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Please Stay for the Q&A . . . How the IRS Says It Is Sorry for a Scandal

July 2013

On May 10, 2013, the nation learned of the biggest Internal Revenue Service (IRS) scandal since the Watergate era. The admission came in answer to a pre-arranged question after a speech to the American Bar Association's (ABA) Exempt Organizations (EO) Committee meeting, kind of as an “Oh, by the way . . . .” Two months later, we still have more questions than answers, the most pressing of which is how the IRS will change a culture that provides little specific information on how it operates or how to comply with its rules regarding advocacy.

At the ABA meeting, Lois G. Lerner, the now-suspended director of the Exempt Organizations Division at the IRS, described how several low-level employees in the EO Division's Cincinnati office had inappropriately flagged for additional review applications of certain nonprofit organizations that used politically charged words such as “tea party” and “patriot.” Applications using such words, almost all of which were submitted by conservative organizations that might criticize the current administration, were being singled out for scrutiny. What quickly became clear was that Lerner's description was merely a fraction of the inappropriate activity by IRS staff and officials.

Lerner's admission now seems calculated to softly leak damaging information forthcoming in a May 14, 2013, Treasury Inspector General (IG) report by Acting Deputy Inspector General for Audit Michael McKenney. The report included more details on how IRS agents in multiple offices had participated in both internal targeting of applications for recognition of tax-exempt status and detailed, invasive questioning of conservative-leaning groups that created enormous time and cost burdens for these organizations. Later information indicated that some liberal groups may have been targeted as well. In short, the IRS was inhibiting the activity of certain nonprofits with a policy or political point of view, and there did not appear to be any legitimate reason or authority to do so.

Lawyers in this area of practice suspected for years that the IRS had put a hold on approval of Section 501(c)(4) social welfare organization applications, only because very, very few were being granted. It was also well known that the IRS had released confidential information about conservative-leaning nonprofit organizations in violation of current laws (including copies of unapproved applications and lists of donors). Withholding approval and leaking donor information can greatly affect an organization's fundraising and ability to carry out its mission. At the time, many practitioners thought the inappropriate disclosures could be explained as inadvertent mistakes, but the IG report and other revelations in the IRS scandal made it clear that inappropriate treatment of nonprofit groups was a targeted effort. What we do not yet know is how much of this activity by IRS staff and officials was intentional, who authorized it and whether the goal was to inhibit legal activities based on a particular point of view.

IRS officials would learn quickly that there was no way to contain the political and legal fallout from the inappropriate targeting of nonprofit groups, as the resignation of the acting IRS commissioner and the suspension of Director Lerner quickly followed. The odd use of a Q&A session to air its mistakes showed that the IRS had little appreciation for the gravity of the situation or the reforms that would be necessary to reestablish the public's trust. Principal Deputy Commissioner Daniel Werfel's June 24 Initial Assessment and Plan of Action “to address the problems with IRS review of tax exempt applications” is a significant and welcome step in the right direction. But as the assessment itself notes, this step came only after “the President and the Secretary of the Treasury installed new leadership at the IRS in late May 2013, and directed a thorough review.”

Undoubtedly, the months ahead will bring some reform to the IRS, if only in the rules for processing exemption applications. Nonprofit groups can also hope these reforms include clearer guidance from the IRS as to what advocacy activities are permissible and how to go about them. Mr. Werfel's Initial Assessment offered 501(c)(4) groups whose applications had been held up an expedited path to approval, and it appears to create a new, but more stringent, “safe harbor” for such entities to engage in political activities. The implications of the expedited procedure and whether it effectively puts new limits on political activity by all nonprofits remain to be seen.

Failing to give clear guidance for compliance creates even greater uncertainty and cost throughout the nonprofit community than inappropriate disclosures and targeting. The nonprofit community also deserves more timely decisions by the EO Division regarding whether applications will be granted, be denied or require further information. The scandal, while disturbing and disruptive, is a chance for meaningful, positive change. It is not yet clear, however, if the IRS will take this opportunity or eventually revert back to the pre-scandal status quo.

Nonprofit tax lawyers also learned a valuable lesson from this episode—never leave before the Q&A portion of an IRS official's presentation.