Tax compliance is a critical area for nonprofit organizations, as errors can lead to significant penalties, loss of public trust, and even the revocation of tax-exempt status by the Internal Revenue Service (IRS). Understanding and adhering to tax laws is essential for maintaining a nonprofit’s integrity and ability to serve its community. This guide highlights common tax compliance issues for nonprofits and provides strategies to avoid these pitfalls.
Introduction
The IRS grants nonprofits tax-exempt status because of their charitable, educational, or religious missions. However, this status comes with stringent compliance obligations, particularly regarding taxes. While nonprofits do not pay income taxes on donations or grants related to their mission, they must navigate a complex landscape of reporting and operational standards to maintain their tax-exempt status.
Common Tax Compliance Issues for Nonprofits
1. Failure to File Form 990
- Overview: Nonprofits are required to file Form 990 with the IRS annually. This form provides the IRS and the public with financial information about the nonprofit’s operations, including revenues, expenditures, and compensation.
- Common Errors:
- Not filing on time: Missing the deadline can lead to penalties and interest.
- Incomplete or inaccurate filings: Errors or omissions can attract IRS scrutiny.
- Prevention Strategies:
- Maintain good records: Keep detailed financial records to make filing easier and more accurate.
- Engage a CPA or tax advisor experienced with nonprofit tax issues to prepare the form.
- Set internal reminders: Develop a calendar of compliance deadlines to ensure timely filings.
2. Misclassifying Employees and Contractors
- Overview: Properly distinguishing between employees and independent contractors is crucial for tax purposes. Misclassification can lead to back taxes, penalties, and interest on unpaid employment taxes.
- Common Errors:
- Treating employees as contractors: To avoid payroll taxes, some nonprofits might incorrectly classify employees as independent contractors.
- Lack of documentation: Failing to file necessary forms like W-2s for employees and 1099s for contractors.
- Prevention Strategies:
- Understand the criteria: Review IRS guidelines on employee versus contractor classification.
- Consult with a CPA: Get professional advice when classifying workers to ensure compliance.
- Keep detailed job descriptions: Document the nature of work, payment terms, and other contractual details clearly.
3. Unrelated Business Income Tax (UBIT)
- Overview: Nonprofits must pay taxes on income from business activities that are not related to their exempt purpose. This is known as Unrelated Business Income Tax (UBIT).
- Common Errors:
- Failing to identify unrelated business income: Not recognising when an activity falls outside the exempt purpose can lead to noncompliance.
- Incorrect expense allocation: Failing to properly allocate expenses between related and unrelated activities.
- Prevention Strategies:
- Regular reviews: Periodically review activities to determine if they may generate UBIT.
- Proper tracking and allocation: Use separate accounts for unrelated business activities and allocate expenses appropriately.
- Seek expert advice: Consult with a CPA to manage and report unrelated business income correctly.
4. Violations of Charitable Contribution Substantiation and Disclosure
- Overview: Nonprofits must provide donors with written acknowledgement of contributions, especially for donations of $250 or more.
- Common Errors:
- Lack of timely acknowledgements: Failing to provide acknowledgements in a timely manner can lead to donor disqualification of deductions.
- Inadequate details in acknowledgements: Not including all required information, such as a description of the donated items and a statement of no goods or services provided.
- Prevention Strategies:
- Systematic processing: Implement a system to issue acknowledgements promptly after receiving donations.
- Include all necessary details: Ensure that acknowledgements have all the required information as per IRS guidelines.
- Educate staff: Train staff involved in donation processing on the importance and requirements of proper acknowledgement.
5. Poor Tracking of Donor-Designated Funds
- Overview: When donors specify how their contributions should be used, nonprofits must honor these restrictions. Failure to do so can lead to compliance issues and donor disputes.
- Common Errors:
- Commingling funds: Not separately tracking restricted donations can complicate compliance and reporting.
- Misusing designated funds: Using donor-restricted funds for general or other purposes.
- Prevention Strategies:
- Separate accounting: Use fund accounting to track restricted and unrestricted funds separately.
- Clear communication with donors: Ensure that all restrictions are understood and documented when the donation is made.
- Regular audits: Conduct regular internal or external audits to ensure funds are used in accordance with donor restrictions.
6. Lobbying and Political Activity Violations
- Overview: Nonprofits, especially 501(c)(3) organisations, are restricted in the amount of lobbying they can conduct and are prohibited from engaging in political campaign activities.
- Common Errors:
- Excessive lobbying: Engaging in more lobbying than the IRS permits based on the organisation’s size and expenses.
- Engaging in prohibited political activities: Participating in campaign activities for or against political candidates.
- Prevention Strategies:
- Understand the boundaries: Be clear on what constitutes lobbying versus advocacy.
- Train staff and volunteers: Educate your team on what activities are allowed under your tax-exempt status.
- Monitor activities: Keep a close eye on activities that could be construed as lobbying or political campaigning and maintain detailed records.
The Role of CPAs in Ensuring Tax Compliance
CPAs are invaluable in helping nonprofits navigate complex tax landscapes. Here are ways they can assist:
- Proactive Tax Planning: CPAs can help nonprofits plan for their tax obligations, ensuring that they take advantage of all applicable exemptions and credits.
- Training and Education: They can provide training for nonprofit staff on tax compliance, including how to properly document and report activities to maintain tax-exempt status.
- Audit and Assurance Services: CPAs conduct audits that can help uncover and correct compliance issues before they become problematic.
- Representation Before the IRS: If issues arise, CPAs can represent nonprofits in dealings with the IRS, helping to resolve issues efficiently and effectively.
Conclusion
Tax compliance is essential for maintaining a nonprofit’s integrity and ability to fulfil its mission. By understanding common pitfalls and implementing strategies to avoid them, nonprofits can ensure they remain in good standing with the IRS and their donors. Working with a CPA can provide the expertise needed to navigate these challenges and maintain the focus on serving the community. Ensuring tax compliance is not just about following the law; it’s about sustaining the trust and support that keep nonprofits thriving.
