Paul L. Caron
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Friday, August 31, 2018

Weekly SSRN Tax Article Review And Roundup: Eyal-Cohen Reviews Black's Section 511, Innovation, And Jobs

This week, Mirit Eyal-Cohen (Alabama) reviews Steve Black (Texas Tech), Do You Want Innovation and Jobs? Repeal § 511, 57 Washburn L.J. 431 (2018).

Mirit-Cohen (2018)This essay begins with a provocative title. In the name of innovation and job growth, the author advocates for the elimination of tax on unrelated business income (UBIT) imposed under § 511. UBIT is essentially tax on income of an exempt organization that if the organization is involved in the trade or business that is not substantially related to its exempt purpose.

The author provides helpful history on the passage of UBIT noting that in the past many universities were engaged in commercial activities while still pursuing their charitable purposes. In the late 1940s, educational institutions were involved in fields like banking, real estate, and mainstream commerce. They invested in enterprises such as department stores, factories, and real estate holdings. They owned citrus groves, movies theatres, and cattle ranches. For example, Mueller Macaroni Company, a pasta business that was donated to NYU, created “macaroni profits” that went untaxed by the University. Yet, soon after competitors and pasta rivals (the “macaroni monopoly”) uproared against unfair competition portraying nonprofits as having an unfair advantage with those entities that paid their full share of tax. 

These sentiments brought Congress to enact the Revenue Act of 1950 that created the unrelated business income tax imposed on income from business operations not directly connected to the organization’s non-profit activity. Subsequently, universities were forced to determine what is “unrelated business activities” under the threat that an organization which had too much of the latter will lose its tax-exempt status. The author exemplifies through caselaw how the IRS and the courts had been inconsistent in formulating and enforcing a framework for what is considered “unrelated business income.”

Universities squeezed out of “business” areas began to focus on “passive” activities such as intangible property. Currently, apart from private colleges with large endowments that are taxed under the new § 4968, income derived from dividends, interest, certain payments with respect to securities loans, annuities, and all deductions directly connected with such income is excluded under § 512. That focus on passive rather than active business, in the author’s opinion, creates a loss to the economy and U.S. society as a whole. In their attempt to avoid UBIT, the author argues, universities have created inefficient, artificial barriers to prevent them from moving IP into the marketplace.

Today, for-profit research centers such as Google and Bell labs create taxable revenues to the nonprofit organization in which they operate. On the other hand, revenues from tax-exempt labs remain untaxed even if they result from agreements between nonprofit scientific research laboratories and for-profit corporations. The author claims that while this serves to protect businesses from unfair competition by non-taxpaying organizations it does not encourage innovation and development of useful technology. Thus, we should not put hurdles such as UBIT in the way of nonprofit organizations who are the most invested in the development of innovation. 

UBIT is portrayed by the author as a significant impediment to universities by encouraging them to research and create, but not see their invention through to the market by using the royalties tax exclusion in new ways. UBIT does so by channeling the activities of nonprofits not only to “passive” resources but also into areas “related” to their exempt purposes. The threat, not only of UBIT but of losing their exempt status, leads administrations to avoid the university’s research mission, the author contends. Research projects are pursued until the point they look like they might have commercial success and thereafter they sit idle waiting for some business to come along and discover them. Accordingly, the author concludes, “unique guardians of inventions…. [universities] should not relinquish their duties over their wards too soon.” His solution is to repeal § 511 altogether (although he mentions in passing he also supports a graduate moratorium of UBIT, a sunset provision for IP only, or a lower tax rate for universities on their UBI). At the end of the essay the author slightly agrees to limit the repeal of UBIT to a certain ratio of the business activity to the organization’s total revenue.

But the question remains, are we going to see greater innovation output and more jobs created by universities and nonprofits if we take off the UBIT ‘leash’? The author firmly determines that “universities can create jobs” but cites to Census and Kauffman Foundation data finding new jobs in the U.S. between 1980-2005 were created by young companies. Moreover, are universities more efficient in delivering innovations to the marketplace? The latter requires product development, marketing, and other commercial steps to successfully compete in the market. The author himself questions whether an exempt organization is an appropriate vehicle for business transactions and that his proposal bears “real risk of commercializing campus life”.

Missing in the essay is a discussion of the various agents in the innovation process. In Innovation Agents, 76 Wash. & Lee L. Rev. (2018), I posit that different innovation agents provide distinct kinds of social welfare. Each tells only part of the story of the evolving role of discoveries. Indeed, aside from for-profit players, essential innovations are also generated by nonprofit agencies and universities.  These innovation agents are instrumental in countering the “knowledge filter” and the tendency of certain innovation agents to place high screeners and barriers in their research.  For-profit innovation agents often decide not to pursue ideas that would ultimately lead to valuable innovations.  Some consider investments in “basic research” a wasteful expenditure because it carries no guarantee of enhancing the company’s earnings. For these reasons, other innovation conduits such as universities and nonprofit agencies are essential for cultivating discoveries that might otherwise be abandoned or lie dormant. For example, many universities fulfill an important role in developing drugs that treat rare diseases or uncommon conditions.

By its very nature, “basic research” generates enormous uncertainty. It is difficult to predict whether and when basic research will yield any financial benefit and, if it does, who will be the final beneficiary.  Yet, universities and nonprofit agencies are innovation agents that are not guided directly by market forces thus are more likely to engage in more basic building block type research than private markets.  These agents’ contributions tend to be rooted in extended periods of fundamental study and discovery.  Their lack of profit motive distinguishes them from private-sector agents, help fill a void, and ensure that basic research is undertaken regardless of its duration or ambiguity. Economic development, thus, depends upon the combined efforts and spillovers of various innovation agents such as entrepreneurs, intrapreneurs, universities, and nonprofits. Industry works and follows closely research and patent development. University patents proven to have commercial value will either be purchased, developed in collaboration, or copied toward their expiration period by the industry. Patents that remain stasis are not necessarily so due to UBIT.

Here’s the rest of this week’s SSRN Tax Roundup:

https://taxprof.typepad.com/taxprof_blog/2018/08/weekly-ssrn-tax-article-review-and-roundup-eyal-cohen-reviews-blacks-section-511-innovation.html

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