Is Your Form 990 at Risk for an Exam? (article)
The IRS may be faced with a declining workforce and budget, but it's still active in monitoring compliance for not-for-profit organizations. In its 2018 work plan, the IRS stressed its data-driven approach to selecting Form 990s to examine. Each filed return is scanned and analyzed on 200 data points. Those meeting certain criteria are flagged for potential exam. Some of those data points include:
Inaccurate or Incomplete Form 990
One of the fastest ways for the IRS to flag your Form 990 for further review is if your filing has missing schedules or parts of schedules, a mismatch on name/EIN/exemption type, or is even just lacking a signature.
Evidence of Debt Financed Income, but No 990-T
If your organization's Part X, Balance Sheet, has amounts on line 23, "secured mortgages and notes payable to unrelated third parties," or line 24, "unsecured notes and loans payable to third parties," and you have an amount on Part VIII, Statement of Revenue, Line 6 for gross rents, but no 990-T, the IRS may double check your facts. In many instances, debt financed income is subject to unrelated business income tax (UBIT).
Zero Asset Balance, but No Schedule N, Liquidation, Termination, Dissolution or Significant Disposition of Assets
It would be unusual for an organization to have a zero asset balance with no record of disposing previously held assets. If your not-for-profit is going out of existence or getting rid of more than 25 percent of its net assets through a contraction, sale, exchange, or other disposition, then a Schedule N should be included in your 990.
Illegal Political Contributions
Part VI, the Checklist of Required Schedules, is another area the IRS will be interested in. See Line 3, "Did the organization engage in direct or indirect political campaign activities on behalf of or in opposition to candidates for public office?" A "yes" response indicates the not-for-profit may have engaged in prohibited political activity. If your organization is marking yes, it should be prepared for scrutiny of its Schedule C, Political Campaign and Lobbying Activities.
Unrelated Business Income (UBI)
With all the new provisions in the Tax Cuts and Jobs Act relating to UBI, if your organization checked yes on Part V, Statements Regarding Other IRS Filings and Tax Compliance, line 3a for having unrelated business income of greater than $1,000, but did not file a Form 990-T, the IRS will be taking another look. Since it is a revenue generator, UBI is a consistent focal point for regulators. Organizations should be particularly careful that they properly report any UBI and work with a professional to minimize exposure and tax liability.
Lack of Independent Board Members
Regulators are on the lookout for potential fraud, and as such, they'll be looking carefully at Part VI of the Form 990, Governance, Management and Disclosure. One of the first questions in Part VI includes information about the governing body. If less than 50 percent of your voting members of the governing body are independent, that will raise red flags. Another red flag would be a yes answer to "Did any officer, director, trustee, or key employee have a family or business relationship with any other officer, director, trustee or key employee?" If you're reporting business transactions in Part IV of Schedule L, Transactions with Interested Persons, you also run the risk of the IRS examining your Form 990. These types of relationships can signal to the IRS that the organization has private inurement issues or excess benefit transactions.
If there are wages shown on Part VII, Compensation of Officers, Directors, Trustees, Highest Compensated Employees and Independent Contractors or Part IX, Statement of Functional Expenses, Line 6 or 7 and a zero in the number of W-2s issued, the IRS may dig into whether you have a worker classification issue and owe payroll taxes. They may also be wary if the organization’s number of 1099s significantly exceeds the number of W-2s.
Zero Net Asset Balance
Another fraud risk could appear in Line 5 of Part VI. A "yes" answer to Line 5 indicates a significant diversion of assets, and organizations should be prepared to explain the diversion to mitigate regulator concerns over potential fraud or embezzlement.
If an organization's mission has moved too far away from its original exempt purpose without properly informing the IRS, there could be risk of exam or losing exempt status. If you have changes in your program services, answer yes to question 2 or question 3 in Part III, Statement of Program Service Accomplishments and describe in detail on Schedule O. Major changes should also be incorporated into the Articles of Incorporation and Bylaws.
Transactions with Disqualified Persons
Loans to or receivables from disqualified persons in your Balance Sheet (Part X, lines 5 and 6) that do not decrease from the prior year could flag your Form 990 for further review. Regulators will also be looking carefully at organizations that mark yes to lines 25a or 25b in the Part IV Checklist of Required Schedules. If either of these is marked and there is incomplete detail on Schedule L, Part I and/or no related Form 4720 filed by the disqualified person self-assessing first-tier excise tax, the IRS will want to know why.
Other Risk Factors
In addition to statistical selection, the other most common factors used by the IRS to select 990s for exam include the following:
- Referrals from a current or former employee
- Referrals from a board member or manager
- Referrals from the public (donors, competitors, etc.)
- Press and social media stories and allegations
- Organization's website or related organizations' websites
How Not-For-Profits Can Reduce Their IRS Exam Risk
Accurate and complete Form 990 reporting is the best defense against an IRS audit. If your organization has any of these red flags, you may want to seek guidance from a professional. An experienced tax advisor can help identify potential exposure areas and ensure you have the proper support and documentation in place in the event the IRS chooses your return for exam.
For More Information
For comments, questions or concerns about IRS exams of Form 990s, please contact us.
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