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Lawsuit challenging IRS’s exempt org application process allowed to proceed

May 30, 2014

Z Street, Inc. v. Koskinen, (DC Dist Col 5/27/2014) 113 AFTR 2d ¶2014-855

A district court has denied IRS’s motion to dismiss the complaint of a non-profit corporation alleging that applications for exempt status under Code Sec. 501(c)(3) of organizations whose activities relate to Israel, and whose positions with respect to Israel contradict those of the government, are subject to heightened review in violation of the First Amendment. The court found that IRS’s various arguments in favor of dismissal were based on the flawed assumption that the case involved the assessment and collection of taxes, when in fact it involved a constitutional challenge to the process of determining exempt status.

Background—jurisdiction. Federal courts are courts of limited jurisdiction. When a defendant files a motion to dismiss a complaint for lack of subject matter jurisdiction, the plaintiff bears the burden of establishing jurisdiction by a preponderance of the evidence.

The Code strictly limits the circumstances under which a suit to enjoin the assessment or collection of any tax is permitted. Under Code Sec. 7421(a), no suit for the purpose of restraining the assessment or collection of any tax can be maintained in any court by any person, whether or not that person is the one against whom the tax is assessed, except as otherwise provided. This rule is sometimes referred to as the Anti-Injunction Act, or AIA.

The Declaratory Judgment Act (DJA, 28 USC 2001) in general authorizes a suit for declaratory judgment by any interested party in any federal court in cases of actual controversy, except with respect to federal taxes. As a result of the express nonapplicability of the DJA to tax controversy cases, declaratory judgments have generally been denied to taxpayers in suits contesting validity of tax assessments and collection. But, the nonapplicability has been generally held to relate only to suits where tax liability itself is contested.

In general, under sovereign immunity principles, the U.S. may not be sued without its consent. One way to establish the government’s consent is via the Administrative Procedure Act (APA), a relevant provision of which provides that “[a]n action in a court of the United States seeking relief other than money damages and stating a claim that an agency or an officer or employee thereof acted or failed to act in an official capacity or under color of legal authority shall not be dismissed nor relief therein be denied on the ground that it is against the United States or that the United States is an indispensable party.” (5 USC 702)

Facts. Z Street was incorporated as a Pennsylvania non-profit corporation on Nov. 24, 2009, for the purpose of “educating the public about Zionism; about the facts relating to the Middle East and to the existence of Israel as a Jewish State; and about Israel’s right to refuse to negotiate with, make concessions to, or appease terrorists.” Approximately one month after its formation, Z Street filed an application with IRS seeking to be recognized as a tax-exempt organization under Code Sec. 501(c)(3).

On July 19, 2010, Z Street’s counsel spoke with Agent Diane Gentry (the agent who was handling Z Street’s Code Sec. 501(c)(3) application) on the status of the organization’s application. Z Street’s complaint alleges that during that conversation, Agent Gentry told Z Street’s counsel that she had two major concerns about approving the application: first, that the organization engaged in “advocacy” activities that are not permitted under Code Sec. 501(c)(3); and second, that IRS had special concerns about applications from organizations whose activities relate to Israel and whose positions with respect to Israel contradict the current policies of the U.S. Government. According to the complaint, Agent Gentry told Z Street’s counsel that the IRS carefully scrutinizes all Code Sec. 501(c)(3) applications that are connected with Israel, and that “these cases are being sent to a special unit in the D.C. office to determine whether the organization’s activities contradict the Administration’s public policies.”

On Aug. 25, 2010, Z Street filed an initial complaint in the Eastern District of Pennsylvania, then filed an amended complaint on Dec. 17, 2010. The amended complaint alleges, based on Agent Gentry’s statements to Z Street’s counsel, that IRS maintains an “Israel Special Policy” with respect to the Code Sec. 501(c)(3) applications of organizations whose stance on Israel differs from that of the Obama administration, and that such applications are subject to additional review procedures not otherwise applicable. Z Street’s sole claim in this action is that the so-called Israel Special Policy represents impermissible viewpoint discrimination in violation of the First Amendment, and Z Street requests: (i) a declaration that this policy is unconstitutional, and (ii) an injunction that orders IRS to disclose information about the policy and that also bars the agency from employing the policy when it “expeditiously and fairly” adjudicates Z Street’s application.

IRS filed a motion to dismiss the complaint on Aug. 8, 2011, then the case was transferred was the Eastern District of Pennsylvania to the District of Columbia. The transfer order stated that the case was “best construed as a controversy arising under” Code Sec. 7428 , which provides for declaratory judgments in suits related to the classification of organizations under Code Sec. 501(c)(3), but further noted “[t]he Court shares Plaintiff’s view that this is a case about constitutionally valid process” and that Code Sec. 7428 established Z Street’s right to challenge that process. The case was transferred on Mar. 15, 2012.

Court has jurisdiction. The court first found that it has subject matter jurisdiction over Z Street’s claim. In so concluding, it rejected IRS’s contrary arguments that the AIA barred the court from granting the injunctive relief sought, the DJA’s tax exception barred the court from granting the declaratory relief sought, and the complaint should be dismissed on sovereign immunity grounds.

With regard to the AIA and DJA claims, the court noted that, in the District of Columbia Circuit, whether the AIA or DJA prohibit a suit against IRS depends on whether the action is fundamentally a “tax collection claim.” (Cohen v. U.S., (CA DC 2009) 104 AFTR 2d 2009-5841104 AFTR 2d 2009-5841) The court examined Z Street’s claim and found that Z Street wasn’t alleging that IRS unlawfully denied it a preferred tax status, but only that IRS subjected it to unconstitutional viewpoint discrimination in considering its application—and prevailing on its claim wouldn’t provide an answer as to whether Z Street was in fact entitled to exempt status. Further, the court found that neither the requested declaration nor injunction has any direct implications for the assessment or collection of taxes.

The court also rejected IRS’s alternative argument that sovereign immunity bars Z Street’s suit. It concluded that the APA provides an express waiver of sovereign immunity for suits such as this, citing 5 USC 702’s waiver for suits for non-monetary damages that allege wrongful action by an agency or its officers or employees. The court dismissed IRS’s assertion that there was no “final agency action” to review under the APA in this case, stating that the “final agency action” provision was essentially an exhaustion requirement and not a limitation on the court’s jurisdiction.

Availability of equitable relief. The court then considered, and ultimately rejected, IRS’s argument that Z Street failed to state a claim for relief because it has an adequate remedy at law and injunctive relief is thus unavailable. The adequate remedies supposedly available, according to IRS, were: (i) a Code Sec. 7428 suit to compel a court determination as to whether Z Street qualifies for tax-exempt status under Code Sec. 501(c)(3); (ii) if IRS determines Z Street doesn’t qualify for Code Sec. 501(c)(3) status, Z Street can challenge that determination in the Tax Court; (iii) if any tax is assessed against Z Street, it can pay the tax then sue for a refund under Code Sec. 7422; and (iv) a donor can claim a deduction for a donation to Z Street and, if it’s disallowed, sue for a refund. However, the court found that none of these “paths to the courthouse” would provide Z Street with an adequate remedy for the alleged harm. Specifically, Code Sec. 7428 provides a means to challenge an IRS determination as to an organization’s qualification for tax-exempt status, but Z Street’s actual entitlement to exempt status isn’t at issue—rather, the case concerns the constitutionality of the process of determining entitlement to exempt status. The court similarly rejected IRS’s argument that Z Street could have sought relief under the deficiency or refund provisions, noting that those provisions are essentially about a taxpayer’s tax liability, not the constitutionality of the process.

Motion to dismiss denied. The court found overall that IRS’s arguments in favor of dismissing this case rest on the characterization of Z Street’s claim as a complaint about tax liability, which it was not. Z Street’s complaint didn’t implicate an assessment of taxes to be paid or a even a determination of its status under Code Sec. 501(c)(3). Accordingly, the court denied IRS’s motion to dismiss.

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