Chapter 3: Managing Your Nonprofit’s Risks
What Are Audits and How Can Nonprofits Avoid Them?
Non-profits don’t have to pay federal taxes, but they may have to undergo rigorous (and sometimes costly) audits. “Audit” is a term for an exhaustive examination of your financial records. We’ll talk about two types of audits you may experience:
- IRS audit.
- Independent audits.
The IRS chooses to audit organizations from time to time to make sure their tax returns are accurate. If the IRS audits you, you’ll need to supply documents and other financial records to prove that everything is in order. That means digging up old bank statements and receipts you’ve kept in your filing cabinets.
The IRS might audit you for a variety of reasons, such as…
- Mistakes on your return. Nonprofits have to file payroll tax returns and IRS Form 990, which thoroughly details your organization’s activities, mission, and other information. Any errors on these returns can cause an IRS agent to flag your return.
- Random selection. Sometimes the IRS randomly chooses nonprofits to audit — a sort of spot-checking system to verify compliance.
- Complaints against your nonprofit. If donors, former employees, or other people file a complaint about your organization, the IRS may choose to look into the allegations and audit your organization.
Mistakes on Form 990 could cause the IRS to flag your tax return.
Another avenue for audits is through your state’s laws. Many states require nonprofits to conduct an annual independent audit of their financials. An independent audit is when you hire a CPA — one who is not connected with your organization — to examine your financial records. (Find out if your state requires an audit. Read the National Council of Nonprofits article “State Law Nonprofit Audit Requirements ” for more details.)
Not all states require these audits. Usually, your state audit requirement is tied to the amount of contributions you receive. For instance, in Mississippi, any NPO with more than $100,000 in contributions for that year is required to undergo an independent audit. If your organization is a smaller nonprofit with donations less than the amount set by your state, it may not have to worry about a state-required audit.
Some states require NPOs to undergo independent audits.
Non-Profit Tips for Avoiding Audits
Audits reveal financial mistakes, which means they could expose your board to more liability. One financial error can cause your NPO to lose its 501(c) status and pay thousands in taxes. Ultimately, that single oversight can also trigger D&O lawsuits against your board.
So how can your non-profit avoid these costly mistakes on its tax return? Here are some tips to help you avoid an audit:
- Have a specialist prepare your IRS form 990. This form lists your financial data and disclosures. It provides the IRS with information about your organization’s programs, board members, mission, and activities. The form is long and complicated. It’s 12 pages on its own, not including all the supplemental material and schedules you need to attach. Your personal accountant may not be very experienced with nonprofits, which is why you should find a non-profit tax specialist to prepare your filing.
- Avoid murky business arrangements. As we mentioned earlier, all your business agreements should be conducted at arm’s length. You shouldn’t partner with anyone who has a relationship to your board or another conflict of interest. In general, the IRS tends to audit non-profits that participate in joint ventures with for-profit organizations because non-profits can’t unfairly compensate private parties.
Next: Are Nonprofit Volunteers a Liability?