Nonprofit Accounting Basics

Payroll Audit Program by IRS, Many Nonprofits to be Examined

Note: Articles published before January 1, 2017 may be out of date. We are in the process of updating this content.

The IRS has begun an ambitious program of payroll audits this year. The program will select 2,000 entities for examination this year and the two years following. Of these 2,000 to be examined in each year, approximately 500 will be nonprofit organizations.

We have seen this program in action first hand at several organizations and have heard from other practitioners about how it is being manifested in many other instances. In addition to the special audit program, we have also seen payroll tax issues elevated to a new level of importance in all nonprofit examinations. This is an area where the IRS feels it can collect significant revenue, so it is being aggressive.

The IRS appears to be targeting a wide swath of nonprofits, from 501(c)(3) charities to 501(c)(7) country clubs, with an extensive range in size. As expected, the largest issue of interest to the IRS has been employee vs. independent contractor. Organizations under examination can expect to be required to provide substantiation for independent contractor status of everyone in that category. Foreign employees and proper withholding and filings seem to be the next most popular area of interest with lots of questions about visa/residency status and Form 942 filings and tax withholding. Non-filing of Form 1099 is also being examined carefully. The IRS will try to impose backup withholding taxes and penalties when Forms 1099 are not filed. We have seen and heard of proposed tax, penalty, and interest amounts in seven-figure amounts for some larger organizations under audit.

For organizations who believe they may have misclassified a significant number of workers as independent contractors instead of as employees, consideration should be given to the recently announced Voluntary Classification Settlement Program (VCSP) as unveiled by the IRS in Announcement 2011-64 ( Filing under this program is not penalty free, but penalties are greatly reduced when an organization participates in the program. Organizations considering this program should carefully consult with their tax and legal advisors before embarking on this course as there may be many ramifications to consider when reclassifying persons to the employee status. This program is not available to organizations currently under examination.

It is definitely time for organizations to self-assess their payroll tax situations. This is doubly true if there are significant independent contractors or non-US persons being paid by the organization.