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Top 10 Form 990 Audit Triggers No One Told You About

Audit Trigger

Timely and accurate filing of Form 990 is essential to the ongoing success of your nonprofit. We often run into the false notion that since it is a nonprofit filing the return, that the IRS really doesn’t pay that much attention to what’s reported. They DO pay attention! In fact, Form 990 can be the very thing that generates an audit of your organization.

Introduction

There are several situations that can trigger an IRS audit of a nonprofit. It could be a whistle-blower who reports what they believe is non-compliant behavior. It could also result from banking irregularities, or maybe something negative about the organization going viral and catching the IRS’s (or your AG’s) attention.

What most nonprofit leaders don’t realize, however, is that Form 990 is the primary source for audits of nonprofits by the IRS. In fact, the IRS computer system has built-in analytical tools that look for certain data points and inconsistencies. Raise the right flag(s), and you may be getting a letter informing you of some hassle ahead.

Let’s look at the top 10 Form 990 audit triggers, in no particular order.

1. Failure to File a Complete Return

Filing an incomplete return happens quite a bit when you have someone preparing Form 990 that doesn’t really know what’s required. We’ve even seen it happen with tax pros who aren’t well versed in nonprofits. Usually, though, it’s returns prepared by an employee or volunteer trying to save money. Form 990 is a complex return, especially for those required to file the long version (greater than or equal to $200,000 annual revenue).

Not every incomplete return will result in an audit. It really depends on what was left out. The bigger concern is that the IRS regards incomplete returns the same as ones that were never filed! That means that if a corrected return is not filed by the due date, the incomplete return will be tossed out and late fees will start piling up as if you never sent a return in at all.

BONUS: Inconsistent Returns – This could be an 11th point, but we’ll make it a subpoint of number 1. Inconsistent returns can also alarm the IRS that something is amiss with your nonprofit. It could be inconsistencies from one section of the return to another, or it could be changes to how you report information from year-to-year. It’s important to set a pattern of disclosure and stay with it. Now, if something changes, or you find prior year errors and need to change methods of disclosure, do it! An audit isn’t guaranteed to happen, and better to be accurate than keeping on doing something incorrectly.

2. Acknowledging a "Diversion" of Assets

Part VI, Line 5 asks an interesting question:

Did the organization become aware during the year of a significant diversion of the organization’s assets?

If you don’t speak the IRS’s language, and chances are good that you don’t, this question sounds odd. Diverted where?

What the IRS is asking here is whether there has been any embezzlement or some other transactions that have resulted in the nonprofit’s money or other assets being “diverted” to personal or otherwise inappropriate use. A “yes” answer to this question should be accompanied by a detailed explanation of what that diversion entailed, and how it was remedied. Even with an explanation, an audit is possible here.  Without an explanation, it’s virtually certain. We had it happen to a client who prepared their own return and answered “yes” to this question accidentally. Painful lesson in the cost of do-it-yourself.

Now, if your organization experienced such a diversion, don’t answer “no” out of fear of audit. Always answer truthfully, as all returns are filed under penalty of perjury.

3. Acknowledging Prohibited Political Activity

Part IV, Line 3 and/or Schedule C, Part I asks whether or not the nonprofit was involved in any prohibited political activity in the prior year. This question is primarily aimed at 501(c)(3) organizations to see if they participated in campaigns for public office (which is strictly prohibited), or excess lobbying activity.

Again, a truthful answer is necessary. But know ahead of time that a “yes” answer could spell trouble.

4. Unrelated Business Income

Unrelated business income, or UBI, is any income a nonprofit generates from an ongoing activity where the activity is not directly related to the organization’s exempt purpose. An extreme example of this might be a 501(c)(3) church that runs a public coffee shop as a perpetual fundraiser. See our article on UBI for more information on what it is.

UBI is not illegal or inappropriate. As long as it is correctly reported, taxes are paid on the profit, and it doesn’t make up a significant percentage of overall revenue, it’s a legitimate income stream opportunity. But, it automatically subjects the nonprofit to a higher level of scrutiny.

There are two avenues frequently seen where UBI can trigger an audit. One is acknowledging UBI greater than $1,000 on the Form 990 without filing a required Form 990-T. The “T” return is where the income and expenses for UBI activity is reported and taxes calculated and paid. Failure to complete the T is an audit guarantee.

The second area is more subjective. As mentioned above, UBI activity should not represent a big part of a nonprofit’s revenue picture. Letting UBI creep above 20% of total income, or have too much expenses allocated to the activity tells the IRS that your nonprofit may not really be exclusively about a charitable purpose.

5. Acknowledging Excess Benefit Transactions with Disqualified Persons

Here’s another great example of a question that novices won’t likely understand. And, a “yes” answer to Part IV, Lines 25a or 25b is a big audit trigger. It may also trigger some nasty penalties called intermediate sanctions.

Some definitions are necessary here. First, the IRS says that: an excess benefit transaction is a transaction in which an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of a disqualified person, and the value of the economic benefit provided by the organization exceeds the value of the consideration received by the organization. A disqualified person is any person who was in a position to exercise substantial influence over the affairs of the applicable tax-exempt organization at any time during the lookback period. The lookback period is the five-year period before the excess benefit transaction occurred.

That’s a lot to digest, but the plain English version is this: Monetary or other benefits provided to those in power (officers, directors, key employees, or anyone related to those persons) in excess of reasonable employee compensation, or in excess of what that individual may have paid for is prohibited. Acknowledging that such a thing happened, while necessary if true, is a massive audit trigger, as well as the potential for monetary fines (intermediate sanctions) levied against the board members personally. Nasty stuff.

6. Unreasonable Compensation

The IRS requires salaries and wages paid to employees of a nonprofit to be limited to reasonable compensation. The IRS doesn’t do a great job of defining “reasonable”…it’s more of a “know it when we see it” sort of thing. That said, the best way to understand what the IRS requires is that employee compensation should be comparable to other similar nonprofits, be objectively tied to the job description, and be within the organization’s ability to pay without hindering their ability to carry out their mission.

Form 990 lists your highest compensated employees. The IRS looks at this reasonableness question two ways: 1) Is compensation excessive? If so, they may determine that the organization is focused on individual gain, and not public benefit. And 2), Is compensation too low for the size and budget of the nonprofit? While #2 is less likely to generate an audit, it can happen. #1 is one of top audit triggers!

7. Foreign Grant Activity

US nonprofits are allowed to operate in foreign countries, as well as grant monies to foreign charities. We have quite a few client organizations whose mission is conducted wholly off-shore. Foreign activity, however, is a heavily scrutinized area by the IRS, due primarily to the risk of having a US charity being under the shadow control of a foreign entity that the IRS has no jurisdiction over.

Form 990 asks questions about foreign bank accounts, activities in foreign countries, and foreign organization grant-making. Inconsistencies here, or answers to questions that may indicate a lack of US control, is a big audit trigger. If your nonprofit has foreign activities, make sure you’re working with a professional compliance team like Foundation Group to ensure you’re doing things the correct way.

8. Fundraising Income and Expense Discrepencies

Schedule G of Form 990 is where nonprofits report their income and expense activity for each individual fundraising event conducted in the past year. It is also a source of potential audit.

One of the things the IRS looks for is inconsistencies in income and expenses. If your nonprofit reports a hefty income, but very little in the way of expenses for that same fundraiser, it raises a flag. It’s more problematic in reverse. It is reasonably common to see an imbalance, especially when a big donor comes through and pushes a particular fundraiser through the ceiling. Expect more scrutiny when it goes the other way…big expenses, but little revenue, resulting in a net loss on the campaign.

Of all the audit triggers, this one happens less frequently, but it’s something to be aware of.

9. Non-Employee Services, But No 1099-NEC

This is a fairly common occurrence, and it can trigger inquires in extreme cases.

Your nonprofit reports on Form 990 that it paid independent contractors in the past year.  But, you did not distribute Form 1099-NECs to these vendors, as the IRS requires. Not only does that subject your organization to a penalty per 1099, but it can also raise a red flag with the IRS if the amount of non-employee compensation is relatively high.

First, make sure your contractors are really contractors, and not employees. Second, if you pay contractors, it needs to be reported on Form 1099-NEC before January 31.

10. Loans to Disqualified Persons

Congratulations, if you made it to this point in the article! It’s a lot to talk about.

Our final top 10 Form 990 audit trigger involves loans to disqualified persons, a.k.a., insiders (officers, directors, etc.). First of all, a nonprofit lending money to an insider is considered unethical at best. In most states, it’s also prohibited by law.

While it may be a violation of state law in your area, it isn’t technically against IRS regulations federally. That said, Form 990 asks specifically if the organization has lent money to a disqualified person. That can be enough to raise concern. The real audit trigger, however, is failure to see that receivable number decrease year-over-year.

For example, say your nonprofit’s board President borrowed $20,000 from the nonprofit. Further, let’s assume it was not against state law, and a legal contract was signed, including a stated interest rate. If the 2019 Form 990 shows that loan outstanding at $20,000, and the 2020 Form 990 doesn’t show a decrease in that amount, it’s telling the IRS that the borrower isn’t paying back the loan. That is prohibited private benefit, and an audit may be coming your way!

Conclusion

The good news is, the IRS audits relatively few nonprofits each year. But for those who are unlucky enough to get an audit notice in mail, you can expect that Form 990 problems were the most likely cause of it. Work with a tax professional who knows these triggers, and can help your nonprofit avoid the headache of a visit from Uncle Sam!

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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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