In a previous news brief, Nonprofit fraud isn’t worse – but it’s different, we commented on how fraud that occurs in a Nonprofit is different from a for-profit entity.  Nonprofits should be aware that if a fraud does occur within their organization, there may be additional reporting requirements due to the occurrence of the fraud.

Many 501(c) exempt organizations are required to file Form 990, Return of Organization Exempt From Income Tax.  Since the 2008 redesign of Form 990, nonprofit organizations have been held to a higher standard of transparency.  Part VI, Section A, covers certain management and board governance best practices.  Question 5 asks “Did the organization become aware during the year of a significant diversion of organization’s assets?”  The instructions indicate that a significant diversion occurs when the gross amount exceeds the lesser of 5% of gross receipts, 5% of total assets at year end, or $250,000.

If a significant diversion of funds occurs during the year, Form 990 requires the organization to include on Schedule O the nature of the diversion, dollar amounts of cash and property involved, corrective actions taken to address the matter and pertinent circumstances of the diversion. The instructions clarify the organization should not identify the person or persons who diverted the assets by name, presumably because Form 990 is a public document and naming an individual could result in a claim of defamation, libel, or slander against the organization.

Be aware that if the organization answers that the organization did have a significant diversion of funds, the IRS is likely to select the return for audit. In 2012, the IRS reviewed tax filings of 285 organizations that reported a significant diversion of assets on their 2009 Forms 990.  In the Exempt Organizations 2012 Annual Report, the IRS noted it intended to conduct examinations and review the governance practices of the organizations both before and after diversion events.  We have seen additional scrutiny by the IRS of organizations that report a significant diversion of funds.

Significant diversions must be reported no matter who is involved whether it be an officer, a director, an employee or an unrelated third party. If assets are diverted by an individual who stands in the position of a disqualified person to the organization, the diversion could also amount to private inurement of the organization’s net earnings which can threaten the non-profit’s tax-exempt status. A disqualified person is any person who was in a position to exercise substantial influence over the affairs of the organization at any time during a 5-year period ending on the date of the transaction. Persons who hold certain powers, responsibilities, or interest are among those who are in a position to exercise substantial influence over the affairs of the organization including any officer, director, or trustee, among others.

In the case of section 501(c)(3) public charity, 501(c)(4), and 501(c)(29) organizations, it also can be an excess benefit transaction taxable under section 4958 and reportable on Schedule L. Under section 4958 any disqualified person who benefits from an excess benefit transaction with a (c)(3), (c)(4), or (c)(29) organization is liable for a 25% tax on the excess benefit. That could increase to 200% if not corrected by a certain date. In the case of  501(c)(3) private foundations, a diversion by a disqualified person is also a self-dealing transaction subject to penalties and reportable on Form 990-PF.

If an organization discovers that a misappropriation of funds has occurred within the exempt organization, management should immediately inform their board of directors of the situation.  Organization leaders should conduct an investigation to gain an understanding of all of the facts.  An investigation may be conducted by board members, a committee, or an independent third party such as outside counsel.  Reviewing governance policies and internal control procedures will be important.  Governance may find it necessary to make changes in internal control procedures, change personnel, and seek restitution or alternative recoveries.  The organization should take steps to protect against future diversions.  Contact us if you are concerned about the potential for a significant diversion in your organization for additional advice and guidance on evaluating your internal controls.