At the same time the Internal Revenue Service was targeting tea-party groups, the tax agency took the unusual step of trying to impose gift taxes on donors to a prominent conservative advocacy group formed in 2007 to build support for President George W. Bush’s Iraq troop surge.
The probe of the group, Freedom’s Watch, began in the unit led by Lois Lerner, the IRS official already under scrutiny for her role in the more recent targeting of conservative groups.
While the IRS confirmed the existence of the gift-tax initiative in 2011, the identity of the group involved—as well as the affiliation of individual donors—remained a mystery.
Former officials of Freedom’s Watch say they believe all five of the IRS audits involved donors to their group, based on conversations with IRS agents and donors at the time of the audits in 2011.
The IRS declined to comment, citing taxpayer confidentiality.
The gift-tax probe, after it became public in 2011, prompted an outcry from Congress and was quickly halted.
The now-defunct Freedom’s Watch, which operated with a budget of about $56 million during its roughly two-year existence, spent about $10.7 million on issue ads in 2008, including television ads during special elections for House races in Louisiana and Mississippi.
Such groups, which are organized under section 501(c)(4) of the tax code, are allowed to engage in some political-campaign activity, as long as that isn’t their primary focus. They also don’t have to disclose their donors’ identities.
Critics say many groups abused their tax-exempt status by playing an outsize role in politics and that the IRS’s scrutiny was appropriate.
Lawmakers on both sides of the aisle have decried the tactics used by the agency, in particular the targeting of groups by their political leanings and their often heavy-handed questioning of groups seeking tax-exempt status.
In February 2010, the same month the tea-party targeting started, according to a recent inspector general’s report, Freedom’s Watch was subjected to an IRS audit that focused largely on its political activities, an uncommon but not unprecedented action, election lawyers say. The probe broadened into other areas, including executive compensation.
About a year later, as many as five donors to Freedom’s Watch were subjected to IRS audits of their contributions that sought to impose gift taxes on their donations to the group, according to lawyers and former officials of Freedom’s Watch.
Tax experts say that effort was highly unusual. The IRS generally hadn’t sought to impose the gift tax on donations to tax-exempt groups such as Freedom’s Watch in at least 20 years, perhaps longer, following an unfavorable court ruling and changes in the law by Congress, according to lawyers and IRS documents.
The IRS action “was kind of like a nuclear bomb going off,” said Rob Kelner, who heads the election-law practice at Covington & Burling LLP. “Although we always knew this was a possibility, it disrupted that long-standing understanding among election lawyers that this was an area where the IRS wasn’t likely to go.”
The IRS efforts were made public after a lawyer brought up the audits at a tax conference in mid-2011. Republican lawmakers including Ways and Means Chairman complained to the agency, saying the abrupt action was unfair and would chill constitutionally protected free speech.
The gift tax was designed largely to prevent people from avoiding estate taxes by giving away their assets during their lifetimes. It is broadly worded and could be applied to many types of transfers. Legislation in the 1970s clarified that campaign contributions to parties, candidates and political action committees aren’t subject to the gift tax.
The legislation didn’t exempt donations to 501(c)(4) groups such as Freedom’s Watch, and for years the IRS has taken the position the gift tax still applies to donations to 501(c)(4)’s. But in recent years it hasn’t enforced that position, lawyers say.
“It’s perfectly plain to see that Freedom’s Watch’s donors were singled out…in a complete break with decades of precedent and IRS procedure,” said Ari Fleischer, a board member of the group and former White House press secretary for Mr. Bush, in an interview.
In response to questions in 2011, the IRS confirmed it had sent the gift-tax audit letters to five taxpayers. The five letters resulted from “a single matter,” then-IRS commissioner Douglas Shulman said in May 2011. In July, in response to the outcry on Capitol Hill, the IRS announced it was ending the audits and wouldn’t conduct any more until after a review.
Mr. Shulman and Ms. Lerner didn’t respond to requests for comment.
Last week Ms. Lerner invoked her Fifth Amendment right against self-incrimination at a congressional hearing.
Ms. Lerner, who has denied wrongdoing in the agency’s focus on tea-party groups, has been placed on administrative leave.
The lawyer who represents Freedom’s Watch, Jeff Altman, said his informal conversations with IRS agents indicated the five people who got the audit letters were all donors to Freedom’s Watch.
Private conversations with at least three of Freedom’s Watch donors or their attorneys confirmed they received the letters, he said.
The audit of Freedom’s Watch was conducted by Ms. Lerner’s exempt-organizations unit. The gift-tax audits were conducted by workers in the estate and gift-tax unit, housed in a separate division of the sprawling IRS.
In a 2011 letter, GOP lawmakers asked whether the exempt-organizations unit played a role in the gift-tax audits. In a written response, a top IRS official implied the exempt-organizations unit referred the matter to the estate-and-gift tax unit.
The official, Steven Miller, who was recently ousted as acting commissioner, said the gift tax unit didn’t have access to the names of donors to 501(c)(4) groups. Instead, those names are directly available only to Ms. Lerner’s unit.
Referrals of tax-return information from one unit to another are appropriate when necessary and not unusual, Mr. Miller’s letter said. Then-Commissioner Shulman’s May 2011 letter also said the gift-tax audits were the result of an “internal referral.”
Freedom’s Watch’s two-year audit came after two complaint letters were sent to the IRS, one by the Democratic Congressional Campaign Committee, the party’s House election arm, and another entity whose name is redacted in letters provided to Mr. Altman by the IRS.
Mr. Altman said the IRS told him the audit was triggered by the letter from the entity that had its name redacted.
The group ended up paying about $12,000 in owed taxes for discrepancies in deductions the group had taken, out of a budget of about $56 million.