Written by Daniel Crespo

The Government Accountability Office (GAO) recently released its report on the IRS’s Form 990 Series (including EZ and PF) analysis and non-compliance identification models.  The GAO assessed (1) the IRS’s use of data to select returns for examination and, (2) the process IRS has established for selecting returns. In its assessment, the GAO analyzed (1) examination data from fiscal years 2016 through 2019, including results from the largest Form 990 model, and (2) model documentation for a generalizable sample.

Interestingly, the Tax Exempt and Government Entities (TE/GE) division within IRS identifies exempt organization returns for examination from many sources and categorizes examinations into three groups, known as portfolios: (1) Data Driven Approaches, (2) Referrals and Other Casework, and (3) Compliance Strategies. All three rely on data, to some extent, to make decisions on selecting returns for examination.

Comment:  Given the extent and critical nature of the GAO’s report, Lawrence Associates expects that the IRS will enhance its review and audit processes of nonprofit Forms 990 in the coming years in order to demonstrate effective remediation of the issues identified by the GAO. Indeed, the GAO has already issued a list of 13 recommendations focused on enhancing the examination selection and risk scoring functionality of the IRS Form 990 model.[1]

In turn, nonprofits should expect to see a targeted increase in scrutiny by the IRS, and penalty assessments as the agency recalibrates and validates its Form 990 models in a manner that results in higher rates of discrepancy detection going forward.

Of course, none of this specifically indicates what the IRS is looking at.  Stay tuned.  Perhaps we will speculate on that in a future blog.

The GAO found that the IRS used the data to select 70% of its examinations in fiscal year 2019, and nearly 50% of those data-based examination selections were driven by IRS models determinations.[2] Of the returns examined that were selected using the model, 87% resulted in a change to the return, indicating that IRS had effectively identified noncompliance.[3]

Nevertheless, the GAO report was largely critical of the IRS’s Form 990 model, particularly with respect to its noncompliance risk scoring and examination selection functionality. Specifically, the GAO found that the IRS model did not improve change rates compared to prior selection methods and also found that a higher model score is not necessarily associated with a higher change rate.[4] In fact, examinations of “pick-up” returns and substitutes for returns (SFRs) accounted for most closed examinations and produced a higher change rate than examinations of primary returns scored by the model, with 61% of changed returns the IRS had credited to its Form 990 model actually having been a pick-up or SFR return, rather than one that one that the model had identified for examination in the first instance.[5]

The GAO found several additional shortcomings in the IRS’s evaluation processes as well, including:[6]

The IRS has not fully implemented or documented internal controls in its established processes for analyzing data for examination selection.

The IRS has not defined measurable objectives for using data to select returns for examination.

The IRS’s models have deficiencies affecting the validity and reliability of return scoring and selection. In particular, the IRS has incomplete definitions and procedures and does not always follow its definitions when assigning point values for identifying potential noncompliance for examination.

The IRS did not consistently document the processing and use of data in decision-making on examination selection.

The IRS does not regularly evaluate examination selection. Examination data was inconsistent across years and the IRS only tracked one prior year of data.

The IRS did not save data on all returns that its Form 990 model scored. As a result, the IRS could not assure that its models are selecting returns as intended and that deficiencies are being identified and corrected.

[1] See Id. at pp. 37-38.

[2] U.S. Government Accountability Office, Tax Exempt Organizations: IRS Increasingly Uses Data in Examination Selection, but Could Further Improve Selection Processes, GAO-20-454, Jun. 2020, at p. 1, available at: https://www.gao.gov/assets/710/707607.pdf

[3] Id.

[4] Id. at pp. 13-16.

[5] Id. at p. 13.

[6] Id. at p. 1.