How Nonprofits Became Tax-Exempt
The uproar over allegations of politically motivated investigations by the Internal Revenue Service shouldn’t be surprising given Americans’ long love affair with nonprofits and their strong disdain of partisanship, especially within bureaucracies.
After independence, and especially after ratification of the Constitution, Americans began forming businesses, charities and other associations at unprecedented rates. Unshackled from British law and the threat of monarchical tyranny, they sought to invest in long-term stability, and in each other, in ways that required the establishment of large and lasting organizations.
To create these institutions, early Americans adapted corporate laws from Britain. At first, incorporation required both for-profit and nonprofit organizations to obtain a charter from state governments. Charters were special laws passed by state legislatures and signed by governors under the rules of state constitutions.
Before the Civil War began in early 1861, more than 22,000 businesses and untold numbers of churches, charities, promotional associations and other nongovernmental organizations incorporated.
While not all successfully began operations or lasted very long, business corporations supplied much of the nation’s early transportation infrastructure, financial services, manufacturing and mining production, and utilities (water power, potable water, gas lighting and telegraphs). Similarly, nonprofit corporations provided early Americans with many religious, charitable, educational, literary and promotional services.
Special incorporation, however, spawned political favoritism. New York, for example, denied the Bank of New York a charter from 1784 until 1791 for purely partisan reasons: The bank was controlled by Federalists while the governor and his allies in the legislature were Democrats. In the early 19th century, politicians also denied the Merchants Bank of New York a charter for several years. Other entrepreneurs across the U.S. also complained that their charter applications were denied for purely partisan reasons.
Luckily for the development of the U.S. economy, early entrepreneurs stymied by state governments had several other options. They could charter in another state, as several banks did in New Jersey when New York proved intransigent. At some risk, entrepreneurs could also form an unincorporated joint-stock association and contractually assert the legal advantages held by duly chartered corporations, including perpetual succession, entity shielding and defined liability.
Most then bided their time and applied for a charter when the political winds were more favorable.
Entrepreneurs also quickly learned to make their charter bids appear nonpartisan. But then legislators began asking for nonpartisan incentives to vote for charters, such as cash, stock and a variety of favors, including in at least one reported case, a favor of an intimate nature. Matters got so bad that in 1812, New York’s Democratic governor, Daniel Tompkins, prorogued the legislature in response to widespread accusations that agents of the Bank of America (not the bank of the same name active today), including the state printer and the state treasurer, had exerted “undue influence” on several lawmakers.
Federalists immediately painted Tompkins’s suspension of the legislature as an act of partisan interference with business even though his action was legal under New York’s first constitution.
Early nonprofits were generally immune from such politics and were rarely cash cows that corrupt legislators could plunder. Swamped with charter applications from churches, libraries, cemeteries and societies for the advancement of beet sugar, silk, viticulture and other entities, state legislatures soon streamlined their chartering processes, ultimately creating general incorporation laws that allowed nonprofits to simply fill out a few forms and pay a small fee. The U.S. soon became a “nation of joiners,” where voluntary associations proliferated and addressed problems that were the province of governments in other countries.
Facing accusations of corruption and favoritism, state governments slowly extended the general incorporation principle to businesses. Although special chartering persisted into the 20th century in some states, by the late 19th century most businesses in most states obtained charters under general incorporation laws (especially those of New Jersey and later Delaware).
By World War I, several hundred thousand business corporations were active in the U.S. A century later, there are millions of business corporations and the nation rightly prides itself on the speed and ease with which businesses can form and incorporate.
Now, however, it is the nonprofit sector that appears to be subject to partisan politics and bureaucratic bungling. Nonprofits can incorporate as quickly, easily and cheaply as ever, but that is of little use if the IRS can harass them or simply delay their 501(c) applications to be exempted from taxes.
Many nonprofits rely on donations, which are difficult to obtain until tax-exempt status is officially granted. Others are only worth forming or operating if they are tax exempt.
Yet the IRS can take as long as a year to make a decision on routine 501(c)(3) applications (for nonprofits providing religious, educational, charitable, scientific, literary and other specific services).
That means it took less time to obtain tax exemptions, which were built into many early charters, in the 18th century. Unlike early state governments, the IRS faces no direct competition and apparently doesn’t fully appreciate the services that nonprofits provide the American people.
(Robert E. Wright is the Nef Family Chair of Political Economy at Augustana College in South Dakota and the author of “Corporation Nation,” which will be published in December by the University of Pennsylvania Press. The opinions expressed are his own.)
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