The backlog of unprocessed applications for tax-exempt status has reached an unprecedented level – the IRS website currently states that applications received in April 2012 are, as of August 2013, just being assigned for evaluation. For the foreseeable future, applications that the IRS concludes may require correspondence before rulings are issued can expect to wait more than a year before the application is even assigned to an agent. Organizations waiting in this queue—likely, thousands of charities—have passed the 270-day statutory threshold, and thus are eligible to file declaratory judgment actions in court, before the IRS even opens their applications to consider the merits.
Acknowledging the damage caused by these excessive delays, both the Treasury Inspector General for Tax Administration1 and the National Taxpayer Advocate2 have recently suggested that charities may need to pursue declaratory judgments in order to obtain relief. Now may be the time for some charities to seriously consider this option.
The IRS-Exempt Organizations Division employs a multi-tiered system for triaging exemption applications.3 Applications that are not substantially complete are rejected and closed within 60 days. Applications that are complete and straightforward should result in a determination letter within 90 days. Applications that require minor additional information will trigger a letter requesting additional information within 120 days. The remaining applications—those labeled for "further development"—are held in a queue until they are assigned to a tax law specialist for additional review. The IRS takes no steps to review the merits of applications in this last category until the cases are assigned.
All available evidence suggests the queue is growing quickly. The National Taxpayer Advocate noted in its 2012 Annual Report that the inventory of open applications increased from 15,570 in fiscal year 2010 to 33,505 in fiscal year 2012,4 and it is clear that this backlog has only continued to increase. Of the approximately 60,000 new applications the IRS receives every year 30% percent are assigned for further development.5
The IRS will not provide guidance to applicants unlucky enough to be designated as needing "further development" until their applications are assigned. Moreover, it is not always clear what triggers the tabling of any particular charity application. An applicant can check the IRS website, or call the Exempt Organizations Division's 1-877 hotline, but these efforts yield only generic information—for example, you can learn the month in which applications currently being assigned were filed.6 For the last several months the IRS has been working to assign applications filed 16 months ago, in April of 2012.7 Therefore, every applicant that is currently being assigned to an agent passed the 270-day threshold months ago.
The recent investigations into the IRS's handling of exemption applications of conservative organizations appear to have only made the delays worse. Since news of the "scandal" broke in May, our experience is that the IRS determinations process has stalled even further. It is possible that new leadership may improve the determinations process, but at this juncture the IRS does not appear to have a solution for clearing its backlog of open cases.
These extensive delays in obtaining exemption can be devastating to a new charity. Most importantly, donors are reluctant to contribute to a new organization without a favorable determination, which greatly restricts a new charity's access to funding. Unfortunately, worthy charitable projects may be withering—and some may die altogether—before the IRS even assigns their application for review. In some instances, the viability of a charity's key program may be tied to external events with limited windows to take action or capture public attention; charities frequently are forced to abandon these programs as a result of IRS processing delays. Finally, exemptions for state income, sales, and property taxes often require a prior determination from the IRS; thus, delays in securing an IRS determination may cause the charity to incur additional (and, in some states, non-refundable) expense.
Declaratory Judgment: An Option Worth Considering
Charities that have applied for tax-exemption under section 501(c)(3) have a right to bring suit if the IRS does not respond to the application within 270 days.8 In some cases, the application has been assigned, and the IRS may have requested additional information in the course of reviewing the file. For cases in this phase of development, applicants must allow a reasonable period of time for the reviewing agent to consider the charity's responses to questions or other supplemental materials before seeking relief in court. Similarly, organizations that have not responded in a timely manner to IRS inquiries may not be able to sue. But neither of these limitations apply to the many organizations that have not yet had any substantive response from the IRS when the 270-day period is up.
To bring suit, the charity must file an appropriate pleading for declaratory judgment with the United States Tax Court, the United States Court of Federal Claims, or the United States District Court for the District of Columbia. Decisions regarding when and where to file suit will, of course, depend on the particular facts and circumstances of each case, so charities wishing to pursue a declaratory judgment should consult with their tax advisors. It is important to ensure that the original application and any responses to IRS questions are complete enough to convince a court that the administrative record supports granting exempt status.
Recourse to declaratory judgment actions is not a new option for charities, but in the past it has been customary to work with the IRS to resolve application delays. There is no indication that these delays will improve in the current environment—and, if threatened budget cuts hit the IRS, the delays will inevitably get worse. Charities that have been flagged for further review need to seriously consider whether their best chance for obtaining their tax exemption is through the courts.