The Internal Revenue Service has released its work plan for the coming year outlining its priorities for examinations and audits of tax-exempt organizations.
The FY 2017 Tax Exempt and Government Entities Work Plan, released in late September, describes the accomplishments of the IRS’s TE/GE unit over the past year, along with its priorities in the year ahead.
“With regard to the applications for exemption, in order to make that area more efficient they are saying if you send in an application and we don’t have all the information we need we’re going to send it back to you, said Laura Kalick, national nonprofit tax consulting director at BDO USA. “That’s as opposed to taking the application and assigning it to a specialist, making somebody work the case and then finding out that they need some essential information. Now they’re just going to send it back, tell you what they need and you send it back in.”
The IRS is also trying to make the determination and ruling process more consistent, so the TE/GE unit has established what it calls “knowledge networks.”
“This is information on specific topics, and their agents have access to these knowledge networks,” said Kalick. “In addition to that, they’re taking the information from the knowledge networks and they’re making what they call ‘snapshots’ available to the public so the public also knows what their position is on certain issues. That’s really helpful too.”
The IRS hopes to make the process more efficient for granting tax-exempt status to charities. “At one time there were so many applications that it was just taking forever to get an application through,” said Kalick. “Part of the reason was because in 2006 the Pension Protection Act said that if you don’t file a return for three years, you’re going to be automatically revoked. They had thousands and thousands of organizations that had to reapply for exempt status.”
The IRS now has a formal procedure in place for identifying and preventing erroneous automatic revocations by notifying the organization before revoking its tax-exempt status. “That’s really a good thing because, for whatever reason, organizations haven’t filed returns, and many times it’s a small organization with just volunteers,” said Kalick. “Something happens, and they just don’t know that they haven’t filed the return and that they’re going to receive a revocation notice.”
The fiscal year 2016 work plan laid out the five focus areas for examinations and the FY 2017 plan repeats them:
Exemption: issues include non-exempt purpose activity and private inurement;
Protection of assets: issues include self-dealing, excess benefit transactions, and loans to disqualified persons;
Tax gap: issues include employment tax and unrelated business income tax liability;
International: issues include oversight on funds spent outside the U.S., exempt organizations operating as foreign conduits, and Report of Foreign Bank Account (FBAR) requirements;
Emerging issues: issues include non-exempt charitable trusts and IRC 501(r).
“The areas that they’re really focusing on is unrelated business income and employment taxes because those two areas are what they call the tax gap, and that’s where they’re really able to get more revenue if they can be successful in an audit,” said Kalick. “Based on their new way of identifying organizations for audit, which is getting different pieces of data from the Form 990, I understand they have about 190 different data points that they do the analytics with. Based on this type of analysis, they have a 90 percent change rate on the audits that they did in 2016, which is a really good use of their resources.”
The work plan says the IRS conducted 4,984 examinations for the fiscal year as of June 30, 2016. Nearly half of them fall under the category of filing, organizational, and operational, accounting for 2,109 of the exams. However, the next two biggest categories are unrelated business income, where the IRS did 611 examinations, and employment taxes, for which it conducted 1,323 exams. “That’s where they’re really looking for things,” said Kalick.
The work plan also describes exactly what the IRS is looking for in the areas of unrelated business income, specifically gaming, nonmember income, expense allocation issues, net operating loss adjustments, rental activity, advertising, debt-financed property rentals and investment income.
“The investment income that they’re really looking at is the alternative investments that generate unrelated business income,” said Kalick.
Lowering the Chances of an Audit
She advises nonprofit organizations to get a fresh set of eyes to look at their tax return to see what types of issues might catch the attention of the IRS. “You can’t necessarily avoid an IRS audit, although one type of thing that is clearly going to expose you to an IRS audit is if you request a refund,” said Kalick. “If you request a refund, let’s say of unrelated business income tax, the IRS is going to look at that return very closely. They’re not going to want to give you back money that you’ve already paid in, so if you think that you deserve a refund, you need to thoroughly go through your entire operations and make sure there are no other questions because it’s a very good clue the IRS will open an examination.”
Organizations should also be looking at their income tax positions as part of the accounting standard ASC 740-10, Accounting for Uncertainty in Income Taxes, and its earlier incarnation FIN 48. “A lot of organizations adopted FIN 48 many years ago, but they don’t go through the exercise every year of looking at their revenue streams,” said Kalick. “We firmly suggest you review this every year and look at these things as if the IRS is going to audit you and all the facts are known, which is basically what ASU 740-10 says.”
Kalick also recommends that organizations do a “mock audit” of themselves to see if the IRS might find fault with how they are complying with employment taxes.
“If you’re going to be audited on your 990, they will open an employment tax audit as well if you have a field examination,” she said. “You can have an employment tax audit that is teed off by something else. If you have an employee or somebody that you’ve classified as an independent contractor, and then all of a sudden at the end of the year they decide that they should have been classified as an employee, that individual can submit an SS-8 and ask the IRS to look at it. That’s going to be an audit of the employment taxes. Independent contractor vs. employee is probably the biggest issue you should be reviewing—people you’ve classified as independent contractors to see if they really are.”
Kalick also recommends that tax-exempt organizations be careful to check for any mathematical errors or inconsistencies on their returns, along with how they report unrelated business income.
“Mathematical errors are an easy thing for you to pick up, and you have to look at various places for inconsistencies,” she said. “On your front page you’re going to indicate how much growth in UBI and how much net UBI is reported on the 990-T. On page 9, you’re going to have your various different revenue streams and how you classify them. On page 9 you really need to be mindful of whether you classify a large amount of money as miscellaneous, and you put all the miscellaneous in the related column. The IRS doesn’t know what’s in there, and somebody could look at that and say what’s in there. So if you have a large number in the miscellaneous category, you should try to classify and explain what you have in there, and even if you want to put something on Schedule O, that’s fine too. But large categories of miscellaneous income are problematic.”
Another focus area for the IRS examiners, according to the work plan, is non-exempt purpose activity.
“Organizations should look at their application for exemption and understand what they said to the IRS they are going to do,” said Kalick. “If they are doing something different than what they indicated, they need to justify that is within their exempt purpose and is really not a far deviation from what they said. Let’s say your classification is a 501(c)3, but when they look at your activity it really is (c)6 activity or (c)4. They will revoke the exemption and then you’ll have to reapply. What did you say you were going to do and are you still doing the same things? That’s very important.”
Casting a Wider Net
The IRS auditors are looking not only at the returns but also at public sources, such as newspaper articles and websites, along with referrals from government agencies and the public, including whistleblowers who stand to claim a reward if the IRS can collect back taxes.
“There’s actually a whistleblower form, and if somebody wants to report something and the IRS is successful in getting money, there is another form where the person who reported it can actually receive some compensation for having reported it,” said Kalick. “You really need to look at your website and make sure your website is not presenting something that could be a violation of the law.”
Charities also need to be careful about any political activity that could endanger their tax-exempt status.
“A lot of organizations that are 501(c)3’s have a program that allows your constituency to contact their congressperson about certain issues,” said Kalick. “That’s fine but that would constitute lobbying, and these programs don’t cost the organization a lot of money. If you’re making the 501(h) election, then you’re going under an expenditure test, but if you haven’t made the 501(h) election, then you’re going under the facts and circumstances test, so you really need to just cover all these bases and look at how you’re portraying yourself to the public.”
The IRS is also keeping tabs on what it calls “emerging issues.”
“Here they’re looking at section 501(r),” said Kalick. “That’s a new provision for hospitals that says in addition to the normal 501(c)3 requirements you need to meet additional requirements. Two of those requirements include the community health needs assessment and the financial assistance policy, and both are supposed to be on your website. There were regulations issued and all organizations have to be in compliance with those regulations. The IRS has 30 agents that are looking at just this issue. If an organization does not have these two things on their website, then that’s really going to be problematic, and it’s just really easy for the IRS to see.”
Another area of concern for the IRS is the complaints, lawsuits and congressional investigations of its handling of applications for tax-exempt status from Tea Party groups that led to the ousters of several high-ranking IRS officials, including the director of the Exempt Organizations unit, Lois Lerner. A federal judge ordered the IRS last week to finish making a determination by November 11 on the applications of 38 conservative groups that have been awaiting decisions for years of their applications for tax-exempt status under section 501(c)4 of the Tax Code.
“What they did this year as part of the Protecting Americans from Tax Hikes Act, or PATH Act, is they now have a new form that a new 501(c)4 organization must file electronically to give notice to the IRS of its intent to operate as a (c)4 organization,” said Kalick. “This is not a requirement to apply for exempt status on a 1024, but you must give notification. You must file a Form 990, and this does not mean that the IRS is not going to contact you and ask you to fill out a 1024. It just means that the IRS is now going to know who you are, as opposed to organizations just filing Forms 990 and the IRS not being aware of who these organizations are. That’s going to be interesting.”
The IRS is also dealing with issues involving the Form 1023-EZ. “The Taxpayer Advocate looked at 400 of these organizations and found that about 37 or 38 percent did not have appropriate organization clauses, purposes clauses or dissolution clauses,” said Kalick. “The IRS says they’re going to do some predetermined application reviews and evaluations of the data.”
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