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Risk Modeling – An Examination Road Map for Exempt Organizations
In an effort to become more efficient, the IRS has been using data-driven decision making on electronically filed (e-filed) Forms 990, 990-EZ and 990-PF. It’s no secret the IRS has strained resources, but risk modeling allows the agency to use those limited resources more effectively and efficiently. Risk modeling was first tested in 2014 to identify inconsistencies and missing information on e-filed returns. Based on successful testing, the program went live in 2016 and continues to be developed and tested through 2018.
During fiscal year (FY) 2016, the IRS closed 6,440 examinations that resulted in an overall 81 percent change rate. Included in those examinations were 203 returns that were pulled for examination using the new risk modeling program, which resulted in an 85 percent change rate. The risk modeling program started with 150 queries and increased to 200 queries. These queries are run on the return to identify red flags. The primary issues identified during FY 2016 included: filing, organizational and operations; discontinued operations modifications and revocation; private inurement and private benefit; political, legislative and governance; unrelated business income (UBI); employment tax issues; and other miscellaneous issues.
The primary issues for the returns examined per the FY 2017 Work Plan aligned with the IRS’s five strategic issue areas:
- Exemption – Including nonexempt purpose and private inurement
- Protection of assets – Focusing on self-dealing, excess benefit transaction and loans to disqualified persons
- Tax gap – Including employment tax and UBI tax liability
- International issues – Including oversight on funds spent outside the U.S., exempt organizations operating as foreign conduits and Report of Foreign Bank and Financial Accounts requirements
- Other emerging issues such as nonexempt charitable trusts and Internal Revenue Code (IRC) Section 501(r)
These focus areas remain the same for 2018.
In May 2017, the IRS brought a new Compliance, Planning & Classification (CP&C) unit online to streamline and consolidate processes and functions occurring within the IRS’s Tax Exempt & Government Entities (TE/GE) division. According to the IRS, the CP&C provides a more “comprehensive approach to identify, research, and monitor compliance risks, using data analytics.” For FY 2018, the IRS planned to launch a compliance strategy tool and an internal submission portal to accumulate areas of noncompliance. Collaboration among issue experts and data analysts is a critical part of the IRS’s compliance strategy going forward. The IRS also implemented a new governance board to review the recommended compliance strategies and determine which strategies to pursue. We anticipate the IRS will report further developments with the risk modeling program in its FY 2019 Work Plan, which is typically released in the fall.
In line with the IRS Work Plans, the number of examinations on tax-exempt organizations has increased over the last several years. The TE/GE division is working to ensure organizations are complying with the requirements of exemption and all federal tax laws. We’ve seen examinations that focus on a number of areas, including but not limited to:
- Compensation matching issues
- Expense reimbursements
- Net operating losses on Form 990-T
- Advertising income from periodicals
- Documentation for expenses following an accountable plan
- IRC §501(r) for hospitals
- Anonymous donors
While the IRS won’t disclose which queries it uses, we can make assumptions. We believe the top “red flags” include inconsistent or inaccurate answers, failure to follow best practices and the presence of “high-risk” areas within the return. As the number of red flags increases for a particular return, as does the likelihood for examination selection. Based on public information and experience with IRS examinations, the following areas may be considered a high-risk area in a return:
- History of unrelated business losses
- Employment tax and retirement plans
- Transactions including loans with disqualified persons
- Policies, procedures and other governance practices
- Significant changes in operations
- Hospitals and IRC §501(r)
- Foreign reporting
It’s important for exempt organizations to keep in mind that the tax return tells a story, and the IRS is listening. An exempt organization needs to take ownership of its returns and ensure the correct story is being told—this includes answering all questions accurately. Tax returns provide a significant amount of information to the IRS and the public, not only about an organization’s financial situation but also about its management.
Contact Rebekuh, April or your trusted BKD tax advisor if you have questions.