As the Internal Revenue Service ramps up its audit staff, its gaze is extending beyond the for-profit sector. IRS audits of public charities are also increasing.
We have recently assisted several charities with their audits and observed some common themes. In each case, the Revenue Agents:
- asked for information already explicitly provided in the charities’ Forms 990
- quickly requested interviews with organizational leadership
- followed-up with Information and Documentation Requests (commonly known as IDRs) addressing many of the same answers provided in the interviews. In addition, the information requested by the IRS was detailed and significant.
All three factors may have resulted because the Revenue Agents assigned to our our recent audits seemed to be newer and less-experienced. It may be that the Tax-Exempt and Government Entity (TE/GE) Division is also hiring new agents and assigning these new Revenue Agents ‘learning experience’ audits. Unfortunately, charities, including our clients, are the ones suffering from this training.
In each of these recent cases, the Revenue Agents have immediately requested detailed and substantial information about the charity’s purposes and activities. The IRS appears to be questioning whether the charity remains organized and operated exclusively for charitable purposes. While the IRS Notice of Audit did not threaten the charities’ tax-exemption, revocation is always a risk. Revenue Agents are asking for substantiation of all activities, all expenses, all board activities and all contracts, as well as documentation related to any other organization that appears related, whether through similar activities or overlapping board membership.
Revenue Agents have also quickly asked for extensive information about activities in which the charities engaged. The Revenue Agents are questioning whether the activities resulted in unrelated business taxable income, and if so, whether unrelated business income tax was paid by or on behalf of the nonprofit and whether the nonprofit’s exemption should be revoked because the nonprofit derived excessive unrelated business taxable income. Similarly, the Revenue Agents are questioning all claimed payments of expenses in what appears to be an automatic examination of potential excess benefit transactions. For example, simple expense reimbursements to officers, directors, and/or volunteers made by our clients are requiring substantial documentation – of the expense, of the authorization for the officer, director, or volunteer to pay the expense, the exempt purpose of the expense, proof of reimbursement and authorization of the reimbursement. This type of probing could expose an individual error by the charity. But even if the charity did everything right, it will need to spend substantial time, and potentially money, proving it was entitled to a basic operational expense.
The Revenue Agents are also asking for information about political campaign activities conducted by the charity’s officers and members. These questions go to the issue of whether the charity was indirectly engaging in impermissible political campaign activities.
In addition to gathering information and documentation that could expose each charity’s exemption, Revenue Agents also are looking into employment classification issues, whether the charity paid the correct amount of employment taxes, and whether the charity filed the correct employment tax forms. At the same time, Revenue Agents are examining whether compensation paid to certain officers constitutes an excess benefit transaction in violation of the private inurement rules.
Not only are these issues complex, but the collection of information and documentation is exhaustive and time-consuming. Due to potentially significant financial penalties, however, we recommend that charities respond in a careful, deliberate and thoughtful manner and retain an attorney experienced in nonprofit audits to review the response prior to submitting it to the IRS. The attorney should also participate in any interviews and handle all follow up questions.
Timely and proper audit responses may end up saving the charity’s tax-exemption, as well as significant income and excise taxes. Oftentimes, an attorney can notice a legal error made by a Revenue Agent, which can save the charity substantial funds. In one recent case, the Revenue Agent argued that the IRS still had months to assess the charity, but the charity’s attorney persuaded him he had incorrectly calculated the deadline. A significant assessment and an entire year of potential problems immediately disappeared due to the expiration of the statute of limitations. In another case, each member of a charity’s board avoided the assessment of a personal excise tax by establishing that the presumption of reasonableness existed when the board approved the CEO’s compensation arrangement.
Tax-exempt organizations do not simply live outside the federal tax system. They are like every other business – except they agree to an entire regime of rules and regulations in exchange for not paying income taxes. The IRS is now coming after them to make sure they are keeping up their side of the bargain. Handling an audit improperly can cost the charity and its board members money (income and excise taxes) and result in the revocation of its tax exemption.