District Court Upholds IRS Test to Determine Exempt Status of Political Advocacy Groups

(Parker Tax Publishing August 2017)

A district court held that the facts and circumstances test in Rev. Rul. 2004-6, which is used to determine whether an exempt organization has made expenditures that subject the organization to income tax, and to determine whether certain organizations qualify for tax exempt status, was not unconstitutional on its face. The court rejected a conservative group's arguments that the test was void for vagueness under the due process clause of the Fifth Amendment or unconstitutionally vague and/or overbroad in violation of the First Amendment. Freedom Path, Inc. v. IRS, 2017 PTC 323 (N.D. Tex. 2017).

Background

Freedom Path, Inc., a conservative advocacy organization, applied for recognition as a tax exempt social welfare group under Code Sec. 501(c)(4) in 2011. In 2013, the IRS sent Freedom Path a proposed denial of its application. The IRS applied the facts and circumstances test under Rev. Rul. 2004-6 to analyze Freedom Path's television advertisements and mailers and determined that many of the organization's communications were political campaign interventions. The IRS proposed to deny Freedom Path's application on the basis that it was not operated exclusively for the promotion of social welfare.

In 2014, Freedom Path sued the IRS, alleging that it targeted the group for unconstitutional and unlawful treatment based on its conservative political views. Freedom Path alleged that the IRS delayed its application, wrongly subjected it to burdensome information requests, and leaked its confidential tax information. The parties stipulated to an order enjoining the IRS from continuing to process Freedom Path's application during the lawsuit and, thus, no final determination on Freedom Path's application for exempt status had ever been issued.

Under Code Sec. 527(f)(1), a Code Sec. 501(c)(4) social welfare group that engages in political campaign intervention is subject to tax on the lesser of the amount expended on that activity or the group's investment income for the year. A social welfare group can, however, maintain a segregated fund for political campaign intervention activities. The segregated fund is treated for tax purposes as a Code Sec. 527 political organization, which gives social welfare groups a way to participate in political campaign intervention while still avoiding federal income tax.

The IRS uses the facts and circumstances test in Rev. Rul. 2004-6 to determine whether a group that is otherwise tax exempt has spent money on a prohibited function, thereby subjecting the group's income to tax under Code Sec. 527(f). The IRS also uses this test to determine whether applicants for exempt status under Code Sec. 501(c)(4) qualify for such status. The test is used to determine whether an applicant's activity is primarily social welfare or is inordinately dedicated to political campaign intervention. The test contains 11 factors, six of which tend to show that an activity is campaign related and five that tend to show it is not. Six hypothetical examples are included in the test to illustrate its application. The factors are not weighted, and the ruling permits consideration of other, unspecified factors.

Parties' Arguments

Freedom Path moved for summary judgment on its claim that the Rev. Proc. 2004-6 test was unconstitutionally vague in violation of Freedom Path's Fifth Amendment due process clause. Freedom Path also argued that the test was overly broad and promoted viewpoint discrimination in violation of the First Amendment. Freedom Path's Fifth Amendment argument was that the test failed to provide a person of ordinary intelligence with fair notice of what is prohibited. Freedom Path said that the test provided no way of distinguishing permissible issue advocacy from campaign speech that would adversely affect its ability to obtain Code Sec. 501(c)(4) status. Noting that the 11 factors are not weighed against each other, the organization asserted that the IRS's failure to clarify or quantify the "primarily engaged in social welfare" standard exacerbated the uncertainty of the test as it relates to Code Sec. 501(c)(4) applicants. Freedom Path also argued that the test violated the First Amendment because it was unconstitutionally vague and promoted viewpoint discrimination. According to Freedom Path, the test, which was intended to identify campaign intervention activity, also wrongly encompassed a substantial amount of issue advocacy. The Supreme Court, according to Freedom Path, had held in campaign finance cases that multifactor tests used to separate issue advocacy from political activity were overbroad. Further, Freedom Path asserted that its experience showed that the IRS was using the test to harass and delay disfavored groups.

The IRS responded to Freedom Path's vagueness challenge by arguing that as a civil regulation, the test required less specificity than a criminal law. The IRS reasoned that economic regulations are held to a lower standard because they are limited in scope and the affected entities are likely to have recourse to clarify their meaning before acting. According to the IRS, the factors listed in the test were clear and did not require a person of average intelligence to guess at their meaning. The IRS also contended that the test did not invite arbitrary or discriminatory application because its factors were discrete and objective, that a 2013 report of the Treasury Inspector General for Tax Administration found only an appearance of partiality but no actual discrimination in the IRS's selection of applications for greater review based on their name and political alignment, and that judicial and administrative review mitigated the potential for abuse. Finally, according to the IRS, even if Rev. Rul. 2004-6 was vague, it lacked the harmful consequences the vagueness standard was intended to prevent because organizations had the option to bypass the test and establish a segregated fund.

The IRS's response to Freedom Path's First Amendment argument was that Rev. Rul. 2004-6 did not substantially burden protected speech so as to render the rule overbroad. The IRS asserted that a law should be invalidated only if its overbreadth is substantial, that the rule did not prohibit speech but only categorized speech for which expenditures may be taxable, and that the rule should therefore be reviewed leniently for overbreadth, similar to disclosure requirements in campaign finance law or rules for determining what is a political action committee.

District Court's Decision

The district court held that the facts and circumstances test in Rev. Rul. 2004-6 was not unconstitutionally vague. The court applied a less strict vagueness standard than for a criminal law because Rev. Rul. 2004-6 is a civil regulation. In that context, the court found no controlling precedent to support a holding that the test was void for vagueness. According to the court, the factors included in the test were specific and not indefinite or subject to varying individual sensitivities. The court also determined that a multifactor test did not make a tax rule vague per se. The specific and objective factors set out in the Rev. Rul. 2004-6 test, the court said, were not unconstitutionally vague.

The district court also concluded that the Rev. Rul. 2004-6 test did not violate the First Amendment. Although Freedom Path had correctly pointed out that multifactor tests are not permitted when deciding whether speech will be punished, the court found that Rev. Rul. 2004-6 did not ban, restrain, or punish speech. Rather, the court held that the test permissibly regulated whether expenditures for certain types of speech will be subsidized for tax purposes. The court held that Rev. Rul. 2004-6 implemented Congress's intent to subsidize social welfare groups' issue advocacy but not their political campaigning. According to the court, this statutory policy was clearly constitutional. Further, the Supreme Court has held that the denial of a tax deduction generally does not infringe on the right to free speech. The court also held that Freedom Path failed to show that Rev. Rul. 2004-6 contributed to viewpoint discrimination. The court noted that the ruling does not on its face single out any viewpoint or inquire into a group's intent. Moreover, according to the court, the test's consideration of timing and other contextual factors was only an argument related to its alleged overbreadth, not an independent constitutional defect.

For a discussion of the rules on interventions in political campaigns by social welfare organizations, see Parker Tax ¶60,504.10.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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