Charitable Diversions: Tax Implications and Tips for Addressing Them

Editor: Annette B. Smith, CPA

Exempt Organizations

Federal tax laws and state charity laws require charitable organizations to use their assets exclusively for charitable purposes. The misuse of charitable assets has been a long-standing concern, and enforcement in this area has been a challenge for government authorities.

Until recently, diversion issues were uncovered primarily through audits or third-party referrals. This changed following the 2008 redesign of Form 990, Return of Organization Exempt From Income Tax,which requires more transparency by tax-exempt organizations. A key question now included on Form 990 asks, “Did the organization become aware during the year of a significant diversion of the organization’s assets?” (Form 990, Part VI, Section A, line 5).

A “diversion” includes any unauthorized conversion or use of the organization’s assets, other than for the organization’s authorized purposes, including embezzlement and theft, and is considered significant if it, along with all diversions for the tax year, exceeds the lesser of: $250,000; 5% of the organization’s gross receipts for the tax year in which the diversion or diversions occurred; or 5% of the organization’s total assets. Public disclosures responding to this question have prompted IRS inquiries and media attention.

Effect of Form 990 Reporting

In 2012, the IRS reviewed tax filings and publicly available online information of 285 organizations that reported a significant diversion of assets on their 2009 Forms 990 and considered how governance practices might contribute to these diversions. In the Exempt Organizations FY 2012 Annual Report & FY 2013 Workplan, the IRS noted it intended to conduct examinations and review the governance practices of the organizations both before and after diversion events.

In October 2013, a Washington Post report identified more than 1,000 nonprofit organizations that reported a significant diversion of assets since the 2008 redesign of Form 990 (Stephens and Flaherty, “Inside the Hidden World of Thefts, Scams and Phantom Purchases at the Nation’s Nonprofits,” The Washington Post (Oct. 26, 2013)). The report revealed that most diversions were attributable to theft or embezzlement and found that despite Form 990 instructions requiring specific details regarding the diversion, many organizations provided few details. In conjunction with its investigation, TheWashington Post created an online database listing organizations reporting a diversion and excerpts of the related Form 990 reporting.

Federal Tax Implications

Diversions give rise to many concerns. In addition to the financial loss to the organization and reputational and state law concerns, there may be federal tax implications for the organization and the persons responsible for the diversion. In cases involving “disqualified persons” (generally, insiders), a significant diversion of assets may constitute a prohibited inurement. In these cases, the IRS may assess intermediate sanctions taxes under Sec. 4958 (in the case of public charities) or self-dealing taxes under Sec. 4941 (in the case of private foundations).

Although the definition of disqualified person varies depending on the type of charity involved, the term generally includes board members and trustees, officers, substantial contributors, and their family members and related entities. Excise taxes generally apply to the disqualified person who benefited from the transaction and sometimes to the organization’s managers who knowingly approved of the transaction. When a diversion involves someone other than a disqualified person, the IRS will explore whether the persons responsible for the diversion reported the income for tax purposes.

In all cases of diversion, the IRS will consider whether the diversion was significant enough to jeopardize the organization’s exempt status and whether the organization has taken appropriate steps to address the diversion and prevent future occurrences.

Reporting Requirements

Organizations filing Form 990 are required to report a significant asset diversion on Part VI, Section A, line 5, and provide details on Schedule O, Supplemental Information to Form 990 or 990-EZ, explaining the nature of the diversion, the amounts involved, and corrective actions taken. (A diversion that occurred in a prior year must be reported in the year discovered.) A diversion resulting in an excess benefit transaction under Sec. 4958 also must be disclosed on Part IV, line 25, and on Schedule L, Transactions With Interested Persons. A private foundation filing Form 990-PF, Return of Private Foundation, should consider reporting diversions in Part VII-B, “Statements Regarding Activities for Which Form 4720 May Be Required.” These could raise self-dealing, taxable expenditure, qualifying distribution, and other concerns for the private foundation.

In addition, the private foundation may be required to complete Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code, and possibly report and pay excise taxes on the transaction. Individuals involved in the diversion also may have reporting requirements. For example, a disqualified person (or an organization manager) who is liable for tax imposed by Sec. 4941 or Sec. 4958 also must file Form 4720.

After the Diversion

After discovering a diversion, an organization’s leaders should immediately consider what steps to take next, including conducting an investigation to gain an understanding of all the facts. An investigation may be conducted by board members, a committee established by the board, or an independent third party such as outside counsel. Reviewing governance policies and internal procedures and taking corrective action also will be important. Corrective actions may include changes in internal procedures or personnel, seeking restitution or alternative recoveries, and cooperating with federal and state officials. Finally, the organization should take steps to protect against future diversions and comply with all reporting requirements noted above.

These steps may be critical to mitigating any adverse federal income tax implications and regaining the confidence and trust of the public, contributors, and other stakeholders.

EditorNotes

Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.

For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@us.pwc.com.

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.