The Internal Revenue Service’s streamlined application process for tax-exempt status could be allowing corrupt charities to claim exemptions before the IRS has enough information to check on them and enable them to carry out illegal activities, according to a pair of new reports.
The reports, posted Thursday by the Treasury Inspector General for Tax Administration, cast a wary eye on charity fraud at a time when questions have emerged in Congress about them as well.
Over the summer, House Ways and Means Oversight Subcommittee chairman Bill Pascrell (D-New Jersey) sent a letter to outgoing IRS Commissioner Chuck Rettig demanding answers to a set of questions prompted by a New York Times article about a scammer who used the same address in Staten Island, New York, to apply for tax-exempt status for 76 fake charities using the names of seemingly legitimate-sounding nonprofits like the American Cancer Society of Michigan and the United Way of Ohio (see story). In most cases, the scammer used the streamlined Form 1023-EZ, which the IRS began allowing organizations to use for applying for tax-exempt status after a scandal erupted in 2013 over slow approval of applications by Tea Party groups and other political organizations, mostly on the right, for tax-exempt status under Section 501(c)4 of the Tax Code, usually reserved for social welfare groups. The so-called “Tea Party targeting scandal” led to the departures of a number of high-ranking IRS officials, including Lois Lerner, director of exempt organizations at the agency. The TIGTA reports issued Thursday mostly look at applications for tax-exempt status under the related Section 501(c)3 of the Tax Code, mostly reserved for charities, like the ones that prompted the scandal this past summer.
In one TIGTA report, the inspector general found that more information is needed by the IRS to make informed decisions on the streamlined Form 1023-EZ applications.
“Without sufficient information on the streamlined application, the IRS may approve tax exemption for organizations that do not meet the legal requirements, and could allow unscrupulous individuals to use the exemption for illegal activities,” said the report. “This could also diminish public trust in legitimate tax-exempt organizations.”
After the Tea Party targeting scandal erupted in 2013, under fire from conservatives in Congress, the IRS in the following year released Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, a simplified electronic application for smaller organizations to request and obtain exemption from federal income taxes. Form 1023-EZ requires applicants to attest, rather than demonstrate, that they meet the requirements for 501(c)(3) status. They don’t need to submit their organizing documents to the IRS. Instead they can simply attest that they meet those organizational requirements that they used to have to provide evidence for in the past before they could qualify for tax-exempt status.
However, the limited information they now need to provide isn’t enough to provide convincing proof of their bona fides. “Based on our assessment of internal and external stakeholder opinions, states’ reporting requirements, comparison with the information required on the long application form, our testing of the application process and limited examination compliance efforts, we determined that the information provided on the Form 1023-EZ is insufficient to make an informed determination about tax-exempt status and does not educate applicants about eligibility requirements for tax exemption,” said the report.
TIGTA went undercover and said it obtained 501(c)(3) status for four of five nonexistent organizations that it created. The IRS correctly identified one of the investigators’ fictitious applications as potentially ineligible and sent a request for additional documentation, but that didn’t happen with the others.
“Our undercover testing illustrates vulnerabilities in the IRS’s tax-exempt status determination process,” said TIGTA. “The IRS relies on a Form 1023-EZ examination strategy to detect noncompliance after organizations are approved; however, less than 1% of tax-exempt organizations are examined each year.”
TIGTA also found the online guidance for the Form 1023-EZ is inaccurate. The online web page used to apply for tax-exempt status includes educational links to help Form 1023-EZ applicants, but one of the links takes the applicant to a web page containing inaccurate information for applicants using the Form 1023-EZ.
TIGTA recommended that the IRS revise the activities description narrative on Form 1023-EZ, assess the feasibility of requiring applicants to submit their organizing documents as an attachment to Form 1023-EZ, notify applicants when extra time is needed to process their Form 1023-EZ applications, and update its online guidance with accurate information on the application process for Form 1023-EZ filers.
IRS officials agreed with the second and fourth recommendations and said they will consider notifying applicants when their submissions need additional time to process. However, they contended that requiring detailed activity descriptions is unnecessary to make determination decisions.
“The draft report recommends conforming the narrative length on the EZ form to that on the ‘long’ form,” wrote Sunita Lough, commissioner of the IRS’s Tax-Exempt and Government Entities division, in response to the report. “While we share a concern for the integrity of the tax-exempt sector, it’s unclear that an increase in paperwork would yield corresponding compliance, especially when applications for exemption are necessarily prospective.”
Lack of coordination with state regulators
In the other report released Thursday, TIGTA reviewed the IRS’s enforcement program for tax exempt organizations that participate in illegal or nonexempt activities. TIGTA found that the IRS and state charity regulators are limited by their own laws and procedures, restricting them from coordinating with each other as a way to identify tax-exempt organizations that are potentially engaging in illegal or other nonexempt activities. Currently, no state attorney general offices have formal disclosure agreements with the IRS.
That could be allowing bogus charities to defraud the public. “If the IRS does not identify potential illegal or fraudulent activities by tax-exempt organizations, unscrupulous individuals could take advantage of this preferred tax status to commit crimes,” said the IRS. “This could result in diminished public trust in legitimate tax-exempt organizations.”
Even when the IRS does identify potential problems with a charity, it may not classify or record the information correctly when it makes a referral to examiners to take a closer look. TIGTA identified 3,726 closed referrals from the IRS’s Exempt Organization function alleging potential fraudulent or illegal activities during fiscal years 2018 through 2020. For these referrals, classifiers inaccurately recorded the results for 42 cases on the referral database. In addition, for the 15,522 unique referral cases closed during fiscal years 2018 through 2020, TIGTA’s analysis identified 980 closed cases for which two referral database fields included conflicting information about the final dispositions of the referrals.
The computer systems themselves are to blame for many of the mismatches and errors. TIGTA also found that 2,934 data fields were missing the required information because the referral database system controls don’t require these fields to be completed prior to the case closing. TIGTA reviewed two samples of 46 referral cases closed between fiscal years 2018 and 2020 that alleged potentially fraudulent or illegal activities to determine whether the IRS’s assessments of the referrals were sufficiently researched and properly documented. All 46 referral cases sampled were sufficiently researched. However, five of the 46 referrals did not have enough documentation to justify the decision to not pursue an examination.
However, during this review and as in prior reviews, TIGTA found that the IRS has processes in place to identify whether a tax-exempt organization engages in substantial activities that do not further their tax-exempt purpose.
TIGTA recommended that the IRS should ensure that its classification managers periodically emphasize to their classifiers the importance of including supporting documentation in the case files for selecting or not selecting referrals for examination. The IRS should also implement controls in its referral database system to ensure that complete and accurate data is input into the database; and review the fields on the referral database to determine whether any of them could be eliminated to avoid confusion, conflicting information in similar fields, and redundancy. The IRS agreed with of TIGTA’s recommendations and plans to take corrective actions, but pointed out that many of the referrals don’t pan out in the end.
“We welcome your review of our process for evaluating referrals, including those that allege fraudulent or illegal activities,” Lough wrote in response to this report. “As stated in the report, few of these referrals have ultimately merited examination because, most commonly, there is insufficient corroborating evidence for the allegation. You sampled referrals that alleged potentially fraudulent or illegal activities and found all were sufficiently researched. Nevertheless, we continually strive to improve our procedures and appreciate your recommendations to ensure accurate and complete data in the system of recordation for all referrals.”