2. Destination of Income Approach The second structural alternative is an explicit return to the destination of income test under which any exempt organization would be taxed only on revenue that is not used for activities directly related to the conduct of exempt activities. This approach would introduce substantial simplification while focusing directly on the exempt activities of exempt organizations. This approach would protect the integrity of exemption only if it were applied in conjunction with renewed attention to section 502 and clarification of the derivative exemption doctrine that has brought the Mueller and Roche's Beach model back into the law after they had supposedly been overturned. The exempt parent would not be taxable on the earnings distributed to it, provided that it used such income for its exempt purposes, but the taxable subsidiary would not itself qualify for exemption based on its distribution to the exempt parent. An exempt subsidiary would be able to claim the benefits of the destination of income approach only if it used the funds for its own exempt activities. A destination of income approach limited to income earned directly by the exempt organization would have certain unanticipated consequences. For example, a university would be taxable on any tuition revenue used to capitalize taxable subsidiaries even if the taxable subsidiary distributed its earnings to the exempt parent. The earnings would be taxable to the exempt parent if they were not used for the parent's exempt purpose. The same principle would apply to partnership distributions to an exempt partner, whether in an investment partnership or an operating joint venture such as a whole hospital joint venture or a joint venture between a university and a taxable company to market the practical applications of research performed by the university. A destination of income structure would not eliminate the complexity relating to the determination of what activities are exempt activities. Current law defines exempt purposes but offers no guidance on translating purposes into activities. For example, are intercollegiate athletics an exempt educational activity or a commercial activity? The Service had ruled that all college athletics, whether intramural or intercollegiate, are educational activities, as is the broadcast of games. If one disregards the tax status of the sponsoring entity, there is little compelling reason to treat intercollegiate athletics as educational activities? Addressing longignored questions of what exempt purpose properly support exemption and what activities are directly related to these purposes would, ultimately, simplify exempt organization taxation, but the process of addressing this issue would not be an effortless path to simplification and few would find it a welcome prospect. The destination of income approach would raise questions of unfair competition and questions of charitable efficiency or internal diversion. Questions of unfair competition would become newly important because the scope of commercial activity would become irrelevant. In effect, the new destination of income approach would raise the questions of allegedly unfair competition that fueled the effort to enact current law. The new debate would, however, focus directly on commercial activities conducted by exempt organizations themselves and not on the commercial activities of feeder organizations. Questions of charitable efficiency, the diversion of time and resources from exempt activity, would also be important. What evidence would establish use of revenue from commercial activities for exempt activities? How would investment in the commercial activities be treated? Would investment in business expansion and business efficiency be consistent with exemption? How would business losses be treated? Would exceptions from taxation be provided for a start-up period? Could an organization remain exempt without regard to the scope of its commercial activities even if the commercial activities never produced revenue used for any purpose other than maintaining or expanding the commercial activities themselves? Would commercial activities that never produced revenue for exempt activities be consistent with exempt status? If the current system is retained, there are elements of simplification that would also prevent the kind of diversion of resources to non-exempt purposes that undermines the integrity of exemption. These simplification measures do not resolve the fundamental structural issue of the relationship between UBIT and exemption. (1) Repeal the "regularly carried on" element in the definition of an unrelated trade or business and replace it with a small organization exception The regularly carried on element is a proxy variable for commerciality. The examples in the regulations relate to limited amounts of unrelated business income earned by small scale organizations that would appear likely to use the UBI for exempt activities. None of these factors and implicit assumptions proved relevant in the NCAA opinion issued by the basketball fans on the Court of Appeals for the Tenth Circuit. Rather than a costly, uncertain, and timeconsuming litigation strategy to deal with this ill-advised and baseless opinion, it would be simpler to clarify the law by addressing directly the apparent purpose by enacting a small organization exception. Section 514 has no apparent purpose other than to prevent the leveraging of exempt organizations' assets. However, the exclusion of qualified educational organizations suggests that the provision has only limited impact. In view of the many other forms of commercial activity that are currently regarded as consistent with exempt status and in view of the ability of exempt organizations to issue bonds in public bond markets, there is little reason to regard borrowing money using exempt organization property as collateral as inherently inconsistent with exempt status. One approach that seems to be missing from this paper would be to simplify the modifications and exceptions by repealing some or all of them. This approach would not, however, result in either simplification or rationalization of the current structure even if it were politically possible. Reducing the total number of modifications and exceptions would be largely irrelevant to the operational simplification of UBIT as it affects particular organizations. The problem with the modification and exceptions is not that they are complex for individual organizations but that they reflect the conceptual incoherence of the relationship between UBIT and exemption. By tracing the legislative history of the current UBIT provisions, this paper has taken the position that Congress did not adequately consider the relationship between UBIT and exemption E. Simplification of the EITC Through Structural Changes Submission to the Joint Committee on Taxation for its Study of the Overall State of the Federal Tax System By Annette Nellen, Esq. CPA I. Introduction The earned income tax credit (EITC) is one of the most complex provisions of the federal income tax law, yet its purpose is to provide a benefit to low-income taxpayers who should not be facing such complexity. While there have been various proposals over the past several years to simplify the EITC, few changes have been made and recent law changes, such as the enactment of the child credit, have made the EITC even more complex for many of the individuals who claim it. In addition to complexity, the EITC is also prone to fraud and additional provisions have been added to combat this. At credit levels of 7.65%, 34% and 40% depending on the type of individual claiming the EITC, the credit results in a refund of all or some portion of the employee's share of FICA and Medicare taxes. In these situations, the EITC is basically a mechanism to refund a tax that perhaps just as easily could not have been withheld in the first place. Such a result could be achieved by using a system similar to the income tax withholding system that doesn't begin until a certain income level is reached. If further simplifications were made to conform definitions used for the EITC, such as "qualifying child," to other definitions used in computing federal taxable income, such as "dependent," the structural change would be more feasible and further simplification could be achieved. The EITC could be restructured to be an immediate offset of payroll taxes in more than one way. For example, all employees could have an exemption from Social Security (FICA) and Medicare taxes (referred to in this paper as "payroll taxes") on a specified amount of wages. Of course, to offset the reduction in tax collections, the tax rates and maximum amount of earned income subject to payroll taxes would need to be adjusted. Another alternative would be to have payroll taxes computed on a graduated rate basis tied to the worker's wage base (similar to how federal income tax withholding is computed). Because the current EITC structure can result in refunds greater than the worker's payroll tax amount,' additional changes would be needed to maintain the current level of benefit provided by the EITC to taxpayers with one or more For example, in 2000 the maximum EITC for an individual with two or more qualifying children is $3,888 when earned income is between $9,720 and $12,690. The employee's share of payroll taxes on $12,690 of income is only $971 ($12,690 x 7.65%). qualifying children. These changes might be achieved through increased dependency exemptions or child credits for individuals with specified amounts of earned income. Beyond simplification, an additional potential benefit of an alternative structure and simplification of qualifying status requirements would be that it might make it easier to move to a return-free tax system. Structural changes as described above would also serve to provide the EITC benefit to low-income taxpayers in each paycheck without a need for individuals to apply to receive an advance EITC. In addition, these structural changes could be implemented in a manner so as to reduce the current high marginal tax rates that result from the phase-out provision of the EITC. Format of the Paper Section II of this paper provides a brief background to the EITC as relevant to appreciating and evaluating appropriate structural changes. Section II reviews the history and rationale of the EITC, issues surrounding it (many of which stem from the complexity of the EITC), and relevant data on the usage of the EITC to better understand who it applies to and its effects to low-income individuals. Section III examines the possible mechanics and feasibility of an alternative structure for the EITC that would simplify the operation of this program and provide an effective and low-cost benefit to low-income individuals. Focus on Simplicity The focus of the change proposed in this paper is simplification of the EITC. Thus, there is little discussion of making changes to modify the social and economic policies underlying the EITC. This is not to say that non-tax policy aspects of the EITC are not important, but to emphasize that this paper has been prepared for inclusion in a tax law simplification study. 2 However, the underlying policy cannot completely be ignored and the discussion of the advantages and disadvantages of the proposals outlined in this paper does note some of these issues. Broader discussions of EITC reform should include a review of the welfare function of the credit. Under today's EITC structure, the amount of the benefit received is dependent on a worker's marital status and number of children (with the benefit capped at two children). The EITC does not provide equivalent benefit to all low-income workers with respect to whether they earn above or below the poverty line for their family size. Also, while the EITC has been viewed by many as an effective tool in increasing employment of low-income workers, perhaps more so than other welfare policies, the use of the tax law to provide welfare benefits beyond the level necessary to remove individuals with income below the poverty level from federal income and payroll taxes should be evaluated in any major EITC reform effort. The rationale for such evaluation includes the fact that the EITC has grown in complexity with its expansion over the years and the fact that it is a program administered by the Internal Revenue Service, rather than an agency with expertise in the administration of welfare programs. Also, the amount of the benefit provided has increased significantly since the EITC was first introduced in 1975, and the 2 See "Should EITC Benefits Be Enlarged For Families With Three or More Children?” prepared by the Center on Budget and Policy Priorities, July 10, 2000. |