Nonprofits Under Fire: How the IRS Can – and Cannot – Revoke Federal Tax-Exempt Status

Earlier this year, President Trump called for the revocation of Harvard University’s 501(c)(3) tax-exempt status. [1] This comes as environmental groups were grappling with rampant rumors that the Trump administration was moving – reportedly through an Executive Order that was to be issued on Earth Day (April 22) – to redefine the IRS’ qualifications for 501(c)(3) tax-exempt status in a way that would exclude conservation and climate nonprofits; that did not happen and the White House disavowed the rumors. This past Spring, then-Interim U.S. Attorney for the District of Columbia Ed Martin wrote to the nonprofit that runs Wikipedia (the Wikimedia Foundation) questioning its 501(c)(3) tax-exemption eligibility. There also have been regular calls from President Trump to revoke the 501(c)(3) tax-exempt status of George Soros’ Open Society Foundations.

All of this preceded the U.S. Department of Education’s Final Regulations that exclude from the federal Public Service Loan Forgiveness (PSLF) program nonprofit organizations that the Department believes do not qualify for 501(c)(3) tax-exempt status due to having a “substantial illegal purpose,” which it defines to include those that aid or abet violations of federal immigration laws, support terrorism (domestic or foreign), aid or abet illegal discrimination, or violate state tort laws (including those against trespassing, disorderly conduct, or public nuisance), among others. [2] This means that employees working for employers that fall into these categories will no longer qualify for federal student loan forgiveness. While these final regulations are limited to the PSLF program only, many observers view this as a precursor to potential IRS efforts to seek to audit and revoke the federal tax-exempt status of nonprofit organizations that it believes are engaging in similar activities that have a “substantial illegal purpose,” under the precedent of the U.S. Supreme Court’s 1983 Bob Jones University decision. [3]

Finally, there were the complaints filed by Ed Blum’s American Alliance for Equal Rights with the IRS asking the Service to audit and revoke the tax-exempt status of the Gates Foundation and two other 501(c)(3) foundations due to their race-restricted scholarship programs, as well as an editorial by a Wall Street Journal editor calling for the IRS to audit and revoke the exempt status of 501(c)(3) organizations that engage in “illegal” DEI (diversity, equity, and inclusion) activities as one of their principal purposes.

While these announcements have sent a wave of fear, apprehension, and alarm through wide swaths of the nonprofit sector, it is important to note that, with one narrow exception, neither the President, the Justice Department, the Treasury Department, the Education Department, the U.S. Attorney for the District of Columbia, nor the IRS have the ability to revoke the federal tax-exempt status of any entity through Executive Order or with the mere stroke of a pen. [4] There are well-established procedures for revoking federal tax exemption and they all involve the IRS. With two exceptions – one of which is the automatic revocation for failure to file an IRS Form 990 for three years in a row – those procedures require individual case-by-case IRS audits of each organization, with ample opportunity for the entity to defend itself, and including multiple routes of appeal. There simply is no lawful mechanism for the President, IRS, or others in the Trump administration to revoke the tax-exempt status of most nonprofits without following this longstanding process.

The one exception referenced above involves Internal Revenue Code (IRC) Section 501(p), which was enacted by Congress in 2003 (in the aftermath of 9/11) and which provides for the automatic “suspension” (not revocation) of the federal tax-exempt status of an organization upon designation or identification by the federal government of the organization as supporting or engaging in terrorist activity or supporting terrorism, as defined under the Immigration and Nationality Act, the International Emergency Economic Powers Act, and the United Nations Participation Act. [5] These federal laws seem to relate to “foreign” and “global” (and not domestic) terrorism. No court challenges are permitted in the event of such a suspension. Approximately ten organizations have reportedly had their tax-exempt status suspended under Section 501(p) since its enactment.

Note that nonprofit organizations are generally organized and operated as both nonprofit and tax-exempt entities. “Nonprofit” status refers to incorporation status under state corporate law; “tax-exempt” status refers to federal income tax exemption under the IRC. Even if, following the IRS audit and appeal process (and any ensuing litigation), an organization’s tax-exempt status is revoked, it still remains a nonprofit corporation (albeit a taxable one). Even post-revocation (including in the event of a 501(p) suspension), the IRS has no authority to shut down a nonprofit, seize its assets, or otherwise take control of the organization.

If the IRS questions the federal tax-exempt status of a nonprofit organization, it can initiate an audit (technically called an “examination”) of the organization, auditing one or more IRS Forms 990 that were filed by the entity; those are the tax years under examination and the IRS is effectively determining whether the Forms 990 at issue were accurate and reflected full compliance with the applicable tax laws. For 501(c)(3) tax-exempt organizations (which comprise the vast majority of all tax-exempt entities), there can be many bases for threats to their exempt status, including not meeting the “organizational” or “operational” tests, private inurement, impermissible private benefit, having a substantial non-exempt purpose, engaging in too much lobbying, engaging in prohibited political campaign activity, or having too much unrelated business income, among others.

The IRS conducts several types of audits of exempt organizations. The two most common are correspondence examinations and field examinations, the latter being much more invasive, involving one or more auditors on site reviewing information and documents and conducting interviews. Field exams generally take several months to conduct, at a minimum, and often much longer.

There are four potential outcomes of an IRS examination of an exempt organization: a no-change letter, no-change letter with written advisories, negotiated closing agreement, or proposed revocation of exempt status. The first three outcomes enable the organization to retain its tax-exempt status, but in the second or third options, with certain conditions and/or required changes.

If the IRS concludes an audit with a proposed revocation, the organization will have 30 days (or longer if an extension is negotiated) to “protest” the proposed ruling and avail itself of the IRS Appeals process. [6] During the pendency of the IRS Appeal, the organization remains tax-exempt, and during the pendency of the audit and appeal process, the IRS is barred by law from disclosing anything publicly about the matter. Once the protest is filed, it will be assigned to an IRS Appeals Officer, and the organization (and/or its representative(s)) will have the opportunity to have an Appeals conference with the Appeals Officer to make its case for denying the proposed revocation or otherwise proposing a settlement. Note that the Appeals conference is an informal meeting between the organization’s representatives and the Appeals Officer; the IRS agent who conducted the underlying examination does not participate in the conference. The Appeals Officer (with the approval of their manager) has broad authority to order the IRS examination division to issue a no-change letter or no-change letter with written advisories, to negotiate a settlement with the organization, or to finalize the revocation.

If the IRS Appeals Officer decides to uphold the proposed revocation, the organization will be issued a final adverse determination letter, at which point the entity will have lost its federal tax exemption. The revocation will be published in the Federal Register. Following the receipt of the letter, the organization will have 90 days to petition the U.S. Tax Court, the U.S. Court of Federal Claims, or the U.S. District Court for the District of Columbia for a declaratory judgment as to its qualification for tax-exempt status. [7] Like other federal litigation, if unsuccessful at the lower court level, appeals by the nonprofit organization or the IRS to higher courts are permitted. [8]

If, at the end of the process, the nonprofit loses its federal tax-exempt status, as stated above, it still remains a private nonprofit corporation, just a taxable one, required to file IRS Forms 1120 (the federal corporate tax return) annually and pay federal (and state, if applicable) corporate income tax on its net annual income. Of course, if the nonprofit makes the necessary conforming changes to its organization or operations, it always has the option to prospectively re-apply to the IRS for recognition of its 501(c)(3) tax-exempt status. It also has the option to transfer its assets to an existing 501(c)(3) entity or to a newly created 501(c)(3) organization, following which it can then dissolve (once all outstanding liabilities have been satisfied).

[1] Note that federal law (26 U.S. Code Section 7217) makes it a federal crime for senior officials of the executive branch, including the President, to request that the Internal Revenue Service (IRS) conduct or cease an audit or other investigation of any taxpayer (including tax-exempt entities); there is an exception for written requests by the Treasury Secretary to the IRS as a consequence of the implementation of a change in tax policy.

[2] The Final Regulations define the following activities as indicative of a “substantial illegal purpose”:

• Aiding or abetting violations of 8 USC § 1325 or other federal immigration laws
• Supporting terrorism, including by facilitating funding to, or the operations of, cartels designated as Foreign Terrorist Organizations consistent with 8 USC § 1189 or by engaging in violence for the purpose of obstructing or influencing federal government policy
• The use of puberty blockers, including GnRH agonists and other interventions, to delay the onset or progression of normally timed puberty in an individual who does not identify as their sex, for children in violation of federal or state law
• The use of sex hormones, such as androgen blockers, estrogen, progesterone, or testosterone, to align an individual’s physical appearance with an identity that differs from their sex, for children in violation of federal or state law
• Engaging in the trafficking of children to another state for purposes of emancipation from their lawful parents in violation of federal or state law
• Engaging in a pattern of aiding and abetting illegal discrimination
• Engaging in a pattern of violating state laws, which is defined as a final, non-default judgment by a state court of (1) trespassing, (2) disorderly conduct, (3) public nuisance; (4) vandalism, or (5) obstruction of highways

See Federal Register: William D. Ford Federal Direct Loan (Direct Loan) Program.

[3] See Bob Jones University v. United States, 461 U.S. 574 (1983).

[4] Congress would seemingly have such authority, but, to date, such legislative action has not been publicly contemplated.

[5] See Publication 5588 (Rev. 2-2024).

[6] See IRS Publication 892 (Rev. 2-2017).

[7] Note that if the court petition is filed prior to the issuance of the final adverse determination letter, the IRS is not permitted to revoke the organization’s tax-exempt status during the pendency of the litigation.

[8] Note that the IRC provides that a court will not issue a declaratory judgment unless the court determines that the organization has exhausted its administrative remedies; if a protest is not filed with IRS Appeals with respect to an adverse determination, the court may determine that the organization has not exhausted its administrative remedies.

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For more information, contact the author at jtenenbaum@TenenbaumLegal.com.