As addressed in another BKD Thoughtware® article, the IRS has been using data-driven decision making on electronically filed Forms 990, 990-EZ and 990-PF to help make the examination process more efficient. Some potential high-risk areas the IRS has on its radar are described below.
Unrelated Business Income
Organizations with a history of gross income on Form 990, Part I, line 7a and losses on line 7b may be at risk. The IRS has argued that a history of losses on an activity is indicative the activity isn’t a trade or business; therefore, the losses can’t be used to offset the net income from other unrelated business activities. Although this will be less of an issue for tax years beginning after December 31, 2017, due to Section 512(a)(6)—which requires organizations to report activities separately and limit losses to a particular activity—the IRS has the authority to adjust prior-year net operating loss (NOL) carryforwards.
The Tax Exempt and Government Entities FY 2017 Work Plan (FY 2017 Work Plan) specifically identified the various subcategories for unrelated business income (UBI) that were examined in 2016. These categories included gaming, nonmember income for social clubs (including investment income), expense allocation, NOL adjustments, rental activity, advertising, debt-financed property rentals and investment income.
The IRS views UBI issues to align with its “tax gap” priority. It’s prudent for organizations to document the business purposes for any activity that may fall into the history of loss category, ensure expense allocations are consistent and reasonable and confirm the net income for the other subcategories of UBI mentioned above is properly calculated.
Employment tax has been a focus area for the IRS for the past several years and aligns with the tax gap priority. Form 990 collects information related to employment tax and compensation in various areas including Part V (lines 1 and 2), Part VII, Part IX (lines 5 through 11) and Schedule J. Organizations should pay close attention to ensure the information reported on these lines is accurate and doesn’t raise questions through inconsistencies or mismatching of information. For example, the ratio of the number of Forms W-2 and 1099 reported in Part V may point to a worker classification issue. If contractors are reported in Part VII and professional expenses on Part IX, line 11, but no Forms 1099 are reported in Part V, this may indicate a compliance error.
Schedule J discloses certain fringe benefits for disqualified persons, including whether these fringes were considered part of compensation, if a written policy was followed for payment of these expenses and if substantiation was required. The responses provide insight to determine if an accountable plan is used for reimbursing expenses (which was an issue reported on examinations in the FY 2017 Work Plan) and if these items are properly included in taxable compensation to the employee.
Schedule J also discloses participation in a nonqualified retirement plan. Although disclosing the use of this type of plan may not be a red flag in itself, early retirement incentive plans was an area noted by Margaret Von Lienen when discussing employment tax issues at the Chicago-Kent College of Law conference in June 2018.
Organizations should take time to review their expense reimbursement policies, employee versus independent contractor classification and retirement plans. Failure to disclose or properly report the amount of compensation paid to those considered disqualified persons may give rise to excise tax under the excess benefit transaction rules and create additional employment tax liabilities for the organization.
Private Benefit & Private Inurement
The FY 2018 compliance program specifically states that organizations showing indicators of potential private benefit or inurement to individuals or private entities may be subject to examination. Disclosures on Schedule L and Form 990, Part IV related to diversion of assets assist the IRS in identifying potential private benefit and inurement issues. In particular, the IRS has inquired about loans and forgiveness of loans involving officers and other employees during examination. Although public charities and other exempt organizations are allowed to transact with disqualified persons, it must be at fair market value and not give rise to a benefit to the individual. Organizations with Schedule L disclosures also should disclose a conflict of interest policy on Form 990, Part VI, including the procedures to identify and monitor potential conflicts. In addition, organizations should have policies in place that provide for the rebuttable presumption of reasonableness standards in the context of excess benefit transactions. These policies include a comparability component, approval by those independent of the transaction and documentation the transaction was approved following those procedures.
Part VI of Form 990 identifies board composition and best practices for oversight of exempt organizations. The IRS has said in the past that a well-governed organization with policies and procedures that are considered best practices is more likely to comply with federal tax law. Organizations that don’t have these policies in place should consider implementing those that are practicable for them. Although these policies aren’t required by the IRS, their absence, coupled with certain other transactions reported on Form 990, may provide a red flag to the IRS.
Organizational & Operational Tests
In recent years, the IRS has brought back the organizational and operational tests to determine if organizations are operating in accordance with their exempt purpose. Part III of Form 990 discloses new and discontinued activities, while Part VI discloses changes in the organization’s governing documents. While organizations are permitted to evolve over time, they should be mindful if there’s a significant change in their operations or organizing documents that may not exactly align with the organization’s original exempt purpose.
Hospitals & §501(r)
Compliance with a financial assistance policy under §501(r)(4) was specifically identified as a compliance check area in the FY 2018 Work Plan. Schedule H identifies specific areas within the regulations under §501(r) with which hospitals must comply or risk losing their tax-exempt status. The wrong answers, including not following the Community Health Needs Assessments or financial assistance policy requirements, may cause further inquiry. The IRS also is cross-checking all answers found on Form 990 against §501(r) requirements on a hospital’s website. It’s imperative for hospitals to correctly answer all questions on Schedule H and ensure the requirements for public disclosure of certain information are easily found on the hospital’s website.
International issues considered a priority by the IRS may be identified through disclosures on Schedule F. Organizations that provide grants to foreign organizations should thoroughly articulate disclosures for their grant monitoring procedures. This can help avoid concerns the organization is a conduit organization or lacks oversight with respect to the use of those funds. Schedule F and Form 990, Part V, line 4 ask questions that disclose ownership or other transactions that may give rise to a foreign reporting requirement. All foreign investments, foreign bank accounts, ownership and transactions with foreign entities should be analyzed annually for proper reporting.
Keep in mind this article doesn’t cover every possible high-risk area the IRS may identify. Exempt organizations should take ownership of their tax returns and ensure all information provided is accurate, consistent and complete. Contact April, Becky or your trusted BKD advisor for more information.