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IRS Stepping Up Nonprofit Oversight

The headline for this article is not really “new” news.  The Internal Revenue Service has been stepping up enforcement of its regulations governing nonprofits for several years now.  Those who have been keeping up with the changes to the Form 990 annual reporting requirement know this to be true.  What is new this time is that the IRS is focusing hard on two, key areas:  1) nonprofit pay practices and, 2) abusive activities by charities.  Let’s take a look at each of these.

1) Nonprofit pay practices. The topic of nonprofit pay practices has long been an area of concern for the IRS.  Federal regulations require that compensation paid to employees of tax-exempt organizations must be “reasonable”.  Unfortunately, “reasonable” is a subjective evaluation of the situation as a whole, not necessarily an objective check list.  Moreover, the IRS is the ultimate arbitor of what is considered reasonable.  So what is new?  The overall economic downturn, along with the focus on executive pay, has ramped up IRS scrutiny of the compensation nonprofits pay their executives.

The IRS recently surveyed 489 nonprofit hospitals, looking at executive compensation.  They found the average, annual pay package for the top executive to be $490,000.  Executive pay at the top 20 hospitals surveyed averaged a whopping $1.4 million.  The IRS did not necessarily determine these amounts to be unreasonable.  But, according to Lois Lerner, the IRS director of tax-exempt organizations, the findings “raised some eyebrows”.  As stated above, reasonableness is a subjective determination.  What did come out of the survey, however, was a renewed focus on executive compensation practices of all tax-exempt organizations.  She further stated to attorneys representing nonprofits at Georgetown University’s recent Representing & Managing Tax-Exempt Organizations conference, “If you’re not looking, we’re looking.”

The issue of executive compensation is not just a question of reasonableness.  It is also about arms-length transactions.  We counsel with clients everyday, explaining the absolute necessity of conducting transactions with insiders at arms-length…especially compensation issues.  If one of your board members is also a paid staff member, you must make sure that person has no vote and does not exert undue influence in determining his/her compensation.  This is a very big deal to the IRS.  We will soon be taking a closer look at the topic of executive compensation.

See also the Wall Street Journal story, “IRS Probes Nonprofit Pay Practices”

2) Abusive activities. The current economic downturn has also focused IRS attention on the potential for illegitimate charities, those with ill-intent, to use this situation to manipulate a vulnerable public.  Ms. Lerner mentioned this at the same Georgetown University conference, saying, “During hard times, there is often a rise in questionable or fraudulent activity, in overly aggressive or inappropriate fund raising, and in tax-avoidance accommodation schemes of less than sterling character.  We’re trying to stay ahead of the curve to curtail predatory, abuse of tax-exempt organizations.”

The IRS will typically be looking at specific categories of nonprofits in maintaining its vigilance against fraud.  Organizations with the greatest opportunity to abuse the current economic climate, such as those engaged in credit/mortgage counseling, will receive the most scrutiny.  It is rather obvious for us to tell you to maintain above-board operations.  If your nonprofit conducts any programs that target recipients in financially dire straights, just know that the IRS is looking over your shoulder more closely than usual.

For more information, see the article in The Chronicle of Philanthropy, “IRS Watches for Potential Abuses as Charities Grapple with Bad Economy”

Greg McRay, EA

Greg McRay, EA

Greg McRay is the founder and CEO of The Foundation Group. He is registered with the IRS as an Enrolled Agent and specializes in 501(c)(3) and other tax exemption issues.

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