05/29/2013 04:56 pm ET Updated Jul 29, 2013

Focusing on the Wrong IRS 501(c)(4) Scandal

There are a number of scandals regarding the way the Internal Revenue Service administers the law involving tax exemption organizations that engage in political activities. But the selective targeting of Tea Party applications is at once the most offensive -- and the least significant. Here's why.

No individual or organization should be singled out for unfavorable treatment or even special review because of their political or ideological views. If that is what the IRS did with Tea Party and other conservative groups that sought 501(c)(4) tax exemptions, that is plainly wrong and should not be tolerated. But it now appears that some liberal groups may have been given similar treatment. That is because the problem of excessive political involvement by non-profits is not limited to one side of the ideological spectrum. Moreover, while the technique may have been clumsy, there is no doubt that there was considerable use of 501(c)(4) social welfare organizations -- including but not limited to Tea Party folks -- to engage in significant political spending beyond what the tax laws allow. Thus, while it makes perfect sense to look for smoke where there is fire, the IRS clearly went about it in the wrong way.

In order to understand the real scandals involving (c)(4) groups, it is necessary to see how that section fits into the tax-exempt universe that includes section 501(c)(3) groups that consist of charitable, educational, and religious organizations, and those that are political organizations exempt under section 527. If an organization fits under any of the three sections -- plus other parts of section 501 that deal with other tax-exempt groups -- the organization does not have to pay any income tax. What is important about that "benefit" is that it does not save much if any money for most of these groups. That is because most of what they receive are gifts, and the IRS does not treat gifts as taxable income to the recipient. Moreover, most legitimate social welfare groups would probably have enough deductible expenses to offset whatever taxable income they had and so would still owe nothing.

However, there are two other benefits that do matter. If the organization is exempt under section 501(c)(3), contributions to it are tax deductible by the donor, and private charitable foundations are allowed to give to it. Being able to assure donors that the IRS has found the organization to fall under section 501(c)(3) is, as a practical matter, essential to raise tax-deductible money. But since contributions to 501(c)(4) groups are not tax deductible, advance assurance is of no significance. Indeed, those groups need not apply for exempt status, but only have to file an annual Form 990 tax return as a (c)(4). Thus, while it was surely frustrating, annoying, and perhaps costly because of increased legal fees to do battle with the IRS, the Tea Party groups could have operated as a (c)(4), no matter how long the IRS took. And even if the IRS eventually said "No," there would almost certainly be no adverse tax consequences.

Second, charitable and social welfare organizations do not have to make public the names of their donors, although the IRS receives information on their largest supporters. By contrast, section 527 organizations are subject to either federal or state election laws and therefore do have to make disclosures based on those laws, but not the Tax Code. Section 527 has been around for years, and it is the means by which entities such as political parties are exempt from income taxation, which, as noted above, is not likely to be a significant benefit for most of those organizations. Since the early 1970s, political parties as well as independent political committees that directly support candidates for federal office have been required to disclosure their donors who give more than $200 in a given year. Starting in the 1990s, other groups, which were not then subject to the federal election law disclosure requirements, began to seek exemption under section 527, which at that time had no independent requirement that they disclose their donors. After Congress closed that disclosure loophole for section 527 groups, many newly formed organizations shifted to section 501(c)(4), to which the new disclosure rules did not apply. Thus, what now matters is whether the IRS concludes that a group is a 527 or a 501(c)(4) entity, not for income tax purposes, but for disclosure reasons.

With that background, it is now possible to appreciate the true IRS scandals. Section 501(c)(4) requires that the organization be "operated exclusively for the promotion of social welfare," which does not include endorsing or opposing candidates for elected office. The IRS has a regulation that interprets "operate exclusively" to mean "operate primarily" for those purposes. As a result, a group could spend almost half of its money on political activities and still qualify for (c)(4) status -- and not disclose the names of its major donors, even if all the money that they gave was earmarked for electoral purposes. There is some question as to whether "exclusively" allows any political spending, a determination made more complicated by section 501(c)(3)'s prohibition on participating in "any political campaign on behalf of (or in opposition to) any candidate for public office." But even if exclusively does not mean zero, it almost certainly means more than 51 percent, which is how the IRS interprets it. Although the IRS has been implored to change its rule to limit political spending by (c)(4)'s considerably, it has refused to do so, under both Republican and Democratic administrations. That is real Scandal Number 1.

Scandal Number 2 arises because a competent lawyer can write a (c)(4) application that will sail through readily, as it should because the application is only a statement of what the group proposes to do. Moreover, it is almost impossible for the IRS to be able to tell in advance which groups will carry out their plans as advertised. In order to be sure that a group does what it said it would do -- actually operate exclusively for tax exempt purposes -- the IRS would have to review its annual tax return and probably ask more questions, obtain its books and records, and talk to staff. That takes time and money, and it also raises the question of targeting all over again: because the IRS can't audit every (c)(4), it has to pick and choose, which potentially leads back to the Tea Party dilemma. Moreover, examining (c)(4) tax returns is a very low priority activity for the IRS, both because it raises no tax revenue (since the group could retain its exempt status under section 527), and it may well catch the attention of the group's political supporters in Congress, leading to the kind of inquiries now underway. Therefore, even if the IRS narrowed the extent to which (c)(4) entities could engage in political activities, the lack of incentives to investigate would remain, as would the problem of the time and money needed to do the job properly.

There are two simple solutions that Congress could enact tomorrow that would deal with the real problem, which is lack of disclosure of major political donors to (c)(4) groups. First, it could apply the same no electoral politics standard now applicable to (c)(3) groups to (c)(4)'s. Groups that wanted to do electoral activities and maintain their tax exemption would have to use section 527 and make timely disclosures of their significant contributors. But that would prevent social welfare organizations from engaging in a modest amount of political activity, with the inevitable problem of line drawing and IRS oversight.

Second, Congress could require disclosure of all (c)(4) donors over $200 (the federal election threshold), but that could discourage significant contributions to all (c)(4) organizations, even those that stayed clear of electoral politics. In the alternative, Congress could allow (c)(4)'s to make political expenditures, but only with money earmarked for that purpose, and then limit disclosure to $200+ contributors to that earmarked fund. That option, which has been debated in Congress since Citizens United, but not enacted because of Republican opposition, would eliminate the non-disclosure problem, and make the job of enforcing section 501(c)(4) much easier. The failure of Congress to adopt either of these two simple fixes is 501(c)(4) Scandal Number 2.

An optimist might hope that the Tea Party (c)(4) scandal would eventually be understood to be of little tax significance, although singling out any group based on ideological reasons is unacceptable no matter how little it harms the target, That same optimist might also hope that Congress would dig deeper and see where the real (c)(4) scandals lay and do something about those problems. However, a realist would expect business as usual, even though there are simple and effective fixes already on the table, if only the scandal-mongers were willing to look at them.