With individual tax filing season nearly upon us, many myths abound concerning what may initiate an IRS audit on a Form 1040. While falsehoods about the chances of sustaining an individual audit may persist, the Tax Exempt and Governmental Entities Division (TE/GE) of the IRS actually modified its audit triggering guidelines in 2016.
The advent of electronic filing has made the audit selection process more efficient, and the IRS has 150 factors that it tests on each 990, and an organization that does not meet the criteria on a high enough percentage of those factors will be flagged for examination.
The 2016 approach looked for discrepancies in the return, including the following:
- Inconsistent reporting: There are a number of line-items that show up both on the first page of the 990 and later on, or in attached schedules. If these amounts do not agree throughout the entire return, the chances of an audit will increase.
- Contradicting answers to questions: There are more than 80 questions asked of a nonprofit when it completes its annual 990. Many questions answered affirmatively require additional schedules to be added to the return. The absence of these schedules will reflect poorly on the return. Furthermore, if a schedule is present but the underlying question is answered in the negative, the IRS will have a concern.
- Unrelated business income activities: Although nonprofits are traditionally exempt from paying taxes, the exemption applies only to the stated exempt purpose of the organization and related activities. A charity that carries on other business may be subject to unrelated business income tax (UBIT). Column C of Part VIII of the 990 includes an area to list unrelated business income, and the inclusion of data in that column without a corresponding Form 990-T will draw the attention of the IRS. Rental activities are another potential source of unrelated business income. Although many forms of rent are not subject to UBIT, income derived from renting real property (land, buildings) that is subject to acquisition indebtedness is taxable unless 85% of the property is used for the exempt purpose. Showing rental income in Part VIII and a substantial mortgage balance in Part X may encourage the IRS to examine the presence of unrelated business income.
The implementations in 2016 have led to a higher level of changes to returns and a more efficient audit process. Therefore, for 2017, the IRS is expanding some of its analytics to attempt to detect returns with a “high risk of private inurement and private benefit.” Questions on the 990 about compensation, related parties, conflicts of interest and other matters will give the IRS a snapshot into the potential for private benefit arising from a public charity. Part VII of the 990 also requires the disclosure of the salaries of key employees. The easiest way to avoid scrutiny from the IRS in regards to private inurement and benefit is to have a written conflict of interest policy that is followed and to avoid any transactions with related parties that are not at an arm’s length.
By Dan Massey, CPA, Manager