IRS Audit Issues for Exempt Organizations

The primary objective of an IRS audit of an exempt organization is to determine whether the organization is organized and operated in accordance with its exempt function.

Maintaining Charitable Purpose

An entitys organizational articles or governing documents must state its charitable purpose; a deficiency cannot be cured by the entitys activities. Also, the entity must operate in accordance with its exempt purpose. It must comply with reporting and disclosure requirements, including filing annual information returns and other documents and making them available for public inspection. IRS examiners perform in-depth reviews of activities and operations to ensure that an entity continues to meet the statutory exemption requirements.

If an entity materially changes its activities and, thus, becomes inconsistent with its charitable purpose, it may not be able to rely on a new determination letter recognizing exempt status. Any such changes must be reported to the IRS immediately, so that a determination can be made as to status. By not reporting a material change, an organization may lose exempt status and be required to file retroactive returns.

UBIT

Another issue under IRS scrutiny is unrelated trade or business income (UBI). Under Sec. 512 and 513, UBI is income derived from any trade or business regularly carried on by an exempt organization that is not substantially related to its exempt purpose or function (except that the organization uses the profits derived from that activity). Examples of UBI include debt-financed rental income (under Sec. 514) and sales of merchandise unrelated to its exempt purpose. An organization with more than $1,000 in gross income from UBI must file Form 990-T, Exempt Organization Business Income Tax Return (and proxy tax under section 6033(e)), and is subject to corporate tax rates on unrelated business taxable income.

Political Expenditures

A Sec. 501(c)(3) entity that makes an expenditure for a political campaign or on behalf of or against a candidate for public office is subject to an excise tax of 10% of the expenditure, under Sec. 4955. If the political expenditure is not timely corrected, the IRS will assess an additional tax of 100% of the expenditure. It requires the entity to recover part or all of the expenditure when possible, establish safeguards to prevent future political expenditures and take any corrective action that it prescribes, by the earlier of the date that it assessed the tax or mailed a deficiency notice.

In addition, the IRS can assess taxes under Sec. 4955 on an organizations manager(s) when he or she either knew of a political expenditure or negligently failed to determine the expenditures nature. The assessment would be 2.5% of the expenditure (up to $5,000 per expenditure); for an uncorrected expenditure, an additional tax of 50% of the expenditure (up to $10,000 per expenditure) would apply.

Conclusion

Recently, the IRS also has been performing limited-scope audits of exempt organizations, in which it concentrates on specific issues. This saves time and allows it to audit more organizations.

From Timothy W. Mulcahy, CPA,  and Jason Chin, Holtz Rubenstein & Co., LLP, Melville, NY