IRS 501(c)(3) Audits – 5 Potential Sources

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Free t-shirts for all audit targets! (no, not really)

There is one phrase in the English language that generates more fear and trepidation than any other out there:  IRS AUDIT.  Just hearing the words is enough to cause many a fearless person to break out in a cold sweat and to shrink in terror.  It is bad enough when an individual has to deal with IRS questions.  But when it happens to a nonprofit organization, there is plenty of pain to go around.  Directors, employees, members, donors…all can be affected.  Plus, just the potential bad publicity is enough to cause nonprofit leaders to reach for the Rolaids.

So how does a nonprofit avoid an IRS examination?  It helps to understand some of the situations and events that can trigger an audit.  In this article, we are going to look at 5 sources of audits and give you advice on how stay out of Uncle Sam’s cross-hairs.

1.  Complaints. One of the most common causes of IRS examinations is a complaint filed by a third  party.  Such “whistle-blower” situations may or may not have a shred of credibility to them.  Typically, if the IRS decides to look into the allegations, it will start out as a compliance exam.  It is possible for one of these exams to progress to the status of a full-blown audit, but most do not…at least for those organizations that are operating completely above board.

But how do you prevent this?  Admittedly, anybody can fabricate a complaint.  But substantiating it is another matter.  Unless the complaint contains credible (or, at least, believable) substance, it is often set aside by the IRS.  Operating in a transparent manner and maintaining good communication with the public goes a long way toward minimizing the risk of complaints.

2.  IRS Form 990. Form 990 is the federal information return filed annually by tax-exempt organizations.  The purpose of Form 990 is to inform the IRS (and the public) about the nonprofit’s activities, finances, and governing structure.  It is also a prime contributor to IRS audits.  Why?  Form 990 is intentionally designed  to reveal the degree of regulatory compliance the organization is operating within.  The best way to avoid Form 990-inspired audits is to operate in compliance to begin with, then make sure whoever is preparing the return knows what they are doing.  Unfortunately, most tax preparers are not experienced with the specifics of IRS tax-exemption.  Find one who is.

3.  Payroll tax returns. This is another example of required filings coming around to bite an organization.  How?  Errors and omissions constitute one way.  If the IRS sees odd things on payroll tax returns, scrutiny is invited.  Another thing the IRS looks at is consistency of information.  Let’s say your nonprofit pays its staff as independent contractors (usually not a good thing), but reports the payroll on Form 990 as salary.  This type of mismatch is an open invitation for questions to be asked.  As with Form 990, it pays to get competent advice and assistance.

4.  Public shenanigans. I guess you could say this is related to #1 above (complaints), but it is different.  This type of examination is practically begged for.  Acting out publicly in a manner contrary to federal regulations is simply baiting the IRS to come knocking.  The current situation involving the organization ACORN is a prime example.  Though they haven’t been audited yet, it is likely coming.  Other examples include blatant, political campaign involvement, excessive compensation of charity leaders, and conflicts of interest.  Even if the IRS doesn’t see it directly, these situations often lead to third-party complaints.  Know the rules and stay within them.  And, if you have a lime-light seeking leader, or you are one yourself, consider yourself warned.

5.  Random audits (bad luck!). This category is the one you can do the least about.  It just happens.  A few years ago, the IRS decided to review executive compensations within the nonprofit community.  They set out to look at 1,000 501(c)(3) organizations to gauge the level of compliance with standards of reasonable compensation.  They set their target on organizations whose key executives had total compensation packages in excess of $100,000.  One of our client organizations happened to be chosen.  Not that they had done anything to cause suspicion…they simply met the criteria.  The audit lasted about 3 weeks and was not only stressful for those involved, it cost the organization valuable time and employee resources.  Fortunately, the IRS found no significant problems, but much energy was spent in the pursuit.

Of course, there are other reasons your nonprofit could be audited, but this list represents some of the most common causes.  In an upcoming article, we’ll take a look at what to do if you get the dreaded notice that your organization is about to be examined.

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About Greg McRay

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.

5 Responses to “IRS 501(c)(3) Audits – 5 Potential Sources”

  1. brad mashak November 25, 2009 12:30 pm
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    is the 501 c 3 records (financial and other) public records????

    • Greg McRay, EA November 25, 2009 2:31 pm
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      Mostly, yes. Tax exempt organizations are required to provide financial reports upon request, so long as the requester allows sufficient time for the charity to comply. Also, the charity is allowed to charge a small expense fee for the overhead necessary, but that is very rare. In addition, the federal return filed by tax exempt organizations (Form 990) becomes public record once filed with the IRS…and can usually be seen at Guidestar.org within a few months of filing. FYI…donor information is NOT public record.

  2. Melissa Shank April 23, 2010 10:47 pm
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    Our local community Little League organization has to say the least a very bad reputation. Last year we did a father son softball fund raiser. We had of course refreshments, tshirts and 50/50 drawings to raise funds for a newly developed Field Committee. This money was to be used to fix and repair our fields. When all was said and done the $2200.00 we collected had mysteriosly dwindled to $800.00. Now we have found out that the monies for a $10,000.00 simplicity tractor have also come up missing. Futhermore, when asking for an audit, we have been informed that there has not been an audit for 2-3 years and that income taxes have not been filed either for maybe the same amount of time. In order to make sure that we have had an audit of the books and our 990 Form or whatever forms need to be filed have been done. If in a verbal request, this information is requested what is the time frame for receivng the information? What is the time frame allowed in a written request? We were not aware that there had not been an audit until we requested the information to apply for grants.Any information you can give me would be greatly appreciated. I want to see all IRS and Audit information for the last 4 years. Thanks in advance for all your help.

    • Greg McRay, EA May 5, 2010 11:36 pm
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      Sounds like this organization has some serious problems…likely even embezzlement. Stakeholders such as yourself should band together and demand accountability. Or, find another sports club if they won’t respond. There is not much more advice I can give you. While the IRS probably needs to be aware of this situation, that method of forced accountability could prove fatal to the future of the org. Tough situation, indeed. Good luck.

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