Counsel (Technical),
91serving under the Chief Counsel who is the "chief law officer" for the Service as an Assistant General Counsel of the Treasury De- partment
92The Division reviews interpretations of the Code and regulations, and prepares formal opinions of the Chief Counsel. The Division has about 50 attorneys, including a Director and 5 Branch Chiefs. The five Branches are simply adminis- trative units for distributing the Division's workland.
Although the Division has no formally designated areas of specialization,
93three docket attorneys work exclusively on exempt organization matters and about three others devote half their time to such cases. All opinions on exempt organization matters are reviewed by one of four individuals in Branch 5 — the Branch Chief, two Assistant Branch Chiefs, and recently one additional attorney-reviewers.
94We have no data on the annual volume or disposition of exempt organization matters in the Chief Counsel's Office, or on the time required to dispose of indi- vidual cases. Recently the Chief Counsel's office began maintaining a record of the number of cases pending. As of July 31, 1974, there were 98 exempt organization matters pending in the Chief Counsel's office, of which 43 were particular exemp- tion qualification cases including some arising under provisions other than 501(c)(3).
The other 55 matters were proposed Revenue Rulings on issues that had already been decided in individual cases. Pending issuance of Chief Counsel opinions, 50 to 100 additional cases involving similar questions were being held in Technical's Exempt Organizations Branch.
The staff of the Chief Counsel's office is generally well regarded professionally.
However, within the Service as well as outside there is frustration with the time required for Interpretative Division opinions. A principal factor producing delays in the Division has been a staff shortage at the reviewing level. Docket attorneys with several years experience are typically at GS-13 or 14; just when they are qualified to become reviewers, the competition of private firms for tax lawyers becomes most attractive. The resulting shortage creates a review bottleneck in all areas, not merely exempt organization matters. In recent years about 500 pending cases of all types have been carried over by the Interpretative Division from one fiscal year to the next; nearly 40 percent of these are typically pending at the review level.
The apparent volume of exempt organization cases, and the unusual breadth of judgment required for their disposition, would seem to justify a specialized legal staff for exempt organization matters. Increased staff at the reviewer level also seems appropriate for such cases, in view of the severe effects on new charitable organizations from protracted recognition delay. There are indications that the Chief Counsel's office may now be considering an exempt organizations unit; as noted earlier, the office has recently begun identifying the portion of its workload con- sisting of exempt organization cases. Consideration is being given to the creation of a new Assistant Director of the Interpretative Division for Employee Plans and Exempt Organizations, paralleling the responsibilities of the new Assistant Com- missioner, but apparently no decision has yet been made on establishment of an Exempt Organizations Branch of docket attorneys.
Revocation and Modification
A determination letter or ruling recognizing 501(c)(3) exemption may be revoked
or modified (for example by according the organization 50l(c)(4) status which is tax
exempt but not eligible to receive deductible contributions) if the Service finds
either that 501(c)(3) status should never have been recognized or that as a result of
factual or legal changes the organization no longer qualifies for 501 (c)(3) exemp-
tion. The organization may not challenge the revocation or modification in court
unless and until it (or a donor) is assessed for taxes.
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Procedure. Revocation or modification of exempt status is initiated by a letter to the organization from the key District Director advising of the proposed action and the reasons therefor. Except when the action results from a change in the applicable legal requirements (for example a statutory change or published Revenue Ruling altering the exemption qualification standards previously applied), it is normally a consequence of information developed during an audit. The organization generally has an opportunity to discuss the problem with the revenue agent conducting the audit and to submit further information to him.9 6
Once the key District Director notifies the organization of a proposed revocation or modification of its status, the procedure and the organization's rights to protest are the same as those following a District Director's determination letterdenying 501(c)(3) status upon an initial application for recognition, with automatic referral to the National Office for technical advice if agreement is not reached at the District level.97 Within the National Office, the case is reviewed as described earlier.
The only significant difference is that revocation or modification, unlike an adverse initial determination of status, also presents the issue of retroactivity. In addition, in some instances there may be an alternative to revocation or modification that is not available in the case of an initial application, that is, assessment of an unrelated business tax.
Retroactivity. Section 7805(b) of the Internal Revenue Code permits the Secretary of the Treasury or his delegate to prescribe the extent, if any, to which any tax ruling or regulation shall be applied without retroactive effect. This authority has been successively delegated, with exceptions not pertinent here, to the Assistant Commissioner (Technical), whose personal approval is necessary for each case of relief from retroactivity under section 7805(b).98
In exempt organization cases, the Service provides that revocation or modifica- tion "may be retroactive if the organization omitted or misstated a material fact, operated in a manner materially different from that originally represented, or engaged in a prohibited transaction with the purpose of diverting corpus or income of the organization from its exempt purposes, and such transaction involved a substantial part of the corpus or income of such organization.99 If the exemption is no longer appropriate due to changes in the organization's character, the revocation or modification may be retroactive to the year in which the changed conditions or activities began, depending on whether the organization notified the Service of such changes at the time.1 0 0 A revocation or modification due to changes in the applicable law or Revenue Rulings is normally effective as of the year in which the law changed.101 In any event, revocation or modification will ordinarily take effect no later than the time at which the organization received written notice of the proposed action.1 0 2
If the key District Director believes that a proposed revocation or modification should not have complete retroactive effect, he must submit his recommendation with supporting reasons through the Exempt Organizations Branch of the National Office's Technical staff to the Assistant Commissioner (Technical) for approval, regardless of whether the affected organization agrees with the proposed action.1 0 3
On the other hand, the organization must be notified by the key District Director if the action is proposed to be applied retroactively, and the reasons therefor.104 It is then up to the organization to protest the retroactivity as a separate issue in the course of its administrative appeals. If the organization does not itself raise the issue, it will be resolved without the organization's assistance; a second referral for technical advice or a section National Office conference will not be permitted on the issue of retroactivity alone.105
Since the deducibility of contributions by donors also depends on an organiza- tion's 501(c)(3) status, any change in that status will affect the donors as well as the organization itself. Contributors and grantor foundations thus have a substantial interest in any revocation or modification of any organization's 501(c)(3) status, including particularly any retroactive application of such change.
2601 Generally, contributions to an organization by persons unaware that the recipient has ceased to qualify under 501(c)(3) continue to be deductible if made before the Service has published an announcement in the Internal Revenue Bulletin that contributions are no longer deductible.106 This requires careful contributors to monitor issues of that bulletin, without waiting for the periodic updating of IRS Publication No. 78, Cumulative List of Organizations Described in Section 170(c) of the Internal Revenue Code of 1954.
Advance assurance of deductibility may be suspended in some cases without awaiting final revocation or modification of 501(c)(3) status. If the District Director upon preliminary information has "serious doubt concerning the continued qualification" of an organization, he may afford the organization an opportunity for a written protest and district conference within 10 days before recommending to the National Office that advance assurance to contributors be suspended. Upon such a recommendation the National Office will provide an immediate conference to the organization. If it then concurs with the District Director's recommendation, the National Office will publish in the Internal Revenue Bulletin a notice that assurance of deductibility of contributions has been suspended and notify the district office to publish a local press release to the same effect. In "extraordinary circumstances for good cause shown," the Assistant Commissioner (Technical) may take such action without preliminary notice to the organization or any opportunity for protest and conference.107 Suspension of advance assurance of deductibility was utilized by the Service in numerous cases of racially segregated private schools during the period 1971-1972.108
Unrelated business activities and 501(c)(3) status. A proposed revocation in a close or difficult case, in which a substantial part of an organization's activity is the conduct of a business that is arguably unrelated to its exempt purpose, can sometimes be resolved by leaving the organization's 501(c)(3) status undistributed but assessing an unrelated business tax under section 511 on the income from the particular activities that gave rise to concern. The broad language of section 501 (c)(3) and of the unrelated business tax provisions (sections 511-515), and particularly the amorphous language of the pertinent Treasury regulations, facilitate such a resolution in some cases.109
Section 501 (c)(3) requires that an organization be "organized and operated exclusively" for charitable purposes. Prior to the Revenue Act of 1950, the Service took the position that an otherwise exempt organization could not qualify for exemption if it engaged in business, even if it also carried on a charitable program or if the business activity was merely a "feeder" for such a program. In 1950 Congress provided that such activities were to be subject to an unrelated business tax if not "substantially related" to the performance of the organization's exempt purpose,110 but were not to affect exempt status.111 The Service reflected the change by a Treasury Regulation specifying that such business activities, even though substantial, do not disqualify an organization for 501(c)(3) status if the business activities are "in furtherance of" the organization's exempt purpose and are not themselves the organization's "primary purpose."112 However, the regulations also provide that an organization is not "organized exclusively" for exempt purposes as required by 501 (c)(3) if it is empowered by its charter to engage in business "otherwise than as an insubstantial part of its activities,"113 and that an organization is "operated exclusively" for exempt purposes as required by 501(c)(3) only if engaged "primarily" in activities "which accomplish" such purposes with
"not more than an insubstantial part of its activities" in furtherance of other purposes.114
The application of these regulations requires the finest semantic distinctions between activities that are "substantially related t o , " those "in furtherance of" and those "which accomplish" exempt purposes, as well as between an organization's
"primary" purpose /and its other purposes. The Service advises its own employees
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that, "The regulations' terms 'exclusively,' 'primarily' and 'insubstantial' present difficult conceptual problems," and that questions involving application of these terms "can more readily be resolved on the basis of the facts of a particular case."
115There are no published Revenue Rulings construing these terms, and virtually no judicial precedents,
116thus leaving the Service free in some cases to find that a business activity, though a substantial part of an organization's operations, has not become the organization's "primary" purpose (which would require revocation) but instead is merely taxable as not being "substantially related"
to an exempt purpose.
It would be misleading, however, to assume that such a "compromise" is readily resorted to whenever a difficult 501(c)(3) revocation case involves business activities. The unrelated business tax is applicable to numerous other categories of exempt organizations. The service is well aware that efforts to rationalize the requirements of the unrelated business tax provisions with those of section 501(c)(3) must be applicable also, on a consistent basis, to similar activities conducted by other categories of exempt organizations.
1*
7Frequency of revocations and modifications. There are no data available on modifications of status, but the Service has furnished figures on final revocations posted to the Exempt Organization Master File (EOMF) as follows:
FY 1971 FY 1972 FY 1973 501(c)(3) organizations 220 78 117 Other exempt organizations 629 256 233 Total 849 334 350 a. The FY 1971 figures represent cumulative data from the time the EOMF was
established in 1964-1965.
The Commissioner's Annual Report for FY 1969 reported 167 revocations recommended by examiners (auditors) that year, or less than 1.5 percent of the 11,845 exempt organization returns examined. Similar figures were not provided by subsequent annual reports until FY 1973, for which the Commissioner reported 251 revocations recommended, or less than 1.2 percent of the 22,028 exempt organiza- tion returns examined that year.
118Neither report identifies how many 501(c)(3) organizations are included in those figures or how many recommendations led to actual revocations, and there appears to be no reliable way to relate those figures to the final revocation figures shown above. In the absence of additional information, the only available data suggest that annually between 1 percent and 2 percent of exempt organization audits lead to proposed revocations, with obviously some lesser percentage resulting in actual revocations
119and an unknown mix of status modifications.
Advance Rulings on Proposed Transactions
At the written request of any taxpayer, the Service will issue a ruling on the tax effects of particular transactions proposed to be entered into by the taxpayer.
Requests for such "private letter rulings" must be submitted to the National
Office's Technical staff with a statement of facts, copies of relevant documents, and
the requesting taxpayer's analysis of the tax issues involved. Intended to provide
reliable guidance when the tax consequences of an imminent transaction may have
an important effect on the consummation or shaping of the transaction—typically
where the stakes are too high for the parties to proceed without such assurance, as
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in a corporate sale or merger—such advance rulings are issued directly to the taxpayer. If the transaction is then consummated, a copy of the ruling letter must be attached to the taxpayer's return for the year involved.
120About 30,000 such advance rulings are issued by the Service each year.
121This procedure applies also to exempt organizations. Indeed, determination rulings on exemption qualification are regarded by the Service as merely a particular variety of such advance rulings, albeit an unusual one in volume.
No information is available on advance rulings (other than for exemption determinations) requested by or issued to exempt organizations generally. However, the Service has made public the following data on the number of requests by private foundations for advance rulings under the Tax Reform Act of 1969 (not including foundation status classification rulings):
Period Month of December 1960 Calendar 1971 Calendar 1972 Calendar 1973 January - March 1974
Tax Reform Act Advance Ruling Requests
20 380 416 1,221 314
The recent increase primarily reflects requests for Service approval of private foundation procedures for making grants and scholarships to individuals.
122These rulings requests encounter an organizational problem within the Service: although foundations are required by section 4945 to obtain advance Service approval of such procedures, and these requests must be submitted for approval to the Exempt Organizations Branch (Technical), that Branch has referred such rulings requests to the Individual Income Tax Branch (Technical) for review in light of Code section 117, which excludes from an individual taxpayer's "gross income" amounts received as scholarships or fellowship grants. The Individual Income Tax Branch, primarly concerned that company-sponsored foundations may be used as a device for compensating company employees by granting scholarships to their children, has taken a much more restrictive approach to such grants than those concerned with philanthropy feel is necessary or appropriate. The inability thus far of Technical's Individual Income Tax Branch and Exempt Organizations Branch to resolve their differences of approach has delayed approval of dozens of foundation scholarship programs whose rulings requests have continued for many months to remain pending.
123In the meantime, any foundation grant or scholarship made to individuals without advance Service approval of the grant-making procedures would subject the foundation and its managers to penalty taxes under section 4945.
Such protracted delay due to an intra-Service organizational impasse seems an unduly high price for philanthropy to pay in the name of ideally coordinated interpretations of related Code provisions. We believe the Service should establish a more effective mechanism for resolving such internal differences, and that when the differences arise from a rulings request that is required to be submitted under the Code's exempt organization provisions, as in this instance, final responsibility should be accorded the Service unit charged with interpreting those provisions.
The Service has generally applied to philanthropy the same policy against issuing advance rulings on questions of fact that it applies under other areas of the Code;
this includes determinations of fair market value. Several provisions of the Code
relating to valuation of foundation-owned property and to transactions between
foundations and their disqualified persons (who may constitute the only practical
market for Code-mandated disposition of a foundation's excess business holdings)
turn upon determinations of fair market value.
124Without an advance ruling, severe
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penalties may result from good faith transactions if the Service subsequently disagrees on valuations. We understand that the Service is currently attempting to develop criteria for approval of such determinations.125
Compliance Functions
About 72 percent of the Service's budget for exempt organizations matters is expended in performing compliance functions, that is, monitoring and enforcing compliance by exempt organizations with the Code's requirements.126 These resources have been concentrated overwhelmingly on private foundations. For example, in FY 1973 the Service audited 14,958 private foundations, 2,046 other 501(c)(3) organizations, and 1,976 organizations in all other exempt categories,127
even though the 25,133 private foundations constituted less than 12 percent of the 220,074 active 501 (c)(3) organizations and less than 4 percent of the total 643,586 active exempt organizations known to the Service,128 and foundation grants accounted for only 9.6 percent of private charitable contributions in 1973.129
We first review the organization and conduct of the Service's exempt organiza- tion audit program, and then its results.
Organization of Compliance Activities
As noted earlier, the Service's field organization in the exempt organization area consists of about 580 revenue agents and tax auditors who are members of the audit staff at the district level, serving under the managerial direction of the Audit Division Director in each of the 16 key districts, with a Regional Exempt Organiza- tion Program Coordinator under the Assistant Regional Commissioner (Audit) coordinating audit programs and monitoring key-district workloads in each of the seven Internal Revenue regions. Approximately two thirds of the key district specialists are assigned to Examination Groups performing the audit function; the balance are assigned to Determination Letter Activity Groups. Consistent with the Service's general organizational structure separating administrative supervision in the field from functional supervision by the National Office in Washington, all exempt organization field personnel are subject to the functional supervision of the National Office's Audit Division under the Assistant Commissioner (Compliance).
National Office Audit Division
Both the Peterson Commission and congressional hearings on the Tax Reform Act of 1969 focused attention on the need for a more vigorous exempt organization audit program by the Service. As a result, Commissioner Thrower in 1969 established for the first time an Exempt Organization Examination Branch in the National Office's Audit Division. Staffed by about 20 professionals, the Branch was divided in 1972 into a Procedures Section and an Examination Section, with the latter then being assigned responsibility also for the Audit Division's pension trust program.
The Examination Section, comprised of about 10 people (of whom three handle only pension trust matters), perform two main functions: first, it designs and monitors an annual exempt organization audit plan to be implemented by the field staff, which includes subject areas to be examined and predetermined audit cycles for various types of exempt organizations; and second, it prescribes uses to be made of the computerized Exempt Organization Master File (EOMF) data in determining selection of exempt organization returns for audit and for other purposes.