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Article Excerpt
INTRODUCTION
Although most types of revenue earned by nonprofit organizations are tax exempt, nonprofits engage in two types of taxable activities (Plunkett and Christianson, 2004). First, a nonprofit can conduct taxable activities without the use of a separate legal entity. These activities are referred to as "unrelated business activities" and are taxable if they are unrelated to the organization's primary exempt mission (Internal Revenue Code section 512). Unrelated business activities are reported on the Internal Revenue Service (IRS) form 990-T. Second, a nonprofit can place taxable activities into taxable subsidiaries organized as either corporations or partnerships. The taxable subsidiaries report their results on IRS Form 1120s (for corporations) or IRS Form 1065s (for partnerships). (1)
The first of these two organizational choices, unrelated businesses, has been the subject of significant descriptive analyses, several academic studies, and a recent spate of regulatory debate and legislation. The IRS annually produces a large amount of descriptive information about nonprofits' unrelated business activities. Cordes and Weisbrod (1998) and Hines (1999) examine why nonprofit organizations would engage in unrelated business activities. Sansing (1998), Cordes and Weisbrod (1998), Yetman (2001), Omer and Yetman (2003), Yetman (2003), Hofmann (2007), and Omer and Yetman (2007) provide evidence that nonprofits aggressively (but not necessarily illegally) avoid the tax on unrelated businesses primarily by shifting expenses from tax-exempt to taxable activities. Congressional concerns over the increase in and aggressive tax planning by nonprofits' unrelated businesses led to a provision in the Pension Protection Act of 2006 that requires nonprofits to publicly disclose their unrelated business income tax returns (i.e., their IRS 990-Ts). However, that same law does not require that nonprofits disclose their taxable subsidiaries' tax returns (i.e., their subsidiaries' 1120s or 1065s), which is an issue we discuss further in the paper.
Although the attention given to nonprofits' unrelated business activities by researchers and regulators is warranted, we suggest that it is incomplete as it ignores taxable subsidiaries. Our paper attempts to fill this gap. First, we seek to describe, as much as our data permit, the taxable subsidiaries of nonprofit organizations. Nonprofits are allowed to set up and operate controlled taxable subsidiaries with few restrictions, and many have done so, yet there is little by way of descriptive information on taxable subsidiaries. Second, we empirically examine some factors associated with the choice of conducting taxable activities via a subsidiary versus conducting them directly as an unrelated business. Finally, we frame our results within their policy implications.
Given the existing empirical and descriptive analyses of nonprofits' unrelated business activities, it is perhaps surprising that so little is known about their taxable subsidiaries. To our knowledge no empirical analyses of taxable subsidiaries have been conducted. Existing research on taxable subsidiaries is limited to one brief descriptive analysis (Steuerle, 2001) and one research paper by Sansing (2000), which indirectly examines taxable subsidiaries by modeling the social welfare effects of joint ventures between nonprofit and for-profit organizations. We are unaware of any IRS descriptive analyses of nonprofits' taxable subsidiaries, although it has "plans to collate information" on them (Internal Revenue Service, 2000).
To summarize our results, we find that one of every nine nonprofit organizations in the IRS Statistics of Income sample has a taxable subsidiary. (2) Of large nonprofits with total assets above $100 million (about 15 percent of the IRS Statistics of Income sample), over one in three has a taxable subsidiary. The taxable revenues earned by nonprofits' taxable subsidiaries are at least as large as the taxable revenues earned by their unrelated businesses. The average (median) taxable revenue generated by a subsidiary is approximately $10 million ($300,000).
Our cross-sectional empirical tests of organizational form choice suggest that nonprofits place their taxable operations into subsidiaries rather than conduct them as unrelated businesses when the relative amounts of taxable revenue are high, consistent with attempts to mitigate loss of tax-exempt status due to excessive unrelated business revenues (a nonprofit cannot lose its exempt status for large amounts of taxable subsidiary revenues). We also find that nonprofits are more likely to place relatively more risky taxable activities into subsidiaries, consistent with the attempt to provide some degree of legal liability protection for the exempt parent (separate subsidiaries provide some degree of legal distance whereas unrelated businesses do not). We also find that prior to the Taxpayer Relief Act of 1997, some nonprofits used a subsidiary as a tax-planning tool (the Tax Act largely removed subsidiary tax planning ability). Nonprofits appear to trade off these benefits with costs of using a subsidiary. For some nonprofits, tax planning is more difficult with a subsidiary as compared with an unrelated business. Also, stricter state governance makes use of the subsidiary form more costly relative to an unrelated business.
We also examine the time-trend of unrelated business revenues around taxable subsidiary creations and dissolutions. A taxable subsidiary can be formed from a completely new business, or from the movement of an existing unrelated business or previously exempt activity from the parent nonprofit. Likewise, a taxable subsidiary can be dissolved as a result of the parent nonprofit abandoning the activity, or by the parent nonprofit transferring the activity to an unrelated business or exempt activity. Our evidence suggests that when nonprofits create new taxable subsidiaries, a substantial portion of the new subsidiaries' revenues were previously earned by unrelated businesses, consistent with many taxable activities beginning life as unrelated businesses but at some point migrating to taxable subsidiaries. In addition, our evidence suggests that the parent nonprofit abandons taxable activities when taxable subsidiaries are dissolved.
The paper proceeds as follows. In the next section, we provide a descriptive analysis of taxable subsidiaries. The following sections present and empirically test our cross-sectional model of subsidiary choice. Then we examine taxable subsidiary creation and dissolution. Finally, we discuss the policy implications of our results, and conclude.
DESCRIPTION OF TAXABLE SUBSIDIARIES
Data
To provide our descriptive and empirical analyses, we collect information about nonprofit organizations and their taxable activities. (3) The most direct source of taxable subsidiary information is the IRS form 1120 if it is a corporation or its 1065 if it is a partnership, neither of which is publicly available. Unrelated business activities are likewise reported on an income tax return (i.e., the IRS 990-T), which is not publicly available during our sample time frame (although the Pension Protection Act of 2006 requires nonprofits to make 990-Ts filed after August 17, 2006 publicly available).
Although the primary data sources are not publicly available, nonprofits do provide some information about both their unrelated businesses and their taxable subsidiaries on their publicly available IRS form 990. Specifically, on part VII of the IRS 990, a nonprofit reports the amount of total revenue earned from unrelated businesses, and on part IX it reports the amount of total revenue earned by controlled (50 percent or more owned) taxable subsidiaries, as well as the percentage owned and the end-of-year total assets. (4) Many nonprofits report owning multiple taxable subsidiaries. For purposes of our analysis, we sum the taxable revenues of subsidiaries for each nonprofit. (5) The IRS began to collect taxable activity data in 1991, and the most recent year of available data is 2002, providing us with 12 years of data. After removing observations that did not earn any type of taxable revenue, we are left with 28,123 panel observations across 12 years.
Descriptive Analysis
Table 1 contains a description of the taxable revenue earned from unrelated businesses and taxable subsidiaries for the most recent year of the sample. In the 2002 sample year, there are 4,184 observations that earn some amount of taxable revenue, either directly through unrelated business activities or indirectly through controlled subsidiaries, or both. Because of the size-weighted sampling methods used by the IRS to create this database, the sample contains a larger proportion of larger nonprofits, and since larger nonprofits are more likely to conduct taxable activities, all statistics in the paper should be interpreted in light of this sample. We present three columns in the table. The first contains the 3,284 observations that operate an unrelated business, regardless of whether they also had a taxable subsidiary. The second column contains the 1,845 observations that operate a taxable subsidiary, regardless of whether they also had an unrelated business. The third column contains the 945 observations that have both unrelated businesses and taxable subsidiaries. The total number of unique observations is 4,184 (3,284 plus 1,845 less 945).
Nearly 20 percent of the 2002 SOI population report operating an unrelated business. The average (median) amount of unrelated business revenues earned by these observations is $1.1 million ($127 thousand). Roughly ten percent of the unrelated businesses report negative revenues. (6)
Almost 11 percent of the 2002 SOI population report taxable subsidiaries. The average (median) number of taxable subsidiaries per nonprofit is 1.8 (1.0), and ranges from 1 to 12. These subsidiaries are organized as either corporations or partnerships. The average (median) amount of taxable revenues earned by these observations' subsidiaries is $8.8 million ($208 thousand). These results show that the amounts of taxable revenues earned by nonprofits' subsidiaries are at least as large as the amounts of unrelated business revenues earned. About ten percent of the subsidiaries report negative revenues.
Approximately six percent of the 2002 SOI population report operating both unrelated businesses and taxable subsidiaries. The average (median) amount of taxable revenues earned by these observations' subsidiaries is $12.2 million ($437 thousand), while the average (median) amount of unrelated business revenues is $2.4 million ($384 thousand). This result again shows that the amounts of taxable revenues earned by nonprofits' taxable subsidiaries are at least as large as the average amounts of unrelated business revenues earned. In terms of relative assets, Table 1 shows that the assets of nonprofits' taxable subsidiaries are roughly one-seventh the size of the parents' total assets on average, suggesting that the subsidiaries are not trivial in size.
Turning to ownership percentages, we find that average ownership is approximately 88 percent, while approximately 68 percent of the observations are 100 percent owned. Steuerle (2001) suggests that one reason a nonprofit would establish a separate taxable subsidiary is to raise outside equity capital and/or to pay equity-based compensation to its officers. Our statistics suggest that while some taxable subsidiaries possibly raise outside equity capital and could pay equity based compensation, at least 68 percent do not.
The National Taxonomy of Exempt Entities (NTEE) as established by the Internal Revenue Service classifies nonprofits into 26 primary industry codes using the letters A through Z. Figure 1 shows the proportionate use of taxable subsidiaries across nonprofit industries. We omit industries Q (international) and X (membership organizations) as there are fewer than 100 observations in the panel sample, industry Y (religious organizations) as they are not required to file an IRS form 990, and industry Z (organizations...
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