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sharply different tax treatment because one just barely meets the test and escapes the private foundation rules, while the other just misses the test and falls subject to all of them. The bill would be quite arbitrary in its application.

(2) Limitations ought to be imposed upon all exempt organizations or upon none. To do otherwise, from this viewpoint, results in a discrimination which must not be allowed in the tax laws.

10. Private Operating Foundation Definition

Present law.-"Operating foundation", a term not found in present law, is sometimes used to describe the type of organization, contributions to which qualify for the unlimited charitable contribution deduction under present law but nevertheless do not qualify under the 30-percent deduction provision. (See Tax Treatment of Charitable Contributions, below.) In order to qualify for such treatment under present law, substantially more than half the organization's assets and substantially all its income must be used or expended directly for its exempt purposes or functions.

Problem. Certain types of organizations which are included in the category of private foundations largely depend for their source of funds upon contributions from other private foundations. Although such organizations perform useful work, nevertheless, many of the problems giving rise to the limitations described above appear to be present in the case of these organizations.

House solution.-The bill provides that an "operating foundation," eligible to receive qualifying distributions from other private foundations (but otherwise subject to the limitations imposed upon private foundations) is an organization substantially all of the income of which is expended directly for the active conduct of its exempt purposes or functions, provided that either (1) substantially more than half its assets are devoted to such activities or to functionally related businesses or (2) substantially all its support (other than from endowments) is normally received from at least 5 independent exempt organizations and from the general public (but no more than 25 percent of its support may be received from any one such exempt organization). These two categories of organizations relate generally to (1) museums and similar organizations and (2) special-purpose foundations, such as learned societies, associations of libraries, and organizations which have developed an expertise in certain substantive areas and which receive grants of funds and direct their research in those specified substantive areas.

Arguments For.-(1) Operating foundations make a significant contribution to the framework of American culture. The bill recognizes an operating foundation is carrying out its charitable purpose and perly permits private non-operating foundations to pay over their own income to it.

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(2) The provision permitting private foundations to make grants to such institutions may be important to the preservation of major sources of learning.

Arguments Against.—(1) The bill is discriminatory because while it

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allows a grant to be made to an operating foundation which is supported by at least five independent private foundations, it would not allow a grant to a foundation which received its support from one (or less than five) private foundations. An organization in the latter category which is engaged in worthy, and beneficial programs should also be treated as an operating foundation.

(2) Museums, etc., may range from the world-famous Smithsonian Institution to organizations which are little more than the whim of a wealthy person. Blanket exemptions for such organizations would point to a route for easy avoidance by private foundations generally. (3) Operating foundations should not be subject to any of the limitations imposed upon private foundations generally. (In rebuttal, it is noted that this might provide too great an incentive for private foundations to avoid the limitations by creating operating foundations which they control.) It is contended by others that operating foundations ought to be subject to the same rules as private foundations.

11. Hospitals

Present law. Hospitals qualify for exempt status and may receive deductible charitable contributions as "charitable" organizations.

Problem.-It has been contended by some agents that hospitals (unlike educational organizations, churches, and others) must provide some significant amount of charitable services on a no cost-or-loss basis in order to be exempt as "charitable" organizations.

House solution.-The bill provides that hospitals are to have the same status as churches and educational institutions for purposes of tax exemption, charitable contributions, and a variety of other matters. The other requirements for exemption-no inurement of profits to private individuals, operation and organization exclusively for exempt purposes, no substantial legislative activities, and no political electioneering activities continue to apply to hospitals.

Arguments For.-(1) These provisions are necessary to eliminate challenges to the tax-exempt status of hospitals on the ground that the hospitals are accepting insufficient numbers of patients at no charge or at rates that are substantially below cost.

(2) By establishing hospitals as a separate exempt category and removing the indefinite test of to what extent a hospital must serve. those who cannot pay, this bill removes the uncertainty surrounding the hospital's continued ability to draw necessary support from the public or from private foundations to accomplish its function.

(3) Hospitals perform a useful function of the sort that deserves treatment in section 501 (c) (3) on the same basis as the other organizations specifically named in that provision.

(4) The present environment of governmental assistance to permit medical care to be made available to those otherwise unable to pay, appears to make obsolete the need for hospitals themselves to subsidize the providing of medical care to poor people. This is as true regarding hospitals as it is regarding schools and churches.

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Arguments Against.—(1) In order to be tax exempt, hospitals historically have been required to render service to the poor whether or not there was an ability to pay for the services rendered. These provisions would do away with that requirement and many marginal income families that are now ineligible for payment of hospital care under Medicaid, and who do not have sufficient resources to pay for hospital treatment might be denied care now available to them. This is especially true in States that do not pay for hospital care of people who are eligible for general assistance under the welfare programs of the State. The bill will pose particular hardships on poor families priced out of hospital care by continually rising health costs and this will put greater pressure on Congress to expand the Medicaid program at the very time Congress is seeking to contract and moderate

it.

(2) To the extent hospitals contend Medicare and Medicaid does not pay their full costs they would also contend that they are providing charitable services for those patients. If the bill were not changed these hospitals could refuse Medicare or Medicaid patients with impunity or could limit their services to such patients unless the Government met the hospitals' unilateral cost demands. Without the balancing effect of the present Internal Revenue Service position, government might be faced with the choice of either complying with such payment ultimatums or seeing millions of poor and aged citizens denied necessary care in community nonprofit hospitals.

(3) There is no substantial evidence that contributors to hospitals will decrease or stop their donations because the Internal Revenue Service is questioning the tax-exempt status of a hospital (or hospitals) on the ground that sufficient charitable services are not being rendered to the poor.

(4) The extent of free and "below cost" hospital care has diminished greatly with the advent of public programs such as Medicare and Medicaid. The pressure to provide free care has lessened to the extent that these multi-billion dollar programs and private hospital insurance are now paying for many of those whose bills previously went unpaid.

(5) The bill discards the charitable basis-the "community service to all" concept-on which tax exemption of hospitals is founded.

(6) If there is a legitimate complaint that Internal Revenue rulings are too vague on this point, a clarifying amendment establishing statutory standards is the appropriate remedy rather than the blanket approach of the House provision.

(7) Since the need for new legislative language has arisen because of uncertainties in administration, then the resolution of such uncertainties could be handled on an administrative basis.

12. Effective Dates

The provisions described above apply to taxable years beginning after December 31, 1969, except that additional time is permitted in the case of existing organizations to reform their governing instruments to conform to the new law as to business holdings and distributions of income. Also the 5-percent minimum distribution requirement will not apply, in the case of existing organizations, until taxable years beginning after December 31, 1971. However, any organization

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that was a private foundation (under the rules of this bill) for its last taxable year ending before May 27, 1969, will be subject to the bill's requirements until it terminates its status as described previously in Change of Status.

B. OTHER TAX-EXEMPT ORGANIZATIONS

1. The "Clay Brown" Provision or Debt-Financed Property Present law.-Under present law, charities and some of the other types of exempt organizations are subject to tax on rental income from real property to the extent the property was acquired with borrowed money. However, this provision does not apply to all tax-exempt organizations and there is an important exception which includes rental income from a lease of 5 years or less. Nor does the tax apply to income from the leasing by a tax-exempt organization of assets constituting a going business.

Problem. During the past several years weaknesses in the present provision relating to debt-financed property have been exploited in several different respects. As a result a large number of tax-exempt organizations have used their tax-exempt privileges to buy businesses and investments on credit, frequently at what is more than the market price, while contributing little or nothing themselves to the transaction other than their tax exemption.

In a typical Clay Brown situation a corporate business is sold to a charitable or educational foundation, which makes a small or no down payment and agrees to pay the balance of the purchase price out of profits from the property. The charitable or educational foundation liquidates the corporation, leases the business assets back to the seller, who forms a new corporation to operate the business. The newly formed corporation pays a large portion of its business profits as "rent" to the foundation, which then pays most of these receipts back to the original owner as installment payments on the initial purchase price. In this manner in the Clay Brown case (1965 Supreme Court case), a business was able to realize increased after-tax income, and the exempt organization acquired the ownership of a business valued at $1.3 million without the investment of its own funds. In the recent (1969) University Hill Foundation case, the Tax Court upheld the acquisition of 24 businesses by the University Hill Foundation in the period 1945 to 1954. Other variants of the debt-financed property problem have also been used.

House solution.-The House bill amends the code to provide that all exempt organizations' income from "debt-financed" property is to be subject to tax in the proportion the property is financed by debt. Thus, for example, if a business or investment property is acquired subject to an 80 percent mortgage, 80 percent of the income and 80 percent of the deductions are taken into account for tax purposes. As the mortgage is paid off, the percentage taken into account diminishes. Capital gain on the sale of debt-financed property is also taxed. The amendment makes exceptions for property to be used for an exempt purpose within a reasonable time, and also for property acquired by gift or inheritance under certain conditions. Also there is a special exception for the sale of annuities, and for debts insured by the

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Federal Housing Administration to finance low and moderate income housing. For years before 1972, only indebtedness incurred on or after June 28, 1966, will be taken into account.

Arguments For.-(1) This provision would cure the defect in the present law which allows an exempt organization to acquire a going business for an inflated price, without the investment of its own funds, and pay the owners from the untaxed earnings of the business.

(2) The bill creates fair competition between tax-free and taxpaying organizations seeking to purchase a going business.

(3) The bill discourages an owner of a going business from seeking to sell it to a tax-free organization in an arrangement by which he in effect, converts his ordinary income from the operation of that business into a tax-favored capital gain.

(4) Tax-exempt organizations should be taxed on their debtfinanced income because in such cases they are, in effect, using their tax-exempt status to "earn" income for them. It is suggested that the exemption was intended simply to remove from tax income on contributions from the general public, not as a tool for generating income without public contribution. In this regard, both the United States Catholic Conference and the National Council of Churches have expressed approval both of the objectives and the approach of the House bill.

Arguments Against.-(1) Other provisions of the bill extend the unrelated business income tax to organizations which previously were tax-exempt on income from a going business. Thus, they can no longer purchase a business with tax-free earnings, and this provision of the bill is now unnecessary.

(2) Rather than devise special rules for business purchased by taxexempt organizations, the general rules of the bill governing debtfinanced acquisitions could be applied.

(3) The House provisions go too far in that they apply to debtfinanced cases whether or not the property is leased back to the sellers.

(4) This is an infringement on the tax-exempt status generally available for charitable organizations with respect to investment income

2. Extension of Unrelated Business Income Tax to All Exempt Organizations

Present law. Under present law the tax on unrelated business income applies only to certain tax-exempt organizations. These include: (a) Charitable, educational, and religious organizations (other than churches or conventions of churches);

(b) Labor and agricultural organizations;

(c) Chambers of commerce, business leagues, real estate boards, and similar organizations;

(d) Mutual organizations which insure deposits in building and loan associations and mutual savings banks; and

(e) Employees' profit sharing trusts and trusts formed to pay (nondiscriminatory) supplemental unemployment compensation.

Problem. In recent years, many of the exempt organizations not now subject to the unrelated business income tax-such as churches, social clubs, fraternal beneficiary societies, etc.-have begun to engage