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Preventative Tax Planning for Tax-Exempt Organizations

December 04, 2012

Kevin D. Fontana, CPA, MSA, MST
Manager

In recent years, the IRS has increased the number of audits of tax-exempt organizations and the methods used to select an organization for audit.  This is primarily the result of the new 990 as well as recent high-profile fraud cases and increased public scrutiny of such organizations.  As such, it would be wise for all tax-exempt organizations to take a hard look at their operations, policies and activities to help prevent a costly outcome of an IRS examination.  This article will focus on some of the high-risk audit areas, the factors used by the IRS in selecting tax-exempt organizations for audit, and will then provide some preventative steps that tax-exempt organizations can take to help minimize risks and ensure compliance with IRS requirements.  Although this article is geared towards 501(c)(3) organizations, many of the concepts can be applied to all types of tax-exempt organizations.

An audit of a tax-exempt organization is not just an audit of the financial information.  An audit also focuses on the organizational and operational requirements of tax-exempt organizations, including governance, operations, management, activities, etc.   Audits of tax-exempt organizations are designed to accomplish a variety of objectives, including the following (not an all-inclusive list):

  • To determine if the organization is being operated for public, not private, interests
  • To determine whether or not the organization engages in significant non-exempt activities
  • To determine if the organization is paying excessive compensation or benefits
  • To determine the existence (and the extent) of any lobbying activities

The Internal Revenue Code (IRC) and Regulations require that exempt organizations be organized for a qualifying exempt purpose and operate to further that exempt purpose.  Therefore, during an audit, the IRS will review governing documents to ensure that they are consistent with the exempt purpose and that they have not been modified or amended in any manner that is inconsistent with that purpose.  In addition, the IRS will scrutinize the activities of the organization to ensure that they are consistent with the exempt purpose and to determine whether any substantial part of the organization’s activities furthers a non-exempt purpose or results in a private benefit.  In order to determine if such activities exist, the IRS will review board and committee minutes, handbooks and other materials, and even attend various programs that the organization provides.  It is, therefore, crucial that tax-exempt organizations document the specifics of each activity and ensure that all of its materials are consistent with its exempt mission.

Another audit area that the IRS focuses on is “private inurement”, or transactions with insiders (i.e. board members, founders, and related parties, etc.) that result in greater than fair market value to the insider.  If an organization’s assets are determined to have been used in such a manner that results in private benefit, then the organization could lose its exempt status and/or be subject to monetary penalties and fines.  In addition, significant excise taxes can be levied on those insiders who benefited.

Common IRS Audit Targets

In the past, the IRS has typically targeted certain types of organizations and/or activities for audit.  These organizations include:

  • Organizations with gaming activities
  • Organizations engaged in joint ventures with for-profits
  • Credit counseling agencies
  • Hospitals
  • Colleges and universities

While these types of activities and organizations are permitted, there is a higher risk of audit for a variety of reasons.  However, in recent years, the IRS has increased its audits of all types of tax-exempt organizations, and has begun developing new models to help determine which organizations to audit. 

For example, in 2012, the Exempt Organizations Division of the IRS began looking at organizations that reported unrelated business activities on Form 990, but which have not filed Form 990-T.  In addition, models are being developed by the IRS to identify 1) organizations that consistently report significant gross receipts from unrelated activities, but pay no unrelated business income tax, and 2) organizations that report salaries and wages expenses, but which are not filing employment tax returns.  Typically, the fact that an exempt organization is carrying on a trade or business that is not substantially related to its exempt purpose will not result in a loss of exempt status.  Rather, the organization simply must properly report and pay tax on the unrelated income.  However, if a significant portion of the organization’s activities are unrelated to its exempt purpose, then it may jeopardize the organization’s exempt status.

Other recent trends by the Exempt Organizations Division include using the new 990 to develop risk models that help assess the likelihood of noncompliance.  For example the section in the new Form 990 where the organization describes its activities and program service accomplishments has questions that ask whether an organization has undertaken any new programs and activities not previously reported to the IRS, or whether an organization has ceased conducting certain programs.  The IRS may use this information to help select organizations to be audited.  In addition, the IRS is focusing on the governance and management sections of the 990, on the premise that those organizations that lack proper governance and policies will be more likely to engage in activities that are not exempt or not permitted.  Recently, the IRS has become more aggressive in pursuing revocations of tax-exempt status and is actively pursuing cases for intermediate sanctions for excess benefit transactions and private inurement. 

So what are some of the preventative measures that an organization can undertake to help mitigate the risks and negative outcomes of an audit?

First, it starts with good governance and policies to ensure there is transparency throughout the organization.  Every exempt organization should take the steps necessary to be able to answer “yes” to each of the Form 990 questions in Part VI, as applicable.  The IRS would not put questions about these policies on the Form 990 if it didn’t think that every tax-exempt organization should have these policies in place.  Note though, that these questions come with strict rules and complicated requirements.  Consult your tax advisor to help ensure that the requirements of each question are fully understood before drafting and implementing policies that don’t actually meet the criteria established by the IRS to answer “yes”.  If the organization can’t answer yes because one or some of the requirements are not met, it’s a good idea to at least describe the policy that has been adopted by the organization in the Schedule O narrative, and why it feels that its policy is sufficient. 

Second, having the policies in place doesn’t ensure compliance.   The policy must actually be adhered to and followed by the members of the organization’s board and management.  For example, executive compensation and conflict of interest policies require regular and consistent monitoring by the board.  Specifically, the rules pertaining to reasonableness of executive compensation are complicated, and compensation decisions require appropriate and contemporaneous documentation.  This is a “hot button” issue with the IRS, and can’t be taken lightly. 

Next, avoiding certain activities and transactions that can potentially jeopardize the exempt status of the organization are a must.  The best way to do this is to ensure that the organization’s activities are consistent with those described on the organization’s Form 1023 – Application for Recognition as a Tax-Exempt Status Under Sec. 501(c)(3).  Board members and management should review the Form 1023 to make sure they have a clear understanding of why the organization was granted exempt status so that they can properly manage the activities of the organization to remain tax-exempt.  Also, if new activities are undertaken, it is imperative that the organization consider and document how those activities further its exempt purpose.  This information must be reported on the organization’s annual Form 990 filing. 

Finally, an active and knowledgeable board is key to preventing negative outcomes of an IRS audit.  Board members should fully understand what the exempt purpose of the organization is, what it means to be exempt, what activities the organization is conducting and how those activities further the organization’s exempt purpose.  Board members should also review and understand the organization’s annual Form 990.  

Being granted tax-exempt status is a privilege, not a right, but there are costs to maintaining that status and the benefits that come with it.  Don’t take the Form 990 lightly – it could help you to avoid the potentially dire consequences of an audit. 

 

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