Taxation with Reservations: Taxing Nonprofit Political Expenditures After Citizens United

Abstract

Section 527 of the Internal Revenue Code generally exempts political organizations from federal income tax, but not on their net investment income. Section 527(f) imposes a similar tax on the “political activity” of Section 501(c) tax-exempt organizations like trade associations, labor unions, and tax-exempt lobbying organizations, in order to discourage use of such organizations to avoid the Section 527 investment income tax. The definition of “political activity” for these purposes was clarified in 1980, when Treasury promulgated regulations under Section 527(f). These regulations left the door open for future investigation and regulation in the form of “Reserved Regulations,” and Treasury assured taxpayers that any adverse changes to the regulations would be prospective. The Reserved Regulations remain reserved to this day. The “reserved” gap in the regulations did not matter much for the first thirty years. Section 501(c) organizations, which are usually corporations (or unincorporated labor unions), were already constricted in their conduct of Section 527-type political activity by federal election laws that prohibited them from making independent expenditures supporting or opposing candidates. When the Citizens United decision came down, the first wave of reaction concerned the potential uses and perceived abuses of this new freedom by business corporations. Quickly, however, commentators noted that the Supreme Court had also created an opportunity for Section 501(c) organizations—free from income taxation, and (if careful) free from disclosure obligations—to engage in heretofore unprecedented levels of independent, expressly political activity. In theory, Section 527(f) and its Treasury Regulations discouraged this free-for-all by taxing the political expenditures of such entities, except that until the Reserved Regulations are promulgated, any political expenditures “allowed” by the FECA escape the tax. After Citizens United, what is “allowable” has mushroomed: A literal reading of the existing regulations renders all of those independent expenditures untouchable under Section 527(f). While some practitioners and their clients may be willing to operate as if this literal, but in our view unreasonable, outcome is the best interpretation under the circumstances, others may prefer a more nuanced and, we believe, credible approach. In this article we examine the background of Section 527(f) and the Reserved Regulations, summarize the Internal Revenue Service's few attempts to interpret the latter, and then present our proposal for a revised interpretation of the current regulations. We hope this proposed framework will be helpful both to practitioners and counsel who are wrestling with similar matters, and to Treasury, should it decide it is finally time to promulgate the Reserved Regulations.