On October 28, the U.S. Court of Appeals for the Fifth Circuit issued an opinion in the case Memorial Hermann ACO v. Commissioner. The decision fundamentally uproots a longstanding interpretation regarding the amount of nonexempt activities 501(c)(4) organizations may engage in without jeopardizing their 501(c)(4)status. We recommend that 501(c)(4) organizations review this alert to become familiar with the decision, assess their individual risk, and consult with counsel on how to proceed.
Background
Internal Revenue Code (“Code”) section 501(c)(4) requires 501(c)(4) organizations to operate “exclusively” for social welfare purposes. Treasury regulations interpreting this requirement provide that an organization “is considered to be operated exclusively for the promotion of social welfare if it is “primarily” engaged in promoting social welfare. This standard is commonly referred to as a 501(c)(4)’s “primary purpose.” All other 501(c)(4) activities– including political activities – are “nonexempt” activities.
“Primarily” is not defined in the Code or Treasury regulations. For years, the regulated community and the IRS has largely interpreted “primarily” to mean more than 50 percent of a 501(c)(4)’s total activities each year (a majority). Yet, this position has never been unanimous. Case law exists in which courts have applied the “substantial” nonexempt purpose test to 501(c)(4)s. This test stems from Better Business Bureau of Washington, D.C. v. United States, in which the U.S. Supreme Court found that language in the Social Security Act requiring that an organization “must be devoted to educational purposes exclusively” meant that “the presence of a single non-educational purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of truly educational purposes.”
Since Better Business Bureau, the “substantial” nonexempt purpose test has become the standard for measuring section 501(c)(3) nonexempt activity. While there is no bright line limit for nonexempt activity under the “substantial” test, 5 percent or less of total activities each year is generally considered to be a safe harbor and courts have found activities in the range of 16 to 20 percent each year to be substantial.
Memorial Hermann ACO v. Commissioner
Memorial Hermann involved an appeal from a U.S. Tax Court denial for declaratory judgment for an organization that was denied 501(c)(4) tax-exempt status by the IRS. The IRS’s briefs, oral arguments, and related filings in Memorial Hermann repeatedly argued that the presence of a “substantial” nonexempt purpose would make an organization ineligible for 501(c)(4) status. On the other hand, Memorial Hermann argued that in relying on the “substantial” test, the Tax Court applied the wrong legal standard for determining section 501(c)(4) status. The Fifth Circuit disagreed, finding that since both section 501(c)(3) and 501(c)(4) use the term “operated exclusively,” the Better Business Bureau standard interpreting this language applies to both types of organizations. Notably, the Court did not find compelling Memorial Hermann’s argument that internal IRS training materials and agency statements have long relied on the “primary purpose” standard, citing the U.S. Supreme Court’s Loper decision for the proposition that it the Court is not required to give “Chevron deference” to the IRS’s interpretation of section 501(c)(4).
The Fifth Circuit ultimately upheld the U.S. Tax Court’s denial of Memorial Hermann’s petition for a declaratory judgment, finding that the organization was not tax-exempt under section 501(c)(4). Because nonexempt activities were nearly 80 percent of Memorial Hermann’s total activities – significantly beyond what both the “substantial” and “primary purpose” tests have historically permitted, the decision provides taxpayers with no new information on the “substantial” test limit for nonexempt activities.
Unanswered Questions
The Memorial Hermann decision leaves many questions unanswered for 501(c)(4)s that are eager for IRS guidance:
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Will the IRS now apply the Memorial Hermann “substantial” standard to other 501(c)(4) organizations formed instates within the Fifth Circuit (Texas, Louisiana, and Mississippi)?
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How should organizations formed in states outside of the Fifth Circuit respond, if at all?
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May 501(c)(4)s with an IRS determination letter who represented to the IRS in their exemption application that they would engage in more than “substantial” nonexempt activity continue to rely on their determination letter?
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Do self-attesting 501(c)(4)s without an IRS determination letter that have been operating under the “primary purpose” standard have any protection at all?
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If the “substantial” standard will now be applied to other 501(c)(4)s, would it be applied retroactively to past tax years or only prospectively?
As these outstanding questions illustrate, the ramifications of the Memorial Hermann decision for other 501(c)(4) taxpayers are far from certain at this point.
Guidance
In the aftermath of this decision, absent new guidance from the IRS, we recommend that all 501(c)(4) clients – regardless of the duration of their existence – discuss with counsel how to proceed, including whether to file a Form 1024-A application to obtain an IRS determination letter.
While the exemption application remains voluntary for 501(c)(4)s, a 501(c)(4) that has obtained an IRS determination letter may generally rely upon that determination indefinitely, absent a material change in the organization’s character, purposes, or methods of operation.
One potential way for a 501(c)(4) to protect itself from an adverse IRS finding is to rely on an IRS determination letter issued in response to an exemption application in which the 501(c)(4) is explicit that the organization’s nonexempt activities (including political activities) will be more than “substantial.”
Please contact Katherine LaBeau or another ELG political law attorney to file a 501(c)(4) exemption application or for additional guidance on how this development applies to your 501(c)(4) organization.