Is Your 501(c)(3) Audit-Ready?

In the wake of the Trump Administration’s recent scrutiny of various nonprofit organizations, including Harvard University, and threats to revoke organizations’ tax-exempt status, nonprofit organizations should take proactive steps in the event of an IRS audit that may target their federal tax-exempt status. Proactive planning and preparation measures are essential to being well-equipped to deal with potential IRS inquiries or an audit. The faster and more efficiently an IRS inquiry can be concluded, the better likelihood of avoiding a full audit or worse, revocation of status. An organization may be particularly vulnerable where there has been any level of political involvement that could be viewed as controversial, but also involvement with activities and efforts focused on renewable energy and diversity, equity & inclusion (“DEI”) may now cause additional scrutiny of an organization’s tax-exempt status. Common potential foot-faults that can bring an organization into the crosshairs (and which are oftentimes not fully considered in light of potential risk of revocation of tax-exempt status) include negotiating typical agreements, including commercial contracting and similar arrangements, where contractual provisions may call for representations and commitments from a non-profit around its DEI efforts or similar efforts. Extra care should be taken to review such instances and other potential activities that may increase the organization’s risk of IRS audit.

Set forth below are key considerations for ensuring your nonprofit is IRS audit ready.

• First, an organization’s federal tax-exempt status cannot be revoked by the President, whether by executive order or otherwise. Short of an act of Congress to change the legal requirements for tax-exemption, only the IRS has the authority to grant or revoke tax-exempt status in accordance with the requirements of the Internal Revenue Code and Treasury Regulations.
• Once granted, tax-exempt status, particularly 501(c)(3) status, typically is revoked for one of the reasons listed below. For each reason, we identify proactive steps your organization can begin taking to be prepared for a potential IRS audit.
  1. Failure to file the annual Form 990 information return for 3 consecutive years.
     
     Recommended Action: Confirm your Form 990 has been filed for at least the past 3 years, and locate your records of the filings and all attachments and supporting documents. If you discover any late or missing filings, take steps to submit the 990 for any open years as soon as possible.
  2. Private benefit or private inurement, such as self-dealing by entity insiders.
     
     Recommended Action: Review your organization’s governing documents to ensure self-dealing is clearly prohibited and review the board’s processes for handling potential conflicts of interest. Confirm your organization has an up-to-date conflicts of interest policy. Review any transactions involving your organization and any board members, founders, employees or major donors to ensure there has been no self-dealing.
  3. Substantial lobbying activities.
     
     Recommended Action: Certain types of tax-exempt entities, like 501(c)(4) social welfare organizations, can engage in substantial lobbying activities. However, while some lobbying is permitted (and routine) for 501(c)(3) organizations, if your nonprofit engages in “too much” lobbying activity, it can lose its 501(c)(3) tax-exempt status. Review your organization’s policies regarding lobbying to ensure they are sufficiently limited. Review all lobbying activities over the past several years and quantify the relative amount of time and expense spent by the organization on those activities in comparison to the organization’s exempt purpose to put the organization in the best position to defend such activities in case of an audit.
  4. Political campaigning.
     
     Recommended Action: Unlike lobbying, which is permitted to some extent, all political campaigning is prohibited for a 501(c)(3) entity and can cause issues for other tax-exempt organizations. Review your organization’s governing documents to ensure political campaigning does not occur. Additionally, we recommend review of activities and expenditures over the past several years to determine whether any such items relate to political campaigns or in support or opposition of candidates running for office.
  5. Generating too much unrelated business income (UBI), which is income earned by regularly engaging in trade or business activities that are not substantially related to the organization’s tax-exempt purpose.
     
     Recommended Action: Review your organization’s accounting practices to confirm whether income is properly classified (or not) as UBI. Calculate the percentage of UBI relative to the organization’s total income, donations or earnings and be prepared to explain whether and how various expenditures relate to the organization’s exempt purposes.
  6. Operating for substantial illegal purposes, violating fundamental public policy, or failing to operate in accordance with your organization’s stated purpose.
     
     Recommended Action: This is a broad category, and could provide the greatest latitude for the IRS to challenge an organization’s tax-exempt status. For instance, in Bob Jones Univ. v. U.S., 461 U.S. 574 (1983), the Supreme Court held that 501(c)(3) status could be revoked where the organization’s policies violated clearly defined public policy by engaging in racial discrimination. It is possible IRS could examine tax-exempt status for entities that engage in significant DEI efforts if they are determined to be illegal, violate fundamental public policy, or are inconsistent with your organization’s stated purpose. Review your organization’s governing documents and understand the charitable purposes for which the organization exists and for which tax-exempt status was initially granted. Review your organization’s public-facing websites, information, communications, committees, programs and initiatives to confirm they support or relate to your organization’s exempt purpose. Documentation is key.

• What happens if tax-exempt status is revoked?
  • Of the reasons listed above, only failure to file the 990 for 3 consecutive years allows the IRS to immediately and automatically revoke tax-exempt status without advance notice. The IRS will notify you of this automatic revocation by letter and by publication in the Internal Revenue Bulletin. Even if this type of automatic exemption occurs, your organization can still apply for retroactive reinstatement of its tax-exempt status or appeal the determination.
  • In the remaining instances, unless there has been a change in law or regulations that directly affects tax-exempt status, revocation can only occur after the IRS has notified the organization of an audit or investigation (an “examination”) of its tax-exempt status and completes the examination. Examinations tend to be interactive, giving the organization ample opportunity to provide relevant documentation and information to the IRS examiners before a final determination is made. Gathering documentation and information according to the “recommended actions” above can help make the examination process smoother and faster.
  • In the event an examination does result in revocation of tax-exempt status, the organization may file a protest with the IRS Office of Appeals within 30 days following the date of the notice. If the organization receives a final, adverse determination, it may file a lawsuit in U.S. Tax Court, the District Court for the District of Columbia, or the U.S. Court of Federal Claims within 90 days.
  • Finally, keep in mind that an entity’s federal tax-exempt status, including under Code section 501(c)(3), is separate from the entity’s non-profit status under state law. Therefore, even if your organization’s federal tax-exemption is revoked, it could remain a nonprofit entity for state purposes unless the state separately takes action to revoke nonprofit status.

Our team is ready to help and assist your tax-exempt organization navigate the present and ever-changing landscape involving eligibility for federal tax-exempt status. Let’s continue the discussion.