Researcher evaluates tax break for “trickle down charity”

Law’s Matthew Rossman calls on IRS to better determine if regional economic development organizations that claim to be charities really are

An upcoming law review article suggests the Internal Revenue Service should do a better job determining whether a recent wave of nonprofits the author terms “regional economic development organizations” (REDOs) are actually charitable and should be tax exempt. Professor Matthew Rossman’s research at Case Western Reserve University School of Law suggests the IRS can adapt its private benefit doctrine to REDOs, many of which are, in reality, business accelerators and incubators that seek the tax breaks of nonprofit status. Rossman proposes the phrase “trickle down charity” to describe economic development practiced by such organizations. He writes that no matter how altruistic the organization's objectives, it is not a charity if it mainly benefits private individuals or enterprises. “This is exactly what is at issue in trickle down charity,” he said. “As my article contends, the IRS should enliven this doctrine so that it more effectively evaluates charitable economic development.” His article, “Evaluating Trickle Down Charity – A Solution for Determining When Economic Development Aimed at Revitalizing America's Cities and Regions Is Really Charitable,” has been selected for publication in The Brooklyn Law Review’s Summer 2014 edition. "As our nation's philanthropic sector becomes more entrepreneurial, ambitious and influenced by the private sector, longstanding legal standards on what constitutes charity struggle to stay relevant," he argues in the article. Rossman believes the article is the first in a law review to identify and consider the recent widespread emergence of charities providing direct assistance to for-profit businesses. Rossman has taught and written about nonprofit organizations engaged in economic development for more than 15 years. REDOs are now active in almost every metropolitan area in the Unites States, he said. Often, these organizations seek and get IRS classification as a Section 501(c)(3) charity. The designation allows for:

• An exemption from federal income tax for organizations that are operated exclusively for religious, charitable, scientific, or educational purposes.
• Many other benefits, including additional tax breaks, eligibility for tax-deductible donations and government and foundation funding, and exemptions from laws that, when taken together, amount to a large public subsidy of charitable activity.

In return, a nonprofit organization agrees to mainly benefit the public at large or those who need charitable aid. Rossman writes that charities have evolved beyond traditional community service organizations, such as soup kitchens and homeless shelters. REDOs, according to Rossman, tend to be highly sophisticated business ventures that accomplish their missions in ways less obviously charitable. Many REDOs act like venture capital firms by investing in, and providing technical assistance and management talent to, for-profit enterprises whose primary objective is to make money for those who own them, he said. "While influential and, in some cases, transformative to cities and regions in economic distress, these organizations turn the traditional charitable services delivery model on its head by aiding those who are not members of a charitable class in the hope that someday those who are will benefit," Rossman explained. It would be difficult to estimate how much is lost to the IRS in tax dollars due to REDOs, he said. "But it is fair to say that REDOs attract many millions of dollars of contributions from foundations, individual and corporate donors and government agencies that are tax exempt and/or shielded from tax due to the tax law's deduction for donations to charities," he said. "Moreover, REDOs that seek charitable status are no longer confined to highly distressed urban areas, but are serving regions of the country that many would consider relatively affluent," Rossman said. "Finally, even those that work in poor areas have expanded the geographic scope of their service areas to also include the middle- and high-income portions of the regions they serve. These are all relatively recent developments. As a result, the IRS methodology historically used to evaluate REDOs is way out of date." His solution involves the IRS modernizing its standards and process for evaluating regional economic development organizations to better ensure they can demonstrate their charitable status and are held accountable for the nonprofit missions they claim to serve. A version of his article is available at ssrn.com/abstract=2376470