Your client, Sally Smith, seeks your counsel about the disposition of her privately held company. She would like to leave a philanthropic legacy other than the conventional gifts to her community-based charities and alma maters. Rather dismayed with “big philanthropy,” she would like to be able to agitate for “structural change” through participation in the political process. She’s content to let the charitable donee find a buyer of her business. Fortunately for Sally, the U.S. Supreme Court has ruled that entities can spend money on electioneering communications and advocate directly for the election or defeat of specific candidates. “See Political Expenditures Allowed,” p. 33.
The next day, another client, Jack Jones, has a slightly different request from you. Ordinarily he would be content to establish a private foundation (PF) with his largest holding, a lucrative apparel manufacturer and leader in the environmental sustainability movement. He knows from his business peers there are restrictions on how PFs can manage “business holdings.” Some charities would rather not own a business for even a brief time because of liability concerns. He’s also concerned the pursuit of profit by any noncharitable owners may impair the firm’s ability to be a leader in the environmental sustainability movement. His strongest preference is that the business remain operating in the hands of a tax-exempt entity and effectively insulated from the normal pressure of increasing profits.
Let’s examine how an Internal Revenue Code Section 501(c)(4) organization could meet the objectives of both clients notwithstanding some downsides.
IRC Section 501(c)(4) Requirements
Section 501(c)(4) requires an organization to be organized and operated “exclusively for the promotion of social welfare.”“Exclusively” has been interpreted to mean “primarily engaged in the promotion of the common good and general welfare.”1 Prominent examples of such organizations include the AARP, the National Rifle Association and the NAACP.2
An organization must avoid primarily benefiting a private group, though an incidental benefit is permitted. Additionally, the net income of a Section 501(c)(4) can’t be distributed to any private shareholder or individual. The Internal Revenue Service distinguishes between primarily public and incidentally private. For example, an organization operating an airport serving the general public on land owned by local government would be a social welfare organization.3 An organization encouraging industrial development by making loans to businesses relocating in a high unemployment area also would qualify as a social welfare organization.4
The IRS also illustrates when the organization isn’t operated exclusively to promote social welfare. An organization must operate primarily to further the common good and general welfare of the people of the community (such as by bringing about civic betterment and social improvements).5
An organization that restricts the use of its facilities to employees of selected corporations and their guests is primarily benefiting a private group rather than the community and, therefore, doesn’t qualify as a Section 501(c)(4) organization.6
Similarly, an organization formed to represent member-tenants of an apartment complex doesn’t qualify, because its activities benefit the member-tenants and not all tenants in the community, while an organization formed to promote the legal rights of all tenants in a particular community may qualify under Section 501(c)(4) as a social welfare organization.7 An organization isn’t operated primarily for the promotion of social welfare if its primary activity is operating a social club for the benefit, pleasure or recreation.8
Public Support Not Required
Generally, a Section 501(c)(3) public charity must pass a public support test, most typically under IRC Section 509(a)(1) or Section 509(a)(2). This requires the organization to attract support (for example, contributions or program service revenue) from a wide range of donors. A Section 501(c)(4) organization doesn’t have to meet the public support test and can be funded entirely by one individual or entity. The inapplicability of the public support test would be attractive to Jack, who’s contemplating contribution of all his stock without seeking public support.
Jack is pleased the excess business holdings restrictions of IRC Section 4943, which apply to Section 501(c)(3) organizations, don’t apply to Section 501(c)(4) organizations. A PF can’t own more than 2% of a company if the PF and disqualified persons combined own greater than 20%. Jack can keep the company intact and retain some ownership during his lifetime.
Documentation Required
Although Section 501(c)(4) organizations aren’t required to file Form 1024 for recognition of their exemption, they must file Form 8976 to notify the IRS of their intention to operate as a
Section 501(c)(4) organization. Penalties under IRC Section 6652 will be imposed for failure to notify the IRS within 60 days as required under IRC Section 506. Form 990 must be filed annually. Tax-exempt status will be automatically revoked if the organization doesn’t file in three consecutive years.
Tax Consequences for Donors
Contributions to civic leagues or other Section 501(c)(4) organizations generally aren’t deductible as charitable contributions for federal income tax purposes. They may be deductible as trade or business expenses, if ordinary and necessary in the conduct of the taxpayer’s business. Notwithstanding the lack of an income tax deduction, donors can avoid paying all capital gains taxes on any appreciated property contributed.
Prior to the passage of the Protecting Americans from Tax Hikes Act of 2015 (PATH), it wasn’t clear whether contributions to a Section 501(c)(4) organization were taxable gifts. PATH eliminated any doubt by exempting such contributions.9 So a gift to a Section 501(c)(4) organization removes the asset and subsequent appreciation from the gross estate without use of the unified estate and gift credit. This benefit will be especially attractive should the credit revert to the pre-Tax Cut and Jobs Act levels.
These incentives would be attractive to Sally and Jack, especially if they’ve exhausted their credits and/or have charitable contribution carryforwards that won’t be used during the 5-year period.
The Section 501(c)(4) organization may be required to disclose the nondeductibility of any contributions when it solicits them.
Risks for Donors
Anonymity can attract bad actors looking to circumvent the campaign contribution limits and mandatory disclosures rules. Money going to a Section 501(c)(4) organization is “dark” as it’s not required to disclose its donors. So a contributor might think their contributions will be free from public and legal scrutiny. However, the Department of Justice (DOJ) and the Federal Elections Commission (FEC) will be looking for evidence that the Section 501(c)(4) organization is a straw man for the contributions of one or multiple donors. Organizations like Campaign Legal Center analyze campaign finance data and often file complaints with the FEC.
The 2022 case of U.S. v. Fuentes-Fernandez shows the DOJ’s willingness to look for a straw man. It prosecuted the president of a super political action committee (PAC) who established two Section 501(c)(4) organizations that sent contributions to the PAC. The president texted to contributors: “You can use a third party [501(c)(4)] to not disclose the true donor.”10 The defendant pled guilty to falsifying campaign finance reports and paid a fine of $150,000.11 The risk of contributions being categorized as dark should be addressed by creating governance protocols that create distance between political office holders and the contributors to the Section 501(c)(4) organization as well as the organization itself. These protocols are especially vital if the founding donor remains the only or majority contributor to the Section 501(c)(4) organization. A contributor to a Section 501(c)(4) organization needs to be alert to any indications it’s a conduit to PACs and super PACs.
Other Pitfalls
As with the gifts of a closely held enterprise to any charity, take care to avoid the “prearranged sale” rules. A buyer waiting in the wings will trigger unrealized capital gains that become part of gross income.
Contributors to a Section 501(c)(4) organization need to be aware their anonymity will be lost if the Section 501(c)(4) organization itself triggers state campaign finance laws. Such laws often mandate disclosure of donors to the Section 501(c)(4). Any Section 501(c)(4) organization activity that benefits a public official and can be linked with a particular government action can trigger the “honest services fraud rules” under the federal mail and wire fraud statute.12
Rules of Thumb
In deciding among certain tax-exempt entities including an IRC Section 527 political organization, several rules of thumb emerge. If the donor desires the charitable income tax deduction, the only option is the Section 501(c)(3) organization. If the donor desires maximum ability to engage in candidate election advocacy, Section 527 is the only option. A Section 501(c)(4) organization will be attractive for the donor content with limited engagement in candidate election advocacy. It will be the most attractive choice for the donor seeking involvement in legislative, candidate and public advocacy.
But remember, it’s possible for a Section 501(c)(3) organization to participate in political matters through a separate 501(c)(4).
Finally, whatever tax-exempt entity is chosen, the contributors and founder(s) must be ready for uninvited inquiry and scrutiny from regulators, the press and legal authorities. For a summary of the rules regarding common tax-exempt organizations, see “Federal Tax Law Attributes of Common Tax-Exempt Organizations,” this page.
Endnotes
1. Treasury Regulations Section1.501(c)(4)-1(a)(2)(i).
2. For a detailed analysis of the various types of Internal Revenue Code Section 501(c)(4) segments by size and purpose, see www.urban.org/research/publication/camps-campaign-funds-history-anatomy-and-activities-501c4-organizations.
3. www.irs.gov/charities-non-profits/other-non-profits/social-welfare-organizations-examples.
4. Ibid.
5. Ibid.
6. Ibid.
7. Ibid.
8. Ibid.
9. IRC Section 2501(a)(4).
10. www.justice.gov/usao-pr/pr/super-pac-and-its-president-plead-guilty-dark-money-scheme-file-false-reports-fec.
11. Ibid.
12. 18 U.S.C. Section 1346.