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How to Prepare for and What to Expect from an IRS Audit: Kinder and Gentler No More

In the late 1990s the Internal Revenue Service was the subject of hearings on Capitol Hill. One member of Congress after another took to the airwaves to chastise the IRS for its mistreatment of taxpayers. Regardless of whether the abuse of the IRS by Congress was justified, it did impact the way the IRS worked. Audit rates continued a downward trend, and the IRS began working on its image. However, the pendulum is swinging back. A number of former IRS commissioners have bemoaned the low audit rate and continuously express concern about what this has done to voluntary compliance. 

This lack of audit coverage is especially prevalent in the Exempt Organization Division of the IRS. The division has issued its “FY 2008 EO Implementing Guidelines.”  The introduction to this document clearly states how the IRS wants this to change: 

“Exempt Organizations has a new way of doing business. In the place of separate and distinct determinations and examination activities, we now bring a flexible and interdisciplinary array of new tools and talent to bear on the critical issues and opportunities that confront us in working toward our strategic goals: (1) to enhance the enforcement of the tax laws, and (2) to improve customer service.”

It is interesting to note that enforcement of the tax laws was listed first. While this new emphasis on enforcement may not result in more audits, it may result in more correspondence with the IRS. One of the new procedures is a compliance check. The IRS will gather information from a large number of organizations by using letters and questionnaires rather than resource-intensive examinations. They use this information to identify compliance problems and to “fashion the most appropriate strategy for addressing them.”

Do not be fooled by the innocent sounding language, however. Several years ago, the IRS reviewed returns of tax-exempt private clubs and checked to see whether clubs that reported investment income or other unrelated business income in excess of $1,000 on the Form 990 also filed a Form 990T. Many clubs were found to not be in compliance.  The first they heard about the noncompliance either was a tax bill from the IRS or an invitation to an audit. In spite of the publicity this program received and the amount of guidance private clubs receive on the taxability of investment income, this area continues to be a problem. 

The FY 2008 EO Implementing Guidelines do have some good news. Nowhere in the document are member-owned 501(c)(7) clubs mentioned. Generally, the examination focus this year will be on:

  • Executive compensation
  • Political activity
  • Tax-exempt hospitals (and the community benefit standards)
  • Credit counseling organizations
  • Seller-funded down payment associations
  • Colleges and universities
  • Conservation easements, and
  • Employment taxes.

Other than the employment taxes, which applies across the board, none of the other issues impact clubs to any degree. In the case of employment taxes, the IRS compares information provided to the IRS with that provided to the Social Security Administration.  During FY 2007, the IRS conducted checks of 100 organizations and started examinations of another 400 organizations that had discrepancies between the two filings.

While the focus is not on clubs, they are not totally in the clear. The IRS revoked the exempt status of several clubs that were deemed to no longer be private because of the advertising they did (in the yellow pages) as well as the amount of nonmember business.  In each case the violations were egregious. While not out to get clubs, the IRS will continue to focus on some key areas including unrelated business income. In addition, the enforcement by the IRS on clubs seems to go in cycles and is more prevalent in certain regions of the country. However, if you are one of the few clubs examined, the fact that you are an anomaly is no comfort.

Preparation Is Key

If you turn out to be one of the clubs selected for an audit by the IRS, what steps should you take and what can you expect? The first thing to realize is that you should be preparing for an IRS audit every day of the year. Start now and make sure that your records are proper and complete. Nothing is more important in surviving an audit than proper recordkeeping. Analyze the items that may be questionable, and ensure that you can document and support any and all positions taken on a return before the return is filed. 

The new Form 990, which will need to be filed by all clubs within a year beginning in 2008, will have additional issues which may need to be considered by the club. The IRS is going to be reviewing these returns in detail, and while the IRS has stated that the answers to the corporate governance questions will not result in an audit, they have indicated that they will consider them in the overall analysis of the entity. Clubs should review the Form 990 early and determine how the club will be reflected to the IRS and the general public as a whole.

If the club is going to be the subject of an audit, it will receive a letter in the mail from the IRS setting a date for the audit and requesting certain records. It is important to note that this should be the only way you are contacted. There have been a number of phishing sites established which purport to come from the IRS asking for information which is merely an attempt to steal identifying information. The IRS does not correspond by e-mail. 

The first two steps to take when the notice is received are to notify the board of directors and contact your CPA or legal advisor immediately. The club should sign a power of attorney for your representative and allow the CPA to be the principal point person with the IRS. It is not in the club’s best interest to deal with the IRS on its own with no representation.

One of the first things your representative will do is to review the return selected for examination to determine any potential exposure. This will be done in conjunction with the manager, controller and treasurer of the club. The representative also will contact the agent and usually attempt to limit the scope of the audit and the amount of records being requested. This is not always successful but does give the club a better idea of the interest of the IRS.

Generally, the IRS will want to conduct the audit at the club. However, this is not required and arrangements can, and in many cases should, be made to hold the audit in a different location as long as the information requested by the IRS is present. The agent will want to see the club and speak with someone familiar with the financial process, but care must be used in determining the proper person to discuss the issues. Frequently, the controller will meet with the agent once, and the remainder of the contact will be with the representative. In fact, the club should never meet with the agent without the representative present.

Know What the IRS Wants to Know

The IRS can be interested in a number of areas, but for a tax-exempt club, certain areas are more common than others. The principal focus of the IRS will be determining if the club is fulfilling its exempt purpose as a private club. To do that it will look at a number of items including whether:

  • The club is organized for pleasure, recreation or other nonprofitable purpose and the activities are conducted to that end
  • There is private inurement to any members
  • The club discriminates on the basis of race, color, or religion
  • It has met all of its fining requirements including
    • Forms 990 and 990T
    • Forms 1099
    • Forms W-2 and other employment tax returns
  • It properly reports unrelated business income and the allocation of expenses among the categories
  • It is involved in traditional activities
  • It has had a sale of club property and whether the position taken is proper, and
  • It properly treats workers as either employees or independent contractors.

The IRS can look at a number of additional items that will be based specifically on the club examined.

Generally, the IRS will provide a list of documents that it wants to see when it begins the audit. Among the most common are:

  • Organizational instruments
    • Articles of incorporation
    • Bylaws
    • Application for exemption
    • Exemption letter from the IRS
  • Minutes of the board
  • Financial information
    • Internal statements
    • General ledgers
    • Subsidiary ledgers
  • Bank statements/cancelled checks
  • Invoices
  • Nonmember usage records
  • Employment tax returns
  • Employee/independent contractor contracts
  • Club newsletters
  • Prior and subsequent year tax returns

If you have other items of interest, such as the sale of property or rental income or have held a professional golf tournament at the club, they will want to see any contracts relating to those items as well.

While a club may be tax-exempt, it is still subject to tax on its unrelated business activities. This area generally will be a focus of any audit. A club’s unrelated business income includes all gross income except:

  • Dues, fees, charges, or similar amounts paid by members for services provided them, their dependents or their guests;
  • Investment income set aside for charitable purposes; and,
  • Gain on the sale of property used by the club for exempt purposes to the extent that the proceeds are reinvested in similar property within a period beginning one year before and ending three years after the date of sale. The net proceeds may also be used for capital improvements to other club property used for exempt purposes.

Expenses “directly connected” with the production of the unrelated business income are deductible. 

The IRS requires clubs to keep detailed records on the extent of nonmember use and has set forth certain situations where, for audit purposes, a host-guest relationship will be assumed.

Two safe harbors are provided. If a member or the member’s employer makes payment directly to the club, a host-guest relationship will be assumed:

  • Where a group of eight or fewer individuals, at least one of which is a member, uses the club’s facilities
  • Where 75 percent or more of a group using club facilities are members.

In all other situations, the club must substantiate a host-guest relationship, and records must be maintained.

Communication with the agent is key to the audit process. Many times an issue can be addressed early on in the process; generally, the earlier the better. A simple (or not so simple) explanation can address an issue long before it becomes a problem. If little or no headway is being made with the agent, then a discussion with the agent’s supervisor may be appropriate. If that is not successful, a club can go to the Appellate Division within the IRS, request technical advice from the national office or if all else fails, the club can take the IRS to court. The club must make a strategic decision at every stage of the process. It is obvious that the earlier in the process the issue is raised and addressed, the cheaper and more streamlined the process.

While the IRS has become a little more aggressive in its audit program, it is important to remember that the IRS is not out to get clubs or to revoke a club’s tax-exempt status. However, it does want to make sure that the rules are followed. The IRS did revoke the tax-exempt status of several clubs during 2007. However, the clubs that lost status engaged in frequent business with the general public, regularly exceeded the 15 percent limit on nonmember business, (See sidebar on 15/35% test) and the income from the nonmember sources benefited the club’s members. Allowing nonmembers to use the club facilities will not cause a revocation of status as long as the rules are followed.

The importance of keeping records of income and expenses cannot be overemphasized. Without records, it is the taxpayer’s word against the IRS, and the IRS usually wins. Unless you have at least some substantiation, the courts will not rule in your favor. Fairness is not in the lexicon of the tax court.