IRS Audits of Non-Profit Organizations

Yes. Exempt organizations are subject to examination under the same general authority the IRS uses for everyone else — Internal Revenue Code Section 7602 — and those examinations are administered by the Exempt Organizations function within the TE/GE division. There is an important wrinkle, though. For a non-profit, an examination does two jobs at once: it reviews books and records to determine whether any tax is owed, and it evaluates whether the organization still qualifies for tax-exempt status at all. That second question is what makes an exempt organization audit feel higher-stakes than a routine business exam, and it is why the early handling of one matters so much.

This distinction trips up a lot of boards, and getting it right changes how you should respond. A compliance check is a review of whether the organization is meeting recordkeeping and information-reporting requirements. It is not an examination, because it does not directly determine tax liability for any period. An examination — an audit — is a review of your books and records to determine tax liability and exempt status, and it may involve contacting third parties.

Why does the label matter? Because participation in a compliance check is generally voluntary, and because a compliance check can become an examination if the answers raise concerns. Organizations sometimes treat a compliance check casually, volunteer far more than was asked, and inadvertently open a door. Others panic and stonewall, which invites escalation. The right posture is somewhere in between: respond accurately, respond completely to what was actually asked, and understand what you are agreeing to before you send anything. The IRS also uses educational letters that require no response at all — knowing which of the three you are holding is the first real decision in the case.

The procedures vary depending on the technique the IRS chooses, and the choice is generally made by an IRS group manager based on the issues involved, the intended scope, and the most efficient way to get the information. In practice you will encounter:

– Correspondence examinations — limited in scope, typically focused on only one or two items on a return, and handled through letters and phone calls with your officers or representative. These are the most common and the most containable.
– Office / OCEP examinations — conducted through the Office Correspondence Examination Program, where the IRS may ask officers or representatives to bring records to an IRS office if issues become complex or responses are inadequate.
– Field examinations — an IRS revenue agent conducts an on-site review at your offices, looking at operations, governance, and records directly. Broader in scope and considerably more demanding.
– Team examinations — reserved for large, complex organizations, using a team of specialized agents and coordination across IRS functions and sometimes other government agencies.

A point worth knowing: a correspondence examination can be converted to a field examination. That conversion is often driven less by the underlying facts than by how the early correspondence was handled — incomplete answers, missed deadlines, or responses that raise new questions. Keeping a narrow exam narrow is one of the most valuable things representation does.

Selection is far less random than people assume. The most common sources of an exempt organization examination include:

– The Form 990 itself. The return is a detailed disclosure document covering finances, governance, compensation, and program activities — and it is public. Internal inconsistencies, blank answers to governance questions, mismatches between narrative and numbers, or figures that look out of line for your size and sector all draw attention.
– IRS compliance strategies. TE/GE publicly identifies focus areas it is actively working. Recent strategies have included loans to officers, directors, and disqualified persons that may amount to private benefit or inurement; organizations reporting employees paid more than $1 million; hospitals’ compliance with the Community Benefit Standard; and organizations involved in compensating athletes for name, image, and likeness. If your organization sits inside a named strategy, your odds go up regardless of anything you did wrong.
– Referrals and complaints. Disgruntled former employees, ousted board members, competing businesses, and members of the public can and do refer organizations to the IRS.
– Media coverage and public filings. Because Forms 990 are public and widely searchable, journalists, watchdogs, and researchers surface issues that then reach the IRS.
– Cross-agency and cross-return mismatches. Payroll filings that do not reconcile to the 990, missing Forms 990-T where the return shows business-like revenue, or state-level problems can all generate federal interest.

Here is the insight most boards miss: the Form 990 is not really a tax return, it is a public relations and compliance document that happens to be filed with the IRS. A return that is technically accurate but carelessly narrated — vague program descriptions, unexplained large “other” categories, governance questions answered “no” without context — invites questions that a well-prepared return would have answered in advance.

Across exempt organization examinations, a handful of themes come up again and again:

– Private inurement and private benefit — whether the organization’s assets or earnings are benefiting insiders rather than the charitable purpose.
– Excess benefit transactions — unreasonable compensation, bargain sales, below-market loans, and personal use of organizational assets.
– Unrelated business income — revenue-generating activity that is not substantially related to the exempt purpose, and whether Form 990-T was filed.
– Employment tax and worker classification — treating staff as independent contractors, unreported fringe benefits, accountable-plan failures, and unremitted payroll taxes.
– Political campaign intervention and lobbying — particularly for 501(c)(3) organizations, where the campaign prohibition is absolute.
– Substantiation and disclosure — donor acknowledgment letters, quid pro quo disclosures, and non-cash contribution reporting.
– Grants and foreign activity — whether grants are properly documented and monitored, and whether funds sent abroad are controlled and used for exempt purposes.

This is the single most under-appreciated risk in the non-profit world, because the penalty does not fall on the organization — it falls on people, personally.

Under Internal Revenue Code Section 4958, often called the “intermediate sanctions” rules, an excess benefit transaction occurs when an applicable tax-exempt organization provides an economic benefit to a disqualified person that exceeds the value of what the organization received in return. A disqualified person is broadly anyone in a position to exercise substantial influence over the organization’s affairs during the five-year period ending on the date of the transaction — officers, directors, key employees, and certain family members and related entities.

The consequences are steep and layered:

1. A 25% excise tax on the excess benefit, payable personally by the disqualified person who received it. If more than one disqualified person is liable, they are jointly and severally liable.
2. An additional 200% tax on the excess benefit if the transaction is not corrected within the taxable period. This second-tier tax is what turns a manageable problem into a catastrophic one — and it is why prompt correction matters enormously.
3. A 10% excise tax on organization managers — including board members — who knowingly participated in the transaction, unless participation was not willful and was due to reasonable cause. This tax is capped at $20,000 per transaction, and liability is joint and several.

Read that third one again if you serve on a board. A volunteer director who approved a compensation package without doing the homework can end up personally liable for an excise tax. Correction — repaying the excess with interest — is the mechanism that avoids the 200% tier, which is why identifying and fixing these transactions early is far better than defending them late.

Yes, and this is one of the highest-value things a board can do. Treasury regulations under Section 4958 provide a rebuttable presumption of reasonableness for compensation arrangements and property transfers. If the organization satisfies three conditions, the burden effectively shifts to the IRS to prove the arrangement was unreasonable:

4. The arrangement is approved in advance by an authorized body composed of individuals who do not have a conflict of interest with respect to it.
5. The authorized body obtains and relies on appropriate comparability data before making its determination — real market data for similar positions at similar organizations, not a hallway conversation.
6. The authorized body adequately documents the basis for its determination contemporaneously — in the minutes, at the time, not reconstructed two years later during an audit.

Organizations that do this consistently walk into an examination with the strongest possible position on the issue most likely to be raised. Organizations that skip it — or that do it but never write it down — spend the audit trying to reconstruct a defense from memory. The cost difference between building this habit and defending its absence is not close.

Possibly. Tax-exempt does not mean tax-free. If your organization regularly carries on a trade or business that is not substantially related to the purpose that justifies your exemption, the net income from that activity can be subject to unrelated business income tax, reported on Form 990-T. As a general rule, an exempt organization with $1,000 or more of gross income from unrelated business activity must file Form 990-T, and a $1,000 specific deduction is available in computing the tax.

Two complications catch organizations off guard. First, various exclusions and exceptions apply — for activities conducted substantially by volunteers, for certain passive investment income, for the sale of donated goods, and more — so the analysis is genuinely fact-specific rather than intuitive. Second, since the 2017 tax law, organizations with more than one unrelated trade or business must generally compute income separately for each one. That “siloing” rule means losses from one unrelated activity can no longer freely offset profits from another, which changed the math for many organizations that had grown comfortable netting everything together.

The audit exposure here is rarely a small tax bill. It is the argument that follows if unrelated activity has grown so large it overshadows the exempt purpose — at which point the conversation shifts from “you owe UBIT” to “should you be exempt at all.”

For 501(c)(3) organizations the line on political campaign intervention is absolute: they are prohibited from participating or intervening in any political campaign on behalf of, or in opposition to, any candidate for public office. There is no “insubstantial” allowance here — the prohibition is categorical, and violations can result in loss of exemption and excise taxes. Lobbying is treated differently: a 501(c)(3) may lobby, but only to an extent that is not a substantial part of its activities (with an alternative expenditure-based test available by election for eligible organizations).

In practice, the problems that surface in examinations are usually not deliberate campaigns. They are a newsletter that endorsed a candidate, a facility rented to one campaign but not another, a leader’s personal advocacy that got published on organizational letterhead, or social media accounts where the line between personal and organizational voice dissolved. Clear written policies and disciplined use of organizational channels prevent most of these.

Serious, and time-sensitive. Most exempt organizations must file an annual return or notice, and which one depends on size:

– Form 990-N (e-Postcard) — for organizations with gross receipts normally $50,000 or less. Electronic only.
– Form 990-EZ — for organizations with gross receipts under $200,000 and total assets under $500,000 at year end.
– Form 990 — for organizations with gross receipts of $200,000 or more, or total assets of $500,000 or more.
– Form 990-PF — for private foundations, regardless of size. Private foundations and certain supporting organizations cannot use the 990-N.

Returns are generally due the 15th day of the fifth month after the close of your accounting period — May 15 for calendar-year organizations — with an automatic six-month extension available on Form 8868 filed before the original due date.

Now the part that makes this urgent. Under Internal Revenue Code Section 6033(j), an organization that fails to file its required annual return or notice for three consecutive years has its tax-exempt status revoked automatically, by operation of law. No IRS discretion, no warning letter required, no hearing. The revocation date is the due date of the third missed return, and the IRS notifies the organization by Notice CP-120A and posts it on a publicly searchable Auto-Revocation List. Many organizations do not discover the problem until a grantmaker or a donor checks that list.

The downstream damage is real: the organization becomes subject to income tax and may need to file corporate or trust returns, contributions are no longer deductible to donors for the revoked period, grant eligibility evaporates, and state-level exemptions and charitable registrations often unravel in sympathy. It is also worth noting that filing a Form 990-N carries no late-filing penalty of its own — which lulls small organizations into treating it as optional. It is not. Three missed e-Postcards revoke an exemption just as effectively as three missed full returns.

Usually, yes — and the path you qualify for depends heavily on how quickly you act. Revenue Procedure 2014-11 sets out four routes:

7. Streamlined retroactive reinstatement. Available to organizations that were eligible to file Form 990-EZ or 990-N for each of the three years missed, that have not previously been auto-revoked, and that apply within 15 months of the later of the revocation letter date or the date they appeared on the Auto-Revocation List. No reasonable-cause showing is required — approval deems reasonable cause to have existed. This is by far the cleanest outcome.
8. Retroactive reinstatement within 15 months. For organizations that do not qualify for the streamlined route but still apply within the 15-month window. Requires a reasonable-cause statement covering at least one of the three years, plus filing the delinquent annual returns.
9. Retroactive reinstatement more than 15 months after revocation. Still possible, but the bar rises: reasonable cause must be shown for all three years, along with the delinquent filings.
10. Post-mark date reinstatement. Available at any time regardless of eligibility for the other three, but exemption is restored only going forward from the application date — leaving a taxable gap that can be expensive and awkward to explain to donors.

Reinstatement is applied for on Form 1023, 1023-EZ, 1024, or 1024-A with the appropriate user fee, and the IRS asks that applicants write the applicable Revenue Procedure 2014-11 caption at the top of the application to route it correctly. One more detail that surprises people: while Forms 990 are generally e-filed, the delinquent returns submitted as part of a reinstatement package are filed on paper to a specified address. Getting these mechanics wrong is a common reason packages stall.

The strategic point is simple and worth repeating: that 15-month window is the difference between a clean retroactive fix and a much harder, more expensive one. If your organization has been revoked, the clock is the single most important fact in your case.

For organizations with gross receipts of $1 million or less, the penalty is generally $20 for each day the return is late, capped at the lesser of $10,000 or 5% of the organization’s gross receipts for the year. For organizations with gross receipts over $1 million, the penalty is $100 per day, with a maximum of $50,000 per return. These penalties can also apply to returns that are filed incomplete or inaccurate — not just late ones — and separate penalties can reach responsible individuals who fail to comply after an IRS demand. Reasonable cause relief is available, but it has to be requested and supported.

Meaningfully, yes. Congress built special procedural protections into Internal Revenue Code Section 7611. The IRS may begin a church tax inquiry only if an appropriate high-level Treasury official reasonably believes — based on facts and circumstances recorded in writing — that the church may not qualify for exemption or may be carrying on an unrelated trade or business or other taxable activity. Before beginning, the IRS must give the church written notice of the inquiry, including an explanation of the concerns and of the church’s rights, among them the right to a conference before any examination of church records. There are further notice requirements before an actual examination begins, and limits on the years reachable for unrelated business income.

These protections are real, but they are frequently misunderstood as a blanket shield. They are not. Churches are generally excepted from the annual Form 990 filing requirement, but that exception does not extend to payroll tax obligations, unrelated business income and Form 990-T, or the rules against inurement and campaign intervention. And the Section 7611 protections apply to church tax inquiries specifically — they do not insulate every routine tax matter a religious organization might face. Knowing precisely which protections apply, and insisting on them procedurally, is where representation earns its keep in these cases.

The general rule is a three-year statute of limitations on assessment, running from the date the return was filed. But there are two traps. First, if a return was never filed, the limitations period generally never starts — which is precisely the situation for an organization with unfiled Forms 990. Second, the IRS may ask the organization or individuals to sign Form 872 consenting to extend the assessment period. That request often arrives framed as a routine formality. It is not routine; whether to sign, and on what terms, is a strategic decision with real consequences, and it should never be made without understanding what the IRS is still developing and why it needs more time.

Expect requests spanning both financial and governance material. Commonly:

– Articles of incorporation, bylaws, and any amendments; the IRS determination letter.
– Board and committee minutes — often the single most revealing document set in an exempt organization exam.
– Financial statements, general ledger, bank statements, and the underlying accounting records.
– Payroll records, Forms W-2 and 1099, and worker classification documentation.
– Compensation studies, comparability data, employment contracts, and expense reimbursement policies.
– Conflict of interest policy and completed annual disclosure statements.
– Grant agreements, program files, and documentation of how funds were monitored.
– Donor acknowledgment letters, quid pro quo disclosures, and fundraising event records.

A word of caution that applies to every audit but especially this one: produce what was requested, accurately and completely, and no more. Volunteering additional years, additional entities, or additional documents “to be helpful” is one of the most common ways a narrow examination becomes a broad one.

There is a range of outcomes, and most cases resolve well short of the worst one:

– No change — the IRS accepts the return as filed.
– No change with a written advisory — no adjustment, but the IRS flags practices to correct going forward. Take these seriously; they establish awareness if the issue resurfaces.
– Agreed adjustments — tax on unrelated business income, employment tax assessments, or excise taxes, sometimes with penalties.
– Excise taxes on individuals — Section 4958 taxes assessed against disqualified persons and, where applicable, organization managers.
– Closing agreement — a negotiated resolution in which the organization corrects identified problems and preserves exemption.
– Revocation of exempt status — the outcome everyone fears. It is comparatively rare, and it is usually the endpoint of serious, uncorrected inurement, substantial non-exempt activity, or campaign intervention — not of a single technical error.

If you disagree with proposed adjustments, you have appeal rights within the IRS, and the procedures for unagreed exempt organization issues are described in IRS Publication 892. Those rights are real, but they depend on preserving the record properly during the examination — another reason the early handling matters more than the eventual argument.

A short, disciplined sequence prevents most self-inflicted damage:

11. Identify exactly what you received — educational letter, compliance check, or examination notice. They call for different responses.
12. Note every deadline in writing and calendar it. Missed response dates escalate cases faster than bad facts do.
13. Stop informal contact. Route all communication through one designated person or your representative — not the executive director, the treasurer, and a helpful board member all calling separately.
14. Preserve records. Do not clean up, reorganize, or discard anything. Retroactively “fixing” minutes or documentation is far worse than the underlying problem.
15. Do a quiet internal assessment before you respond, so you know what the IRS is likely to find before it finds it.
16. Engage representation and file a Form 2848 power of attorney so the IRS deals with your representative directly.

That last step changes the dynamic more than boards expect. Volunteer directors and mission-focused executives are not trained to sit across from a revenue agent, and the instinct to over-explain — to tell the whole story of the organization’s good work — introduces facts and issues nobody asked about. A representative keeps the conversation on the actual scope of the exam.