Presenting a live 110‐minute webinar with interactive Q&A IRS Audits of Non‐Profits Preparing for Auditors' Red Flags With Income, Activities and Business Relationships T d ’ f l f 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUESDAY, DECEMBER 21, 2010 T oday’ s faculty features: Laura Kalick, Director of Non-Profit Consulting, BDO USA, Bethesda, Md. Pamela Baker, Partner, SNR Denton, Chicago Nancy Kuhn Director Jackson & Campbell Washington D C Nancy Kuhn, Director , Jackson & Campbell, Washington, D.C. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
Transcript
Presenting a live 110‐minute webinar with interactive Q&A
IRS Audits of Non‐ProfitsPreparing for Auditors' Red Flags With Income, Activities and Business Relationships
Laura Kalick, Director of Non-Profit Consulting, BDO USA, Bethesda, Md.
Pamela Baker, Partner, SNR Denton, Chicago
Nancy Kuhn Director Jackson & Campbell Washington D CNancy Kuhn, Director, Jackson & Campbell, Washington, D.C.
The audio portion of the conference may be accessed via the telephone or by using your computer's speakers.Please refer to the instructions emailed to registrants for additional information. If you have any questions,please contact Customer Service at 1-800-926-7926 ext. 10.
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• Payroll tax and self-employment tax gap– More than $200 billion annually– Payroll tax audit will analyze targeted issuesPayroll tax audit will analyze targeted issues
TYPICAL IRS AUDIT PROCESS Nancy Kuhn, Jackson & Campbell
TYPICAL IRS AUDIT PROCESS WITH NON‐PROFITS
IRS Audit Process With Non-ProfitsIRS Audit Process With Non Profits
• Several methods used for identification of non-profits for audit– Automatic: Information returns don’t add upAutomatic: Information returns don t add up– Front page of the newspaper– Team examination program
M k t t t di– Market segment studies– Targeted compliance programs
• “TEP” audits– Reserved for large organizations with multiple issuesReserved for large organizations with multiple issues– Team of specialized agents, engineers, other agencies– Comprehensive information document requests (IDRs)
• The IRS has taken the position that a well‐governed organization is more likely to• The IRS has taken the position that a well‐governed organization is more likely to be tax‐compliant.
Th F 990 h d t ti• The Form 990 has new governance and management questions.
• IRS examination agents have a check sheet to fill out regarding management and governance issues for 501(c)(3) organizations.
• Many of the initial IDRs may focus on governance issues.
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Good Governance PracticesGood Governance Practices
Mission statement
Code of ethics and whistleblower policy
Fundraising policy
Financial audits
C ti tipolicy
Due diligence
Duty of loyalty
Compensation practices
Document‐retention policy
Transparency
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IRS Examination ProcessIRS Examination Process
Initial contact and letter confirming date for meeting with initial IDRsInitial contact and letter confirming date for meeting with initial IDRs
• Current mission statement
• Articles of incorporation and by‐laws provided to officers and directors
• How often did the board meet?
• How often were the board members provided with written financial reports of the organization?the organization?
• Application for exemption and IRS correspondence
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Initial Contact And IDRsInitial Contact And IDRs
• Auditor’s financial workpapers• Auditor s financial workpapers
• Publications of the organization
• Records of examinations of other taxing authorities
• Web site pages from previous periods
• Family or business relationships among board members
• Minutes from meetings of the board of directorsg
• IRS may ask the organization to sign Form 872‐Consent to extend the statute of limitations
• Watch out for fishing expeditions to cover years that are not being examinedWatch out for fishing expeditions to cover years that are not being examined
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Open Tax YearsOpen Tax Years
• No statute of limitations on exemption issues
• Generally the last three tax years
• If no return filed, then open back to when a return was filed
• If incomplete information, IRS could assert return not filed
• Filing Form 990 does not necessarily count toward filing Form 990‐T
• If a net operating loss (NOL) is carried over to an open year, then the IRS can look at the years in which the loss was generated in order to determine the validity of the loss.
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Exemption Issues• Private inurement• Private inurement • Substantial private benefit• Numerous and egregious excess benefit transactions• Political campaign intervention p g• Excess lobbying activity [501(c)(3)]• Particular services for members [501(c)(6)]• Substantial unrelated activities• Changes in law• Illegal activity• Non‐compliance with law
C• Commensurate test
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Exemption Issues (Cont )Exemption Issues (Cont.)
Loss of exemption means taxation at corporate rates
Investment income would be taxed.
Not all expenses can be used to offset income, e.g.:p , g
- Non‐qualified deferred compensation
- Administrative expenses of a PAC
Lobbying expenses- Lobbying expenses
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Exemption Issue: Lobbying For 501(c)(3)Exemption Issue: Lobbying For 501(c)(3) Public Charities
Allowed, if not “substantial,” for public charities (but not private foundations)
Substantial is a facts‐and‐circumstances test without even a clear definition ofSubstantial is a facts and circumstances test, without even a clear definition of lobbying or bright lines, and may include volunteer efforts.
501(h) election creates a clear expense related safe harbor with clear definitions and501(h) election creates a clear expense‐related safe harbor with clear definitions, and allows lobbying of up to $1M per year based upon levels of total expenses.
• Excise tax if limits exceeded in particular year
E j di d l h li i d 150% fi i d• Exempt status jeopardized only when limits exceed 150% over a five‐year period
• Election recommended in most cases; may not be a good idea for very large organizations where $1 million is a really small percentage of total expense
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Exemption Issue: Political ActivityExemption Issue: Political Activity
Absolute prohibition and possible loss of tax exempt status for 501(c)(3)Absolute prohibition and possible loss of tax exempt status for 501(c)(3)
Other 501(c) organizations:
• Cannot be primary purpose
• Subject to income taxes on lesser of political activities or investment income (IRS Form 1120‐POL)
• Look at $$ and activity (time sheets are very important records)
• Be careful to avoid substantial private benefit
• After the Citizens United case, there have been many organizations formed that are involved in political activities.p
• IRS may be establishing a specific audit program in order to determine if the primary purpose test has been violated and to address other concerns.
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EXECUTIVE COMPENSATION Pamela Baker, SNR Denton
ISSUES
Executive Compensation Audits
Part of general “random” audit Part of general random audit Follow-on from 2006-2008 compliance project on non-profit
hospitalsF ll f 2008 2010 li j t bli d Follow-on from 2008-2010 compliance project on public and private colleges and universities Follow-on from 2009: Present compliance initiative on
governance Follow-on from executive compensation initiative: Errors and
omissions in Form 990 report on officer compensation
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Key Audit Items
Compliance with “rebuttable presumption” Compliance with rebuttable presumption
Specific problem areas– Personal use of employer-owned property– Non-accountable expense allowances– Spouse travelSpouse travel– Club memberships– Personal elements of business travel
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Rebuttable Presumption
A/k/a “intermediate sanctions” A/k/a intermediate sanctions Applies to 501(c)(3) and 501(c)(4) organizations Includes elements of good governance for other non-profits Rebuttable presumption that compensation is reasonable and
not an “excess benefit” if three components are satisfied for compensation of “disqualified individuals”:1. Compensation is approved by an independent, non-conflicted
body before the compensation is paid.2. An appropriate amount of compensation is based on
appropriate comparability data.3. Contemporaneous documentation of the decision
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Rebuttable Presumption (Cont.)
Most 501(c)(3)s and 501(c)(4)s purport to rely on the rebuttable Most 501(c)(3)s and 501(c)(4)s purport to rely on the rebuttable presumption.
If ti i ti fi d th th IRS t If presumption is satisfied, then the IRS must prove compensation was unreasonable.
If presumption is not satisfied, then the organization must affirmatively establish that the compensation was reasonable.
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Executive Compensation “Compliance Check”
Initial document request
Will identify the year(s) in question Will identify the year(s) in question
Will identify (likely by position) the individuals whose compensation is being checked
Will i th f ll i t b d d Will require the following to be produced:
– Copy of the organization’s formal written compensation policy
– Written document approving compensation by unconflicted body
– List of members of the unconflicted body
– Copies of published surveys or outside expert reports used in determining the compensation amountsg p
– Documentation to support the factors applied in the comparability data used
– Copy of the employment contract if any
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– Copy of the employment contract, if any
Executive Compensation Audit
May also include request for documentation to align W-2s or 1099s with amounts reported on Form 990
Wh i ti h l d fi l thi– When an organization has a non-calendar fiscal year, this may require multiple years’ compensation committee determinations.T k ti d f d ti l hi h– Take caution re: deferred compensation accruals, which are reported multiple times on Form 990 (accrual, vesting, payout).
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Executive Compensation Audit: Practical Tips
You should seek to meet with IRS reviewer to go over assembled You should seek to meet with IRS reviewer to go over assembled documentation.– Orally explain how organization determines compensation
W lk th h d t ti t dd i di t– Walk-through documentation to address any immediate questions
It is preferable not to invite IRS reviewer to the organization’s premises; it is better to meet in a neutral location (such as attorney’s office).
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Executive Compensation Audit: Best Defense Is A Good Offense
Be sure to have a compensation philosophy (different than Be sure to have a compensation philosophy (different than committee charter) For example, as part of a sample compensation philosophy:
T t l t di f bl iti t– Target salary at median of comparable positions at comparable organizations
– Provide annual incentive under “pay for performance” h t t di ( % f l ) b t id i tiapproach; target median (as % of salary) but provide incentive
resulting in total cash compensation as high as 75th percentile– Provide benefits in aggregate at market median
Ties in with IRS governance initiative
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Executive Compensation Audit: Best Defense Is A Good Offense (Cont.)
You should be sure compensation committee members have no conflicts of interest each time a compensation decision is made.p– Not related to the person whose compensation is being
determined– Not under the direction or control of the person whose– Not under the direction or control of the person whose
compensation is being determined– Has no pay subject to the approval of the person whose
compensation is being determinedcompensation is being determined– Has no material financial interest affected by the compensation
arrangementIs not in an interlocking compensation determination– Is not in an interlocking compensation determination arrangement
Ties in with IRS governance initiative
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Executive Compensation Audit: Best Defense Is A Good Offense (Cont.)
Know your disqualified persons. IRS audits may cover the “top six” employees who are not officers. You need to satisfy the rebuttable p y ypresumption on all qualified persons.– Five-year look-back– In a position to exercise substantial influence over the affairs of– In a position to exercise substantial influence over the affairs of
an organization (e.g., department heads)– Family member of substantial influence
E tit d 35% b th b t ti l i fl f il– Entity owned 35% by the substantial influencer or a family member
Need annual update, intervening flagging procedure for new hires, promotionspromotions The list may be very long for a large organization. Ties in with governance initiative
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Most/many will be separately scheduled on Form 990 Schedule J.
Executive Compensation Audit: Best Defense Is A Good Offense (Cont.)
Comparability data/expert report or expert opinion Comparability data/expert report or expert opinion– IRS has compensation “engineers” who will do a thorough and
knowledgeable review of compensation data.H bl h ?– How are comparables chosen? Organizations Job function
– Use for-profit comparators? Allowed IRS is closely reviewing as part of governance project IRS is closely reviewing as part of governance project.
– Is compensation within the parameters of the comparability data and the compensation philosophy?
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Executive Compensation Audit: Best Defense Is A Good Offense (Cont.)
Were data taken into account for each compensation decision –e.g., decision to increase the matching contribution on 403(b) or 401(k)? Other one-off decision? Are data current? Is the decision or consultant’s report reasoned? Does the
consultant certify as to expertise? Is there an opinion? Use of comparability data is a complex field, with lots of room for
both:– Good judgmentj g– Inadvertent foot-faults
Is there a written employment/compensation agreement?Majority of organizations have them for at least some– Majority of organizations have them for at least some disqualified persons.
– “First bite at the apple” rule is under scrutiny in the IRS governance project Take caution re: falling out of compliance
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governance project. Take caution re: falling out of compliance with contract amendments or renewals.
Executive Compensation Audit: Best Defense Is A Good Offense (Cont.)
Contemporaneous documentation– Usually in minutes– Usually in minutes– Keep minutes up to date (within 60 days, generally)– If documentation is late, it is still better than no documentation.– If possible, you should have minutes approve specific dollar
amounts, not just “salary as discussed.”– Attach comparability data, analyses
Coordination with Form 990 Governance initiative
Board required to see Form 990– Board required to see Form 990– Better governance to have direct input before finalized– Compare amounts on form with minutes approving
ti
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compensation
Take-Aways
The IRS audits executive compensation issues in conjunction The IRS audits executive compensation issues in conjunction with many other types of audits.
Th b t d f i d ff The best defense is a good offense.– Focus on rebuttable presumption– Meticulous ongoing documentation
GovernanceHave a written philosophy– Have a written philosophy
– Have regular procedures in place– Follow the procedures and the philosophy
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UBI AND ALLOCATION OF Laura Kalick, BDO USA
EXPENSES
Focus On UBI And Allocation Of ExpensesFocus On UBI And Allocation Of Expenses
• Statistics of Income
‐ In 2006 tax year, fewer than 50% of returns filed showed positive amounts of UBITUBIT.
• New Form 990
‐ First page matches gross UBI with net UBIT reported on Form 990‐T
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UBIT IssuesLoss activities Income from affiliates
Mission‐creep activity
Advertising
Rental Income
Joint ventures
Trade shows
Certification programsRental Income
Debt‐financed income
Royalties
Certification programs
Testing
Internet activities
Merchandise sales
Particular services for members
Sponsorships
Publishing
Alternative investments
Attribution from taxable affiliates
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Unrelated Trade Or BusinessUnrelated Trade Or Business
• UnrelatedUnrelated
• Regularly carried on
• Trade or business — Requires a profit motiveIf there are losses from the activity on a continual basis, the IRS and the courts have taken the position that there is no profit motive, and therefore the trade or business requirement has not been metbusiness requirement has not been met.
• Portland Golf Club, 497 US 154(1990) There may be a legitimate reason for the lossThere may be a legitimate reason for the loss.
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College And University Survey:College And University Survey:Possible Reasons For Losses
• A= Business was in start‐up phase
• B= Actual costs were significantly greater than anticipated or budgetedg y g p g
• C = Competitive pressures prevented pricing to allow for full recovery of costs
• D = Less demand for product or service than was projected
• E = Business was in business cycle downturn• E = Business was in business cycle downturn
• F = Budgeted to operate at breakeven or a loss because doing so contributed to the organization’s exempt mission
G B i i i di h• G = Business was in winding‐up phase
• H = Other
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Item Must Be Deductible Under IRCItem Must Be Deductible Under IRC
• Ordinary and necessary: IRC 162; e g salaries and benefits based on time spent• Ordinary and necessary: IRC 162; e.g., salaries and benefits based on time spent on unrelated activity
• Directly connected to UBI activity: Proximate and primary — deduct in full• Must use appropriate depreciation schedulesMust use appropriate depreciation schedules• Non‐qualified deferred compensation is not deductible for tax purposes• Fifty percent of business meals• Items thrown into overhead to allocate between related and unrelated uses,Items thrown into overhead to allocate between related and unrelated uses,
e.g. dual uses, cannot contain related expenses― Examples:
- Development officer and fundraising expensesp g p- Government relations- Community benefit studies
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Reasonable Method To Allocate OverheadReasonable Method To Allocate Overhead To A Dual Use
• Dual use: Allocate on a reasonable basis• Dual use: Allocate on a reasonable basis • Gross receipts allocation method is never reasonable if users are charged
different amounts. • More than one method may be reasonable and may not have to be the best• More than one method may be reasonable and may not have to be the best.
- Rennselaer Polytechnic: Action on decision (1987‐014, 6/29/1987)• IRS will not litigate until regulations are changed and “reasonableness” test
is amendedis amended.• Tax‐exempt bond implications
- IRC 145 provides that an IRC 513 unrelated trade or business use is not a qualified use for purposes of the private activity bond rules If an organizationqualified use, for purposes of the private activity bond rules. If an organization allocates a portion of a building to unrelated business activity, then that is documentation regarding the use of the proceeds.
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RELATED FOR‐PROFIT Pamela Baker, SNR Denton
ENTITIES AND PERMISSIBLE ACTIVITIESACTIVITIES
Related Organizations: Dos And Don’tsRelated Organizations: Dos And Don ts
• For-profit/non-profit structure is key– Wholly-owned subsidiary
• C corporationC corporation– Joint venture with for-profit– Sale of tangible business assets to for-profit, with royalty
agreement for intangiblesagreement for intangibles– Contractual relationship (fundraiser, management company)
• EO joint venture with a for-profit organization– EO must have control or will recognize UBIT/endanger exemptEO must have control or will recognize UBIT/endanger exempt
status– If with another EO, must ensure fulfillment of exempt status,
public supportpublic support• Supporting organization structure is an alternative.
FIN 48 (ASC 740‐10): Disclosure OfFIN 48 (ASC 740‐10): Disclosure Of Uncertain Tax Positions
Must disclose whether a material position taken or expected to be taken on anyMust disclose whether a material position taken or expected to be taken on any income tax returnIs “more likely than not” to be sustained upon audit, assuming the organization is auditedaudited
- Based on technical merits of the position
- Look to tax law, administrative practices and precedents
E l t h iti i di id ll it it- Evaluate each position individually, on its own meritsThe amount must be quantified, and interest and penalties taken into account and then disclosed in a footnote to the financial statements.The FIN 48 footnote must be disclosed on Schedule D of the new Form 990The FIN 48 footnote must be disclosed on Schedule D of the new Form 990 (federal , state and local and foreign income tax positions).
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What Is A Tax Position?What Is A Tax Position?
Tax benefit on return filed or expected to be filedTax benefit on return filed or expected to be filed
Expense allocation
Decision not to file a return
Allocation or shift of income between jurisdictions
Exempt organizations
• Tax exemptionp
• Unrelated business income
• Private foundation excise tax on investment income
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FIN 48 Vs IRS Mock AuditFIN 48 Vs. IRS Mock Audit
• FIN 48: Income tax issues at federal, state and local, international levels
• IRS mock audit: Other federal tax issues including employment taxes, pensions, g p y , p ,tax‐exempt bonds, etc.
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Where To LookWhere To LookForm 1023 or Form 1024
Articles of incorporation and by‐laws
Board of directors minutesBoard of directors minutes
Compensation agreements
Tax opinions
Correspondence with taxing authorities
Web sites
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Web sites
Where To Look (Cont )Where To Look (Cont.)
Financial statementsFinancial statements
Major contracts
Form 990 and Form 990‐T and work papers• Compare gross unrelated business income and net unrelated business income
Q ti l ifi ti f “ th i ” l t d• Question classification of “other income” as related• Question NOL
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DocumentationDocumentation
• The more questionable the position, the “heavier” the documentation required
• Highly certain tax positions still require documented evidence
• Based on clear and unambiguous tax law• Based on clear and unambiguous tax law
• May need tax opinions on issues identified
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FIN 48 And IRS Mock AuditsFIN 48 And IRS Mock Audits
• Identify federal income tax positions (both)• Identify federal income tax positions (both)
• Identify state and local and international tax issues (FIN 48)
• Identify other tax issues (mock IRS audit)
• Determine if position is highly certain, and document (both)
• For uncertain positions, determine if it is more likely than not that a tax position would be sustained if organization is examined by taxing authorities, and document (both)
• Measure tax positions that would not be sustained (FIN 48)
• Aggregate unsustainable tax positions to determine if material (FIN 48)gg g p ( )
• Disclose material uncertain tax positions in footnote (FIN 48)
• Organize files and document, document, document (BOTH)
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RELEVANCE OF TERRORIST Nancy Kuhn, Jackson & Campbell
FINANCING EXAMS
Anti-Terrorist FinancingE IExam Issues
• International grants – Documentation and follow-up
• Financial investigations unit (FIU)IRS EO it t d t t d d t t ti l f d l t– IRS EO exam unit to detect and deter potential fraudulent transactions/funding of terrorism by charities
Anti-Terrorist Financing E I (C t )Exam Issues (Cont.)
• Treasury’s best practices– Guidance is voluntary, due diligence– Check OFAC listCheck OFAC list– Document international grants– Follow-up through reporting system
I t t i d t l• Internet is good tool• Pictures • Documented results
Anti-Terrorist Financing E I (C t )Exam Issues (Cont.)
• Exam techniques– Cooperation is key
• IRS will assume the worstIRS will assume the worst• Documentation to confirm charitable program• Documentation to confirm dollars went to intended recipients
D t ti t fi h it bl lt• Documentation to confirm charitable results– Respect power of coordinated agencies
