Death and Taxes: Are We All Paying the Price?

By Sommer Hamilton

In the U.S. income tax system, we all pay our way. But mounting evidence in accounting research points to a disturbing trend when it comes to nonprofit organizations and the income tax they incur for unrelated business activities: Their tendency is to avoid or even evade taxes.

On average, corporations and individuals understate their taxable income by 17 percent — that’s when they subtract more expenses than they actually accrued or make errors in their tax filings. But in a representative sample of 1990s tax data from more than 12,000 nonprofits, research from Texas A&M’s Mays Business School finds that 19 percent of nonprofits overstated their expenses by a whopping average of 30 percent.

That means nonprofits are paying less than they should — or sometimes nothing at all — in income taxes for business activities unrelated to their primary (and tax exempt) purpose.

This finding is part of a growing body of evidence indicating that nonprofits might seek to avoid the tax system known as the unrelated business income tax (UBIT), says Thomas C. Omer, Ernst & Young Professor at Mays Business School and co-author of a Journal of the American Taxation Association article on the trends in nonprofit tax avoidance.

As the number of nonprofits in America continues to climb, he says, what today is perceived as a small problem might have ever bigger effects on the economy. Nearly 500,000 nonprofits have formed in the past decade, adding to the 1 million already in place and making the nonprofit industry one of the fastest growing in the United States. “Avoiding the UBIT is like having a stop sign in the neighborhood that nobody stops at,” Omer explains. “It might not be a big problem now, but wait till that street becomes a freeway.”

Income taxes for nonprofits come into play when nonprofits pursue opportunities or offer services that don’t directly align with their mission, such as a church that operates a regular daycare center or a health awareness nonprofit that runs a pay-per-use workout facility. Such businesses are often run from the same building with some of the same staff as the nonprofit, using shared central resources such as office supplies and air conditioning. That can make shifting such shared expenses to the taxable entity easier for nonprofits, thus misreporting the taxable income and reducing the tax paid.

Omer and his co-author, University of California at Davis’ Robert J. Yetman, also use their extensive sample to determine what policies and practices can encourage or deter tax avoidance by nonprofits.

They find that higher UBIT rates add incentive for nonprofits to avoid income taxes and that the more complex the tax return, the more likely the tax avoidance.

As expected, tax avoidance decreases the more nonprofits are required to report to their state governing agencies and the more risk there is of detection by those agencies.

The researchers are the first outside the IRS with access to nonprofit data of such detail. They relied on years of confidential and public tax forms (the IRS 990 and 990-T) supplied by nonprofits, finding evidence of understated income (and overstated expenses) by comparing information in the forms. More detailed IRS audits could have revealed even more areas of concern, Omer says.

Nineteen percent of nonprofits overstated their expenses by a whopping average of 30 percent.

For nonprofits, the taxable activities subject to the UBIT are typically a small percentage of the funding they use to support their nonprofit mission. So what’s surprising is that even given such a relatively small piece of the total pie,
nonprofits managers still show a tendency to avoid paying taxes. “These groups are still acting the way a giant corporation paying millions in taxes would,” Omer says.

Mirroring the growth of nonprofits nationwide, the proportion of nonprofits reporting taxable activities has jumped from less than 5 percent in 1975 to more than 14 percent in 1999. As a result, the economic impact of such organizations is growing. And if Omer and Yetman’s 19 percent of nonprofits continue to overstate their expenses, the system’s slow leak will have to be filled by taxpayers elsewhere.

Whether nonprofits are just misunderstanding the tax law or are intentionally skewing the numbers is beyond the scope of Omer and Yetman’s findings.

“I don’t think of these nonprofits as being natural tax evaders,” Omer says. “I can only observe and say the evidence suggests the errors on these tax returns go one way, and that’s always in favor of the nonprofits.”