You may have heard jokes or other light-hearted comments about IRS audits. However, actually receiving an audit selection letter from the IRS is usually not a laughing matter. The IRS routinely audits exempt organizations to ensure compliance with federal tax requirements. Any organization can be randomly selected for an audit, but typically the IRS is looking for several common audit triggers. Understanding the six nonprofit IRS audit triggers outlined below in order to implement procedures to address these potential audit triggers should help lessen the chances of selection.
1. Form 990 Indicators
The IRS uses aggregate Form 990 data to target areas of concern or non-compliance assuming forms are completed accurately. When a Form 990 is submitted with incomplete or inaccurate information, it gives the appearance of a non-compliant organization. The IRS has stated this conclusion may lead to an examination (audit). The IRS also uses the Form 990 to identify governance issues that they feel can lead to non-compliance. The numerous questions in the 990 related to board and management governance provide the IRS with insight into organizations that may be more likely to have issues that should be examined.
The IRS has a robust referral program for exempt organizations that allows referrals from individuals, groups, other government agencies, and more. When the IRS receives a referral, the agency reviews the relevant information and then makes a decision as to whether an audit is warranted. While most people may consider a referral “whistle blowing,” a lot of referrals to the IRS come from state agencies that coordinate information with the IRS. These state referrals may come from non-filing in a state, payroll issues, or other tax-exempt issues related to the states where the nonprofit is operating.
3. Foreign Activities
Currently, the IRS is focusing significantly on large foreign grant activities. The IRS is concerned that money sent overseas could be diverted away from charitable purposes. They have previously found areas of non-compliance concerning control of overseas expenditures, reporting of foreign bank accounts, and inadequate record keeping.
4. Fundraising Income/Expense Discrepancies
If there are large amounts of fundraising income, then the IRS generally expects to see related amounts of fundraising expenses. The IRS may initiate an audit if it feels fundraising expenses are not in proper proportion to fundraising income.
5. Compensation Issues
Most nonprofit organizations are aware that the IRS frowns on unusually high executive compensation. However they also focus on unusually low compensation amounts reported in relation to the size of the organization. In this scenario, the IRS may be concerned regarding a lack of reporting transparency and may decide to open an audit.
6. Unrelated Business Income (UBI)
The IRS seriously reviews organizations that have a history of substantial UBI (income not related to exempt function) that have not paid any taxes since these organizations may be allocating too many expenses to UBI. A recent program that the IRS conducted with universities confirmed the need to expand efforts in this area.
Watch CRI’s Video: Managing Unrelated Business Income Tax (UBIT).
CRI’s not-for-profit CPAs can work with your organization to ensure compliance in common audit trigger areas. If your organization is selected for an audit, then we can help navigate the process and make it as pain-free as possible.