IRS 501(c)(3) Audits – 5 Potential Sources
There is one phrase in the English language that generates more fear and trepidation than any other out there: IRS AUDIT. Just hearing the words is enough to cause many a fearless person to break out in a cold sweat and to shrink in terror. It is bad enough when an individual has to deal with IRS questions. But when it happens to a nonprofit organization, there is plenty of pain to go around. Directors, employees, members, donors…all can be affected. Plus, just the potential bad publicity is enough to cause nonprofit leaders to reach for the Rolaids.
So how does a nonprofit avoid an IRS examination? It helps to understand some of the situations and events that can trigger an audit. In this article, we are going to look at 5 sources of audits and give you advice on how stay out of Uncle Sam’s cross-hairs.
1. Complaints. One of the most common causes of IRS examinations is a complaint filed by a third party. Such “whistle-blower” situations may or may not have a shred of credibility to them. Typically, if the IRS decides to look into the allegations, it will start out as a compliance exam. It is possible for one of these exams to progress to the status of a full-blown audit, but most do not…at least for those organizations that are operating completely above board.
But how do you prevent this? Admittedly, anybody can fabricate a complaint. But substantiating it is another matter. Unless the complaint contains credible (or, at least, believable) substance, it is often set aside by the IRS. Operating in a transparent manner and maintaining good communication with the public goes a long way toward minimizing the risk of complaints.
2. IRS Form 990. Form 990 is the federal information return filed annually by tax-exempt organizations. The purpose of Form 990 is to inform the IRS (and the public) about the nonprofit’s activities, finances, and governing structure. It is also a prime contributor to IRS audits. Why? Form 990 is intentionally designed to reveal the degree of regulatory compliance the organization is operating within. The best way to avoid Form 990-inspired audits is to operate in compliance to begin with, then make sure whoever is preparing the return knows what they are doing. Unfortunately, most tax preparers are not experienced with the specifics of IRS tax-exemption. Find one who is.
3. Payroll tax returns. This is another example of required filings coming around to bite an organization. How? Errors and omissions constitute one way. If the IRS sees odd things on payroll tax returns, scrutiny is invited. Another thing the IRS looks at is consistency of information. Let’s say your nonprofit pays its staff as independent contractors (usually not a good thing), but reports the payroll on Form 990 as salary. This type of mismatch is an open invitation for questions to be asked. As with Form 990, it pays to get competent advice and assistance.
4. Public shenanigans. I guess you could say this is related to #1 above (complaints), but it is different. This type of examination is practically begged for. Acting out publicly in a manner contrary to federal regulations is simply baiting the IRS to come knocking. The current situation involving the organization ACORN is a prime example. Though they haven’t been audited yet, it is likely coming. Other examples include blatant, political campaign involvement, excessive compensation of charity leaders, and conflicts of interest. Even if the IRS doesn’t see it directly, these situations often lead to third-party complaints. Know the rules and stay within them. And, if you have a lime-light seeking leader, or you are one yourself, consider yourself warned.
5. Random audits (bad luck!). This category is the one you can do the least about. It just happens. A few years ago, the IRS decided to review executive compensations within the nonprofit community. They set out to look at 1,000 501(c)(3) organizations to gauge the level of compliance with standards of reasonable compensation. They set their target on organizations whose key executives had total compensation packages in excess of $100,000. One of our client organizations happened to be chosen. Not that they had done anything to cause suspicion…they simply met the criteria. The audit lasted about 3 weeks and was not only stressful for those involved, it cost the organization valuable time and employee resources. Fortunately, the IRS found no significant problems, but much energy was spent in the pursuit.
Of course, there are other reasons your nonprofit could be audited, but this list represents some of the most common causes. In an upcoming article, we’ll take a look at what to do if you get the dreaded notice that your organization is about to be examined.