Significant, Indeed: What to Make of Nonprofit Fraud and Significant Diversions of Assets (Part 2)

Previously in this series, we’ve provided a primer on what constitutes a diversion of assets, as well as how to manage an internal investigation if a diversion is discovered at your organization. However, once you discover fraud, you must also report it to the IRS. Why does the IRS need to know, when their primary focus should be on tax compliance? And what do they need to know? Read on to learn more.

Transparency is necessary. In 2009, tax filings and publicly available data on the 285 organizations that reported a significant diversion of assets revealed that nearly $170 million in significant diversions was identified, resulting in 82 civil or criminal charges. These were all charges levied by either the organizations that were involved, or by local authorities, many of whom were understandably outraged by the fraudulent activity. As a result, 47 people were incarcerated or served probation for the diversion of assets. Interestingly, however, none of this activity came about as a result of IRS actions.

In April 2012, the IRS announced the results of a study it had launched in order to determine whether or not a well-governed organization was more likely to be tax-compliant. It found that there were two lynchpins between “good governance” practices and tax compliance: a board of directors that was significantly involved in setting compensation, and the establishment of procedures for the proper use of charitable assets.  At the same meeting, the IRS announced a new review program in which it would audit organizations that had indicated having a significant diversion of assets.

The revised Form 990 Part VI, Section A (Governing Body and Management) line 5 asks:  Did the organization become aware during the year of a significant diversion of the organization’s assets? The instructions to Form 990 further explain how this question should be answered. As you may recall, the Governing Body and Management section was controversial when it was added to the Form 990; segments of the public argued that only questions authorized by the statute should be reported on the form. The IRS responded, maintaining that a well-governed organization was more likely to be tax-compliant. In order to ensure that taxes are properly collected, therefore, they had to have the authority to ask these questions.  Many in the nonprofit sector agreed that the transparency provided by the new form allowed the public to gain information that was necessary, especially in the case of a donor who was considering making a gift to a charity.

Follow appropriate procedures and protocols. With all this in mind, what is supposed to be reported, and when?  “Significant” means the gross value of all diversions (not taking into account restitution, insurance or similar recoveries) discovered during the organization’s tax year to the extent that they exceed the lesser of:

1) 5 percent of the organization’s gross receipts for its tax year,
2) 5 percent of the organization’s total assets as of the end of its tax year, OR
3) $250,000.

If the organization became aware of the diversion during the tax year, even though the diversion occurred in another year, the diversion is supposed to be reported.  The organization is supposed to report on Schedule O the nature of the diversion, the amounts or property involved, corrective actions taken to address the matter and other pertinent circumstances.

Do you think it is black and white as to whether there has been a “significant diversion of assets?