The IRS dropped a bombshell last week when it admitted that it made mistakes in the way it gave heightened scrutiny to certain applications for 501(c)(4) status by conservative political organizations (e.g., Tea Party groups).  This week, the Justice Department began a criminal investigation on the matter, and the full report on the incident  by the Treasury Inspector General for Tax Administration (“TIGTA”) was released, as well. This situation has had all the makings of a good scandal as it unfolded, from the surprisingly unofficial way it came to light (apparently during a Q&A session at an ABA Exempt Organizations meeting) to uncertainty about exactly who at the IRS knew what, and when.

We’ll leave it to other blogs and publications to surmise about political motivations behind the screening, and whether the order to do this came from higher-ups at the agency. However, as attorneys that regularly work with exempt organizations, and that often interact with the IRS on applications for tax-exempt status, we would like to speak to certain elements of the application process that are routine, and how that routine appeared to go off track here.

Political Activity a Legitimate Issue for Review. It is important to emphasize that the IRS does have a responsibility to look into the amount of political activity that a potential 501(c)(4) organization plans to conduct. The Citizens United decision, which we discussed in an earlier post, increased the allowable political activity of certain organizations, including 501(c)(4)s, and opened the floodgates for new applications—2,774 in fiscal year 2012 compared to 1,777 in 2011 and 1,741 in 2010.

While 501(c)(4)s are allowed to engage in some political activity in furtherance of their exempt purpose, they are prohibited from doing so as their “primary” activity. So it’s certainly appropriate for the IRS to look at a 501(c)(4)’s political activity, but it should do so for 501(c)(4) applicants across the political spectrum. Here, additional review was given only to applicants with names that contained the phrases “Tea Party,” “Patriots” or “9/12 Project”; that focused on issues of government spending, government debt or taxes; that sought to educate the public “to make America a better place to live”; or that criticized how the country is being run.

After this targeted scrutiny was brought to the attention of the EO director mid-2011, the criteria was changed to focus more generally on potential lobbying and political activities of organizations and the amount of such activities. But at some point in early 2012, the more politicized search terms were put back in place as workers felt the general terms were too broad. Bad move.

Apart from this apparent lack of impartial review, we are also troubled by the indirect approach used by the IRS to essentially regulate the political activity of 501(c)(4)s more generally. The industry needs guidance on what amount of political activity is allowable without jeopardizing an organization’s 501(c)(4) status. The IRS should be issuing formal guidance on this issue, either in the form of Treasury regulations or an IRS ruling, which would go through the appropriate administrative review and, once issued, would apply to all 501(c)(4)s, old and new, conservative and progressive. Instead, the IRS appears to be regulating the matter at the gate—through the determination process. This is a bad approach to policy-making and will inevitably lead to a lack of accountability and inconsistency (particularly if existing 501(c)(4)s are not subject to the same standards).

Centralization of Review. In defending its actions, the IRS has said that exempt organization workers centralized the 501(c)(4) applications in question for additional review, based on the criteria discussed above, to deal with the influx of new applications.

In our experience, it is not unusual for the IRS to try to increase efficiency and consistency by grouping applications for review that raise common issues or questions. Trends and evolving notions of charitable work often can mean that the IRS will see a wave of similar applications that present novel questions, and it can make sense to group and review them in bulk—we’ve seen it happen fairly recently with, for example, applications addressing renewable energy, conservation and international philanthropy.

The problem here is the manner in which the selection apparently was handled, by focusing on very narrow criteria that gives the appearance of bias against conservative organizations. The TIGTA report says as much, and notes that its statistical review shows that many applications indicating potential impermissible political activity were not given additional review or development (page 9-10).

Follow-up Questions. Many organizations that had filed for 501(c)(4) status also received follow-up questions from the IRS, and some received multiple sets of questions. There were complaints about the information in the questions, and whether it was relevant.

Again, in our experience, it is not uncommon to get follow-up questions from the IRS on an application, and often, the questions are extensive (sometimes several pages long). Many organizations will have borderline activities, relationships or other factors that may or may not be problematic, and the IRS needs to get more information in order to be sure tax-exempt status is appropriate.

The TIGTA report indicates, in more than half of potential political cases where additional information was sought, that the requested information was unnecessary—including information about donors. The report attributes the unnecessary questions to lack of managerial review and lack of the specialists’ knowledge about permissible activities for 501(c)(3) and 501(c)(4) organizations.

Again, we have experienced this as well, outside of the political context. Often questions are sent out for applications of all sorts that seem unnecessary, duplicative or irrelevant, and we have to manage that. But if the questions were politically motivated or meant to intimidate, that is entirely inappropriate.

Delay in Processing. Some applicants have had their status pending for as long as three years now. The TIGTA report attributes this largely to management and oversight problems within the IRS (e.g., changes in management during this timeframe, miscommunication between different departments) (pages 11-15). The Wall Street Journal today ran an article about the impact this has had on 501(c)(4) organizations in terms of funding complications, time spent dealing with the process and burnout.

Unfortunately, this problem is not unique to 501(c)(4)s. The IRS backlog for processing all applications for tax-exempt status is simply unprecedented—14 months now!  In fact,  we’ve written recently about the slow processing time for applications for exempt status,and the impact on new charities.

Essentially, the  IRS currently is sitting on a mountain of applications for exempt status—and not just for 501(c)(4)s. This delay is causing hardship for many organizations that are unable to fully fundraise or undertake program activities until their status is certain. However, the three-year delay that many of these potential 501(c)(4) organizations have experienced is simply in another league.

Inspector General Recommendations. Ultimately, the TIGTA report contains recommendations for addressing the problems that have surfaced, including the following:

• Adding or  improving training of IRS specialists, including proper ways of identifying applications that require review of political activities, distinguishing between advocacy and partisan political activity, and developing proper requests for additional information;
• Improving the process of review, including how to process applications that raise potential political activity issues (with the posting on guidance online for transparency) and how to formally request assistance from the Technical Unit;
• Implementing oversight to bring to a close those cases that have been pending for years; and
• Prioritizing the issuance of guidance on how to measure whether political activity is a primary activity of an organization.

In a news conference Wednesday, President Obama announced that these recommendations will begin to be implemented swiftly, and we’re hoping that solid improvements for all tax-exempts (not just 501(c)(4)s) will come from this unfortunate situation.

The Wall Street Journal made a powerful point in its weekend editorial: “Other than the power to prosecute, the taxing authority is the most awesome power the government has,” and President Obama also emphasized this point in demanding “absolute integrity” by the IRS. This agency makes decisions every day about whether organizations qualify for exempt status, and the public deserves to feel assured it recognizes the gravity of that and is handling applications with fairness, consistency and competency.