IRS To Take On Karl Rove? Tax Laws Could Take A Bite Out Of Secret Political Spending

WASHINGTON -- Top Republican political strategist Karl Rove's method of secretly funneling unlimited contributions from big donors was so hugely successful in the 2010 campaign that Democrats are now trying to copy it. But his model may yet end up backfiring spectacularly.

In one scenario, groups like Rove's Crossroads Grassroots Political Strategies could find themselves subject to massive fines, ranging as high as 35 to 70 percent of the money they received in secret donations.

In another scenario, their deep-pocket donors could be hit by a 35 percent tax on their contributions.

Rove may well have found a way around the nation's federal election laws. But now the key question is whether the Internal Revenue Service is willing to be assertive. Because if it is, then just like with Al Capone, it could be the IRS that gets him.

In Crossroads GPS's solicitations for money, the group describes itself as a tax-exempt 501(c)(4) organization, and due to a controversial loophole in federal campaign finance rules, the names of donors to those organizations do not have to be disclosed publicly.

But contrary to popular belief, Rove's group has not formally attained 501(c)(4) status. The group's application, requesting the IRS to classify it as a "social welfare" group, is still pending.

And while the designation is typically not much more than a formality -- organizations routinely call themselves (c)(4) groups before they've been formally approved -- tax and campaign finance experts contacted by The Huffington Post said the IRS could well deny Crossroads GPS's application.

IRS guidelines for 501(c)(4) status state that social welfare groups "must operate primarily to further the common good and general welfare of the people of the community" -- which "does not include direct or indirect participation or intervention in political campaigns on behalf of or in opposition to any candidate for public office."

Intervening in political campaigns isn't prohibited, it just can't be the primary activity.

Were Crossroads GPS denied its 501(c)(4) status, the organization could be on the hook for tens of millions of dollars in fines. And operating in secrecy would suddenly come with an enormous new price tag.

THE RISE OF 501(c)(4)s

In the 2010 cycle, Rove wasn't the only one to use a 501(c)(4) as a source of clandestine funds. A slew of other , mostly conservative, often interrelated groups did so as well, led by the Wall Street-backed American Action Network .

Indeed, more of these groups seem to be popping up every day, with Rove's organization often cited as a role model.

"If people look at what Crossroads did over the course of the last couple of years, that'll give them a good sense of our activity," said Bill Burton, a former aide to President Barack Obama and one of the co-founders of Priorities USA, a newly-formed Democratic 501(c)(4), in an interview with The Huffington Post last week.

Crossroads GPS spokesman Jonathan Collegio confidently insists that his group "is comfortably within the guidelines set out by the IRS" for social welfare groups. "GPS invested millions of dollars in social welfare issue advocacy advertising before the FEC's 60 day reporting window last summer," he said in an email.

And, Collegio added, "we've been one of the most heavily active issue advocacy organizations in Washington over the last six months."

But when it comes to defining political activities, the IRS doesn't engage in the same kind of legalistic hairsplitting that the Federal Election Commission does, and much of the spending Collegio puts on the non-political side of his group's ledger, the IRS might well decide does not belong there.

"Lots and lots of things that would not be considered 'express advocacy' by the FEC, the IRS would consider intervention in a political campaign," said Donald Tobin, a tax and campaign finance law expert at the Moritz College of Law.

TIPPING THE SCALE

To qualify as a legitimate 501(c)(4) organization, in its first fiscal year Crossroads GPS would need to have spent more on what the IRS considers non-political expenditures than on political ones, said Marcus S. Owens, a Washington lawyer who used to head the IRS division that oversees tax-exempt organizations.

"My guess is they haven't," he said.

And there's not enough time to take dramatic measures to restore the balance, either -- the group's first fiscal year ends on May 31.

Consider the numbers: Crossroads GPS dropped a whopping $17 million on campaign spending that it considered obligated to report to the FEC -- most of it on televised attack ads -- in the run-up to the November 2010 elections.

And while Collegio said the group raised a total of $43 million in 2010 -- leaving plenty available for other purposes -- there are few indications that it spent more than a fraction of that money on anything that, by IRS standards, is unrelated to campaigning.

Asked for examples of big-ticket expenditures that weren't election-related, Collegio came up short. Crossroads GPS made a $750,000 ad buy in March attacking public sector unions, and recently launched an anti-Obama wiki , he said. But all that only amounts to pocket change for the group.

Collegio also cited as unrelated to elections the $1 million Crossroads GPS spent to run an ad in California during August 2010, that called on Democratic Sen. Barbara Boxer "to stop the Medicare cuts." Boxer was facing reelection three months later.

"What Crossroads is going to argue is that these ads you're talking about are lobbying -- and lobbying is a social welfare purpose -- because they say in the tagline: 'Call Barbara Boxer,'" Tobin said. "But that is using federal election law jurisprudence, not tax jurisprudence."

The IRS, he said, takes a "fact and circumstances approach" to decide whether ads -- or groups -- are basically there to influence elections.

And the group's primary purpose really couldn't be clearer. Its own blog recently linked to a Wall Street Journal story in which Rove and fellow Republican strategist Ed Gillespie -- the co-founders of Crossroads GPS and its Super PAC twin American Crossroads -- announced that they're "raising $120 million in the effort to defeat President Barack Obama, win a GOP majority in the Senate and protect the party's grip on the House in the 2012 election."

"There's a good chance the IRS will deny the (c)(4) application," said Lloyd Mayer, who teaches tax law at the University of Notre Dame.

So what would the group do should it come to that? Collegio told The Huffington Post he was "not going to argue hypotheticals based on a tax expert's opinion." And he stuck to his guns, adding: "[t]he laws as they are set out by the FEC and IRS are clear, and Crossroads follows them closely."

MILLIONS IN PENALTIES

But without its 501(c)(4) status, the group would find itself in real trouble.

Experts say the most likely scenario is that the IRS would classify Crossroads GPS as a "527" organization instead.

Unlike 501(c)(4), Section 527 of the U.S. Code is specifically intended for organizations that are primarily engaged in political advocacy. It exempts them from taxes and allows unlimited donations from individuals and corporations. And, thanks to recent Supreme Court decisions, it no longer imposes any limits on what they can say in their ads.

But Section 527 also explicitly requires political groups to publicly disclose from whom they got their money and how they spent it.

Karl Sandstrom, a former FEC commissioner now at the Washington law firm of Perkins Coie, predicts that "the IRS would come in and say, 'you're not properly a (c)(4), all indications are that you're operating as a political organization. And political organizations have a responsibility to file regular reports with the IRS, and you failed to do so.'"

Suddenly in violation of those disclosure rules, the group would then be subject to a massive penalty, established in the statute as the maximum corporate tax rate (35 percent) times all the money that should have been disclosed but wasn't.

For Crossroads GPS, that turns out to be a lot.

"You would aggregate all donations that were not disclosed, and you would take that amount at 35 percent," said Tobin. If indeed the group took in $43 million in donations in 2010 alone, that would mean well over $15 million in penalties right there.

"In addition, the organization is also taxed on non-disclosed expenditures, so my reading of the statute would subject all expenditures that were not disclosed to the FEC to the 35 percent tax," Tobin said. So Crossroads GPS would also owe more than a third of however much it spent beyond the $17 million it has already reported.

In a twist sure to be frustrating to disclosure advocates, however, the group still would not have to disclose its donors' identities once it paid its fines. But that would be secrecy at a very high price, indeed.

The tax experts consulted by The Huffington Post say that another possible path exists for Crossroads GPS should it be denied its 501(c)(4) status: It could conceivably declare itself a regular, tax-paying corporation. But the group would arguably take a huge hit there, as well.

In that case, the company would potentially have to pay corporate income tax on all the money in took in as donations. And all those campaigns ads wouldn't be deductible, as they don't qualify as ordinary and necessary business expenses.

WAITING ON THE IRS

Why, then, is Collegio still so confident? And why, given these huge potential pitfalls, are political (c)(4)s the hottest thing in D.C.?

Because the IRS may be afraid of a fight.

"That's the issue here," said Mayer, the Notre Dame law professor. "Because usually when there are penalties -- especially of this magnitude, especially when you're dealing with an organization this politically sensitive -- the IRS blinks."

An IRS spokesman declined to comment for this story.

Mayer described what he considers a likely scenario: The IRS denies Rove's group its (c)(4) status, but ends up letting him off with just a slap on the wrist.

"The IRS can waive those penalties if they find that the failure was due to reasonable cause and not due to willful neglect," Mayer said. "And, of course, reasonable cause is all in the eye of the beholder."

"That would be the easy way out," he added.

Another possibility is that the IRS could just decide to let the issue drag out indefinitely, Mayer said. As it is, the earliest opportunity for decisive action may not be for almost another year.

Experts say that at this point, the IRS would be wise to hold off on any action until Crossroads GPS files it annual tax form, a Form 990. By law, that form has to include a lot of detailed information about donations and expenditures.

But Crossroads GPS will have four and a half months after the end of its fiscal year to file its taxes. That won't be until Oct. 15. And tax rules make it pretty easy to get extensions for as long as six months, or until mid-April 2012 -- still before the November elections, but not soon enough to stop the proliferation of copycats 501(c)(4)s.

The IRS is notoriously skittish about making political decisions, Mayer said.

"They will go after these (c)(4)s, but they may not have the stomach or the resources to fight a battle royale all the way to the Supreme Court." That's particularly the case if Rove's group fights back hard -- as it would be expected to do -- and accuses the IRS of trying to limit free speech, he said.

But this time around, the IRS could also face a lot of heat if it blinks -- not just if it doesn't.

This past fall, IRS Commissioner Doug Shulman was besieged with letters demanding that he enforce the (c)(4) rules.

Senate Finance Committee Chairman Max Baucus (D-Mont.) requested an investigation into the use of tax-exempt groups for political advocacy, generally speaking.

Sen. Dick Durbin (D-Ill.) sent a letter requesting an investigation of the tax status of Crossroads GPS and other groups like it.

And campaign finance reform groups Democracy 21 and the Campaign Legal Center called for an investigation of Crossroads GPS, in particular.

"If the IRS investigation establishes that the facts and circumstances show that Crossroads GPS is primarily engaged in participating or intervening in political campaigns," the letter from the reform groups said, "appropriate penalties should be imposed on the organization, including penalties that take into account the need to deter similar widespread violations from occurring in future elections."

THE COST OF GIVING

There have also been some signs lately that the IRS is getting a bit bolder in this area.

Last December, when it released its annual workplan, the IRS' Exempt Organizations Division noted its intention to broaden its historical historical concentration on 501(c)(3) organizations -- groups that are not only tax-exempt, but can accept tax-deductible contributions.

"Beginning in FY 2011, we are increasing our focus on section 501(c)(4), (5) and (6) organizations," the workplan said.

And during the last two weeks, media reports have disclosed that the IRS is examining what could be the first five of many cases in which taxpayers who donated large amounts of money to 501(c)(4)s failed to report them on their gift tax returns.

Gift taxes are not an issue for most people; gifts under $13,000 -- or $26,000 per couple -- don't need to be reported at all. And there is a $5 million lifetime exemption for gifts made after 2010.

But for the really big donors, especially those who give away several million dollars a year, the gift tax could result in a hefty assessment on some or all of their contributions. The gift tax rate is 35 percent this year. And unless Congress acts, it will jump to 55 percent in 2013, even as the lifetime exemption falls to $1 million.

The IRS insisted in a statement to reporters that the examinations were "not part of a broader effort looking at donations to 501(c)(4)s" but rather were initiated by career employees looking at non-filing of gift and estate tax returns.

But this could nevertheless be the tip of a very big iceberg. The examinations in the news were based on 2008 donations to (c)(4)s -- back when such groups were still severely limited in what sorts of campaign ads they could run.

The 2010 elections brought a huge infusion of campaign money, a good chunk of which is thought to have come from a handful of deep-pocket donors, such as the Koch brothers on the right, and George Soros on the left. For the IRS, cross-referencing those huge donations with gift tax filings would be the work of seconds. (Groups that don't disclose their donors publicly still have to report them to the IRS in a confidential section of their Form 990s.)

What it all comes down to is that, just as 501(c)(4)s weren't designed to enable non-disclosure of massive political spending, the gift tax may turn out to be an accidental -- but hugely effective -- enforcement mechanism.

By contrast, the gift tax issue wouldn't be an issue at all if donors hadn't tried to circumvent disclosure with (c)(4)s, as donations to 527 groups are, by statute, exempt from the gift tax.

"That's sort of one of the underlying themes here, that there is a potential cost to your anonymity," said Ofer Lion, a Los Angeles tax lawyer who represents tax-exempt organizations. "Your anonymity is currently worth 35 percent of your contribution," he said. "And 55 percent in 2013."

Clarification: In discussions after this report was published, a Crossroads spokesman, Jonathan Collegio, said that Karl Rove helped form the group, but said that Rove didn't found it, as the report stated. In addition, The Huffington Post did not ask Crossroads to account for all of its spending. Instead, Crossroads was asked to offer just a few examples of its non-political spending. The story did not intend to convey that those examples represented the totality of Crossroad's non-political spending. While Collegio declined to offer a detailed accounting of Crossroads' spending in post-publication discussions, he did say that Crossroads "spent a comfortable majority of its resources over the last fiscal year engaging in social welfare advocacy activity, well beyond the IRS guidelines for 501c4 organizations, and which will be detailed on its 990 report."

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Dan Froomkin is senior Washington correspondent for The Huffington Post. You can send him an email, bookmark his page ; subscribe to his RSS feed , follow him on Twitter , friend him on Facebook , and/or become a fan and get email alerts when he writes.