Most Americans think nonprofits and universities amass large endowments to help them, like rainy-day funds, weather tough economic times without sacrificing valuable programs. Unfortunately, that doesn’t seem to be the case for many institutions.
Research has shown that the largest nonprofits and universities tend not to spend from their endowments in tough times, choosing instead to cut programs. Maintaining huge endowments for their own sake has become the goal for many administrators.
And those endowments benefit greatly from the tax exemption offered to all nonprofits on the assumption that such funds will be used toward a public good. But what happens when the money isn’t being used for anything at all?
Many federal and state laws seek to curb the misuse of nonprofit resources, but there are virtually no limits to the non-use of nonprofit funds. When a nonprofit makes a profit (or “surplus,” if you prefer), it has three options: spend it, give it to another nonprofit, or save it.
For some nonprofits, the process of making a profit and saving it — endowment building — is big business. It’s time to push federal policy makers to change the way the system works, by either penalizing nonprofits that hoard money or providing incentives for them to spend their endowments more quickly.
Harvard University, Yale University, and Howard Hughes Medical Institute added an average of $1.5 billion to their endowments in the last year along. At the same time, dozens of other nonprofits, including museums, hospitals, and universities, increased their endowments by hundreds of millions of dollars.
Society expects a return on its investment when it provides a subsidy to an organization. For example, Americans expect nonprofits to use such subsidies to provide goods and services that benefit the greater good.
But the very nature of a massive endowment means that those benefits to society are not being realized. Instead, the money given to a nonprofit by taxpayers simply sits in an investment account, growing ever larger.
In fact, for some nonprofits, the ability to build an enormous endowment enables the organization to realize even greater profits elsewhere. That is the case with nonprofit hospitals, the majority of which use their endowments primarily to engage in tax arbitrage, whereby they borrow money at a low interest rate, thanks to their ability to issue low-interest debt, and then use that money to fund operations instead of using their endowment funds, which are earning a much higher rate of return.
To be sure, the vast majority of nonprofits do not hold giant endowments. Most food pantries and homeless shelters operate on a shoestring and seek money constantly. However, the biggest endowments are growing so fast that the federal government needs to adopt a new approach.
To curb endowment hoarding by the richest nonprofits, I suggest we tax any funds in an endowment that aren’t being used to advance the organization’s charitable mission.
The value of this approach is that it respects an organization’s right to decide where it wants to spend its money. What’s more, it doesn’t force the government to introduce onerous new regulations that are costly to put in place. And it would affect only a small number of nonprofits — just those with big endowments. The sole goal is to ensure that society gets what it bargained for from nonprofit organizations.
Here’s how it would work:
First, we should eliminate the blanket income-tax exemption for nonprofits and replace it with a system akin to the business-expense deduction that applies to for-profit companies. Anything a nonprofit spent to further its charitable purpose would be deductible, including salaries, overhead, and virtually all expenses related to the organization’s mission.
Second, a standard deduction would be allowed on top of an organization’s regular expenses to permit a modicum of savings each year. (I suggest approximately $10 million a year, but more detailed economic analysis could determine a better figure.) Nonprofits often have great swings in their finances, with a banner year followed by a down year. By permitting a certain level of savings to account for these scenarios, nonprofits could make plans without the risk of incurring tax liability, and small nonprofits could save funds for a rainy day without worry.
Third, nonprofits would be allowed to save money toward a specific capital project tax free for up to five years, provided the money is actually spent on the designated capital project. That would allow nonprofits to save for new buildings or equipment or any other large capital expense that furthers their charitable missions, all without running the risk of incurring tax liability.
After that, all other profits the nonprofit kept would be subject to income taxation. The Harvards of the world would be free to build their endowments to the moon and back, but for those amounts over and above the standard deduction, if they are not going to be actively spent on a designated capital project within five years, the organization would have to pay taxes on the income.
This proposal has a clear benefit to society: No longer would the public be subsidizing the endless accumulation of endowment funds for the nation’s largest nonprofits — which, of course, isn’t the purpose taxpayers intended when they provided that advantage. But government funds would still subsidize nonprofits that spend their income toward their charitable missions.
Shaking up the current nonprofit tax system is scary, no doubt, but it has become increasingly necessary as more and more dollars get locked up in endowments rather than in promoting social good.n
Michael Ryan Fricke is a lecturer of business administration at the University of Illinois at Urbana-Champaign. This piece is adapted from an article that is scheduled to appear in the St. John’s Law Review.