IRS Takes a Tougher Stance

The tax agency’s new approach sparks concern among charities

The Internal Revenue Service has a message for charity officials: Cross the line, and the odds are higher than ever that you’ll get caught.

The agency has been increasing the number of nonprofit examinations it conducts

each year, as well as taking other approaches aimed at showing charity leaders, the public, and Congress that it means business.

“We’re touching a significant number of organizations and a significant cross-section of different types and sizes of organizations,” says Lois G. Lerner, director of the IRS’s exempt-organizations office. “Charities need to be aware.”

In the past five years, Ms. Lerner’s division has added about 100 full-time employees, bringing the total to 905 workers. Most of the new employees have been added to the audit division, which grew from 432 full-time workers in 2001 to 501 this year.

The IRS expects to complete audits of about 6,000 organizations this year, as well as contact another 5,000 groups through a new review process that is less time-consuming and comprehensive than an audit — but that requires them to clarify or correct information submitted to the tax agency.

‘More Audit Activity’

Even with the increased enforcement, the percentage of organizations contacted by the IRS within a given year remains small — about 2 percent of the roughly 650,000 nonprofit organizations and foundations that are expected to file informational tax returns with the agency in 2006.

Yet lawyers and accountants who represent nonprofit groups say they have already started to notice a difference.

“There’s more audit activity going on in my practice today than I’ve ever seen,” says Bruce R. Hopkins, a lawyer in Kansas City, Mo., who has represented charities for 36 years. “The size of the entity doesn’t matter. If the IRS is after you, they don’t care if you’re large, small, or in between.”

Ms. Lerner says new technology, better coordination among units within the IRS as well as with other federal and state agencies, and revised audit techniques are making it harder for nonprofit groups to get away with bad behavior. The tax agency also in 2002 created a “customer education and outreach” unit within its tax-exempt division to help cut down on the number of inadvertent mistakes charities make.

Charity leaders and others following the IRS’s actions are divided over whether the agency’s approach is really translating into fair and effective oversight.

Sen. Charles E. Grassley — the Iowa Republican who is head of the Senate Finance Committee, which has been investigating charitable abuses — says the IRS is headed in the right direction but still has far to go.

“Unfortunately, the enforcement push is probably just scratching the surface,” he says. “The nonprofit sector is a huge piece of the economy, and it’s hard for enforcement to keep pace.”

Many nonprofit observers say they welcome a reinvigorated IRS in the hope that better enforcement will catch wrongdoing before it leads to a major scandal and, thus, strengthen public confidence in nonprofit groups as a whole.

“It sends a message to people that the IRS is watching, and that if you do these kinds of things, you’re more likely to get caught,” says Charles M. Watkins, a Washington tax lawyer.

Legal Hassles

Other charity representatives, however, worry that the real result of recent IRS changes may be new administrative and legal headaches for legitimate charities rather than an increase in serious abuses caught.

Some of the highest-profile cases in recent years, they say, seem to have more to do with creating a tough IRS image than with real substance. As an example, they point to the agency’s review of the National Association for the Advancement of Colored People over allegations that it took a partisan stance in the 2004 presidential election. The two-year investigation generated extensive publicity and ended with the IRS concluding that the charity had done nothing wrong.

Several tax lawyers say the IRS has started to focus too much on small infractions, while missing the big problems. The agency’s 2003 review of pay and perquisites at some 2,000 organizations, for example, did little to curb high salaries, they say, but it did prompt the IRS to look into whether executives made personal calls on office cellphones.

An added concern is the relative inexperience of many of the new employees at the IRS. The tax-exempt office has had to fill jobs left empty by the 168 auditors and senior staff members who have left since 2003 — mainly because they reached retirement age — in addition to hiring for the newly created positions. Some tax lawyers believe inexperience on the part of the new agents has led to tax laws being misinterpreted and misapplied.

Mr. Watkins says an IRS agent recently told one of his charity clients that it should have deducted the cost of preparing the legal documents related to a donor’s pledge to preserve a historically important property from the value of the gift, thereby making sure the donor couldn’t write off that portion of the gift.

“I’ve never known the IRS to take that position,” says Mr. Watkins, who has been representing charities for the past 20 years.

“They don’t have enough gray heads in there to make well-thought-through policy decisions,” says Marc Owens, a Washington lawyer who used to oversee nonprofit groups at the IRS. Mr. Owens represents several charities that have been audited, including the NAACP.

The IRS is prohibited by law from commenting on specific cases. But Ms. Lerner says the cellphone issue was part of a look at all the perks officials received — such as travel expenses for their spouses and personal use of an organization’s automobiles — that weren’t in their employment contracts. “Once we’re in there doing an audit, it is important for our folks to look at everything,” she says.

Internal reviews have shown that the overall quality of the exempt-organizations department’s audits and the written advice it provides remain high, Ms. Lerner adds. As an added step, she says, she has asked senior employees to serve as mentors to the new workers to help pass on as much knowledge as possible.

Ms. Lerner says the issue raised in the NAACP case — concern about improper political campaigning by charities — is something the tax agency intends to be vigorous about investigating.

For political activities related to the 2004 election, the IRS sent warning letters to more than 60 charities, revoked the tax-exempt status of four charities, and forced another organization to pay a penalty. Ms. Lerner says the IRS will be even more active during this fall’s elections.

Lessons From Pay Review

High executive compensation and benefits have been harder to tackle. Ms. Lerner says the 2003 compensation audits turned up some evidence of abuse, such as improper loans to executives. But, she said, because of the way federal law was written, it was difficult to prove whether many compensation levels were clearly excessive. A full report on the compensation audits will be issued by the end of the year, Ms. Lerner says.

The experience has prompted Ms. Lerner to make sure her office understands the scope of an abuse before investing time and energy in audits.

For example, after Congressional and state officials said in hearings over the past two years that some nonprofit hospitals may not be providing enough benefit to society to justify their tax-exempt status, the IRS in June sent questionnaires to 544 hospitals to gain a clearer picture of the issue. The hospitals were not required to fill them out, but 517 organizations returned the surveys. The office will report on the results and what it plans to do about them, Ms. Lerner says.

“We gather information and decide where we have to focus our resources and how,” she says. “We hear a lot of noise, a lot of anecdotes. It doesn’t always mean there’s widespread abuse.”

Members of Congress want the IRS to move faster to deal with its concerns about hospitals and take “at least some real and meaningful steps now,” according to a Senate Finance Committee aide who spoke on condition of anonymity. “While a survey can be useful, the recent House and Senate hearings have made it clear that there is wide agreement that business-as-usual for tax-exempt hospitals has to end,” the aide said.

The exempt-organizations office also is working more closely with other units of the tax agency to identify problems common to all types of organizations, tax-exempt or not, such as whether employment taxes are paid on time.

As a result, it says it has become much more aggressive in going after charities that fail to forward payments of taxes they withheld from employees for Social Security and Medicare. In 2004, the most recent year for which it has data, the IRS identified about 20,000 charities that withheld such payments from their employees but did not send the money to the government.

Credit-Counseling Groups

One of the best examples of the way the IRS plans to approach enforcement in the future, Ms. Lerner says, involves nonprofit credit-counseling agencies.

After hearing from state and federal regulators of numerous instances of debtors being misled by such groups, the revenue service spent two years quietly investigating 63 of the largest organizations. Other parts of the IRS, including the division that oversees large businesses, helped Ms. Lerner’s office identify cases in which a charitable credit-counseling group made substantial payments to for-profit businesses owned by the founder of the charity.

At a May news conference to announce the results of the investigation, the head of the IRS, Mark W. Everson, said that bad credit-counseling organizations had “poisoned an entire sector of the charitable community.”

The tax agency revoked the tax exemptions of 41 of the 63 groups it examined, and said it was concerned about all of the 743 other credit-counseling groups.

Of the 110 new credit-counseling groups that sought tax-exempt status while the investigation was under way, only three were approved. The tax agency also laid out steps that credit-counseling groups could take to make sure they could retain their tax-exempt status.

Ms. Lerner says the IRS wanted to send a clear message that such organizations could not expect to get away with skirting tax law by hiding behind existing groups or creating new ones.

The effort was “incredibly successful,” Ms. Lerner says. “It’s a model for where we’re going as we move forward.”

In the past, the tax agency would have announced that it had identified an abuse and then taken months or even years to write rules outlawing it, giving charities ample time to clean up their act before the agency came down on them. Coordination among units of the IRS was rare, as were news conferences to try to publicize the enforcement activities of the IRS’s tax-exempt office.

While the new approach has drawn praise from many observers, some lawyers say the IRS may be trading speed for fairness in some cases.

“When there’s a body of law that’s been in existence for a number of years, and the IRS decides to change it, they’re supposed to go through a process,” says Mr. Hopkins, the Kansas City lawyer. “They’re supposed to have a hearing and comment period.”

David C. Jones, president of the Association of Independent Consumer Credit Counseling Agencies, says he was delighted when he first heard about the tax agency’s crackdown. His association, he says, had spent years trying to call the tax agency’s attention to improper practices in the industry.

But the severity of the IRS’s new approach took Mr. Jones by surprise, particularly a statement that nonprofit credit-counseling groups should not take payments from banks and other creditors. Mr. Jones joined an effort to persuade Congress to override the revenue service, and this year the law was revised to allow credit-counseling groups to receive up to 50 percent of their support from creditors.

“I was very supportive of the IRS and I still am,” Mr. Jones says. “I just think there’s been an over-amount of zeal that has caused them to condemn the whole industry.”

Part of the IRS’s strategy calls for improving the way it collects and processes information from charities. The agency is developing a revised informational return for charities designed to make it easier for the federal government to enforce charity tax laws by asking new questions and requiring more specific and detailed replies.

The agency is also promoting electronic filing, which will help it create a database of the charity and foundation information that the agency collects. It is asking Congress to require more groups to file their returns electronically. Today, it says, only about 8,000 organizations file electronically.

In addition, the tax agency has tried to improve the way it teaches charities about the law.

Through its new “outreach” office, the IRS says it reached nearly 15,000 charity officials through forums and workshops last year, and talked to 20,000 individuals via speeches and conference calls on specific charity tax issues.

Ms. Lerner says she anticipates many more changes as she looks for additional ways to have a bigger impact with the budget and staff she oversees.

Many IRS observers, however, question how much more effective the office can be without an increased budget.

“More money needs to go to [the exam unit] and audits so we can identify organizations that are problems and sort them out,” says Mark B. Weinberg, a Washington lawyer. “Right now, audit coverage is still pretty spotty.”

But that is unlikely to happen given the pressure in Washington to reduce the size of government and cut federal spending, which has made lawmakers unsympathetic to pleas for more money.

“Every government agency rattles the tin cup,” says Senator Grassley, the Finance Committee chairman.

Ms. Lerner is optimistic she can improve charity tax enforcement with her current budget.

She says being relatively new to the IRS has helped her get a fresh look at the office’s operations. Ms. Lerner came to the IRS in 2001 from the Federal Election Commission, where she was acting general counsel.

What she and others lack in direct IRS experience, she says, is countered by the lessons they are able to apply from successes at other organizations.

“You get a lot of energy in. It really stirs us up and makes us think about how we’re doing things,” she says. “We’re evolving all the time.”