Despite a well documented rocky relationship with Congress over the past several years which has led to substantial funding reductions, the IRS has found a way to increase its audit activity with tax-exempt organizations over the past several years. How, you might ask? The IRS has used big data analytics to determine the most effective audit targets. As a result of the requirement that most tax exempt organizations have to file their Form 990 series returns electronically, the IRS has the ability to design programs to select audit targets by designing edit checks to capture inconsistencies found in the tax returns. That has created an opportunity for the IRS Exempt Organizations Division (EO) to efficiently target outliers at a time when budget cuts have left IRS staff levels depleted.
As recently as December 2014, the U.S. Government Accountability Office (GAO) released a report regarding tax-exempt organizations which was critical of the IRS's effectiveness in its oversight of charities. In response to the GAO report, EO announced its intention to rely more on data mining queries from the redesigned Form 990 “to detect high risk areas of noncompliance and to prioritize enforcement efforts.” The most common reason the IRS cites for revoking a charity’s tax-exempt status is the organization not operating for tax-exempt purposes. The other primary reasons for revocation include failure to file tax returns, render statements, or maintain records and inurement/private benefit.
The Form 990 contains a great deal of information, much of which represents responses to questions intended to gauge whether a tax-exempt entity continues to be organized and operated in a manner consistent with tax-exempt status. The manner in which an organization responds to questions regarding both specific rules and best practices reflects the organization's diligence in operating within the rules of tax exemption.
By use of data analytics, the IRS knows what answers it wants to see on a return and can easily target taxpayers which have reported a particular question contrary to the IRS's ideal response or best practices. Alternatively, the taxpayer may have reported a potentially taxable activity such as rental revenue or miscellaneous income.
Areas of focus
While no tax-exempt entity is immune from being targeted for audit, there are ways organizations can mitigate the possibility that they will fall afoul of the IRS's computer analysis. The first line of defense is to ensure that all policies and procedures that the IRS considers best practices are documented by the organization and studiously followed. That is a joint responsibility of both the board and the senior team of the organization to understand the rules and to apply them appropriately to guard one of the most important assets the organization has – its tax exempt status.
A few of the areas targeted by the IRS for audit include the following:
- The IRS is keen to ensure that the board of directors recognizes its accountability for the actions of the organization and considers a board's lack of access to the Form 990 before it is filed with the IRS to be a red flag (Part VI, line 11).
- A written conflict of interest policy annually signed by interested persons (board directors, officers, key employees) and closely monitored is another key policy (Part VI, lines 12a-c).
- Tax-exempt bond issues which are not accompanied by post-bond issuance policies on arbitrage, nonqualified bonds, and VCAP are another source of IRS skepticism (Schedule K, Part III, line 9, Part IV, line 7, and Part V).
- Reporting an Unrelated Business Income Tax loss has increasingly been a focus of EO. A loss from unrelated business activity signals either an under reporting of income or over reporting of expense deductions. Unrelated business income, or UBI, is always of interest to the IRS for the simple reason that it is one of the few areas in which the IRS can wring tax dollars out of tax-exempt organizations.
Even when the policies are in place and the organization has documented its procedures in full, oftentimes policies become outdated when IRS rules change. In practice, too, procedures may not be followed, leaving the organization open to criticism, at the very least, should their weaknesses be exposed upon audit. Several years ago we identified for our client boards the areas on the Form 990 to which they should pay particular attention in fulfilling their fiduciary responsibility. See the Top Ten Areas of Focus for Board Members.
Use of tax risk mitigation tools
A pre-emptive strike, such as the organization having a "mock audit" performed every 5-6 years, may be the ounce of prevention the organization needs should an IRS audit occur.
Mock audits, or tax check-ups as they are otherwise known, are performed by senior tax professionals. A partner and a senior manager descend upon the organization for a day or two, closely examining the various documents that may have ramifications on the tax-exempt status of the organization. Interviews with key personnel are conducted, while conflict of interest and expense reimbursement policies, deferred compensation, and employment contracts are a sampling of the documents to be analyzed by the team members. Source documents such as 1099s and executive W-2s, expense reports, the Form 990, review of compensation practices, and general ledger detail for revenue (to determine the potential for UBI activity) are all perused to determine the organization's potential for IRS scrutiny.
The mock audit serves to identify and alert organizations to potential weaknesses in the organization's identification of UBI. However, should the mock audit indicate a substantial flaw in the organization's UBI analysis, a more in-depth course of action may be considered. Another tax risk mitigation tool is the UBI study which provides a much deeper foray into the specific activities of the organization, with a detailed report produced to educate the organization on each of its revenue streams, with specific findings and recommendations to the organization on changes to their UBI and expense methodologies.
Given the expected increase in analytic methods available to the IRS, tax-exempt organizations should invest in tools such as mock audits and UBI studies to develop the most robust defense against a potential IRS audit.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.