This is part two of a three-part list of highlights from the Exempt Organizations Symposium held by the American Bar Association Tax Section’s Exempt Organizations Committee on September 8, 2022. You can find Part 1 here.

The Tao of DAO: Charity and Decentralized Autonomous Organizations

Glossary

• DAO – generally, a member controlled entity that operates without a central authority, but rather relies on blockchains, smart contracts, and digital assets (or tokens) to operate for a specific purpose
• Membership entity – members are those who hold tokens
• Blockchain – peer to peer transactions, distributed ledger (tamper-resistant), decentralized consensus system
• Smart contracts – terms of agreement set in the computer code and program automatically executes certain actions based on specific data received [oracle]
• Tokens – digital asset that denotes membership in the DAO (usually can be bought and sold based on agreed upon rules for each token and each DAO)

Can a DAO be a Tax-Exempt Organization?

501(c)(3) Exempt Purposes: A DAO can be formed for charitable or other tax-exempt purposes. This might be relatively easy to show if the DAO is a grantmaking organization. However, whether other activities would be consistent with a contemplated tax-exempt status may be more complicated.

Organizational Test: It may be difficult for a regulator to accept that a DAO meets the Organizational Test through blockchain and without filing an organizational document filed with some regulatory authority (e.g., articles of incorporation). But a DAO may meet the state definition of an unincorporated association, generally, two or more persons coming together for a common purpose.

Operating Within an Existing Exempt Organization: An exempt organization can create a DAO to use as part of its operations. The exempt organization may be a fiscal sponsor or, if it is a public charity, a donor advised fund sponsoring organization.

Fiduciaries: Can an algorithm replace a fiduciary where the entity holds assets in charitable trust? Regulators will probably find this problematic as it may have no person to enforce against if there is any unlawful conduct.

Minutes of meetings: The blockchain record would be recorded and tamper-resistant.

Ongoing skepticim: Is this more of a tech play to get around existing regulatory and banking structures? This was not the purpose of a DAO, but its existence places tension on these structures.

Sex, Drugs & Insurrection: Hot Topics in Illegality

Illegal activities may jeopardize a 501(c)(3) organization’s tax-exempt status under multiple theories.

To remain exempt, a 501(c)(3) organization must not have a single non-exempt purpose that is substantial in nature, regardless of the number or importance of other charitable activities. This is reviewed both quantitatively and qualitatively. Accordingly, nonqualifying acts involving violence or moral turpitude would generally be considered much more harshly than other nonqualifying acts even if less substantial in scope.

A great many violations of local pollution regulations relating to a sizable percentage of an organization’s operations would be required to disqualify it from 501(c)(3) exemption. Yet, if only .01% of its activities were directed to robbing banks, it would not be exempt. This is an example of an act having a substantial non-exempt quality, while lacking substantiality of amount. A very little planned violence or terrorism would constitute `substantial’ activities not in furtherance of exempt purposes. 

GCM 34631 (1971)

In the tax code, “charity” is interpreted in its generally accepted legal sense, which includes the common law requirement for all charitable trusts that their purposes may not be illegal or, even if not illegal, contrary to public policy.

Practical Tips: (1) avoid illegal activities (consider alternate legal possibilities); (2) mitigate the risks and degrees of illegality (consider board support, insurance policies, potential damages, potential criminal actions to staff and volunteers; (3) consider whether activities may be safer through a non-501(c)(3) activity subject to a more lenient primary purpose test as opposed to the 501(c)(3) nonsubstantiality test.

The IRS has said that it is not in a position to determine whether an illegal act under a provision of law other than the Internal Revenue Code has actually been committed, and that there must be a final judicial determination before it can revoke tax-exempt status based on illegality. Illegality with respect to state laws are outside of the IRS’s purview. And state laws may and often do differ.

Consequently, some organizations may choose to incorporate in a state in which a particular activity (e.g., abortion) is not illegal. Note that one state does not have the jurisdiction to dissolve a corporation formed in another state for illegality based on state laws.

Best practices: (1) ensure compliance; (2) properly document board actions (can help evidence due care); (3) maintain attorney-client privilege; (4) preserve 5th Amendment rights against self-incrimination.

Notet that state regulators may decide to replace leadership rather than impose monetary sanctions on a charity, which would harm the charity’s intended beneficiaries.

Providing or Funding Abortions

Dobbs opinion was followed by state law bans on abortion. See below list with an understanding that this information may be changing daily.

• Abortion Bans. Seventeen states have abortion bans in effect, each at different times during pregnancy: Alabama, Arkansas, Florida (15weeks), Georgia (6weeks), Idaho, Indiana (in effect September 15), Kentucky, Louisiana, Mississippi, Missouri, North Carolina (20weeks), Ohio (6weeks), Oklahoma, South Dakota, Tennessee, Texas, and Wisconsin (pre-Roe).
• Abortion Bans Blocked While in Litigation. Seven states have litigation pending on abortion bans: Arizona, Iowa, Michigan, North Dakota, South Carolina, Utah, and Wyoming.

IRS guidance on abortions: “You can include in medical expenses the amount you pay for a legal abortion.” IRS Publication 502 (Medical and Dental Expenses)

Texas law: Texas prohibits a manufacturer, supplier, physician, or any other person from providing to a patient any abortion-inducing drug by courier, delivery, or mail service.

• Texas law (zombie law brought back to life after Dobbs): Whoever furnishes the means for procuring an abortion knowing the purpose intended is guilty as an accomplice.
• Texas Heartbeat Act: Authorization of private citizen civil actions for aiding and abetting illegal abortions.

Extraterritorial Application of Anti-Abortion Laws

Second, as I see it, some of the other abortion-related legal questions raised by today’s decision are not especially difficult as a constitutional matter. For example, may a State bar a resident of that State from traveling to another State to obtain an abortion? In my view, the answer is no based on the constitutional right to interstate travel. May a State retroactively impose liability or punishment for an abortion that occurred before today’s decision takes effect? In my view, the answer is no based on the Due Process Clause or the Ex Post Facto Clause. Cf. Bouie v. City of Columbia, 378 U.S. 347 (1964).

Justice Kavanagh (concurring opinion in Dobbs):

Insurrection

Several examples were provided of nonprofit groups that allegedly advocated for violence related to the Capitol insurrection and false claims of a stolen election which still are recognized as exempt under 501(c)(3). As noted above, the IRS does not determine whether an illegal act outside of the Internal Revenue Code has actually been committed, and has stated that there must be a final judicial determination before it can revoke tax-exempt status based on illegality.

IRC 501(p) provides for the suspension of tax-exempt status for terrorist organizations described in IRC 501(p)(2) and the denial of deductions for contributions made to such organizations during the period of their suspension. There have been a few cases involving charities and purported support of terrorist organizations, including United States v. Mubayyid

Revenue Ruling 75-384 held that a nonprofit organization formed to promote world peace and disarmament by nonviolent direct action and whose primary activity is the sponsoring of anti-war protest demonstrations in which demonstrators are urged to commit violations of local ordinance and breaches of public order does not qualify for exemption under IRC 501(c)(3) or IRC 501(c)(4).

Drugs

The IRS has provided little guidance on the issue of the illegality of drugs and tax exemption. However, in 2020, the IRS denied Iowaska Church of Healing 501(c)(3) status based on illegality and violation of public policy. In 2006, the Supreme Court expressly recognized the sacramental consumption of Ayahuasca as a sincere and lawful exercise of religion by a church. But the IRS argued that Iowaska Church of Healing is not an organized church or operated exclusively for religious purposes. The case is currently pending.

The Federal Controlled Substances Act prohibits the manufacture, distribution, dispensing, and possession of marijuana. The IRS has cited to operations that violate the Act as a reason for denying 501(c)(3) status. [See, e.g., PLR 202217009.]

The presentation also noted the impact of the war on drugs on racial equity. See, e.g., Race and the Drug War:

• People of color experience discrimination at every stage of the criminal legal system and are more likely to be stopped, searched, arrested, convicted, harshly sentenced and saddled with a lifelong criminal record. This is particularly the case for drug law violations.
• Nearly 80% of people in federal prison and almost 60% of people in state prison for drug offenses are Black or Latino.
• Research shows that prosecutors are twice as likely to pursue a mandatory minimum sentence for Black people as for white people charged with the same offense. Among people who received a mandatory minimum sentence in 2011, 38% were Latino and 31% were Black.
• Black people and Native Americans are more likely to be killed by law enforcement than other racial or ethnic groups. They are often stereotyped as being violent or addicted to alcohol and other drugs. Experts believe that stigma and racism may play a major role in police-community interactions.