21 May 2020

5 Ways to Prepare for an IRS Audit

Founder Raul Rivera

When we hear about the IRS conducting audits for churches and ministries, it is common to allow fear, worry, and uncertainty to creep into our minds. We often wonder if our books are in order, or think about what was discussed at the previous board meeting.

Certainly, no one wants to go through an audit, but if you and your church are well-prepared for an IRS audit, then you will find the process to be nearly stress-free. 

In today’s blog, I will discuss how and why an audit happens, what goes on in the audit process, who can be audited, and five ways to prepare for an audit.

How and why does an audit occur?

It is unfortunate, but many church audits begin when a church member or church employee feels hurt by the church in some way or another. As a form of retaliation, the member or employee may use his or her firsthand knowledge of the church’s activities as a means to get even.

Perhaps this is a scenario that hits close to home for you. Regardless, well-meaning pastors and church leaders often unknowingly make decisions that could jeopardize their church’s tax-exempt status or result in hefty fines and penalties if discovered by the IRS.

The audit process

The Internal Revenue Manual (IRM) defines a church tax inquiry (church audit) as 

any inquiry to a church … that serves as a basis for determining whether the organization qualifies for tax exemption as a church, or whether it is carrying on an unrelated trade or business or otherwise engaged in activities subjected to any [Internal Revenue Code] IRC tax. (See IRM 4.76.7.4)

Furthermore, section 7611 of the IRC gives guidelines for how the IRS may begin a church tax inquiry. According to section 7611, the IRS may begin a church tax inquiry only if the following are met:

  • An appropriate high-level treasury official reasonably believes, based on written data, that a church is not operating in a manner consistent with its purpose and section 501(c)(3), or the church is conducting any unrelated business activities.
  • The IRS sends the church a written inquiry notice containing an explanation of the concerns it has that have caused the inquiry, the subject of the inquiry, and the legal authority it is given to perform said inquiry based on its concerns. 

Now, the IRS cannot simply knock on the doors of your church with the intention of performing an audit. There are specific requirements and steps that the IRS must follow before conducting a church audit. One of those requirements is the “Reasonable Belief Requirement.” 

According to the IRS, they can “begin a church audit only if an appropriate high-level treasury official reasonably believes, based on a written statement of facts and circumstances, that the organization: (a) may not qualify for the exemption; or (b) may not be paying tax on unrelated business or other taxable activity. This reasonable belief must be based on facts and circumstances recorded in writing.”

The IRS may use the following sources, including, but not limited to, the examples below to support the reasonable belief requirement:

  • Newspaper or magazine articles or ads,
  • Television and radio reports,
  • Internet web pages,
  • Voters guides created and or distributed by the church,
  • Documents on file with the IRS, 
  • Reliable information reports from concerned members of the church or the general public, and
  • Records concerning the church in possession of third parties or informants.

The IRS website states that the IRS must derive the facts and circumstances forming the basis for a reasonable belief from information lawfully obtained. If this information is obtained from informants, it must prove to be reliable. 

The failure of the church to respond to repeated IRS routine requests for information is a factor in determining if there is reasonable cause for commencing a church audit. So, it is imperative to answer all correspondence sent by the IRS promptly.

Who can be audited?

Now, you are probably wondering about who can be audited? 

Any person can find themselves being audited by the IRS—pastors and church members included. However, the IRS has several criteria to look for when viewing filed tax returns. Though anyone can be audited, not everyone is likely to be audited. With that being said, it should be noted that religious institutions are not necessarily shielded from IRS audits. That is why it is best to always be prepared in the event the IRS should audit your church or ministry. 

Rowe v. United States is a great example that demonstrates how churches may be subject to IRS scrutiny through audits against their clergy members despite special procedural safeguards for such religious institutions. To help safeguard yourself and your organization, we recommend using the StartRIGHT Service to help you start right and stay in compliance.

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How to prepare and protect your church from an IRS audit

Many pastors ask what they can do to protect their church during an audit, which is a valid question. Here are a few suggestions for you to consider to help safeguard and protect your ministry. 

1. Maintain board meeting minutes.

Recording board meeting minutes is extremely important. Board meeting minutes serve as the official documentation of the corporate acts of your church. Without board meeting minutes, your church cannot prove that the church properly approved corporate actions such as the appointment of board members, the adoption of your bylaws and policies, and the approval of salaries. As a nonprofit organization, all corporate actions of the church must be properly documented in well-maintained board meeting minutes.

2. Document all salaries and compensation.

The approval of salaries and compensation should be documented diligently. Salaries paid by your church should be approved by the board of directors annually during a properly called board meeting. Additionally, honorariums to guest speakers should be treated appropriately. This means that your church should obtain Form W-9 from every guest speaker, and a 1099-MISC should be given to each speaker that receives $600 or more from your church in one year.

3. Review your church’s activities.

When reviewing your church’s activities, you will want to make sure that each ministry and department directly relates to your church’s purpose. If you find an activity that may be considered an unrelated trade or business activity (e.g., a bookstore or coffee shop), then you will want to consider starting a church-owned business.

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4. Review your church’s printed and publicized materials.

Since the IRS can use any printed or publicized material as a source of “reasonable belief” to begin a church inquiry, you will want to be sure to keep a close guard on such materials. This also includes your church’s website. It is best not to include any advertisement type on your church’s website because, depending on the facts and circumstances, they may be considered unrelated business activity and could potentially jeopardize your church’s tax-exempt status.

5. Review all of your church’s internal governing documents.

There are several documents that your church must review and maintain regularly, such as:

  • Your church’s articles of incorporation, amendments, annual reports, charity registration, IRS approval letter, and any letters regarding the church updating its public record.
  • Your church’s bylaws.
  • Your church’s written doctrines.
  • Your church’s policies and procedures. (You will want to make sure that your church has a conflict of interest policy, accountable reimbursement policy, and a benevolence policy.)
  • Corporate contracts such as leases and titles to property.
  • Accounting and bookkeeping records.
  • Current and accurate membership records.

Facing an audit stress-free

Perhaps you are unsure where to begin or what your next steps should be. To help you with this process, I recommend using our bookkeeping service to help you keep compliant and accurate financial records. By hiring a bookkeeper to handle your church or ministry’s finances, you can be sure your books are in good hands, making the idea of an IRS audit less stressful.

If you are still uncertain about how your church or ministry would hold up in an IRS audit, I encourage you to call our team at 877-494-4655. Our specialists will help you determine how your church or ministry would hold up, and what further steps you can take to keep your ministry safe.

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Please feel free to comment. We always appreciate good dialogue. However, we do moderate each comment to ensure that it is on topic and not derogatory to other participants. We ask that you keep your comments brief and pertinent to the topic so that others may benefit.

Blessings,
Raul Rivera


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