The October 15 deadline for many plans

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1 THE PPC NONPROFIT UPDATE THE PPC NONPROFIT UPDATE, SEPTEMBER 2013, VOLUME 20, NO. 9 Employee Benefit Plans What You Need to Know, Part 2 The October 15 deadline for many plans Form 5500s is drawing near. So, as promised, here is Part 2 of our series on employee benefit plans. This article will focus on common deficiencies in plans and steps plan management can take to help prevent or detect compliance issues. We will follow up with an additional article about common deficiencies in plan audits in an upcoming issue of The PPC Nonprofit Update. To recap from our last article, most tax-exempt benefit plans, such as the 403(b) plans used by many nonprofit organizations, are subject to the provisions of the Employee Retirement Income Security Act of 1974 (ERISA). The Department of Labor (DOL) reviews Form 5500 schedules as well as financial statements and auditor s reports. Deficiencies can lead to hefty fines for plan sponsors. In addition to the DOL, the IRS reviews Form 5500 filings and audits selected tax-exempt plans. Their findings may result in excise taxes; penalties and interest; or, in extreme cases, loss of tax-exempt status. For these reasons, it is critical for plan administrators and plan auditors to arm themselves with information about plan compliance. This is not an easy task given the voluminous and complex rules and frequent law changes. While by no means all-inclusive, this list of commonly noted deficiencies is a good place to start for novices and a good refresher for veterans. Plan Deficiencies Plan deficiencies include failures to comply with the relevant ERISA rules, tax laws, or plan document provisions. The following are issues frequently noted by the DOL and/or the IRS in their examinations. Inaccurate Definition of Compensation. This is often an area of confusion. Should pre-tax contributions be withheld for bonuses? Severance? The types of compensation eligible for deferral are (or should be) defined in the plan document. Over time, administrative changes, such as new payroll systems or mergers, can cause plans to stray from the actual plan provisions. In this Issue: Employee Benefit Plans What You Need to Know, Part AICPA Audit Guide for Yellow Book and Single Audits Released Legal Entity Choice May Impact UBIT Tips on Charitable Travel Tax Brief This newsletter is also available online. Please call (800) , or order online at ppc.thomsonreuters.com.

2 2 THE PPC NONPROFIT UPDATE, SEPTEMBER 2013, VOLUME 20, NO. 9 Exclusion of Eligible Employees. Certain eligibility criteria are defined by statute for tax-exempt plans, while others are set forth by the plan document. For example, many plans have a minimum service requirement for eligibility. It is crucial that plan administrators monitor this and notify newly eligible employees in a timely fashion. Inappropriate Distributions. This issue often arises due to confusion with service providers over approvals. One party may think the other is responsible for approving loan or hardship withdrawal applications when in fact no one is actually doing it! As a result, distributions are made that do not comply with plan provisions or meet legal requirements. Failure to Amend. Plans need to be updated periodically to comply with new laws and regulations. In addition, internal changes at a plan sponsor, such as acquisitions or dispositions, may require changes to the plan. These amendments need to be made in a timely fashion in order to keep the plan in compliance. Discrimination against Non-key Employees. Employers cannot discriminate in favor of highly compensated employees. To prevent this, most plans must perform an annual discrimination, or top-heavy, test and, in the case of a failure, make additional contributions for nonkey employees. Late Remittances. Plans are required to remit contributions withheld from employee pay to the plan trustee or custodian as soon as the funds can be reasonably segregated from the employer s assets. While the absolute latest that funds can be submitted is the 15th business day of the month following withholding, after an employer establishes a pattern, any deviation from that pattern may be considered a late remittal by the DOL. Preventing and Detecting Compliance Issues There are a few steps plan management can take to help prevent or detect compliance issues such as those in the preceding list. Be familiar with the plan document. A best practice is to read over the document at least once a year. This will help to prevent any straying from provisions over time as well as highlight issues with current practices. It is also a good idea to revisit the document in conjunction with any significant changes at the plan sponsor, such as new system implementations, process changes, mergers, acquisitions, or layoffs. Educate yourself and your team. Because this is a complex and ever-changing field, regular training is important. This doesn t have to mean attending an expensive out-of-town conference. There are many quality webinars available on this topic. In addition, your accounting firm or other service providers may provide training classes or have good suggestions. Work closely with service providers. Outsourcing a function does not equal outsource responsibility. Work closely with third party administrators and trustees or custodians to make sure everyone is on the same page as to who is doing what. This is especially important during periods of change. When issues are identified, it is best to be proactive. There are several voluntary resolution methods available from the DOL and IRS. Plan management should work with ERISA counsel to determine which course of action is best. Remember, these provisions were all designed to protect plan participants, and that should be everyone s number one priority AICPA Audit Guide for Yellow Book and Single Audits Released The AICPA released the 2013 update of its audit guide, Government Auditing Standards and Circular A-133 Audits (GAS/A-133 Audit Guide) in June. The GAS/A-133 Audit Guide is developed to help auditors understand and properly apply the auditing and reporting requirements of Government Auditing Standards and OMB Circular A-133. You can access the 2013 edition of the GAS/A-133 Audit Guide on Checkpoint at ppc.thomsonreuters. com if you subscribe to the AICPA materials. [You can purchase a subscription by calling (800) ] The audit guide also can be purchased from the AICPA at cpa2biz.com. General Content Chapter 1 provides general guidance that is applicable to both Yellow Book and OMB Circular A-133 audits.

3 The remaining chapters are contained in two separate parts that discuss important considerations for audits conducted under Government Auditing Standards (Part I) and important considerations for Single Audits and program-specific audits conducted under OMB Circular A-133 (Part II). Each part contains chapters with topics related to planning, performing, evaluating the results of, and reporting on the audits. Both Parts I and II apply to audits on nonprofit organizations under an OMB Circular A-133 compliance audit. For nonprofit organizations that are required to have audits in accordance with the Yellow Book but do not meet the criteria for a single audit (a Yellow Book-only audit), only Part I applies. Highlights of New Guidance The 2013 edition has been extensively rewritten to incorporate the clarified auditing standards and the December 2011 revision of Government Auditing Standards throughout the GAS/A-133 Audit Guide, including its illustrative auditor reports. Although all of the changes are important, we especially want to bring to your attention the ones discussed below. Independence Guidance. Chapter 2 has been comprehensively rewritten. Carefully read its extensive discussion on independence, including what constitutes a nonaudit service (yes, the auditor s assistance with preparing the financial statements is a nonaudit service), what auditors need to do before providing a nonaudit service, when and how to apply the conceptual framework for independence, what management s responsibilities are, and what the auditor s responsibilities are. Report Changes. All of the reports have been rewritten to incorporate changes in the standards. Yellow Book Reports. Notable changes to the Yellow Book reports include: The title Independent Auditor s Report was added to the reports on internal control over financial reporting and compliance and other matters. The restricted use alert was replaced with a purpose alert. The reference to a management letter was removed. Report wording assumes the entity is a governmental entity. Revisions needed for not-for-profit entities are provided in notes to the reports. Single Audit Reports. Notable changes to Single Audit reports include: Major headings were added to clarify that the reporting includes several distinct reports: A report on compliance for each major program. A report on internal control over compliance. THE PPC NONPROFIT UPDATE, SEPTEMBER 2013, VOLUME 20, NO. 9 3 A report on the schedule of expenditures of federal awards, if applicable. (Reporting on the SEFA is illustrated both in the reports on the financial statements and the reports on compliance and internal control over compliance.) Subheadings were added in the report on compliance for each major program. The illustrated report language and use of subheadings are modified if the opinion on a major program is modified. The restricted use alert was replaced with a purpose alert for reporting on internal control over compliance (but not for reporting on compliance). An example was added to show how the auditor might include a table in the report to more clearly set out findings. In addition, the revised reports on the financial statements for use in a Yellow Book-only audit or a single audit are illustrated. The 2013 editions of PPC s Guide to Audits of Nonprofit Organizations and PPC s Guide to Single Audits include illustrations of reports tailored for a nonprofit organization. Applicability of AU-C 600 (Group Audits). The GAS/A-133 Audit Guide indicates that when more than one independent auditor is involved in a single audit, the auditor should use professional judgment to adapt and apply the guidance in AU-C 600, Special Considerations Audits of Group Financial Statements (Including the Work of Component Auditors). However, AU-C 600 is not directly applicable to a compliance audit because each major program is opined on separately. Unlike a financial statement audit, there is no entity-wide opinion on compliance. Due to the unique nature of an OMB Circular A-133 compliance audit, the concept of a component generally is applied only when other auditors have been separately engaged to perform a portion of a Circular A-133 compliance audit. The 2013 edition of PPC's Guide to Single Audits has been updated for relevant changes in the GAS/A-133 Audit Guide, as well as the 2013 OMB Circular A-133 Compliance Supplement.

4 4 THE PPC NONPROFIT UPDATE, SEPTEMBER 2013, VOLUME 20, NO. 9 Legal Entity Choice May Impact UBIT The type of legal entity used by exempt organizations for business and investment activities can affect their unrelated business income tax (UBIT) liability. Partnership Income General Rule. A partnership s income and deductions flow through to its partners. These partnership items retain their character in a partner s hands for unrelated business income (UBI) purposes. For example, partnership interest income is treated as interest income to a partner. Therefore, an organization s ownership of a partnership interest will normally generate UBI only if the partnership engages in an activity that would be an unrelated business if conducted by the partner organization or if the partnership has debt-financed property [IRC Sec. 512(c)(1)]. Does the Type of Partnership Matter? There are basically two types of partnerships: general and limited. A fundamental difference is that a general partner can participate in the management of the partnership, whereas a limited partner is legally precluded from management participation. Consequently, the ownership of a limited partnership interest is a passive investment similar to owning a rental property or royalty interest. Nevertheless, the UBI rules are the same whether an exempt organization owns a general or limited partnership interest. Reporting Rules. The general reporting rules applicable to for-profit partners also apply to exempt organization partners (EOP). An organization must report its share of the partnership UBI whether or not it is actually distributed; i.e., partnership income automatically flows through to the partners. If an EOP s tax year differs from that of the partnership, the organization reports its share of the partnership s income and deductions for the tax year of the partnership that ends within its tax year [IRC Sec. 512(c)(2); Reg (c)-1]. Sale of Partnership Interest. Gain or loss on the sale or disposition of a partnership interest normally is not subject to UBIT. However, gain or loss is includible in UBI in two instances: (1) the partnership interest is debtfinanced; or (2) the partnership owns debt-financed property (TAM ). Thus, the IRS has ruled that an EOP is subject to the debt-financed property rules on the sale of property even though it is owned indirectly through a partnership. S Corporation Income Qualified plan retirement trusts and tax-exempt charitable organizations ( qualified tax-exempt entities ) can be S corporation shareholders [IRC Sec. 1361(c)(6)]. An S corporation s income, losses, deductions, and credits flow through to a qualified tax-exempt entity in essentially the same way partnership income flows through to partners, but there s a profound difference S corporation items do not retain their character in the hands of a shareholder. Instead, a qualified tax-exempt entity (other than an employee stock ownership plan) must treat its entire share of S corporation income as UBI [IRC Sec. 512(e)]. In addition, any gain or loss on the sale or other disposition of S corporation stock must be included in UBI. This exception to the general rules exclude gain or loss on the sale of assets from UBI [IRC Sec. 512(b)(5)]. Special basis adjustment rules are used to calculate basis for gain or loss purposes [IRC Sec. 512(e)(2)]. Controlled Organization Income An exempt organization s portfolio income (e.g., interest and dividends) and passive income from rental real estate is normally excluded from UBI. However, certain payments received or accrued, directly or indirectly, from a controlled entity are included in the controlling organization s UBI to the extent the payment reduces the net unrelated income (or increases any unrelated loss) of the controlled entity. The payments subject to this rule are interest, annuities, royalties, and rents (but not dividends), and net of any deductions allocable to them. Income is included in the parent s UBI in the year the payment obligation accrues, whether or not payment is received in that year [IRC Sec. 512(b)(13)(A)]. In addition, these types of payments are includible in UBI under certain circumstances to the extent they exceed what is deemed allowable under IRC Sec. 482 [IRC Sec. 512(b)(13)(E)(iv)]. The IRS can reallocate the gross income, deductions, credits, and other allowances of related taxpayers in order to clearly reflect the income of each of the related organizations or to prevent tax evasion. Control Defined. A corporation is controlled if the exempt organization owns (by vote or value) more than 50% of its stock. Control is determined by applying the constructive ownership rules of IRC Sec Thus, a second-tier taxable subsidiary can be deemed owned for control purposes by other members of the affiliated group besides its first-tier parent (Ltr. Rul ). In the case of a partnership, control means ownership of more than 50% of its profits interest or capital interests.

5 UBI Calculation. If the controlled entity is tax-exempt, the unrelated income or loss is the amount of the controlled entity s UBI or loss. If the controlled entity is taxable, net unrelated income is the portion of its taxable income that would be UBI or loss if it were tax-exempt and had the same exempt purpose as the controlling organization [IRC Sec. 512(b)(13)(B)]. This income inclusion rule prevents tax-exempt organizations from converting taxable UBI into nontaxable passive income by placing the unrelated business in a separate entity and sheltering that entity s income by having it make deductible payments in the form of interest, annuities, rent, or royalties back to its tax-exempt parent. Exempt organizations should carefully consider the severe tax ramifications of an S corporation before investing. Tips on Charitable Travel Travel in service to, or on behalf of, a charitable organization as a volunteer can be doubly rewarding. There s not only the satisfaction of giving back to the community, but also a charitable income tax deduction (provided the taxpayer itemizes deductions on Schedule A of Form 1040) for unreimbursed travel expenses [Reg A-1(g)]. The IRS recently published tips for volunteers concerning the tax deductibility of charitable travel (Summertime Tax Tip ). Qualified Organization The organization must be a qualified charity. It must be both tax-exempt and eligible to receive charitable contributions. People often mistakenly assume that an organization qualifies simply because it is not-for-profit or is tax-exempt, regardless of whether it also satisfies the requirements of IRC Sec. 170(c). The Subjective Test Unreimbursed travel expenses are deductible only if there is no significant element of personal pleasure, recreation, or vacation in the travel. As noted in a Tax Court summary opinion, the meaning of this language is far from self-evident. It is clear that the deduction will not be jeopardized simply because the volunteer THE PPC NONPROFIT UPDATE, SEPTEMBER 2013, VOLUME 20, NO. 9 5 enjoys the trip (Tax Tip) or enjoys providing services to the charity (Field, TC Summary Opinion ). A taxpayer working on an archaeological excavation sponsored by a charitable organization for several hours each morning with the rest of the day free for recreation and sightseeing will not be allowed a deduction even if he or she works very hard during those few hours. In contrast, a charitable organization s local chapter member who attends an all-day regional meeting will not be subject to the travel disallowance rule by attending the theater in the evening (IRS Notice 87-23, CB 467). The Court in the Field case considered the relevant question to be the extent and duration of the charitable services provided by the taxpayer and not some quantum measure of pleasure derived by the taxpayer. Consequently, both Field and the previous IRS example imply that the relationship of service time to free time is critical. The Tax Tip adds that you can deduct your travel expenses only if your work is real and substantial throughout the trip. Consequently, you cannot deduct expenses if you have nominal duties or do not have any duties for significant parts of the trip. The personal pleasure rule also applies to expenses paid indirectly; e.g., the volunteer makes a contribution to the charitable organization and the charity then pays the travel expenses. What s Deductible? Deductible travel expenses include, for example: air, rail, and bus transportation, automobile expenses, reasonable food and lodging costs necessarily incurred while away from home, and transportation costs between the airport or station and the hotel. There is no deduction for the value of a volunteer s time or services. The Rest of the Story The IRS tax tips do not mention two important additional rules for deducting charitable travel: Substantiation. Unreimbursed volunteer expenses have the same substantiation requirements that apply to cash contributions. To substantiate a cash gift, a donor must produce one of the following [Reg A-13(a)(1)]: a cancelled check;

6 6 THE PPC NONPROFIT UPDATE, SEPTEMBER 2013, VOLUME 20, NO. 9 The PPC Nonprofit Update is published monthly by Thomson Reuters/Tax & Accounting, P.O. Box 966, Fort Worth, Texas , (800) COPYRIGHT 2013 BY THOMSON REUTERS/ PPC. Reproduction is prohibited without written permission of the publisher. Not assignable without consent. This publication is designed to provide accurate information regarding the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, investment, or other professional advice. If such assistance is required, the services of a competent professional should be sought. Reports on products or services are intended to be informative and educational; no advertising or promotional fees are accepted. Tax & Accounting Research and Guidance P.O. Box 966 Fort Worth, Texas PRSRT STD U.S. POSTAGE PAID Thomson a receipt (or letter or other communication from the donee charity) showing the donee's name, contribution date, and contribution amount; or when neither a cancelled check or receipt is available, "other reliable written records" showing the donee's name, contribution date, and amount. The Van Dusen case held that substantial compliance (rather than strict compliance) with Reg A-13(a)(1) was enough to support a charitable deduction for a volunteer s unreimbursed expenses. A contribution of $250 or more must, in addition to meeting one of the three recordkeeping requirements described previously, be supported by a contemporaneous written acknowledgment from the donee charity [Reg A-13(f)(1)]. A taxpayer who incurs unreimbursed expenditures when rendering services must obtain a statement from the charity that describes the services provided [Reg A-13(f)(10)]. (See the July 2011 issue of PPC s Nonprofit Update for further discussion of the Van Dusen case and the substantiation rules.) Service to the Charity. The Tax Tip does not make it clear that a charitable deduction for unreimbursed expenses is permitted under Reg A-1(g) only if the expenditures are made incident to the rendition of services to a charitable organization. A volunteer s activities, although beneficial to the organization, may not necessarily be considered services to it. For example, suppose Charity (C) sends several of its officers and selected others to a conference that covers topics of interest to C. Volunteer (V), who is neither an officer nor a selected delegate, attends the conference. Since V is not acting at the request or direction of C, V s expenses are not deductible even though V s attendance could be beneficial to C (See Rev. Rul , CB 94). Charitable organizations should remind their volunteers of the opportunity to deduct out-ofpocket expenses and diligently provide the necessary supporting documentation. Tax Brief IRS FOCUSING ON SECTION 457(b) PLANS. Taxexempt entities can sponsor non-qualified deferred compensation plans for select groups of highly compensated employees, managers, directors, or officers. The Employer Plans Compliance Unit expects to send compliance check letters and questionnaires to approximately 200 sponsors of Section 457(b) plans, or Top Hat plans, in the IRS fiscal year ending September 30, 2013, and to another 200 in the fiscal year ending September 30, The objectives of these requests for information are to learn more about the actual operation of these plans, verify that they are satisfying applicable statutory requirements, identify noncompliance issues, and identify ways to remove any barriers to statutory compliance.

Gaming activities are a significant

The PPC Nonprofit Update, October 2010, Volume 17, No. 10 THE PPC NONPROFIT UPDATE Winning Score for Nonprofits: Gaming Activities Fun, UBI Taxes Zero! Gaming activities are a significant revenue source