I Survived an IRS Audit

Uh oh. We are all afraid of getting audited by the IRS, but we don't really know what would happen in one. Here is the True Life story of an environmental organization's audit, how they survived, and their tips for the rest of us.

It's the phone call everyone dreads: "Hello, your organization has been selected for an IRS audit." The call came to Karl Dickson (pictured left), board treasurer of an environmental nonprofit in Milwaukee, and his caller ID showed that the call came from an unidentified cell phone. Karl's instincts were to suspect a scam.

Karl questioned the caller who told him (not very believably) that "most IRS agents don't have an office" and therefore use cell phones. She also told him they had been selected by random and that he was called because his number was on the IRS Form 990. She told him to expect a letter. (What? No IRS agent flashing a badge? Not even certified mail? If we're going to be audited, at least can we have some drama?)

What the letter said

But the letter did arrive a few days later (at the end of this article is a link to the actual letter). Behind the generic IRS publication, "Your Rights as a Taxpayer," was a two-page list of documents that the IRS required (ask yourself how hard it would be for you to comply with such a request):

  • Original application for 501(c)(3) status, articles of incorporation, bylaws, and any amendments
  • IRS letter granting tax-exempt status. (Shouldn't the IRS have this?)
  • Minutes of all board meetings and committees to help the IRS determine whether the organization had "sufficient and adequate internal controls" and to "determine the extent of board oversight"
  • Brochures, newsletters, and any advertising from the organization. (I know they're in a box somewhere)
  • And lastly, financial records including:
    • Chart of accounts
    • General ledger
    • Working trial balance
    • Cash receipts and cash disbursements journal
    • Cancelled checks
    • Invoices
    • Bank statements
    • Credit card statements
    • Expense reports
    • Three years of Form 990s
    • Contracts, Notes
    • Copies of all 990s, W-2, W-4, and any other federal documents
    • Description of membership benefits if any; and
    • Detail of any Fundraiser Fees and Event Schedules

The letter went on to say that they were looking at the financial information to determine

  • Whether all income was related to the organization’s mission
  • Whether all expenses were "fair and reasonable" and
  • Whether all expenses were appropriately classified between program activities, fundraising, and administration.

Even for Karl, who is a Certified Public Accountant (and therefore a conscientious file-keeper), the list was exhausting. "You think you’re organized but you don't really know until you actually have to put your finger on those documents."

"I was expecting the finance requests, but wasn’t really prepared to find the original tax-exemption application. I was grateful to the original board members who kept it and passed it along."

Karl told the rest of the board about the audit, but received little more than moral support from them. Most were puzzled: why is our little organization -- with a budget of $100,000 -- picked for an IRS audit?

The organization had been spun off from a larger museum. Was this the reason behind the audit? "Your guess is as good as mine," Karl said, "but the IRS agent did focus extensively on whether we were still operating under the same manner in which our tax-exempt status was given."

Karl takes his boxes to the IRS office

Karl chose to attend the IRS meeting alone so that there wouldn’t be any conflicting answers to questions and kept the board informed of the process via email.

He carried a cardboard box with all the documents, balancing a couple of binders precariously on top and went into the nondescript building.

Wait a minute . . . I've been in taxes for years at a big accounting firm and my first visit to the IRS is for a $100,000 nonprofit?

As he waited in the secured lobby, Karl had a moment of anxiety about the organization's work preserving rainforests in Costa Rica: Did our foreign transactions spark the audit? What if I can't remember all the details of everything?

Soon a middle-aged woman with a no-nonsense, formal demeanor showed him her badge and escorted him to a conference room. The room’s walls were bare except for a picture of the president and the room contained a table, two chairs, and the American flag. At least there aren't any handcuffs in the room.

The agent asked Karl to walk her through the documents. Surprisingly, most of the questions weren't about finance, but about organizational structure and activities. After half an hour (but it seemed like forever!) she said she would take more time with the documents and would call with any questions. She noted that Karl had the right to appeal her judgment.

Imagine you're at your "day job" and the ringing phone isn't a customer but an IRS agent with questions about the nonprofit where you serve as the volunteer board treasurer; the questions are about finances from two years ago! As the weeks wore on, the IRS agent phoned him often ("we're not allowed to email you questions" -- what?) and Karl found it helpful to say he needed to "research the answer," to give him time to confer with another board member before responding.

The questions were mostly about specific transactions:

  • “What service did this vendor perform for the organization?”
  • “Why is this expense classified as this?”
  • “Why is this considered restricted revenue?”

It reminded Karl of an accounting test. The phone calls and questions were crazy making, but ultimately he remembered everything and he received notice that the audit was complete.

The results and Karl’s advice

The IRS agent ended up only reporting three minor findings including that the organization had filled out one 1099 incorrectly (yes, it was that thorough). Now that lightning has struck Karl, it probably won't strike him again, but here are his tips for the rest of us:

1. Keep a binder with key organizational documents, such as articles of incorporation, approval letter, a conflict of interest policy (if you have one), and other documents.

2. Keep a binder for minutes from the board and any committee meetings. Put a sticky tab on each page where a motion was approved.

3. At the end of each year, put all the brochures, reports, and documents from the year and put them into a folder

4. Save all financial documents in line with your document retention policy (a sample policy can be found here.).

We would add: have a conscientious and calm treasurer like Karl.

In the end, the IRS audit was time consuming but not terrifying. As Karl notes, "Even though you’re fairly confident that everything is correct, no one likes an audit."

Karl Dickson, C.P.A., is board treasurer of the Tirimbina Rainforest Center in Milwaukee (Tirimbina is in Costa Rica). Steve Zimmerman, C.P.A., is a finance and strategy consultant to nonprofit organizations and a regular contributor to Blue Avocado.

Thank you especially, Karl, for sharing the actual IRS letter with Blue Avocado readers. Now we know what to expect. Click below to view.

See also in Blue Avocado:

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Comments

Would obtaining legal counsel before meeting with the IRS be a good idea? That would be my first thought. Karl? Jan?

Karl didn't think of obtaining legal consel partly because the organization didn't have the resources for it, but also because while nervous about what they would focus on, he felt that the 990 was honestly put together and didn't have anything to hide. If there were significant findings he might have considered legal counsel for the appeal.

Also, he didn't contact his auditor, because he had prepared the 990. If you have an auditor prepare the 990 you would want to make sure they know.

This is a very instructive article -- especially the recommendations about how to organize documents. Thanks!!

I've just been through with the non-profit I work for. That letter is the same one we got earlier this year and I would echo Karl's advice. We fortunately had something similar to his recommendations already in place making it fairly painless. We also worked with our auditor, who was experienced with IRS audits. This might be worth looking into if you find yourself on the receiving end of one of those letters. In the end all was well as anticipated, but glad it is behind us.

Karl talks about a box of records. will the IRS take electronic records? We have most of the organizational records on our server, but it would take forever to print everything out....

Typically the IRS will take electronic records. They offered Karl the option of coming to his office, but he didn't want them coming to his place of business. Remember, he is a volunteer! Hence, it was easier for him to go to them.

Karl's experience sounds like a souped-up version of the annual audit we go through with our accountant. Does the IRS really want us to all live in fear of the service it provides?

I am the executive director of a small hospital conversion foundation. We too were audited recently. Our audit was for confirmation of the appropriateness of our public charity status and took place in the foundation's office over a two day period. We had less than ten days to pull all of the documents required by the audit. I am an attorney and a stickler for document compliance so the records were in good shape, but I was startled when the auditor wanted not only grant contracts and grantee reports, but my notes from site visits too.
The auditor told me that she had recently been switched from small business audits to doing exclusively nonprofit audits, as had another auditor in her office. I think the IRS is indeed increasing its scrutiny of nonprofits.

I'm Executive Director at a nonprofit that was audited starting in late 2009 and extending until December 2011. The inquiry was in regards to our management of an events center in our building and if that was related to our mission. The IRS made three requests for information before we received the official audit letter for tax year 2007. Upon receiving the letter, we informed our CPA who conducts an annual audit, and hired a well-respected and experienced tax attorney. Our organization has a $700,000 budget approximately and nets about $100,000 per year from the events center so we were not taking any chances in losing this precedent-setting case. Following the submittal of arguments to the audit letter, the IRS denied our claim. We therefore had to prepare an appeal. Earlier this month we received verbal confirmation that the IRS agreed with all our arguments, was dropping the audit, and off-handedly admitted that the initial reviewer was wrong, had been transferred to another IRS office and being mismanaged by her supervisor, and the case should have never gotten to this point.

Over the two years, we spent hundreds of hours collecting data, preparing information even beyond Karl's list with charts of cross-referenced information requested by the IRS, meeting with attorneys and CPAs, and preparing our statements and appeals. Not to mention the roughly $20,000 we spent on professional expertise to assist in the case. We were highly benefitted by our organizational policies on information retention (both in boxes and electronically), an extremely smart and organized staff member that essentially functions as our CFO, and the excellent advice of our hired professionals. Though we spent money we really didn't have set aside for such an occasion, it was recognized by the Board and staff of being the lesser consequence and therefore worth our investment to prove we were right.

Wow, what a story. Thank you for telling it! Jan

I was the board president of a small ($200,000) non-profit when we received "the letter". We had one part-time administrative person who we had to pay an additional $450 so she could pull all the documents together. In a subsequent phone call, it was clear that the IRS auditor had thoroughly read every single document (What a waste!) and was really focused on whether we really, really were a nonprofit. I was asked about every program and board action -- no financial questions! We passed, but the lesson we learned was to keep the board minutes very brief - action only -- so as to reduce the number of seemingly irrelevant questions. As we're a volunteer-run organization, every little thing we did was in our minutes -- but not any more.

I am humored by the improper grammar of the attachment to the IRS letter. Paragraph 2 of the attachment states: "to verify the organization is meets the organizational requirements of its exemption." Either the word "is" should be eliminated or the word "meets" should be "meeting" but "is meets" just doesn't pass the IQ test and we're dealing with an entity that is checking us for accuracy? :) Ed Greany, President of a 501c3

Awesome comment, Ed! You should get a lifetime pass on IRS audits for catching this one. Jan

Our organization ($10M budget) recently had a similar audit, and my take was just a little different. Slightly panicked when I (I'm the CFO) received the same letter, I called the agent who was a nice guy and appears to have an office in San Francisco. He talked me through the process. Because virtually all of our files (organization docs, minutes, audits, 990s, grants, etc.) are in electronic form (mostly pdfs stored on a shared drive) gathering the documents that he wanted to see when he arrived took a couple of hours. In our case, he planned to sample some documents (1099s, expense reports, copies of checks) so I provided lists of the relevant data, most of which had been prepared and saved as part of the relevant year's financial audit.

When he arrived, he said that our audit was triggered by an informant's complaint (while the identity of the informant is confidential, I have an idea who it was based on an earlier lawsuit, but that is a different, long story).

We talked for half an hour about the business, and he set about investigating the complaint points (which were quickly dismissed) and then conducting his normal audit. All told, he was at our office for about 6 hours. He was very professional, friendly but diligent in goging about the audit. It was very much like monitoring visits we receive periodically from our government funders -- no more or less stressful (once we got over the idea that it was an IRS Audit).

The audit actually proved useful to us. The agent gave me some very helpful advice about 1099s that we send to landlords of our clients. He also gave me a hammer to use to get employees to do a better job of identifying "business purpose" on some expense reimbursement requests. While I would not necessarily encourage anyone to request an IRS audit, I think, based on our experience, that most of us need not face them with great fear and trepidation. Mike

Thank you for this very helpful article. The IRS refusal to use email is absurd. Several years ago I prepared a complex tax-exemption application for an LLC with multiple exempt members. The agent (who was out stationed somewhere in Orange County) had a number of questions that required me to send long faxes, such as 60 page commercial leases, that would have been more securely sent and received by email. Speaking of shouldn't the IRS have this, she also asked me to prove the members were exempt. I responded by printing out their listings from IRS pub 78 and faxing them to her. Gabrielle Lessard gabrielle.lessard at k2-legal.com

Great comment about the security (or lack thereof) of a fax vs. email. It is absurd!

Thanks Karl for telling your story. I now know what to expect for my clients.

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