The Internal Revenue Service has published an article on tax-exempt organizations that everyone practicing in estate and philanthropic planning should keep close at hand for easy reference and for some perspective — especially during this time of increased Congressional and IRS scrutiny of charities.

It's rare to find this much valuable data about tax-exempt organizations in one place — and even rarer to find such data placed in the context of the historical development of the tax-exempt sector. The article, which can be found on the IRS website at www.irs.gov/taxstats/charitablestats/article, is in the Winter 2008 issue of the Statistics of Income Bulletin (an IRS publication), written by Paul Arnsberger, Melissa Ludlum, Margaret Riley and Mark Stanton and called “A History of the Tax-Exempt Sector: An SOI Perspective” (“SOI” stands for statistics of income.)

The SOI division of the IRS has conducted annual studies of organizations exempt from Internal Revenue Code Section 501(c)(3) for every tax year since 1985. The information for the studies comes from sampling the various tax returns filed by IRC Section 501(c)(3) organizations (such as Forms 990, 990-PF, 990-T and 4720).

Statistical articles tend to be dry. What makes this article different is that the statistics are placed in the context of the fascinating historical development of the tax-exempt sector in the United States. The final section of the article also proves (with data from 1985 through 2004 and in some cases 2006) that the charitable sector, comprised of both public charities and private foundations, is a substantial and growing part of the overall U.S. economy.

The aggregate book value of assets, as reported by charities that filed IRS Form 990 information returns for tax year 2004, was $2.5 trillion. That's a profound increase of 222 percent over the total report for tax year 1985. These organizations also reported 171 percent more revenue for 2004 than for 1985.

The tax-exempt organizations are not just doing better — they're doing more good work. Much of their additional revenue went to charitable expenditures such as program service activities and grants. Total charitable expenditures for 2004 were 182 percent larger than those reported for 1985, a real annual rate of growth of nearly 6 percent. To put that in context? The Gross Domestic Product grew at a real annual rate of 3 percent during the same period.

Context Is Key

As the article by Arnsberger et. al. notes, the tax-exempt sector in the United States is unique among developed countries in both size and scope. This uniqueness is only partially the result of generous tax subsidies under the income, gift and estate taxes put in place in the early part of the 20th century. Other factors date back to the early 17th century. Indeed, the early settlers, without an established governmental framework, formed charitable and other voluntary associations, such as hospitals, fire departments and orphanages to address a wide variety of issues and ills of the era.

Alexis de Tocqueville observed during his visit to the United States in 1831 that “Americans of all ages, conditions, and dispositions constantly unite together. Not only do they have commercial and industrial associations to which they belong but also a thousand other kinds, religious, moral, serious, futile.” The French philosopher also identified two types of voluntary associations that today comprise the modern tax-exempt sector: public service organizations and membership organizations. Early public service, or as they're now known, “charitable” organizations, included schools, churches and other voluntary organizations designed to provide services to the public.

The authors attribute the continuing popularity of voluntary charitable organizations in the United States, even in the midst of strengthening state and federal governments, to two possible factors: First, these voluntary organizations, with their well-established structures and programs, were able to fill a gap in social welfare programs when the young government's efforts proved insufficient. Secondly, many early Americans embraced charitable organizations over government programs because they feared the rebirth of the monarchy-based governments that they, or their ancestors, had come to this country to escape.

With the nation's wealth increasing after the Civil War, private philanthropy was a growing force in the charitable sector and the private family foundation emerged. The robber barons became fabulously wealthy during the Industrial Revolution. At the same time, there was a corresponding restructuring of the traditional American agrarian way of life. Workers left the farms and, along with immigrants arriving from foreign lands, flooded cities in search of factory jobs. The resulting urban overcrowding led to social ills of Dickensian proportions. Such problems led a number of U.S. industrialists, John D. Rockefeller, Sr., and Andrew Carnegie among them, to create private foundations that remain prominent today. Indeed, Carnegie in his famous essay, “The Gospel of Wealth,” articulated some of the early philanthropists' perspectives when he said that a wealthy individual should “consider all surplus revenues which come to him simply as trust funds, which he is called upon to administer, and strictly bound as a matter of duty to administer in the manner which, in his judgment, is best calculated to produce the most beneficial results for the community.”

Membership organizations, including fraternal societies like the Freemasons, also were very popular among early Americans. By the 19th century, there flourished mutual benefit associations, serving members in areas such as banking and insurance. Around this time, labor and agricultural organizations, established to promote the interests of their members, also started to take root throughout the country.

Today's Laws

A more recent spur to tax-exempt sector growth has been the federal government's support for charitable and membership organizations by providing exemptions from income and other taxes and subsidies for donations. The article spends significant time on the history of legislation regarding the tax-exempt sector.

While legislative history may sound dull, it's actually not. The section is well-written. It's also very interesting for those of us who deal with today's laws to see from whence they came.

The basic structure of tax exemption for charitable and other voluntary organizations is a product of legislation enacted between 1894 and 1969. Over that 75-year period, Congress established the basic principles and requirements of tax-exemption, identified business activities of tax-exempt organizations that were subject to taxation, and defined and regulated private foundations as a subset of tax-exempt organizations.

The basic concept of charitable tax law revolves around three major principles:

  1. Organizations that operate for charitable purposes should be exempt from federal income tax.
  2. Charitable organizations are required to be free of private inurement — that is, a charitable organization's income cannot be used to benefit an individual related to the organization.
  3. The tax code provides for an income tax deduction for contributions, designed to encourage charitable giving.

Key events in the history of exempt organization legislation are:

  • The Revenue Act of 1913 — established an income tax system with tax-exemption for certain organizations.

  • The Revenue Act of 1917 — introduced an individual income tax deduction for charitable donations.

  • The Revenue Act of 1918 — added the estate tax deduction for charitable bequests.

  • The Revenue Act of 1943 — required that the first Forms 990 be filed.

  • The Revenue Act of 1950 — established the unrelated business income tax.

  • The Revenue Act of 1954 — established the modern tax code, including IRC Section 501(c) for exempt organizations. It also put limits on a charity's political activities.

  • The Tax Reform Act of 1969 — established private foundation rules, including the 5 percent minimum charitable payout requirement and excise taxes on net investment income, self-dealing, jeopardy investments, excess business holdings and taxable expenditures.

Today's Giving

These laws and this history have combined to make Americans extremely generous and turn the tax-exempt sector into a powerful force.

Public charities filed more than 276,000 information returns for tax year 2004. These organizations held more than $2 trillion in assets and reported nearly $1.2 trillion in revenue — 70 percent of which come from program services.

In 1985, the IRS Master File listed about 335,000 active public charities. By 2004, this number had tripled to 933,000. And not all public charities are included in this figure, as most churches and certain religious organizations need not apply for recognition of tax exemption.

One thing that did not change between 1985 and 2004 was the number of universities on the list of the top 10 public charities by size of assets. Six of the top 10 charities were universities in 1985 (Harvard, Yale, Stanford, Columbia, Princeton and Cornell) and 2004 (Harvard, Stanford, Yale, Princeton, MIT and Columbia). And it doesn't look like that lineup will change any time soon. On May 25, 2008, it was announced that David M. Rockefeller, the 92-year-old grandson of John D. Rockefeller, is giving $100 million to his alma mater, Harvard. It's the largest gift by an alumni in the university's history. And, according to The New York Times, Harvard already had the largest endowment of any university in the world, with assets of $35 billion.

On the private-foundation front, the years 1984 through 2004 also represented a period of significant growth. The number of private foundations more than doubled between 1984 and 2004, from 31,170 to 76,897.

During the same 20-year period, the fair market value of foundation assets more than tripled, from $138 billion to $481 billion and foundation giving also increased threefold.

Some of the growth can be attributed to provisions in the Deficit Reduction Act of 1984 that allowed more favorable tax treatment for contributions of marketable securities to private non-operating foundations. A lot of that private foundation money came from the investment and high tech worlds. The best example of that, of course, is the Bill & Melinda Gates Foundation. The largest foundation in the world, with a current endowment of $38 billion, its money comes primarily from the Gates fortune, built on Microsoft, but also now from Warren Buffett, who made his money through investing and has pledged the vast majority of his $62 billion fortune to the Gates Foundation. If history repeats itself, perhaps Gates and Buffett will spur a new golden age of private philanthropy the way Rockefeller and Carnegie did a century ago. We will have to wait and see. That page in the history of the tax-exempt sector has yet to be written.