CHAPTER ONE
What Is a Nonprofit Organization?

One of the most striking features of life as we settle into the third millennium is the awesome sweep of societal reform around the globe. Freedom of thought and action is now permitted in societies that previously knew only totalitarianism and suppression. Frequently, a country earns the label emerging democracy by introducing startling economic and political changes. Sometimes, this is accomplished by elections; sometimes, a revolution is necessary. Struggles for individual freedom are today commonplace throughout the world, whether in Eastern Europe, on the African continent, or in the roiling Middle East.

Countries that are planning transitions to a democratic state are discovering a fact that some Western countries learned a long time ago: In order to create and maintain economic and political freedom, which is the essence of a true democracy, the power to influence and cause changes cannot be concentrated in one sector of that state or society. There must be a pluralization of institutions in society, which is a fancy way of saying that the ability to bring about changes and the accumulation of power cannot belong to just one sector-namely, the government. A society that has achieved this type of pluralization is sometimes known as a civil society.

A strong democratic state has three sectors: (1) a government sector, (2) a private business sector, and (3) a nonprofit sector. Each sector must function effectively and must cooperate with the others, to some degree, if the democracy is to persist for the good of the individuals in the society. A democratic society must be able to make and implement policy decisions with the participation of all three sectors. Ideally, a democratic society can solve some of its problems with minimal involvement of government if there is a well-developed and active nonprofit sector-charitable, educational, scientific, and religious organizations; associations and other membership organizations; advocacy groups; and similar private agencies.

Of all countries, the United States has the most highly developed sector of nonprofit organizations. The reach of the U.S. government is often curbed by the activities of nonprofit organizations, but that is a prime mark of a free and otherwise democratic society. The federal, state, and local governments acknowledge this fact (sometimes grudgingly) by exempting most nonprofit organizations from income and other taxes and, in some instances, allowing tax-deductible gifts to them. These tax enhancements are crucial for the survival of many nonprofit organizations.

When an individual in the United States perceives either a personal problem or one involving society, he or she does not always have to turn to a government for the problem's resolution. The individual, acting individually or with a group, can attempt to remedy the problem by turning to a nongovernmental body. There are obvious exceptions to this sweeping statement: Governments provide a wide range of services that individuals cannot, such as national defense and foreign policy implementations. Still, in U.S. culture, more so than in any other, an individual is often likely to use nongovernmental means to remedy, or at least address, personal and social problems.

A BIT OF PHILOSOPHY

For most Americans, this mind-set stems from the very essence of our political history-distrust of government. We really do not like governmental controls; we prefer to act freely, as individuals, to the extent it is realistic and practical to do so. As the perceptive political philosopher Alexis de Tocqueville wrote in 1835, "Americans of all ages, all conditions, and all dispositions constantly form associations" (meaning nonprofit organizations) and "whenever at the head of some new undertaking you see the government in France, or a man of rank in England, in the United States you will be sure to find an association." About 150 years later, John W. Gardner, founder of Common Cause, observed: "In the realm of good works this nation boasts a unique blending of private and governmental effort. There is almost no area of educational, scientific, charitable, or religious activity in which we have not built an effective network of private institutions."

This "effective network of private institutions" (the nation's nonprofit organizations) is called the independent sector, the voluntary sector, or the third sector of U.S. society. For-profit organizations are the business sector; the governmental sector is made up of the branches, departments, agencies, and bureaus of the federal, state, and local governments.

Nonprofit organizations, particularly charitable ones, foster pluralization of institutions and encourage voluntarism. Society benefits not only from the application of private wealth to specific public purposes but also from the variety of programs that individual philanthropists, making gifts of all sizes, make available for support. Program choice-making is decentralized, efficient, and more responsive to public needs than the cumbersome and less flexible government allocation process. As John Stuart Mill observed, "Government operations tend to be everywhere alike. With individuals and voluntary associations, on the contrary, there are varied experiments, and endless diversity of experience."

At the time a constitutional income tax was coming into existence, in 1913, Congress legislated in spare language and rarely embellished on its statutory handiwork with legislative histories. Therefore, there is no contemporary record in the form of legislative history of what members of Congress had in mind when they started creating categories of tax-exempt organizations. It is generally assumed that Congress saw itself adhering to the political philosophical policy considerations that many other governments have adopted over the centuries pertaining to nonprofit organizations, which is that taxation of these entities is inappropriate, considering their contributions to the well-being and functioning of society.

Thus, in the process of writing the Revenue Act of 1913, Congress apparently viewed tax exemption, at least for charitable organizations, as the only way to consistently correlate tax policy with political theory, and viewed exemption of charities in the federal tax statutes as an extension of comparable practice throughout history. Presumably, Congress simply believed that these organizations ought not be taxed, and found the proposition sufficiently self-evident that an explanation of its actions was not necessary.

The Supreme Court has infrequently ruminated about the rationale for tax exemption for nonprofit organizations. Soon after enactment of the (constitutional) income tax, the Court concluded that the foregoing rationale was the basis for the federal tax exemption for charitable entities. In 1924, it stated that "[e]vidently the exemption is made in recognition of the benefit which the public derives from corporate activities of the class named, and is intended to aid them when [they are] not conducted for private gain."1

One of the most significant of the Court's considerations of the rationale for tax exemption appears in a case concerning the constitutionality of a state's real estate tax exemption for the real property of religious organizations.2 The majority opinion in this case focused primarily on the constitutionality of this tax exemption, because the law accorded exemption to churches and other religious entities, but included observations about tax exemption for nonprofit organizations generally.

The real estate tax exemption at issue came into being, wrote the Court, because the state, "in common with the other States,.determined that certain entities that exist in a harmonious relationship to the community at large, and that foster its 'moral or mental improvement,' should not be inhibited in their activities by property taxation or the hazard of loss of those properties for nonpayment of taxes."3 The state granted exemption with respect to a "broad class of property owned by non-profit, quasi-public corporations which include hospitals, libraries, playgrounds, scientific, professional, historical, and patriotic groups."4 The Court continued: "The State has an affirmative policy that considers these groups as beneficial and stabilizing influences in community life and finds this classification useful, desirable, and in the public interest."5 Also: "Qualification for tax exemption is not perpetual or immutable; some tax-exempt groups lose that status when their activities take them outside the classification and new entities can come into being and qualify for exemption."6

A concurring Court opinion observed that a "range" of "private, nonprofit organizations contribute to the well-being of the community in a variety of nonreligious ways, and thereby bear burdens that would otherwise either have to be met by general taxation, or be left undone, to the detriment of the community."7 It was stated that nonprofit groups that receive tax exemption contribute to the "diversity of association, viewpoint, and enterprise essential to a vigorous, pluralistic society."8

Another concurring opinion referred to a "class of nontaxable entities whose common denominator is their nonprofit pursuit of activities...