Coase-Sandor Working Paper Series in Law and Economics

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Exemption is the term most often used by scholars, practitioners, and policy makers to describe the relationship between nonprofit organizations and the federal tax system in the United States. But although the term is useful as shorthand to characterize the complicated connections between the nonprofit sector and federal tax law, it also should be recognized as the misnomer that it largely is. The nonprofit sector is subject to a wide range of federal taxes— some of which apply broadly to nonprofit and for-profit entities alike, others of which fall almost exclusively on organizations that are ostensibly “exempt.” Insofar as nonprofit entities are excused from payment of federal income tax, exemption comes with a heavy load of compliance burdens, disclosure obligations, and other behavioral restrictions that dictate the day-to-day lives of these organizations. Rather than existing at several steps’ remove from the federal tax system, nonprofit entities are, in fact, tangled up in tax.

Indeed, if the relationship between the nonprofit sector and the federal tax system were to be summarized in a single word, entanglement rather than exemption would be the more appropriate term. Nonprofit organizations in the United States are caught in a complex web of nonprofit-specific code provisions, the most significant of which are summarized and evaluated in previous editions of this book upon which this chapter builds (Simon 1987; Simon, Dale and Chisholm 2006). Even seemingly unrelated tax statutes often tie back to the nonprofit sector in winding ways. There is, moreover, no non-entangling option; even total exemption would result in interactions between tax authorities and nonprofit organizations at exemption’s boundaries.

Some interactions between the federal tax system and the nonprofit sector are probably desirable. Insofar as the federal tax system seeks to support nonprofit organizations, such support almost inevitably involves a considerable degree of contact. The dominant dilemma in the design of the federal tax rules for nonprofit organizations is how to manage entanglement without releasing all strings.

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