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IRS Gift Rule Turned on Politics as Crisis Prompts Reform

Photographer: Tom Williams/CQ Roll Call

Danny Werfel, the acting IRS commissioner, will make his first public appearance at a House hearing today since taking over May 22. Close

Danny Werfel, the acting IRS commissioner, will make his first public appearance at a... Read More

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Photographer: Tom Williams/CQ Roll Call

Danny Werfel, the acting IRS commissioner, will make his first public appearance at a House hearing today since taking over May 22.

(Corrects top gift tax rate under ‘Annual Limit’ subhead in story that ran June 3.)

The last time the Internal Revenue Service waded into a fight on politically active nonprofit groups, the agency capitulated quickly and let people make undisclosed, untaxed payments to groups financing campaign ads.

In 2011, under pressure from Republicans, the IRS shut down an attempt to impose gift taxes on donations to so-called social welfare organizations. The move led to a “free-for-all” by donors while clearing up decades of ambiguity on how it would enforce the law, said Ofer Lion, an attorney at Hunton & Williams LLP in Los Angeles.

The new controversy surrounding IRS scrutiny of small-government groups focuses attention again on how the agency handles politically sensitive issues. Lessons from the 2011 episode were obvious and yet recurred in 2013, as a lack of clear rules and management left the agency vulnerable to employee misconduct, open to charges of bias against Republicans and their allies and flat-footed when confronted with an outcry from lawmakers.

“It took a crisis to get reform, and I think that’s where we are now,” Greg Colvin, a partner at Adler & Colvin in San Francisco, said of the gift tax case. “It’s going to take a crisis like this to cause the IRS and Congress to realize that you can’t keep tolerating this kind of inadequate supervision and have the IRS refereeing what is and is not political.”

The IRS’s enforcement of tax laws on nonprofit groups re-enters the spotlight this week as Congress returns from a one-week recess, intent on searching for evidence of partisan motivations or senior executives’ involvement in targeting anti-tax Tea Party groups. The IRS revealed May 10 that some small-government groups got extra attention because of their names. Since then, six congressional committees have started inquiries, the Justice Department began a criminal probe, and three employees left their jobs early or were placed on leave.

First Appearance

Danny Werfel, the acting IRS commissioner, will make his first public appearance at a House hearing today since taking over May 22. Tomorrow, the House Ways and Means Committee is asking groups singled out for tougher scrutiny to testify about their experiences. The House Oversight and Government Reform Committee will meet June 6 to review an audit of spending on IRS conferences, including parody videos.

Congressional investigators are interviewing IRS employees and seeking past-due answers to lists of questions they sent the agency. The IRS says it is trying to be “exceedingly thorough” as it prepares responses.

The 2011 gift-tax flap and the new controversy over applications for tax-exempt status both stem from the same corner of the tax code.

Social Welfare

Groups organized under section 501(c)(4) are required to operate “exclusively” for the benefit of social welfare and don’t have to disclose their donors. Contributions aren’t tax-deductible and the groups don’t have to pay taxes on their investment income.

The IRS interprets that law to let 501(c)(4) groups engage in political activity, as long as that’s not their primary purpose. Many of those groups, including the Republican-allied Crossroads GPS and the Democratic-allied Priorities USA, spent heavily on campaign ads last year.

Such groups spent $256 million during the 2012 election cycle, according to the Washington-based Center for Responsive Politics, which tracks campaign finance issues.

The controversy for the past month has revolved around the scrutiny applied to groups applying for tax-exempt status.

Five Donors

The gift-tax issue is different because it involves donors to the groups. In 2011, the IRS sent letters to five donors, opening audits on whether their contributions to the groups should count as taxable gifts.

The Wall Street Journal reported May 31 that all five donors had given to Freedom’s Watch, which was formed to support President George W. Bush’s policies in Iraq. One of the group’s main backers was Sheldon Adelson, chairman and chief executive officer of Las Vegas Sands Corp. (LVS)

The IRS was on solid legal ground, according to a 2012 analysis by the Congressional Research Service. The tax code specifically exempts contributions to charities under section 501(c)(3) and political groups under section 527 from the gift tax. The IRS hadn’t been enforcing the gift tax for contributions to 501(c)(4) groups although it had, in effect, said in a 1982 revenue ruling that the tax could be applied.

Annual Limit

The gift tax, now at a top rate of 40 percent, applies only to taxpayers who exceed an annual limit of $14,000 per person and a lifetime limit of $5.25 million. People under those limits would have their gifts counted toward those caps, potentially undermining their estate planning.

From a tax collection perspective, conducting the gift-tax audits made sense, Lion said. The IRS has gift tax returns from wealthy individuals as well as donor lists from the nonprofit groups, and it could match the two to look for noncompliance.

“If you’re a revenue-collecting agent at the IRS, you get paid to bring in big bucks,” he said. “These were huge targets.”

Attorneys for the letters’ recipients started airing their concerns publicly, and Republicans began complaining. Senator Orrin Hatch of Utah, the top Republican on the Senate Finance Committee, and Representative Dave Camp, the chairman of the House Ways and Means Committee, wrote to complain and seek more information.

Enforcement “runs an unacceptable risk of chilling political speech, which receives the highest level of constitutional protection under the First Amendment,” Hatch and five other senators wrote to the IRS on May 18, 2011.

Current Controversy

The IRS backed off. In an echo of the current controversy, the agency insisted that the decisions were made by lower-level employees operating on their own authority to examine gift taxes and not based on political motives.

In a 2011 letter to lawmakers, then-IRS Commissioner Douglas Shulman wrote that the five cases stemmed from a “single matter” in which an employee “followed up on an internal referral,” suggesting that the idea might have stemmed from the exempt organizations office.

Steven Miller, then a deputy commissioner, stopped the audits, which hadn’t yet resulted in any taxes being assessed. On July 7, 2011, Miller released a memorandum saying that if the IRS imposed the gift tax in the future, it would only do it prospectively and after notice to the public. Thus far it hasn’t done so.

Practice Stopped

“It shows to me that they were unwilling to be political,” said Donald Tobin, a law professor at Ohio State University. “The mere raising of this in the press caused them to say, very quickly, we’re not going to enforce here.”

The IRS acted similarly in 2012, when the first allegations about targeting of Tea Party groups began surfacing. Miller ordered the practice stopped in early 2012; he just wasn’t public about it. Instead, he and other IRS officials gave lawmakers incomplete answers for a year while the agency’s inspector general worked on a report.

Miller became acting commissioner in November 2012 and was forced out of that job last month. For donors, his 2011 decision removed any potential threat of the gift tax.

Colvin, who represented one of the recipients of the letters, said he had long advised his clients that they might owe a gift tax. Some paid and some didn’t, he said, leading to an unfair situation in which the most scrupulous taxpayers were being disadvantaged.

‘Careful Donors’

“The prospect that the most careful donors would be subject to gift tax while most of the rest of the donating world would not is just a terrible way to administer the tax law,” he said.

Lion had talked with clients about redoing contributions as payments for specific services, which would fall outside the gift tax. Such maneuvers aren’t necessary any more.

“There’s no need for any fancy structuring,” he said.

Now the focus turns again to the IRS, which hasn’t proposed rules on the gift tax’s application to these contributions to social welfare groups or on how the IRS should decide whether a particular group is too political to qualify.

That’s about to change. The May 14 inspector general’s report that detailed scrutiny of the groups recommended that the IRS create clearer rules for employees and conduct more training. The inspector general, J. Russell George, is looking further into those questions.

Fair, Impartial

So are the IRS and Congress. President Barack Obama said May 15 that he wants to ensure the laws are clear, “so that we can have confidence that they are enforced in a fair and impartial way.”

Whatever they come up with may put the IRS back in the political thicket.

“The IRS is going to be even more reluctant to engage in these political questions that they’re really delegated to determine,” Tobin said. “They’re the wrong agency to be doing the job because of how much we care about nonpartisan tax enforcement, but it’s the job that’s assigned to them.”

To contact the reporter on this story: Richard Rubin in Washington at rrubin12@bloomberg.net

To contact the editor responsible for this story: Jodi Schneider at jschneider50@bloomberg.net

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