Getting Rid of Dark Money Requires a New Tax-Exempt Designation

A recent court decision highlights the need for a new tax-exempt classification that would make political spending by social welfare organizations more transparent, and better delineate the types of nonprofit organizations lumped under 501(c)(4).

Such a designation would carve out politically active groups for separate treatment, setting boundaries on political expenditures and mandating donor disclosures on anonymous dark money contributions to campaigns.

The US Court of Appeals for the Fifth Circuit’s October ruling in Mem’l Hermann Accountable Care Org. v. Commissioner could ultimately mark a turning point in the debate over dark money. More immediately, it has illustrated the illogical mishmash that defines the current 501(c)(4) tax-exempt designation.

The court took a hard line on 501(c)(4) tax-exempt status requirements in its decision—ostensibly about an accountable care organization—suggesting a potential shift toward stricter scrutiny for organizations that claim to be social welfare organizations while also engaging in substantial political activities.

The current 501(c)(4) section encompasses a wide array of social welfare organizations, with some ability to participate in politics compared with their 501(c)(3) counterparts, which are more restricted. The current status quo, at least outside of the Fifth Circuit, is that 501(c)(4) organizations can engage in political activities as long as politics isn’t a primary purpose.

There isn’t a precise definition for 501(c)(4) organizations, which tend to encompass both groups focused on social welfare and those primarily involved in political influence.

Consequently, high-profile advocacy groups such as AARP and the National Rifle Association are grouped with homeowners’ associations and local sports leagues—and are regulated under the same code section in terms of tax treatment and permissibility of political activity.

These organizations don’t need to disclose their donors publicly in most situations, which makes them attractive for political advocacy purposes. Dark money is a consequence of this benefit—where 501(c)(4) organizations use their tax-exempt status to raise donations without disclosing donors. These funds can then be directed toward elections or issue advocacy and often will be subject to little transparency.

For some time, 501(c)(4) organizations have been stretching the boundaries of what’s permissible and have been relying on the IRS’s inability or unwillingness to police their activities. There are about 73,000 501(c)(4) organizations in the US. Many don’t have political advocacy as a substantial purpose, but those that do haven’t historically been held accountable.

The catchall status of 501(c)(4) as a tax code section betrays the overall lack of clear and enforceable standards for regulating these organizations effectively, even if the IRS had the political will to do so.

This lets them be conduits for untraceable political contributions. Holding all entities organized under that section to the same transparency and financial disclosure requirements makes little policy sense.

In examining whether the primary operations of a 501(c)(4) accountable care organization constituted a permissible tax-exempt purpose, the Fifth Circuit determined that the relevant standard was whether that organization had a “substantial nonexempt purpose.” Such a purpose would disqualify the entity as a tax-exempt 501(c)(4) organization.

The court rejected the more lenient “primary purpose” standard of prior holdings and justified its ability to do so under the new agency deference framework post-Loper Bright. The court’s new interpretation aligns 501(c)(4) with the more restrictive 501(c)(3) standard in the Fifth Circuit, based on shared language between the two sections.

This shift has significant implications for some 501(c)(4) organizations, which have relied on the more lax “primary purpose” standard to justify a focus on political activities.

The ruling signals that substantial political activities can’t coexist with social welfare exemptions. It also presents an opportunity to formalize these principles through a new 501(c)(4)(C) classification, drawing clear boundaries between social welfare organizations and those involved in political advocacy.

To address the issues raised by dark money opponents and the Fifth Circuit’s decision, a new designation could create a distinct tax-exempt classification for politically active social welfare organizations.

This would create clear rules for organizations that engage in political advocacy, setting parameters that balance their social welfare mission with transparency and accountability. This also could cleave off more traditional social welfare organizations, such as community groups and service-oriented nonprofits, that don’t need to be subject to the same level of scrutiny.

Under such a designation, organizations receiving donations over $10,000, an amount that aligns with some campaign finance law contribution thresholds requiring disclosure, would be required to disclose these donors. This would shine a light on high-dollar donations that currently remain anonymous, providing transparency around the financing sources that may be driving political influence and parity with campaign finance contribution requirements.

Additionally, a new classification could enable spending limits on political activities—ensuring that no social welfare organizations spend more than a given percentage of revenue on political outlays. A 50% cap would prevent these groups from operating as de facto political entities while still allowing some degree of advocacy, broadly in keeping with the limits in place prior to the Fifth Circuit decision.

This new designation could come with dedicated federal oversight, allowing regulatory bodies such as the IRS to focus enforcement efforts on politically active social welfare organizations categorized under 501(c)(4)(C) rather than the entire 501(c)(4) sector. This separation would free traditional social welfare organizations from additional scrutiny while limiting the additional administrative overhead placed on regulators.

The more explicit the statutory drafting is, the less room there would be for administrative agencies under an unfriendly presidential administration to interpret them in ways that undermine their intent.

As 501(c)(4) entities have increasingly become vehicles for anonymous political contributions, the need for reform is undeniable. The proposed designation would address dark money issues without disrupting the work of traditional social welfare organizations or unduly burdening regulators.

For policymakers and the IRS, a separate sub-category under 501(c)(4) would answer growing public demand for campaign finance transparency and increased demand for specificity in post-Loper Bright legislation.

The case is Mem’l Hermann Accountable Care Org. v. Commissioner, 5th Cir., 23-60608, Opinion 10/28/24.

Andrew Leahey is a tax and technology attorney, principal at Hunter Creek Consulting, and adjunct professor at Drexel Kline School of Law. Follow him on Mastodon at @andrew@esq.social

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