- Cullman, Alabama


May 16, 2013

COMMENTARY: How Nonprofits Came to Acquire Their Tax-Exempt Status

The uproar over allegations of politically motivated investigations by the Internal Revenue Service shouldn't be surprising given Americans' long love affair with nonprofits and their strong disdain of partisanship, especially within bureaucracies.

After independence, and especially after ratification of the Constitution, Americans began forming businesses, charities and other associations at unprecedented rates. Unshackled from British law and the threat of monarchical tyranny, they sought to invest in long-term stability, and in each other, in ways that required the establishment of large and lasting organizations.

To create these institutions, early Americans adapted corporate laws from Britain. At first, incorporation required both for-profit and nonprofit organizations to obtain a charter from state governments. Charters were special laws passed by state legislatures and signed by governors under the rules of state constitutions.

Before the Civil War began in early 1861, more than 22,000 businesses and untold numbers of churches, charities, promotional associations and other nongovernmental organizations incorporated.

While not all successfully began operations or lasted very long, business corporations supplied much of the nation's early transportation infrastructure, financial services, manufacturing and mining production, and utilities (water power, potable water, gas lighting and telegraphs). Similarly, nonprofit corporations provided early Americans with many religious, charitable, educational, literary and promotional services.

Special incorporation, however, spawned political favoritism. New York, for example, denied the Bank of New York a charter from 1784 until 1791 for purely partisan reasons: The bank was controlled by Federalists while the governor and his allies in the legislature were Democrats. In the early 19th century, politicians also denied the Merchants Bank of New York a charter for several years. Other entrepreneurs across the United States also complained that their charter applications were denied for purely partisan reasons.

Luckily for the development of the U.S. economy, early entrepreneurs stymied by state governments had several other options. They could charter in another state, as several banks did in New Jersey when New York proved intransigent. At some risk, entrepreneurs could also form an unincorporated joint-stock association and contractually assert the legal advantages held by duly chartered corporations, including perpetual succession, entity shielding and defined liability.

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