"Here, Freedom Path does not know how much political campaign intervention is too much, and the IRS cannot even agree with itself on the answer."
The recent decision in Freedom Path, Inc. v. Internal Revenue Service addressed whether the IRS’s standards used to deny Freedom Path’s tax exemption as a 501(c)(4) organization were unconstitutionally vague. The United States District Court for the District of Columbia partially agreed with Freedom Path, acknowledging that the relevant guidance failed to satisfy the heightened scrutiny warranted by the First Amendment for regulations that impact free speech. However, outstanding issues remain, namely how much political activity social welfare organizations may engage in and what constitutionally appropriate criteria the IRS and taxpayers can rely on to determine eligibility for tax exemption under Section 501(c)(4).
For many years, social welfare organizations have operated within unclear IRS parameters governing the amount of political or other nonexempt activity that could jeopardize the tax-exempt status of a 501(c)(4) organization. The permissible thresholds of political or nonexempt activity—based on Treasury Regulations and IRS guidance—range from 49% of total activities to as low as 10%.
Two recent federal court cases highlight the uncertainty for 501(c)(4) organizations. The first was Memorial Hermann, summarized in our prior alert here. But, even after the Fifth Circuit’s decision in that case, the permissible threshold of nonexempt activities was not clear; rather, the Fifth Circuit simply asserted that, in its view, 49% was too high. Note that in an October 6 decision, Mira Vista Homeowners Association, Inc. v. Commissioner, the Tax Court cited Memorial Hermann to deny tax-exempt status to a homeowner’s association that mostly conducted nonexempt activities and only incidentally benefitted the public. However, the Tax Court did not provide any additional analysis of the permissible threshold of nonexempt activity.
In the second of these two cases, Freedom Path v. Internal Revenue Service, the district court issued a memorandum opinion and order on September 30 addressing both parties’ motions for summary judgment. This alert addresses this recent Freedom Path opinion.
The primary issue before the district court was whether, as Freedom Path claimed, the standards applied by the IRS in denying Freedom Path’s tax exemption as a 501(c)(4) are unconstitutionally vague. The IRS, on the other hand, cross-moved for summary judgment, defending the constitutionality of those standards and maintaining the validity of its decision to deny exemption because Freedom Path engaged in too much political, and therefore nonexempt, activity.
Much of the opinion discusses the appropriate vagueness standard under the Fifth Amendment prohibition on regulations that affect speech covered by the First Amendment, resulting in the court applying a heightened vagueness review.
The court ultimately sided with Freedom Path on this issue, agreeing that the IRS’s standards used to evaluate what constitutes nonexempt political activity (the “Political Activity inquiry”) and how much political activity is permissible (the “Primary Activity inquiry”)—specifically, under Revenue Ruling 2004-06, 2004-1 C.B. 328 and Treasury Regulation section 1.501(c)(4)-1, respectively—failed to satisfy the heightened vagueness standard required for regulations that relate to and impact free speech.
However, the court also noted its inability to determine whether Freedom Path is eligible for tax exemption based solely on the parties’ existing briefing, due to the lack of a non-vague standard proposed by either party. The court further recognized that it would be futile to remand Freedom Path’s application to the IRS since a long-standing appropriations rider prohibits the IRS from issuing any regulation, revenue ruling, or other guidance regarding the standard for permissible 501(c)(4) activity. Therefore, the court requested both parties to submit briefs that provide standards upon which the court could rely that are not vague. Thus, we can expect both parties to submit new motions suggesting clearer interpretations that align with statutory and constitutional principles.
For social welfare organizations, the uncertainty regarding the IRS’s standards governing political activity presents ongoing challenges, particularly given the court’s decision to strike existing guidance. There remain even more questions about what taxpayers can rely on to assess whether a particular activity constitutes political or nonexempt activity and the extent to which the organization can engage in that activity.
Covington will be closely monitoring new developments in this case as the parties submit new motions and the court works to establish a constitutionally valid framework. In particular, it will be noteworthy to see the IRS’s response, which may influence how the IRS evaluates applications for exemption for 501(c)(4)s moving forward.
If you have any questions concerning the material discussed in this client alert, please contact the following members of our Tax practice.
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