Who Investigates Nonprofit Organizations?

Have you ever wondered who investigates nonprofit organizations? The responsibility to investigate, audit, and prosecute legal violations of tax-exempt organizations lies primarily with the IRS and various agencies of state government.

State law recognizes the existence of the entity, whether it be a corporation, a trust, an LLC, or an unincorporated association, and recognizes exemption from income taxes at the state level. Meanwhile, the IRS grants exemption from federal income tax and qualification to accept tax-deductible donations and grants. The federal government has an interest in ensuring that the exempt organization (‘EO”) does not abuse these unique privileges while state and local governments have an added interest to ensure the EO does not commit fraud, violate state law, or mislead donors or consumers. 

While Federal tax laws are the same nationwide, state laws governing EOs can vary dramatically among the states. This article lists the most common violations by tax-exempt organizations and the agencies in charge of enforcement.

What are the causes that trigger an investigation?

EOs enjoy certain privileges not available to for-profit companies – one of which is access to funding from private donors and foundations. As such, EOs have different reporting requirements. Listed below are the most common legal violations and the agencies that are in charge of enforcement.

Issue	Agency Responsible
Non-filing of or inconsistencies in Form 990 and its related schedules	IRS
Unrelated Business Income	IRS
Excess Benefit Transactions	IRS
Compensation issues and non-filing and nonpayment of employee taxes	IRS, State, Department of Labor and state-equivalent
Failure to comply with fundraising and charitable solicitation laws	States (typically Secretary of State or Attorney General’s office)
Fraudulent transactions	State Attorney General
State-related tax violations (TPT, Sales Tax, Use Tax)	State (Department of Revenue or equivalent)
Failure to file annual report	State (Agency that handles corporate filings)

Internal Revenue Service – Federal violations and abuse of tax-exempt status

The IRS audits EOs to determine whether they comply with the federal laws governing tax-exempt EOs. 

To be recognized as exempt from tax under IRS Code Section 501(c)(3), the organization must apply by submitting Form 1023 or Form 1023EZ. Additionally, there are many other types of exempt entities that apply for exemption by filing Form 1024. Some of the most common are:

• Social Welfare Organizations (501(c)(4),
• Labor and Agricultural/Horticultural Organizations (501(c)(5),
• Business Leagues (501(c)(6), and
• Social Clubs (501(c)(7).

Federal law mandates most exempt organizations file returns. The annual tax filing is an information return and the form varies based on the EO’s revenues. Generally, all exempt organizations must file some version of Form 990 each year. Form 990 – Return of Organization Exempt From Income Tax provides annual financial and additional information about the organization, including the following:

• Governance issues;
• Revenue and expenses;
• Related party transactions;
• Grants made or received;
• Unrelated business activity;
• Salaries paid,
• Fundraising activities conducted, and
• Transactions with disqualified persons.

Failure to file Form 990 or filing an incomplete return can subject the organization to late filing or failure to file penalties. Failure to file for three consecutive years will result in an automatic revocation of the EO’s tax-exempt status.

Unrelated Business Income

The federal government allows nonprofit and exempt organizations to earn a small amount of income from sources that are not related to the EO’s exempt purpose. Such income streams are subject to what is called the Unrelated Business Income Tax (UBIT).

The IRS defined “Unrelated Business Income” as revenues obtained by an organization that

• Comes from trade or business
• Are not substantially related to the exempt purpose and activities of an organization, and
• Are recurring or “regularly carried on.”

The IRS requires EOs to report UBI and pay taxes on it at corporate rates. Similarly, when the EO’s unrelated business income becomes excessive, its tax-exempt status may be revoked.

Excess Benefit Transactions

The law prohibits EOs from paying excessive benefits to its insiders. This is why Form 990 has a section that requires EOs to disclose excess benefit transactions received by an insider (also known as a disqualified person).

An excess benefit occurs when a 501(c)(3) that is not a private foundation or a 501(c)(4) overpays or enriches an insider. This may be in the form of below-market interest on loans, above-market compensation packages, influence on purchasing goods and services, or other transactions that severely benefit another.

When there is an excess benefit transaction, the person receiving the benefit will be subjected to penalties. Consequently, board members who knowingly approve the transaction or fail to object may be subjected to penalties. Most importantly, the EO may lose its tax-exempt status. Since the violation of this provision is subject to “intermediate sanctions,” excess benefit transactions must be disclosed to the public which may negatively impact the EO’s image and therefore the EO’s public goodwill and fundraising prospects. Learn more about excess benefit transactions and how to avoid them in this in-depth article.

Non-Filing and Non-Payment of Employee Taxes

When an organization hires employees, it is required to file and pay employee insurance and employee taxes such as

• Federal income tax withholding (FITW),
• Social Security and Medicare taxes (FICA), and
• Federal unemployment taxes (FUTA).

Because EOs are working with a limited budget, they often opt to hire independent contractors rather than employees to save money. In our blog about hiring independent contractors, we note that EOs sometimes misclassify employees as contractors for various reasons, including cost savings on taxes and insurance. When employees are misclassified as independent contractors, workers will not be entitled to employee-related privileges such as insurance coverage, workers’ compensation, or unemployment benefits. The employer portion of payroll taxes will not be paid. Misclassification exposes the organization to liability. The IRS, the state taxing authority, the Department of Labor, and its state equivalent all have the power to audit EOs’ worker classification and levy fines and penalties on nonprofits that violate the law.

Another problem arises when EOs fail to realize that they must register to do business in each state and comply with the employment laws of each state where they have remote employees. This issue can be very messy to untangle. Accordingly, EOs should consult with counsel in each state or at a minimum work with a payroll service that can assist with multi-state compliance.

How audits are triggered

Anyone can file a complaint (called a referral) against an EO for potential noncompliance with tax rules. Complainants can be the members of the organization, donors, grantors, the general public, government agencies, the State, and even competitors. To make a referral of an EO, submit Form 13909, Tax Exempt Organization Complaint (Referral) Form. Form 13909, and any supporting documentation, can be submitted via mail to IRS EO Classification, Mail Code 4910DAL, 1100 Commerce St., Dallas, TX 75242-1198, by fax to 214-413-5415, or by email to [email protected].

State – for State-Related Tax Violations, Misconduct, and Other Nonprofit Violations

In most states, but not Arizona, the Attorney General has common law authority to oversee charities. Thus, when complaints involve improper behavior such as governance disputes, fraud, or issues with donor-restricted funds, the State Attorney General can intervene and start an investigation. The public can also report violations to the Attorney General’s office. While the office may not act on all complaints, the Office of the Attorney General may investigate complaints when a pattern emerges that indicates repeated violations of the law.

More: Top 15 Nonprofit Board Governance Mistakes

Noncompliance with Fundraising and Solicitation Requirements

Forty-one states and the District of Columbia require some charities to register solicitation activities. Most states require an initial registration as well as an annual renewal. This requirement varies by state, so be sure to check with the State you intend to solicit donations from. Some states take unregistered solicitations more seriously than others. Potential penalties include fines, bans from soliciting in the state, inclusion on a list of non-compliant organizations, and even criminal liability. To avoid being penalized due to noncompliance, always consult your lawyer, accountant, or the State where you will conduct your fundraising activities.

Noncompliance with State Tax laws

The tax-exempt status refers to federal income tax exemptions and does not automatically constitute an exemption from paying state taxes such as the Transaction Privilege Tax (TPT), Sales Tax, or Use Tax. Some states have broad exemptions from paying TPT/Sales and Use tax for 501(c)(3)s. Other states have narrow exemptions for specific types of organizations. When the State suspects that an EO has failed to pay all state-related taxes, the State may audit the EO.

Fraudulent or Misleading Solicitations, Misappropriation of Charitable Funds, and Misconduct of Leaders and Members

In most states, the state, the Attorney General has the power to investigate and enforce the law against nonprofits that are violating the laws applicable to charities. Offenses such as fraud, violations of fundraising laws, and misappropriation of donations are taken seriously.

Why is there a need to investigate nonprofit/charitable organizations?

Exempt organizations and nonprofits are created for the benefit of the community or the members that they serve. And because they have access to funds not otherwise enjoyed by profit organizations, an audit or an investigation of the books and conducts of business may be required. An investigation or an audit may be required in the following situations:

1. When a donor requires an independent audit.

Donors may require an independent audit before granting a donation. Reasons may vary, but the primary reason why an audit may be required is to establish compliance with laws that makes organizations tax-exempt. This is important since donations made to tax-exempt organizations and other nonprofits are often tax-deductible expenses. Take this scenario, for example:

A donation had been made to a tax-exempt organization, and the donor subsequently claimed such gift as a tax-deductible donation. Later on, it was discovered that the organization, at the time of the donation, had failed to retain its tax-exempt status. The donation, therefore, is not deductible and the donor may be subjected to fines and penalties if they are audited.

2. When an organization receives state-funding.

Certain states require nonprofits that receive state or federal funding to submit an independent audit report as a condition of soliciting funds in the state. This is to establish compliance with laws and ensure that the requirements and conditions of the grant are followed.

Ellis Carter is a nonprofit lawyer with Caritas Law Group, P.C. licensed to practice in Washington and Arizona. Ellis advises nonprofit and socially responsible businesses on corporate, tax, and fundraising regulations nationwide. Ellis also advises donors with regard to major gifts. To schedule a consultation with Ellis, call 602-456-0071 or email us through our contact form.