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IRS Obstacles in Detecting Noncompliance of Tax-Exempt Organizations

It was a quiet night on a recent Friday, and I was killing time surfing the Web looking for something interesting. For all of us who either work for or with tax-exempt (T/E) organizations finding a report entitled, HIGHLIGHTS: Obstacles Exist in Detecting Noncompliance of Tax-Exempt Organizations, would surely grab your attention. This is what I learned after I took a closer look.

In February 2021, the Treasury Inspector General for Tax Administration (TIGTA) of the U.S. Treasury Department issued the aforementioned report as requested by the House Ways and Means Committee, the chief tax-writing committee of the House of Representatives. The objective was to review the IRS’ policies and audit procedures to identify improper conduct by T/E organizations and determine whether the IRS has sufficient information to combat abuse and enforce federal tax laws. The Exempt Organizations (EO) Unit, within the Tax Exempt and Government Entities (TE/GE) Division at the IRS, is responsible for oversight of T/E organizations’ compliance with such laws, ultimately to identify situations in which unscrupulous taxpayers may develop schemes using T/E organizations for their personal financial gain.

Let me give you a little background about the basis for the TIGTA’s 2021 report. The TIGTA reviewed a random sample of 53 of the 3,675 closed EO examination cases during fiscal 2019. If you are wondering how likely it is for a T/E organization to have been selected for audit during 2019, your chances of not getting selected are pretty good. Only one in 742 T/E organizations was selected compared to one in 156 for for-profit businesses. Since churches and other religious organizations are not required to file Form 990, the activities of these organizations is much more difficult to monitor and it was estimated that only one in 5,000 of these organizations were examined.

So, what did the TIGTA find. First, and not surprising to me, information reported on the Form 990 and other tax filings is difficult to indicate noncompliance. As a result, similar to many other types of abuse and noncompliance, the IRS relies on referrals to identify abuse in T/E organizations. In fact, of the 3,675 closed examinations in 2019, 1,672 (45%) of those examinations came from either referrals or requests for refunds or credits of amounts previously assessed or paid, including penalties, interest, or other adjustments. This speaks to the importance of getting your informational and tax returns filed accurately and timely. The remainder of closed examinations were primarily the result of data-driven approaches based on queries of specific quantitative criteria.

And what were the results of these 3,675 closed examinations. Depending on how you look at it, for the most part, they did not have a significant impact on the T/E organizations. Of these examinations, 31% resulted in an agreed tax or penalty change and 22% resulted in a written advisory which means that there was no change to the T/E organization’s tax-exempt status, but the E/O identified some aspect of the organization’s activities that could possibly jeopardize the organization’s tax-exempt status. There were a number of other results of these examinations with only 2% resulting in revocation of the organization’s tax-exempt status.

Then what are the underlying factors in making it difficult to identify noncompliance in T/E organizations? First, unscrupulous organizations and the individuals behind them are smart and they develop fraudulent schemes that are hard to detect. Second, the government has created its own potential problems due to the complexity of the tax law; limited resources available to pursue noncompliance, including the training of personnel related to the wide variety of T/E organizations and the criteria under which they operate; and a lack of filing requirements for certain T/E organizations.

I mentioned earlier that information provided on a T/E organization’s returns typically would not identify noncompliance. Once again, I would completely agree with this TIGTA finding. The TIGTA felt that a combination of looking at the returns or financial records of other filers, along with the T/E organization’s filings would greatly increase the opportunities to identify illicit activities. However, the IRS would need a basis for requesting this information from unrelated parties. In fact, the TIGTA concluded that asking for additional information on the T/E organization’s tax filings would not increase the likelihood of detecting noncompliance.

Even though referrals are a common source of initiating an examination given the whistleblower’s or third party’s presumed knowledge of inside information, the surprising fact is that these examinations are more likely to be closed with no changes to the return than those that result from compliance strategies or data-driven approaches. In 2019, even though the percentage difference was small, 15% of “referral examinations” resulted in no change compared to 13% for other examinations. This is considered a negative by the IRS as it can be interpreted as a poor use of taxpayer funds.

As previously mentioned, examination cases are selected through a combination of data analytics, issues raised by the EO, and referrals. Given the fact that referral examinations are not resulting in changes to returns and churches and other religious organizations are not required to file informational returns, the issue of case selection has become more important and relevant to the EO function.

This becomes even more critical when you consider that of the 3,675 examination cases closed in 2019, there were 900 cases considered as “non-examined closures.” In these cases, the examiner with manager approval, determined that the issues previously identified did not have merit or the statute of limitations was nearing. Once again, an inefficient use of EO time and resources that can be added to the time incurred for examinations that resulted in no changes. As a result, steps are being taken to minimize these non-examined closures.

As of the date of this TIGTA report, the TE/GE Division did not have a formal feedback mechanism in place that allowed EO examiners to provide input on the cases selected for examination. Cases were being closed without tracking the results of each noncompliance issue identified. This resulted in an inability for the EO to know whether an adjustment was due to the issue(s) identified by the examiner or due to an issue identified during the examination which could potentially lead to a false sense of the effectiveness of the original examination criteria. Procedures are now being implemented by the TE/GE Division to segregate issues that initiated the examination, as well as additional issues identified during the examination and the results of all the issues identified.

A second initiative being undertaken by the IRS is to improve the process by which examiners submit ideas or issues to be used in identifying future examinations. During the 2019 audit period, employees submitted 45 EO compliance ideas. However, the TIGTA report indicated that these employees did not receive any feedback as to how their ideas were addressed or utilized. In fact, this was the only formal recommendation made by TIGTA that examiners who submit ideas should receive relevant feedback related to their submissions.

In summary, even though many obstacles exist in detecting noncompliance of tax-exempt organizations, the TIGTA felt that examiners generally followed examination procedures and that sufficient information is being provided to the examiners to detect tax-exempt organization noncompliance. As far as how this may impact you or your T/E organization, I would recommend that everyone keep up the good work to submit timely and accurate filings. This will hopefully alleviate any concerns if you receive that dreaded letter from the Exempt Organizations unit.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.