Two questions tax practitioners hear frequently — “What are the risks of an IRS audit?” and “What outcome can we expect if we are audited?” If you ask your tax advisor these or similar questions, it’s likely you will not get an answer. It is not ethical to give tax advice based upon probability of audit risk, and no one can predict the outcome of an IRS examination. However, the IRS recently published its annual examination statistics for exempt organizations, and the numbers can reveal useful information.
Below is a breakdown of the over 6,000 examinations displayed in this most recent IRS report, sorted by the primary issue examined for each 2017 return. Bear in mind, a single organization may have had more than one type or return examined. For example, a single organization may file a Form 990 for organizational, financial, and operational issues, a Form 940/941 for employment tax issues, and a 990-T for Unrelated Business Tax issues. Therefore, the 6,101 tax returns may not equate to the total number of organizations examined. This is a breakdown of the total number of returns examined.
Fiscal Year 2017 Closures by Primary Issue
What the IRS is Looking For
The issues the IRS might be examining, making recommendations regarding, issuing penalties for, or assessing taxes on, in each listed area include:
Filing, Operational, and Organizational
Includes verification of the exempt activities or filing requirements of the organization, including obtaining delinquent returns. The revenue agent would be assuring that the revenue sources are related, the expenditures meet the exempt purpose, the overall exempt purposes disclosed on Part III of the Form 990 are in line with the original application for exemption and any later notifications of changes were approved by the organization’s governing board, and compliance with requirements attested to in the Form 990 Part V compliance questions.
Employment Tax Issues
Includes unreported compensation, tips, accountable expense reimbursement plan compliance, worker reclassifications, and noncompliance with FICA, FUTA, and backup withholding requirements.
Unrelated Business Income
Includes gaming, nonmember income, expense allocation issues, Net Operating Loss adjustments, rental activity, advertising, debt financed property rentals, and investment income. Organizations should carefully evaluate revenue annually, and not only the type of revenue, but also the source of revenue.
Includes not only revocations of overall exempt status, but also terminations and foundation status changes. Careful review of the public support test on Schedule A and continued adherence to the organization’s mission are important factors to maintaining current exempt status in the appropriate category under IRC section 501.
Includes the potential for an organization’s activities to inure, or provide private benefit, to key individuals associated with the organization, including assessments of excise taxes. These transactions are commonly uncovered with organizations lacking independent boards through disclosures of the number of board members on Part VI and transactions with “Interested Persons” on Schedule L Parts II, III, and IV. Those parts of Schedule L disclose transactions which the organization believes do not violate the excess benefit rules of IRC section 4958. Transactions the organization already determined to be excess benefit transactions would be disclosed on Part I of Schedule L.
Political, Legislative, and Governance
Includes exempt function vs. taxable expenditures, financial oversight of the governing body, net investment income adjustments, and political expenditures of 501(c)(3) organizations. These disclosures are generally found on Schedule C of the Form 990. Organizations may have additional filings such as Forms 1120-POL or Form 4720 if there are violations.
Includes miscellaneous excise tax on gaming returns, taxes on self-dealing and failure to distribute income, healthcare issues, Chapter 41 and 42 taxes, and other abatements and penalties. This category includes many of the private foundation categories of transactions which are found on the Form 990-PF. This is a complex form which needs to be well understood to avoid triggering unwanted additional scrutiny by the IRS for inadvertently checking a box incorrectly.
How Audited Nonprofits Were Affected
While the details of the required changes were not discussed in the IRS report, the agency is touting its success by reporting 82% of the examinations resulted in changes. This means 5,000 returns had some type of change. The examinations resulted in 63 revocations, which represents 1.03% of the total examinations closed in 2017. Of those, the majority (36) were because the organization was not operating for an exempt purpose. Only three were due to private inurement or private benefit. One third (21) were due to discontinued operations, failure to provide records, and operating as a different subsection of IRC Section 501(c). For example, the organization may not have been a charitable 501(c)(3) organization but a 501(c)(6) trade association operating for bettering a particular trade or business group. In the membership organization realm, only three – were due to excessive non-member use of facilities.
As part of the IRS Post Determination Compliance Program, the IRS examined 1,400 exempt organizations that filed Forms 1023 or 1024, selected through a statistically valid sampling process. About 57% resulted in no changes. The remaining 43% resulted in various changes, such as amendments to organizational documents and failure to file returns, including 14 revocations.
The IRS also examined 565 organizations, randomly chosen, that were granted tax exempt status through filing the short form application, Form 1023EZ. Of these, approximately 49% closed with no changes. The remaining 51% closed requiring amendments to organizing documents or various other written advisories. Five resulted in either terminations or revocations.
What Do These Statistics Mean for Exempt Organizations?
While this is interesting information, how can it help exempt organizations? This information could be used to develop and implement self-audit procedures. Organizations can periodically and systematically look discerningly at various parts of their operations. How often and what areas to look at depends on the organization’s situation.
Your tax advisor can help you develop such procedures or perform a mock IRS exam. It is always best to catch areas of noncompliance or risk before the IRS does, so corrections can be made. As stated on the IRS website, the goal of the Exempt Organizations Examinations program is to promote voluntary compliance. Further information on how the IRS conducts exempt organization examinations can be found here.
If you have compliance questions, please contact your tax advisor or Clark Nuber.
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