The Internal Revenue Service has released its work plan for the coming year outlining its priorities for examinations and audits of tax-exempt organizations.
Laura Kalick
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.”
Focus Areas
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.