UPDATE December 2015: Recent legislation clarifies that lifetime gifts to organizations exempt from tax under sections 501(c)(4), (c)(5), and (c)(6) are not subject to the gift tax. See section 408 of the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act), enacted on December 18, 2015, as part of the Consolidated Appropriations Act, 2016 (Pub. L. 114-113).
News reports suggesting that the IRS has opened federal gift tax examinations of five donors to section 501(c)(4) nonprofit organizations have generated considerable concern over the past few weeks. In a letter dated May 31, IRS Commissioner Douglas H. Shulman responded to that concern, stressing that these audits were not politically motivated and were not part of a larger enforcement effort specifically aimed at section 501(c)(4) contributions. Still, as this issue could continue to be raised in individual cases, donors and organizations alike should be aware of their options for dealing with the legal issues surrounding transfers to section 501(c)(4) organizations.
For more information, see the following topics below:
Background of the Section 501(c)(4) Donor Audits
The audits have surfaced in the midst of increased focus on the role of section 501(c)(4) organizations in election campaigns. The use of anonymous contributions to section 501(c)(4)s has led critics—including some Members of Congress—to call for stepped up enforcement of the amount of political campaign intervention conducted by these organizations. Late last year, the IRS Exempt Organizations Division announced (see here, page 28) an upcoming enforcement project focusing on section 501(c)(4) organizations, specifically including their political activities.
Given this background, it would be natural to see these examinations as an opening salvo in a larger review of payments to politically active advocacy organizations, perhaps meant to discourage large-scale giving to such groups as the 2012 election cycle begins. Indeed, six Republican members of the Senate Finance Committee sent a letter to the IRS questioning the timing and political nature of the IRS's enforcement of the gift tax on contributions to section 501(c)(4) organizations. The Senators also referenced news reports stating that the gift tax had "rarely, if ever" been enforced with respect to section 501(c)(4) contributions.
In a response to the Senators dated May 31st, IRS Commissioner Douglas Shulman asserted again that these gift tax audits are "not part of any broader effort to look at donations to 501(c)(4) organizations." Rather, the examination "activity was conducted as part of on-going work that focuses broadly on gift tax non-compliance." Commissioner Shulman also explained that "[t]he recent publicity on this issue resulted from a single matter where an IRS employee followed up on an internal referral by sending letters to five taxpayers." He emphasized that there was "no involvement by any political appointee, inside or outside the agency, in the initiation of these letters" and that he "had no conversations with anyone outside of the IRS regarding any enforcement strategy for this category of cases." A previous statement by the IRS also specified that the agent opening the examinations was in the Estate and Gift Tax Branch of the IRS.
The Significance of the IRS Statements and the Current Gift Tax Audits
Commissioner Shulman has gone out of his way to insist that the Service has not embarked on a special project—or "any broader effort"—to curb political giving to section 501(c)(4) organizations through gift tax enforcement efforts. Thus, one can reasonably infer that gift tax referrals were not planned as a standard part of the current initiative focusing on political activities of section 501(c)(4) organizations.
The five examinations in question resulted from an "internal referral," meaning that an IRS employee, presumably outside the Estate and Gift Tax Branch, referred the case. He or she may have been following up on widespread media reports of large contributions to section 501(c)(4) groups during recent election cycles, or may have noticed large contributions in the list of contributions reported on the Form 990 Schedule B for one or more section 501(c)(4) organizations.
Importantly, though, outside of an approved research project on the subject—and the IRS statements strongly imply that none currently exists—IRS employees do not have unfettered access to organizations' donor information on Schedule B. The applicable limits would prevent an individual gift tax agent from browsing organizations' donor information to identify large donors to audit. Normally, only Exempt Organizations employees would see the Schedule B, either during normal review of the organization's Form 990 or as part of an Exempt Organizations audit. It would not be surprising if such a review or audit were the origin of the internal referral Commissioner Shulman mentioned. While the current audits do not indicate any systematic gift tax review of section 501(c)(4) organizations' donor data, they do show that IRS agents may come across large payments to section 501(c)(4) organizations in the course of their regular enforcement work and take the position that such payments are taxable gifts.
Federal Gift Taxation of Contributions to Section 501(c)(4) Organizations
The federal gift tax imposes a tax of up to 35% (and higher for previous tax years) on gifts valued above certain dollar amounts. A gift is defined as a transfer where full consideration is not received in return. The tax law specifically excepts gifts to section 501(c)(3) charitable organizations and section 527 political organizations from the gift tax. There is no similar exception in the statute for contributions to section 501(c)(4) organizations. While the case law is mixed, several courts have rejected IRS attempts to impose gift tax on contributions to political campaigns, even before there was an explicit exception for such contributions—on grounds easily extendible to many contributions to section 501(c)(4) organizations.
In 1982, the IRS published a ruling refusing to accept these courts' rationale and maintaining that gratuitous contributions to organizations other than section 501(c)(3) and section 527 organizations are subject to gift tax. While that official position would likely be the IRS starting point in an examination, it is certainly susceptible to challenge given the substantial body of contrary authorities. Even Congress's Joint Committee on Taxation has noted (see here, page 45, note 129) that the cases on political contributions might prevent gift taxation of section 501(c)(4) contributions.
IRS statistics reflect that the agency generally audits approximately 1,500 to 2,000 gift tax returns per year, primarily focused on gifts to individuals, rather than organizations. Taxpayer confidentiality makes it impossible to know what the IRS has done in particular cases, but the perceived lack of enforcement with regard to gifts to section 501(c)(4) organizations has created a widespread sense that the IRS has not in practice followed the strict rule it announced in 1982. This public perception is one reason critics think it would be unfair for the IRS suddenly to ramp up enforcement now.
Although a publicly available copy of one of the five audit letters flatly asserts that gifts to section 501(c)(4) organizations are subject to the gift tax, that letter merely announced the beginning of an examination—not its conclusion. Even in the five cases confirmed by the Service, it is not clear that the Service will ultimately assess tax or succeed in collecting it once the facts have been fully developed. Given the public attention the issue has received, it would not be unusual for the IRS to consult with IRS legal counsel to determine the strength of its legal position before proceeding.
What Next for Donors and Section 501(c)(4) Organizations?
If the IRS were now actively to enforce the position that contributions to section 501(c)(4) organizations are subject to gift tax, donors and organizations would have a number of legal arguments they could raise against application of the gift tax, depending on their particular circumstances. Such a challenge could result in the IRS dropping or drastically reducing any gift tax assessment before the conclusion of the internal IRS appeal process—and before the donor would have to compromise his or her confidentiality to pursue a public challenge in court. Caplin & Drysdale attorneys have developed such arguments to protect our clients and can work to establish the tax position right for you or your organization. Our attorneys have significant experience defending against IRS audits of exempt organizations and donors and are intimately familiar with IRS processes and procedures.
Prospectively, a number of structures for funding section 501(c)(4) activities other than through simple contributions can reduce the tax exposure of funders and organizations alike. The depth of Caplin & Drydale attorneys' exempt organizations and gift tax law experience allows us to work with funders and recipient nonprofit organizations to minimize unwanted tax exposure for both. In addition, the firm's complementary election law experience allows us to ensure that clients understand any potential for public disclosure under relevant federal or state lobbying disclosure or campaign finance rules if alternatives to section 501(c)(4) contributions are pursued.
For more information, please contact:
Douglas N. Varley, email@example.com, 202.862.7818
Marcus S. Owens, firstname.lastname@example.org, 202.862.5020
Diara M. Holmes, email@example.com, 202.862.7829
Michael W. Durham, firstname.lastname@example.org, 202.862.5031
Elizabeth A. Grossman, email@example.com, 202.862.7860
Beth Shapiro Kaufman, firstname.lastname@example.org, 202.862.5062
Trevor Potter, email@example.com, 202.862.5092
Kirk L. Jowers, firstname.lastname@example.org, 202.862.5057
Joseph M. Birkenstock, email@example.com, 202.862.7836
Matthew T. Sanderson, firstname.lastname@example.org, 202.862.5046