organization training courses in preparation for such cases.) These procedures apply to chapter 42 excise taxes asserted against foundation managers and self-dealers, whose liability for such taxes is determined in conjunction with the private foundation audit, even if the foundation's own liability for returns or tax is not affected; a copy of the examination report asserting tax against such individuals is furnished to the foundation as well as to the affected individuals upon completion of district review.
No protest right or technical review is accorded when an audit leads to a "No Change Advisory Letter." These are ussued when the audit results in a finding that the organization remains entitled for the present to its exempt status but that it has engaged in activities which, if continued or increased, may jeopardize its exempt status in the future. Since no change is made in the organization's tax liability or status, the organization does not receive a copy of the revenue agent's examination report on which such finding is based and is not accorded an opportunity to protest either the factual or the legal premises for the cautionary advice.154
Except in cases where a "No Change Advisory Letter" is the ultimate outcome of a proposed revocation or modification that has been taken to the National Office for technical advice, the issuance of such a letter will not have been reviewed by the substantive exempt organization experts of the National Office's Technical Staff.
Consequently, the in terrorem effect of such a letter can discourage exempt organizations from pursuing activities which, though perhaps controversial, may be entirely permissible by the more sophisticated standards of the National Office's Technical staff, without any opportunity for testing the issue unless the affected organization risks continuing the activity in reliance upon the anticipated favorable outcome of a future revocation proceeding. No specific data are available on the number and type of "No Change Advisory Letters" issued, but the Service estimates that about 100 to 150 such letters were issued during 1973.
Audit personnel and training. Field personnel assigned to exempt organization matters are generally revenue agents or tax auditors experienced in income tax auditing, with the higher-grade revenue agents performing the examination (audit) function while the tax auditors are assigned largely to processing exemption applications.155 Training for exempt organization audits consists of a four-week examinations course covering all types of exempt organizations, with one third of the course lessons devoted to 501 (c)(3) organizations.
The course is conducted by senior exempt organization field specialists, with materials on 501(c)(3) organizations based on (1) extracts from Revenue Rulings issued during the period 1956-1970 and from judicial decisions of the period 1945-1969; (2) references to Treasury Regulations under section 501(c)(3) and to the Exempt Organizations Handbook issued by the National Office's Technical staff;
and (3) the Audit Technique Guidelines discussed at pages 2601-02 above. These Audit Technique Guidelines include 34 pages relating to 501(c)(3) organizations, focusing primarily on whether the organizational and operational tests for exemption qualification continue to be met, with particular emphasis on private inurement and legislative or political activities, and whether any taxes are due from the organiza- tion (unrelated business income, employee withholding and chapter 42 excise taxes) or from individuals (for example, "Determine whether any assets are being used for personal purposes. This may be income to the user").
With regard to charitable fund-raising activities, the Audit Technique Guidelines observe that, "Professional fund-raisers usually get a percentage of the gross depending on their experience and ability," without advising that this practice is unanimously condemned and prohibited by the ethical standards of the American Association of Fund-Raising Counsel, the National Society of Fund Raisers, the National Information Bureau, and the Council of Better Business Bureaus.156
2610
The examinations training course also includes eight case problems, of which two concern 501(c)(3) organizations—both based on data from hypothetical audits of 1970 returns. One involves an organization promoting open occupancy housing and the other involves a hospital.
Subjective opinions expressed informally both by Service personnel and by experienced private attorneys have tended to be critical of the qualifications and training of the Service's exempt organization field staff. In a survey of 2,247 private foundations conducted by the Council on Foundations in March 1974, 78 of the 489 respondents on the question reported that agents auditing them did not seem knowledgeable in foundation law and practice.
157(The very recent introduction of tax-law specialists into the field staff, under the new Assistant Commissioner for Employee Plans and Exempt Organizations, should produce improvement; see pages 2623 and 2630 below.)
Incidence and Results of Exempt Organization Audits Incidence
Since 1969 the Service has audited more than three times as many private foundations as public charities, and twice as many 501(c)(3) organizations as all other categories of exempt organizations combined. Indeed, this emphasis so increased over the period 1969-1973 that in FY 1973, private foundation audits accounted for 88 percent of all 501(c)(3) audits and for 79 percent of all exempt organization audits. (To place this emphasis in perspective, private foundations constituted less than 12 percent of all active 501 (c)(3) organizations in FY 1973 and less than 4 percent of all exempt organizations known to the Service; thus, about two thirds of the private foundations and about 2.9 percent of all exempt organizations were audited in FY 1973.) The following data were supplied by the Service:
Exempt Organization Audits Completed
Total FY 1969 FY 1970 FY 1971 FY 1972 FY 1973 FY 69-73 Private
foundations 2,896 2,830 3,303 7,804 14,958 31,391 Other 501(c)(3)
organizations (public
Subtotal Other exempt
organizations
Total 4 4
8 ,014 ,504
1,518 4 3
8 , 554 ,989
1,543 3 ,
8, 310
683
993 1 0 ,
5, 920 379
,299 17,
1,
1 8 , 004
976
980 4 1 , 19,
6 1 , 802
531
333
a. Figure for FY 1970 is years (returns) rather than cases (entities).
During FY 1974 the Service had budgeted, for private foundation audits, 63.9
percent of the total man-hours to be devoted to the exempt organization examina-
tion program.
158Apparently, however, with the fulfillment in December 1974 of
the Service's 1969 commitment to Congress to audit all foundations within five
2611 years, greater attention to other exempt organizations may now be expected. At least for the near term this is reflected in the Service's selection of exempt organiza- tions to be included in the Taxpayer Compliance Measurement Program (TCMP), in which the Service analyzes data from special and unusually thorough audits conducted on a scientifically selected sample basis to evaluate taxpayer compliance characteristics.
Although long utilized by the Service in the income tax area, the TCMP program has not previously been applied to exempt organization returns. It is now being applied to 11,500 of the exempt organization returns filed during the 18-month period that commenced August 1974. These include returns of 3,500 private foundations (other than those on the NOCC list), 3,500 public charities and 3,500 organizations exempt under section 501 (c)(4)—each selected to provide stratified samples based on asset and income range. The Service expects data from the TCMP-Exempt Organization program to identify tax administration gaps in formulating the Service's long-term enforcement policies and to lead to improved selection of returns for audit, identify alternative methods of operation, and achieve greater operating economies.159
Results
The results of the exempt organization audit program cannot be measured in statistical terms alone. The fact that there is a program is itself a powerful incentive for exempt organizations to keep their houses in order. But since the audit program is intended to disclose whether exempt status has been maintained and whether taxes are due, it can be assessed preliminarily, at least, in terms of exemption revocations and tax collections. If the available information on 501 (c) (3) and other final revocations (see page 2602 above) are related to the comparable data shown above on completed audits, the results are as follows:
All 501(c)(3) organizations All other ex-
empt organi- zations
FY 1972 Audits
Com- pleted
10,920
5,379 Final Revoca-
tions
78
256
FY 1973 Audits
Com- pleted
17,004
1,976
Final Revoca-
tions
117
233
Total FY 72-73 Audits Final
Com- Revoca- pleted tions
27,924
7,355 195
489
Not all revocations become final in the same fiscal year in which the audit is completed, but the totals for 1972 and 1973 suggest that revocation of exempt status results from less than 1 percent of 501 (c)(3) organization audits and from about 6 percent of audits of other exempt organizations.
Data furnished by the Service shows that about $7 million of net tax deficiencies were assessed in the returns of public charities, and about $1.2 million in those of private foundations, for the year 1970 through 1972. Net tax deficiencies for private foundations and public charities for the years 1970 through 1973 are as follows:
2612
FY 1970
Private foundations Other 501(c)(3) Organizations FY 1971
Private foundations Other 501(c)(3) Organizations FY 1972
Private foundations Other 501(c)(3) Organizations FY 1973
Private foundations Other 501(c)(3) Organizations
No. Audits Completed 2,830 1,724 3,003 2,007 7,804 3,116 14,958 2,046
Net Tax Deficiencies Assessed
N o .
56 47
124 89
139 181
635 336
Amount
$ 455,149 1,225,893 403,150 2,455,151 359,377 3,309,399 9,506,359a
1,771,066 We are advised by the Service that this figure includes a limited number of highly unusual cases of a nonrecurring nature, including a multiplier effect of first level, second level and penalty taxes, and that the figure is there- fore distorted in relation to the figures for prior years. Published reports indicate that one case alone involved jeopardy assessment of such penalties multiplied to $2.6 million. Note also that these figures represent assessments, not collections.
It seems clear that the concentration of audits on private foundations has not led to substantial penalty tax collections under the chapter 42 provisions. Only
$749,000 of such penalty taxes have been collected through June 30, 1974, although more than 26,000 private foundation audits were completed during FY 1971-1973:
Private Foundation Penalty Tax Collections (in thousands of dollars)
FY 1971 FY 1972 FY 1973 FY 1974 Total Sec. 4941 Self-dealing $ 8 $ 45 $ 78 $229 $360 Sec. 4942 Failure to
distribute
income 94 160 254 Set 943 Excess
business
holdings 27 51 13 3 94 Sec. 4944 Investments
jeopardizing charitable
purposes - - 16 8 24 Sec. 4945 Taxable ex-
penditures 1 7 1_ 8 17 Total $36 $103 $202 $408 $749 a. These figures do not take account of assessments not collected, including the
1973 assessment discussed in the note to the preceding table. For the reasons explained in that note, we do not believe that the 1973 assessment will affect the trend of the figures discussed above. 1974 data a r e from News Release IR-1453, December 9, 1974, all other data from Annual R e - ports of the Commissioner through FY 1973.
2613 The foregoing data indicate plainly that by the Service's traditional audit criteria, the concentrated focus on auditing private foundations has not been rewarding.
However, the Service itself recognizes that traditional cost-benefit measurements are inappropriate for exempt organization matters. Official policy in this respect was stated as follows in a 1972 Treasury Department memorandum that was formally endorsed by the Commissioner and incorporated generally in instructions to the Service's field staff:1 6 0
These private foundation provisions must be interpreted and administered in light of their special purpose and their individual structure as a group r the Code. Their purpose is not to raise revenue; they are designed to act as a guardian to insure that foundation assets will be put to charitable uses. In interpreting and administering these provisions, a strict adversary position should not automatically be taken. They call for an extraordinary degree of care and judgment in their application. We should not assume that private foundations are subject to a presumption of impropriety in their dealings or that it is the role of the Treasury Department to discourage their existence.
Sanctions should be imposed only where appropriate, and every effort should be made to carry out the Congressional intent to benefit, rather than impede, charity. Each factual situation must be examined on its own merits and a threshold decision made whether it violates the basic intent and spirit of the provisions. If it does not, then the purportedly charitable activity should be allowed to continue, and we should not attempt to proscribe such activity by creating formalistic, unworkable, or unreasonable rules, through strained interpretations of the Code provisions.161
Apart from revenue considerations, and whether or not justified by the Service's 1969 commitment to Congress, the concentration of the Service's exempt organiza- tion audit program on private foundations has been accompanied by a concomitant neglect of public charities. We discuss at pages 2644-47 and 2661-62 below some of the byproducts of this relative neglect of public charities.
Independence and Objectivity
The programs of philanthropic organizations are diverse; they reflect priorities that range across a wide economic and political spectrum. It is the very diversity assured by private decision making that constitutes the public's protection against use of philanthropic funds to imbalance the social dialogue. The maintenance of this diversity gives a constitutional dimension to the determination of 501 (c)(3) status, which for practical purposes is a license to operate:
The tax laws relating to charities are unique in their impact on First Amendment activity. In practice, exercise of the right of association to advance common interests frequently depends on qualification of the association for section 501(c)(3) exemption. Moreover, speech and speech- related activities are a primary means—and often the only means—whereby the
"religious," "charitable," and "educational" purposes specified in the statute can be advanced. The Revenue Service, whose task it is in the first instance to interpret and apply the statutory classifications, is continually charged with the delicate task of determining whether particular forms of First Amendment activities qualify for the statutory benefits.162
It is therefore essential that government oversight of philanthropy be non- partisan, objective, and non-ideological. We turn now to an examination of the Internal Revenue Service's record in this respect and some factors that appear pertinent in shaping that record.
2614
The Service's Record
The 1952 reorganization of the Service was prompted largely by the scandals of the Truman administration.163 One result of the scandals was a hypersensitivity to political influence among the employees who survived the Service's thorough house- cleaning.164
Pride in nonpartisan professionalism, enhanced by placing all Service positions under career civil service except for the Commissioner himself,165 thus became an organizational tradition and an important part of the Service's institutional character. "The IRS has spent the last 22 years-since its reorganization was approved by Congress—trying to ensure a non-political, non-partisan, career service approach to tax administration. . . , "1 6 6 This objectively professional approach was formulated into a "Statement of Principles of Internal Revenue Tax Administra- tion" which was formally issued as a Revenue Procedure in 19641 6 7 and is republished in each issue of the Internal Revenue Bulletin:
The function of the Internal Revenue Service is to administer the Internal Revenue Code. Tax policy for raising revenue is determined by Congress.
With this in mind, it is the duty of the Service to carry out that policy by correctly applying the laws enacted by Congress; to determine the reasonable meaning of various Code provisions in light of the Congressional purpose in enacting them; and to perform this work in a fair and impartial manner, with neither a government nor a taxpayer point of view.
A t the heart of administration is interpretation of the Code. It is the responsibility of each person in the Service, charged with the duty of inter- preting the law, to try to find the true meaning of the statutory provision and not to adopt a strained construction in the belief that he is "protecting the revenue." The revenue is properly protected only when we ascertain and apply the true meaning of the statute.
The Service also has the responsibility of applying and administering the law in a reasonable, practical manner. Issues should only be raised by examining officers when they have merit, never arbitrarily or for trading purposes. At the same time, the examining officer should never hesitate to raise a meritorious issue. It is also important that care be exercised not to raise an issue or to ask a court to adopt a position inconsistent with an established Service position.
Administration should be both reasonable and vigorous. It should be conducted with as little delay as possible and with great courtesy and considerateness. It should never try to overreach, and should be reasonable within the bounds of law and sound administration. It should, however, be vigorous in requiring compliance with law and it should be relentless in its
attack on unreal tax devices and fraud.
In judging how well the Service adheres to these principles, we look first to its record prior to 1969 in applying the restrictions of section 501(c)(3) concerning legislative and political activities of exempt organizations, and then to the results of recent congressional investigations into attempted misuse of the Service for political and ideological purposes since that time.
Political activities cases prior to 1969. Any organization is disqualified for 501(c)(3) status if a "substantial" part of its activities consists of "propaganda, or otherwise attempting, to influence legislation," or if it participates in an election
"on behalf of any candidate."168 Regardless of the merits of these restrictions
2615 (which are considered by another study undertaken for this Commission),169 and of the similar restrictions imposed on private foundations by the Tax Reform Act of 1969 without regard to whether the proscribed activity is substantial,170 it is apparent that the statutory language is susceptible of wide latitude in interpreta-
t i o n .1 7 1 Since 1934 when this language first became part of the Internal Revenue Code, the Service's administration of these provisions seems to have fluctuated—in some periods more strict, in others more relaxed. But whether right or wrong on the legal issues involved (such as whether an organization may be disqualified merely for having objectives whose ultimate achievement would require legisla- tion),1 7 2 the Service's handling of such cases does not appear to have reflected any particular partisan or ideological bias, with relatively few exceptions.173
A principal exception seems to have been the Service's treatment of "subversive"
organizations during the height of the Cold War. On February 4, 1948, the Commissioner announced: "The tax laws do not contemplate and it has never been our policy to grant tax exemption or other tax privileges to subversive organiza- tions." A year earlier the Service had begun summary revocations of exempt organizations on the Attorney General's List. During 1947 and 1948 alone, 35 such revocation rulings were issued. Some of the affected organizations had been recognized as exempt for over 15 years; one had received a favorable ruling only 6 months before its revocation.1 7 4 At no time was the term "subversive" defined by any Revenue Ruling, Revenue Procedure, or Treasury Regulation.175 Instead the Service relied upon its unilateral determination that a "subversive" (undefined) organization could not be "educational."1 7 6
In 1955 the Service revoked the exemption of the Institute of Pacific Relations on the ground that it was engaged in disseminating partisan propaganda. When subsequently challenged in court, the Service's only supporting evidence was a report and hearings of the Senate Internal Security Subcommittee, which had been transmitted to the Service by Senator McCarran with the request that the Service reconsider the institute's exempt status. The federal court found that the institute had neither disseminated propaganda nor attempted to influence any governmental policies or actions, and that the revocation was unjustified.177
The Service's performance in these Cold War "subversive" cases seems to have reflected the political climate of the period. Under the circumstances of the time, however, the Service was not less objective than other federal agencies, state and local governments, many private institutions, and much of the public at large. The Service's posture on political ideologies at the close of that period may have been best described by Elias Clark in 1960:
The factors which have shaped the political activities restriction come into focus when the problem is viewed from the perspective of the Treasury. To the collector of the taxes and the guardian of the tax law, political theorizing is irrelevant It is concerned on two counts with tax support of controversial issues. First, it does not want the unenviable task of selecting those political purposes which are compatible with charitable principles and rejecting those which are not Within the last decade two congressional committees [the Reece Committee and the Cox Committee] have demonstrated particular interest in the political outlook of tax-free charities. Understandably, there is no desire to provoke the sleeping lion once again. Secondly, the Treasury must replace those tax losses resulting from deductions out of other taxes without destroying public confidence in the system. It is obviously difficult to justify a tax subsidy for a political purpose with which a considerable segment of the population is out of sympathy.1 7 8
There are indications that during the 1960s the Service occasionally cut corners at the behest of the White House.179 The Service was reportedly asked by the White House in 1961 to investigate far-right hate groups that were tax exempt.180