United States: Exempt Organization Tax Issues: Compliance and Risk Avoidance in 2002

This outline addresses new developments in three areas of the tax law: (1) political activities; (2) IRS audits and other activities; and (3) controlled subsidiaries. Other issues that will be discussed in this session of the Symposium are covered by materials prepared by Paula Cozzi Goedert.

There are several recent developments of significance in the laws and regulations governing political activities of exempt organizations. One of these developments, the passage of the Bipartisan Campaign Finance Reform Act of 2002, which amended The Federal Election Campaign Act ("FECA"), is covered in another session of this Symposium and will not be covered here. This handout covers the tax rules governing political activities. The most important developments in the tax area are:

• New disclosure rules applicable to Section 527 political organizations, legislative efforts to amend these rules, and the recent decision in National Federation of Republican Assemblies v. United States, No. 00-0759-RV-C (S.D. Ala. Aug. 27, 2002), holding much of the disclosure rules unconstitutional.

• Announcement 2002-87 requesting comments on possible changes to Form 990, which includes changes affecting Section 501(c) organizations and Section 527 Organizations.

• IRS Fiscal Year 2002 Continuing Professional Education ("CPE") Text, which contains a lengthy section on election year issues. The CPE is an internal training document and is not precedential guidance. Nevertheless, it is an excellent indicator of the Service’s current thinking on election year issues. It can be found on the IRS website, www.irs.gov.

The tax rules governing political activities of tax-exempt organizations are somewhat complex. In general the applicable rules vary, depending upon the section of the Internal Revenue Code under which an organization is recognized as exempt.

Section 501(c)(3) organizations are prohibited from participating in or intervening in political campaigns. Although there is a great deal of published guidance from the IRS with respect to the activities that fall within this prohibition, there are often questions and controversies as to the definition of participating or intervening in political campaigns. In addition, even if an activity does not constitute participation or intervention in a political campaign, it may still be prohibited if it provides more than an insubstantial private benefit to any person, including a candidate for political office or a political party. American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989). The penalty for a Section 501(c)(3) organization that engages in prohibited political activities is revocation of exempt status. However, a Section 501(c)(3) organization that is formed for the purpose of engaging in a particular political campaign may not be deterred by the threat of revocation of its exempt status, which would not likely take place before the election took place. To provide a deterrent to such organizations, Section 4955 imposes monetary penalties and Section 7409 gives the Service authority to seek an injunction.

Organizations exempt under Section 501(c)(4) (social welfare organizations) and Section 501(c)(6) (business leagues) may participate in political campaigns as long as such activities are not their primary activities. See GCM 34233; Rev. Rul. 81-95, 1981-1 C.B. 332. However, because gifts to Section 501(c)(4) and (6) organizations are subject to gift tax, they are not desirable for organizations engaging in fundraising.

Membership dues, to the extent allocable to political campaign activities, are not deductible as business expenses. Code § 162(e)(3). Section 501(c)(4) and (c)(6) organizations that engage in political activities are required to provide notice to their members setting forth the percentage of dues that are estimated to be applicable to political activities. Section 6033(e)(1)(A)(ii). Alternatively, such organizations may pay a proxy tax at the highest corporate rate (currently 35 percent) on these amounts.

Organizations exempt under Sections 501(c)(4) and (c)(6) that make expenditures for political activities are taxed under Section 527(f) of the Code on the lesser of their investment income or the amount of their political expenditures, unless the expenditures are made through a separate segregated fund. These organizations must disclose information about their political activities on Form 990, Return of Organization Exempt from Income Tax.

Organizations exempt under Section 501(c) (other than Section 501(c)(3) organizations) may establish and maintain separate segregated funds to receive contributions and make expenditures in political campaigns. Treas. Reg. § 1.527-6(f). These funds are treated as organizations separate from the Section 501(c)(4) or (c)(6) organizations. If the separate segregated fund meets the requirements for a political organization under Section 527(e)(1), discussed below, then its "exempt function" income (generally funds raised for political activities) less its "exempt function" expenses (generally expenses used for political purposes), is exempt from federal income tax. Section 527(c). If it does not meet the requirements of a political organization, then it is subject to tax under general tax principles.

In order to be treated as a separate organization, the fund must be established and maintained by the organization separate from the assets of the organization. Treas. Reg. § 1.527- 2(b)(1). The amounts in the fund must be dedicated for use only for political campaign activities. Id. The organization maintaining a segregated fund must keep records that are adequate to verify receipts and disbursements of the fund and identify the political campaign activity for which each expenditure is made. Treas. Reg. § 1.527-2(b)(2). Separate segregated funds do not need to be separately incorporated but can be as simple as a separate bank account.

Transfers of funds from an organization’s general treasury to a separate segregated fund are likely to be treated as political expenditures of the Section 501(c)(4) or (c)(6) organization and thus may subject the organization to the Section 527(f) tax. However, amounts collected by a Section 501(c)(4) or (6) organization that are designated for the separate segregated fund and are promptly and directly transferred to such fund are not treated as political expenditures by the exempt organization and thus do not subject the organization to the Section 527(f) tax. Treas. Reg. § 1.527-6(e). A Section 501(c)(4) or (6) organization may pay indirect expenses (such as overhead and record keeping) that are necessary to support the political campaign activities engaged in by the separate segregated fund without incurring the Section 527(f) tax. See TAM 9433001 (Jan. 26, 1994).

The essence of Section 527 is that organizations that qualify as a "political organization" are treated as tax-exempt organizations on income from dues, contributions, and fundraising used for political campaign activities and are taxed on other income such as investment income. By establishing a separate segregated fund that meets the definition of a political organization under Section 527, an organization can limit its tax liability on investment income to investment income earned by the separate fund.

Contributions to Section 527 political organizations are not subject to gift tax. Code § 2501(a)(5).

Section 527 defines the term "political organization" to mean a party, committee, association, fund, or other organization (whether or not incorporated) organized and operated primarily for the purpose of accepting contributions or making expenditures for an "exempt function." Code § 527(e)(1).

The term "exempt function" (referred to in this outline as exempt political campaign activities) includes:

• influencing or attempting to influence the selection, nomination, election, or appointment of an individual to any Federal, State or local public office or office in a political organization, whether or not such individual is selected, nominated, elected, or appointed;

• influencing or attempting to influence the election of Presidential or Vice- Presidential electors, whether or not such electors are elected; and

• making expenditures related to one of the offices just described if such expenditures, if incurred by an individual, would be allowable as a deduction under Section 162(a) of the Code.

Code §§ 527(e)(1); (e)(2). Political campaign activities may qualify as exempt regardless of whether they support or oppose a particular candidate. The determination of whether a particular activity qualifies as a tax-exempt political campaign activity is based on facts and circumstances. Note that nonpartisan voter education activities -- which can be engaged in by Section 501(c) organizations, including Section 501(c)( 3) organizations -- do not qualify as tax-exempt political campaign activities for Section 527 Political Organizations.

In order to be taxed only as a political organization, an organization must be both organized and operated primarily for exempt political campaign activities. Treas. Reg. §§ 1.527- 2(a)(2); 2(a)(3). In addition, the organization’s dues, contributions and fundraising income must be set aside in a segregated fund (or a number of segregated funds) for use only for political campaign activities. Code § 527(c)(3); Treas. Reg. § 1.527-2(b)(1). Non-segregated funds are included in the organization’s taxable income when received. The organization may make an insubstantial amount of expenditures from a segregated fund for non-exempt activities without adverse tax consequences, provided that such expenditures (i) are not illegal; (ii) do not finance an illegal activity; and (iii) do not financially benefit the organization. Treas. Reg. § 1.527- 2(b)(1). If the organization’s expenditures for non-exempt activities from a segregated fund are more than insubstantial, the entire amount in the segregated fund must be included in the organization’s taxable income. Id. However, the organization’s status as a Section 527 organization will not necessarily be affected. Because a political organization is not prohibited from engaging in non-exempt activities, provided that such activities are not primary, the organization may make substantial expenditures for non-exempt activities from a particular segregated fund without jeopardizing its Section 527 status or the tax-exempt status of its other segregated funds. An organization that loses its Section 527 status is subject to tax under general tax principles.

A Section 527 organization need not be terminated once a candidate’s political campaign ends. The organization’s excess funds may be held in reasonable anticipation of future exempt use. Treas. Reg. § 1.527-5(c)(1). For example, the organization’s excess funds may be held if the candidate intends to run again. If the organization determines that its excess funds are not needed for future political campaign activities, the organization must transfer such excess funds within a reasonable period of time to another Section 527 organization, a public charity, or the general fund of the U.S. Treasury or any State or local government. Code § 527(d). Excess funds that are not needed for future exempt use and not transferred as provided in Section 527(d) are treated as diverted for the personal use of the candidate and are included in the candidate’s gross income. Id.

Many Section 501(c) organizations have a related Section 501(c)(3) organization. Because Section 501(c)(3) organizations are absolutely prohibited from engaging in political campaign activities, a Section 501(c) organization with an affiliated Section 501(c)(3) organization must ensure that its political campaign activities are not attributed to its Section 501(c)(3) affiliate. As long as the organizations are separately incorporated and maintain adequate records to show that tax-deductible contributions are not used to support the lobbying and/or political activities of the Section 501(c) organization, those activities will not be attributed to the related Section 501(c)(3) organization and will not jeopardize the Section 501(c)(3) organization’s tax exempt status. See Regan v. Taxation with Representation of Washington, 461 U.S. 540 (1983); Branch Ministries v. Rossotti, 211 F.3d 137 (D.C. Cir. 2000).

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