By Albert B. Crenshaw
Washington Post Staff Writer
Tuesday, April 5, 2005; Page E01

Charities and other nonprofits exempted from taxes because they serve a public purpose have become a hotbed of tax evasion and abuse, according to the head of the Internal Revenue Service.

"We can see that tax abuse is increasingly present in the sector," and unless the government takes effective steps to curb it, such organizations risk "the loss of the faith and support that the public has always given to this sector," Internal Revenue Commissioner Mark W. Everson said in a letter to the Senate Finance Committee detailing abuses his agency has found.

Everson said that the IRS is finding problems in virtually every type of tax-exempt organization. Nonprofits include not only charities, but colleges and universities, many hospitals, pension plans, trade associations and think tanks. In fact, eight of the 10 largest private employers in the District are nonprofits.

"Unfortunately, we have no precise way to gauge the revenue impact of these issues," Everson said, though he noted that the nonprofit sector, including pension plans and the like, now totals roughly 3 million entities controlling $8 trillion in assets.

"It's a seminal letter that rips off the rose-colored glasses with which we usually look at tax-exempt organizations," Senate Finance Chairman Charles E. Grassley (R-Iowa) said yesterday. "What's going on isn't a pretty picture in the harsh light."

The Finance Committee began examining the nonprofit sector last summer, finding, among other things, that localities and transit systems were collecting fees for allowing corporations to benefit from tax shelters designed to help finance public works. Several provisions of last fall's tax bill were aimed at abuses uncovered by the panel, but members have suspected, and Everson's letter confirms, that many more exist. Another hearing will begin today.

The findings have already sent alarms through the nonprofit community. Last month the industry-convened Panel on the Nonprofit Sector offered a preliminary report on how laws could be tightened and practices improved to curb abuse.

In some cases fraud and abuse are committed by the nonprofit itself, such as when a charity is established to benefit its main donor; in other cases, the nonprofit acts an enabler for tax-shelter promoters, such as when a municipality or union takes a fee to participate in a deal that allocates "profits" to it and losses to wealthy individuals.

Everson said in his letter, which covered 14 pages, that nearly half of the IRS's list of 31 major abusive tax-shelter schemes "have the potential to involve tax-indifferent parties," as the IRS calls entities that don't have to worry about paying taxes.

Everson raised particular concerns about nonprofit hospitals and how hard it is to distinguish them from for-profit hospitals; political activity by nonprofits; misuse of entities set up to allow religious leaders to hold property and conduct business for the benefit of a religious organization; and deals designed to allow members of a tribe to benefit from gambling revenue without owing taxes.

A key issue for the government is not just collecting more revenue, but also ensuring that tax benefits extended to "this sector of the economy achieve their intended results."

Grassley agreed. "In exchange for these very generous tax breaks, charitable assets should be going to those in need. More and more, we're seeing that some people view charities and charitable gifts as a chance to help themselves, not others," he said.

Acknowledging that "our enforcement presence faded in the late 1990s," Everson attributed much of the growth of problems to "weak governance practices" among nonprofits and "a culture [in the sector] that has become more casual about compliance [with tax laws] and less resistant to noncompliance."

Everson, who said that the IRS lacks adequate resources to rein in bad conduct, also noted that while the nonprofit sector has evolved and grown over the years, tax law and regulation have changed much less. "Since 1969 there has been only limited review of the rules relating to tax-exempt status," Everson said.

For example, many tax penalties are a function of the tax that should have been paid. When the entity is tax-exempt and thus owes no tax, doubling the taxes owed as a penalty is meaningless.

Also, in some cases, the IRS's only weapon is to revoke an organization's tax exemption -- "a 'remedy' that may work a disproportionate hardship on innocent charitable beneficiaries," Everson said.

Among the most serious problems highlighted by Everson is the growth of entities that allow taxpayers to make a deductible donation but delay shifting the money or other assets to the ultimate charitable beneficiary. These include "donor-advised funds" and "supporting organizations."

Donor-advised funds have been around since the 1930s but have become more popular in recent years, in part because major mutual fund companies have started selling such funds to the general public.

Supporting organizations are charities that support other charitable or tax-exempt organizations. University endowment funds, for example, may be supporting organizations.

There are three categories of supporting organizations, one of which is a particular source of problems because its supporting relationship is "least formalized," Everson said.

Both donor-advised funds and supporting organizations allow donors to take a deduction without requiring that the donation be received by the ultimate beneficiary, leaving assets to be held in the fund or organization and accumulate tax-free. And unlike private foundations, they are not subject to minimum payout rules or prohibitions on self-dealing. "They are, therefore, uniquely tax-favored," a study by the Congressional Research Service last month said.

"We have found that certain promoters encourage individuals to establish purported donor-advised fund arrangements that are used for a taxpayer's personal benefit, and some charities that sponsor these funds may be complicit in the abuse," Everson said.

Supporting-organization abuses include donations of money that is then lent back to the donor, and the possibility of donating assets and then buying them back at a discount, Everson and the CRS observed.

A related problem is the valuation of non-cash assets donated to these and other charities. When such assets are not publicly traded securities, the taxpayer has an incentive to inflate the value, and the charity has little incentive to challenge that. That leaves the IRS with the arduous task of revaluing the donation and then possibly defending its revaluation in court.

Currently, Everson said, the IRS is auditing 50 donors of conservation easements and several exempt organizations that receive such easements. It is doing a "pre-audit review" of 400 open-space easement donations, "to be followed by a similar review of 700 facade easements."

Donation of easements on the facades of houses in historic areas has grown dramatically. The homeowner donates an easement -- giving up the right to alter the facade -- and deducts the amount by which that has reduced the value of the house. But because of restrictions that often already apply to such property, "the taxpayers may, in fact, be giving up nothing, or very little," Everson said. "A taxpayer cannot give up a right that he or she does not have." Such easements have become a significant issue in the District.