While Internal Revenue Code Section 501(c)(3) organizations are the typical vehicle for philanthropy, many organizations enjoy tax-exempt status under IRC Sections 501(a) and 401(a), such as trade associations, fraternal societies and employees’ pension and profit sharing plans. Some recent billion dollar contributions to Section 501(c)(4) organizations have raised their profile as a destination for philanthropic support.
Key Requirements
Section 501(c)(4) provides a tax exemption for civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare or certain local associations of employees, provided that no part of the net earnings of the entity inures to the benefit of any private shareholder or individual. An organization is operated exclusively for the promotion of social welfare if it’s engaged primarily in promoting in some way the common good and general welfare of the people of a community.1 Examples include the NAACP or the local volunteer fire department. Others are community associations working to improve public services, housing and residential parking. An organization fails the requirement of being operated primarily for the promotion of social welfare if its primary activity is operating a social club for the benefit, pleasure or recreation of its members or carrying on a business with the general public in a manner similar to organizations that are operated for profit.
Policy and Political Arenas
The promotion of social welfare doesn’t include direct or indirect participation or intervention in political campaigns on behalf of or in opposition to any candidate for public office.2 But social welfare organizations are permitted to engage in political activity so long as the organization remains engaged primarily in activities that promote social welfare. Political activity can’t be its primary purpose. However, permissible political activity includes seeking legislation favorable to the organization’s programs as well as lobbying. For example, the organization could support or oppose ballot measures or distribute voting guides on issues of importance to it.3 The permissible activities in the political arena might attract the philanthropically minded who believe the most impactful changes for the common good can come through legislation.4 However, any expenditure it makes for political activities may be subject to tax under IRC Section 527(f).
Tax Consequences of Contributing
Although their income is tax-exempt, Section 501(c)(4) organizations aren’t charitable organizations and don’t qualify for the charitable income tax deduction under IRC Section 170. Contributions may be deductible under IRC Section 162 as trade or business expenses, if ordinary and necessary in the conduct of the taxpayer’s business.
Prior to passage of the Protecting Americans From Tax Hikes Act of 2015 (PATH), the courts and the Internal Revenue Service denied gift tax deductions to Section 501(c)(4) organizations notwithstanding that transfers to Section 501(c)(6) organizations were exempted. IRC Section 2522 didn’t appear to allow a gift tax deduction for transfers to Section 501(c)(4)s. Nor was there any exclusion from the definition of taxable gift under the adequate consideration and ordinary course of business exceptions within the meaning of Treasury Regulations Section 25.2512-8. After PATH, IRC Section 2501(a)(6) now specifically exempts from gift tax transfers to Section 501(c)(4) organizations as well as to Sections 501(c)(5) and 501(c)(6) organizations.
Growing Awareness
In the last several years, a number of prominent philanthropists have used the Section 501(c)(4) vehicle notwithstanding the lack of an income tax deduction. Why the appeal? First, the lack of the income tax deduction likely isn’t an impediment because most mega-philanthropists either have exceeded the adjusted gross income limitations or are simply indifferent to the unavailability of the deduction. The size of their net worth dwarfs the income from their assets. Second, avoiding the recognition of gain through lifetime gifts of appreciated assets saves not only capital gains (20%) and net investment income (3.8%) taxes but also the federal estate (40%) levy. Let’s examine two highly publicized examples.
Contributions From Entrepreneurs
Preserving a corporate mission. Philanthropists with the bulk of their wealth tied up in a closely held business may find the Section 501(c)(4) organization especially attractive as the excess business holdings prohibition of IRC Section 4943 doesn’t apply.
Last September, Patagonia’s Yvon Chourod gifted his company (worth an estimated $3 billion) to fund Holdfast Collective, a non-profit environmental group. The donor retained for his family trust the 2% of the company with voting control and gifted the remaining 98% to the Section 501(c)(4) organization. Patagonia would operate as a for-profit company whose “profits” would support environmental efforts of Holdfast Collective. Each year, the money Patagonia makes after reinvesting in the business will be distributed to the nonprofit to help fight the environmental crisis.5 The structure, according to Chourod, was designed to avoid selling the company or taking it public, which could have meant a change in its values.6
Steering history. Of course, there’s no requirement that a Section 501(c)(4) organization keep the shares in a business. When 90-year-old and childless Barre Seid transferred his electronics company, Trippe Lite, to the Marble Freedom Trust (Trust), he was trying to answer “how to steer history.” The purpose of the Trust is maintenance and expansion of human freedom consistent with the Declaration of Independence and U.S. Constitution. The shares were soon sold for $1.6 billion to Eaton Corporation, an Irish conglomerate. As Seid was advised by a global law firm, the issue of a constructive sale of the heavily appreciated stock was presumably successfully addressed.
Clear Sailing Ahead?
The Chourod and Seid contributions show how the Section 501(c)(4) organization can handle successfully a gift of a privately held business. Notwithstanding the attractiveness of the technique to address estate planning and philanthropic needs, there may be some unavoidable risks.
The first could be an irreconcilable conflict in balancing the need of a business to return profits back to the business to assure its future growth and profitability and the demands of the non-profit shareholders to seek profits for its support.
The other is possible legislation specifically treating transfers to Section 501(c)(4)s as taxable events for income and transfer-tax purposes. High profile contributions from the likes of the Dalio or Koch families will likely trigger Congressional attention. The Department of the Treasury is already gathering information on Section 501(c)(4) organizations via Form 8976 as required under IRC Section 506.7
The funding of Section 501(c)(4) organizations is done almost exclusively with appreciated stock. Congress could dramatically curtail their appeal by allowing contributions of cash only. Additionally, another reform could be the prevention of donations from private foundations (PFs) and donor-advised funds (DAFs) to Section 501(c)(4) organizations, including those with a similar mission. Under current law, the deductibility of transfers to DAFs and PFs ultimately supporting Section 501(c)(4) organizations operates as a backdoor charitable income tax deduction.
Finally, Congress could impose a similar reporting requirement of listing all donors who give over a threshold amount similar to the disclosure rules for a Section 501(c)(3) organization’s donors giving more than $5,000.
Supplant or Complement?
Could the Section 501(c)(4) be the vehicle that encourages more of the mega-wealthy to better the common good? Perhaps an even more interesting question might be will the level of donor control afforded Section 501(c)(4)s make them better suited as a supplement to Section 501(c)(3)s, rather than as a complement to them, as is the case now.
Endnotes
1. Treasury Regulations Section 1.501(c)(4)–1(a)(2)(i).
2. Treas. Regs. Section 1.501(c)(4)-1(a)(2)(ii).
3. For a comparison between Internal Revenue Code Section 501(c)(4) and other IRC Section 501(c) differences, see www.irs.gov/charities-non-profits/common-tax-law-restrictions-on-activities-of-exempt-organizations.
4. For an excellent comparison and contrast between the permissible activities of Section 501(c)(3) and 501(c)(4) organizations, see https://bolderadvocacy.org/wp-content/uploads/2022/01/501c3-and-501c4-Permissible-Activities-Comparison.pdf.
5. www.patagonia.com/ownership/.
6. Ibid.
7. See www.irs.gov/statistics/soi-tax-stats-receipts-of-forms-8976-notices-of-intent-to-operate-under-section-501c4-irs-data-book-table-13 for the number of notices filed under IRC Section 506 for the 2020 and 2021 reporting periods. Organizations operating under any other Section 501(c) section shouldn’t file this notice.