September 29, 2011
The “Super Committee” charged with deficit reduction should take notice of a tax policy that permits the wealthiest Americans to divert a third of their tax obligations away from the Treasury and to causes of their own choosing. The same system also subsidizes conversion of taxable investment income to tax-free income and removal of billions in investment assets from the reach of estate and gift taxes.
The system at work lies in the intricate body of tax law that subsidizes the creation and perpetuation of so-called “private foundations.” Briefly described, these are trusts or similar entities that control hundreds of billions of dollars in investment securities in the form of “endowments.” Although they are accorded the status of “charities” under section 501(c) of the Internal Revenue Code, they do not meet any accepted definition of a charity. They do not raise money from the general public, but are instead the creatures of wealthy families and their corporate affiliates. Nor do they actually perform charitable works. Rather, they make discretionary “grants” to actual “operating charities” selected by trustees, as and when they see fit.
As of 2008, private foundations controlled $650 billion, two-thirds of which was made up of investment securities that earned investment income of over $60 billion. No income taxes were paid on these revenues. Neither the assets nor the earnings are subject to death taxes.
Ending these tax benefits could solve a substantial part of the Super Committee’s ten-year goal. But a more important reason exists for reform: the tax code. It has established that most un-American of institutions: permanently entrenched wealth with the capacity and intent to influence the national agenda.
It goes without saying that private foundations are huge players in the world’s financial markets, as venture capitalists, real estate developers, futures traders, and investors in stocks and bonds. Although discouraged from lobbying, they do in fact lobby prodigiously at all levels of government. But their greatest influence on the national agenda is promoting and funding research, public opinion polls, academic studies, advocacy groups, and other intellectual fodder in support of their pet causes. These activities are designed to “leverage” tax dollars in furtherance of their agendas. The names MacArthur, Pew, Kaiser, Koch, and Ford are the most familiar, but these “persuaders” number in the scores if not hundreds.
The modern system, in summary, works like this. A rich family or corporation creates an endowment to further “charitable” causes selected by the founder, subject only to extremely loose standards of public good. By way of example, the charitable purposes of foundations established by the Buffett family promote abortion rights, education of poor children, nuclear non-proliferation, environmental protection, and human rights. The endowment is donated free of gift tax, and is also removed from the reach of otherwise applicable death taxes. Moreover, the founder receives an immediate deduction from his income taxes for the gift, in effect getting 35% or more of it back from the taxpayers.
The foundation invariably takes this money and invests it. Although foundations do have to pay taxes on so-called “unrelated business income” (UBI), investment earnings are not considered UBI and thus are free from income tax. If, as some politicians argue, lower taxes on capital gains, interest, and dividends constitute a subsidy for the rich, this tax-free universe for foundations is Valhalla itself.
In 1969 the Congress placed some limitation on the Topsy-like growth of private foundations by imposing an “excise tax” to the extent — and only to the extent — that the foundations do not “pay out” at least 5% of the endowment’s current value in any year. Because foundation investment earnings historically almost invariably exceeded that “distributable” amount, most have had excess earnings to add to the endowment each year.
Apologists for private foundations argue that these remarkable benefits are a well-tuned public policy to support charities. They equate their activities with those of schools, institutions for the performing and fine arts, hospitals, and other “operating charities.” The private foundations argue that, like conventional charities, they are being subsidized for doing work the government would otherwise have to perform. It is against this claim that their conduct should be measured.
The first consideration is that they do not support works that the people, acting through their governments, consider wholesome and helpful. They make grants only to those causes their founders and trustees have decided are more important than what government does. Notwithstanding the warm sentiments Bill Gates, Warren Buffett, and others have for higher taxes, their foundations’ very existence shows disapproval for what the government does and how it does it. If they felt otherwise, they would be more efficient in their largesse by foregoing foundations, paying income taxes on their investments, and dying with these assets in their taxable estates.
A more important consideration is that private foundations do not even support their own goals. The tax code has paradoxically encouraged giving for charity, but not spending on charity. The founder, as noted, receives an immediate tax deduction as if he had put money in the hands of the needy instead of an “endowment.” But the empirical evidence is that the “gift” stays in the foundation’s money bin forever and is never used to support foundation goals.
A 2007 IRS study — which has not been updated — tracked, over a ten-year period, the top 100 foundations by asset size. It calculated endowment growth and “distributions” as a percent of their respective endowments (the so-called “payout rate”).
It comes as no surprise that all endowments grew. That is a natural consequence of making investments on which no income tax is paid.
The eye-popping statistic is the payout rate of each. With the exception of a mere handful of outliers, every one of the 100 foundations on the list paid almost exactly 5% out for expenses and actual charitable use. To underline a crucial point: 5% is not the average or median distribution by all 100 foundations; it is the individual payout rate of each one of them over a decade — all while endowments were growing steadily and, presumably, the needs of their beneficiaries were increasing.
A sober observer can reach but one conclusion: over ten years, through hundreds of iterations of decisions made by one hundred boards of trustees, private foundations unerringly chose self-perpetuation over the needs of their intended beneficiaries.
As shameful as this performance is, private foundations respond with sophistry: we are good, therefore should be around for future generations; therefore we should not spend our money. This syllogism assumes, incorrectly, that it is public policy to perpetuate eternal memorials to the agendas of dead wealthy people. America’s tradition is quite the opposite: reduction of plutocracy and actual spending on charity.
What is required is a system that matches up the founder’s charitable deduction and the foundation’s tax benefits with public policy. As a start, the charitable deduction for endowment gifts to private foundations should be discounted to present value based on the express undertakings of the foundation to expend the gift or, if none are made, the historic rate of principal distributions from the foundation’s endowment gifts. (Present value calculations such as this are routinely performed in business and tax matters.) Existing foundations should be brought into conformity by increasing the “distributable amount” for excise tax purposes to 10% of endowment value, and by taxing investment income at the same rates as unrelated business income. Under such a regime, foundations may choose to persist in self-perpetuation, but they will have to adapt to a tax structure that demands their fair share.