Tax-exempt status is one of the most valuable designations an organization in the United States can obtain. It signals legitimacy, unlocks significant financial benefits, and empowers mission-driven groups to pursue their work with public support and private contributions. But tax exemption is not an unconditional privilege. It comes with a host of rules and limitations. One of the most significant and evolving principles governing tax-exempt organizations is the “illegality doctrine.”

The illegality doctrine holds that organizations engaging in illegal activity, or formed with an illegal purpose, cannot qualify for tax-exempt status under the Internal Revenue Code. This rule applies with full force to both 501(c)(3) charitable organizations and 501(c)(4) social welfare organizations. Yet while the rule sounds straightforward, its application is anything but simple. In practice, the doctrine raises challenging questions about federalism, free speech, harm reduction, and the tension between legality and public policy.

Let’s begin with the legal foundation.

Origins in Trust Law and the Supreme Court’s Endorsement

The illegality doctrine is rooted in the common law of charitable trusts, where courts have long refused to uphold trusts established for illegal purposes. This tradition migrated into federal tax law, notably with the Supreme Court’s decision in Bob Jones University v. United States (1983). There, the Court upheld the IRS’s revocation of the university’s tax-exempt status due to racially discriminatory admissions policies, despite the school’s religious rationale. The Court reasoned that tax-exempt status should not subsidize activities that violate “fundamental public policy.”

This case established a critical legal precedent: organizations cannot claim tax-exempt status if their purposes or activities are illegal or violate deeply held public norms. The ruling confirmed that the IRS could look beyond formal organizational documents to determine whether a group truly served the public good.

Statutory and Regulatory Framework

Under Section 501(c)(3) of the Internal Revenue Code, an organization must be “organized and operated exclusively” for religious, charitable, scientific, or educational purposes. Courts have interpreted this to mean that even a single, substantial non-exempt purpose—especially one that is illegal—can disqualify an organization.

Similarly, Treasury regulations implementing Section 501(c)(3) prohibit tax exemption where an organization operates for illegal purposes or engages in activities that are substantially illegal. The IRS has relied on these rules to deny or revoke status in a variety of circumstances: from organizations promoting civil disobedience and polygamy to those engaged in tax fraud or marijuana distribution.

The same general principles apply to 501(c)(4) social welfare organizations, which are granted more latitude in terms of political engagement but are still bound by the legality doctrine. Revenue Ruling 75-384 and subsequent cases affirm that organizations under both 501(c)(3) and 501(c)(4) must not violate the law or public policy if they wish to retain tax benefits.

Illegality in Practice: Case Studies and Enforcement

While the doctrine is well established, its enforcement has often been case-specific. Take, for instance, the Iowaska Church of Healing case. This organization applied for 501(c)(3) status while promoting religious ceremonies involving ayahuasca, a hallucinogenic tea that includes a Schedule I controlled substance under federal law. Despite sincere religious motives, the IRS denied exemption, and the courts upheld the decision. Until the group obtains a federal exemption under the Controlled Substances Act, its religious use of ayahuasca remains illegal, disqualifying it from tax-exempt status.

Another illustrative case is the IRS’s 2019 denial of a cannabis-related charity’s 501(c)(3) application. The organization proposed education, research, and support services related to THC and CBD treatments. If the words “THC” and “CBD” were removed, the proposal would read like that of a standard health nonprofit. But with them included, the IRS deemed the activities to be in violation of federal drug laws—and therefore illegal. This decision underlines the conflict between state and federal law, particularly in harm reduction and public health advocacy.

Concerns have also emerged that certain tax-exempt organizations may be involved in illegal political actions. Lawmakers have called for heightened scrutiny of charities allegedly participating in or supporting unlawful conduct. Though section 501(p) of the IRC already provides for suspension of status for organizations designated as terrorist entities, these developments have reignited debate about how the IRS should handle domestic illegal conduct and whether further legislative clarity is needed.

Quantitative vs. Qualitative Tests for Substantiality

A major interpretive question under the illegality doctrine is what constitutes “substantial” illegal activity. The IRS applies both a quantitative and qualitative test.

Quantitatively, the IRS looks at the proportion of time, resources, and attention an organization devotes to non-exempt or illegal activity. If the illegal activity is more than an “insubstantial” part of operations, the organization fails the operational test under 501(c)(3).

Qualitatively, the gravity of the illegal activity also matters. For example, a small percentage of an organization’s efforts spent promoting violence or engaging in fraud may still disqualify it. As one IRS memo noted, even if only 0.01% of an organization’s operations involved bank robbery, the seriousness of the conduct would render the organization ineligible for exemption.

This framework gives the IRS broad latitude. Organizations that merely encourage or are affiliated with criminal conduct may also be found in violation, particularly if the organization’s leadership is complicit.

The Intersection of Illegality and Public Policy

The doctrine doesn’t stop at criminal violations. It also extends to conduct that is contrary to “established public policy.” This fuzzier standard was central to the Bob Jones case and has since been applied in cases involving racial discrimination, gender bias, and other forms of civil rights violations.

For instance, in Nationalist Movement v. Commissioner, the Fifth Circuit held that an organization promoting white nationalism was not entitled to 501(c)(3) status, as its activities violated public policy and failed to provide a public benefit.

This overlap between illegality and public policy raises significant concerns, particularly around First Amendment rights. Religious and advocacy organizations worry that controversial or unpopular views could be labeled “contrary to public policy” and used as a pretext for denying exemption.

To date, courts have attempted to distinguish between illegal conduct and mere ideological advocacy. The IRS, too, has recognized that organizations can advocate for legal reform (such as marijuana legalization or immigration law changes) without being disqualified—so long as they are not actively violating current law.

Implications for 501(c)(4) Organizations

While 501(c)(3) groups must operate exclusively for charitable purposes, 501(c)(4) social welfare organizations are allowed to engage in lobbying and, to a limited extent, political campaign intervention. But they are not immune from the illegality doctrine.

In the cannabis denial letter referenced earlier, the IRS applied the same principles to a 501(c)(4) applicant. Even though the organization did not distribute marijuana directly, the IRS concluded that limiting services to cannabis users constituted “promotion” of illegal activity. The denial warned that advocacy groups, even those operating under state law, could be disqualified if their core mission violates federal law.

This sets a precarious precedent for organizations that work in controversial areas. It remains unclear where the IRS will draw the line, especially when private benefits, state law inconsistencies, or harm-reduction strategies are involved.

Policy Recommendations and Future Outlook

Legal scholars, IRS officials, and Congress alike have debated reforms to clarify the scope of the illegality doctrine. Suggestions include:

• Publishing formal regulations defining “substantial illegal activity”
• Differentiating between direct conduct and advocacy for legal reform
• Providing safe harbors for harm-reduction nonprofits
• Requiring the Department of Justice or another agency to formally designate illegal activity before the IRS acts

Some also argue for expanding section 501(p) to encompass domestic terrorist groups, or enhancing criminal penalties for abuse of tax-exempt status.

Until such reforms materialize, tax-exempt organizations must tread carefully. Lawyers and nonprofit leaders should conduct rigorous legal reviews of programs that may intersect with federal law. Activities that are legally permissible in one state may nonetheless disqualify a group federally.

The illegality doctrine remains a powerful tool for the IRS and a legal landmine for the nonprofit sector. It compels organizations to not only pursue public good but to do so within the boundaries of law and policy. Navigating this terrain requires not only compliance but strategic foresight, especially in a nation where laws evolve faster than the tax code.

In the end, the question isn’t just “Is this mission worthwhile?” but also: “Is it lawful?” And when tax exemption is on the line, the answer must be unequivocally yes.