Common Audit Triggers for Nonprofits (And How to Avoid Them)

Nonprofit organizations with 501(c)(3) status may be exempt from federal (and possibly state) income taxes.

However, this does not mean that these organizations cannot be audited by the Internal Revenue Service (IRS) or even by independent auditors.

So, what are some of the most common mistakes made by nonprofits that can trigger an audit? By being aware of these common issues, nonprofit accountants, executive directors, and other organization decision-makers can potentially avoid the stress and hassle that comes along with an audit.

Referrals from Government Agencies and Beyond

Believe it or not, many audits originate not from the IRS directly but as the result of a direct referral from an individual, group or other government agency. Specifically, the IRS has its own referral program in place where outsiders can submit their concerns regarding nonprofit organizations that may be operating outside of IRS guidelines. When this occurs, the IRS will look closely at the information submitted and determine independently whether an audit is warranted.

Discrepancies with Fundraising Income and Expenses

Another mistake that is likely to trigger an audit with the IRS is a large amount of fundraising income being reported without corresponding fundraising expenses. Typically, when large amounts of money is brought into a nonprofit organization, this is a direct result of massive fundraising efforts. When these amounts are not in reasonable proportion to each other, an audit may be triggered to investigate the matter further.

Foreign Grant Activities and Bank Accounts

When nonprofit organizations have foreign bank accounts or are otherwise sending money overseas, this can also be a “red flag” that leads to an audit through the IRS. Specifically, the IRS may be concerned that money being diverted overseas may not be used for the charitable purposes for which it was intended. This could result in an audit and thus a closer look into foreign bank accounts and recordkeeping.

Unrelated Business Income (UBI)

Meanwhile, nonprofit organizations with large amounts or unrelated business income (or income that is deemed unrelated to the organization's exempt status) may be audited if the organization has not paid any taxes on this income. When this occurs, the concern is that these organizations may be improperly categorizing business expenses as unrelated business income.

Form 990 Data (Or Lack Thereof)

IRS Form 990 is routinely used by the IRS to pinpoint potential areas of concern within nonprofit organizations. When organizations submit Form 990 with incomplete data or inaccuracies, the IRS may consider this a red flag that needs to be examined further—which could increase the organization's chances of being audited. More specifically, this form includes detailed questions about the makeup of the organization's board, as well as management and other important issues. This form must be filled out once per year, so it's critical that nonprofits take the time to fill it out extensively and accurately.

Compensation Red Flags

Last but not least, it is possible that a nonprofit organization could trigger an audit as a result of exceptionally high executive compensation figures. In other cases, unusually low compensation for executive members could also raise an eyebrow, so it's important for nonprofits to ensure that their executive compensation aligns with national averages—especially when compared to the overall size of the nonprofit itself.

Best Practices for Avoiding an IRS Audit

While this is by no means a comprehensive list of the actions that can trigger an audit for a nonprofit organization, it does cover some of the most mistakes. At the end of the day, by avoiding these mistakes and by having a dedicated financial advisor/tax preparation specialist with which to consult, nonprofit organizations can set themselves up for success. Meanwhile, taking common-sense measures like practicing proper reporting methods and completing forms as accurately as possible can make all the difference.

Believe it or not, performing an independent internal audit can also be a great way to reveal any discrepancies that could ultimately trigger an IRS audit. From there, the organization can take proactive measures to improve its reporting and resolve any issues before a formal audit can be initiated, which can save a lot of hassle down the road.

For nonprofits facing an audit or simply looking to reduce their risk of an audit, there's never a bad time to get in touch with a business financial advisor who specializes working directly with nonprofit organizations.

To learn more about LGT and how we can serve you, contact us here.