Editors’ Note: Ellen Aprill continues HistPhil‘s forum marking the 50th anniversary of the Tax Reform Act of 1969 with a post on the constitutionality of private foundation excise taxes. This post is adapted from an article that will be published in the spring issue of Pittsburgh Tax Review, based on papers presented to a symposium on the TRA held last November at the University of Pittsburgh School of Law.

One of the most significant parts of the Tax Reform Act of 1969, whose semi-centennial we have recently marked, was the enactment of Section 4941 of the Internal Revenue Code, which took aim at private foundation self-dealing.

This provision has, as a practical matter, forbidden almost all transactions, direct or indirect, between a disqualified person – an insider – and a private foundation. Under this provision, it does not matter whether the transaction results in a “benefit or a detriment to the private foundation.” The code lists five broad categories of self-dealing transactions, including any direct or indirect “transfer or use of the income or assets of the private foundation.” (Importantly, the few exceptions include one for reasonable compensation to a disqualified person for reasonable and necessary personal services.)

The category of disqualified person also reaches broadly. The term includes substantial contributors, foundation managers, certain of their family members and entities controlled by any of these. The initial or first-tier tax on the self-dealer is 10 percent of the “amount involved” with respect to the act of self-dealing for each year or part of a year in the taxable period. (A separate set of excises taxes applies to foundation managers who knowingly engage in an act of self-dealing.) The “amount involved” is the greater of the amount of money and the fair market value of the other property given or the amount of money and the fair market value of the other property received, valued as of the date of the act of self-dealing. The self-dealing transaction must be corrected to avoid the second-tier taxes of 200% of the amount involved for the self-dealer and of 50% of the amount involved for a foundation manager who refuses to agree to all or part of the correction of the amount involved up to a maximum of $20,000.

The fiftieth anniversary of the private foundation excise taxes is an appropriate time to confront foundational question about them. In fact, the tests announced in the 2012 Supreme Court case National Federation of Independent Business v. Sibelius (NFIB) calls upon us to reconsider the constitutionality and character of section 4941 of the Internal Revenue Code and other private foundation excise taxes.

In NFIB Chief Justice Roberts, joined by Justices Ginsburg, Breyer, Sotomayor and Kagan, upheld the individual mandate or shared responsibility payment of the Affordable Care Act (ACA) as constitutional, not under the commerce clause, but under Congress’s power to tax, despite Congress dubbing it a penalty. In reaching this conclusion, the Chief Justice articulated a set of tests for Congressional exercise of the taxing power under the Constitution. In doing so, he relied on several of the same cases as courts did in the 1980’s when reviewing challenges to the private foundation excise taxes.

Chief Justice Roberts, citing United States v. Kahriger (tax on gambling), described the essential feature of any tax as producing “at least some revenue for the government.” He noted Congressional Budget Office data that the ACA individual mandate was expected to raise $4 billion per year by 2017. The Chief Justice continued by contrasting the individual mandate to a so-called tax on child laborers:

Our cases confirm this functional approach. For example, in Drexel Furniture, we focused on three practical characteristics of the so-called tax on employing child laborers that convinced us the “tax” was actually a penalty. First, the tax imposed an exceedingly heavy burden—10 percent of a company’s net income—on those who employed children, no matter how small their infraction. Second, it imposed that exaction only on those who knowingly employed underage laborers. Such scienter requirements are typical of punitive statutes, because Congress often wishes to punish only those who intentionally break the law. Third, this “tax” was enforced in part by the Department of Labor, an agency responsible for punishing violations of labor laws, not collecting revenue.

Importantly, the NFIB opinion acknowledges that taxes can have a regulatory effect and purpose, and that they can affect behavior: “Every tax is in some measure regulatory. To some extent it interposes an economic impediment to the activity taxed as compared with others not taxed.”

The opinion also warns that “Congress’s ability to use its taxing power to influence conduct is not without limits,” that “there comes a time in the extension of the penalizing features of the so-called tax when it loses its character as such and becomes a mere penalty with the characteristics of regulation and punishment.” Further, “[i]n distinguishing penalties from taxes, this Court has explained that ‘if the concept of penalty means anything, it means punishment for an unlawful act or omission.’” NFIB concludes that “we need not here decide the precise point at which an exaction becomes so punitive that the taxing power does not authorize it.”

Cases from the 1980’s upholding various private foundation excise taxes as constitutional prefigure NFIB. While they do not rely on Drexel Furniture, they do rely on other cases that have a prominent place in NFIB. The Tax Court’s 1987 decision in Miller Charitable Fund v. CIR held constitutional another provision of the 1969 Tax Reform Act, the section 4942 excise tax on private foundations for failure to distribute income as required. The case acknowledged this excise tax was designed to address perceived abuses of the exempt status of private foundations. Relying on Sonzinky v. United States (tax on sawed-off shotguns) and United States v. Sanchez (tax on marijuana), as did the Supreme Court in NFIB, the Tax Court upheld the tax to be a constitutional tax “despite its regulatory purpose and effect.”

Other cases address section 4941 specifically. In 1982, a federal district court case, Rockefeller v. United States upheld the constitutionality of section 4941. The transaction at issue involved a first-tier tax, then 5%, on indirect self-dealing between a private foundation established in the will of Winthrop Rockefeller and his son for sales of stock at less than fair market value during administration of the estate. The court found such indirect self-dealing. As in Miller, the court upheld the private foundation excise tax as constitutional. It, too, relied on many of the same cases as did the Supreme Court decades later in NFIB – Sanchez, Sonzinsky, and Kahriger. The amount of the section 4941 tax in Rockefeller was enormous—$2,067,558.95, which included $341,865 in section 4941 taxes imposed for each of the calendar years of 1975 through 1980, plus $358,233.95 of interest. But language from the case would uphold the section 4941 excise tax even when it produces little revenue, as currently is the case. The court wrote, “Although § 4941 has a regulatory effect on the activities of charitable organizations and might not raise any revenue, it ensures that revenue will be collected under income, estate, and gift tax laws which otherwise might have gone uncollected.”

However, following a 1980 District Court case, Farrell v. United States, Rockefeller found section 4941(a)(1), the first-tier tax, to be a penalty for purposes of section 6601(3). Section 6601(3) imposes no interest on an assessable penalty if paid within ten days of notice and demand. Such was the case in Farrell, and thus, the executor was entitled to a refund of interest paid. Farrell relied on two earlier cases, both bankruptcy cases, to decide that section 4941 imposes a penalty. The bankruptcy cases turned on the definition of a penalty under the 1898 Bankruptcy Act as an enactment “which has as its purpose the punishment of conduct perceived as wrongful,” language reminiscent of NFIB. Farrell rejected the government’s argument that the definition of penalty under the bankruptcy code did not control its definition under the Internal Revenue Code.

As in the private foundations excise tax cases from the 1980’s, the character of section 4941 as a tax or a penalty seems uncertain under NFIB. NFIB acknowledges that a tax can have a regulatory intent and effect. At the same time, NFIB’s discussion of penalty turns, at least in part, not on the purpose of or motive for an assessment, but on its level—whether it imposes a heavy burden. Under a strong reading of NFIB, the first-tier tax on self-dealing might fail the case’s tests for a constitutional tax by taxing the entire amount of a self-dealing transaction and not just the amount by which the private foundation, and thus the public, is harmed. Even if the first-tier tax passes muster, the second-tier tax of 200% for failure to correct may exceed Congress’s taxing power. It gives a disqualified person little if any meaningful choice of whether or not to pay the tax. Further, the cases addressing section 4941 view its regulatory purpose as rendering self-dealing unlawful, another key characteristic of a penalty, according to NFIB.

Even if these excise taxes fail the NFIB tests for congressional exercise of the taxing power, they are unlikely to risk being held unconstitutional. As Professor Erik Jensen has observed, “[W]e need to remember that in most cases the tax-versus-penalty characterization will not matter. Unless the Commerce Clause is substantially reined in in subsequent cases, by far most governmental charges will continue to be valid whether characterized as penalties or taxes.” Nonetheless, in light of NFIB, private foundation excise taxes do not fit easily into either the category of constitutional taxes or constitutional penalties. The difficulty in characterizing section 4941, of course, may lie with NFIB itself. That is, applying NFIB to section 4941, rather than illuminating the excise tax provision, exposes the weakness of the Supreme Court’s distinction between a tax and a penalty.

Reviewing the cases involving the constitutionality of the private foundation excise taxes underscores another aspect of NFIB, that the constitutional meaning of tax is not identical to the term’s statutory meaning. Although NFIB upheld the individual mandate as a tax for constitutional purposes, it did not so characterize it for purposes of section 7421, the statutory provision known as the Anti-Injunction Act related to the timing of any judicial challenge to a tax, because Congress did not call the mandate a tax.

NFIB does not in this regard undermine the line of cases from the 1980’s treating section 4941 as a tax for constitutional purposes but as a penalty for at least some statutory purposes, such as imposition of interest. Still, the status of section 4941 is uncertain under both NFIB and under the private foundation cases from the 1980’s. If section 4941 is to be viewed under NFIB constitutionally as a tax and not a penalty, such reconsideration questions the wisdom of imposing the section 4941 excise tax on self-dealing transactions that benefit private foundations and of setting the second-tier tax at a confiscatory 200%. If we view it instead as a penalty, then the questions become whether the first-tier tax is high enough to deter self-dealing in an era of low enforcement and why, unlike other private foundation excise taxes, the IRS has no authority to abate the first-tier tax in any circumstance. Thus, how we characterize section 4941 matters. It affects how we evaluate its success and what changes we conclude would improve its effectiveness.

-Ellen Aprill

Ellen P. Aprill is John E. Anderson Char in Tax Law at Loyola Law School. Before coming to Loyola in 1989, Aprill served for two years in the Office of Tax Policy in the United States Department of the Treasury, and practiced for several years with the law firm of Munger, Tolles & Olson in Los Angeles.