IRS Audits – Think Outside the Box
By Lyndel Lackey, HoganTaylor Tax Partner
As an exempt organization, receiving that initial letter or phone call from the IRS notifying you that your organization has been selected for examination definitely gets your attention. Your mind immediately starts thinking about where your organization may be at risk. The obvious areas immediately come to mind, such as:
- Have any unrelated business activities been properly addressed and reported?
- Have any lobbying activities been properly addressed and reported?
- Has the organization avoided involvement in political campaign activity?
- Have amounts paid to insiders been properly analyzed to avoid appearance of private benefit or inurement?
However, our observations regarding recent IRS audits and questions from exempt organizations emphasize in my mind that there are other areas of audit risk for non-profit organizations, which was also confirmed in discussions at the AICPA National Not-for-Profit Industry Conference recently attended by several of HoganTaylor’s Nonprofit Practice leaders. Now is when we need to “think outside the box”, and explore risk areas that may not be obvious at first glance to the exempt organization. This thinking does present an exempt organization an opportunity to be pro-active in its risk analysis, and potentially avoid future assessment of tax and penalties in these areas. Following are some “outside the box” topics that warrant discussion, and some suggestions regarding how best to mitigate risk in these areas.
- Are payments for employee business expenses complying with “accountable plan” rules? In some cases an organization may pay its key employees a fixed allowance for business mileage incurred in the performance of their duties. If the employee is not required under the organization’s policy to substantiate the expenses, and return any excess advances, then the reimbursement plan would be considered a non-accountable plan. Under that scenario, some or all of the allowance payment could be considered additional wages to the employees, subject to applicable employment taxes. We suggest that exempt organizations determine that their reimbursement plans require that all employees must substantiate covered expenses, and that any excess reimbursement is required to be returned to the organization within a reasonable period of time, as defined in IRS regulations.
- Are workers that perform services for the organization being classified properly, whether as employees or independent contractors? Exempt organizations periodically may require the services of workers that may work in specialty areas, where the organization does not have employees that can provide the needed services. An example of this is a manual labor intensive task required, where the organization engages outside workers to perform these tasks. In order for the IRS to determine that workers are properly classified, they analyze the working relationship between the organization and the worker, and also determine whether the organization exercises behavioral and financial control over the worker. The IRS also uses a 20-factor test to help in its determination of proper worker classification. If the IRS determines that a worker has been improperly classified, and should have been classified as an employee based on the factors mentioned, they will assess employment taxes on the payments to the workers, with limited relief available under certain circumstances. We suggest analyzing any contemplated worker relationship before engaging the worker, and insure in good faith that the worker is properly classified.
- Are payments to vendors properly analyzed where compliance with Form 1099 filing requirements are met? We have observed that exempt organizations may have token compliance in the 1099 area by preparing and filing 1099’s for payments to individuals who are indeed independent contractors. However, payments to business entities for services received are generally subject to 1099 reporting requirements, unless an exception applies. General exceptions are annual payments less than $600 for non-employee compensation, payments to an entity treated as a C- or S-Corporation for tax purposes, payments for merchandise, and limited items that are not of a service nature. If no exception applies, and a 1099 is not prepared and filed, there are separate failure to file and failure to furnish penalties of $100 per occurrence, with those penalties schedule to increase. We suggest reviewing your 1099 preparation procedures, and insure that compliance with these rules is being met.
- Similarly, are payments to vendors in compliance with backup withholding rules? We are observing some compliance shortfalls in the area of obtaining EIN’s from vendors, and therefore issues with backup withholding arise. If in a vendor arrangement a taxpayer identification number/EIN has not been provided by the vendor to the organization, the organization is required to withhold backup withholding on reportable payments at a 28% percent rate at the time it makes the payment to the payee. In an audit situation, this can potentially result in a large withholding tax assessment, with related penalties. We suggest mandating that Form W-9 be obtained on all vendors that would fall under these requirements.
- Is corporate credit card use complying with IRS requirements? Somewhat similar in nature to the discussion in 1 above, corporate credit card usage can present compliance issues. In some organizations, key employees may not be required to submit itemized receipts for business expense charges on an organization credit card. IRS guidelines indicate that in those scenarios that the payment is considered to have been made under a non-accountable plan, and that the entire payment is taxable to the key employee, and therefore wages for employment tax purposes. Specifically, the IRS requires substantiation for all lodging, and other business expenses more than $75. If your organization has a corporate credit card in use, we suggest analyzing policy to insure that these IRS requirements are met.
Having addressed these “outside the box” risk areas, I think this discussion gives exempt organizations an opportunity to monitor these areas of potential risk. With the current emphasis on “good governance” practices, I think this discussion should be a motivating factor to implement best practices in these areas, which helps the overall risk management of the organization. We would be happy to discuss any of these areas that are of concern to you.