Proxy Tax

What Is Proxy Tax?

A proxy tax is a tax penalty assessed against mostly tax-exempt organizations but may have to pay taxes on funds used to pay for lobbying activities. Organizations potentially subject to a proxy tax include those organized under 501(c)(4), 501(c)(5), and 501(c)(6) of the tax code.

A proxy tax will be levied against a tax-exempt organization if that organization fails to correctly estimate the amount of money it will spend on lobbying activities in a given year. In such a case, the proxy tax rate levied would be the highest marginal corporate tax rate for that tax year. 

How Proxy Tax Works

Proxy tax is a concern for organizations that are both tax-exempt but also engage in lobbying, like professional organizations, business leagues, or chambers of commerce. Membership fees for these organizations are largely tax-deductible.

To achieve tax-exempt status, such organizations must be “of persons having some common business interest, the purpose of which is to promote such common interest and not to engage in a regular business of a kind ordinarily carried on for profit,” according to Internal Revenue Service guidelines. Such organizations may not exist for the pecuniary benefit of one or more of its shareholders, and the organization must primarily exist to improve business conditions generally. 

At the same time, it is common for such business leagues to engage in lobbying activity, which is a not tax-exempt purpose under the United States Internal Revenue Code. To maintain a bright line between such lobbying activity and the other tax-exempt activities, the IRS requires business leagues to estimate what percentage of their funds will go to lobbying versus other, tax-exempt activities. These organizations must provide notice to their dues-paying members as to what percentage of their dues will be tax-deductible.

Suppose it turns out that actual lobbying activities exceed the amount estimated. In that case, the tax-exempt organization will be required to make up the tax revenue forgone because dues-paying members overestimated the share of their tax-deductible dues. This compensatory tax is called a proxy tax.

Organizations must tell to their dues-paying members as to what percentage of their dues are tax deductible.

Example of Proxy Tax

Let’s say that you pay $1000 in annual dues to your local business league, under the assumption that only 50% of that money will go toward lobbying activity. If it turns out that 75 percent of your dues went to lobbying activity, then the business league will be responsible for paying a proxy tax on the difference.