HD35 - The Extent of Unfair Competition Between Nonprofit Organizations and Small For-Profit Businesses in Virginia

  • Published: 1988
  • Author: General Assembly. Joint Subcommittee
  • Enabling Authority: House Joint Resolution 303 (Regular Session, 1987)

Executive Summary:
While competition between commercial for-profit businesses and nonprofit organizations is not new, in recent years it has become much more widespread. The major reason for this is the dramatic growth in the nonprofit sector. Tax-exempt organizations are one of the fastest growing segments of the economy with annual revenues exceeding $300 billion in 1985. Their percentage of the Gross National Product has grown from 2.99 percent in 1980 and 3.29 percent in 1983 to approximately eight percent in 1985. The tax-exempt community ranges from informal social or neighborhood clubs with limited resources to complex, multi-million dollar medical complexes.

Nonprofit organizations traditionally formed for charitable, educational, scientific or religious purposes, and thus exempt from federal income taxes and recipients of other special treatments such as postal subsidies, are increasingly engaging in commercial activities which compete with small for-profit businesses. This ever-increasing amount of nonprofit competition is not only from nonprofits per se but from for-profit subsidiaries which are spun off from the nonprofits. Small businesses which pay federal and state taxes for the privilege of doing business have begun to question and object to these activities. They do not object to the existence of most nonprofit organizations when providing genuine charitable services and if they are "playing on a level field". They do, however, find competition with nonprofit organizations unfair because of the many subsidies and special treatments received from all levels of government.

Historically, nonprofit organizations have provided services to those in need when the public and private sectors were unable or unwilling to do so. They are the "third sector" of society because they are private in organization, but public in mission. They relied on gifts, contributions, and volunteers to accomplish their missions. These traditional nonprofit charitable organizations are being replaced by "commercial" nonprofits which derive their income from the sale of goods or services produced in competition with those traditionally furnished by for-profit businesses. Cutbacks in federal grants, heightened competition for private donations, declining demand for some services, and changes in the orientation of the economy from manufacturing to service, all have led such organizations to seek for-profit activities as sources of dependable operating revenue. Nonprofit organizations view their expansionary efforts as necessary in furthering their tax-exempt purposes and recognize that some competition with for-profit businesses has always existed, yet is now increasing.

Competition is occurring not only in traditional service industries such as health care, travel and merchandise sales, but also in newer fields such as laboratory testing, audio-visual services, data processing, and consulting. Most of the complaints regarding unfair competition concern organizations operating under § 50l(c)(3) of the Internal Revenue Code which include religious, educational, charitable and scientific organizations. Public universities and hospitals are among the main targets of small business complaints. Businesses maintain that universities take business away from the private sector through on-campus stores and restaurants, computer sales, research projects, alumni group travel tours, etc. They object to hospitals using resources generally unavailable to for-profit firms to create new corporate structures in which the original nonprofit hospital become only one of many corporate entities, both nonprofit and profit-making, and which allow the hospitals to venture into nearly any area without risking the nonprofit status of the original entities.

An example of the expansionary efforts by hospitals in Virginia, as reported in the February 15, 1987 edition of The Washington Post, is that of Roanoke Hospital Association, a nonprofit group operating several hospitals in the Commonwealth, which purchased an advertising agency in January to add to its other for-profit ventures including two health clubs, an interior decorating firm, a pharmacy, and a helicopter ambulance service.

Nonprofit-owned hearing aid suppliers, laundries, prosthetic services, prescription drug centers, cooperatives that sell low-cost supplies to farmers, humane societies that neuter dogs, and nonprofit health clubs are just a few other targets of unfair competition allegations.

Concern over the commercial activities of nonprofit organizations and the effects of such on for-profit businesses has led a number of states and the federal government to investigate the issue. Action at the national level has prompted more states to look into the issue, and in August 1986, the White House Conference on Small Business ranked unfair competition between nonprofit organizations and small for-profit businesses third on its list of priorities. The House Ways and Means Subcommittee on Oversight, chaired by Rep. J. J. Pickle of Texas held hearings in the summer of 1987 on the federal treatment of commercial and other income-producing activities of organizations that have tax-exempt status. Until then there had been no comprehensive review of the unrelated business income tax rules since 1969 and there are many unanswered questions about the scope and nature of tax-exempt organizations' income-producing activities, the administration of the unrelated business income tax by the Internal Revenue Service and the courts, and the extent of compliance with the law. One of the findings of the Subcommittee was that in 1986, of the more than 840,000 tax-exempt organizations on record, only approximately 27,000 reported unrelated income-producing activities subject to tax and about one-half of the $57 million of unrelated business income tax collected by the IRS that year was attributable to only two audits. Congress is not expected to adopt any changes in the law this year because the Subcommittee was only gathering information and will not be considering any specific legislative changes.

The federal government attempted to address this same unfair competition issue in 1950 by imposing a tax on the income which resulted from unrelated activities carried on by tax-exempt organizations. It is now apparent that the UBIT is not accomplishing its original goal because no monitoring systems were established to ensure compliance with the law. The General Accounting Office recently completed a study of the competition between taxable businesses and tax-exempt organizations and found that part of the problem with the UBIT stems from the fact that the IRS has no concrete rules for defining unrelated business income. However, in recognition of the fact that they may have been lax in the enforcement of the UBIT, the IRS plans to audit 3,000 returns filed by tax-exempt organizations throughout the country to determine the accuracy of every item reported. This information will be used to develop audit selection criteria and audit procedures to assure that the income of nonprofit organizations is reported accurately.

The number of states which had some level of activity on the issue, ranging from the passage of legislation to the formation of study committees, has increased from twenty-two in 1985 to thirty-four in 1987.

Concern over the potential detrimental effects that unfair competition from nonprofit organizations could have on the small businesses of the Commonwealth prompted the 1987 General Assembly to pass House Joint Resolution No. 303, calling for a study of the issue. A copy of the resolution appears as Appendix 1 to this report.

Delegate Harvey B. Morgan of Gloucester, chief patron of the resolution, served as Chairman of the joint subcommittee. Other members of the House of Delegates appointed to serve were: Bernard S. Cohen of Alexandria, Alson H. Smith, Jr. of Frederick, and William T. Wilson of Alleghany.

Senator Richard L. Saslaw of Fairfax County served as Vice Chairman of the joint subcommittee. Other members of the Senate appointed to serve were: John H. Chichester of Stafford and Elman T. Gray of Sussex.

Two citizen members were also appointed to serve: Mr. Thomas Inman, II of Newport News, representing small business interests, and Mr. Guy T. Tripp, III, Esquire, of Richmond City, representing nonprofit interests.

C. William Cramme', III, Senior Attorney, and Terry Mapp Barrett, Research Associate, of the Division of Legislative Services served as legal and research staff. Barbara Hanback with the House Clerk's Office provided administrative and clerical duties for the joint subcommittee.