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Nonprofit tax preparation is not just about filing the right forms—it’s about protecting your organization from unnecessary IRS scrutiny. Even well-intentioned nonprofits can raise red flags if they make small mistakes on their returns. The IRS pays extra attention to nonprofits, especially those with larger budgets, because they benefit from tax-exempt status and rely heavily on donor trust.
When problems occur, the consequences can be serious: delayed funding, costly audits, or even the loss of exemption. But most issues can be avoided with clear processes, strong bookkeeping, and professional tax services.
This article covers the seven most common red flags that trigger IRS audits or reviews during nonprofit tax preparation; and how your organization can avoid them.
Why IRS Scrutiny Matters for Nonprofits
Nonprofits exist to serve the public good, not to make profits for private individuals. That’s why the IRS requires careful reporting: to ensure tax-exempt funds are being used appropriately.
What’s at Risk if You Get Flagged
- Penalties and back taxes – Mistakes may lead to fines or retroactive tax bills.
- Loss of tax-exempt status – Repeated issues can cause your nonprofit to lose its exemption, forcing you to pay corporate income tax.
- Damaged reputation – Donors, grantors, and community partners often review your IRS filings. Errors or inconsistencies can hurt confidence in your organization.
Why Scrutiny Is Higher for Nonprofits
The IRS is particularly watchful of nonprofits because tax-exempt status is a privilege, not a right. Every dollar a nonprofit receives is money that would otherwise be taxable. For example, when your nonprofit receives a $500,000 donation, the government wants to be sure it’s used for charitable purposes; not for executive perks or unrelated business ventures.
The good news is that with proper accounting services, most of these risks can be prevented.
Red Flag 1: Incomplete or Late Form 990
For nonprofits, the Form 990 is like a yearly report card. It provides a detailed look at revenue, expenses, leadership, and mission-driven activities. Donors, journalists, and watchdog groups often review it; and so does the IRS.
Common Errors That Cause Problems
- Forgetting to list board members or staff properly
- Leaving out schedules required for certain activities
- Reporting revenue without clear explanations
- Filing after the deadline without requesting an extension
Why It Matters
Missing or late Form 990s are one of the quickest ways to attract IRS attention. Worse, if you fail to file for three consecutive years, your nonprofit’s tax-exempt status is automatically revoked. Regaining it can take months and requires additional filing fees.
Tip: Always build in extra time before the deadline. A CPA who understands tax preparation for non profit organization can make sure nothing is overlooked.
Red Flag 2: Unrelated Business Income
The IRS allows nonprofits to earn money outside of donations, but only if those activities are connected to the mission. If too much unrelated business income (UBI) shows up on your return, the IRS may question your exempt status.
Examples of UBI
- A theater nonprofit running a coffee shop on the side
- A museum renting out its gift shop to outside vendors
- A community nonprofit running a parking lot for unrelated events
Some UBI is allowed, but it must be reported and may be taxable. If it becomes a major revenue stream, the IRS may decide your organization is acting more like a business than a charity.
Best Practices for Handling UBI
- Keep separate accounts for unrelated business activities
- Track all related expenses—these may offset taxable income
- Consult CPA services to determine if your activity qualifies as UBI
Red Flag 3: Excessive Executive Compensation
Nonprofits need strong leadership, but high salaries can raise eyebrows. The IRS is concerned about “private inurement”—where insiders personally benefit from nonprofit funds.
What the IRS Looks For
- Salaries far above industry averages
- Benefits like housing, luxury travel, or bonuses without clear justification
- Lack of board oversight in approving pay
How to Stay Compliant
- Use salary comparison data from similar nonprofits
- Have independent board members approve compensation packages
- Keep minutes showing how compensation was decided
Example: If a nonprofit director earns $450,000 while peers in similar organizations earn $180,000, the IRS may open an inquiry.
Following IRS guidelines on reasonable compensation and keeping transparent documentation can prevent issues.
Red Flag 4: Poor Bookkeeping Practices
Strong bookkeeping is the foundation of accurate nonprofit tax preparation. Without it, mistakes are almost guaranteed.
Common Signs of Weak Bookkeeping
- Commingling personal and organizational funds
- Missing receipts for donor-funded programs
- Expenses categorized inconsistently from year to year
Why It Matters
The IRS assumes poor bookkeeping could be hiding fraud—even if that’s not true. Donors also expect transparency. If your financial statements don’t match your tax filings, trust can erode quickly.
Outsourcing bookkeeping through nonprofit tax services ensures records are accurate, consistent, and audit-ready.
Red Flag 5: Large or Unusual Expenses
A sudden spike in expenses can signal trouble to the IRS. While growth and change are normal, unusual spending patterns should be well-documented.
Examples That Raise Questions
- Fundraising costs doubling from one year to the next
- Entertainment expenses without clear business purpose
- Large program expenses without explanation of outcomes
How to Avoid Misunderstandings
- Provide explanations in Form 990 for big changes
- Keep supporting documents like invoices and board approvals
- Consider using assurance services for added credibility
Example: If a nonprofit reports $200,000 in travel expenses one year compared to $50,000 the year before, the IRS may want to know why. With proper documentation, say, expansion into new regions, this won’t be an issue.
Red Flag 6: Failure to Report Donor Contributions Correctly
Donor reporting errors are one of the most common triggers for nonprofit audits. Contributions are highly visible, and the IRS expects accuracy.
Mistakes to Avoid
- Not distinguishing restricted vs. unrestricted gifts
- Forgetting to provide donors with acknowledgment letters for gifts over $250
- Failing to report in-kind donations such as donated services or goods
Why It Matters
Misreporting contributions doesn’t just upset the IRS—it can also upset donors. Imagine a foundation discovering that its restricted grant was listed as unrestricted. That can harm relationships and credibility.
Professional financial planning and analysis helps align donor reporting with both compliance and long-term strategy.
Red Flag 7: Weak Governance and Board Oversight
Governance is about accountability. If your nonprofit doesn’t demonstrate strong oversight, the IRS may assume resources are being misused.
Warning Signs of Weak Governance
- Family members making up most of the board
- No records of board meetings or votes
- Missing conflict-of-interest policies
Building Strong Governance
- Maintain written policies for conflicts of interest
- Ensure your board has independent, diverse members
- Keep detailed records of board discussions and decisions
Ready CPA supports nonprofits not only with tax filing but also with governance best practices to strengthen credibility with regulators and donors alike.
How to Avoid IRS Scrutiny
Avoiding IRS scrutiny doesn’t require extraordinary effort—just clear systems and accountability.
Practical Steps
- Keep organized digital records with tools like QuickBooks Online or Xero
- Review your Form 990 with your board before submission
- Document all executive pay decisions and unusual expenses
- Separate unrelated business income from mission-driven activities
- Work with professionals who specialize in nonprofit tax services
If your nonprofit’s budget is $500,000 to $10 million, outsourcing bookkeeping and compliance to a CPA firm can protect you from costly mistakes and free your staff to focus on the mission.
Why Choose Ready CPA for Nonprofit Tax Preparation
At Ready CPA, we’ve helped nonprofits across New Orleans and nationwide stay compliant and confident in their reporting.
- Nonprofit expertise – Decades of combined experience in nonprofit accounting and compliance.
- Advisory-focused approach – Ongoing support for budgeting, planning, and decision-making.
- Bookkeeping support – Flexible outsourcing to meet your needs year-round.
- Transparent fees – Fixed pricing with no surprises.
- Local + national reach – Serving South Louisiana, the Mississippi Coast, the Alabama Coast, and clients across the U.S.
Whether you need one-time filing help or ongoing accounting services, our team is here to help.
Take the Next Step
Nonprofit tax preparation doesn’t have to be overwhelming. With the right systems and a trusted CPA partner, you can reduce risk, avoid IRS red flags, and keep your focus where it belongs: on your mission.
Book a Call with Ready CPA today to discuss how we can support your nonprofit.
Or simply Contact Us to learn more about our CPA services.
FAQs
Do all nonprofits have to file Form 990?
Yes. Most tax-exempt organizations, including charities, must file a version of Form 990 each year. The type of form depends on annual revenue. Missing three years in a row means automatic loss of exemption.
What happens if my nonprofit reports unrelated business income?
You may owe taxes on that income. If it grows too large, the IRS may reclassify your nonprofit as a taxable business.
Can board members be family members?
They can, but too many related individuals on the board may raise IRS concerns. It’s best practice to maintain independence and diversity.
How can nonprofits avoid IRS audits?
Keep thorough records, file accurate Form 990s on time, document compensation and board decisions, and work with a CPA specializing in nonprofit tax preparation.
How much does nonprofit tax preparation cost?
Costs vary by size and complexity, but at Ready CPA, we offer fixed-fee pricing so nonprofits know exactly what to expect.