Seven Red Flags of Form 990: Avoid an Audit

By Jenna Senn

The IRS may decide to audit your nonprofit organization for various reasons, with one of the most frequent triggers being a red flag raised by your annual Form 990 filing, "Return of Organization Exempt From Income Tax."

Continue reading to discover seven common areas of IRS scrutiny and discover strategies to minimize your audit risk.

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.

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.

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.

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.

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.

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.

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:

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.

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.

The good news with all of this is that there are steps to minimize the chances of your Form 990 triggering an audit. By following the 7 tips above, your organization will understand how to walk the line as much as possible, without raising any major flags.

Most importantly, retain a CSH professional with nonprofit expertise to assist with preparing Form 990. You'll be much less likely to submit incomplete, inconsistent, or inaccurate information.

Clark, Schaefer, Hackett & Co. is hosting a free webinar on Tuesday, August 27, 2024 at 1PM EST. Our presenters will cover this topic in more depth along with topics such as how to make your 990 appeal to grantors and donors. Please join us to learn more and discover the tools to position your organization for 990 success. Click here to register.