Recently, the Internal Revenue Service has come under scrutiny for targeting certain conservative groups (e.g., tea party) with respect to applications for exempt status for income tax purposes. Congress will undoubtedly hold more hearings, and a special prosecutor may be appointed. It will be great TV for the cable channels. Witnesses already can’t remember anything, and a key IRS person has already tried to apply her Fifth Amendment rights (however, only after she made a self-serving statement that, according to Alan Dershowitz, waived her Fifth Amendment rights). Of course, some in Congress have already attributed this to the president and have mentioned impeachment. Enough of that. You can follow it in the tabloids (uh, newspapers) or cable TV. This article explains the entities that are involved in the targeting by the IRS. The applicable entities are exempt from income tax under section 501(c)(4) of the Internal Revenue Code. Such entities are commonly referred to as “social welfare” organizations. Why have these entities become so popular with politically oriented groups? And why do these entities seek an exemption under section 501(c)(4) instead of section 527, which should be the obvious choice for entities involved in the political process because section 527 generally provides a tax exemption for political organizations. Let’s take a closer look. Section 501 of the Internal Revenue Code exempts from taxation certain organizations. Perhaps the most well-known tax-exempt entities fall under section 501(c)(3) of the code and typically operate exclusively for religious, charitable or educational purposes. Section 501(c)(4), on the other hand, provides an exemption to “social welfare” groups. Such entities are unique among the world of tax-exempts because limited electoral advocacy has long been considered a legitimate activity for such entities. Probably the most important feature of such entities is the ability of their donors to remain anonymous to the general public. Contributions to such organizations are not tax-deductible and not currently subject to gift tax. Some of the entities involved in the current controversy have tried to qualify as charities under section 501(c)(3) so that their donors could deduct their contributions, but charities are subject to many more requirements and restrictions than 501(c)(4) entities. For example, charities are not allowed to pursue a lobbying agenda. The AARP, the National Rifle Association and the Sierra Club are a few examples of politically engaged 501(c)(4) organizations that do not qualify for charitable status due to political involvement. Many social welfare organizations conduct activities of a charitable or educational character and might qualify for tax exemption under 501(c)(3) but for the fact that they engage in lobbying or other political activities on a scale not permitted by that designation. Although contributions to a 501(c)(4) entity offer no tax benefit to the donors, that designation exempts from tax the organization itself. So are 501(c)(4) organizations always political? No. Odds are your homeowners’ association is such an entity. Indeed, politics cannot be the primary activity of a 501(c)(4) organization. To qualify as a social welfare organization, the entity must operate primarily to further the common good and general welfare of the people of the community (for example, by bringing about civic betterment and social improvements). What constitutes civic betterment and social improvement is, of course, subject to interpretation. But it is firmly established, at least for now, that seeking legislation related to the organization’s civic purpose is a permissible activity for the organization, so long as that activity is not its primary focus. So why seek a tax exemption under section 501(c)(4) instead of section 527? After all, section 527 generally exempts from tax political organizations engaged in selection, nomination, election, or appointment of any individual running for office. Organizations qualifying for tax-exempt status under section 527 typically include political parties, action committees, and so-called “super PACs.” Why risk additional scrutiny from the IRS for obtaining a 501(c)(4) status when instead an organization could qualify under section 527 and offer the same tax consequences to the donors and the entity? The preference for 501(c)(4) is usually caused by certain donors’ desire for anonymity in making the contributions. The law requires section 527 entities to disclose donors who give $200 or more to the organization during the tax year. The disclosed information is made public and is available online. The disclosure can be avoided, but only if the organization is willing to pay a 35 percent tax on the amount of contribution. On the other hand, Section 501(c)(4) entities are not required to make any public disclosures revealing their donors. They must, however, disclose to the IRS the name and address of any donor who contributes more than $5,000 in money or property during the tax year, but the IRS generally cannot make this information public. Generally, taxpayers do not receive a tax deduction for making political contributions. The denial of a charitable deduction for donations to social welfare organizations is thus consistent with the nondeductibility of most lobbying expenses and all political contributions, even if they serve the taxpayer’s business interests. On the other hand, critics of 501(c)(4) organizations have argued that the anonymity afforded to those donors is inconsistent with the disclosure regime of the Federal Election Campaign Act. The same critics have questioned whether the interpretation of section 501(c)(4) as permitting social welfare entities to engage in political campaign activity is altogether erroneous and contradictory to the language of the statute. Congress drafted section 501(c)(4) to grant tax-exempt status to organizations “operated exclusively” for the promotion of social welfare. The Treasury, in interpreting this language, stated that an organization must be “primarily engaged” in promoting the common good or general welfare rather than politics. In other words, according to the Treasury, an organization operates “exclusively” for social welfare when it “primarily” engages in qualified activities. The critics argue that the Code should be read to allow 0 percent of the expenditures on political activities, whereas the regulations can arguably be read to allow 49 percent. Recently, a lawsuit emphasizing this inconsistency has been filed against the IRS by David Gill, a former Democratic candidate for the Illinois 13th Congressional District. According to Citizens for Responsibility and Ethics in Washington, one of the parties in the suit, Gill was favored to win the race until the American Action Network, a 501(c)(4) organization, spent $1.5 million on political advertising against him. On May 29, the conservative American Center for Law and Justice also filed a lawsuit on behalf of 25 tea party and conservative organizations against the IRS alleging that the agency and the Obama administration unlawfully delayed, and therefore effectively denied, approval of 501(c)(4) status to the organizations. Questions have also arisen regarding the applicability of the gift tax to contributions to 501(c)(4) organizations. The gift tax rules do not contain an exemption for these donations, thus indicating that such donations are arguably subject to tax. In 2011, the IRS confirmed that it attempted to assess gift tax on donations to Freedom’s Watch, a conservative-backed 501(c)(4) organization. The IRS initiated an audit of the organization and its backers. Once the gift tax probe became public, the agency quickly backpedaled in response to political pressure. Subsequently, the IRS has stated that it will not pursue examinations on this issue. According to the agency, it has “little history to draw on in this area” and therefore is not in a position to issue current guidance. Any future action, IRS has indicated, will be prospective and after notice to the public. Recent public events and the associated congressional hearings and investigation, as well as pending litigation, may lead to changes in the treatment of 501(c)(4) organizations. On May 21, lawmakers from the Senate Finance Committee made clear that they intend to use the current controversy as a launch pad to consider changing the laws that govern social welfare organizations. Committee Chairman Max Baucus (D-Mont.) was quoted as saying: “Today there are countless political organizations at both ends of the spectrum masquerading as social welfare groups in order to skirt the tax code.” Baucus has indicated that the current controversy warrants another look at the current treatment of 501(c)(4) organizations. For now, however, they remain effective in exempting the entity from taxation while also concealing the identity of the donors who wish to influence the political process without drawing attention or paying gift tax.
Chester Grudzinski and Stas Getmanenko are attorneys with Kelly Hart & Hallman. www.kellyhart.com