The ubit: Leveling an uneven playing field or tilting a level one?

Fordham Law Review

Volumn 76, Issue 2, 2007, Pages 857-892

  Knoll, Michael S ^a,b  

^a UNIVERSITY OF PENNSYLVANIA LAW SCHOOL   (United States)

^b UNIVERSITY OF PENNSYLVANIA   (United States)

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EID: 38049103661     PISSN: 0015704X     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Conference Paper

References (140)

1. Currently, the eating establishments within Lincoln Center cannot be seen from the street and are mostly inside of venues that require tickets for entry. They also compete with private restaurants, but not as directly as will the new restaurants.
2. Helmut K. Anheier & Stefan Toepler, Commerce and the Muse: Are Art Museums Becoming Commercial?, in To Profit or Not to Profit: The Commercial Transformation of the Nonprofit Sector 233, 233-48 (Burton A. Weisbrod ed., 1998).
3. Id. at 288. This source was published before the completion of the hospital facility and refers to the Houston Oilers, now the Tennessee Titans.
4. Bruce Murphy, Missions Collide When Non-profits Try Business, Milwaukee J. Sentinel, May 31, 2004, at 1A. Some of these ventures were for-profit while others were not.
5. Press Release, Yale Sch. of Mgmt., Yale School of Management Receives Twin Grants Totaling $4.5 Million from the Goldman Sachs Foundation and the Pew Charitable Trusts to Foster Business Growth Among Nonprofit Organizations; Partnership Creates First-of-Its-Kind Business Plan Competition (Feb. 7, 2002), available at http://mba.yale.edu/news_events/CMS/ Articles/203.shtml. Universities are frequently in competition with for-profit entities in providing postgraduate training programs.
6. See I.R.C. § 61(a)(2) (2000).
7. See id. § 501(c)(3).
8. The statute was drafted on August 16, 1954.
9. See I.R.C. § 511 (2000).
10. The unrelated business income tax (UBIT) is sometimes also justified as protecting tax collections against erosion.
11. This essay, which is part of a broader project on the relationship between taxes and competitiveness, is an outgrowth of Michael S. Knoll, Taxes and Competitiveness (Univ. of Pa. Law Sch., Inst. for Law & Econ., Research Paper No. 06-28, 2006).
12. Throughout this essay, all section references, unless otherwise indicated, refer to the Internal Revenue Code of 1986, as amended and codified in title 26 of the U.S. Code.
13. Boris I. Bittker & George K. Rahdert, The Exemption of Nonprofit Organizations from Federal Income Taxation, 85 Yale L.J. 299 (1976) (tracing taxable exemption back to the Revenue Act of 1894, the corporation income tax of 1909, and the Revenue Act of 1913).
14. I.R.C. § 501(c)(3).
15. Id.
16. Henry B. Hansmann, The Role of Nonprofit Enterprise, 89 Yale L.J. 835, 838 (1980). Henry Hansmann has cataloged the consequences of nonprofits enjoying a taxinduced advantage in competitiveness over for-profit businesses, interference with diversification, and encouragement of managerial inefficiency.
17. I.R.C. § 501(c)(3).
18. Trinidad v. Sagrada Orden, 263 U.S. 578, 579 (1924).
19. Id. at 580 n.1.
20. Id. at 580-81.
21. Id. at 582.
22. Id. at 581.
23. Roche's Beach, Inc. v. Comm'r, 96 F.2d 776, 778-79 (2d Cir. 1938).
24. Id.
25. See generally C.F. Mueller Co. v. Comm'r, 14 T.C. 922 (1950).
26. C.F. Mueller Co. v. Comm'r, 190 F.2d 120, 122 (3d Cir. 1951), rev'g 14 T.C. 922.
27. Benjamin Fine, University Dollars Yielding Tax-Free Business Profits, N.Y. Times, Dec. 13, 1948, at A1.
28. Id.
29. Id. Educational institutions that owned commercial real estate generally leased the land to long-term tenants. In many cases, the tenant was also the party that had sold the land to the school. Such a transaction is called a sale-leaseback because the seller leases the property back from the buyer.
30. Id.
31. Imposition of Tax on Unrelated Business Income of Charitable, etc., Organizations, ch. 736, 68A Stat. 169 (codified as amended at I.R.C. § 511 (2000)).
32. Id. § 511(a)(2)(B).
33. Id. § 511(a)(1). The corporate income tax schedule is set out in I.R.C. § 11.
34. See Evelyn Brody, Of Sovereignty and Subsidy: Conceptualizing the Charity Tax Exemption, 23 J. Corp. L. 585, 605-06 (1998);
35. Charles T. Clotfelter, Tax-Induced Distortions in the Voluntary Sector, 39 Case W. Res. L. Rev. 663, 677-79 (1989);
36. Mark A. Hall & John D. Colombo, The Donative Theory of the Charitable Tax Exemption, 52 Ohio St. L.J. 1379, 1442-43 (1991);
37. Henry B. Hansmann, Unfair Competition and the Unrelated Business Income Tax, 75 Va. L. Rev. 605, 605-07 (1989).
38. But see Ethan G. Stone, Adhering to the Old Line: Uncovering the History and Political Function of the Unrelated Business Income Tax, 54 Emory L.J. 1475, 1484 n.29 (2005) (arguing that the purpose behind the UBIT was not to prevent unfair competition, but to protect and justify (politically) the tax exemption of charities by discouraging them from engaging in commercial activities).
39. Revenue Revision of 1950: Hearings Before the Comm. on Ways and Means, H. of Reps., 81st Cong. 580 (1950) (statement of Rep. John Dingell, Member of the H. Comm. on Ways and Means).
40. S. Rep. No. 81-2375, at 28 (1950), reprinted in 1950 U.S.C.C.A.N. 3053, 3081; see also H.R. Rep. No. 81-2319, at 38 (1950).
41. Treas. Reg. § 1.513-1(b) (2006).
42. The language of § 501(c)(3) requires that an exempt organization be organized and operated "exclusively" for exempt purposes. Interpreted literally, § 501(c)(3) would prevent an exempt organization from engaging in any commercial activity. The courts, however, have never interpreted the requirement of exclusive operation literally. Instead, in order to maintain the exemption, the courts require than an entity must be organized and operated "primarily" for exempt purposes.
43. I.R.C. §§ 512(a)(1), 513 (2000).
44. John D. Colombo, Commercial Activity and Charitable Tax Exemption, 44 Wm. & Mary L. Rev. 487, 500-07 (2002). For an in-depth survey of the cases interpreting the phrase "unrelated trade or business,"
45. see Carla Neeley Freitag, Unrelated Business Income Tax, 874-2d Tax Mgmt. Portfolio (BNA), at A-43-A-90 (2001).
46. I.R.C. § 511(a). Corporations are taxed under I.R.C. § 11. Trusts are subject to tax under I.R.C. § 1(e). See also id. § 511(b).
47. Id. § 512(b). The limitation that deductible expenses be directly related to the unrelated business is considered to be narrower than the limitations of deductible business expenses to those that are ordinary and necessary.
48. However, with a tax-exempt entity there is an obvious incentive for the entity to allocate as much of its expenses from exempt activities to the unrelated business activity as possible. When so allocated, such expenses reduce tax liability, whereas if they are allocated to the exempt activity they generate no tax savings. Thus, to limit the expenses that can be allocated, the Internal Revenue Code (the Code) only allows the direct expenses of earning the unrelated income to be allocated to that income.
49. Section 514, which sweeps the income from debt-financed properly into the UBIT, is discussed Part IV.C.
50. See supra Introduction.
51. Although firms listed on stock exchanges are often reluctant to issue new equity publicly, they often issue equity in other forms.
52. The New York University alumni group was not the only possible or even feasible purchaser of Mueller. In addition to the former owners, who had to be induced to sell through an acceptable offer, there were other potential buyers.
53. See Hansmann, supra note 34, at 610 (arguing that the charitable tax exemption reduces the cost of capital and thereby provides an advantage for nonprofits relative to for-profit firms).
54. The argument follows that in Knoll, supra note 11.
55. Because the perpetuity does not decline in value as payments are made, but rather holds its value, no depreciation allowance is necessary.
56. The assumption that all parties earn the same before-tax cash flow on their funds is common.
57. See Myron S. Scholes et al., Tax and Business Strategy: A Planning Approach 120 (2005).
58. The calculation in the text can be expressed more generally. Let the annual before-tax cash flow from the candidate investment be c and the before-tax interest rate on the benchmark asset be r. In that case, the present value (PV) of the candidate investment to a tax-exempt investor, PV(N), is as follows: PV(N) = c/r.
59. This calculation can also be expressed more generally. Denote the tax rate paid by the taxable owner as t. Thus, the taxable owner earns c(1 - t) on the candidate investment and earns r(1 - t) on the benchmark asset. Thus, the present value of the candidate investment to the taxable owner, PV(P), is as follows: PV(P) = c(1 - t)/r(1 - t) = c/r.
60. In practice, hurdle rates are further obscured by risk, which differs across assets and is often difficult to measure. The discussion in this essay ignores risk.
61. The argument has not been totally missed. Similar arguments have been made by others. See, e.g., William A. Klein, Income Taxation and Legal Entities, 20 UCLA L. Rev. 13, 61-68 (1972).
62. For a proposal to allow charities to issue equity and in effect become for-profit enterprises, see Anup Malani & Eric A. Posner, The Case for For-Profit Charities (Univ. of Chicago Law Sch., John M. Olin Law & Econ. Working Paper No. 304 (2d Series), 2006), available at http://ssrn.com/abstract_id=928976.
63. Assume for now that P is a pass-through entity for tax purposes. The possibility of a corporate P is taken up later. See infra Part IV.A.
64. I ignore risk, which would complicate the exposition markedly, but should not change the qualitative results substantially. For a discussion of how to adjust tax-based calculations for risk, see Scholes et al., supra note 52, at 127-30.
65. I discuss both leveraged investments and the possibility of issuing tax-exempt debt in detail below.
66. The result reported in the text - that if P borrows to purchase the asset, the most P can bid for the asset is still $1 million - holds whether P is taxed as a separate corporation or as a pass-through entity.
67. UBIT) = c(1 - t)/r. That is obviously less than PV(N) = PV(P) = c/r when t is positive.
68. See Scholes et al., supra note 52, at 184.
69. As used in this essay, the term "effective marginal tax rate" (EMTR) excludes implicit taxes.
70. differentially taxed) = c(1 - at)/r(1 - t). That is obviously greater than PV(N) = PV(P) = c/r when t is positive and a is less than one.
71. See Scholes et al., supra note 52, at 125-27.
72. See id. at 130-32.
73. See Knoll, supra note 11.
74. See David F. Bradford, Untangling the Income Tax 113 (1986).
75. differentially taxed) = c(1 - at)/r(1 - t). That is obviously less than PV(N) = PV(P) = c/r when t is positive and a is greater than one.
76. In a series of articles, I argue that negative implicit taxes are the key to understanding the cross-border, dividend-stripping transactions in Compaq Computer Corp. v. Commissioner of Internal Revenue, 277 F. 3d 778 (5th Cir. 2001), and IES Industries v. United States, 253 F.3d 350 (8th Cir. 2001).
77. See Michael S. Knoll, Implicit Taxes and Pretax Profit in Compaq and IES Industries, 114 Tax Notes 679 (2007);
78. Michael S. Knoll, Compaq Redux: Implicit Taxes and the Question of Pre-tax Profit, 26 Va. Tax Rev. 821 (2007).
79. Scholes mentions implicit negative taxes only in a footnote. See Scholes et al., supra note 52, at 125 n.4.
80. There is extensive finance literature that shows that some assets can support proportionately more debt than other assets.
81. I.R.C. § 1 (2000).
82. Id. § 1(h). In the discussion that follows, I ignore the possibility of deferral.
83. 2 is positive.
84. The federal corporate tax rate is 35%. The federal individual tax rate is 15% on dividends and capital gains. Because the individual level tax is on income after the payment of corporate level tax, the incremental tax due to the individual level tax is 9.75%. That incremental tax liability is calculated as follows: 9.75% = (1 - 35%)(15%).
85. It is worth much less (only $650,000) to N if N can only hold some shares, and so the corporate tax still must be paid.
86. Although our conclusions are similar - without the UBIT, nonprofits would generally have a tax-induced advantage in the competition to acquire assets held by for-profit investors through corporations - the analysis in the text differs from that of Hansmann, supra note 34, at 610. Nonprofits have a tax-induced incentive to acquire for-profit businesses, but not because their cash flows would exceed those earned by taxable buyers, as Hansmann argues. Instead, nonprofits have an incentive to acquire businesses that would generate large amounts of income taxed at both the corporate and individual level because high-bracket investors pay a higher total tax rate on such investments than on the benchmark asset, whereas nonprofits pay the same tax (zero) on both investments.
87. For a discussion of different methods of integrating the corporate and personal income taxes, see, for example, Michael J. Graetz & Alvin C. Warren, Jr., Integration of the U.S. Corporate and Individual Income Taxes: The Treasury Department and American Law Institute Reports (1998).
88. Because of the commutative property of multiplication, the total tax burden with flat taxes is the same whether state taxes are deductible from federal income or federal taxes are deductible from state income.
89. 2 = t′/(1 - t).
90. 2)/r, which is also the value to the for-profit entity.
91. It is too high because it uses the corporate tax rate, not the capital gains/dividends tax rate, and because it applies to the entire business, not the portion that would be financed by corporate equity.
92. Economic Report of the President: 2007 Report Spreadsheet Tables, State and Local Government Revenues and Expenditures, Selected Fiscal Years, 1938-2004, tbl.B-86, available at http://www.gpoaccess.gov/eop/2007/B86. xls.
93. Id.
94. Id.
95. See Jill R. Horwitz, Does Nonprofit Ownership Matter?, 24 Yale J. on Reg. 139, 144 (2007) ("[C]harities . . . are largely eligible for state . . . property tax exemptions.");
96. David E. Pozen, Remapping the Charitable Deduction, 39 Conn. L. Rev. 531, 533 (2006) (describing the property tax exemption accorded nonprofits as one of the cornerstones of U.S. nonprofit tax law);
97. Richard D. Pomp, Revise the Property-Tax Exemption, 14 Chron. of Philanthropy, May 2, 2002, at 37 ("Most states grant property-tax exemptions for charities.").
98. For thoughtful discussions of the similarities and differences between a wealth tax and an income tax, see Deborah H. Schenk, Saving the Income Tax with a Wealth Tax, 53 Tax L. Rev. 423, 435-41 (2000);
99. David Shakow & Reed Shuldiner, A Comprehensive Wealth Tax, 53 Tax L. Rev. 499, 500-31 (2000).
100. The wealth tax rate is calculated as follows: 3.5% = 35% x 10%. Because a stock of capital generates income at a rate of 10%, a wealth tax of 3.5% has the same expected burden as an income tax of 35%.
101. Such a tax would also treat issued debt (borrowings) as a reduction in wealth.
102. This result can be expressed mathematically. Assume that a parcel of non-depreciable real estate produces a cash flow of c per period in perpetuity. If we denote the before-tax interest rate by r and the tax rate paid by the taxable owner by t, then the charity will value the real estate at c/r. Similarly, the taxable investor will value the real estate at c(1 - t)/r(1 - t), which also equals c/r. If we denote the property tax by p, then the taxable investor will value the property at [c(1 - t) - p]/r(1 - t), which equals c/(r - p)/r(1 - t). If, however, the charity is exempt from the property tax, it will still value the property at c/r. Thus, the charity will be able to outbid the taxable investor for the real estate.
103. In addition, nonprofits might not even have an advantage in competitiveness from the exemption. If, for example, the tax benefits of the exemption can be easily transferred through leasing, then nonprofits do not have a substantial advantage in obtaining use of the property, only title. See Knoll, supra note 11.
104. See Hansmann, supra note 16 (arguing the converse - that without the UBIT, the exemption of nonprofits from the federal income tax will discourage mere efficient for-profit firms, thereby imposing a welfare cost).
105. Other nonprofits, which are not themselves educational institutions, also invest in private equity and hedge funds. For example, the Rockefeller Foundation has one-third of its $3.7 billion endowment invested in such funds. Stephanie Strom, Nonprofits Face Threat to a Tax Loophole, N.Y. Times, May 16, 2007, at A15.
106. Id.
107. The original 1950 Act contained a limited inclusion of income from debt-financed property. The Tax Reform Act of 1969 substantially expanded the scope of that provision to cover a much broader range of transactions.
108. See Andrew W. Needham & Christian Brause, Hedge Funds, 736 Tax Mgmt. Portfolio (BNA), at A-4, A-46-A-48 (2007).
109. See Strom, supra note 95.
110. Id.
111. Comm'r v. Brown, 380 U.S. 563, 580 (1965) (Harlan, J., concurring).
112. Id.
113. The discussion in the text ignores Clay Brown's partners.
114. Only $5000, which was paid out of the company's assets, was immediately paid in cash.
115. See Brown, 380 U.S. at 579.
116. At higher ordinary income tax rates, assuming that the long-term capital gains rate is 40% of the ordinary income tax rate, the tax benefit to the seller from the charitable bootstrap is even larger.
117. Caria Neeley Freitag, Debt-Financed Income (Section 514), 875-2d Tax Mgmt. Portfolio (BNA), at A-2 (2001).
118. S. Rep. No. 81-2375, at 30-31 (1950), reprinted in 1950 U.S.C.C.A.N. 3053, 3084.
119. That failing has since been remedied by other provisions of the tax law.
120. That is the case now and was the case at the time of Brown for most productive assets.
121. The value of the shelter increases with the buyer's tax rate. Furthermore, overstating the sales price does not harm the seller as long as the seller can report gain using the installment method without having to pay interest on the deferred gain.
122. The classic example is Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir. 1976). In Estate of Franklin, the owners of a motel transferred title to a group of doctors for a small amount of cash and a large amount of seller-financed nonrecourse debt, which no one expected to be repaid. The operators of the motel leased the facility back from the doctors. The purpose behind the transaction was to increase the depreciation deductions generated by the hotel markedly and to transfer those deductions to high-bracket taxpayers.
123. See William K.S. Wang, Apply UBIT to De Facto Leverage, But Not to 'Spurious Leverage', 95 Tax Notes 925 (2002) (arguing and criticizing § 514 for being so broad as to apply to "spurious" leverage - debt that is offset by held bonds).
124. See Bittker & Rahdert, supra note 13, at 322-23.
125. Although charitable investors have an advantage when competing against for-profit investors for real estate subject to property taxes, the existence of such an advantage does not mean that they will own all the real estate. There are numerous factors that limit their ownership of real estate. First, charities' investment funds are limited and they are prevented from raising equity because of the non-distribution constraint. Second, another party might be a more efficient owner, manager, or user of real estate. That will allow it to increase its bid relative to the less efficient nonprofit. Third, charities like other investors are careful to diversify their investments. Holding an undiversified portfolio of assets increases risk exposure without compensation. Fourth, lenders are usually reluctant to lend the full purchase price of an asset.
126. If the rent escalates, it is usually based on a set schedule or set to an index, such as the consumer price index (a measure of inflation).
127. If the lessee is creditworthy, then the only risk borne by the lessor is the risk associated with the change in the property's value at the end of the lease. If the lease is sufficiently long, then the present value of the residual is small and so the risk is small. If the lessor is not as creditworthy, then the risk is the joint risk that the property declines in value and that the lessee cannot pay. Such a risk, of course, varies depending on the property and the lessee.
128. See Richard A. Brealey et al., Principles of Corporate Finance (8th ed. 2006); Stephen A. Ross et al., Corporate Finance (6th ed. 2002). Similarly, the lessor's position is analogous to lending to the lessee to purchase the property.
129. I.R.C. § 61(a)(4) (2000).
130. Id. § 103(a).
131. See Scholes et al., supra note 52, at 196-97.
132. See I.R.C. § 141(b)(1).
133. See id. §§ 103, 141.
134. There is evidence that long-term, tax-exempt bonds pay interest at rates that imply implicit tax rates below the top statutory tax rate.
135. e is less than r.
136. See Washlick, supra note 98, at 152.
137. I.R.C. § 145(b).
138. There is no maximum on hospital debt. See id. § 145(b)(1). There is, however, still a prohibition on using hospital bonds to finance unrelated activities - they count towards the 5% bad use. Because many activities carried out by nonprofit hospitals as part of their exempt function are also carried out by for-profit hospitals, that raises the question whether the differences in the services provided by nonprofit and for-profit hospitals are significant enough to justify the subsidy. See also Horwitz, supra note 88.
139. I.R.C. § 148(f)(2).
140. Note that if the tax-exempt borrowing rate was 6.5%, the project with the UBIT would have a present value of $1 million. That the UBIT gives the right answer in that circumstance, however, is a coincidence. It occurs because the UBIT tax rate, which is the corporate tax rate of 35%, is also the personal tax rate that sets the interest rate on the tax-exempt bond.