Monday, March 18, 2013
A hot topic in legal education recently has been the concept of law schools opening affiliated law firms as a way to "bridge the gap" from law school to practice. For several links about the concept, visit Paul Caron's Tax Prof Blog and Johnny Buckles' prior post (along with the perceptive comment) here.
Would law schools opening law firms for students create tax exemption problems? My view is "almost certainly not" though the issues depend in part on the exact structure involved. While I could probably write a book-length post about this, I'll try to simply highlight what I see as the key issues and a few thoughts.
First, I'll address a situation in which a law school operates a law firm as a part of the law school (e.g., the firm is not a separate legal entity).
The main question raised by this structure (a law school operating law firm as an "operating division" of the school itself) is whether the "commerciality" limitation somehow imperils the law school's tax exemption (this is probably only an issue if the law school is a private institution; state university law schools generally do not have to rely on Section 501(c)(3) for tax exemption; state universities are exempt either under Section 115 of the code as an "instrumentality" of state government or by simple constitutional principles of federalism; Ellen Aprill at Loyola Los Angeles has written the bible about this issue).
While the commerciality limitation is very complex, I have little doubt that it poses no trouble for law schools running law firms. Commercial activity raises essentially two issues for charities. The first is whether the activity endangers their tax exemption. The second is whether, if the activity is OK from an exemption standpoint, the activity will nevertheless be subject to tax under the Unrelated Business Income Tax (UBIT). These issues are related, but not the same.
Let's concentrate on the exemption issue. The regulations make clear that charities can engage in some activity that is not itself charitable. The way the regulations put it is that a charity must engage "primarily" in activities that further its charitable purpose and cannot engage in more than an "insubstantial" amount of activities that are not "in furtherance of" a charitable purpose. See Treasury Regulations 1.501(c)(3)-1(c)(1).
While there is some disagreement regarding what the phrase "in furtherance of" means in this regulation, the way I analyze these problems is by first classifying commercial activity as "related" or "unrelated" activity per the unrelated business income tax. If a commercial activity is "related" under the UBIT, then it is no problem whatsoever for the charity, because the test for relatedness under the UBIT requires "functional" relatedness - that is, the commercial activity has to be closely connected to the charity carrying out its exempt purpose. This test is not met simply because an activity provides an income source for the charity to spend on charitable works; the regulations state that to be related, there must be a "causal connection" between the activity and the charitable purpose. Regs. 1.513-1(d)(2). A commercial activity that meets this test for UBIT purposes is virtually certain to be an activity that is "in furtherance of" a charity's charitable purpose for purposes of Regs. 1.501(c)(3)-1(c)(1), and hence is not a problem. In fact, Example 1 in the regulations, dealing with a performing arts school that charges admission for student performances, isn't far-removed from the law school law firm.
If an activity is unrelated, then in theory that activity can create exemption problems for the charity. This is where those of us that work in the area disagree; some people believe that an unrelated activity must be "insubstantial" (whatever that may mean) in order to avoid exemption problems. I take a different view: I think that an unrelated activity can be "unlimited" in size as long as revenues from that activity are being used by the charity to expand charitable outputs. See, e.g., John D. Colombo, Reforming Internal Revenue Code Provisions on Commercial Activity by Charities, 76 Fordham L. Rev. 667, 671-74 (2007).
But I don't think we get to that latter question here. If law schools operate a law firm as part of the educational enterprise to bridge the gap between law school and practice, I have little doubt that the law firm would be viewed as "related" activity under the UBIT, and hence simply not a problem. The law-school-operated-firm is pretty clearly advancing the educational mission of the law school; if an art museum can sell art reproductions in its museum store as a means of furthering its educational mission (see Rev. Rul. Rev. Rul. 73-104, 1973-1 C.B. 263), there really isn't much to argue about with the law-school law firm. (Another relevant precedent is the "medical practice plan" used by some medical schools for their faculty to practice medicine as a means of both supplementing their salary and sharpening their practice skills; while the IRS at one time challenged exemption for these practice plans, the agency lost a series of cases and eventually gave up. See, e.g., University of Massachusetts Medical School Group Practice Plan v. Comm'r, 74 T.C. 1299 (1980). If a medical school can open a for-profit medical clinic for its faculty, I don't see a law school opening a law firm for its students/recent graduates as much of an issue).
So my conclusion is that a law-school operated law firm is a "related" activity under the UBIT, and therefore poses no commerciality problems to the law school's underlying exemption. That conclusion also means that the revenues from the firm would not be taxed under the UBIT.
A more interesting question arises if the law firm is a separately-incorporated entity. In this case, the issue would be whether this separate entity would qualify for a charitable tax exemption at all. I personally find this a closer case. The IRS's position is that separate corporate entities must "stand on their own" for exemption purposes - the law firm in this case would have to have its own charitable purpose. One possibility, of course, is that the law firm would be exempt as an educational organization - after all, the purpose here is still an educational one: to give third-year students or recent graduates specific skills training as a bridge to private practice. But the IRS takes a dim view of organizations claiming exemption when all they do is operate a for-profit business. While a law firm whose primary purpose was to represent the poor would have an easy claim to exemption, the IRS's general view is that providing services to people who can pay for them, like the middle class, isn't a charitable purpose. See Rev. Rul. 70-585, 1970-2 C.B. 115, Situation 4, where the IRS held that an organization whose purpose was to build affordable middle-class housing in an otherwise wealthy neighborhood was NOT a charitable purpose. Even nonprofit hospitals must provide "something extra" beyond simply providing health services to paying patients to qualify for exemption. See IHC Health Plans v. Comm'r, 325 F.3d 1188 (10th Cir. 2003). So I'm not entirely sure that a separately-incorporated "bridge" law firm would get exemption. It would be very interesting to see how the IRS would rule on such a creature.
But if the law school operates the firm as part of the law school legal entity, I just don't see much of a problem from an exemption perspective. Perhaps some others would like to chime in via the comments section with their own analysis (the comments are moderated, so it might take a day or so for them to show up).