I'm no good at hiding the ball, so let's just note from the outset that their arguments are, as a general matter, pretty bad. That should come as no surprise, but it may still be worthwhile to walk through them. Since this diary got pretty long pretty quickly, I'll just focus on the two wackiest.
AARP's Revenues Dwarf Their Charitable Activities
This is true as far as it goes, but it doesn't go very far. During the hearings (which I watched, being a lawyer and having audited charities for several years), the GOP made a lot of hay out of the fact that despite AARP's large and increasing revenues, their charitable expenditures remained flat. The GOP report says:
[D]espite the significant increase in revenues, AARP’s charitable affiliates do not appear to be benefiting from this windfall....So one might ask, what is AARP doing with the
remaining hundreds of millions of dollars AARP receives each year from their insurance business?
This darkly insinuates that there's something shady about the increase in revenue without a corresponding increase in charitable activity. The authors of the GOP report seem to be dimly grasping toward something called the “commensurate in scope” test for 501(c)(3) exemption. As the IRS explained in
FSA 199910007:
The Service held that such an organization can itself be exempt as an organization described in section 501(c)(3), if the amount of contributions shows that it is carrying on “a charitable program commensurate in scope with its financial resources....The Exempt Organization Council took the position that an exemption under section 501(c)(3)should not be denied if the facts show that the organization is engaged in carrying on a real and substantial charitable program reasonably commensurate with its financial resources.
This test is a sub-test of the “organizational test” for charities, and it's really pretty commonsensical: to be a bona fide charity that qualifies for exemption, the organization must actually devote its resources to charitable work.
Straightforward, and, ultimately, irrelevant in this context. The commensurate in scope test applies only to 501(c)(3) organizations, and the AARP “mother ship” that's under investigation is a 501(c)(4). If we look at the most recent tax return for the AARP Foundation, 501(c)(3) arm of AARP, it devoting about $118 million of its $119 million revenues on program expenses (what we would consider its charitable expenses). Or: the AARP Foundation passes the commensurate in scope test with flying colors.
AARP Has Revenue That Should Be Taxed
From the letter written by GOP representatives to the IRS:
[A]t a recent Ways and Means joint Health and Oversight Subcommittee hearing, a tax-exempt expert questioned whether certain revenue categorized by AARP, Inc. as royalty payments exempt from the Unrelated Business Income Tax (UBIT) are, in fact, flat commissions....As you know, commissions are not exempt from UBIT, and would therefore be subject to taxation
This is just a bizarre argument, and I have a hard time making it sound reasonable.
Let's just take a step back for a moment and go over the broad strokes of exempt org taxation. As a general matter, exempt orgs are taxed on their unrelated business income. To be taxable, it must be unrelated to the charitable mission (as opposed to, say, Girl Scout cookies, which are sold to teach the members about entrepreneurialship) and it must be business income (meaning it must be regularly carried on, as opposed to, say, a charity holding a gala once a year). Since many charities earn investment income and their investment activities are both unrelated and regularly carried on, Congress has passed a series of exceptions for interest, dividends, capital gains, royalties, and so on. That income would be taxable but for the special exception laid out in 26 USC 512(b).
But what's a royalty? There's the rub: Congress never defined it, so it's been the subject of litigation ever since. The GOP called an “expert” to testify on this topic, of course. The expert in question is William Josephson, a former partner of Fried Frank (an unquestionably good firm); one has to wonder whether he's all there, though. He testified:
While further investigation is required, the impression I have from reading theInvestigative Report is that the income AARP receives from its insurance business, which it treats as UBI tax exempt royalties, is not necessarily measured by production or by gross or taxable income, but is, in fact, more like flat fee commissions paid on each insurance policy sold. If so, there would be a substantial issue as to whether or not such commission income is properly excluded from UBI tax as a royalty under the Sierra Club line of decisions or more properly included as income under the Texas Farm Bureau line of decisions
The problem here is that Sierra Club and Texas Farm Bureau aren't two distinct lines of cases at all.
Sierra Club v Commissioner is a seminal case in UBIT law, and is widely considered the definitive statement on royalties. It came after
Texas Farm Bureau and superseded it, incorporating its holding into its own. Put differently, there aren't two distinct lines of cases; there's really only Sierra Club, which unified and interpolated previous cases. Per Sierra Club, what makes revenue a royalty is the passivity of the income. Unfortunately, there's no one sentence that contains the holding, so in the interest of brevity I'll summarize: the difference between a tax exempt royalty payment and a taxable service contract is the amount of work done by the charity as part of the agreement. If a charity assists in marketing and provides office space and administrative support for the sales, then there could be UBIT. If they just collect a fee, then it's passive royalty income and exempt from UBIT. Weirdly, the “expert” cited by the GOP thinks there's something untoward about the fee structure: AARP collects a fee per sale rather than per use of its trademark, but the Sierra Club court expressly disavows such a theory:
However, if Sierra Club copyrighted the designs on its t-shirts and then licensed the designs to a t-shirt manufacturer in exchange for a one percent royalty fee on gross sales, the royalty fees would be excluded from UBTI under § 512(b)(2).
(emphasis mine)
Or: the expert simply doesn't understand the law of UBIT and royalty income, and instead advances a bizarre, utterly made-up theory of UBIT to support the equally bizarre notion that AARP is abusing its exemption.