IRS Audits of Tax-exempt Entities
Few words make nonprofits more nervous than IRS audit and for good reason. Because tax-exempt nonprofits enjoy many tax advantages the IRS must protect from exploitation, tax-exempt nonprofits typically face more tax-regulation than for-profit companies. When a for-profit corporation makes a tax mistake, it usually results in them writing a check. In contrast, when a tax-exempt nonprofit makes a major tax mistake, its tax-exempt status, and therefore its existence, is on the line.
Reasons for Selection
Although there are many reasons a nonprofit organization may be selected for an audit, several things heighten the chance of being selected. Things like irregularities on Form 990s, failure to file a Form 990, citizen complaints, having a relationship with another taxpayer currently being audited or receiving negative media attention can all increase your chance of being audited beyond the random internal IRS computer process.
Types of Audits
IRS audits take different forms. A field audit occurs when the IRS notifies the nonprofit by letter that it wishes to visit the premises, conduct a few interviews, and review various documents. A more common audit is the correspondence audit which takes place through written correspondence and the provision of IRS-requested documents. The IRS also conducts compliance checks via correspondence. A compliance check is not a formal audit, but may turn into one if there are irregularities in the information provided. Keep in mind, however, if the outcome of an audit is unfavorable, it is possible to appeal the decision.
Regardless of the reason for an audit, nonprofits receiving an audit or compliance check letter from the IRS have the right to representation. A good nonprofit lawyer or accountant can help minimize the damage by managing the process, negotiating problematic issues, and ensuring the IRS does not overreach.
While it is always a good idea to conduct periodical internal audits, in order to uncover and correct potential problems, an organization may begin their own contemporaneous audit when they receive an IRS audit letter. This effort is looked upon favorably may provide room for negotiation. The IRS typically focuses on the nonprofit’s Form 990, so the following examples walk through common inquiries made during an audit of a nonprofit’s Form 990.
Areas of Focus
Qualification for Exemption. When the IRS audits a tax-exempt organization, one threshold issue is whether the tax-exempt organization continues to qualify for tax-exemption. Charitable organizations should expect an examination of the following:
1. Whether the organization meets the required tests for maintaining their exempt status. For an organization to maintain it’s exempt status under IRC Sec. 501(c)(3), it must show that it meets the following tests:
- the organizational test, and
- the operational test
The organizational test requires the organization’s articles and/or bylaws include an acceptable purpose clause and an acceptable powers clause. The organizing documents must also include a dissolution clause for the distribution of assets upon the organization’s dissolution. The operational test requires that the organization must meet four requirements, as follows:
The organization must engage primarily in activities, which accomplish one or more of the exempt purposes specified in IRC Sec. 501(c) (3), and Treas. Reg. 1.501 (c)(3)-1 (c)(1)
- The organization cannot allow its net earnings to inure to the benefit of private shareholders or individuals (Treas. Reg. 1.501(c)(3)-1(c)(2))
- The organization cannot engage in substantial lobbying or political activities. (Treas. Reg.1.501(c)(3)-1(c)(3)
- The organization must serve a valid public purpose and confer a public benefit
2. To satisfy the operational test, the organization must demonstrate it has refrained from engaging in certain prohibited (or limited) activities as follows:
- Private inurement
- Substantial legislative activity
- Political activity
3. Whether the organization conducted activities which generated taxable unrelated business income; and
4. Whether the organization met all other filing requirements, such as the obligation to file form 990-T to report unrelated business income.
Governing Body and Management. The IRS typically seeks to verify exempt operations and ascertain the board’s independence, as well as the director’s role in the organization’s operations. Documents requested may include the following:
- Articles and Bylaws as well as any amendments
- Board and committee meeting minutes
- Conflict of Interest Policy
- List of current and former officers, directors, and key employees
- Disclosure of any relationships among current or former officers, directors, or key employees
- Member list, membership categories, and details regarding member benefits
- Correspondence files
Solid governing documents, policies, procedures, and well-kept meeting minutes are key to satisfying the IRS’ governance review. In particular, a regularly enforced Conflict of Interest Policy will avoid many audit concerns.
Financial Compliance. The IRS will want to review the organization’s financial compliance. The financial review may include a review of the following documents for the tax years under examination:
- Records of all grants received or awarded
- The organization’s chart of accounts
- The organization’s bank and/or investment records
- Internal and independent auditor reports and financial statements as well as copies of any management letter
- Year-end summary general ledger(s) and the beginning and year-end trial balance
- Year-end adjusting entries and explanations as well as all subsidiary ledgers and supporting documents
- All expense reports
- Documentation detailing allocations for the Statement of Functional Expenses
- Books and records for assets and liabilities
- Work papers and analyses documenting the reconciliation of the Form 990
Tax Compliance. The IRS will want to confirm all required filings are being filed on time and taxes are being paid. Accordingly, auditors will typically request the following tax documents:
- Forms 990 and 990-T and any extensions for tax years in question
- Any other federal tax returns filed
- Employment tax returns, i.e. W-2’s, W-4’s, 1099’s, 940’s, and 941’s
- Records relating to time reporting, work completed, and any other documents used to determine amount of compensation paid.
Conclusion. Be savvy about the audit process by periodically conducting internal audits and legal compliance checks. Adhere to current best practices by adopting policies and procedures to help enforce legal compliance. Finally, keep clear board and board committee minutes documenting board decisions. A nonprofit that anticipates audit issues and designs its operations accordingly will find an IRS audit to be a much less stressful, less threatening, and less expensive experience.
Ellis Carter is a nonprofit lawyer licensed to practice in Washington and Arizona. Ellis advises tax-exempt clients on federal tax matters nationwide.