Best practices to mitigate tax risk for an exempt organization

• July 12, 2022
• Laura Kenney

Exempt organizations risk embarrassment and possibly sanctions if they make tax-related mistakes. Seemingly simple mistakes on a tax filing or engaging in certain activities could force an organization to spend valuable time and resources for months – or even years – on damage control.

In this article, we will attempt to answer a simple question: What can tax-exempt organizations preemptively do, right now, to protect themselves?

Here are a few best practices and policies nonprofits should consider.

Adopt and follow written policies

One of the best ways to implement good controls across your organization is to create and enforce written policies. Organizations should have clear, thoughtful, well-communicated policies and procedures that guide anything from what board members should do if they have a conflict of interest to how the organization should accept nontraditional contributions.

The IRS believes that if nonprofits have strong policies and procedures in place, they will be more likely to comply with tax laws.

Know the tax rules

Tax-exempt entities need to be aware of all tax requirements that may impact them.

Remaining compliant with every tax rule and regulation isn’t always easy. Organizations are often tight on resources; rules are sometimes counterintuitive; and a common perception is that nonprofits don’t have any tax issues.

One of the more common tax rules for a tax-exempt organization is that net revenue from business activities not related to the organization’s exempt purpose may be subject to unrelated business income tax.

For example, many organizations receive revenue from renting their conference space. Some organizations treat this as unrelated business taxable income and others do not. As is often the case with many tax positions, it is essential to understand the many nuances, exceptions and gray areas in the rules. The answer to whether the conference rental is taxable or not is very dependent on the organization’s specific facts and circumstances – and there’s not always a bright line test.

Understanding the tax rules also provides a foundation for good tax planning and beneficial structuring, as well as minimizing tax risks.

A few other tax areas that tax-exempt organizations should understand include:

• Is there any worker reclassification exposure? If so, that could be a costly mistake.
• Are your nonqualified deferred compensation agreements set up correctly? Especially in light of the excise tax on excess compensation, it’s important to carefully consider items like severance agreements, sabbaticals and early retirement incentives.
• Is your executive fringe benefit tax treatment in order? The federal rules related to this item are not always intuitive, leading to tax exposure for many organizations.
• All organizations should ensure they’re following the accountable plan rules carefully for their travel, meals and entertainment reimbursements.

If organizations have alternative investments, we recommend they make sure they’re complying with federal and state tax filing requirements. This means that, like those in the for-profit sector, tax-exempt organizations may need to be aware of quarterly estimated tax requirements; know the tax extension requirements to avoid penalties; and be aware of any additional disclosure filings generated from direct and indirect foreign investments to avoid the potential for significant noncompliance penalties.

Documentation is key

Documentation is another excellent risk management tool.

We recommend reviewing and documenting not only any new activities, to determine if they are related to the exempt purpose or not, but also revisiting certain existing activities with a fresh set of eyes.

Sometimes there is turnover in the financial management level, and executives “inherit” tax positions from their predecessors. Sometimes the facts change – or the tax laws change. So, it can be very worthwhile to have good documentation; then there’ll be no need to completely reinvent the wheel.

To give a typical example, many colleges, universities and private schools provide their Presidents and Heads of School with campus housing. Most of the time the President or Head of School is required to live in the President’s house and living there is essential to the performance of the responsibilities of the position. Customarily, schools treat it as nontaxable. But to qualify for tax-free treatment, the requirements in the tax law must be followed.

What if the Head of School of a nonresidential day school, rather than a boarding school, is provided the on-campus housing? What if the college President’s house is a couple of miles away from the main campus? What if there are three Presidents over a period of time, and the middle one negotiates the ability to forgo living in the President’s house; does this mean that the first and third were not also technically required to live in the house to perform their responsibilities? Do all of these qualify as tax-free?

Properly documenting previous tax-related decisions goes a long way in helping nonprofit financial management avoid expending valuable time and energy trying to remember, explain or justify why they came to their conclusion.

And although being consistent is often a fine approach, just because “that’s how we’ve always done it” or the perception “that’s how everyone else treats it” is not always the strongest stance.

Proper documentation helps reduce tax exposure – and helps an organization’s leadership enjoy confidence in its excellence.

Review the IRS’s new Audit Technique Guides

The Internal Revenue Service has also provided a tax risk management tool. The IRS has “Audit Technique Guides” for various types of tax-exempt organizations. The guides are meant to help IRS examiners, but also can be excellent resources for tax-exempt board members, executives and their advisors.

Interestingly, but also predictably, a few of the many areas the IRS audit plans cover are:

• Unrelated business activities that produce continual losses.
• Donors reported on the IRS form as anonymous when “otherwise identifiable”; and
• Employer-provided housing.

There are several guides, including those for public charities, private schools and colleges/universities, other educational organizations, religious organizations, other 501(c)(3) organizations, social clubs, business leagues, and one audit guide for fundraising activities that applies to many types of exempt organizations. Here is a link to the guides for you.

Ask for help

Clearly, there are various potential tax-related issues that nonprofit organizations need to consider. There are many additional potential red flag areas, from corporate sponsorship rules to compensation matters to unrelated business activities.

The good news is that, with a continual improvement frame of mind, just about any tax-related mistake can be corrected. And organizations can avoid the risk from most tax-related oversights by planning, documenting, and implementing strong governance and written policies.

For further assistance, contact a member of CLA’s National Exempt Tax Practice.

, Nonprofit general | Comments Off on Best practices to mitigate tax risk for an exempt organization