IRS scandal may unleash a flood of conservative donors

FORTUNE — The Internal Revenue Service’s effort to scrutinize conservative groups, many bankrolled by “shadow money” from Wall Street to Kansas to Las Vegas, has sparked a political firestorm. But the aftermath may ignite donations to the secretive entities by right-leaning corporations and investors, former top IRS executives and campaign finance lawyers say.

The targeting effort has landed the IRS in hot water with the White House; Congress, whose House Ways and Means Committee holds hearings Friday on the matter; and the Federal Bureau of Investigation. Carl Levin, a Democrat from Michigan and the congressman most feared by tax-dodging corporations and investors, has an “active investigation” into the affair, persons close to him said. President Obama fired IRS acting commissioner Steven Miller Thursday night, citing the scandal.

But despite the maelstrom and a looming possible tightening of IRS regulations, the type of tax-exempt entity at the heart of the scandal “is still going to be the primary target for funding,” said lawyer Bruce Hopkins, an expert on nonprofit taxation. One might assume that donors would be scared off by the scrutiny, but in fact the opposite may be true. A senior former IRS official, who declined to be named because he said he did not want to “tarnish” the agency, called the scandal “a gift to these organizations.”

A report released on Tuesday by the government watchdog of the IRS slammed the targeting and found that the famously bureaucratic agency failed to curb its search of groups by keywords such as “Tea Party” and “patriot” for more than 18 months after top officials learned of it.

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During the 2012 presidential campaign, 85% of the $254 million spent on political activities by the groups, known as 501(c)4s, came from conservative groups, according to the Center for Responsive Politics. Big groups, including Americans for Prosperity, had deep-pocketed donors like the oil billionaire Koch brothers from Kansas. While it’s unknown how much of the $94 million that Wall Street — more than any other industry — contributed to Super PACs supporting failed Republican contender Mitt Romney, some of the biggest PACs were allied with the groups, according to Center data.

The scandal has conservatives seeing red — and aiming to fundraise from outraged donors.

“There is a lot of newfound indignation about the IRS,” said Jonathan Collegio, a spokesman for Crossroads GPS, a 501(c)4 co-founded by Republican strategist Karl Rove. Karl Sandstrom, a campaign finance lawyer and former vice chairman of the Federal Election Commission, said the scandal would likely “excite the dollars” from “large donors with a good deal of mistrust for government.”

For nearly a decade, the IRS had been scrutinizing an established type of tax-exempt organization, known as a 501(c)3, that is widely used by hospitals, universities, credit counseling agencies, charities, and housing assistance programs.

But in 2010, amid a landmark Supreme Court ruling in Citizens United that opened the door to secret corporate money in politics, 501(c)4s exploded in number and size, drawing hundreds of millions of dollars from wealthy donors, many conservative, and leaving the IRS overwhelmed and flooded with allegations of abuses by some of the groups.

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The number of organizations registered with the IRS more than doubled in recent years, the IRS said, from 9,555 in 2009, the last year the agency disclosed such data. But the groups are not required to register with the agency, and there are “well over 100,000 of them” said Gregory Colvin, a lawyer specializing in campaign finance by nonprofits.

Under current regulations, which both sides complain are murky, the groups do not have to disclose their donors and can participate in campaign and election activities as long as that is not their “primary” purpose.

Marc Owens, a former IRS head of exempt organizations who is now in private practice at Caplin Drysdale, said that the IRS “decided to use nomenclature, which is silly. But it’s also clear that the organizations the IRS was trying to identify are the sorts that should be given careful scrutiny — they are not PTAs or Little Leagues.”

Often associated with so-called Super PACs, the giant, campaign fundraising machines, they are likely to grow as magnets for money. “The big groups with fundraising machines,” Colvin said, “are going to be undaunted by this.”

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