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1 Non-Profits and Associations Forum: Dealing with the IRS Best Practices for Avoiding an Audit and How to Navigate the Process if Your Organization is Selected Click to edit Master title style Presented by: Marlis Carson, Senior Vice President and General Counsel National Council of Farmer Cooperatives Douglas W. Charnas G. William (Will) Tysse Bradley A. Ridlehoover McGuireWoods LLP George W. Wilson, Jr. CliftonLarsonAllen

2 Moderator Marlis Carson Marlis Carson is Senior Vice President and General Counsel for the National Council of Farmer Cooperatives, a trade association based in Washington, D.C. In addition to overseeing NCFC s legal, financial, and tax compliance issues, Marlis coordinates the activities of NCFC s Legal, Tax and Accounting Committee on federal issues impacting farmer cooperatives. She also serves as NCFC s corporate secretary/treasurer. Marlis Carson Senior Vice President and General Counsel (202) mcarson@ncfc.org Washington, D.C. Practice Education Bar Admission Tax Antitrust Exempt Organizations B.S., Sterling College, Sterling, Kansas JD, George Washington University Law School Virginia McGuireWoods 2

3 Douglas W. Charnas Douglas Charnas is a partner in the Washington, D.C., office of McGuireWoods. He advises for-profit businesses and nonprofit entities on a range of legal matters, including formations, governance, operations, acquisitions, reorganizations, taxes (including obtaining and maintaining tax-exempt status for nonprofit entities), and controversies with the IRS (where he has served as a senior attorney and special assistant to the Chief Counsel) and the Justice Department. He is an adjunct professor at Georgetown Law Center, where he teaches a course on S corporations and limited liability companies in the LLM program in tax, and is the secretary/treasurer of the Edgar J. Murdock Inn of Court for Tax. Douglas W. Charnas Partner (202) dcharnas@mcguirewoods.com Washington, D.C. Practice Education Bar Admission Tax Tax Controversy and Litigation Nonprofit & Tax-Exempt Organizations Corporate Mergers & Acquisitions Georgetown Law Center LLM, Taxation, 1983 Case Western Reserve University, JD, 1978 Ohio University, AB, 1975 District of Columbia Ohio McGuireWoods 3

4 G. William Tysse Will Tysse, a partner in the Washington, D.C. office of McGuireWoods LLP, focuses his practice on employee benefits and executive compensation. He has extensive experience advising public, private and nonprofit clients on all aspects of non-qualified deferred compensation arrangements, including excess and supplemental retirement plans, cash and equity incentive plans, and employment and severance agreements. G. William Tysse Partner (202) gtysse@mcguirewoods.com Washington, D.C. Practice Education Bar Admission Employee Benefits Executive Compensation Qualified Retirement Plans Health and Welfare Benefits Corporate Securities Compliance Mergers and Acquisitions Master Limited Partnerships University of Virginia School of Law, JD, Editorial Board, Virginia Law Review, 2004 University of Oxford, MSt, with Distinction, 2001 University of Virginia, BA, with Distinction, 2000 District of Columbia Virginia McGuireWoods 4

5 Bradley A. Ridlehoover Bradley A. Ridlehoover, an associate in the Richmond office of McGuireWoods LLP, focuses his practice on tax controversy matters including assisting clients with Internal Revenue Service (IRS) audits, administrative appeals, and tax litigation. He represents individuals, businesses, and estates before the U.S. Tax Court and federal district courts. Brad has experience handling cases involving income, estate, gift, and excise tax matters. Bradley A. Ridlehoover Associate (804) Richmond, Virginia Practice Education Bar Admission Tax Tax Controversy and Litigation ERISA Litigation New York University School of Law, LLM, Taxation, 2009 The College of William & Mary, JD, 2008 Presbyterian College, BA, BS Business Administration, Political Science with Honors, 2005 Georgia New York Virginia McGuireWoods 5

6 George W. Wilson, Jr., CPA In the increasingly complex technical environment in which we live, George is a visionary business consulting professional with over 30 years of experience. George serves as outsourced CFO for various nonprofit organizations and for profit entities and he provides vital vision and leadership for developing and implementing information technology initiatives that help to advance industry leadership for firms in today's competitive marketplace. George capitalizes on his unique skill sets of business process and technology understanding, providing an excellent resource for his clients. His cross-functional perspective allows for the alignment of the client s business strategy and its technology strategy. George earned his B.S. degree in accounting from the University of Maryland in College Park, Maryland. George is a member of the American Institute of Certified Public Accountants (AICPA), the Maryland Association of CPAs, American Bar Association (Technology Related), and the International Legal Technology Association. George has been a presenter and has written many articles about various business and technology subjects. George is a board member of U.S. English Foundation, Inc. and is an emeritus board member for the Information Technology Alliance. George W Wilson, Jr., CPA, CITP, CGMA CliftonLarsonAllen LLP Principal George.Wilson@cliftonlarsonallen.com Gaithersburg, MD Practice Consulting Professional Nonprofit Organizations For-Profit Entities Information Technology Education University of Maryland Professional Admission American Institute of Certified Public Accountants Maryland Association of CPAs American Bar Association McGuireWoods 6

7 OVERVIEW IRS Examination Process Generally Issues Likely to Trigger Examination UBIT Basics Issues IRS College University Compliance Project IRS ACT Recommendations Compensation Issues Employee Benefits & Retirement Plans IRS Examinations Process Internal View Positioning for an Examination Panel Discussion The Examination Process Panel Discussion McGuireWoods 7

8 IRS Examination Process - Generally What may trigger an IRS examination? Random selection Whistleblower Form 990 or other reporting McGuireWoods 8

9 IRS Examination Process - Generally Traditional Examination Field audits Correspondence audits Compliance Checks IRS gathers data IRS educates organizations regarding tax compliance, record-keeping, and reporting obligation Failure to respond can result in traditional examination McGuireWoods 9

10 Purpose of examinations To verify correctness of income or gross receipts, deductions and credits To determine that the organization is operating in the manner stated and for the purpose set forth in its application for recognition of exemption In many cases, IRS closes examinations without changes McGuireWoods 10

11 IRS Examination Process - Generally Phases of Tax Controversy Opening of examination (field or correspondence audit) Information gathering Exchange of documents through Informal Document Requests/Summons Issue presentation Examination closing Appeals Litigation McGuireWoods 11

12 Planning for an Examination Internal Preparation Before IRS Initial Meeting Inform senior management team Consider whether and how to inform board of directors and any other necessary stakeholders Suspend document destruction McGuireWoods 12

13 Planning for an Examination Internal Preparation Before IRS Initial Meeting Review IRS correspondence Review records Organizational documents Operating documents Books and financial records Employment tax records Research potential tax issues identified Determine exposure (tax implications of each issue) Examine statute of limitations Discuss other areas of potential dispute not identified Evaluate defenses to potential penalty McGuireWoods 13

14 Planning for an Examination Internal Preparation Before IRS Initial Meeting Assemble team to attend initial IRS meeting Designate a single point of contact Develop a communications strategy Develop a document exchange strategy McGuireWoods 14

15 Beginning an Examination Initial Meeting with the IRS Exam Team Provide Power of Attorney Form 2848 if you have a representative attend Get to know the IRS team Ask questions Discuss process for gathering information Information Document Requests Summons (to taxpayer and third party summons) Deadlines Discuss procedures for any on-site visits Discuss whether interviews are necessary McGuireWoods 15

16 Handling an Examination: Information Exchange All requests for documents or information MUST be in writing Beware of scope Information Document Requests How do you respond? When do you respond? What if you do not have answers in response? What if your response is bad? What if you do not respond at all? Summons (to taxpayer and third party summons) What is it? Can be enforced in court Motion to quash McGuireWoods 16

17 Handling an Examination: Information Exchange Typical Requests in Initial Information Document Requests Governing instruments (including all amendments) Pamphlets, brochures, and other printed material describing organization Copies of Form 990 for all years under examination Minutes of meetings of board or directors and standing committees All books and records Auditor s report Copies of any other filed federal return (990-T, 1120-POL) Copies of employment tax returns (W-2, W-3, 941, 1096, 1099) McGuireWoods 17

18 Common questions that may be asked Do you have corporate credit/debit cards? If so, who has them? What is approval process, if any, for charges? What documentation do you have for expenses and approval of expenses? Are there any outstanding legal issues or lawsuits? If yes, explain. Have you been sued before? If yes, explain. What were the legal issues discussed during year being examined (if not clear from legal invoices)? Questions regarding specific disbursements identified in general ledger or check register McGuireWoods 18

19 Common questions that may be asked (continued) Review of 1099 s and vendor list may result in questions about why a specific vendor did not have a Form 1099 issued. If not issued and organization does not have a W-9 on file showing that a 1099 was not required, then the vendor will be asked to fill out a W-9. Did you go out for bids on the paid work performed by any board members? Review of all employee W-2 s and top employees that get paid $100,000 or more each year, as reported in Form 990, will be reviewed to see that they are consistent. What is your process for setting executive compensation? Where are the minutes of the independent governing body? McGuireWoods 19

20 Handling an Examination: On-Site Visit What if the IRS wants to conduct on-site visit Planning: Who is present for tour? Who conducts tour? What actions should be taken before the tour? Tour Managing/Controlling exam team Recording devices/photography Security procedures McGuireWoods 20

21 Handling an Examination: Taxpayer Interviews What if the IRS wants to interview someone in your organization? Is it required? Summons issued? Is it a good idea? If you agree to an interview, what should you do? Prepare, Prepare, Prepare Only answer what is asked Talking your way out of a problem McGuireWoods 21

22 Handling an Examination: Issue Presentation Once the exam team concludes the information gathering process, they will provide you with proposed adjustments Generally, they will provide draft reports with these adjustments Responding to Proposed Adjustments: Presentation of Additional Facts to Support Your Analysis Presentation of Law (written) Analysis of Issues (written or by conference) McGuireWoods 22

23 Concluding an Examination No-Change Letter Adjustments to Return Fully agreed case Partially agreed case Unagreed case Opportunity to challenge adjustments at IRS Appeals and/or court McGuireWoods 23

24 Audit, Appeal, Litigation When to bring in outside legal counsel Audit Appeal Litigation McGuireWoods 24

25 UBIT Concerns The IRS has indicated its concern that unrelated business income of nonprofits is being underreported. The Colleges and Universities Compliance Project appears to have confirmed the IRS s suspicions. IRS examinations of colleges and universities focus on unrelated business taxable income. All nonprofits can expect greater scrutiny of their unrelated trade or business activities as a result of this increased scrutiny of this area of the nonprofit tax laws. McGuireWoods 25

26 UBIT Basics IRC 511 imposes a tax on the unrelated business taxable income of an exempt organization. An activity must meet three criteria to be an unrelated trade or business: It must be a trade or business It must be regularly carried on It must not be substantially related to the organization s exempt purpose Exempt organizations report unrelated business income and compute the tax on Form 990-T McGuireWoods 26

27 UBIT Basics Definition of Trade or Business A trade or business is generally defined as any activity carried on for the production of income from the sale of goods or performance of services McGuireWoods 27

28 UBIT Basics Fragmentation Rule Fragmentation Rule An activity will not lose its identity as a trade or business merely because it is carried on within a larger aggregate or similar activities that may, or may not, be related to an organization s exempt purposes. Examples: Advertising Museum gift shop item by item analysis PLR Seminary providing rental housing for students, faculty, potential students, family members of students, and guest speakers found to have UBTI from income from all users other than students because the housing was operated in a manner similar to a commercial hotel. McGuireWoods 28

29 UBIT Basics Exploitation Rule Exploitation Rule Generally, selling items produced in connection with an exempt function activity is not an unrelated trade or business, but this rule will not apply if the organization has exploited the exempt function in excess of what is necessary to accomplish the exempt purpose. Examples Sale of furniture that has been renovated by handicapped individuals Sale of apple butter at agricultural fair after demonstration on how to prepare apple butter McGuireWoods 29

30 UBIT Basics Dual Use Rule Dual Use Rule The dual use rule recognizes that a facility may be used for both exempt and nonexempt or commercial functions Example A university-owned ski facility primarily for students is also made available to the general public. Income from the use of the ski lift by the general public is unrelated trade or business income. Under Treasury regulations, when facilities are used both to carry on exempt activities and to conduct unrelated business, the expenses, depreciation, and anything attributable to such facilities shall be allocated between the two uses on a reasonable basis. There are two methods that can be applied to allocate those expenses IRS Method = days facility used for unrelated business days facility is available for use Rensselaer Method = days facility is used for unrelated business days facility used for all purposes Rensselaer is more favorable for nonprofit organizations McGuireWoods 30

31 Meaning of Regularly Carried On A business is regularly carried on if it is conducted with a frequency and continuity that is similar to a commercial or for profit business If the organization conducts the business only infrequently or intermittently, the business will not be regularly carried on Examples Fundraising gala held once every year Annual advertising book distributed to members at the annual convention, where advertising is solicited year-round McGuireWoods 31

32 Specific Exclusions from UBTI There are a number of exclusions under the unrelated trade or business income rules Income will not be subject to unrelated business income tax if: Substantially all of the work in carrying out the activity is carried out by volunteers The trade or business is carried on for the convenience of members, students, patients, etc. Student bookstore or dormitory Hospital pharmacy for patients Hospital gift shop, parking lot, cafeteria Substantially all of the merchandise sold is donated (referred to as the thrift shop exception) McGuireWoods 32

33 Specific Exclusions from UBTI (continued) Income will not be subject to unrelated business income tax if: It is derived from bingo games that are legal under state law and are not regularly conducted by for profit organizations It is attributable to the distribution of low cost items in connection with a charitable solicitation It is a qualified sponsorship payment McGuireWoods 33

34 Modifications to Computation of UBIT The following items are generally excluded from unrelated business taxable income (unless attributable to debt-financed property): Dividends, interest, payments with respect to securities loans, and annuities Royalties (from intangible property rights but not services) Rents Gains from the sale or exchange of property (unless inventory or held primarily for sale to customers in the ordinary course of a trade or business) Additional income excluded from UBTI includes: Income from charitable gift annuities over the life or lives of one or two individuals Certain research income McGuireWoods 34

35 Debt-Financed Property Income otherwise exempt from UBIT is taxable to the extent it is derived from debt-financed property Debt-financed income can arise in a number of ways: Investing on margin Investing in leveraged investment funds Investing in a partnership that carries on a trade or business or invests in a trade or business that is conducted by a partnership McGuireWoods 35

36 UBIT Results of IRS Colleges and Universities Compliance Project Revealed areas of concern UBIT Compensation and Comparability Data Employment Tax Retirement Plans McGuireWoods 36

37 UBIT Results of IRS Colleges and Universities Compliance Project Unrelated business income (UBI) is the income from a trade or business regularly conducted that is not substantially related to the organizations exempt purpose Unrelated business taxable income (UBTI) is the UBI that is taxable after deducting expenses directly connected to the trade or business UBTI upon which an exempt organization pays tax is based on the total UBI from all activities and subtracting total allowable deductions - - losses from one activity can offset profits from another activity McGuireWoods 37

38 UBIT Results of Irs Colleges and Universities Compliance Project Compliance Project examinations resulted in substantial increases in UBTI Primary reasons Disallowance of expenses that were not connected to unrelated business activity Lack of profit motive Improper expense allocation Errors in computation or substantiation Reclassifying exempt activities as unrelated McGuireWoods 38

39 UBIT IRS Act Recommendations Formalize Rev. Rul calling for a commensurate test Provide formal guidance for allocating indirect costs for dual use facilities/personnel Publish a comprehensive revenue ruling on a range of UBI issues (e.g., facility rentals, dual use properties, catering/food services, bookstore operations, technology transfers) Adopt a new Form 990-T Expand access to relevant IRS materials by leveraging electronic databases and web based resources McGuireWoods 39

40 Compensation What are the drivers for compensation issues? Private Inurement An organization is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of a private shareholder or individual Generally understood to apply only to those individuals who are in a position to control the disposition of the income or resources of the charitable organization for their own personal, private benefit and not for their benefit as members of the charitable class generally benefited by the organization Excess Private Benefit A benefit to a private person that is more than insubstantial Intermediate Sanctions Excess Benefit Transactions Any transaction in which an economic benefit is provided by a IRC 501(c)(3), (4) or (29) organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration received for providing such benefit McGuireWoods 40

41 Compensation Compensation related to items that can result in an excess benefit transaction Salary, fees, bonuses Severance Payments Deferred and non-cash compensation Fringe benefits Travel expenses Loans McGuireWoods 41

42 Reasonable Compensation IRM Reasonable compensation is the value of services that would ordinarily be paid for like services by like enterprises (whether taxable or tax-exempt) under like circumstances IRC 162 standards apply in determining the reasonableness of compensation, taking into account the aggregate benefits provided and the rate at which any deferred compensation accrues The fact that a bonus or revenue-sharing arrangement is subject to a cap is a relevant factor in determining the reasonableness of compensation The fact that a state or local legislative or agency body or court has authorized or approved a particular compensation package paid to a disqualified person is not determinative of the reasonableness For determining the reasonableness of compensation, all economic benefits provided by an organization in exchange for the performance of services are included, except for economic benefits that are disregarded McGuireWoods 42

43 Compensation Intent to Treat Benefit as Compensation An economic benefit is not treated as consideration for the performance of services unless the organization providing the benefit clearly indicates its intent to treat the benefit as compensation when the benefit is paid Such intent to provide an economic benefit as compensation for services is not required if the economic benefit is excluded from the disqualified person's gross income for income tax purposes An organization is treated as clearly indicating its intent to provide an economic benefit as compensation for services only if the organization provides written substantiation that is contemporaneous with the transfer of the economic benefits under consideration Reasonable Cause. If an organization's failure to report an economic benefit is due to reasonable cause, the organization will be treated as having clearly indicated its intent to provide an economic benefit as compensation for services McGuireWoods 43

44 Compensation Rebuttable Presumption Payments under a compensation arrangement are presumed to be reasonable if all of the following conditions are satisfied. Approval in Advance by an Authorized Body. The compensation arrangement is approved in advance by an authorized body of the organization composed entirely of individuals who do not have a conflict of interest as to the compensation arrangement Comparability. Prior to making its determination, the authorized body obtained and relied upon appropriate data as to comparability Documentation. The authorized body adequately documented the basis for its determination concurrently with making that determination McGuireWoods 44

45 Compensation Rebuttable Presumption If the above three requirements are satisfied, IRS may rebut the presumption that arises only if it develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the authorized body With respect to any fixed payment, rebuttal evidence is limited to evidence relating to facts and circumstances existing on the date the parties enter into the contract pursuant to which the payment is made (except in the event of substantial nonperformance) With respect to all other payments (including non-fixed payments subject to a cap), rebuttal evidence may include facts and circumstances up to and including the date of payment Absence of Presumption. The fact that a transaction between an organization and a disqualified person is not subject to the rebuttable presumption of reasonableness does not create any inference that the transaction is an excess benefit transaction McGuireWoods 45

46 Compensation Rebuttable Presumption An authorized body has appropriate data as to comparability if, given the knowledge and expertise of its members, it has information sufficient to determine whether the compensation is reasonable or the property transfer is at fair market value In the case of compensation, examples of relevant information are: Compensation levels paid by similarly situated organizations, both taxable and taxexempt, for functionally comparable positions; The availability of similar services in the geographic area Current compensation surveys compiled by independent firms Actual written offers from similar institutions competing for the services of the disqualified person For organizations with annual gross receipts of less than $1 million reviewing compensation arrangements, the authorized body is considered to have appropriate data as to comparability if it has data on compensation paid for similar services by three comparable organizations in the same or similar communities for similar services McGuireWoods 46

47 Compensation Rebuttable Presumption For a decision by an authorized body to be documented adequately, the written or electronic records of the authorized body must note: The terms of the transaction that was approved and the date it was approved, The members of the authorized body who were present during debate on the transaction that was approved and those who voted on it, The comparability data obtained and relied upon by the authorized body and how the data was obtained, and Any actions taken regarding the transaction by anyone who is a member of the authorized body but who had a conflict of interest as to the transaction. If the authorized body determines that the reasonable compensation for a specific arrangement, varies from the range of comparable data obtained, the authorized body must record the basis for its determination. Concurrently. For a decision by an authorized body to be documented concurrently, records must be prepared by the later of: The next meeting, or 60 days after final action by the authorized body McGuireWoods 47

48 Compensation Correction of Excess Benefit Transaction An excess benefit transaction is corrected by undoing the excess benefit to the extent possible and taking any additional measures necessary to place the applicable tax-exempt organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards In general, a disqualified person corrects an excess benefit only by making a payment in cash or cash equivalents to the organization equal to the correction amount McGuireWoods 48

49 Compensation IRS Colleges and Universities Compliance Project IRS focused on IRC 4958, which provides, in part, that organizations may pay no more than reasonable compensation to their disqualified persons Most private colleges and universities examined by IRS attempted to meet the rebuttable presumption standard, but about 20% failed to do so because of problems with their comparability data, including: Institutions were not similarly situated to the school relying on the data, based at least on one of the following factors: location, endowment size, revenues, total net assets, number of students, and selectivity Compensation surveys neither documented the selection criteria for the schools included nor explained why those schools were deemed comparable to the school relying on the study Compensation surveys that did not specify whether amounts reposted included only salary or included total other types of compensation, as required by IRC 4958 McGuireWoods 49

50 Compensation IRS Colleges and Universities Compliance Project IRS focused on employment tax issues associated with compensation Wages were adjusted for following reasons - - failure to include in income the personal use of automobiles, housing, social club memberships, and housing misclassification of employees as independent contractors failure to withhold tax on non-resident aliens failure to include in income the value of certain graduate tuition waivers and reimbursement McGuireWoods 50

51 Employee Benefits/Executive Compensation 457(f) plan compliance issues Forthcoming 457(f) regulations IRS 457(b) compliance initiative Top ten 403(b)/457 examination issues McGuireWoods 51

52 457(f) Plan Compliance Issues What is a 457(f) plan? Any nonqualified (e.g., not 401(a) or 403(b)) plan, agreement or arrangement that defers compensation to a future year and is not eligible under 457(b) 457(b) plan = limited amounts of deferred compensation (generally $18,000 in 2015) and other restrictions Compensation deferred under a 457(f) plan is taxable in the first year in which it is no longer subject to a substantial risk of forfeiture Bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay and death benefits are exempt McGuireWoods 52

53 457(f) Plan Compliance Issues What is a substantial risk of forfeiture? Right to deferred compensation must be conditioned on future performance of substantial services (e.g., if employee has right to quit and still receive compensation, it is not subject to a SRF) Similar definitions exist under Sections 83 and 409A IRS has expressed some desire to harmonize the 457(f) definition with the 409A definition (IRS Notice ) Section 409A regulations state that: a SRF cannot be added or extended (e.g. rolling risk ), except in exchange for materially greater compensation salary deferrals can never be subject to a SRF a restrictive covenant can never constitute a SRF a good reason termination provision can constitute a SRF only if it meets certain conditions McGuireWoods 53

54 457(f) Plan Compliance Issues What are substantial services? Regulations under Section 83 suggest that a vesting period of less than 24 months may fail to constitute substantial services Restrictive covenants (noncompete, etc.) do not constitute a SRF under Section 409A and ordinarily do not constitute a SRF under Section 83, depending on facts and circumstances Incidental consulting services (e.g., requirement that former employee be available to provide consulting services upon request as a condition of vesting in deferred compensation) generally will not constitute a SRF Terminal leaves of absence (e.g., employee on leave continues to vest but is not expected to return after leave period ends) also a potential problem McGuireWoods 54

55 457(f) Plan Compliance Issues What is a bona fide severance plan? In Notice , IRS expressed desire to define bona fide severance plan consistent with the involuntary separation pay plan exemption under Section 409A The Section 409A exemption requires that: Compensation is triggered only by an involuntary severance Involuntary includes good reason only if it meets certain conditions Total compensation cannot exceed the lesser of 2x the employee s base rate of pay or 2x the 401(a)(17) limit for the year of termination All compensation must be paid before end of second year following the year of termination McGuireWoods 55

56 Forthcoming 457(f) regulations Regulations have been forthcoming for years but may finally be on the horizon for real In March, IRS officials states they expected that 457(f) regulations could be issued before summer, depending on other projects Regulations are expected to fulfill the promise of Notice to define substantial risk of forfeiture and bona fide severance plan in accordance with Section 409A, among other things McGuireWoods 56

57 Section 457(b) compliance initiative In June 2013, IRS announced it would be selecting about 400 nongovernmental 457(b) plans for a compliance check, lasting through September 30, 2014 IRS stated it would be focusing on: verifying that the entity is eligible to sponsor a 457(b) plan and that 457(b) deferrals have been reported correctly on participants W-2s verifying that participation in the plan is limited to a select group of highly compensated employees, managers, directors or officers verifying that the plan does not contain features not permitted in a 457(b) plan, such as loans, age 50 catch-up provisions, and contributions placed in a secure trust verifying that unforeseeable emergency distributions have been made correctly (see Rev. Rul ) McGuireWoods 57

58 Top ten 403(b)/457 examination issues 1. Excess employee contributions (including violating 15-year catch-up rule for 403(b) plans) Excess employee contributions may result from poor internal controls or failure to aggregate 403(b)/401(k) plans Violations of 15-year rule may occur where $15,000 lifetime limit is exceed or employee is not employed by eligible employer 2. Violation of universal availability rule for 403(b) plans E.g., not allowing part-time employees who regularly work more than 20 hours per week to participate 3. Excess 415(b) (employee/employer combined) contributions to 403(b) plans Limit is lesser of $53,000 or 100% of compensation in 2015 McGuireWoods 58

59 Top ten 403(b)/457 examination issues (b) plan loans that violate IRS requirements Common violations include: failure to make required payments when due; poor documentation; and loans from multiple vendors that in the aggregate exceed the IRC Section 72(p) limits 5. Hardship distribution failures for 403(b) plans Common violations include: inadequate documentation and distributions from multiple vendors that in the aggregate exceed the amount needed to relieve the hardship 6. Unforeseeable emergency distribution failures for 457 plans Common violations include: inadequate documentation, lack of proper internal controls, and distributions that exceed the amount needed for the unforeseeable emergency McGuireWoods 59

60 Top ten 403(b)/457 examination issues (f) operational failures E.g., plan that has non-compete language as one of the risks of forfeiture that in operation is not likely to ever be applied (f) cafeteria-style benefits E.g., plans that allow participants to choose from different types of benefits with a default selection into a 457(f) plan (b) annuity contract problems E.g., the annuity contract is outdated and has not been updated for current IRS requirements 10. Ineligible plan sponsors of 403(b) and 457 plans 403(b) 501(c)(3) or public educational organization (c)(3) or state/local government McGuireWoods 60

61 IRS Examination Process An Internal View For a small organization (staff of 12), internal reviews are sometimes a challenge Some areas of focus: Executive Compensation Travel Expenses Corporate Credit Cards Banking Keeping files secure Board-directed funds McGuireWoods 61

62 Executive Compensation Board reviews compensation & bonus each year Board sets goals CEO self-assessment Board meets with CEO Periodic reviews of salary surveys Documentation McGuireWoods 62

63 Travel Expenses Employee travel flagged by auditors: All staff use corporate credit card issued by organization (no personal use). Staff file separate report for each trip. Board chairman reviews CEO expenses quarterly. Internal reviews of corporate card statements and documentation; auditors pull samples for review. McGuireWoods 63

64 Banking Banking Safeguards: Statements are received & reviewed by office manager. CFO also reviews statements, investment reports. Investment Committee sets policy, reviews periodically. Significant investment changes reviewed/approved by Investment Committee, reported to board. McGuireWoods 64

65 Keeping files secure Financial, employee records contain sensitive information Files in locked office Limit staff members with access McGuireWoods 65

66 Board-directed funds Auditors flagged funds that had been on the books for years. Need plan to spend the funds or must remit to original donors: Research board minutes for purposes Present research to board and get approval for expenditures Document, document, document Avoid unintentional set-aside of funds McGuireWoods 66

67 UBIT concerns Identify and document all sources of UBI Part II of IRS Form 14018, Compliance Questionnaire for Colleges and University, is a very useful tool Identify alternative investments (e.g., private equity, limited partnership or foreign corporations) Ensure compliance with record-retention requirements related to UBI documents McGuireWoods 67

68 Allocation of Expenses Sensitive issue for IRS Form 990 requires expenses to be identified within three categories Program Service Management and General Fundraising UBI expenses are reported on Form 990-T Form 990-T, like Form 990, is a public document McGuireWoods 68

69 Allocation of Expenses Anticipate IRS questions regarding the profit motive of the UBI activity Look at whether UBI activities reported on Form 990-T have a history of generating tax losses Be prepared to explain which items of expense (and how much) are properly allocated to UBI activities (and not exempt activities) McGuireWoods 69

70 Allocation of Expenses IRS requires that an organization use a reasonable basis for allocating expenses An organization must be clear on the methodology it is using to allocate expenses An organization must be prepared to support and defend its methodology for allocating expenses This required careful documentation McGuireWoods 70

71 Allocation of Expenses Many organizations use employee time as key driver of overhead cost allocation Timesheets maintained by employees are strong evidence supporting the allocation of time McGuireWoods 71

72 Positioning An Organization for an Examination Panel Discussion Eye toward examination Use of for-profit subsidiaries for Unrelated Business Activities Documenting for-profit motive and allocation of expenses Setting compensation Establishing and maintaining deferred compensation and employee benefits McGuireWoods 72

73 The Examination Process Panel Discussion Establishing the Team for an Examination Internal CPA Lawyer Privilege issues use of Kovel letter Responding to IRS information document requests (IDR) What to expect from IRS Appeals Should we go to court McGuireWoods 73

74 Questions or Comments? McGuireWoods 74