It is an uncertain time to be a tax-exempt public charity or private foundation. The federal government has recently scrutinized certain tax-exempt organizations (see here), and draft congressional legislation proposed a tax increase on private foundations (see here and here). Despite recent record-low audits of exempt organizations (see here), there is potential for increased inspection, and tax-exempt organizations should take steps now to prepare for an Internal Revenue Service ("IRS") audit.
Most tax-exempt organizations are classified under Section 501(c)(3) of the Internal Revenue Code ("IRC"). They are exempt from federal tax so long as they are organized and operated exclusively for an exempt purpose. Exempt purposes can include religious, charitable, scientific, testing for public safety, literary and educational purposes. IRC Section 501(c)(3) and the related regulations provide detailed rules for maintaining tax-exempt status, including private benefit and inurement prohibitions, lobbying restrictions, an excess benefit transaction excise tax and unrelated business income tax provisions. Exempt organizations file public annual returns of their income, expenses and compliance with federal law with the IRS on a series Form 990.
IRS tax audits of exempt organizations generally focus on determining whether the organization is organized and operated in accordance with its tax-exempt purpose, and whether the organization has completely and correctly filed applicable returns. IRS tax audits can result in tax adjustments if the IRS determines the organization is liable for taxes (examples include unrelated business taxable income, private foundation excise taxes and excess benefit transactions). The IRS also can revoke a tax-exempt status if it determines that the organization is not operating in support of its tax-exempt purpose.
Practice Point: Tax-exempt organizations are under increased scrutiny. What can you do now to prepare for an IRS audit? Tax-exempt organizations should conduct a self-audit and governance review to ensure activities continue to support the approved tax-exempt purpose. The review should examine the organizational documents, policies and procedures, as well as operations past and present to ensure they conform to the tax-exempt purpose. One area of particular scrutiny are transactions with related parties and whether they are "prohibited transactions" subject to excise tax and fines. Organizations should also review books and records to ensure compliance with the tax laws, including private benefit and inurement limitations, grant and scholarship constraints and lobbying prohibitions. The review should also implement training and recordkeeping procedures to ensure continued compliance. A candid assessment of the exempt organization’s activities may help to avoid IRS penalties and excise tax, and even revocation of exempt status.
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This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.
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