United States: IRS Exempt Organizations Compensation Audits—Update and Strategy

The Internal Revenue Service (IRS) continues to conduct a program they announced last year of correspondence-type audits of the executive compensation paid by approximately 2,000 exempt organizations (see On The Subject dated June 25, 2004, at www.mwe.com/info/news/ots0604f.htm). The IRS sends a standardized letter (IRS Letter 3878) and, in some cases, additional Information Document Requests (IDR) to ask nonprofits for significant amounts of information. In March 2005, the latest wave of Section 501(c)(3) nonprofits received notification that their Form 990 had been selected for an IRS compensation correspondence audit. Although Section 501(c)(3) organizations that reported combined aggregate compensation to any individual in excess of $1 million are a possible target of these audits, several letters have gone to organizations with executive compensation of less than $1 million. Some letters request information on physician compensation in addition to, or instead of, executive compensation. Also, while we are not aware of any Section 501(c)(4) organizations receiving IRS Letter 3878, the law is equally applicable to them and, the IRS letter is worth study, if not additional compliance efforts.

Organizations selected for this audit receive IRS Letter 3878, which contains 11 standardized questions and several additional questions if facts and circumstances warrant. Some organizations selected for audit receive a separate IDR, asking approximately 35 additional questions. The questions contained in each IDR are strikingly similar and are clearly drawn from a single master list.

The purpose of IRS Letter 3878 (and attached IDR) is that the IRS would like all details on every type of economic benefit provided to disqualified persons and, to the extent not reported on the applicable Form 990, would like such benefits reconciled to the amounts actually reported. Furthermore, the IRS is requesting detailed information on the exempt organization’s internal review processes, including the use of outside consultants and hard copies of any data supporting the reported compensation levels. The IRS also requires identification and discussion of any business or financial ties between the exempt organization’s disqualified persons and its independent contractors.

In McDermott’s experience handling the executive compensation audits for various clients, we believe that some of the questions asked in both Letter 3878 and the IDR are overly broad and are subject to multiple interpretations. Some questions have no relevance to the Form 990 ostensibly under audit. Furthermore, many of the questions are either inappropriate or based on potential misunderstandings of the law. Careful, strategic and thoughtful responses to the IRS questions are critical to successfully navigating these audits.

In a separate, but related development, the IRS has decided that when field agents are investigating potential excess benefit transactions (such as unreasonable compensation) they need not obtain technical advice from the IRS National Office before asserting penalties. This delegation of authority provides the IRS with more flexibility at the local level to interpret the rules and to assert penalties. This is not a good development for exempt organizations because it can lead to inconsistent treatment across the country and subjective determinations by different IRS agents.

In addition to the significant tax issues presented, nonprofits should be aware that the IRS correspondence audits also implicate issues (e.g., "waste of charitable assets", excessive compensation, loan prohibitions) that arise under state nonprofit corporation and charitable trust laws. Accordingly, a comprehensive response to the audits should also recognize the potential for these state law concerns to arise. Finally, given the sensitive nature of the questions asked, protecting initial draft responses under the attorney-client privilege is also of utmost importance.

The IRS has stated that roughly one-half of the 2,000 expected IRS correspondence audit letters have been issued and that the rest are expected to be issued by late spring. The IRS expects to complete this project by September 30, 2005.

McDermott Will & Emery counsels many nonprofit clients in the steps they should take if they receive an IRS Letter 3878 and is developing compliance strategies that will lower the overall costs of responding to such audits as well as place clients in the best possible legal position, both with respect to the year of the correspondence audit and future years.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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