IRS Examination Selection: Internal Controls for Exempt Organization Selection Should Be Strengthened
Published: 2015-07-13T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: IRS examines tax-exempt organizations to enforce their compliance with the tax code. Examinations can result in assessment of taxes or revocation of tax-exempt status, among other things.
GAO was asked to review IRS's criteria and processes for selecting exempt organizations for examination. This report (1) describes these processes and (2) assesses the adequacy of examination selection controls.
GAO reviewed IRS criteria, processes, and controls for selecting organizations for examination and spoke with IRS officials; assessed whether IRS controls followed Standards for Internal Control in the Federal Government ; reviewed random probability samples from two populations of examination files; and conducted tests on populations and random probability samples from three databases used in EO examination selection to determine the adequacy of EO's control implementation (for files closed in fiscal year 2014). GAO also conducted eight focus groups on internal controls topics with EO staff who conduct research or make examination selection decisions.
section_title: What GAO Found
paragraphs: The Exempt Organizations (EO) unit within the Tax Exempt and Government Entities (TE/GE) division at the Internal Revenue Service (IRS) reviews organizations' applications for tax-exempt status to determine whether to grant status and oversees existing exempt organizations' compliance with the tax code. To identify exempt organizations for possible examination, EO uses a variety of information sources: for example, EO receives referrals of exempt organization noncompliance from third parties, such as the public, and other parts of IRS.
EO uses various controls intended to help it select exempt organizations for examination, in an effort to adhere to TE/GE's mission of “applying the tax law with integrity and fairness to all.” For example, EO maintains well-documented procedures for several examination selection processes in the Internal Revenue Manual (IRM), IRS's primary, official source of instructions to staff; staff can deviate from procedures that are included in the IRM only with executive management approval. In focus groups, EO staff generally told GAO that these procedures were valuable tools to help them administer the tax law.
However, there are several areas where EO's controls were not well designed or implemented. The control deficiencies GAO found increase the risk that EO could select organizations for examination in an unfair manner—for example, based on an organization's religious, educational, political, or other views. Examples of internal control deficiencies GAO found include the following:
Staff could deviate from procedures for some selection processes without executive management approval. GAO found that procedures for some processes—such as applying selection criteria to organizations under consideration for review—are not included in the IRM, as required by IRS policy. As a result, staff are not required to obtain executive management approval to deviate from these procedures. This increases the risk of unfair selection of organizations' returns for examination.
EO management does not consistently monitor selection decisions. GAO found that IRS does not consistently monitor examinations and database files to ensure that selection decisions are documented and approved, to help ensure fairness. GAO's review of examination files found that approval of some selection decisions was not documented, as required by EO procedures. For example, GAO's analysis of a sample of files suggests that an estimated 12 to 34 percent of cases where staff initially selected an organization for examination, but ultimately decided not to perform the examination, were missing the indication of management approval of the final decision, as required in the IRM. Continuous monitoring is an element of internal control; EO management has not been conducting sufficient monitoring to ensure that required approvals were taking place.
section_title: What GAO Recommends
paragraphs: GAO is recommending that IRS take 10 actions to improve selection control design and implementation, such as ensuring that all selection procedures are included in the IRM and thus subject to executive management approval, and developing additional examination selection monitoring procedures. IRS generally agreed with the recommendations.

section_title: Letter
paragraphs: There are 1.6 million tax-exempt organizations in the United States.  These organizations have varied purposes and missions, ranging from  small social services groups to large nonprofit health systems. Taken as a  whole, exempt organizations represent at least 5 percent of gross  domestic product.
An exempt organization must be organized for one of the exempt  purposes in the Internal Revenue Code (IRC)—such as providing charity,  social welfare, programs for veterans, or furthering the interests of the  organization’s membership—and must operate in accordance with that  purpose. Under the IRC, exempt organizations generally are not subject  to federal income taxes. For example, contributions received from  sources such as individual donations or grants are not taxable. However,  exempt organizations are required to pay employment taxes. In addition,  they may be required to pay taxes on unrelated business income, such as  from personal property rentals or web site advertising, and most domestic  private foundations must pay excise taxes on net investment income.
The Exempt Organizations (EO) unit within the Tax Exempt and  Government Entities (TE/GE) division at the Internal Revenue Service  (IRS) oversees exempt organizations’ compliance with the tax code. EO  reviews organizations’ applications for exempt status and determines  whether to grant it. Additionally, EO conducts examinations, which are  reviews of the activities and finances of exempt organizations to  determine whether they are operating in accordance with their exempt  purposes, and have paid taxes they owe.may impose excise taxes for certain types of violations, or—if the  violations are serious enough—it may revoke an organization’s exempt  status. In addition, IRS can assess taxes if an organization has not fully  paid employment taxes or taxes on unrelated business income, as well as  advise organizations on future tax compliance. In fiscal year 2014, IRS  closed 8,084 examinations of exempt organizations.
If IRS finds noncompliance, it  You asked us to review IRS’s criteria and processes for selecting exempt  organizations for examination. This report (1) describes the processes for  selecting exempt organizations for examination, and (2) assesses the  adequacy of the controls (including procedures) for selecting examination  cases that EO uses to achieve TE/GE’s stated mission of “applying the  tax law with integrity and fairness to all.”
For the first objective, we reviewed IRS documents that describe the  criteria, processes, and controls for selecting exempt organization returns  for examination. These documents included relevant sections of the IRC,  regulations, the Internal Revenue Manual (IRM), EO procedures and  training documents, worksheets to guide examinations and reviews, and  summaries of processes prepared by EO officials. We also interviewed  IRS officials responsible for overseeing each process. In addition, we  obtained data from the following IRS databases: Return Inventory  Classification System (RICS), Referrals database, Exempt Organizations  Compliance Area (EOCA) database, and EOCA Classification database.  The databases contain information on initiated and closed examinations,  classification of referrals, and other reviews that can lead to an exempt  organization’s return(s) being selected for examination. testing of the data and review of documentation and interviews, we  determined that these data were reliable for the purposes of this report.
Classification is the process of identifying potential noncompliance in a return and making  a recommendation on the examination potential for the return.
IRM Part 1, Chapter 1, Section 23.1. returns for examination, and two focus groups of selected EO staff who  conduct examinations. We asked questions on internal control related  topics, such as the clarity of EO procedures and the adequacy of training  to apply these procedures. We used NVivo qualitative data analysis  software to conduct a content analysis of themes from the focus groups.
To assess how well EO implemented its procedures and controls and  applied examination selection criteria, we used IRM sections, EO  procedures documents, and other documents as criteria. We reviewed  databases used to document examination selection decisions and  random probability samples of database files and examination files. We  used the results of those reviews to determine whether selected controls  were implemented effectively. We also reviewed a non-generalizable  sample of 11 projects that were active during fiscal year 2014. We  selected those projects to include projects of various sizes (based on  numbers of returns examined) and time frames, and we included  politically sensitive projects and some projects that relied on data queries  of Form 990, Return of Organization Exempt From Income Tax. We  reviewed the project files for each project to test whether the  documentation—such as development and approval of examination  selection criteria—followed project development procedures. Finally, we  interviewed EO officials about the processes and controls, and to discuss  any potential deficiencies we identified.
We designed uniform data collection instruments for our file and database  reviews to consistently capture information on the completeness of  required documentation and approvals related to case selection. IRS  verified the criteria we used in our instruments. To ensure accuracy, two  analysts reviewed each file or database entry we assessed, and  reconciled any differences in responses. We then analyzed the results of  these data collection efforts to identify main themes and develop  summary findings.
We conducted this performance audit from May 2014 to July 2015 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives. More detailed information on  our scope and methodology appears in appendix I.
subsections: section_title: Background
paragraphs: The tax code provides for 35 different categories of exempt organizations,  each covering one or more types of permissible activities. The majority of  these organizations are covered by section 501 of the IRC. Section 501  includes private foundations and public charities, as well as other  organizations, such as social welfare organizations, business leagues,  and veterans’ organizations. However, other types of entities are also  wholly or partially tax exempt, such as farmers’ cooperatives and political  organizations, as are education-oriented programs such as educational  savings accounts and tuition programs.
Most organizations seeking exemption must submit an application to  IRS. If the information in the application meets the requirements for tax  exempt status, IRS will issue a determination letter approving tax exempt  status. Tax exempt organizations are generally not required to file an  income tax return. Instead, if an organization normally has $50,000 or  more in gross receipts, and meets other requirements, it must annually  file one of three versions of the Form 990 information return, which  require information on employees, revenue and income, assets and  liabilities, program activities, and compensation. Most organizations that  fall below the gross receipt threshold of $50,000 and need not file a Form  990 information return are required instead to file an electronic postcard,  Form 990-N, which asks for names and contacts associated with the  organization, and confirmation of the organization’s annual gross receipts.
During examinations, EO reviews a specific return—such as a Form 990  or employment tax return—as well as the organization’s activities. There  can be open examinations on one organization spanning several years,  or related returns for a single tax period for that same organization. Some  examinations are a result of compliance projects that IRS initiates to  identify areas of noncompliance or address known areas of  noncompliance. For example, a project on gaming in charity fundraising  activities, an activity often conducted by veterans organizations, led to a  relatively high examination rate—compared with other rates by tax- exempt status—for those organizations in fiscal year 2014. Table 1 shows  the examination rate by organization exempt status for fiscal year 2014.
section_title: EO Process for Selecting Exempt Organizations for Examination
paragraphs: EO’s process for selecting returns for examination is complex and  includes multiple steps (see figure 1). Referrals, which are complaints  against exempt organizations submitted to EO, involve additional steps;  they are excluded from figure 1 and discussed later in this report.
EO uses a variety of sources to identify exempt organizations for possible  examination, and conducts review steps that filter out some  organizations. Through ongoing programs, time-limited projects, and data  queries, EO identifies organizations with characteristics that may pose  high noncompliance risks. Referrals point EO toward particular  organizations that may be noncompliant. In addition, EO reviews  organizations’ claims for tax refunds and examines those that are  questionable; EO selects examination cases for training examiners; and  some cases are selected based on programs run by other parts of IRS  that relate to exempt organizations. EO also identifies some organizations  for examination in the course of conducting other examinations. For a  breakdown of closed examinations by source during fiscal year 2014, see  table 2. Primary examination sources are listed in the rows, and  examinations that are initiated based on other examinations are reflected  in the third and fourth columns.
subsections: section_title: EO Identifies Groups of Organizations with Characteristics That Pose Noncompliance Risks
paragraphs: Ongoing programs. Every year, EO identifies organizations with  characteristics that are known to pose a risk of noncompliance. For  example, through a document matching program, EO matches wages  reported on Form W-2, Wage and Tax Statement, to those reported on  exempt organizations’ employment tax returns; organizations with  mismatches have an increased probability of noncompliance.Additionally, ongoing programs are used in EO’s oversight role. For  example, EO performs annual reviews of a random sample of  organizations that recently received favorable determination letters to  check if the organizations are current with their filing requirements and  are operating in accordance with their tax exempt purposes.
Compliance projects are time-limited efforts to study noncompliance  risks. Through compliance projects, EO identifies specific areas of  potential noncompliance (such as fundraising) or specific types of  organizations (such as community foundations), selects and reviews a  subset of relevant organizations, and addresses any noncompliance it  finds. Compliance projects identify organizations for review using data  queries, random samples, and/or nonprobability samples. A committee of  TE/GE officials, including EO managers and analysts, has historically  been tasked with developing new compliance projects and obtaining  approval from EO executives.
Projects that identify areas of significant noncompliance—based on the  nature of the issues involved and the number of examinations that result  in tax assessments or organization status changes—become part of EO’s  ongoing programs. However, in the past few years, EO has decreased its  focus on compliance projects and developed a new focus on Form 990  analytics queries (see below).
Form 990 analytics queries identify organizations for review with data  queries on Form 990, Return of Organization Exempt from Income Tax.  For example, some queries check for missing Form 990 schedules that  should be filed, based on boxes checked on Form 990 or Form 990  responses above certain dollar thresholds. To assure alignment with IRS  objectives, EO is in the process of aligning Form 990 analytics queries  with five focus areas that correspond to agency-wide IRS objectives.
EO  initiated the Form 990 analytics strategy in 2010, and developed and  began testing about 150 data queries by 2012. Of the original 150 Form  990 analytics queries, EO had completed testing for 11 and was in the  process of testing 20 others, as of April 2015. Successful queries are run  on an ongoing basis. As with compliance projects, queries that identify  areas of significant noncompliance—based on the nature of the issues  involved and the number of examinations that result in tax assessments  or organization status changes—become part of EO’s ongoing programs.
section_title: Referrals Identify Particular Organizations that May Be Noncompliant
paragraphs: Referrals are complaints of exempt organization noncompliance made by  third parties, including the public and other parts of EO and IRS.  (Although referrals can be made from sources within EO, 90 percent of  referrals are from sources external to EO.) Referrals will be discussed in  greater detail later in this report.
section_title: Some Examinations Are Conducted for Other IRS Divisions, and Some Are Used for Training
paragraphs: Examinations conducted in conjunction with other IRS divisions. EO  conducts some examinations as part of programs managed by other  divisions of IRS. For example, EO conducts some examinations for the  Global High Wealth program, managed by IRS’s Large Business and  International Division, which monitors high wealth individuals and the  networks of enterprises and entities they control. Additionally, EO  conducts some examinations of exempt organizations for the National  Research Program, an IRS-wide effort to develop and monitor measures  of taxpayer compliance run by IRS’s Office of Research, Analysis, and  Statistics. IRS initiated a National Research Program study on  employment tax noncompliance in 2010, focusing on Form 941,  Employer’s Quarterly Federal Tax Return, for tax years 2008, 2009, and  2010.
Training examinations, used for training examiners, are identified  through database queries selecting for lower-grade cases with  compliance issues, and cases with particular topics relevant to training.
section_title: Most Claims Are Allowed in Full, but Some Lead to Examinations
paragraphs: Claims are exempt organizations’ requests for tax refunds, adjustments  of tax paid, or credits not previously reported or allowed. For example,  recognition of tax-exempt status occurs after an organization was formed,  effective to the formation date. As a result, an organization can file a  claim for refund of income taxes paid for the period for which its exempt  status is recognized. Most claims are allowed in full, but claims that raise  questions may be considered for examination.
section_title: EO Identifies Some Organizations to Examine Based on Other Examinations
paragraphs: In the course of examining an exempt organization’s tax return, EO  examiners may become aware of other tax returns that are at risk for  noncompliance and should be examined. EO has two sets of procedures  in place for opening examinations on those returns when this occurs.
Related pickups. Examiners may expand the examination of a return to  include the organization’s tax returns for prior or subsequent years. They  may also expand the examination to include different forms filed by the  organization—for example, by expanding the examination of a Form 990  to include Form 941, Employer’s Quarterly Federal Tax Return.  Examination staff must obtain manager approval for these examinations.
Substitutes for return. When beginning an examination of a particular  tax return, EO examiners check whether the organization is current in its  filing requirements for all its returns. If EO examiners find that a return is  missing, and are unable to secure the return through contact with the  organization, they may prepare a blank, “dummy” return called a  substitute for return (necessary because IRS tracks its examinations  based on returns). The organization’s related activities, records, and/or  documents may then be examined.
section_title: EO Conducts Research on Some Organizations as Part of the Selection Process
paragraphs: For some cases, EO’s Exempt Organizations Compliance Area (EOCA)  may conduct a compliance check or compliance review, processes that  can serve as intermediate research steps (see table 3). Some  organizations are filtered out through these steps, some are brought into  compliance and do not require further work, and some are sent for  classification (see below). Other cases are not sent for intermediate  research and are sent directly for classification, or directly to Case  Selection and Delivery, which manages the pool of returns that may be  sent for examination.
Compliance checks involve contact with an exempt organization through  a letter or questionnaire. For example, in fiscal year 2014, EOCA sent  compliance check letters to organizations that did not file a required Form  990, and to organizations that reported certain types of income on their  Form 990 but did not file related required forms. These contacts are a  form of education for an organization and can result in the organization  coming into compliance with requirements—for example, by filing a  required return. Compliance checks may also be used to determine  whether an organization is adhering to record-keeping requirements, and  they are used for document matching cases. With some compliance  checks, the contact is sufficient to bring an organization into compliance,  or to determine that it was already in compliance. Other cases may be  sent to EOCA’s classification group or a triage team (see below), which  determines which cases meet criteria for examination.
Compliance reviews do not involve contacting the reviewed  organization. EOCA conducts research using IRS data, external  databases, and publicly available information, including information on the  Internet. Items reviewed may include tax returns, applications for  exemption, and websites. For example, compliance reviews are used for  the program mentioned above that reviews organizations that were  recently granted exempt status, to determine whether they are now  operating in accordance with their exempt purposes.
section_title: EO May Use Claims Classifiers, Other Classifiers, and Triage Teams to Determine Which Returns Have Examination Potential
paragraphs: Some cases identified through a compliance project may be sent straight  to Case Selection and Delivery, the pool of returns that may be sent for  possible examination (see below). For other cases, an intermediate  research step may or may not be conducted (see above), and the next  step is classification, a review of the examination potential of a return.
Claims Classification. Classifiers apply their experience and technical  expertise to determine whether a claim is allowable by reviewing taxpayer  documentation. With management approval, claims classifiers  recommend processing refunds, credits, or adjustments for claims which  are clearly allowable, as most claims are. Claims that raise questions are  sent for possible examination.
Other Classification. Classification of most non-claims cases is done by  experienced examiners who conduct further research on an organization.  They decide which returns to filter out and which to send forward for  possible examination, based on their professional judgment of the  likelihood of noncompliance and the significance of the identified issues.  Returns are classified by one of two groups, EOCA classification and  Exempt Organizations Examinations classification, depending on how the  case originated and the details of the case. The two groups use different  criteria and procedures, but have similar functions and results;  classification by either group may result in a correspondence  examination, a field examination, or accepting a return as filed and  filtering it out from further review.
Triage Teams. For some EOCA compliance projects, examination  selection decisions are made using project-specific criteria applied by  project-specific teams, called triage teams, instead of through the usual  classification groups. For example, compliance projects that use  questionnaires may have triage teams compare questionnaire responses  with Form 990 data to select organizations for examination. Triage teams  look at the compliance check or compliance review results and apply the  project-specific criteria to determine which returns to filter out, and which  to send forward for possible examination.
section_title: Returns Selected for Potential Examination May or May not Be Sent to Examiners, Depending on Resources
paragraphs: Case Selection and Delivery. After identification of organizations for  possible examination, and after any intermediate research steps and  classification, most returns that are selected for possible examination are  sent to EO’s Case Selection and Delivery unit. (Returns that were  classified by EOCA generally skip this step and may be sent straight to  examination by EOCA examiners.) At Case Selection and Delivery, the  returns become part of a pool of returns that may be sent for examination.  Claims that raise questions (see above) are sent for examination. High- priority and certain other referrals (discussed below) are also sent for  examination, according to EO officials. Aside from these referrals and  claims, decisions are made based on available resources. Different  examinations must be conducted by different grades of examination staff,  depending on the nature of the issues involved and the level of income on  the return; large and complex organizations are examined through EO’s   Additionally, field examinations generally  Team Examination Program.involve in-person contact and so must be conducted in the geographic  area of the exempt organization. Examination offices tell the Case  Selection and Delivery unit the grades of examiners available. The unit  then sends returns to the offices based on those grades and, in the case  of field exams, on the locations of the offices. In fiscal year 2014, 93  percent of returns sent to the Case Selection and Delivery Unit were  ultimately sent to examination offices.
section_title: Examiners and Managers Make the Final Decision on Whether to Conduct an Examination
paragraphs: Dismissals. After selected returns arrive at examination offices,  managers and examiners conduct risk assessments on the returns. They  may choose not to conduct the examinations, if returns seem to pose  limited noncompliance risk or for other reasons. In this report we use the  term “dismissed” to refer to such returns. There were 1,858 returns  dismissed in fiscal year 2014, for reasons summarized in table 4. The  most frequent reason for dismissing a return was that the return was  approaching its statute of limitations; IRS must ensure there is adequate   Other reasons for dismissal included  time to complete the examination.lack of examination potential, and finding no concerns with a claim for a  tax refund. A manager may make the decision to dismiss a return if it has  not yet been assigned to an examiner. Examiners who identify returns  that they believe should be dismissed are required to fill out a form stating  the reason and have that form signed by their manager.
section_title: EO Processes Thousands of Referrals on Potential Noncompliance Each Year
paragraphs: EO has special procedures for processing referrals—complaints of  potential noncompliance of exempt organizations—and selecting  organizations for possible examination based on referrals. Referrals are  the third largest source of EO examinations. EO receives referrals from  many sources. They may originate externally—most commonly from the  general public—or from other IRS divisions that identify potential  noncompliance. Figure 2 summarizes the sources of referrals received in  fiscal year 2014; data from recent years showed similar breakdowns.
Processing referrals involves several steps, depending on the allegation  in the referral or the type of organization involved. Figure 3 summarizes  the steps for different referral types.
Referral classification. EO currently has five classifiers, part of Exempt  Organization Examinations, who sort incoming referrals into basic  categories, based on an initial review of the referral. All referrals are to be  logged into the Referral Database. Referrals are sorted to identify those  that do not involve exempt organizations and therefore should go to other  IRS divisions (misroutes), referrals that do not mention an organization or  a violation of the tax code (“no issue” referrals), and referrals that should  be classified for possible examination. After sorting, EO sends an  acknowledgment letter to the individual who submitted the referral (except  IRS employees).
Each of these classifiers specializes in one or more types of referrals,  such as political activity referrals, and reviews those referrals for  examination potential, according to the EO referrals manager. The  majority of referrals are considered general referrals, meaning that a  single classifier makes a decision about examination potential. For these  referrals, there are no specific criteria for identifying examination  potential. Instead, referrals are classified using the facts and  circumstances of each referral, which involves a classifier using his or her  experience, and all available data on the referral, to determine whether  potential noncompliance exists. Some referrals, such as those originating  with whistleblowers or those pertaining to the Tax Equity and Fiscal  Responsibility Act, have additional steps or criteria for classification. The  classifier is responsible for documenting his or her decision in the Referral  Database, as well as providing an explanation for the decision. According  to the EO referrals manager, this includes mentioning any research  conducted to corroborate the allegation and, for referrals classified as “no  issue,” an explanation of the decision not to pursue.
Referral committees. Referrals that deal with political activity allegations  or what IRS has identified as sensitive allegations or organizations are  also reviewed by a three person committee. The committees are composed of a rotating set of senior examination staff or managers who  make the final decision about examination potential. According to the  Internal Revenue Manual (IRM), committee members should rotate every  12 months on a staggered schedule to maintain continuity and expertise;  volunteers are to be solicited in a memorandum from the Director of  Examination for EO. EO has three types of committees to review  referrals.  1.  Political Activities Referral Committee. Reviews allegations of  potentially noncompliant exempt organization political activities,  including churches. The Political Activities Referral Committee  reviewed 501 referrals in fiscal year 2014.  2.  Church Committee. Reviews referrals concerning churches for  allegations other than political activity.  EO currently has two Church  Committees, which handle the same types of cases. Church and High  Profile Committees (see below) combined reviewed 43 referrals in  fiscal year 2014.  3.  High Profile Committee. Reviews referrals concerning exempt  organizations that have attracted media attention, that have financial  transactions with known or suspected terrorist organizations, or are  referrals from elected officials.
A committee may also review referrals involving other factors, identified  by a classifier, which indicate that committee review is desirable for  reasons of “fairness and integrity,” according to the Referrals Procedures  document.
Each committee member is responsible for reviewing the referral and  providing a determination on examination potential, along with comments,  into the Referral Database. Political activity referrals, and other referrals  as requested, are sent for a compliance review to provide additional  information to committee members to inform their decisions. Referral  committee members are to use the reasonable belief standard as criteria  for examination selection. The outcome for the referral is determined by a  majority, i.e., at least two of the three committee members being in  agreement. This outcome is automatically tallied in the database when  members enter a decision. Committee decisions are considered final and  cannot be overturned, although, as discussed below, church  examinations must go through additional steps before initiation.
Referrals prioritization. For each referral selected for potential  examination in fiscal year 2014, a priority level was assigned that guides  how quickly the referral is sent to the field for examination. For political  activity referrals, the Political Activities Referral Committee determines  whether a political activity referral is high priority or “other,” based on  criteria in the Referrals Procedures document.  All other referrals are  assigned one of seven priority levels. For fiscal year 2014, priority levels  were intended to feed into 16 workload priorities, as laid out in a   These priorities  memorandum from the Director of EO Examinations.guided examination management in deciding which cases to work. EO  management has discontinued the prioritization memoranda, according to  EO officials. Instead, starting with fiscal year 2015, referrals requiring  collaboration with another IRS business division and those dealing with  fraud are considered high priority, and therefore will be examined before  other referrals. The Case Selection and Delivery unit assigns other  referrals to the field based on grade level and location of examination  staff, as described earlier in this report. Referrals that are assigned for  examination may be dismissed if examination management or staff do not  find examination potential, if the return is approaching the statute of  limitations, or for other reasons.
Referral outcomes. Most referrals are not selected for potential  examination; referrals that are selected may not actually become  examinations due to resource constraints, or other considerations,  according to EO officials. Table 5 summarizes referrals processing during  fiscal year 2014.
section_title: Churches Undergo Additional Reviews before Examinations Are Initiated
paragraphs: Statutory requirements must be met before EO can initiate an  examination on a church. Specifically, after determining that there is  reasonable belief (based on facts and circumstances recorded in writing)  that a church may not qualify for exemption, IRS must first issue a Notice  of Inquiry to the church. An inquiry serves as a basis for determining  whether the organization qualifies for exemption as a church, whether it is  engaged in activities subject to tax, or whether an excess benefit  transaction has occurred. If there is a reasonable belief that an inquiry is  necessary—based on facts and circumstances of the case, including  committee review if a referral is involved—then the information is sent to  a designated official, who must be an “appropriate high-level Treasury  official.” Currently, the designated official is the Director, Exempt  Organizations, who must also get concurrence from the TE/GE  Commissioner, according to EO officials. Under the statute, an  “appropriate high-level Treasury official” must reasonably believe that an  inquiry is necessary.
According to the IRM, division counsel and an EO area manager must  review the notice before it can be issued. If a church does not respond  to the inquiry or cannot resolve IRS’s concerns, EO examination staff will  prepare a Notice of Examination and a memorandum on why an  examination is necessary, according to the IRM. Two levels of division  counsel and the designated official must approve the notice. These  statutory procedures are followed for employment tax issues, but do not  apply to routine requests, such as solicitation of a delinquent employment  tax return or information requested to resolve inconsistencies revealed in  the matching program, among other things.
We identified at least 72 referrals on potential political activity in churches in the Referral  Database that were selected for examination by classifiers in fiscal year 2014 and 40 in  fiscal 2013. Although selected by classifiers, these referrals would not necessarily become  examinations, as they would need to follow the notice of inquiry procedures under IRC  §7611. Also, between June 2013 and April 2014, EO suspended examinations on new  political activity issues, while procedures related to political activity examinations were  being reviewed and updated, according to EO officials. That hiatus likely also affected the  number of church exams. official is the Director of EO, who acts in concurrence with the TE/GE  Commissioner.
section_title: Organizations with Complex Financial Transactions May Be Reviewed for Potential Fraud
paragraphs: The Financial Investigations Unit examines exempt organizations that are  selected as a result of projects or queries, or have been identified with  potential indicators of fraud. There were 121 Financial Investigations Unit  examinations of exempt organizations initiated in fiscal year 2014.  Classifiers and examination staff may refer returns to the Financial  Investigations Unit if they believe indicators of fraud or other criteria are  met, as listed in the IRM. form describing the issues and consult with an exempt organizations  fraud specialist. A Fraud Technical Advisor must approve placing the  return in fraud development status. If the Financial Investigations Unit  finds indicators of fraud, the case will be referred to IRS’s Criminal  Investigation division. The Financial Investigations Unit has also provided  classifiers with supplemental criteria to help identify potential fraud.  Classifiers may also refer a return to the Financial Investigations Unit.
IRM Part 25, Chapter 1, Section 2 and IRM Part 4, Chapter 75, Section 21.8.
The Criminal Investigation division is not part of TE/GE, but they do investigate cases  involving exempt organizations.
U.S. Attorney for prosecution, which may lead to an indictment  and eventual trial.
Referrals from U.S. Attorneys, local law enforcement, and  other informants. Criminal Investigation staff conduct preliminary  reviews of the referral, and then develop cases in the same  manner as those originating from EO Examination.
The criteria for moving forward with a prosecution resulting from a referral  are based on the judicial district of the taxpayer. Each U.S. Attorney has  different types of cases or minimum tax revenue loss they are willing to  prosecute; there is no checklist of criteria, according to a senior IRS  analyst working in Criminal Investigations. For example, one region may  prosecute a tax revenue loss of $250,000, while another region may  prosecute a loss of $100,000.
section_title: Design and Implementation of Some Controls Was Adequate; Other Controls Should Be Strengthened to Reduce the Risk of Unfair Examination Selection
paragraphs: We found that the design of certain examination selection controls aligned  with the IRM or with standards for effective internal control (see sidebar  and figure 4). We also found that the implementation of some of these  controls (i.e. the steps used for examination selection) aligned with these  standards. As such, these controls may serve as tools to help EO meet  TE/GE’s mission of applying the tax law with integrity and fairness.  However, we found that other controls were deficient in either their design  or their implementation. These control deficiencies increase the risk that  EO could fall short of TE/GE’s mission and select organizations for  examination in an unfair manner—for example, based on an  organization’s religious, educational, political, or other views. Effective  internal control helps agencies adapt to shifting environments, evolving  demands, and new priorities. As programs change and agencies strive to  improve operational processes and implement new technology,  management should continually evaluate its internal control system so  that it is effective and updated when necessary.
subsections: section_title: Multiple Examination Selection Processes Met Both Design and Implementation Control Standards
paragraphs: We found several examples of examination selection processes that met  design and implementation internal control standards.
Design of Internal Controls. Agency management designs control  activities in response to its objectives and risks to achieve an effective  internal control system. Control activities are the policies, procedures,  techniques, and mechanisms that enforce management directives to  achieve an agency’s objectives and address related risks. Internal control  standards require control activities to be effective and efficient in  accomplishing an agency’s control objective. As part of their control  activities, agencies must ensure that internal controls are clearly  documented. IRS requires primary sources of guidance with an IRS-wide  or division-wide impact—such as policy documents, procedures, and  guidelines—to be included in the IRM. This requirement is intended to  ensure that IRS employees have the approved policy and guidance they  need to carry out their responsibilities in administering the tax laws.
In alignment with IRM requirements, EO maintains well-documented  procedures for several examination selection processes. For example,  EO management has developed IRM sections for referrals classification,  claims processing, Financial Investigations Unit case processing, and  examinations. During our focus groups, employees working closely with  these IRM procedures generally reported they were useful. For  examinations, there were IRM sections on several different types of  examinations and steps in the process, including substitutes for return,  related pickups, the Team Examination Program (used for large and  complex organizations), and church examinations.
In focus groups, we found that staff who use these (and other IRM  sections) to conduct their work generally view them as valuable tools that  help them administer the tax law (see text box).
Selected EO employee focus group participants’ statements  regarding IRM procedures:   “I came off the streets and can read the IRM and understand it.  Kudos to the IRM to the degree that this is my springboard to know  what to do and how to do it.”  “The IRM is excellent, it tells you everything.”  “I go straight to the IRM. It's there to provide fair and consistent  treatment.”
To further align with IRM requirements, EO is working to draft and  implement IRM procedures for testing and adopting 990 analytics  queries.requiring approval to test queries not already listed in EO’s annual   For example, EO will likely formalize its current practice of  workplan, according to one of the draft IRM sections. This new draft IRM  also describes certain development work to be conducted prior to  implementing a query. EO plans for both IRMs to be implemented in the  last quarter of this fiscal year, according to EO officials. Having written  procedures will help ensure that EO is taking action to address internal  control risks. EO’s publishing these procedures in the IRM increases  transparency to the public.
Implementation of Internal Controls. Internal control standards require  that control design be adhered to in practice, known as control  implementation. EO’s control design for examination selection includes  requirements for various types of documentation of examination decisions  and approvals. We found that multiple EO processes successfully  implemented several types of such controls. For example, both EOCA  procedures and referrals procedures require Case Chronology Records— records that track actions taken on a case—and we found that in practice,  100 percent of cases closed in fiscal year 2014 contained Case  Chronology Records.implementation of controls for recording decisions and approvals.
section_title: EO Has Established Key Factor for Building a Positive Control Environment
paragraphs: Internal control standards require that management and employees  establish and maintain an organization-wide environment that sets a  positive and supportive attitude toward internal control and conscientious  management. An agency’s management plays a key role in providing  leadership in this area, especially in setting guidance for proper behavior.  The IRM sets standards of conduct for treating taxpayers fairly, stating  that it is the duty of agency officials to determine the correct amount of tax  owed with strict impartiality as between the government and taxpayer,  and without favoritism or discrimination between taxpayers. It also says  that agency representatives must adhere to the law and recognized  standards of legal construction in making conclusions of fact or  application of the law.who conduct examinations and other reviews consistently equated  fairness with assessing organizations strictly by whether they comply with  tax law and with treating similar types of taxpayers equally. EO  employees’ relatively uniform understanding of fairness and the alignment  of their understanding with the IRM is a significant step toward EO  achieving a positive control environment, the foundation for all other  control standards.
We found in focus groups that EO employees  Selected EO employee focus group participants’ statements  regarding the meaning of fairness:   “(You should) treat everyone alike, it doesn’t matter who filed the  information, it’s what they filed. (You look to see) are they doing the  right activity (as permitted by their tax exempt status), organizing  properly, and capturing transactions accurately. It doesn’t matter the  perspective of an organization. And you should support everything you  do by regulations and code.”  “You should treat each organization in a specific regulation section in  the same manner. If it’s a 501(c)(4), if one organization is allowed to do  something, then they all are—they are treated fairly and equally.”
section_title: Other Controls Needed Improvement or Standards Were Not Followed
paragraphs: We found that while EO had established various procedures over its  examination selection processes, there were several areas where EO’s  controls were not well designed or implemented (see table 6). Taken as a  whole, these control deficiencies increase the risk that EO could select  organizations for examination in an unfair manner—for example, based  on an organization’s religious, educational, political, or other views.
section_title: Deficiencies in Control Design
subsections: section_title: Compliance Check, Compliance Review, and EOCA Classification Procedures Are Not Documented in the IRM as Required
paragraphs: Internal control standards require that controls, and an agency’s  documentation of them, should be properly managed and maintained. As  noted previously, IRS requires primary sources of guidance with an IRS- wide or organizational impact—such as policy documents, procedures,  and guidelines—to be included in the IRM. This requirement is intended  to ensure that IRS employees have the approved policy and guidance  they need to carry out their responsibilities in administering the tax laws.  Moreover, including primary guidance in the IRM fulfills certain legal  requirements. For example, one way IRS complies with the Freedom of  Information Act is by making most IRM guidance available online to the  public.
EO’s primary sources of guidance for compliance checks, compliance  reviews, and EOCA classification are not included in the IRM, as required  by the IRM. In 2008, EO officials drafted high-level descriptions of  compliance checks and compliance reviews for the IRM, but these were  never published. According to EO officials, staffing levels were insufficient  to complete this work. Instead, EO has developed procedure documents  for compliance checks, compliance reviews, and EOCA classification  outside of the IRM. These documents provide instructions to staff about  the required approvals, documentation, and other steps taken as part of  each case selection process. The compliance check and compliance  review processes also have job aid documents with information relevant  to processing cases.
By not complying with agency requirements and standards for internal  control, the internal procedures for compliance checks, compliance  reviews, and EOCA classification are not covered by the same standards  as the IRM. For example, deviations from the IRM are only allowed with  approval by executive management and with appropriate communication  to employees, whereas these standards do not explicitly apply to other  documents. Reliance on procedures that are outside of the IRM creates  the risk that EO staff could deviate from procedures without executive  management approval, which could result in unfair selection of  organizations’ returns for examination. Excluding these procedures from  the IRM also reduces transparency, since they would be available to the  public if they were in the IRM.
section_title: Some Aspects of Procedures for Examination Selection Are Outdated or Inaccurate
paragraphs: Internal control standards require that controls should be documented  and properly managed and maintained. According to the IRM, IRS  program managers are responsible for ensuring that IRM content is  reviewed annually for accuracy and completeness and for analyzing  issues that may necessitate changes. Likewise, supplemental  guidance—such as job aids and desk guides—must be reviewed at least  annually to ensure the content remains accurate.examination selection procedures, including the IRM, contained outdated  and, in some cases, inaccurate material, such as the following examples:
A provision in the IRM for manually selecting returns for the Team  Examination Program, rather than using standardized criteria based  on an organization’s income and assets, is not actually used,  according to EO officials. Further, the IRM requires that a worksheet be completed for returns under consideration for the program. The  worksheet includes a section on factors considered in the examination  selection decision and a section for reviews and signatures. EO  officials stated that the worksheet has not been used since 2012 and  they are currently updating that section of the IRM.
A section on closing dismissed examinations requires that a stamp  with management signatures be placed on original, non-electronic,  returns that are dismissed. However, this requirement is not  implemented consistently—in our file review, we found very few of the  paper files had this stamp—and given the increasing reliance on  electronic copies of returns, this requirement may be becoming less  relevant. Further, EO has another control in place (discussed in  appendix II) which suffices to document management approval for  dismissed returns. EO management said they will use the signatures  on paper returns until all forms can be electronically signed.
A section on requirements for opening an examination of a related  return states that staff should document the manager’s approval to  expand the examination, and a written statement of approval should  be included in the examination file. EO officials told us that  managers approve related pick-ups within the Reporting Compliance  Case Management System (RCCMS), the database EO uses for  tracking examinations, which has replaced the need for written  documentation of approval within the file.
We also found examples of outdated and inaccurate guidance in  procedures documents. Specifically, in the September 2014 Referrals  Procedures document we found the following:
The procedures include criteria for sending a referral to a “High  Priority Committee.” However, there is no High Priority Committee,  according to EO officials. The EO officials described this as a  “typo” and said that all mentions of the High Priority Committee  should be replaced with “High Profile Committee.” This mistake  was also in the previous year’s version of the document.
The procedures include a requirement that subject matter experts  periodically review referrals screened out by the classifier  responsible for political activity referrals to confirm that exclusion  from committee review is appropriate. EO officials stated that this  requirement was originally formulated in 2012, but the reviews  have not been conducted because of a subsequent decision to  send all political activity referrals for committee review.
We provided EO with these, and other, citations of outdated or inaccurate  procedures. The EO Director acknowledged that there are outdated  procedures and IRM sections for EO processes, and that many of these  are the result of changes that have occurred over the past 18 months. EO  officials said they were in the midst of an effort to update outdated and  inaccurate guidance in the IRM and anticipated completing this process  by the end of August 2015. Outdated and inaccurate procedures pose the  risk that employees might follow incorrect procedures and therefore  inconsistently administer tax laws.
section_title: Monitoring to Ensure Case Files Procedures Were Followed Is Not Sufficient
paragraphs: According to internal control standards, controls should generally be  designed to assure that ongoing monitoring occurs in the course of  normal operations. Monitoring involves management assessments of the  design and operating effectiveness of internal control systems. It also  includes ensuring that individual managers and supervisors know their  responsibilities for internal control and the need to make control and  control monitoring part of their regular operating processes. We found  several deficiencies in closed examination and dismissed examination  files, as well as the Referrals, EOCA, and EOCA Classification database  files that did not follow procedures. For example, 4 out of 15 committee  referrals (political activities, churches, and high profile committees) we  reviewed that were selected for examination were missing a required  description of the allegation for the committee. Also, an estimated 22  percent of examination returns that were dismissed in fiscal year 2014 did  not have the required management signature. Taken as a whole, the  deficiencies we found point to insufficient monitoring of case processing.  See appendix II for details on the deficiencies.
For each of the processes above, EO provided information on its  monitoring activities to help ensure that procedures were followed and  that internal controls were operating effectively (see examples in table 7).
The EO referrals manager said that he randomly reviews one referral per month from each of the five  classifiers, and documents the results.  By having multiple reviewers assess certain referrals, the referrals committees also play a role in  ensuring examination selection criteria are applied appropriately.  The EOCA manager said that an analyst conducts quality reviews of a random sample of compliance  checks, although these are not conducted regularly due to limited resources. A review of the EOCA  database showed that out of 61 quality reviews performed for fiscal year 2014, 30 were performed in  the approximately 3-month period between February 3 and May 9, 2014, and 24 were performed in the  month-and-a-half period between June 30 and August 11, 2014. Seven reviews were performed in the  remaining 7-and-a-half months of the fiscal year.  For claims that are dismissed and approved within the Case Selection and Delivery group, the  manager said she conducts a review for the required forms and of claim dollar amounts to ensure the  correct claim amount is in RCCMS.  EO has procedures that require mandatory reviews of certain examinations, such as those of church  tax audits and revocations, to ensure technical and procedural accuracy. EO also has procedures for  conducting quality reviews on a sample of cases to evaluate the managerial, technical, and procedural  aspects of examination cases. While these reviews span many issues, many unrelated to examination  selection processes, certain procedural issues related to examination selection may be assessed, such  as whether prior year, subsequent year, or related returns were included in the examination where  warranted.
In spite of these monitoring activities, we found that EO employees were  not always following documentation requirements for select EO  examination selection procedures. As such, the current level of ongoing  monitoring of examination and database files to ensure that selection  decisions are documented and approved, to help ensure fairness, is  inadequate. Additional monitoring may help management further evaluate  EO’s internal control system and make changes to ensure staff are  consistently following procedures.
section_title: IRS’s Process for Tracking and Maintaining Closed Case Files is Inadequate
paragraphs: Internal control standards require that files be readily available for review  and properly managed and maintained. The IRM also states that all  records are required to be efficiently managed until final disposition. Yet  IRS was not able to locate all of the examination files we requested for  review in a timely way. Based on our estimates, 13 percent of the  closed examination files could not be located in time for us to review them  during the audit. Specifically, IRS could not locate the files until June  2015, whereas we submitted our original request for the files in early  February 2015.
Initially EO officials said the IRS unit that stores the files was unable to  locate some of the files. More specifically, EO was told that the unit was  unable to locate 3 of 13 of these files’ blocks—group of files with  consecutive control numbers. This can mean that the block was not  created or it was shelved in the wrong location. Other files showed as  checked out by IRS staff and not returned to their proper file location. At  the end of our audit, IRS located 10 of the missing files after undertaking  a specific search for the files. However, the length of time it took to locate  these files—nearly 4 months—shows that IRS’s process does not ensure  that all files are readily available for review.
According to EO officials, missing claims files are generally due to the  difficulties of working with paper files. Missing case files can result in lost  revenue to the federal government (if a case goes to court), create  unnecessary taxpayer burden (if EO later needs to contact the taxpayer  regarding material that would have been in the file), make cases  unavailable for other units such as quality review groups or advisory  groups, and hinder congressional oversight.
section_title: EO Lacked Clearly Documented Selection Criteria for Some Projects and Controls for Certain Project Activities
paragraphs: Internal control standards require that internal controls and all  transactions and significant events need to be clearly documented, and  that all documentation and records should be properly managed and  maintained. EO projects must adhere to certain requirements as they are  developed, and these requirements can vary depending on the type of  project. All project teams are required to develop project-specific  procedures. For projects not associated with Form 990 analytics queries,  project teams are required to obtain managerial approval of a proposal.  The project proposal should contain, among other things, a description of  the project objectives, the criteria to be used to select returns, and the  signatures of EO executives and select functional directors. Other  requirements depend on whether the cases selected for review are sent  directly for field examination, or whether the cases are subject to an  intermediate step like a compliance check or compliance review, or an  examination through the office/correspondence examination program.  The documents associated with a project—such as the proposal,  procedures, selection criteria, and training materials—are maintained by  the project team leader.
We identified select areas where project documentation could be  improved. Our review of 11 project files found that some project  requirements were not always met:
For one project in our sample, EO officials were unable to provide any  documentation to support the project requirements we assessed in  our project file review, including an approved project proposal.
Of the seven projects requiring a project proposal—specifically, those  projects not associated with 990 analytics queries—we found that  none of the project proposals fully described the criteria to be used for  the project, including the one project missing documentation. For  example, three project proposals described that a judgmental (non- probability) sample would be used but the judgmental sample was not  fully described. One of these projects’ proposals listed criteria for its  first phase, conducted several years ago, but did not reflect selection  criteria for a subsequent phase of the project. There was a  memorandum in the file describing selection criteria for the more  recent phase, but no documented management approval. Another  project proposal described how the original sample of cases for which  compliance reviews would be conducted was to be pulled, but not  how information gathered during the compliance reviews would be  used to select cases for examination. EO officials told us that when  criteria are added or changed for a project, executives may be briefed  and any briefing documents should be included in the project file.  However, of the seven projects with incomplete criteria, we only found  one file with an executive briefing document describing selection  criteria. Two other projects had memoranda in the file describing  selection criteria but lacked evidence of executive review or approval.
EO officials told us about improvements they had made to project controls  over the past few years. For example, EO officials told us that over the  past year they increased efforts to reorganize how project file  documentation is stored to help ensure consistency across projects.  Likewise, projects using a compliance review or using the  office/correspondence examination program had an added control  developed toward the end of fiscal year 2013—a document capturing the  date on which certain control activities were performed and the individual   Yet these and other improvements do not  responsible for each activity.address the need to fully describe selection criteria in a project proposal,  or document executive briefings and approvals when criteria are added or  changed. With project proposals lacking clear selection criteria, EO  management risks the potential of projects selecting organizations for  review in an unfair manner.
According to internal control standards, procedures that enforce  management directives help ensure that management directives are  carried out. Yet EO does not have procedures describing the steps or  requirements for triage teams—project team members responsible for  deciding which organizations will be examined—when making or  documenting examination selection decisions in the project files. Specifically, there is no procedure requiring that triage teams document  the specific selection criteria they use to identify organizations for  examination. While broad selection criteria are generally described in the  project proposal, the triage team may apply additional criteria to filter out  cases and align with available resources for working examinations. EO  officials told us that these selection criteria decisions would generally be  documented in meeting minutes or elsewhere in the project files. Of the  two projects using triage teams with closed examinations in fiscal year  2014, one project had dozens of files in the meeting minutes project  folder, making it difficult to assess documentation of selection criteria,  while the other project was missing documentation altogether.
Triage teams are composed of subject matter experts, including project leads, analysts,  and managers. They review the results of compliance checks or compliance reviews and,  using their professional knowledge and expertise, apply project-specific criteria to make  selection decisions. year 2014, the same project as mentioned above was missing project file  documentation altogether. The other project had several spreadsheets  that tracked examination selection decisions, but it was not always clear  which organizations had been selected. More than 2,000 of the  compliance checks and compliance reviews conducted in fiscal year 2014  were, or will be, subject to triage team review. Having procedures to  ensure triage teams documenting selection criteria and decisions clearly  and consistently will help EO ensure that management directives are  consistently followed and that examination selection decisions are made  fairly.
Internal control standards also state that program managers need  operational data to determine whether they are meeting their agencies’  strategic and annual performance plans and meeting their goals for  accountability for effective and efficient use of resources. We did not  review the project files for 2 of the 13 projects in our sample because EO  officials told us that these projects were not active in fiscal year 2014.  Although no examinations should have been conducted as part of these  older projects, we found 156 closed examinations attributed to them in the  Returns Inventory and Classification System (RICS) database. For one  project, EO officials said that the majority of the project work was  conducted between 2006 and 2008 and that the project was concluded by  2009. EO officials said it was likely that EO examination staff miscoded  these examinations, and that this is more likely to happen when an  examination is associated with a newer project of a similar name. EO  uses data on closed examinations, by project, to track performance  against workplan goals. Without adequate controls to ensure that  examinations are appropriately coded—for example, by ensuring that  project codes for closed projects without anticipated future examinations  are not utilized by staff—EO management may not have the information it  needs to ensure the efficient and effective use of resources.
section_title: Deficiencies in Control Implementation
subsections: section_title: EO Lacks Complete Data Dictionaries for Examination Selection Databases
paragraphs: The IRM states that all data elements in IRS databases should be defined  and documented as part of the database design process. However, EO  does not have complete and up-to-date data dictionaries—documents  that define each data element in an information system—for the systems  it uses to track and document examination selection decisions. EO does  not have a data dictionary for the Reporting Compliance Case  Management System (RCCMS)—which EO uses for tracking  examinations and will use for additional selection purposes in the future— nor for the EOCA or EOCA classification databases. EO’s data  dictionary for the referrals database is incomplete, as it defines fewer than  half of the data elements in the database. In addition, EO has an outdated  data dictionary for RICS, which it uses to identify populations of cases for  review. For all of these systems, EO describes selected data elements  and how they are to be used in procedure, training, or other documents.  For example, EOCA procedure and job aid documents define several  codes used in the EOCA database and define common data elements  from the database.
EO officials cited various reasons for not having data dictionaries or for  having outdated dictionaries. For RCCMS, EO officials said they use as  their data dictionary a document which lists the data elements within each  data table. The document shows the relationships between data  elements, but does not contain a description of each data element.  Officials overseeing the EOCA and EOCA classification databases said  they did not have adequate resources to develop this type of  documentation, and also that data elements are already defined in other  documents. The manager overseeing the referrals database said that  the database predates his tenure, but fields have been added over the  years, particularly in response to audits conducted by the Treasury  Inspector General of Tax Administration. Finally, EO officials said the  RICS data dictionary is outdated due to lack of staffing and because  documents listing transcribed lines from Form 990 filings, which are used  by staff to develop examination selection queries, were kept up to date  instead.
Without complete and up-to-date data dictionaries, data element  definitions are not available in a single document for individuals newly  using the system, including EO employees and system developers. Also,  since data dictionaries assist users and developers with understanding  these databases, not having an adequate and up-to-date dictionary may  result in an increased risk of data elements not being used accurately. To  illustrate, the referrals database has certain obsolete data elements used  to document decisions when procedures were different, yet we found that  individuals were sometimes still entering information into these fields.
section_title: EO Lacks Required Privacy Impact Assessments for Some Examination Selection Databases
paragraphs: The E-Government Act of 2002 requires agencies to conduct a Privacy  Impact Assessment before developing or procuring information  technology systems or projects that collect, maintain, or disseminate  information about members of the public or initiating a new electronic  collection of information for 10 or more persons. EO has not conducted  Privacy Impact Assessments for three of its databases used in  examination selection processes—specifically, the referrals, EOCA, and  EOCA classification databases. These systems house thousands of  records describing reviews conducted on exempt organizations, including  organizations’ names, Employer Identification Numbers, and other  taxpayer information.
We were initially told that the Tax Exempt and Government Entities  (TE/GE) division does not consider the databases to be systems, and  therefore they were not covered by requirements in the E-Government  Act. However, in responding to our subsequent questions on the subject,  IRS Chief Counsel stated that these databases likely fall within the  purview of the Act. Accordingly, in early April, EO officials began to  evaluate whether the databases require a Privacy Impact Assessment  with IRS’s Office of Privacy, Governmental Liaison, and Disclosure  (henceforth, the Privacy Office). This evaluation involved TE/GE  responding to a questionnaire and the Privacy Office assessing these  responses to determine whether Privacy Impact Assessments are  necessary to comply with E-Government Act requirements. As a result of the assessment, the Privacy Office determined that Privacy Impact  Assessments were required for each of these three systems. According to  a Privacy Office official, creating a final approved Privacy Impact  Assessment can take 1 to 3 months.
section_title: Only One Classifier Reviews Each Type of Referral, Risking Potential Perception of Unfairness and Succession Planning Problems
paragraphs: Internal control standards require that key duties and responsibilities be  divided or segregated among different people to reduce the risk of error  and to achieve organizational goals. Referrals classification divides work  among its five classifiers based on expertise for a particular type of  referral. One classifier is responsible for each of the following area(s):  1.  Fraud and terrorism referrals, and referrals that request  collaboration with another IRS division.  2.  Political activity referrals.  3.  Tax Equity and Fiscal Responsibility Act and state referrals.  4.  Employee status, whistleblower, and international referrals.
5.  High profile and church committee referrals.
In addition, each classifier, except for the individual responsible for  political activity referrals, also reviews general referrals, which are  referrals that do not fit into these categories. The classifiers review the  referrals they are responsible for and make classification determinations.  Each classifier has several years of experience and some have received  specialized training to work with the types of referrals under his or her  specialty. Aside from general referrals, classifiers are not cross-trained on  referral specialties, according to the EO referrals manager.
The specialization of the classifiers allows for in-depth knowledge of  complex issues and for the opportunity to apply experience; however,  internal control risks accompany this approach. First, for political activity,  church, and high profile referrals, the classifier appears to serve as an  initial gatekeeper for determining whether a referral is reviewed by a  committee. Although committee reviews are intended as a safeguard  against unfairness in the examination selection process, referrals that do  not make it past the classifier do not undergo committee review. For  example, according to the EO referrals manager, all political activity  referrals are supposed to go to the Political Activities Referral Committee  to ensure that they receive the benefits of committee review. However,  the political activity referrals classifier exercises some judgment in  determining which referrals are categorized as political activity referrals.  Further, in our review of the Referrals Database, we found that about 5  percent of political activity referrals classified in fiscal year 2014 were not  reviewed by the committee. The classifier for the high profile and church  referrals has more discretion in deciding which referrals go to the  committee. In our database review, we found that about 91 percent of  these referrals were not reviewed by the committee. According to the EO  referrals manager, this is often because they did not contain enough  information or did not deal with tax issues (known as “no issue”  referrals). These numbers highlight the extent to which classifiers make  decisions outside of the committee review process.
According to internal control standards, key duties and responsibilities  should be divided or segregated among different people to reduce the risk  of error. Spreading classification responsibilities for sensitive referrals to  more than one classifier could help decrease the potential influence of  any one classifier. Even if other safeguards are in place, having the same  individual initially classify all political activity or all high profile and church  referrals creates the potential for unfairness, particularly for referrals that  the classifier labels as “no issue” and therefore are not sent for committee  review.
The lack of cross-training among the classifiers also creates concerns  about succession planning. For example, three of the five classifiers are  eligible for retirement, according to the EO referrals manager. Internal  control standards require that management should ensure that skill needs  are continually assessed and that the organization is able to obtain a  workforce that has the required skills that match those necessary to  achieve organizational goals. As a part of its human capital planning,  management should also consider how best to retain valuable  employees, plan for their eventual succession, and ensure continuity of  needed skills and abilities. The EO referrals manager agreed that they  should have a succession plan, but said that they are working with a  “bare bones” staff and do not have the resources to take time away from  current classifiers’ duties for training. TE/GE executives agreed that  cross-training classifiers is ideal, but also stated that it is currently not  feasible given existing resources. However, without cross-training or  provisions for succession planning, EO is risking its ability to process  referrals upon the departure of one of its classifiers. It is inevitable that  classifiers will eventually need to be replaced. By completing some cross- training ahead of those departures, referrals classification could benefit  from overlapping specialties and spreading responsibility for classifying  sensitive referrals to reduce the potential for error and potential  unfairness.
section_title: Referral Committee Membership is Not Rotating as Required
paragraphs: According to internal control standards, procedures that enforce  management directives, such as IRM requirements on the rotation of  staff, help ensure that management directives are carried out.  Management should also design and implement internal controls based  on the related costs and benefits. The IRM requires that committee  members rotate every 12 months, on a staggered schedule.
The members of the referral review committees are not rotating every 12  months. Based on start dates for committee members provided by EO  and our database review, we found 87 percent of current committee  members were serving for more than a 12 month period, as of April 30,  2015. Specifically, current committee members who exceeded their 12-month tenures have been serving on the committees for an average of 34  months (see table 8). In addition, although not reflected in this table,  some committee members may have served on another committee prior  to their current term, according to the EO referrals manager. Our  database review showed that some committee members have served on  committees since 2009.
Rotating staff may help ensure that a variety of staff serve on the  committees, which serve as a safeguard in the classification of political  activity and sensitive referrals. If the required committee rotation serves  as an internal control to address risks in the referrals examination  selection process, then by not following its procedures, EO has the  potential to fall short of its goal of fairness.
Committee member volunteers are to be senior EO technical employees,  and should be solicited in an annual memorandum from the Director of  EO Examinations, according to the IRM. EO did not have records of an  issued memorandum soliciting volunteers, although all of the current  members are volunteers, according to an EO official. The EO referrals  manager told us that it is difficult to get volunteers because of the  potentially high volume of work, particularly for political activity referrals,  and the difficulty providing prospective committee members with an  estimate of the time commitment required. However, by not utilizing all  avenues for soliciting volunteers—such as the memorandum from the  Director of EO Examinations—EO is not reaching the pool of potential  volunteers and maximizing opportunities to rotate committee members.
Yet management should also design and implement internal controls  based on the related costs and benefits. The current committee members  have likely developed an expertise in assessing these cases, and training  new members may require additional resources. Although a provision for  rotations is consistent with internal controls, it is possible that a rotation of  more than 12 months may suffice. If EO believes that to be the case, it  could revise the IRM accordingly.
section_title: Conclusions
paragraphs: The Exempt Organizations unit (EO) is faced with the challenging task of  overseeing the diverse population of exempt organizations and enforcing  their compliance with the tax laws. EO’s reliance on a variety of sources  and processes to select organizations’ returns for examination  underscores the importance of it having a robust internal control system  to ensure selection fairness and integrity, in accordance with the Tax  Exempt and Government Entities (TE/GE) division’s mission. EO has  some controls in place that are consistent with internal control standards,  and has implemented some of these controls successfully. However,  there are several areas where EO’s control system could be  strengthened, as noted by the control deficiencies identified in this report.  Many of these deficiencies pose a risk that could lead to returns being  selected, or not selected, for examination based on criteria or practices  that fall short of TE/GE’s mission of ensuring fairness and integrity. For  example, internal controls monitoring is one way to help reduce risk, but  without consistent monitoring, there is the possibility returns could be  selected for unfair reasons.
Control design improvements. To reduce the risk of returns being  selected unfairly, EO could make several improvements to its  examination selection control design. Formalizing additional procedures  in the Internal Revenue Manual (IRM) would ensure coverage using  standards that dictate when deviations from selection procedures are  appropriate, and would increase transparency. Ensuring that all  procedures are current and accurate would reduce the risk of employees  following incorrect procedures and administering tax laws inconsistently.  Enhancing both the monitoring of database files used to document  examination selection decisions and monitoring the content of  examination files would increase EO management’s ability to address and  rectify problems such as missing signatures, errors in applying criteria,  and inappropriate justifications for case selection or dismissals—each of  which might result in case selection decisions inconsistent with TE/GE’s  mission. Improving tracking of closed examination files would have  multiple benefits, including facilitating congressional oversight. More  consistent documentation and approval of criteria in EO’s project files  would reduce the risk that inappropriate selection criteria could be  developed. Finally, more accurate coding of examinations would reduce  the risk of ineffective or inefficient resource allocation decisions for  compliance activities.
Control implementation improvements. EO could also make several  improvements to control implementation that would reduce the risk of  returns being selected unfairly. Maintaining up-to-date EO database  documentation of data element definitions used to track case selection  would reduce the risk of inaccurate use of data elements. Additionally, EO  has the opportunity to provide cross-training for referrals classifiers and to  quickly benefit from their resulting skills enhancements. This would allow  shared responsibility for reviewing political activity and sensitive referrals,  and also could reduce the potential for unfairness. Providing training for  classifiers currently onboard, rather than waiting until a classifier departs  and it becomes a necessity, would help preempt a significant void of  knowledge and an increased backlog of work. Finally, rotating the staff  who serve on referral review committees would help ensure that a variety  of staff serve on committees, providing a safeguard for maintaining  fairness and objectivity in the classification of political activity and  sensitive referrals.
section_title: Recommendations
paragraphs: To better ensure the Exempt Organization (EO) unit’s adherence to the  Tax Exempt and Government Entities (TE/GE) division’s mission of  “applying the tax law with integrity and fairness to all” in selecting exempt  organizations to review or examine, we recommend that the  Commissioner of Internal Revenue direct EO to take the following nine  actions:  1.  Complete the development and formally issue the Internal  Revenue (IRM) sections on compliance checks and compliance  reviews, and develop and formally issue an IRM section on  Exempt Organization Compliance Area (EOCA) classification.  2.  Develop, document, and implement a process to ensure that  Internal Revenue Manual (IRM) sections and other procedures are  reviewed and updated annually, and that updates reflect current  practice, as required.  3.  Develop, document, and implement additional monitoring  procedures in order to ensure case selection controls, including  ensuring that procedures for obtaining required signatures and  documenting explanations for selection decisions, are being  followed.  4.  Develop, document, and implement procedures to ensure that all  criteria or methods used in projects to select returns for  examination are consistently documented and approved, including  procedures related to documenting changes that occur during the  course of a project, or new phases of a project.  5.  Develop, document, and implement procedures for examination  selection done by triage teams, including a process to consistently  document selection criteria and triage team examination selection  decisions.  6.  Determine what additional controls may be needed to ensure  examinations related to projects are properly coded.  7.  For the databases EO uses during examination selection,  develop complete and up to date data dictionaries to define data  elements used in the databases.  8.  Provide cross-training for referrals classifiers, prioritizing training  for classifiers who work with political activity, high profile, and  church referrals; and develop, document, and implement a  system to ensure that those referrals are not always reviewed by  the same classifier.  9.  Ensure that referral committee members rotate every 12 months  by soliciting volunteers. If EO does not believe that 12 months is  an appropriate rotation length, then the Internal Revenue Manual  (IRM) should be revised to require an alternative rotation  schedule.
In addition, we recommend that the Commissioner of Internal Revenue  take the following action:  1.  Determine what additional controls may be needed to ensure that  all closed examination files are tracked and maintained  accurately.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to IRS for review and comment. In its  written comments, reproduced in appendix III, IRS generally agreed with  our findings and recommendations. In its comments, IRS described the  steps it plans to take to implement the recommendations. IRS also  provided technical comments, which we incorporated where appropriate.
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section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: This report (1) describes the processes for selecting tax-exempt  organizations for examination, and (2) assesses the adequacy of the  controls (including procedures) for selecting examination cases that the  Exempt Organizations (EO) unit uses to achieve the Tax Exempt and  Government Entities (TE/GE) division’s stated mission of “applying the  tax law with integrity and fairness to all.”
For the first objective, we reviewed Internal Revenue Service (IRS)  documents that describe the processes and criteria for selecting exempt  organization returns for examination. These documents included sections  of the Internal Revenue Manual (IRM), procedures documents, training  documents, worksheets for reviewing files, and summaries of selection  processes prepared by EO officials. We also interviewed IRS officials  responsible for overseeing examination selection. In addition, we  obtained data from the following IRS databases: Returns Inventory and  Classification System (RICS), Referral database, Exempt Organizations  Compliance Area (EOCA) database, and EOCA Classification database.  The databases contain information on initiated and closed examinations,  classification of referrals, and compliance reviews and compliance  checks. Based on our testing of the data and review of documentation  and interviews, we determined that these data were reliable for the  purposes of this report.
IRM, Part 1, Chapter 1, Section 23.
In  two focus groups of selected EO staff who conduct examinations.total, our groups involved 41 participants with an average of about 17  years of IRS experience, with a range from 8 months to 37 years of  experience. The focus groups were held at IRS offices in Ogden, Utah;  Dallas; and Atlanta. We asked questions on internal control related topics,  such as the clarity of EO procedures and the adequacy of training to  apply these procedures. We used NVivo qualitative data analysis  software to conduct a content analysis of themes from the focus groups.
To assess how well EO implemented its procedures and applied  examination selection criteria, we used IRM sections, EO procedures  documents, and other documents as criteria. We reviewed the  populations of cases or referrals closed during fiscal year 2014 in the  Referral, EOCA, and EOCA Classification databases.populations, we looked for completeness of required fields used in  conducting research or selecting returns for examination. For our  population-level analyses, we considered any control with a non- adherence rate greater than 5 percent to be ineffective. We also selected  random probability samples of the database files to review required text,  such as justifications for selecting or not selecting a return for    Within the  examination or review. Finally, we selected random probability samples of  dismissed examination files, and closed examination files from processes  described earlier in this report.samples we reviewed.
section_title: Appendix II: Effectiveness of Procedural Control Implementation for Selection Decisions and Approvals
paragraphs: The Exempt Organizations (EO) unit has procedures in place to  document multiple types of examination selection decisions and  approvals. Internal control standards state that control activities such as  these procedures help ensure that management directives are carried  out. Table 10 summarizes our findings on the effectiveness of  implementation of the procedures, using a tolerable error rate of 5 percent  (meaning that up to 5 percent of cases could fail to adhere to a  procedure, and the procedure would still be considered effective). We  found that some procedures were implemented successfully, and some  were not. For some procedures, we were unable to obtain sufficient  information to make a conclusive determination about whether  implementation was successful. See appendix I for more details on our  sampling methodology.
section_title: Appendix III: Comments from the Internal Revenue Service
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Jeff Arkin, Assistant Director;  Carl Barden; Jehan Chase; Deirdre Duffy; Ted Hu; Laurie C. King;  Meredith Moles; Jessica Nierenberg; Neil Pinney; Amy Radovich; Robert  Robinson; Cynthia Saunders; Albert Sim; Lindsay Swenson; and James  R. White made major contributions to this report.
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