When U.S. sanctions laws are applied to U.S. charities, funds can be frozen indefinitely, despite tax rules that require they be distributed for charitable purposes when a charity shuts down. In the Oct. 10, 2016 issue of Tax Notes, attorneys Cherie L. Evans of Evans & Rosen LLP and Kay Guinane, Director of the Charity & Security Network, explain how the “Gap Between Tax and Sanctions Law Blocks Life-Saving Aid.” After summarizing the relevant provisions of tax and sanctions law and key court cases, the article explains how designation of a U.S. charity as a supporter of terrorism leaves its funds in legal limbo, rather than ensuring that they ultimately are distributed to a charity that can use them for humanitarian or other charitable purposes. The authors recommend that the Department of Treasury review its regulations to address this gap and protect charitable funds for charitable purposes.

                Relevant Provisions of the Law of Tax-Exempt Organizations

Evans and Guinane begin with an explanation of the standards for organizations to be tax-exempt under the Internal Revenue Code (IRC). To be recognized as a charitable organization under Section 501(c)(3), a charity must satisfy an organizational test, which looks to the group’s governing documents to confirm that its purposes are charitable and that its assets are dedicated to those purposes. This requires that “upon dissolution, such assets would, by reason of a provision in the organization’s articles or by operation of law, be distributed for one or more exempt purposes . . . or would be distributed by a court to another organization to be used in such manner as in the judgment of the court will best accomplish those exempt purposes.” (Reg. section 1.50(c)(3)-1(b)(4)). An organization must also satisfy an operational test, which checks that the organization engages primarily in activities aimed at accomplishing its charitable purposes.

Section 501(p), added in 2003, provides that when an organization is designated as a supporter of terrorism its tax-exempt status is suspended. This generally forces the organization to dissolve, which would normally invoke the rule requiring distribution of its assets to another 501(c)(3) organization (Reg. section 1.501(c)(3)-1(b)(1)).  However, because the funds are frozen pursuant to sanctions law, this does not happen unless unusual steps are taken.

The Process of Designating Terrorist Organizations and Their Supporters in Sanctions Law

Evans and Guinane explain the basis for the executive branch’s broad powers to put people and organizations on the terrorist list. The International Emergency Economic Powers Acts (IEEPA), passed in 1977, gives the president the authority to declare a state of emergency by Executive Order, in response to “any unusual and extraordinary threat” to the “national security, foreign policy, or economy” from outside the United States. IEEPA further allows the president to “investigate, regulate, or prohibit” financial transactions with foreign countries and individuals and to seize assets of theirs in U.S. jurisdiction.

Evans and Guinane highlight the implications for nonprofits: “IEEPA bars anyone, including charities, from engaging in transactions described in the relevant executive order with designated persons or entities, including designated terrorist organizations. Violation of those prohibitions can result in criminal prosecution, civil sanctions, or placement on the terrorist list.”

With Executive Order 13,224, issued on September 24, 2001, President George W. Bush declared a state of emergency based on the 9/11 attacks and authorized Treasury to designate specially designated global terrorists (SGDTs) and to freeze their U.S.-based assets. Under the order, one could also be designated for providing material support to or being “otherwise associated with” an SGDT. The authors draw special attention to the lack of a “knowledge or intent requirement” for such designation.

Next, the authors detail the redress procedures, or lack thereof. Treasury can make its initial designation based on “classified information, open source news reporting, or hearsay.” When the designation is published in the Federal Register, it may, but is not required to, include a list of reasons. A listed person or entity can then request reconsideration under 31 C.F.R. § 501.807, but Treasury has discretion to grant or decline an in-person meeting.

As an additional wrinkle, the process is exempt from the Administrative Procedure Act’s “right to a hearing before a quasi-independent administrative law judge,” because Treasury operates the sanctions regime under the authority of the president. Designation can be challenged in a federal court at any point, but the standard of review is limited to “whether Treasury’s action was arbitrary or capricious, based on the administrative record.” If a designated charity loses its appeal it remains on the list, freezing the assets indefinitely. There is no formal process in the case of U.S. charities to ensure these assets are released to another charity for charitable purposes.

Legal Limbo for Frozen Charitable Funds

Despite the broad authority provided by IEEPA, Guinane and Evans note that Treasury has refused to use its discretion to fix this inherent gap and to address blocked or charitable frozen assets. Of the nine U.S. charities designated since 2001, the dissolution of only one resulted in distribution of assets for a charitable purpose. Because the president may regulate or prohibit transactions by designated entities, he has the flexibility to allow charitable assets to be distributed appropriately and without risk. Further, Treasury could make use of its licensing process to allow and control an otherwise prohibited transaction. But, in letters to attorneys requesting release of funds, the executive branch has refused to do so, stating that “humanitarian relief is not a compelling need or consistent with national security.”

Key Court Cases on Due Process and Asset Freezes

Five cases involving U.S. charities have challenged Treasury’s review process on constitutional grounds. In two of the most recent actions, Al Haramain and Kindhearts, courts found the current process to be a violation of organizations’ Fourth and Fifth Amendment rights. A third case, Holy Land Foundation, raised the issue of whether an indefinite asset freeze constituted a taking of property without process or compensation after some period of time.

In Al Haramain, the court highlighted the significant problems caused by Treasury’s unwillingness to provide its reasoning for freezing the charity’s assets. While it recognized the difficulty of classified information as evidence, the court criticized Treasury’s failure to mitigate the harm by providing an unclassified summary or the use of a lawyer with a security clearance. The court in Kindhearts pointed out the same difficulties and proposed a review and disclosure process to address both the need for information and secrecy. Both courts ultimately “reasoned that designated entities should be provided with the reasons for the designation in a timely manner and with a meaningful administrative hearing,” in order to prevent violation of their Fifth Amendment right not to be deprived of property without due process of law.

The court in Al Haramain refused to consider asset freezing/blocking orders to be “per se reasonable in all circumstances” and rejected OFAC’s claim of inability to produce a warrant. Similarly, in Kindhearts, the court found Treasury’s freezing of assets to be a seizure. In both cases, the courts refused to accept the government’s argument that these seizures fell within an exception to the Fourth Amendment and instead found violations thereof.

Evans and Guinane note that despite these findings, “Treasury has not altered its procedures,” and “[c]haritable assets continue to be frozen indefinitely.”

In the Holy Land Foundation (HLF) case, the charity asserted that Treasury’s asset blocking was a taking without just compensation, in violation of the Fifth Amendment. Though the court held the freeze to be temporary and not of sufficient length to be considered a taking, it did indicate that long-term blocking could eventually “ripen[] into a vesting of the property in the United States.”

Evans and Guinane argue that updates to Treasury’s process “to better protect charitable assets and to respect [charities’] due process rights” would strengthen respect for constitutional rights and U.S. listing regimes themselves. Regulatory review and improvement could “increase the credibility and integrity of the . . . process by making it more transparent and accountable.” It might help address the chilling effect on important humanitarian work by legitimate organizations fearing designations. It also could contribute to better informed designation decisions. In addition, it could combat the perception of unfairness that might arise from the seemingly preferential treatment afforded corporations like Chiquita Brands International and HSBC when they were found to have association with terrorist organizations.

The authors propose a regulatory review particularly aimed at closing the gap created by the legal regimes of the tax code and sanctions law. Specifically, they propose that a warrant be required for seizure of property, adequate notice with reasons for sanctions be provided, and a right to a timely administrative hearing. They also suggest a process for charities “to cure problems identified by Treasury.” There should be procedures for dealing with classified information and a right to challenge a designation in federal court. During the pendency of a hearing or appeal, they suggest funds be administered by a conservator to ensure use for charitable purposes. And finally, if a charity loses its appeal and has exhausted its remedies, there should be formal process to distribute the funds to charitable organizations. Such changes would increase the fairness of the sanctions regime as a whole, while always safeguarding the interests of donors and their intended beneficiaries.

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