The Internal Revenue Service succumbed to pressure from Republican members of Congress last month when it suddenly shut down its examinations into whether five large donors had violated the law by not declaring their contributions to political 501(c)(4) groups as gifts, a lawyer representing progressive donors alleged Monday.
The IRS initially defended the examinations after their existence was made public, saying they had been initiated by career civil servants, and were not political in nature.
But noting the historic lack of enforcement of the provision, six Republican members of the Senate Budget Committee, led by Sen. Orrin Hatch (R-Utah), and House Ways and Means Committee Chairman Dave Camp (R-Mich.), accused the IRS of pursuing a Democratic political vendetta.
And on July 7, the IRS shut everything down until further notice. The five donors have never been identified.
The agency, however, had been on solid legal ground in pursuing those cases, said Marcus S. Owens, a Washington lawyer who used to head the IRS division that oversees tax-exempt organizations. Owens said his four progressive clients are "outraged" by the IRS's cave-in and believe that dropping the investigation was the political decision -- not launching it.
"The clear implication left by the IRS action on July 7 is that IRS enforcement activity can be curtailed by intervention from a handful of members of Congress, whatever their party affiliation, when political contributions are at risk," Owens wrote in a letter to the Treasury Department, which oversees the IRS.
"Best as I can tell, the agency sort of made a snap decision under pressure from Republican members of Congress to just freeze everything in place," Owens told HuffPost. "The problem is they reacted to political pressure and they shut down audits without any apparent justification other than it was irritating members of one political party. And that has a corrosive effect on tax law."
The letter calls on Treasury and the IRS to issue immediate guidance clearing up the issue.
Anything that could possibly affect donations to political 501(c)(4) groups is inevitably a hot-button issue in Washington. Such groups -- organized under a section of the tax code intended for "social welfare" groups -- played an enormous role in the 2010 election, mostly in support of conservative candidates, and are expected to play an even bigger role in 2012.
The groups -- freed from spending limits by recent Supreme Court cases, and exploiting a disclosure loophole created by the Federal Election Commission -- can now accept unlimited secret donations from corporations and individuals.
According to Owens, however, those donations are clearly subject to the gift tax under tax law that exempts only charitable groups and political groups organized under section 527 of the tax code. That was restated in an 1982 ruling by the IRS.
"The IRS position was clear. It was crystal clear," Owens said.
Gift taxes are not a big issue for most people; gifts under $13,000 per person don't need to be reported at all, and there's a $5 million lifetime exemption for gifts made after 2010. The tax is intended to prevent wealthy individuals from avoiding estate taxes through gifting.
For the really deep-pocketed big donors, especially those who give several million dollars to 501(c)(4)s at a time, the gift tax would be a huge blow. 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. Donors who gave to 501(c)(4)s instead of 527s (which require disclosure) could end up paying in a big way.
Owens said his four clients are not wealthy, and probably would not be affected by the gift tax anyway, but do give money regularly to political groups.
What precisely led the IRS to back down? Neither IRS nor Treasury officials had any comment on Monday.
Owens said he suspects it was mostly an attempt to avoid controversy, rather than an active attempt to appease Republicans.
Lloyd Mayer, who teaches tax law at the University of Notre Dame, agreed. "The worst fear of most career government servants is being drawn into the political spotlight," he said. "The political heat got a little bit too hot, and the IRS blinked, rather than stick to its position, which I think was right."
But the move backfired, Mayer said.
"To actually abandon existing audits -- not even try to bring those cases -- in the face of clear political pressure certainly gives the appearance that if you get enough members of Congress to write a letter, they'll back off," he said. Particularly "if you can play the partisan card; if you can say the reason they're going after me is a partisan issue."
Owens said that message has been heard loud and clear.
"Since the July 7th memorandum, I've actually had a client with a tax issue -- not a political issue -- ask whether there might be a political solution to his tax issue. 'Call up Orrin Hatch and ask him to write a letter,'" he said.
"The IRS is being put in an untenable position because of political pressure from both sides," said Brad Smith, chairman of the Center for Competitive Politics, a group that opposes campaign finance regulations. The original gift tax inquiries "kind of popped out of nowhere after comments by Sen. Baucus and others on the other side of the political spectrum," he said.
Last fall, Senate Finance Committee Chairman Max Baucus (D-Mont.) asked the IRS to investigate the use of tax-exempt groups for political advocacy, generally speaking, and Sen. Dick Durbin (D-Ill.) requested an investigation of the tax status of the Karl Rove-associated group Crossroads GPS and others like it.
Smith's proposed solution "is that Congress needs to back off trying to use the tax code to regulate campaign finance."