Picture this scenario: A local commercial theatre producer files suit against one of the leading nonprofit theatres in the country for “unfair competition,” citing “artificially low” ticket prices. The nonprofit theatre’s attorney warns that if the commercial producer wins the suit, the institution, in all likelihood, will lose its tax-exempt status, after 15 years of operation. To make matters worse, the lawyer also believes that the commercial producer stands a good chance to win.
Sound preposterous? Not if the U.S. Small Business Administration has its way.
Late last fall. the SBA Office of Advocacy quietly issued a report proclaiming that organizations it dubs “commercial nonprofits” are “competing head-on” with for-profit firms in many areas of activity, that they are coming to resemble their for-profit competitors in both structure and operation, and therefore they ought to “play by the same rules.”
“Unfair Competition by Nonprofit Organizations with Small Businesses: An Issue for the 1980s” is a 40-page document authored by SBA’s Frank Swain, following an agency-sponsored symposium on the “unfair competition” issue, which brought together representatives from the executive and legislative branches of government, private industry and academia last summer.
A close examination of the report reveals that the trouble is not just with the question of “unrelated business income,” but with the concept of the tax-exempt status itself. Nonprofit organizations benefit from special treatment in many forms of federal legislation, ranging from corporate income tax exemption to preferred postal rates. And the SBA questions why.
“What are the rationales for granting nonprofits tax-exempt status and are they still valid?” The report’s author doesn’t think so; the rationale for exemption may have been acceptable when the nonprofit sector was composed chiefly of charity organizations, he says but it is not adequate today. The report quotes former Internal Revenue Service Commissioner Sheldon Cohen: “Nonprofits are a whole can of worms that Congress has yet to look at in a broad way. I have been blowing the trumpet for years to get lawmakers to spell out clearly what should be tax-exempt and what should not be.”
Calling for a “critical reappraisal of the principles that supposedly justify the special tax treatment that nonprofits receive,” the SBA report argues that the explosive growth of the nonprofit sector now directly threatens the small business community. In 1983, it says, more than 780,000 nonprofit organizations accounted for nearly 3.5 percent of gross national product—up from 2.8 percent in 1984—and that “commercial nonprofits” have come to “dominate the nonprofit sector.” But the SBA fails to mention that, in comparison, there are currently more than 14 million small businesses under its jurisdiction, which together account for nearly 40 percent of the gross national product.
Through specific examination of competition by nonprofit and for-profit firms in the same industry—in this case, health care, education and research—the report concludes that nonprofit activity in any industry where commercial counterparts exist can result in either oversupply or price cutting, and that “entry by tax-favored nonprofit organizations into the commercial arena constitutes indirect government regulation of the business environment to the advantage of nonprofit firms.”
The SBA says that the most common justification for exemption is that an organization provides services that would not be supplied by competitive for-profit firms. This narrow view is particularly sticky for nonprofit theatres since, unlike the other performing arts, there does exist an active profit-motivated sector of the theatre.
Interestingly, of the four commercial theatre producers reached by phone, all refused to comment on the BA’s “unfair competition” charge.
William Stewart, managing director of the nonprofit Hartford Stage Company, however, noted, “Over the past decade, the commercial theatre has come to depend on the nonprofit theatre for the research and development activity which produces both new work and revivals. In only one of the past 10 Broadway seasons has commercial product outpaced nonprofit-originated material. The nonprofit theatre’s tax-exempt status is, in no way, in competition with the commercial theatre. Rather, the two are inextricably linked.”
For most arts organizations that do not have an active commercial counterpart, the main significance of the SBA report is likely to rest on its ramifications for earnings projects considered unrelated business activities. The findings of the report are predicated on the distinction between two kinds of nonprofit organizations: 1) “donative non-profits,” which operate with a funding base of gifts and grants, and 2) “commercial nonprofits,” those which depend to a large degree on fees and charges for their services.
Nowhere in the report is the point made that as many nonprofit organizations have watched their donative funding base erode, they have, of necessity, turned to earned income activities simply to survive. Over the past three seasons, nonprofit arts institutions have seen their funding from the National Endowment for the Arts shrink and the competition for private contributions escalate. To compensate for the loss of these funds, many have cultivated other earnings projects—lobby concessions, gift shops, licensing of computer software, real estate holdings, restaurant operation, facilities and mailing list rentals and the like—to supplement box office earnings in order to maintain a moderate ticket-pricing policy.
The Internal Revenue Code does not prohibit nonprofits from engaging in commercial activities. As the report notes, 501(c)(3) nonprofits can engage in business activities, because “it is the primary purpose of the organization, and not its activities, which determines tax-exempt status. As long as the proceeds from the business activities are directed to tax-exempt purposes, the organization can freely operate commercial ventures and retain its tax-exempt status.” The IRS does, however, tax the income from such activities that are clearly outside of the organization’s primary purpose; this unrelated business income tax, the SBA claims, was enacted to discourage “unfair competition” by nonprofits with for-profit firms. The SBA believes that this method is inadequate and ineffective.
How does the Small Business Administration plan to address the prob. lem of “unfair competition”? Acknowledging that wholesale abolition of the federal tax exemption is unlikely to occur, the report urges “re-formers” to concentrate on “effecting incremental changes to federal laws with a view toward discouraging nonprofits from engaging in for-profit business activities.” Some of the SBA proposals include the following changes in the federal tax law:
1. Outright prohibition of, or a higher tax on, unrelated business activities. The SBA recommends increasing the tax to the highest marginal corporate rate (46 percent), instead of the lowest (16 percent) as a disincentive to nonprofits engaging in unrelated business activities.
2. Clearer definition of “unrelated trade or business.” The SBA asserts that instead of just focusing on the extent to which the business activities relate to the nonprofit’s exempt purpose, “the IRS should look at the extent to which the activities impact on commercial firms.”
3. Make unrelated business a criterion for tax exemption. The SBA suggests the IRS should regulate 501(c)(3) nonprofit organizations by calculating each nonprofit’s unrelated income as a percent of total revenues. Beyond a yet-to-be-specified limit, the nonprofit would “be presumed to be operating for other than tax-exempt purposes.”
“It was bound to happen,” John Mellquham wrote recently in Fund Raising Management. “When you consider the almost geometric growth of demands on nonprofit organizations to provide services and programs, coupled with rising costs, increased competition, better management and the use of skilled professionals, it’s no wonder the folks at the U.S. Small Business Administration are hopping mad.” McIlguham continues, “Just looking over the list of participants should be enough to frighten even the most entrepreneurial of nonprofits. The minute Congress and lawyers get involved, there’s trouble brewing.”
Arlene Shuler, executive director of Volunteer Lawyers for the Arts, notes that the SBA distortion of the role of nonprofit organizations in American life could have a negative effect on the public’s understanding of nonprofits. “In seeking to prove that nonprofit organizations unfairly compete with small businesses,” she charged, “the SBA resorts to misleading statements. For instance, the report suggests that because nonprofits are exempt from federal and state taxes, they can increase their market share by offering services and goods at below-market prices, thereby leading to price cutting. This argument entirely ignores the fact that nonprofit organizations are exempt from taxes because they serve the public interest—often by providing important services at little or no cost. As to the possible effect of price-cutting, I certainly haven’t seen any New York law firm cut their prices because of VLA’s free legal services to artists.”
Robert Smucker, director of government relations for Independent Sector, a Washington-based national coalition of nonprofit organizations, agrees. “Nonprofit organizations are required under current law to prove that they are serving the public interest. The burden of proof as to whether earnings activities are related or unrelated to the organization’s central purpose falls to the organization itself. Certainly the distinction is important, but the requirements necessary to establish the related nature of earnings should not be so strict as to make it impossible to prove.”
The distinctions between nonprofit and for-profit organizations have become more and more blurred, as each sector adopts and adapts ideas from the other; nevertheless there remains the fundamental difference that only one sector is in business to make money. Nonprofit theatres and their counterparts in other fields may be called on to make this case in the near future.
At this time, the future of the SBA report is unclear. Both the Independent Sector and the American Arts Alliance are monitoring the report’s progress, but the prospect of congressional action on the agency’s recommendations is, in this election year, remote. Nevertheless, insiders believe that the SBA will wage an intensive lobbying campaign next year, and “unfair competition” may become the issue in 1985. If so, it will be indeed ironic, following the Office of Management and Budget’s attempts to prohibit nonprofits from any lobbying activities, for another government agency to lobby directly against nonprofits.
But the road is likely to be rocky, for the SBA recommendations raise serious questions about the future of numerous organizations with a long history of high standing in the community, from the Girl Scouts to the American Cancer Society. On the other hand, millions of small businesses with substantial lobbying impact are likely to support the SBA recommendations.
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