HOW TO HANDLE AN INTERNAL REVENUE SERVICE AUDIT

John Christopher, Dinsmore & Shohl

No one likes to be audited by the Internal Revenue Service. However, as a recent audit of the Alpha Chapter House Corporation of the Kappa Alpha Order shows, preparation before an audit can make all of the difference in the world. Mark Shuford, the President and Treasurer of the Alpha Chapter House Corporation testifies to that. “Two things I took away from this experience that are worth passing along: one, having Swisher Davis handle all of our payroll, bookkeeping and tax filings made life so much easier as they had great records and all the right answers. Two, this should probably serve as a wakeup call to all house corporations that they need to make sure their records are in order and that … they should think about employing an outside accounting firm to help them do their job.”  Mark goes on to say that having an experienced advisor assisting with the audit was a calming influence in an otherwise stressful situation.

The audit ended favorably for the Alpha Chapter House Corporation, perhaps in part because the officers of the corporation were well prepared for, and well advised during, the audit. This article describes in some detail the audit process and how preparation like that undertaken by Alpha Chapter House Corporation can help other organizations prepare for an IRS audit.

The audit of the Alpha Chapter House Corporation was not an unusual occurrence. Based upon normal IRS procedures, it is highly likely that all national fraternities will be audited at least once every five years. While the audit of fraternity foundations, local chapters, alumni groups and house corporations are, generally, less frequent, we have noticed an increase in audit activity of house corporations over the last 24 months.

An IRS audit may be signaled by the receipt of a telephone call from a local Internal Revenue Service agent informing you that your organization will be audited.  However, you are entitled to receive — and you should ask for — a written request detailing the year or years under audit and exactly what information the agent wants you to provide.  The agent will often request organizing instruments (articles of incorporation), by-laws, minutes of meetings, all books and records pertaining to the assets and liabilities of your organization, receipts and disbursements, check register, canceled checks and bank statements, copies of any other federal tax returns filed, correspondence files, pamphlets, magazines and membership information.

The time and place of the audit should be stated in the letter you receive from the IRS.  If the time scheduled for you is inconvenient or if you need more time to assemble the materials requested by the agent, do not hesitate to call the agent and explain the situation.  However, do not delay merely for the sake of delay.  The audit will not go away, and you will only succeed in alienating the agent.  Any early contact with the agent will most likely set the tone for the audit; therefore, be polite and businesslike in your dealings with him.  IRS agents are often treated poorly by those they are assigned to audit, and in our experience, setting a polite and business-like tone may develop goodwill with the agent that could be helpful during the audit.

As soon as you have been notified of the audit, contact the person who prepared the tax returns that are being audited and/or your other tax advisor, and follow the instructions he or she may give you for handling the audit.  Next, gather the materials requested by the agent and have them arranged in a logical and orderly fashion. This is where ongoing recordkeeping and good advisors are key. Solid recordkeeping procedures will make gathering and organizing the requested information far easier than if procedures are not in place. Further, your advisors will help you give only what is asked for and not offer anything extra. Offering more than what is asked for is a good way to open the door for an inquiry that goes beyond the agent’s original scope. If you cannot provide everything requested by the agent, be sure that you have a good explanation as to why it is unavailable.  Finally, be prepared for the auditor’s visit.  In this case, the old trial lawyer’s adage that “preparation, preparation, preparation” is the key to success is certainly appropriate. Meeting with your tax advisor to review the requested materials and to discuss possible issues that might be raised is an important aspect of the organization’s preparation. Your advisor will assist you with formulating a response if the agent raises such an issue.

With regard to the actual handling of the audit, remember that IRS agents are people, and treat the agent in the same manner that you would like to be treated if you were doing the agent’s job.  Give the agent a separate room, if possible, and offer him or her coffee or tea. Make sure the agent is out of the normal traffic patterns of your employees and staff.  IRS agents often pick up issues and problems by hearing the everyday conversation in an office.  By the same token, instruct your employees not to engage in conversation with the agent, but to refer the agent to you or a designated contact person.  Before you leave the room, make sure that the agent knows how to reach you or the contact person when the agent has questions or needs help.  Do not hover over the agent.  Leave him or her alone and let the agent do his or her work.  If the agent raises a question which you cannot answer, do not panic.  Tell the agent that you need to check further for the information and that you will let him or her know.  Then make sure you follow through on this item.

Finally, find out the time parameters of the audit.  You should know when the agent will arrive, when he or she will leave, and if the audit has been concluded or if another visit is necessary.  Otherwise, an agent may continue to appear unexpectedly at your office or house, and this is not desirable.

Some of the issues that may be raised by an agent auditing a national fraternity or a local group include:

1) Late filing or non-filing of Forms 990 and/or 990-T.

2) Failure to file other required forms such as Form 1099.

3) Improper use or allocation of set aside funds or failure to follow correct procedures in setting funds aside.

4) Lack of documentation for transactions.

5) Compensation, reimbursement policies or fringe benefits as they relate to officers, staff and volunteers such as chapter visitors.

6) The handling of local housing loans.

7) Receipts from fund raising projects.

8) Nonmember income and whether the 15 and 35 percent gross receipts tests have been violated.

9) Commingling of chapter and house corporation receipts and expenses.

Most of these issues relate to whether the organization will be required to pay taxes plus interest on unrelated business income, but a few of the issues can affect the organization’s tax exempt status.  It is very unlikely that an agent will suggest revocation of exemption, but if this is mentioned, you should seek competent professional advice immediately.  This is a far more serious matter than a proposed imposition of tax.  Sometimes an agent will request that you sign an agreement with the IRS on behalf of your organization.  Never sign anything with the IRS without seeking professional advice about the effect this document will have on your organization.

If the agent raises issues or proposes adjustments to your tax returns and if you cannot fully satisfy the agent’s concerns or convince the agent that they are unfounded, you should refer the agent to your tax advisor.  You will be required to give your accountant or counsel a power of attorney, Form 2848, authorizing your representative to act for you in discussions with the IRS.  From then on, the agent is supposed to speak only with your representative and not directly with you.  If the agent contacts you after you have furnished him or her with a signed power of attorney, you should remind him or her politely to call your representative.

Your representative will do any necessary research on the issues raised by the agent and present the agent with factual materials and legal arguments.  Usually, your representative will have at least one meeting with the agent and generally will attempt to settle the matter at the lowest possible level of the IRS — with the agent or his or her supervisor.

Your representative should be someone who has had experience in handling Internal Revenue Service audits of exempt organizations so that he or she is aware of IRS policies and procedures on this particular subject.  For example, sometimes in an exempt organization audit it is possible to agree that a questioned item will be handled differently in the future in order to avoid having to pay tax or having an exemption revoked.  This is not usually possible in other types of audits, but the announced mission of the IRS in dealing with exempt organizations is not to collect the most tax possible, but to make sure that the requirements which the law imposes for maintenance of exemption are being followed.  A word of caution: In most cases, it is a mistake to try to use outside influence to settle an audit.  For example, do not try to exert political influence or go over the agent’s head through non-authorized channels except in very rare circumstances and on the specific advice of your representative.

If your representative cannot settle the matter at the agent level, he or she will consider appealing the matter to the Appellate Division of the Internal Revenue Service, at which time a written protest must be filed setting forth legal arguments and the facts upon which the organization relies.  If the problem is not resolved before it reaches the IRS Appellate Division, it is best at this stage to involve a lawyer if you have not already done so, since a court proceeding is the next available step.

If a legal issue involved in the case is a novel one, your advisor may suggest requesting technical advice from the National Office of the Internal Revenue Service; in some cases, the IRS itself may initiate such a request.  This can be a lengthy process, and it may be that at some stage of the proceedings the organization will be asked to sign a waiver of expiration of the statute of limitations.  The matter can then proceed without the statute of limitations expiring against the government.  In most cases it is in the organization’s best interests to sign such a waiver.  Otherwise, the IRS will usually issue an immediate deficiency notice so that its interests are protected.  Nevertheless, the waiver should not be open-ended.  If possible, waivers should be signed for six-month intervals only so that the matter can be reviewed periodically to determine whether it is still wise to extend the statute of limitations.  If one or more issues in the case have been settled, your advisor should attempt to secure a partial waiver, so that the statute is extended only as to unagreed issues.

As a last resort in resolving the issues, the organization may file suit to the Tax Court without first paying the tax; or, it may file suit to other federal courts if it wishes to pay the tax first.  An organization should not necessarily be fearful of litigation, but it is not a matter to be taken lightly.  It is expensive, time consuming and there is always a chance that the matter will be decided entirely against you.  Therefore, before authorizing litigation, you should be sure that the matter cannot be settled in any other way and that you have at least a 50-50 or better chance, based upon your advisor’s judgment, of being successful in court.  Your representative will advise you whether a particular court will be a better forum in which to raise the issue involved in your case and what the procedure is for taking the matter to that court.

Most controversies of fraternities with the IRS are generally resolved short of the litigation stage.  If you follow the above approaches and your tax advisor’s recommendations, it is less likely that your organization will be involved in one of the relatively few cases reaching the courts.