Avoiding IRS Tax Audits of Your Nonprofit
Even if your nonprofit is meeting all of its tax obligations, here's how to avoid the hassle of an IRS audit.
By far the least welcome interaction your nonprofit can have with the IRS is an audit -- the process where an IRS employee examines your nonprofit's tax returns, books, and records. Even for nonprofits that have absolutely nothing to hide tax-wise, the audit process can be disruptive and time-consuming, with interviews and visits to your office not uncommon.
Until recently, IRS audits of nonprofits were relatively rare, usually only involving extremely large nonprofit organizations like hospitals and colleges. But this is changing. In the past few years, the IRS has placed a new emphasis on enforcement in all areas, including tax compliance by nonprofits. As a result, it has increased audits and other contacts with all types of nonprofits. So it's worth learning how to avoid drawing attention to your organization.
Why Would the IRS Want to Audit a Charitable Organization?
The IRS says that its audits of public charities are meant to accomplish the following objectives.
- Ensure that nonprofits are truly operated for public (not private) interests.
- Determine whether nonprofits are engaged in any substantial nonexempt (that is, taxable) activity, such as running unrelated businesses.
- Ensure that nonprofits protect and preserve their assets exclusively for tax-exempt purposes.
- Evaluate procedures for accounting for money paid to individuals or noncharitable organizations.
- Determine whether nonprofits pay any excessive compensation, fees, or benefits.
- Determine whether nonprofits engage in lobbying or participate in political campaigns.
- Determine whether nonprofits should be classified as public charities or foundations.
Potential Penalties for Noncompliance
If the IRS decides that your group has failed to comply with applicable tax laws and regulations, the agency has the power to impose monetary penalties, excise taxes, and even revoke your nonprofit's tax exemption, in extreme cases. Excise taxes may also be imposed on directors, officers, employees, and others who participated in improper activity through your nonprofit organization.
Why Certain Groups Get Audited
When your nonprofit group is first contacted by the IRS about an audit, your first response is likely to be "Why us?"
The IRS has many ways of selecting returns for audits. It uses a computerized -- and somewhat mysterious -- system called RICS to select many nonprofit returns for audit. No one outside the IRS knows exactly how this works. The IRS simply says that "RICS applies the criteria selected by the Planning and Program Group to identify returns and line items for potential examination."
For example, RICS could be used to identify returns in which nonprofits are allocating expenses to reflect unrelated business income and/or wages, but not filing an employment tax return (Form 941) and not filing Form 990-T.
Audits can also result from referrals from outside the examination group. These may come from other divisions of the IRS, Congress, other government agencies, watchdog groups, and the general public.
The IRS has even created a special form that members of the public can fill out to report inappropriate activities by nonprofits -- Form 13909, Tax-Exempt Organization Complaint (Referral) Form. (See the online version of Form 13909 at www.irs.gov.)
The IRS also pays attention to media reports regarding questionable behavior by nonprofits. So, not only can negative news stories result in public embarrassment, they may prompt an audit as well (so much for the old saying "There's no such thing as bad publicity").
In addition, the IRS commonly targets certain types of nonprofits for special scrutiny. In the past, these have included:
- nonprofits that conduct gambling fundraisers
- nonprofits engaged in joint ventures with for-profit companies
- nonprofits that sponsor travel tours
- credit counseling agencies
- donor advised funds
- colleges and universities
- community foundations
- nonprofits engaging in political activities
- student loan organizations, and
- nonprofits that fail to file required IRS returns.
The upshot seems to be that, depending on your group's basic mission and activities, you may not be able to entirely avoid the risk of an audit. If, for example, your nonprofit is a college that regularly runs alumni travel tours, you've already got two red flags flying, so be sure to scrupulously comply with your tax obligations in order to get through an audit if it happens.
But it's also clear that, by meeting your basic tax obligations and being constantly aware of your need to maintain transparency and accountability in your dealings with the media and the public, you can significantly reduce your level of audit risk.
For more information on meeting your tax obligations and avoiding audits, see Every Nonprofit's Tax Guide; How to Keep Your Tax-Exempt Status & Avoid IRS Problems, by Stephen Fishman (Nolo).