector. Second is to 
discuss briefly some compliance issues concerning the sector. 
Third, I am going to talk briefly about the rationale for tax 
exemption. You should have before you a pamphlet prepared by 
the staff which includes a wealth of information about the tax-
exempt sector, including a historical development as well as a 
description of present law rules. If I could draw your 
attention, however, to a smaller document which you should also 
have before you, it is a summary table of types and tax 
treatment of section 501(c) organizations. The number on the 
bottom is JCX-30-05. I just want to walk you through a little 
of that table to hit a few of the highlights of the sector 
before going on to my other two areas.
    Chairman THOMAS. If you will wait just a moment, Mr. Yin. 
Members are going through trying to find it. It is the one with 
the eagle on the cover and it is printed sideways----
    Mr. YIN. It is just about a six- or seven-page document.
    Chairman THOMAS. It is done on the long side. Thank you.
    Mr. YIN. You will see, if you turn to the first page, that 
we list here the 28 separate categories of exempt organizations 
under section 501(c). Now, I should preface by saying that 
these are not all of the exempt organizations allowed under the 
Internal Revenue Code. There are a whole group of additional 
organizations that are exempt. Most significantly, of course, 
are the ones involving retirement and other benefit vehicles. 
Here, we are focusing simply on the 501(c)s and you have 28 
categories. If you look at the third column, you will see, just 
glancing down, that there are a range of dates in which these 
exemptions came into being. In general, there were no one or 
two watershed events when Congress sat down and determined that 
certain organizations should be exempt. They largely have come 
into the law piecemeal. You also notice in the dates that some 
of the dates are quite old. Some of the exemptions date back to 
1894, which is even before the passage of the 16th amendment. 
Some of them, of course, are quite recent. If you look to the 
far right-hand column, you will see the number of entities 
within each of these categories as listed under the IRS master 
file. Now, I need to give you a little caution about the 
numbers in the master file because the master file does not 
necessarily exclude all organizations that have dissolved, if 
the IRS hasn't received notice of that. It also does not 
include all organizations. Most particularly, some churches, 
are not recorded in the IRS master file. Having said that, as 
Mr. Walker indicated, there are about a million-and-a-half 
entities listed in the IRS master file, and if you notice on 
that first page, the third line, the charitable category, 
501(c)(3), makes up the bulk of that, about a million entities 
in the charitable sector that are on the master file. Within 
that million, about 10 percent of them comprise 80 percent of 
the assets and revenue in the charitable sector.
    There are other categories which have a large number of 
organizations, but there are a number of categories which have 
very few. In fact, nine of the categories have under 50 
organizations and four of the categories have fewer than five 
organizations. The remaining columns simply identify some of 
the common features that are applicable to some or most exempt 
organizations. If you look under the column called ``Subject to 
UBIT,'' that is the Unrelated Business Income Tax, that is your 
fifth column, you will see that virtually all of these 
organizations are subject to a UBIT. If you look under the 
column called ``Taxed on Investment Income,'' you will see 
that, generally, the organizations are not taxed on their 
investment income, except there are some important exceptions 
to that. If you look at the next column, about contributions, 
whether contributions to the organizations are deductible, you 
will see that, in general, it is limited to charitable 
organizations and a couple of others that allow charitable 
deductions. Some of the organizations' contributions are 
deductible as business expenses, but not as charitable 
contributions.
    Finally, if you look at the next column involving ``Subject 
to Private Inurement``--this is the doctrine which prohibits 
the use of organizations' assets to benefit the insiders of the 
organization--you will see a somewhat mixed group. That is, 
some of them are subject to those rules and some of them are 
not subject to those rules. Turning now to compliance issues, I 
just wanted to highlight a couple of points. In terms of the 
entity, the key point is that exemption is a privilege and not 
a right and it is a privilege subject to certain specific 
conditions laid out by Congress. Most of the compliance 
questions in this area as it relates to the entity relate to 
whether one or more of the conditions are being satisfied or 
not. There are, of course, various policy tools which Congress 
has enacted, including taxes, which attempt to encourage or 
discourage certain types of activity on the part of one or more 
of these organizations, and in that regard, the effectiveness 
of a tax is not necessarily measured by how much revenue it 
raises, but rather on how successful it is in encouraging or 
curbing the particular behavior that the tax is designed to 
address. Before I leave the compliance area, I should mention 
that there is another compliance issue in this area not 
relating to the entities as such but on the contribution side, 
and on that score, there is a balance. The balance is between 
the amount of additional charitable giving that would be 
induced by a policy tool that would ``not otherwise occur,'' 
and those last words are very important. Then to determine the 
nature of the policy tool that tries to induce that type of 
change in behavior and whether the policy tool is susceptible 
to noncompliance or not. Last, I want to address briefly what I 
suspect many of you may have in your minds, which is now that 
we see there are all these different categories of exempt 
organizations and they have come in in different times and they 
have different labels and all of that, is there some master 
scheme here? Is there some overriding purpose in which we say 
that some organizations are exempt and others are not? The 
short answer to that question, which is certainly a very fair 
one to ask, as best we can determine, there is no master 
scheme. I suppose that would be expected, given the fact that 
many of these exemptions came into the law piecemeal so that 
there wasn't a master plan as such that was laid down.
    However, having said that, there are a few general 
explanations that one can use to explain some or many of the 
exemptions, and let me just mention four explanations. Some of 
these explanations overlap with one another. First, it is 
important to know that when an organization is exempt from 
Federal taxes, that determination is an issue of the Federal 
tax code and that that is different from whether an 
organization is a nonprofit organization, which is largely a 
determination based on State law. In general, under State law, 
what nonprofit means is an organization is prohibited from 
distributing its earnings to members. Not all nonprofit 
organizations under State law are tax-exempt, and conversely, 
some tax-exempt organizations may not necessarily be subject to 
this constraint that is typically applied to nonprofit 
organizations. Despite that, some have argued that the 
distinctive characteristics of a nonprofit organization may 
make certain classes of them appropriate choices for Federal 
tax exemption. A second general explanation is that if you 
review the organizations, you will quickly see that some number 
of them carry out activities that one might classify as 
governmental functions in nature. Just as it would generally 
not be productive for the government, for example, to tax 
itself, it is argued sometimes that it is not productive for 
the government to tax an organization that is carrying out 
largely a governmental function. Certain charities and 
organizations may fit within this general explanation.
    A third explanation would be that certain organizations, 
because of their structure, and in particular their 
relationship to their members, don't provide the kinds of 
circumstances in which taxation would be appropriate. Let me 
try to give you a simple example. Let us assume that all of the 
Members of the Committee decided to form a social club together 
in which you all agreed to assess yourselves certain membership 
fees which are then used to essentially purchase certain kinds 
of activities in which you all wish to engage in. Let us assume 
that in a given period, the amount of fees that are collected 
by the club are in excess of the costs of the club, and so in 
some general sense, one could argue that the club has made a 
profit. When you realize that if, in fact, under the terms of 
the club that you formed, all of the excess, if you will, is 
simply reinvested into the club to provide additional benefits, 
future benefits for the members, I think it is easy to realize 
that in some sense, this arrangement that you have made is no 
different from simply each of you purchasing on your own, 
spending some money to purchase current and future benefits, 
perhaps in current benefits or capital expenditures, and that 
there is really no income in this picture at all. Some part of 
the explanation for some of the organizations' exemption may be 
attributable to this type of an explanation. Finally, the 
fourth explanation I will offer is that some organizations are 
exempt because it is an explicit attempt by Congress to provide 
an incentive, which the exemption represents. A good example of 
that, of course, might be some of your retirement vehicles and 
other employee benefit vehicles. Thank you very much. I would 
be happy to answer any questions.
    Chairman THOMAS. Thank you very much. You were obviously 
trying to get the attention of the Members. As soon as you 
mentioned the social club, every Member was trying to figure 
out who was going to be the social Chairman.
    [Laughter.]
    [The prepared statement of Mr. Yin follows:]
  Statement of George Yin, Chief of Staff, Joint Committee on Taxation
    Mr. Chairman, Mr. Rangel, members of the Committee, I am pleased to 
testify today on the tax-exempt sector. I first provide a brief 
overview of the size and growth of the exempt sector, discuss some of 
the reasons why organizations have been granted tax-exempt status, and 
describe some common tax law features of exempt organizations. I 
conclude my testimony by focusing on charitable organizations, the 
largest category by far of exempt organizations. I summarize the 
requirements for exempt status as a charitable organization and review 
selected current issues relating to those organizations.

      A. Overview of Organizations Exempt from Federal Income Tax

Size and growth of the exempt sector generally

    Since the inception of the Federal income tax, the Congress has 
exempted certain types of entities from income taxation. Many exempt 
entities, such as charitable organizations, are familiar. Yet 
charitable organizations are but one type of exempt entity. The benefit 
of tax exemption is extended to groups as diverse as social welfare 
organizations, title holding companies, fraternal organizations, small 
insurance companies, credit unions, cooperative organizations, and 
cemetery companies. The statistics reported in this document do not 
include churches, which are not required to file returns with the 
Internal Revenue Service (``IRS''), and are not recorded in the IRS 
Master File of Exempt Organizations.
    There are now 28 different types of organizations listed in the 
main exemption section of the Code (section 501), and numerous other 
exemptions provided elsewhere.\1\ The number and financial holdings of 
these organizations are large and have grown significantly since 
record-keeping began in 1975. The revenue reported to the IRS by such 
organizations has increased from approximately $0.3 trillion (in 2001 
dollars) in 1975 to about $1.2 trillion in 2001. The 2001 revenue 
represented approximately 12.2 percent of gross domestic product in 
that year. The assets reported by the organizations have similarly 
increased, from approximately $0.5 trillion (in 2001 dollars) in 1975 
to almost $2.9 trillion in 2001.
---------------------------------------------------------------------------
    \1\ In general, my testimony does not discuss entities that are 
exempt under section 401 of the Code, which are subject to a completely 
different regulatory apparatus than those exempt under section 501.
---------------------------------------------------------------------------
    While a large majority of exempt entities fall into familiar 
categories, such as charitable organizations, there are also a fair 
number of organizations that fall into more obscure categories. Eight 
categories have fewer than 150 qualifying entities each, with four 
categories having fewer than five entities each
Size and growth of the charitable sector

    Charitable organizations described in section 501(c)(3) represent 
by far the largest category of exempt organizations, comprising about 
two-thirds of all exempt organizations. The 2004 IRS Master File of 
Exempt Organizations shows 1,010,365 charitable organizations. In terms 
of asset size and revenues, the share of charitable organizations in 
the exempt sector is similar. In 2001, the total revenue of charitable 
organizations (including private foundations but not including churches 
and other organizations not required to file) was about 9.3 percent of 
gross domestic product.
    Among charitable organizations not including churches, the largest 
categories of organizations are hospitals and post-secondary 
educational organizations. In 2001, hospitals held 29 percent of total 
assets and collected 42 percent of total revenues in the exempt sector. 
Colleges and universities held 21 percent of the total assets and 
collected 11 percent of total revenue.
    There has been significant recent growth in the number and size of 
charitable organizations. The number of such organizations has 
increased from 259,523 in 1976 to 1,010,365 in 2004, an increase of 289 
percent. The total asset value and revenues (in 2001 dollars) reported 
to the IRS by charitable organizations similarly increased from about 
$360 billion and $155 billion, respectively, in 1975, to over $2 
trillion and about $942 billion, respectively, in 2001.
    The growth in the number and size of charitable organizations has 
been accompanied by growth in the amount of charitable deductions. In 
1975, the total amount claimed as charitable deductions was about $43.7 
billion whereas in 2002, the total was about $145 billion (both numbers 
in constant 2000 dollars).

                      B. Reasons for Tax Exemption

    There is no unifying theme or singular principle that explains tax 
exemption for the many diverse organizations in the exempt sector, 
although there are some factors that may help to explain the exemption 
for certain of them.
    Over the years, Congress has granted tax exemption only to certain 
types of organizations. As an initial matter, not all ``nonprofit'' 
organizations are afforded tax exemption, and not all tax-exempt 
organizations have the typical characteristics of a ``nonprofit'' 
organization. The term ``nonprofit'' generally refers to an 
organization's form under State law, not its Federal tax status. State 
law generally does not prohibit ``nonprofits'' from earning a profit, 
as one might expect. Instead, State law typically prohibits the 
distribution of earnings by nonprofit corporations (but not necessarily 
by other forms of entities) to their members.
     The Federal exemption is extended in some instances to 
organizations that are not subject to a State-law constraint on 
distributions, as some entities are not required for exemption purposes 
to be organized in corporate form. Therefore, exemption may be obtained 
by some organizations that do not fit the classic definition of 
``nonprofit.'' However, the Federal tax laws applicable to certain 
types of exempt organizations (though not all) contain prohibitions, 
such as the ``no private inurement'' and ``no private benefit'' 
doctrines, that are in some respects similar to the State-law 
constraint.
    For some organizations, exemption from tax may be explained based 
on the nature of its activities. For example, charitable activities or 
activities that provide a public benefit may be viewed as governmental 
in nature and therefore not appropriate subjects of taxation. This may 
explain the exemption for charitable organizations, social welfare 
organizations, U.S. instrumentalities, and State and local governments. 
Promotion of certain activities may also be viewed as desirable policy, 
and therefore tax exemption is intended to encourage the activity. This 
may explain the tax exemption for arrangements to provide employee 
benefits, arrangements for individuals to save for health, retirement, 
and education, and the exemption for small or rural commercial 
organizations that engage in certain activities, such as farming, 
provision of financial services, insurance, electricity, or other 
public good.
    Exempt status may also be attributable to the structure of an 
organization. Some organizations are funded exclusively by their 
members and expend all funds exclusively for members. If such an 
organization collects more in membership dues than its expenses, the 
excess is reinvested in the organization for the benefit of the 
members. Under general tax principles, the organization may not be 
considered as having any income because there has not been a shifting 
of benefit from the member to the organization--the organization merely 
facilitates a joint activity of its members. Thus, in some cases, the 
Code adopts a result that might occur even in the absence of statutory 
law, e.g., social clubs, fraternal organizations, voluntary employees' 
beneficiary associations, cemetery companies, and homeowners 
associations.
    Another factor that may explain some cases of tax exemption is the 
nature of the legislative process. As noted, Congress did not provide 
exemption for all organizations that are not organized for profit; 
rather, the general rule is that an organization is subject to tax 
absent a specific exemption. Such a rule means that once broad 
categories of exemption are codified, there will be specific classes of 
organizations that do not fit within the broad category and that seek 
and receive exempt status. Social welfare organizations, business 
leagues, labor, agricultural, and horticultural organizations and other 
organizations may be examples.
    Another factor to consider is simple expediency, in that taxing 
certain small organizations was viewed at the time the exemption was 
granted as too costly to administer, especially when often little or no 
tax would be due. This appears partially to explain the reason for 
exempting single-parent title holding companies from tax as well as 
social clubs. As stated in 1916 legislative history: ``the securing of 
returns from them has been a source of annoyance and expense and has 
resulted in the collection of either no tax or an amount which is 
practically negligible.''

           C. Common Tax Law Features of Exempt Organizations

In general

    Despite varying standards regarding qualification for exempt 
status, different categories of exempt organizations share some common 
characteristics. For example, many types of exempt organizations are 
subject to a prohibition against ``private inurement,'' and most exempt 
organizations are subject to the general rules regarding the taxation 
of unrelated business income. Contributions to a limited number of 
exempt organizations are deductible as charitable contributions, while 
contributions to others may be deductible as a business expense but not 
as a charitable contribution. Most exempt organizations also are 
subject to rules regarding lobbying and political campaign activities 
and are required to file annual information returns.
Private inurement prohibition.

    The doctrine of private inurement generally prohibits an exempt 
organization from using its assets for the benefit of a person or 
entity with a close relationship to the organization. For example, 
section 501(c)(3) provides that an organization will qualify for 
charitable exempt status only if ``no part of the net earnings [of the 
organization] inures to the benefit of any private shareholder or 
individual.'' The regulations under section 501(a), which generally 
apply to organizations subject to the inurement proscription, define 
``private shareholder or individual'' as ``persons having a personal 
and private interest in the activities of the organization.'' Inurement 
thus applies to transactions between applicable exempt organizations 
and persons sometimes deemed ``insiders'' of the organization, such as 
directors, officers, and key employees. The issue of private inurement 
often arises where an organization pays unreasonable compensation 
(i.e., more than the value of the services) to such an insider. 
However, the inurement prohibition is designed to reach any transaction 
through which an insider is unduly benefited by an organization, either 
directly or indirectly.
    There is no ``de minimis'' exception under the inurement 
prohibition, and an organization that engages in an inurement 
transaction may face revocation of its exempt status. Until 1996, there 
was no sanction short of revocation of exempt status in the event of an 
inurement transaction. In 1996, however, Congress imposed excise taxes, 
frequently referred to as ``intermediate sanctions,'' on ``excess 
benefit transactions'' between certain exempt organizations and 
``disqualified persons.'' The intermediate sanctions rules, which apply 
only to transactions involving organizations exempt under sections 
501(c)(3) and 501(c)(4), impose excise taxes on a disqualified person 
who receives an excess benefit and, under certain circumstances, on 
organization managers who approved the transaction. No such sanctions 
are presently imposed against the organization itself.
    Section 501(c)(3) organizations (but not other organizations) also 
are subject to a prohibition against conferring more than incidental 
``private benefit.'' The private benefit prohibition applies to non-
fair market value transactions with individuals or entities, not merely 
with insiders, and thus is in some respects broader than the private 
inurement prohibition.
Unrelated business income tax

    In general, an exempt organization may have revenue from four 
sources: contributions, gifts, and grants; trade or business income 
that is related to exempt activities (e.g., program service revenue); 
investment income; and trade or business income that is not related to 
exempt activities. In general, the Federal income tax exemption extends 
to the first three categories, and does not extend to an organization's 
unrelated trade or business income. In some cases, however, the 
investment income of an organization is taxed as if it were unrelated 
trade or business income.
    The unrelated business income tax was introduced in 1950 to address 
the problem of unfair competition between for profit companies and non 
profit organizations conducting an unrelated for profit activity. The 
unrelated business income tax generally applies to income derived from 
a trade or business regularly carried on by the organization that is 
not substantially related to the performance of the organization's tax-
exempt functions. Most exempt organizations are subject to the tax.
    Most exempt organizations generally may operate an unrelated trade 
or business so long as it is not a primary purpose of the organization. 
Therefore, engaging in a substantial amount of unrelated business 
activity before jeopardizing exempt status is permitted. By contrast, a 
charitable organization may not operate an unrelated trade or business 
as a substantial part of its activities.
    Certain types of income are specifically exempt from the unrelated 
business income tax, such as dividends, interest, royalties, and 
certain rents, unless derived from debt-financed property or from 
certain 50-percent controlled subsidiaries.
    For the tax year 2001, 35,540 organizations filed unrelated 
business income tax returns, reporting a total of $7.9 billion of gross 
unrelated business income. This translated into unrelated business 
taxable income (after taking into account allowable deductions) of 
approximately $792 million and total tax of approximately $226 million.
Contributions

    Another feature of a minority of tax-exempt organizations is that 
contributions to such organizations may be deductible by the donor as 
charitable contributions for income, estate, and gift tax purposes. 
Contributions to charitable organizations, for example, generally are 
deductible for income, estate, and gift tax purposes, although the 
amount of deduction may be affected by such factors as the recipient 
organization's classification as a public charity or private foundation 
and the type of property contributed. Other types of organizations that 
are eligible recipients of charitable contributions include: certain 
Federal, State, and local government entities, if the contribution is 
exclusively for public purposes; certain fraternal beneficiary 
societies, if the contributions are used for charitable purposes; 
cemetery companies, if the contributions are used for certain purposes; 
and certain organizations of war veterans.
    Contributions to other types of exempt organizations generally are 
not deductible as charitable contributions. Under certain 
circumstances, however, contributions to a membership organization, 
such as a social welfare organization or trade association, may be 
deductible as a business expense under section 162. In addition, 
contributions to tax-exempt employee benefit arrangements (e.g., 
qualified retirement plans) or individual savings arrangements (such as 
individual retirement accounts) may be deductible.
Lobbying and political activities

    Tax-exempt organizations are also subject to rules regarding the 
permissible level of lobbying and political campaign activities. In 
general, the lobbying and political activity rules applicable to 
charitable organizations are more severe than the rules applicable to 
other types of exempt organizations.
Information returns
    Exempt organizations are required to file an annual information 
return, stating specifically the items of gross income, receipts, 
disbursements, and such other information as the Secretary may 
prescribe. The requirement that an exempt organization file an annual 
information return does not apply to certain exempt organizations, 
including organizations (other than private foundations) the gross 
receipts of which in each taxable year normally are not more than 
$25,000. Also exempt from the requirement are churches, their 
integrated auxiliaries, and conventions or associations of churches; 
the exclusively religious activities of any religious order; certain 
state institutions whose income is excluded from gross income under 
section 115; an interchurch organization of local units of a church; 
certain mission societies; certain church-affiliated elementary and 
high schools; and certain other organizations, including some that the 
IRS has relieved from the filing requirement pursuant to its statutory 
discretionary authority.

D. Summary of Requirements of Exempt Status of Charitable Organizations 
           and Selected Issues Relating to Such Organizations

In general

    In general, the requirements for exempt status of an organization 
under section 501(c)(3) of the Code are that (1) the organization must 
be organized and operated exclusively for certain purposes; (2) there 
must not be private inurement to organization insiders; (3) there must 
be no more than an incidental private benefit to private persons who 
are not organization insiders; (4) no substantial part of the 
organization's activities may be lobbying; and (5) the organization may 
not participate or intervene in political activities. Permitted 
purposes are religious, charitable, scientific, testing for public 
safety, literary, educational, the fostering of national or 
international amateur sports competition, or the prevention of cruelty 
to children or animals. Failure to satisfy any of these requirements 
should result in an organization not qualifying for exempt status under 
section 501(c)(3), or should result in a loss of such status once a 
violation is detected by the IRS. Most of the Federal law of charitable 
organizations is designed around ensuring that each of the requirements 
is satisfied by an organization initially and on an ongoing basis. Each 
of the requirements is simple to state, but none are simple, as each 
carries with it a significant body of statutory, common, and 
administrative law.
    If an organization satisfies each of the requirements, there is a 
further question of what type of charitable organization it is. A 
section 501(c)(3) organization is either a public charity or a private 
foundation. In general, the basis for distinguishing between public 
charities and private foundations is the level of public support an 
organization receives over time. Organizations with widespread public 
support tend to qualify as public charities; organizations funded by 
just a few donors tend to be classified as private foundations. There 
is a substantial body of law detailing how to determine whether an 
organization is publicly supported. Certain organizations also may 
qualify as public charities as a matter of law (e.g., churches, 
hospitals). The classification matters because private foundations 
generally are subject to more restrictions on their activities than are 
public charities, are subject to tax on their net investment income, 
and contributions to private foundations generally do not receive as 
favorable treatment as do contributions to public charities for 
purposes of the charitable contribution deduction.
    Satisfaction of the requirements for exemption, classification of 
an organization as a public charity or private foundation, plus the 
resulting benefit that contributions to charitable organizations 
generally are tax deductible provides the simplest snapshot of the law 
of charitable organizations.
Exempt purposes of section 501(c)(3) organizations

The meaning of charity--present law

    In general, there are two approaches to the meaning of the term 
charitable--the legal sense and the ordinary and popular sense. The 
legal definition is derived from the law of charitable trusts and is 
broader than the ordinary sense of the term, which generally means the 
relief of the poor and distressed. Since 1959, Treasury regulations 
have defined the term ``charitable'' in the legal sense, to include:

           Relief of the poor and distressed or of the underprivileged; 
        advancement of religion; advancement of education or science; 
        erection or maintenance of public buildings, monuments, or 
        works; lessening of the burdens of Government; and promotion of 
        social welfare by organizations designed to accomplish any of 
        the above purposes, or ((i) to lessen neighborhood tensions; 
        (ii) to eliminate prejudice and discrimination; (iii) to defend 
        human and civil rights secured by law; or (iv) to combat 
        community deterioration and juvenile delinquency.

    This definition is broad, encompassing several ideas that would not 
generally be considered as charitable in the ordinary sense. In 
addition to meeting the regulatory definition of charitable, an 
organization described in section 501(c)(3) is not organized and 
operated for exempt purposes if a purpose of the organization is 
against public policy or is illegal.
    In addition to the public policy requirement, certain common law 
principles inform the Federal tax law definition of charity. The 
charitable class requirement provides that an organization be organized 
to benefit a sufficiently large or indefinite class of people. The 
community benefit doctrine permits exemption as a charitable 
organization if the result of an activity inures to the benefit of the 
community, even though a private person is the immediate beneficiary of 
the activity.
The meaning of charity and the rationale for tax exemption
and charitable deductions

    There is no agreed upon explanation of the rationale behind the 
charitable tax exemption and tax deduction. Some of the basic 
rationales that have been offered, described in greater detail in Part 
II.C of this pamphlet, may be summarized as follows: (1) charitable 
organizations serve the public and therefore should be supported 
through provision of tax benefits; (2) charitable organizations provide 
goods and services that otherwise would have to be provided by the 
Government and therefore should be supported by the Government; (3) it 
is difficult to measure the net income of charitable organizations, and 
therefore they should be exempt from tax; (4) charitable organizations 
promote pluralism; (5) charitable organizations are efficient providers 
of services but have inherent limits on their ability to raise capital 
compared to for-profit entities and therefore need government support 
in the form of tax exemption (and charitable contributions); and (6) 
exemption is afforded to those organizations that can prove their worth 
through sustained donations.
Educational purposes

    Tax exemption for educational organizations was provided in the 
Tariff Act of 1894, and has been replicated in each subsequent income 
tax act. Educational organizations have been eligible to receive tax 
deductible contributions since 1917. Like the term charitable, the term 
educational has no precise meaning. The Treasury regulations set forth 
the basic definition as relating to the ``instruction or training of 
the individual for the purpose of improving or developing his 
capabilities.'' This definition is consistent with provision of 
exemption for organizations that fit within the common conception of an 
educational organization, such as schools, colleges, and universities. 
Yet educational organizations are not limited to such traditional 
forms. The ``instruction of the individual standard'' may be met by 
many other types of organization. The Treasury regulations also provide 
that educational means the ``instruction of the public on subjects 
useful to the individual and beneficial to the community.'' The IRS and 
the courts have permitted a broad array of organizations to be 
considered educational under this standard.
    A primary issue in determining whether some method the organization 
uses to convey information, irrespective of content. In general, the 
analytical exercise is to determine whether an organization's 
presentation of information is objective and balanced, or whether the 
organization instead is an advocate or a mouthpiece for propaganda.
Religious purposes

    The Federal tax exemption for organizations operated for religious 
purposes was, along with charitable and educational purposes, provided 
for originally in the Tariff Act of 1894, and religious organizations 
were designated as eligible for charitable contributions in 1917. There 
is no definition of ``religious'' provided by regulation. The manifest 
reason is the constitutional law framework that limits Federal 
involvement in religion. The IRS has developed a multi-factor list of 
characteristics that inform whether an organization may be considered a 
church (which is a kind of religious organization), and the IRS is 
careful to point out that this list is not comprehensive and that in 
each case, the facts and circumstances will be considered. In many 
cases in which a religious organization's claim to exempt status is 
questioned, the issue of whether the organization serves religious 
purposes often is not addressed because exempt status may be denied on 
other grounds, for example, private benefit or private inurement, 
commerciality, or violation of the political activities prohibition.
    The Constitutional concerns regarding Federal involvement in 
religious organizations extend to the application of regulatory 
requirements. For example, certain religious organizations are exempted 
from the requirement to apply for tax exempt status, from annual 
information return requirements, and special audit procedures apply to 
churches. As a result, although religious organizations, particularly 
churches, constitute a significant part of the charitable sector, 
information about such organizations is scarce.
Scientific purposes

    Scientific purposes were the first addition to the original three 
exempt charitable purposes and were added in 1913. Charitable 
contributions to scientific organizations were made deductible in 1917. 
A tax exempt scientific purpose hinges on the performance of basic or 
fundamental research in the public interest. Scientific research that 
is ``applied'' or ``practical'' may be subject to the unrelated 
business income tax, but generally is not inconsistent with exempt 
purposes. There is no precise definition of scientific research, and, 
in general, courts and the IRS have determined whether an organization 
is engaged in scientific research on a case-by-case basis. Scientific 
research must be in the public interest. Scientific research does not 
include activities of a type ordinarily carried on as incidental to 
commercial or industrial operations.
Selected issues involving charitable organizations

Selected issues relating to the public charity-private foundation 
        distinction

    In 2005, thirty-six years after Congress first drew a meaningful 
legal distinction between publicly supported organizations and private 
foundations, it may not be as clear, given the growth and diversity of 
publicly supported organizations, why some of the private foundation 
rules are not relevant for certain public charities, or whether some of 
the private foundation rules are performing their intended purpose. For 
example, the retention of substantial holdings in a commercial 
business, the making of investments or expenditures that jeopardize or 
are inconsistent with exempt purposes, or the maintenance of large 
endowment funds raise some of the same concerns whether conducted by a 
public charity or a private foundation.
    In defining a private foundation, the 1969 Act provided that an 
organization that provides support to a public charity (a ``supporting 
organization'') is considered a public charity and not a private 
foundation. Thus, supporting organizations receive the benefit of the 
favorable charitable contribution deduction rules and avoid the excise 
tax regime applicable to private foundations. Donors to supporting 
organizations may take a fair market value deduction for contributions 
of capital gain property such as closely held stock, which would not be 
permitted for gifts to private foundations. As a public charity, 
supporting organizations also are not subject to the private foundation 
self-dealing rules (e.g., barring loans and other transactions with 
insiders), limitations on business holdings, or subject to the private 
foundation payout rules. However, unlike other public charities but 
like private foundations, supporting organizations generally do not 
have broadly based support, and may resemble private foundations in 
other respects.
    Community foundations and donor advised funds, which generally 
qualify as public charities, offer limited ways for donors to exercise 
post-transfer control or direction over the use of funds or other 
property transferred to a charity for which the donor is entitled to a 
deduction in the year of transfer. Contributors to community 
foundations and donor advised funds receive the benefit of the 
favorable public charity rules and some elements of the control over 
distributions without being subject to the legal constraints placed on 
a private foundation. Thus, a donor can fund an account in a community 
foundation or donor advised fund with cash or capital gain property, 
take a fair market value deduction, accumulate income in the fund, and 
from time to time recommend that amounts be paid out of the fund for 
charitable purposes. Community foundations and donor advised funds, 
like supporting organizations, resemble private foundations in many 
ways, but are considered.
Selected issues relating to the unrelated business income tax

    In general, exempt organizations have greater discretion than 
taxable organizations in determining whether to report income as 
taxable or not, through the questions of whether income is from a 
regularly conducted trade or business, and whether the conduct of such 
a trade or business is ``substantially related'' to exempt purposes. In 
addition, even if an exempt organization treats income as unrelated and 
therefore as subject to tax, an exempt organization might allocate 
expenses for an exempt activity to an unrelated activity in order to 
minimize or eliminate the tax.
    Issues often arise regarding whether certain types of receipts 
constitute royalties, which generally are excluded in determining an 
organization's unrelated business taxable income. Two issues that have 
been the source of considerable debate in this area are: (1) whether 
income from an affinity credit card program constitutes a royalty and 
(2) whether income from a mailing list rental constitutes a royalty. 
Notwithstanding several court decisions, a taxpayer that provides more 
than a small amount of clerical services may risk having payments 
received in exchange for a license classified as payments for services 
rather than as excludable royalties.
Charitable hospitals

In general

    The Code does not provide a per se charitable exemption for 
hospitals. Rather, a hospital qualifies for exemption if it is 
organized and operated for a charitable purpose and meets additional 
requirements of section 501(c)(3). The promotion of health has long 
been recognized as a charitable purpose that is beneficial to the 
community as a whole. It includes not only the establishment or 
maintenance of charitable hospitals, but clinics, homes for the aged, 
and other providers of health care.
    Medical care generally is provided by government-owned, for-profit, 
and tax-exempt organizations. In the hospital sector, tax-exempt 
organizations dominate, with approximately 60 percent of the nation's 
hospitals operating as charitable institutions. Historically, 
charitable hospitals were characterized as voluntary because they 
generally were supported by philanthropy, staffed by doctors who worked 
without compensation, and served, almost exclusively, the sick poor. 
However, the character of the charitable hospital sector has changed 
significantly over the past several decades due to the growth of such 
resources as employer-provided health insurance and governmental 
programs such as Medicare (for the elderly and disabled) and Medicaid 
(for the poor). Today, charitable hospitals generally provide medical 
and other health-related services in a manner similar to their for-
profit counterparts. They operate under the same healthcare 
regulations, compete for the same patients and doctors, and derive 
funding from many of the same sources as other types of hospitals.
Evolution of the legal standard

    Financial Ability Standard.--Much like the nature of the health-
care industry itself, the definition of the term charitable as applied 
to hospitals has not been static. In 1956, the IRS adopted the 
``financial ability standard,'' requiring that a charitable hospital be 
``operated to the extent of its financial ability for those not able to 
pay for the services rendered and not exclusively for those who are 
able and expected to pay.'' This standard effectively meant that a 
charitable hospital could not refuse to accept patients in need of 
hospital care who could not pay for such services. However, the IRS 
acknowledged that hospitals normally charge patients who are able to 
pay for services in order to meet the hospital's operating expenses and 
stated that the ``fact that the hospital's charity record is relatively 
low is not conclusive that a hospital is not operated for charitable 
purposes to the full extent of its financial ability.'' The ruling's 
requirement that charitable hospitals provide some amount of free or 
reduced-rate care reflected the view that hospitals and other health 
care institutions were only charitable if they both provided relief to 
the poor and promoted health.
    Community Benefit Standard.--The financial ability standard 
governed charitable hospitals until 1969. Congress had criticized the 
financial ability standard as imprecise concerning the extent to which 
a hospital must accept patients who are unable to pay. In addition, the 
creation of Medicare and Medicaid in 1965 had a fundamental effect on 
hospitals; a substantial portion of the free care previously subsidized 
by charitable hospitals now was reimbursed through these governmental 
programs. In response to these developments, the IRS adopted the 
``community benefit standard,'' which remains the test applied by the 
IRS for determining whether a hospital is charitable. Under the 
community benefit standard, the promotion of health care is ``one of 
the purposes in the general law of charity that is deemed beneficial to 
the community as a whole even though the class of beneficiaries 
eligible to receive a direct benefit from its activities does not 
include all members of the community, such as indigent members, 
provided that the class is not so small that its relief is not of 
benefit to the community.'' Applying this community benefit standard, 
the IRS found that a hospital's operation of a generally accessible 
emergency room open to all persons, regardless of ability to pay, 
provided a benefit to a sufficiently broad class of persons in the 
community. The requirement of the financial ability standard that 
charitable hospitals provide care to patients without charge or at 
rates below cost was removed. The community benefit standard applies 
not only to traditional hospitals, but also other health care provider 
organizations, such as clinics or health maintenance organizations 
(HMOs).
Credit counseling organizations

    In a 1969 ruling, the IRS concluded that a credit counseling 
organization was exempt as a charitable or educational organization 
described in section 501(c)(3) by virtue of aiding low-income people 
who had financial problems and providing education to the public. The 
organization had two functions: (1) educating the public on personal 
money management, such as budgeting, buying practices, and the sound 
use of consumer credit through the use of films, speakers, and 
publications; and (2) providing individual counseling to low-income 
individuals and families without charge. As part of its counseling 
activities, the organization established debt management plans for 
clients who required such services, at no charge to the clients. The 
organization was supported by contributions primarily from creditors, 
and its board of directors was comprised of representatives from 
religious organizations, civic groups, labor unions, business groups, 
and educational institutions. In 1978, a court held that the law did 
not require that an organization must perform its exempt functions 
solely for the benefit of low-income individuals to be considered 
charitable. The court found the debt management plans of the agency at 
issue were an integral part of its counseling function.
    During the period from 1994 to late 2003, 1,215 credit counseling 
organizations applied to the IRS for tax exempt status under section 
501(c)(3), including 810 from 2000 to 2003. As of late 2003, the IRS 
has recognized more than 850 credit counseling organizations as tax 
exempt under section 501(c)(3). A number of new credit counseling 
entities have engaged in aggressive marketing and advertising while 
providing very little legitimate credit counseling or financial 
training. In addition, many of today's credit counseling organizations 
conduct as their primary activity, and derive most of their revenues 
from, debt management planning and other activities. Because of these 
changes in the industry, Congress and the IRS have expressed concern 
that tax-exempt credit counseling organizations are not fulfilling 
their exempt purpose. The IRS has commenced a broad examination and 
compliance program with respect to the credit counseling industry. The 
IRS concluded in a recent legal memorandum that many credit counseling 
organizations may not qualify for exemption under section 501(c)(3) 
because of operation for a substantial nonexempt purpose, substantial 
private benefit, and private inurement.
    Thank you for the opportunity to testify. I would be pleased to 
answer any questions.

                                 

    Chairman THOMAS. Mr. Holtz-Eakin, head of the Congressional 
Budget Office. Welcome. Thank you.

   STATEMENT OF DOUGLAS HOLTZ-EAKIN, DIRECTOR, CONGRESSIONAL 
                         BUDGET OFFICE

     Mr. HOLTZ-EAKIN. Thank you, Mr. Chairman, Congressman 
Rangel, and Members of the Committee. The CBO is pleased to 
have the opportunity to be here today. We have submitted our 
written statement and I will briefly make four points. Point 
number one, which has been touched on already, is that there 
are economically significant, measured by sales or employees or 
purchases, economically significant entities who compete with 
traditional for-profit firms and who are exempt from Federal 
income taxation. The key characteristic of these entities is 
that their ownership structure differs from a traditional 
structure in which there are conventional shareholders, and 
that as a result of this traditional--the absence of this 
traditional owner claimant, the managers of these entities have 
greater incentives to lower prices, increase costs, or bolster 
their retained earnings instead of returning any profit to 
their owners. For this reason, the responses to any attempted 
taxation of these entities might lead to a much lower tax 
liability and a lower receipt than any initial appearance might 
suggest, and I thought I would briefly expand on those. These 
entities, which have been touched on by both Mr. Walker and Mr. 
Yin, are significant. They generate substantial revenues by 
selling goods and services. They incur substantial costs. In 
particular, they hire a great many workers in the economy and 
they purchase many inputs from other firms. These entities, 
which we call business entities and which collectively we refer 
to as the untaxed business sector, form an economically 
significant component of the U.S. economy.
    Three types of entities appear to stand out in this regard. 
The first are nonprofits, for example, nonprofit hospitals, 
engaged in business-like activities, at least in part, or 
universities with spin-off businesses such as R&D partnerships 
or private firms. The second are cooperatives, such as credit 
unions and others, in which the clients are often the owners of 
the activity itself. Finally, business enterprises of State and 
local governments, such as municipal utilities that are 
operated on a fee-for-service basis. They are large. It is 
difficult to get a handle on the absolute magnitude both 
because size can be measured in output, size can be measured in 
employment, it can be measured in investment and assets. We 
provide some estimates, as well. I think it is fair to say that 
this is an important aspect of the U.S. economy. Let me talk a 
bit about the two issues that might present a policy maker. 
First, the issue of economic policy. What is the impact of 
having side-by-side traditional for-profit firms and these 
business entities competing in retail markets? There, the 
question really depends on how any apparent surplus, any excess 
of price per unit over cost per unit, and that would include 
tax costs, how that surplus affects managerial behavior. One 
possibility is that that surplus simply gets translated into 
higher input costs--pay the workers more, live in bigger 
offices with nicer furnishings, and if so, the fact that you 
can have the same price with a higher cost interferes with 
traditional market discipline that rewards economic efficiency 
and allows these entities to maintain their competitive status. 
An alternative possibility is that this surplus is translated 
into lower prices and allows these entities to expand and, 
indeed, could allow the sector as a whole to expand, drawing 
more workers, drawing more capital into that sector at the 
expense of other parts of the economy. So there is a policy 
level efficiency issue that arises in examining them. The 
second is what would happen to budgetary impacts if there were 
any attempt to bring them into the Federal income tax system, 
and there, you essentially run the same logic in reverse. How 
would an attempt to tax the apparent surplus lead managers to 
respond? It could be that they, again, lower prices, and if so, 
and if sales were to other businesses, you could raise profits 
elsewhere and capture that indirectly, although you wouldn't 
get it directly from these entities. Alternatively, if there 
are sales, final sales to consumers, it is unlikely you would 
get them. It could be that in the process of doing that, you 
would expand them at the expense of their competitors by giving 
them an incentive to lower prices even more. It could be that 
they do this in the form of higher compensation, in which case 
it could be picked up under the individual income tax if this 
was wages or salaries, for example. In either event, that 
attempt would have the impact, to the extent that the managers 
followed these incentives, to lower any retained surplus and 
thus affect their ability to grow in the future if those 
retained earnings are the source of expansion in the untaxed 
business sector. So, we thank you for the chance to be here 
today and I will look forward to your questions.
    Chairman THOMAS. Thank you very much.
    [The prepared statement of Mr Holtz-Eakin follows:]
Statement of Douglas Holtz-Eakin, Ph.D., Director, Congressional Budget 
                                 Office
    Mr. Chairman and Members of the Committee, I am grateful for the 
opportunity to appear before you.
    My testimony addresses several tax policy, budgetary, and economic 
issues that arise from the presence of economic entities whose revenue 
comes primarily from selling goods and services in direct competition 
with traditional for-profit firms and whose income is exempt from both 
the federal corporate and individual income taxes. In my discussion of 
the Congressional Budget Office's (CBO's) analysis of those issues, I 
will refer to such organizations individually as ``business entities'' 
and collectively as ``the untaxed business sector.'' Three types of 
business entities have the characteristics noted above:

      Certain nonprofit institutions--for example, nonprofit hospitals 
that are wholly engaged in businesslike activity or universities that 
have undertaken ``spinoff'' business activities (such as research 
development partnerships with private firms);
      Cooperatives, including credit unions, which differ from other 
businesses primarily because their clients are their owners; and
      Business enterprises of state and local governments, such as 
municipally owned utilities, that are operated on a fee-for-service 
basis.

    CBO's analysis--which was restricted to the exemption from federal 
income taxation and does not consider any other tax treatment received 
by these entities--leads to several conclusions:

      The ownership structure of untaxed business entities differs 
significantly from that of conventional for-profit firms in that there 
are no separate claimants, such as shareholders, for the entities' 
residual profits. The lack of owners in the usual sense is what 
primarily determines how any attempt to tax such entities is likely to 
affect federal revenues and the economy.
      Because of the absence of owner-claimants, managers of these 
entities have different incentives from those of managers of privately 
owned businesses. Instead of seeking to return profits to owners, the 
entities' managers have incentives to lower prices, increase costs, or 
bolster retained earnings.
      Accordingly, taxation of these entities might not generate as 
much revenue as initially anticipated. Taxation would bolster managers' 
incentives to reduce or eliminate entities' tax liabilities by using 
more of any surplus to cut prices, boost costs, or both. As a 
consequence of being taxed, however, those entities would retain fewer 
funds for expansion.

What Is an ``Untaxed Business``?
    Business activity can be thought of as the provision of goods and 
services for a price. Only those consumers who pay the price receive 
the goods or services, and the entities that provide them finance their 
production with the receipts from those private transactions. In the 
United States, most business activity is undertaken by privately owned 
for-profit firms. The government often provides and finances through 
taxation services that are not amenable to being provided by 
businesses, such as those whose benefits reach beyond the buyer or 
seller and benefit others as well.
    There is no bright line, of course, between the kinds of goods and 
services that conventional businesses produce and those that have broad 
public benefits. Nonprofit entities, which are deemed to serve a public 
purpose and for that reason are not taxed, provide a number of them. 
Some nonprofit entities, such as nursing homes and mental institutions, 
may be less likely than their for-profit counterparts to take advantage 
of consumers who have limited information. In the case of cooperatives 
and state and local government businesses, the tax benefit that they 
receive has been justified in the past as an offset to the monopoly 
power of for-profit firms, power that might cause prices to be too 
high. Tax exemption may also encourage the provision of services when 
there are too few customers in an area to motivate a for-profit entity 
to engage in business activity. Over time, however, economic growth, 
technological advances, and increases in population may have altered 
the circumstances that justified the formation of many of those 
entities in the past.
    Many untaxed business entities sell goods and services that compete 
directly with those provided by traditional for-profit firms. The 
surplus generated by untaxed entities escapes the income tax system if 
it is passed on to retail customers in the form of lower prices or if 
it is retained for reinvestment. But the income tax system does capture 
surplus that is passed on to workers or managers as higher pay or to 
commercial customers as lower prices that then allow them to increase 
their profits.
    The Internal Revenue Code subjects the surplus generated by most 
business activity to the income tax. Profits generated by firms that 
are organized under the tax code as C corporations are taxed once at 
the corporate level and a second time at the individual level, when 
they are received as dividends or capital gains. Firms organized as 
proprietorships, partnerships, limited liability companies, S 
corporations, and other so-called pass-through entities are not subject 
to the corporate tax. However, the surplus they generate is taxed at 
the individual level.
Which Businesses Make Up the Untaxed Sector?
    Three types of entities have the characteristics of businesses but 
are not subject to income taxation either at the ``firm'' level or 
through the pass-through mechanism. The three are nonprofit 
institutions, cooperatives, and state and local government enterprises.
Nonprofit Institutions
    Many nonprofit institutions produce output that is sold to 
customers in much the same way that private businesses sell goods and 
services. The most prominent example is nonprofit hospitals that 
finance virtually all of their health care services with revenue from 
sales. On average, nonprofit health care institutions receive 
relatively few donations, garnering 92 percent of their income from 
program revenue (revenue from the sale of services). Those health care 
institutions alone represent about half of the total revenue of all 
nonprofit entities that must file financial information returns. (All 
nonprofit entities whose gross receipts exceed $25,000 must file 
financial information with the Internal Revenue Service.)
    Many nonprofit institutions whose primary activity fulfills a 
public purpose also engage in substantial business activity. The tax 
code contains provisions to tax income from business activity that is 
unrelated to a nonprofit's public purpose. In practice, however, much 
of that unrelated business income (such as income from royalties, 
payments from corporations for the right to associate their name with a 
nonprofit organization's activities, and income from the sale of 
membership lists) has been classified under tax law as related to the 
entity's public purpose and thus is not subject to taxation. 
Universities, for example, receive royalties from research development 
partnerships with private business and receive income from athletic 
events that compete with professional sports leagues.
    CBO estimates that businesslike nonprofit institutions add roughly 
$314 billion of value to the economy, or 3.4 percent of net domestic 
product (see Table 1). That estimate is based on the share of each 
entity's revenue that comes from payments made by customers. Of the 
revenue for all nonprofit institutions, 65 percent accrues to entities 
whose program revenue exceeds 75 percent of their total revenue. CBO 
assumed in its calculation that their share of net domestic product 
(the net value added to the economy) was proportional to their share of 
total revenue.
Cooperatives
    A second type of untaxed entity is cooperatives--businesses whose 
owners are also its clients. Virtually all of the activity of 
cooperatives is conducted in a businesslike fashion--that is, their 
goods and services are sold to (or for) their client-owners. They 
operate under several different sections of the tax code but, with only 
a few exceptions, are exempt from taxes on their income.

 Table 1. Estimated Size of the Untaxed Business Sector and Its Share of
                          Net Domestic Product
------------------------------------------------------------------------
                                                             Percentage
                                               Billions of    of Total
               Type of Entity                    Dollars     NetDomestic
                                                              Product a
------------------------------------------------------------------------
Nonprofit Institutions that Serve Households        314.0           3.4
------------------------------------------------------------------------
Cooperatives (Four industries) b                     32.1           0.5
------------------------------------------------------------------------
State and Local Business Enterprises                127.4           1.4
------------------------------------------------------------------------
Source: Congressional Budget Office based on data for 2000 through 2003
  from a variety of sources including the national income and product
  accounts, Census of Governments, and the National Center for
  Charitable Statistics.
a. U.S. net domestic product in 2002 totaled $9,192 billion.
b. The four industries are credit unions and three types of utilities
  providing electric, telephone, and water services.

    Many cooperatives are small and generate only a modest volume of 
sales, but some cooperatives are quite substantial enterprises. The 
larger credit unions compete effectively with segments of the 
commercial banking industry. Moreover, cooperatives include such large 
and well-known firms as Land O'Lakes, Southern States, and Welch's. 
Information on the size of the cooperative sector is not available, but 
in 2001 and 2002, four industries together--credit unions and three 
types of utilities providing electric, telephone, and water services--
earned $77 billion in total revenue.
    CBO estimates that cooperatives in those four industries added 
roughly $32 billion in value to the economy in 2002, or about 0.3 
percent of net domestic product. Again, CBO's estimate incorporated the 
assumption that those cooperatives' share of businesses' contribution 
to net domestic product was proportional to their share of businesses' 
total output.
State and Local Government Businesses
    The third category of untaxed entities comprises firms owned by 
state and local governments that are operated on a fee-for-service 
basis but that are typically exempt from federal taxation under the 
doctrine of intergovernmental tax immunity. The most common of those 
entities are utilities--primarily electric, water, and gas--which have 
many private-sector analogues. Others, such as water and sewer services 
and solid waste collection, have fewer for-profit counterparts. States 
and localities also operate a number of transportation and recreation 
businesses. (Transportation enterprises include parking garages, ferry 
boats, wharves, and airports. Businesses related to recreation include 
swimming pools, golf courses, hotels, and motels.) Miscellaneous 
commercial activities undertaken by states include a commercial bank 
and a flour mill in North Dakota and the manufacture of vaccines by a 
public entity in Massachusetts. In addition, states and localities 
operate such businesses as liquor stores and lotteries to generate 
additional revenue.
    CBO estimates that the value added to the economy by state and 
local entities that might be performing tasks similar to those carried 
out in the for-profit sector is roughly $127 billion, or 1.4 percent of 
net domestic product. (Again, CBO assumed that the state and local 
government sector's share of net domestic product was proportional to 
its share of total revenue.) The state and local sector received a 
total of $93 billion in revenue from operating water, electric, and gas 
utilities in fiscal year 2002. Another $194 billion of charges and 
miscellaneous revenue is attributable to the sale of private goods, 
such as motel room rentals.
Issues Surrounding the Tax Treatment of Untaxed Businesses
    Several objections have been raised to the differential tax 
treatment granted to these business entities. Competitors of tax-exempt 
businesses have objected that it is unfair, and analysts have been 
concerned about its effects on economic efficiency. Evaluating fairness 
is problematic. To begin with, such an exercise reflects the values of 
the observer. In addition, fairness is best evaluated with respect to 
the owners of firms; the institutions are merely legal constructs that 
exist to organize and facilitate production. But owners change over 
time, making it impossible to trace how former owners of competing or 
potentially competing firms were affected. Eliminating the differential 
tax benefit would not redress any past inequities and could introduce 
new ones.
    Differential tax treatment could lead to inefficiency in several 
ways. Untaxed firms have the opportunity to use their surplus (which 
includes their tax savings) to offset any higher production costs they 
might incur and still compete with taxed firms on the basis of price. 
Consequently, the tax benefit may interfere with the market's 
discipline, which rewards efficient firms and penalizes inefficient 
ones. Alternatively, using the tax savings to reduce the price of the 
firm's output could shift the economy's mix of production toward less-
valued goods and services.
    The favored treatment of untaxed businesses, however, stems from 
their public--purpose nature, and the continuation of that treatment 
will depend on the judgments of policymakers.
The Tax Exemption and Forgone Receipts
    The three categories of untaxed businesses have a significant 
attribute in common: the absence of conventional owners, which relieves 
them of the need to report and distribute profits in the usual sense. 
The incentives of managers of untaxed businesses thus differ from those 
of managers of commercial businesses. Not seeking to maximize profits 
or surplus, they have greater latitude with regard to their costs of 
production and prices. Indeed, the purpose of some untaxed entities in 
part is to sell output at prices lower than its costs. As a result, 
taxing the untaxed business sector may yield much less revenue than 
might be expected, given the scale of its activities.
    The scope of tax-avoidance options available to for-profit firms is 
limited by the necessity to deliver a return to the firms' owners. The 
tax-avoidance strategies that nonprofit businesses, cooperatives, and 
state and local government enterprises can command are more numerous 
because of those entities' ownership structure. That statement is true 
regardless of whether the entity attempts to reduce the price and 
increase the availability of the good it sells or whether it takes less 
care to adopt lowest-cost methods of production and as a result pays 
its operators and employees higher wages than they would otherwise 
receive. Hence, if a tax was imposed, a nonprofit business entity could 
more easily distribute any surplus to its managers or customers than a 
for-profit firm could; a cooperative would have more latitude to 
deliver its surplus to its owner-clients as lower prices than to parcel 
it out; and state and local government businesses could distribute 
their surplus in several different ways without necessarily handing it 
over as explicit profits to the state or locality. (They could 
distribute it as lower prices to their customers, higher wages to 
employees and managers, or some combination of lower taxes and more 
public services to the voters who ultimately control those businesses.)
    A surplus that is passed on in the form of lower prices or higher 
pay reduces profits. Without conventional owners and the necessity to 
distribute profits as dividends or retain them as earnings, untaxed 
business entities could avoid a tax by passing on the surplus and 
minimizing taxable profits (see Box 1).
    If a tax was imposed, previously untaxed business entities would 
probably choose among tax-avoidance strategies on the basis of their 
circumstances. For an electric utility owned by a state and local 
government, for example, the shares of the surplus received by 
individuals in the jurisdiction differ depending on whether the surplus 
is distributed as a lower price, higher pay, or reduced tax burden. 
Similarly, the shares of any surplus received by an individual owner-
client of a cooperative will differ if the surplus is distributed as a 
reduction in prices instead of as profits. Regardless of the particular 
strategy an untaxed business entity chooses, the difference between its 
ownership structure and that of a private firm provides it with 
substantially more flexibility in undertaking measures to avoid taxes 
and still meet its objectives.

----------------------------------------------------------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------
           Box 1.
----------------------------------------------------------------------------------------------------------------
           Taxing the Surplus from a Hypothetical Municipal Golf Course

           As an illustration, imagine a municipal golf course that is run as efficiently as a private
            competitor and priced the same--say, $40 per round. The municipal course incurs $36 in
            costs per round and generates a surplus of $4. The corporate tax rate is assumed to be 30
            percent and the individual rate, 20 percent.

           Presented as an equation, price ($40) = cost per round ($36) + before-tax profit per round
            ($4). In the absence of any taxes, the entire surplus of $4 per round can be paid to the
            untaxed municipal treasury to offset other costs of local government. In contrast, the
            private competitor must record the equivalent $4 per round as a profit and pay a 30
            percent tax ($1.20).

           Should a corporate tax be imposed on the municipal firm, rather than paying it, the firm
            might distribute the surplus to its customers as a price cut and charge only $36 per
            round. Costs would equal revenue, and the surplus would still escape the tax. The golf
            course's books would show the following: $36 = $36 + 0.

           Alternatively, the golf course might pay its employees higher wages. The price per round
            would still be $40, but costs would be increased to $40, leaving no surplus to tax. In
            that case, however, the surplus would be subject to individual income taxes. If the
            individual rate was 20 percent, only 80 cents would be collected rather than the $1.20
            that would be collected from a for-profit firm. The golf course's books would show the
            activity this way: $40 = $40 + 0.

           Another option for the municipal firm would be to convert the $4 surplus to the local
            government's general fund by shifting $4 of its general fund costs to the golf course. No
            tax is collected on revenue that goes into the general funds of state and local
            governments. The golf course's books would, again, show the following: $40 = $40 + 0.
----------------------------------------------------------------------------------------------------------------

    The opportunities for tax avoidance are even greater for secondary 
business activity carried on by untaxed entities whose primary activity 
is pursuing socially beneficial objectives. Profits from any business 
activity in which such an entity engages--whether related or unrelated 
to its main activity--are difficult to segregate from profits earned in 
the pursuit of its primary purpose. As a result, the taxation of any 
non-primary-activity profits becomes extremely difficult in the face of 
skillful management and accounting. In tax year 2000, a total of $4.8 
billion of gross unrelated business income was reported by more than 
11,000 organizations classified as 501(c)(3) under the tax code. The 
organizations reported total deductions for business expenses of about 
the same amount--for a net loss of $49,000. Fewer than half reported 
unrelated business income that was subject to taxation, and the 
revenues raised totaled only $4.1 million.
    Because of those opportunities and incentives, any shift toward 
taxing the currently untaxed business sector can be expected to yield 
considerably less revenue than the size of the sector might otherwise 
suggest. The Joint Committee on Taxation has estimated that taxing some 
of the institutions in the sector in a manner analogous to the taxation 
of C corporations would yield about $2 billion in revenue a year. If 
the estimates covered more of the sector's businesses, the revenue gain 
would probably be larger. But it appears that the amounts involved are 
small relative to the size of the entire economy--and might in fact be 
even more modest if the estimates did not take into account the scope 
such firms have for tax avoidance.
The Economic Effect of Taxing the Untaxed Business Sector
    Taxation of currently untaxed business entities would be unlikely 
to generate much revenue for the government, but it would have the 
economic consequence of constraining their growth. Taxation of their 
surplus would amplify the incentives they already have to lower their 
prices and incur higher costs, which could significantly reduce the 
amount of internal capital that those institutions accumulated. That 
constraining effect of taxation on growth would tend to be much 
stronger than it is for privately owned for-profit firms, which must 
pay tax on their profits but face strong incentives to retain the 
after-tax surplus or distribute it to owners.

                                 

    Chairman THOMAS. Dr. Colombo, and I will just go from left 
to right across the panel with our guest witnesses. Dr. Colombo 
is a professor of law at the University of Illinois College of 
Law. Obviously, based upon his written testimony, he has spent 
a long time looking at this area. Dr. Colombo?

STATEMENT OF JOHN D. COLOMBO, PROFESSOR, UNIVERSITY OF ILLINOIS 
           COLLEGE OF LAW, URBANA-CHAMPAIGN, ILLINOIS

    Mr. COLOMBO. Thank you, Mr. Chairman, and I want to thank 
the Committee for inviting me today. I am a professor of law at 
the University of Illinois at Urbana-Champaign and I have 
taught and written about tax-exempt organizations for the past 
18 years. I would like to make three points about tax exemption 
that I think are useful in organizing this area. First, when 
you think about tax exemption, it really is helpful to divide 
the world into charities exempt under 501(c)(3) and everything 
else. When people hear the phrase ``tax-exempt organization,'' 
they tend to equate it with the charitable contributions 
deduction under section 170, but that is not the way things 
work. section 501(c) lists 28 different kinds of organizations 
that are tax-exempt, but with a couple of exceptions, only 
charitable organizations are eligible to receive deductible 
contributions. In addition, the underlying rationales for 
exemptions vary between charitable organizations and everything 
else. Most of us think that charitable organizations are exempt 
because they are improving general public welfare in some way. 
For non-charitable entities, however, the rationale tends to be 
much more entity-specific, for example, the social club pooling 
of resources rationale that you heard from Mr. Yin. Finally, 
charitable organizations, as Mr. Yin pointed out, are by far 
the largest subset of exempt organizations, both numerically 
and financially.
    Second, it is useful to remember that within this special 
group of charitable organizations, we also have two categories, 
public charities and private foundations. Again, people 
sometimes get confused about this, but a private foundation is 
an exempt charity under section 501(c)(3) just as much as a 
church or a private school. We do more highly regulate private 
foundations, and the reasons for that heightened regulation 
relate to the public accountability concept. Public charities 
get their money from a broad cross-section of the general 
public and hence are accountable to the general public. Private 
foundations generally get their money from a single donor or 
family and hence are accountable to their primary donor. If you 
have public accountability, then you have some reason to 
believe that the managers of a charity will be careful about 
what they do because the public is watching them. Think back to 
the outcry that happened when the Red Cross announced that it 
was going to divert some money donated to it for 9/11 victims 
to other needs. People got mad, this Committee got involved, 
and the Red Cross changed its mind. When you do not have this 
public accountability, then there is enormous room for abuse, 
which is why Congress adopted the much tighter regulatory 
scheme for private foundations in 1969, including the 
prohibitions on self-dealing, the stricter limits on the kinds 
of investments private foundations can hold, and stricter 
limits on deductions for donations to private foundations. The 
accountability principle tells us that there are two 
particularly important issues here. One is transparency, is the 
public getting information it needs to hold charities 
accountable, and the other is whether taxpayers have found 
structures that avoid the private foundation regulations but 
yet are not truly accountable to the public.
    My final point concerns the overall system for identifying 
exempt organizations, and here, I want to talk specifically 
about that subgroup of exempt charities. Charitable tax 
exemption just sort of happened. We never really agreed on a 
core rationale for exempting charities. The operation of 
charities has changed dramatically over the years. Private 
nonprofit hospitals, for example, were largely shelters for the 
poor until World War II. Now, they are mostly very large fee-
for-service businesses. So, why are they still exempt? Some 
people think it is because they provide free care to the poor, 
but free care is not currently required by the tax laws for 
hospitals to be exempt. So, here is an example, and there are 
others, where we have ended up with a disconnect between our 
traditional views of charities and how they operate in the real 
world today. Over a decade ago, my colleague, Mark Hall, and I 
suggested a system in which charitable tax-exemption under 
501(c)(3) would be limited to entities that were substantially 
dependent on donations for their operating revenues each year. 
We still think that system would make a lot of sense. People 
donate to organizations because they see the needs these 
organizations serve and see a lack of resources to meet those 
needs. If an organization doesn't get significant donations, 
then either it isn't doing anything the public thinks is 
worthwhile or the public sees that they have ample resources 
without donations. In either case, such organizations don't 
need tax-exemption. Using donative status, therefore, seems to 
be a pretty good way to distinguish organizations that do 
things that ought to warrant tax-exemption from those 
organizations that don't. Whether you agree with our donative 
idea or not, I would urge the Committee to give some thought to 
the overall rationale for charitable exemption as it debates on 
these issues. If you don't like my theory, that is fine. There 
are lots of them out there. Find one that you do like and 
conform the law to that theory and you will have made an 
enormous improvement in the law relating to tax-exempt 
organizations. Thank you very much.
    Chairman THOMAS. Thank you very much.
    [The prepared statement of Mr. Colombo follows:]
Statement of John Colombo, Professor, University of Illinois College of 
                    Law, Urbana-Champaign, Illinois

Mr. Chairman, Members of the Committee:

    My name is John Colombo. I am a professor of law at the University 
of Illinois College of Law in Urbana-Champaign, and I have taught about 
and written on issues of tax-exempt organizations for the past 18 
years. I think my job today is to give you some background and context 
regarding tax exemption rules, particularly as they apply to private 
foundations and trade associations.
Charitable Exemption vs. Other Exemption
    Let me start with two very basic and very useful distinctions to 
keep in mind when assessing policies regarding nonprofits and tax 
exemption. The first distinction is that when it comes to tax 
exemption, there are charities exempt under Code Section 501(c)(3) and 
then there is everything else. Section 501(c) grants exemption to 28 
different kinds of organizations, but the ``charities vs. everything 
else'' distinction is a very useful way to think about this for several 
reasons. First, in general only charities exempt under 501(c)(3) are 
eligible to receive additional major tax benefits like tax-deductible 
contributions. Other exempt entities, like trade associations (which 
are exempt under Sec. 501(c)(6), rather than Sec. 501(c)(3)), get 
exemption from having to pay the corporate income tax on their 
earnings, but are not permitted to receive deductible contributions.
    Second, the underlying rationales for exemption vary between 
charitable organizations and everything else. Although we academics 
carry on a lively debate about the rationale for charitable tax 
exemption, all of us would agree, I think, that at some level exemption 
for charities is tied to a concept that they are improving general 
public welfare in some way. For non-charitable entities, however, the 
rationale tends to be much more entity-specific.
    For example, trade associations are exempt if they carry on 
activities designed to promote a common business interest of its 
members; such organizations must not ``engage in a regular business of 
a kind ordinarily carried on for profit.'' \1\ These organizations are 
exempt because they represent simply a pooling of resources by people 
with a common interest to conduct activities that, if conducted by the 
members themselves, would not be profit-making businesses. Hence we 
believe that creating an ``association'' for members to pool their 
resources in this manner should not result in taxation of those pooled 
resources. But if a trade association does conduct regular business 
activities or provides specific services for members, then the 
organization should not be exempt because it no longer represents this 
nontaxable collective pooling of resources, but rather is now engaging 
in a for-profit business.
---------------------------------------------------------------------------
    \1\ Treas. Regs. 1.501(c)(6)-1.
---------------------------------------------------------------------------
    Third, charities constitute the bulk of exempt organizations under 
501(c). Data complied in 2002 indicated that there were in excess of 
900,000 exempt charitable organizations in the IRS's master file, 
constituting well over half the total number of all exempt 
organizations.\2\ Trade associations under 501(c)(6) were the next most 
numerous category, with approximately 84,000 organizations, but still 
less than a tenth of the number of charitable organizations.
---------------------------------------------------------------------------
    \2\ Marion Fremont-Smith, Governing Nonprofit Organizations 6-7 
(Belknap Press 2003). This number is likely significantly higher than 
what is reported, because churches do not have to file with the IRS for 
recognition of exemption under Section 501(c)(3) and therefore are not 
included in the IRS Master File.
---------------------------------------------------------------------------
Public Charities vs. Private Foundations
    The second major distinction in tax-exemption law occurs within the 
charitable sector itself. This distinction is between public charities 
and private foundations. People often get confused about the tax-exempt 
status of private foundations; so the first thing to remember is that 
private foundations are charitable organizations eligible for exemption 
under Section 501(c)(3) just as much as a church or a private school. 
The IRS has long recognized that making monetary grants to other 
charities is itself a charitable activity, and that's largely what 
private foundations do--make grants to other charitable organizations. 
Historically, in fact, private foundations preceded the income tax. The 
wealthy industrialists of the 19th century, such as Andrew Carnegie, 
for example, created trusts to benefit charitable organizations long 
before we had a functioning income tax. As a result, prior to 1969, 
private foundations and public charities were treated pretty much the 
same for tax purposes.
    In the 1969 Tax Reform Act, however, Congress decided to subject 
private foundations to more specific regulation designed to prevent 
abuses of the private foundation form. The best way to understand why 
we have this heightened regulation of private foundations is to focus 
on two main differences between private foundations and public 
charities: accountability and continuing control.
    Public charities are organizations that are accountable to the 
general public because they get their money in one way or another from 
a broad cross-section of the public. Private foundations, however, 
generally receive their funding from a single individual or family, and 
therefore are accountable to and controlled by that primary donor.
    These two distinctions are the basis for our different regulation 
of public charities and private foundations. When you have true public 
accountability and ``public control'' over assets, then you have some 
reason to believe that the managers of the charity will be careful 
about their mission and the execution of that mission, because a 
publicized misstep will have significant adverse effects on the public 
funding of that organization. Think back to the adverse publicity for 
the United Way a couple of years ago when its CEO's salary and perks 
were disclosed in the national media, or the outcry that happened when 
the Red Cross decided to divert some money donated for 9/11 victims to 
other needs--I believe, in fact, that this Committee held hearings 
about the Red Cross's decision and was instrumental in bringing the 
weight of public accountability to bear on that.
    When you do not have this public accountability, however, and you 
have significant continuing control by one person or family over 
donated wealth, then there is enormous room for abuse, which is why we 
have the much tighter regulatory scheme for private foundations. This 
tighter regulatory scheme generally is set forth in Sections 4940-4946 
of the Code, and includes a requirement that a foundation pay out a 
certain amount of its assets each year to other charities, a 
prohibition on self-dealing transactions of any kind, limits on the 
kinds and size of certain business holdings of a foundation, limits on 
certain kinds of investments that a foundation can make, more stringent 
limits on lobbying, and so forth. In addition, in 1969 Congress also 
tightened the rules with respect to charitable donations to private 
foundations, again to avoid abuse situations in which individuals could 
eliminate tax liability by making gifts of certain kinds of property, 
like stock of a privately-held corporation, that could still be 
controlled for by the donor after the gift. So while individuals can 
make deductible donations of up to 50% of their adjusted gross income 
to public charities, and in many cases can take a deduction for the 
full fair market value of donated property to public charities, 
deductions to private foundations are limited to 30% of AGI and 
deductions for property gifts generally are limited to the taxpayer's 
tax basis in the property, not its market value.
Defining ``Charitable'' Organizations for Tax Exemption
    While I think this short summary gives a useful overview of the two 
main distinctions in our tax exemption laws (charities vs. everything 
else, and within the ``charity'' category, public charities vs. private 
foundations), I would like to close with an additional thought about 
tax exemption, particularly as it applies to charitable organizations.
    One of the core problems with tax exemption for charities over the 
years has been that exemption more or less ``just happened'' without a 
great deal of thought regarding why we hand out tax exemption. Many 
organizations, such as churches and private schools, for example, were 
already exempt from state property taxes when Congress passed the first 
corporate income tax law in 1894; these organizations were not 
businesses in any sense of the word, and hence exemptions were 
incorporated into the ``new'' income tax law without much debate.
    As a result, while we have this vague notion that we grant 
exemption to charities because they ``do good things'' for society, 
there has never been a specifically-articulated rationale that allows 
us to tie down exactly what good behavior should be rewarded with 
exemption. Currently, the IRS relies on the 400-years of legal 
precedent in the law of charitable trusts to define charitable 
organizations. As the operation of nonprofit organizations has changed 
over time, however, difficult questions have come up regarding tax 
exemption for certain nonprofits. For example, in the 1800's private 
nonprofit hospitals were essentially shelters for the poor. Today, most 
of them are very large fee-for-service businesses. So why are modern 
private nonprofit hospitals still exempt? Is it because they ``do good 
things'' for society? There is no question that nonprofit hospitals in 
fact do good things for their communities, but one could argue that 
many for-profit businesses do good things for their communities, as 
well. Is it because they provide free care for the uninsured poor in 
some cases? Maybe so, but that is not currently required by law and the 
empirical evidence on whether nonprofit hospitals provide significant 
charity care is mixed.\3\ So in some cases we have ended up with a sort 
of disconnect between our traditional views of charities and the way 
they operate in the real world today.
---------------------------------------------------------------------------
    \3\ Under the ``community benefit'' test of exemption promulgated 
by the IRS in 1969, free care for the uninsured is not a requirement 
for a hospital to receive exemption under Section 501(c)(3). See Rev. 
Rul. 69-545, 1969-2 C.B. 117; John D. Colombo, The Role of Access in 
Charitable Tax Exemption, 82 Wash. U.L.Q. 343, 347 (2004). For a review 
of the empirical evidence, see John D. Colombo, The Failure of 
Community Benefit, 15 Health Matrix 29 (forthcoming 2005).
---------------------------------------------------------------------------
    Over a decade ago, my colleague Mark Hall and I suggested a system 
in which tax exemption under Section 501(c)(3) would be limited to 
entities that were substantially dependent on donations for their 
operating revenues each year.\4\ There is a reason why limiting 
exemption to donative organizations makes sense--in brief, donations 
are the signal that people believe an organization is doing something 
worthwhile, and is not otherwise being sufficiently funded by the 
private market or by the government. People donate to organizations 
because they see the needs these organizations serve and see a lack of 
resources to meet those needs. In contrast, organizations that do not 
get significant donations either aren't doing anything the public 
thinks is worthwhile, or the public sees that they have ample resources 
without donations. In either case, such organizations do not need tax 
exemption. Using donative status, therefore, seems to be a pretty good 
way to distinguish organizations that do the things that ought to 
warrant tax exemption from those organizations that do not. In fact, if 
I asked all of you to name your paradigm charities, I suspect that most 
of you would name donative entities--your church, the Salvation Army, 
the Red Cross, the United Way, maybe certain arts organizations.
---------------------------------------------------------------------------
    \4\ John D. Colombo and Mark A. Hall, The Charitable Tax Exemption 
(Westview Press, 1995); Mark A. Hall and John D. Colombo, The Donative 
Theory of the Charitable Tax Exemption, 52 Ohio St. L.J. 1379 (1991).
---------------------------------------------------------------------------
    I think that any discussion of reforming the rules for tax 
exemption ought to include some thought about the overall system for 
granting tax exemption, particularly for charitable entities under 
501(c)(3), and whether you agree with my suggestion about using 
donations as this core rationale or not, I would urge the Committee to 
give some thought to this general point as it deliberates on these 
issues.
    Thank you.

                                 

    Chairman THOMAS. Dr. Hill is a professor of law. Thank you 
for being with us, and we look forward to your testimony.

 STATEMENT OF FRANCES R. HILL, PROFESSOR, UNIVERSITY OF MIAMI 
              SCHOOL OF LAW, CORAL GABLES, FLORIDA

    Ms. HILL. Thank you, Mr. Chairman, Mr. Rangel, and Members 
of the Committee for the opportunity to present testimony this 
morning. I am here to suggest that although there are many 
rationales that have been suggested over the years for exempt 
status, we have, in fact, not settled on one, but there is one 
that is, in fact, fundamental to the law, even as currently 
implied, and what we need to do is recognize it, make it 
operational, make it practical, and build the law around it. 
That is the fundamental message. The rationale is based on 
providing a public benefit to a defined category of 
beneficiaries. The exempt sector is large, growing, and 
diverse. It must be accountable, but it should not be 
improperly constrained. Evidence of malfeasance by certain 
organization managers or the inattentiveness or even 
dereliction by certain directors should not be generalized to 
the entire sector, just as these tacky, unacceptable, and 
thoroughly regrettable forms of behavior should not be excused 
by reference to the benefits provided by exempt organizations. 
government oversight, both with regard to lapses and with 
regard to structure, continues to be vitally important.
    Of all the multiple types of exempt organizations that we 
have had outlined to us today, they certainly differ in their 
requirements for exemption, the activities that support exempt 
status, but they share the common feature that in every case, 
exemption depends upon providing a public benefit to a defined 
class of beneficiaries. This public benefit rationale is an 
analytical framework for understanding current law and deciding 
whether current law and the way it is being administered are 
consistent with the proper use of the tax subsidy. Preventing 
misuse of exempt organizations' resources is a matter of 
central responsibility. In fact, we have probably focused 
exclusively on simply bad behavior, on what some have called a 
non-distribution constraint, what some have called a private 
benefit prohibition. This is what academic analyses have 
focused on. This is what Congress has focused on for a very 
long time, things like section 4958, the inurement concept and 
the private benefit concept. The idea of preventing 
impermissible private benefits is important, but preventing 
these impermissible private benefits will not in itself assure 
that exempt entities operate for a public benefit, and that is 
what I am urging the Committee to focus on as its work goes 
forward. A rationale, a framework for understanding exemption 
is vitally important. It should not just be a justification for 
either the status quo or for one's preferred reform ideas. A 
framework ensures that the law in this area does not simply 
become a cluster of isolated requirements that are easily 
manipulated to support activities largely unrelated to the 
provision of a public benefit. When the law is easily 
manipulated, a classic moral hazard results. Aggressive actors 
pursuing problematic programs win at least passive acceptance, 
while entities that are attempting to comply are given little 
useful guidance and find few positive rewards for their 
efforts.
    I am going to try to move the concept of a public benefit 
beyond some warm and fuzzy invocation of the good that exempt 
organizations do on to a usable, practical concept. This 
concept certainly requires that we reconceptualize exempt 
organizations, which I believe, despite all the good work that 
has been done by government agencies, private scholars over the 
years, remains incompletely described and incoherently 
conceptualized. Exemption should be efficient, and it is 
efficient only if it is dedicated to providing a public benefit 
to designated beneficiaries. Right now, it is impossible to 
answer the question of whether the increase in number and 
revenue of exempt entities means that there has been a 
commensurate increase in the provision of public benefits to a 
charitable or other exempt class. Part of this is because we 
have focused so long on simply preventing private benefits, and 
the other reason is that we have not conceptualized what 
constitutes a public benefit and we have not asked a number of 
fundamental questions about this sector. My testimony on page 
five in the written form outlines a number of questions that 
remain amazingly unaddressed after all of these years, and it 
is perhaps now time to address the longstanding question and 
move forward also to address the new challenges. We don't know 
what is meant by a public benefit. It is not simply a matter of 
saying zoos should not run gift shops because those things are 
commercial, or museums shouldn't have little coffee shops in 
them. I like a cappuccino when looking at the art. Personally, 
I don't think it does any harm. The question is how to tax it. 
There are obviously more substantial examples, but I use a 
somewhat trivial one to suggest that not everything that is 
commercial is in our capitalist republic tainted. It is a 
question of the terms of engagement.
    It is the work of Congress, ultimately, I think, to think 
about public benefits and to exercise oversight and to work 
with the IRS and Treasury to help define it. Part of the 
concept of a public benefit is who is being benefited. What is 
the charitable class? As Professor Colombo referred to, 
certainly, there was dynamic testimony before this Committee in 
the past relating to what constitutes a charitable class when 
it was unfortunately suggested the 9/11 victims' surviving 
family members were not a charitable class because although 
they may well have certainly been quite distressed, they were 
not poor. The IRS, of course, clarified what it meant by this 
testimony immediately. I bring this up only to suggest that 
what constitutes a charitable class or an exempt class requires 
careful thought and is not an easy question, but one we need to 
know. Number three, much of the diversion of resources from 
exempt functions to non-exempt functions occurs within exempt 
organizations not by just simply doing private benefits outside 
them and we need a mechanism to find out what is going on 
inside exempt organizations. At the moment, I would submit, we 
do not know. This is not to suggest malfeasance or a plot. It 
is not to suggest that people who work with data are ignorant 
or inattentive. We don't have the conceptual framework, and I 
have in my written testimony suggested how we might go about 
asking some of these questions. I would like to point out to 
the Committee that questions of operating through complex 
structures of multiple types of exempt entities, or exempt 
entities and taxable entities, should not be regarded as 
inherently wrong or problematic. The question remains, how do 
they operate, and then my fifth question, how are resources to 
be transferred?
    There is no guidance on what kind of resource transfers can 
be engaged in consistent with various types of exempt status. 
Some of these are efficient and productive and necessary. 
Others are beyond problematic and should be interdicted fairly 
quickly. UBIT, what is it there for these days? It was enacted 
to make sure that taxable entities were not put at disadvantage 
when they were making spaghetti. Long ago, a Member of this 
Committee expressed the fear that all noodles in America would 
be made by universities, referring to the famous Mueller 
Macaroni New York University Law School example. Well, that 
didn't happen, but there was a justifiable concern about the 
tax advantage. The issue with UBIT, the Unrelated Business 
Income Tax issues now, is are resources being diverted inside 
the entity to business activities? Why are we capitalizing 
business activities with deductible charitable contributions? I 
submit we need to know to the extent this is happening and 
think about whether that is appropriate. Finally, a new issue. 
Tax shelter promoters are enticing exempt organizations to 
serve as accommodation parties in the niftily designed 
transactions that are undermining the very integrity of the 
Internal Revenue Code. I would urge this Committee to become 
engaged in making sure that whatever else is done with tax 
shelters, tax-exempt organizations are not made enablers of 
these unworthy schemes, and that I think the IRS has done a 
good job in this area of at least identifying the issue.
    I would like to make one point about IRS staffing and 
funding. I am not an expert on IRS staffing, but I believe they 
need more people with a more finely developed expertise and 
they need to be able to retain them longer to develop 
experience in administering the tax law, and frankly, if you 
will pardon a professor for being a capitalist, that requires 
paying people. I believe that Congress could usefully exercise 
oversight to make sure that the IRS is hiring and keeping 
people with an appropriate level of expertise, because without 
expertise, the moral hazard of misusing exempt organizations 
will, in fact, become worse. There has been little precedential 
guidance in recent years, and I hope I have given you enough of 
a list to suggest to you that very fundamental issues remain 
unaddressed, but should not do so any longer. Thank you, and I 
look forward to questions.
    Chairman THOMAS. Thank you very much, Professor Hill.
    [The prepared statement of Ms. Hill follows:]
Statement of Frances R. Hill, Professor, University of Miami School of 
                          Law, Miami, Florida
    Thank you for the opportunity to present this testimony. The 
comments presented are my personal views and do not represent the 
views, if any, of the University of Miami or the University of Miami 
School of Law.
    Exempt entities provide important benefits to the public. Without a 
vibrant, diverse, dynamic and growing exempt sector, many important 
social, cultural, and economic needs of the American people could not 
and would not be served. All of us are beneficiaries of this sector no 
matter how fortunate or unfortunate our circumstances.
    Maintaining the vibrancy and dynamism of the exempt sector that 
provides such important benefits to the public is enhanced by 
continuing oversight from Congress and responsible administration of 
the law by the Internal Revenue Service (the ``Service'). Such efforts 
must protect the public interest in ensuring that exemption serves 
public purposes. At the same time, efforts to constrain the creativity 
of the exempt sector by unduly circumscribing the independence of 
exempt entities would be counterproductive. The exempt sector must be 
accountable but should not be constrained. Evidence of malfeasance by 
certain organization managers or the inattentiveness or even 
dereliction by certain directors should not be generalized to the 
entire sector, just as these unacceptable behaviors should not be 
excused by reference to the benefits provided by exempt organizations. 
Government administration and oversight should be seen as part of a 
larger process of ensuring accountability through participatory 
monitoring by organization members and beneficiaries.
    The twenty-eight types of exempt entities enumerated in section 
501(c) of the Internal Revenue Code of 1986, as amended (the ``Code'') 
differ in their requirements for exemption and the activities that 
support exempt status. But, they share the common feature that, in 
every case, exemption depends upon providing a public benefit to a 
defined class of beneficiaries.\1\ This common feature provides a 
rationale for exemption and an analytical framework for understanding 
whether current law and the way it is being administered are consistent 
with the foundational reason for exemption.
---------------------------------------------------------------------------
    \1\ For analyses of these various types of exempt entities, see 
Frances R. Hill and Douglas M. Mancino, Taxation of Exempt 
Organizations Warren, Gorham & Lamont, 2002, with semiannual 
supplements) (``Hill and Mancino'').
---------------------------------------------------------------------------
    While current law indeed provides that provision of benefits to the 
designated class of beneficiaries is the foundational requirement for 
exemption, this requirement has not been developed as an affirmative 
requirement. Instead, administrative efforts, policy discussions, and 
academic analyses focus largely on preventing impermissible private 
benefit. Preventing misuse of exempt organizations' resources is a 
matter of central importance. But, it does not provide either a 
rationale for exemption or an analytical framework for understanding 
exemption. As exempt entities engage in an ever-broadening range of 
activities and as the exempt sector grows larger, more dynamic and more 
diverse, this is an appropriate time to consider the reasons for the 
exemption and the relationships between these fundamental rationales 
and current law.
    A rationale or framework addressing the reasons for exemption is an 
analytical and policy tool, not a justification offered to defend every 
element of current law. Without such a framework, a rationale rather 
than a mere rationalization, rules become isolated requirements that 
are easily manipulated to support activities largely unrelated to the 
statutory purposes exempt entities are created to serve. When the law 
is easily manipulated, resources are diverted from activities that 
serve exempt purposes to activities that serve other ends and 
confidence in the exempt sector erodes. The result is a classic moral 
hazard in which aggressive entities pursing problematic strategies win 
at least tacit acceptance, while entities that are attempting to comply 
are given little useful guidance and find few positive rewards for 
their efforts.
    This is not to suggest applicable law and acceptable practices will 
not or should not change. The world in which exempt entities operate is 
changing and the needs addressed by exempt entities are changing. 
Change in activities undertaken, structures created, and relationships 
with other sectors developed should be seen as practical adaptations to 
changing circumstances. At the same time, certain things need not and 
should not change. Exempt entities should always operate to provide a 
public benefit to the beneficiaries they have been organized to serve. 
Exempt entities should never be treated as the private domain of 
managers or board members or substantial contributors who treat either 
the tangible or intangible resources of the exempt organization as 
something to be used for personal benefit. The challenge is to 
reconcile useful change with these foundational principles. This is the 
work of every person who cares about the exempt sector. In a democracy, 
views on how to do this can be expected to differ.
    My comments today will focus on a public benefit framework for 
exemption. I shall address the following topics: (1) the elements of a 
public benefit framework; (2) oversight priorities arising from a 
public benefit framework; (3) oversight priorities for data collection 
and research; (4) oversight priorities relating to guidance and 
compliance; and (5) oversight and ensuring that exempt entities operate 
for a public benefit.
I. Elements of a Public Benefit Framework
    Exemption is a subsidy granted for defined public policy 
purposes.\2\ The Code, the applicable regulations, and the legislative 
history all support the nexus between exemption and provision of a 
public benefit. No one would disagree that provision of the statutorily 
mandated public benefit is the essential activity of any exempt entity.
---------------------------------------------------------------------------
    \2\ Regan v. Taxation with Representation, 461 U.S. 540 (1983).
---------------------------------------------------------------------------
    Yet, the concept of a public benefit has not figured centrally in 
either policy discussions or academic analyses of exempt entities. 
Instead, both policy makers and commentators have equated the absence 
of private benefit with the presence of a public benefit. The dominant 
academic framework in the last quarter century was based on the private 
benefit avoidance framework presented by Professor Henry Hansmann in 
terms of a ``nondistribution constraint.'' \3\ Much of policy focus 
during this same period was on developing an administrable private 
benefit provision, which was enacted in the excess benefit transaction 
provision of section 4958.
---------------------------------------------------------------------------
    \3\ Henry Hansmann, The Role of Nonprofit Enterprises, 89 Yale L.J. 
835 (1980); Reforming Nonprofit Corporation Law, 129 U. Pa. L. Rev.497 
(1981).
---------------------------------------------------------------------------
    Concern with private benefit is a fundamentally important element 
in the law relating to exemption. But, the mere absence of a private 
benefit does not provide a rationale for exemption that can provide 
guidance for administration and oversight of the exempt sector. A 
rationale for exemption and a framework for analysis, policy, 
administration, and oversight depends on developing the concept of a 
public benefit, which provides an affirmative rationale for exemption 
consistent with the exempt purposes set forth in current law. A public 
benefit rationale for exemption points toward additional issues that 
are critical in determining whether entities are serving their intended 
exempt purposes.
    Making public benefit a focal point of inquiry leads to the 
question of whether current law and the manner in which it is being 
administered are consistent with the efficiency of exemption. To the 
extent that exemption means that a public benefit is being provided to 
an appropriate class of beneficiaries, it is operating efficiently. To 
the extent that exemption serves simply as a mechanism for avoiding 
taxes on income that would be taxed if performed by another type of 
entity, then exemption is inefficient. A focus on efficiency in this 
sense permits one to raise the question of whether increases in the 
number and revenue of exempt entities mean that provision of public 
benefits has increased to a commensurate extent. The only response in 
light of current data is that no one can say with any certainty. As 
this testimony suggests below, development of a public benefit 
framework for exemption permits the kind of analysis that can lead to 
collection of the information required to answer this fundamental 
question.
    A public benefit framework directs attention to a fact that has 
been curiously overlooked. Analyses of exempt organizations have 
overlooked the significance of the noun and focused instead on the 
adjective. Ignoring the fact that exempt activities are conducted 
through organizations is a central analytical error. This error is 
compounded by the unarticulated ``organizational presumption'' of 
current law and its administration.\4\ Activities conducted by exempt 
organizations are generally presumed to be consistent with the 
organization's exempt status. In practice, the definition of an exempt 
activity is an activity conducted by an exempt organization. But, no 
one knows what exempt entities are in fact doing. Current law 
anticipates that exempt entities will engage not only in exempt 
activities but also in permissible activities that do not in themselves 
support exemption and which are not intended to be the organization's 
primary activity. But, to the extent that these permissible activities 
become characterized as exempt activities by invoking the 
organizational presumption as the core element of characterization, 
exemption becomes inefficient.
---------------------------------------------------------------------------
    \4\ Frances R. Hill, Targeting Exemption for Charitable Efficiency: 
Designing a Nondiversion Constraint, 56 Sn. Meth. L. Rev. 675 
(2003)(``Targeting Exemption'').
---------------------------------------------------------------------------
    A second problem obscured by the lack of attention to the concept 
of an organization is the difficulty of determining the primary purpose 
of an organization. Section 501 and the regulations there under provide 
that exempt organizations of all types are exempt only if they are 
organized and operated primarily for an exempt purpose. There is no 
guidance on what constitutes ``primary'' for this purpose. Is a 
peppercorn of exempt activity sufficient? No one can say, and there is 
no guidance on how to determine which activities in fact support 
exemption. This is not simply a problem of data but more fundamentally 
a problem of conceptualizing exempt organizations. This issue is 
particularly important in light of the dynamism of the exempt sector. 
Balancing this necessary dynamism with an administrable concept of what 
is a primary purpose is not an easy task but it is a necessary one 
which should no longer be deferred.
    The dynamism of the exempt sector has led some to suggest that the 
kind of activities in which exempt entities are permitted to engage 
should be closely constrained. This not likely to be a useful or 
workable approach. The idea that certain activities should be performed 
solely by exempt entities or solely by taxable entities is no longer 
either plausible or desirable. Efforts to prohibit taxable schools or 
to ban gift shops at zoos or restaurants at museums would seem to serve 
no useful purpose. The question posed here is not what activities are 
permissible but what activities are consistent with the efficient 
provision of a public benefit to an appropriate class of beneficiaries. 
To the extent that exempt entities use resources for activities that do 
not provide a public benefit, exemption operates inefficiently. This 
kind of inefficiency cannot be addressed by a ``nondistribution 
constraint'' implemented through the private benefit provisions. The 
absence of private benefit does not establish the presence of a public 
benefit. Addressing exemption inefficiency requires specification of a 
public benefit framework implemented through a ``nondiversion 
constraint'' that imposes disincentives on the diversion of resources 
from exempt activities to other activities.\5\
---------------------------------------------------------------------------
    \5\ For a discussion of a nondiversion constraint, see Targeting 
Exemption, supra note 4.
---------------------------------------------------------------------------
II. Oversight Priorities: Reconciling a Public Benefit Framework with 
        Unaddressed Issues and Contemporary Developments
    The following discussion of six contemporary developments in the 
exempt sector should not be read as identification of problematic or 
abusive behavior. As noted above, the dynamism of American social, 
cultural and economic life are strengths of our country. This is true 
with respect to the exempt sector as well as to the taxable sector. At 
the same time, exemption must continue to serve its public purposes by 
providing public benefits to appropriately defined beneficiaries. The 
six oversight priorities arising from a public benefit framework for 
understanding exemption are: (1) what constitutes a public benefit; (2) 
identifying beneficiaries; (3) overcoming internal diversions of 
resources; (4) operation of complex structures; (5) transfers of 
resources among various types of exempt and taxable entities; (6) the 
role of the unrelated business income tax (``UBIT'') provisions from a 
public benefit perspective; and (7) interdicting the abuse of exemption 
represented by serving as accommodation parties in tax shelter 
transactions. Each of these will be discussed in turn.
1. Specifying What Is Meant By a Public Benefit
    Some subsections of 501(c) specify permissible exempt benefits in 
some detail. The primary exception is section 501(c)(3). The broad 
range of exempt purposes under section 501(c)(3) is consistent with 
providing public benefits that range from such tangible benefits as 
food, clothing, and shelter to intangible benefits like education.
    Efforts to address perceived abuses by restricting the nature of 
benefits, with only certain kinds of benefits treated as qualifying 
public benefits, would introduce a counterproductive inefficiency that 
robs the exempt sector of its dynamism and its ability to fulfill its 
purposes. The issue is not to restrict activities, but to determine 
what kinds of activities should be funded with exempt funds.
2. Identifying Appropriate Beneficiaries Entitled to Receive Public 
        Benefits
    Many types of exempt entities have clearly defined criteria for 
beneficiaries, who are also members of the organization. This is the 
case with respect to section 501(c)(5) labor organizations, section 
501(c)(6) business leagues, section 501(c)(7) social clubs, section 
501(c)(8) fraternal benefit organizations, section 501(c)(10) fraternal 
societies, section 501(c)(19) veterans organizations, and section 
501(c)(21) black lung trusts.
    Section 501(c)(3) does not specify categories of persons who may 
receive the benefits providing the foundation for exemption. 
Beneficiaries of section 501(c)(3) are in some cases readily identified 
but in other cases are not. Generally recipients of more tangible 
public benefits are more readily identifiable, while recipients of less 
tangible but still vitally important benefits are not readily 
identifiable as a distinct ``charitable class.'' This distinction 
causes significant confusion with respect to organizations providing 
intangible benefits to a charitable class that is not readily 
identifiable. In these cases, it is easy but wrong to take the position 
that the organization is providing no public benefit to appropriate 
beneficiaries. Greater attention to issues of the concept of a 
charitable class would help eliminate such confusion and would protect 
the diversity and dynamism of the exempt sector.
3. Overcoming Internal Diversion of Resources by Addressing the 
        Organizational Presumptions
    As discussed above, exempt purposes are pursued through exempt 
organizations. Current law requires that exempt purposes constitute an 
organization's primary purpose. However, current practice is based on 
an ``organizational presumption'' that treats activities as exempt 
activities if they are conducted by an exempt entity. The resulting 
circularity facilitates an internal diversion of resources to 
activities that are only tangentially, at best, related to exempt 
purposes.
    There are two possible approaches to addressing this kind of 
internal diversion. One is to provide guidance on what constitutes an 
organization's primary purpose. While this would seem to be fundamental 
to administering current law, in fact there is no practical, useful 
guidance at all on this matter.
    A second approach would be to direct tax benefits only to 
expenditures for exempt activity while not constraining other 
activities. This approach treats an exempt organization as an aggregate 
of activities, only some of which are treated as exempt, and makes the 
benefits of exemption available only with respect to funds used for 
exempt activities. This approach is based on targeting the benefits of 
exemption to those activities that in fact provide a public benefit to 
an appropriate class of beneficiaries.
4. Complex Structures
    Exempt entities are increasingly operating in complex structures of 
related exempt entities of different types with different exempt 
purposes serving differently defined beneficiaries. How these various 
purposes and beneficiaries are to be appropriately served is a question 
of what public benefits are being provided. In the worst case, 
activities that are consistent with the exempt status of one type of 
exempt entity can jeopardize the exempt status of other types of exempt 
entities. The issue is to avoid inappropriate diversion of resources 
while at the same time appropriately protecting the exempt statuses of 
the various entities. Complex structures may also involve both taxable 
and tax exempt entities. These structures can create synergy that 
enables exempt entities to provide a public benefit more efficiently. 
At the same time, issues of diversion and potential conflicts of 
interest require more timely guidance and continuing oversight.
5. Transferring Resources
    Exempt entities may choose to fund projects or programs operated by 
other exempt entities. There is virtually no guidance on such 
transfers. Unaddressed issues include questions of what kinds of 
transfers between what types of entities are permissible, what kind of 
oversight and recordkeeping are required, and under what circumstances 
transfers might jeopardize the exempt status of either the transferor 
or the recipient. These kinds of questions arise with respect to 
transfers between exempt entities of the same type, between exempt 
entities of different types, and between exempt and taxable entities.
6. UBIT and Public Benefit
    The UBIT provisions exist to tax the income derived from unrelated 
trade or business activities. The original purpose of the UBIT 
provisions was to prevent unfair competition with taxable business 
engaged in the same activities. The issue now is more a matter of 
diversion of resources to capitalizing the unrelated trade or business 
than a matter of unfair competition with taxable entities. UBIT is not 
designed to address this kind of diversion and in fact does not do so. 
The issue is whether UBIT should be reconsidered or whether some other 
form of no diversion constraint should be considered. In addition, the 
extent of unrelated trade or business activity that is consistent with 
exempt status remains unaddressed. It should also be noted that those 
activities subject to the unrelated business income tax represent only 
a portion of the commercial activities exempt entities engage in 
because the exceptions to UBIT have come to be so expansively applied.
7. Exempt Entities as Accommodation Parties in Tax Shelters
    Serving as an accommodation party in a tax shelter can never be 
treated as an activity that provides a public benefit.\6\ More 
attention is needed to efforts of shelter promoters to entice exempt 
entities to play this role.
---------------------------------------------------------------------------
    \6\ See new Chapter 37, Exempt Entities and Tax Shelters, in the 
most recent supplement to Hill and Mancino, suprara note 1.
---------------------------------------------------------------------------
    The appropriate response is likely to involve some mixture of tax 
on the fee on the theory it is a taxable fee for providing a service, 
as well as penalties imposed on organizations, organization managers, 
and professional advisers and the possibility of revocation of 
exemption. Revocation by itself is unlikely to have much effect on 
special purpose exempt entities created for the purpose of serving as 
an accommodation party. In addition, the Service has historically been 
reluctant to revoke exempt status even in cases of quite egregious 
private benefit.
III. Oversight Priorities for Data Collection and Research
    A public benefit framework directs attention to the question of 
whether the growth in the number of exempt entities and the increase in 
their revenue is matched by an increase in provision of benefits to 
appropriate beneficiaries. This question can be answered only by 
developing a more precise idea of what exempt entities are in fact 
doing.
    There are two important components to this inquiry. The first 
relates to the sources of funds and the second relates to the uses of 
funds and what empirical patterns, if any, can be identified between 
sources and uses. Looking at the relationship between sources and uses 
of funds inside organizations creates an empirical basis for assessing 
claims that all funds, however derived, are used for exempt activities. 
This is a rationalization for ignoring the primary purpose issue and 
for defining virtually anything an exempt organization does as an 
exempt activity.
    Current data provide little basis for addressing this issue. Most 
research is based on Form 990, which is publicly available. But, the 
data on Form 990 are collected for compliance, not for research. In 
addition, there is no external check on the reliability of this self-
reported data.\7\ The data needed will necessarily be based on the 
books and records of organizations, which poses a significant barrier 
to research. Such research should not be linked to enforcement efforts 
by the Service.
---------------------------------------------------------------------------
    \7\ See, General Accounting Office, Tax-Exempt Organizations: 
Improvements Possible in Public, IRS, and State Oversight of Charities 
(2002)(GAO-02-526).
---------------------------------------------------------------------------
IV. Oversight Priorities Relating to Guidance and Compliance
    Guidance and compliance are inextricably interrelated. Compliance 
initiatives are one means of identifying areas requiring issuance of 
additional guidance. Guidance permits organizations and their 
professional advisers to comply more effectively. Guidance is also a 
necessary predicate for compliance initiatives and public acceptance of 
such initiatives. Concerns about compliance burdens on exempt entities 
are important, and issuance of timely guidance will ease the compliance 
burden.
    The Service has issued little precedential guidance in recent 
years. The lack of a program for issuing precedential guidance with 
respect to the most significant foundational issues exacerbates the 
moral hazard of giving greater scope for aggressive actions while 
failing to assist those seeking to comply. Any such comprehensive 
program for issuing guidance requires personnel with a high level of 
expertise and experience in the substantive area. The issues to be 
addressed call for a sophisticated understanding of the technical 
rules, an appreciation of the policy purposes being served, and a well-
honed sense of what kinds of approaches the Service can administer.
    Any priorities identified through the oversight process must 
necessarily lead to administrable tax policies. There are substantial 
questions about what the Service can administer at its current funding 
and staffing levels. The lack of guidance and the slow pace of 
compliance efforts suggest to this outside observer that the Service 
requires additional resources and additional personnel. The Service 
seems particularly short of persons with the required expertise in 
developing guidance. It is also important to provide funds for 
attracting, training, and retaining young lawyers who now may not be 
inclined to consider careers with the Service.
    These comments should not be construed as lack of confidence in the 
skill and commitment of the many dedicated tax professionals who work 
on exempt organization matters. There are simply too few persons with 
the requisite expertise to provide the guidance needed by the exempt 
sector. I urge Congress to consider substantially increasing the 
funding for the exempt organization function at the Service.
V. Oversight and Public Benefit
    Oversight efforts can help ensure that the provision of public 
benefits is the criterion for retaining exempt status. This is 
consistent with the mission of exempt entities and the commitments of 
the dedicated people who work in the exempt sector.
    Oversight can help develop greater understanding of how the 
provision of public benefits is funded and what are the main reason 
that organizations divert particular types of funds to other uses. Such 
empirical research and consideration of the policy responses to such 
research are not likely to be developed rapidly or in response to one 
or another example of indefensible behavior. Incremental efforts based 
on greater understanding of what exempt entities in fact do and how 
they do it seems the most productive approach to ensuring that this 
vital sector can continue to make its unique contributions. Continued 
consideration of an appropriate framework for exemption will keep 
attention focused on what should never change in exempt organization 
law and what changes are appropriate accommodations to changing 
circumstances.

                                 

    Chairman THOMAS. Mr. Cohen, I didn't out you when the 
Ranking Member wanted to know if there were any IRS folk in the 
room----
    [Laughter.]
    Chairman THOMAS. --but obviously Mr. Cohen is a former 
Commissioner of the Internal Revenue Service and has at least a 
historically intimate understanding of the structure. I want to 
thank you. I want to thank you for your testimony, and the time 
is yours.

   STATEMENT OF SHELDON S. COHEN, PARTNER, MORGAN, LEWIS AND 
 BOCKIUS, AND COMMISSIONER, INTERNAL REVENUE SERVICE, 1965-1969

    Mr. COHEN. Thank you, Mr. Chairman, Mr. Rangel, and Members 
of the Committee. I am pleased to appear before you, and I 
should preface my remarks by saying I appear on my own behalf, 
not on behalf of my clients or my firm. I did have ten 
wonderful years at the Revenue Service at various times and I 
have produced two daughters who both served for ten to 12 years 
at the Revenue Service, so----
    Chairman THOMAS. That must be a genetic flaw.
    Mr. COHEN. We have done our duty.
    [Laughter.]
    Mr. COHEN. If you will forgive me, I am going to skip 
around on my testimony because much of it has been covered and 
I know you don't want to hear that again. A piece of history 
would help you. George Boutwell was the first Commissioner of 
Internal Revenue. He was later Governor of Massachusetts and a 
U.S. Senator. Boutwell, in his manual on running the Revenue 
Service in 1862, spelled out that he was going to exempt--he 
had no statutory authority--he exempted most charities and what 
we would now call exempt organizations. He did it on the basis 
that it was impracticable and that it was useful. They served a 
useful purpose. Lest you think it is a late arrival in the 
income tax, it arrived in the 1862 version that Abraham Lincoln 
signed. Also, I would like to suggest that one of the problems 
of administration that occurs is if you give the Commissioner 
$5 million, $50 million more to help administer the tax laws, 
or $500 million, as has been asked in the President's budget, 
and you were Commissioner of Internal Revenue, how many of 
those dollars would go into exempt organizations? Do you 
remember Willie Sutton? Why did he rob banks? That is where the 
money is. You folks and your compatriots on the Appropriations 
Committees hold him responsible and the organization 
responsible for bringing in money, particularly at a time like 
this when they are running huge deficits. So, I doubt that much 
of that would be allocated. Now, if you express an interest, 
more of it will be.
    One other aside. In the early seventies, there was a 
conference at Dichley, which is a conference center in Britain. 
Jack Nolan, who was then the immediate past Assistant Secretary 
of Treasury for Tax Policy under the Nixon Administration and I 
were representatives of the United States. Those Dichley 
conferences are about ten or 12 Americans and ten or 12 Brits 
and they talk about a topic of current interest for three, 
four, five days. They get into the depth of it. One of the 
things we discovered, Jack and I, was that the British use a 
different system of encouraging charities than we. They have a 
Charities Commission. That commission is composed, I think, of 
three commissioners--it was then--and their object is to 
encourage charity. They write the rules. They write the rules 
of what is charity, what qualifies for tax-exemption. Those 
rules are enforced by England Revenue. So, you don't have the 
Commissioner of Internal Revenue with the two hats, one to 
encourage and move charity forward and the other one to 
restrict it and audit it. We planted that idea in the Ways and 
Means Committee in the mid-seventies. Unfortunately, it went 
the way every--and I understand completely the charities. My 
own clients would react the same way. It is the devil I know 
for the devil I don't know every time, even though it might be 
better, it might be worse, and therefore I will take it as it 
stands. I have covered the same area as many others in my 
testimony in regard to the multiplicity of organizations. They 
arise with no rhyme or reason. Why is there a section 501(c)(2) 
and (c)(25), both of which cover title-holding organizations, 
both of which were enacted at various times, and because there 
was some restriction on (2), instead of amending (2) and 
allowing multiple entities to own the title-holding entity, 
(25) is enacted, and there are several areas like that. There 
are many veterans' organizations covered with different 
categories and different qualifications. There are, likewise 
many pension plans where they have just thrown in one--there 
are several categories where there either is one organization 
or no organization, as Mr. Yin has indicated, which would 
indicate that little thought had been given to the 
organizational structure.
    Once we get past (c)(3), you and your staffs and the rest 
of the world really don't pay any attention, and yet there are 
at least a half-a-million other organizations. Of course, one 
of the things we said, we don't know about many of these 
organizations. These organizations are not required to file a 
1023. So, they don't even have to tell the Service they exist. 
Now, normally, the Service will ask them to file a 1023 when 
they get the 990. They are required to file 9nineties. The 
small organizations that don't file 9nineties, those that make 
less than 25, in my day, they had to file a postcard that 
somebody had to sign certifying that they were in existence and 
that they were under--it was less. It was $5,000 or $10,000 
then, but it is now $25,000. Again, you don't know about them. 
You don't know about the churches because we don't have a list 
of churches. They don't have to apply. I have asked a variety 
of questions that are very much like the questions that others 
have raised on the--but I feel it is important that every 
organization should be registered. They should have to tell the 
Revenue Service, here we are. I don't have any problem with the 
exchange of information to the States, because most of those 
exchange agreements were signed while I was in office. States 
now have the same kinds of restrictions that the Federal 
government has on the passing on of that. That is, it is a 
Federal crime for a State official to violate the confidence of 
the information. The States' Attorney Generals, we have many of 
the State Attorney Generals are active and effective. Most are 
not. That is, the State Attorney General is generally the 
parent of the State entity which is the charity of whatever 
category and they pay no attention, and it is very difficult. I 
have been in situations where a client has felt the charity was 
abused. That is, he gave money to the charity, it didn't do 
what it was supposed to do, and tried to activate the State 
Attorney General. Many will, as I say, effectively try to make 
sure that the right thing is done. Many will ignore it. Thank 
you, Mr. Chairman.
    Chairman THOMAS. Thank you very much, Mr. Cohen.
    [The prepared statement of Mr. Cohen follows:]
Statement of The Honorable Sheldon S. Cohen, Partner, Morgan, Lewis and 
     Bockius, and Commissioner, Internal Revenue Service, 1965-1969
    Chairman Thomas and distinguished members of the Committee, I am 
Sheldon Cohen, senior counsel in the Washington D.C. office of the law 
firm of Morgan, Lewis & Bockius and a former Chief Counsel and 
Commissioner of the Internal Revenue Service. I am pleased to appear 
before you today at your request to testify on issues relating to the 
historical background of certain organizations that are tax-exempt 
under Section 501(c). My testimony today is in my personal capacity and 
represents my own views and not those of my firm or any of its clients. 
By way of background, I served in the Internal Revenue Service on 
several different occasions. During the period 1952-1956, I served as a 
legislative draftsperson during the drafting of the 1954 Code and 
Regulations. In the period from January 1964 through January 1969, I 
served as Chief Counsel for one year and then as Commissioner of the 
Internal Revenue Service for four years. I have also served as an 
officer and Trustee of the National Academy of Public Administration 
and have served as a panel member of several studies dealing with the 
administrative aspects of the Internal Revenue Service. I also served 
as Co-Chair of a study of the collection and privacy portions of the 
Internal Revenue Code for the Administrative Conference of the U.S. 
(The changes recommended by that group, co-chaired by Justice Scalia in 
one of his prior positions as chair of the Administrative Conference of 
the United States, were adopted by the Congress in 1976.)
    Given our limited time today, I will first discuss some background 
information about a number of the numerous organizations that are tax-
exempt under Section 501(c) and some of the changes Congress and the 
IRS have made over the years as various problems have arisen with 
respect to different exempt organizations. Then, I will briefly address 
some of the critical questions that arise with respect to evaluating 
these organizations' qualification for exemption from Federal income 
tax. I have attached an appendix to my written testimony listing all of 
the categories of organizations exempt under Section 501(c).
    Questions about the tax-exempt sector are increasingly important 
given that the sector is growing in both size and assets and has been 
playing an ever more important role in our society. The number of 
organizations exempt from tax in the United States has increased 
tremendously in the past 30 years. According to the Statistics of 
Income Division, there were only about 220,000 organizations (excluding 
private foundations) exempt under Section 501(c) filing Form 990 annual 
information returns with the IRS in 1975. (Please note that this figure 
does not include churches and religious organizations and a few other 
organizations not required to file Form 990.) By 1995, the number of 
organizations filing an annual information return with the IRS had 
skyrocketed to approximately 1.2 million exempt organizations. The 
sector has even grown tremendously in the past 10 years alone--today, 
there are over 1.8 million organizations exempt from tax under Section 
501(c) filing Form 990 with the IRS each year.
    There are 28 categories of tax-exempt organizations under Section 
501(c), and approximately 1 million of the organizations exempt under 
Section 501(c) are categorized under Section 501(c)(3). Section 
501(c)(3) organizations stand apart from other exempt organizations, 
and have, over the years, received a good deal of the attention focused 
on the non-profit sector. In fact, they have received almost all of the 
attention.
    Section 501(c)(3) organizations are distinguished by being 
considered charitable in nature and include organizations such as 
universities and schools, hospitals, scientific research organizations, 
social service organizations, community development groups, performing 
arts groups, and environmental support organizations. Also exempt under 
Section 501(c)(3) are private foundations, which operate programs, 
provide services and/or make grants in order to fulfill their 
charitable purposes.
    Organizations exempt from Federal income tax under one of the other 
Section 501(c) subsections of the Internal Revenue Code provide an 
array of not-for-profit services, and are frequently formed as 
membership organizations to primarily benefit their members. These 
other tax-exempt organizations are distinguished from Section 501(c)(3) 
organizations because they are not considered to be charitable in 
nature or to primarily benefit the public. Unlike Section 501(c)(3) 
organizations, most of these other exempt organizations are not 
eligible to receive tax-deductible charitable contributions. The 
primary advantage they receive for qualifying under Section 501 is, 
therefore, exemption from Federal income tax. As you requested, I will 
not be addressing Section 501(c)(3) organizations or organizations that 
are exempt under Section 501(c)(5), which are labor, agricultural and 
horticultural organizations, or Section 501(c)(6) organizations, which 
are business leagues.
    One of the hot topics in the exempt organizations field today 
concerns the exemption of credit unions. Credit unions can potentially 
be exempt under two sections--501(c)(1) and 501(c)(14). Section 
501(c)(1) exempts federal instrumentalities from tax. Organizations 
exempt under this section include the FDIC, Federal Land Banks, Federal 
Reserve Banks and similar organizations. Also included are Federal 
credit unions organized and operated in accordance with the Federal 
Credit Union Act, which are considered instrumentalities of the United 
States. Section 501(c)(1) organizations are not required to file Form 
990 annual informational returns, they are not subject to the unrelated 
business income tax and they are entitled to receive tax-deductible 
contributions. In the 1970s, the IRS conducted a review of the 1,000 or 
so organizations exempt under this Section. This review revealed that 
many of these organizations did not qualify as Federal 
instrumentalities and were classified under Section 501(c)(1) 
inadvertently. As a result, there are only about 150 Section 501(c)(1) 
organizations today.
    Credit unions that are state chartered and other mutual financial 
organizations may obtain exemption under Section 501(c)(14) rather than 
Section 501(c)(1). Exemption under Section 501(c)(1) is preferable for 
credit unions because the IRS has assumed an audit position that 
501(c)(14) credit unions are subject to the unrelated business income 
tax whereas 501(c)(1) organizations are not, given that the Internal 
Revenue Code does not address this point.
    Organizations that are exempt under Section 501(c)(2) and Section 
501(c)(25) are title holding companies for tax-exempt organizations. 
Section 501(c)(2) provides exemption for single parent organizations, 
and was added to the Code in 1916. Section 501(c)(25) was added to the 
Code in 1986 in response to the IRS' position that title-holding 
entities which otherwise qualified under Section 501(c)(2) could not be 
exempt if two or more of its parent organizations were unrelated.
    Section 501(c)(4) was incorporated in the Code in 1913 and includes 
organizations to promote the common good and general welfare of the 
community, such as civic leagues, social welfare organizations, 
homeowners' associations, etc. They are similar to Section 501(c)(3)'s 
but they are permitted to engage in some legislative and political 
activities, so long as this does not constitute their primary activity. 
Section 501(c)(4) does not include social clubs or other clubs 
organized for pleasure or recreation. Such organizations are instead 
exempt under Section 501(c)(7) and have been exempt since 1916. A few 
years ago, the IRS made an enforcement drive to ensure that social 
clubs were properly paying the unrelated business income tax on their 
investment income.
    Many veterans organizations used to be exempt under Section 
501(c)(4) and (c)(7). In 1969, 501(c)(4) organizations were made 
subject to the unrelated business income tax. Given that veterans 
organizations often provide insurance, many were concerned that their 
insurance activities would be taxable. As a result, Section 501(c)(19) 
was passed in 1972 to specifically provide exemption for veterans 
organizations offering insurance to their members.
    Section 501(c)(8) exempts fraternal organizations which were 
historically created to provide insurance to their members. I believe 
there are about 30,000 Section 501(c)(8) organizations. Section 
501(c)(10) was added in the Tax Reform Act of 1969 to exempt certain of 
these organizations that stopped providing insurance to their members, 
like the Masons.
    Section 501(c)(9) is for VEBAs--Voluntary Employees' Beneficiary 
Associations, which provide for life, sickness, accident and other 
benefits to their members who must all have a common employment-related 
bond. In the early 1980s, VEBAs were used in an abusive scheme in which 
employers were seeking to take advance deductions for contributions to 
welfare plans that provided benefits in the nature of deferred 
compensation. Congress solved this problem by passing Section 419 in 
the Deficit Reduction Act of 1984, which places objective limits on the 
amount an employer can deduct for contributions to welfare plans for 
employees.
    Section 501(c)(12) originated in 1916 and is designed for mutual 
and cooperative associations. Section 501(c)(13) has been around since 
1913 and provides exemption for non-profit cemeteries.
    There are several subsections of 501(c) that exempt very few 
organizations in practice. I understand that there are only 2 
organizations currently exempt under Section 501(c)(23). Section 
501(c)(23) was passed in 1982 to exempt associations organized before 
1880 more than 75 percent of the members of which are present or past 
members of the Armed Forces and a principal purpose of which is to 
provide insurance and other benefits to veterans or their dependents. 
It is my understanding that there is also only a single remaining 
organization that is exempt under Section 501(c)(18) (Employee Funded 
Pension Trusts, which must have been created before June 25, 1959) and 
Section 501(c)(24) (Trust Described in Section 4049 of ERISA). I do not 
believe there are any organizations exempt as Section 501(c)(22) Trusts 
for Multiemployer Plans Under ERISA. Section 501(c)(20) (Group Legal 
Services Plan) expired in 1992, although there are still a handful of 
organizations exempt under this Section. Furthermore, I understand that 
there are only about 50 or significantly fewer organizations exempt 
under Section 501(c)(11) (Teachers' Retirement Fund Associations of a 
Purely Local Character), Section 501(c)(16) (crop financing 
organizations), Section 501(c)(21) (Black Lung Benefit Trusts), Section 
501(c)(26) (State-Sponsored High-Risk Health Coverage Organizations) 
and Section 501(c)(27) (State-sponsored Workmen's Compensation 
Reinsurance Corporations).
    These are just some examples of the numerous organizations that are 
exempt under Section 501(c), and some of the various considerations 
that have arisen over time. As Congress reviews exempt organizations, 
there are several questions to consider with respect to those 
organizations that are exempt under subsets of Section 501(c) other 
than Section 501(c)(3).
    First, given that exempt organizations have been added to the Code 
piecemeal over time to address particular contemporary factors, the 
most basic issues in assessing these organizations are to determine 
whether they still serve their intended purpose and whether the Code 
should be amended to reflect current realities. As you can see from 
this review of Section 501(c), specific exemptions were made to address 
particular concerns at various points in time. In many instances, 
Congress and the IRS have reacted to the realities--the concerns, needs 
and abuses--of the tax-exempt sector. Nonetheless, although many, if 
not most, of these organizations are still serving the purpose for 
which they were granted exemption, others merit revisiting.
    The second question is whether all organizations exempt under 
Section 501 should be required to apply to the IRS for recognition of 
their exempt status. Of all the Section 501(c) organizations, only 
those exempt under Section 501(c)(3) are required to apply to the IRS 
for recognition of their exempt status. Other organizations are 
nonetheless required to file an annual information return, Form 990, 
but only if they have gross receipts over $25,000 a year. In practice, 
the IRS tends to request that any organization filing a Form 990 submit 
an application for recognition of tax exemption. But because 
organizations that have gross receipts of less than $25,000 a year are 
not required to file Form 990, small organizations may escape the IRS' 
notice completely or for a long time.
    Third, Congress may want to consider whether the Code should be 
amended to institute penalties against insiders who deal unfairly with 
all Section 501(c) exempt organizations. Although nine categories of 
organizations exempt under Section 501(c) are prohibited from having 
any benefits ``inure'' to insiders at an organization, only Section 
501(c)(3) and (c)(4) organizations are subject to rules which sanction 
the actual individuals who deal improperly with an exempt organization. 
Attention has been focused on exempt organizations recently in part 
because of high profile cases in which private individuals received 
inappropriate benefits from charities with which they were affiliated. 
Private foundations are subject to the ``self-dealing'' rules of 
Section 4941 (passed by Congress in the Tax Reform Act of 1969) and 
public charities are regulated by the ``intermediate sanctions'' 
provisions of Section 4958 (passed in 1996). Section 501(c)(4) 
organizations were also specifically made subject to the intermediate 
sanctions rules. These rules are an important part of IRS oversight of 
exempt organizations, in large part because they provide a way to halt 
and redress abuse of tax-exempt resources without revoking the exempt 
status of an organization that may be making valuable contributions to 
our society.
    Finally, although these categories of organizations exempt under 
Section 501(c) merit review, IRS resources are scarce. The question of 
whether the IRS is devoting appropriate audit attention to these 
organizations may depend to a large extent on budgetary constraints and 
the need for enforcement efforts in other areas.
    In closing I would like to thank the Committee and its staff for 
allowing me to give you my views on this topic.

                                APPENDIX

   Types of Exempt Organizations under Internal Revenue Code Section 
                                 501(c)

------------------------------------------------------------------------
 Internal Revenue Code
        Section                     Description of activities
------------------------------------------------------------------------
501(c)(1)                Corporations organized under Act of Congress
                          Instrumentalities of the United States
------------------------------------------------------------------------
501(c)(2)                Title holding corporation for an exempt
                          organization
------------------------------------------------------------------------
501(c)(3)                Charitable, religious, educational, scientific,
                          and literary organizations, international
                          amateur sports competitions, organizations
                          that prevent cruelty to children and animals,
                          and organizations that test for public safety
------------------------------------------------------------------------
501(c)(4)                Civic leagues, social welfare organizations and
                          local employees' associations
------------------------------------------------------------------------
501(c)(5)                Labor, agricultural, and horticultural
                          organizations
------------------------------------------------------------------------
501(c)(6)                Business leagues, chambers of commerce, and
                          real estate boards
------------------------------------------------------------------------
501(c)(7)                Social and recreational clubs
------------------------------------------------------------------------
501(c)(8)                Fraternal beneficiary societies that provide
                          life, sickness, or accident benefits to
                          members
------------------------------------------------------------------------
501(c)(9)                Voluntary employees' beneficiary associations,
                          which provide for payment of life, sickness,
                          accident, or other benefits
------------------------------------------------------------------------
501(c)(10)               Domestic fraternal societies that do not
                          provide life, sickness, or accident benefits
                          to members
------------------------------------------------------------------------
501(c)(11)               Teachers' retirement fund associations
------------------------------------------------------------------------
501(c)(12)               Local benevolent life insurance associations,
                          mutual ditch or irrigation companies, mutual
                          or cooperative telephone companies, and like
                          organizations
------------------------------------------------------------------------
501(c)(13)               Cemetery companies
------------------------------------------------------------------------
501(c)(14)               State-chartered credit unions and mutual
                          financial organizations
------------------------------------------------------------------------
501(c)(15)               Certain mutual insurance companies or
                          associations that provide insurance to members
                          substantially at cost
------------------------------------------------------------------------
501(c)(16)               Farmers cooperatives organized to finance crop
                          operations
------------------------------------------------------------------------
501(c)(17)               Supplemental unemployment benefit trusts
------------------------------------------------------------------------
501(c)(18)               Employee-funded pension trusts
------------------------------------------------------------------------
501(c)(19)               War veterans organizations (e.g., American
                          Legion Posts)
------------------------------------------------------------------------
501(c)(20)               Group Legal Services Plan Organizations
------------------------------------------------------------------------
501(c)(21)               Black Lung Benefit Trusts
------------------------------------------------------------------------
501(c)(22)               Trusts for Multiemployer Plans Under ERISA
------------------------------------------------------------------------
501(c)(23)               Association organized before 1880 more than 75%
                          of the members of which are present or past
                          members of the Armed Forces and a principal
                          purpose of which is to provide insurance and
                          other benefits to veterans or their dependents
------------------------------------------------------------------------
501(c)(24)               Trust Described in Section 4049 of ERISA
------------------------------------------------------------------------
501(c)(25)               Title-Holding Corporations or Trusts for
                          Multiple Parents
------------------------------------------------------------------------
501(c)(26)               State-sponsored high-risk health coverage
                          organizations
------------------------------------------------------------------------
501(c)(27)               State-sponsored Workers' Compensation
                          Reinsurance Organizations
------------------------------------------------------------------------
501(c)(28)               The National Railroad Retirement Investment
                          Trust established under Section 15(j) of the
                          Railroad Retirement Act of 1974
------------------------------------------------------------------------

    Chairman THOMAS. Mr. Hopkins, you are last not because you 
are least but because, based upon your testimony, I thought it 
would be appropriate that you would bat cleanup in terms of 
your background, the structure that you presented, and the, 
what I consider to be a kind of a withering analysis of what 
has been done recently and what could be done. The time is 
yours.

  STATEMENT OF BRUCE R. HOPKINS, ATTORNEY, POLSINELLI SHALTON 
          WELTE SUELTHAUS, P.C., KANSAS CITY, MISSOURI

    Mr. HOPKINS. Thank you, Mr. Chairman, Mr. Rangel, and other 
Members of the Committee. Thank you very much for the 
opportunity to appear before you today. I do have a prepared 
statement and I will summarize it briefly here. Basically, my 
testimony consists of three segments. One is a summary of the 
history, the evolution of the Federal tax law pertaining to the 
tax-exempt sector in the United States. We have heard a bit of 
history, examples, and from the standpoint of a constitutional 
law, tax-exemption for these organizations is traceable to the 
Revenue Act 1913, but as we have heard, tax-exemption can be 
found in earlier laws. So, these rules are rapidly approaching, 
at least the constitutional ones, 100 years of existence. 
Second, I will provide the Committee with my view of the 
present day state of the statutory law of tax-exempt 
organizations. Then, third, if there is time, I have been asked 
to provide a summary of the law concerning tax-exempt labor 
organizations. My testimony essentially centers on four points. 
The first one is that the statutory law concerning tax-exempt 
organizations has evolved over the decades in a disorderly and 
unplanned fashion. My second point is that Congress made major 
revisions in this law in 1917, 1950, and 1969, but overall, 
Congress has frequently modified and expanded the law 
concerning the sector. Nearly 30 tax acts over the decades have 
brought some revisions or addition to this area of the law. My 
third point is that the Federal tax law today concerning exempt 
organizations is unbalanced and uneven. The fourth point is 
that many aspects of today's law of exempt organizations are 
unclear. As the sector has grown, this sector has fostered or 
facilitated misunderstandings and abuses by certain tax-exempt 
organizations and tax law professionals. Federal tax law that 
addresses the gaps in the present day structure would provide a 
full legal regime that could address this problem. This, in 
turn, would facilitate the ability of the IRS to provide 
meaningful guidance within that framework.
    In my prepared statement, I have provided the Committee 
with the history and evolution of the statutory law, 
summarizing each of the 28 Acts. This history illustrates the 
point I made a minute ago, that the statutory law in the exempt 
organizations area has, indeed, evolved in a disorderly 
fashion. Another factor shaping the evolution of the Federal 
statutory law of exempt organizations is Congressional reaction 
to positions taken by the Internal Revenue Service. In the 
attached statement, I have provided 18 instances where 
statutory exempt organizations law was created in response to a 
policy position of the agency. Today, the tax-exempt sector of 
the United States is confronted with a dazzling array of 
Federal tax law reform proposals, and many of these proposals 
are reflective of the inadequate state of the Federal statutory 
tax law of exempt organizations. In short, there are many more 
gaps in this body of law than there should be. I have been 
practicing in the field for 35 years and it never ceases to 
amaze me how redundant, disparate, irregular, unbalanced, and 
uneven the Federal tax statutory law can be. In my view, this 
aspect of the tax law consists of 20 elements, and I have 
listed these elements in my statement. What I think is striking 
is that of these elements, only six of them are generally 
adequately reflected in existing law. In my prepared statement, 
I have identified 12 areas where statutory exempt organizations 
law is necessary, and I will just take a minute to identify six 
of these at the present time. One, you have already heard 
testimony on, create laws spelling out the criteria for tax-
exempt status, and this is just not confined to charitable, 
educational, scientific entities, but 501(c)(4) social welfare 
entities, (c)(5) labor organizations, and (c)(6) entities, 
business leagues, could use a great deal of clarification. 
Number two, spell out the elements of the private inurement 
doctrine and the private benefit doctrine. Number three, 
amplify the political activities rules, both for charitable 
entities and other forms of tax-exempt organizations. Number 
four, codify a version of the commerciality doctrine. Number 
five, develop statutory law concerning tax-exempt 
organizations' use of the Internet. Six, consider whether there 
is a need for more reporting and disclosure. There are a number 
of proposals being discussed, including a five-year review 
filing with the IRS, an annual notice requirement for small 
organizations, and certification as to compliance with the 
unrelated business rules. This type of statutory law is 
required to eliminate the imbalances in the present law and to 
provide the IRS with a complete regulatory framework within 
which to provide guidance in the form of regulations, revenue 
rulings, private determinations, and more. My sense here is 
that there are a number of questions the Committee may have, 
and I think, unless directed otherwise, I will simply submit my 
discussion of the law concerning labor organizations to you in 
the form of the prepared statement and I will stop at this 
point and, like the other members of the panel, be happy to 
take any questions that you might have.
    Chairman THOMAS. Thank you.
    [The prepared statement of Mr. Hopkins follows:]
    Statement of Bruce Hopkins, Attorney, Polsinelli Shalton Welte 
                 Suelthaus, P.C., Kansas City, Missouri
    I have been asked to provide the Committee with a summary of the 
history and evolution of the federal tax law pertaining to the 
charitable sector of the United States. The term ``charitable'' 
includes charitable, educational, scientific, and religious 
organizations within the meaning of Internal Revenue Code section 
(``IRC Sec. '') 501(c)(3)). This sector thus embraces both public 
charities and private foundations.
    Tax exemption for these organizations is traceable to the Revenue 
Act of 1913 and can be found in earlier laws. Therefore, we are rapidly 
approaching the centennial of these rules.
    I have also been asked to provide the Committee with my view of the 
present-day state of the statutory law of tax-exempt organizations.
    Further, I have been asked to provide a summary of the law 
concerning tax-exempt labor organizations.
Summary of Testimony
    My testimony essentially centers on four points:

    1.  The statutory law concerning tax-exempt organizations has 
evolved over the decades in a disorderly, unplanned fashion. Congress 
has not been sufficiently explicit about the rules governing tax-exempt 
organizations.
    2.  Congress made major revisions in this law in 1917, 1950, and 
1969. Overall, Congress has frequently modified and expanded the law 
concerning the exempt sector. Nearly 30 tax acts have brought some 
revision and/or addition to this area of the law.
    3.  The state of the federal tax law today is that it is unbalanced 
and uneven.
    4.  Many aspects of today's statutory law of tax-exempt 
organizations are unclear. As the sector has grown, this situation has 
fostered or facilitated misunderstandings and abuses by certain tax-
exempt organizations and tax law planners. Federal tax statutory law 
that addresses the gaps in the present-day overall statutory regime 
would provide a full legal structure that would address this problem. 
This, in turn would facilitate the ability of the IRS to provide 
meaningful guidance within that framework.

    As background, I have been in the private practice of law for 35 
years, representing charitable and other tax-exempt organizations. I 
have taught in two law schools, and continue to present at conferences 
and seminars around the country. I have written several books, 
including The Law of Tax-Exempt Organizations (8th ed., annually 
supplemented). I write a monthly newsletter on exempt organizations law 
subject, Bruce R. Hopkins' Nonprofit Counsel.
Summary of Statutory Law Evolution
    Tax exemption for charitable organizations began in 1913, when 
Congress enacted the first constitutional federal income tax. There 
have, of course, been many major pieces of tax legislation since then. 
The following acts are of major consequence: establishment of the 
concept of federal income tax exemption in 1913; enactment of the 
charitable contribution deductions in 1917, 1921, and 1932; enactment 
of the unrelated business rules in 1950; and enactment of the public 
charity and private foundation definitions and rules in 1969.
    Thus, the statutory law of tax-exempt organizations was initiated 
in 1913, and given major boosts in 1950 and 1969. Indeed, today's 
statutory structure (along with the charitable giving rules) was shaped 
substantially by the 1969 legislation.
    In somewhat of a second-tier categorization of important exempt 
charitable organizations legislation, the limitations on legislative 
activities were enacted in 1934, the prohibition on political campaign 
activities was adopted in 1954, public charity lobbying rules were 
enacted in 1976, excise taxes on legislative and political expenditures 
were enacted in 1987, and the excess benefit transactions (intermediate 
sanctions) rules were enacted in 1996.
    Nearly every tax act of any consequence since then (particularly in 
1974, 1976, 1982, 1984, 1986, 1987, 1993, 1996, 1997, 2000, 2002, 2003, 
and 2004) has added to this body of law. (Additional legislation that 
would have augmented this collection of law, passed in 1992, 1995, and 
1998, was vetoed.)
    Below, I have provided the Committee with the history and evolution 
of this statutory law, summarizing each of the 28 acts. Also, I traced 
the history of these acts by year and Internal Revenue Code sections. 
This history illustrates the fact that the statutory law of tax-exempt 
organizations has indeed evolved in a disorderly fashion.
    Another factor shaping the evolution of the federal statutory law 
of tax-exempt organizations is Congressional reaction to positions 
taken by the IRS. In the attached statement, I have provided 18 
instances where statutory exempt organizations law was created in 
response to a policy position of the agency.
State of the Statutory Law
    Today, the tax-exempt sector of the United States is confronted 
with a dazzling array of federal tax law reform proposals. These are 
found in a recent report from the staff of the Joint Committee on 
Taxation, a paper prepared last year by the staff of the Senate 
Committee on Finance, the Administration's fiscal year 2006 proposed 
budget, and the interim report recently published by Independent 
Sector's Panel on the Nonprofit Sector.
    Some of these proposals are referenced below. Before addressing 
them, however, I note that many of these proposals are reflective of 
the inadequate state of the federal statutory tax law of tax-exempt 
organizations. There are many more gaps in this body of law than there 
should be. The Department of the Treasury, the Internal Revenue 
Service, and the courts, from time to time, attempt to fill these voids 
but the absence of a full and balanced statutory regime contributes to 
the need for many of the reforms being advocated at this time.
    The state of the federal statutory law of tax-exempt organizations 
can best be described in words that may be somewhat redundant: 
disparate, irregular, unbalanced, and uneven. This aspect of the tax 
law (other than the charitable giving rules) consists of the following 
20 elements:

     1.  Criteria for exemption
     2.  Organizational test
     3.  Operational test
     4.  Public charities and private foundations
     5.  Private inurement
     6.  Private benefit
     7.  Intermediate sanctions
     8.  Legislative activities
     9.  Political activities
    10.  Commerciality
    11.  Unrelated business
    12.  Tax-exempt subsidiaries
    13.  For-profit subsidiaries
    14.  Exempt organizations in partnerships
    15.  Exempt organizations in other joint ventures
    16.  Internet use
    17.  Reporting requirements
    18.  Disclosure requirements
    19.  Corporate governance principles
    20.  Fundraising

    Of these 20 elements, only six of them are generally adequate 
reflected in existing statutory law: the subjects of public charities 
and private foundations, the intermediate sanctions rules, the law as 
to attempts to influence legislation, the unrelated business rules, 
tax-exempt subsidiaries (often supporting organizations), and the 
reporting requirements.
    By contrast, the statutory law concerning the income, gift, and 
estate tax charitable giving rules is far more complete and balanced, 
enabling the IRS to issue timely and meaningful guidance.
    These gaps in the exempt organizations statutory law cannot be 
properly filled by tax regulations and rulings. Treasury and the IRS 
try this from time to time and often trigger litigation over whether 
the department and agency have the authority to promulgate the rules. 
Some examples of these attempts are the regulations concerning the 
facts-and-circumstances test for qualifying as a publicly supported 
charitable organization, and the advertising and travel tour 
regulations in the unrelated business context.
    In fact, two law changes made by the IRS years ago reverberate in 
controversy today. Back in 1959, the IRS promulgated what was then 
radically new regulations defining what is charitable, educational, and 
the scientific. Before these rules, the definition of charitable and 
the like was quite narrow. Also, in 1969, the IRS ruled that promotion 
of health is a stand-alone definition of what is charitable, setting in 
motion today's ongoing debate over the scope of that term.
    The IRS lacks the capability to promulgate sufficient regulations 
in this area and, to a large degree, should not be placed in that 
position. Indeed, these holes in the statutory structure create an 
environment where the IRS issues private letter rulings containing 
questionable, incorrect, and even ludicrous statements. Here are some 
examples of IRS private letter rulings that fit these criteria:

    1.  Ruling purporting to state the ``traditional attributes of a 
charity'' (none of which are correct) (Exemption Denial and Revocation 
Letter 20044044E).
    2.  Ruling that an exempt organization's website is evidence of 
unwarranted commerciality (Ex. Den. and Rev. Ltr. 20044045E),
    3.  Ruling stating that ``avoidance of regulation'' is nonexempt 
activity (Priv. Ltr. Rul. 200452036).
    4.  Ruling applying private benefit standard to social welfare 
organizations (Ex. Den. and Rev. Ltr. 20044008E).
    5.  Ruling applying commerciality doctrine to social welfare 
organizations (Priv. Ltr. Rul. 200501020).
    6.  Technical advice memorandum declaring that charities must 
devote assets of for-profit subsidiary to charitable ends (Tech. Adv. 
Mem. 200437040).

    Ideally, then, the full statutory design would be established by 
Congress and then the IRS could provide meaningful guidance within that 
framework.
    As noted, these voids are mirrored in the reform proposals being 
advocated in various quarters. For example, proposals to add law 
concerning tax exemption for hospitals, credit counseling agencies, 
fraternal beneficiary societies, donor-advised funds, and to some 
extent supporting organizations reflect the paucity of law concerning 
the criteria for tax-exempt status.
    Here are some proposals for the Committee's consideration:

     1.  Create law spelling out the criteria for tax-exempt status. 
For example, legislation could address what is charitable, educational, 
and scientific. Other categories of exemption, however, could also 
benefit from this type of clarification, such as social welfare 
organizations (IRC Sec. 501(c)(4) entities), labor organizations (IRC 
Sec. 501(c)(5) entities, and business leagues (IRC Sec. 501(c)(6) 
entities). It is in this setting that law could be created stating 
criteria for exemption for hospitals, donor-advised funds, fraternal 
beneficiary societies, and the like.

            It may be noted that, as an example of this imbalance, the 
        statutory law spelling out the criteria for exemption for 
        multi-parent title-holding companies (IRC Sec. 501(c)(25)), of 
        which there are few, is three times the size of the statutory 
        law concerning the bulk of the tax-exempt sector: entities 
        referenced in IRC Sec. 501(c)(3)-(7).
     2.  Develop law outlining an organizational test for at least the 
principal categories of tax-exempt organizations.
     3.  Spell out the elements of the private inurement doctrine, 
including the criteria for determining the reasonableness of 
compensation, lending arrangements, rental arrangements, and sales 
transactions.
     4.  Codify a version of the private benefit doctrine, in the 
process clarifying whether the doctrine applies to tax-exempt 
organizations other than charitable entities.
     5.  Amplify the political activities rules, both for charitable 
entities and other forms of tax-exempt organizations, particularly 
social welfare organizations (IRC Sec. 501(c)(4) entities), labor 
organizations (IRC Sec. 501(c)(5) entities), and associations (business 
leagues) (IRC Sec. 501(c)(6) entities).
     6.  Codify a version of the commerciality doctrine, in the process 
clarifying whether the doctrine applies to tax-exempt organizations 
other than charitable entities.
     7.  Enact rules concerning the use of for-profit subsidiaries by 
tax-exempt organizations.
     8.  Enact rules concerning the involvement of tax-exempt 
organizations in partnerships and other joint ventures.
     9.  Develop statutory law concerning exempt organizations' use of 
the Internet, such as for advocacy, unrelated business, and fundraising 
purposes.
    10.  In the context of reporting and disclosure, consider whether 
the proposals for a five-year review filing with the IRS, an annual 
notice requirement for small organizations, and certification as to 
compliance with the unrelated business rules for large exempt 
organizations.
    11.  Enactment of federal law corporate governance principles.
    12.  Federal law concerning charitable fundraising.

    This type of statutory law is required to eliminate the imbalances 
in the present law and to provide the IRS with a complete regulatory 
framework within which to provide guidance in the form of regulations, 
revenue rulings, private determinations, and more.
History and Evolution of Statutory Law
    The original statutory tax exemption for nonprofit organizations in 
U.S. law for charitable organizations was part of the Tariff Act of 
1894.\1\ The provision stated that ``nothing herein contained shall 
apply to . . . corporations, companies, or associations organized and 
conducted solely for charitable, religious, or educational purposes.'' 
\2\
---------------------------------------------------------------------------
    \1\ 28 Stat. 556 (Act ch. 349).
    \2\ The income tax law enacted in 1894 was declared 
unconstitutional by the U.S. Supreme Court in Pollock v. Farmer's Loan 
& Trust Co., 158 U.S. 601 (1895), overruled on other grounds in State 
of S.C. v. Baker, 485 U.S. 505 (1988). Congress first created the 
office of the Commissioner of Internal Revenue and enacted an income 
tax in 1862, to finance Civil War expenses; that tax was repealed in 
1872.
---------------------------------------------------------------------------
    After ratification of the Sixteenth Amendment by the states in 
1913, which provided Congress with the authority to enact an income 
tax, Congress enacted the Revenue Act of 1913, exempting from federal 
income tax ``any corporation or association organized and operated 
exclusively for religious, charitable, scientific, or educational 
purposes, no part of the net income of which inures to the benefit of 
any private shareholder or individual.'' \3\
---------------------------------------------------------------------------
    \3\ 38 Stat. 114, 166.
---------------------------------------------------------------------------
    The federal income charitable contribution deduction was enacted 
when Congress passed the Revenue Act of 1917.\4\ The Revenue Act of 
1921 brought the estate tax charitable contribution deduction, which 
was made retroactive to 1917.\5\ The gift tax charitable contribution 
deduction can into being as part of the Revenue Act of 1932.\6\
---------------------------------------------------------------------------
    \4\ 40 Stat. 300.
    \5\ 42 Stat. 227.
    \6\ 47 Stat. 169.
---------------------------------------------------------------------------
    In the Revenue Act of 1918, the enumeration of tax-exempt 
charitable organizations was expanded to include those organized ``for 
the prevention of cruelty to children or animals.'' \7\ The Revenue Act 
of 1921 further expanded the statute to exempt ``any community chest, 
fund or foundation'' and added ``literary'' groups to the list of 
exempt entities.\8\ The Revenue Acts of 1924,\9\ 1926,\10\ 1928,\11\ 
and 1932 \12\ did not provide for any changes in the law of exempt 
organizations.
---------------------------------------------------------------------------
    \7\ 40 Stat. 1076.
    \8\ 42 Stat. 227.
    \9\ 43 Stat. 282.
    \10\ 44 Stat. 40.
    \11\ 45 Stat. 813.
    \12\ 47 Stat. 193.
---------------------------------------------------------------------------
    The Revenue Act of 1934 carried forward the tax exemption 
requirements as stated in the prior revenue measures and added the rule 
that ``no substantial part'' of the activities of an exempt charitable 
organization can involve the carrying on of ``propaganda'' or 
``attempting to influence legislation.'' \13\ The Revenue Acts of 1936 
\14\ and 1938 \15\ brought forward these rules, as did the Internal 
Revenue Code of 1939.\16\
---------------------------------------------------------------------------
    \13\ 48 Stat. 700.
    \14\ 49 Stat. 1674.
    \15\ 52 Stat. 481.
    \16\ 53 Stat. 1.
---------------------------------------------------------------------------
    Tax-exempt organizations were required to file annual information 
returns, beginning in 1944. This requirement came into the federal tax 
law as part of the Tax Revenue Act of 1943.\17\
---------------------------------------------------------------------------
    \17\ 58 Stat. 21.
---------------------------------------------------------------------------
    The unrelated business rules were enacted as part of the Revenue 
Act of 1950.\18\ These rules tax the net income of charitable and other 
tax-exempt organizations when they regularly carry on businesses that 
are not substantially related to the achievement of exempt purposes. 
This was a radical addition to the law, in part because it introduced 
the concept that some or all otherwise tax-exempt organizations could 
be taxed. This would lead to many more federal taxes on or in 
connection with ``tax-exempt'' organizations.
---------------------------------------------------------------------------
    \18\ 64 Stat. 906.
---------------------------------------------------------------------------
    The rules for charitable and like organizations, as stated in the 
tax exemption law provision that remains in use today,\19\ came into 
being as a consequence of enactment of the Internal Revenue Code of 
1954.\20\ The previous rules were retained and two additions to the 
statute were made: The listing of exempt organizations was amplified to 
include entities that are organized and operated for the purpose of 
``testing for public safety,'' and organizations otherwise described in 
the provision became forbidden to ``participate in, or intervene in 
(including the publishing or distributing of statements), any political 
campaign on behalf of any candidate for public office.''
---------------------------------------------------------------------------
    \19\ IRC Sec. 501(c)(3).
    \20\ 68A Stat. 163.
---------------------------------------------------------------------------
    Enactment of the Revenue and Expenditure Control Act of 1968 
brought rules concerning cooperative hospital service 
organizations.\21\ These rules were amended by provisions of the  Tax 
Reform Act of 1976, the Revenue Act of 1988, and the Taxpayer Relief 
Act of 1997. The rules pertaining to cooperative service organizations 
of operating educational organizations were enacted in 1974 \22\ (as 
was statutory law concerning political organizations).\23\
---------------------------------------------------------------------------
    \21\ 82 Stat. 269.
    \22\ 88 Stat. 235.
    \23\ 88 Stat. 2108.
---------------------------------------------------------------------------
    The Tax Reform Act of 1969 \24\--the most significant of the modern 
tax acts from the standpoint of the law of tax-exempt organizations--
introduced a stupendous array of exempt organizations laws, including 
the exemption recognition application rules, rules differentiating 
public charities from private foundations, imposing taxes on various 
aspects of the operations of private foundations, and revising the 
unrelated debt-financed property rules.\25\
---------------------------------------------------------------------------
    \24\ 83 Stat. 487.
    \25\ While, as discussed, there was law pertaining to, and law 
practices concerning, tax-exempt organizations before 1969, enactment 
of the Tax Reform Act of 1969 ushered in the contemporary bases of this 
area of the law (other than the unrelated business law structure) and 
the modern exempt organizations law practice).
---------------------------------------------------------------------------
    The Tax Reform Act of 1976 brought law concerning declaratory 
judgment rules for charitable organizations, lobbying by public 
charities (the expenditure test), and amateur sports organizations.\26\
---------------------------------------------------------------------------
    \26\ 90 Stat. 1520.
---------------------------------------------------------------------------
    The Tax Equity and Fiscal Responsibility Act of 1982 amended the 
law concerning amateur sports organizations.\27\ The Tax Reform Act of 
1984 brought the church audit rules, changes in the U.S. 
instrumentalities rules, and the child care organizations rules.\28\ 
The  Deficit Reduction Act of 1984 brought the tax-exempt entity 
leasing rules.\29\
---------------------------------------------------------------------------
    \27\ 96 Stat. 324.
    \28\ 98 Stat. 494.
    \29\ Id.
---------------------------------------------------------------------------
    The Tax Reform Act of 1986 changed the Internal Revenue Code formal 
reference to the Code of 1986 (which, as amended, is its status 
today).\30\ This act also introduced the law concerning provision of 
commercial-type insurance, liquidations of for-profit entities into 
tax-exempt organizations, and multiparent title-holding corporations; 
also, it revised the exempt entity leasing rules.
---------------------------------------------------------------------------
    \30\ 100 Stat. 1951.
---------------------------------------------------------------------------
    The Revenue Act of 1987 brought taxes on public charities for 
engaging in excessive lobbying and political campaign activities, as 
well as fundraising disclosure requirements for noncharitable 
organizations.\31\ Enactment of the Omnibus Budget Reconciliation Act 
of 1993 introduced rules concerning the nondeductibility of expenses 
for lobbying and political campaign activities, and disclosure rules as 
to these activities for associations.\32\ The 1993 legislation also 
introduced law in the charitable giving arena, concerning 
substantiation requirements and quid pro quo contributions.
---------------------------------------------------------------------------
    \31\ 101 Stat. 1330.
    \32\ 107 Stat. 312.
---------------------------------------------------------------------------
    Legislation known as the Taxpayer Bill of Rights 2, enacted in 
1996, added the intermediate sanctions rules, expanded the penalties 
for failure to timely file complete annual information returns, 
expanded the contents of these returns, revised disclosure rules, and 
added the private inurement language to the law pertaining to tax-
exempt social welfare organizations.\33\ The Small Business Job 
Protection Act of 1996 added revisions to the unrelated business rules, 
exemption opportunities for charitable risk pools and state tuition 
programs, and the ability of exempt charitable organizations to own 
stock in small business corporations.\34\
---------------------------------------------------------------------------
    \33\ 110 Stat. 1452.
    \34\ 110 Stat. 1755.
---------------------------------------------------------------------------
    The enactment of the Taxpayer Relief Act of 1997 caused several 
changes and additions to the law of exempt organizations, including 
various modifications of the unrelated business income rules.\35\
---------------------------------------------------------------------------
    \35\ 111 Stat. 788.
---------------------------------------------------------------------------
    The Victims of Terrorism Tax Relief Act of 2001 brought rules 
concerning the provision of assistance by charitable organizations to 
individuals who are victims of terrorism and clarified the law 
concerning exempt organization-funded disaster relief programs.\36\
---------------------------------------------------------------------------
    \36\ 115 Stat. 2427.
---------------------------------------------------------------------------
    The Jobs and Growth Tax Relief Reconciliation Act of 2003 changed 
the tax rates for dividends and capital gains, which has had an impact 
on charitable giving and rules pertaining to the administration of 
charitable remainder trusts.\37\
---------------------------------------------------------------------------
    \37\ 117 Stat. 752.
---------------------------------------------------------------------------
    The Military Family Tax Relief Act of 2003 introduced rules by 
which the tax-exempt status of charitable organizations could be 
suspended if designated as supporting or engaging in terrorist 
activity.\38\ The Working Families Tax Relief Act of 2004 extended the 
rules concerning charitable contributions of computer technology and 
equipment used for educational purposes.\39\
---------------------------------------------------------------------------
    \38\ 117 Stat. 1335.
    \39\ 118 Stat. 1166.
---------------------------------------------------------------------------
    The American Jobs Creation Act of 2004 introduced rules concerning 
the treatment of charitable contributions of patents and other forms of 
intellectual property, rules concerning the treatment of charitable 
contributions of motor and other vehicles, increasing reporting for 
noncash contributions, an exclusion from unrelated business income for 
gain or loss on the sale or exchange of certain brownfield properties, 
and extended the IRS user fee program.\40\
---------------------------------------------------------------------------
    \40\ 118 Stat. 1418.
---------------------------------------------------------------------------
References by Present-Law Internal Revenue Code Sections
    The following provisions of the Internal Revenue Code, concerning 
tax-exempt charitable organizations, are correlated by the year of 
enactment:
1913

    Tax exemption for charitable organizations created, with inclusion 
of private inurement doctrine (predecessor to IRC Sec. 501(c)(3)).
1917

    Income tax charitable contribution deduction enacted (predecessor 
to IRC Sec. 170).
1918

    Tax exemption for charitable organizations expanded (predecessor to 
IRC Sec. 501(c)(3)).
1921

    Estate tax charitable contribution deduction enacted (predecessor 
to IRC Sec. 2055). Tax exemption for charitable organizations expanded 
again (predecessor to IRC Sec. 501(c)(3)).
1932

    Gift tax charitable contribution deduction enacted (predecessor to 
IRC Sec. 2522).
1934

    Addition to law of prohibition on substantial legislative 
activities by exempt charitable organizations (predecessor to IRC 
Sec. 501(c)(3)).
1944

    Tax-exempt organizations become required to file annual information 
returns (predecessor to IRC Sec. 6033).
1950

    Unrelated business income rules enacted (predecessor to IRC 
Sec. Sec. 511-514).
1954

    Tax exemption for charitable organizations expanded again (IRC 
Sec. 501(c)(3)). Addition to law of prohibition on political campaign 
activities by exempt charitable organizations (id.).
1968, 1974, 1976, 1988, 1997

    Enactment of rules concerning tax-exempt charitable cooperative 
entities (IRC Sec. 501(e), (f)).
1969

    Enactment of exemption notice rules (IRC Sec. 508), definitions of 
public charities and private foundations (IRC Sec. 509), the private 
foundation rules (IRC Sec. Sec. 507, 4940-4948), expansion of the debt-
financed income rules (IRC Sec. 514), and introduction of the planned 
giving rules (such as for charitable remainder trusts (IRC Sec. 664)).
1976

    Enactment of declaratory judgment rules for charitable 
organizations (IRC Sec. 7428), public charity lobbying rules (IRC 
Sec. Sec. 501(h), 4911), and rules concerning amateur sports 
organizations (IRC Sec. 501(c)(3)).
1982

    Addition of rules concerning amateur sports organizations (IRC 
Sec. 501(j)).
1984

    Enactment of church audit rules (IRC Sec. 7611), the child care 
organizations rules (IRC Sec. 501(k)), and the tax-exempt entity 
leasing rules (IRC Sec. 168(h)).
1986

    Enactment of the commercial-type insurance rules (IRC Sec. 501(m)), 
liquidations of charitable and other exempt organizations (IRC 
Sec. 337), and revision of exempt entity leasing rules.
1987

    Enactment of excise taxes on public charities for excessive 
lobbying (IRC Sec. 4912) and for political campaign activity (IRC 
Sec. 4955).
1993

    Enactment of general charitable gift substantiation rules (IRC 
Sec. 170(f)(8)) and quid pro quo contributions rules (IRC Sec. 6115).
1996

    Enactment of the intermediate sanctions rules (IRC Sec. 4958) and 
extension of the doctrine of private inurement to exempt social welfare 
organizations (IRC Sec. 501(c)(4) entities). The unrelated business 
rules (IRC Sec. Sec. 512, 513) were revised, rules concerning 
charitable risk pools (IRC Sec. 501(n)) and prepaid tuition plans (IRC 
Sec. 529) were enacted, and charitable organizations were accorded the 
ability to own stock in small business corporations (IRC Sec. 512(e)).
1997

    The unrelated business income rules were modified again and the 
corporate sponsorship rules (IRC Sec. 513(i)) were enacted
2001

    Congress clarified rules for providing assistance by charitable 
organizations to victims of terrorism and natural disasters.
2003

    Tax rates for dividends and capital gains lowered (affecting the 
charitable remainder trust distribution ordering rules). The tax 
exemption suspension rules (IRC Sec. 501(p)) were enacted.
2004

    Enactment of rules concerning the treatment of charitable 
contributions of patents and other forms of intellectual property (IRC 
Sec. 170(m)), rules concerning the treatment of charitable 
contributions of motor and other vehicles (IRC Sec. 170(f)(12)), 
increasing reporting for noncash contributions (IRC Sec. 170(f)(11)), 
an exclusion from unrelated business income for gain or loss on the 
sale or exchange of certain brownfield properties (IRC 
Sec. 512(b)(19)), and extension of the IRS user fee program (IRC 
Sec. 7528).
Other Law
    The foregoing statutory framework has been augmented and expanded 
over the decades by court opinions, Department of the Treasury 
Regulations, and Internal Revenue Service public and private 
determinations. Indeed, in some instances, the statutory law was 
enacted in response to the position of a court, the Treasury 
Department, or the IRS.
    In the tax-exempt organizations context, for example, Congress has 
added 18 provisions to the Internal Revenue Code to overturn an IRS 
position. They are:

     1.  Enactment of law in 1950 (IRC Sec. 513(a)(3)) to exempt from 
unrelated business income tax sales of items acquired by gift, to 
overrule IRS position that nonprofit thrift shops were not tax-exempt.
     2.  Enactment of cooperative hospital service organization rules 
in 1968 (IRC Sec. 501(e)), to overrule IRS position that cooperatives 
could not qualify for tax exemption by reason of IRC Sec. 501(c)(3).
     3.  Enactment of cooperative service organization of educational 
organizations rule in 1974 (IRC Sec. 501(f)), to overrule IRS position 
that this type of entity could not qualify for tax exemption by reason 
of IRC Sec. 501(c)(3).
     4.  Enactment of definition of term agricultural in 1976 (IRC 
Sec. 501(g)), to overrule IRS position that the term, for purposes of 
IRC Sec. 501(c)(5), does not encompass the harvesting of aquatic 
resources.
     5.  Enactment of public entertainment rules in 1976 (IRC 
Sec. 513(d)((2)), to overrule IRS (and courts') position that horse 
racing at exempt agricultural organizations' fairs was nonexempt 
activity.
     6.  Enactment of trade show rules in 1976 (IRC Sec. 513(d)(3)), to 
overrule IRS position that order-taking and selling at these shows was 
nonexempt activity.
     7.  Enactment of law in 1976 (IRC Sec. 513(e)) to allow exempt 
hospitals to provide certain services to other exempt hospitals, to 
overrule IRS position that these services were nonexempt functions.
     8.  Enactment of law in 1978 concerning securities lending 
transactions (IRC Sec. 513(b)(1)), to overrule IRS position that 
securities lending by exempt organizations was unrelated business.
     9.  Enactment of law in 1978 (IRC Sec. 513(f)) to exempt bingo 
games from unrelated business rules, to overrule IRS position to the 
contrary.
    10.  Enactment of special rules for amateur sports organizations in 
1982 (IRC Sec. 501(j)), to overrule IRS position that these 
organizations could not qualify for tax exemption by reason of IRC 
Sec. 501(c)(3).
    11.  Enactment of child-care center rules in 1984 (IRC 
Sec. 501(k)), to overrule IRS position that day care and like 
organizations could not be exempt educational entities because of too 
much private benefit.
    12.  Enactment of rules in 1986 (IRC Sec. 513(h)) to allow 
charitable organizations to distribute low-cost articles in fundraising 
context, to overrule IRS position that charities were selling these 
articles.
    13.  Enactment of charitable deduction rule for certain payments to 
institutions of higher education in 1988 (IRC Sec. 170(l)), to overrule 
IRS position that no portion of these payments was deductible as 
charitable gifts.
    14.  Enactment of a rule in 1993 that tax-exempt title-holding 
companies (IRC Sec. 501(c)(2) and (25) entities can generate a certain 
amount of unrelated business taxable income, to overrule IRS position 
that these entities could not have any active unrelated business 
income.
    15.  Enactment of rules in 1996 (IRC Sec. 512(d)) to exempt certain 
associate member dues from unrelated business income taxation, to 
overrule IRS attempt to tax many forms of these dues.
    16.  Enactment of rules in 1996 (IRC Sec. 512(b)(17)) concerning 
foreign source income taxable as unrelated business income, to overrule 
IRS position that certain forms of this income were nontaxable 
dividends.
    17.  Enactment of rules in 1997 concerning revenue received by tax-
exempt organizations from controlled subsidiaries (IRC 
Sec. Sec. 512(b)(13), 318), to overrule IRS position that these rules 
did not extend to revenue from second-tier subsidiaries.
    18.  Enactment of corporate sponsorship rules in 1997 (IRC 
Sec. 513(i)) to overrule IRS position that payments by corporate 
sponsors were forms of unrelated business income.

    Some amendments to the Internal Revenue Code in this context were 
added at the request of the IRS. Examples of this are the intermediate 
sanctions rules (IRC Sec. 4958) and the commercial-type insurance rules 
(IRC Sec. 501(m)).

    There is relatively little law on the federal tax exemption for 
labor organizations. This category of exemption, in present-day IRC 
Sec. 501(c)(5), was first added to the statutory law in 1909 
(Corporation Excise Tax Act of 1909, 36 Stat. 11). The statute provides 
merely that tax exemption is available for ``labor'' organizations. No 
criteria for exemption are provided--an instance of the need for 
statutory criteria for exemption if the federal statutory law in this 
context is to be brought into balance.
    The tax regulations amplify this aspect of exempt organizations 
law. There it is provided that an exempt labor organization is an 
entity that has as its objects the betterment of the working conditions 
of its members and development among its members of a higher degree of 
efficiency in their occupations, and does not cause its net earnings to 
inure to the benefit of a member (Reg. Sec. 1.501(c)(5)-1(a)). This 
category of exemption is not available for organizations that have as 
their principal activity the investing and management of funds 
associated with savings or investment plans, including retirement 
savings programs (Reg. Sec. 1.501(c)(5)-1(b)). The regulations make it 
clear that exempt labor organizations are nonetheless subject to the 
unrelated business rules (Reg. Sec. 1.501(c)(5)-1(c)).
    There are a few court opinions and IRS revenue rulings on the 
subject. This law amplifies somewhat the concept of the exempt labor 
organization. One court held that a labor organization is an entity 
that is organized to ``protect and promote the interests of labor'' 
(Portland Cooperative Labor Temple Association v. Commissioner, 39 
B.T.A. 450 (1939)).
    Labor organizations have traditionally engaged in collective action 
directed toward the workers' common objective of improving working 
conditions. They include labor unions that negotiate with employers on 
behalf of workers for improved wages, fringe benefits, hours and 
similar working conditions, and certain union-controlled organizations, 
such as strike funds, that provide benefits to workers that enhance the 
union's ability to effectively bargain (Rev. Rul. 67-7, 1967-1 C.B. 
137), and publishers of labor newspapers. Exempt labor organizations do 
not include strike funds that provide income to union members but are 
not controlled by unions (Rev. Rul. 76-420, 1976-2 C.B. 153).
    Labor organizations may also meet the requirements for exemption by 
providing benefits that directly improve working conditions or 
compensate for unpredictable hazards that interrupt work. Examples of 
these benefits include operating a dispatch hall to match union members 
with work assignments and providing industry stewards who represent 
employees with grievances against management (Rev. Rul. 75-473, 1975-2 
C.B. 213; Rev. Rul. 77-5, 1977-1 C.B. 148). Conversely, managing saving 
and investment plans for workers, including retirement plans, does not 
bear directly on working conditions (Rev. Rul. 77-46, 1977-1 C.B. 147). 
Accordingly, the IRS does not accord exemption to organizations that 
manage retirement savings as their principal activity (cf. Morganbesser 
v. United States, 984 F.2d 560 (2d Cir. 1993), which led to 
promulgation of the above-referenced Reg. Sec. 1.501(c)(5)-1(b)).

                                 

    Chairman THOMAS. Given the sheet that Members have in front 
of them from Mr. Yin in terms of the catch-as-catch-can 
historical picture of how this developed, it appears to me, 
based upon the testimony that you made, notwithstanding 
understood rationales or not understood rationales as to why 
various provisions are in the law, yet all of you think it is 
possible to create a coherent definition, theory, and 
structure. Mr. Cohen?
    Mr. COHEN. I was privileged to be the youngest person who 
drafted the 1954 Code. Before the 1954 Code, the Internal 
Revenue Code had not been really amended much since 1939. It 
was first enacted in 1939 as a Code, and then, of course, the 
war came and there was just emergency legislation. Nobody did 
it coherently. So, we had to do it coherently. Two of us were 
assigned. One was assigned to do only substantive provisions, 
to rearrange them in some kind of a substantive order. I was 
assigned to do all the administrative provisions. You can 
imagine what a job that was. There were separate administrative 
provisions for every single tax. That is, there was no unified 
set of rules. That took a year. It took us a whole year to do 
that. Before we started the job, we had small groups--now, this 
is the kind of job where you would need a group like that, that 
would sit down for a sustained period of time--they may be 
insiders or outsiders or a combination of it--and try to 
rationalize and give you alternatives. That is, they will come 
back with policy decisions that only you folks can make. You 
can't assign this to your inside staff and give them 6 months 
and say, do it, while they are doing everything else because it 
will never get done that way. It has to be a special project in 
which there is a devoted set of staff that work on it and work 
to make it coherent. So, for example, we have insider penalties 
that apply to (c)(3)s, that apply to certain (c)(3)s. They 
don't apply to (c)(4)s. They did apply to (4)s, but they didn't 
apply to many of the other organizations. All those kinds of 
things and the things that Bruce and the others have raised 
need to be considered, but that takes time and staff.
    Chairman THOMAS. I will tell you that in today's world, 
where we have a Presidential panel to look at fundamental tax 
reform and they have 6 months to report back, you just outlined 
a time line which the VH1 generation can't focus on in terms of 
length. If we were to pursue this, is it worthwhile at all to 
create a kind of an onion approach, or going down in a 
hierarchial way, to look at what is most important at the 
Federal level, which we obviously ought to be focusing on--the 
panel indicated that tax-exempt tends to be a State 
classification, and should we then look at what charity is and 
create a definition for charity first, or do you just have to 
jump into this and begin to sort out a structure with what is 
there, because I think you will find that this Committee and 
even any structure that we put together probably won't be able 
to agree on all of those particular levels and produce a 
product in any reasonable timeframe. Mr. Hopkins?
    Mr. HOPKINS. I would like to respond to that. I think, as 
you have heard, the charitable sector does predominate and it 
performs--along this way we are made, I think the Committee 
would find that a lot of what it did in the 501(c)(3) context 
could be used in other areas, particularly (c)(4)s, (c)(5)s, 
and (c)(6)s. So, as a practical matter, it might make sense to 
start writing a better law as to what charitable, scientific, 
educational is, and work with the private inurement doctrine, 
private benefit doctrine, intermediate sanctions, and if that 
could be accomplished, then I think you would have a template 
that could be used in many respects with resect to other 
categories of exempt organizations.
    Chairman THOMAS. Okay. Let us start with charity. Normally, 
if you talk about the charity area, lists were made, or at 
least referred to as to which ones were the most numerous. So, 
if I asked the panel if you were to select out the area in 
which there was the most dollar involvement in the charity 
area, and I don't know that the volume relates to dollar 
amount--you understand it better than I do--where would the--is 
there an area in which half of the charity concept is involved, 
or 25 percent, or do they all have 3 percent and you just have 
to look at the entire universe?
    Mr. Colombo?
    Mr. COLOMBO. Yes. The IRS can probably give you, or the GAO 
can probably give you more statistics. Financially, it is 
pretty clear that hospitals and health care providers are the 
1,000-pound gorilla of the charitable organization area, that 
they command a large portion of the revenue in the charitable 
area. In terms of the conceptual problems, I really don't think 
you can lay them out that way. There is this charitable sector, 
and I think you can divide charities from everything else and 
work in the charitable sector. I think it would be very hard to 
focus on a little piece of the charitable sector itself without 
focusing on the area as a whole.
    Chairman THOMAS. Well, does anybody have the percentage 
that hospitals are of the charitable areas so that you know 
what we are biting off? We have to start somewhere. Anybody. 
You guys fight it out.
    Mr. YIN. In our document, in the pamphlet on page 21, we 
actually have a table showing the breakdown of the charitable 
organizations and Professor Colombo is exactly right. The 
largest, at least by assets and revenue, is in the health area, 
and of that, the largest component would be hospitals. The next 
largest looks like it would be education. Of course, in that 
would be the colleges and universities. Then there are a couple 
of other areas that are somewhat large, as well.
    Chairman THOMAS. Okay. I accept your structure and 
category. Now I turn to the definitions that are offered. Mr. 
Colombo, we are going to deal with charity. You want to define 
charities as those who live off of contributions or donations 
because it appears as though their services are recognized on a 
voluntary basis to be supported by people freely providing 
their money. If that is going to be the definition of charity, 
do nonprofit hospitals fit your definition?
    Mr. COLOMBO. No, not most of them. I think there would be a 
few. Children's hospitals, the Shriners' hospitals probably get 
significant donations. As a sector, the last number I saw was 
that about two percent of their revenues come from donations, 
and I suspect most of that goes to like the children's 
hospitals.
    Chairman THOMAS. Well, this goes to the point that the 
Ranking Member made early on in terms of IRS and is a real 
reason why IRS is going to have to appear before us, because in 
1969 when they were defining charity, they decided that relief 
of the poor and distressed is not an essential criteria for 
charity, and so I would turn, Professor Hill, to your offering 
of a definition of public benefit to a defined population. If, 
in fact, nonprofit hospitals don't have to provide services to 
the poor or distressed to be classified as a charity, and it 
isn't based upon donation, then I appreciate the offers of 
definitions, but we are either going to have a wholesale 
revision of what is and what is not defined as a charity or 
both of your definitions are going to have to be boozed up 
quite a bit.
    Ms. HILL. Definitions always have to be boozed up quite a 
bit, and those of us who come to hearings do so because we 
think maybe the process of having them boozed will be useful in 
the end. To be responsive to the question of how can a public 
benefit concept help and does it apply to hospitals, I would 
like to get on the table a consideration also of the human 
services sector. If you look at the table on page 21, we notice 
that that is also quite significant here in terms of revenue 
and the number of entities, and I think we can all think of the 
social services sector as the direct delivery of goods and 
services to people who probably would come closest to a 
charitable class in our view--the hungry, the homeless, those 
needing clothes, food, shelter, assistance with various 
problems. I bring them into it because in my testimony, I 
raised the question, what is public benefit? What is a 
charitable class? The difficulty here in answering the question 
is to say, does a charitable class have to be the same for all 
kinds of charities? Does it only have to be poor people or 
distressed people? Well, that would leave out the arts 
organizations. If it is only the poor people, then, of course, 
social services are good, but churches become problematic 
because rich people also love God and wish to go to church. I 
think with hospitals, if we think only of charity care as the 
public benefit, and I do think there should be more charity 
care in this country across the board, of all kinds of health 
care providers, including outpatient clinics, but I think part 
of that problem isn't rooted in the exempt sector. Part of that 
problem, as this Committee knows much better than I, is rooted 
in the larger problem of health care policy and whether a 
health care insurance net linked to employment is the best way 
to go. These are huge questions which kind of transcend it. I 
would say that if we begin by saying what is the public 
benefit--let us take a university. Is it the students who 
presumably are going to get out and get nice jobs, are they the 
beneficiaries of education, or is it society more generally who 
has then this educated pool of young people who would be good 
citizens? I think one can ask the same question about 
hospitals. What are all the public benefits they represent? How 
do we count the public benefit? I think that charity care is 
one part. Education of doctors and other health care providers 
is another. Frankly, there is a benefit to all the rest of us 
who may not be ill at the moment, but we do not have to watch 
people die before our very eyes and have some hope.
    Chairman THOMAS. Professor Hill, everything you said about 
that aspect, in my mind, corresponds to hospitals generically, 
some of which are for profit, some of which are not-for-profit. 
So, what is the criteria for placing some in not-for-profit and 
those others in for-profit except the self-definition that they 
have chosen, which if we are looking at for a rationale for all 
the money we are dealing with, the definitions that were 
provided early on in an abstract way, I think we start bumping 
up against reality immediately. All I am trying to do is get 
you to share the problems we are going to have as a Committee 
if you simply said, go in, begin defining, and structure the 
areas.
    Ms. HILL. May I just follow up?
    Chairman THOMAS. Sure.
    Ms. HILL. One more perspective on this whole question of 
comparing activities conducted in the taxable sector, 
activities conducted in the exempt sector. I think we have to 
be careful when we talk about the comparison and the benefits 
with the exemption that we are sure that the taxable entities 
are making a profit, not generating losses and thereby not 
having a tax burden. I think it would be very useful to have 
side-by-side comparisons of universities, of hospitals, of 
schools that are taxable and tax-exempted social service 
providers. Then I think the discussion of the benefit of the 
exemption in the two and whether there is really a difficulty 
in having the activities across two sectors, an inappropriate 
taxation becomes more real, and I do not have those data. 
Others may.
    Chairman THOMAS. My problem when you introduce that is that 
one is a conceptual problem of defining somebody as a charity 
and not. The other one is an examination of the Tax Code to see 
if the deductions are appropriate for a for-profit to wind up 
not paying taxes, and those are two entirely different 
pursuits, both of which are probably worthwhile, but with 
setting aside the examination of the Tax Code and the 
deductible aspects of it for for-profits to examine the 
definition you have provided me with that I am now trying to 
apply to this area. Mr. Holtz-Eakin?
    Mr. HOLTZ-EAKIN. Let me pull out pieces of both of these 
concepts, largely because it supports the testimony that we 
submitted. The first is the notion of a public benefit. To the 
extent that the activity that an entity is engaged in has such 
broad public benefits that no single individual would be 
willing to write the check, you would see very little data to 
support that entity with sales. At the other extreme, if there 
is really just a private benefit or transaction that makes 
sense for the entity and the individual, you could support the 
entity's activities with sales like revenues. In the same way 
with charity, the ultimate of charity is to conduct a 
transaction at below the regular price or even give it away for 
free, and to the extent that you do that, you will be unable to 
support the entity with sales. To the extent that you do not, 
you will have a lot of sales. So, the index that we organized 
our testimony around was what fraction of the income comes from 
program revenue? How much does it look like a sales-driven 
entity? That encompasses both the flip side of public benefits/
private benefits and the flip side of charity, collecting at 
market prices. That is a continuum. It is not a bright line, 
but it allows you to organize things, and they range greatly. 
The hospital number we have is 92 percent of income comes from 
program revenue in a hospital in the tax-exempt hospital 
sector. Food, agriculture, nutrition, 8.5 percent. So, there is 
an enormous diversity there.
    Chairman THOMAS. Yes. We are using this only for 
illustrative purposes because I think it is a good example and 
it is a big segment, and if you are going to try to deal with 
changing the law, you probably ought to start with the big 
segment instead of dealing at the bottom end of you will never 
get to the bulk of the questions in front of us. So, I don't 
want anyone to think that I am focusing on a section for the 
purpose of doing that. I just thought, based upon the 
definitions you gave me and I began playing with them during 
the testimony, that I had one I couldn't find an easy category 
for and it turns out to be the biggest one right on top.
    Mr. Walker, and then I will recognize the gentleman from 
New York.
    Mr. WALKER. Mr. Chairman, obviously, you are not going to 
be able to decide on a definition today, but I think it 
illustrates a very fundamental point. As has been testified by 
a number of the individuals here, we have a number of different 
types of 501(c) entities that have come into effect over the 
last 100 years. If you look at the data that has been provided 
by the Joint Committee on Taxation, of the 28 categories, five 
have less than ten filers. Eleven have less than 1,000 filers. 
We have basically created a fragmented and layered approach to 
this area, like many other areas in the Federal government, 
without adequate definitional guidance, without adequate 
transparency, and without appropriate accountability, and I 
would respectfully suggest that this is illustrative of a need 
to step back and say, what are we trying to accomplish? Who 
should benefit? We need some basic definitions so that we can 
rationalize this area, and it is illustrative of a much broader 
need, as well, I would suggest.
    Chairman THOMAS. I thank the gentleman, but it seems to me 
that donations sounds like a perfectly good way to define 
charity if you need them, and then we run into a problem using 
that definition. The idea of benefit to a defined population 
sounds really good, but if you begin to apply it, you find out 
that IRS walked away from that in the fifties and especially in 
1969 with hospitals in terms of saying that charitable service 
doesn't have to necessarily define the charity, or service to 
the poor. So, all I am saying is we need help. It is obvious 
that what we need is a degree of rigor and structure designed 
to, if you only did this, it is a great improvement, as 
somebody said. If you do this in addition, it is great. To 
throw the whole area of 501(c) on us means we don't know how to 
get out of the box. The gentleman from Florida just said this 
sounds like a can of worms, and I am thinking it is a bucket of 
worms rather than a can of worms. A quickly follow-up by Mr. 
Walker.
    Mr. WALKER. Mr. Chairman, very quickly, obviously, we are 
in the fact-gathering business, and so if we can help this 
Committee try to be able to obtain some facts with regard to 
particular aspects of 501(c)(3) or organizations, we are happy 
to do that.
    Chairman THOMAS. Facts are valuable, but structure to 
understand, analyze, and use the facts are probably more 
important to us.
    Mr. JOHNSON OF TEXAS. Would the gentleman yield?
    Chairman THOMAS. The gentleman from Texas.
    Mr. JOHNSON OF TEXAS. I would just like to point out, 
concerning these hospitals, that we have now introduced 
Medicare and Medicaid, which were not, I don't think, in the 
law as heavily as they are now when the hospital charitable 
contribution was initiated. Therefore, I think there has to be 
a consideration of those items, as well, when you talk about 
that.
    Chairman THOMAS. That is partially true, but Medicare began 
in 1965 and the definition I was referring to from the IRS was 
1969 in which relief for the poor, distressed is not an 
essential criteria for charity, so it was even after Medicare 
was enacted into law. The gentleman from New York.
    Mr. RANGEL. Thank you, Mr. Chairman. Mr. Cohen, you have 
indicated that no matter what amounts of money we give to IRS 
for oversight, that would probably go where they think they 
could get the best savings, but I know because of your great 
history in this area that the credibility of the system also is 
important. Even though the money may not be in these 501(c)s, 
if there is abuse and corruption, they have to send some type 
of a signal that people cannot get under the radar just because 
there is not a lot of money involved. Today, there is a lot of 
talk about 501(c)(3)s that are set up as educational 
institutions and that they are either violating the law or the 
spirit of the law, and the question I would ask, I guess, Mr. 
Hopkins, is that if some lobbyist wanted to influence the 
conduct of Congress and they had clients, either domestic or 
foreign, but it would violate the law if they approached the 
Member directly, but yet the foundation would receive large 
sums of money from the lobbyist and then invite the Members of 
Congress to be educated by visiting with the country where 
these businessmen came from or the locations where they had 
their business, would that be legal under the law as you 
understand it as a lawyer?
    Mr. HOPKINS. This does not sound like a hypothetical 
question.
    [Laughter.]
    Chairman THOMAS. I tell the gentleman that as long as we 
stay in the hypothetical area, I don't believe it violates the 
fundamental purpose of this hearing, but as soon as the 
hypothetical becomes specific, then I think we will be dealing 
with those issues with the IRS and others in front of us in a 
more systematic way. However----
    Mr. RANGEL. Mr. Chairman, I appreciate----
    Chairman THOMAS. --given the background and experience, Mr. 
Hopkins, of the panel members, you probably are the most 
appropriate to respond to the hypothetical as outlined by the 
gentleman from New York.
    Mr. HOPKINS. Thank you, Mr. Chairman. The concept of what 
is educational and the concept of what is legislative overlaps 
a little bit, and I think, without getting into the details 
here, by the way, the regulations are fairly comprehensive on 
the point. If there is an attempt to objectively present facts 
and information about a particular topic, that is educational. 
If there is an advocacy element at some point, it can shift 
over to lobbying or even political campaign activity. The 
funding of it by itself shouldn't change the outcome. In other 
words, you were talking about lobbyists contributing money to 
an entity. It is the function, not the funding, if you will. 
So, what we try to do in the law is separate the presentation 
of objective material as contrasted with an efficacy----
    Mr. RANGEL. I can understand that. My second and last 
question to you would be, if the not-for-profit then hired 
people that--strike that. If people that worked for the not-
for-profit also was in the consulting business as a lobbyist 
and remainder under 501(c)(3), in your opinion, would that be a 
violation of the law?
    Mr. HOPKINS. Well, that is a different body of law. Now, we 
are talking about educational versus private benefit, or in a 
more technical sense, private inurement. What we are talking 
about here is a situation where what looks to be educational on 
its face is, in fact, a shifting of the resources of the 
charity over to someone in an inappropriate manner. That would 
be a private inurement or a private benefit situation. I am not 
saying that is----
    Mr. RANGEL. I am not either.
    Mr. HOPKINS. It is hypothetical----
    Mr. RANGEL. That would be an abuse of the system.
    Mr. HOPKINS. If the resources were shifted unduly to 
someone in their private capacity, the answer is yes.
    Mr. RANGEL. Now let me ask Professor Hill a question. We 
are getting more involved in not-for-profits being audited for 
political activities and dealing with an organization has 
historically been known, in the hypothetical, for its efforts 
in the civil rights area and voter registration and things of 
that nature. If an office of not-for-profit makes a statement 
that is critical of the major parties and then the eve before 
the election, the IRS says that there is going to be an 
investigation, how would the IRS monitor, or how would the 
Congress be able to monitor the IRS and at the same time seek 
out to get rid of these abuses with subjective matters such as 
the one that I described in the hypothetical?
    Ms. HILL. Yes. Your hypothetical raises important issues of 
conducting audits with respect to what is, in some of its 
elements, constitutionally protected First amendment political 
speech. When conducted through a 501(c)(3) organization, the 
Supreme Court has said in taxation with representation that 
lobbying in that case could be conditioned and those people 
believed that the political prohibition in section 501(c)(3) is 
constitutional and would be so held, and one did look to the 
McConnell v. Federal Election Commission comments in that case. 
The question that arises, and I am going to be a little 
hypertechnical here and mention code sections, and I apologize 
to anyone in the room whose eyes are going to glaze over, but I 
am a professor and inherently boring, so here we go. Generally, 
an organization is audited when it files its information 
return, but we know that the information return is filed long 
after an election and there is something of a mismatch in this 
area between interdicting improper political activity of 
501(c)(3) and the time at which the IRS can normally take 
action. Congress enacted section 6852, in the larger scheme of 
things quite recently, to provide that in the case of a 
flagrant violation of the political prohibition of section 
501(c)(3), Congress, the IRS could audit at that point in what 
constitutes a version of a jeopardizing assessment. They could 
close the taxable year and audit, but the violation has to be 
flagrant.
    Further, there has been for a time now in the Code section 
7409 that allows the IRS, with careful procedural limitations, 
to seek a declaratory judgment action in a court to interdict 
the behavior immediately in the case of flagrant participation 
in a political campaign in violation of the exempt status. I 
don't believe the IRS has ever used 7409. When the IRS begins 
to seek information, then, from a 501(c)(3) organization before 
the filing of a return, the technical issue which is now 
unaddressed is is that consistent or inconsistent with section 
6852, especially if, hypothetically, the speech in question or 
the other activity in question doesn't appear to be flagrant. 
Passionate, maybe, but not flagrant. So, what we have here is a 
technical issue of great importance to the administration of 
the tax law and great importance to the conduct of our 
elections, and that is where I think the law stands now. 
Certainly the IRS may audit. It seems to be a requirement that 
the activity in question be flagrant and that there be a 
showing that it be flagrant. So, one would have to look case by 
case.
    Mr. RANGEL. Thank you, Professor. Thank you, Mr. Chairman. 
Now that you have whetted my appetite as to the breadth of this 
serious problem that would demand these hearings, can you share 
with me as to when we can get to the rubber can hit the road 
with the IRS, because this distinguished panel certainly has 
laid out a blueprint of something that demands and screams out 
for correction.
    Chairman THOMAS. I tell the gentleman that we will, as we 
normally do, based upon minority witnesses--as you were aware, 
we worked with the staff in creating this particular hearing. 
We will do additional ones, but as is usually the case with 
this Committee, ultimately, a significant amount of the work 
will be turned over to the Subcommittee. The Subcommittee on 
Oversight has historically been the Subcommittee that reviews 
it periodically. It may be worthwhile to bring it back to the 
full Committee to take a look at this, because I do believe we 
need to move expeditiously, one, because we should, but two, I 
want to make sure that the press doesn't cover this as us 
rushing belatedly to an issue that the Senate initiated for the 
purpose of raising revenue, because I have been doing this for 
22 years, as the gentleman from New York has. So, we will be 
working together to plan and structure additional hearings, one 
to look at theory and practice, but two, eventually, you have 
to put theory and practice to the test and we will be dealing 
with the IRS on some decisions they have made and querying them 
as to why they thought they could do what they did when they 
did it.
    Mr. RANGEL. The reason I thought it was urgent, Mr. 
Chairman, is because I thought some in the majority wanted to 
pull up the tax code by its roots and start all over again, and 
I--we have John, how many do we have here, the Ambassador--and 
I wanted to ask the panel whether they would have any specific 
recommendations that they could send in to us during this 
period so that we could present them before Treasury and the 
IRS. Of course, if we are pulling up the Code by the roots, 
then we don't need any recommendations because we will start de 
novo. Just in case you decide not to do tax reform this year or 
next year, may I ask the panel to send what recommendations 
they have for this complicated code and the one that would 
follow this year or next year so that we can see what happens?
    Chairman THOMAS. I tell the gentleman it might be most 
fruitful if we get our staffs together so that we can structure 
as a Committee the kinds of questions that we might want to 
submit to this panel and others, frankly, to begin to collect 
that kind of data so that we can, in the anticipation of the 
old dandelion concept, you want to try to pull it out by its 
roots and you don't and the root is still there and it grows 
back, we may need to do some gardening. So, I am looking 
forward to----
    Mr. RANGEL. Could we get a statement from the IRS person as 
to what he thinks the problem is so that we can tell staff what 
we would be looking for in----
    Chairman THOMAS. I think that will be useful in a 
structured manner, but as this panel clearly indicates, there 
is a lot of fruitful work that can be done conceptually to try 
to figure out where we need to go and how we need to get there, 
and then we can begin to apply it practically by dealing with 
the current world.
    Mr. RANGEL. Thank you, Mr. Chair.
    Chairman THOMAS. I look forward to working with the Ranking 
Member on that.
    Mr. RANGEL. Thank you.
    Chairman THOMAS. The Chair would only say for the record 
that in propounding his hypothetical, it might have been more 
appropriate if the hypothetical structure had included the fact 
that there were complaints filed with the IRS, hypothetically, 
and that the IRS examined 130 of those cases, hypothetically, 
and the one that the gentleman hypothesized over was the one 
that was publicly announced by the organization, meaning there 
were 129 additionally hypothetically that were being examined, 
as well. Does the gentlewoman from Connecticut wish to be 
recognized?
    Ms. JOHNSON OF CONNECTICUT. Thank you very much. My 
question is going to go to Mr. Hopkins to enlarge on that 
portion of his testimony that he alluded to, tax-exempt labor 
organizations, because your testimony is very helpful. This 
goes to the whole panel. Lots of you made very specific 
recommendations as to how we go about it. I found that very 
helpful. I thought that it was interesting that in addition to 
your overall suggestions and your history, you did focus on one 
area, and I want you to have a couple of minutes to enlarge on 
that. I do want to, though, mention to Mr. Colombo, you may 
have a living, live example of the public benefit of nonprofit 
hospitals as we watch whole departments of delivering services 
move from the nonprofit to the for-profit setting where they 
can also earn more and be relieved of the responsibility to 
cross-subsidize charitable services or to take part in the 
mandates that govern the hospitals, that they must take anyone 
who comes, and so on. So, sometimes, you can see through 
people's behavior where the public benefit lies and where it 
collides with the underlying need to get fairly compensated for 
your work. Mr. Hopkins?
    Mr. HOPKINS. Thank you very much. The reference in my 
presentation to labor organizations is in there, sort of a 
disconnect, I understand this, from the rest of the testimony. 
It is in there because the Committee staff asked me to briefly 
address the point. To put it in context, you have heard 
testimony from a number of witnesses, including Mr. Cohen, 
about how unbalanced the Code is today, and for example, he was 
making reference to 501(c)(25), which is the multi-parent title 
holding company provision which occupies about, what, three-
quarters of a page of the Internal Revenue Code and reflects 
maybe four or five entities in the United States, contrasted 
with labor organizations, which obviously involve millions of 
individuals. There are two words in the Internal Revenue Code 
describing tax-exemption for labor organizations and the two 
words are ``labor organizations.'' That is all the Code itself 
says about labor organizations. This category of exemption was 
added to the Code back in 1909, so it precedes even the 
constitutional law that Mr. Yin was referring to. The code 
provision is silent on criteria for exemption, and in my view, 
it is one of the examples of an area that should be remedied by 
this Committee. Now, briefly, in the tax regulations, you will 
find some law where it is provided that an exempt labor 
organization is an entity that has as its objects the 
betterment of the working conditions of its members, and to 
some degree, it functions to develop among its members a higher 
degree of efficiency in their occupations. The private 
inurement doctrine does apply in this context. There is a major 
regulation that was adopted a few years ago that makes it clear 
that entities that have as their principal activity the 
investing and management of funds associated with savings or 
investment plans cannot be exempt. There are a very few court 
opinions and IRS rulings on the subject. In this context, the 
law is amplified a bit and illustrates the fact that the 
exemption includes more than labor unions. It embraces entities 
like collective bargaining Committees, certain forms of strike 
fund entities, and publishers of labor newspapers. That is 
about the substance of the law that we have today concerning 
labor organizations.
    Ms. JOHNSON OF CONNECTICUT. I thank the gentleman. I 
believe my time is about to expire. I will yield back.
    Chairman THOMAS. Mr. McCrery?
    Mr. MCCRERY. Thank you, Mr. Chairman. Before I get to the 
CBO Director on some of his comments about business activity, 
tax-exempt business activity, just to give you a heads-up, I 
want to get back to Professor Hill, Professor Colombo, on this 
question of some sort of conceptual framework for determining 
who should be tax-exempt, what entities should be tax-exempt, 
and Professor Hill, you used the term public benefit. We need 
to think in terms of the public benefit that is being served by 
this tax-exempt entity. Then there was some conversation about 
hospitals. I must admit, I am having a hard time 
conceptualizing the public benefit of a tax-exempt hospital, 
but I have to say in fairness, if I were to ask the not-for-
profit hospitals if they like their situation now, they would 
say yes, and I would go to the for-profit hospitals and I would 
say, well, do you like your situation now, oh, yes, sure. So, I 
am not sure we would make either one happy if we were to change 
the current arrangement. If there is some public benefit to be 
served, and I suppose one could say that health care is a 
public benefit and providing the lowest-cost health care would 
be a public benefit, then we could justify, I suppose, 
exempting hospitals, and all health care providers, for that 
matter, from taxation. If that were the case, then we would 
probably want to require all health care providers to be tax-
exempt and not-for-profit, I would assume. So, that gets into a 
real sticky wicket. So, help us further define that public 
benefit concept and how it would be applied in the real world.
    Ms. HILL. I think that when one looks at the hospitals, 
that really the conceptual hurdle is bigger than public 
benefit. It is grasping exactly the idea that you have set out, 
but it very well may be appropriate to have the same activity 
conducted simultaneously by taxable and exempt entities, and 
there may be not a problem with that. I suggest that because we 
are living in a world now where, as you all know, there is a 
great deal of convergence of activities in taxable entities and 
tax-exempt entities. I teach at an exempt entity. I do not 
think that taxable universities should be closed down or forced 
to become tax-exempt. With respect to the hospitals, the idea 
of looking at who is the benefited class and doing it in a way 
that gets beyond simply the pricing structure of the provision 
of the service, I think may help here. Certainly, the question 
of the pricing structure of the service and whether it is any 
different in taxable or tax-exempt entities, as Professor 
Colombo notes in his testimony and as I believe to be the state 
of the research in this area, the data are inconclusive on 
pricing structure, whether there is a difference, and I think 
that they are inconclusive as to sort of care provided to those 
who cannot pay and under what circumstances and do we count 
things like government payments to determine charity care. If 
we think only of the provision of free medical care to people 
who cannot pay, then, of course, hospitals have no--exempt 
hospitals have a much weaker case. If that is our criterion, 
then the question is, well, should they be partly exempt or 
fully not exempt, and if we then make that conclusion, the 
question is, what do we tax? In my previous comments, the 
related issue previously raised, I suggested that we look at 
how we determine whether taxable entities are making a profit, 
distributing dividends to shareholders, and whether that 
concerns us.
    Frankly, I am not concerned that we have an economy in 
which there is a choice in certain areas to be taxable or tax-
exempt, and whether Congress wishes to condition, for instance, 
education on do we provide scholarships based on need? Is it 
wrong to provide scholarships only on academic merit? Should 
all our scholarships be on need, which I think would be the 
analogous question? Should we provide care to people who cannot 
pay it? Is that the only criteria for exempt status? I believe 
that if we begin to ask those questions carefully, Congress 
would provide a useful role here. If we simply dig in our heels 
and become protective, we are not going to get very far.
    Mr. MCCRERY. Thank you. I would be interested in hearing 
any comments in writing from Professor Colombo on that subject 
and also from Dr. Holtz-Eakin on the question of how do these 
tax-exempt businesses conflict with tax-paying businesses? How 
do they interact, and are tax-paying businesses hurt in certain 
cases by the existence of tax-exempt. You don't have time right 
now, but if you would like to point out something in your 
testimony that is relevant, I will look at it. Thanks.
    [The information follows:]

    Thank you for your question about the Congressional Budget Office's 
(CBO's) testimony presented at the Ways and Means Committee's April 20 
hearing on the tax-exempt sector. As I understand it, you are 
interested in how nonprofit entities that are exempt from Federal 
income taxes compete with business entities that are subject to them, 
and how equalizing the tax treatment would affect that competition.
    It is useful to focus on activities that are tax-exempt as opposed 
to entities that are tax-exempt. For that reason, CBO presented 
fractions of income generated by sales activities. Nonprofit 
organizations provide both goods and services that are not provided by 
the private sector and ones that are, at subsidized prices (or no cost) 
rather than at market prices. Many such entities have little sales 
revenue and are probably not in competition with firms in the for-
profit sector. CBO's testimony focused on those tax-exempt entities 
that have substantial sales to the public and that compete with private 
firms.
    The attached table identifies examples of that competition. The 
health sector, particularly hospitals, is the primary example of 
nonprofits that sell at market prices many of the same goods and 
services provided by for-profit firms. As shown in the second column, 
that sector receives almost 92 percent of its revenue from the sale of 
goods and services and provides a relatively small portion at 
subsidized prices to those with limited ability to pay. The entities in 
the sector look very much like for-profit entities, which receive 
almost all their revenue from sales.
    The pervasiveness of competition offered by businesslike nonprofit 
entities is greater than is suggested by the data in column 2. Even in 
those categories where overall income from program revenue is very low, 
substantial competition exists. The last column of the table estimates 
the share of revenue earned by entities for which program revenue 
exceeds 75 percent of their total revenue. For example, for the 
category ``Environmental Quality, Protection, and Beautifcation,'' the 
19 percent share of program revenue (shown in column 2) suggests that 
those activities might offer little competition with those provided by 
for-profit firms; however, almost 9 percent of total revenue in that 
category comes from entities earning more than 75 percent of their 
revenue from program sales (as shown in the last column). On the basis 
of that metric, some of those entities may compete substantially with 
for-profit entities.
    Fully 65 percent of total revenue in the nonprofit sector is earned 
by entities for which program revenue exceeds 75 percent of total 
revenue. Those potential competitors with the for-profit sector are 
found in all categories of nonprofit organizations.
    Universities and museums are examples of entities that are in 
competition with the for-profit sector and that are also engaged in 
activities that provide public benefits. They have increasingly moved 
into commercial activities in order to earn a surplus that can be used 
to further their provision of public benefits. Many universities have 
entered into research partnerships with for-profit firms that look very 
much like business enterprises, and they also compete with professional 
sports for advertisers' and sports fans' dollars. Museums have expanded 
their gift shops, selling many items not related or only tangentially 
related to their tax-exempt mission that are readily available from 
for-profit firms. The Washington Post has had several articles in 
recent weeks that detail the commercial activity of a range of 
nonprofit entities.
    CBO's testimony concludes that taxing currently tax-exempt 
nonprofit organizations is not likely to level the competitive 
playingfield. The efforts of for-profit firms to avoid paying taxes are 
restrained by their need to deliver the surplus to shareholders. It is 
the absence of those shareholders that primarily determines a nonprofit 
organization's economic behavior: it is free to retain a surplus or 
dissipate it by lowering prices or increasing costs. A nonprofit's 
response to being taxed would be to shrink or eliminate the tax base by 
retaining less of its surplus. That surplus would instead be used to 
provide additional price reductions or to cover cost increases. If 
nonprofits used formerly retained surpluses to further reduce prices, 
competition with the for-profit firms might intensify in the short run. 
But over a longer period of time, those nonprofits' reduction in 
retained earnings might cause them to shrink.
    Ultimately, the key to competition from tax-exempt entities is the 
variety of state laws that determine an entity's ability to organize 
itself as a nonprofit organization--not federal tax policy. Once an 
entity is organized as a nonprofit, managers have greater latitude with 
the uses of its surplus. That latitude, by itself, provides a 
substantial ability to compete through lower prices. As I noted in my 
testimony, the additional exemption from Federal income taxes 
contributes to the overall surplus, but is not the primary source of a 
nonprofit entity's ability to compete via lower prices.
    I hope that you find this information useful. If you would like to 
discuss it, please call me at 226-2700 or Dennis Zimmerman at 226-2683.

                                 

    Mr. SHAW. [Presiding.] Thank you.
    Mr. Levin, you may inquire.
    Mr. LEVIN. Thank you for coming, all of you. I had the 
benefit of taking a taxation course from the very gifted 
professor, but I must say we did not spend very much time on 
this particular provision, this section, so I am not quite sure 
what is the purpose of this hearing except it does fill in some 
gaps of our legal education. So, let me just ask you, go down 
the row, and if you would, tell us what you think is the major 
problem in this section of the Code. I know you may not like to 
pick out one, but if you would do so. What do you think is the 
major issue or the major problem? Yes, Mr. Colombo?
    Mr. COLOMBO. Well, I can start with that. I think the major 
problem is the lack of a core rationale for tax-exemption for 
charitable entities and the detail about how that tax-exemption 
is conferred. I think that is very important because this is a 
significant and growing sector of our economy. There is more 
and more money going into charitable organizations and more and 
more money coming out of charitable organizations. That trend 
has accelerated over the past years and I think it is just 
going to accelerate further. So, we need to spend some time 
thinking about an area that is growing very rapidly and for 
which we don't have very good ideas about what the underlying 
rules are.
    Mr. LEVIN. Ms. Hill?
    Ms. HILL. I think the core problem in this area is that one 
of its very strengths, that the exempt sector is so dynamic and 
so malleable and so easy to enter is inviting abuse of the 
sector on all fronts and the IRS is incapable now at current 
funding levels, current expertise levels, and the current state 
of the law of stopping any of it. I simply want to express the 
hope that as Congress addresses it, we don't make this sector 
rigid and unable to function. The very creativity of it on all 
fronts is meaning that it is far beyond hospitals, it is far 
beyond universities, that charities are being used and abused 
for activities that have nothing to do with the provision of a 
public benefit. If you would like a more specific response in 
writing with detailed lists, I would be glad to do that for 
you, as well.
    Mr. LEVIN. Okay. You can talk more in your answer about the 
IRS, if you would.
    Mr. Walker.
    Mr. WALKER. If I had to pick one, I would say a lack of a 
set of criteria or a clear definition of what should be tax-
exempt and what should not.
    Mr. YIN. Mr. Levin, if you would define this area broadly, 
I would suggest three areas that would be worth looking at. 
Certainly one would be the one that Mr. McCrery was questioning 
on just a moment ago. More broadly, I think the issue of 
oversight and transparency in the exempt area, to what extent 
do we have a handle on what is going on. Then, as I said, if 
you take the term, this area broadly, I would include the 
charitable contribution area as another area that is worth 
looking at.
    Mr. LEVIN. Thank you. Dr. Holtz-Eakin?
    Mr. HOLTZ-EAKIN. With the caveat that this constitutes the 
sum total of my legal education in this area----
    [Laughter.]
    Mr. HOLTZ-EAKIN. --it sounds to me that one of the major 
things that is going on here is there is an attempt to apply a 
bright-line exemption to entities when it is, in fact, 
activities that are either public purpose or charitable in 
nature, and these entities have a great mixture of activities 
within them and it would be useful to distinguish between those 
two things.
    Mr. LEVIN. Yes, Mr. Cohen?
    Mr. COHEN. You will excuse my irreverence, but this is a 
perfect opportunity for my favorite quotation from Pogo. We 
have met the enemy and it is us. It is your lack of attention, 
our lack of attention. It is understanding that the Revenue 
Service's capacity is greater than it is. For example, Mr. Yin 
in good faith says we ought to have a five-year review of tax 
exemptions because people are abusing it and, therefore, we 
ought to look at it a second time. That is a wonderful idea, 
but we don't have the personnel to look at it the first time.
    Mr. LEVIN. I like your irreverence. Yes?
    Mr. HOPKINS. Mr. Levin, on page six and seven of my 
prepared statement, I have outlined in somewhat of a level of 
priority 12 areas that I would encourage the Committee to look 
at, and number one on the list, and you have heard this from at 
least two of the other witnesses, is create law spelling out 
the criteria for tax-exempt status. I think that seems to be a 
consistent theme that you have heard today. I will work in one 
more, which is the elements of the private inurement doctrine 
because the private inurement doctrine from a pure law point of 
view is the fundamental legal distinction between a nonprofit 
and a for-profit. Those two areas, I think you would find, 
would be very productive ones to look at very carefully.
    Mr. LEVIN. Thank you.
    Mr. SHAW. Mr. Camp, and I would like to announce that Mr. 
Walker is going to have to leave following Mr. Camp's 
questioning and he will be replaced by Mike Brostek of the 
government Accountability Office. Mr. Camp?
    Mr. CAMP. Thank you. I will direct my question, my first 
question, to Mr. Walker, then. Do you think if we have greater 
enforcement of our current law and better oversight by the IRS 
that most of the abuses within the tax-exempt sector could be 
eliminated?
    Mr. WALKER. I think you are going to need additional 
transparency and additional data sharing as a basis to have 
more targeted and more effective enforcement, as well as some 
supplemental intermediate sanctions to be made available to the 
IRS to provide more appropriate accountability mechanisms 
rather than merely pulling the tax-exempt status.
    Mr. CAMP. Is that the timing issue that Professor Hill 
talked about that you are referring to there, in terms of the 
enforcement?
    Mr. WALKER. I am not sure what----
    Mr. Camp. Intermediate sanctions. Well, you mentioned----
    Mr. WALKER. Well, that is, for example, in a prior life, I 
was Assistant Secretary of Labor for Pensions and Health, and 
there are tax-exempt entities that I had to deal with there, 
for example, 501(c)(9) VEBAs, Voluntary Employee Benefits 
Associations, also outside of 501(c), pension plans. It is 
very, very important that you have adequate transparency and 
intermediate sanctions other than pulling the tax-qualified 
status. There need to be sanctions that are there, that if 
people end up engaging in inappropriate or unacceptable 
activities, that you can bring to bear. For example, as is the 
case for foundations, I believe, you have prohibited 
transactions. If certain kinds of transactions occur between 
parties, then there can be excise taxes that can be imposed and 
sanctions that can be imposed on the violating individuals 
rather than necessarily the entity. That would be an example.
    Mr. CAMP. It is my understanding that since 1996, the IRS 
has had an intermediate sanctions available for--if there has 
been a situation where there has been private inurement. Is it 
your opinion that that has been ineffective, or perhaps I 
should direct that to Mr. Yin, if that is not in your field.
    Mr. WALKER. I will be happy to have him answer, but my 
understanding is that doesn't apply universally. It doesn't 
apply to all the 501(c) entities.
    Mr. CAMP. All right. Mr. Yin, do you want to clarify that?
    Mr. YIN. That is correct. It is likely directed at the 
501(c)(3)s and the public charities within that. The private 
foundations have a separate set of rules that are more 
stringent than the public charities.
    Mr. CAMP. What are the current restrictions and 
requirements on private foundations?
    Mr. YIN. On private foundations, the analog would be the 
self-dealing rules, and essentially, they prohibit any kind of 
transaction with an insider. In contrast to that, the 
intermediate sanctions would allow a transaction with an 
insider, but supposedly at arm's length rates and so forth. 
Obviously the inquiry in the intermediate sanctions area is 
much more difficult because there, you have to judge to what 
extent is the inside transaction at fair, arm's length rates as 
opposed to some kind of internal benefit going to the insider.
    Mr. CAMP. Aren't there also other requirements, like 
restrictions on holdings and----
    Mr. YIN. In the private foundation area, that is correct.
    Mr. CAMP. Yes.
    Mr. YIN. I thought you were just addressing on the 
intermediate sanctions point.
    Mr. CAMP. I would like to know what are some of the other 
requirements and restrictions on private foundations.
    Mr. YIN. Well, there are restrictions on requiring them to 
make certain amounts of distributions each year. There are 
restrictions on--on ownership, exactly right. There are also 
restrictions on excess benefit holdings. They can't hold too 
much interest in the business.
    Mr. CAMP. I would just like to comment briefly on your 
report, the options to improve compliance and reform tax 
expenditures, particularly with regard to conservation 
easements, your statement there. I just want to say that in 
Michigan, land conservation easements are becoming a really 
prominent way to preserve valuable land and shoreline. I just 
want to ensure that the highest standards are met in terms of 
land conservancies, obviously, as everyone else does, but I am 
afraid that the changes you suggest would make it virtually 
impossible for a landowner to take advantage of these 
provisions to, in effect, preserve their land forever, some of 
this incredibly beautiful land. So, I wonder, do you think 
stricter standards on appraisals and licensing for appraisals 
and increased penalties for overstated appraisals in this area 
might assist in this area?
    Mr. YIN. I think that is a step in the right direction. In 
fact, in the staff options, we do lay out some improvements in 
the appraiser and the appraisal process. However, it would seem 
that that is just a small step in terms of addressing the 
underlying difficulty. The underlying difficulty is that for a 
variety of reasons, easements are unusually difficult to 
determine what the appropriate value is. It is just a partial 
interest in the property. It is a property interest which is 
crafted by the donor and, therefore, may have few, if any, 
comparables. Then, at least in certain circumstances, perhaps 
not the ones that you are describing, there are State and local 
restrictions on the use of property already in existence and, 
therefore, that would need to be taken into account in figure 
out what the appropriate value of the easement right is. 
Because of the difficulty of the value, it becomes a very 
difficult both compliance problem for the donor and a very 
difficult enforcement problem for the Internal Revenue Service. 
If you put all of the change, if you will, into the appraisal 
process, it really doesn't address the underlying issue, which 
is that it is very difficult at the outset to figure out what 
circumstances should be examined at all.
    Mr. CAMP. Thank you, Mr. Chairman. I see my time has 
expired.
    Mr. SHAW. Mr. Cardin?
    Mr. CARDIN. Thank you, Mr. Chairman. Let me thank all of 
our witnesses for their testimony. It is clear to me in hearing 
your testimony and looking at the material that has been 
submitted that the issue of oversight and compliance needs some 
attention.
    Mr. Camp talked about, and Mr. Walker responded by perhaps 
the sanctions are not as broad or as much discretion to IRS as 
is needed in order to bring about more compliance with 
Congressional intent. There is a question as to whether we have 
enough exams. With the exam rates as low as they are, why would 
there be much concern about even the sanction authority of the 
IRS if the chances of sanctions being used are so minimal, 
considering the number of exams? There is also the question of 
political will, whether there really is a will of our Nation to 
be more stringent on tax-exempt organizations. Then there is 
the whole evolution of section 501. It has developed over a 
long period of time, as you all have pointed out, and it is not 
100 percent clear as to what the expectations are for tax-
exempt entities. So, do we need Congressional clarification? 
Let me start with Mr. Cohen, because he is a former 
Commissioner, and try to get his reaction as to how you would 
suggest we get a handle on appropriate oversight and compliance 
as to the role of the IRS and Congress as to trying to give 
fair notice to the taxpayers, but also to develop consistent 
oversight and compliance strategy on behalf of our Nation.
    Mr. COHEN. I was fortunate, or unlucky, as the case may be, 
to be the object of Congressional inquiry by Mr. Patman, who 
ran several years of hearings, vigorous hearings, on tax-
exemptions, which led to much of the 1969 Act that restricted 
them. So, I paid a lot of attention. He caught me. He had my 
attention. I have to say to you, but for that, it would have 
been a backorder. Before I came to the Revenue Service the 
second time as Commissioner in 1965, it was a backorder, and 
that is why he was taking on some fairly obvious problems. You 
had some Members of this Committee during the late 19seventies 
period that got involved in it again, but again, it has been an 
area that not much attention certainly by the full Committee 
and very little by the Oversight Committee. You just don't 
spend the time. Therefore, it is not number one for the top 
people down at 12th Street who mind this operation. Yes, in an 
ideal world, everybody would be paying attention to everything, 
but we know that is not the way the world works. The world 
works, what is important today is what is important to you 
folks.
    Mr. Mr. CARDIN. Mr. Cohen, let me just interrupt you for a 
moment. Our Tax Code depends upon voluntary compliance. We 
depend upon--that is the hallmark of the American Tax Code. Is 
this a satisfactory situation? Are we overreacting? Do we have 
enough voluntary compliance? Maybe we have the right policy 
today.
    Mr. COHEN. We have just seen the Commissioner's new 
research study, and we have not had a research study since 
1988, so we have had the first report of that. It shows a tax 
gap in the order of 15.5 to 16 percent. That is about 11 or 12 
percent higher than it was the last time we did it about 11 or 
12 years ago. So, surely, it is slipping. It is slipping, and 
you can almost look at the numbers. As you see the audit levels 
fall, you see compliance levels fall. People react to not 
seeing the cop on the beat, in the city parlance. So, yes, we 
need more compliance effort. The money is well spent. The 
Commissioner generally has a rule that he won't ask for a 
dollar unless he can bring in large multiples of that. Indeed, 
the problem is that as you cut the Commissioner's budget and 
personnel--personnel went from close to 120,000 down to about 
95,000, between 95,000 and 100,000--you find that the 
Commissioner--the first thing that is cut is not proportional. 
It is compliance, because that is the only optional money he 
has. He has to produce returns. He has to process returns. He 
has to collect money. There are a number of functions that he 
has to do, and so he has no leeway there. He can audit more 
returns or less returns. He can audit the returns more 
intensively or less intensively. Of course, what happens is he 
slips off. You do some audits, but you do them less intensively 
and therefore they are less effective. You and I react to the 
fact that our neighbor is being audited. If a neighbor is being 
audited and talks about it, he talks about it, it has an effect 
on all of our behavior. It is like driving down a major 
superhighway. If we don't see a traffic policeman, we tend to 
go five or ten miles an hour above the limit. If we see a 
traffic policeman, we go two miles above the limit. We all 
chisel a little bit. Therefore, we need to see that audit to 
have an effect on our behavior. Now, we are not seeing it, so--
--
    Mr. Mr. CARDIN. I agree with that comment and I appreciate 
your response. Thank you, Mr. Chairman.
    Mr. SHAW. Thank you, Mr. Cardin. Mr. Herger?
    Mr. HERGER. Thank you, Mr. Chairman. Mr. Yin, recently, the 
Joint Committee on Taxation made a number of recommendations to 
improve tax compliance, one of which would restrict the use of 
conservation easements. I welcome this proposal and I believe 
this is an area the Committee should focus attention on because 
there has been a large amount of evidence that taxpayers are 
taking inappropriate deductions related to conservation 
easements. Consider a Washington Post article from December of 
2003 which quotes a Florida business consultant as advising his 
clients to purchase golf courses and prohibit building on the 
fairways as a way in which to reap large tax benefits. He 
refers to one investor who paid $2.4 million for a golf course 
and received a $4.8 million tax deduction. This taxpayer 
received a tax deduction worth twice what he paid for the 
property. This article also mentions luxury homebuilders in 
North Carolina who paid $10 million for a tract in the 
mountains, developed a third of the land, and then claimed a 
$20 million deduction. Evidence suggests these are not isolated 
incidents. Perhaps this is not surprising, given the easements 
are today held by various government agencies, national 
environmental groups such as the Nature Conservancy, and 
according to the Post article, about 1,260 local trusts. Mr. 
Yin, my understanding is that your proposal would eliminate 
charitable tax deductions relating to conservation easements on 
personal residence and would limit the deductions related to 
other properties. This proposal is scored as raising $1 billion 
over 10 years, not an unsubstantial amount of money. My 
question is simply this. Do we know how much fraud in dollar 
terms currently exists with respect to conservation easements? 
Two, does the Joint Tax Committee proposal go far enough to 
eliminate the potential for fraud relating to golf courses and 
other types of investments similar to what I mentioned earlier? 
If not, what more can be done to ensure that the Federal 
government, through the charitable deduction allowed for 
conservation easements, is not subsidizing large amounts of tax 
fraud?
    Mr. YIN. Thank you, Mr. Herger. Obviously, it is very 
difficult to provide estimates of fraud because fraud involves 
a particular intention on the part of the taxpayer which would 
have to be judged on a very highly factual determination. I 
think that it is fair to say, however, that the IRS recently in 
connection with the hearing over on the Senate side published 
their letter which indicated the top areas of compliance 
difficulty in the EO area, and one of the areas that they 
clearly identified was the difficulty that they have in 
enforcing the laws relating to easements. Now, how much of that 
is fraud as opposed to simply overvaluation but not rising to 
the level of fraud, I don't know if they know. I don't believe 
we know, either. In terms of whether the Joint Committee 
proposal goes far enough, obviously, that is going to be your 
judgment and the Committee's judgment on those sorts of issues. 
We did try to offer a balanced approach. I am comfortable 
with--I am personally comfortable with the proposal as it is 
offered, but obviously, that is not my judgment. It is going to 
be your judgment.
    Mr. HERGER. Thank you very much, Mr. Yin. I think we can 
see enough and enough has been pointed out again through the 
media, through yourselves, through these hearings, to indicate 
that perhaps we are just beginning to see the tip of the 
iceberg here. We all want to see legitimate deductions made, 
but we are also very concerned about what is perceived as--even 
if it may be within the law today, those exemptions that are 
being made that clearly, I think, in most of our judgments are 
not ethical, are not fair and not proper, and I would certainly 
like to urge your continued involvement in this and I thank 
you.
    Mr. SHAW. Mr. Johnson?
    Mr. JOHNSON OF TEXAS. Thank you, Mr. Chairman. I wonder if 
Mr. Holtz-Eakin and Mr. Brostek could talk about this subject. 
Almost 10 years ago, Congress put the immediate sanctions rules 
into place that allow the IRS to punish tax-exempt entities 
that break the private inurement rules. I would like to know 
whether this type of sanction has been effective and whether 
incremental change like this might serve as a model for reform 
of the tax-exempt laws by this Committee.
    Mr. HOLTZ-EAKIN. I could go first and hand it to Mr. Yin, 
who I think knows a lot more about this than I do.
    Mr. JOHNSON OF TEXAS. Okay.
    Mr. YIN. Mr. Johnson, of course, as you do indicate, the 
law, though it has been in effect for 10 years, it is still--on 
the larger scheme of things, that is a relatively short period 
of time, so our experience is still somewhat limited. In the 
report that Mr. Camp referenced, the late January report by the 
Joint Committee staff, we did provide some options to improve 
the intermediate sanctions rules in areas where we felt that 
they did seem to be a little bit on the lax side. We put in 
some suggestions on modifying the initial contract exception 
and also on the rebuttable presumption of reasonableness. Now, 
these are relatively small changes in the procedure of how the 
rules would work. I think we are not really yet in a position 
of being able to give you guidance that they are completely 
ineffective or completely effective, and so it is a little bit 
early to make that----
    Mr. JOHNSON OF TEXAS. Well, has the number of violators 
increased or decreased?
    Mr. YIN. Well, in terms of the number of violators, of 
course, prior to the law, there wasn't a rule against it as 
such. That is that--well, I take that back. The prohibition or 
the penalty was to lose your tax exemption, and because that is 
such a draconian outcome, that was rarely imposed and so it is 
difficult to know, as comparison to what prior behavior is, 
whether the current behavior is improved. Again, I would 
suspect that, in time, we will get a better handle on how it is 
working.
    Mr. JOHNSON OF TEXAS. Yes, sir?
    Mr. BROSTEK. I think the point that Mr. Yin is making is an 
important one. IRS can apply those sanctions when it knows 
there is a problem that needs to be corrected. One of the 
things that IRS itself admits is that it doesn't have enough 
information to know the various kind of noncompliance that are 
occurring out there. They are trying to improve the Form 990 
that gives them some of that type of information, but that will 
need to be married up with greater transparency so the news 
media and the public can help keep an eye on the entire 
universe, and probably with some improved governing standards 
to help ensure that within an organization, there is a check 
and balance to ensure that this kind of abuse doesn't occur.
    Mr. JOHNSON OF TEXAS. Transparency, you have all mentioned 
that. It needs to be fixed. Let me ask one other question. I 
brought up Medicare and Medicaid earlier. It seems to me that 
there is plenty of appropriations from public funds for all 
sorts of health care providers for helping the poor and the 
elderly and it seems to me the absence of clear standards for 
the community benefit provided for not-for-profit hospitals may 
be a problem. In Texas, for example, we require a set 
percentage for charity care--I think it is four or 5 percent--
and unreimbursed Medicaid costs in order to claim 501 status. 
It seems to me a step in the right direction, and I might add 
that hospitals in our district go way above that. A larger 
concern, though, is that standards, once they have been met, 
may breed a feeling of, we have crossed the line. We don't owe 
anything else to anybody. The problem is complicated further 
when one considers that some for-profit hospitals offer a 
notable amount of charitable unreimbursed care. Do you have any 
suggestions on ways to encourage a more equitable charitable 
care across the board? I guess that is for GAO or CBO, as well, 
or all of you, if you have a comment.
    Mr. BROSTEK. Well, we don't have a position at this time on 
that. We haven't looked at it.
    Mr. HOLTZ-EAKIN. I think it is certainly the case that if 
you look back, and I think Mr. Cohen would know the history 
better than anyone on this, the notion of what constitutes 
charity was heavily influenced by the existence of Medicare and 
Medicaid and perhaps a false optimism that poverty would not be 
a problem in the presence of these programs. So, if one would 
like to come back and come up with a clearer standard of 
performance, you would have to probably not leave it in the 
hands of an administrative decision but actually have the 
Congress develop a standard that they felt was appropriate.
    Mr. JOHNSON OF TEXAS. Thank you.
    Mr. COHEN. I was at the meeting, the cabinet meeting at 
which the President decided to go for Medicare. It was 
accidental. I was there to report on something else. I was also 
Commissioner of Internal Revenue at the time that Medicare 
began to pay out, and it led the Revenue Service to that 1969 
ruling. That is, if Medicare was going to pay a good piece of 
what used to be charity, then how are you going to deal with 
the hospital system and how are we going to deal with health 
care? The availability of health care is a public good, and 
that is what we had to deal with.
    Mr. SHAW. I am going to have to cut that off. Mr. Pomeroy, 
then Mr. Beauprez. Mr. Pomeroy is going to share the time with 
Mr. Thompson and then we are going to wind this hearing up 
before this vote.
    Mr. POMEROY. Thank you, Mr. Chairman. I will be very brief. 
It seems to me that this hearing, which has been extremely 
interesting, has highlighted basically two separate facets of 
this question. One is the very confused state of the Tax Code, 
which allows nonprofit status or tax-exempt status to be 
achieved through any number of ways. Second, the whole 
enforcement question, eyeballing whether or not those that have 
qualified are actually appropriately conducting themselves for 
purposes of maintaining that qualification. To that end, I 
would like to speak of while this Committee grinds along on the 
question of who has got this exemption and why, that is a long-
term proposition that is going to be tough sledding. I would 
hope that we don't get distracted and not proceed on the 
enforcement question, which we can do something about very 
quickly through, among other things, resource commitment to the 
IRS and some clarity in terms of directing them to take this 
action. To that end, and underscoring the importance of taking 
that action, a couple of issues, items in the recent press I 
would like to put into the record, yesterday's Financial Times, 
as well as a story from the Business section of Sunday's 
Washington Post, both detailing abuses in trusts in this area. 
Specifically quoting from the Financial Times article, 
``Foundation directors and donors have come under fire for 
excessive pay, insider dealing, alleged conflict of interest 
between their foundations and their private business dealings, 
as well as outright tax fraud.'' Then on the Washington Post 
story, it is detailing how the founder of AmeriDebt, the 
bankrupt Maryland credit counseling firm, took $70 million from 
its operation between 1999 and 2003. I think this makes a 
compelling case for why we need to help the IRS with its 
enforcement activity. We need to raise their budget relative to 
being able to completely audit this activity, and especially in 
wake of passing the bankruptcy bill, we have got to, in the 
Oversight Subcommittee, really bear down on nonprofits----
    Mr. SHAW. Without objection, the documents are placed in 
the record.
    [The information follows:]
April 16, 2005 Saturday
FTC Moves to Freeze Assets; AmeriDebt Founder Transferred Money to 
        Offshore Trusts, Agency Says
Caroline E. Mayer, Washington Post Staff Writer
    The founder of AmeriDebt Inc., the now bankrupt Maryland credit-
counseling firm, took $70 million from its operations between 1999 and 
2003 and spent lavishly on his wife, girlfriend and himself, including 
paying $179,000 to an interior decorator, $13,500 to a yachting company 
and $2,500 on a restaurant tab.
    That's what the Federal Trade Commission said in court papers as it 
sought to freeze the assets of Andris Pukke. A hearing on the matter 
was held yesterday in Federal court in Greenbelt. Those assets included 
$18.3 million transferred to domestic and offshore trusts, and $2 
million sent to an account in Latvia for his father, the agency said.
    In 2003, the FTC sued Pukke, his wife, the nonprofit AmeriDebt, and 
DebtWorks Inc., the for-profit private firm Pukke set up to process 
AmeriDebt customer accounts. The suit alleged that the Pukkes and their 
companies deceived financially struggling consumers seeking help with 
their debts by charging high fees--hiding them by calling them 
voluntary contributions. They operated falsely as a nonprofit 
organization while siphoning off money through DebtWorks to make money 
for the Pukkes, the suit said.
    A recent filing in a related class-action lawsuit alleged that 
Pukke and his girlfriend traveled to Tahiti, Bora Bora, San Tropez, Las 
Vegas, Aspen, the Cayman Islands and Cabo San Lucas, that he gave her a 
new Mercedes, and that he spent $15,000 for a mattress and $8,000 for 
sheets for his Malibu mansion. He sold a Miami Beach home for $7 
million, that suit said.
    AmeriDebt, based in Germantown, was once one of the nation's 
largest and most aggressively marketed debt-management firms, 
advertising heavily on cable TV and the Internet. Also the target of 
several lawsuits by state attorneys general, AmeriDebt is now bankrupt 
and its accounts have been taken over by a third-party firm.
    AmeriDebt is one of more than 50 nonprofit credit counseling firms 
under investigation by the Internal Revenue Service for misusing their 
tax-exempt status for the benefit of their operators. There is little 
Federal regulation of the firms. The bankruptcy bill that passed 
Congress this week contains a provision that requires debtors to seek 
debt counseling before filing for bankruptcy protection.
    Last month, the FTC settled its lawsuits with AmeriDebt, but its 
case against Pukke and his wife continues, with the agency seeking $170 
million in consumer refunds.
    ``An individual profiting $70 million on a fraudulent promotion is 
certainly among the largest we have seen,'' said Joel Winston, the 
agency's associate director for financial practices. ``The question is 
where did it go? We're trying to freeze whatever money and property he 
has, seek repatriation of the money he has put overseas and have a 
receiver appointed by the court to audit his affairs and determine 
where all of his money and assets are.''
    John B. Williams, Pukke's attorney, did not return phone calls. 
Previously he has said that evidence shows that AmeriDebt benefits to 
all consumers far surpassed the $170 million that consumers paid the 
credit-counseling firm because it was able to reduce interest rates and 
get rid of late fees and interest charges for many of its customers.
    In court papers opposing the freeze, Pukke's lawyers said the FTC 
and the class-action plaintiffs have failed to prove consumers were 
injured.
    The monetary transfers, the papers added, occurred in the past 
``when Mr. Pukke was in much better financial condition. Mr. Pukke now 
has limited assets and all of his available income goes to the IRS, Mr. 
Pukke's wife pursuant to court orders in a pending divorce case, and 
personal living expenses which are not extravagant.''
    In depositions with the FTC, Pukke invoked his Fifth amendment 
privilege, the agency said.
    U.S. District Judge Peter J. Messitte said he would rule next week 
on the request to freeze his assets.
    According to the FTC filing, ``Mr. Pukke has dissipated assets'' by 
transferring money to the trusts, close friends and relatives and by a 
``lavish lifestyle.'' The commission said that DebtWorks transferred 
$200,000 to Pukke's girlfriend although she never worked at DebtWorks. 
The girlfriend also used a DebtWorks credit card to pay $215,000 in 
charges, including a $1,688 bill at a clothing store and a $2,165 
three-night stay at the Viceroy Hotel in Santa Monica, the lawsuit 
said.
    Pukke's wife received $250,000 from DebtWorks although she never 
worked for the firm, either, the FTC said, and another $150,000 through 
the company's credit card.
    The agency said that Pukke established the domestic and offshore 
trusts, including one in Nevis and another on Cook Islands in 2002, 
shortly after the FTC notified AmeriDebt and DebtWorks that they were 
under investigation. ``Clearly,'' the agency said in legal papers, 
``Mr. Pukke created these trusts in an effort to put his assets out of 
reach of the FTC and other creditors.'' As of June 2004, the trusts 
were valued at $18.3 million.
    The class-action lawsuit said Pukke ``has hardly been skimping on 
his domestic lifestyle. . . . His primary residence cost him $27,906 
per month, including over $24,500 for mortgage, property taxes and 
utilities and $1,400 for domestic help. This pales in comparison to the 
monthly cost of operating his secondary home, which is $84,699.''
    In July 2004, the lawsuit said, Pukke spent $8,119 for dining and 
$6,583 for travel. His monthly car payment was $10,653. With other 
personal and professional expenses and taxes of $75,000, Pukke claims 
to spend more than $390,000 a month, it said.
    In opposing a motion by the class-action lawyers to appoint a 
receiver, Pukke lawyers argued that the plaintiffs were citing old 
spending habits and were not likely to succeed on the merits of the 
claim.

                                 

    Mr. POMEROY. We have to bear down on these nonprofits. I 
would like to finish my thought. We have to bear down on these 
nonprofits that are providing credit card counseling and debt 
counseling. I believe it is principally a scam and we need to 
get to the bottom of it. I yield the balance of my time to Mike 
Thompson.
    Mr. THOMPSON. Thank you, Mr. Pomeroy. I want to align 
myself with Mr. Camp. I believe that conservation easements are 
critically important for protecting literally thousands of 
acres throughout my district, in my district for critical 
wildlife habitats, salmon and steelhead restoration. It is 
responsible for clean air and clean water. At the same time, 
Mr. Herger raised some valid issues. We need to make sure these 
are legitimate procedures done by the right reasons and it is 
something that benefits more than just the person making the 
donation. Mr. Yin, you have commented on numerous occasions now 
on these changes that I believe if they were taken at face 
value would do irreparable harm to the whole idea of 
conservation easements. So, I would like to ask that you do, 
and if you have already done it, let me know, but do some more 
work in this regard to see if we can't associate a value to the 
good conservation easements done by the legitimate 
contributors. These in many instances save governments a lot of 
money. They don't just protect valuable, important properties. 
So, before we rush into any reform in this regard, I haven't 
seen anything other than anecdotal references to problems, so I 
would encourage you to do and provide an analysis to this 
Committee that looks at both the potential problems, but the 
very specific values that these bring to the table.
    Chairman THOMAS. [Presiding.] The gentleman from Colorado.
    Mr. BEAUPREZ. Thank you, Mr. Chairman. I will be very quick 
and very direct. Mr. Colombo, many have talked about your 
comments, as well as many of the others on the panel, about the 
need to define what is a charitable contribution, what 
qualifies as a tax-exempt organization. I found your rather 
straightforward definition to be pretty useful, that an 
organization ought to be able to survive primarily on 
donations. Then it crossed my mind that any number of business 
entities out there that in a different environment we would 
call it profit margins, net income, might say that is the 
income that one who does business with that business entity 
provides so that it is sustainable. Does that fit your 
definition or not?
    Mr. COLOMBO. The Internal Revenue Service and the courts 
have developed pretty good tests about what constitutes a 
donation and what doesn't. The test is generally what we call a 
quid pro quo test, or the absence of a quid pro quo, and there 
is not any question that normal sales transactions don't fit 
that kind of model. So, I just don't see a problem, to tell you 
the truth. We pretty much know what a donation is. At the 
edges, we may get into a little bit of a problem, at the edges 
of what donations are, but mostly, we know what it is, and 
mostly, I know when we get one.
    Mr. BEAUPREZ. All right. Very quickly, type three 
supporting organizations. Mr. Yin, I am going to guess that you 
might be the one to opine on this. I know that they have come 
under intense scrutiny, especially in the other body, recently. 
There has been some concern. From personal experience back home 
in my own State, I know community foundations, private family 
foundations seem to do an enormous amount of good, as well. Is 
the abuse so rampant that we maybe are tempted to throw the 
baby out with the bathwater, or is what we really need, as has 
also been suggested here, more oversight and more 
accountability, more transparency?
    Mr. YIN. Well, Mr. Beauprez, as you know, supporting 
organizations are granted public charity status as opposed to 
private foundation status and some have argued that they more 
closely resemble private foundations and should be more subject 
to those rules. The type three that you referred to are 
specifically the ones that have drawn the most attention 
because they are least under the control, if you will, of the 
organization that is being supported, and therefore least 
subject to the same level of scrutiny that the charitable 
organization which is being supported is normally subject to. 
So, that is the reason why that is an area that has drawn some 
attention recently.
    Mr. BEAUPREZ. The solution would be, in your opinion?
    Mr. YIN. Well, there are a variety of solutions. Obviously, 
you would first have to determine there is a problem 
sufficiently great enough to deserve a solution. Assuming that 
you did, there would be a variety of solutions, one of which 
would be to permit support organizations of type one and type 
two but to not permit the type three.
    Mr. BEAUPREZ. I thank the entire panel very much and am 
sorry we have to rush.
    Chairman THOMAS. The Chair would also like to thank the 
panel. The Chair believes that perhaps the government witnesses 
might want to get with staff. I think it would be very helpful 
for Members if we prepare a glossary so that the terminology 
that is being used, they understand the meaning of as we move 
through these various structures. I want to thank the other 
panelists, and I hope that you aren't thankful that this is the 
only opportunity to assist the Committee, let me put it that 
way, because we are going to continue to examine the area, but 
we need to work on these fundamentals that we have talked about 
before we get excited and think we can fly in making judgments 
over real world events. So, I do want to thank you. The 
Committee owes you a debt of gratitude and we expect to use you 
more in the future. With that, the Committee stands adjourned.
    [Whereupon, at 1:15 p.m., the hearing was adjourned.]
    [Questions submitted from Representative Herger to George 
Yin, and his response follows:]

              Question Submitted by Representative Herger

    Question: Mr. Yin, recently the Joint Committee on Taxation made a 
number of recommendations to improve tax compliance, one of which would 
restrict the use of conservation easements. I welcome this proposal and 
I believe this is an area the Committee should focus attention on 
because there has been a large amount of anecdotal evidence that 
taxpayers are taking inappropriate deductions related to conservation 
easements.
---------------------------------------------------------------------------
    \1\ Joint Committee on Taxation, Options to Improve: Tax Compliance 
and Reform Tax Expenditures (JCS02-05), January 27, 2005, at section 
VIII.F.
---------------------------------------------------------------------------
    Consider a Washington Post article from December of 2003, which 
quotes a Florida business consultant as advising his clients to 
purchase golf courses and prohibit building on the fairways as a way in 
which to reap large tax benefits. He refers to one investor who paid 
$2.4 million for a golf course and received a $4.8 million tax 
deduction. This taxpayer received a tax deduction worth twice what he 
paid for the property! This article also mentions luxury-homebuilders 
in North Carolina who paid $10 million for a tract in the mountains, 
developed a third of the land, and then claimed a $20 million 
deduction.
    Evidence suggests these are not isolated incidents. Perhaps this is 
not surprising, given that easements are today held by various 
government agencies, national environmental groups--such as the Nature 
Conservancy--and, according to the Post article, about 1,260 local land 
trusts.
    Mr. Yin, my understanding is that your proposal would eliminate 
charitable tax deductions relating to conservation easements on 
personal residences and would limit the deductions related to other 
property. This proposal is scored as raising $1 billion dollars over 10 
years, not an insubstantial amount of money. My question is simply 
this: Do we know how much fraud, in dollar terms, currently exists with 
respect to conservation easements?
    Does the Joint Tax Committee's proposal go far enough to eliminate 
the potential for fraud relating to golf courses and other types of 
investments similar to what I mentioned earlier? And, if not, what more 
can be done to ensure that the Federal government, through the 
charitable deduction allowed for conservation easements, is not 
subsidizing large amounts of tax fraud?
Response:
Dear Mr. Herger:
    This letter responds to your written request made in connection 
with a hearing of the House Committee on Ways and Means regarding 
charities and other tax-exempt organizations held on April 20, 2005. 
You asked: (1) whether it is known how much fraud, in dollar terms, 
currently exists with respect to conservation easements; and (2) 
whether the recent proposal of the staff of the Joint Committee on 
Taxation to limit the deductibility of certain contributions of. 
conservation easements (the ``easement proposal'') is sufficient to 
eliminate fraud relating to golf course easements and other abusive 
easement donations, and what more could be done to eliminate such 
fraud. You also asked these questions orally at the hearing.
    The easement proposal was contained in a report that we prepared in 
response to a request from Senate Finance Committee Chairman Grassley 
and Ranking Member Baucus. The report contains options to improve lax 
compliance and reform tax expenditures in almost all areas of the 
Federal tax law. One of these options relates to the charitable 
contribution of easements. As explained in the report, the charitable 
contribution deduction for easements is an exception to the general 
rule that prohibits a charitable deduction for a contribution of a 
partial interest in property. This exception was enacted generally to 
encourage landowners to contribute property rights to a qualified 
organization in order to protect such rights in perpetuity for 
conservation purposes.
    The report makes a number of observations about the contribution of 
easements and concludes that noncompliance concerns warrant 
consideration of curtailing the tax benefits provided with respect to 
such connibutions.\2\ In particular, the easement proposal notes that 
the proper amount of the charitable contribution deduction is difficult 
to determine because the valuation of the easement right being 
contributed is often highly speculative. For example, there is 
generally no ready market for such easements, the terms of which may 
vary from donor to donor, and no available data regarding comparable 
sales. This situation makes enforcement of the law very problematic, as 
the mere identification of potential overvaluations may require 
considerable administrative expense such as the cost of appraisals. A 
serious challenge to a claimed deduction would entail a greater 
commitment of resources. The easement proposal also raises the concern 
that the current definition of ``qualified conservation contribution,'' 
which in most instances does not require that a contribution be 
pursuant to a clearly delineated governmental conservation policy, is 
not sufficient to ensure that conservation purposes are being served. 
We note further that the often difficult issues of valuation and 
assessment of the appropriate purpose of a contribution generally are 
even more difficult in the easement contribution context because the 
taxpayer retains an ongoing interest in the underlying property. To 
address these concerns, the easement proposal limits the extent of 
deductibility, modifies the definition of qualified conservation 
contribution, and imposes additional requirements on appraisers.
---------------------------------------------------------------------------
    \2\ IRS Commissioner Everson has identified overvalU8(ion of 
conservation easements as a top compliance concern of the IRS. See 
Lercel-fi ``om JRS Commissioner'' Mark W Everson to The Honorable 
Charles E. Grassley, March 30, 2005; Written Stateement of Mark W. 
Everson, Commissioner of Internal Revenue, Before the Committee 011 
Finance, United Stales Senate, Hearing on Exempt Organizations: 
Enforcement Problems, Accomplishments, and Future Direction, April 5, 
2005.
---------------------------------------------------------------------------
    Regarding your first question, as discussed above, a primary 
compliance concern addressed by the easement proposal is overvaluation. 
An easement may be overvalued as a result of fraudulent intent on the 
part of the donor or because of more innocent reasons. In addition, an 
easement may be overvalued even if the easement serves a legitimate 
conservation purpose. The easement proposal is intended to reduce 
claimed overvaluations for purposes of the charitable deduction 
regardless of the reason or circumstances of the overvaluation. As a 
practical matter, even with a detailed review of taxpayer returns 
showing information regarding easements, we would be unable to 
determine whether an easement serves legitimate conservation purposes, 
or whether the contribution results from fraudulent intent on the part 
of the donor, without making an independent assessment of the 
circumstances surrounding each contribution. As a result, we are unable 
to determine the amount of fraud, in dollar terms, that exists with 
respect to conservation easements. However, because we are concerned 
that the current definition of conservation purpose is not adequate to 
address noncompliance, the easement proposal suggests, among other 
things, that the requirement that the conservation contribution serve 
clearly delineated governmental conservation policy -- currently 
applicable only 10 a limited class of conservation contributions--be 
extended to all forms of conservation contributions. The intent is that 
such a change in the law would improve the integrity of the tax system 
by providing tax incentives only for donations that serve identified 
conservation or preservati on purposes.
    With regard to your second question, the easement proposal to curb 
noncompliance in easement donations in a number of ways. Your request 
gives two specific examples of potentially abusive conservation 
easement donations: (1) golf Oillse easements; and (2) easements placed 
on a parcel of land to be developed by a builder of luxury homes. Such 
examples raise questions about the legitimacy of the conservation 
purpose purportedly served by the easement donation and the accuracy of 
the claimed value of the easement. The easement proposal was designed 
to address each of these concerns. For most conservation easements, the 
easement proposal seeks to ensure that a legitimate conservation 
purpose is served by requiring a showing that an easement donation is 
pursuant to a clearly delineated governmental conservation policy--a 
showing that may be particularly difficult to make, for example, in the 
case of a golf course easement. In the absence of such a showing, no 
deduction would be allowed. In addition, even where a clearly 
delineated governmental conservation policy purportedly exists, the 
easement proposal would address the overvaluation of easements of the 
type you describe by: (1) denying a deduction where the property has 
been used or is reasonably expected to be used as a personal residence; 
(2) denying a deduction for 67 percent of the appraised value of a 
conservation easement where the property has not been used and is not 
reasonably expected to be used as a personal residence; and (3) 
imposing additional requirements on appraisers who value such 
easements. In short, we believe that the easement proposal would limit 
significantly noncompliance in connection with easement donations, 
particularly noncompliance involving the valuation of easements.
    I hope this information is helpful to you. If we can be of further 
assistance in this matter, please let me know.
                                 ______
                                 
    [Submissions for the record follow:]
              Statement of of America's Community Bankers
    America's Community Bankers (``ACB'') \1\ is pleased to submit this 
written statement in connection with the Committee's hearing on ``An 
Overview of the Tax-Exempt Sector.'' ACB commends the Chairman for 
calling this important hearing to examine tax-exempt entities. 
Providing tax-exempt status to charitable, educational and other non-
profit organizations can further important societal goals, but not in 
every instance.
---------------------------------------------------------------------------
    \1\ America's Community Bankers is the member driven national trade 
association representing community banks that pursue progressive, 
entrepreneurial and service-oriented strategies to benefit their 
customers and communities. To learn more about ACB, visit 
www.AmericasCommunityBankers.com.
---------------------------------------------------------------------------
    Congress and the American taxpayers deserve to know whether the 
substantial tax benefits that have been granted under section 501(c) of 
the Internal Revenue Code are being used for the purposes intended by 
Congress and whether these benefits are being abused in ways that harm 
organizations and people that do pay federal income tax. ACB believes 
that it is also important for the Committee to examine whether the 
rationale used for granting specific tax exemptions continues to be 
valid.
ACB Position
    ACB strongly believes that the rationale for the tax-exempt status 
of complex credit unions is no longer valid and gives credit unions an 
unfair government-created competitive advantage that harms community 
banks that compete against them. The strength of our economy is built 
on free and fair competition. However, the free market is frustrated by 
those credit unions that compete head-to-head with taxpaying community 
banks, particularly those banks and savings associations that are 
mutual in form.
    We believe that the original policy rationale for granting credit 
unions tax-exempt status is no longer valid, particularly with regard 
to large, complex credit unions that are indistinguishable from 
taxpaying banks and savings associations. Approximately 100 credit 
unions have assets of $1 billion or more. At the same time, there are 
8,378 banks and thrifts that have assets of less than $1 billion. Small 
community banks are competing against billion-dollar credit unions that 
are full-service financial service providers that compete in all 
aspects of the financial services market. Because of the tax-subsidy, 
these credit unions are able to grow faster than the community banks 
with which they directly compete.
    The credit union tax exemption means that credit unions have a 40 
percent price advantage over taxpaying banks and savings associations. 
According to the Congressional Budget Office (``CBO''), between 2006 
and 2015, the credit union tax exemption will cost the federal 
government a cumulative total of $15.2 billion. The CBO said on this 
issue, ``With their current tax advantage, credit unions can use their 
retained earnings to expand and thus displace the services of other 
thrift institutions--even though the latter may provide those services 
more efficiently.'' Furthermore, the median American family pays $4,038 
in federal income tax, while the entire $662 billion credit union 
industry pays $0. Credit unions should not be permitted to be full-
service financial services providers at the expense of tax-paying 
depository institutions and the American taxpayer.\2\
---------------------------------------------------------------------------
    \2\ Special Report No. 119, The Tax Foundation.
---------------------------------------------------------------------------
Credit Unions Are Not The Only Cooperatively Owned Financial 
        Institutions.
    Many cooperative banks, savings associations, and savings banks are 
cooperatively owned--just like credit unions. Mutual savings 
institutions do not have shareholders. Their profits are reinvested in 
the institution, returned to members in the form of higher rates on 
deposits or lower rates on loans, or given to the community.
    Mutual institutions have existed in this country for more than 100 
years, well before credit unions. Mutual banks and associations lost 
their tax exemption in 1952, when Congress determined that they had 
reached a sufficient degree of maturity, were very ``bank-like,'' and 
competed with other taxpaying financial service providers. At that 
time, mutual banks and associations could not even offer checking 
accounts, much less business loans. Yet, many of today's credit unions 
look more like commercial banks than the mutuals of 53 years ago--
offering share draft accounts (checking) and small business loans.
    Contrary to credit union industry statements forecasting that 
taxation will lead to their untimely demise, mutual savings 
institutions have not collapsed under taxation. Despite the revocation 
of their tax exemption in 1952, mutual savings institutions continue to 
experience growth. Last year, the nearly 700 mutual savings 
institutions (from the smallest with $20 million in assets to the 
largest with $8 billion in assets) paid nearly $900 million in 
corporate taxes. By contrast, the credit union industry, which has over 
2.5 times as many assets as the mutual institutions, paid $0. Just as 
Congress determined that the safety and soundness argument was not 
persuasive in the context of expanding the tax on mutual savings 
institutions decades ago, the assertion that today's credit unions 
cannot withstand taxation should also be rejected. And, as Congress 
concluded in 1952 about mutual institutions, complex credit unions have 
matured to be ``bank-like.''
Credit Unions Are Not Fulfilling Their Mandate to Serve Persons of 
        Modest Means.
    Congress chartered credit unions in 1934 to serve persons of modest 
means. In return, credit unions were exempted from taxation. However, 
an October 2003 General Accounting Office (``GAO'') report indicates 
``that credit unions served a slightly lower proportion of low- and 
moderate-income households than banks.'' Similarly, a 1991 GAO report 
found ``no evidence that today's credit union members are for the most 
part of small means.''
    Further, the credit union industry has vehemently opposed efforts 
to require credit unions to engage in special efforts to serve low-
income customers or neighborhoods like banks and savings institutions. 
In fact, in a March 30, 2005 editorial the Credit Union Times, by Mike 
Welch, stated: ``ACB apparently thinks credits unions' first obligation 
is to serve communities in which they operate. Wrong. CUs' number one 
obligation is to serve the changing financial needs of the members who 
own it. Of course, the community will also be served as a by-product.'' 
The comment is self-serving and ignores the substantial federal safety 
net provided to credit unions through the National Credit Union Share 
Insurance Fund, in addition to the substantial tax subsidy under 
discussion today. This would be like a bank saying that serving 
shareholders is sufficient and serving the bank's community is a mere 
afterthought. Credit unions' not-for-profit status is no excuse for an 
exemption from community reinvestment responsibilities. Banks and 
savings institutions have Community Reinvestment Act responsibilities 
regardless of whether they make a profit.
Sophisticated Credit Unions Hide Behind the Small Credit Union Image.
    Over the years, two distinct credit union industries have emerged. 
The first adheres to its statutory mission. The other hides behind the 
small credit union image to preserve its federal tax exemption. Even 
the National Credit Union Administration recognizes that the expansion 
that it has allowed to occur within the credit union industry now makes 
many credit unions indistinguishable from banks and savings 
associations. At a November 18, 2004 NCUA Board meeting, Board Member 
Deborah Matz observed that many legislators consider small credit 
unions to be the symbol of all credit unions. As a result, she 
reasoned, it is important to preserve small credit unions so that the 
entire credit union industry will not be taxed.
    We see no value in subsidizing credit union conglomerates that 
offer diverse, high-end financial products and services to the general 
public. It is a common misperception that credit unions offer only 
basic banking services to local hospital employees, schoolteachers, and 
government workers. In reality, many credit unions have evolved into 
complex financial institutions that do not have meaningful membership 
restrictions.
    For example, credit unions offer commercial loans, stocks, mutual 
funds, margin and option accounts, trust services, and other 
sophisticated products. Furthermore, many credit unions do not have a 
distinct field of membership and offer financial products and services 
to the general public. For instance:

      LA Financial Credit Union's field of membership includes 
all of Los Angeles County and its 10.1 million residents. Los Angeles 
County is home to more than 25% of California's population and more 
people than reside in 42 of this nation's 50 states.
      Suncoast Schools FCU in Tampa, FL caters to persons in 14 
counties and has assets of over $4 billion.
      Citizens Equity First CU in Peoria, IL serves over 14 
counties and employees of over 550 select companies.
      Rhode Island-based Greenwood Credit Union advertises that 
membership ``is open to all responsible people who want to be 
members.''
      $800 million Greylock Federal Credit Union in 
Massachusetts recently ran radio advertisements telling listeners if 
they ``have a pulse,'' they are probably qualified to join Greylock 
Federal Credit Union.
CUSOs Contribute to Credit Union Growth.
    Many credit unions have formed subsidiaries known as credit union 
service organizations (``CUSO''s) that have contributed significantly 
to the dramatic growth of complex credit unions. CUSOs offer 
sophisticated products such as trust administration and investment 
services. CUSOs also provide non-traditional financial services such as 
real estate brokerage, pre-paid legal service plans, and travel agency 
services. In many cases, CUSOs are established to offer services not 
permitted by a credit union's charter. Income generated from bank-like 
products and non-traditional financial services offered through CUSOs 
should not be exempt from taxation.
Federal Credit Union Income Should Be Transparent.
    We urge the Committee also to examine a more narrow issue--the 
credit union exemption from filing a Form 990, Return of Organization 
Exempt from Income Tax. Under current law, all organizations exempt 
from tax under section 501(a) are required to file a Form 990 with the 
Internal Revenue Service (``IRS''). This form discloses items of gross 
income, receipts, disbursements and other information required under 
the tax regulations. In Revenue Ruling 89-94, the IRS exempted federal 
credit unions from filing these annual information returns under the 
theory that a federal credit union is an ``instrumentality of the 
United States.'' Financial disclosures were required prior to 1989.
    Federal credit unions should not be given the same rights and 
privileges that are afforded to the federal government. Federal credit 
unions are not owned by the United States, nor do they possess any 
special governmental attributes or purpose that would justify an 
exemption from these disclosure rules. In fact, credit unions are 
profitable, retail financial service organizations whose activities 
should be appropriately disclosed in order to efficiently administer 
the tax laws. Therefore, we believe that if federal credit unions 
remain tax-exempt, they should be required to file a Form 990.
Conclusion.
    We reemphasize that our concern remains with the sophisticated 
credit unions that have grown beyond their common bond and are as bank-
like as mutual institutions that are taxed. From a competitive 
perspective, these credit unions have become tax-free community banks, 
creating situations in which a billion dollar, tax-free credit union 
sits opposite a $50 million, non-stock, taxpaying mutual savings bank. 
We commend the Committee for undertaking an examination of the tax-
exempt sector, and we look forward to working with the Committee on 
this important issue.

              Taxes and Authorities: A Comparison of Credit Unions and Other Depository Institution
----------------------------------------------------------------------------------------------------------------
                                                                      2005 Federal Savings
        Issue            2005 Credit Unions    1952 Mutual Savings        Associations       2005 National Banks
                                                   Associations        Including Mutuals
----------------------------------------------------------------------------------------------------------------
Income tax liability   $0                     Lost exemption in      $7.5 billion.\4\       $30 billion.\6\
 2003                  Would have paid $1.32   1952.                 Federal mutual
                        billion if taxed at                           savings associations
                        the same rate as                              paid over $285
                        banks and savings                             million in 2003. All
                        associations.\3\                              federally insured
                                                                      mutuals paid $1
                                                                      billion.\5\
----------------------------------------------------------------------------------------------------------------
CRA obligations        No CRA obligations.    Predated the CRA.      The CRA requires       Same as federal
                                               Mutual savings         insured depository     savings
                                               associations worked    institutions to        associations.
                                               to maintain and        serve and help
                                               foster the economic    foster growth in
                                               strength of            each of the
                                               communities they       communities they
                                               served.                serve, including low-
                                                                       to moderate-income
                                                                      areas within their
                                                                      communities.
----------------------------------------------------------------------------------------------------------------
Interest on consumer   Federal credit unions  No. Checking accounts  Federal savings        Same as federal
 checking accounts      may pay interest on    were not permitted.    associations may not   savings
                        both consumer and                             pay interest on        associations.
                        business checking                             business checking
                        accounts.                                     accounts. Offering
                                                                      interest bearing NOW
                                                                      accounts to
                                                                      individuals and
                                                                      nonprofit
                                                                      organizations is
                                                                      permissible.
----------------------------------------------------------------------------------------------------------------
Field of membership    Federal credit unions  Mutual savings         Not applicable.        Not applicable.
                        may serve only         associations were
                        persons within their   authorized to lend
                        field of membership.   within their
                        Over the years,        communities, which
                        membership             generally was
                        restrictions have      defined to comprise
                        been liberalized       a 50-mile radius.
                        legislatively and by
                        regulation. In 2003,
                        the NCUA greatly
                        expanded its field
                        of membership rules.
                        At a minimum, the
                        new rules will allow
                        56 million
                        additional people to
                        qualify for credit
                        union membership.
                        Separately, some
                        states have very
                        liberal field of
                        membership
                        interpretations.
----------------------------------------------------------------------------------------------------------------
Lending limits         A federal credit       Historically, mutual   Lending limits track   The single borrower
                        union may lend to      savings associations   those for national     limit generally is
                        any one member up to   could lend up to a     banks. Federal         15% of the bank's
                        10% of its deposits.   percentage of          savings associations   capital and surplus
                                               assets, generally      also have an           on an unsecured
                                               between 15-20% of      additional lending     basis. An
                                               assets to a single     limit authority for    additional 10%
                                               borrower, depending    residential            limit is available
                                               upon loan type.        development loans.     if collateralized
                                                                                             with fully
                                                                                             marketable
                                                                                             securities.
----------------------------------------------------------------------------------------------------------------
Business lending       Federal credit unions  No.                    Federal savings        National banks have
 authority              may make business                             associations may       general commercial
                        loans of up to                                make commercial        lending authority.
                        12.25% of total                               loans in an
                        assets. However, a                            aggregate amount
                        recent rule adopted                           totaling 20% of
                        by the NCUA allows                            total assets, 10% of
                        credit unions to                              which must be in
                        exclude purchases of                          small business
                        participation loans                           loans.
                        and non-member loans
                        from the statutory
                        cap if approved by
                        the NCUA.
----------------------------------------------------------------------------------------------------------------
Unsecured consumer     Yes (12-year term      No.                    Yes.                   Yes.
 loans                  limit).
----------------------------------------------------------------------------------------------------------------
Insurance/securities   Yes.                   No.                    Yes.                   Yes.
 powers
----------------------------------------------------------------------------------------------------------------
\3\ Banks and savings associations pay approximately 40% of their income in federal and state taxes each year.
  According to the NCUA's 2003 Annual Report, Federal credit unions had a net income of $3.3 billion, 40% of
  which is $1.32 billion. President Bush's FY 2005 budget estimates that credit unions' federal tax exemptions
  will cost a cumulative total of $7.88 billion between 2005 and 2009.
\4\ SNL Database.
\5\ Id.
\6\ Id.


                                 

   Statement of American Association of Debt Management Organizations
About The American Association of Debt Management Organizations

    The American Association of Debt Management Organizations (AADMO) 
is an industry trade association representing the nation's independent 
debt management organizations. Founded in 2001, AADMO's focus has been 
on industry education with an emphasis on regulatory and compliance 
issues affecting its members.
    AADMO is the credit counseling and debt management industry's 
largest trade association and has as its mission to promote and ensure 
the continued operation and viability of credit counseling and debt 
management organizations. AADMO provides its members and the consumer 
public with information about the credit and debt counseling industry. 
AADMO members are debt management organizations, personal finance 
educators, credit and debt information publishers, credit counselors, 
consumer lawyers and many others.
    AADMO is the only trade association to have held state law 
compliance workshops with the New York State Banking Department and the 
California Department of Corporations prior to enactment of their 
respective laws governing credit counseling. AADMO is also the only 
trade association for the industry to publish a formal summary of state 
laws that has been reviewed by state regulators.

                         Copyright  2005 AADMO

                           Table of Contents

Introduction

Overview Credit Counseling Agencies' Commitment to Education

Educational Aspects of the Debt Management Plan

Identifying the Beneficiaries of Debt Management Plans

Volunteer Staffing and the Credit Counseling Process

The Potential Impact of IRS Revocation of Credit Counseling's 501(c)(3)

Tax-Exempt Status on Credit Counseling Agencies and American Consumers

Recommendations
Introduction

    Since their creation, non-profit credit counseling agencies (CCAs) 
have provided invaluable assistance and education to American consumers 
in financial distress. For over twenty-five years, the Internal Revenue 
Service and the courts have recognized the educational work of CCAs by 
confirming their tax-exempt status pursuant to Section 501(c)(3) of the 
Internal Revenue Code. The explosive growth of unsecured consumer debt 
over the last fifteen years has increased the need for credit 
counseling, and the need for debt management plans (DMPs) which CCAs 
administer. This explosive growth has caused change and growth within 
credit counseling; it has also created an opportunity for abuse by some 
CCAs. The now notorious conduct of a few CCAs has caused the IRS to 
consider revoking tax-exempt status to all CCAs, including those who 
continue to fulfill their educational purpose. Such blanket revocation 
would be a drastic overreaction. Blanket revocation would fail to 
recognize the continued educational work of credit counseling, and the 
important role credit counseling plays in assisting financially 
distressed and vulnerable American consumers and in protecting all 
Americans from an epidemic of bankruptcy filings such as has never been 
seen.
Overview

    Over 1.6 million Americans filed for personal bankruptcy in 2003 
\1\ and another 1.6 million through the period ending September 30, 
2004. Generally, the number of consumers declaring bankruptcy has 
increased by nearly 10% each year over the last several years.\2\ These 
are alarming statistics. Of even greater concern for policymakers are 
the millions of Americans and American families on the verge of 
bankruptcy, or at a point of financial distress where there appears to 
be little hope and few options. The well-being of our national economy 
is threatened if these people choose bankruptcy in ever-growing 
numbers. Most consumers do not want to choose bankruptcy, but they need 
real help with their immediate financial distress and their long-term 
ability to understand and manage their finances. Whether they succeed 
or fail affects not only the debtors themselves but their children, 
their employers, their communities, and the national economy.
---------------------------------------------------------------------------
    \1\ http://www.uscourts.gov/Press_Releases/fy04bk.pdf
    \2\ http://www.uscourts.gov/Press_Releases/603b.pdf
---------------------------------------------------------------------------
    Increasingly, financially distressed families have turned to non-
profit credit counselors for relief from financial distress. In 2001, 
nearly 2.5 million consumers sought the assistance of credit counseling 
agencies. In 2004, it is estimated that closer to seven million people 
sought assistance from a credit counseling organization.\3\ These 
numbers dwarf the already high numbers of bankruptcy filings, and make 
two facts undeniably clear: a substantial number of American families 
are in serious financial distress, and a substantial number of those 
distressed Americans are primarily burdened by unsecured credit card 
debt. If these Americans are abandoned, we risk a bankruptcy 
catastrophe.
---------------------------------------------------------------------------
    \3\ According to the Executive Office for U.S. Trustees, ``The 
credit counseling industry handles approximately $6 billion annually, 
more than the amount distributed from chapter 7 and chapter 13 
bankruptcy cases combined.''
---------------------------------------------------------------------------
    Historically, the non-profit status and eligibility for 501(c)(3) 
tax exemption of credit counseling agencies was confirmed by the IRS 
and the courts in a series of early decisions. At that time, the model 
for credit counseling agencies reflected the nature and magnitude of 
the problem: small, community-based agencies who could provide helpful 
advice and general education to the many and tangible assistance to the 
few. The helpful advice and general education included one-on-one 
sessions or lectures to groups on subjects such as family budgeting, 
expense reduction, and balancing a checkbook. The tangible assistance 
took the form of the debt management plan, which is discussed in 
greater detail below. Debt management plans provided financial 
resources to the CCA in the form of creditor ``fair share'' (again, 
discussed in greater detail below), but because the problem was small, 
a CCA would look for and receive funding from other sources as well; a 
commonly cited example is the United Way.
    The past thirty-five years have seen an explosive growth of 
consumer credit. Between 1970 and 2004, consumer debt in the United 
States increased from 131 billion to over 2.05 trillion dollars.\4\ 
Consumer credit is an essential element of the consumer-driven American 
economy, and the availability of credit is essential to the stability 
and self-improvement of millions of Americans. At the same time, the 
aggressive marketing of credit cards to consumers has become an 
accepted part of the credit card issuer's business model. With 
unsecured consumer debt being higher than ever and more concentrated 
than ever on less-than-perfect American consumers, that part of the 
American financial spectrum populated by consumers in financial 
distress tied directly to unsecured debt has grown substantially.
---------------------------------------------------------------------------
    \4\ http://www.federalreserve.gov/releases/g19/hist/cc_hist_mh.html
---------------------------------------------------------------------------
    Over this time, credit counseling agencies grew in size and in 
number to meet the increased demand for their services, and in 
particular the increased demand for the tangible assistance of a debt 
management plan. CCAs developed new practices to reflect the new 
economies for credit counseling, and their increased role as financial 
trustees dictated that many CCAs took on a more professional business 
approach, departing further from the ``church basement'' model of a 
charitable organization. As more consumers came to CCAs needing the 
tangible assistance of a debt management plan, the ``fair share'' 
payments by creditors slowly displaced charitable support from other 
groups such as the United Way. CCAs moved increasingly toward a 
telephone-based counseling relationship, which permitted consumers to 
obtain counseling from home and on the consumer's schedule, without the 
need to take the day off work and arrange day care for children. CCAs 
also generally found that to the extent these distressed American 
consumers were embarrassed or ashamed at having gotten into such 
trouble with consumer debt, telephone counseling was less humiliating 
to these consumers, encouraged greater candor, and created a more 
productive platform on which to base counseling and educational 
efforts. Clearly, the move by CCAs toward a telephone-based counseling 
relationship also permitted CCAs to reach larger geographic regions.
    Creditors also made adjustments, reducing their ``fair share'' 
contributions to reflect the economies of scale now common at CCAs. 
Credit card companies also encouraged CCAs to develop modern business 
practices, including computerized client data management systems and 
electronic payment systems.
    Unfortunately, the rapid growth and reshaping of credit counseling 
also permitted the emergence of some of the worst-behaving entities in 
credit counseling. These worst entities abandoned any commitment to 
education, and moved fully into the mode of indiscriminately marketing 
Debt Management Plans to the general public. At one end of the consumer 
spectrum, they invited American consumers who were otherwise able to 
pay their credit card debt, at the contractual rates of interest, to 
use the debt management plan as a means of paying less than the agreed-
on rate. This indiscriminate marketing of the debt management plan 
offended credit card companies, who historically had made substantial 
concessions to consumers on debt management plans--slashing interest 
rates or eliminating interest altogether, waiving accrued fees and 
penalties, and re-aging a consumer's delinquent account as a current 
debt.
    Credit card companies responded to the indiscriminate marketing of 
debt management plans by limiting their concessions and further 
reducing their ``fair share'' contributions. Both of these moves had 
the unintended effect of hurting legitimate CCAs more than they hurt 
the worst players (who had no resources devoted to genuine education 
and counseling, who would always operate more leanly than legitimate 
CCAs, and who were constantly increasing their ``market share'' through 
aggressive and dishonest marketing). Where the worst CCAs had never 
committed to education, many legitimate CCAs struggled to meet their 
educational commitments with reduced creditor support. More 
significantly, the reduction in creditor concessions came to mean that 
the debt management plan provided a less substantial benefit to those 
Americans who desperately needed it. This fact did not matter to the 
worst CCAs, who have shown a willingness to aggressively market Debt 
Management Plans by promising what they cannot deliver.
    At the other end of the consumer spectrum, the worst CCAs marketed 
their Debt Management Plans to consumers who were so deeply in 
financial distress that bankruptcy was the only reasonable solution. 
These worst CCAs did not care that these consumers would be squeezed 
for their last few dollars before seeking bankruptcy protection; they 
did not care that the consistent failure of these consumers would 
eviscerate the CCA's retention rates for its Debt Management Plan. All 
the worst CCAs cared about was signing consumers up and getting 
exorbitant startup and monthly fees for as long as they could, 
regardless of the long-term effects on the consumer, the creditors, or 
the economy.
    Not all the worst CCAs were ``home-grown'' products; a number of 
them were escapees from other legitimate attempts at consumer-friendly 
regulation. The Credit Repair Organizations Act and the National Do Not 
Call Registry are two examples of laws which prohibit certain predatory 
and/or deceptive practices, but which do not apply to non-profit 
organizations. It is widely claimed that a number of predatory and 
dishonest business entities took on the mantle of non-profit status in 
order to escape the application of these laws.
    The primary source of regulatory oversight of credit counseling has 
been the various states. Some states do not regulate credit counseling 
at all.\5\ Of the states that do, their laws often lack clarity and 
uniformity. Banks issue consumer credit on an interstate basis, and 
consumers freely move from state to state taking their unsecured debt 
with them. The growing need for credit counseling is not a local 
problem, and the growth of credit counseling has lessened the local 
quality of many credit counseling agencies. Nevertheless, these 
agencies still must contend with the divergent and/or redundant 
requirements of the various states' laws (including various 
requirements as to licensing, bonding, insurance, disclosure, and other 
compliance issues). At the same time, enforcement of these various 
states' laws is insufficient, ineffective, or altogether absent. What 
this means is that CCAs that intend to comply with the applicable laws 
have been burdened with exhaustive legal compliance costs,\6\ while the 
worst CCAs were able to ignore legal compliance without fear of 
effective enforcement.
---------------------------------------------------------------------------
    \5\ For example, see Alaska and Colorado
    \6\ The New York State Banking Department announced in December 
2004 to allocate all of the Department's operating expenses to its 
regulated entities--such as ``budget planners'' (i.e. non-profit credit 
counseling).
---------------------------------------------------------------------------
    In a climate of explosive growth, rapid development, and 
ineffective regulatory oversight, the conditions were ripe for the 
worst CCAs to take a controlling position in the world of credit 
counseling. For every dollar that a legitimate CCA spent on genuine 
education and counseling, the worst CCAs had a free dollar they could 
spend on marketing. Nevertheless, other CCAs grew in size and 
geographic range, moved toward a telephone-based counseling 
relationship, and adopted a more professional business approach, yet 
remained true to their fundamental educational and charitable purposes.
    Regrettably, it was the worst CCAs who of course finally caught the 
attention of the public, the IRS, and other regulators. These worst 
CCAs had a number of features that were shared by other CCAs which had 
grown and developed over time: they were large, telephone-based, they 
followed a professional business model, and they aggressively marketed 
their services. These are features that would not have been found the 
last time the regulators looked meaningfully at credit counseling 
agencies. Yet these features were not the ones that cried out for 
regulatory action against these worst CCAs: it was the fact that the 
worst CCAs were dishonest, predatory, and abusive to consumers. Their 
commitment to education was non-existent. Their marketing was 
widespread and dishonest. These worst CCAs promised what they could 
never deliver, then failed to deliver even what they could. They 
charged exorbitant upfront fees, which reflected a business model that 
focused on signing new consumers up for services, and did not focus as 
much (if at all) on actually providing those services. These worst CCAs 
not only failed to be legitimate 501(c)(3) educational or charitable 
organizations; they failed to even be legitimate businesses.
    The current challenge to the IRS is to immediately address the 
status of these worst CCAs without letting the conduct of these few 
entities cloud IRS' understanding of the explosive growth of consumer 
debt and the corresponding growth and development of non-profit credit 
counseling.
    As the IRS steps back in to provide regulatory oversight and 
guidance to these agencies, it must recognize that the core values and 
practices which originally justified 501(c)(3) exempt status for credit 
counseling still exist in modern CCAs. The fact that specific practices 
have changed or developed reflects changes and developments in our 
world, not an abandonment of those core values and practices.
    Credit counseling agencies still provide low cost or free financial 
education and counseling to the public and still provide tangible 
assistance in the form of debt management plans to those American 
consumers for whom such plans are appropriate. Credit counseling 
agencies still provide a positive option to collection actions, 
lawsuits, and bankruptcy. The ability of legitimate credit counseling 
agencies of any size to carry on their educational and charitable 
purposes still depends on their continued status as 501(c)(3) 
organizations. Without this tax status, credit counseling agencies will 
no longer be able to provide financially distressed consumers with the 
affordable and reliable services they desperately need. A decision by 
the IRS to revoke 501(c)(3) status to all CCAs based on the abusive 
practices of the worst CCAs would be factually and historically 
baseless, and would have disastrous unintended consequences on American 
consumers and the American economy.
Credit Counseling Agencies' Commitment to Education

    From their inception in the 1950s, credit counseling organizations 
have engaged in public education and have provided consumers with 
access to financial literacy programs. This commitment to education has 
always been, and should always be, an essential component to the 
maintenance of the 501(c)(3) tax-exempt status granted to credit 
counseling organizations. Credit counseling agencies seeking to obtain 
and retain 501(c)(3) status should devote a preponderance of available 
resources to the development, procurement and dissemination of client 
and community oriented financial literacy programs.
    Each year, millions of financially distressed American households 
use the credit counseling and debt management services of CCAs, 
inclusive of their educational components. With proper oversight and 
guidance from the legislative and regulatory community, non-profit 
credit counseling organizations will continue to rehabilitate and 
educate financially distressed consumers.
Educational Aspects of the Debt Management Plan

    It is difficult to teach long-term financial accountability to 
people in short-term, immediate financial distress. Distressed 
consumers typically seek immediate relief from their financial crisis, 
but what they really need is long-term behavioral change. Behavioral 
change is undeniably an educational goal. A debt management plan, when 
used appropriately, can serve both these short-term and long-term goals 
and is the best available educational tool for credit counseling.
    In the short term, the debt management plan provides a ``safe 
harbor'' for the distressed consumer, who is otherwise consumed by 
fears over unpayable bills, creditor calls, collection agency calls, 
legal actions, late fees, over the limit fees, ``default'' credit card 
interest rates and, more generally, the fear of being financially out 
of control, in free fall, and on the verge of bankruptcy. This ``safe 
harbor'' permits the distressed consumer to look past ``quick fixes'': 
avoidance behavior (i.e. avoiding calls from creditors or collection 
agents), problem-shifting behavior (i.e. shifting old credit card debt 
onto new credit cards, or shifting unsecured credit card debt into 
secured home equity loan debt), or ultimately hopeless behavior 
(bankruptcy). This ``safe harbor'' gives the consumer the short-term 
practical stability necessary to begin to take long-term responsibility 
for the consumer's financial situation, with hope for the future. This 
stability extends to all aspects of the consumer's life, including the 
consumer's family and employment.\7\
---------------------------------------------------------------------------
    \7\ http://www.csus.edu/indiv/a/andersenj/Research/
FinancialProblems.pdf
    Substantial research has concluded that financial problems are 
stressors that affect marital quality and satisfaction.
---------------------------------------------------------------------------
    In the long term, the debt management plan can provide education 
that is both informational and practical. The informational aspect 
begins with the first counseling session. A distressed consumer often 
does not have a working budget of personal income and expenses. A first 
counseling session should accomplish this goal (and must accomplish 
this goal if the CCA is going to claim that it only recommends a debt 
management plan to appropriate consumers). The informational aspect 
should continue throughout the debt management plan and beyond, and 
should touch on a wide range of issues in personal finance. Whether it 
does continue is a measure of the commitment to education of the 
individual CCA. The practical aspect is the consumer's exercise of 
living within a budget and incrementally paying down credit card debt 
with a long-term goal of paying the debt off. The CCA works with the 
consumer to understand how the debt management plan will work; to 
encourage the consumer to stay on the plan; to assist the consumer when 
new challenges make it difficult to stay on the plan; and to share the 
consumer's sense of accomplishment as steady, incremental payments 
begin to produce substantial reductions in the consumer's debt, a goal 
which the consumer once felt incapable of reaching.
    By the end of a successful debt management plan, the consumer has 
learned from the practical experience of living within a budget. The 
consumer has accomplished the goal of reducing his or her debt. The 
consumer has gained factual information, ongoing access to educational 
resources, and a better understanding about budgeting and debt. The 
informational and practical aspects of education through the debt 
management plan combine to encourage the consumer's long-term 
behavioral change and to ensure that these consumers, and their 
children, will not only get out of financial distress, but will not get 
into financial distress again.
Identifying the Beneficiaries of Debt Management Plans

    Public benefit is simply the sum total of private benefits, when 
the benefits are numerous and broad in scope. For example, a halfway 
house for recovering drug addicts can narrowly be said to only provide 
private benefits to recovering drug addicts, a particularly narrow 
target audience, yet it takes very little consideration to realize that 
the families of these individuals also benefit, as does the community 
at large. Often the best way of identifying who benefits from a 
solution is to identify who is affected by the problem.
    The American economy is a consumer-driven economy. The easy 
availability of credit to American consumers has become a necessary 
component of our economy, and credit card issuers have been largely 
unregulated in their marketing of credit to consumers. It is a 
predictable side effect of the easy availability and constant marketing 
of credit that some American consumers will end up in financial crisis 
because they overuse credit. As consumer credit card debt has exploded, 
the number of consumers in financial distress has predictably followed 
suit. When these distressed consumers cannot pay their credit card 
debts, it is not only the creditors that are affected. The distressed 
consumers are affected, by the wide range of negative financial events 
including higher fees, collection actions, legal actions, and 
bankruptcy. The consumers' families are affected, as it is known that 
financial distress is one of the leading causes for the breakup of 
families. The consumers' employers are affected, as employers recognize 
that financial difficulties are a leading cause of decreased employee 
productivity, increased absenteeism, and increased turnover. 
Responsible consumers at large are affected, as creditors increase the 
cost of consumer credit to account for the cost of bankruptcies and 
write-offs. Ultimately the economy as a whole is affected, as the 
increased cost of credit discourages consumer activity.
    Credit counseling agencies are asked by consumers to assist and 
intervene in a pre-existing contractual relationship between the 
consumers and their creditors, where the creditors already have a 
contractual claim for repayment of a large and growing amount of debt. 
When administering debt management programs, credit counseling agencies 
fulfill a four-part role; acting as the agent, advocate, counselor and 
educator of financially distressed households. The immediate tangible 
benefits that a credit counseling agency can provide to its client, the 
consumer, can be measured by the concessions that the CCA obtains from 
the consumer's creditors, i.e. the agreement by the creditors to accept 
less from the consumer than that to which the creditors are otherwise 
entitled pursuant to their contracts with the consumer.
    To treat the creditor's acceptance of less than the contractual 
amount as a benefit to the creditor is arbitrary. A CCA which asked a 
consumer's creditors to accept nothing, i.e. to simply write off a 
consumer's debt entirely, would be rejected by the creditors, and would 
be unable to provide any real benefit to the real beneficiary--the 
consumer.
    Often the notion that a debt management plan confers a substantial 
private benefit on creditors is coupled with the accusation that CCAs 
are merely ``collection agents'' for the credit card industry. Anyone 
making this accusation has not been through a collection process, and 
does not understand it. In collection, the creditor writes off a debt, 
and writes off the consumer. The collection agent buys the debt, for 
pennies on the dollar. The collection agent does not work with the 
consumer to create a budget or to address the full range of the 
consumer's debts. The collection agent has no concern about the impact 
on the consumer of the collection process, and devotes no time to 
addressing the consumer's underlying financial management issues. In 
collection, various collection agents compete with each other to get a 
greater share of blood from a stone. The stone is the consumer. 
Collection is a degrading process.
    While creditors do make a business decision to participate in debt 
management plans, the CCAs administering those plans are focused on the 
current and future financial well-being of the consumer.
    The long-term educational work of credit counseling agencies, 
directed at clients on debt management plans, at non-DMP clients, at 
high school and college students who have not yet taken on credit card 
debt, and at the public at large, is substantially funded by creditor 
payments. These are often called ``fair share'' payments. As noted, the 
creditors who have aggressively marketed consumer credit share some 
responsibility for the explosive increase in the number of consumers in 
financial distress.
    It is perfectly appropriate for these credit card issuers, as 
opposed to the public at large or charities such as the United Way, to 
take financial responsibility for funding the efforts of credit 
counseling agencies. The voluntary agreement by credit card issuers to 
take financial responsibility for a side effect of the product they 
market is certainly preferable to the approach of others, for example 
the tobacco industry, who denied the existence of a problem caused by 
their product, and let the public pick up the tab until they were 
forced to take responsibility.
    The explosive growth of consumer credit caused the attendant growth 
in the numbers of consumers in financial distress and the number of 
consumers seeking the assistance of credit counseling. Undeniably, 
because the problem is large the numbers involved are also large. Large 
amounts of money are paid to creditors through debt management plans, 
and large amounts of money are paid by creditors to CCAs through ``fair 
share'' payments. Large numbers, however, do not equate with a 
fundamental change in the educational mission of credit counseling 
agencies, any more than the explosive growth in the number of colleges, 
and the larger amounts of money involved in college education, has 
changed their fundamental purpose.
    When CCAs were first approved for 501(c)(3) status, CCAs were 
heavily controlled by creditors, creditor representatives sat on CCA 
boards of directors, and creditor ``fair share'' payments were 
typically set at 15 per cent of revenues paid through debt management 
plans. Today, credit counseling agencies are more independent of 
creditors, creditor representatives do not sit on CCA boards, and 
creditors pay ``fair share'' that is not only at an historic low 
percentage, but also based on a wider range of factors more directly 
focused on the CCA's commitment to education. While the numbers have 
gotten larger, the commitment to credit counseling's educational 
purpose has remained the same and, at least at the better CCAs, only 
gotten better.
    Consumer credit, just like banking, is a public concern made up of 
millions of private concerns. Legislators and regulators sometimes 
prefer to treat banking issues and financial issues as private issues 
until such time as the private issues fester into public crises, like 
the Great Depression or the savings and loan scandal. Consumer debt 
today threatens to become another crisis. The proponents of bankruptcy 
reform recognize this fact.
    Credit counseling is not the problem. It is part of the solution, 
and benefits all Americans. It is worthy of continued 501(c)(3) status. 
Increased regulatory oversight is of course appropriate; revocation of 
501(c)(3) status is not.
Volunteer Staffing and the Credit Counseling Process

    At one time, a consumer's issues with unsecured debt typically 
involved no more than three credit cards. Today, it is not surprising 
for a consumer to come to a CCA with twenty or more credit cards; the 
average is approximately ten. The range of issues relating to these 
credit cards has increased and become more complex, and the range of 
other consumer issues has changed in the same way. As a single example, 
thirty years ago the relationship between credit and divorce was not 
the issue that it is today. Moreover, the increased extension of 
unsecured credit card debt means that a consumer is often coming to a 
CCA with tens of thousands of dollars in unsecured debt. There is 
simply more at stake.
    Because the size of and complexity of the problems have grown, a 
reliance by CCAs on volunteers would be not only impractical but 
irresponsible. Errant financial analysis or advice given by a well-
meaning volunteer could have disastrous consequences for a consumer 
already on the brink of bankruptcy. Many CCAs rigorously train and 
educate their counselors. Indeed, many states require counselors to be 
certified as having demonstrated certain financial literacy skills.\8\
---------------------------------------------------------------------------
    \8\ For example, see California and Virginia
---------------------------------------------------------------------------
    Moreover, many CCAs following best practices attempt to establish 
ongoing, long-term relationships between clients and individual 
counselors, because experience supports the belief that the client 
benefits more with a counselor who knows the client's story and 
progress. Reliance on part-time volunteers would diminish these 
benefits. Finally, effective credit counseling is based on a consumer 
providing detailed financial information to the counselor. Given 
current real concerns over privacy and identity theft, it is 
unreasonable to entrust such information to volunteers.
The Potential Impact of IRS Revocation of Credit Counseling's 501(c)(3)
Tax-Exempt Status on Credit Counseling Agencies and American
Consumers

    Financially distressed American consumers are in great need of 
short-term assistance and long-term education. They are also extremely 
vulnerable to the predatory practices of unethical organizations. As 
recent history makes clear, credit counseling is not immune from 
invasion by unethical organizations looking to make a quick buck at the 
expense of those who desperately need help. Greater regulatory 
oversight and effective enforcement is clearly needed. However, IRS 
revocation of credit counseling's 501(c)(3) tax-exempt status will not 
accomplish these goals. Instead, revocation will hurt legitimate credit 
counseling agencies, hurt vulnerable consumers, and hurt the American 
economy.
    Revocation will hurt legitimate credit counseling agencies by 
giving an immediate unfair advantage to the CCAs that have abused their 
non-profit status and disregarded their educational mission. The 
organizational and operative decisions of these agencies have been 
geared to maximizing profit. These are the agencies that have caught 
the attention of the IRS, the FTC, the Congress, and other regulators. 
Yet in the for-profit world of credit counseling that IRS revocation 
would mandate, the practices of these very agencies would necessarily 
become the industry standard for any agencies that remain.
    Moreover, many of these very agencies are already largely 
structured to operate as for-profit businesses, while legitimate CCAs 
may find it difficult or impossible to complete a successful transition 
of their operations and assets from a non-profit to a for-profit 
structure while meeting all state laws applicable to the winding up of 
a non-profit organization.
    There has been no indication that IRS has made provision for such 
transitions, or for working with all the state regulatory entities to 
coordinate such transitions. Most legitimate CCAs will simply not 
survive the cost and service interruption occasioned by such a 
transition.
    In a for-profit world, a CCA which commits time and resources to 
public education cannot compete with a CCA which does not. Public 
education will have to be abandoned. In a for-profit world, sign up 
fees will not be limited by regulation or by concern over the 
consumer's welfare, but instead will only be limited by ``what the 
market will bear''. In a market where the consumer base is financially 
distressed, ``what the market will bear'' typically equates with 
predatory practices; consider, for example, ``what the market will 
bear'' in payday lending rates.
    Revocation will hurt vulnerable consumers. There is currently no 
``consumer-friendly'' alternative to non-profit credit counseling 
agencies. Consumers in financial distress will be left to collection 
agents, payday lenders, predatory home equity lenders, litigation, and 
bankruptcy. Consumers currently enrolled in debt management plans with 
legitimate CCAs may find themselves without a plan if revocation ends 
or seriously disrupts the CCA's operations.
    Further, revocation of the tax exempt non-profit status of credit 
counseling organizations would create an immediate dilemma for the 
hundreds of thousands of American families who are currently enrolled 
in debt management programs and who reside in States that require non-
profit and/or 501(c)(3) tax exempt status as a condition of the 
licensing or legal \9\ operation of a credit counseling agency.
---------------------------------------------------------------------------
    \9\ For example, see Kentucky, Maine, Oregon and Rhode Island
---------------------------------------------------------------------------
    Revocation will hurt the American economy. Bankruptcy filings will 
certainly double. The most recent versions of Congressional bankruptcy 
reform legislation contemplate that non-profit credit counselors will 
play a role in stemming the tide of bankruptcy filings. IRS revocation 
would be contrary to the expressed intent of Congress and will mean 
that non-profit credit counselors are not available to fill this 
important role. The social costs associated with financial distress 
will increase: broken families and loss of employment productivity are 
simply two examples of these social costs.
    Without non-profit credit counseling, more Americans will turn to 
the high-risk option of taking out home equity loans to pay off high 
credit card debt. This practice is already a significant problem, and 
is only going to grow because a large number of these loans are 
adjustable-rate loans destined to increase as interest rates climb. 
Thus, in addition to bankruptcies, revocation of credit counseling's 
501(c)(3) status will increase the number of home foreclosures. Home 
ownership is recognized as a powerful stabilizing force in the American 
consumer economy, and any measure that increases home foreclosures is 
perilous.
    Finally, the costs of revocation detailed above will impact on all 
aspects of the American economy. As financially distressed consumers 
file for bankruptcy in increased numbers, the cost of credit will 
increase for all consumers, including those who use credit responsibly. 
As those costs increase, the consumer spending decisions of all 
Americans will be impacted. While non-profit consumer counseling 
assists the percentage of Americans who suffer ill consequences 
associated with a ready stream of available consumer credit, all 
Americans will suffer if increased costs turn that stream into a 
trickle.

                            Recommendations

    1. AADMO recommends that the Internal Revenue Service complete its 
comprehensive review of the credit counseling industry, properly 
sanction those who have abused the 501(c)(3) status conferred upon them 
by the IRS and provide the industry with immediate and ongoing guidance 
relative to the application of the tax code to the credit counseling 
process.
    2. AADMO encourages the IRS to treat credit counseling 
organizations fairly when making recommendations to Congress vis-a-vis 
the future look and feel of the credit counseling process. Legitimately 
operating credit counseling organizations are well aware that there are 
bad players in their midst. Unfortunately, these players have operated 
freely for far too long; long enough to seriously eclipse long 
established, well-intentioned and legitimate organizations through 
their negative actions. The tax laws and the rules and regulations 
necessary to properly supervise and control the non-profit segment of 
our economy, including non-profit credit counseling organizations, are 
already in place. All that is needed now is regular review, consistent 
guidance and fair enforcement of existing federal and state codes by 
the regulatory sector.
    3. Enlightened legislative interaction is also needed. AADMO 
recommends and supports the passage of a uniform, pre-emptive federal 
statute to replace the myriad of conflicting state laws now in use to 
regulate credit counseling and debt management service providers. We 
respectfully suggest that model credit counseling and debt management 
agencies should be involved in the legislative drafting process and 
that credit counselors should be regulated through statutes developed 
solely for the credit counseling and debt management process.
    4. Credit counseling and debt management are unique services as 
compared to debt collection and debt settlement. A single, pre-emptive 
federal credit counseling statute will create an even playing field for 
service providers and guarantee consumers equal access to quality 
products and services regardless of their state of residence.
    5. AADMO encourages the legislative and regulatory community to 
allow time for recent increases in state and federal oversight 
activities, media scrutiny and IRS actions to have their impact on the 
credit counseling process. We recommend that those charged with 
oversight responsibility study the impact of recent actions taken by 
regulators against CCAs, determined to be abusing their 501(c)(3) 
status, on the consumers enrolled in the DMP programs of said 
providers. A cooling off period is needed to assess impacts of actions 
already taken and to guarantee millions of American households that 
they will not be thrust into deeper financial chaos as a result of 
hastily enacted and ill-advised regulatory schemes.

                                 

   Statement of David Hayes, Independent Community Bankers of America
    The Independent Community Bankers of America represents the largest 
constituency of community banks of all sizes and charter types in the 
nation, and is dedicated exclusively to representing the interests of 
the community banking industry. Founded in 1930, ICBA is celebrating 
its 75th anniversary year. For more information, visit ICBA's website 
at www.icba.org.
    On behalf of the 5,000 members of the Independent Community Bankers 
of America, I am pleased to submit written testimony for the Ways and 
Means Committee hearing on the Overview of the Tax-Exempt Sector. The 
ICBA commends you and the Committee members for undertaking this 
important hearing and for examining the current state of the tax-exempt 
sector.
Credit Union Tax Exemption Warrants Committee Examination
    As part of the examination into the current status of tax-exempts, 
the ICBA requests the Ways and Means Committee closely examine the tax 
system inequities posed by the rapidly growing $655 billion tax-exempt 
credit union industry. The origins of the credit union tax exemption 
reach back to the Great Depression, a time when basic financial 
services were limited. Over time, the tax-exempt credit

union industry has dramatically changed to support the same customer 
base as taxpaying financial institutions.
    Today there are more than one hundred credit unions with $1 billion 
or more in assets providing sophisticated banking products and services 
to wealthy and middle-income members while benefiting from tax-exempt 
status. Another noteworthy aspect of today's tax-exempt credit union 
industry is that corporate credit unions have been set up to provide 
the same wholesale services as taxpaying correspondent banks. For 
example, U.S. Central Credit Union in Lenexa, Kansas holds more than 
$35 billion in assets and is owned by 72 member credit unions.
Research Indicates Tax Exempt Credit Unions Not Serving Special Purpose
    A growing body of research from the Congressional Budget Office, 
the General Accountability Office and the Tax Foundation indicate that 
there is little or no evidence that today's tax-exempt credit unions 
are better serving the moderate and low-income individuals their tax-
exempt status was intended to foster. Instead, tax-exempt credit unions 
continue to push the envelope on expanding their commercial lending 
business.
    The credit unions recently sought and won regulatory approval to 
increase their business lending through the Small Business 
Administration (SBA). Notably, these SBA loans are not subject to the 
legal 12.25 percent of assets business-lending cap Congress 
specifically placed on the credit unions. Credit unions continue 
aggressive measures to skirt the legal 12.25 percent business-lending 
cap, notably the advancement of the ``Credit Union Regulatory 
Improvement Act'' (H.R. 3579) in the 108th Congress. The bill would 
raise the current statutory limit on business lending by tax-exempt 
credit unions to 20 percent from 12.25 percent, double the size of 
loans that would be excluded from the cap from $50,0000 to $100,000 and 
exclude certain other business loans from any limit.
    This Ways and Means Committee hearing on tax-exempts provides a 
solid opportunity to examine such credit union activities and the 
ongoing justification for the special tax treatment the credit union 
industry enjoys.
Tax-Exempt Credit Unions Compete Directly With Taxpaying Community 
        Banks
    Today, tax-exempt credit unions compete aggressively against 
taxpaying community banks and continue to expand their financial 
service power, size, and scope. The top federal income tax rate applied 
to C corporation community bank income and S corporation community bank 
income allocated to shareholders is 35%. Additionally, income generated 
by C corporation community banks is subject to double taxation when 
distributed in the form of dividends or capital gains, creating a 
combined tax burden exceeding 57%.
    In sharp contrast, tax-exempt credit unions pay no federal income 
tax yet compete directly with taxpaying community banks. The dramatic 
tax burden differential between taxpaying commercial banks and tax-
exempt credit unions places community banks at a severe competitive 
disadvantage and highlights a specific example of where the tax code is 
extremely unfair. A fair and unbiased tax system would apply the same 
tax treatment to similar industries and economic actions and 
transactions.
Tax Foundation Credit Union Study Shows $31 Billion Tax Loss
    The ICBA would like to call to the Committee's attention the most 
recent independent research conducted on the credit union industry. 
Notably, a new Tax Foundation study concluded that credit unions have 
used their tax-subsidized status to greatly expand in size and scope. 
The nonpartisan Tax Foundation estimated that the rapidly growing 
credit union tax subsidy will cost $31 billion in lost Federal revenue 
to the U.S. Treasury over the next decade.\1\ This study noted how 
large, multi-group and geographic-based credit unions have far exceeded 
their original tax-exempt statutory mission and unfairly use their tax-
free status to compete with taxpaying community banks.
---------------------------------------------------------------------------
    \1\ ``Competitive Advantage: A Study of the Federal Tax Exemption 
for Credit Unions,'' by Professor John A. Tatom, Ph.D. Tax Foundation, 
2005. www.taxfoundation.org
---------------------------------------------------------------------------
    Other important finding of the independent Tax Foundation's 
research into the tax-exempt credit union industry include:
Who benefits from the credit unions' tax exemption?
    Corroborated by other studies of credit unions and banks, the 
direct and indirect evidence gathered for this study shows that the 
equity holders of credit unions receive the tax saving as unusual 
returns. These unusual returns do not show up as relatively high 
dividends, however. Instead, they occur as unusually large retained 
earnings accumulated as net worth in their credit unions. The 
shareholders' extra

income reinvested in the credit union provides new capital that allows 
the credit union to grow faster than other institutions.
    Of the 50 basis points in subsidy that the tax exemption provides, 
at least 33 basis points accrue to owners in the form of larger equity 
and larger assets. Approximately 6 basis points may accrue to credit 
union borrowers through lower interest rates, and not more than 11 
basis points are absorbed by higher labor costs. There is little or no 
effect on deposit rates or other costs.
    Today credit unions continue to grow faster than banks, have little 
practical limitations on membership, and make business loans that 
increasingly have no limits on who can borrow, how much or for what 
purpose.
 Little justification for credit union tax exemption.
    Today the principal justification for the tax exemption would seem 
to be that it already exists and, therefore, removing it could 
adversely impact thousands of institutions and their customers. Under 
current law, as it is being enforced, there is no good policy argument 
based on equity or efficiency for maintaining the tax exemption. And 
these institutions and customers are perceived, incorrectly, to be 
relatively lower income or associated with the economic security and 
progress of lower income people.
  Tax exemption no longer linked to special mission or 
        meaningful restrictions.
    Credit unions are among the most rapidly growing financial firms in 
the country.
    Congress eliminated the tax exemptions for savings and loans and 
mutual savings banks decades ago on the grounds that they were similar 
to profit-seeking corporations. Since then, large credit unions have 
come to resemble large thrifts and banks. The looser field of 
membership requirements also has allowed credit unions, especially 
large ones, to expand their growth opportunities, reinforcing the 
competitive advantage obtained from their tax advantages.
 Tax reform and credit unions.
    Fiscal neutrality would require removing the special tax treatment 
of credit unions.
    Taxing some financial institutions that offer the same consumer 
deposits and loans while not taxing others, in particular credit 
unions, distorts the allocation of resources. It promotes the 
employment of deposit and credit resources in the tax-free credit union 
sector at the expense of their competitors, banks, thrift institutions 
and finance companies.
    Tax reform of credit union income taxation is a ``no-brainer'' when 
viewed in a broad tax neutrality context. It is also compelling when 
either the size of the revenue loss or the ineffectiveness of the tax 
break for achieving any social goal is considered.
    This study could not find any net benefit to members that could not 
or would not be available in the absence of tax-subsidized credit 
unions. Most notably, the credit union subsidy, by its very nature, has 
largely failed to deliver financial services to low-income people.
    Credit unions are not compelled by regulators to meet a higher 
standard in the service of low- and moderate-income customers, and 
there is no evidence that they do so voluntarily. The $650 billion 
credit union industry may have outgrown in size and scope its original, 
tax-exempt mission.
Conclusion
    These points from the Tax Foundation's study make a clear case that 
the Ways and Means Committee re-assess the tax-exempt status of the 
rapidly expanding credit union industry as part of the review of tax 
exempts. Community banks play a vital role in the U.S. economy as a 
critical source of lending for individuals, small businesses and farms 
across America. The ICBA respectfully requests the Ways and Means 
Committee further examine policies that would help make the tax code 
more equitable as it is applied to tax-exempt credit unions and 
taxpaying community banks. As the Ways and Means Committee examines the 
tax-exempts, we urge a fresh policy evaluation of the estimated $31 
billion in lost tax revenue from the tax-exempt credit union industry.
    We sincerely appreciate the opportunity to offer our comments for 
this important hearing and to highlight areas where the tax code is 
unfair. The ICBA looks forward to working with the Committee and we are 
encouraged by your ongoing efforts to fairly assess the standing of 
tax-exempt entities such as the credit union industry.

                                 
             Submission of the American Bankers Association
    The American Bankers Association (ABA) appreciates the opportunity 
to comment to the Ways and Means Committee on the tax-exempt sector. 
Our comments focus on the evolution of traditional credit unions 
serving ``people of small means'' to full service, financially 
sophisticated institutions that compete head-to-head with tax-paying 
banks.
    ABA on behalf of the more than two million men and women who work 
in the nation's banks, brings together all categories of banking 
institutions to best represent the interests of this rapidly changing 
industry. Its membership--which includes community, regional and money 
center banks and holding companies, as well as savings associations, 
trust companies and savings banks--makes ABA the largest banking trade 
association in the country.
    This statement addresses three central points:

     I.  A new breed of credit unions has emerged that offers products 
and services virtually indistinguishable from tax--paying banks. These 
``morphed'' credit unions are a far cry from traditional credit unions, 
whose tax subsidy was intended to benefit individuals with limited 
resources who might not otherwise have access to financial services.
     II.  Being a non-profit cooperative does not, alone, justify a tax 
exemption. Fairness dictates equal tax and regulatory treatment for 
similarly situated institutions.
    III.  Congress has repeatedly recognized that there are limits to 
tax exemptions and has acted to eliminate them for entities that stray 
from their intended public policy goals.
I. A New Breed Credit Unions Has Emerged
    As Chairman Thomas recently stated, ``Tax-exemption is an important 
benefit and the Congress has a responsibility to oversee and assure the 
American taxpayer that the tax-exempt sector is living up to its legal 
responsibilities.'' ABA supports this view and would like to recommend 
that Congress examine certain credit unions' tax-advantaged status. 
While many credit unions remain true to their original mission, today 
growing a number of credit unions have abandoned their roots and 
inappropriately taken advantage of their tax-exempt status to gain 
ever-increasing market share.
    Traditionally, credit unions were based on a simple concept: permit 
a closely-knit group of people to pool their resources and to provide 
small loans for one another. The focus was on individuals with limited 
resources who might not otherwise have access to financial services. 
Membership was limited to people with close bonds because familiarity 
was critical to the ``character'' loans made by credit unions. The 
commonality of interest among members--their common bond--was the 
essence of credit unions. It gave them a special and unique place in 
our financial system.
    As the industry matured, however, a new breed of institution 
evolved that bears little resemblance to a traditional credit union. 
With the freedom to seek new markets almost without restriction and to 
offer a full range of banking and financial products, many aggressive 
credit unions have leveraged their tax advantage to grow rapidly. 
Today, there are 99 credit unions with assets greater than $1 billion. 
In nearly half the states in this country, a credit union would rank 
among the top ten banks in terms of size. As Gene Portias, president of 
the Credit Union Association of Oregon, stated: ``In a lot of places, 
credit unions are the major financial institution.'' \1\
---------------------------------------------------------------------------
    \1\ ``CUs, Banks Put Up Dueling Bills in Oregon,'' American Banker, 
March 25, 2003.
---------------------------------------------------------------------------
    These complex, aggressive institutions increasingly dominate the 
industry, yet still try to hide behind the veil of a ``traditional'' 
credit union. In spite of their metamorphosis into highly competitive 
financial institutions virtually indistinguishable from banks, these 
morphed credit unions enjoy the tax-preferred status conferred on the 
industry when it was comprised of small self-help organizations.
    Continuing the special tax treatment for institutions that look and 
act like tax-paying banks has public policy consequences. The size of 
the ``tax expenditure'' as the Office of Management and Budget calls 
it, is already big--more than a billion dollars per year. And basic 
economics tells us that it will get bigger as tax-favored

firms take business away from taxpaying firms. Simply put, as these 
morphed credit unions get larger, so does the tax expenditure.\2\
---------------------------------------------------------------------------
    \2\ Tax expenditures are defined in the law as ``revenue losses 
attributable to provisions of the federal tax laws which allow a 
special exclusion, exemption, or deduction from gross income or which 
provide a special credit, a preferential rate of tax, or a deferral of 
liability.''
---------------------------------------------------------------------------
    Not only is the credit union tax expenditure growing, but it is 
being misdirected to subsidizing financial services for individuals who 
clearly don't need it. The credit unions' own surveys suggest that 
their image of serving moderate--and lower-income people is no longer 
valid. The typical credit union member has higher than average income, 
more years of education, and is more likely to own a home than non-
credit union members. And now with an aggressive push by credit unions 
into business lending, businesses can get taxpayer-supported financial 
services.
New Breed of Credit Unions Serving Wealthy, Not ``People of Small 
        Means''
    The rapid growth of the credit union industry has been accompanied 
by significant changes in membership demographics. The focus on 
``people of small means'' was clearly enunciated in the preamble to the 
Federal Credit Union Act. This vision has gradually diminished as the 
metamorphosis to big, wealthy and sophisticated credit unions has 
progressed.
    Think Federal Credit Union exemplifies how that focus has changed 
in its 2003 Annual Report when it stated: ``Yesterday our challenge was 
to provide financial services to members who could not get services 
elsewhere. Today our challenge is to provide financial services to 
members who can get services anywhere.''
    The profile of the average credit union member today--higher than 
average income, better educated, and more likely to be in a 
professional occupation than his or her non-member counterpart--is not 
one typically associated with people needing taxpayer-supported 
financial services. According to a recent demographic survey conducted 
by the Credit Union National Association (CUNA), the average household 
income of credit union members is 20 percent higher than nonmembers--
$55,120 versus $45,790.\3\
---------------------------------------------------------------------------
    \3\ CUNA National Member Survey, 2002.
---------------------------------------------------------------------------
    A recent study by the GAO came to the same conclusion. Their 
analysis showed that 64 percent of households that primarily use a 
credit union are middle and upper income, as compared to 58 percent of 
households that primarily use banks. The fact is that bank customers 
are more likely to be from low- and moderate-income households than are 
credit union customers--yet credit unions continue to enjoy the tax 
expenditure purportedly because they serve people of modest means. As 
Bruce Shawkey of Credit Union Management magazine stated, ``--[C]redit 
unions' `bread and butter' members are middle-aged white males with 
mid-to-upper-incomes.''
    Even some credit union executives seem disturbed by the fact that 
credit unions have strayed so far from their original mandate to serve 
people of small means. Citing CUNA's numbers on the average household 
income of members served by credit unions, Armando Cavazos, president 
of Credit Union One in Ferndale, Michigan, said, ``We should almost 
feel guilty about serving people of affluence.'' \4\
---------------------------------------------------------------------------
    \4\ ``How to Head Off Coming Under CRA Dominates Debate at CUNA 
Convention,'' American Banker, October 14, 1994, p. 9.
---------------------------------------------------------------------------
    Jim Blaine, CEO of State Employees CU in Raleigh, NC, conceded 
``Maybe we've gotten so sophisticated we don't want to get our hands 
dirty with poor folks any more. That's what we were created to do, and 
sometimes I think we're forgetting that.'' \5\
---------------------------------------------------------------------------
    \5\ ``Are Credit Unions Dodging Their Responsibilities? One CEO 
Thinks So.'' Credit Union Journal, December 2, 2002, p. 11.
---------------------------------------------------------------------------
    And, Ed Gallagly, president/CEO of Central Florida Credit Union, 
says, ``There's no question that subconsciously--and even consciously--
some credit unions are trying to run-off unprofitable members. I hate 
to use that term run-off but that's what's happening.'' \6\
---------------------------------------------------------------------------
    \6\ ``Are Members Really Leaving Credit Unions? CEOs Offer Their 
Take,'' Credit Union Times, April 14, 2004, p. 42.
---------------------------------------------------------------------------
    Communities are not being served, either. Credit unions, unlike 
banks, are not required to meet the obligations set forth in the 
Community Reinvestment Act (CRA). In a study of Virginia credit unions, 
professors Murphy and O'Toole found that ``banks and savings 
institutions in Virginia are putting a greater percentage (88 percent) 
of their deposits back into the community in the form of loans than are 
credit unions (76.3 percent). In other words, tax treatment of credit 
unions has not resulted in a higher proportion of loans going to better 
meet the credit needs of the communities they serve.'' \7\
---------------------------------------------------------------------------
    \7\ A Study of the Evolution and Growth of Credit Unions in 
Virginia: 1997-2002, by Neil Murphy and Dennis O'Toole, November 2003.
---------------------------------------------------------------------------
    Is the tax benefit being passed on fully to credit union members? 
In more and more cases, the answer is no. In some case, it is going to 
build elaborate corporate headquarters like Golden 1 Credit Union's new 
200,000 square foot headquarters in Rosemont, California, costing more 
than $30 million and GTE Federal Credit Union's new 125,000 square-foot 
headquarters located on a 12.5 acre campus in Tampa, at a cost of about 
$22 million.
    And Digital Credit Union in Massachusetts paid $5.2 million for the 
naming rights for an arena in Worcester (MA) in 2004. Is this an 
appropriate use of the credit union tax exemption?
Business Lending--Extending Tax-Subsidized Services to Commercial 
        Entities
    In addition to serving a wealthier customer base, the new breed of 
credit unions is looking for profitable opportunities in commercial 
lending, thus further extending the tax exemption beyond its original 
purpose. Business lending by credit unions grew by almost 50 percent in 
2004. More than 420 credit unions have at least 5 percent of their 
total loans in business loans and almost 240 have at least 10 percent 
of their loan portfolio in business loans. Nearly 200 credit unions are 
designated guaranteed lenders by the Small Business Administration 
(SBA), and approximately 300 credit unions have either purchased or 
participated in business loans made to non-members.
    ``Successfully banking the small-business owner is one of the keys 
to increased credit union profitability,'' the Credit Union Executive 
Society noted. And many credit unions are following this course to 
boost profits. Jean Faenza, EVP for Telesis Community CU, describing 
her credit union's pursuit of business owners, stated: ``Remember, 
every business owner is a consumer who has other accounts--small 
business are employers. We're greedy--we want all of those accounts.'' 
\8\
---------------------------------------------------------------------------
    \8\ ``Show of Hands Indicates CU Interest in Biz Lending,'' Credit 
Union Journal, September 15, 2003, p 11.
---------------------------------------------------------------------------
     Lending by credit unions is big business. For example:

      Less than one year after commencing operations, CU 
Business Group, LLC said it had processed more than $50 million in 
business loans--with the average-sized loan worth more than $600,000. 
Larry Middleman, CU Business Group's President/CEO, noted that the 
``[l]oan packages are much larger than we anticipated.'' \9\
---------------------------------------------------------------------------
    \9\ Credit Union Journal, September 1, 2003.
---------------------------------------------------------------------------
      The average business loan outstanding at Florida's Vystar 
Credit Union is $487,000; at California's Telesis Community Credit 
Union, it is $769,000.
      Coastal Federal Credit Union with $1.4 billion in assets 
has ventured into complex commercial real estate transactions where the 
average size loan exceeds $4 million.\10\
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    \10\ Credit Union Times, March 30, 2005, p. 23.
---------------------------------------------------------------------------
      Texans CU's credit union service organization, Texans 
Commercial Capital, LLC, has approximately $214 million in business 
loans on its book and funded Prism Hotel's acquisition and construction 
financing of the 280-room Radisson Memphis Hotel in Tennessee.\11\
---------------------------------------------------------------------------
    \11\ ``Texans CU's Business CUSO Taking Off; LoansRange from Multi-
Million to Just Thousands,'' Credit Union Times, February 2, 2005, pp. 
1, 36.
---------------------------------------------------------------------------
      OmniAmerican CU has established a $10.5 million line of 
credit and $2 million for working capital to Wide Open Spaces LLC for a 
real estate development project.

    These are loans for which any bank would compete.
Subsidizing a ``Super Competitor''
    Competition in financial services occurs on the local level. The 
fact that the banking industry as a whole is much larger than the 
credit union industry has no bearing on head-to-head competition in the 
local market. The credit union tax exemption adversely affects tax-
paying banks. It gives credit unions a significant price advantage over 
tax-paying banks that offer the same products and services and enables 
credit unions to grow much more rapidly.
    The fact is that in more and more communities, it is the credit 
union that is many times larger than the local banks. For example,

      In North Carolina, State Employees Credit Union (SECU), 
which has assets of over $12.1 billion and 176 branch locations, 
competes directly with almost one hundred community banks, but is 44 
times larger than the average-sized community bank.
      The Credit Union of Texas, with $1.5 billion in assets, 
is almost seven times larger than the 17 community banks it competes 
with in its market.
      Visions FCU with $1.6 billion in assets boasts that it 
was the largest mortgage lender in Broome County (NY) for 2003.

    Some aggressive credit unions are now so large that they dominate 
the deposit market in their areas, competing head-to-head with large 
and small banks alike. For example:

      With $2.9 billion in assets, Vystar Credit Union in 
Northeast Florida dominates its market area with more deposits than 
First Alliance, Wachovia and Bank of America combined.
      With $5.3 billion in assets, Boeing Employees' Credit 
Union in WashingtonState dominates its market area with more deposits 
than Washington Mutual and Bank of America combined.
      With $1.8 billion in assets, ENT Federal Credit Union in 
Colorado dominates its market area with more deposits than Wells Fargo 
and World Savings Bank combined.

    It is obvious that the tax subsidy provides credit unions a very 
large pricing advantage. For example, professors Murphy and O'Toole 
found that ``--credit unions are enabled to offer a 67 basis point 
advantage in loan pricing and deposit pricing over banks as a direct 
result of the fact that credit unions do not pay state or federal 
taxes. In a highly competitive industry, the 67 basis point government 
subsidy is substantial.'' \12\
---------------------------------------------------------------------------
    \12\ A Study of the Evolution and Growth of Credit Unions in 
Virginia: 1997-2002, by Neil Murphy and Dennis O'Toole, November 2003.
---------------------------------------------------------------------------
    And the competition is not just banks versus credit unions, but it 
is these morphed credit unions pitted against traditional credit 
unions. Lorraine Ratoni, CEO of Sacramento County Grange Credit Union 
noted: ``We're losing members to larger credit unions. We're having a 
harder and harder time competing.'' \13\
---------------------------------------------------------------------------
    \13\ ``Friendly Foes: Once Allies, Credit Unions Now Compete for 
Customers,'' by Barbara Marquand, Sacramento Business Journal, May 24, 
1999.

---------------------------------------------------------------------------
Laura Bruce, writing for Bankrate.com, states

       ``To say credit unions don't compete with one another or with 
banks just doesn't ring true anymore. There's competition. Some of it's 
for sheer survival; some of it's for market share. Not all credit 
unions have jumped into the fray. Some employment or organization-based 
credit unions may have a very successful niche and be able to stay 
small and survive, maybe even thrive--but they're part of a shrinking 
minority.'' \14\
---------------------------------------------------------------------------
    \14\ ``The Changing Face of Credit Unions'' By Laura Bruce, 
Bankrate.com, December 19, 2003

    Should traditional credit unions be allowed to be squeezed out by 
larger, aggressive credit unions?
Policies Fuel Credit Union Consolidation and Unlimited Growth
    Through pro forma approvals of multiple common bonds, rapid 
approvals of community charters beyond any reasonable definition of 
``local,'' and liberal interpretations facilitating expansion of 
business lending and other service offerings, NCUA has fueled the 
evolution towards larger, more complex credit unions. Today, a single 
credit union can serve thousands of unrelated groups, or huge 
geographic areas with millions of people.
    Mergers and acquisitions have also played an important role in the 
expansion of many large credit unions. The result is fewer, but larger, 
credit unions. Over the last 4 years, nearly 1,100 small credit unions 
have disappeared.\15\
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    \15\ http://www.ncua.gov/news/speeches/2005/matz/463,20,Slide 20.
---------------------------------------------------------------------------
    Community charters are the fastest growing segment of the credit 
union industry. Federal law permits a credit union to serve anyone in a 
``well-defined, local community, neighborhood or rural district.'' \16\ 
In fact, the number of federal credit unions with community charters 
has more than doubled from 464 in 1999 to 1,051 as of year-end 2004.
---------------------------------------------------------------------------
    \16\ Public Law No.: 105-219.
---------------------------------------------------------------------------
    The use of the term ``community'' has reached absurd proportions. 
NCUA and various state regulators have approved community expansions 
that include some of the largest cities in the country, entire 
Metropolitan Statistical Areas (MSAs), multiple counties across state 
lines and even entire states as part of a credit union's field of 
membership. The result, according to GAO, is that the average size of a 
community charter approved by NCUA jumped almost three-fold from a 
population of 134,000 people in 1999 to 357,000 in 2003.\17\ And this 
growth occurred in spite of NCUA's acknowledgment that when Congress, 
in 1998 legislation, added the requirement that community credit unions 
be ``local,'' it intended to limit the size of such credit unions.
---------------------------------------------------------------------------
    \17\ Credit Unions: Financial Condition Has Improved, but 
Opportunities Exist to Enhance Oversightand Share Insurance Management. 
General Accounting Office, October 2003 (GAO-04-91), p 35
---------------------------------------------------------------------------
    As Scott Waite, Senior Vice President and Chief Financial Officer 
of the $3 billion-plus Patelco Credit Union, said on the credit union's 
expansive community charter in Northern California: ``[I]f you walk 
past our front door, you can join.'' \18\
---------------------------------------------------------------------------
    \18\ Bankrate.com
---------------------------------------------------------------------------
    A few of the many other examples that illustrate just how far the 
definition of ``local community'' has gone include:

      NCUA approved a community charter application for LA 
Financial CU to serve the 10 million plus residents of Los Angeles 
County--larger than the population in 42 states and a geographic area 
equivalent in size to the states of Rhodes Island and Delaware 
combined.
      Wescom Credit Union's field of membership includes the 16 
million people living in Los Angeles, Ventura, Orange, Riverside, and 
San Bernardino Counties.
      In 1999 and 2000, Meriwest Credit Union added the three 
million residents of Alameda and Santa Clara Counties and expanded its 
reach into Contra Costa and San Mateo Counties with a combined 
population of 1.7 million, and into the City and County of San 
Francisco--representing another 750,000 people.
      Boeing Employees CU in Washington State amended its field 
of membership to include the whole state of Washington.

    To evade field of membership limitations, credit unions have been 
forming charitable foundations. Anyone who makes a donation to the 
foundation is eligible to join the credit union. For example, $1.9 
billion GTE FCU advertises on its website: ``You can join GTE FCU even 
if you are not eligible for membership through your employer or a 
family member. GTE FCU sponsors a non-profit educational financial 
club, CUSavers.''
    And some credit unions do not even go through the pretense of 
having a common bond. As Greenwood CU in RhodesIsland states, 
``membership . . . is open to all responsible people who want to be a 
member.''
II. Being a Not-for-Profit Cooperative Does Not Justify the Tax 
        Exemption
    As morphed credit unions stretch their fields of membership across 
ever-larger geographic areas and venture into new business activities, 
an important justification for their tax exemption has disappeared. 
With the focus on people of small means displaced by marketing efforts 
to affluent individuals, another justification for the tax subsidy no 
longer applies.
    Since morphed credit unions no longer embody the traditional 
characteristics that justify continuing their tax exemption, they have 
been forced to offer a new justification. According to Dick Ensweiler, 
Chairman of the Credit Union National Association, ``Credit unions have 
the tax status that they do because they are not-for-profit, 
cooperatively owned, democratically governed, and generally led by 
volunteers from among the membership.'' \19\
---------------------------------------------------------------------------
    \19\ American Banker, April 2, 2004.
---------------------------------------------------------------------------
    But being a not-for-profit cooperative does not justify being tax 
exempt.
    In fact, most financial institutions that had traditionally been 
described as ``cooperative, member-owned and not-for-profit'' are now 
subject to federal taxation. Those institutions include mutual 
insurance companies, mutual savings banks, and mutual savings and loan 
associations. Each of these financial institutions lost their tax 
exemption years ago--mutual insurance companies in 1942, and mutual 
savings banks and mutual S&Ls in 1951. Why?
    In the 1951 decision, Congress determined that:

      These cooperative and mutual institutions were in 
``active competition'' with taxable institutions and continuing their 
tax exemption would be ``discriminatory;'' and,
      They had evolved into institutions whose ``investing 
members are becoming simply depositors, while borrowing members find 
dealing with a savings and loan association only technically different 
from dealing with other mortgage lending institutions in which the 
lending group is distinct from the borrowing group.'' \20\
---------------------------------------------------------------------------
    \20\ 56 Stat. 798.

    Thus, Congress determined that mutuality alone was not sufficient 
to continue the tax exemption for these institutions. This conclusion 
is particularly telling because of the similarities between mutual 
savings institutions and credit unions, as noted by the U.S. Treasury 
Department: ``Mutual thrifts are the federally insured depository 
institutions most similar in structure to credit unions, because like 
credit unions, mutual thrifts generally do not have corporate stock, 
are not-for-profit entities, and are owned by their depositors, or 
members, rather than by shareholders.'' \21\
---------------------------------------------------------------------------
    \21\ Comparing Credit Unions with Other Depository Institutions, 
United States Department of the Treasury, January 2001, p.25.
---------------------------------------------------------------------------
    The tax preference originally provided to credit unions was a way 
to subsidize financial services for individuals with low and moderate 
income. Many traditional credit unions still dedicate themselves to 
this purpose. But the metamorphosis to wealthy and sophisticated credit 
unions shows how quickly this goal can be abandoned.
    If the tax exemption is no longer conditioned upon the policy goal 
of serving low- and moderate-income individuals, can the special tax 
treatment for morphed credit unions be justified?
III. Congress Has Acted to Limit Tax Exemption
    Financial entities that have retained their tax-exempt status are 
generally subject to limitations that restrict either their size or the 
breadth of their membership. Moreover, their tax-exempt status remains 
based on narrowly crafted congressional directives relating to the 
service of niche markets or to achieving limited policy goals. With the 
erosion of both the common bond and the easing of limits on credit 
union products and services, credit unions' are free to stray from 
their original mission.
    The question of where the line should be drawn to control the 
taxpayer expenditure needs to be answered. Every expansion of a morphed 
credit union expands the tax expenditure. OMB estimates that the credit 
union ``tax expenditure'' will exceed $7.5 billion over the next five 
years.\22\ And most of the tax subsidy goes to the most aggressive 
credit unions--those that are least likely to embrace traditional 
credit union principles. In fact, the largest 100 credit unions absorb 
40 percent of the tax expenditure--quite a contrast with the 29 percent 
of just 6 years ago.
---------------------------------------------------------------------------
    \22\ OMB, February 2005, for the fiscal years 2006 through 2010.
---------------------------------------------------------------------------
    This is a substantial subsidy and, with no restraints, it will grow 
rapidly. Basic economics tells us what happens when a tax-exempt firm 
and a taxpaying firm offer the same products: the tax-exempt firm grows 
at the expense of the taxpaying firm. As business flows to the tax-
exempt firms and away from taxpaying institutions, the size of the tax 
expenditure will grow.
    As mutual insurance companies and mutual savings banks became 
similar to, in the words of the Congressional Budget Office, ``profit-
seeking corporations'', Congress eliminated their tax exemption.\23\ 
The public deserves a thorough review to assure that the tax 
expenditures are being appropriately spent and not disadvantaging 
competing businesses that carry out the same activities on which they 
pay taxes.
---------------------------------------------------------------------------
    \23\ Budget Options, CBO, March 2003, p. 218.
---------------------------------------------------------------------------
    Credit unions that have adhered to the traditional principles 
should continue to benefit from the tax preferences. Morphed credit 
unions that no longer serve a tight-knit group of people, that do not 
focus on people of limited resources, and that actively compete with 
tax-paying entities, however, should assume the same responsibilities 
to the public that other financial institutions do.
    Congress needs to ask: ``At what point do these diversified credit 
unions cease to be the type of institutions the Congress envisioned to 
be worthy of a tax exemption?''
Conclusion
    Complex, aggressive credit unions, which have evolved into full-
service financial institutions serving the general public, are a far 
cry from the small, traditional credit unions that served distinct 
groups of ``people of small means'' that Congress sought to assist when 
it provided tax subsidies to credit unions in the 1930's.
    Many credit unions continue to serve an important purpose in our 
financial system. They have maintained a limited common bond of 
membership and have focused on providing services to moderate and lower 
income individuals as laid out in the preamble to the Federal Credit 
Union Act. For many other credit unions, however, this focus has been 
abandoned, and expansionist policies have enabled the conglomeration of 
hundreds of unrelated groups within a single credit union. The focus 
has vanished for many credit unions adopting so-called community 
charters. These morphed credit unions are indistinguishable from tax-
paying banking institutions.
    The growing size of the tax expenditure, the increasing evidence 
that credit unions are serving the affluent, and the competitive 
implications for taxpaying institutions raise the question of whether 
continuing the special tax treatment for all credit unions can be 
justified. There may be reasons to preserve special tax and regulatory 
treatment for the many credit unions that have remained true to the 
spirit of the original credit union charter. But, for many other 
morphed credit unions with community charters or hundreds of unrelated 
groups, which offer products and services identical to banks, the 
question must be asked: Are their special tax and regulatory treatments 
still appropriate?

                                 

    Statement of John H. Graham IV, American Society of Association 
                               Executives
    Testimony is submitted on behalf of the American Society of 
Association Executives (``ASAE''), 1575 I Street, NW, Washington, 
DC20005. The core purpose of ASAE is to advance the value of voluntary 
associations to society and to support the professionalism of the 
individuals who lead them. ASAE's more than 22,000 members manage more 
than 12,000 trade associations, individual membership societies and 
philanthropic organizations in the U.S. and in 50 countries around the 
world. The number of people who belong to associations represented by 
ASAE totals more than 200 million.
BACKGROUND:

    According to the Internal Revenue Service (IRS), there are more 
than 1.8 million tax-exempt organizations in the U.S. Trade and 
professional associations, business leagues, and chambers of commerce 
comprise a relatively small percentage of that overall population. 
Slightly more than 86,000 501(c)(6) organizations are listed on the IRS 
exempt organization master file for fiscal year 2004. To meet the 
requirements of Section 501(c)(6), an organization must possess the 
following characteristics:

    a)  It must be an association of persons having some common 
business interest and its purpose must be to promote this common 
business interest;
    b)  It must be a membership organization;
    c)  It must not be organized for profit;
    d)  No part of its net earnings may inure to the benefit of any 
private shareholder or individual.

    While the number of 501(c)(6) organizations has grown in recent 
years--from 82,706 in fiscal year 2001 to just over 86,000 in fiscal 
year 2004--that growth has been moderate in comparison with charities 
and foundations organized under Section 501(c)(3) of the tax code.
    Because of the services and benefits derived from associations, 
Congress has determined they should benefit from tax exemption. The 
first integrated federal income tax statute, enacted in 1913, provided 
exemptions for business leagues, as associations were known at that 
time. The 1913 Act also provided exemptions for charitable, scientific, 
or educational organizations.
    As tax-exempt entities, associations are barred from accumulating 
equity appreciation for private benefit. Instead, these organizations 
undertake programs or initiatives to benefit members and the public 
rather than private individuals. Their earnings, therefore, must be 
dedicated to furthering the purpose for which they were organized.
    Congress first gave associations favored tax treatment largely in 
recognition of the benefit the public derives from their activities. 
The legislative history also indicates that the exemption was based 
upon the theory that the government is compensated for any loss of tax 
revenue by its relief from the financial burden that would otherwise 
have to be met through appropriating public funds. In simple terms, 
associations earn their exempt status by meeting many of the needs of 
their members and the general public that the government would 
otherwise have to meet.
    In the case of trade associations and professional societies, 
advocacy activities to assist public decision-making constitute a part 
of many association agendas. Associations promote and encourage civic 
activism and involvement, providing their members with the tools they 
need to speak effectively on the issues they believe in. Associations 
make significant contributions to the democratic process by serving as 
a bridge between elected officials and voters.
    However, associations are engaged in much more than ``special 
interest'' advocacy. In fact, trade associations spend three times more 
on professional development and public information campaigns than on 
direct lobbying.
    Ninety-five percent of associations offer educational programs to 
their members, making associations the primary professional development 
resource for America's workforce post-college. This responsibility is 
significant and staggering.
    Associations are the originating source for codes of ethics and 
professional and safety standards that govern a host of professions and 
disciplines in this country. As an example, dentists hold positions of 
trust in our society because organizations like the American Dental 
Association (``ADA'') hold their members to principles of ethics and 
codes of professional conduct that reflect a commitment to high 
standards of care. Quality education and academic freedom in this 
country is assisted by organizations like the American Association of 
University Professors (``AAUP'') that define fundamental professional 
values and standards for instructors of higher education, and whose 
procedures on academic due process remain the model for professional 
employment practices on campuses across the nation.
    Businesses and the government depend heavily on associations for 
their research and statistical information, which is often not 
available elsewhere. As an example, when lawmakers were looking to keep 
our markets moving and investors trading after the tragedy of Sept. 11, 
2001, they consulted the Security Traders Association (``STA'') about 
the possibility of reducing fees investors pay to the Securities and 
Exchange Commission (``SEC'').
    Associations also promote volunteerism, logging nearly 200 million 
volunteer hours in community service per year, according to the most 
recent survey completed by ASAE.
    The impact of association activities on segments of the economy is 
equally significant. Association-sponsored meetings and conventions now 
account for more than 26 million overnight stays in hotels each year. 
Associations drive the $102 billion U.S. meetings industry. Ninety-two 
percent of associations hold meetings accounting for 67 percent of the 
total meetings business, according to a study by the Convention 
Industry Council (``CIC'').
STATUTORY REQUIREMENTS & EXISTING OVERSIGHT:

    Trade and professional associations qualify for exempt status only 
if they meet strict statutory requirements that they be organized and 
operated in furtherance of their primary exempt purpose. Entities must 
submit an application to the IRS to obtain tax-exempt status and 
provide supporting evidence including Articles of Incorporation, 
Articles of Association, or other organizing documents; financial data; 
and a full description of the purposes and activities of the 
organization. The IRS can approve or deny the application. In fiscal 
year 2004, the IRS received 86,964 applications for Section 501(c) 
exempt status. The IRS approved 69,302 applications, and denied 1,049. 
The remaining 16,715 applications were not approved for various 
reasons, mostly because they were withdrawn by the organization or they 
were incomplete. Of the 86,964 applications in FY 2004, 1,813 were 
filed for Section 501(c)(6) trade association status; 1,489 were 
approved.
    Upon receiving tax-exempt status, associations must annually file a 
Form 990 to disclose their financial transactions and activities for 
the year if annual gross receipts are more than $25,000. Those that 
have less than $100,000 in gross receipts and year-end assets of less 
than $250,000 may file Form 990-EZ. In addition to entities with less 
than $25,000 in receipts, certain types of exempt organizations such as 
churches and religious organizations are not required to file. All tax-
exempt organizations that file must make their last three Form 990s 
widely available for public inspection as well, either in person or 
through posting on a Web site.
    Since 1950, associations have also paid unrelated business income 
tax (``UBIT'') on net income earned from any activity unrelated to the 
organizations' exempt purpose. Passive income such as dividends, 
interest, and income from certain research activities are not treated 
as unrelated business income. The courts and the IRS have developed 
standards over the years for determining when an activity will be 
treated as a trade or business regularly carried on by an exempt 
organization.
    In addition to the statutory requirements to receive and maintain 
exempt status, the IRS maintains oversight of the exempt community 
through the Tax-Exempt and Governmental Entities (``TE/GE'') Division. 
As mentioned earlier, the number of exempt applications filed with the 
IRS Exempt Organization (``EO'') Division has steadily increased each 
of the last five years. Despite this growth, EO staffing levels have 
not kept pace in previous years and were insufficient to maintain 
adequate oversight of the exempt sector, according to IRS Commissioner 
Mark Everson. Everson said in a statement April 5, 2005, that the 
agency's enforcement presence ``faded'' in the late 1990s. The U.S. 
Government Accountability Office (``GAO'') submitted a report to this 
committee at its April 20, 2005 hearing stating, in part, that staffing 
levels for the TE/GE Division at the IRS have been essentially flat 
since 1974: 2,075 agents in 1974 versus 2,122 in 2004. The 2004 IRS 
Data Book states that 863,494 returns were processed from tax-exempt 
organizations in calendar year 2003, and the number of returns examined 
by the IRS in fiscal year 2004 was 5,800. More recently, the IRS 
followed through on its commitment to hire more than 70 additional 
Exempt Organization Division examination agents in fiscal year 2005 and 
improve its current training for agents and examiners.
    The EO Division also continues to consider modifications to the 
Form 990 filed by tax-exempt groups. The goal appears to be to improve 
the scope and quality of the Form 990 and ensure more accurate and 
complete reporting from exempt organizations.
    The IRS is also moving forward with implementing new regulations 
requiring certain large corporations and tax-exempt organizations to 
electronically file their income tax or annual information returns 
beginning in 2006. For tax year 2005 returns that are due in 2006, the 
regulations require that corporations with total assets of $50 million 
or more file their Forms 1120 and 1120S electronically. In addition, 
tax-exempt organizations with total assets of $100 million or more will 
be required to file their tax year 2005 Form 990 electronically. 
Beginning in 2007, the electronic filing requirement will be expanded 
to include the tax year 2006 tax returns of corporations and tax-exempt 
organizations with $10 million or more in total assets. In addition, 
private foundations and charitable trusts will be required to 
electronically file their Form 990-PF electronically, regardless of 
their asset size.
NONPROFIT GOVERNANCE:

    The tax-exempt community has been proactive and largely self-
regulating in considering issues related to governance in recent years.
    More than a year ago, ASAE and its members gathered for a first-
ever National Consensus Conference on Nonprofit Governance in New York, 
Jan. 12-13, 2004. The discussion among the roughly 150 nonprofit 
executives in attendance focused on how, and to what extent, nonprofit 
organizations can voluntarily strengthen their governance principles 
and practices. The conference proved to be a good starting point for 
developing and disseminating guidelines for nonprofit governance. Among 
the principles considered were: the role of the nonprofit 
organization's governing board in setting policy and providing 
oversight; the independence of the governing board from management; the 
presence, composition and role of an audit committee, or at least a 
committee fulfilling the audit committee function; codes of 
organizational conduct for nonprofit governance; chief executive 
compensation review; accurate and complete financial disclosures; 
policies and procedures for investigating complaints; and policies and 
procedures for document destruction.
    In considering the applicability of corporate governance provisions 
to nonprofits, however, it is important to note the diverse nature of 
the tax-exempt community, and recognize there is no ``one size fits 
all'' blueprint for governance standards. As pointed out earlier in 
this document, the nonprofit community is diverse, ranging from 
fraternal societies and small social clubs, to charities and scientific 
societies to trade associations and chambers of commerce. The size and 
resources of various nonprofit organizations impact the necessity for, 
as well as their ability to implement, certain governance practices.
    Despite their complexity, tax-exempt organizations are not 
precluded, nor should they be excused, from responsible governance. The 
development of ``best practices'' for nonprofit governance requires 
realistic cost-benefit analysis, and careful attention that the 
essential work of these exempt organizations, and the value they bring 
to society, continues unabated by unnecessary and burdensome compliance 
measures.
    Organizations representing the interests of the 501(c)(3) 
charitable community, such as Independent Sector, have also been 
working to enhance compliance and accountability in the nonprofit 
sector.
    The Panel on the Nonprofit Sector, comprised of leaders of 
nonprofit organizations and convened by Independent Sector, released an 
interim report March 1, 2005, that lists recommendations in 15 major 
areas, including actions to be taken by the nonprofit sector itself, by 
the IRS, and by Congress. The panel encourages the nation's 1.3 million 
charities and foundations to adopt and implement a conflict of interest 
policy; ensure its board includes individuals with financial literacy 
skills; and develop specific practices and procedures to encourage and 
protect whistleblowers.
    The panel also is supporting stronger disclosure rules, such as: 
suspension of exempt status of any organization that fails to file 
required Form 990 returns with the IRS for two or more consecutive 
years; a requirement that chief executive officers certify that their 
Form 990 returns are correct and complete; mandatory electronic filing 
of Form 990 to improve the accuracy and timeliness of information; and 
a requirement that charitable organizations conduct an independent 
audit of their finances if they have annual revenues of $2 million or 
more.
CONCLUSION:

    ASAE appreciates the committee's consideration of the legal history 
of the tax-exempt sector, as well as its size, scope and impact on 
society, and agrees that tax exemption is an important benefit, and 
that Congress has a responsibility to oversee and assure that the tax-
exempt sector is accountable and deserving of public trust.
    ASAE believes that disclosure and transparency benefit both 
nonprofit organizations and the communities they serve. By their very 
nature, tax-exempt nonprofit organizations are organized for a ``higher 
purpose,'' often to provide a valuable role or function that might 
otherwise fall to the government, as earlier stated. The performance 
and long-term survival of these organizations is highly dependent on a 
measure of public confidence. While not untouched by isolated instances 
of fiscal mismanagement or ethical abuse, the vast majority of 
nonprofit organizations have embraced their responsibility to institute 
governing practices that ensure public trust.
    Countless association activities today not only further the exempt 
purpose of the organization, but also contribute to improving the 
general welfare of communities across the country. ASAE urges the 
Committee, in its continued examination of the tax-exempt sector, to 
consider the important, growing role associations play in American 
society, and how changes to current statutory requirements might impact 
an enormous number of programs and services now offered by 
associations.

                                 

                       Association of the Fundraising Professionals
                                                      Cleveland, OH
                                                     April 26, 2005
The Honorable Bill Thomas
U.S. House of Representatives
2208 Rayburn House Office Building
Washington, DC20515

Dear Congressman Thomas:

    I am writing to urge you to protect the charitable sector from 
unnecessary and overly burdensome regulations such as those presented 
by the Senate Finance Committee, particularly those proposals that 
would modify the tax rules regarding non-cash charitable contributions 
(known as ``in-kind'' contributions).
    The new proposals include recommendations to completely eliminate 
or substantially modify deductions for in-kind contributions. Many 
charities heavily rely upon non-cash donations, and there is no 
legitimate reason to attack this lifeline. I work for Cleveland State 
University as a Major Gifts Officer. I have helped the Fenn College of 
Engineering secure equipment gifts to upgrade laboratories and software 
gifts valued at $1,000,000 (discounted educational value). In-kind 
gifts have enabled Cleveland State to offer some of the latest 
technological advances to our engineering students, especially during a 
time when the state of Ohio continues to cut funding for higher 
education and funds are not available for lab equipment and software 
upgrades!
    Changing the in-kind contribution rules would unfairly compel 
charities to divert valuable time and resources to new valuation 
compliance schemes. The inability of the Internal Revenue Service to 
address improper donor behavior should not result in penalties for 
charities and the communities and populations that they serve. 
Significant revision of the in-kind contribution rules would greatly 
diminish my organization's ability to provide altruistic services.
    Furthermore, these proposals are not based on any credible evidence 
of wide-spread abuse. In fact, empirical data indicates that there is 
NOT widespread abuse among the charitable sector and that proposals are 
unnecessary. Reports collected by the FBI, the Federal Trade 
Commission, State Attorneys General and even watchdog groups like the 
Better Business Bureau show that reports of charity fraud are less than 
1 percent of all complaints of fraud. This is consistent with every 
single year's annual findings in the annual report on Fraud in the 
United States published by the FTC.
    It appears that many of the suggestions are driven by a desire to 
raise federal revenues from the charitable sector. Such an effort is 
completely inconsistent with the notion of tax-exempt status, and I 
hope you will strongly oppose such proposals.
    The Senate Finance Committee's proposals to alter the non-cash 
charitable gift incentives come at a precarious time for charities. 
Americans are a generous people, but many charities are still 
recovering from the past several years when charitable giving has been 
flat and even decreased for many organizations.
    At the same time, we understand that your committee seeks to gather 
information on the size, scope, and impact on the economy of the 
nonprofit sector; the need for congressional oversight; IRS oversight 
of the sector; and what the IRS is doing to improve compliance by the 
sector with the law. These are laudable objectives. We are interested 
in assisting the committee in identifying appropriate areas for further 
study as well as criteria and standards to better define and outline 
the sector and its players.
    Again, I urge you to oppose changes to the in-kind contribution 
rules as well as any unreasonable and burdensome legislation that would 
harm the charitable sector. I very much appreciate your support.
    Thank you for your consideration.
            Sincerely,
                                                  Deborah S. Miller
                President, Association of Fundraising Professionals
                                          Greater Cleveland Chapter

                                 

Statement of David C. Jones, Association of Independent Consumer Credit 
                          Counseling Agencies
    Mr. Chairman and members of the Committee, the Association of 
Independent Consumer Credit Counseling Agencies (AICCCA) welcomes this 
opportunity to submit comments for the Committee's consideration on the 
important topic of the proper policy and enforcement mix for the tax-
exempt sector. While credit counseling agencies are members of that 
broad sector they do have a unique role, responsibilities, and 
regulatory structure. This makes it important that Congress 
differentiate between them and other tax-exempt entities and adopt 
appropriate policies going forward. A ``one size fits all'' approach to 
tax-exempt organizations is not the right policy prescription.
Ongoing Federal and State Oversight and Regulation

    We were privileged to have our testimony heard at the November 20, 
2003 hearing held by your Subcommittee on Oversight regarding Non-
Profit Credit Counseling Organizations. At that hearing, we described 
the difficult challenges and regulatory issues that our industry faced. 
We also expressed strong support for the consumer protections that the 
credit counseling industry must implement and enforce to protect some 
of our most vulnerable citizens: Individuals and families that have 
become burdened by unmanageable levels of debt. AICCCA continues to 
strongly support these consumer protections; we continually demonstrate 
our commitment by undertaking strong self-regulation for our 
Association members.
    The consumer credit counseling sector continues to receive intense 
government scrutiny due to the practices of a few rogue agencies. On 
April 13, 2005, the Senate Permanent Subcommittee on Investigations 
(PSI) issued a bipartisan Subcommittee report on abusive practices 
committed by certain ``bad actor'' credit counseling agencies. This 
report incorporated information from a PSI hearing held in March 2004 
and associated staff investigations; AICCCA applauded that 
investigation and provided written testimony in support of that 
hearing. The PSI's report contains five important recommendations for 
the nation's creditors, the FTC and IRS, and the credit counseling 
industry. AICCCA supports the intent of all five of these 
recommendations.
Those PSI recommendations are:

    1.  Complete elimination of abusive practices through ongoing IRS 
audits and FTC enforcement actions.
    2.  Establish regular periodic review of an agency's tax-exempt 
status.
    3.  Ensure that each tax-exempt agency provides affirmative 
financial counseling and education programs.
    4.  Continue creditor support of and standards for the credit 
counseling sector, including a requirement to maintain accreditation 
within the industry.
    5.  Clarification of IRS and FTC standards regarding tax-exempt 
status and acceptable trade practices in regard to accreditation; 
independent boards; assurance of public benefits; full disclosure of 
relationships with creditors and for-profit service providers; 
reasonable fees; and controls on improper incentives for client 
enrollment or referrals.

    While AICCCA supports the broad scope of all these recommendations, 
we do believe that certain clarifications and fine-tuning are required. 
For example, we applaud the PSI's recognition of the key role that 
agency accreditation plays in assuring consumer protection. However, we 
believe that PSI erred in only mentioning the standards of the Council 
on Accreditation (COA). While the AICCCA accepts COA accreditation, it 
believes that accreditation through the International Standards 
Organization (ISO) to specific credit counseling sector requirements is 
considerably more rigorous. For example, ISO accreditation employs more 
frequent compliance audits.
    The AICCCA also supports the credit counseling provisions included 
in section 106 of S. 256, the bankruptcy reform legislation signed into 
law by the President on April 20, the same day as your hearing. That 
legislation requires every consumer to consult with an approved credit 
counseling agency before filing for bankruptcy, and to complete an 
approved financial education course before receiving their bankruptcy 
discharge from debt. The new powers vested in the Justice Department's 
Executive Office for United States Trustees (EOUST) are intended to 
enforce minimum standards for non-profit credit counseling agencies 
approved to provide pre-bankruptcy counseling to the nation's 
consumers. Once issued, these standards will be in addition to the many 
and varied existing state regulations as well as the powers of the IRS 
to audit and regulate the industry to assure compliance with tax-exempt 
status requirements. For many consumers, a counseling agency's 
participation in the pre-bankruptcy counseling program as an EOUST-
approved agency will become a critical stamp of approval when they seek 
financial advice and assistance.
    States continue to have the lead role in regulating the credit 
counseling sector, and they have been quite active on two fronts. 
First, many states have revised and strengthened their existing state 
laws in response to the well-publicized abuses of a few rogue agencies. 
Second, the states are engaged in the process of promulgating a new 
model law for statehouse consideration. On April 7th through 9th, 2005, 
the National Conference of Commissioners for Uniform State Laws 
(NCCUSL) met under the guidance of bankruptcy Judge William Hillman to 
consider the final draft of the model Uniform Debt Management Act. Over 
the past two years, the AICCCA has participated continuously with the 
NCCUSL in this drafting effort, and we support the great majority of 
the provisions of this proposed uniform law intended for adoption by 
all states beginning with the 2006 legislative sessions.
    Joint Committee on Taxation Proposal
    On January 27, 2005, the staff of the Joint Committee on Taxation 
issued JCS-02-05, Options to Improve Tax Compliance and Reform Tax 
Expenditures. While this large report covers the non-profit universe as 
well as other tax and enforcement matters, it includes specific 
recommendations regarding the treatment of the credit counseling 
industry. These recommendations appear on pages 327 through 337 in 
section L. entitled, Establish Additional Standards for Credit 
Counseling Organizations (sec. 501(c)(3) and 501(c)(4)). This report 
suggests that additional legislation is required and proposes the 
enactment of a number of specific requirements beginning on page 331 
entitled, Description of Proposal, Additional requirements applicable 
to all credit counseling organizations. Some of these proposals are 
eminently reasonable and are consistent with current regulation as well 
as AICCCA self-regulatory standards. For example, requirements (1) 
through (8) on pages 331 and 332 are in alignment with AICCCA standards 
and the Code of Practice requirements for our members; agree with, 
expand, or restate current laws and regulations; and represent 
reasonable regulatory application.
    However, there is one unrealistic recommendation that threatens the 
viability of the non-profit credit counseling sector and its ability to 
carry out the critical new ``gatekeeper'' role assigned to it by the 
new bankruptcy reform legislation. The section entitled, Additional 
requirements for charitable or educational organizations, on page 332, 
is poorly conceived and represents an alarming lack of understanding of 
the credit counseling industry. This section would require that, ``(4) 
the aggregate of the agency's debt management plan services (measured 
by time, resources, effort expended by the agency, and any other 
factors prescribed by the Secretary) during the four-year period that 
includes the agency's current taxable year and the immediately 
preceding three taxable years does not exceed 10 percent of the 
agency's total activities during such four-year period;''.
    On page 336, the report also refers to an IRS counsel memorandum 
released in July of 2004. This memorandum also suggested a 10% limit on 
debt management plan (DMP) activities and is the likely source for the 
Joint Committee on Taxation's proposed provision. It states that, ``The 
10-percent limit applicable to charitable and educational organizations 
comports with the traditional levels of such activity before the 
dramatic growth in the industry.'' While this may or may not have been 
true far in the past, the statement completely ignores the fact that 
even 15 years ago consumers did not have the broad access to credit or 
carry the large levels of indebtedness that have become common today. 
The fact is that consumer debt, and the stresses that accompany it, 
have grown much faster than the credit counseling industry. As a 
result, the number of consumers for whom a DMP is an appropriate 
alternative to filing bankruptcy has grown so large that no agency 
could limit DMPs to 10% of total activities and even begin to meet the 
needs of consumers. Further, the thrust of the newly enacted bankruptcy 
reform bill is at complete odds with this unrealistic ceiling. That new 
law will send at least 1.5 million additional consumers through the 
doors of approved credit counseling agencies on an annual basis, and 
some significant percentage is expected to opt for entering into a DMP 
as an alternative to bankruptcy. How can Department of Justice-approved 
counseling agencies fulfill their role and recommend a DMP where it 
appears to be the suitable course for a given consumer if that 
recommendation risks jeopardizing the agency's tax-exempt status?
    AICCCA believes that, if enacted, this provision would eliminate 
all non-profit credit counseling agencies without exception. Even 
though legitimate credit counseling agencies typically enroll in debt 
management plans only between 10% and 25% of those they counsel, those 
who are enrolled must receive continuing support as they repay their 
debts over a three-to-five-year period. Many of these support 
activities are mandated by current state laws that have compelled all 
reputable credit counseling agencies to devote an ever-increasing 
portion of their activities to DMP support. This means that a large 
part of any agency's activities involve continuing efforts (education, 
re-budgeting, re-counseling, monthly payment processing) to assist 
consumers that are in the process of repaying their debts under 
structured plans. While credit counseling and education are the primary 
activities of any legitimate credit counseling agency, activities 
necessary to support those who qualify for debt management plans will 
always constitute far more than 10% of an agency's work, especially 
given current levels of consumer indebtedness. This JCT proposal is 
unnecessary, unrealistic, and at total odds with state regulation and 
the new bankruptcy reform bill. The level of resources devoted to DMP 
support can and does vary significantly between legitimate counseling 
agencies. AICCCA strongly recommends that this inflexible and misguided 
JCT recommendation be rejected in favor of flexible oversight of an 
agency's activities to assure that they meet all applicable standards 
and serve the best interests of clients.
    There are other JCT recommendations that are also cause for serious 
concern. For example, also on page 336, the report refers to the IRS 
memorandum suggestion that income from DMP activity could be considered 
unrelated business income in some cases and therefore taxable. However 
the report makes no proposal of its own on this subject and relies on 
present law to determine this issue. As this issue was decided by the 
federal district court in the 1976 Consumer Credit Counseling Service 
of Alabama decision, the AICCCA concurs that reliance on present law is 
appropriate. This income flows from activity that is an integral part 
of a non-profit's overall mission. Credit counseling agencies should 
not be asked to operate under the threat that a judicial decision on 
which they have relied for more than a quarter century may be reversed 
by regulatory fiat or ill-considered legislation.
    Finally, while projected revenue raising should not be the primary 
focus of any proposed reform of the tax treatment of credit counseling 
agencies, AICCCA would note that the JCT's estimate for increased 
revenue flowing from full adoption of its credit counseling 
recommendations is both minor and unrealistic. JCT projects that 
adoption would generate $100 million over a ten year period, or only 
$10 million a year. Even this modest figure is wildly optimistic, as 
adoption of the ten percent DMP activity limit would cause credit 
counseling agencies to lose their tax-exempt status and become 
ineligible to provide services in most states, or to participate in the 
pre-bankruptcy counseling program established by the new reform bill. 
They would thus be forced to cease their operations, and defunct 
entities generate no tax revenues.
Federal Regulation

    The AICCCA trusts that the Congress will consider carefully any 
legislation designed to regulate the credit counseling industry. 
Whatever Congress does, it must recognize that the Tax Code is not an 
efficient mechanism for direct regulation of activities. Once a credit 
counseling agency has met and maintains reasonable criteria for tax-
exempt status, any further regulation of its activities should be done 
directly. And, before taking such a step, Congress must recognize that 
counseling agencies already operate in a complex federal and state 
regulatory environment.
    Well-meaning but poorly conceived attempts to protect citizens from 
headline-grabbing abuses have had an opposite and unanticipated effect 
in many states. For example, Maryland has passed a law with such high 
bonding requirements that most legitimate small-to-medium-sized 
agencies cannot comply with it. Unfortunately, Kansas and New York have 
passed similar laws. In contrast, Georgia enacted a law that does not 
require high bonding levels but that nonetheless protects its citizens 
by requiring appropriate insurance coverage that is within the 
financial reach of responsible credit counseling agencies.
    In another area of ongoing debate, Virginia recently passed a 
provision that allows for-profit credit counseling firms to serve their 
citizens. AICCCA believes that the credit counseling sector should 
remain non-profit, and observes that the profit motive was clearly at 
the heart of all of the recent abuses of rogue agencies that received 
wide media coverage. If the JCT's ill-advised DMP activity limit were 
adopted it would drive legitimate non-profit agencies out of business 
and leave the credit counseling function wide open to participants for 
whom profit maximization is the primary goal.
    AICCCA is gratified that no direct federal regulation of credit 
counseling, beyond the EOUST standards for pre-bankruptcy counseling 
eligibility, are being contemplated at this time. If a federal 
regulation statute were enacted, it would impose yet another layer of 
rules on an industry that is struggling to support consumers who are in 
serious need of unbiased advice and expertise. The counseling industry 
is also in the process of preparing for its considerable 
responsibilities under the new bankruptcy reform law. If new regulation 
is to be imposed it would be far more preferable for the states to 
enact the uniform law that is undergoing final NCCUSL review and 
approval.
Conclusion

    The abuses that have been the focus of the many hearings and 
investigations into the credit counseling industry over the past 
several years--and which have caused complaints and lawsuits, generated 
many new state laws, and fed unending negative press coverage--are the 
result of a relatively few maverick agencies. The AICCCA believes that 
appropriate IRS oversight and the enforcement of existing law are in 
the process of proving their ability to protect consumers from those 
abuses that have occurred. In addition, both the AICCCA and the 
National Foundation for Credit Counseling have long-established and 
rigorous consumer protection standards that accredited member agencies 
must meet and maintain.
    If the members of the Ways and Means Committee decide that new tax 
legislation that affects credit counseling is worthy of consideration, 
the AICCCA stands ready to provide any assistance or insight that is 
requested. Our members are dedicated to serving the best interests of 
consumers in need of counseling and personal finance education 
nationwide. As you go forward, we ask you to differentiate between 
credit counseling agencies and the great number of other types of tax-
exempt entities. We also implore you to refrain from adopting ill-
conceived and unrealistic requirements for agencies to qualify for and 
retain tax-exempt status that could undermine their ability to survive 
and serve the financial assistance needs of millions of Americans in 
economic distress.

                                 

                        Central Arkansas Area Agency on Aging, Inc.
                                        North Little Rock, AR 72119
                                                        May 2, 2005
The Honorable Bill Thomas
U.S. House of Representatives
2208 Rayburn House Office Building
Washington, DC 20515

Dear Congressman Thomas:

    I am writing to urge you to protect the charitable sector from 
unnecessary and overly burdensome regulations such as those presented 
by the Senate Finance Committee, particularly those proposals that 
would modify the tax rules regarding non-cash charitable contributions 
(known as ``in-kind'' contributions).
    The new proposals include recommendations to completely eliminate 
or substantially modify deductions for in-kind contributions. Many 
charities heavily rely upon non-cash donations, and there is no 
legitimate reason to attack this lifeline. [Please insert a sentence or 
two here about how your organization relies on in-kind gifts.]
    Changing the in-kind contribution rules would unfairly compel 
charities to divert valuable time and resources to new valuation 
compliance schemes. The inability of the Internal Revenue Service to 
address improper donor behavior should not result in penalties for 
charities and the communities and populations which they serve. 
Significant revision of the in-kind contribution rules would greatly 
diminish my organization's ability to provide altruistic services.
    Furthermore, these proposals are not based on any credible evidence 
of wide-spread abuse. In fact, empirical data indicates that there is 
NOT widespread abuse among the charitable sector and that proposals are 
unnecessary. Reports collected by the FBI, the Federal Trade 
Commission, State Attorneys General and even watchdog groups like the 
Better Business Bureau show that reports of charity fraud are less than 
1 percent of all complaints of fraud. This is consistent with every 
single year's annual findings in the annual report on Fraud in the 
United States published by the FTC.
    It appears that many of the suggestions are driven by a desire to 
raise federal revenues from the charitable sector. Such an effort is 
completely inconsistent with the notion of tax-exempt status, and I 
hope you will strongly oppose such proposals.
    The Senate Finance Committee's proposals to alter the non-cash 
charitable gift incentives come at a precarious time for charities. 
Americans are a generous people, but many charities are still 
recovering from the past several years when charitable giving has been 
flat and even decreased for many organizations.
    At the same time, we understand that your committee seeks to gather 
information on the size, scope and impact on the economy of the 
nonprofit sector; the need for congressional oversight; IRS oversight 
of the sector; and what the IRS is doing to improve compliance by the 
sector with the law. These are laudable objectives. We are interested 
in assisting the committee in identifying appropriate areas for further 
study as well as criteria and standards to better define and outline 
the sector and its players.
    Again, I urge you to oppose changes to the in-kind contribution 
rules as well as any unreasonable and burdensome legislation that would 
harm the charitable sector. I very much appreciate your support.
    Thank you for your consideration.
            Sincerely,
                                                        Ann C. Leek
                                        Vice President, Development

                                 

       Statement of Gary Kohn, Credit Union National Association
    Credit unions are exempt from federal and most state taxes 
because--unlike many other insured financial institutions--credit 
unions are member-owned, democratically operated, not-for-profit 
organizations generally managed by volunteer boards of directors and 
because they have the specified mission of meeting the credit and 
savings needs of consumers, especially persons of modest means.
    Congress itself came to the above conclusion just seven years ago, 
when it passed the Credit Union Membership Access Act (PL 105-219). 
Since 1998, nothing has changed in the structure and focus of credit 
unions.
    The Credit Union National Association (CUNA), and the 86 million 
members of the credit unions in the United States, urges you to leave 
the tax status of credit unions unchanged, recognizing that the tax 
exemption is sound public policy, based on the following:

      The original justification for the tax exemption still 
holds;
      Credit unions serve those of modest means at reasonable 
costs;
      Over 86 million credit union members receive substantial 
benefits;
      The tax exemption ensures the cooperative alternative is 
available;
      Credit unions of all sizes benefit their members; and,
      There is no evidence of market disruption from the tax 
exemption.

    The following pages detail each of these six points:
Original justification for the credit union tax exemption still holds

    Since inception, the credit unions tax exemption has had absolutely 
nothing to do with either field of membership restrictions or the 
extent to which credit union service offerings were limited. Rather, 
the original reason for the tax exemption was based solely on the 
cooperative structure of credit unions. The U.S. Treasury Department 
underlined this fact in its most recent comprehensive report on credit 
unions outlining the rationale for the tax exemption for federal credit 
unions:

     Two reasons were given for granting this exemption (in 1937): (1) 
that taxing credit unions on their shares, much as banks are taxed on 
their capital shares, ``places a disproportionate and excessive burden 
on the credit unions'' because credit union shares function as 
deposits; and (2) that ``credit unions are mutual or cooperative 
organizations operated entirely by and for their members . . .'' Thus, 
the tax exemption was based primarily on the organizational form of 
credit unions . . . (Quotes within this excerpt are from H.R. REP. NO. 
1579, 75th Cong., 1st Sess. P. 2.) \1\
---------------------------------------------------------------------------
    \1\ U.S. Department of the Treasury ``Comparing Credit Unions and 
Other Depository Institutions'', January 2001. Page 28.

    Similarly, the rationale for the tax exemption for state chartered 
credit unions hinges on their cooperative structure. In a 1991 report, 
---------------------------------------------------------------------------
the GAO found:

     Under current law, state credit unions are exempt from tax under 
Internal Revenue Code section 501(c)(14)(A). This section states that 
credit unions that are (1) operating on a nonprofit basis, (2) 
organized without capital stock, and (3) operating for mutual purposes 
can qualify for exemption.\2\
---------------------------------------------------------------------------
    \2\ GAO, July 1991. Page 292.

     Today, credit unions continue to operate as democratically 
controlled mutual institutions, serving their members on a non-profit 
basis. Rather than distributing net income among stockholders (as do 
banks), the bulk of it is returned to members in lower loan rates and 
fees, or higher yields on savings. The balance is retained by the 
credit union to comply with statutorily mandated net worth requirements 
that protect the federal share insurance fund and the taxpayer from 
loss. These retained earnings are not accumulated for the benefit of 
management or stockholders. They exist only for the benefit of members 
---------------------------------------------------------------------------
in the future by providing for the stability of the credit union.

    As indicated at the outset, Congress recently reaffirmed the tax 
treatment of credit unions in the findings to the Credit Union 
Membership Access Act of 1998. Specifically, the findings read:

      The Congress finds the following: . . .

      (4)  Credit unions, unlike many other participants in the 
financial services market, are exempt from Federal and most State taxes 
because they are member-owned, democratically operated, not-for-profit 
organizations generally managed by volunteer boards of directors and 
because they have the specified mission of meeting the credit and 
savings needs of consumers, especially persons of modest means.\3\
---------------------------------------------------------------------------
    \3\ Pub. L. No. 105-219. August7, 1998.

    By way of contrast, mutual savings banks lost their tax exemption 
because they competed with taxed institutions AND because they engaged 
in widespread proxy voting schemes and were not democratically 
controlled (voting was based on the size of each member's deposit not 
on the basis of one-member-one-vote as is the case with credit unions). 
The U.S. Treasury underlined this fact in its recent comprehensive 
report on credit unions. The report states: ``In 1951, however, 
Congress removed the thrift tax exemption because these institutions 
had evolved into commercial bank competitors, and had lost their 
``mutuality,'' in the sense that the institutions' borrowers and 
depositors were not necessarily the same individuals.
    The significance of the credit union tax exemption is well 
understood by public officials. Last year, both President Bush and 
Senator Kerry wrote letters affirming their appreciation for the 
important service that credit unions provide to their 86 million 
members, and indicating their support for the continuation of credit 
unions' tax exemption. Their support was added to that of a number of 
members of Congress, including: Senate Banking Committee Chairman 
Richard Shelby, House Majority Leader Tom DeLay; House Majority Whip 
Roy Blunt; House Minority Whip Steny Hoyer; and nearly 200 other 
members of Congress.
Credit unions serve those of modest means at reasonable costs

    A recently published study found that: ``Households that use a bank 
only have higher median incomes than those who use a credit union 
only'' and ``Among households that use both a bank and a credit union, 
those that use a bank primarily have higher median incomes than those 
that use a credit union primarily.'' \4\
---------------------------------------------------------------------------
    \4\ Jinkook Lee and William Kelly, Who Uses Credit Unions, Third 
ed. Filene Research Institute, 2004. Page 15.
---------------------------------------------------------------------------
    A significant way credit unions provide value to America's working 
class and modest income consumers is through the pricing of their 
services. Numerous studies and reports show that credit unions charge 
fewer and lower fees than do banks for the same kinds of services.\5\ 
In particular, minimum balances to avoid fees are typically much lower 
at credit unions than at banks. Lower rates on loans, especially on 
used cars and small loans are another way credit unions serve those of 
modest means. Credit unions also serve America's low and moderate-
income households with member business loans. The Treasury reported in 
1999 that 45% of credit union member business loans were to borrowers 
with household incomes below $50,000.\6\ In addition, Home Mortgage 
Disclosure Act (HMDA) data consistently shows that low income or 
minority applicants are significantly more likely to have their loans 
approved at a credit union than at any other type of lender.
---------------------------------------------------------------------------
    \5\ 2004-2005 Credit Union Fees Survey, Credit Union National 
Associa1tion. Big Banks, Bigger Fees 2001, US Public Interest Research 
Group. New Jersey Department of Banking and Insurance, various surveys. 
The Money Talks Personal Finance Advice website at www.moneytalks.org.
    \6\ US Department of the Treasury. Credit Union Member Business 
Lending. January 2001.
---------------------------------------------------------------------------
    Throughout most of their history, credit unions have actually been 
hamstrung in their efforts to serve members of modest means because 
field of membership rules generally restricted eligibility to 
occupational groups. Four years ago, the National Credit Union 
Administration adopted an expedited program known as Access Across 
America to permit federal credit unions to add underserved areas to 
their fields of membership. Since the beginning of 2001, over 92 
million potential members from underserved areas have been added to 
credit union fields of membership. Credit unions acknowledge it will 
take some time to reach out to and serve members in these communities. 
However, in the three years ending December 2003, credit unions that 
added such underserved areas experienced membership growth over three 
times that of other credit unions (17.4% vs. 5.2% over the three year 
period.)
86 million CU members receive substantial benefits

    Credit unions provide substantial, tangible benefits to members 
that far exceed the amount of the tax exemption. These benefits are 
realized in the form of lower fees, lower loan rates, and higher yields 
on savings. CUNA has estimated that these benefits total over $6 
billion a year.\7\ That is the additional amount that credit union 
members would pay if they were to conduct all the business they do at 
banks instead of credit unions. That is about four times the roughly 
$1.5 billion that credit unions would pay in federal income tax.
---------------------------------------------------------------------------
    \7\ The Benefits of Credit Union Membership. CUNA Research and 
Policy Analysis White Paper, 2004.
---------------------------------------------------------------------------
    The tax exemption is leveraged as it is for the benefit of credit 
union members because of the cooperative structure of credit unions. 
When comparing banks to credit unions, the amount that banks pay in 
dividends to stockholders is more significant than is the tax 
exemption. Further, credit unions either do not compensate directors 
(as is the case with federal credit unions), or (in the case of state-
chartered credit unions) generally compensate only the board Treasurer 
or reimburse incidental expenses incurred by other directors. The 
savings realized in not compensating all directors are then passed on 
to members. Finally, credit unions ratios for expenses and loan losses 
compare very favorably to similarly sized banks.
Tax exemption keeps the cooperative alternative available, and supports 
        safety and soundness

    Credit union regulation, which is much more restrictive than that 
for other financial institutions, includes: limits on who the credit 
union can serve, limits on business lending, lack of access to capital 
markets, higher capital requirements than other depository 
institutions, etc. The tax exemption is the incentive that encourages 
credit union CEOs and boards to continue to operate as credit unions 
rather than shedding those restrictions by converting to a bank 
charter. Such conversions would only limit the range of choices 
available to America's consumers, especially those of modest means.
    Because the tax exemption is an important part of the reason credit 
unions remain cooperatives, it serves to protect taxpayers from losses 
to the share insurance fund. There are two important connections 
between the stability of NCUSIF and credit unions' tax exemption. 
First, the primary buffer for a deposit insurance system is the capital 
or net worth maintained in insured institutions. Because credit unions 
have no access to capital markets, their only source of capital is the 
retention of earnings. A tax on net income would thus disincent credit 
unions from retaining earnings, weakening protection for NCUSIF. In 
fact, the cost to the taxpayer of FSLIC's losses far exceeded the total 
taxes paid by FSLIC insured institutions prior to FSLIC's failure.
    Second, as cooperatives credit unions have a systemic inclination 
to avoid risky activities. In their 1996 study of the National Credit 
Union Share Insurance Fund, Edward Kane and Robert Hendershott show 
that the cooperative structure of credit unions presents credit union 
decision makers with incentives that are strikingly different from 
those faced by a for-profit financial institution, making it less 
feasible for credit union managers to benefit from high-risk 
strategies.\8\ This is an especially useful trait for federally insured 
depository institutions.
---------------------------------------------------------------------------
    \8\ Edward Kane and Robert Hendershott, The Federal Deposit 
Insurance Fund that Didn't Put a Bite on U.S. Taxpayers   Journal of 
Banking and Finance, 20(September, 1996), pp.1305-1327.
---------------------------------------------------------------------------
Large credit unions stand out in providing credit union benefits

    There is no relation between the size of an institution and the 
absence or presence of reasons to justify the tax exemption. Members of 
large credit unions relate to the institutions to which they belong in 
exactly the same way as do members of smaller credit unions. Regardless 
of the size of the credit union, each credit union member has one equal 
vote, and thus an equal say, in the direction of the credit union.
    Large credit unions are democratically controlled, not-for-profit 
cooperatives in every way that are smaller credit unions. The boards of 
directors of large credit unions are composed of volunteers just as 
they are at small credit unions. A large credit union may be more 
likely to offer a broader array of services, and to be a greater 
presence in a local market. But neither activity makes it less a 
cooperative than a smaller credit union. No one suggests that as soon 
as the congregation of a church, synagogue or mosque exceeds a certain 
size, it should no longer be tax exempt. Likewise, it would be 
ludicrous to say the American Heart Association should lose its tax 
exemption simply because of its size while a small local charity should 
not.
    Because of their size and efficiency, large credit unions are often 
more able to provide the benefits of the cooperative to members, such 
as lower loan rates and fees and higher dividend rates. Larger credit 
unions are also more able to offer special programs benefiting low- and 
moderate-income households. In a survey conducted in 2002, when asked 
how many of up to 18 services geared to low/moderate income households 
were offered, only 6% of credit unions with assets below $20 million 
offered at least half of the services. Fully 42% of credit unions with 
assets over $500 million offered that many of the services. Large 
credit unions are also more likely than small credit unions to 
participate in outreach activities to attract low/moderate income 
members, and to have added underserved areas to their fields of 
membership under NCUA's Access Across America program.\9\
---------------------------------------------------------------------------
    \9\ 2003 Serving Members of Modest Means Survey Report. CUNA.
---------------------------------------------------------------------------
No evidence of market disruptions from credit union tax exemption

    There is no evidence that the credit union tax exemption adversely 
affects banks or thrifts; other financial institutions continue to 
thrive in the presence of credit unions. In fact, the FDIC recently 
reported that banks recorded record profits for the fourth year in a 
row.\10\ Aggregate bank return on assets (ROA) has exceeded 1% for the 
past 12 years, averaging 1.23%. And credit unions are only growing 
marginally faster than banks. In the decade ending in 2004, total 
banking institution assets grew at a compound annual rate of 7.25% 
compared to 8.4% for credit unions. Credit unions now account for 6.2% 
of the combined assets of all depository institutions. At the growth 
rates of the past decade, it will take until the year 2053 for the 
credit union share to climb to just 10%. And, although more credit 
unions have become interested in recent years in business lending to 
their members, credit unions as a whole hold a very small portion of 
the market: Less than 1% of the business loan market in the U.S.
---------------------------------------------------------------------------
    \10\ Federal Deposit Insurance Corporation, Quarterly Banking 
Profile, Fourth Quarter 2004.
---------------------------------------------------------------------------
    The health of the banking industry over the past decade has not 
been confined to just large banks. In a 2003 conference, Federal 
Reserve Gov. Mark Olson said: ``The year that just ended was one of 
record profits for the industry as a whole, and for community banks in 
particular'' and ``Community banking has a long history of strength and 
success and a bright future. The past year was a good one for community 
banks. Once again the vitality and adaptability of the community 
banking franchise were amply demonstrated.'' \11\ Two Federal Reserve 
economists have recently described the strong performance of the 
nation's smaller banks. They found that ``small banks have grown 
considerably more rapidly than large banks and have tended to meet or 
exceed them in some measures of profitability.'' \12\
---------------------------------------------------------------------------
    \11\ Comments before the 2003 Chicago Federal Reserve Bank 
Conference: Whither the Community Bank?
    \12\ William F. Bassett and Thomas F. Brady. The Economic 
Performance of Small Banks, 1985-2000.   Federal Reserve Bulletin, 
November 2001.
---------------------------------------------------------------------------
    As Federal Deposit Insurance Corp. Chairman Donald E. Powell told 
the convention of the Independent Community Bankers of America March 
12, ``In the banking business, times are surely good.''
Summary.

    America's credit unions continue in their long tradition of 
providing members affordable financial services driven by their 
cooperative, not-for-profit structure. As a result, 86 million members 
receive significant benefits from their credit unions even while the 
rest of the financial services industry thrives. The public policy 
rationale for the credit union tax exemption is just as valid today as 
it was at credit unions' inception.
    The Credit Union National Association--the nation's largest credit 
union trade association representing 90 percent of the nation's 9,000 
credit unions--is pleased to offer these comments and suggestions to 
the Ways and Means Committee as it conducts its overview of the tax-
exempt sector. We look forward to working with the Chairman, Members 
and staff of the committee as it continues its overview, and stand 
ready to answer any questions or expand on or otherwise further explain 
our remarks.

                                 

                                                Fair Housing Center
                                                   Toledo, OH 43624
                                                     April 26, 2005
The Honorable Bill Thomas
U.S. House of Representatives
2208 Rayburn House Office Building
5Washington, DC 20515

Dear Congressman Thomas:

    I am writing to urge you to protect the charitable sector from 
unnecessary and overly burdensome regulations such as those presented 
by the Senate Finance Committee, particularly those proposals that 
would modify the tax rules regarding non-cash charitable contributions 
(known as ``in-kind'' contributions).
    The new proposals include recommendations to completely eliminate 
or substantially modify deductions for in-kind contributions. Many 
charities heavily rely upon non-cash donations, and there is no 
legitimate reason to attack this lifeline. [Please insert a sentence or 
two here about how your organization relies on in-kind gifts.]
    Changing the in-kind contribution rules would unfairly compel 
charities to divert valuable time and resources to new valuation 
compliance schemes. The inability of the Internal Revenue Service to 
address improper donor behavior should not result in penalties for 
charities and the communities and populations which they serve. 
Significant revision of the in-kind contribution rules would greatly 
diminish my organization's ability to provide altruistic services.
    Furthermore, these proposals are not based on any credible evidence 
of wide-spread abuse. In fact, empirical data indicates that there is 
NOT widespread abuse among the charitable sector and that proposals are 
unnecessary. Reports collected by the FBI, the Federal Trade 
Commission, State Attorneys General and even watchdog groups like the 
Better Business Bureau show that reports of charity fraud are less than 
1 percent of all complaints of fraud. This is consistent with every 
single year's annual findings in the annual report on Fraud in the 
United States published by the FTC.
    It appears that many of the suggestions are driven by a desire to 
raise federal revenues from the charitable sector. Such an effort is 
completely inconsistent with the notion of tax-exempt status, and I 
hope you will strongly oppose such proposals.
    The Senate Finance Committee's proposals to alter the non-cash 
charitable gift incentives come at a precarious time for charities. 
Americans are a generous people, but many charities are still 
recovering from the past several years when charitable giving has been 
flat and even decreased for many organizations.
    At the same time, we understand that your committee seeks to gather 
information on the size, scope and impact on the economy of the 
nonprofit sector; the need for congressional oversight; IRS oversight 
of the sector; and what the IRS is doing to improve compliance by the 
sector with the law. These are laudable objectives. We are interested 
in assisting the committee in identifying appropriate areas for further 
study as well as criteria and standards to better define and outline 
the sector and its players.
    Again, I urge you to oppose changes to the in-kind contribution 
rules as well as any unreasonable and burdensome legislation that would 
harm the charitable sector. I very much appreciate your support.
    Thank you for your consideration.
            Sincerely,
                                             Michael P. Marsh, CFRE
                   Vice President, Development and Public Relations

                                 

                                International Community Association
                                                   San Diego, 92121
                                                        May 5, 2005
Chairman Bill Thomas
Committee on Ways & Means
U.S. House of Representatives
1102 Longworth House Office Building
Washington D.C. 20515

    On behalf of the International Community Foundation (ICF) and our 
Board of Governors, I am calling attention to the fact that the Senate 
Finance Committee staff had recommended that no grants from donor 
advised funds to foreign organizations be permitted unless the foreign 
organization is on a list specifically approved by the IRS. Here, ICF 
concurs with your Panel's recommendation that no special rules be 
created specific to international grants through donor advised funds.
    ICF believes that an approved IRS list of foreign nonprofits will 
be difficult and costly to effectively administer. Without clear multi-
lingual guidelines on how a foreign nonprofit can get listed, otherwise 
worthy groups could be precluded from receiving support leading to a 
potential chilling effect in overseas grantmaking by U.S. public 
charities at a time when there is a need for expanded goodwill 
initiatives originating from our country overseas. Yet, according to 
USA Giving, in 2002 international giving amounted to less than 1.9% of 
total charitable gifts. Of this amount, less than $843 million in 
grants were made to overseas nonprofits.
    It is the opinion of ICF that so long as public charities engaged 
in international giving through donor advised funds provide full public 
accountability and disclosure, ensure good governance and undertake the 
proper due diligence and controls with their overseas grantmaking 
(including pre-grant evaluations, site visits and follow up reporting), 
the current IRS requirements are more than satisfactory. As your report 
recommends, to the extent that current law does not provide adequate 
safeguards against potential abuses in overseas grantmaking, such 
abuses can be specifically targeted through rules applicable to all 
charities.
    If your Panel has specific questions about ICF's views on your full 
report or would like additional clarification on our foundation's 
position specific to proposed changes in rules for grants to foreign 
grantees, we would welcome the opportunity to speak to you in person.
            Sincerely,
                                                        Richard Kiy
                                                    President & CEO

                                 

Statement of John McCarthy, International Health, Racquet & Sports Club 
                              Association
    This is in response to your request for statements at the April 20 
Committee hearing regarding an Overview of the Tax-Exempt Sector. IHRSA 
is the business association representing the nation's 6,000 private 
fitness club entrepreneurs. Our members employ more than 100,000 
workers and provide a needed service to our communities and clients, 
all the more important given a new awareness of the public health and 
economic costs of obesity and poor physical condition.
    IHRSA members are largely small businesses, and are proud of their 
ability to compete and provide service demanded by our clients. 
However, it is clear that for many of our members their, major 
competitors are operating under a different set of competitive factors 
due to tax competition. When tax exempt facilities provide adult 
fitness services, they are clearly competing in a commercial arena with 
tax-paying small-businesses. We want to be clear. There is plenty of 
room for competition, and we salute those exempt providers who truly 
serve their entire community across geographic, age and income 
categories. But we clearly see the inadequacy of the current tax exempt 
legal, reporting and enforcement structure. It does not assure that 
such competition from tax exempt providers is fair or consistent with 
their exempt purposes. A tax exemption is a privilege, not a right, and 
does not include a license to compete in commercial markets.
    IHRSA regularly meets with state tax and Internal Revenue Service 
officials on these issues. Their response, particularly in recent 
years, has been consistent--they are highly sympathetic with our 
concerns but are hard pressed to address the situation due to limited 
enforcement resources and guidelines.
    IHRSA congratulates the Ways and Means Committee for its review of 
the basic policy issues behind tax exemption. Whatever the original 
justification of some of our largest exempt organizations, it cannot be 
denied that in the current hyper-competitive business environment, the 
distinctions between the services offered by certain exempt 
organizations and our fully taxed proprietary small business members 
are barely noticeable. As appears to be the case in some other service 
sectors, tax-exempt providers of adult fitness services too often 
appear to be, in the phrase of the Congressional Budget Office's 
statement at this hearing, simply part of ``the untaxed business 
sector.''
    IHRSA strongly endorses your call for additional Ways and Means 
Committee hearings to look into basic issues underlying the rationale 
for tax exemptions. The law today, largely unchanged in several 
generations, may not be adequate to appropriately treat, to use a 
charitable term, the clearly very mixed commercial and public 
activities pursued by highly competitive exempt organizations.
    In addition to hearings looking into fundamental issues regarding 
the rationale for tax exemption, we would like to suggest the Ways and 
Means Committee take three actions, which would advance progress on 
this difficult issue.

    1.  The Committee should hold oversight hearings focused on unfair 
competition by tax exempt organizations with commercial businesses, and 
particularly in the provision of adult fitness services.
    2.  The Committee should encourage the IRS to immediately adjust 
990 reporting forms to elicit more specific information about the 
actual use by all elements of the local community of exempt 
organizations' adult fitness services.
    3.  The Committee should support enhanced enforcement capability 
for IRS and a prioritization of commercial competition problems.
    IHRSA stands ready to support the Committee in these efforts and 
appreciates your interest in these key tax issues.

                                 

                      Statement of Barbara R. Levy
    As a member of the Association of Fundraising Professionals and a 
thirty plus year fundraiser, I am alarmed at the proposal to eliminate 
the deduction of non-cash contributions to charity. For so many 
charities, this proposal would slash income drastically. It has the 
potential of causing some charitable organizations to close their 
doors. Congress has done enough to make life difficult for the not-for-
profit sector, please don't make this ``the last straw.''
    Instead, Congress should support every aspect of the non profit 
sector as they are fulfilling the services that many governments offer 
their citizens. With education budgets and medical coverage being 
slashed, let's give our tax paying citizens an opportunity to help 
themselves and their communities through charitable acts.
    Let the IRS scrutinize tax returns a bit more carefully and 
collectively help the nation and the taxpayers.

                                 

 Statement of Brad Thaler, The National Association of Federal Credit 
                                 Unions
Introduction
    Chairman Thomas, Ranking Member Rangel and Members of the 
Committee, the National Association of Federal Credit Unions (NAFCU), 
the only national trade association that exclusively represents the 
interests of our nation's federal credit unions, appreciates this 
opportunity to submit comments for the record of today's hearing which 
is an overview of the tax-exempt sector. NAFCU represents approximately 
800 federal credit unions--financial cooperatives from across the 
nation--that collectively hold approximately 66 percent of total 
federal credit union assets and serve the financial needs of 
approximately 26 million individual credit union members.
    The universe of tax-exempt entities is very large; there are over 
1.8 million federal income tax-exempt organizations, not including 
churches and religious organizations, under Sec. 501(c) of the Internal 
Revenue Code. Credit unions constitute a very small portion of that 
universe of federal income tax exempt organizations. In fact, our 
nation's approximately 9,000 credit unions account for merely one-half 
of one percent of all federal income tax-exempt organizations. Yet 
while small in number, credit unions play an important role in directly 
serving their members, and ultimately in indirectly benefiting the 
American public since studies have shown that the presence of credit 
unions benefits not only credit union members but all Americans who use 
federally-insured depository institutions.
    NAFCU would like to take this opportunity to emphasize this point 
to the members of the Committee: the credit union federal income tax 
exemption benefits not just credit unions and their members, but all 
who have savings in any regulated depository institution. Credit union 
critics have erroneously claimed that some credit unions today are no 
different than banks and thus should forfeit their federal income tax 
exempt status. Such claims simply do not stand up to close scrutiny. 
While credit unions--like all financial service providers--have evolved 
and grown over the years to meet the changing financial services needs 
of their members, the basic structure, philosophy and guiding 
principles of credit unions remain the same today as when the federal 
income tax exemption was granted to credit unions in 1937. Congress 
reaffirmed this fact just seven years ago, when as part of Section 4 of 
the ``Findings'' contained in the Credit Union Membership Access Act 
(P.L. 105-219) Congress declared that:
    ``Credit unions, unlike many other participants in the financial 
services market, are exempt from Federal and most State taxes because 
they are member-owned, democratically operated, not-for-profit 
organizations generally managed by volunteer boards of directors and 
because they have the specific mission of meeting the credit and 
savings needs of consumers, especially persons of modest means.''
    As part of that legislation, the Treasury Department was asked to 
examine credit unions and their role in the financial services 
marketplace, including ``the potential effects of the application of 
Federal laws, including Federal tax laws, on credit unions in the same 
manner as those laws are applied to other federally insured financial 
institutions.'' The Treasury Report (Comparing Credit Unions with Other 
Depository Institutions, U.S. Department of Treasury, January 2001) 
found that credit unions were, indeed, serving their purpose and that 
there was no reason--or recommendation--to remove the federal income 
tax exemption from credit unions. This position was supported by then 
candidate and now President George W. Bush in 2000, when he stated ``. 
. . as part of my overall commitment to lower taxes and provide more 
opportunities for working Americans, I support continuing the tax-
exempt status of credit unions''. During the 2004 campaign, President 
George W. Bush reiterated that position when he noted that ``I support 
strongly the tax-exempt status of credit unions and will continue to 
highlight the important contributions that credit unions make to our 
financial system.'' Treasury Secretary John Snow recently told a credit 
union audience ``We oppose this talk of taxation of you and your 
industry--it's a truism I think in economics, you always get less of 
anything you tax. Well, we don't want to get less of what you do.'' 
Reflecting the bipartisan nature of this issue, in also supporting the 
credit union federal income tax exemption, 2004 Democratic presidential 
nominee John Kerry wrote to NAFCU that ``. . . I want you to know that 
I will continue to support America's credit unions and oppose any 
efforts to change the existing tax-exempt status of credit unions.''
Bankers Myths vs. The Credit Union Reality
    Some critics of credit unions would have you believe that credit 
unions pay no taxes at all. That is false. Credit unions still pay many 
taxes and fees, among them payroll and property taxes, but Congress has 
determined that federal income taxation of member-owned shares in a 
credit union would put a ``disproportionate and excessive'' burden on 
credit unions due to their nature.
    Other critics of credit unions would have you believe that credit 
unions are growing bigger and bigger and really are no different than 
banks, which pay corporate income taxes. Again, that is false. The 
defining characteristics of a credit union, no matter what the size, 
remain the same today as they did in 1937: credit unions are not-for-
profit cooperatives that serve defined fields of membership, generally 
have volunteer boards of directors and cannot issue capital stock. They 
are restricted in where they can invest their members' deposits and are 
subject to stringent capital requirements. A credit union's 
shareholders are its members (and each member has one vote, regardless 
of the amount on deposit), while a bank has stockholders.
    While credit unions have grown, like all financial institutions, 
over the years, they are quite tiny when compared to banks. Federally 
insured credit unions had $647 billion in assets as of December 31, 
2004, while FDIC-insured institutions held over $10.1 trillion in 
assets, and last year Federal Deposit Insurance Corporation (FDIC)-
insured institutions grew by an amount exceeding the total assets of 
all credit unions combined. The world's largest credit union, with just 
over $22.9 billion in assets, is dwarfed by the nation's largest bank 
with over $967 billion in assets. Although banks claim there is 
``competition'' from credit unions, banks continue to see record 
profits quarter after quarter. According to Federal Reserve Board 
statistics, the credit union share of total household assets is 
extremely small, just 1.4 percent as of December 31, 2004 (the same 
percentage of household assets that credit unions had in December of 
1980). Banks, on the other hand, accounted for 18.7 percent of 
household assets as of December 31, 2004.
    Furthermore, while banks continue to attack the credit union 
federal income tax exemption, the number of banks that pay no corporate 
federal income tax at the corporate level continues to rise through 
increases in the number of banks organized as Subchapter S corporations 
and through the utilization of other tax avoidance measures. According 
to NAFCU's analysis of FDIC call report data, as of December 31, 2004, 
nearly 20% of all FDIC-insured institutions paid no federal corporate 
income tax. These 1,771 FDIC-insured institutions not only account for 
nearly 20% of all FDIC-insured institutions; they collectively hold 
over $286 billion in total assets, or more than 44% of the total assets 
of all federally-insured credit unions combined. Of these 1,771 FDIC-
insured institutions that paid no corporate federal income tax, 693 of 
them (ranging in size up to $18.4 billion) were not Subchapter S 
corporations.
The Credit Union Income Tax Exemption Benefits Everyone
    Consumer advocates have also recognized and supported the federal 
income tax exemption of credit unions. In the fall of 2003 the Consumer 
Federation of American (CFA) examined the federal income tax status of 
credit unions and reaffirmed these points in a study entitled ``Credit 
Unions in a 21st Century Financial Marketplace''. In the study CFA 
concluded, among other things, that:

      The benefits that credit unions deliver to the public far 
exceed the costs, as measured by the tax exemption, through lower cost 
services and paying higher interest rates; and,
      The value of tax breaks enjoyed by banks is ``far 
greater, in absolute and relative terms, than the value of the credit 
union tax exemption.''

    Furthermore, even bankers have admitted that credit unions' 
influence in the market has led them to better serve their customers. 
An article in the January 31, 2005 issue of the American Banker 
newspaper entitled ``Feeling Heat from Deposit Competition'' reported 
that ``Zions Bancorp [of Salt Lake City, Utah] was one of the many 
large regional banks that while making record profits for the 4th 
quarter of 2004 and for the calendar year, gave in to deposit pricing 
pressure in the fourth quarter [of 2004].'' The article continued: 
``Zions said pressure from other banks and specifically credit unions 
in Utah prompted it to raise rates on money market accounts by 20 basis 
points late in the fourth quarter.''
    A September 2004 report and analysis by Robert M. Feinberg, 
Professor of Economics at American University, entitled ``An Analysis 
of the Benefits of Credit Unions to Bank Loan Customers'' found that 
``the presence of a substantial credit union presence in local consumer 
lending markets has a significant impact on U.S. bank loan customers, 
saving them at least $1.73 billion per year in interest payments.'' A 
January 2005 study by Robert J. Tokle, Professor of Economics at 
IdahoStateUniversity, entitled ``An Estimate of the Influence of Credit 
Unions on Bank CD and Money Market Deposits in the U.S.'' estimated 
that bank customers benefit to the tune of $2.0 to $2.5 billion 
annually in just interest on deposits due to the presence of credit 
unions. The credit union federal income tax exemption, therefore, does 
not just benefit credit unions and their members, but each and every 
American who uses a federally-insured depository institution.
    The loss of the federal tax exemption would seriously threaten the 
fundamental nature of not-for-profit credit unions and significantly 
change the role that they play in the consumer financial services 
marketplace. Almost all federally insured credit unions must build 
their capital reserves through retained earnings, and all are 
prohibited from accessing the open capital markets by law. As noted by 
former NCUA Chairman Dennis Dollar in a letter to The Honorable Sheryl 
Allen (a member of the Utah State House of Representatives) regarding 
potential safety and soundness implications from the taxation of credit 
unions in that state: ``. . . it is certain that any resulting net 
worth considerations that might arise (from taxation) could indeed 
become a significant issue . . . [as a result of] credit unions having 
their retained earnings negatively impacted [by taxation].'' 
Furthermore, because of their structure, any taxes imposed on credit 
unions would be passed directly to their members in the form of lower 
savings rates, higher borrowing rates and/or higher fees--in essence a 
tax increase on America's 85 million credit union members. Finally, 
credit unions boards and management would be driven to make decisions 
in a manner similar to banks, with the end result being a decision-
making process driven by tax considerations or other issues rather than 
what is in the best interest of members. As a result, a very 
unfortunate consequence could be a shift in orientation to profit-
motivated interests, instead of providing low-cost financial services 
to member-owners.
Conclusion
    In summary, the basic structure, philosophy and guiding principles 
for credit unions, large and small, remains the same today as it was in 
1937; i.e., they continue to be member-owned, democratically-
controlled, not-for-profit organizations generally managed by volunteer 
boards of directors with the mission of meeting the credit and savings 
needs of consumers, especially persons of modest means. Thus, we 
believe there is more than ample justification for continuing the 
federal income tax exemption for all credit unions, regardless of size, 
charter type, field of membership or services offered.

                                 

Statement of Mary Martha Fortney, National Association of State Credit 
                           Union Supervisors
    The National Association of State Credit Union Supervisors (NASCUS) 
is a professional association representing the forty-eight (48) state 
and territorial regulatory agencies that supervise the nation's more 
than 4,000 state-chartered credit unions. NASCUS has been committed to 
enhancing state credit union supervision and advocating for a safe and 
sound state credit union system since its inception in 1965. NASCUS is 
the sole organization dedicated exclusively to the promotion of the 
dual chartering system and advancing the autonomy and expertise of 
state credit union regulatory agencies. NASCUS appreciates the 
opportunity to provide a submission for the record to the House 
Committee on Ways and Means Hearing on An Overview of the Tax-Exempt 
Sector.
    NASCUS understands and respects that it is not the position of 
state regulators to set tax policy. Tax policy is rightfully a concern 
for our elected officials, both state and federal. NASCUS does believe, 
however, that our elected officials must have access to accurate 
information to develop sound public policy.
State and Federally Chartered Credit Union Taxation Explained
    NASCUS wants to clarify the tax treatment of state-chartered and 
federally chartered credit unions. Under our current tax system, state-
chartered credit unions are taxed differently than federal credit 
unions. Section 501(c)(1) of the Internal Revenue Code grants federal 
credit unions their tax exemption, while state credit unions are 
exempted under Section 501(c)(14).
    In his written testimony, the Honorable Sheldon Cohen, Partner, 
Morgan, Lewis and Bockius, and Commissioner, Internal Revenue Services 
from 1965--1969, distinguishes the difference between Section 501(c)(1) 
and Section 501(c)(14) of the Internal Revenue Code, noting that credit 
unions receive their tax exemption under one of these sections. He 
explains that a Section 501(c)(1) designation exempts federal 
instrumentalities from federal taxes and notes that a Section 501(c)(1) 
designation is preferable for credit unions because the IRS has taken 
an audit position that Section 501(c)(1) entities are tax exempt. 
State-chartered credit unions are taxed according to state law and do 
not enjoy the totally exempt status as their likewise non-profit 
federally chartered credit unions.
Current tax policy threatens the credit union dual chartering system
    As the association representing state credit union regulators, our 
concern with federal tax policy is that state and federal charters are 
treated fairly, so an unintended tax advantage is not provided for 
either state or federally chartered credit unions in our nation's tax 
policy.
    Together, the Federal Credit Union Act, the Internal Revenue Code 
and case law grant federal credit unions a broad tax exemption as 
instrumentalities of the federal government. State credit unions are 
provided a federal exemption under Section 501 (c)(14) of the Internal 
Revenue Code andvarious state statutes mandate when and whether state-
chartered credit unions are taxed.
    As Mr. Cohen references in his testimony, for tax purposes, it is 
preferable for credit unions to be designated as Section 501 (c)(1) 
organizations. NASCUS does not want the tax burden on any credit unions 
increased. But treating credit unions differently for tax purposes 
solely based on their charter is simply wrong, and continues to 
threaten the dual chartering system we so highly value in America.
NASCUS Advocates Fairness in the Tax System
    NASCUS does not advocate any new taxes for credit unions--whether 
they are state or federally chartered. However, they should receive the 
same tax treatment; both state and federally chartered credit unions 
should be tax-exempt.
    NASCUS does not believe that it was ever the intent of Congress to 
benefit, via preferential tax treatment, one charter over another 
charter for like institutions. Congress recognized the cooperative 
nature of credit unions and approved their tax-exempt status in 1934 
when it voted to approve the Federal Credit Union Act. President 
Roosevelt signed the Act and it became law. Congress has never wavered 
in its position that credit unions should be tax exempt. Further, 
President Bush's Administration has publicly acknowledged its support 
of credit unions' tax-exempt status.
    NASCUS supports equal treatment of the state and federal credit 
union charter regarding federal tax policy. State credit unions should 
be granted the same tax exemptions as their federal counterparts. State 
and federal credit unions provide the

same not-for-profit financial services and should not be accorded 
disparate tax treatment due solely to their choice of charter.
    NASCUS is pleased to have the opportunity to submit written 
testimony to the House Ways and Means Committee regarding the Overview 
of the Tax-Exempt Sector Hearing. We appreciate your time studying our 
concerns; we are available for dialogue or to answer questions.

                                 

   Statement of Rick Cohen and Jeff Krehely, National Committee for 
                        Responsive Philanthropy
``Reforming the United States Philanthropic Sector''
    The National Committee for Responsive Philanthropy (NCRP) has long 
advocated for significantly improving philanthropic accountability and 
responsiveness and the means for providing necessary government 
oversight and enforcement. It is insufficient to call for stronger 
oversight and enforcement of the standards of philanthropic 
accountability if the standards are inadequate or completely missing. 
This statement outlines the elements of philanthropic accountability 
that should be the basis for both public policy and foundation self-
regulation to create a truly responsive and accountable philanthropic 
sector.
    For several years, the media have regularly uncovered and reported 
on egregious instances of abuse and mismanagement in the nation's 
private foundations and other tax-exempt institutions. Leaders of the 
nonprofit and philanthropic sectors' leaders have responded to these 
scandals and the resulting increased public scrutiny in a very 
defensive and self-interested fashion. Often, self-regulation is the 
suggested remedy to these ethical and illegal ills. In other cases, the 
suggested solutions to these problems involve minor mechanical changes 
to current oversight efforts. Based on NCRP's perspective--as well as 
the sheer size and diverse scope of the nonprofit and philanthropic 
sectors--such a response is wholly inadequate and would do little to 
clean up current abuses, prevent future abuses, or restore public faith 
in the sectors.
    It is time to recommend comprehensive reforms to bring new 
standards of public and private accountability to the approximately 
70,000 private foundations that control $500 billion in philanthropic 
assets in the United States today.\1\ Independent research estimates 
that at least 45 percent of those $500 billion belong to the American 
public, having been accumulated thanks to various tax breaks that 
foundations receive at their inception and throughout their 
institutional lives.\2\
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    \1\ Significantly more organizations, perhaps as many as 100,000, 
are counted as private foundations with the IRS, but we estimate that a 
third or so are actually public charities that failed to meet their 
public support test.
    \2\ Mark Dowie. American Foundations: An Investigative History. 
Cambridge: MIT Press, 2002.
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    Speaking of the American people, public trust in the nation's 
charities and foundations is at historically low levels. They have read 
the news stories about scandals in philanthropy, and they have 
concluded what most of the media and many lawmakers--but only a few 
leaders of philanthropy--have as well: It's time for change. The 
current laws and regulations pertaining to foundations were established 
more than 30 years ago, when the philanthropic sector was much smaller, 
both in numbers and dollars. In the last ten years alone, the number of 
foundations has doubled and their assets have more than tripled.
    The U.S. Congress has a responsibility and obligation to pass new, 
better laws to regulate private philanthropy. Because foundations wield 
so much financial power and influence over their grantee 
organizations--which know foundations the best--calls for reform will 
not be coming from the nonprofit sector. And the public has no say in 
who sits on foundation boards of directors, so there are no outside 
share--or stakeholders to bring foundations into line. The government, 
therefore, must step in and take action. No other entity has the 
authority, integrity, or courage to do so.
    This statement will provide concrete suggestions for reform of the 
nation's philanthropic sector. Foundation leaders will be unhappy with 
many of them, but this statement was crafted not to please the 
philanthropic elite, but to bring a sense of democratic and fair 
governance and oversight to billions of dollars that are not living up 
to their legal mandates or ethical obligations.
    The suggestions are organized into three broad areas:

      Maximizing foundation accountability and transparency
      Maximizing foundation support for nonprofits
      Maximizing foundation support for justice and democracy

    These suggestions were drafted based on NCRP's observation of and 
research on current deficiencies among the nation's foundations, as 
well as comments from our organizational members and board of 
directors.
    It is an honor and privilege to offer this statement to the United 
States House of Representatives Ways and Means Committee. They are 
offered in the hopes of aiding the Committee's efforts to bring about a 
new era of reform and transparency for the United States philanthropic 
sector.
Maximizing Foundation Accountability and Transparency

      Use the foundation excise tax: Reduce and consolidate the 
private foundation investment excise tax to 1% of investment income and 
devote the bulk of the tax payment to IRS and state government 
oversight of nonprofits and foundations--as the foundation excise tax 
was originally intended to be used when first enacted. The remainder 
can and should be used to supplement government oversight through 
grants for nonprofit activities such as research and data collection on 
the nonprofit sector, nonprofit accountability standard setting, and 
special investigations.

    NCRP's legislative proposal for making the foundation excise tax a 
tool for a more accountable philanthropic sector includes the 
following:

    1.  Reduce the foundation tax to a simplified, consolidated 1 
percent of private foundation investment income, but require that the 
money that foundations ``save'' from the tax reduction go to nonprofit 
organizations in the form of grants--as opposed to being used by 
foundations to increase foundation executives' salaries, foundation 
trustees' compensation, and other expenses.
    2.  Dedicate 20 percent of the remaining excise tax to more than 
double the budget of the Tax Exempt/Government Entities division of the 
Internal Revenue Service from its current budget of less than $60 
million to approximately $130 million, enabling it to more effectively 
oversee and audit private foundations, public grantmaking foundations, 
donor advised funds, and other philanthropic grantmaking mechanisms, as 
well as nonprofits in general, to weed out the more than a few bad 
apples currently undermining the accountability of philanthropy and 
charity.
    3.  Dedicate 40 percent of the remaining excise tax to create a 
fund of $140 million, which the Commissioner of the Internal Revenue 
Service (IRS) can use to supplement the charity investigative and 
oversight arms of state attorneys-general offices.
    4.  Allocate 15 percent (or approximately $50 million) of the 
remaining excise tax for the IRS Commissioner to grant to nonprofit 
organizations whose research, ratings, and evaluation efforts 
complement and augment the oversight functions of federal and state 
agencies.
    5.  Use another 15 percent of the excise tax for the generation of 
IRS statistics on the finances of foundations and charities comparable 
with the research IRS generates on other sectors of the economy.
    6.  Reserve the remainder of the excise tax revenues to support 
special initiatives of the Tax Exempt/Governmental Enterprises division 
of IRS and for additional research and data collection and 
dissemination.

    The private foundation excise tax, originally set at 4 percent of 
foundation investment income when enacted in 1969, was intended to pay 
for IRS costs of overseeing tax-exempt organizations. Had the reduction 
of the foundation excise tax been enacted to start in 2004, $144 
million would have been potentially freed up for grantmaking in the 
first year and nearly $200 million in the second year.
    Oversight and enforcement of the nonprofit sector has changed since 
1969, when Congress last implemented broad changes to rules pertaining 
to nonprofits and foundations. The responsibility is no longer just 
that of the Internal Revenue Service's Tax Exempt Division, but also 
the charity oversight offices of states attorneys-general, few of which 
were on the radar screen 35 years ago; their on-the-ground roles in 
monitoring foundations and nonprofits overall should be supported by 
the excise tax whose primary purpose was meant to bolster foundation 
and nonprofit accountability.
    Bolstering philanthropic oversight is crucial, given the explosive 
growth in the number of private foundations, plus other kinds of 
grantmaking charities, while IRS audits of foundations plunged from 
1,200 in 1990 to less than 200 in 1999 and considerably less today.

      Improve IRS forms 990PF and 990: The 990 needs to be 
radically overhauled to reveal important information about foundations 
(and public charities) for necessary review and oversight; foundations 
and nonprofits should be able to e-file; and there should be 
significant penalties for foundations that do not file their 990PFs on 
a timely basis. All publicly disclosed data should be available in a 
free, publicly accessible and searchable format.

    Some of the recommendations below--such as disclosure of insider 
relationships between foundations and outside vendors providing 
services for hire--can be implemented through changes to the IRS Forms 
990PF and 990. Institutions filing these forms should also be regularly 
required to state in specific terms how their grantmaking and/or 
programmatic activities further their tax-exempt purposes.

      Increase disclosure of corporate philanthropy: The bulk 
of corporate giving to nonprofits is not disclosed to the public due to 
the privacy of corporate tax returns and the unwillingness of the SEC 
to demand disclosure. The recent trajectory of corporate abuses 
including philanthropic misbehavior makes the need for enhanced 
disclosure clear.

    Corporations undoubtedly have a variety of motives for giving to 
charity. Tax breaks, positive publicity, and a genuine concern for the 
public good could all encourage a company to donate its money, time, 
products, or services to charity. In more sinister cases, corporate 
charitable gifts could also be used as bribes to encourage corporate 
directors to overlook financial improprieties, as in the case of Enron.
    Corporations receive significant tax breaks for their giving--the 
money that they donate is in a sense ``public,'' since it is actually 
lost tax revenue for the government and the general public. Further, 
whether or not it is a motivation for giving, being seen as a good 
corporate citizen undoubtedly helps a company's bottom-line. For 
example, in 1999 Philip Morris spent $75 million on charitable 
contributions, and $100 million to publicize these donations.\3\ 
Corporate philanthropy, then, can be viewed in many cases as government 
subsidized advertising for for-profit corporations. Further, there is 
evidence that corporate philanthropy is being used to perpetrate and 
perpetuate scandals in corporate America--to the eventual detriment of 
shareholders, nonprofits, and citizens alike.
---------------------------------------------------------------------------
    \3\ Michael E. Porter and Mark R. Kramer. ``The Competitive 
Advantage of Corporate Philanthropy.'' Harvard Business Review, 2002.
---------------------------------------------------------------------------
    For these reasons, NCRP recommends that the SEC adopt disclosure 
requirements for all corporate philanthropic donations--in-kind or 
cash, through a foundation or directly from the corporation. The amount 
donated, as well as the recipient of the funds, needs to be made public 
through paper and electronic means on an annual basis. Such a policy 
would help restore some faith in corporate America, as well as the 
recipients of its charity.It would also allow researchers and advocates 
to understand a significant piece of US private giving and work to make 
it more fair and responsive to the country's neediest and most 
disadvantaged citizens.

      Disclose grantmaking by public charities: Private 
foundations are not the only charitable grantmakers. While some public 
charities such as community foundations routinely and completely 
disclose their grantmaking, the grantmaking disclosure performance of 
public charities overall is spotty. The public deserves to know who 
receives how much of charitable grantmaking whether from public or 
private charities.

    Current IRS regulations for both public charities and private 
foundations require the public disclosure--on IRS Form 990 or 990-PF--
of grantees (including the organization's name and full contact 
information), specific purposes of grants made, and potential conflicts 
of interest. Based on our use of literally thousands of these documents 
for various research projects, only one foundation comes to mind that 
follows these requirements. More often than not, the only information 
offered is the name of the grantee organization and the grant amount. 
Contact information, a specific (or even general) description of how 
the money will be used, and conflict of interest information are 
rarely, if ever, provided.

      Disclose the grantmaking from donor-advised funds: Donor-
advised funds (DAFs) are increasing rapidly, but there is virtually no 
disclosure of their grantmaking, much less oversight of their 
philanthropic probity. At a minimum, a comprehensive regime of DAF 
disclosure should be established.

    In 2003 alone, nearly 70,000 new DAFs were established, according 
to the Chronicle of Philanthropy.\4\ A private financial adviser has 
set up a website (www.donoradvisedfunds.com) to educate potential 
clients why they should set up DAFs instead of private foundations. 
According to this website: ``Starting a private foundation can involve 
substantial start up costs and administrative expanses, such as the 
yearly filing of a Form 990-PF. But one of the most important 
differences is that Donor Advised Funds receive more favorable tax 
treatment than a private foundation. Donor Advised Funds allow donors 
to take a federal income tax deduction up to 50% of adjusted gross 
income (AGI) for cash contributions and up to 30% of adjusted gross 
income (AGI) for appreciated securities; versus 30% of AGI for cash 
contributions and 20% of AGI for appreciated securities for a private 
foundation. Donor Advised Funds also offer the ability to recommend 
grants anonymously, if desired.''
---------------------------------------------------------------------------
    \4\ Leah Kerkman and Nicole Lewis. ``Donor Funds Are on the Rise 
Again.'' The Chronicle of Philanthropy, May 27, 2004.
---------------------------------------------------------------------------
    Another perk, this site points out, is that donors get all of these 
tax breaks, but do not have to make grants to any charitable 
organizations anytime soon--while the funds continue to grow. But it is 
recommended, however, that a DAF make a minimum grant contribution of 
$250 annually.
    If donors want to continue to receive significant tax breaks for 
``giving'' through DAFs, then they must be held accountable in 
radically new ways. At a minimum, DAFs should have the same disclosure 
requirements that public charities and private foundations have, and 
they should be required to pay out at least 6 percent of their 
financial holdings annually to charities.

      Disclose all insider relationships with foundation 
vendors: Foundations only list a small number of their outside vendors 
providing accounting, investment, consulting, and other services, 
without any obligation to identify which are related to foundation 
trustees or officers. Disclosure of vendors should include all firms 
with business relationships with foundation insiders, piercing the 
``doing business as'' shield some insider vendors currently hide 
behind.

    Stronger definitions of and restrictions against foundation trustee 
self-dealing also should be implemented, especially a standard that 
eliminates the practice of investing foundation assets through 
foundation trustees' firms or funds. The Bielfeldt Foundation, in 
Peoria, Illinois, paid nearly millions of dollars to three members of 
the Bielfeldt family for investment services. The foundation's assets 
were invested in risky commodities futures trading, resulting in a 64 
percent loss in value in just two years. These types of services should 
be outsourced on a competitive basis to companies that are qualified to 
invest what are largely public dollars.

      Don't count foundation CEO and staff salaries in 
foundation payout: NCRP continues to advocate that foundation salaries 
and other foundation administrative expenses should be removed from 
calculations of qualifying distributions (payout). Removing 
administrative costs from foundation payout--while maintaining or 
increasing the required foundation payout rate--will result in more 
grant dollars going to nonprofits and provide funders with incentive to 
be more efficient when spending money on themselves as opposed to their 
grantees. NCRP does not advocate that there should be specific limits 
or caps on the salaries of foundation executive directors or staff, but 
that foundation trustees should review executives' salaries very 
carefully and include in their calculations pensions, stock options, 
and other perks. In addition, foundations should disclose the total 
compensation paid--including benefits, severance packages, and other 
payments--to senior staff members.

    According to NCRP analyses of IRS data on private foundations, in 
2000 $2.5 billion in foundation administrative expenses were included 
in their payout calculations. On average, throughout the 1990s, each 
year nearly half of these payout-related administrative expenses--44 
percent--was used for foundation executive, board of trustee, and staff 
salaries and related benefits. As a matter of principle, foundations 
should not be allowed to count a $1 million severance package to an 
outgoing CEO as the legal and financial equivalent of a $1 million 
grant to a nonprofit organization. Foundations receive tax breaks in 
exchange for their charitable purpose, which is to get their assets 
into the hands of nonprofit organizations. The constitution of 
foundation payout should reflect this legal reality.

      Limit foundation trustees' compensation: In nearly all 
cases, foundation trustees should not be compensated for their board 
service. If trustee compensation is deemed necessary, NCRP calls for 
limiting compensation or fees for foundation trustees (not including 
reimbursement for reasonable travel and incidental expenses) to no more 
than $8,000 per year from all sources (i.e., not only fees, but also 
compensation through contracts for services such as legal, accounting, 
and investment functions). Like salaries and other administrative 
costs, foundation trustee fees should be removed from foundations' 
qualifying distributions.

    If a public charity paid its board members, most foundations would 
probably not even consider it for a grant. Ideally, all board service 
in the nonprofit sector should be thought of as volunteer work, not as 
a highly paid part-time job. And many board positions are highly paid. 
A study from the Center for Effective Philanthropy, for example, found 
that the median hourly compensation rate of foundation board trustees 
in its research sample was $324.\5\
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    \5\ The Center for Effective Philanthropy. Effective Governance: 
The CEO Viewpoint. 2004.
---------------------------------------------------------------------------
    Ideally these rates should be reduced to a maximum of $8,000 per 
trustee per year, and such payments should not count toward a 
foundation's annual grants payout.

      Promote foundation diversity: Despite some progress, the 
diversity of the philanthropic sector still needs improvement. Racial, 
ethnic, gender, and class diversity should be addressed and increased, 
particularly among private foundation board members who are still 
overwhelmingly white, male, and upper class. Information on the 
diversity of foundation board members, senior staff members, 
professional staff, and other staff should be publicly disclosed.

    A semi-regular survey from the Council on Foundations tracks the 
racial and gender diversity of foundation board members. In 1982, 77 
percent of all foundation board members in the survey were men. By 
2002, some erosion of the gender divide occurred, but not much, with 
men representing 65 percent of all foundation board members. Similarly, 
in 1982, 96 percent of all board members in the survey were white, 
which fell to 89 percent in 2002.
    Because foundations are using largely public dollars and many claim 
to serve minority and other disenfranchised populations, it makes sense 
that foundation staff and board members should reflect the citizens of 
the United States--or, at the very least, the communities the 
foundations strive to serve--in racial, gender, ethnic, and class 
terms.
Maximizing Foundation Support for Nonprofits

      Emphasize core operating support grantmaking: NCRP 
maintains that at least half of foundation grant dollars should be in 
the form of core operating support or flexible grants as opposed to 
restrictive, program--or project-specific grants. NCRP's research 
indicates that giving nonprofits flexible, unrestricted grant support 
leads to stronger organizations, better support for the communities 
they serve, and improved relationships between grantors and grantees. 
Unlike foundations, nonprofits cannot simply give themselves grants to 
cover their core administrative costs. Additionally, in program or 
project support, the full cost of nonprofits' reasonable related 
administrative or ``indirect'' expenditures should be included in the 
foundations' grants.
      Increase foundation grants payout: NCRP reaffirms its 
longstanding position that private foundation spending, or payout, 
should be a minimum of 6 percent annually, with all administrative and 
operating expenses excluded from the payout and qualifying 
distributions calculations.

    Right now, private foundations are required to pay out 5 percent of 
their assets each year. Again, this 5 percent currently includes 
foundation overhead expenses, as well as grants to nonprofit 
organizations and program related investments. Many foundations pay out 
exactly 5 percent each year, effectively turning the 5 percent floor 
into a 5 percent ceiling. IRS data show that smaller foundations tend 
to exceed the 5 percent minimum much more frequently than larger 
foundations; smaller foundations also tend to have little--and in some 
cases, no--overhead costs.
    Interestingly, the foundations with the most overhead costs tend to 
also have the lowest payout rates, even when taking overhead costs into 
consideration. For example, the IRS analyzed the payout rates of the 50 
largest foundations from 1985-1997, and found that only thirteen 
actually met or exceeded 5 percent. The other 37 foundations fall short 
of this legal requirement, sometimes by more than one full percentage 
point. Looking at the ratio of grants to assets, only four of these top 
50 foundations met or exceeded 5 percent in 1997.
    Many foundation leaders oppose increasing the foundation payout 
rate because they claim that any rate about the current 5 percent 
increases their minimum spending requirement to a level that is not 
sustainable, effectively drawing down foundation assets to nothing.
    Most research on payout and returns on investments do not, however, 
substantiate the claims that these individuals have made. For example:

      Research that the Council on Foundations commissioned 
shows that foundations could have maintained a 6.5 percent payout rate 
from 1950 to 1998 and would have still increased their assets by 24 
percent.
      A study conducted at Harvard University on the investment 
returns of 200 of the nation's largest foundations found that they 
earned an average return of 7.62 percent, while paying out an average 
of only 4.97 percent.
      US Bancorp's Piper Jaffrey who presented at a recent 
meeting of Northern California Grantmakers found that an investment 
portfolio made up of 70 percent equity stocks and 30 percent government 
bonds earned nearly an inflation-adjusted 8 percent return from January 
1980 through December 2002.
      Lincoln Investment Planning, Inc. reports that the S&P 
500 earned an average annual return of 10.2 percent from 1926 through 
December 2002. Investments in small stock companies yielded an average 
return of 12.2 percent for the same period.

    Further, IRS data show that many foundations annually receive new 
infusions of money beyond returns on investments, including new 
contributions from individuals and profits from real estate holdings. 
Assuming that the only source of revenue for foundations is returns on 
investments simply does not reflect the reality of the philanthropic 
sector. And considering that the foundation sector has more than 
quadrupled in size over the past 25 to 30 years, it is mathematically 
impossible that a one or two percent increase in foundation payout 
would drain foundation assets and bankrupt the sector.
    Establish foundation-comparable donor-advised fund payout 
requirements: There is currently no payout minimum for donor-advised 
funds. There should be a minimum grants payout from donor-advised 
funds, established at a 6% level comparable to the payout rate that 
should be required of foundations. Considering the substantial tax 
breaks that DAFs receive--and their recent proliferation--they must be 
required to provide some minimal return to society, as everyone is 
impacted by the lost tax revenue from these charitable vehicles.

      Promote philanthropic support for social equity: 
Foundations need to better address the needs of disadvantaged and 
disenfranchised populations--and the nonprofits that serve them. Toward 
that end, there should be more foundation grantmaking devoted to social 
justice organizing and advocacy, significantly higher proportions of 
grantmaking devoted to racial/ethnic minorities, low-income 
populations, immigrant populations, the disabled, gay/lesbian/bisexual/
transgender communities, and a willingness to make grants to smaller 
organizations as opposed to the current propensity of many foundations 
to make only a few large grants to a small number of large nonprofit 
recipients.

    In 2002, civil rights and social action nonprofit organizations 
received only 1.7 percent of all foundation grant dollars. Minority 
populations in general are underserved by foundations. Grants 
designated for African Americans/Blacks amounted to only 1.9 percent of 
all grant dollars in 2002; for Hispanics/Latinos the figure was 1.1 
percent; for the disabled, 2.9 percent; the homeless, 1 percent; single 
parents 0.1 percent; and gays and lesbians, 0.1 percent. These are the 
groups of people who have been hardest hit by discrimination in 
society, and they are entitled to receiving a greater share of 
philanthropic dollars.\6\
---------------------------------------------------------------------------
    \6\ The Foundation Center. Foundation Giving Trends, 2004.
---------------------------------------------------------------------------
    Despite the fact that the overwhelming majority of nonprofit 
organizations in the United States are financially small institutions, 
nearly half of all foundation grant dollars was given out in grants 
that were larger than $1 million in 2002. Only 18 percent of all grant 
dollars were given through grants that were smaller than $100,000. 
These data suggest that foundations are not supporting the countless 
small, community-based organizations that the nation's most 
disadvantaged communities and populations depend on for critical human 
services and political representation.

      Maintain and support small foundations: While some very 
small foundations may very well be economically impractical, NCRP does 
not believe that small foundations are any less accountable or 
probative than large foundations, and in many cases, because of their 
smallness and localism, they are more responsive to disadvantaged 
constituencies than others. Therefore, NCRP calls for maintaining and 
working with small foundations--and resisting calls for establishing 
and raising arbitrary minimum capitalization levels for foundations.

    The scandals and abuses in foundations that have been reported in 
the press are not exclusive to small foundations. Foundations in all 
parts of the country and of all sizes have been engaged in illegal and/
or unethical behaviors, according to these press accounts and the 
foundations' IRS filings. It is irresponsible to pass blame for the 
recent foundation scandals from the entire foundation sector to just 
one segment of the sector, as some nonprofit and foundation leaders are 
attempting to do. Doing so is inaccurate, irresponsible, and unethical.
Maximizing Foundation Support for Justice and Democracy

      Encourage democratic participation: Foundations should be 
encouraged to support nonprofit public policy advocacy, community 
organizing, nonpartisan voter registration drives, and civic 
engagement. It is perfectly legal for them to do so, and these 
activities do more to advance a broad public interest agenda than most 
service organizations and programs that foundations currently support.
      Foundation investment activism: Foundations invest 
hundreds of billions in corporate shares, giving them the opportunity 
of voting their proxies on critical matters of corporate governance, 
corporate accountability, and other corporate policies. The failure of 
foundations to take these affirmative steps with proxy actions results 
in missed opportunities for social change. NCRP encourages foundations 
to use their powers as shareholders to promote social change. 
Unfortunately, the majority of foundations do not take advantage of 
this position of power that they currently hold.
      Promote mission-based investing: It makes social and 
economic sense for foundations to devote part of their investments to 
mission-based investment options such as community loan funds, equity 
funds, and other charitable instruments. Mission-based investing should 
be a standard component of a foundation accountability regime.
      Prevent portfolio concentrations: Foundations should not 
invest more than a very small proportion of their investments in any 
one particular corporation, as the law currently calls for, they should 
desist in asking for exceptions to that standard, and those foundations 
that have received approval to circumvent this standard should return 
to the philanthropic norm of preventing such investment concentrations.

    The experience of the David and Lucille Packard Foundation is a 
great example why foundations should avoid such concentrations. The 
majority of the foundation's investments was held in Hewlett-Packard 
company stock. The economic boom of the 1990s--fueled in large part by 
the technology sector--boosted the foundation's assets to around $10 
billion. Following the economic downturn in 2001--which hit the 
technological sector especially hard--the foundation's assets shrank by 
$8.3 billion, forcing Packard to eliminate entire grantmaking program 
areas and lay off staff members.
Conclusion
    Current regulations, laws, and oversight are clearly not working. 
The drumbeat of scandalous stories in the nation's newspapers will not 
stop anytime soon. But it is not the responsibility of the media to 
police the philanthropic sector. Responsibility rests with the 
government, at both the state and federal level. Not only do the 
current laws and regulations need to be actually enforced, but stronger 
and more relevant laws and regulations are needed to reflect the 
current realities that both foundations and the charities that they 
support face.
    NCRP was created nearly 30 years ago, which was the last time the 
U.S. Congress took an active interest in holding foundations more 
accountable to their grantees and the general public. We are encouraged 
that the House Ways and Means Committee is returning to these very 
important issues, and look forward to an ongoing dialogue that we hope 
will strengthen philanthropy so that it can better serve the people and 
communities who need it the most, as well as remain true to the U.S. 
citizens who bear the brunt of tax breaks that support the 
philanthropic sector.

                                 

   Statement of Paul Hazen, National Cooperative Business Association
    The National Cooperative Business Association appreciates the 
opportunity to submit testimony about cooperatives and their tax 
treatment. This is a critical issue for cooperatives, their members and 
the communities in which they operate. NCBA is the nation's only 
national organization representing cooperatives across all sectors of 
our economy--including agriculture, childcare, electricity, finance, 
food retailing and distribution, healthcare, housing, insurance, 
purchasing and shared services, telecommunications and many others.
    Cooperative taxation principles and specific provisions of the 
Internal Revenue Code reflect the member-owned and governed structure 
of cooperatives. Generally, cooperatives themselves do not have taxable 
income because they pass through that income to their members in the 
form of patronage refunds. Members pay tax on the patronage refunds 
they receive. Though cooperatives may not be taxed on income and 
business derived from their patrons, they typically do pay taxes on 
non-patron income.
    Co-ops operate as not-for-profit businesses in that they return any 
profits they earn to their members based on the amount of business the 
members do with the co-op. Some cooperatives are organized under 
section 501(c) of the Internal Revenue Code and are entitled to a tax-
exemption if they meet certain criteria, e.g., operate on an at-cost 
basis. While these exemptions address different types of cooperatives, 
they are based on the same tax principles applied to other types of 
cooperatives. Cooperatives that file under section 501(c), however, are 
subject to restrictions not applied to other cooperatives.
     How successful a cooperative is either in terms of size or meeting 
the needs of its members should not be a measure of whether and how it 
is taxed. Cooperatives may be Fortune 500 companies or they may be 
small, community-based businesses. But regardless of the size or the 
success of the cooperative, the structure remains the same. They are 
member-owned and member-controlled. And the tax principles and 
provisions that apply to them appropriately reflect that structure.
Cooperatives--A Business Structure that Promotes Ownership and 
        Accountability
    Cooperatives are a vital part of the economy. An estimated more 
than 40,000 co-ops in this country are, by definition, businesses that 
are owned and democratically controlled by their members. These are the 
people who buy the goods or services the cooperative provides, rather 
than outside investors. Cooperatives serve some 120 million members by 
providing them with agricultural processing and marketing services, 
childcare, education, healthcare, affordable housing, financial 
services, group purchasing, food and other consumer goods, electricity 
and telecommunications services, among many others. Cooperatives and 
their members generate millions of dollars in economic activity, 
creating jobs, wealth, and opportunity.
    Cooperatives return surplus revenues--that is, income over expenses 
and investment--to members proportionate to their use of the 
cooperative, not proportionate to their ``investment'' or ownership 
share. Co-ops are motivated, not by profit, but by service to their 
members. Their goal is to meet their members' needs for affordable and 
high-quality goods or services. For this reason, outside capital 
investment is often hard to attract. Co-op equity consists largely or 
solely of member equity.
    Cooperatives' member-owned and member-governed structure also 
promotes accountability and trust among consumers. A national survey 
commissioned by cooperative organizations together with the Consumer 
Federation of America found that consumers trust the cooperative 
structure more than the investor-owned structure.
    Cooperatives fall into four categories:

      Producer-owned cooperative--These cooperatives are owned 
by farmers or craftsmen who form a co-op to jointly market, process or 
produce a similar product. There are 1,600 farmer--or rancher-owned 
marketing or processing cooperatives in the United States. New 
generation cooperatives--small co-ops that specialize in value-added 
agricultural processing--are becoming more popular.
      Consumer-owned cooperatives--The largest co-op category, 
these cooperatives are owned by the consumers who buy the businesses' 
goods or services. They include food co-ops, rural electric and 
telecommunications cooperatives, credit unions, housing co-ops, parent-
owned childcare co-ops, and consumer-owned HMOs.
      Purchasing and shared services--These cooperatives are 
owned by individuals or small businesses that buy goods or services as 
a group to lower costs. As more and more small businesses see 
purchasing co-ops as the key to their survival, this segment of the co-
op community is growing. NCBA estimates that, nationwide, more than 
50,000 independent businesses are members of purchasing co-ops. The 
nation's 1,600 farm supply and service co-ops fall into this category, 
since they are effectively purchasing co-ops for farmers and ranchers.
      Worker-owned cooperatives--These cooperatives are owned 
and controlled by their employees. They are similar to companies with 
Employee Stock Ownership Plans, known as ESOPs. However, in a worker 
cooperative, the employees benefit from the profitability of the 
company earlier than ESOP employees. Members of worker-owned co-ops 
receive annual taxable dividends on the company's earnings, rather than 
waiting for retirement to cash in their stock.

    The cooperative structure lends itself to addressing economic 
challenges facing America today, especially in rural areas. 
Municipalities are using cooperatives to provide needed services at 
lower costs. Communities are using the cooperative model to provide 
affordable housing that allows seniors to age in place. Cooperatives 
are also addressing soaring health care costs and other services for 
seniors. Cooperatives also help retain the wealth and purchasing power 
of communities. Instead of being drained away from communities by 
outside interests, money is put back into local economies by co-op 
member-owners. Studies show that the patronage refunds play a 
significant role in the economy of the communities in which they 
operate. These refunds can be critical to maintaining the vitality or 
revitalizing communities, particularly in rural America.
Cooperative Taxation Reflects Unique Structure of Co-ops
    Cooperative taxation, though addressed under different provisions 
of the Internal Revenue Code, generally follows the same basic tax 
principles regardless of the type of cooperative. The principles 
reflect the common member-owned and member-governed cooperative 
structure.
    Unlike investors, members join a cooperative to benefit from the 
goods and services it offers, not to make a substantial return on their 
investment. Farmers join an agricultural co-op to benefit from the 
leverage the group has in negotiating a price for their crop or the 
premium enjoyed through the co-op's product branding. Small businesses 
join a purchasing co-op to reduce their costs or to reach otherwise 
inaccessible markets, such as international markets.
    Following is a general description of the tax principles common to 
all types of cooperatives.
    Single Tax Principle: Surplus Member Revenues Not Taxable: 
Cooperatives do not pay income tax for surplus revenues generated by 
member business and distributed to or used in the service of members. 
For some cooperatives, surplus revenues from member business are 
returned to members as patronage refunds at the end of the year. 
Refunds can be either cash or equity held by the co-op and allocated to 
individual members. The co-op deducts these refunds from its tax 
liability, creating a single tax treatment of those revenues at the 
patron level. Patronage refunds effectively constitute patron 
``overcharges'' or ``underpayments'' returned to members at the end of 
the year.
    Treatment of Non-Member Revenues: Cooperatives pay corporate income 
tax on non-member surplus revenues. This is the same tax treatment as 
any other type of corporation. Some co-ops, such as credit unions, 
serve only members. As a result, they have insignificant or no non-
member income. IRS rulings and case law have upheld interpretations of 
``member business'' that allow some non-member revenue to be treated as 
member revenue and therefore not taxable at the cooperative level. 
Generally, any income derived from activities for which the principle 
purpose is serving members is not taxable.
    Some cooperatives have no surplus revenues from member business to 
return to their members. Essentially these cooperatives attempt to 
operate as close to cost as possible. That is, they offer ``refunds'' 
in advance, discounts at the point of purchase, discounts negotiated in 
advance from suppliers, lower fees, better interest rates on savings, 
or lower interest rates on loans.
    Tax Treatment of Patronage Refunds: Co-ops with surplus member 
revenue may return those surpluses to patrons in the form of cash or 
retained equity in the cooperative, or both. In some cases, patrons pay 
tax on the refund they receive. Patronage refunds arising from personal 
expenses, such as electricity for the home, groceries and other 
consumer goods, and interest refunds, are not taxable at the individual 
level.
Tax Code Provisions Embody Cooperative Taxation Principles
    Cooperatives are covered under several sections of the Internal 
Revenue Code. Subchapter T, section 1381-1388, provides single tax 
treatment of surplus member revenue, or pass-through treatment, for 
businesses that operate on a ``cooperative basis.'' Members are taxed 
on any surplus returned in the form of patronage refunds. Cooperatives 
filing under Subchapter T include agricultural and other producer 
cooperatives, purchasing cooperatives, some banks within the Farm 
Credit System, worker cooperatives, and some types of consumer 
cooperatives, such as housing and food co-ops.
    Under section 521, certain types of farmer cooperatives are allowed 
to pass through earnings from non-patron income sources to their 
patrons. Refunds are taxable at the patron level. To qualify for filing 
under this section, these co-ops must meet thresholds for member versus 
non-member business and other criteria.
    Some cooperatives file under Section 501(c), which provides six 
different types of exemptions. These include service cooperatives 
serving non-profit hospitals, credit unions and educational service 
cooperatives. While each exemption has its own history, all are based 
on member ownership and a purpose of serving their members. For 
example, public law states that ``credit unions . . . are exempt from 
federal and most state taxes because they are member-owned, 
democratically operated, not-for-profit organizations . . .'' PL 105-
219, August 7, 1998.

      Under section 501, member revenue is generally exempt 
from taxation if the conditions of the exemption are met. These 
requirements are in addition to those imposed on other cooperative 
businesses.
      Section (501)(c)(1) provides tax exemption for ``federal 
instrumentalities'' that are cooperative organizations, such as banks 
for cooperatives. Some Farm Credit Associations receive tax treatment 
under this section.
      Section 501(c)(3) provides tax exemption for co-ops, such 
as student housing cooperatives, that operate for charitable or 
educational purposes.
      Section 501(c)(12) provides tax exemption for rural 
utility cooperatives--providing electricity, telecommunications, or 
water--so long as 85 percent of the income comes from members and is 
for the sole purpose of meeting losses and expenses (i.e., operation 
at-cost). This is a requirement Subchapter T cooperatives do not face.
      Section 501(c)(14) provides tax exemption for credit 
unions. It requires them to operate ``without profit'' and ``without 
capital stock,'' requirements Subchapter T cooperatives do not face. 
Credit unions generally cannot serve non-members, a restriction not 
imposed on Subchapter T co-ops.
      Section 501(e) provides tax exemption for service 
cooperatives serving non-profit hospitals. Like other tax-exempt 
cooperatives, these cooperatives face additional operational 
restrictions.
      Section 501(f) provides tax exemption for educational 
service cooperatives.

    Some cooperatives covered by 501(c) are exempt from federal income 
tax on non-member revenue under certain thresholds, generally related 
to whether most of the co-op's income is for its exempt purpose. This 
results from the additional statutory or regulatory requirements 
specific to these cooperatives and does not constitute preferential 
treatment. Generally, this is consistent with the concept of a 
``purpose'' test applied to non-member revenue for non-501(c) 
cooperatives--that is, the non-member income that is not taxable meets 
the primary member service purpose of the cooperative.
Conclusion 
    Co-ops are member-owned and member-run businesses that return any 
profits they earn to their members based on their patronage with the 
co-op. This model of business is more accountable and instills more 
confidence than companies owned by shareholders in search of 
unrealistic returns. At a time of rising deficits, cooperatives are 
poised to meet economic challenges such as high health care costs, a 
growing aging population and senior housing in rural America.
    From large agricultural co-ops to the local food co-op, all 
cooperatives are owned and governed by their members. The tax treatment 
cooperatives receive reflects their member-owned and member-controlled 
structure. NCBA urges the committee to retain that treatment.
    Thank you for opportunity to provide testimony. We would be pleased 
to discuss the tax treatment of cooperatives further with the 
committee.

                                 

                                          Ohio Hospital Association
                                                       Columbus, OH
                                                        May 2, 2005
The Honorable Bill Thomas
Chair, U.S. House Ways and Means Committee
Washington, DC 20515

Dear Chairman Thomas:

    On behalf of the Ohio Hospital Association (OHA), we thank you for 
the opportunity to submit comments for the record regarding the hearing 
held April 20, 2005, on the Tax-Exempt Sector.
    OHA is the oldest state hospital association in the nation, 
representing more than 170 acute-care hospitals and 40health systems 
across Ohio. Our governing Board of Trustees is comprised of 
representatives from the whole gamut of providers in Ohio--from large, 
urban teaching facilities to small, rural hospitals, and from every 
corner of the state. Each of our members is dedicated to providing its 
community with the highest quality health care service all day, every 
day. The majority of these hospitals are not-for-profit, 501(c) (3) 
organizations.
    Our members earn their tax-exempt status through a wide range of 
services that benefit the community. Ohio hospitals annually provide 
more than half a billion dollars in charitable services to the elderly, 
uninsured, and indigent for which they receive no reimbursement. They 
help educate patients on whether they qualify for discounts and public 
health coverage. Hospitals care for everyone who comes through their 
doors, regardless of ability to pay.
    However, the immense amount of charity care hospitals provide is 
only part of the story. Our hospitals provide hands-on training for the 
next generation of nurses, technicians, pharmacists, and physicians. 
They conduct blood drives, wellness and health diagnosis fairs, 
vaccination events, and mobile screening services for cancer and other 
life-threatening diseases, saving thousands of lives and health care 
dollars each year. They help local and state government prepare for 
natural and man-made disasters. Hospitals provide everything from 
community education about health risks, diet, and exercise, to basic 
items like bandages, thermometers and pedometers. In short, hospitals' 
vital contributions to society cannot be measured in dollars alone.
    Just like churches, universities, and other organizations, 
hospitals receive considerable financial relief by way of their tax-
exempt status. And like churches, universities, and other 
organizations, hospitals provide such a diverse and high-level of 
service to their community that they more than earn their keep. 
Moreover, the savings achieved by tax-exempt status are re-invested in 
the community, stretching the value of the government's dollar. While 
short-term government revenues might increase if hospitals did not 
receive 501(c) (3) status, the long-term loss of access to health care 
and of economic development would outweigh the small gains.
    Like all of our nation's laws and regulations, those regarding the 
tax-exempt sector deserve periodic review and occasional improvement. 
As the Congress continues its evaluation of this sector, we look 
forward to working with you to ensure the government's resources are 
being used wisely and that our fellow citizens continue to receive the 
high-quality health care they deserve.
            Sincerely,
                                                    James R. Castle
                                                  President and CEO

                                 

                             Phoenix Children's Hospital Foundation
                                                  Phoenix, AZ 85006
                                                     April 26, 2005
The Honorable Bill Thomas
U.S. House of Representatives
2208 Rayburn House Office Building
Washington, DC 20515

Dear Congressman Thomas:

    I am writing to urge you to protect the charitable sector from 
unnecessary and overly burdensome regulations such as those presented 
by the Senate Finance Committee, particularly those proposals that 
would modify the tax rules regarding non-cash charitable contributions 
(known as ``in-kind'' contributions).
    The new proposals include recommendations to completely eliminate 
or substantially modify deductions for in-kind contributions. Many 
charities heavily rely upon non-cash donations, and there is no 
legitimate reason to attack this lifeline. In particular, gifts of real 
estate have been tremendously beneficial to Phoenix Children's 
Hospital. In the past two years, gifts of real estate have generated 
over $800,000 in revenue for Phoenix Children's Hospital. These dollars 
were used to provide charitable healthcare to children whose families 
had no means to pay. Our donors were motivated to donate real estate by 
the resulting charitable tax deduction. Their property was fairly 
appraised at the time it was donated resulting in their desired and 
fair tax deduction.
    Changing the in-kind contribution rules would unfairly compel 
charities to divert valuable time and resources to new valuation 
compliance schemes. The inability of the Internal Revenue Service to 
address improper donor behavior should not result in penalties for 
charities and the communities and populations which they serve. 
Significant revision of the in-kind contribution rules would greatly 
diminish my organization's ability to provide altruistic services.
    Furthermore, these proposals are not based on any credible evidence 
of wide-spread abuse. In fact, empirical data indicates that there is 
NOT widespread abuse among the charitable sector and that proposals are 
unnecessary. Reports collected by the FBI, the Federal Trade 
Commission, State Attorneys General and even watchdog groups like the 
Better Business Bureau show that reports of charity fraud are less than 
1 percent of all complaints of fraud. This is consistent with every 
single year's annual findings in the annual report on Fraud in the 
United States published by the FTC.
    It appears that many of the suggestions are driven by a desire to 
raise federal revenues from the charitable sector. Such an effort is 
completely inconsistent with the notion of tax-exempt status, and I 
hope you will strongly oppose such proposals. The tax-exempt sector 
provides an array of services to the public and advocates for under 
served populations, including children, minorities, women and the 
elderly. We fight disease, domestic violence, pollution and crime while 
promoting education, literacy and family values. Without the tax-exempt 
sector, there would be an enormous burden on the federal government to 
provide these services. Please ensure the stability of this sector by 
opposing these new, unnecessary regulations.
    The Senate Finance Committee's proposals to alter the non-cash 
charitable gift incentives come at a precarious time for charities. 
Americans are a generous people, but many charities are still 
recovering from the past several years when charitable giving has been 
flat and even decreased for many organizations.
    At the same time, we understand that your committee seeks to gather 
information on the size, scope and impact on the economy of the 
nonprofit sector; the need for congressional oversight; IRS oversight 
of the sector; and what the IRS is doing to improve compliance by the 
sector with the law. These are laudable objectives. We are interested 
in assisting the committee in identifying appropriate areas for further 
study as well as criteria and standards to better define and outline 
the sector and its players.
    Again, I urge you to oppose changes to the in-kind contribution 
rules as well as any unreasonable and burdensome legislation that would 
harm the charitable sector. I very much appreciate your support.
    Thank you for your consideration.
            Sincerely,
                                             Heidi A. Droegemueller
                                            Director of Major Gifts

                                 

                              Read ``Write'' Adult Literacy Program
                                                 Moriarty, NM 87035
                                                        May 4, 2005
The Honorable Bill Thomas
U.S. House of Representatives
2208 Rayburn House Office Building
Washington, DC 20515

Dear Congressman Thomas:

    I am writing to urge you to protect the charitable sector from 
unnecessary and overly burdensome regulations such as those presented 
by the Senate Finance Committee, particularly those proposals that 
would modify the tax rules regarding non-cash charitable contributions 
(known as ``in-kind'' contributions).
    The new proposals include recommendations to completely eliminate 
or substantially modify deductions for in-kind contributions. Many 
charities heavily rely upon non-cash donations, and there is no 
legitimate reason to attack this lifeline. Twenty-three (23%) of 
Torrance County reads below a first grade level. The need for our 
literacy program is apparent. At least 45% of our annual budget is in-
kind contributions. This consists largely of donated space and 
volunteer hours. Our volunteer tutors donate over 2,500 hours per year 
to help adults learn to read, write, and comprehend English. In-kind 
space for our office is donated by the Moriarty Community Library which 
values up to $10,000. Neither the tutors nor the Library receive any 
benefit other than the success of the students and our program. Without 
our in-kind donations the program would not exist.
    Changing the in-kind contribution rules would unfairly compel 
charities to divert valuable time and resources to new valuation 
compliance schemes. The inability of the Internal Revenue Service to 
address improper donor behavior should not result in penalties for 
charities and the communities and populations which they serve. 
Significant revision of the in-kind contribution rules would greatly 
diminish my organization's ability to provide altruistic services.
    Furthermore, these proposals are not based on any credible evidence 
of wide-spread abuse. In fact, empirical data indicates that there is 
NOT widespread abuse among the charitable sector and that proposals are 
unnecessary. Reports collected by the FBI, the Federal Trade 
Commission, State Attorneys General and even watchdog groups like the 
Better Business Bureau show that reports of charity fraud are less than 
1 % of all complaints of fraud. This is consistent with every single 
year's annual finding in the annual report on Fraud in the United 
States published by the FTC.
    It appears that many of the suggestions are driven by a desire to 
raise federal revenues from the charitable sector. Such an effort is 
completely inconsistent with the notion of tax-exempt status, and I 
hope you will strongly oppose such proposals.
    The Senate Finance Committee's proposals to alter the non-cash 
charitable gift incentive comes at a precarious time for charities. 
Americans are a generous people, but many charitable giving has been 
flat and even decreased for many organizations.
    At the same, we understand that your committee seeks to gather 
information on the size, scope and impact on the economy of the 
nonprofit sector; the need for congressional oversight; IRS oversight 
of the sector; and what the IRS is doing to improve compliance by the 
sector with the law. These are laudable objectives. We are interested 
in assisting the committee in identifying appropriate areas for further 
study as well as criteria and standards to better define and outline 
the sector and its players.
    Again, I urge you to oppose changes to the in-kind contributions 
rules as well as any unreasonable and burdensome legislation that would 
harm the charitable sector. I very much appreciate your support.
    Thank you for your consideration.
            Sincerely,
                                              Tina J. Cates-Ortega,
                                                          President

                                                      Betty Miller,
                                                   Program Director

                                 

          Statement of Steven M. Rose, Walpole, Massachusetts
The public charity reforms proposed by the JCT do not go far enough. 
        The problems need to be solved for decades to come. Please 
        consider the following 6 proposals:
    1. Compensation Speed Limits: Please enact firm numerical ``speed 
limits'' on public charity insider compensation. Legally require only 
``government sector compensation comparisons'' for public charity 
compensation. The JCT proposals for compensation limits are not 
quantitative enough and will just further burden our limited Government 
resources to interpret and police. Firm numerical speed limits on 
insider compensation (along with fines for breaking and/or evading the 
speed limits) will be much more efficient and will maximize the amount 
of money applied to each charities' exempt purpose, as opposed to 
enriching well connected insiders and their advisors. Public charity 
insiders have developed schemes to evade and defeat the current 
intermediate sanctions regime and they will do the same under a new 
regime if speed limits are not clearly posted. Just like Government 
public service, one should not be working at a public charity in order 
to ``get rich,'' this only sullies and conflicts with the charitable 
purpose. This is all about finding the most efficient way to limit 
greed and increase accountability.
    2. Report ALL Compensation and Fee Arrangements and Amounts Paid: 
Public charity compensation and fee reporting should be greatly 
expanded to report to the public ALL compensation and fees directly and 
indirectly paid by public charities. Public charities are ``taxpayer 
subsidized organizations'' and like the Government all compensation and 
fee information and arrangements should be disclosed for the public to 
see. This encourages public charity integrity and transparency. Hiding 
most of the compensation and fee picture from public view does not 
serve the public interest, it serves special insider interests and 
allows for undisclosed ``special'' or ``patronage'' like arrangements 
to run rampant among insiders, outside of Public and Government view. 
More comprehensive Public disclosure of compensation and fee 
arrangements and amounts paid is very important to help determine 
whether individuals connected to public charities are overpaid at ALL 
LEVELS of the public charity.
    3. Directly Connect Each Donor's Charitable Contribution to Public 
Charity Information: Most donors are unaware of and/or don't know where 
to find information on the public charity they are contributing their 
hard earned money to, and many public charity insiders would like it to 
stay that way. That's unfair and should definitely change. When 
soliciting money and after receiving any charitable contribution, the 
public charity should be required to inform each donor of a web site 
where the donor may review the public charity's detailed and fully 
disclosed returns, related entity returns and audited financial 
statements. This would be like giving the investor (contributor) an 
opportunity to look at the financial prospectus and other fully 
disclosed financial information filed with the SEC before they invest 
(contribute). A simple and decent provision that would connect the 
contributor to the charity's financial information will help 
immeasurably toward making sure that public charity insiders and their 
advisors are continually reminded that they are accountable to the 
Public for the money they receive.
    4. U.S. Government Posting of Public Charity Filings on the 
Internet: The U.S. Government should establish and maintain a web site, 
much like the SEC, for promptly posting all public charity filings and 
disclosures so the Public can readily review them in order to make 
important evaluations about how a particular charity is using its 
money. The U.S. Government should charge each public charity a small 
fee according to the size of the charity for this very important public 
service.
    5. A Visible and Welcome Place to Report Public Charity Abuse: 
Public charity reform should include a formal mechanism and place for 
the public to confidently report complaints and concerns about charity 
abuse. The current avenue for raising concerns about possible terrorist 
involvement, financial corruption and other abuse of public charities, 
is an uncertain and difficult route to take. Congress needs to enact 
laws that clear all roadblocks and welcome concerns about the conduct 
of public charities. Please consider the establishment of an ``Exempt 
Organization Commission,'' modeled after the SEC. Please also review 
Massachusetts Attorney General Reilly's ``Act to Promote the Financial 
Integrity of Public Charities, Section 3, Audit Committees; Procedures 
for Submission of Complaints and Concerns'' (see www.bostonbar.org/sc/
bl/docmat0304.htm for a copy). The U.S. Government should enact similar 
procedures to promote integrity.
    6. Conflict of Interest Provisions: Please consider enacting strict 
conflict of interest provisions modeled after state ``conflict of 
interest'' laws, especially for large public charities. Conflict of 
interest laws help to insure the integrity of state and local 
government. They can be applied as well to insure the integrity of 
public charities, which exist, like the government, to serve the public 
interest. Firm and clear conflict of interest provisions that prohibit 
self-dealing among insiders are crucial to public charity reform. The 
Massachusetts conflict of interest laws can be viewed at: www.mass.gov/
ethics/. Conflict of interest ``red flags'' were raised last summer and 
this prompted Massachusetts Governor Romney to veto a provision that 
would have increased secrecy with public pensions funds and he said 
(July 4, 2004 Boston Globe): ``Given our history in Massachusetts of 
abuse and potential self-dealings, we're very concerned about 
confidentiality provisions as they relate to investments of billions of 
dollars of public pension funds.'' No question about it, these very 
same concerns apply to the significant amounts of public charity money 
being ``secretly'' managed by public charity insiders with ``No Public 
Accountability or Transparency.'' We need more public charity openness 
as opposed to secrecy (confidentiality); secrecy serves the self-
indulgent monetary interests of insiders, and is a recipe for 
corruption.
    The more quantitative and exact the rules are, the less likely they 
will be subject to ``evasive interpretation'' by money hungry insiders 
and their public charity paid advisors. Clear rules that require 
minimal time and money to understand and comply with and will greatly 
lessen the burden on the Government and public charities. This 
objective will help public charities spend much more of their time and 
money on fulfilling the charitable purpose. I hope members of Congress 
will listen to the often under-represented concerns of people who are 
Not public charity insiders when writing new rules needed to safeguard 
our nation's charitable assets, for decades to come.
    I've tried to limit my comments to 2 pages. However, since November 
of 2002, I've submitted a great deal of information about charity abuse 
to Senators Grassley and Baucus. Unfortunately, I know, first hand, how 
really bad the abuse is. It's disheartening. So much depends on the 
integrity of our country. Like you, I want to do all that I can to help 
fix what I know is broken. Please feel free to contact me, if you would 
like more information. Thank you for your public service.

                                 

                    San Diego County Veterinary Medical Association
                                                 San Diego CA 92120
                                                     April 18, 2005
The Honorable Bill Thomas
Chairman, Committee on Ways and Means
United States House of Representatives
1100 Longworth House Office Building
Washington, DC 20515

Dear Representative Thomas:

    Concerns surrounding unfair business competition by tax-exempt 
organizations continues among the tax paying small business community 
nationally. Although currently not a direct problem for the veterinary 
industry in San DiegoCounty, we have concerns that this activity may 
soon be attempted here as it is done in other communities nationwide. 
Our perspective is proactive rather than reactive at this time.
    In some communities throughout the U.S., societies for the 
prevention of cruelty to animals and like organizations have begun to 
expand their services beyond their charitable mission. In an attempt to 
generate revenue for their organization they are providing inherently 
commercial, veterinary medical services to the general public without 
regard for their charitable need or financial ability to pay.
    Hearing testimony transcripts from a California legislative panel, 
as well as a recent Internal Revenue Service Panel would indicate that 
most of these business activities by tax-exempt organizations go 
unreported to the IRS pursuant to the Unrelated Business Income Tax 
(UBIT) reporting requirement. Criteria that provide examples of what 
``unrelated business income'' activities are, are absent with the 
exception of ``animal boarding'' referenced as ``unrelated'' to a 
charitable mission. A solitary example in itself may encourage an 
absence of income activity reporting.
    The many other veterinary medical services that are provided by 
these charities to the general public without regard to charitable need 
apparently go unreported by most. In contrast, veterinarians operating 
small business hospitals and clinics are taxed fully and at several 
levels.
    I am the President of this local veterinary association 
representing 650 members and I appreciate the opportunity to make you 
aware of our concerns, which we feel are representative of the almost 
100,000 veterinarians nationally. In the March 1, 2005 Panel on the 
Nonprofit Sector Interim Report presented to the Senate Finance 
Committee we could not find UBIT reporting on their current agenda for 
providing recommendations for ``strengthening the accountability of 
charities and foundations'' but assume this issue will be addressed in 
their final report. We hope that you will direct and support efforts to 
define and enforce appropriate regulations, enhanced example 
guidelines, and oversight. Doing so will show fair support for a 
substantial small business sector as well as increase the taxable 
revenue paid to the governmental coffers.
    We commend philanthropic and charitable organizations for the 
distinctive role they play in our society. Animal assistance 
organizations have a significant and vital charitable role in serving 
the plight of abandoned and abused animals. Some also provide subsidies 
for medical services to a needs-based population. Veterinarians commend 
and support that compassionate mission and many lend their own services 
to these organizations and provide pro bono contributions to the 
community on many levels on a regular basis. The practice of veterinary 
medicine, both clinically and from its operational perspective, fairly 
belongs in the established and well-regulated small business arena. 
Taxation exemption should not be allowed when provided to the general 
public by a ``charity''.
                                                     Keith Hilinski
                                                          President

                                 

    Statement of Peter V. Berns, Standards for Excellence Institute
    On behalf of the Standards of Excellence Institute we appreciate 
the opportunity to submit comments as the Ways and Means Committee 
undertakes a broad review of issues concerning the tax-exempt, 
nonprofit sector in the United States.
    The Standards for Excellence Institute is a national initiative 
that promotes a comprehensive system of nonprofit sector self-
regulation. Originated in Maryland, it now includes active programs in 
six other states with outreach to groups anywhere in the nation. The 
Institute couples a strong ethics and accountability code--Standards 
for Excellence--with the resources needed to achieve the highest 
standards in governance, management and operations. The program 
provides educational resource packets, clinics and person to person 
technical help to assist groups interested in understanding and 
implementing the individual standards. There is also a voluntary system 
of certification, based on an extensive peer review process, leading to 
the award of a ``Seal of Excellence'', which is subject to periodic re-
certification. The program was cited as a model in the Finance 
Committee's discussion paper last year.
    A careful review of the tax-exempt nonprofit community will clearly 
find some examples of abusive practices, excessive compensation, and 
areas such as tax shelters and credit counseling that demand 
examination and corrective action by the Congress and regulators at the 
federal and state level. What is less clear is how many of these 
problems require new laws or regulations rather than more effective 
enforcement of existing rules. It appears that many of these practices 
are already illegal, and there is uniform support from the nonprofit 
sector for more rigorous enforcement by the Internal Revenue Service, 
and a need for more resources for that purpose. We strongly support the 
work and recommendations of the Panel on the Nonprofit Sector convened 
by Independent Sector on these issues.
    A careful review will also find that the nonprofit sector is 
extremely diverse, and that ``one size fits all'' reforms could be a 
terrible mistake. Simply put, the level of regulation and reporting 
appropriate and necessary for large national organizations may present 
an impossible burden for groups that have small staffs, limited 
resources, and may rely completely on volunteers in serving the 
community. These make up the vast majority of tax-exempt organizations 
across the country.
    From years of providing assistance to hundreds of organizations, 
and from our experience implementing the Standards for Excellence 
program, we have come to understand that better management and 
accountability cannot be assured simply by new laws and law 
enforcement.
    Adoption of new stringent regulations, new reporting requirements, 
and new accreditation programs for nonprofits will not change two 
essential facts. First, tens of millions of well-intended individuals 
are involved in the management and operation of the nations' charities, 
and many already know they should be doing more in terms of management, 
but simply lack the time and resources. Second, for the most part, 
nonprofits' compliance with legal requirements or with voluntary 
standards of `best practice' is essentially self-enforced.
    Our research and experience have shown that nonprofit board and 
staff leaders have high expectations for themselves and their 
organizations, that unfortunately often exceed the level of performance 
they are able to achieve with the time and resources available to them.
    Any effective program to broadly improve the governance, management 
and accountability of nonprofit organizations must address the 
obstacles that prevent them from improving these areas within their 
organizations.
    First, there must be an accessible, user friendly and clear 
statement of standards that provides guidance and sets high 
expectations for how nonprofits are governed, managed and operated.
    A second significant problem is that we have under-invested in the 
infrastructure of nonprofit organizations and the nonprofit sector. 
Facing increasing demands for services they provide, with limited staff 
and resources to perform core mission activities, few can afford the 
time, effort and expense that is required to improve their governance 
and management practices. In fact, most of the incentives at present 
encourage nonprofits to spend as little as possible on their management 
and administration.
    We need to make clear that it's OK, in fact that it is expected, 
for board and staff leaders to pay attention to internal organizational 
health and to invest in building well run, responsibly governed, 
sustainable nonprofits. And we need to make resources available to 
support them as they endeavor to do so.
    A further major obstacle is that there are limited financial 
resources available to support those of us who are trying to help the 
helpers. The assistance that is currently available from state 
associations of nonprofits, local management support organizations, as 
well as national groups, is limited by our reliance on members' dues, 
fees, and already stretched thin philanthropic support.
    Improvement and expansion of programs such as the Standards for 
Excellence, and of training and information to promote basic legal 
compliance, will require more than is foreseeable from these sources.
    This is a logical area for partnership between government and the 
nonprofit sector. Nonprofit organizations deliver many vital government 
funded programs and services, and provide programs and services to 
citizens where government efforts are limited or non-existent.
    Just as it made sense years ago to develop federal and state 
programs to support the development and growth of small businesses, it 
makes sense now for both federal and state governments to invest in 
strengthening the capacity of nonprofits to serve the community.
    The national version of the Standards for Excellence is available 
on the web at http://www.standardsforexcellenceinstitute.org/public/
html/explore_b.html.
    Appended to these comments is additional information on the 
Standards for Excellence Institute and its national programs.
                                 ______
                                 
    The Standards for Excellence Institute is a national initiative to 
promote the highest standards of ethics and accountability in nonprofit 
governance, management and operations, and to facilitate adherence to 
those standards by all nonprofit organizations. The Institute uses as a 
vehicle the Standards for Excellence program, a system of nonprofit 
sector self-regulation originated by the Maryland Association of 
Nonprofit Organizations and now replicated by nonprofit associations in 
Ohio, Pennsylvania, Georgia, Louisiana, North Carolina and Illinois.
    The Standards for Excellence program has been developed to 
strengthen nonprofit organizations' ability to act ethically and 
accountably in their management and governance, therefore enhancing the 
public's trust in the nonprofit sector. The program promotes widespread 
application of a comprehensive system of self-regulation in the 
nonprofit sector--the first of its kind in the United States.
    The Standards for Excellence: An Ethics and Accountability Code for 
the Nonprofit Sector (Standards, Standards for Excellence) is the 
centerpiece of the program. The Standards are based on the fundamental 
values of honesty, integrity, fairness, respect, trust, compassion, 
responsibility and accountability, and provide a guideline for how 
nonprofit organizations should act to be ethical and accountable in 
their program operations, governance, human resources, financial 
management and fundraising.
    Standards for Excellence set a high benchmark,exceeding the minimum 
legal requirements by establishing a new standard to quantify how well 
managed and responsibly governed nonprofit should operate.
    The Standards cover eight areas of nonprofit governance and 
operations:

      Mission and Program
      Governing Board
      Conflict of Interest
      Human Resources
      Financial and Legal Accountability
      Openness
      Fundraising
      Public Affairs and Public Policy

    The Standards cover a broad range of topics such as: how many times 
each year an organization's board of directors should meet, what 
subjects should be covered in an organization's personnel policies, and 
when audited financial statements should be prepared. The Standards 
also encourage organizations to have procedures in place to evaluate 
their programs and require board member, staff and volunteers to 
disclose any conflicts of interest.
Standards
    The Standards for Excellence Institute works with its affiliates to 
implement the Standards in their organizations in a number of ways. The 
Institute provides affiliates with extensive written educational 
materials detailing best practices, outlining model policies, and 
providing user-friendly samples. Specialized training seminars are 
available on a range of topics that are pertinent to implementing the 
Standards in your organization. Ongoing one-on-one technical assistance 
is also accessible, allowing your organization to personally contact 
the Institute to address any questions that might emerge during the 
implementation process.
Putting The Standards for Excellence Program to Work
If you are a nonprofit organization you can . . .
      Set a new benchmark for your organization by implementing 
the Standards for Excellence: An Ethics and Accountability Code for the 
Nonprofit Sector, with the support of your Board of Directors and 
Staff;
      Show a copy of the Standards for Excellence Introductory 
Video to your Board of Directors and Staff; or
      Apply for the Seal of Excellence through the Standards 
for Excellence voluntary certification program (Now available in 
Maryland, Ohio, Pennsylvania, and Louisiana).

If you are a foundation or a grantmaker you can . . .
      Distribute copies of the Standards for Excellence: An 
Ethics and Accountability Code for the Nonprofit Sector to the 
nonprofits in your area as a blueprint for well managed, responsible 
governed organizations.
      Encourage and/or underwrite the organizations you support 
to use the Standards for Excellence as a tool for strengthening 
operations.
      License the Standards for Excellence Program and launch a 
full-scale Standards program in your region.
      Support the Standards for Excellence programs operating 
in your region.
      Sponsor a Standards for Excellence Institute training for 
nonprofits or grantees in your region.
If you are an association you can . . .
      Purchase copies of the Standards for Excellence: An 
Ethics and Accountability Code for the Nonprofit Sector to distribute 
to nonprofits in your area as a blueprint for well managed, responsible 
governed organizations.
      Contract with the Standards for Excellence Institute to 
provide training for nonprofits or grantees in your region.
      Apply for the Seal of Excellence through the Standards 
for Excellence voluntary certification program (Now available in 
Maryland, Ohio, and Pennsylvania). Soon to be available in additional 
states and jurisdictions.
      Become a supporter of the Standards for Excellence 
program by partnering with current or potential Standards replication 
partners.

    Affiliation to the Standards for Excellence Institute provides your 
organization and/or you, as an individual, access to a wealth of 
knowledge and support that will enable you to abide by the highest 
level of standards set forth by the nonprofit sector.

    Affiliate packages are available for:

       Nonprofit Organization--501(c)(3), 501(c)(4), or 501(c)(6)
       Individual Associates--not employed by a nonprofit
       Foundations/Federated Funding Agencies/Grantmaking Organizations
       Full Time Students

    Affiliate Benefits include:

      Discounts on purchases of Standards booklets
      Access to the Standards Educational Resource packages and 
permission to make additional copies of the materials
      Contacting Standards For Excellence Institute's expert 
staff through telephone technical assistance
      Access to information from our comprehensive nonprofit 
management library
      Participation in online forums with other members
      Discounts on customized Standards training programs

    Fees are determined by the type of membership and are based on a 
sliding scale. To receive more information about membership please 
refer to www.standardsforexcellenceinstitute.org

                                 
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