How the IRS spun out of control

WASHINGTON — Steven Miller, the top enforcement official at the Internal Revenue Service, thought he might have trouble on his hands.

Election season was well underway in March 2012 when tea party organizations started to complain angrily of IRS harassment over their requests for tax-exempt status. The media was looking into it. Congress had picked up the scent.

Miller dispatched an advisor to Cincinnati, where a field office handles applications from nonprofits, to figure out what was up. What he learned would blow up into a crisis that would damage the agency’s reputation and lead to his ouster last week.

With little oversight from Washington, agents in Ohio had been singling out some conservative groups for extra scrutiny, seeking to make sure they were not too heavily involved in politics to qualify as tax-exempt.

Worse yet, the agents had sent the organizations letters with numerous intrusive questions, including the groups’ positions on political issues and the names of their donors.

Miller failed to tell Congress what he knew for more than a year, despite repeated queries from House committees. On Friday, at times chagrined and combative as he spoke to House members, Miller called the IRS’ focus on conservative groups “obnoxious” and described what happened as “horrible customer service.”

No evidence yet suggests that the IRS agents in Cincinnati had a political agenda. But ample evidence has emerged in congressional testimony and in an inspector general’s report that they were overwhelmed by an influx of applications from new politically oriented nonprofits. At the same time, they were left to fend for themselves, unsupervised by Washington managers who never created rules on how to evaluate the new groups.

“Cincinnati basically became an island of its own out there,” said Paul Streckfus, a former IRS attorney. He suggested the missteps and clumsy response stemmed from a “hidebound” and insular culture at the IRS. “They don’t trust outsiders,” he said. “They know they’re always under attack, and they have a bunker mentality: ‘If we keep our heads down long enough, we will survive the latest onslaught.’”

The scandal, which appears to have started with one specialist in Cincinnati, was slow-building, born of a dysfunctional bureaucracy and a fateful reorganization years ago that placed more authority in the hands of accountants and lawyers 500 miles from headquarters in Washington.

“In my view, there was a failure of management in D.C. to get their hands around this early enough,” said Marvin Friedlander, who retired in 2009 after 41 years with the IRS. “Cincinnati should have reached out to Washington headquarters people, and Washington should have gotten ahead of the curve.”

The inquiry has put a spotlight on an obscure branch of the IRS, the Tax Exempt/Government Entities Division, which is largely housed in an office building in downtown Cincinnati.

Former employees describe staff in the Cincinnati office as well-intentioned but overworked, struggling to keep up with more than 60,000 applications a year from groups that want to be classified as tax-exempt, such as churches, chambers of commerce, PTAs and advocacy groups.

The applications are reviewed by about 200 people in a “determinations unit,” about 140 of those in Cincinnati. To keep ahead of the flood, former employees say, the staff frequently resorts to shortcuts.

“That office is given direction to move as quickly as possible, but also be accurate,” said Philip Hackney, an assistant law professor at Louisiana State University who worked in the IRS chief counsel’s office from 2006 to 2011. “It’s impossible. They miss a lot of stuff.”

The agency has had to work with a smaller staff — overall, the exempt division has about 860 people, Miller told Congress last year, down nearly 10% from its peak. Once, lawyers from national headquarters regularly compiled briefings on emerging issues and conducted weeklong training sessions in Cincinnati. But those were scrapped in 2004.

In years past, the office had spent little time worrying about so-called social welfare organizations formed under section 501(c)4 of the tax code, instead focusing more attention on charity groups.

But that changed in 2010, after the Supreme Court’s decision in Citizens United. Political operatives stepped up their use of social welfare groups as vehicles to spend hundreds of millions to shape the outcome of elections — all of it from hidden sources. Social welfare organizations are not required to reveal their donors, unlike political committees.

To qualify, however, such groups cannot have politics as their “primary purpose.” But the rules don’t say how much political activity is too much. That fraught issue was left in the hands of agents with mostly accounting backgrounds who were ill-suited to deal with questions of politics and the 1st Amendment.

In the past, former employees said, similarly tricky situations would have been kicked up to IRS lawyers in Washington. That changed after an IRS reorganization a decade ago.

“The concern was that the lawyers in D.C. had other work to do, and Cincinnati should be able to handle most or all of the cases,” said Friedlander, a former branch chief in the exempt organizations division.

In performing evaluations, IRS employees are supposed to follow a highly scripted, step-by-step process laid out in a massive manual. A portion of Chapter 20 explains how to handle tax-exempt applications. It mentions politics just three times, but does not address the new politically engaged 501(c)4s.

In March 2010, a manager in a Cincinnati determinations unit asked a screener to get a handle on the issue, according to the report from the Treasury Department’s inspector general for tax administration. The agent started pulling applications with political-sounding names, such as “tea party” and “patriots.”

The inspector general’s report concluded that one-third of the groups singled out for extra review had such conservative words in their applications. The report did not identify the ideological bent of the others.

In reviewing the applications, accountants rely on advice from IRS “technical units,” staffed mostly with lawyers. But the inspector general’s report suggests the two staffs were at odds, with determinations employees pressing technical workers for responses and getting impatient with what they saw as advice that was “too lawyerly.”

“It’s like in the Army; there’s tension between different units,” said Streckfus, now editor of the EO Tax Journal, which tracks IRS policy toward exempt organizations. “It’s not one big, happy family.”

As part of their review, screeners send letters to applicants for tax-exempt status, asking for additional information.

Given the sensitivity of examining these new political organizations, someone should have raised red flags to headquarters, Friedlander said.

But the Cincinnati staff is sometimes reluctant to do that, former employees said, because waiting for answers from headquarters can mean major delays — and backlogs. “That makes a mess of their inventory,” Streckfus said. “Pretty soon they are being blasted for, ‘Why can’t you move cases?’”

In February 2011, asked at a conference about the backlog of tax-exemption applications, Holly Paz, a top IRS official in the exempt organizations division, said that a wave of retirements had left the determinations unit strapped. “We are looking at that, and trying to figure out how to move cases and people around,” she said, according to a transcript on the EO Tax Journal’s website.

Indeed, throughout the process, responsibility for the review of political groups kept shifting, as new managers took over different units, the inspector general’s report shows.

In March 2011, while still waiting for advice from the technical unit, a determinations unit manager told staff that they needed to keep working on the applications, most of which had sat idle for 13 months.

By June, top officials knew there was a problem. Paz sent out an email saying the focus on tea party groups “may have resulted in over-inclusion.”

Several weeks later, with 100 cases already pulled aside, her boss, Lois Lerner, director of exempt organizations, was briefed on the politically loaded terms being used to screen applications. She gave orders to revise them, immediately. But Lerner’s warning didn’t stick.

In January 2012, a memo was sent to the staff to watch out for groups involved in “limiting/expanding government” and “educating on the Constitution and Bill of Rights.”

That month, the first letters went out to the affected groups. While most letters came from Cincinnati, the hub of the tax-exempt division, others came from offices in Washington, D.C., and Laguna Niguel and El Monte, Calif.

It’s not clear who, if anyone, in senior management reviewed those letters. They were startling in their scope: Reviewers asked for donation lists, event guest lists and even descriptions of conversations at those events.

“Terrible,” Friedlander said. “Nobody is saying, ‘Hey, this is really sensitive stuff and this is really inappropriate, and really abusive.’”

When the letters arrived, the organizations balked. Their protests quickly reached Congress and the media.

Lerner eventually stopped new letters from going out. And Miller came up with a new rule: If groups called to complain about the donor information being sought, staff could tell them they didn’t have to send it in.

“When the national office saw the terms those guys were using, I know they were freaking out,” said Hackney, the former IRS lawyer.

Miller was finally briefed on the details of the screening on May 3, 2012.

Senior officials tried to blunt concerns by sending follow-up letters telling organizations to forget about the donor lists. If they had already sent the names, the IRS promised to destroy the list.

But in statements to Congress, Miller and Lerner didn’t let on that anything was wrong, save for one cryptic allusion by Miller last June about unspecified “issues” with the reviews. They denied any targeting of conservative groups and never revealed that the agency had already flagged the questions as inappropriate. Instead, they depicted the requests for information as part of the normal give-and-take of the evaluation process.

In testimony before a House Ways and Means subcommittee in July, Miller described the complaints about the IRS as “noise” coming from small groups that didn’t really understand the tax rules.

As late as September, in a letter to the Senate Finance Committee, Miller outlined a detailed legal justification for the agency’s decision to request a list of donors. Earlier this month, two days before she disclosed the improper screening, Lerner passed up a chance to reveal it to a congressional subcommittee.

Gregory Colvin, a San Francisco-based attorney who specializes in political and lobbying activities of nonprofit groups, said the IRS operates in a “culture of denial.”

“In their own minds, they’re thinking, ‘Since we’re correcting it, it didn’t happen,’” he said.

With the inspector general’s report set to be released, Lerner planted a question about the issue at a conference in Washington on May 10 and, once it was asked, read a statement apologizing for what happened.

The admission — not to mention the bizarre manner in which the IRS chose to disclose it — set off a firestorm that intensified with the release of the inspector general’s report last week. Miller, who had become the acting IRS commissioner, and another official have resigned. The IRS remains under investigation by the inspector general and now faces a criminal probe by the U.S. Department of Justice. More congressional hearings are slated for Tuesday and Wednesday.

Colvin says his practice has seen an uptick in inappropriate queries from field agents, not just on political questions but on other issues such as an organization’s governance structure.

“It seems like there’s more initiative being taken by agents to ask things and require things of applicants that are not appropriate,” he said. “It seems to indicate they’re not well-supervised.”

joseph.tanfani@latimes.com

matea.gold@latimes.com

melanie.mason@latimes.com

Staff writer Ralph Vartabedian contributed to this report from Los Angeles.