On May 14, 2013, the Treasury Inspector General for Tax Administration (TIGTA) issued a report finding that beginning in early 2010, the IRS used “inappropriate criteria” to identify organizations applying for tax-exempt status under Internal Revenue Code section 501(c)(4), commonly referred to as social welfare organizations (in comparison to section 501(c)(3) “charitable organizations”). Under section 501(c)(4) and Treas. Reg. section 1.501(c)(4)-1(ii), an organization qualifies for exemption from income tax if it is “primarily engaged” in promoting social welfare, which cannot include participation or intervention in political campaigns on behalf of or in opposition to any candidate for public office. Therefore, a social welfare organization may be involved in political activities as long as such activities are not the organization’s primary activity. The IRS rightfully may investigate applications for section 501(c)(4) status to ensure that groups claiming exemption are not primarily engaged in political activity, most notably political campaigns. Here, the question arose as to how and why the IRS appeared to focus on certain organizations applying for section 501(c)(4) status.
TIGTA’s audit was initiated based on concerns expressed by members of Congress with the overall objective of determining whether allegations were founded that the IRS (1) targeted specific groups applying for tax-exempt status; (2) delayed processing of targeted groups’ applications; and (3) requested unnecessary information from targeted groups. TIGTA found that the IRS used inappropriate criteria that identified Tea Party and other organizations applying for tax-exempt status based upon their names or policy positions instead of indications of potential political campaign intervention.
A mere three days after TIGTA’s report was made public, Congress held its first official hearing looking into the scandal. Steven T. Miller, the acting IRS Commissioner, soon resigned and Lois Lerner, the director of the IRS tax-exempt organizations division, invoked her Fifth Amendment rights when asked to testify before Congress and was ultimately placed on administrative leave.
Taxpayers and their representatives should use the current IRS scandal to evaluate their procedures in dealing with the IRS, state departments of revenue, as well as any government agencies. As information slowly becomes public, three major lessons for taxpayers emerge from this scandal that should guide dealings with the IRS and other government agencies:
- Tax controversy starts at the planning stages
The common myth is that good planning will avoid any real tax controversy. This assumption is simply not the case. Depending on the initiatives and programs the IRS implements, a taxpayer may be at risk for a costly, time-consuming audit. The recent IRS scandal highlighted that what seemed to be perfectly appropriate activity and tax reporting to the taxpayer was ultimately subject to intense scrutiny by the IRS. Similarly, the business and tax planning executed by various international companies that recently came under scrutiny shows that merely playing a “wait and see” approach to the IRS could lead to heightened investigation.
As Judge Learned Hand once famously stated, “[a]nyone may arrange his affairs so that his taxes shall be as low as possible; … nobody owes any public duty to pay more than the law demands." All companies should arrange their affairs to legally reduce their tax to the lowest amount as such duty is owed to the company’s employees and owners. However, taxpayers should execute such business and tax planning with an eye on how the IRS will view, and potentially attack, such planning. In short, executing your planning through the lens of a future audit may minimize your ultimate exposure.
- Responding to an Information and Document Request
In multiple instances, the IRS asked for irrelevant, and in some cases inappropriate, information of the social welfare organizations. For example, the Determinations Unit requested information about donors of the organizations as well social media postings. In too many instances, taxpayers turn over information requested by the IRS without questioning whether the information is required to be produced. For example, the IRS generally cannot request a taxpayer to create a document, including a tax return or spreadsheet summarizing company records. Before turning over a document or information, a taxpayer should remember that once a document is turned over, an admission is put in writing, a spreadsheet is created at the examiner’s request, or a recorded interview is complete, you cannot take back the document, the admission, the spreadsheet, or the interview responses. Consider turning over only what is asked, required, and not privileged, your smoking gun today is the IRS’ smoking gun tomorrow.
- Representation before the IRS
When we need help with selling real estate, we hire a real estate broker. When we need help selling or buying investments, we hire an investment banker. Yet, when we deal with the most powerful department of revenue in the world, too often we handle it on our own. The IRS speaks a different language and operates under multiples regulations, procedures, rulings, and internal guidelines. When it comes to the IRS, the taxpayer cannot have a “let’s see how it goes” or “this is just routine” attitude – there is simply too much at stake. The Internal Revenue Code specifically provides that a taxpayer may be represented in any IRS inquiry. By engaging an experienced advocate, the taxpayer can ask the IRS to deal with its representative. Under the Internal Revenue Code, such representative may appear on behalf of the taxpayer and the IRS (absent an administrative summons) may not require a taxpayer to accompany the representative. Such tactic prevents the “gotcha” admissions that occur when the taxpayer (including in-house professionals) or return preparer meets with the IRS. And such tactic allows the taxpayer to match the IRS’ strategy of carefully considering the impact of each issue on the ultimate resolution of the IRS inquiry.
In recent years, the spotlight has been on the “tax shelters”, “tax gap”, and the enactment of legislation to penalize or otherwise deal with perceived abuse of the internal revenue laws. The recent IRS scandal spotlights the other dark side of the tax arena—aggressive behavior on the part of those entrusted to enforce the tax laws. Arguably, the IRS personnel simply went from fact finders to advocates for a result. And this can happen in any case with any IRS employee. So what can be done? What should be done is for the IRS and Congress to supplement the Taxpayer Bill of Rights with rules that focus solely on the amount and kind of information the IRS may seek from a taxpayer. The Code sets few boundaries and allows the IRS to determine what they need. For years, courts limit the amount of discovery parties can request even in multi-billion dollar cases and Congress and the IRS should create a similar type of limitation for IRS examinations. Taxpayers need to know what to expect with IRS examinations and other IRS inquiries. Right now the only limit on the IRS is time—three years from the date the return was filed. That is not enough protection for taxpayers.
In summary, taxpayers should structure their affairs to legally minimize their tax liabilities for the greater good of their employees and owners or request exemption from income taxes for the greater good of the community. In either case, taxpayers must plan for the knocking on the door by the IRS from day one. And if the IRS knocks, taxpayers should be a "cooperative advocate" for their well-structured planning.