Yesterday, the United States District Court for the District of Columbia issued a notable Memorandum Opinion and Order in Freedom Path, Inc. v. Internal Revenue Service, et.al.
In 2013, Freedom Path was denied 501(c)(4) tax-exempt status by the Internal Revenue Service (“IRS”) on the basis that it engaged in excessive political activity. The organization sued for a declaratory judgment that the denial was erroneous on the grounds that Treasury Regulations and Rev. Rul. 2004-06, which the IRS used to interpret both how much non-exempt activity a 501(c)(4) may do and what qualifies as non-exempt political activity, are unconstitutionally vague. The Court agreed and granted summary judgment for Freedom Path on these issues.
However, the Court could not determine whether Freedom Path was entitled to 501(c)(4) tax-exempt status using the IRS guidance that it found unconstitutionally vague; it has therefore ordered the parties to submit briefs proposing new standards for both 501(c)(4) tax-exempt status and political activity. We will continue to monitor the case and the standards that the IRS proposes in its brief.
While this opinion applies only to Freedom Path, it foreshadows likely future constitutional challenges to Treasury Regulations and IRS guidance, as applied to both 501(c)(4)s and 501(c)(3)s, and it may influence future IRS action on the 501(c)(4) exemption and political activity standards.
Background
501(c)(4) organizations must operate “exclusively” for social welfare purposes. Treasury Regulations interpret this to mean that a 501(c)(4) must be “primarily” engaged in promoting social welfare. All other activity – including political activity – must be secondary for an organization to be exempt under section 501(c)(4).
The meaning of “primary” is far from settled. For years, the IRS has signaled that it means more than 50 percent of a 501(c)(4)’s total activities each year. Yet a 1945 Supreme Court opinion, Better Business Bureau v. United States, interpreted the word “exclusively” in a different provision of federal tax law to mean “substantial,” and the IRS has adopted this interpretation in Freedom Path and another recent federal case, Memorial Hermann ACO v. Commissioner. There is no bright line limitation under the “substantial” test, but old court cases suggest that more than 15 percent of total activities each year may be substantial.
Like the standard for 501(c)(4) exemption, the guidance on determining whether a 501(c)(4) activity qualifies as political is challenging for organizations to decipher and apply. Revenue Ruling 2004-06 relies on a series of “facts and circumstances” to determine whether an advocacy communication is political, but there is no set number or combination of factors that must be. The Freedom Path Court found that the revenue ruling failed to provide “explicit guidelines” to help the IRS “avoid arbitrary and discriminatory enforcement” of the 501(c)(4) political activity limitation. This, in combination with uncertainty over what that limitation is to begin with, led the Court to find both standards unconstitutionally vague because in applying them, “an applicant like Freedom Path has no good way of knowing even which standard its application will be judged under, no less how the IRS will ultimately judge it.”
Key Takeaways
Notably, this court order applies only to Freedom Path. Yet, other 501(c) organizations should take note of this case for three key reasons:
First, the order signals that other federal courts may entertain a vague argument for IRS regulations and guidance as applied to other 501(c)(4) organizations, or even as applied to 501(c)(3) organizations who rely on similar IRS guidance to decipher what qualifies as political activity and to determine how much legislative lobbying activity they may do.
Second, it will lead to an IRS brief that publicly spells out the agency’s proposed alternative standards for a 501(c)(4) exemption and political activity. While these standards will not be binding for the IRS outside of this case or on any other organizations, they will nonetheless provide critical insight into current IRS thinking on these issues.
Third, the case and the standards that emerge from it are likely to serve as informal guidance to the IRS on the amount and classification of 501(c)(4) political activity going forward.
ELG will continue to monitor the Freedom Path case and share insights with clients from the IRS brief that will result from this order. While the Form 1024-A IRS exemption application remains voluntary for 501(c)(4)s, a 501(c)(4) that has obtained an IRS determination letter may rely upon it indefinitely, absent a material change. In this evolving legal landscape, 501(c)(4)s that have not submitted an exemption application may consider doing so to obtain explicit IRS approval for both the exemption standard they seek to reply upon and their intended political activities.
Please contact partners Katherine LaBeau or Ezra Reese, or your ELG contact for further guidance.