IRS Audits: why they happen, what to expect, and how to avoid themMary Jo Alexander, CPA, Tax Director, Mauldin & Jenkins, LLC | October 2014
If your organization receives that unexpected letter from the IRS, what would you do?
The thought of an IRS audit is unsettling. Unlike for-profit entities, and depending on the circumstances, a nonprofit organization’s exempt status and very existence could be at risk. Yet, the IRS has an obligation to protect the public’s trust. Taxpayers are benefiting from and relying on a tax deduction on the basis that their contribution will be put to good use by a reliable, law-compliant entity. The federal government is receiving fewer tax dollars as a result of contributions. The IRS wants to make sure that this sacrifice of tax revenue, these donated goods and monies, have been put to proper use.
If your organization is being examined, you will receive a phone call to schedule an appointment and a confirmation letter requesting documents and records required for the IRS Agent to conduct the examination. This is considered a field audit. Alternatively, this could be completed at your representative’s office or the local IRS office.
A correspondence audit is a request to provide the documents via mail to the IRS.
A compliance check is not an exam or audit. It is a written inquiry or questionnaire to determine if specific issues have been reported completely and properly. If irregularities are discovered, this could turn into a full audit.
Putting this in perspective, according to the Foundation Center, there are over 1.5 million nonprofits in the United States. Per the IRS Exempt Organization Unit FY 2012 Annual Report and FY 2013 Workplan, the IRS conducted approximately 11,000 audits and 3,000 compliance checks. The IRS Exempt Unit has not issued an annual report since then. FY 2014 is about to close and what the FY 2015 Workplan entails is unknown. While there has been an increase in audits in recent years, it’s apparent that relatively few are selected. Nevertheless, it is best to be prepared and to know your rights.
You are entitled to representation by a nonprofit attorney or accountant. This professional will communicate with the IRS to manage the process, negotiate and make sure that the IRS does not go beyond what is necessary. In the event of an unfavorable audit result, you are entitled to appeal the Agent’s decision.
Why did the IRS select your organization in the first place? What can you do to minimize the chances of being selected?
Random selection is feasible and there are audit quotas to fill. Note that the IRS Exempt Unit, often communicated via their workplan, has well-defined areas for investigative focus such as university related organizations, hospitals, etc. They do conduct profiling to identify situations they want to explore further with certain types of nonprofits.
What’s critical to minimizing the chances of an audit is to file an accurate, complete Form 990. Form 990 is a convoluted document that must be prepared with care to ensure that data and responses are consistent throughout the return. The IRS can readily flush out inconsistencies, prompting further investigation.
Be sure to have good governance policies in place and adopted by the board. Also maintain board and committee minutes. Know your board. At least 50% of the board should be independent, that is, not organization employees, not directors of related organizations, etc. Send the board an annual survey identifying relationships with current and former officers, directors and key employees.
Be in compliance with other tax filing requirements including 990-T filing, employment returns, etc. This is clearly reported on the Form 990. The 990 filing should not leave the reader with unanswered questions due to inconsistencies. If you have employees, the expectation would be that you have filed all employment returns. Be sure you have your workers properly classified as employee or non-employee. If you have large amounts of other income, that might suggest an opportunity for unrelated income. The IRS will be looking for potential unrelated business income since this generates tax revenue.
An exam of a charitable organization will confirm the organization’s ongoing qualification for tax-exempt status. The organization will need to demonstrate that it meets the organizational test via its articles and/or bylaws. Also it must meet the operational test, that the primary activities accomplish an exempt purpose as defined in IRS Sec.501(c)(3), no earnings have gone to the benefit of private shareholders or individuals, that there was no substantial lobbying nor any political activities.
Try to anticipate what issues could arise and work towards resolving those now by adopting best practice policies and internal procedures to ensure compliance.
If selected for audit or compliance check, fully cooperate and seek advice of experts as needed.
Mary Jo Alexander, CPA, is a Tax Director for Mauldin & Jenkins, LLC. With over 20 years of tax experience, Mary Jo “MJ” specializes in nonprofit taxation.