The IRS has just proposed new regulations that would effectively prevent many so-called 501(c)(4) organizations from engaging in political activity. These regulations are deeply flawed both from tax and First Amendment perspectives and should be opposed by anyone who supports free speech. Unfortunately, there seems to be a great deal of confusion about what 501(c)(4) organizations are and why they are tax-exempt (though donations to them are not tax-deductible). Once these points are understood, the unfairness of the proposed new regulations is laid bare.
A 501(c)(4) organization is not a charity. Charities are organized under a different section of the Internal Revenue Code, section 501(c)(3), and gifts to them are generally deductible from the donor’s taxable income. A 501(c)(3) organization exists for religious, educational, charitable, scientific, literary, or other similar purposes and is prohibited from participating in political activities.
A 501(c)(4), by contrast, is organized for purposes of “social welfare.” Organizations in this category include not just political groups but volunteer fire departments, veterans’ organizations, civic-improvement leagues, and many others. They are allowed to participate in political activities, within limits. Donors to a 501(c)(4) group cannot deduct the donations from their taxable income, and nothing in the proposed new regulations would change that.
The newly proposed rules would change the status not of the donors’ income taxes but those of the organization. If a political group is eligible to use section 501(c)(4), then under current rules, it is tax-exempt. If you take away that tax exemption, as the new rules threaten to do, it will have to pay taxes on its income, which includes the donations it receives.
The very idea of taxing a nonprofit may seem strange. Since 501(c)(4) groups typically spend every penny they take in and don’t make any profits or distribute any earnings to shareholders, how can they have any liability for income taxes? The answer is that under IRS rules, any organization’s expenses are deductible only if it is engaged in profit-making activities. This rule is not completely illogical. It’s intended to prevent people from deducting expenses for their hobbies: Otherwise, you could declare your unprofitable hobby to be a business and write off everything you spent on it.
For example, consider what would happen if a bunch of fishermen decide to form an organization to promote fishing, buying boats and tackle and running fishing trips. Remember, if they were acting individually, none of them would be able to deduct their fishing expenses. If they form a club, all their contributions count as income to the club, and none of the expenses of the club are deductible — from either the donors’ individual taxes or those of the corporation — because the club is not engaged in a profit-making activity. This makes sense, because we do not want to permit individuals to create deductions for their hobbies by engaging in them collectively rather than individually.
However, we do give the fishing club a tax exemption, to put its members in the same position for tax purposes that they would be in if they were fishing individually: Each member earns money, pays taxes on that money, and then spends that money on fishing. To subject the club to a tax on that income, the money spent on fishing, would be to impose an additional tax on the members’ fishing. To prevent abuses, however, the tax exemption for non-profit groups typically exclude any investment income of the group because otherwise that income would never be subject to tax, whether in the hands of the individual members or of the group.
Now, what about political activities of the kind at issue in the proposed new rules? As with the fishermen, individuals can earn money, pay taxes on that money, and use what’s left to engage in political activities. But under the proposed rules — which would remove a 501(c)(4)’s tax exemption if it engages in virtually any political activity — if they choose to do so collectively, rather than individually, the organization will be subject to income tax on the amount it collects. If an individual spends $1,000 on posters, he will get $1,000 worth; but if he donates $1,000 to the organization, it will have to pay $350 to the IRS and will be left with only $650 to purchase posters.
Needless to say, there is no tax rationale for this proposed rule change. It doesn’t prevent any tax abuses, and it violates fundamental principles of tax fairness by treating similarly situated taxpayers in completely different ways. The purpose of the proposed new rules seems to be precisely to impose a prohibitive tax on group political activities that would not be imposed if the group’s members engaged in them individually. This appears to be a straight-up violation of the First Amendment.
It has been argued that the proposed rules are justified as a way to force political groups to organize under a different tax-exemption provision, section 527, which requires them to disclose their donors. But if the government has a legitimate interest in forcing the disclosure of donors to political groups — a question that is far from clear, as either a policy or a constitutional matter — it should do so directly, with a statute requiring disclosure, rather than through the back door, by twisting the tax code to impose taxes on individuals engaged in collective political activities. For all these reasons, the proposed regulations are fundamentally unfair and ought to be withdrawn.
— Douglas B. Levene teaches corporate finance and business law at the Peking University School of Transnational Law.