Office of Advocacy

Testimony of Russell Orban, Assistant Chief Counsel for Tax Policy
Office of Advocacy
U.S. Small Business Administration

Before

Internal Revenue Service Panel

on

Unrelated Business Income Tax
February 10, 1999

Thank you for this opportunity to testify before you regarding the proposed regulations that seek to clarify the current state of the law regarding the tax treatment of income that is generated by travel and tour activities of tax exempt organizations. These regulations would answer the question what activities are substantially related to the purpose for which its tax exempt status was granted to an organization pursuant to Internal Revenue Code (IRC) § 501. Section 513(a) sets out that an unrelated trade or business is any activity carried on for the production of income which is not substantially related to the performance of the organization’s exempt purpose. We commend the Internal Revenue Service for starting this process and we are convinced that it can produce a positive result.

My name is Russell Orban. I am appearing on behalf of the Office of Advocacy of the Small Business Administration. My comments today are made pursuant to notice received under section 7805(f) of the Internal Revenue Code which provides the Office of Advocacy with the statutory authority to comment on proposed regulations(1) and also under general authority of the Office of Advocacy to monitor Agency compliance with the Regulatory Flexibility Act (RFA) (2)as amended by the Small Business Regulatory Enforcement Fairness Act (SBREFA). (3)The Office was created in 1976 to represent the views and interests of small business in federal policymaking activities. The Chief Counsel’s Office participates in rulemaking when he deems it necessary to ensure proper representation of small business interests. The views expressed are solely those of the Office of Advocacy and do not necessarily reflect the views of the U.S. Small Business Administration or any other government agency.

THE PROBLEM WITH UNRELATED BUSINESS INCOME

It has been our longstanding position that the engagement of tax exempt organizations or government agencies in profit-making activities should always be reviewed very carefully and with some healthy skepticism. Competition by exempt non-profits with for-profit business is essentially government subsidized competition with the private sector. To the extent that the federal government subsidizes nonprofit organization activity through the income tax-exemption, through lower postal rates or though other legal exemptions or preferences, nonprofit commercial activity can be carried on with a lower cost than the for-profit sector. This creates a competitive advantage and contributes to the overall feeling in the small business community that the system which allows such activity is unfair. The Internal Revenue Code is the principal mechanism for balancing the need to encourage nonprofit services with the advantages of the exempt status. The Internal Revenue Service plays a pivotal role in making the system work.

To work properly, the law and implementing regulations must be clear and uniformly enforced. Our office has concluded that the current law and regulations do not live up to this standard. We have been joined in this conclusion by the non-profit community, which seeks to avoid costly audits and uncertainty; by the IRS and the Treasury Department which has testified about the need to clarify the issue and the difficulty of applying the current standard, by Congress and finally, time and time again by the small business community. We are appreciative that the IRS long recognized the problems caused by the current situation and seek to address the issue directly.

Our Office became aware of the problem shortly after we created over 20 years ago. The first Task Force Study we ever commissioned addressed government sponsored competition for small businesses, including competition from exempt non-profits. In 1980 the first White House Conference on Small Business brought thousands of businesses together from around the country to recommend a small business agenda for the federal government. They recommended action be taken to protect taxpaying small businesses from government subsidized, unfair competition. A similar recommendation was made at the 1986 White House Conference on Small Business.

The 1995 White House Conference on Small Business brought 2000 small business owners to Washington DC, each either appointed by their Congressman or elected by over 25,000 small business owners participating in preliminary conferences in every state in the union. One of their top recommendations was a resolution calling on the government to prohibit tax-exempt organizations from engaging in direct competition with taxpaying small businesses in profit making activities.

THE SCOPE OF THE PROBLEM

Every year, the problem gets more serious. The growth of tax-exempt competition has exploded in the service oriented nonprofit sector. The number of active 501( c)( 3) non-profits, the category of non-profit most likely to compete in the travel and tours area had ballooned to over 579,384 in 1994. Again, these are just the organizations that are required to file a report.

In 1994, the latest year for which we have data, the total revenue for most 501©(3) organizations (excluding private foundations and most religious organizations and again, reflecting only those required to report) was $589 billion or about an 8.5 percent slice of our gross domestic product. Of this, program services activities, that is non-donative activities including related and unrelated business income, represented more than 70 per cent of the total revenue for them. These organizations are substantial, well run businesses. The record shows that there has been a steady decline in the reliance on traditional donative sources for funding. In 1946 exempt charitable organizations received 41 percent of their support from dues, assessments, private contributions and government grants. By 1975 it was down to 29 percent; 1983 was 22 percent and 12 percent in 1994.

And for the most part, running a exempt non-profit organization is BIG business. These organizations held a trillion dollars in assets in 1994 and we are confident they have grown dramatically during the recent prolonged business boom. The size of these organizations gives small businesses some idea of the size of the problem they face. For example, the top 5 percent of these organizations (those with assets of $10 million or more) hold 87 percent of the tax exempt organization’s revenues assets and produce 80 percent of the revenues. The top 20 percent (organizations with over $1 million in assets) hold 97 percent of the assets and take in 94% of the revenue. These are very large operations indeed and are skilled at marketing, sales, management, quality control and have access to some of the best lawyers, accountants and consultants. They are formidable competitors in any arena. So when these groups, including some you will hear from today, such as educational institutions or museums or scientific trek conductors decide they want to provide tours to their target markets, it has serious consequences for small business.

No discussion of statistics would be complete, however, without pointing out the need for more. The Statistics on Income group does a marvelous job putting out a wealth of information as do many other sources. More information would be welcome, however. For example, in SOI’s 1994 analysis of non-profits, the total revenue listing for the "education" NTEE category was $112 billion. That is the category where one is likely to find all college revenues and college backed tours; but the figure seemed low to us. The footnote explains that the figure does not include state and local run colleges and universities. I get travel brochures from my alma mater monthly and it turns out those are not even included.

Another problem is trying to find out specific information from IRS Form 990. I am specifically referring to Part VII, "Analysis of Income-Producing Activities" The form is set up in such a way that no business code is attached to "related or exempt function income". The box is there, but it is tied to another areas. A compilation of that information would have helped me to know how much money is going to exempt nonprofits for tour and travel related activities that those organization categorize as exempt because it is related. It is simply a matter of taking the "a" box out from under the label. It is a small point, but it would provide a better base on which to make policy decisions.

THE PROBLEM WE FACE TODAY

The Unrelated Business Income Tax (UBIT) was designed to require taxation for commercial activities undertaken by tax-exempts outside their recognized activities. Small businesses, unsubsidized by tax breaks, do not view the current system as a fair one. The Department of the Treasury in testimony before Congress, has expressed this same concern:

Limits on the scope of such tax exemption are appropriate and necessary. … The role of the … not-for-profit sector should similarly be restricted to that of supplementing, and not supplanting, the activities of for-profit businesses.(4)

The crux of the problem that has generated these complaints is the inadequacy of the UBIT to spell out precisely what is and is not taxable. More specifically, the difficulty is in determining what types of activities are "substantially related" and therefore exempt. As we made clear in our letter, the lack of useful guidance to clarify the gray areas where most nonprofit travel and tour activities occur, the lack of objective standards, the shear number of nonprofits and their increasing emphasis on commercial activity, have fueled the debate. Unfortunately, small travel and tour providers are concerned that the absence of meaningful regulations laying out the parameters of the "substantially related test" allow tax-exempt organizations to compete freely against small businesses but without the same tax load.

In this regard, a hearing and further outreach and discussion with all parties offers the Service an opportunity discuss other options. The soft shoulders of the "substantially related" test make doing business uncertain for the small firms that complain about unfair competition, for the Service which must enforce the law and even for the nonprofits which must comply with the law.

We are, therefore, pleased that the Service has agreed to address this issue through a proposed regulation. However, we share the view of many commentators that any proposed rule should lay out more solid ground-rules. The proposed rule iterates current technical advise memoranda and private letter rulings without listing factors that lead to taxation or documentation that tax-exempts should provide to justify the exemption of income from their travel tour program.

APPLICABILITY OF THE REGULATORY FLEXIBILITY ACT

The ‘Special Analyses’ section of the proposed rule states as follows:

"It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and, because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S. C. chapter 6) does not apply."

Information Collection Requirement

The Office of Advocacy believes that the proposed regulations do impose a collection of information requirement on small entities. The preamble says:

" In particular, because the IRS relies heavily on review of records to determine whether an organization’s trade or business activities further an exempt purpose, comments are requested on whether the IRS should specify the types of records organizations should keep to establish the activities purpose."

This statement puts organizations on notice that they are going to have to have sufficient records to satisfy the facts and circumstances test that is proposed. It also invites comments as to whether it should specify the types of records it should require. Even if the Service decides that the proposed rule is interpretative, a classification we feel is debatable, the RFA as amended by SBREFA provides that an analysis still should be done "to the extent that such interpretative rules provide a collection of information requirement." (5)"Collection of information" is defined within the title to include "recordkeeping requirements," which are defined as a "requirements imposed by an agency on persons to maintain specified records."(6) As such, SBREFA requires the burden on small entities be analyzed with an opportunity for the public to comment on the analysis.

Legislative Rule vs. Interpretative Rule. .

In order to get to an examination of whether a proposed regulation requires a collection of information, the service must first have determined that the rule is interpretative rather than legislative and therefore Section 553(b) of the Administrative Procedures Act does not apply. We think there is at least a colorable case that the proposal is legislative.

A "rule" that is subject to the RFA is any rule "for which the agency publishes a general notice of proposed rulemaking pursuant to section 553(b) of the APA or any other law." (7)Section 553(b) of the APA provides, "…Except when notice or hearing is required by statute, this subsection does not apply- (A) to interpretative rules..." The Service has steadfastly maintained over the years that the vast majority of its rules are interpretative rules and therefore not subject to the APA or the RFA.

The distinction between legislative and interpretative is important in this case because it is necessary for the Service to first make a decision that a proposed rule is interpretative and therefore not subject to "notice and comment" rulemaking before it can claim exemption from complying with the RFA based on its assertion that no information collection requirement is imposed on small entities.

Generally, a determination whether a rule is "legislative" and, therefore, subject in all cases to the RFA, or "interpretative" and, therefore, not subject to the RFA unless there is an information collection requirement, has rested on whether the rule is the "product of an exercise of delegated legislative power to make law through rules (and therefore a legislative rule),(8) the degree of discretion left to the IRS to fashion a rule and the scope of the rule that was fashioned. (9)In the present case, the IRS is delineating specific facts and circumstances that it maintains will satisfy the law. We contend that it is within their discretion to delineate such facts and that this might be enough to require a regulatory flexibility analysis.

RECOMMENDATIONS

In a letter on June 27, 1996, the Office of Advocacy requested Assistant Secretary Lubick to place on the Department of Treasury business plan a rulemaking to clarify the issue. Although we are gratified that the IRS took action on the rule, judging by the comments that have been filed, it is clear that there are still many areas that need to be addressed.

This hearing was an excellent first step. The IRS should go further and analyze alternative proposals that provide more guidance to non-profits and small businesses alike. Most of the small business comments have asked that the rulemaking be expanded, or withdrawn and re-proposed in a form that covers the needs of the travel and tour industry adequately. Our Office supported the idea of having a hearing and giving all parties a chance to be heard. The hearing provides a full airing for alternatives which then can be analyzed and discussed by the service. This would carry out the intent of the Regulatory Flexibility Act which would help this promulgation process.

Additionally, we would like to see Form 990 improved by adding a requirement to specify the NTEE category even if an exemption is claimed for a related business; and more reporting of the revenues of all 501( c) (3) organizations.

The rule itself should go into more detail rather than simply restating clear-cut examples. Most of the examples tell us very little about the real world of travel and tour offerings. Listing a series of factors the IRS will consider would at least make sure everyone played by the same rules. Small businesses should also have a clear avenue to bring offenders to the Service’s attention.

The rule should set out plainly the types of record that need to be kept to qualify. We feel that if a clear standard is set, exempt non-profits will make every effort to comply.

Thank you for this opportunity to testify.

ENDNOTES

1. 26 U.S.C §7805(f)

2. 5 U.S.C. Chapter 6

3. P.L.104-121

4. Hearings before the Subcommittee on Oversight, Ways and Means Committee, June 22. Serial 100-26 (1987).

5. 5 U.S.C. § 603(a)

6. 5 U.S.C. § 601(7)(A)(I) and (8)

7. 5 U.S.C. § 601 2(b)

8. Administrative Law Treatise, Kenneth Culp Davis, KC Davis Publishing, 1979, p. 36.

9. See Testimony of Commissioner Roscoe Egger, Internal Revenue Service , Implementation of the Regulatory Flexibility Act: Hearings before the Subcom. On Special Small Business Problems of the House Committee on Small Business, 99^th Cong., 2^nd Sess.(1986) p. 70 The difference between legislative and interpretative is: "primarily the degree of discretion that we have in applying the rules. In other words, if the statute is not specific but says ‘this is the objective we want to achieve and you (IRS) write the rules to achieve it’ we regard those as legislative; but when they say ‘these are the rules,’ obviously then they are interpretative."