James P. Sweeney, CPA, MBA, MTAX
James P. Sweeney, CPA, MBA, MTAX, is a partner at McGladrey LLP in Washington, DC and national leader of McGladrey's Exempt Organization Technical Tax Services.
Be prepared for questions on compensation, governance, and unrelated business income at your next audit.
The Internal Revenue Service has recently shown a more aggressive posture in its field audits of exempt organizations. This is only expected to increase due to recent expansion of examination personnel in the Exempt Organization division. The IRS is aggressively challenging intercompany activities of associations and their related affiliates, especially if an affiliate is a 501(c)(3) charitable organization. In addition, focus has moved from general operations to governance issues and also to allocations of expenses to offset unrelated business income.
Affiliate and membership challenges. The IRS is particularly focusing its field audit posture on transactions between associations, their memberships, and affiliated charitable organizations. The IRS is concerned that transactions from a charitable activity to the members of the association without full and adequate consideration being paid from the association or recipient members to the charitable affiliate may result in prohibited private inurement. An example would be research or educational publications being provided by a charitable organization to the members of an association free of charge without payment to the charitable organization by members or the association.
The concern in this field audit posture is that if these transactions are present, especially in more than an insubstantial way, the IRS will challenge the continuing exempt status of the charitable organization. In reality, and in nonegregious situations, it appears that the IRS will in some instances require acknowledgement of the "questionable" transaction by management and the respective boards of the organizations involved, with the understanding that such a transaction will not occur again; if it does, an arm's length charge will be present. Failure to adhere to such an agreement could result in future revocation of exempt status.
Compensation inquiries. The new Form 990 requires substantial compensation disclosures. Although the association community was vocal about the expanded disclosure, the IRS was steadfast in the new requirements, stating that it was concerned with compensation practices of associations and other 501(c)(6) organizations, as these organizations were also subject to a prohibition of private inurement as set forth in the statute under paragraph 6 of section 501(c). Although field agents are reviewing compensation practices of associations during an audit, to date, it is not known if there has been a challenge regarding the reasonableness of current compensation practices.
However, the ancillary focus in the field is substantiation and adherence to the accountable plan rules. When items are found that should have been reported on a Form W-2, this results in an adjustment to the income of the recipient of the benefit, which should have been properly reported on that person's respective Form 1040. Recent audit posture by the IRS is to ask for an extension of the statute of limitations period to assess tax not only for the association but also for the individual's Form 1040. This posture is expected to continue and actually ramp up, based on some recent informal comments by IRS personnel in public forums.
Governance issues. The IRS has recently posted a check sheet on its website that lists governance concerns for charitable organizations, not excluding charitable affiliates of associations. The IRS completes this sheet at the beginning of the audit process and studies it back at IRS headquarters to determine the focus and breadth of the audit of the charitable affiliate.
Although the IRS admits that it does not have statutory authority in the Internal Revenue Code to ask questions or require disclosure of governance, management, and disclosure practices on its Form 990, it believes that existing statutes (namely section 6033) provide it with the authority to do so. During the recent debates regarding the Health Care Reform Act, Senator Chuck Grassley (R-IA) proposed adding to the tax statutes specific language allowing for such governance inquiries. At press time, this proposal has been removed from the pending healthcare legislation; however, we must pay close attention to its possible passage in future tax bills.
Unrelated business income. The IRS is applying literal statutory language with regard to expenses allowable to offset unrelated business income. The expense must be directly and proximately related to the generation of the unrelated business income. Blind allocations of overhead are not being allowed if these relationships cannot be adequately explained.
James P. Sweeney, managing director with RSM McGladrey, leads the firm's Tax Services for Tax Exempt Organizations practice in the mid-Atlantic region. Robert H. Billig, managing director with RSM McGladrey, leads the firm's Not-For-Profit Services practice in the mid-Atlantic region. Email: [email protected], [email protected]