By Gabriel Debenedetti and David Lindsey
WASHINGTON (Reuters) - As they joined Republicans on Tuesday in bashing the Internal Revenue Service for targeting conservative groups that sought tax-exempt status, Senate Democrats had another target: the regulations that require the tax agency to weigh the political activity of such groups.
Beyond the question of what led still-unidentified IRS agents to use what an audit called "inappropriate" criteria in reviewing conservative groups, the rise of tax-exempt groups in American politics is at the core of the scandal.
At issue is how people on both sides of the nation's political divide have formed hundreds of nonprofit, tax-exempt groups under Section 501(c)(4) of the IRS Code. U.S. law does not require them to disclose their donors and says they must operate "exclusively for the promotion of social welfare."
Under Treasury regulations used for decades, however, the law has been defined to mean that such groups must "primarily" be concerned with social welfare causes, such as "bringing about civic betterments."
That has created enough wiggle room for a new generation of 501(c)(4) groups that are largely dedicated to political causes - their version of "civic betterment" - without specifically endorsing any political candidates, which the IRS forbids.
Such 501(c)(4) groups have been big players in recent elections, spending hundreds of millions of dollars to influence voters.
A deluge of applications from conservatives in the last three years led the IRS to inappropriately target groups with names such as "Tea Party" and "Patriots" for extra scrutiny.
As the Senate Finance Committee grilled outgoing IRS chief Steven Miller and former IRS Commissioner Douglas Shulman on Tuesday, Democrats on the panel said that expecting the IRS to determine whether groups are too political to be tax-exempt was too much to ask the tax agency.
They said the law should be interpreted as it was originally intended, and that "social welfare" groups should not be allowed to be political at all.
"Notwithstanding the troubling and unacceptable conduct of the IRS, if political organizations do not want to be scrutinized by the government, they shouldn't seek privileges like tax-free status and anonymity for their donors," Democratic Sen. Ron Wyden of Oregon said.
Wyden added that it has become apparent that groups that ought to be "527" organizations - tax-exempt, politically active groups that must disclose their donors - are applying for 501(c)(4) status to avoid having to reveal their contributors.
"That's a loophole the Congress ought to close," Wyden said.
'TWO SCANDALS HERE'
As Republicans continued to press Miller and Shulman over whether partisanship was behind the agency's actions, other Democrats on the Senate panel echoed Wyden.
"I think there are two scandals here," New Jersey Senator Robert Menendez said. "One is the (IRS') management failures and the whole process of singling out specific groups. The other is how we take statutory authority and then extrapolate it differently than what the Congress meant."
Conservative leaders such as Karl Rove - a Republican strategist who helped found Crossroad GPS, the nonprofit that spent more than $50 million on the 2012 elections - have said they view 501(c)(4) groups essentially as equalizers for conservatives: a way to help them match Democrats' fundraising from organized labor and other big groups.
J. Russell George, the Treasury inspector general who last week issued the audit that described the inappropriate conduct by the IRS, told the Senate panel that his office was launching a broader probe into the IRS' oversight of 501(c)(4) groups.
Senator Max Baucus, a Montana Democrat and chairman of the panel, said recent elections have shown that, "clearly, a Mack truck is being driven through the 501(c)(4) loophole."
Baucus then chided Shulman, whom the senator accused of not responding to senators' concerns in 2010 about how 501(c)(4) groups would be handled.
"You were on notice, and you did acknowledge you're on notice, but nobody did anything about it," Baucus said. "I'm just quite disappointed."
Shulman responded by calling for clearer laws and regulations regarding tax-exempt groups, a rare moment of agreement between him and senators.
"The IRS is given a very, very difficult task of trying to go in and figure out" whether groups are involved in too much political activity to remain tax-exempt, Shulman said.
"The confusion and breakdown that you saw happen in the Cincinnati office is inexcusable, but ... at least this is my belief, that part of it was because of the very difficult task given to these people."
A LOW REJECTION RATE
According to a recent report by the Center for Responsive Politics, the IRS' rate of rejection of applications for groups seeking tax-exempt status is low.
From January 2007 through September 2012, the center estimates, 26 to 28 applications were denied, though other groups may have withdrawn their applications if a rejection were pending.
The IRS' 2012 Data Book indicates that it rejected eight of 2,774 applications from such groups that year.
Conservative groups have complained to Congress about overly aggressive enforcement by the IRS, including demands from the tax agency that the groups answer questions about their donors and any members' plans to run for public office.
But advocates of greater scrutiny of tax-exempt groups fear that the IRS scandal will discourage the tax agency from aggressively challenging applications for tax-exempt status.
"The institutional lesson (the IRS) is learning is that when they push on something in the political sphere, they get smacked," said Arn Pearson, vice president for policy and litigation at Common Cause, a liberal advocacy group. "My concern is that what they're going to do is just really back off, and not do any meaningful enforcement."
(Editing by Fred Barbash and Stacey Joyce)