Premium rates established by mutual companies are set at a level believed to be sufficient to cover any adverse experience which may arise. Because of this, provision is made that any overcharge in the premiums will be returned to the policyholder. These returns, or so-called dividends, are recognized in tax laws as not being income to the individual policyholder. Such returns should not be taxed to the individuals through tax on the company. However, the individual is in effect taxed on these refunds under H.R. 4245 whenever taxable investment income exceeds gain from operations. For the Berkshire this would mean a 1958 tax of approximately $180,000 on dividends to policyholders.

For my own company the figures for 1958 are as follows: The gain from operations, prior to the limitation on dividends, was approximately $5,200,000 and our investment income was $6,800,000. We were forced to pay a tax based on $6,550,000-since we were allowed to claim only the arbitrary $250,000 of the negative. The additional tax on the $1,350,000 disallowed, at the rate of 52 percent is $702,000. The rate of tax on the gain from operations becomes 66 percent rather than 52 percent.

This is a matter which will arise again and again—no legislation can be deemed permanent in nature which has such a gross inequity to policyholders.

Fourth, one of the principal functions of life insurance companies' activities is lending money. In that respect we are similar to banks, small loan companies, and others. However, these latter companies have the right to deduct bad loan losses from ordinary income. There is no provision in the present law according us similar treatment. Normally these losses are of a long-term nature. Our only normal recourse is to offset them against long term gains, if any such gains exist. My company has been active in financing small companies with the consequent assumption of higher risk. Unless we are granted equal treatment in this respect it will tend to inhibit our willingness, and undoubtedly other insurance companies, to finance such companies in the future.

Fifth, the matter of the full deduction of the interest from taxexempt securities received detailed examination in the hearings before the Senate Finance Committee. The law as enacted contains the following:

SEC. 804 (a) (6). EXCEPTION.-If it is established in any case that the application of the definition of taxable investment income contained in paragraph (2) results in the imposition of tax on

(A) any interest, which under section 103 is excluded from gross income, (B) any amount of interest which under section 242 (as modified by paragraph (3)) is allowable as a deduction, or

(C) any amount of dividends received which under sections 243, 244, and 245 (as modified by paragraph (5)) is allowable as a deduction, adjustment shall be made to the extent necessary to prevent such imposition. This subsection was included after the hearings were completed. In applying the tax law to my own company it was found that certain ambiguities exist. Under some interpretations such as in form 1120L (1958) it appears that tax-exempt income is in fact taxed. This arises from the fact that the existence of tax-exempt income produces a higher tax on taxable income. It was the intent of Congress to preserve the status of tax-exempt income. The law needs to be clarified on this point.

The total revenue effect of these changes could be phased in with the growth of the business so as not to decrease the income year by year to the Treasury. Any statistics or information in support or explanation of this testimony will be furnished as the committee desires.

SOME ASPECTS OF TAXATION OF BUSINESS INCOME OF EXEMPT ORGANIZATIONS

Harry K. Mansfield

The specific subject that was assigned to this panel for consideration is entitled "Business Income of Exempt Organizations." This topic certainly focuses attention on one of the major areas in the exemption of organizations from taxation. The designation of the subject, however, carries the implication that no review is here intended as to the basic policy of the Congress in providing an exemption from income tax for selected organizations which are described in section 501 (c) of the 1954 code. Obviously, in considering means for broadening the tax base, one possibility would be to withdraw from these organizations their exemption from income tax. Consideration of such a step would involve policy matters that are far beyond the competence of this panel. Furthermore, any such suggestion would not be responsive to the ground rules of the committee's study which are directed to consideration of means whereby differentials in tax treatment may be eliminated in order to achieve greater equity and fairness. Exemption from income tax of the designated organizations was provided in order to encourage and assist the activities of these organizations and was not prompted by considerations of equity; to maintain this purpose undoubtedly requires continuation of the basic exemption.

The background of this subject, including the state of the law prior to 1950 and the changes made in this field by legislation enacted in 1950, is admirably and adequately set forth by Mr. Sugarman. Under present law, organizations will not be exempt from income tax if their principal purpose is the carrying on of a trade or business and, in any event, unrelated business income of an exempt organization will be subjected to income tax. It should be noted that these principles, enacted in 1950, probably represent an extension of the income tax to situations which had not previously been reached. Certainly, the statute, regulations and court decisions since 1950 do not show any contraction of the tax base in the exempt organization field, contrary to developments in some other areas. The principal questions, therefore, appear to be whether the administration of the present law is in need of substantial improvement and whether there is reason to further amend the statute so as to encompass additional income of tax-exempt organizations.

It seems to me that tax-exempt organizations can have no legitimate quarrel with the tax principles presently in force. Exemption from income tax has been provided by Congress in order to encourage and support activities of organizations deemed beneficial and important to the general welfare. This does not necessarily require permission for such organizations to employ every possible means of furthering and enlarging those activities. Financial support for the approved

activities should presumably be sought primarily from private philanthropy and also from governmental philanthropy (both by means of direct grants to such organizations and by indirect means, such as the tax exemption), rather than from the active conduct of a business enterprise for profit.

When an organization is "operated for the primary purpose of carrying on a trade or business for profit," its claim to be exempt from income tax does not rise to the level of an urgent social necessity simply because its profits are payable to exempt organizations. Nor should exemption be permitted more readily simply because the organization uses its business profits to engage in exempt activities itself, such as charitable or educational activities. To complete the circle, there seems to be no policy reason for differentiating from these cases of predominant business activity the unrelated but incidental business income of an organization which is primarily engaged in exempt activities. To permit a tax-exempt organization to engage in business without restraint would undoubtedly have adverse economic and psychological effects in the community which would probably outweigh any advantages derived from their favored activities; and certainly the existence of a healthy and flourishing business community is necessary to provide adequate revenue for the maintenance. of government. It is not surprising that Congress failed to find sufficient justification for the exemption from taxation of business profits, even the unrelated business profits of exempt organizations, and it is difficult to visualize the advancement by any such organizations of sufficiently strong arguments for reversal of the 1950 legislative determination.

It might be helpful to consider the conduct of business operations under the present law by reviewing the tax situation of different categories of organizations. If the organization's primary purpose is to create income by means of business operations in order to provide funds for exempt organizations and the organization itself conducts no charitable activities that is, if it is solely a "feeder organization" the problem is not particularly difficult. Such an organization is usually a wholly owned subsidiary of an exempt organization. Section 502 of the 1954 code now specifically provides for the taxation of the income of such an organization (but not including an organization renting real property). Conceivably, although not likely, such an organization might not have as its "primary" purpose the conduct of business operations, and in that case the organization would be entitled to an exemption, but its business income would undoubtedly be taxed as "unrelated business income" under sections 511 and 512, since the organization itself does not engage directly in exempt activities to which the business activity might be related. The statute has generally satisfactorily solved the problem of taxing such an organization. A similar class of organizations that are sometimes involved in business activities are independent nonoperating charities—that is, foundations which do not themselves directly engage in exempt activities but simply make grants and distributions to a number of independent operating charities. The rules applicable to "feeder organizations" are also applicable to these organizations. When such organizations have as their "primary purpose" the carrying on of a trade or business for profit, an exemption is denied under section 502. If the

operation of the trade or business is not the "primary purpose" of the organization, its business profits will nevertheless undoubtedly be taxable as "unrelated business income" under sections 511 and 512.

The principal difficulties seem to arise in the case of exempt organizations which are active operating organizations carrying on activities described in section 501 (c) and particularly section 501 (c) (3). If the organization directly engages in charitable activities, for instance, it will not fall within the classification of a "feeder organization" whose income is distributed to other exempt organizations, and thus the provisions of section 502 denying exemption to such organizations probably will not apply. However, the Treasury Regulations take the position that an organization will be denied exemption under section 501 (c) (3) if it is organized and operated "for the primary purpose of carrying on an unrelated trade or business" (Treas. Reg. sec. 1.501 (c) (3)-1(e) (3)). An exemption has been denied under section 501 (c) (3) by at least one court to a trust primarily engaged in the business of speculating in oil stocks even though the trust was admittedly not a "feeder organization" (Randall Foundation, Inc. v. Riddell, 244 F.2d 803 (9th Cir. 1957)). In any event, the rules of sections 511 and 512 taxing income from the conduct of an unrelated trade or business will be applicable. These provisions should, in most instances, be adequate to cover the area of business operations incidentally conducted by charitable organizations.

It must be recognized, however, that there is a gap in the statute. The provisions taxing unrelated business income do not apply to a church or to a convention or association of churches (sec. 511(a) (2) (A)). There seems no good reason why this gap should not be closed especially since the special exemption creates a further difficulty in placing tremendous emphasis and significance upon the definition of these terms. See Moore and Dohan, "Sales, Churches, and Monkeyshines" (11 Tax Law Review 87 (1955)). This statutory exception to the application of section 511 should be removed by Congress.

A considerable part of the difficulties arising in the case off active, operating charities stems from the problem of determining what activities actually constitute taxable business activities. One of the primary reasons for enactment of the 1950 legislation was evidently to overcome the unfair advantage enjoyed by a tax-exempt organization in business competition with a taxpaying organization. Whether or not the concept is sound as a matter of economic theory, it was generally believed that it is much more difficult for a taxpaying business to compete with one that pays no income tax. Certainly, the exemption gave an advantage to the tax-exempt organization in acquiring a business or expanding an existing business out of profits. Nevertheless, use of the test of the existence of business competition to determine when an income tax on unrelated business activities should be imposed does not appear to be satisfactory, nor is it responsive to the statute which imposes a tax only on income from unrelated business income.

The exemption itself is not denied under section 501 (c) (3) simply because of the existence of activities which may be in competition with commercial enterprises if the organization otherwise qualifies. In one sense, some of the very activities described and approved in section 501 (c) (3) constitute the operation of business. This is true, for in

stance, of hospitals, educational institutions, and organizations for the rehabilitation of individuals which make charges for their services. Nevertheless, if the motive of such organizations is not the making of a profit, they have been traditionally entitled to an exemption even though they may derive income in carrying on their activities. And, of course, the gross income derived rarely results in net income because of expenses that more than offset receipts. Furthermore, none of the income is permitted to inure to the benefit of any private shareholder or individual; it is generally used to expand the scope and effectiveness of the organization's exempt activities. Nevertheless, it should be recognized that activities of this kind undoubtedly do compete in a variety of instances with similar activities carried on by other groups organized for profit. The existence of this competition is not of itself any reason for denying the exemption or subjecting that income to taxation. The determination of the application of the tax on unrelated business income should be approached upon the same basis.

In recent decades, exempt organizations have spread their activities on behalf of the public welfare into a large number of new areas in order to meet new needs. A conventional or static definition of approved charitable activities based upon historical concepts cannot fail to be socially undesirable; the fields of public benefaction are continually expanding and changing in nature. Likewise, businesses have sprung up in new areas not envisaged years ago. In many instances, these areas may overlap. It would appear to be difficult and probably unwise to apply the tax laws so as to confine exempt organizations to traditional areas of concern; flexibility in this regard is undoubtedly desirable. Consequently, income derived from activities by exempt organizations in new areas should not become taxable simple because some businesses also may have decided to operate in the same areas on a profitmaking basis.

Essentially, the ultimate question to be resolved must be whether the activity of the exempt organization giving rise to the income is one that deserves public support by means of a tax exemption. If it is, then the exemption should be made available even though the activity might also be in an area occupied by private enterprise. To leave the field of charity for a moment, the principle of coexistence has been approved as a matter of public policy in the case of public housing.

A great deal has been said lately about the unfairness of some research activities conducted by educational institutions. See the testimony at hearings held on April 16 and 17, 1959, by the Internal Revenue Service on its proposed regulations under sections 501 (c) (3) and 501(c) (4). This is not the proper place to attack or defend specific activities, but it is appropriate to consider what basic principles might be applied in this area. And discussion of this troublesome question may well cast light on general principles that may be applied to the taxation of business operations by exempt organizations, with particular consideration being given to the significance of activities that may be in competition with those of taxpaying enterprises.

In the first place, it should be recognized that educational institutions are not limited to the function of teaching students. From early days, universities were acknowledged to have an equally important function of advancing knowledge of all kinds for the general good.