The passage the Inflation Reduction Act of 2022 has the IRS set to receive $80 billion of funding over a 10-year period. An estimated $45.6 billion is designated to tax enforcement, which means more agents in an expanded audit department, additional legal and litigation support, and investments in investigative technology.
With more bandwidth, the IRS may set its sights on the not-for-profit sector. Here’s how you can prepare if your not-for-profit organization is subject to an IRS audit.
IRS Audit Trends for Not-for-Profits
The IRS Tax Exempt & Government Entities Division (TE/GE) issues a program letter annually that highlights compliance program initiatives and priority exam issues, with the compliance program for fiscal year 2023 set to be like that of prior years, focusing on the following:
Reviews will be more likely for worker classifications that reduce Federal Insurance Contributions Act (FICA) and income tax burden by misclassifying workers as independent contractors instead of employees.
A common red flag would be issuing both W-2 and 1099-NEC forms to an individual in the same calendar year.
Form 990-N Issues
Form 990-N filers could be scrutinized to ensure they meet the $50,000 gross receipts eligibility threshold based on other filings, such as Forms W-2, 1099-MISC, 1099-K. Payments reported on those forms exceeding $50,000 could imply that the organization’s normal gross receipts could be potentially higher.
An organization’s tax exemption could be automatically revoked when Form 990-N is incorrectly filed for three or more consecutive years. Additionally, the IRS will conduct compliance checks to inform Section 509(a)(3) supporting organizations that improperly file a Form 990-N when they don’t meet eligibility standards.
Employees With Over $1 Million Annual Compensation
Organizations that pay over $1 million in compensation to at least one covered employee without reporting Section 4960 excise tax on excess compensation on Form 4720 could be prone to investigation.
The IRS has been sending compliance checks to organizations that reported compensation over $1 million on Form 990, Part VII but haven’t filed Form 4720.
Collaborations are set to occur across the IRS on existing and emerging issues, such as syndicated conservation easements, abusive charitable remainder trusts, employer retention credits, and continued review of potentially abusive promoter schemes.
Most of these issues overlap with the 2022 dirty dozen list compiled and published by the IRS, whereas scrutiny of employee retention credit stems from the IRS suspecting fraud based on the returns received.
High-income taxpayers and their related entities may be audited, including private foundations. The IRS may evaluate self-dealing transactions between the high-income taxpayer and the private foundation, and whether investments, business holdings, and charitable purpose expenditures of the private foundation violate excise tax rules.
Issues in Previous Program Letters
The IRS has targeted and examined the following not-for-profit issues in their audits as mentioned in their previous program letters.
- Hospitals with unrelated business income reported significant expenses exceeding gross income on Form 990-T
- Section 501(c)(7) entities focus on investment and nonmember income by tax-exempt pleasure, social and recreation clubs
- Section 4947(a)(1) non-exempt charitable trusts that under-report income or over-report charitable contributions
- Private benefit and inurement to individuals or private entities of exempt organizations
- Former for-profit entities that were converted to Sec. 501(c)(3) organizations
Important Documents for IRS Audits
Not-for-profits are advised to maintain organized records that support annual tax returns and the organization’s qualification for tax-exempt status.
Generally, the statute of limitations for the IRS to audit a return is three years from the due date of the return or the filing date, whichever is later. The statute of limitations could be extended to six years if the organization omits more 25% of gross income when filing a return. It could also be extended indefinitely if the organization fails to file a required return.
The following are example documents found in the Information Document Request (IDR) received during an IRS audit. These documents should be kept on hand in case the not-for-profit is ever selected for an IRS audit.
This list isn’t comprehensive as the IRS could request additional information for specific issues.
Permanent File of Organizing Documents
Not-for-profits are advised to keep a permanent file of many fundamental documents to be better prepared in the event of an audit, such as articles of incorporation, bylaws, tax-exemption application, IRS and state determination letter, policy and employment manuals, and any title documents, such as deeds.
Books and Records for Open Tax Years
Not-for-profits preparing for a potential IRS audit are advised to keep records for open tax years—meaning those that haven’t surpassed the statute of limitations. These include:
- List of names, addresses, and compensation details for officers, directors, and trustees
- Board and committee meeting minutes
- Copies of the organization’s publications, newsletters, brochures, pamphlets, and other literature related to the organization’s activities
- Copies of prior and subsequent year returns
- Form 990-series filed returns and supporting workpapers to reconcile the returns to the books and records, such as chart of accounts, general ledger, trial balance, reconciliation schedules, tax return workpapers, bank statements, audited financial statements, etc.
- Records used to determine and support the organization’s sources of income on the Form 990-series return, including government grants, donations, program service revenue, and so forth
- Records used to determine and support the organization’s expenses, assets, and liabilities reported on the Form 990-series return, such as invoices, contracts, leases, and loan agreements
- Federal employment tax returns, Forms 940, 941, W-2, W-4, plus employee earnings records and employment contracts even if the contract was created prior to the open tax year
- Forms 1096, 1099-MISC, 1099-NEC, and any other similar return, including service contracts and agreements between the organization and independent contractors
- Pension plan information, including the latest IRS approval letter, Form 5500-series filed return, plan documents for deferred compensation plan, or tax-sheltered annuities
- Copies of reports made to other federal agencies
- Correspondence with the IRS
The IRS may examine all components of the organization, including operational requirements, the accuracy of books and records reported on the tax return, and employment tax compliance to identify and focus on specific issues of noncompliance. The IDR typically provides insight into the issues the IRS will examine.
If your organization is selected for an IRS audit, consult with your tax professional right away to determine the level of assistance the organization requires and how to respond. The tax professional can represent the organization to the IRS and serve as a guide through the audit process. Being prepared and timely with your response will help speed up the audit process.
We’re Here to Help
For more information on how to address IRS exam issues, reach out to your Moss Adams professional.
You can also learn more about our Not-for-Profit Practice and additional topics affecting the industry.