The IRS, which has declined to comment on the matter, also said in a court document that Z Street deserved heightened scrutiny because its funds, and those of other groups like it, might end up in the hands of terrorists, a claim that left Z Street's organizers dumbfounded.
The group, citing its free-speech rights under the Constitution, sued and has been given the green light by federal District Judge Ketanji Brown Jackson in Washington to move forward by putting IRS officials under oath and seeking internal IRS documents.
"It's important to the rest of the world because the judge has now said the IRS has to expose its inner workings with regard to the processing of applications and reveal whether in fact it acted improperly. That is really huge," said Lori Lowenthal Marcus, a former Dechert L.L.P. First Amendment lawyer and a founder of Z Street.
"If the government is allowed to discriminate against people based on their viewpoints, it could be because they are communist, or radical, or fill in the blank. That is very problematic for everybody."
The suit is one of several alleging that the IRS targeted advocacy groups because of their conservative views, a charge that emerged as a full-blown controversy in 2013 and resulted in a Treasury Department inspector general's report finding that the IRS had used inappropriate sorting criteria that resulted in singling out conservatives for special scrutiny, delaying the groups' applications.
Most of the groups concerned themselves with domestic politics; Z Street's focus is Israel and U.S. government policies that affect it. The Z Street suit is the first to proceed beyond preliminary pleadings. Lowenthal Marcus' husband, Jerome Marcus, a litigator, and Jay Levin, a lawyer with Reed Smith, have been handling the group's legal work.
Z Street - the Z stands for Zionism - was formed as an organization devoted to what it said was dissemination of facts about Israel and the Middle East.
Its materials and activities supported Jewish settlements on the West Bank. It sought to portray Israel as a force for good and to push back against a picture promoted by critics of Israel - that the Israelis were oppressing Palestinians and thus standing in the way of a peace agreement in the region.
President Obama generally opposes the Israeli government's settlement policies. On Thursday, as the Israelis announced a new round of settlement expansions in the occupied territories, the administration voiced its displeasure, saying this made efforts to resolve territorial disputes between the Israelis and Palestinians more difficult.
Z Street filed its application for tax-exempt status with the IRS in December 2009, shortly after its founding. On July 10, 2010, in the belief that the application had been subject to unnecessary delays, a Z Street lawyer contacted the IRS for an explanation. According to Z Street's lawsuit, IRS agent Diane Gentry said the IRS was concerned generally about groups whose activities related to Israel and whose views contradicted the U.S. government's policies on Israel.
The IRS denied anyone's ever making such a remark, but one IRS official said in an affidavit that the group's application was selected for special scrutiny because of concern that it might provide financial support to groups in Israel, "one of many Middle Eastern countries that have a higher risk of terrorism."
A handful of militant groups in Israel have been designated terrorist organizations by the Treasury Department, a possible basis for the IRS position, but Middle East experts say that far from being the source of terrorist attacks, Israel is in the vast majority of cases a target. Moreover, says Lowenthal Marcus, Z Street only spent its money on conferences, its website - now shut down for lack of funds - and other activities aimed at promoting its point of view in the United States.
"We never sent a dime to anybody," she said.
Tax-exempt status is critical for the group, Lowenthal Marcus said, because it has been unable to raise money without it. As a consequence, it has had to take down the website and curtail most of its activities, she said.