The Internal Revenue Service has suffered major budget cuts—losing more than $715 million in annual funding and thousands of employees since 2010. It weathered fallout after being accused of holding up conservative groups’ tax exemption applications. Now it has taken another hit: An IRS-approved nonprofit is at the center of a sweeping scheme in which wealthy parents paid bribes to get their children into college.
The role of the nonprofit in the scandal, and its concealment of millions of dollars in bribes, has triggered new scrutiny of the IRS, and raised doubts about whether the embattled tax agency can handle the necessary scrutiny of the charitable sector. The agency declined to comment.
“It goes to show the need for a much more sophisticated and real audit program with tax-exempt organizations,” said Marcus Owens, who used to head the exempt organizations division at the IRS. “And even so, they still would have trouble catching them.”
Nonprofit tax practitioners and former IRS officials say the agency needs to have more bite behind its bark going forward: a low rate of auditing nonprofits won’t spur the necessary compliance with tax laws. Tax code Section 6033 requires nonprofit organizations, exempt under Section 501, to file annual returns. The California charity at the heart of the admissions scheme had questionable disclosures.
Mark Everson, who was IRS commissioner from 2003 to 2007, noted that the 2017 tax overhaul included new taxes on nonprofit executives and some university endowments. Those changes signaled Congress’s intent to take a fresh, skeptical look at the tax-exempt sector. The admissions scheme will add to the fervor.
“This just adds to the growing weariness about the health and integrity of the non-for-profit sector,” said Everson, now vice chairman of Alliantgroup LLP.
IRS efforts to investigate tax fraud have been impeded in recent years as the agency has faced steep cuts in staffing and budgets. Tax-exempt organizations filed more than 1.5 million returns in fiscal year 2017, according to IRS data. The overall chance of an agency audit that year fell to 0.6 percent, the lowest rate since 2002.
The admissions scheme—which prosecutors say centered around the fraudulent California charity Key Worldwide Foundation—wasn’t uncovered through an IRS audit. The agency doesn’t announce when it begins audits, so it is possible it has started looking into the organization since the Department of Justice revealed the investigation on March 12.
Tax practitioners caution that even increased audit coverage by the IRS wouldn’t have caught the case, as it involves vast, outright fraud.
The Path Forward
The tax system is voluntary, and the IRS’s rate of auditing nonprofits is low. Greater threats of audits could encourage greater tax compliance and deter fraud, Everson said.
“If you audit one person in a country club, and it’s even a relatively small adjustment, you’re going to have that taxpayer sitting there in his locker room talking about how he just went through an audit, and that I think does encourage compliance,” Everson said. “So it’s important to have criminal investigations groups adequately staffed, particularly with respect to these nontraditional areas.”
One potential step the IRS could take is to conduct more random tax audits, said Cleta Mitchell, a partner at Foley & Lardner LLP in Washington. Conducting truly random audits, and subjecting all charitable organizations to the same potential pain and expense of an audit, would encourage greater compliance among taxpayers, she said.
The IRS in recent years has used a data-driven approach to guide tax-exempt audits, using a system that flags potential problem areas on exempt organizations’ tax returns. Practitioners say that approach has meant audits are narrower in scope.
The agency could also tighten reporting requirements on exemption applications. In 2014, it made it easier for smaller organizations to apply for 501(c)(3) exemptions using a streamlined application, the Form 1023-EZ. But critics have argued that the form is easy for groups to abuse—between 26 and 42 percent of approved entities filing the form between 2015 and 2017 didn’t meet qualifications for a 501(c)(3) organization, according to a report from the National Taxpayer Advocate.
Additional scrutiny of tax-exempts is probably warranted, but the IRS doesn’t have the resources to scrutinize every single charitable organization, said Gregory Lam, a managing partner at Copilevitz & Canter in Kansas City, Mo.
“When it comes to the 1023-EZ, you have this problem of charitable organizations not filling it out honestly and then receiving their tax exemption, but then there’s no other followup by the IRS to see where that organization goes in the future,” Lam said.