Highlights
- Tax-exempt organizations facing potential IRS revocation of their status should be aware of the significant legal, financial and operational implications, as well as the options available to challenge such actions.
- Section 7428 of the Internal Revenue Code provides a critical litigation remedy – a declaratory judgment action – for organizations disputing certain adverse IRS determinations related to tax-exempt status.
- This Holland & Knight alert discusses practical and legal issues involving IRS revocation of an organization's tax-exempt status.
Discussions of the tax-exempt status of universities, nonprofit advocacy groups and other Section 501(c)(3)1 organizations frequently have been in the news lately. The IRS revocation of a Section 501(c)(3) organization's tax-exempt status can raise significant financial and operational burdens. Simply stated, an organization's long-term survival may hang in the balance when the IRS acts to revoke the organization's tax-exempt status.
The Internal Revenue Code provides special remedies for many situations. For a Section 501(c)(3) organization facing a final adverse determination regarding its tax-exempt status, Congress has provided the litigation remedy of a declaratory judgment action under Section 7428.
Section 7428: Declaratory Judgment Actions
The statute contains four parts: 1) creation of the remedy, 2) limitations on the remedy, 3) validation of certain contributions made during the pendency of proceedings and 4) subpoena power for the U.S. District Court for the District of Columbia (D.C. District Court).
Remedy
Section 7428(a) creates a remedy in several factual situations involving tax-exempt organizations, including certain initial classification determinations or the failure of the IRS to make a determination. For a Section 501(c)(3) organization that has had its tax-exempt status revoked by the IRS, Section 7428(a)(1)(A) provides that a declaratory judgment action is available in a case of actual controversy involving a determination by the IRS "with respect to the ... continuing qualification of an organization as an organization described in section 501(c)(3) which is exempt from tax under section 501(a) or as an organization described in section 170(c)(2)." This declaratory judgment remedy is a significant departure from the rule that proceedings seeking injunctive or declaratory relief regarding federal taxes are generally prohibited by the Tax Anti-Injunction Act, Section 7421 of the Internal Revenue Code.2
Section 7428(a) permits an affected organization to file a declaratory judgment action in one of three different forums: U.S. Tax Court, U.S. Court of Federal Claims or D.C. District Court. Many considerations go into choosing which forum to select. For instance:
Appellate Circuit
- Pursuant to Section 7482(b), an appeal of a Tax Court decision is to the U.S. Court of Appeals for the circuit in which the organization's principal office is located or, if none, the U.S. Court of Appeals for the District of Columbia. Appeals of declaratory judgments rendered by the D.C. District Court or the Court of Federal Claims are appealable to the D.C. Circuit or Court of Appeals for the Federal Circuit, respectively. Precedents sometimes differ between these circuits, and that difference may in some cases affect the choice of a trial forum.
Evidence
- As the exempt organization would be confronting a revocation of its exempt status in the Tax Court, the evidence would not necessarily be limited to the administrative record. That is, the Tax Court may make findings of fact based on the evidence presented at trial, even if they differ from the administrative record.3
- The Court of Federal Claims has jurisdiction for Section 7428 cases pursuant to 28 U.S.C. Section 1507. The Court of Federal Claims requires a motion for supplementation of the administrative record to be made on the basis of either the specific law to be applied in the particular case or generally applicable principles of administrative law.4
- The only U.S. District Court that may hear a Section 7428 case is the D.C. District Court.5 Unlike the Tax Court or the Court of Federal Claims, the D.C. District Court does not have a provision expressly permitting supplementation of the administrative record.6
Limitations
Section 7428(b) provides certain limitations that apply to declaratory proceedings:
- The declaratory judgment action under Section 7428 may be filed only by the organization the qualification or classification of which is at issue. It may not be filed by any other person such as a disappointed contributor or donor.
- An organization must exhaust all administrative remedies available to it within the IRS before a court may issue a declaratory judgment or decree under Section 7428. Since the right to appeal to the IRS Independent Office of Appeals usually accompanies a preliminary IRS revocation determination, this typically means preparing a protest and seeking relief until a final determination is .
- If the IRS sends its final adverse determination to the organization by certified or registered mail with respect to an issue referred to in Section 7428(a)(1), a proceeding for declaratory relief may be begun only if the organization files the action within 90 days of such mailing.
- No action may be brought under Section 7428 with respect to any revocation of status described in Section 6033(j)(1), which relates to an organization that fails to file an annual information return or provide the required alternative notice for three consecutive years.
Validation of Certain Contributions During the Pendency of Proceedings
A significant feature of a declaratory judgment action under Section 7428 is the validation of contributions made during the validation period (i.e., the period beginning on the date on which the notice of the revocation was published and ending on the date on which the court first determined in such proceeding that the organization was not described in Section 170(c)(2)).
In the case of a revocation, the organization is treated as having been described in Section 170(c)(2) for purposes of determining certain contributions. Thus, even if there are collateral tax effects from an IRS revocation of exempt status that could be contested in one of the more conventional tax litigation proceedings (e.g., a deficiency proceeding or tax refund suit), the organization may prefer to file a declaratory judgment action to protect the charitable contribution deduction for donors while the issues are litigated.
Only contributions by individuals and organizations described in Section 170(c)(2) may be validated. In the case of individuals:
- Total contributions by individuals during the validation period are not valid to the extent they exceed $1,000.
- Contributions may not be validated for individuals who were at least partially responsible for the activities, or failures to act, on the part of the organization that were the basis for the revocation.
Subpoena Power
Section 7428(d) provides the D.C. District Court with the same nationwide subpoena power to require the attendance of a witness at a trial or hearing that the Tax Court and the Court of Federal Claims already have.
Broader Impact and Considerations
If revocation is done through a revenue procedure, rather than an organization-specific audit and revocation notice, there likely are additional ways to challenge the revocation, including but not limited to, under the Administrative Procedure Act (APA) or on constitutional grounds. If revocation is based on guidance issued via Treasury Department regulation, the exempt organization will have an opportunity to participate in the notice and comment process, and the regulation may again be challenged on similar grounds.
In short, while revocation of tax-exempt status can severely threaten an organization's survival, there are many procedural opportunities to challenge the IRS's determination.
Footnotes
1. Unless otherwise indicated, all "Section" references are to the Internal Revenue Code of 1986, as amended, and all "Reg. Section" references are to the U.S. Department of the Treasury regulations promulgated thereunder.
2. See also 28 U.S.C. Section 2201(a) (authorizing declaratory relief in U.S. courts "except with respect to Federal taxes other than actions brought under Section 7428 of the Internal Revenue Code").
3. See Tax Ct. R. 217(b)(1).
4. See Comments to Court of Federal Claims, RCFC 52.1, Administrative Record.
5. See 28 U.S.C. Section 1346(e).
6. See Court of Federal Claims, RCFC 52.1, Administrative Record; D.C. District Court, LCvR 7(n).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
