7 Areas of Form 990 Audit Scrutiny

Kirsch CPA Group

Sep 10, 2024

The IRS can initiate an audit of your nonprofit organization for any number of reasons. But one of the most common is a red flag sent up by your annual filing of Form 990, “Return of Organization Exempt From Income Tax.” Read on to learn about some potential trouble areas and how you can reduce your audit risk.

Possible Pitfalls

The following areas in particular can spur closer IRS scrutiny:

1. Incomplete or inconsistent information. Missing schedules, blank boxes or unsigned forms aren’t just risky because they draw IRS attention. The agency considers incomplete returns to be unfiled returns, which could result in costly penalties. You also need to watch for inconsistent reporting of revenues or expenses between different sections of your form, or between your form and other publicly available information.

2. Unreasonable compensation. The IRS will notice excessive compensation paid to officers, directors and high-ranking employees. They’ll also take note if compensation is too low. The compensation you list should be in line with benchmarks for similar positions at comparable organizations and appropriate for your budget.

3. Excess benefit transactions. These transactions occur where 1) an organization provides economic benefit — directly or indirectly — to or for a “disqualified person” who was in a position to exercise “substantial influence” over the organization over past five years, and 2) the value of the benefit exceeds the value of the consideration the organization receives. Unreasonable compensation is one example. Such transactions can lead to audits and costly intermediate sanctions.

4. Unrelated business income (UBI). It’s perfectly legal, and often advisable, to have UBI. But it’s important to accurately report the income and related expenses and, if the gross UBI is $1,000 or more, include Form 990-T. In addition, while there’s no official threshold, UBI shouldn’t account for too much of your overall revenue.

5. Foreign grant activity. U.S. nonprofits are allowed to operate overseas, including providing grant funds to foreign organizations. The IRS keeps a close eye on such activities, though, due to concerns about nonprofits being controlled by foreign entities that are outside its jurisdiction and funds being used for noncharitable purposes. It’s especially interested in foreign bank accounts and foreign organization grants.

6. Fundraising discrepancies. The IRS expects to see some correlation between fundraising expenses and income. It can seem off, for example, if an event raises significant funds with barely any corresponding expenses. That can be explained by a major donation, but it might prove harder to explain if you incur substantial expenses for an event or campaign that generates little to no income.

7. Diverted assets. You’re required to disclose embezzlement or fraud if the gross value of all illegally diverted assets uncovered during the tax year exceeds the lesser of:

5% of your gross receipts for the year,
5% of your total assets at the end of the tax year, or
$250,000.

If you report that you’ve been the victim of a fraudulent diversion but don’t provide a detailed explanation on Schedule O, you can count on hearing from the IRS. Describe the nature of the diversion, the dollar amounts and/or other property involved, corrective actions taken to address the matter, and any other pertinent circumstances.

Avoid the Traps

You can take steps to reduce the odds of your Form 990 triggering an audit. First, maintain accurate and comprehensive recordkeeping. For example, if you have high fundraising expenses without commensurate fundraising income, you want your documentation to explain how that happened. Automation can make your recordkeeping easier.

In addition, don’t forget about the rules surrounding disqualified persons. Use good sense when it comes to any transactions with them. Also pay reasonable compensation and avoid excess benefit transactions.

Get Help

Most importantly, retain professionals with nonprofit experience to assist with preparing Form 990. You’ll be much less likely to submit incomplete, inconsistent or inaccurate information.

Know the Audit Types

If your Form 990 or something else leads to an IRS audit, it’s helpful to understand the most common types of audits:

Correspondence. Most audits are conducted via letters and phone calls to your officers or a representative. An IRS auditor will seek additional information about certain items shown on the tax return such as income, expenses and disclosed transactions. These audits can expand to become field audits.

Field. If your initial contact letter sets up an appointment for an agent to visit your office or your accountant’s office, the IRS is conducting a field, or in-person, audit. It typically occurs at the place where the nonprofit’s books and records are located, although some video meetings are held.

Field audits fall into two categories. A general program exam usually is conducted by a single IRS agent who may visit your location, while audits of large, complex organizations may involve a team of examiners.

Schedule an appointment to learn how we can support you