Navigating the Practical Implications of the Illegality and Public Policy Doctrine – ABA Tax

Published on: by Gene Takagi Category:EVENTS, IRS & FEDERAL TAX ISSUES
Image of "good witch" with wand facing "wicked witch" with pointy hat

As part of last month’s American Bar Association Exempt Organizations Committee meeting, Karl Mill (Mill Law Center), Tom Schroeder (Davis Wright Tremaine), and I discussed the use of (1) illegality and (2) violations of fundamental public policy as independent bases for the revocation of tax-exempt status in these ‘not normal’ times and appropriate counsel to charities and other tax-exempt organizations related to this threat. We were supposed to be joined by Kayla Ruben (Morgan Lewis), who substantially contributed to the materials and planning, but, unfortunately, Kayla’s flight was canceled due to weather and mechanical problems. The following is the description of our session in the program:

The Department of Education recently finalized regulations on the public service student loan forgiveness program, drawing upon the illegality and public policy doctrine in the Section 501(c)(3) context, and excluding certain types of activities from loan forgiveness given their “substantial illegal purpose.” This panel will walk through any key insights that can be gained from these regulations as well as 2025 executive orders and other forms of Presidential guidance that seek to establish a new public policy in the United States on topics such as DEI and domestic terrorism. It will also discuss whether and how this guidance impacts how tax-exempt organization practitioners draft IRS filings, such as applications for exemption and scholarship procedures; structure activities, grants and investments; and provide tax opinions and other forms of guidance, including on state law issues, that intersect with these topics.

My Framing Notes

Many nonprofits are worried, particularly those in the social or racial justice space, those with race-based programs, and those that are part of movements that engage in protest activities. Many clients with values embracing DEI, immigrant rights, reproductive rights, gender identity, and climate change mitigation are wondering whether they need to change anything about what they do or what they say they do.

Some are worried enough to consider moving their assets – even relocating to another country.  Or more simply moving endowment or investment funds into an agency fund or single identified beneficiary fund at a community foundation with a lower risk profile.

A colleague recently said at another conference that lawyers telling clients only what the law is weren’t doing their jobs. Compliance in and of itself doesn’t eliminate all risks.

Similarly, lawyers telling clients about every way the federal government can harm them and leaving it at that are not doing their jobs. Such advice without more can help perpetuate the intimidation and culture of fear that the administration is using to advance its priorities.

But we also need to understand that we’re not responsible for determining the risk tolerances of our clients. We have much to offer regarding advice on existing guardrails and bureaucratic systems, but we probably know much less than they do about their unique circumstances – a dysfunctional board, employee unrest, a disgruntled former employee or board member, previous reputational harm, etc. And it’s likely that some of these organizations – probably very few – are going to be targeted and some will fall — and many, many others will be harmed by the pullback of federal funding, and the whims and fears of their private funders.

It’s important to understand the threats are not just based on reasonable interpretations of law; they are also based on how agencies will try to enforce these laws and how resources will be allocated to enforcement targeting left-leaning nonprofits. The threats are both to the organization and to the missions they pursue and the values embedded in their missions.

In addition, the threats are not just based on alleged violations of law and whether exemption can be revoked based on such violations, but they include a substantial loss of funding, a loss in reputation, physical safety risks, and employees’ mental health risks.

Panel Discussions and Resources

  • Section 501(c)(3) organizations must be organized and operated “exclusively” for Section 501(c)(3) purposes – their purposes cannot be illegal (the illegality doctrine) nor can they be contrary to fundamental public policy (the public policy doctrine)
  • The administration and some members of Congress have threatened to use the illegality and public policy doctrines to revoke 501(c)(3) status from certain organizations, but the biggest threat to the vast majority of nonprofits is likely not the actual carrying out of these threats to more than a very small number of targeted organizations; the biggest threat is having nonprofits and their supporters give in to the intimidation and retreat from their charitable missions and values, silence and scrub their mission-related communications, and engage in anticipatory obedience based on rhetoric rather than on the established rule of law
  • Some nonprofits are under greater risks, particularly those relying on federal contracts and grants, which may require these nonprofits to certify a set of representations framed according to the federal government’s priorities, suggesting enforcement based on unreliable interpretations of law
  • The final Public Service Loan Forgiveness rule resulting from Executive Order 14235, Restoring Public Service Loan Forgiveness, has made the “illegality” risk for revocation of tax-exempt status feel more real and imminent even though revocation remains a formal, audit-driven process with constraints
  • Lawyers should avoid unnecessarily amplifying the threat but also should not presume to determine a client’s appropriate level of risk tolerance
  • For lawyers – acceptable reasons for discussing the PSLF regulations to nonprofits in the context of the illegality and public policy doctrines:
    • Pushing for constitutional limits on the definition of ‘supporting terrorism’
    • Employer actions as constitutionally protected (e.g. 1st amendment right to protest)
    • Preventing misattribution of employee actions to employers
    • Defending DEI programs as constitutional private remedial actions, not conceding that they are unlawful discrimination
    • Defending legality of gender-affirming care and supporting minors’ exercise rights to petition for emancipation
  • Leadership duties are principally to the mission and not the bottom line; board members should determine whether the mission is best advanced with a healthier bottom line or by holding the line
  • A good amount of time was spent looking at Section 1981 (which generally prohibits race discrimination on the making or enforcing of contracts but was intended to protect formerly enslaved persons, giving them the same rights as white citizens) and some strategies for mitigating such risks, but, at least for now, Section 1981 risks relate more to private actions by someone asserting a discrimination claim versus its use by the IRS to claim a substantial illegal purpose
  • Practical takeaways
    • Race-conscious programs can lawfully further charitable purposes within the definitions provided in the regulations, but if participation in the program requires a contract, there may be some risks of an attack based on an asserted violation of Section 1981 – One Tip: work with an attorney to frame participation criteria without creating an enforceable contract
    • Grantmaking with race-conscious criteria (e.g., BIPOC-led organizations) or for a race-conscious program can also lawfully further charitable purposes, but if there is a grant agreement that has all the elements of a contract, there may be some risks of an attack based on an asserted violation of Section 1981 – One Tip: work with an attorney to replace grant agreements in certain circumstances with a grant award letter that does not include all of the elements of a contract but still states legal requirements applicable to the grant (the attendees and my co-presenters kindly suffered through my musings of the possibility of an expenditure responsibility grant agreement that did not include all of the elements of a contract, but that was quickly dismissed with my concession)
    • Scholarship programs with race-conscious criteria similarly raised potential Section 1981 risks and avoidance tips, but with some extra information about (1) risks if they were administered by a school receiving federal funds, (2) possible state law prohibitions for public schools (e.g., CA Prop. 209), (3) taking a more risk-tolerant approach designed to meet a strict scrutiny challenge (e.g., document remedial purpose tied to evidence of specific disparities, monitor with time limits and periodic reviews, state why race-eligibility is required and alternative race-responsive criteria would be insufficient)
    • Investments using race-conscious (and ESG) criteria may also be vulnerable to some attacks based on the priorities being set forth by the federal government, and this has impacted how many investment policies are worded
    • Exemption applications emphasizing race-conscious programs and priorities may be receiving extra scrutiny from some IRS agents, but this does not appear to be a clear trend from anecdotal evidence; Forms 990, on the other hand, appears to be shifting in how “DEI” is being de-emphasized in descriptive language (see, e.g., Deleting DEI, Pro Publica)
    • Tax opinions may be less of a safeguard with what seems to be a trend towards an assumption that there is no change in IRS enforcement practices, which conflicts with the rhetoric of the federal government
    • State law compliance may be as important or even more important to protect a nonprofit’s ability to operate; noncompliance in any one state may have greater impact than the potential repercussions in that state (e.g., it might cause a charitable fundraising platform to disallow an organization’s use of its services across all states, it might also cause the nonprofit to be in breach of its contracts if they include representations of legal compliance)
    • Basic compliance – timely filings, employment law compliance, accurate representations, etc. – may continue to be the most urgent compliance priority for the vast majority of nonprofits

Additional Resources

My Unsung DEI Song

This was another parody song I wrote in connection with a conference that I never got the chance (i.e., courage) to perform, but I provide it here before it loses its relevance. The original song is Popular from Wicked (in the style of Jeff Goldblum).

DEI
You wanna do DEI!
We’ll teach you the proper ploys
To ignore the noise
Legal ways to make it work
Ooh!
We’ll show you what steps to take!
How to not placate!
Everything that really counts to do –

DEI!
We’ll help you with DEI!
Comply with employment laws
There’s no need to pause
The stuff you’re supposed to do
But be smart
There may be an Ed Blum waiting for you!

Don’t be offended by our frank analysis
Certain risks are better than mission paralysis
Because you’ve chosen to become a
Pal, an expert and advisor
There’s nobody wiser!
Not when it comes to –

DEI
Go on with your DEI
Rethink how words should be spun
1981
Instead of contracts you don’t need
Let-ter
No low hung fruit to stop you

From DEI like before – er

La la, la la!
Go on supporting DEI!