The College Tax Scam: Addressing University Exploitation of The 501(c)3 Tax Status

In the past decade, the tax-exempt status held by higher education institutions has come under increased scrutiny. In 2016, Congress sent a letter to private institutions with endowments over $1 billion, challenging the increase in tuition at rates far above inflation, despite these institutions’ large and growing assets. [1] A significant portion of this growth in college endowments has come from huge land-holdings, with universities paying essentially no property tax as they are 501(c)3 organizations. For example, while imposing massive tuition increases, Columbia University has become the largest landowner by number of addresses in New York City, owning 209 properties, with the next largest private property-holder being New York University (NYU). [2] Columbia and other universities' commercial land holdings illustrate that their organizations are not being exclusively operated as academic or research centers and, therefore, lack justification for 501(c)3 benefits. However, the most egregious display of 501(c)3 status abuse still lies in the college sports complex. 

To understand why there exist so many alleged abuses of universities’ tax status, specifically with regards to college sports, it is necessary to return to the original intent of the tax system. The 1969 Tax Reform Act created universities’ tax-exempt status by developing Section 501(c)3 of the Internal Revenue Service (IRS) Code: to support public goods such as education and philanthropy. [3] However, the growing college athletics complex actively detracts from the educational mission that qualifies colleges for tax-exempt status, invalidating their eligibility for 501(c)3 benefits. Furthermore, this issue is exacerbated by a lack of resources possessed by the IRS to enforce its own legal provisions. Therefore, new legislation must be created to enforce these requirements. 

Section 501(c)3 stipulates that every religious, charitable, scientific, literary, or educational organization in the United States that fits certain requirements is a private foundation and, therefore, qualifies for tax benefits. [4] The rationale behind exempting 501(c)3s is straightforward: instead of paying taxes to the government, they can use that money to further invest in the public goods they are providing, which may have a greater impact than government spending. Fundamentally, this section of 501(c)3 highlights that charities must be set up exclusively for the purpose of qualifying for that tax exemption. [5] 

Given these qualifications, college sports cannot be classified as a tax-exempt endeavor, since their profits are not being invested in educational pursuits. Instead, universities are investing their sports profits into paying for lucrative coaching contracts, upgrading sports facilities, and accruing further sponsorships. The IRS has recognized this issue and, on May 2, 2013, the agency’s Exempt Organizations division released the Colleges and Universities Compliance Project final report, in which the division audited 34 organizations, revealing several areas of noncompliance related to the underreporting of Unrelated Business Taxable Income (UBTI). [6]  The most underreported taxable income was related to the following athletic-dominated areas: fitness, recreation centers and sports camps, advertising, facility rentals, arenas, and golf. The report also found that the compensation of head coaches and investment managers often greatly exceeded salaries of the president of the college/university and other key school officials. At the end of the report, the IRS issued written advisories to twenty-four institutions on a number of activities that could result in tax liability in the future, which failed to adequately punish the colleges. [7] This report highlights both that colleges are using their 501(c)3 status to shield otherwise taxable revenue from the IRS and that they are disproportionately funding their athletics compared to their academics. In turn, this directly violates colleges’ 501(c)3 status, as the IRS has admitted that universities are pursuing non-educational endeavors that would disqualify their non-profit, tax-exempt status. 

Section 501(c)3 specifically includes three primary requirements for a university to meet this tax-exempt  status: (1) no institution-sanctioned lobbying activities; (2) an independent board that serves public interests; and (3) offering instruction on publicly useful subjects. [8] Evidently, one of the glaring problems with universities receiving tax-exempt status is that college sports teams accrue billions of dollars in revenue from sponsorships and ticket sales without paying taxes. By deriving revenue from a non-academic endeavor, the school cannot claim to be set up exclusively for an academic purpose. In fact, these ventures often detract from academics, as a recent study has shown that spending per-athlete has increased by 25 percent over recent years, while instructional spending has essentially plateaued. [9] Therefore, athletics actually threaten the tax-exempt status for the entire university, not just athletic revenue. 

The question then becomes whether the colleges’ affiliation to non-academic, often profitable activities, such as athletics and real estate, invalidates their 501(c)3 status. First, Congress has already recognized that profitable ventures attached to non-profit universities invalidate at least that component of the university's revenue from tax exemption. This decision was affirmed by the U.S. Court of Appeals for the Third Circuit in C. F. Mueller Co. v. Commissioner of Internal Revenue (1951). NYU School of Law attempted to apply its tax-exempt status to profits generated by C. F. Mueller Company, a for-profit pasta maker that had been donated to its law school in 1947. [10] However, the Court of Appeals found that even this indirect connection to non-academic profits made these revenues taxable under the unrelated income business taxes (UBIT). [11] The Mueller case, when applied to college sports, highlights that even universities that reinvest athletic-related funds into academics are not entitled to claim tax exemption for their revenue from athletics. The crux of this decision directly applies to college sports, as these revenues, even if reinvested in an academic form, are taxable. 

However, the university is not actively investing these earnings in education. Therefore, the organization is not exclusively operating to serve its “social-good” qualifying purpose—which violates its status as a 501(c)3 organization. Quantitatively, in 2019, universities collectively generated $18.9 billion dollars from TV deals, sponsorships, and ticket sales, which ultimately translated to greater spending in athletics, without any proportional increase in academic expenditure. [12] Thus, tuition has increased in part due to greater athletic investment that has simultaneously detracted from education, which demonstrates that colleges are no longer set up exclusively for their stated 501(c)3 purpose.

The controversy over college athlete pay, moreover, underscores the true nature of athletics as an enterprise lacking an educational mission. Over the past few decades, college athletes have clamored for income, as they generated millions of dollars for universities off of their jersey sales, sponsorships, and ticket sales. However, universities have never acquiesced to athletes’ demands to be paid, since it would result in the university losing income and questions surrounding their status as a 501(c)3. [13] Universities and athletic conferences instead contend academics and sports are intertwined. The Atlantic Coast Conference, for its part, argues that college sports “seek to maximize the educational and athletic opportunities of its student-athletes, while enriching their quality of life.” [14] This allows student-athletes to be considered unpaid amateurs partaking in an extracurricular activity, rather than a profitable profession and, therefore, enables college sports to be deemed as educational. 

However, the Supreme Court’s decision in The National Collegiate Athletic Association (NCAA) v. Alston (2021) signaled a fundamental shift in this distinction, by ruling that college athletes were allowed to be compensated. [15] The Supreme Court upheld the lower court’s decision that NCAA restrictions on “education-related benefits” for college athletes violated antitrust laws. In turn, this allowed college athletes to gain their own sponsorships. Importantly, the Supreme Court recognized that college sports do not serve an explicit academic purpose and again challenged the colleges’ claim to being exclusively an educational and research institution. 

Furthermore, the power of sports and its negative influence on academics has been evident in numerous scandals over the last decade. Most recently, Operation Varsity Blues (OVB) exposed the problem of admitting athletes without the requisite academic credentials that hurts the educational opportunities of all students, especially those who lost their place to the athletes. [16] There have been many other cases involving athletes at universities and their ability to work around the education system, without having to uphold the same academic rigors as their peers. 

Strikingly, the IRS has limited oversight in terms of evaluating if educational institutions are meeting all of the requirements laid out in this section of the Internal Revenue Code (IRC). [17] Without the capability to monitor all aspects of tax-exempt status, universities operate almost unchecked. It is imperative that additional legislation is passed to create a new branch of the IRS dealing with nonprofits—ensuring they are continuously meeting their nonprofit status. If universities were to lose their tax-exempt status, the new revenue accrued by the federal government could help other educational initiatives and, in turn, right the wrongs currently being committed by U.S. college sports programs. 

The first step that should be taken to solve this problem is an audit of all universities that have major sports programs. From this, the IRS can determine how much money is being allocated towards educational endeavors from the money made from college sports. The IRS can set a threshold for how much money needs to be reinvested back into the educational component of the university or, alternatively, taxed. Furthermore, the IRS needs to constantly monitor universities to make sure they are allocating their revenue streams to academics and, if not, ensure they pay taxes on their business endeavors. 

Another possible solution to this problem would be to alter the tax structure for colleges and universities on all non-educational endeavors, with colleges falling into tax brackets based on the tuition they charge. This would curb the rising cost of tuition that plagues millions of students in America, since colleges would be incentivized to have lower tuition prices in return for a lower tax rate. Colleges would be allowed to keep aspects of their 501(c)3 status even on their endeavors that are not related to requirements by making education more equitable: lowering tuition prices in exchange for lower tax rates. This would be a great equalizer in forcing universities to invest more in their educational goals and supporting their students. Ultimately, it is imperative for the IRS to look into the problems inherent in universities where for-profit ventures, unrelated to education, go untaxed by the federal government. 

However, it is equally important to note that college athletics would undergo serious change if they became taxed by the federal government. Potentially, this could have an overall negative effect on a university that specifically markets athletics to prospective students. Top sports schools are a major attraction to students when choosing which school to attend. Furthermore, alumni donations heavily revolve around sports programs, which may weaken the financial backing of universities if the athletic complex is forced to comply with taxation law; sports programs would undoubtedly falter if they became taxed, as significantly less money would be spent on sports programs. However, though colleges would undergo significant change, it is important that all organizations that meet 501(c)3 standards are fulfilling their obligations.

Edited by Zac Narimanian

Sources

[1] Stephen Gandel, Big University Endowments Make Billions in Returns in a Bumper Year, The New York Times (2021), online at https://www.nytimes.com/2021/10/15/business/university-endowments.html (visited April 10, 2022). 

[2] Tanay Warerkar, New York's 10 Biggest Property Owners, Curbed NY (2018), online at https://ny.curbed.com/2018/9/14/17860172/new-york-10-biggest-property-owners (visited April 10, 2022).

[3] 26 U.S.C. § 141. 

[4] Id. 

[5] Exemption Requirements - 501(c)(3) Organizations, Internal Revenue Service, online at https://www.irs.gov/charities-non-profits/charitable-organizations/exemption-requirements-501c3-organizations (visited April 11, 2022). 

[6] U.S. Internal Revenue Service, Colleges and Universities Compliance Project Final Project, Washington D.C.: 2013, https://www.irs.gov/pub/irs-tege/CUCP_FinalRpt_050213.pdf (accessed April 9, 2022).  

[7] Id. 

[8] Exemption Requirements - 501(c)(3) Organizations. 

[9] Congressional Research Service, 501(c)(3) Organizations: What Qualifies as 'Educational'?, by Erika Lunder. R42673, Washington D.C.: 2012, https://sgp.fas.org/crs/misc/R42673.pdf (accessed April 9, 2022). 

[10] C. F. Mueller Co. v. Commissioner of Internal Revenue, 190 F.2d 120, 120 (3d Cir. 1951).

[11] Id.

[12] Felix Richter, Infographic: U.S. College Sports Are a Billion-Dollar Game, Statista Infographics (2021), online at https://www.statista.com/chart/25236/ncaa-athletic-department-revenue/ (visited April 10, 2022).

[13] Mike Mcintire, The College Sports Tax Dodge, The New York Times (2017), online at https://www.nytimes.com/2017/12/28/sunday-review/college-sports-tax-dodge.html (visited April 9, 2022).  

[14] Id.

[15] National Collegiate Athletic Association. v. Alston, 594 U.S. 26 (2021).

[16] Kirsten Hextrum, “Operation Varsity Blues: Disguising the legal capital exchanges and white property interests in athletic admissions,” 5 Higher Education Politics & Economics 15, 18 (2019).  

[17] U.S. Government Accountability Office, Tax-Exempt Organizations: Better Compliance Indicators and Data, and More Collaboration with State Regulators Would Strengthen Oversight of Charitable Organizations, by James R. McTigue Jr. GAO-15-164, Washington D.C.: 2014, https://www.gao.gov/assets/gao-15-164.pdf (accessed April 5, 2022).