A lawyerly guide to removing tax exempt status

Editorial note: Alan P. Dye is a partner and Charles M. Watkins is an associate attorney at Webster, Chamberlain & Bean, a Washington DC law firm that specializes in nonprofit and tax-exempt legal services.

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Several members of the Trump administration have recently suggested that the Administration wants to find a way to attack organizations that they believe to be engaged in activities inconsistent with the President’s view of American interests.  Many of these organizations, like the Open Society Foundation, are exempt from federal tax under Section 501(c)(3) of the Internal Revenue Code (the IRC).  One approach that has been widely discussed has been to revoke the tax-exempt status of organizations engaged in activities with which the administration disagrees.  Recently, the Wall Street Journal has reported that the Administration is turning towards use of the IRS’ criminal investigation authority, instead of merely revoking an organization’s exemption, because of difficulties changing IRS audit procedures, particularly the amount of time it takes to audit organizations and revoke their exemptions.  This puts audit procedures front and center in IRS thinking.

An IRS audit is a long, complex process governed by the Internal Revenue Manual (IRM), an internal document published for use of IRS employees that describes the processes to be followed in revoking an exemption.  These include an audit, potential technical advice from the IRS National Office, and an appeal to the Office of Independent Appeals (within the IRS).  If the Office of Appeals sustains the revocation, the organization can challenge the revocation in court.

First Steps

Under current IRS procedures (which could presumably be changed by the Administration), the process begins with an audit or, as it’s referred to in the IRM, an examination.  IRS audits are usually commenced because of analysis of data on Form 990, stories in the press suggesting improper activities, or as a result of a complaint filed by a member of the public or a member of Congress.

As has been noted in the press, IRC Section 7217 prohibits the President, the Vice President, any member of their immediate staffs, and any Cabinet member (other than the Attorney General) from asking the IRS to conduct an audit or criminal investigation of a taxpayer or tax-exempt organization, and requires any IRS employee who receives such a request to report it to the Treasury Inspector General for Tax Administration.  Violations of the law are punishable by fines of up to $5,000 and up to five years in prison.  This law was enacted after reports of abuses committed by the Nixon Administration.  However, it’s not clear what remedy a taxpayer has, if any, when an audit has been initiated in violation of the law.

An audit begins with a letter from an Internal Revenue Service agent indicating that the organization has been selected for audit.   Upon receiving notice of an audit, a tax-exempt organization’s first call should be to tax counsel who is experienced in exempt organizations tax law, and can advise the leadership throughout the audit, coordinate the response, and communicate with the IRS.

The initial letter has attached to it a discussion of the process to be followed and one or more Information Document Requests (IDRs).  In most cases, the auditor will also request an opening meeting with an officer of the taxpayer and/or the taxpayer’s representative, to ask questions about the organization’s activities. The organization will be given 21 days to respond to the IDR’s, and reasonable extensions of that time period are usually freely granted.  The agent will usually grant a 20-day extension.  This would mean that response to the initial IDRs would be provided about 41 days after the initial audit letter is received.

The initial IDRs usually request a copy of the organization’s articles of incorporation and bylaws, its ledger of accounts, its most recent Forms 990 and audited financial statements, and a variety of other internal documents.  The IDRs commonly include a request for information with respect to employment matters, such as Forms 941, W-2, and 1099.  These information returns have little to do with the organization’s entitlement to exemption but involve the possibility that the organization has not filed all appropriate employment tax documents, or may owe taxes and penalties for failure to properly withhold and deposit employment taxes.

It can be time-consuming to accumulate these documents, and additional extensions of time can usually be obtained.

With respect to its continued entitlement to exemption, the organization will be asked to describe its activities and provide copies of print and online publications so that the agent can determine whether the organization has engaged in exclusively charitable activities, has not allowed inurement of the organization’s earnings to board members or other insiders, and has not operated to benefit private interests.  The agent will also be interested in whether the organization is engaged in substantial lobbying activities, which are limited for Section 501(c)(3) organizations, or to any electoral activity, which is prohibited and can provide a basis for revocation of tax-exempt status and/or the imposition of penalties. Finally, the agent will want to determine that there have been no excess benefit transactions taxable under IRC Section 4958.

Because of the time required for an organization to respond to IDRs, for the auditor to review the responses and materials provided (and perhaps to complete several rounds of IDRs), and sometimes for internal referrals to other IRS offices, e.g., if a valuation is required, it can sometimes take years for a complex examination to be completed.  An audit presently being managed in our office was opened in 2021 and has not yet been concluded, because multiple IDRs have been issued and because responsibility for the audit has been shifted twice to a new agent.

The most frequently mentioned potential challenge to tax-exempt status is a finding that the organization engaged in or promoted illegal activity or activity.  This requires a finding that the activity violates state or federal law or encourages others to violate the law.  Under the First Amendment, exemption cannot be revoked merely because an organization advocates policies with which the current administration disagrees. In Revenue Ruling 75-384 the IRS asserted that an organization would not qualify for tax-exempt status if it encourages civil disobedience.

In Bob Jones University v. United States, the Supreme Court went further and held that a university was not qualified for Section 501(c)(3) status if “its purposes or activities are illegal or otherwise contrary to public policy.”  In that case, the activities were not judged to be illegal, but contrary to the general public policy against racial discrimination, because the University  prohibited interracial dating by its students.

These arguments have rarely been applied by the IRS , but could be used by an agent to propose revocation.

Technical advice

If the examining revenue agent and the taxpayer disagree regarding an interpretation of the tax law as to which there is little or no published precedent, such as the public policy argument, the agent may request technical advice (an internal legal opinion) from the IRS National Office.  Alternatively, the taxpayer can request that technical advice be sought, and the examining agent will often agree. If the agent denies the organization’s request for technical advice, that decision can be appealed within the IRS.

If technical advice is to be requested, both sides would then prepare documents presenting the facts and their positions to the National Office.  These are submitted to the Exempt Organizations Division in the IRS National Office, which will eventually issue a technical advice memorandum (TAM), perhaps with assistance from the Office of the Chief Counsel, that explains the Division’s view of the legal issues raised.

In general, the taxpayer has a reasonable amount of time to prepare and file a request for technical advice and the IRS takes varying amounts of time to respond.  It reasonably can be anticipated that the process of requesting and receiving technical advice may take several months.

If the TAM is favorable to the taxpayer, it will be followed by the agent.  If unfavorable, the agent will issue a proposed Revenue Agent’s Report, setting forth the facts, the IRS’ legal analysis and proposed conclusion, and to the extent known, the organization’s analysis.  The organization then may respond with any proposed corrections to the facts, and its own legal analysis and conclusion.

Appeal

When the audit process is complete, if the audit report concludes that the organization’s exemption should be revoked, the IRS agent will issue a Notice of Proposed Revocation, to which the taxpayer may respond by filing a “protest” with the IRS Independent Office of Appeals within 30 days.

Depending on the complexity of the case, within 6-9 months, an appeals officer will issue a notice setting a virtual or physical meeting with the taxpayer. The taxpayer may, at that time, present its position on the audit and will be given a reasonable time (at least 21 days) after the appeals conference to submit any additional relevant facts and a brief outlining its position.

The appeals officer will then consider the case and propose to rule in favor of the taxpayer or the government on the issues raised.  If the appeals officer rules in favor of the government, the taxpayer will be sent a “90-day letter,” which gives the taxpayer 90 days to file a petition for a declaratory judgment under IRC Section 7428 in the U.S. Tax Court,  the U.S. District Court for the District of Columbia, or in the United States Claims Court.  Alternatively, the organization can pay any income tax determined to be due, e.g., on net program service revenue or investment income, and file a refund claim in the Claims Court or the district court where its principal office is located.

Litigation

Litigation in any of the courts can take years.  After the petition is filed, the government answers within a 20-day period, and again extensions are often granted.  Though there is usually not much discovery in a Section 7428 case, because most are decided primarily on the administrative record, it does take a period of time to stipulate to facts and brief the case.  The Claims Court recently decided a case in which the audit commenced in 2016 or early 2017.  Thus, more than eight years (partly due to Covid delays) have elapsed since the commencement of the audit, and the case can yet be appealed by the losing side.

Conclusion

Unless the IRS audit and appeal procedures, which are designed to ensure that taxpayers are afforded due process before tax-exemption is revoked, are dramatically changed by the Treasury Department, it is virtually certain that no organization investigated by the Administration will have its tax-exempt status finally revoked before the end of the Trump presidency.  This is particularly true since the principal argument being made is that organizations will lose their exemption for violations of public policy.  Very few cases have been decided on this basis.  This may explain why the administration is considering bringing criminal charges, though that approach presents even greater obstacles because of the greater due process protections afforded in criminal proceedings and the higher standards required for criminal indictment (“probable cause”) and conviction (“beyond a reasonable doubt”).   Obtaining a criminal conviction of an organization or its leaders for actions generally requires a finding that the taxpayer violated a criminal law, willfully attempted to evade paying a tax, or engaged in some fraudulent behavior.  In cases involving mere policy disagreements, when the organization’s speech is protected by the First Amendment, this would be extraordinarily difficult, and to the best of my knowledge, has never occurred.

Source: https://capitalresearch.org/article/a-lawyerly-guide-to-removing-tax-exempt-status/