If your not-for-profit organization operates on a calendar-year tax basis, the deadline for filing your year-end Form 990 (Form 990 EZ for certain small organizations) is May 15. Besides filing on time, you must ensure the information provided on your form is accurate. Pay particular attention to the following eight issues that commonly trip up nonprofits:
- Unrelated business income tax (UBIT).If your not-for-profit regularly engages in activities that generate profits, for example, sales of books or apparel, it may be on the hook for UBIT. The IRS has issued comprehensive regulations interpreting when UBIT applies. For an activity to be related to your tax-exempt purpose, it must have a causal relationship and “contribute importantly” to your nonprofit’s objective. Since UBIT is common, it’s not an automatic audit trigger. However, if this income represents more than, say, 20% of the organization’s overall revenue, you’re likely to be asking for trouble.
- Excessive compensation. Form 990 lists your organization’s highest-compensated employees (HCEs). If compensation is treated as being “unreasonable” based on the circumstances, it could lead to inquiries. Furthermore, the Tax Cuts and Jobs Act (TCJA) imposes a substantial excise tax if more than $1 million in remuneration — such as wages, bonuses and nonqualified deferred compensation amounts — is paid to a “covered employee.” This group includes your organization’s five HCEs for the applicable tax year. The current 21% tax rate established by the TCJA applies to the portion of compensation above the $1 million mark.
- Fundraising activities. Your not-for-profit must report its income from fundraising activities, as well as its expenses, on Schedule G of Form 990. The IRS is on the lookout for events that produce a relatively small amount of income compared with claimed expenses. In such situations, make sure you have proof to withstand any potential challenge.
- Political activities. In the current political environment, it can be difficult for nonprofits to walk a fine line between advocacy and campaigning. If your organization is exempt under Section 501(c)(3) of the tax code, it’s strictly prohibited from engaging in direct political activity, including candidate endorsements. A 501(c)(3) organization can lose its tax exemption if a substantial part of its activities involves attempts to influence legislation. Section 501(c)(4) (social welfare) organizations, on the other hand, may participate in some political campaigning, so long as the work isn’t the organization’s primary activity.
- Excess benefit transactions. An excess benefit transaction is where a financial benefit is provided by a tax-exempt organization — either directly or indirectly — to, or for the use of, a “disqualified” person in excess of the value received by the organization. For these purposes, a “disqualified” person is someone who has been in a position to exercise substantial influence over the organization’s affairs during the last five years. This prohibition prevents, for example, an officer from pocketing money above a reasonable compensation for his or her services. Not surprisingly, paying an excess benefit is a red flag for IRS computers, so you should avoid this in most situations.
- Foreign activities. Nonprofits are permitted to operate outside the United States without penalty. But your organization is required to answer questions on Form 990 relating to foreign bank accounts, activities in foreign countries and grants by foreign entities. The IRS will likely ratchet up its scrutiny if it finds inconsistencies or evidence of activities that don’t measure up to U.S. standards. Professional advice in this area is an absolute must.
- Diversion of assets. The IRS asks on Form 990s whether there has been any “diversion” of assets during the past year. Essentially, “diversion” means that funds have been misappropriated for personal reasons. If you answer “yes,” to this question, provide a detailed explanation of the event and its resolution. However, don’t be surprised if a “yes” answer leads to an audit, even if you’ve provided a plausible explanation. If you fail to attach an explanation, your audit exposure increases exponentially. Nevertheless, answer the question truthfully.
- Loans to disqualified persons. Generally, loans from a tax-exempt organization to a disqualified person are prohibited on the state level. Form 990 asks if your nonprofit has made such loans. In the event your nonprofit has made a prohibited loan, your Form 990 should reflect a declining balance. Otherwise, it may look as though the loan isn’t being paid off in time — a certain red flag for the IRS.
Although accuracy in all of your organization’s IRS filings is critical, you’ll be relieved to hear that nonprofit audits are rare. But you don’t want to raise suspicions either. Before you file Form 990, meet with your professional tax advisor to assess any risks and resolve any open issues.
Michael Cecere, CPA, MST is a Gray, Gray & Gray partner and chair of the firm’s Non Profit Practice Group. He can be contacted by telephone at (781) 407-0300 or via email at: firstname.lastname@example.org.