A Challenge for the IRS

Lack of funds and manpower taxes agency’s ability to regulate charities

The Internal Revenue Service is falling far short in its role as federal overseer of the nation’s nonprofit organizations, a growing list of critics warns.

Lack of money, employees, and expertise at the tax agency have hindered the I.R.S.’s efforts to crack down on charities that run afoul of the law, say many charity officials and lawyers. While the number of charities has risen by two-thirds over the past 10 years, to nearly 820,000 organizations, the number of revenue-service employees who handle charity audits and applications for exemptions has barely increased. The problems have been compounded in recent years by the departures of some of the agency’s most-experienced employees.

The I.R.S.’s tax-exempt division “has been woefully underfunded,” says Jonathan A. Small, president of the Nonprofit Coordinating Committee of New York, which represents more than 1,000 small and midsize charities. He says the lack of spending is dangerous to charities because “the public’s trust in nonprofits demands strong regulatory oversight.”

The I.R.S. acknowledges that it has had some problems, but it — and many charity observers — say the agency has been doing a much better job than critics suggest. And revenue-service officials stress that the agency is firmly on the road to recovery and that charities will soon begin seeing improvements.

Steven T. Miller, the I.R.S.’s director of Exempt Organizations, asks charities for “a little more patience” as the agency completes a reorganization that began a couple of years ago and carries out new plans. He says the moves will make a tremendous difference in the way the revenue service regulates and helps charities. “We’ll get there,” he says.

Chief among the concerns about the I.R.S. being raised by nonprofit leaders, lawyers, and accountants:

Audits. While few charities relish the idea of coming under the I.R.S.’s microscope, some observers fear abuses will rise if nonprofit activities go unwatched. In 1995, the revenue service audited 10,497, or 2 percent, of the returns filed by all tax-exempt groups. By 1999, the most recent year for which figures are available, the audit rate had dropped to 1.3 percent. “There are nearly no audits going on, and those that are are not very well done,” says Sheldon S. Cohen, a former head of the Internal Revenue Service.

Applications. Lawyers who represent nonprofit groups say the process has become disorganized in recent years, with some organizations’ applications for charity status sailing through with what appears to be a very limited review, while others have gotten held up by revenue agents asking questions that seem irrelevant. Adding to the problem is the fact that the number of groups applying for charity status has soared from about 40,000 in 1990 to approximately 82,000 this year.

Information. Over the past two decades, the agency has scaled back much of the published advice and guidelines, including “revenue ruling” policy statements, that it provides to tax-exempt groups on how to follow tax laws. “Charities don’t know what they can do and what they can’t,” says Conrad Rosenberg, a former I.R.S. official who worked at the revenue service for 37 years. “The result is that the good organizations are afraid to do things they probably can do, and the bad organizations just go ahead and do stuff and afterwards claim they didn’t know better.”

Such concerns prompted Sen. Charles E. Grassley, Republican of Iowa, to ask the General Accounting Office, Congress’s investigative arm, to examine how charities spend and raise funds, and how well the Internal Revenue Service monitors those activities. The report, expected to be completed in the spring, could provide the basis for Congressional hearings (The Chronicle, July 26).

“Example after example of charities misusing funds for improper or illegal purposes necessitates Congressional action,” says Senator Grassley, the ranking minority member of the influential Senate Finance Committee. “I question whether the I.R.S. is best utilizing its resources to detect ‘fraudulent’ charities or, at a minimum, to detect false reporting by approved 501(c)(3) entities,” he told the accounting office.

Senator Grassley says Congress will wait to receive the G.A.O.’s report before defining the scope of any hearings on nonprofit regulation. But some observers say discussions could be as broad as whether the I.R.S. is really the best agency for the job or whether Congress should place all or part of the task of federal oversight into an entirely new government office.

Marc Owens, a former lead charity regulator at the revenue service, says one option might be to create an agency akin to Britain’s Charity Commission for England and Wales, which acts as application clearinghouse, adviser, and investigator for the 180,000 charities in those two regions. Such an agency could oversee charity officials, in much the way securities dealers here are regulated by quasi-governmental agencies under the supervision of the Securities and Exchange Commission, he says.

But unless Congress was willing to devote substantial new money and numbers of staff members to such an agency, says Mr. Owens, “I’m not sure there would be any significant improvement.”

New Structure

In the past couple of years, the Internal Revenue Service, under pressure from Congress, began a sweeping reorganization that included major changes in its charity office. In the past, staff members who regulated tax-exempt groups were scattered around the country working under different supervisors. Now, these employees ultimately report to Mr. Miller, giving his office more power and responsibility, and, the hope is, greater effectiveness.

The I.R.S. also decided in recent years to locate all of its workers who screen applications for tax-exempt status in Cincinnati and place its audit managers in Dallas, while keeping the employees who provide guidance to charities in its Washington office.

The service’s changes have carried many benefits, including making it easier for the public to obtain copies of federal informational tax returns.

But some observers say the reorganization and other steps taken by the service so far have failed to result in widespread improvements.

For example, many say the Internal Revenue Service is not properly processing applications for charity status that nonprofit organizations file. The I.R.S.’s job is to determine that each application meets the legal requirements to qualify as a charity. After a charity is approved, its donors are eligible to take tax write-offs for their gifts.

Until application examiners were shifted to Cincinnati, I.R.S. agents in seven different offices handled the forms. Centralization was intended to make the processing of applications more efficient, especially as the number of groups applying for charity status greatly increased. So far, however, the Cincinnati office has not been able to handle all the applications, and the service has had to forward as many as 40 percent of the forms to agents in other cities who would otherwise be conducting audits of charities.

Uninformed Questions

Some lawyers who represent nonprofit organizations say the application-approval process has taken a turn for the worse in recent years.

One prospective charity represented by a Washington lawyer, Celia Roady, was asked by an I.R.S. agent for a complete set of its books and records, even though Ms. Roady says it should have been obvious that a new group would not have such information. In another case, an I.R.S. agent sent a lengthy list of questions to a low-cost housing organization that were unrelated to its application, such as asking about the group’s magazine when it did not plan to publish one.

Such examples do not reflect a “thoughtful examination of the exemption application,” says Ms. Roady. “Someone was simply trying to create a record, and was just pulling questions out of a hat without showing an understanding of our application.”

Adds Ms. Roady: “The application is the very first point of contact the I.R.S. has with an exempt organization. The service is never going to be able to audit everybody. It’s really critical to do a good job at the beginning.”

A lawyer for a New York law firm that routinely helps organizations file applications for charity status says she and her colleagues have become alarmed by what she describes as the tax agency’s “rubber stamping” of charity applications since the first of the year.

“While it makes it easier for our clients not to have to answer any questions, from the perspective of the taxpayer and prospective donors, it seems unfortunate that the I.R.S. is not more carefully scrutinizing these applications,” says the lawyer, who asked not to be named. “The government’s laxness has become a topic of conversation.”

Donor Confidence

While individual charities may welcome a decline in questions from the tax agency, some nonprofit observers worry that small and new groups, in particular, could be hurt if donors lose confidence that such organizations are being properly monitored.

Foundations, for example, may be increasingly less likely to make grants to new charities, fearing that the organizations have not been properly “vetted” by the tax agency to ensure the groups are sound. Joshua J. Mintz, general counsel of the John D. and Catherine T. MacArthur Foundation, says that while big foundations have the money to check out grant applicants themselves, “smaller groups that lack the resources may have more of a problem” if the I.R.S. isn’t regulating charities properly.

Mr. Miller of the revenue service says that problems with the handling of some applications may stem from inexperienced new hires at the Cincinnati clearinghouse. He also says that the I.R.S. has had trouble filling all its job positions in Cincinnati. The tight job market, until recently, made it difficult to attract employees willing to work for relatively low government salaries, he says, forcing the farming-out of application forms to auditors around the country.

Even so, Mr. Miller says checks by the agency show that the applications have generally been processed well. “The quality is very good,” he says.

New Limits

One change the I.R.S. will soon announce, according to Mr. Miller, is that the agency is putting a firm limit on the amount of money and staff time it spends on processing applications so it can free its auditors to spend more time doing the work they were trained for.

While such a step could result in delays for some organizations applying for charity status, Mr. Miller says it is necessary to discourage abuses.

“Whether our audit presence truly is as down as the numbers would indicate isn’t really the issue, because the perception does exist that we are not really ‘out there’ on the examinations — that we are not taking a look at what is going on — and we need to counteract that perception,” says Mr. Miller.

In addition, he says the I.R.S. plans to “broaden” the pool of charities it audits. In the past decade, the agency has devoted about a third of its audit work to large organizations, such as universities and hospitals. The audit approach led to fewer examinations of charities over all, but Mr. Miller says the revenue service learned valuable information from the reviews that it will now apply in audits of smaller charities.

Some charity officials endorse the notion of the government performing more audits. Lee Cassidy, executive director of the Direct Marketing Association Nonprofit Federation, says that unless charities think there is a chance they will be audited, “eventually, voluntary compliance with tax laws will degrade.” He likens some charities’ attitudes toward toeing the line to jaywalking. “People don’t consider it breaking the law until someone warns them they are going to be fined if they do it.”

In response to criticisms that the I.R.S. has done too little in recent years to help charities that want to comply with the law, the tax agency says help is on the way. As part of its reorganization, the revenue service has created a new “customer education and outreach” office designed specifically to churn out advice for charities.

Through that office, Mr. Miller has released informal position papers on his view of a relatively new law that allows the agency to crack down on charity officials who receive unduly lavish benefits, and the revenue service has provided information about charity gambling and reporting requirements for political organizations.

The outreach office plans to soon issue plain-language publications to help churches follow tax laws, assist new groups that specialize in disaster relief, and give charities advice on how to handle donations of used vehicles. Also on its agenda: holding workshops around the country for small and midsize charities on such topics as employment tax, lobbying, political activities, and the tax treatment of income earned from business operations.

Such information is desperately needed, says Victoria B. Bjorklund, a New York lawyer who is vice chair of a committee that is charged with advising the service on tax-exempt and government organizations.

“People have been starved for information — charities that are large, professionally managed organizations, and those that haven’t seen a lawyer since their incorporation date,” says Ms. Bjorklund.

Roberta Zarin, who recently was hired as the first head of the I.R.S.’s outreach office, says her challenge will be figuring out how to assist groups of all sizes. “We want to help everybody from P.T.A.’s to homeowners associations, to churches, hospitals, and private foundations,” she says.

Congressional Debate

Many charity leaders remain skeptical about whether the I.R.S. will have the money and staff members needed to put its plans into action.

Allowing for inflation, the budget for the I.R.S.’s charity division did not substantially increase during the 1990’s; the division this year has an estimated $65.7-million to spend. Congress is now debating how much money to provide the Internal Revenue Service next year, with an increase likely but a final decision by the House and Senate still pending.

The I.R.S.’s overall reorganization — which consolidated the agency’s bureaucracy into four “operating units,” one of which includes the tax-exempt organizations — will give a higher profile and more clout to financially strapped charity regulators, who have had to vie with other revenue service offices for budget money, says Mr. Miller.

In the future, two key areas of I.R.S. charity enforcement to watch, observers say, will be:

* Enforcement of the new law, discussed by Mr. Miller in his position papers, that allows the agency to fine charity officials for receiving salaries and other benefits that are excessive, rather than revoking the tax-exempt status of the organizations themselves.

Since the law, known as intermediate sanctions, went into effect in 1996, the tax agency has moved to fine officials associated with two nonprofit groups: a Mississippi healthcare network and the Kamehameha Schools in Hawaii.

Critics say that this record does not inspire confidence that the agency is aggressively using the sanctions. But Mr. Miller says that the I.R.S. has other intermediate sanctions cases in the pipeline, although he cannot describe them due to privacy laws. “Intermediate sanctions is an area we have trained our people in, and are focusing on,” says Mr. Miller.

* Electronic filing of informational tax returns, called Forms 990. The hope of some charity leaders is that the I.R.S. will soon post the forms online for revenue agents to use and the public to see. The service once hoped to let charities file online by the end of the 1990’s, and now says the earliest date it could be ready is 2003.

“No regulatory agency is ever going to have substantial resources to track charities,” says C. Eugene Steuerle, a senior fellow at the Urban Institute, a Washington think tank. “Principal enforcement therefore has to be by being in the public eye. The 990’s have to be up on the Web, and the information clear-cut.” While some independent organizations post Form 990 information on their own Web sites, the I.R.S. could provide the data more quickly on its own site, says Mr. Steuerle.

Some charity observers say Senator Grassley’s recent promise to review the I.R.S.’s oversight of charities provides an encouraging sign of real changes ahead. “To me,” says Paul Streckfus, a former revenue-service lawyer who is editor of the EO Tax Journal, “Grassley’s letter was a small ray of hope that maybe someone on Capitol Hill cares about the abuses in the exempt-organizations sector and the fact that the I.R.S. is not very well equipped to deal with them.”

Mr. Owens, who retired from the agency last year after nearly 25 years, says the coming year will prove to be critical.

“The service is in transition,” says Mr. Owens, who is now a lawyer in Washington, “and you don’t know whether it is a transition to better or worse. The signs are definitely mixed.”