Who Investigates Non-Profit Organizations?

So who investigates non-profit organizations? Unlike for-profit organizations where the management is the responsibility of the owners of the corporation, the responsibility to investigate, audit, and exercise complete oversight of nonprofit organizations lies with the IRS and State government.

The state government grants the nonprofit status of an organization and ensures that the nonprofit organization only performs acts stated in its Articles of Incorporation (or its equivalent) and By-Laws. Meanwhile, the IRS grants an organization’s tax-exempt status and ensures that the exempt organization (also known as EOs) does not abuse its tax-exempt status.

While the IRS has relatively uniform laws, state laws governing nonprofits and exempt organizations vary between states. This can cause confusion to board members and trustees and exposes the organization to potential audit.

This article listed the most common violations of nonprofits and tax-exempt organizations and the agencies in charge of the audit. 

What are the causes that trigger an investigation?

Tax-exempt organizations are entitled to certain privileges that non-profit or for-profit organizations do not. Likewise, non-profit organizations also enjoy certain privileges not available to for-profit organizations – one of which is access to funding from the private donors, the state, and the federal government. 

As such, these organizations have different reportorial and audit requirements. Listed below are the most common audit findings and the agencies who trigger or are in-charge of the audit.

Audit Findings/Issues	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 fo employee taxes	IRS, State, Department of Labor and state-equivalent
Failure to comply to fundraising and charitable solicitation laws	State, and IRS
Fundraising Discrepancies	IRS
Violation of code of conduct, fraudulent transactions	State
State-related tax violations (TPT, Sales Tax, Use Tax)	State (Department of Revenue or equivalent)

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

The IRS audits EOs to check if they comply with the laws and rules granting them their tax-exempt status. 

A nonprofit organization that falls under the IRS code 501(c)(3) is tax-exempt from federal income taxation, albeit not automatically. To be tax-exempt, the organization must apply by submitting the necessary documents and complying with the provisions required. 

Additionally, the following organizations may be exempt from federal income tax depending on their primary purpose and business transactions:

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

The federal law mandates most exempt organizations file returns. Form 990 – Return of Organization Exempt From Income Tax provides annual financial and additional information about the organization, such as but is not limited to the following:

1. unrelated business revenues, 
2. grants received, 
3. salaries paid to employees,
4. fundraising activities conducted, and 
5. excess benefit transactions inured by insiders and members of the organization. 

Failure to file Form 990 and the required schedules will subject the organization to penalties and the possible loss of its tax-exempt status. 

Unrelated Business Income

The federal government allows nonprofit and exempt organizations to earn 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

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

The IRS requires that UBI is reported and its corresponding taxes be paid. Similarly, when the EO’s unrelated business income becomes excessive, its tax-exempt status may be revoked.

Excess Benefit Transactions

IRS is particular about “inures to the benefit” of an individual or a private group. This is why Form 990 has a section that requires EO to disclose excess benefit transactions received by an insider (also known as a disqualified person). 

Excess benefits occur 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 excise tax. Consequently, board members who approve the transaction will be subjected to penalties and fines, and most importantly, the organization may lose its tax-exempt status. 

And since the violation of this provision is subject to “intermediate sanctions,” such must be disclosed to the public which may negatively impact the image and integrity of the organization. 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 opt to hire independent contractors rather than employees to make the most out of donations received. In our blog about hiring independent contractors, companies usually erroneously classify employees as contractors for various reasons, including the 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 or unemployment benefits. 

Misclassification exposes the organization to an audit. When tax authorities, state governments, the Department of Labor, and other concerned agencies prove that there is indeed a misclassification of workers, the organization will then be liable to pay taxes, fines, and penalties. 

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 and grantors, the general public, government agencies, the State, and members or part of the IRS. 

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

The State takes primary responsibility for nonprofit organizations. Thus, when complaints involve improper behavior, governance disputes, or issues with local donations, funding, and charitable programs, the State 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 clearly violates the purpose, power and conduct of the nonprofit in question. 

More: Top 15 Non-profit Board Governance Mistakes

Noncompliance with Fundraising and Solicitation Requirements

forty-one states and the District of Columbia require some charities to register solicitation activities. Some only require initial registration, while others require a yearly renewal. This requirement varies by state, so be sure to check with the State you intend to solicit donations from. 

States take unregistered solicitations very seriously. In addition to penalties and fees imposed on the organization, some states file civil and/or criminal lawsuits; worst is that they can file for the revocation of the organization’s tax-exempt status. 

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 exempt nonprofits from paying TPT/Sales and Use tax on certain transactions. Exempt organizations registered in Arizona may be exempted from paying TPT and Use tax depending on the parties involved in the transaction.

Such is not the case for Washington nonprofits, even though they are tax-exempt. These organizations are still required to pay Sales and Use tax on all transactions conducted in the State. 

When the State suspects that an organization failed to pay all state-related taxes and liens, the State may conduct an investigation. 

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

The State, through the Attorney General, has the power to file a lawsuit which subsequently triggers an investigation. Offenses such as grave misconduct, fraud, and misappropriation of donations are taken seriously by the government and the public as these violate the fiduciary principles of a nonprofit – duty of care and duty of loyalty. 

Better Business Bureau – For Complaints Filed Against an Accredited Member

The BBB is an independent organization that rates different businesses according to their reliability and performance and complaint and dispute resolution. Many consumers rely on BBB’s rating system to determine if an organization is trustworthy or not. 

While BBB can act as a facilitator or mediator in resolving complaints and disputes, it does not “audit” the organization in question. The main incentive for members and non-members alike to respond to BBB’s inquiries is the effect it will have on the ratings, and as mentioned, many use BBB’s rating as a reference. 

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 under the following situations:

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 endowment as a tax-deductible expense. Later on, it was discovered that the organization, at the time of the donation, had failed to retain its tax-exempt status. The tax-deductible expense, therefore, is invalid and the donor will be subjected to fines and penalties as a result.  

When an organization receives state-funding

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

When nonprofit organizations expend $750,000 or more

When an organization expends $750,000 or more in a fiscal year, the nonprofit organizations are required to obtain a Single Audit. 

A Single Audit is more detailed and requires more testing than regular independent audits. It checks both the organization’s financial statements and the federal awards. The intention is to ensure that the organization complies with the grant or federal award requirements. 

As a nonprofit organization that is also enjoying tax-exempt status, we have to take it upon ourselves to ensure that we comply with the government’s laws and rules. Audits are there to give assurance to all stakeholders and should be received with an open mind. And as long as we do our best to be compliant, what is there to fear?

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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.