A growing controversy in Washington involving the Internal Revenue Service could mean big changes in the way the agency regulates the political activity of tax-exempt organizations, according to election law experts.

At the White House and on Capitol Hill, President Barack Obama and members of both political parties expressed outrage Monday at reports that the IRS had used political criteria to target conservative groups for extra scrutiny on 501(c)4 applications.

Robert Kelner, chairman of Covington & Burling’s election and political law practice, said the IRS is going to be gun-shy as a result of the scandal. And it’s likely the agency would back away from close scrutiny of political activities for some time.

Less likely, but also possible, is that Congress might take away the IRS’s oversight of political activity of tax-exempt organizations, he said.

"I think there is a growing body of thought that suggests it was a mistake to ever let the IRS regulate the political activity of tax-exempt organizations," Kelner said. "The IRS has trouble doing that well in the best of times, and in the worst of times there is a temptation for IRS personnel to put their thumb on the scale."

Trevor Potter, who heads Caplin & Drys­dale’s political law practice in Washington, said there are still a lot of unknowns, but it is clear the IRS has a mess on its hands. "They’re saying they have thousands of applications that are unprocessed, and a broken method of determining which groups to select" for review, Potter said. "It is clear they are overwhelmed and underorganized."

The situation will prompt review of the IRS’s subjective, multipart test of what is too much political activity for a 501(c)4 group, he continued, which might have contributed to the agency looking at the name of a group and trying to divine what political activity that group might be up to.

Portions of an Inspector General for Tax Administration report containing the findings have been leaked to the news media, and the full report is due this week. A top IRS official apologized and said on Friday that dozens of organizations were singled out because they included the words "tea party" or "patriot" in their applications, the Associated Press reported.

The category of tax-exempt groups has been at the center of debate about regulating political speech and "social welfare organizations" since the U.S. Supreme Court decision in Citizens United v. Federal Elections Commission. In 2010, for example, congressional Democrats called on the IRS to crack down on activists’ use of tax-exempt groups as cover for political advocacy.

The political fallout from the new revelation has been swift in Washington. During a press conference on Monday afternoon, Obama said that while he is waiting for the full report, "I can tell you that if you’ve got the IRS operating in anything less than a neutral and nonpartisan way, then that is outrageous, it is contrary to our traditions."

On Capitol Hill, the chairman of the House Oversight and Government Reform Committee, Representative Darrell Issa, R-Calif., said he would hold hearings about the report. He asked the inspector general to look into the matter last June after receiving complaints from conservative groups that they were undergoing closer scrutiny than were liberal groups.

"The fact that Americans were targeted by the IRS because of their political beliefs is unconscionable," Issa said.

House Minority Leader Nancy Pelosi called for more clarity in the law regarding the activities of tax-exempt organizations, along with greater disclosure and transparency. "We must overturn Citizens United, which has exacerbated the challenges posed by some of these so-called ‘social welfare’ organizations," Pelosi said in a written statement.

Perkins Coie partner Bob Bauer, a former White House counsel and Obama’s presidential campaign lawyer, posted a blog on Monday offering a detailed analysis of possible reforms to avoid this kind of "indefensible" selective enforcement, such as requiring 501(c)4 organizations to conduct no campaign activity.

The government now must decide an unresolved issue: when does an organization pass from a social welfare function into out-and-out electioneering as its "major purpose," he wrote.

"There seems no disagreement that the IRS must stay out of politics—eschewing political judgments and giving no cause to suspect political favoritism," Bauer wrote. "Yet the law and rules as they now stand generate pressures the other way."

Neil Reiff, a founding member of the firm of Sandler, Reiff, Young & Lamb in Washington, expressed skepticism that Congress will change the law. It will be important to watch how the IRS reacts, he said. "I think it’s a huge deal. Has the IRS been wounded to the point they have to pull back?" Republicans will be howling for fairness, Reiff said, and liberal groups could be girding for backlash and added scrutiny.

Jan Baran, a partner at Wiley Rein who has handled tax-exempt matters for clients for 30 years, expects that there will be heightened sensitivity to applying the tax laws evenly. And that likely will mean a delay for everybody applying for the tax-exempt status.

While surprised at the reports, Baran said they explains what he had been seeing in recent years: applications have taken much longer and with more interference by the IRS with respect to groups that seem to be conservative.

Baran said he was in law school when President Nixon used the IRS to scrutinize his political opponents.

"It led to a long period of great sensitivity at the IRS of making sure they are not behaving in a way that is politically improper," Baran said. "My reaction was: This is the IRS, they learned their lesson with Nixon, surely."