DOJ Tax on IRC 7428 Declaratory Judgments

Back in 2017, the Santa Clara County District Attorney prosecuted Jimmy Chen for setting up fraudulent foundations to which clients made deductible donations and then used for private consumption.  Here is an excerpt from the DA’s press release:

Jimmy Chen, 63, of Saratoga, set up private foundations for at least six of his clients as a scheme to help them evade income tax and receive personal benefits. These foundations were established purportedly for charitable purposes, but were used primarily by the clients for personal purposes. Chen set up private foundations and prepared foundation returns for hundreds of clients. Six of the foundations set up by Chen are listed in the criminal complaint.

Because private foundations are tax-exempt entities, this allowed the clients to make donations to their private foundations and deduct the amounts as charitable contributions on their personal income tax returns to reduce their income and pay less tax. The clients used the private foundation funds for personal purposes, including paying for vacation, vehicles, rents, and their children’s college tuition.

Three years later in December 2020, California suspended XC Foundation’s corporate charter, probably for its failure to make annual filings.  Chen set up the XC Foundation but XC claims status as his victim not his co-conspirator.  The next year, the Service issued a NOD revoking XC’s exemption and imposing excise taxes for self-dealing under IRC 4941. XC sought declaratory judgement under IRC 7428 but the Tax Court dismissed the action for lack of jurisdiction.  Since XC’s corporate status had lapsed at the time of filing, the Service argued and the Tax Court accepted that XC was a non-entity therefore incapable of suing anybody for anything.  As a legal matter, according to DOJ, the Foundation did not exist.  California revived XC later that year, but only after the 90 period from the date of the NOD during which a 7428 petition must be filed.  Its a logical but kinda ticky-tack whipsaw argument because XC no longer existed only because the Service revoked the revocation that XC seeks to challenge via 7428.  XC appealed to the 9th Circuit arguing that the circumstances combining to preclude IRC 7428 review deprive it of due process.  DOJ’s argues that XC can still litigate imposition of excise taxes and therefore is granted sufficient process. Just not under IRC 7428.

Its all pretty dry boring stuff, if you ask me.  But DOJ’s brief provides a nice primer on IRC 7428.  Here is an excerpt:

Under the Internal Revenue Code, an organization described in I.R.C. § 501(c)(3) is exempt from tax. I.R.C. § 501(a). Donations made to such an organization generally are deductible under I.R.C. §170(c)(2). Whether an organization satisfies these statutory requirements is an issue that can be litigated and determined in the first instance by either the Tax Court in a federal tax deficiency suit, see I.R.C. §§ 6212, 6213, or by the appropriate federal District Court or the Court of Federal Claims in a tax refund suit, see I.R.C. § 7422, 28 U.S.C. § 1346. Bob Jones Univ. v. Simon, 416 U.S. 725, 746–47 & n. 21 (1974); see also Bluetooth SIG Inc. v. United States, 611 F.3d 617, 621 (9th Cir. 2010) (making a de novo determination of tax-exempt status under I.R.C. § 501(c)(6), without regard to an earlier administrative decision); St. David’s Health Care Sys. v. United States, 349 F.3d 232, 234 (5th Cir. 2003) (taxpayer’s 501(c)(3) status placed at issue in a tax refund suit).

The IRS has a longstanding practice of issuing advance rulings and determination letters that, in some cases, may be of use to taxpayers who wish to avoid litigation. See Treas. Reg. (26 C.F.R.) § 601.201(a); Rev. Proc. 2023-5, 2023-1 I.R.B. 265, 2023 WL 15575 (January 3, 2023). Such letters are not binding on the courts. I.R.C. § 6110(k)(3). Ruling letters are issued based on the taxpayer’s representations, rather than an investigation into the underlying facts, and therefore may be revoked if the representations upon which they are based prove to be inaccurate. Treas. Reg. § 601.201(l)(2); Rev. Proc. 2023-5. Indeed, a “ruling . . . may be revoked or modified at any time in the wise administration of the taxing statutes.” Treas. Reg. § 601.201(l)(1); see also Rev. Proc. 2023-5.

Pursuant to this practice, the IRS has long issued letter rulings to organizations that appear to meet the statutory requirements for tax-exempt status. See Treas. Reg. § 601.201(n); Rev. Proc. 2023-5. The letter requested by the CPA Chen and issued to the foundation in 2008 was such a letter, as was the March 2, 2021 letter, revoking the prior letter, that led to the foundation’s Tax Court petition.

In addition to issuing such letters, the IRS has also long exercised its discretion to provide advance assurance of deductibility to potential donors by maintaining a list of organizations that have received favorable determination letters. See Rev. Proc. 2018-32 § 3.01, 2018-23 I.R.B. 739, 2018 WL 2462877 (June 4, 2018). The list, previously published in a paper pamphlet called IRS Publication 78, is now available as a database, called the Tax Exempt Organization Search, that can be accessed via the IRS website. Donors without inside knowledge of an organization generally may rely on an organization’s appearance in this database (or, previously, in the Cumulative List published in Publication 78) even if the organization’s tax-exempt status later is revoked retroactively. Treas. Reg. § 1.170A-9(f)(5)(ii); Rev. Proc. 2018-32 § 4.01.

When an organization is sustained by fundraising from outside donors, its appearance on this list, though not legally binding in a proceeding concerning either the donor’s or the donee’s tax liability, may be of great practical importance to the “flow of contributions” from third-party donors that sustain the organization. Bob Jones Univ., 416 U.S. at 730. The practical importance of a letter determining tax[1]exempt status, and the organization’s appearance in Publication 78, drove certain high-profile litigation in the 1970s, when the IRS began administrative proceedings to revoke the tax-exempt letter of Bob Jones University on the grounds that that school’s then-policy of categorically denying admission on the basis of race violated public policy. Bob Jones Univ., 416 U.S. at 735.

As a historical matter, the instant type of declaratory judgment proceeding was created in response to that litigation. The Government argued in court that the Bob Jones litigation was barred by the Anti-Injunction Act, I.R.C. § 7241(a), and outside the scope of the Declaratory Judgment Act, 28 U.S.C. § 2201(a), because whether the university qualified as tax-exempt under I.R.C. § 501(c)(3) was an element of the university’s tax liability. The Supreme Court agreed. Bob Jones Univ., 416 U.S. at 727. As the Court explained, a taxpayer confronted with an income tax assessment after the administrative revocation of an administrative letter finding that it is tax exempt “may in accordance with prescribed procedures petition the Tax Court to review the assessment of income taxes.” Id. at 746. Similarly, a foundation confronted with any type of tax may pay that tax, “exhaust the Service’s internal refund procedures, and then bring a suit for relief.” Id. As the Court further explained, “[t]hese review procedures offer the petitioner a full, albeit delayed, opportunity to litigate the legality of the Service’s revocation of tax-exempt status[.]” Id.

Recognizing the importance of the administrative determination of tax-exempt status to organizations like Bob Jones that rely on tax-deductible donations from third parties (who, in turn, rely on Publication 78), Congress responded to the Court’s opinion by enacting I.R.C. § 7428, which creates a remedy “[i]n a case of actual controversy involving . . . a determination by the Secretary . . . with respect to the . . . continuing qualification of an organization as an organization described in section 501(c)(3).” Pub. L. 94-455, Title XIII, § 1306(a) (1976); see also id. at § 1306(b)(8) (amending the Declaratory Judgment Act to remove the barrier recognized by the Court in the Bob Jones case); Bob Jones Univ., 416 U.S. at 750 (“this matter is for Congress”).

The enactment of I.R.C. § 7428 did not, however, deprive courts of jurisdiction to determine in other proceedings whether an entity meets the terms of I.R.C. § 501(c)(3). The text of I.R.C. § 7428 does not state that the remedy created in that section is exclusive, and indeed, we are aware of no authority so stating. Courts hearing the argument have rejected it. Zimmerman v. Cambridge Credit Counseling Corp., 409 F.3d 473, 477 (1st Cir. 2005) (the administrative determination of 501(c)(3) status “is not binding in subsequent litigation challenging the applying entity’s tax-exempt status”); Richie v. Am. Council on Gift Annuities, 943 F. Supp. 685, 692 (N.D. Tex. 1996). Like the university in the Bob Jones case, the foundation here may obtain judicial review via other avenues. The dismissal of this declaratory judgment proceeding does not preclude the foundation from contesting the merits of its tax-exempt status in some future proceeding regarding its tax liability, nor would it prevent a donor from contesting the same issue in a suit regarding the deductibility of a donation. In addition, nothing prevents the foundation from reapplying to the IRS for a prospective determination of its tax-exempt status when it has the legal capacity to do so. See Branch Ministries v. Rossotti, 211 F.3d 137, 143 (D.C. Cir. 2000); Houston Law. Referral Serv., Inc. v. Commissioner, 69 T.C. 570, 577-78 (1978) (“[a]n adverse decision in a declaratory judgment proceeding does not preclude the applicant from filing a new exemption application”).

darryll k. jones