Lloyd Hitoshi Mayer
Professor of Law, Notre Dame Law School
The Donald J. Trump Foundation admits to illegal self-dealing (The Washington Post). The Bill, Hillary & Chelsea Clinton Foundation files amended annual returns to correct numerous reporting errors (Amended Returns Fact Sheet). A white nationalist group avoids filing annual returns for several years, apparently in reliance on a bureaucratic misclassification (The Washington Post). On “Pulpit Freedom Sunday,” thousands of churches violate the prohibition on IRC section 501(c)(3) organizations supporting or opposing candidates (CNN). These and numerous other recent examples of behavior by tax-exempt organizations that clearly violates the applicable tax laws lead to one obvious question: where was the IRS? The growing perception – and sometimes although not always the reality – is that when it comes to the administration and enforcement of those laws there is no one home.
This trend should be of concern not only for tax scholars and policy makers but also for tax-exempt organizations themselves, if for no other reason than increasing instances of individuals and organizations taking advantage of this perceived lack of oversight almost certainly will lead to questions about the wisdom of providing tax and other benefits to such organizations in the first place. While charitable organizations are the most vulnerable in this respect because they enjoy the greatest such benefits and so face the highest public expectations regarding their behavior, commentators have begun to question even the more modest benefits enjoyed by other types of tax-exempt organizations (see, e.g., Philip T. Hackney, What We Talk About When We Talk About Tax Exemption, 33 Virginia Tax Review 115 (2013); David S. Miller, Reforming the Taxation of Exempt Organizations and Their Patrons, 67 The Tax Lawyer 451 (2014)). To understand this trend and therefore how to address it requires understanding the confluence of factors that have lend to its emergence.
Factors Contributing to Administration and Enforcement Difficulties
Unchecked Growth. The traditional tax-exemption categories have been expanded far beyond what many think were their original limits by decades of developments. This is most obvious for section 501(c)(3), where the increasing reliance on fees for services, the decreasing reliance on donated assets and services, and the related adoption of market-level compensation structures and market-based approaches have changed the character of many traditional charities, including hospitals, universities, and even some churches (see, e.g., Roger Colinvaux, Charity in the 21st Century: Trending Toward Decay, 11 Florida Tax Review 1 (2011)). But it can also be seen in the pressure now put on sections 501(c)(4) and 501(c)(6) because of the increasing use of organizations in these categories for political purposes (see, e.g., Ellen P. Aprill, The Section 527 Obstacle to Meaningful Section 501(c)(4) Regulation, 13 Pittsburgh Tax Review 43 (2015)).
Vague Standards. This unchecked growth has been possible in large part because of the vague facts and circumstances-based standards for the various tax exemption categories. Such standards can be found not only in the positive requirements for tax exemption (“charitable,” “educational,” “promotion of social welfare,” etc.) discussed in the articles already cited but also in many of the negative requirements imposed on organizations seeking exemption (private inurement, private benefit, political campaign intervention, etc.). See, e.g., John D. Colombo, In Search of Private Benefit, 58 Florida Tax Review 1063 (2006); Miriam Galston, When Statutory Regimes Collide: Will Citizens United and Wisconsin Right to Life Make Federal Tax Regulation of Campaign Activity Unconstitutional?, 13 Journal of Constitutional Law 867 (2011); Jill S. Manny, Nonprofit Payments to Insiders and Outsiders: Is the Sky the Limit?, 76 Fordham Law Review 735 (2007)). It was in part the vagueness of these requirements that led to the IRS mishandling of exemption applications by many conservative-leaning organization seeking recognition under section 501(c)(4). More broadly the inherent difficulty of applying such uncertain requirements, particularly in an era of growing mistrust of government officials, makes both interpretation and enforcement increasingly challenging.
Shrinking Resources. The IRS has for years had to do more with less as its budgets fail to keep pace with both the scope of the laws it is required to administer and enforce and the growth in the number and complexity of entities its oversees, including tax-exempt organizations. And lack of financial resources is only part of the picture, as in common with the rest of the federal government the IRS is both losing many experienced employees to retirement and finding it increasingly difficult to compete with the private sector for new employees. This resources problem is particularly acute for the Tax Exempt and Government Entities Division as not only the smallest of the four primary IRS operating divisions but also the one that contributes the least to the fisc given that the entities it oversees are mostly exempt from tax. For even today the resource-strapped IRS can muster a significant enforcement effort when it is a high enough priority, as demonstrated, for example, by the hundreds of conservation easement audits and court cases it has pursued in recent years (as documented in Nancy A. McLaughlin, Trying Times: Important Lessons to Be Learned from Recent Federal Tax Cases (2016)).
Numerous commentators have attempted to address these factors and the perceived lack of both sufficient guidance and adequate enforcement of the tax laws applicable to tax exempt organizations. In addition to the articles already cited that primarily address whether the underlying substantive law should be changed, numerous other articles have addressed the best division of responsibility between the IRS and state authorities when it comes to overseeing tax-exempt nonprofit organizations and possible alternatives for such oversight at the federal level. For an overview of those articles and proposals, see Lloyd Hitoshi Mayer, Fragmented Oversight of Nonprofits in the United States: Does it Work? Can it Work?, 91 Chicago-Kent Law Review 937 (2016); Lloyd Hitoshi Mayer, “The Better Part of Valour is Discretion”: Should the IRS Change or Surrender Its Oversight of Tax-Exempt Organizations?; 7 Columbia Journal of Tax Law 80 (2016); Lloyd Hitoshi Mayer & Brendan M. Wilson, Regulating Charities in the Twenty-First Century: An Institutional Choice Analysis, 85 Chicago-Kent Law Review 479 (2010). In a nutshell, I recommend in this series of articles that the IRS and state authorities continue to divide responsibility for oversight of tax-exempt nonprofit organizations, that the IRS (and Congress) resist expanding the scope of the IRS’ oversight to encompass traditional state law areas such as governance and the duty of care, and, most radically, that Congress should seriously consider shifting the locus of federal oversight to a national, self-regulatory organization working in close cooperation with the IRS but funded by the tax-exempt sector itself.
Whatever the merit of my specific proposals, comprehensive consideration of the inadequate administration and enforcement of the tax laws applicable to tax-exempt organizations and the factors that have led to this situation suggests a multi-prong approach addressing at least three issues. The first and most obvious is the need for a more robust administrative vehicle to interpret and enforce these laws, as I have suggested in my previous work. But such a vehicle is almost certainly only part of the needed solution. The other two issues relate to the substantive law setting the requirements for tax-exempt status.
The substantive law needs to be clarified by giving serious consideration to moving away from vague facts and circumstances tests that are both difficult to administer and make the administering agency vulnerable to accusations of improper exercise of its discretion. The area where this issue has become most prominent is with respect to political campaign intervention, as illustrated by the aptly named Bright Lines Project. Consideration should be given to pursuing a similar approach in the numerous other important areas where vague standards risk making the law difficult if not impossible to administer and enforce.
The substantive law also needs to be revised to adjust for the fact that the tax-exempt organizations of today are in many instances very different from the tax-exempt organizations that existed at the time Congress created the current categories. Relatedly, many organizations that qualify for tax exemption appear to be far from the public’s perception of what organizations should enjoy the benefits of that qualification, raising questions about the continued legitimacy of the current substantive standards. Examples of such a disconnect include hospitals that provide minimal or no charity care, universities that accumulate multi-billion dollar endowments, and nonprofits of all types that pay millions in compensation to senior executives (or sports coaches). At the same time care should be taken to ensure that such revisions do not expand the responsibility of the IRS into areas for which it is ill-suited, such as ensuring competent governance of nonprofit entities (historically a state law concern) or regulating money in politics (historically an election law concern).
Only by addressing all three of these areas is it likely that the future of administration and enforcement of the tax laws applicable to tax-exempt organizations will be bright.