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IRS Rattles A Gift Tax Saber

When you make tax policy in government, you have to deal with checks and balances on your power. When you make tax policy in the news columns of The New York Times, you don’t.

Which is why we learned from the newspaper last week that the Internal Revenue Service has sent letters to five unidentified donors to political advocacy groups — we can safely assume that these are big donors — seeking to determine whether they owe gift taxes on what could be millions of dollars in contributions.

I do not believe the IRS can successfully defend such a gift tax assessment in court. I suspect the agency is not even going to try. The Service is unlikely to start a fight with deep-pocketed adversaries, such as billionaire conservative activists David and Charles Koch, who can readily challenge the IRS position all the way to the Supreme Court.

Instead, I think the Service is using somewhat gullible media coverage to scare off other potential donors, and perhaps also to frighten the recipient organizations and their officers.

The organizations in question are exempt from federal income taxes under Section 501(c)(4) of the Internal Revenue Code. These are “civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare.” They can engage in lobbying and electioneering, unlike the better-known charities organized under Section 501(c)(3), which are barred from political activities.

The tax laws specifically exempt gifts to 501(c)(3) organizations from gift tax. Gifts to political candidates and parties are exempt as well. But there is no specific exemption from gift taxes for contributions to 501(c)(4) groups, like Americans for Prosperity, which the Kochs have supported. This would be the basis if the IRS tried to impose the gift tax, currently 35 percent, on any contributions to such an organization that exceed the law’s annual exemption for gifts of up to $13,000 per donee.

The Times noted that the IRS “definitively declared these gifts taxable in 1982.” The paper’s readers might therefore conclude that the matter is pretty open-and-shut. That is not the case.

The 1982 pronouncement was Revenue Ruling 82-216, which the IRS issued after it lost a pair of gift tax cases involving political contributions. Congress had added Section 527(e) to the tax law, exempting contributions to political parties and candidates from gift tax, effective May 8, 1974. The Service took the position that political contributions before that date were taxable gifts.

The courts disagreed. Stern v. United States, decided by the Fifth Circuit in 1971, and Carson v. Commissioner, a 10th Circuit case decided in 1981, both held that political contributions fell outside the statutory definition of a gift.

Donors to political causes — and to today’s public advocacy groups — seek some change in society; the donee organization is merely the instrument by which they try to obtain that change. Donors want to get something back for their contributions to candidates and causes. They are not making a gift, any more than someone makes a gift to a car dealer by paying the sticker price when other buyers are aggressively negotiating better deals.

Even if the contributions to 501(c)(4) groups meet the definition of a gift, the courts are unlikely to uphold a tax if it is seen as interfering with the donors’ constitutionally protected rights of free speech and free association. The Supreme Court’s decision last year in the Citizens United case is a strong sign that the court would take a dim view of the IRS seeking to tax contributions to organizations that advocate positions the donors want to support.

Writing years before Citizens United, Barbara K. Rhomberg, a San Francisco attorney, noted that the IRS could assert gift tax on contributions to 501(c)(4) groups, but she concluded that it would have trouble sustaining its position on both legal and constitutional grounds. She thoroughly explored the topic in two articles that appeared in the professional journal Taxation of Exempts in 2003 and 2004.

At the time, it was just an academic exercise. The IRS had not made any serious attempt to impose gift taxes on supporters of advocacy organizations, though the laws had been in place for many years. Why the sudden change now?

Politics seems like the obvious answer. President Obama and most Democrats abhorred the Citizens United decision, which they argued would give corporations, and the wealthy people who control them, too much influence. An IRS spokeswoman took pains to tell The Times that the recent inquiry was initiated by Service employees who are interested in compliance with the gift tax laws, not by the White House or others in the administration.

Assuming that’s true, it does not tell us how the inquiry came so conveniently to the newspaper’s attention. How did a reporter know to ask for copies of the letters (redacted to remove names) that the IRS sent to those donors, demanding information? The article did not say. While it is possible that the tip came from outside government, perhaps from a lawyer who got wind of the inquiry at a professional conference, my guess is that the story was planted by someone who wants to limit the advocacy groups’ influence, and who thought a scary article in The New York Times might help.

Politics is, after all, a contact sport. The courts can protect our rights to express ourselves, but they cannot always shield us from the backlash. Target Corp. took a lot of heat last year when it exercised its right under Citizens United to participate in a political campaign. Those who applied that heat hoped to deter Target and other corporations from doing it again.

Freedom may not always be free, but a government threat to tax it at 35 percent probably won’t stand up if it is put to the test.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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