Civil War Horses, Con Men and Lois Lerner

I think I have been insulted.

I am reading this morning that the Court of Appeals for the D.C. Circuit is hearing the IRS appeal of the Loving decision.  That decision concerned the recent effort by the IRS to regulate tax preparers, and the IRS lost the case. There were three parts to the IRS effort:

• a unique preparer identification number, called a PTIN (“pea tin”). The PTIN would allow – in theory - the IRS to track which individuals prepared which returns. I say “in theory” because it is not uncommon for larger returns to have two or more preparers and one or more reviewers. Traditionally the highest-ranking last person in the chain is considered the official preparer, but the IRS did not write its regulations that way.

• a competency test. CPAs, enrolled actuaries, attorneys and enrolled agents were exempt, as their credentialing already includes a competency test.

• a continuing education requirement. Tax laws change frequently, so the IRS thought that continuing education would be a good idea. It is.

Here is the rub: where does the IRS get the authority to make these proclamations? I know it sounds a bit quaint to talk about “government of laws rather than of men” in the current political environment, but there are a few sticklers out there who still believe in the concept. One of them was Judge Boasberg in the Loving decision.

Yesterday the IRS trotted out its attorneys, arguing that they have the right to regulate whatever they want under the “Horse Act of 1884.” Folks, that is “18” 84. 

Do you remember the following words?

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

This is the 16^th amendment, creating the income tax and ratified in February 1913. That is “19”13. Which comes after “18”84, for most people. Let’s be blunt here: how can a law from the 1800’s give the IRS any authority over income tax preparers when the income tax was not even created until 1913?

I have to admit, I had to look up the Horse Act of 1884. We must have missed that bright shiny in high school American History. After the Civil War, people brought claims against the U.S. for dead or missing horses. Makes sense, as horses were required to work the farm or for transportation, and their loss would have been keenly felt. Always seeking a vacuum, fraudsters soon appeared to help people press horse claims against the government. Soon all horses were thoroughbreds, and the government was facing more actions than there were horses lost in the Civil War. The government realized they were being scammed by con men and, in defense, starting regulating those people. The government even used the term “enrolled agent,” a term still used today for a class of preparer who has passed a competency examination given by the IRS itself.

So the IRS attorneys are arguing that tax CPAs like me are akin to fraudsters who inflated the value of dead or missing horses in action against the government following the Civil War?

As I said, I think I have been insulted.

I am also reading that Lois Lerner, the former head of the IRS Exempt Organizations Division, is retiring. You may remember that she invoked the Fifth Amendment when appearing before Congress on May 22, 2013. She was the political hack from the Federal Elections Commission who somehow wound up at the IRS reviewing and delaying applications from conservative groups, especially Tea Party organizations, seeking 504(c)(4) status in time for the 2012 presidential election. Good thing she was there too or the election may have gone a different way. She was quite happy to initially throw a few Cincinnati IRS employees under the bus, saying they had gone “rogue.” Later investigation, including e-mails, put a rest to that lie. Congress could have instead spoken with a few practicing tax CPAs, and we could have told them the same thing.  

She has been on “administrative” leave since then, drawing an approximate $170,000 salary. Now she gets to retire. It’s a nice retirement too, as she able to look for another government position and still collect her retirement pay, estimated over $50,000 annually. 

I would love a deal like that. Unfortunately, the IRS thinks of me as a con man.

IRS Apologizes For Targeting Tax-Exempt Applications By Conservative Groups

This has been a difficult few weeks for the IRS.

In March Rep. Charles Boustany (R-La.), chairman of the House Ways and Means oversight subcommittee chastised the agency upon discovering a series of IRS training videos that parodied “Star Trek” and “Gilligan’s Island.” The videos cost the IRS approximately $60,000. The IRS initially refused to make the videos public. They later did after mounting criticism.

In April the American Civil Liberties Union released documents obtained under the Freedom of Information Act showing that the IRS criminal tax division believed the agency could access e-mails and text messages without obtaining a warrant. Rep. Charles Boustany demanded the IRS present its policies for when search warrants are needed to review private e-mails and communications.

Last week the IRS announced that it was changing its policy to require search warrants both for criminal and civil tax proceedings.

Last week we found out that an IRS employee at the Covington campus had been charged with destroying at least 800 fiduciary income tax returns. “Fiduciary” is a fancy term for a trust, and the term includes an estate which receives income and has to pay income tax. The employee – Brady James – is only 30 years old, and he could be facing a maximum prison term of 20 years.

One has to wonder what Brady James was thinking.

Last Friday an IRS employee – Lois Lerner, head of the IRS tax-exempt division – responded to a question concerning tax-exempt applications by conservative groups at an American Bar Association conference. A firestorm ignited, and the IRS quickly scheduled a media conference call for the same day.

She apologized for “inappropriate” targeting of conservative political groups during the 2012 election. IRS employees in Cincinnati singled out approximately 75 organizations using “patriot” or “tea party” in their name. The IRS was trying to get ahead of an AP news report, as well as an expected report by the Treasury Inspector General for Tax Administration.

Why Cincinnati? The IRS breaks up its work functions into units, and these units are located throughout the country. The unit under discussion handles the review of applications for tax-exempt status, and that unit is located in Cincinnati.

The number of organizations filing for tax-exempt status has more than doubled since 2010. To handle the volume, the IRS centralized its review of the applications in Cincinnati. Makes sense, as it allows the development of expertise within the unit and consistency in the process.

Until it goes wrong. Terribly wrong.

The IRS for example responded to the Richmond (VA) Tea Party’s application by requiring additional documentation on 17 different matters. When it did so, the IRS responded by requiring documentation on 53 additional matters. Oh, and the Richmond Tea Party had two weeks to respond.

 “We made some mistakes,” said Lois Lerner. “Some people didn’t use good judgment. For that we are apologetic.”

Heartfelt apology, isn’t it?

Lerner went on to explain that low-level employees initiated the IRS practice. It was not motivated by bias, she said.

COMMENT: Who would even think of bias? Do not pay attention to the fact that groups with words like “progressive” in their name did not receive the same scrutiny.

"It's the line people that did it without talking to managers," Lerner continued. "They're IRS workers, they're revenue agents."

COMMENT: Are there no supervisors in Cincinnati? She makes it sound like her revenue agents are doing whatever they want, without review and apparently without accountability.  I am throwing the B.S. flag on Ms. Lerner.

Lerner told the AP that no high-level IRS officials knew about the practice.

COMMENT: This means some non high-level will take the fall, of course. Hey, there are perks to being a high-level.

Friday was not Lerner’s best moment. At one point she said, "I'm not good at math." Granted, she is an attorney and not an accountant, but still.  That is not a comforting comment from an IRS high-level.

Good grief.

IRS Ends Gift Tax Probes of Non-Profit Groups

On  July 7  the IRS said that it would stop its examinations of tax-exempt 501(c)(4) organizations. The IRS had quite recently been reviewing donors to these organizations for compliance with gift tax return requirements.

There is some uncertainty in the tax literature whether contributions to these organizations would be considered “gifts.” If so, and depending on the amount, there could be a gift tax return requirement. Now, when I say uncertainty, I mean that there is a classroom argument to be made. The IRS has not pursued this matter for nigh near 30 years, so it is not something that has concerned many practitioners.

The classic charity is a 501(c)(3). We are talking about (c)(4)’s, which are “social welfare” organizations. The idea is that the organization promotes the common good, although that common good can be targeted to a certain slice of the population. The AARP, for example, is a 501(c)(4), and that slice is people over age 50. A (c)(4) can even lobby, as long as it is not the primary thing the (c)(4) does. A (c)(3)  cannot go as far with lobbying as a (c)(4) can.

The big difference? Donations to a(c)(3) are deductible on your income tax return. Donations to a (c)(4) are not.

Let’s fast forward. What has changed? Well, in the last election cycle the (c)(4)s raised seven times as much money for Republican causes than for Democrat causes.

Then the IRS announced that it wanted to “look into” the (c)(4)s.

Republicans in both the House and Senate immediately questioned why the IRS was going there.

While the IRS statement is welcome, lawmakers want to find out what, if any, political muscle was used. The IRS says there was none. Republicans of course are highly skeptical.

The IRS is Pursuing 501(c)(4)s

The 2011 Workplan of the IRS Exempt Organizations Division states:

"[i]n recent years, our examination program has concentrated on section 501(c)(3) organizations. Beginning in FY 2011, we are increasing our focus on section 501(c)(4), (5) and (6) organizations."

The (c)(3) is the classic charity – Muscular Dystrophy or March of Dimes, for example. The purpose of a (c)(4) is to pursue a near-endless range of public policy goals through action and advocacy. Many of these entities are barred from (c)(3) status because they express their advocacy through political activity. It is quite common to couple a (c)(3) with a (c)(4). You already know some of the big (c)(4) players, organizations such as AARP and the National Rifle Association.

Now let’s carve-out the meaning of “political activities”:

* Promoting legislation germane to the (c)(4)s purpose is considered a permissible social welfare purpose. Therefore an organization can qualify as tax-exempt under( c)(4) even if the organization’s only activity is lobbying, as long as the lobbying is related to its exempt purpose.
* A social welfare purpose does not include participating in an election in order to advance or defeat a given candidate. Candidate-related activity cannot be the (c)(4)s primary activity. The IRS does not tell us what “primary” means, and advisors differ. Some advisors s feel comfortable with electioneering approaching (but always remaining below) 50% of the organization’s total activities. It is unclear how to even measure activities. What is the measure: dollars spent, time spent by staff and volunteers, a percentage of fixed expenses (such as rent)?

So lobbying is acceptable but electioneering is not.

Donations to (c)(4)s are not afforded the same protection as a (c)(3), and the IRS has held its powder for almost 30 years on whether it would consider (c)(4) donations to be subject to the gift tax.

That has changed.

How would the IRS know who donated to a (c)(4)? A (c)(4) has to disclose to the IRS on its 990 filing contributors who donated $5,000 or more. This list however does not have to be publicly disclosed. Therefore, you and I might not know, but the IRS would. It would not be a difficult task for the IRS to identify donors for audit.

And they have. The IRS has recently sent letters that read as follows:

"Your 2008 gift tax return (Form 709) has been assigned to me for examination. The Internal Revenue Service has received information that you donated cash to [REDACTED], an IRC Section 501(c)(4) organization. Donations to 501(c)(4) organizations are taxable gifts and your contribution in 2008 should have been reported on your 2008 Federal Gift Tax Return (Form 709)."

The federal gift tax applies to a gratuitous transfer of property by an individual. The gift tax is separate from the individual income tax. Not all gratuitous transfers are subject to the gift tax. Transfers between spouses are not considered gifts, for example. An individual can give away $13,000 per year to anyone for any reason without involving the gift tax. Donations to (c)(3)s are not considered gifts, irrespective of the amount. Donations to a 527 organization (that is, a PAC) are not considered gifts. Donations to a (c)(4) are considered gifts.

At least they are considered gifts by the IRS. The IRS pulled out almost 30 years ago, and the limited guidance and cases in this area leaves doubt that the IRS is correct. If one focuses in on the political nature of the contribution, then one has to consider Stern and Carson, for example. In Stern (CA-5, 1971), the IRS lost its argument that campaign contributions were taxable gifts. In Carson (CA-10, 1981) the Tax Court held that Congress did not intend for gift tax to apply to campaign contributions, and the Tenth Circuit affirmed on this point.

We almost undoubtedly will see this matter litigated.

Senators Question IRS Gift Tax Enforcement

You may have read that the IRS has decided to pursue Section 501(c)(4) organizations. This beggars the question: what is a 501((c)(4) organization?

The (c)(4) is a tax-exempt. That is not saying much, as there are over two dozen types of tax-exempts in the Internal Revenue Code. So what is different about this flavor of tax exempt?

The( c)(4) must not be organized for profit and must be operated exclusively for the promotion of social welfare. Examples of (c)(4)s are AARP and the National Association for the Advancement of Colored People. You may also remember MoveOn.org and America Coming Together.

A (c)(4) may further its social welfare purposes through lobbying without jeopardizing its exempt status as long as it is consistent with the organization’s purpose. It cannot however be the organization’s primary activity. If it is, then one should consider a Section 527 organization.

Are donations to a (c)(4) deductible? That depends. Donations to 501(c)(4)s that are public entities (such as a volunteer fire station) are deductible. Donations to other (c)(4)s are not deductible.

So what has happened to draw the IRS’ attention? Tax advisors such as me have known for a long time that donations to a (c)(4) are not deductible, and we make adjustments when a client includes these amounts in a list of contributions. The IRS has now decided to pursue the (c)(4)s with the argument that contributions are taxable gifts by the donors.

A taxable gift? This is a new issue to me, and I have been at this for a while.

It has caught the Senate’s attention. Six senators from the Finance Committee recently wrote a letter to IRS Commissioner Shulman. The Finance Committee writes tax law in conjunction with the House Ways and Means Committee. The Senators wrote (in part):

The applicability of gift taxes to 501(c)(4) contributions is ambiguous. Historically, the IRS has deliberately opted against vigorous enforcement of the gift tax on 501(c)(4) contributions. There are good reasons for this. First, it is unclear if contributions to these organizations are eligible for the gift tax given their gratuitous nature, and the fact that the donations are made with the expectation that the organization will work to advance the donor’s policy views. Moreover, these contributions are clearly not designed for tax planning purposes or to avoid the estate tax. Most importantly, however, enforcement of gift taxes on contributions to 501(c)(4) organizations engaged in public policy debate runs an unacceptable risk of chilling political speech, which receives the highest level of constitutional protection under the First Amendment

This pattern of nonenforcement over a period of nearly three decades, coupled with the troubling issues regarding the adverse impact that enforcement might have on the exercise of constitutionally protected rights, raises important questions regarding the timing of the decision to enforce the gift tax on these contributions. Retroactive enforcement of the gift tax in this highly politicized environment raises legitimate concerns and demands further explanation."

The statement by IRS spokeswoman Michelle Eldridge did not assuage these concerns and left us with only more questions. According to Eldridge, “[a]ll of the decisions involving these cases were made by career civil servants without any influence from anyone outside the IRS.” We would expect that decisions regarding particular enforcement actions would be made by career civil servants. The more pressing question, not answered to date, is whether political appointees inside or outside the IRS were involved in any way in the decision to prioritize this category of cases."

I understand that (c)(4)s are not supposed to be piggybanks, but are there really enough tax dollars here for the IRS to prioritize this issue?

I was too young, but I have understood that President Nixon used the IRS as a political weapon against his opponents. In a country where half the population does not trust the current President to do the right thing, it is unfortunate to have the IRS call its neutrality into question. You can accept or hate the IRS, but it is imperative that the IRS act and be perceived as a neutral entity.

One can argue that perhaps there is no good time for this type of action, but the observation remains that this is not a good time.

I will come back in a separate post with more detail on the tax issues raised by (c)(4)s.