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Tuesday, January 23, 2018

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I Survived an IRS Audit
Steve Zimmerman, CPA, MBA

December, 2011

Uh oh. We are all afraid of getting audited by the IRS, but we don't really know what would happen in one. Here is the True Life story of an environmental organization's audit, how they survived, and their tips for the rest of us.

It's the phone call everyone dreads: "Hello, your organization has been selected for an IRS audit." The call came to Karl Dickson (pictured left), board treasurer of an environmental nonprofit in Milwaukee, and his caller ID showed that the call came from an unidentified cell phone. Karl's instincts were to suspect a scam.

Karl questioned the caller who told him (not very believably) that "most IRS agents don't have an office" and therefore use cell phones. She also told him they had been selected by random and that he was called because his number was on the IRS Form 990. She told him to expect a letter. (What? No IRS agent flashing a badge? Not even certified mail? If we're going to be audited, at least can we have some drama?)

What the letter said

But the letter did arrive a few days later (at the end of this article is a link to the actual letter). Behind the generic IRS publication, "Your Rights as a Taxpayer," was a two-page list of documents that the IRS required (ask yourself how hard it would be for you to comply with such a request):

  • Original application for 501(c)(3) status, articles of incorporation, bylaws, and any amendments
  • IRS letter granting tax-exempt status. (Shouldn't the IRS have this?)
  • Minutes of all board meetings and committees to help the IRS determine whether the organization had "sufficient and adequate internal controls" and to "determine the extent of board oversight"
  • Brochures, newsletters, and any advertising from the organization. (I know they're in a box somewhere)
  • And lastly, financial records including:
    • Chart of accounts
    • General ledger
    • Working trial balance
    • Cash receipts and cash disbursements journal
    • Cancelled checks
    • Invoices
    • Bank statements
    • Credit card statements
    • Expense reports
    • Three years of Form 990s
    • Contracts, Notes
    • Copies of all 990s, W-2, W-4, and any other federal documents
    • Description of membership benefits if any; and
    • Detail of any Fundraiser Fees and Event Schedules

The letter went on to say that they were looking at the financial information to determine

  • Whether all income was related to the organization’s mission
  • Whether all expenses were "fair and reasonable" and
  • Whether all expenses were appropriately classified between program activities, fundraising, and administration.

Even for Karl, who is a Certified Public Accountant (and therefore a conscientious file-keeper), the list was exhausting. "You think you’re organized but you don't really know until you actually have to put your finger on those documents."

"I was expecting the finance requests, but wasn’t really prepared to find the original tax-exemption application. I was grateful to the original board members who kept it and passed it along."

Karl told the rest of the board about the audit, but received little more than moral support from them. Most were puzzled: why is our little organization -- with a budget of $100,000 -- picked for an IRS audit?

The organization had been spun off from a larger museum. Was this the reason behind the audit? "Your guess is as good as mine," Karl said, "but the IRS agent did focus extensively on whether we were still operating under the same manner in which our tax-exempt status was given."

Karl takes his boxes to the IRS office

Karl chose to attend the IRS meeting alone so that there wouldn’t be any conflicting answers to questions and kept the board informed of the process via email.

He carried a cardboard box with all the documents, balancing a couple of binders precariously on top and went into the nondescript building.

Wait a minute . . . I've been in taxes for years at a big accounting firm and my first visit to the IRS is for a $100,000 nonprofit?

As he waited in the secured lobby, Karl had a moment of anxiety about the organization's work preserving rainforests in Costa Rica: Did our foreign transactions spark the audit? What if I can't remember all the details of everything?

Soon a middle-aged woman with a no-nonsense, formal demeanor showed him her badge and escorted him to a conference room. The room’s walls were bare except for a picture of the president and the room contained a table, two chairs, and the American flag. At least there aren't any handcuffs in the room.

The agent asked Karl to walk her through the documents. Surprisingly, most of the questions weren't about finance, but about organizational structure and activities. After half an hour (but it seemed like forever!) she said she would take more time with the documents and would call with any questions. She noted that Karl had the right to appeal her judgment.

Imagine you're at your "day job" and the ringing phone isn't a customer but an IRS agent with questions about the nonprofit where you serve as the volunteer board treasurer; the questions are about finances from two years ago! As the weeks wore on, the IRS agent phoned him often ("we're not allowed to email you questions" -- what?) and Karl found it helpful to say he needed to "research the answer," to give him time to confer with another board member before responding.

The questions were mostly about specific transactions:

  • “What service did this vendor perform for the organization?”
  • “Why is this expense classified as this?”
  • “Why is this considered restricted revenue?”

It reminded Karl of an accounting test. The phone calls and questions were crazy making, but ultimately he remembered everything and he received notice that the audit was complete.

The results and Karl’s advice

The IRS agent ended up only reporting three minor findings including that the organization had filled out one 1099 incorrectly (yes, it was that thorough). Now that lightning has struck Karl, it probably won't strike him again, but here are his tips for the rest of us:

1. Keep a binder with key organizational documents, such as articles of incorporation, approval letter, a conflict of interest policy (if you have one), and other documents.

2. Keep a binder for minutes from the board and any committee meetings. Put a sticky tab on each page where a motion was approved.

3. At the end of each year, put all the brochures, reports, and documents from the year and put them into a folder

4. Save all financial documents in line with your document retention policy (a sample policy can be found here.).

We would add: have a conscientious and calm treasurer like Karl.

In the end, the IRS audit was time consuming but not terrifying. As Karl notes, "Even though you’re fairly confident that everything is correct, no one likes an audit."

Karl Dickson, C.P.A., is board treasurer of the Tirimbina Rainforest Center in Milwaukee (Tirimbina is in Costa Rica). Steve Zimmerman, C.P.A., is a finance and strategy consultant to nonprofit organizations and a regular contributor to Blue Avocado.

Thank you especially, Karl, for sharing the actual IRS letter with Blue Avocado readers. Now we know what to expect. Click below to view.

 Thank you to Jan Masaoka and the Blue Avocado for allowing us to publish this article.

IRS letter to nonprofit re audit.pdf2.32 MB



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