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Why the IRS 501(c)(4) Scandal Happened

As nonprofit attorneys, we frequently work with clients to obtain tax-exempt status for them under Internal Revenue Code (IRC) sections 501(c)(3) and 501(c)(4). We received questions from our clients about why the IRS 501(c)(4) scandal happened and what can be done about it. While the Congress is still investigating the IRS misconduct and the facts are not all out, we see several clear factors that led to the IRS’s decision to single out “Tea Party” applications for special scrutiny.

The regulations that distinguish between 501(c)(4) social welfare organizations and IRC § 527 political organizations are not clear and require interpretation by the agent reviewing each exemption application. A social welfare organization qualifies for tax exempt status under IRC § 501(c)(4) if : “(i) It is not organized or operated for profit; and (ii) It is operated exclusively for the promotion of social welfare.” The second criteria, “exclusively” has been interpreted by the IRS to mean: “primarily engaged in promoting in some way the common good and general welfare of the people of the community.” Further, a 501(c)(4) can participate in elections except that “promotion of social welfare does not include direct or indirect participation or intervention in political campaigns on behalf of or in opposition to any candidate for public office.” As attorneys we know all too well that words like “primarily” and “direct or indirect participation or intervention” are open to interpretation.

By contrast, a political organization formed under IRC § 527 is “a party, committee, association, fund, or other organization (whether or not incorporated) organized and operated primarily for the purpose of directly or indirectly accepting contributions or making expenditures, or both, for an exempt function.” These organizations are largely tax-exempt. The key difference is that § 527 political organizations must publicly disclose their donors’ identities, while 501(c)(4) organizations do not.

In the recent scandal, the IRS blames being overworked and understaffed for its short-cut tactic in singling out “Tea Party” affiliated organizations that might not qualify under 501(c)(4). Considering that the IRS receives 70,000 applications and has fewer than 200 agents working through them each year, the practice of using key words as a method of singling out potential political organizations is not too far-fetched, although only using terms commonly associated with one political party is wrong.

Additionally, the IRS is under heightened pressure to watch out for 501(c)(4) applicants that should be treated as political organizations under IRC § 527 after the Supreme Court decision Citizens United v. Federal Elections Commission changed how money can be used in elections. Citizens United opened the flood gates to allow corporations, including 501(c)(4) nonprofits, to make unlimited contributions to influence elections. Since the Supreme Court issued that decision, money supporting both Republicans and Democrats (and the Tea Party) have been funneled through 501(c)(4) nonprofit organizations as a way to keep the names of their donors private. During the 2012 elections, Americans for Responsible Leadership, an Arizona-based 501(c)(4) organization, used its status as a 501(c)(4) to anonymously launder $11 million for a Super PAC in California to defeat a contested tax hike and to limit political spending for unions. Just recently Americans for Responsible Leadership was again in the news for failing to disclose that it spent (in addition to the $11 million on California ballot initiatives) an additional $9.8 million on Federal electoral campaigns during the 2012 election cycle, which is $4.1 million more than they initially disclosed. Americans for Responsible Leadership’s use of its 501(c)(4) status to give its donors the ability to anonymously donate over $20 million in 2012 state and Federal elections has raised serious questions about the consequences of Citizen’s United for our democratic process.

We are hopeful that the IRS snafu and the controversy over organizations like Americans for Responsible Leadership will result in some significant clarification of the 501(c)(4) regulations and that the nation will find a way to reform campaign finance regulations in the post Citizens United landscape. Just last month the Los Angeles City Council and 77% of the Los Angeles electorate voted to instruct local and state officials to promote the overturning of Citizens United. Last week the Los Angeles Times published an editorial called The right way to investigate the IRS. The LA Times suggests that “[t]he best way to restore confidence in the IRS is to impanel a commission with no stake in the 2014 election and no political ax to grind, and have it recommend whatever changes may be necessary to fix the problems it uncovers.” Dean Alan B. Morrison, in his Huffington Post blog article Focusing on the Wrong IRS 501(c)(4) Scandal, suggests two solutions: either apply the same no-election campaigning rules that govern 501(c)(3) organizations to 501(c)(4) organizations (i.e., prohibiting intervening in political campaigns, but allowing for a limited amount of lobbying), or require disclosure of the names of donors giving $200 or more to the 501(c)(4).

However this issue gets resolved, we hope that it leads to a stronger, more transparent democratic process. To keep up to date on this and many other issues affecting nonprofit organizations follow us on Twitter: @sustainable_law.

If you have specific questions about nonprofit organizations or the tax exemption process please contact us at info@sustainable-lawyer.com or call us at 310-883-7923.

Photo credit: Glyn Lowe Photo works / Foter.com / CC BY

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