IRS Nonprofit Rule’s Durability Is in Doubt After Chevron’s End

Tax lawyers for nonprofits are facing an uncertain landscape after a recent Fifth Circuit decision brushing aside an IRS tax exemption rule.

The US Court of Appeals for the Fifth Circuit ruled that Memorial Hermann Accountable Care Organization isn’t entitled to a tax exemption meant for social welfare groups because it didn’t show its operations exclusively were intended to help the public.

In its decision, the court made clear it wouldn’t automatically respect an IRS rule interpreting Section 501(c)(4), which governs how groups qualify for that type of nonprofit status. Memorial Hermann pointed to the rule in its defense.

The appeals court cited the US Supreme Court decision in Loper Bright Enterprises v. Raimondo scrapping the decades-old Chevron doctrine of judicial deference to agency rulemaking under ambiguous laws. “We no longer are required to provide ‘Chevron deference’ to the Treasury’s interpretation of § 501(c)(4) (although we can certainly consider it),” the court said.

The decision is an example of how the newfound power of the courts to disregard such agency rules could upend an untold number of IRS regulations. Nonprofits already rely on scant IRS rules around tax exemptions, in part because Congress restricts its ability to write new regulations on the subject.

“It creates a great deal of uncertainty,” said Eric Gorovitz, a principal specializing in tax-exempt legal issues at Adler & Colvin. “It calls into question lots of longstanding assumptions about what’s permissible and what’s not in exempt organizations.”

The Oct. 28 decision also could alter how 501(c)(4) nonprofits participate in political activity.

Blocking Change

Organizations must operate “exclusively for the promotion of social welfare” to qualify for the nonprofit exemption, according to the underlying statute.

The Fifth Circuit said “exclusively” actually called for a “substantial nonexempt purpose test,” instead of the “primary purpose test” found in the IRS rule on which Memorial Hermann relied.

The decision “changes how organizations are going to justify their tax-exempt status,” said Eleanor McWaters, a counsel specializing in nonprofits and tax controversy at Crowell & Moring LLP.

For at least a decade, IRS guidance said the agency would expedite tax-exempt applications for organizations with about 60% of operations devoted to social welfare.

It’s unclear how the IRS will react to the decision in audits of tax-exempt organizations or in the approval process for tax-exempt status. An agency spokesperson didn’t immediately respond to a request for comment.

But a restriction on the IRS from Congress in annual spending measures for the last several years blocks the agency from revising the rule or writing a new one. Congress bars the agency from spending funds to work on any rules or guidance related to “whether an organization is operated exclusively for the promotion of social welfare for the purposes of section 501(c)(4).”

“Perhaps the IRS might even change its litigating position or discontinue its optional expedited process,” said Preston Quesenberry, KPMG managing director of exempt organizations and former IRS special counsel. “Or, perhaps practitioners will just have to muddle through an uncertain landscape indefinitely.”

Dark Money

The stricter test the court preferred for the exemption eligibility also could impact political donations from tax-exempt organizations with 501(c)(4) status, which often participate in political activity, as long as that’s a secondary focus to their social welfare operations.

Those organizations are the source of so-called dark money because they don’t have the same disclosure rules as political parties and other organizations governed by a different section of federal tax law.

Tax lawyers are alerting their clients about the court decision and the increased risk if they have political activity, Gorovitz said. But there’s not a clear boundary for how much political activity is allowed.

“What organizations do depends on their risk tolerance,” Gorovitz said.

The decision also brings into question another IRS nonprofit rule that could be vulnerable in litigation. Under that rule, social welfare can’t include political participation, even though the underlying statute doesn’t include that explicit restriction.

That means an organization applying for 501(c)(4) status could say their social welfare mission is political activity to test whether the IRS will deny their status.

“It’s more likely than not that a court would conclude that political activity is not unrelated to the (c)(4) social welfare purposes,” said Alex Reid, national leader of BakerHostetler’s tax-exempt organizations and charitable giving team. “If you get that, then dark money can flow even more freely.”

The case is Memorial Hermann Accountable Care Org. v. Commissioner, 5th Cir., No. 23-60608, 10/28/24