April 12, 2004
Mr. Karl Emerson
EO Project Group Coordinator
Advisory Committee on Tax Exempt and Government Entities
Dear Mr. Emerson,
In response to the Advisory Committee's request for comments on the Internal Revenue Service's tax-exempt organization enforcement and compliance efforts, the AICPA Exempt Organization Taxation Technical Resource Panel is pleased to provide the Committee the following comments based upon our members' experiences and those of our clients. We are providing comments based upon our prior experience as well as providing observations on new processes as described in the Exempt Organizations 2004 Implementing Guidelines. We applaud the Advisory Committee for its review of these enforcement and compliance processes. We also wish to commend the Service for its efforts in identifying and implementing new initiatives.
I. Historical Audit Experience
II. Current Initiatives
III. A Proposal for the Future
I. Historical Audit Experience
Given the complexity of the many issues impacting tax-exempt organizations, and the Service's responsibility to enforce tax rule compliance and protect tax-exempt assets, it is not surprising that there is often disagreement regarding treatment of various items. In identifying and resolving these matters, our members generally find that the Service's agents act professionally and treat organization employees and representatives with respect. However, we do suggest that the Service could enhance the examination process in the following areas:
A. Increased Communication
1. More open communication early in the audit process could greatly facilitate the audit and result in a more efficient resolution. In our experience, the agents can be reluctant to inform an organization about the reason for and scope of an audit. For example, an organization was under audit due to a referral regarding its qualification for tax-exempt status and an allegation that certain of its activities were conducted in an illegal manner. Had this been discussed openly at the outset of the audit, the organization might have more quickly provided the necessary information that would have easily resolved the matter. In many cases, if the reasons for the audit are shared, organizations may work in conjunction with the Service to identify the most appropriate documents that would answer the questions.
2. Co-development of information document requests (IDR) could result in a more efficient information gathering process for both the Service and organization. Often, many of the IDR's are developed based on the agent's experience at other organizations and his or her initial understanding of the organization under audit. As a result, in attempting to identify or address a particular issue, the agent asks for information that results in volumes of data. The data can be difficult to analyze or may be unresponsive to the issue the agent wishes to address. An organization receiving these types of IDR's is often slow to respond. Once it does respond, it can be unclear whether the information provided is utilized.
Those audits that seem to progress most efficiently include co-development of IDR's whenever possible. An agent identifies the issue to be addressed and provides an initial list of the information he or she believes to be relevant. This is then discussed with the organization and its representatives to determine the most relevant information. At that time, any difficulties in providing the requested information can be identified. In some cases, an agreement may be reached to provide a portion of the information (or a sample) to allow the agent to better determine whether this issue is one that warrants further effort.
3. Timely identification and dissemination of common problems identified during audit and the Service's current positions would result in increased compliance. Most tax-exempt organizations work to be tax compliant. If they are aware of a preferred treatment (for tax purposes), they are likely to make reasonable efforts to implement it. General results from tax-exempt organizations audits should be routinely reported, perhaps on the IRS website. These reports should include common areas of non-compliance within an industry or market segment as well as the preferred types of documentation.
B. Areas of Audit Focus
- Audit resources should focus on areas of "significant" exposure to the preservation of charitable assets. Agents typically develop an audit plan based on experience with other organizations. Once developed, the agents often appear to spend time pursuing areas that seem immaterial to the organization currently under audit. The IRS should develop tools to enable an agent to better determine whether an audit issue is (1) likely to arise, and (2) likely to be significant in a particular circumstance. Only those potential issues that meet these two standards should be further developed. This could significantly increase the efficiency of the examination process.
- "Materiality" standards should be developed and implemented as part of the audit approach. Agents sometimes spend significant Service and organizational resources pursuing issues that, even if valid, would result in minimal adjustment/impact. For example, one of our members told of a situation where an agent auditing a large healthcare organization provided a three-page write-up of an issue that resulted in $162 of additional tax. The agent expected that the organization would provide a response. More consideration should be given to the likely results of pursuing an issue before resources are committed to its further development. For those potential issues identified but not developed further due to materiality, a list could be provided to the organization to allow it to consider any changes that it deems appropriate.
C. Audit Duration
The most common comment that we received from our members involved the time necessary for the conduct and completion of an examination. We recognize that to many organizations, any audit will be an inconvenience. However, we believe that there is room for improvement in this area.
- Once notice of examination is given to the organization, audits should begin within a reasonably prompt time frame and be completed as soon thereafter as possible. In team audits, agents generally start fieldwork and work full time on the audit until it is substantially complete. However, with smaller organization audits, agents can come in for one day at a time, often with gaps of weeks or months between on-site visits. Sometimes the Service's personnel assigned to an audit changes between visits. These discontinuities are very disruptive to the audited organization and cause delay.
- Once the fieldwork is complete, audits can remain unfinished for months at a time; six months to a year is not uncommon. We strongly encourage the adoption of protocols to ensure the timely completion of an examination at the end of fieldwork.
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II. Current Initiatives
Increased compliance is a goal shared by the Service and the tax-exempt sector. We support the approach of meeting this challenge through a combination of educational and increased audit efforts. We believe that educational initiatives can be very effective if properly structured. Tax-exempt organizations generally wish to be tax compliant. In most cases, non-compliance is a matter of not understanding the tax rules rather than intentional disregard.
A. "Soft Contacts"
- Educational Letters. We understand the Service has initiated a program to send educational letters to tax-exempt organizations it believes are non-compliant in a specific, discrete area. The letter is designed to inform the recipient organization of the rules with which it appears to be non-compliant and encourage future compliance. The first of these letters regarding the disclosure of fundraising expenses was recently sent to many organizations. We agree that "soft contacts" by mail can be useful —if they are specific. However, the fundraising letters are causing great consternation, confusion and anxiety.
We addressed our specific concerns regarding the fundraising letter, in correspondence dated March 26, 2004. However, we believe that several comments contained in that correspondence are relevant to the educational letter program as a whole:
a. The letters do not appear to consider that the recipient organization may have been disclosing fundraising expenses appropriately. There are many reasons why an organization could properly report contribution income but have little or no fundraising expenses. For example:
1) Volunteers may conduct the fundraising. Since such in-kind contributions are not valued and reported in Form 990, the corresponding expense (the value of the donated fundraising labor) is also not reported.
2) Complex organizations such as hospitals and universities often have foundations (or other supporting organizations) that incur the fundraising expense. The donor may make contributions to any entity within the affiliated group. Thus, the contribution income is recognized by an organization other than the one that incurs and reports the fundraising expense.
3) Expenses incurred to generate revenue that is classified as contribution income, are not always considered fundraising expenses. For example, GAAP classifies efforts to seek government funding (grant revenue) as administrative, rather than fundraising expense. For tax reporting purposes the grant revenue is often classified as contribution income.
b. The letters do not indicate what action the organization should take. In fact, in the letter the Service indicated that it did not want a specific response. Rather, it indicated it "…will be inspecting your Form 990 to evaluate our educational efforts." This only added to the affected organizations' anxiety particularly when they believed they had been properly disclosing the expenses. We recommend that future correspondence of this nature include suggested action, including providing the recipient organization the opportunity to provide a response.
c. For those organizations whose expenses were properly disclosed, there should be a means to ensure the organization does not receive future letters regarding this matter. If an organization were to provide a response sufficiently explaining why the Form 990 was correct as filed, the organization's record should be updated to reflect the response. It is not clear how this will occur. Should organizations attach a statement to the Form 990 explaining why fundraising expenses are properly disclosed? We are aware of at least one situation where this was done in anticipation of these letters, and the organization received a letter anyway. A mechanism should be developed that would indicate the organization's compliance with the disclosure rules and ensure that future correspondence on this matter will not be sent to the organization.
2. Exempt Organization Compliance Unit (EOCU). The Service has indicated that the EOCU may use telephone contacts to elicit information. To our knowledge, this has not been initiated. We would like to express strong reservations about such a program. We believe there are significant issues that need to be addressed before this program is implemented:
a. With whom will contact be made? If there is a Power of Attorney on file, would it be that individual? Otherwise, would it be the person listed in answer to Form 990, Part VI, Question 91? If this is the case, the Instructions to Form 990 should so indicate. Currently, organizations may not list the most appropriate person to contact (e.g. it may be very difficult to make contact with a busy Chief Financial Officer). In fact, with current privacy concerns, it is not uncommon for only the organization's name to be provided in response to Question 91.
Many organizations use paid preparers to prepare their Form 990. Organization personnel may not always have immediate access to detailed workpapers supporting the information included in the return. We recommend that the Service implement a check-the-box system, similar to that on 990-T and many other returns. This box would authorize the Service to contact the return preparer directly in the event of a question pertaining to Form 990. This process would direct the Service to the person who is more likely able to provide the requested information.
b. What are the ramifications of the contact? Could it be construed as an audit? This could be important to know for organizations required to report regulatory investigations to an audit committee or other regulatory body. It might also impact future tax matters. For example, how would it impact an organization's qualification for section 530 relief if it were subjected to a worker classification audit?
c. In general, we are concerned about telephone contact without written confirmation of questions asked and responses given. We encourage the Service to require written responses so that there is a clear record of the questions asked and the responses. We can imagine this could be of particular importance if in a future year questions were raised regarding a change in operations or a proposed retroactive revocation of tax-exempt status.
d. What if any of the contact will be considered subject to public disclosure? Clearly if an organization were to amend its Form 990 as a result of a contact, the amended Form 990 would be subject to public disclosure. However, if an organization provides a written response to a Service inquiry, we believe the response itself would not be subject to public disclosure (just as inquiries and responses generated pursuant to an IRS examination are not subject to public disclosure).
B. Automatic Excess Benefit Transactions
We believe that the excess benefit rules of Internal Revenue Code (IRC) section 4958 represent an important enforcement tool for use in protecting charitable assets. These rules call for a weighing of the value an exempt organization receives from a disqualified person against the value an exempt organization provides. As such, enforcement of excess benefits rules inherently requires application of judgment and the law to specific facts and circumstances.
The Service recently issued a Continuing Professional Education article entitled "Automatic" Excess Benefit Transactions under IRC Section 4958. The article focuses entirely on one aspect of the intermediate sanctions regulations regarding "the establishment of intent" and the required documentation. The article points out for section 501(c)(3) and (4) tax-exempt organizations, the IRC requires an organization to clearly indicate its intent to treat a benefit provided to a disqualified person as compensation for purposes of section 4958. The regulations under IRC section 4958 provide that this intent should be established by written contemporaneous substantiation. The article states "if the written contemporaneous substantiation requirements are not met, the agents should treat the economic benefit as an 'automatic' excess benefit." It later states that certain "other written contemporaneous evidence" may satisfy the documentation requirements.
We have several concerns with this article:
- The use of the term "automatic" implies that agents have no discretion to consider all the facts and circumstances of a particular situation. Yet, it is our understanding from informal discussion with IRS representatives, that agents actually do have some discretion as to whether to pursue an "automatic" excess benefit. We believe that consideration of all facts and circumstances by the agents should be encouraged, however, we are concerned that agents may use this "automatic" concept as a bargaining chip with respect to other issues in the examination. We understand that under current procedures, the agents are required to consult with the National Office and discuss each situation before proposing the sanction. This could be an important control to mitigate the potential that agents will use the concepts discussed in the article in an unintended manner.
- The article does not make it clear that the agent should examine the evidence to see if the payment in question was for a personal item or whether there was an inadvertent failure in a procedure that resulted in a lack of documentation of a business purpose. For example, if a disqualified person failed to attach a receipt for a business expense, there should be no excess benefit if he or she can produce a receipt or other appropriate substantiation.
- The article appears to require "automatic" excess benefit treatment regardless of the amount in question. One of the examples involves $2,500 of personal expenses that were paid to an executive under the organization's otherwise accountable plan. While we cannot dispute that the payment in question might be an issue, we are concerned that agents will spend a great deal of time during examinations looking for small "automatic" excess benefits rather than focusing on other more significant issues. We believe that the Service should adopt some materiality threshold that agents can use when approaching this area (see discussion above in Para. I. B. 2.)
C. Large Scale Limited Scope Audits
This past fall the Service began an initiative of contacting colleges and universities that appear to be non-compliant with respect to their filing and withholding responsibilities for payments made to nonresident aliens. This large-scale coordinated approach is attracting a lot of discussion in the higher education community. While it would be premature to assess the success of this particular initiative, the approach has certain appeal. Organizations are given very specific direction as to what action is expected of them. If noncompliant, they are encouraged to become so. The consequences of not responding are clearly articulated. We recommend that the Service monitor the program's success and potential applicability to other areas.
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III. A Proposal for the Future
As we have expressed in previous correspondence, we are concerned that without an increase in the validation of organizations' actual operations, the public's confidence in the tax-exempt sector will continue to erode. We acknowledge that resource constraints are a reality. However, we have several suggestions that we believe could allow the Service to review more organizations in a more meaningful way.
A. Form 990 Redesign. We will be submitting recommendations for a redesign of the Form 990 shortly. We believe that a redesigned Form 990 would assist the Service in fulfilling its oversight responsibilities as well as providing constituents and the general public with more useful information.
In summary, our comments recommend the Service redesign the current annual reporting format for the tax-exempt sector. We believe that there should be at least two Forms 990—one for sections 501(c)(3) and (4) organizations and another for other tax-exempt organizations. The use of multiple forms could permit them to be tailored to focus on information relevant to the particular tax-exempt status (e.g. public support tests in the case of section 501(c)(3) organizations or nonmember income in the case of sections 501(c)(6) or (7) organizations).
In addition to the presentation of an organization's financial operating results, the Forms should be designed to provide non-financial information regarding the organization's operations. In an era where corporate governance and transparency are increasingly critical, disclosures should be designed to highlight an organization's practices (e.g. a charity's fundraising practices or its transactions with disqualified persons).
Enhanced disclosures could only serve to increase the Service's ability to provide sector oversight. It would be able to more readily diagnose abusive situations and resolve them more timely. We could envision that enhanced disclosures might allow more audits to be conducted as correspondence audits.
B. Redesign the exemption application process for section 501(c)(3) organizations. We again suggest changing the determination process to bring additional scrutiny to the actual programmatic and administrative operations of organizations that have been issued determination letters. As explained on our previous correspondence, dated December 2, 2002, regarding the redesigned Form 1023 (copy attached), our concept is to provide "Universal Advanced Rulings" (UAR's) that would be issued upon an applicant showing it meets the organizational requirements of section 501(c)(3) (e.g. satisfactorily completing the redesigned Form's Part VI). A UAR would require that after a specific period of time, the IRS Determination Group perform a desk review of the applicant's actual operations. This desk review would be conducted in a manner similar to the process that is currently used to review Forms 1023. The organization would be referred for a field audit if information raises the concern that qualification for ongoing tax-exempt status may be in jeopardy. If abuses were identified, the Intermediate Sanctions provisions would likely allow the Service to hold the parties involved responsible, thereby recovering any significant charitable assets that were improperly diverted. In the absence of exemption concerns, a determination of ongoing, non-provisional tax-exempt status would be made.
We believe such a revised process will provide the IRS, other regulatory bodies, and the public-at-large with better information to evaluate an organization's section 501(c)(3) initial qualification and ongoing compliance. Answering specific activity-related questions annually based upon an organization's actual (rather than prospective or intended) conduct of operations, will assuredly lead to better quality information. Requiring applicants to: (1) report annually on their organization's compliance with the section 501(c)(3) qualification mandates; and (2) address how potentially sensitive operations are conducted or implemented will result in increased education of the charitable sector as well as the public-at-large's confidence in its integrity. In addition, ongoing reporting will result in continued education of organizations and their founders, officers, directors and trustees. It will also provide the public with additional specific, current information with which to scrutinize exempt organizations.
We believe it would be a dramatic improvement to the Determinations process if close-to-contemporaneous detailing of actual operations to further evaluate an organization's qualification were used. We believe this process would not only better serve applicants and the public-at-large, but it would also overcome the issue of unreliable reporting of operational information based upon planned rather than actual operations.
C. Use of Technology. We understand that the Service is committed to upgrading is computer technology. We applaud this effort. With the advances in technology, we can envision a system where data contained in an organization's annual filing could be compared electronically to other organizations within market segments. This might allow the Service to identify organizations whose activities are unusual and warrant further review. A linking of exemption application data and the Form 990 (as well as other tax filings) could provide data regarding organizations whose activities have evolved from those presented in the exemption application, perhaps warranting additional review. Sophisticated databases could be developed to enhance the Service's abilities to diagnose potentially abusive situations (conceptually this could be similar to many employers use of technology to monitor employee expense reimbursement practices).
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We commend the Advisory Committee for researching this issue, which will help improve the allocation of IRS resources. If we can be of any further service to you and your committee, please contact Lisa Winton, AICPA Technical Manager, at (202) 434-9234; Diane Cornwell, EO Audit Activity Working Group Co-Chair, at (502) 500-7849; Mary Rauschenberg, EO Audit Activity Working Group Co-Chair at (312) 242-9544; or myself at (703) 637-2670.
Chair, AICPA Exempt Organization Taxation Technical Resource Panel
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