IRS Examination Selection: Internal Controls for Exempt Organization Selection Should Be Strengthened
Released: 2015-07-23T00:00:00

Letter

Background

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.

EO Process for Selecting Exempt Organizations for Examination

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.

EO Identifies Groups of Organizations with Characteristics That Pose Noncompliance Risks

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.

Referrals Identify Particular Organizations that May Be Noncompliant

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.

Some Examinations Are Conducted for Other IRS Divisions, and Some Are Used for Training

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.

Most Claims Are Allowed in Full, but Some Lead to Examinations

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.

EO Identifies Some Organizations to Examine Based on Other Examinations

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.

EO Conducts Research on Some Organizations as Part of the Selection Process

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.

EO May Use Claims Classifiers, Other Classifiers, and Triage Teams to Determine Which Returns Have Examination Potential

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.

Returns Selected for Potential Examination May or May not Be Sent to Examiners, Depending on Resources

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.

Examiners and Managers Make the Final Decision on Whether to Conduct an Examination

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.

EO Processes Thousands of Referrals on Potential Noncompliance Each Year

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.

Churches Undergo Additional Reviews before Examinations Are Initiated

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.

Organizations with Complex Financial Transactions May Be Reviewed for Potential Fraud

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.

Design and Implementation of Some Controls Was Adequate; Other Controls Should Be Strengthened to Reduce the Risk of Unfair Examination Selection

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.

Multiple Examination Selection Processes Met Both Design and Implementation Control Standards

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.

EO Has Established Key Factor for Building a Positive Control Environment

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.”

Other Controls Needed Improvement or Standards Were Not Followed

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.

Deficiencies in Control Design

Compliance Check, Compliance Review, and EOCA Classification Procedures Are Not Documented in the IRM as Required

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.

Some Aspects of Procedures for Examination Selection Are Outdated or Inaccurate

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.

Monitoring to Ensure Case Files Procedures Were Followed Is Not Sufficient

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.

IRS’s Process for Tracking and Maintaining Closed Case Files is Inadequate

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.

EO Lacked Clearly Documented Selection Criteria for Some Projects and Controls for Certain Project Activities

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.

Deficiencies in Control Implementation

EO Lacks Complete Data Dictionaries for Examination Selection Databases

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.

EO Lacks Required Privacy Impact Assessments for Some Examination Selection Databases

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.

Only One Classifier Reviews Each Type of Referral, Risking Potential Perception of Unfairness and Succession Planning Problems

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.

Referral Committee Membership is Not Rotating as Required

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.

Conclusions

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.

Recommendations

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.

Agency Comments and Our Evaluation

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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If you or your staff has any questions about this report, please contact us at (202) 512-9110 or mctiguej@gao.gov. Contact points for our offices of Congressional Relations and Public Affairs are on the last page of this report. GAO staff members who made major contributions to this report are listed in appendix IV.

Appendix I: Objectives, Scope, and Methodology

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.

Appendix II: Effectiveness of Procedural Control Implementation for Selection Decisions and Approvals

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.

Appendix III: Comments from the Internal Revenue Service

Appendix IV: GAO Contact and Staff Acknowledgments

Contact

Staff Acknowledgments

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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