Tax-Law Enforcement: IRS Could Better Leverage Existing Data to Identify Abusive Schemes Involving Tax-Exempt Entities

Abusive tax schemes contribute to the tax gap and threaten the tax system's integrity. When abusive tax schemes involve tax-exempt entities, they also can erode the public's confidence in the charitable sector.

GAO was asked to review what is known about abusive transactions involving tax-exempt entities and how IRS addresses them. This report, among other things, (1) describes ways in which taxpayers have abused an entity's tax-exempt status; (2) examines trends in IRS's compliance efforts; and (3) assesses how IRS identifies emerging abusive tax schemes involving tax-exempt entities.

GAO reviewed research on tax schemes involving tax-exempt entities, and interviewed relevant professionals and researchers about tax schemes involving tax-exempt entities; compiled statistics from IRS audit and disclosure data; and compared documentation and testimony from IRS officials on IRS programs and guidance from its operating divisions with certain internal control and GAO fraud framework criteria.

Taxpayers have used a variety of abusive tax schemes involving tax-exempt entities. In some schemes, the tax-exempt entity is complicit in the scheme, while in others it is not. For example, an abusive tax scheme could involve multiple donors grossly overvaluing charitable contributions, where the tax-exempt entity is not part of the scheme. Conversely, some patient assistance programs—which can help patients obtain medical care or medications—have been used by pharmaceutical manufacturers to make charitable donations that can be viewed as furthering private interests.

Internal Revenue Service (IRS) audits of abusive tax schemes are trending downward, as the figure below shows audits by IRS's Large Business and International division. This trend has occurred amid generally declining IRS resources and corresponds with an overall decrease in audit activity by IRS over recent years.

IRS has a variety of programs working collectively to identify abusive tax schemes involving tax-exempt entities, but some internal control weaknesses exist in its approach. For example, GAO found three ways that IRS data or programs were inconsistent with internal control standards for using quality information. First, database project codes used for identifying data on abusive tax schemes are not linked across IRS's audit divisions and do not consistently identify whether a tax-exempt entity was involved. Second, IRS has not leveraged a database with cross-divisional information to facilitate its analysis and monitoring of audit data across divisions. Finally, IRS has not used existing analytic tools to mine the narrative fields of tax forms. Doing so could provide audit leads on abusive schemes involving tax-exempt entities. These deficiencies inhibit IRS's ability to identify abusive tax schemes and develop responses to those schemes.

GAO is making five recommendations to IRS to strengthen its internal controls, including that it link data across operating divisions, test the ability of a database to facilitate analysis of audit data, and use existing analytic tools to further mine information on tax forms. In commenting on a draft of this report, IRS agreed with all of GAO's recommendations.

Abusive tax schemes used as attempts to evade tax liabilities can be  highly technical tax shelters engineered and marketed by firms. These  schemes threaten our tax system’s integrity and fairness when taxpayers  believe that individuals and businesses are not paying their fair share of  taxes. Abusive tax schemes also contribute to the tax gap, which refers  to the difference between the taxes people and businesses owe, and  what they annually pay voluntarily and on time in the United States. In  2016, the Internal Revenue Service (IRS) estimated the average annual  gross tax gap for tax years 2008 through 2010 to be $458 billion. After  taking into account its enforcement activities and late payments, IRS  calculated that the average net tax gap was $406 billion per year.

When tax-exempt entities such as charities are involved, abusive tax  schemes are even more disruptive, as they also erode the public’s  confidence in the integrity of the charitable sector. This sector included  about 1.3 million religious, charitable, and similar organizations operating  in the United States during fiscal year 2017. Researchers estimated that  giving to charitable organizations totaled $410 billion in 2017 or about 2  percent of the U.S. gross domestic product. Exempt organizations,  including charities, are afforded favorable tax treatment on the premise  that they are organized in accordance with their tax-exempt purpose,  according to IRS. Because of their exemption from federal income tax  and the deductibility of charitable contributions made to them, 501(c)(3)  entities are sometimes used as vehicles to conduct inappropriate  schemes. Consequently, IRS must work to identify and address new  abusive tax schemes involving charities and other types of tax-exempt  entities.

You asked us to review what is known about abusive tax schemes  involving tax-exempt entities and how IRS addresses these schemes.  This report (1) describes ways in which taxpayers have abused an entity’s  tax exempt status through abusive tax schemes; (2) examines trends in  IRS’s compliance efforts and characteristics of taxpayers audited for  using abusive tax schemes involving tax-exempt entities; and (3)  assesses how well IRS identifies emerging abusive tax schemes involving  tax-exempt organizations and what improvements it could make, if any, to  that process.

To describe ways in which taxpayers have abused the tax status of a tax- exempt entity, we reviewed research on noncompliance involving tax- exempt entities and IRS documentation on abusive tax schemes that  could involve tax-exempt entities. We also conducted interviews with  knowledgeable tax, accounting and legal professionals; relevant  researchers; and former IRS officials about schemes that involve tax- exempt entities. Based on the documentation and interviews, we selected  for description in our report three examples of ways tax abusers can  exploit an entity’s tax-exempt status. We selected the three examples  because they represented how abusive schemes generally involved tax- exempt entities; there was documentation on the scheme; there was  evidence that the scheme had been carried out recently; and that the  schemes were shown to have had an effect on taxation.

To examine trends in IRS’s compliance efforts and the characteristics of  taxpayers audited for abusive tax schemes involving tax-exempt entities,  we collected data from the following IRS business operating divisions  (operating divisions) that conduct audits on abusive transactions: (1) Tax  Exempt and Government Entities (TE/GE), (2) Small Business/Self- Employed (SB/SE), and (3) Large Business and International (LB&I). We  received data extracts from the following computer data systems: (1)  TE/GE’s Returns Inventory and Classification System; (2) the Automated  Information Management System—Centralized Information System,  utilized by SB/SE and LB&I; and (3) the Compliance Data Warehouse  used by SB/SE and LB&I. We reviewed documentation on the data,  discussed the data with IRS officials, and conducted electronic reliability  testing; for example, we verified the completeness of analysis variables  and the date ranges for our analysis. Based on our review, we  determined the data were sufficiently reliable for showing trends in IRS’s  compliance efforts. We identified audits with potential tax exempt entities  by selecting audits based on IRS project codes that IRS agreed were  relevant. We also matched the SB/SE and LB&I data with IRS’s Form  8886 data file that identified tax-exempt entities. We used these data to  produce descriptive statistics on audit and taxpayer characteristics, and  IRS compliance efforts for 2008 through 2017. Dollar amounts reported  have been adjusted for inflation in 2018 dollars. Additionally, we found  that IRS had the capability to do Python optical character recognition  analysis of the text fields on IRS Form 8886. We requested that IRS  conduct and provide the results of an optical character recognition  analysis to show how this capability could be used. IRS ran the analysis  using keywords associated with 29 different tax exempt organizations that  we identified, such as “charity” and “foundation,” which are terms found in  26 U.S.C. § 501.

To assess how IRS identifies emerging abusive tax schemes and to  identify potential improvements, we first identified relevant IRS programs,  procedures and activities through interviews with IRS officials and reviews  of documentation, including the Internal Revenue Manual and our  previous reports. We selected criteria appropriate for assessing the  programs, procedures, and activities and confirmed the appropriateness  of these criteria with IRS. These criteria primarily came from Standards  for Internal Control in the Federal Government and A Framework for  Managing Fraud Risks in Federal Programs. We then applied these  criteria to IRS’s programs and enforcement activities that we had  identified. More detailed information on our scope and methodology  appears in appendix I, including a full list of the selected criteria we used.

We conducted this performance audit from February 2018 to September  2019 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.

Section 501 of the Internal Revenue Code provides for tax-exempt status  of certain corporations, trusts, and other organizations. This status  allows qualifying organizations to claim exemption from federal income  taxes. Subsection (c) of section 501 recognizes 28 categories of tax- exempt organizations, ranging from cemetery companies to  multiemployer pension plan trusts. Section 501(c)(3), the section that  recognizes charitable organizations, applied to approximately 1.3 million  organizations in fiscal year 2017. These groups represent the largest  number of 501(c) organizations.

Federal tax law permits individual taxpayers and organizations to reduce  their tax liability by deducting contributions to charitable organizations on  their income tax returns. Individual taxpayers may deduct the amount of a  contribution to charitable organizations from their gross income if they  itemize their deductions. Charitable organizations provide many types of  assistance, such as services for the aging or food and shelter for those in  need. Taxpayers may support these activities by making contributions in  the form of financial donations or in-kind gifts to qualified organizations.

Federal law allows taxpayers to deduct charitable contributions from their  adjusted gross income (AGI). This policy has been in place since  1917. An individual taxpayer may deduct up to 60 percent of his or her  AGI for cash contributions, with 20 percent to 30 percent limits applying in  some cases. A corporation may claim a limited deduction for charitable  contributions made in cash or other property up to 10 percent of its  taxable income for the year.

An entity seeking tax-exempt status under 501(c)(3) from IRS must  submit either a completed Form 1023, Application for Recognition of  Exemption Under Section 501(c)(3) of the Internal Revenue Code, along  with organizing documents, or a completed Form 1023-EZ. Both Form  1023 and Form 1023-EZ require the entity seeking recognition of its tax- exempt status to provide information regarding its charitable purpose, as  well as certain financial data. IRS employees then review the forms to  determine the entity’s eligibility for tax-exemption status.

Most tax-exempt charitable entities are required to file an annual  information return from the Form 990 series. Certain small entities with  gross receipts that are normally $50,000 or less may file Form 990-N  Electronic Notice providing abbreviated information. Although the entity is  filing its information return as a tax-exempt organization, the entity must  pay employment taxes and taxes on unrelated business income, if  applicable. IRS provides programs and products to help the entity  understand specific issues related to its tax responsibilities.

IRS personnel can audit an organization’s or individual’s submitted tax  returns and financial information to verify that the reported tax is correct.  IRS personnel audited 933,785 individual income tax returns in fiscal year  2017, according to IRS data. This was 0.6 percent of individual returns  filed in calendar year 2016. From fiscal year 2006 to fiscal year 2017, the  largest number of individual returns IRS audited was 1,564,690 in fiscal  year 2010. There was a decrease in audits of individual tax returns after  fiscal year 2011, which occurred about the same time that IRS’s budget  declined by about $2.1 billion (15.7 percent) from fiscal years 2011  through 2018, after adjusting for inflation.

Concurrent with IRS’s declining resources were increasing  responsibilities, such as implementing aspects of the Foreign Account  Tax Compliance Act and the Patient Protection and Affordable Care Act.  We reported in 2014 that budget cuts had resulted in a significant staffing  decline and uneven performance at IRS. In March 2019, we reported  that IRS was in the early stages of defining and addressing its workforce  needs, but IRS officials stated that there was room for improvement in  implementing its workforce plans, and that it was working on a corrective  action plan that would address deficiencies noted in our report.

The operating divisions that, along with conducting audits, carry out  service and enforcement, and that deal most often with abusive tax  schemes or tax-exempt entities are TE/GE, SB/SE, and LB&I. These  divisions interact with taxpayers and entities that file tax returns. In  particular, each of the three divisions may audit taxpayers or entities to  determine whether information filed was reported accurately. IRS has set  one of its cross-divisional objectives as identifying “new types of tax  transactions or promotions that are either abusive or potentially abusive  requiring different levels of coordination and varying strategies.”

Another of TE/GE’s audit objectives is to “promote the highest degree of  voluntary compliance with the statutes governing qualification of plans  and exemption of certain types of organizations from tax and to determine  the extent of compliance and the causes of noncompliance with the tax  laws by plans and organizations.” TE/GE accomplishes this objective by  auditing charitable organizations’ compliance with the tax code through its  Exempt Organizations unit. In addition to this function, Exempt  Organizations also reviews organizations’ tax-exempt status applications  and makes tax-exempt status determinations. It also coordinates with  other state and federal agencies. Additionally, it audits entities to identify  and address noncompliance, where it may propose tax assessments or  changes to the tax-exempt status of the audited entity.

TE/GE uses various enforcement processes, such as referrals from the  public and other parts of IRS and data-driven approaches, to select tax- exempt organization for possible audits. IRS projects that Exempt  Organizations will receive approximately 1.6 million filings from tax- exempt and government entities in fiscal year 2019, primarily Form 990  series information returns.

SB/SE mainly oversees small businesses and self-employed taxpayers  and all other businesses with assets of less than $10 million. Examples  of the types of businesses that SB/SE covers include small-business  start-ups, small businesses with or without employees, taxpayers with  rental properties, taxpayers with farming businesses, and individuals  investing in businesses such as partnerships. Overall, IRS projects that  SB/SE will receive approximately 59.4 million tax returns in fiscal year  2019. The Lead Development Center, an office within SB/SE, receives  referrals from and facilitates communication between SB/SE and TE/GE  on the subject of abusive tax schemes.

LB&I oversees tax compliance of large partnerships, S Corporations, and  C corporations with assets of $10 million or more, as well as individuals  with high wealth (those with tens of millions of dollars in assets or  earnings) or international tax issues. IRS projects that LB&I will receive  approximately 400,000 corporate tax-return filings in fiscal year 2019.

LB&I has developed a compliance strategy to identify potential issues that  arise during audits of tax returns.

LB&I also oversees the processing of reportable transaction disclosure  filings by those involved in reportable transactions. A transaction includes  all the factual elements relevant to the expected tax treatment of any  investment, entity, plan, or arrangement. It also includes any series of  steps carried out as part of a plan. Transactions become “reportable”  (meaning a taxpayer must report it to IRS) when they fall under one or  more of the following categories: listed transactions, confidential  transactions, contractual protection transactions, loss transactions, and  transactions of interest.

A listed transaction is any transaction that IRS has identified as an  abusive tax avoidance transaction and has identified in published  guidance as a listed transaction. Taxpayers that have engaged in  transactions that have tax consequences or tax strategies described in  published IRS guidance are required by law to disclose the transaction to  IRS. The fact that a transaction must be reported does not mean IRS  will disallow the tax benefit, but IRS uses the reports to assess  compliance. Appendix IV discusses reportable transaction types in  greater detail.

Taxpayers are required to disclose all types of reportable transactions on  Form 8886, Reportable Transaction Disclosure Statement. Similarly,  advisers helping taxpayers conduct reportable transactions are required  to file Form 8918, Material Advisor Disclosure Statement.

Tax-exempt entities are required to file Form 8886-T, Disclosure by Tax- Exempt Entity Regarding Prohibited Tax Shelter Transaction, when the  entity is a party to a listed, confidential, or contractual protection  transaction, and the entity knows the identify of any other party in the  transaction. Tax-exempt entities that are party to a listed or confidential  transaction may be subject to an excise tax of 100 percent of the income  from the transaction. Transactions that require the filing of form 8886-T  constitute a different, smaller range of activity than transactions requiring  the filing of Form 8886.

The Office of Tax Shelter Analysis, a unit within LB&I, supports LB&I’s  work by coordinating its tax shelter planning and operations. This office  also analyzes information collected from disclosure forms. According to  IRS policy, if the Office of Tax Shelter Analysis determines a formal  investigation is warranted, it presents the information to the LB&I  Technical Tax Shelter Promoter Committee, an office within LB&I that has  sole authority to approve any proposed investigations.

Examples of Abusive Tax Schemes Illustrate Various Ways That Tax- Exempt Status Can Be Exploited by Individuals or Organizations

Taxpayers seeking to reduce their tax liability through charitable  donations may participate in legal tax planning strategies that allow them  to maximize their deductions while giving to charitable organizations. In  contrast to these legal tax planning strategies involving charitable  donations, abusive tax schemes occur when taxpayers conduct  transactions that are not supported by established law to improperly claim  tax benefits, or that have no economic significance or business purpose  other than the avoidance of tax, among other factors.

IRS has long recognized that some charitable donors and tax-exempt  organizations have engaged in abusive tax schemes. One such scheme  can consist of a donor grossly overvaluing a charitable contribution to  obtain a larger deduction on his or her filed tax returns. Another abusive  tax scheme can entail a tax-exempt organization providing benefits to a  private shareholder or individual. As we previously have reported, the  abusive transactions that comprise abusive tax schemes have been a  long-standing, ever-changing, and often hidden problem for IRS.

The following three examples illustrate various ways that an entity’s tax- exempt status can be used in transactions that are not supported by law  or are inconsistent with the law’s intent, and how otherwise legitimate tax- exempt activity can be exploited improperly.

A conservation easement is a legal agreement that grants an organization  the right to restrict the development and use of property for conservation  purposes with the intent of preserving the land or buildings. If statutory  requirements are met, taxpayers may donate an easement to a qualified  organization and receive a charitable income tax deduction for the  appraised value of the easement. A conservation easement becomes  “syndicated” if a person or company promoting the easement (a  promoter) offers multiple investors in a partnership or pass-through entity  the opportunity to claim charitable deductions based on the value of the  easement in return for cash. The Brookings Institution estimated that  investments in syndicated conservation easements totaled $623 million in  2016, an increase of 29 percent from $484 million in 2015. It further  estimated that because tax deductions from syndicated conservation  easement contributions generate a benefit greater than the value of the  investments themselves, the tax deductions resulted in federal tax  revenue loss between $1 billion and $1.9 billion in 2015 and between  $1.3 billion and $2.4 billion in 2016.

According to IRS, in a syndicated conservation easement, promoters  purchase land and convey ownership to a pass-through entity, such as a  partnership. The promoters offer interests in the pass-through entity to  prospective investors who are then able to deduct their share of the value  of the easement as a charitable contribution. In its guidance, IRS said the  conservation easement becomes noncompliant if, for example, the  promoters obtain an appraisal that purports to be a qualified appraisal,  but that greatly inflates the value of the conservation easement based on  unreasonable assumptions about the development potential of the real  property. Because the promoters inflate the value of the property, the  investors may benefit by claiming a charitable deduction on their tax  returns that exceeds their initial investment. Figure 1 shows the steps in  the formation of a syndicated conservation easement and the point at  which the easement becomes noncompliant when promoters obtain an  inflated value for the easement.

IRS has indicated its concern about the potential for abuse of  conservation easements, whether syndicated or otherwise, when used in  ways not supported by the law. In December 2016, the Department of the  Treasury (Treasury) and IRS issued Notice 2017-10 designating  syndicated conservation easements as listed transactions. This notice  provides that certain syndicated conservation easements promoted with a  return on investment of at least 250 percent will be identified as listed  transactions. It also provided details on how Treasury and IRS view  these transactions as forms of abuse. Although promoters who abuse  syndicated conservation easements exploit tax-exempt entities, the law  does not treat the tax-exempt entity as a participant, meaning that even  when a promoter is found to use a syndicated easement in a  noncompliant manner, the tax-exempt entity associated with the scheme  may still be considered compliant.

In addition to the potential for overvaluation of easements, Treasury and  IRS considered that syndicated conservation easements may become  problematic because of the potential they have to involve transactions  that violate the economic substance doctrine. Because of its concerns,  IRS has identified taxpayer abuse of conservation easements as a risk  area for noncompliance.

Syndicated easements also illustrate how noncompliance can cross the  areas of responsibility of IRS’s audit divisions. In this case, the beneficiary  of the scheme may be a small-business taxpayer (SB/SE’s responsibility)  or a corporation (LB&I’s responsibility), even though the scheme hinges  on an inflated appraisal and being able to donate to the tax-exempt  recipient (TE/GE’s responsibility).

A donor-advised fund is a fund or account held by a charity that receives  contributions from donors who may advise, but not control, how the  organization uses the money. The Pension Protection Act of 2006  defined donor-advised funds in the Internal Revenue Code and subjected  the funds to new requirements. Because donor-advised fund accounts  are operated by charities, contributions to these funds are deductible at a  higher percentage of adjusted gross income (generally 50 percent or 60  percent for cash contributions) than donations to private foundations  (generally 30 percent).

Some donors may use the donor-advised funds in ways that IRS  considers improper. For example, prior to tax-law changes in 2006, IRS  said that abusive donor-advised funds are those that appear to be  established to generate questionable charitable deductions, and provide  impermissible economic benefits to donors and their families (including  tax-sheltered investment income for the donors). Figure 2 illustrates how  donor-advised fund accounts operate and highlights where in the process  the parties involved could abuse the funds or raise policy concerns about  how donor advised funds have been used.

Donor-advised funds have grown in various measures in recent years,  according to data compiled by the National Philanthropic Trust. For  example, it reports that from 2013 to 2017, the total grants made by  donor-advised funds grew from $9.83 billion to $19.08 billion, and  contributions grew from $17.24 billion to $29.23 billion. Total assets held  in donor-advised funds increased from $57.1 billion to $110.01 billion as  well, according to the organization’s study. In 2017, about 463,000 donor- advised funds existed in the United States, with an estimated $110 billion  in assets, according to the National Philanthropic Trust. Some of the  largest of these funds in terms of assets are sponsored by financial  institutions, religious groups, and community foundations, while others  are independent, according to our review of selected donor-advised  funds’ sponsoring organizations’ websites and data from the National  Philanthropic Trust.

Patient assistance programs help patients afflicted with certain medical  ailments obtain financial assistance for medical care or free drug products  and these programs may qualify for tax-exempt status. Pharmaceutical  companies may establish their own patient assistance programs or make  monetary donations to independent charities’ patient assistance  programs. In addition to financial support, pharmaceutical companies may  donate medication (through in-kind product donations) to patient  assistance programs. Donations such as these allow pharmaceutical  companies to claim a limited tax deduction for charitable contributions. If  they claim deductions, the deductions may be up to 10 percent of the  corporations’ taxable income when donating to charities.

The possibility of donors receiving private benefits in excess of the  charitable deduction creates potential risks to participating  pharmaceutical companies and compliance challenges for IRS, according federal regulators. For example, because independent charity patient  assistance programs may be 501(c)(3) tax-exempt organizations,  pharmaceutical manufacturers’ profits generated from sales of their  products to individuals receiving help from patient assistance programs  that they donate to may raise issues of inurement. Figure 3 summarizes  how a hypothetical patient assistance program works and highlights  points in the process where potential abuse of the program may occur.

The federal government has investigated cases of potential private  benefit by pharmaceutical companies and patient assistance programs.

For example, IRS filed a court summons in May 2017 in an ongoing  investigation of a patient assistance program over concerns that it spent  the majority of its donations on copayment support that went to patients  who were prescribed medication from companies that had donated  money to the patient assistance program.

The Number of Audits Involving Tax-Exempt Entities Generally Declined and Few Tax-Exempt Entities Filed Prohibited Transaction Reports The Number of Audits Involving Tax-Exempt Entities Generally Declined Across TE/GE, SB/SE and LB&I over a 10-year Period

As shown in the tax scheme examples previously discussed, abusive  schemes with tax-exempt entities can involve the tax-exempt entity  directly or leverage an entity’s tax-exempt status indirectly to reduce  taxes. Consequently, the characteristics of audits involving abusive tax  schemes, such as which IRS operating division is responsible for the  audit, will differ according to the type of scheme. In addition, IRS  generally presents information about abusive tax schemes under a  category it calls abusive tax avoidance transactions. The abusive tax  schemes we have been discussing in this report are a subset of abusive  tax avoidance transactions in which the transaction or arrangement  involves multiple types of entities. IRS data do not allow us to identify  separately the transactions involving multiple entities. The discussion that  follows describes trends under the assumption that over time abusive  transactions involving multiple entities would closely track total abusive  transactions.

TE/GE audited 2,294 tax-exempt entities with what IRS identified as  abusive tax avoidance transactions in the 10-year period from fiscal year  2008 through 2017. As shown in figure 4, the number of abusive- transaction audits fell from a high of 886 in fiscal year 2009 to 10 or less  in fiscal year 2017. This decline represented at least a 98.9 percent  decrease in audits performed by TE/GE (see appendix V, table 6). The  decline in abusive-transaction audits generally corresponds with the  overall decrease in audit activity by IRS over recent years (see appendix  V, tables 2, 3, and 4). During the same 10-year period, TE/GE assessed  a total tax increase of $107 million based on its audits of tax-exempt  entities and the average tax increase per audit was $46,804. The  amount assessed for the tax increase declined from 45.3 million in 2008  to 1.2 million in the merged years of 2016 and 2017.

The effectiveness and efficiency of the audit process may be reflected in  the no-change rate and staff days associated with the audits. The no- change rate—the percentage of audits that results in no tax change—was  13.9-percent (see appendix V, table 11). IRS uses this ratio as an  indicator of how effectively IRS identifies noncompliant taxpayers (a lower  no-change rate on its audits is consistent with more effective audit  selection methods). The lower rate may also reflect higher economic  efficiency because less IRS and taxpayer time and other resources are  used for auditing compliant returns. On average, TE/GE spent 70 hours  per audit of tax-exempt entities from fiscal year 2008 through 2017 (see  appendix V, table 9).

Audits involving abusive schemes where taxpayers leverage an entity’s  tax exempt status—but the tax-exempt entities are not the subject of the  audit—are the responsibility of SB/SE and LB&I. To determine the  minimum number of audits these divisions conducted on abusive  schemes involving tax-exempt entities, we used IRS project codes that  IRS agreed were relevant. For these project codes, SB/SE and LB&I  conducted 4,207 audits over the 10-year period. The numbers of audits  generally decreased over the period except for increases in 2012, 2015,  and 2017 for LB&I audits and increases in fiscal year 2015 and 2017 for  SB/SE audits. Combined SB/SE and LB&I audits fell from 1,176 in fiscal  year 2008 to 99 in fiscal year 2017, a 91.6 percent decrease (see  appendix V, table 13). SB/SE and LB&I recommended about $8.3 billion  in tax changes over the 10-year period. As shown in figure 5, the average  recommended amount was larger for LB&I, but tended to fluctuate more  than the SB/SE amounts. The average tax change amount per audit over  the 10-year period recommended by SB/SE was $89,399. The average  amount recommended by LB&I was $8.6 million.

Figure 5 also shows how both divisions had a surge in recommended tax  amount changes for 2017 compared to prior years. SB/SE’s  recommended changes increased from $270,131 in fiscal year 2016 to  $127 million in fiscal year 2017. LB&I recommended changes increased  from $299 million in 2016 to $555 million in 2017. IRS officials could not  provide an explanation for the surge in 2017 (see appendix V, table 14).

Again, the divisions’ resource use may be reflected in staff days and the  no-change rate. SB/SE and LB&I combined spent 218 hours, on average,  per audit for the audits involving tax-exempt entities identified by project  codes (see appendix V, table 15). The no-change rate for SB/SE audits  we examined involving tax-exempt entities identified by project code was  10.9 percent. LB&I audits involving tax-exempt entities had a no-change  rate of 15.5 percent (see appendix V, table 16).

Audits Involving Tax- Exempt Entities Had Larger Recommended Tax Changes and Used More Staff Hours on Average than the Total of All Abusive Transaction Audits

Numbers of audits of all types of abusive transactions showed a pattern  of decline similar to audits involving tax exempt entities. SB/SE and LB&I  conducted a total of 155,467 audits involving all types of abusive  transactions from fiscal year 2008 to fiscal year 2017. As shown in figure  6, the total number of these audits conducted by each of the operating  divisions fell in most years. Abusive transaction audits conducted by  SB/SE and LB&I fell from 26,519 in fiscal year 2008 to a low of 4,248 in  fiscal year 2017, an 84 percent decrease in audits closed during this  period (see appendix V, table 5).

Audits involving tax-exempt entities resulted in higher average tax  changes than audits for the total of all abusive transactions. Combined,  SB/SE and LB&I recommended a total of $39 billion in tax changes for  the total of all for abusive-transaction audits. As shown in figure 7, SB/SE  recommended tax amount changes that averaged $40,834 per audit and  LB&I recommended tax amount changes that averaged $3 million per  audit. The recommended tax change per abusive-transaction audit was  larger for audits involving tax-exempt entities than for the total of all  abusive-transaction audits in both operating divisions which were (as  described above) $89,399 for SB/SE and $8.6 million for LB&I.

The total recommended tax amount change for SB/SE decreased from  $1.4 billion to $339 million, a 75 percent decrease over the period. For  LB&I, the recommended tax amount change decreased from $7.5 billion  to $866 million, an 89 percent decrease (see appendix V, table 7). We  estimated audits involving tax-exempt entities identified on the basis of  project codes led to SB/SE and LB&I recommending about $8.3 billion in  tax changes over the 10-year period.

The no-change rate for all SB/SE abusive transaction audits over the  period was 8.8 percent. The no-change rate for all LB&I abusive- transaction audits was 14 percent (see appendix V, table 10). Combined,  SB/SE and LB&I spent a total of 6.6 million staff hours for the total of all  abusive transaction audits from fiscal year 2008 to 2017, spending, on  average, 42 hours per audit for all abusive-transaction audits (see  appendix V, table 8). As described above, SB/SE and LB&I spent more in  resources, 218 hours, on average, per audit of tax-exempt schemes, than  the average for the total of all abusive-transaction audits.

Taxpayers with Audits Involving Tax-Exempt Entities Differed by Income

The majority (88 percent) of taxpayer audits involving tax-exempt entities  identified on the basis of project codes for both SB/SE and LB&I had an  Adjusted Gross Income (AGI) of more than $50,000, with about 40  percent of the audits involving the taxpayers with AGI falling between  $100,000 and $500,000. The SB/SE audits had an average AGI of $1.2  million and median AGI value between $200,000 and $500,000. LB&I  audits had an average AGI of $6.2 million and a median AGI value  between $1.0 million and $1.5 million. The majority of business taxpayers  with abusive-transaction audits involving tax-exempts (about 70 percent)  reported zero gross receipts (see appendix V, tables 17 and 18).

Taxpayers Reported Tax- Exempt Entities on Thousands of Reportable Transaction Disclosures, While Few Tax-Exempt Entities Filed Prohibited Transaction Reports

While the audit data examined above show the noncompliance IRS has  found regarding abusive schemes with tax-exempt entities, information  about the taxpayers involved in the transactions can also be derived from  the IRS disclosure forms. Most of the taxpayers identified partnerships as  the entities involved in the listed transactions that they reported. Of the  taxpayer disclosures identifying a tax-exempt entity on Form 8886, 97.8  percent identified the type of reportable transaction as a listed transaction  and 95.5 percent listed a partnership for type of entity involved in the  transaction. Further, 98.1 percent of taxpayers claimed a deduction from  their AGI as the benefit generated by the transaction and 5 percent  claimed an ordinary loss as the tax benefit.

The different disclosure reports that IRS receives from tax-exempt  entities, taxpayers, and tax advisors contain data that identify the  potential involvement of tax-exempt entities with reportable transactions.  However, there are differences in the legal filing requirements, the types  of information supplied, and the number of disclosure forms filed.

Few tax-exempt entities directly disclose their involvement in prohibited  transactions to IRS. Regulations require that certain tax-exempt entities  disclose information on a prohibited tax shelter transaction to which the  entity is a party. For calendar years 2004 through 2016, IRS received 71  Form 8886-T disclosures from tax-exempt entities that were a party to a  prohibited transaction. Moreover, the actual number of filers making  disclosures was smaller, only 33, because some submitted multiple forms  during the period.

Many more tax-exempt entities were identified by taxpayers filing the  Form 8886, which requires a different, broader range of transactions to be  reported than the Form 8886-T. For calendar years 2000 through 2017,  IRS received more than 979,900 Form 8886 disclosure reports from  taxpayers. Of that number the taxpayer identified a tax-exempt entity as  part of the reportable transaction on 32,847 disclosures or 3.4 percent of  all Form 8886 reports. A smaller number was identified by tax advisors on  Form 8918. For calendar years 2007 through 2018, out of the 16,477  Form 8918 disclosure statements received from tax advisors, 155  submissions identified a tax-exempt entity as part of a reportable  transaction.

While detail about the transactions themselves—when they appear in the  form narratives—is not readily available from the Form 8886 disclosure  databases. IRS’s Research, Applied Analytics and Statistics Division has  created an analytic tool for analyzing narrative information that it has  tested on the Form 8886. When we performed a test analysis using this  tool on the narrative fields on the Form 8886, we identified keywords that  may help isolate tax-exempt organization involvement in potentially  abusive schemes and ultimately help select returns for more detailed  review. This more detailed review is required because transactions  reported on the Form 8886 are not necessarily noncompliant.

For our test analysis, we selected certain terms related to known abusive  tax schemes involving tax-exempt entities such as “conservation  easement” or related to the tax-exempt sector such as “charitable  organization” and counted the number of times the terms appeared in the  narrative field of 26,632 Form 8886 disclosures made in fiscal year 2017.  For example, the term “conservation easement” occurred in the narrative  field of 6,767 disclosure forms and the term charitable organization  occurred on 17 disclosure forms. Through further searching on terms that  might relate to charitable organizations, such as “charity,” “sports,”  “children,” “animals,” “foundation,” and “scientific,” we identified 211  occurrences. IRS is not undertaking this type of analysis of taxpayer  disclosures, which would expand its ability to identify tax-exempt entities  and evaluate their potential involvement with reportable transactions, as  discussed later in this report.

IRS Has a Variety of Programs Working Collectively to Identify Abusive Schemes Involving Tax-Exempt Entities, but Some Internal Control Weaknesses Exist in Its Approach Various IRS Programs and Offices Identify and Coordinate on Abusive Tax Schemes

IRS operates various programs to identify abusive tax schemes involving  tax-exempt entities. Not all of these programs exclusively address  abusive tax schemes with tax-exempt entities but nevertheless can  provide relevant information on that issue. For example, the Office of Tax  Shelter Analysis processes disclosures of reportable transactions,  including those related to tax-exempt entities, and the Lead Development  Center may collect information about abusive schemes related to tax- exempt entities as part of its role in dealing with abusive tax transactions  in general.

As figure 8 illustrates, several of these programs in practice are linked by  the Service-wide Compliance Strategy Executive Steering Committee.  This committee is responsible for collecting input from the operating  divisions (TE/GE, SB/SE, and LB&I), as well as other parts of IRS, about  abusive tax schemes that cross divisional responsibilities, including  schemes involving tax-exempt entities. The Executive Steering  Committee also may make decisions about how to address abusive tax  schemes that cross the operating divisions’ responsibility. IRS officials  said that the operating divisions are individually responsible for monitoring  the committee’s performance. Therefore, the committee’s decisions  depend on what information the operating divisions provide. As figure 8  also shows, the operating divisions pass information about abusive  schemes among themselves through referrals, making clear  communication among the operating divisions critical for IRS in identifying  abusive tax schemes.

An IRS office that more directly addresses potential abusive schemes  with tax-exempt organizations is TE/GE’s Compliance Planning and  Classification office (CP&C). This office has several responsibilities  relating to identifying abusive tax schemes and communicating with other  parts of IRS, as well as coordinating with other operating divisions on  potential noncompliance. For example, CP&C is responsible for reviewing  emerging abusive tax schemes, conducting research, and reviewing  suggestions from a computer portal through which staff can raise  potential issues about compliance. The portal also serves as the  foundation to TE/GE’s compliance issue identification process.

IRS Met Some, but Not All, of the Internal Controls Criteria Relating to How the Agency Identifies Abusive Tax Schemes with Tax-Exempt Entities

We found that IRS maintains a variety of programs to identify tax  schemes involving tax exempt entities agency-wide, and these programs  together fully met seven of our 10 criteria. Appendix I contains more  information about the criteria we used in our analysis and a table that  summarizes the results of our analysis. One criterion that IRS fully met  was identifying areas of authority. All of the programs we reviewed had  documentation showing the responsibilities the program was to fulfill and  the roles it was to perform. IRS’s programs also fully met the criterion for  ensuring competency by having documented procedures for training to  enhance staff’s responsibilities across the programs we reviewed and met  the communication criterion by, for example, having coordination  meetings among officials representing the different operating divisions.

In addition, IRS met the criterion for conducting monitoring activities by,  for example, having inventory reports on TE/GE’s issue submission portal  and maintaining a monitoring group over TE/GE’s audit plans. Finally, IRS  met all three of our fraud-related criteria with programs or procedures that  specifically identify fraud, such as TE/GE’s Fraud Investigation Unit, or  that assist auditors in identifying fraud on returns, such as IRS’s Fraud  Handbook. Reviewing whether auditors assessed fraud risk is also part of  TE/GE’s quality review system.

In the following sections, we discuss how IRS did not meet the other three  internal control criteria.

IRS Has Not Assessed Risks That Tax-Exempt Entities Do Not Properly File Form 8886-T

A relatively low number of tax exempt entities filing Forms 8886-T  combined with our analysis of audit data raises questions about whether  tax-exempt entities are filing these forms as often as they should. As we  discussed above, tax-exempt entities filed only 71 Forms 8886-T over a  12-year period from fiscal year 2004 through 2016, where they listed  prohibited transactions. At about the same time, taxpayers in general filed  thousands of Forms 8886 annually where they identified tax-exempt  entities as part of their reportable transactions.

In addition, when we compared Form 8886 filings that identified tax- exempt entities as part of the reportable transaction with SB/SE and LB&I  audit data, again for the same time period, we found 432 closed cases  with tax changes. Although we did not determine whether the subject of  these audits was the abusive scheme involving a tax-exempt entity, the  result of 432 closed audit cases suggests that tax-exempt entities may be  part of more prohibited transactions than those reported on the 71 Form  8886-T filed during the period. The audit cases identified in SB/SE and  LB&I data resulted in about $1.9 billion in tax changes. The average per  audit tax change recommended by SB/SE was $65,143 and by LB&I was  $19 million. A similar analysis could be conducted comparing audit results  with data from Form 8918, which is filed by tax advisors.

IRS officials said the disparity between the number of Form 8886 filings  and the small number of 8886-T filings has not raised concerns because  the legal requirements for tax-exempt entities filing Form 8886-T are  narrower than the requirements taxpayers must follow to file Form 8886,  as we discussed earlier. However, IRS has not undertaken a risk  assessment to test whether this explanation—that the lower number of  filings should be expected because the filing requirement is narrower—is  valid, which is inconsistent with the internal control standards for risk  assessment.

The Office of Tax Shelter Analysis sends Form 8886-T filings it receives  to TE/GE, and the Compliance Planning and Classification office reviews  these filings, but no documented process exists to determine whether all  tax-exempt entities that should file Form 8886-T were filing the form as  required. In addition, IRS provided us with no studies investigating the  causes and consequences of such a small number of filings.

While IRS has adopted processes to help ensure proper filing for other  disclosures, such as Form 8886, it has not extended these to Form 8886- T. In 2011, we recommended that IRS establish a process to periodically  check whether Form 8886 filers met their reporting obligations. In  response to that recommendation, IRS implemented a new indicator and  matching process to review whether filers met their obligations. IRS  officials told us that similar controls do not exist for 8886-T filings.

TE/GE officials said one way that they ensure forms are filed is through  penalties, yet they said they have never assessed the penalty for nonfiling  of Form 8886-T. TE/GE officials also said that another way they ensure  proper filing is through education and cited such documentation as IRS  Publication 557, Tax-Exempt Status for Your Organization. IRS said it  provides other information through its website informing charities of their  responsibilities.

Despite this education effort, it may still be the case that a lack of  knowledge about filing requirements reduces the number of tax-exempt  entities that file. An IRS official suggested that charities may not have the  financial sophistication to realize that they are involved in a prohibited tax  shelter transaction and therefore are required to file a Form 8886-T.  Without a better understanding of the reasons behind the low filing, IRS  cannot be reasonably certain that tax-exempt entities are following the  law on filing Form 8886-T and ensuring tax-exempt entities’ compliance.

IRS Data Do Not Facilitate Some Analysis of Abusive Tax Schemes Involving Tax- Exempt Entities

We were able to use the IRS audit and disclosure data to perform certain  analyses on abusive tax schemes with tax-exempt entities for this report,  but data deficiencies prevented us from undertaking more complete  analysis and hinder management’s use of the data. These deficiencies— which are inconsistent with internal control standards for quality  information—weaken divisions’ ability to identify abusive tax schemes  involving tax-exempt entities as well as the Executive Steering  Committee’s ability to make decisions about how to address abusive tax  schemes across divisions and develop compliance strategies.

First, the descriptions of project codes in audit data do not always clearly  identify abusive tax schemes across operating divisions. For example,  one code LB&I uses to identify abusive transactions in audit data is  “domestic tax shelters.” TE/GE uses two codes both titled, “Abusive Tax  Avoidance Transactions,” and SB/SE uses a code titled, “Tax Shelter List  Projects.” IRS officials provided no additional documentation on what  these codes mean. The lack of specificity hinders analyses of abusive tax  schemes involving tax-exempt entities. IRS officials said that they do not  keep an overall list of project codes that cover abusive schemes involving  tax-exempt entities. This limits their ability to readily assess and manage  audits of abusive tax schemes involving tax-exempt entities. However,  they did say such a list, which would be effective in certain circumstances  or operating divisions, might be possible to produce. Cross-operating  division analysis could enhance the Executive Steering Committee’s  objective to assess emerging issues and develop policy responses.

Second, we found that there were no project codes consistently  identifying abusive schemes involving tax-exempt entities that crossed  operating divisions. Instead, IRS officials said each operating division  assigned its own project codes that identify abusive tax schemes. Having  no uniform way to identify abusive schemes across the operating  divisions makes analysis of schemes that overlap with different operating  divisions’ responsibilities problematic and inhibits IRS from accomplishing  its objectives.

The lack of cross-divisional project codes echoes findings from our 2011  report on abusive tax avoidance transaction data, where we found that  some abusive tax avoidance transaction data were reported  inconsistently across IRS divisions. We said in that report that without  comprehensive or consistent information, IRS does not have the best  information to decide how to evaluate the results of its audits. Our  recommendation to separately track the tax amounts recommended,  assessed, and collected between abusive tax avoidance transaction  issues and nonabusive transaction issues remains open because IRS  said resource and capability constraints preclude it from capturing  information in this way.

Similarly, IRS officials told us it would be costly and logistically prohibitive  to create new project codes identifying abusive schemes involving tax- exempt entities that crossed divisions. However, as we said in our  previous report, tracking audit results for abusive and nonabusive  transactions would provide IRS management with the data needed to  make more informed decisions about program effectiveness and resource  allocation. If, as IRS indicated above, it would be possible to make an  overall list of codes, such a list could be used to achieve the same results  as adjusting the database system.

IRS Does Not Use Available Tools to Identify Abusive Schemes with Tax-Exempt Entities That Cut Across Operating Divisions

Although IRS does not identify some data that would facilitate analysis of  abusive tax schemes involving tax-exempt entities spanning the operating  divisions, we found evidence that TE/GE’s Returns Inventory and  Classification System (RICS) could at least partially support analysis and  monitoring of audit data across the operating divisions. For example, the  RICS user manual states that RICS can access a variety of forms outside  of TE/GE’s purview, such as Form 1065 and the Form 1120 series tax  returns, which typically are handled by SB/SE or LB&I respectively. While  TE/GE uses RICS, officials we spoke with at LB&I, for example, were not  familiar with RICS’ capabilities. TE/GE officials said IRS would have to  study whether using RICS in other divisions would generate productive  audits.

As we discussed earlier in this report, IRS’s Research, Analysis and  Statistics office also has developed the capability to analyze narrative  information, which it has tested on the Form 8886. However, this  analytical tool is not being used operationally to review the Form 8886 or  any other disclosure report. Our analysis shows that the tool has the  potential to help IRS better search disclosure reports for additional  information about transactions that could help IRS identify potentially  abusive schemes involving tax-exempt entities.

For example, it can be used to identify keywords in disclosure reports that  could help determine whether a tax-exempt entity was a party to a  reportable transaction that warrants further investigation for compliance.  However, IRS officials told us they have no plans to use this tool but  agreed that it may be beneficial.

IRS officials also told us that TE/GE does not routinely review Form 8886  filings that show tax-exempt entities as being part of the reported  transaction because the data are not clear indicators of noncompliance.  However, by not using these data for possible leads, IRS may be missing  opportunities to identify known abusive schemes, which is inconsistent  with internal controls on using quality information. Again, our analysis of  the 8886 filings combined with audit results suggests that there is  potential for IRS to use the Form 8886 to identify potential  noncompliance. Without conducting such an analysis, IRS may be  missing opportunities to identify leads on tax-exempt entities in abusive  tax schemes.

Quality Control over Cross- Operating Division Referrals Is Limited

We previously showed that abusive tax schemes involving tax-exempt  entities can involve multiple types of entities that cross IRS’s operating  divisions’ areas of responsibility. We also showed that IRS relies on  auditors to refer potentially noncompliant entities involved in an abusive  scheme to the responsible operating division. Consequently, IRS needs  assurance that auditors’ make referrals when appropriate. However, IRS  lacks a control to ensure that auditors make referrals correctly. An IRS  audit official said that managers are tasked with reviewing auditors’ work  and identifying referrals that should have been made during case  closings. However, there is no documented guidance specifically directing  managers to assess whether auditors correctly identified referrals  involving abusive tax schemes, reducing assurance that such auditors will  make such identifications correctly and route them appropriately. IRS’s  audit quality review systems, which generally measure how well auditors  follow procedures from a random sample of audits, also do not assess  whether referrals of abusive schemes involving tax-exempt entities are  properly identified and routed. The lack of guidance to ensure auditors  make referrals across the operating divisions increases risk that the  responsible division will not be alerted to potential noncompliance to  make further assessments for enforcement action. Absent specific  guidance, there also is increased risk that even when one entity in an  abusive tax scheme is audited, other entities in the scheme may go  unexamined. This is inconsistent with internal controls standards for  control activities.

Abusive tax schemes involving tax-exempt entities pose enforcement  challenges for IRS, as schemes can cross IRS’s operating divisions’  areas of responsibility and evolve over time. While IRS has established  programs to help identify new abusive schemes, opportunities exit to  better ensure that IRS accomplishes its objectives of identifying existing  and emerging schemes. In particular, opportunities exist for IRS to  improve the quality of its data and how it is using the data it has in  managing its programs. Because IRS uses codes to identify abusive  schemes that are not consistent across the operating divisions, its efforts  to formulate policy across operating divisions may be made more difficult.  Also, IRS may not be making the best use of its data by not using existing  tools that may be helpful in analyzing data to identify abusive schemes  involving tax-exempt entities. Next, IRS has an opportunity to reduce the  risk that tax-exempt entities are noncompliant by assessing the number of  Form 8886-T filings. Finally, referrals across divisions play an important  role in IRS’s ability to identify schemes with tax-exempt entities, but IRS’s  internal control activities over referrals are limited. By taking actions to  further strengthen its internal controls, IRS could enhance its efforts to  identify and combat abusive tax schemes that involve tax-exempt entities.

We are making the following five recommendations to IRS:  The Commissioner of Internal Revenue should undertake a risk  assessment of tax-exempt entity Form 8886-T filings. Based on the  findings of the risk assessment, IRS should then determine whether steps  are needed to increase compliance, such as, for example, through  increased outreach to tax-exempt entities or assessment of nonfiling  penalties. (Recommendation 1)

The Commissioner of Internal Revenue should link audit data on abusive  tax schemes involving tax-exempt entities across operating divisions and  use the linked data to assess emerging issues and develop policy  responses. (Recommendation 2)

The Commissioner of Internal Revenue should test the ability of the  Return Inventory Classification System to facilitate analysis and  monitoring of audit data across the operating divisions and to support the  IRS’s enforcement objectives. (Recommendation 3)

The Commissioner of Internal Revenue should use existing data analytic  tools to further mine Form 8886 and Form 8918 data, which could be  used to find audit leads on tax-exempt entity involvement in potentially  abusive tax schemes. (Recommendation 4)

The Commissioner of Internal Revenue should develop guidance to help  managers ensure referrals about abusive schemes involving tax-exempt  entities are made across operating divisions. This could be accomplished  by, for example, adopting specific guidance for audit managers to look for  referral accuracy in their reviews of case closings. (Recommendation 5)

We provided a draft of this report to the Commissioner of Internal  Revenue for review and comment. On August 16, 2019, the IRS Deputy  Commissioner for Services and Enforcement provided written comments  stating that IRS agreed with GAO’s recommendations. In the letter, which  is reproduced in appendix VII, the Deputy Commissioner said that GAO’s  recommendations would provide IRS with additional opportunities for  improving the identification of tax schemes involving exempt entities. IRS  also sent us technical comments, which we incorporated as appropriate.

As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the appropriate  congressional committees, the Secretary of the Treasury, the  Commissioner of Internal Revenue, and other interested parties. In  addition, this report is available at no charge on the GAO website at  http://www.gao.gov.

If you or your staff have any questions about this report, please contact  me at (202) 512-9110 or mctiguej@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made key contributions to this  report are listed in appendix VIII.

To describe ways in which taxpayers have abused a tax-exempt entity  through abusive tax schemes, we conducted interviews with  knowledgeable professionals and researchers. We chose the interview  sources by reviewing relevant articles from academic databases and  reaching out to professional organizations. We narrowed our list of  examples of abusive tax schemes by focusing on those professionals and  researchers who: had recent professional experience as an attorney, accountant, or  other industry professional with a firm specializing in tax-exempt  entities or tax shelters; had recent professional experience in nonprofit management or  affiliation with professional associations specializing in nonprofit  organization or oversight; had published books, articles, or other research on tax-exempt  entities or tax shelters within the last 10 years; were recommended to us by a relevant professional organization,  such as the American Bar Association or the American Institute of  Certified Public Accountants; work for or previously worked in charity tax enforcement at the state previously worked for the Internal Revenue Service (IRS), specifically  in the Tax Exempt and Government Entities Division (TE/GE); or would (in our professional judgment) be able to speak on the topics of  abusive tax avoidance schemes or IRS investigations of tax-exempt  entities.

We conducted literature and court case reviews using academic and legal  databases and covered years 2008 through 2018 using search terms  such as “tax avoidance,” “tax-exempt,” and “shelter.” We combined the  information found in interviews with reviews of relevant literature and  court cases. We categorized the observations from our research by the  following criteria.

Involved multiple entities, at least one of which was tax exempt, and  Involved a transaction or scheme already known to IRS, such as a  listed transaction or transaction of interest or  Involved a transaction mentioned in expert interviews.

We then applied the following factors to make the final three choices for  the examples: how representative the example was of abusive tax- schemes involving tax-exempt entities; how well-documented we found  the example to be in literature reviews; how recent the example had been  used by abusers; and how much impact the example had in terms of  prevalence and tax revenues.

To examine trends in IRS’s compliance and the characteristics of  taxpayers audited for using abusive tax schemes involving tax-exempt  entities, we collected data from the following IRS business operating  divisions that conduct audits on abusive transactions: (1) TE/GE, (2)  Small Business/Self-Employed (SB/SE), and (3) Large Business and  International (LB&I). We received data extracts from the following  computer data systems (1) the Returns Inventory and Classification  System data extracts from TE/GE; (2) the Automated Information  Management System Centralized Information System (A-CIS), utilized by  SB/SE and LB&I; and (3) the Compliance Data Warehouse (CDW)  utilized by SB/SE and LB&I.

IRS performs a number of quality control steps to verify the internal  consistency of the Return Inventory Classification System, A-CIS, and  CDW data. Additionally, we reviewed documentation from the operating  divisions on the data, discussed the data with IRS officials, and  conducted electronic reliability testing. For example, we verified the  completeness of analysis variables and the date ranges for our analysis.  We excluded 178 records from our analysis of SB/SE data because they  were not within our date range. Based on our review, we believe the data  are sufficiently complete and accurate for our purposes.

We identified audits with potential tax exempt entities by selecting audits  based on IRS project codes that IRS agreed were relevant to determine  the minimum number of audits conducted on abusive schemes involving  tax-exempt entities. We also matched the SB/SE and LB&I data with  IRS’s Form 8886, Reportable Transaction Disclosure Statement, data file  of the tax-exempt records. We used these data to produce descriptive  statistics on audit and taxpayer characteristics and IRS compliance efforts  for 2008 through 2017. Tax return information came from Form 1040,  U.S. Individual Income Tax Return; Form 1120, U.S. Corporation Income  Tax Return; and Form 990, Return of Organization Exempt from Income  Tax. Dollars amounts reported for the 10-year period have been adjusted  for inflation in 2018 dollars based on a Fiscal Year, Gross Domestic  Product Price index.

Separately, we compiled descriptive statistics on disclosures of reportable  transactions that also involved tax-exempt entities from Form 8886 and  Form 8918, Material Advisor Disclosure Statement. IRS’s Office of Tax  Shelter Analysis provided the data for Forms 8886 and 8918. We also  performed an analysis of the narrative portions of Form 8886 from tax  year 2017 to identify more information about the descriptions of the  reported transactions. We identified that IRS could conduct Python optical  character recognition (OCR) analysis of the text fields on IRS Form 8886.  We worked with officials at IRS’s Research, Analysis and Statistics office  on using Python computer programming language to conduct the  analysis.

IRS ran the OCR using keywords associated with 29 different tax-exempt  organizations we identified. The keywords we used were based on  characteristics of tax-exempt entities, such as “charity” and “foundation”— terms found in 26 U.S.C. Section 501. We received summary tables and  copies of PDFs of all Form 8886-T, Disclosure by Tax-Exempt Entity  Regarding Prohibited Tax Shelter Transaction, for tax years 2004 through  2016. We checked the reliability of IRS’s summary tables and manually  reviewed the PDF submissions to generate descriptions of the Form  8886-T data.

We conducted reliability testing for all of the data we used for this  objective. For the audit and tax return data, we interviewed relevant IRS  officials and compared our statistical runs with publicly available statistics.  For the Form 8886 and Form 8918 disclosure data, we interviewed  relevant IRS officials. For the 8886-T data, we compared the summary  tables IRS provided with the PDFs of the original Form 8886-T  submissions.

To assess how IRS identifies emerging abusive tax schemes and to  identify potential improvements, we reviewed documentation on programs  that help IRS identify possible abusive tax schemes involving tax-exempt  entities. We identified the programs by reviewing IRS documentation,  including the Internal Revenue Manual, in combination with IRS’s  determination of relevant programs (see appendix VI for more details  about these programs).

We then identified criteria appropriate for assessing the programs’  alignment selected principles from Standards for Internal Control in the  Federal Government (Green Book) and leading practices from our Fraud  Risk Management Framework. To select these criteria, we reviewed the  Green Book and Fraud Risk Management Framework to identify  principles relevant to specific aspects of IRS’s programs for identifying  and initiating enforcement actions against abusive tax schemes involving  tax exempt entities. IRS agreed that these criteria were appropriate. The  following list shows the criteria we selected through this process.

Green Book Principle 3: Establish structure, responsibility, and

Green Book Principle 4: Demonstrate a commitment to recruit,  develop, and retain competent individuals

Green Book Principle 7: Identify, analyze, and respond to risks

Green Book Principle 8: Assess fraud risk

GAO Fraud Risk Management Framework Overarching Concept 1.2  (structure)

GAO Fraud Risk Management Framework Overarching Concept 2.1  (plans exist to assess fraud)

Green Book Principle 10: Design control activities

Green Book Principle 13: Use quality information

Green Book Principle 14: Communicate Internally

Green Book Principle 16: Perform Monitoring Activities  After establishing appropriate criteria, two analysts independently  reviewed appropriate evidence and determined whether the evidence  aligned with the criteria for the programs was based on the attributes for  the Green Book criteria and Fraud Risk Management Framework  guidance. We also considered how the programs met TE/GE’s objective  to “promote the highest degree of voluntary compliance with the statutes  governing qualification of plans and exemption of certain types of  organizations from tax and to determine the extent of compliance and the  causes of noncompliance with the tax laws by plans and organizations,”  and IRS’s objective to “identify new types of tax transactions or  promotions that are either abusive or potentially abusive requiring  different levels of coordination and varying strategies.” We determined the  criterion was met only if all of the programs under review offered sufficient  support. Table 1 shows how we assessed the programs we reviewed on  the criteria.

Appendix II: Types of Tax-Exempt Organizations Listed in Internal Revenue Code Section 501

The federal tax code provides a variety of tax benefits to organizations  often referred to as “tax exempt.” This appendix focuses on organizations  or entities qualifying for a tax-exempt status under 26 U.S.C. § 501. We  discussed the tax benefits and requirements for different types of tax- exempt organizations in our 2014 report on oversight of charitable  organizations. In addition to section 501, there are various other  scattered provisions which give a full or partial tax exemption to certain  specific types of entities and income.

Section 501 distinguishes between charitable organizations, also known  as 501(c)(3) organizations (after the subsection in which they are defined)  from all other organizations qualifying for an exemption under section  501. Organizations that qualify for an exemption under section 501, but  are not charitable organizations have been referred to as mutual benefit  organizations or non-charitable nonprofits. Section 509 further divides  charitable organizations between those that are private foundations and  all other charitable organizations, and private foundations are divided  between operating and nonoperating foundations in section 4942.

Appendix III: Tax-Exempt and Government Entities Budget over Time

Figure 9 shows the declines in the Internal Revenue Service’s Tax- Exempt and Government Entities Division’s budget since an increase  from fiscal years 2009 through 2011.

Appendix IV: Financial Transactions the Internal Revenue Service Requires Taxpayers to Report

The Internal Revenue Service (IRS) defines a transaction as one that  includes all the factual elements relevant to the expected tax treatment of  any investment, entity, plan, or arrangement, and it includes any series of  steps carried out as part of a plan. Department of the Treasury (Treasury)  regulations require that certain transactions be registered and that lists of  investors be maintained by parties who organize or sell interests in the  transaction. A transaction becomes “reportable” (i.e., a taxpayer must  disclose it to IRS on Form 8886) when it falls under one or more of the  following categories: listed, confidential, contractual protection, loss  transactions, and transactions of interest.

Listed transactions: A listed transaction is reportable when it is the  same or substantially similar to one of the types of transactions that  IRS has determined to be an avoidance transaction. IRS provides a  detailed list of the 36 recognized listed transactions on its website.

Confidential transactions: A confidential transaction is offered to a  taxpayer or a related party under conditions of confidentiality and is a  type of transaction for which a taxpayer has paid a minimum advisor  fee. A transaction is considered offered under conditions of  confidentiality for two reasons: the advisor places a limitation on the  taxpayer’s disclosure of the tax treatment or tax structure of the  transaction, and the limitation on disclosure protects the confidentiality  of the advisor’s tax strategies. The transaction is treated as  confidential even if the conditions of confidentiality are not legally  binding on the taxpayer.

Contractual protection transactions: A contractual protection  transaction is a transaction for which a taxpayer or a related party has  the right to full or partial refund of fees if all or part of the tax  consequences from the transaction are not sustained. It also includes  a transaction for which fees are contingent on a taxpayer’s realization  of tax benefits from the transaction.

Loss transactions: A loss transaction is a transaction that results in  a taxpayer claiming a loss. The type of taxpaying individual or entity  determines the applicable amount of the loss. The types of loss  transactions IRS has described are as follows for:  Individuals: at least $2 million in any single tax year or $4 million in  any combination of tax years.

Corporations (excluding S corporations): at least $10 million in any  single tax year or $20 million in any combination of tax years.

Partnerships with only corporations (excluding S corporations) as  partners: at least $10 million in any single tax year or $20 million  in any combination of tax years, whether or not any losses flow  through to one or more partners.

All other partnerships and S corporations: At least $2 million in  any single tax year or $4 million in any combination of tax years,  whether or not any losses flow through to one or more partners or  stakeholders.

Trusts: At least $2 million in any single tax year or $4 million in  any combination of tax years, whether or not any losses flow  through to one or more beneficiaries.

Transactions of interest: A transaction of interest is one that IRS  and Treasury believe to have the potential for tax avoidance or  evasion, but which lacks enough information for IRS and Treasury to  determine whether the transaction should be identified as a tax  avoidance transaction.

Appendix V: Internal Revenue Service Tax Return and Audit Data

Tables 2 and 3 below show Internal Revenue Service (IRS) data for forms  filed and audited, and the audit coverage rate, for individual income tax  and corporate tax returns during fiscal years 2006 to 2017. Table 4  shows the number of returns processed and audited, and the audit  coverage rate, for tax-exempt organizations during fiscal years 2006 to  2015. All three tables show declines in audit coverage rates: the decline  occurred for individual income tax returns after fiscal year 2011 and for  corporate income tax returns after fiscal year 2012. The audit coverage  rate for tax-exempt organizations’ returns declined from fiscal years 2013  to 2015, the last fiscal year for which we have complete data on tax- exempt organization returns.

Appendix VI: Descriptions of Internal Revenue Service Programs Addressing Abusive Schemes with Tax-Exempt Entities

Table 21 lists 10 programs that the Internal Revenue Service (IRS)  operates that may identify or conduct enforcement action on abusive tax  schemes that involve a tax-exempt entity.

Appendix VII: Comments from the Internal Revenue Service

Appendix VIII: GAO Contact and Staff Acknowledgments

James R. McTigue, Jr. (202) 512-9110 or mctiguej@gao.gov.

In addition to the contact named above, Kevin Daly (Assistant Director);  Susan Baker; Jehan Chase; Sara Daleski; Steven Flint; Eric Gorman;  Gina Hoover; Andrew Howard; Edward Nannenhorn; Kevin Newak;  Carolyn Ours; Robert Robinson; Dylan Stagner; and Elwood White made  significant contributions to this review.

Also contributing to this report were Toni Gillich; Sarah Gilliland; John  Hussey; Jessica Lucas-Judy; Cynthia Saunders; Stewart Small; Rebecca  Shea; and Janet Temko-Blinder.

When taxpayers overstate how much they've donated to charities on their tax forms, it improperly reduces their tax bills. In some cases, the charity is complicit, while in others, it is being exploited.

IRS’s different offices may find evidence of abusive schemes involving charities and other tax-exempt organizations in their audits.

Yet IRS doesn’t consistently analyze data from its offices to help identify these types of schemes—even though information about them may be available in existing databases.

We recommended that IRS improve its use of data, databases, and analytics to better combat this problem.