Everyone paying attention to the news media May 9, 2013 and after knows about an IRS scandal brewing specifically related to the Exempt Organizations Division. Many people likely saw Lois Lerner, the Director of the IRS Exempt Organizations Division, plead the Fifth (5th) Amendment today during the House Congressional Hearings. Few know what the real scandal is about.
People are most familiar with 501(c)(3) tax exempt organizations because they provide a tax deduction to the donor. Moreover, Section 501(c)(3) is a tax law provision granting exemption from federal income tax to qualifying non-profit corporations. This exemption does not cover other federal taxes such as employment taxes, or state taxes such as sales and use taxes. 501(c)(3) exemptions apply to corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals. 501(c)(3) tax exempt organizations are prohibited from campaigning and could lose their exempt status or be imposed with excise taxes for violations. For more information, see: Limits on Political Campaigning for 501(c)(3) Nonprofits.
If a nonprofit corporation does not meet the statutory tests to become a 501(c)(3), or does not wish to partake in some of the scrutiny under which 501(c)(3) organizations participate on a yearly basis, the corporation may choose to become a 501(c)(4). According to 26 U.S.C. § 501(c)(4)(A), which was enacted in “501(c)(4) organizations are generally civic leagues and other corporations operated exclusively for the promotion of “social welfare”, such as civics and civics issues, or local associations of employees with membership limited to a designated company or people in a particular municipality or neighborhood, and with net earnings devoted exclusively to charitable, educational, or recreational purposes.” Contributions to 501(c)(4) organizations are usually not deductible; however, 501(c)(4) organizations are, like 501(c)(3) organizations, exempt from federal income tax.
Part One (1) of the Real Scandal: While 26 U.S.C. § 501(c)(4)(A) requires nonprofit corporations applying for 501(c)(4) status to be “operated exclusively for the promotion of social welfare,” the Department of the Treasury implemented an official regulation in 1958 interpreting “EXCLUSIVELY” to mean “PRIMARILY.” See: Senate Finance Committee and the 501(c)(4) Morass. Reg. 1.501(c)(4)-1(a)(2)(i) provides that an organization is operated exclusively for the promotion of social welfare if it is primarily engaged in promoting in some way the common good and general welfare of the people of the community, i.e., primarily for the purpose of bringing about civic betterment and social improvements. Whether an organization is ‘primarily’ engaged in promoting social welfare is a ‘facts and circumstances’ test.” So, for those keeping score, the IRS, an executive agency, which is constitutionally tasked with implementing the laws as written by Congress, decided to interpret a law (the judiciary’s constitutional function) and change a law (the legislative function). A separation of powers crisis lingering from 1958 is part one (1) of the real scandal.
Here’s a hint of what’s coming next: The same distinction exists between “exclusively” and “primarily” within the context of 501(c)(3) organizations. See 26 U.S.C. § 501(c)(3) and Reg. 1.501(c)(3)–1(c)(1).
Part Two (2) of the Real Scandal: “EXCLUSIVELY” and “PRIMARILY” may not seem that different, but it’s a loophole to drive a tractor trailer through. Let me tell you how this works in practice. “Exclusively” is interpreted to mean 100%. “Primarily” is interpreted to mean 51%. So, the Department of the Treasury changing “exclusively” to “primarily” means a nonprofit organization can qualify as a 501(c)(4) organization by engaging in 51% social welfare and 49% “other stuff” instead of 100% social welfare (as Congress intended).
Let’s add a layer. Because people understand that 501(c)(3) organizations can engage in only extremely limited political activity with no lobbying, and 501(c)(4) organizations do not have the same restriction on political activity, 501(c)(3) organizations that wished to engage in lobbying activities (or increased levels of political activity – over 20% of its activities but less than 50%) would create a 501(c)(4) organizational arm to conduct those activities. Until this week. 501(c)(4) organizations provided donor anonymity and fewer reporting requirements than a nonprofit 527 political action group. It was the “not so secret” way to increase political contributions without reporting and donor limits.
What people understand from the news is that employees at the IRS Exempt Organizations Division developed a “list” to identify and isolate nonprofit corporations with the words, “tea party,” “9/12″ and the like. These nonprofit corporations were subjected to intense scrutiny, extended processing times, and crushing lists of follow-up questions. This is only the symptom, not the disease. If the IRS had been implementing the laws AS WRITTEN, not as modified by the Department of the Treasury in 1958, it would be understood that 501(c)(4) organizations are not allowed to engage in any form of political activity – because they must be operated “exclusively,” or 100% of the time, for the social welfare and common good. That said, this salacious scandal would not have arisen. The nonprofit corporations at the heart of this hubbub would have modified their missions to be educational (not political) in nature, or would have applied as nonprofit 527 political action groups, not 501(c)(4) organizations intending to exploit a loophole.
The real scandal is that there are 501(c)(4) organizations in America thwarting the intent of Congress and contributing to problems of campaign finance – not actually serving the social welfare and contributing to the common good.