DATELINE: September 9, 2009, Chicago
Boy, that redesigned Form 990 sure is long and complicated. Undoubtedly some exempt organizations have had second thoughts on completing parts of it, or even filing it at all. They had better think again in light of a recent decision handed down by the United States District Court of New York—American Friends of Yeshivat Ohr Yerushalayim, Inc., v. U.S., 04-CV-1798 (July 29, 2009).
Admittedly, the American Friends is an extreme case, but it does hold some lessons. The organization failed to timely file its Form 990 for the tax years ending June 30, 2000, 2001, and 2002. The American Friends didn’t deny that it failed to file these returns on a timely basis, but sought abatement of the penalties for late filing. The organization filed late returns for the 1996 and 1997 tax years. The apparent excuse for the late filings for 1996 and 1997 was a...
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flood in the bookkeeper’s home, which damaged files. The excuse for 1997 was the bookkeeper’s need for bed rest due to a high-risk pregnancy.
Until August 2000, the office of the American Friends was in New York City. Its bookkeeper was one Michelle Fishman, although her husband, Howard Fishman, occasionally substituted for her. He also was the attorney representing the American Friends in the dispute with the IRS. The office was relocated to Chicago, Illinois, where Isabelle Kogan, the new bookkeeper, was located. Kogan was responsible for receiving tuition payments, paying disbursements, and maintaining the corporation’s financial records, among other responsibilities. Shortly after the relocation, steps were taken to ship a large number of American Friends’ financial documents and files to the new office in Chicago. However, they were never received and at the time of the court proceedings were considered lost by the organization.
American Friends claims that it was unable to timely file its Form 990 for the tax period ending June 30, 2000 because the financial records needed to file the return had been lost. Saul Strauss, the accountant for American Friends, required copies of bank statements for the organization in order to reconstruct the financial records to facilitate preparation of the return. American Friends asserts that it took Kogan several months to obtain duplicate copies of its bank statements, allegedly because the bank was not cooperative. Strauss did not receive the records until sometime in 2002. Once the records were received, it took Strauss some time to reconstruct American Friends’ records for the Tax year ending June 3, 2000.
The IRS assessed American Friends late filing penalties pursuant to 26 U.S.C. § 6652(c)(1)(A) for its failure to timely file its Form 990s. The following penalties were assessed: $50,000 for the tax year ending June 30, 2000, $24,100 for the
tax year ending June 30, 2001, and $8,800 for the tax year ending June 30, 2002.
American Friends claimed it had reasonable cause for its failure to timely file returns. In its letter to the IRS, American Friends explained that it had fired its bookkeeper (the opinion is jumbled on which bookkeeper was fired, and can be read to suggest that both bookkeepers were replaced) and moved to Chicago to work with a new bookkeeper, who never received the records from the old office and had to undertake a laborious and time consuming process of recreating the financial records.
The IRS rejected the argument that the Friends had reasonable cause for their failure to file. The IRS indicated that American Friends was previously assessed late filing penalties for the 1996 and 1997 Forms 990, and asserted that American Friends’ explanation for the late filings in both cases was that the bookkeeper failed to keep the necessary records. Based on this premise, the appeals officer found that American Friends did not exercise normal business care and prudence to ensure that the previously negligent bookkeeper was keeping the records in order. The IRS viewed the American Friends as “recklessly indifferent.”
The court noted that before a taxpayer can claim reasonable cause for failure to file a tax return, it must first demonstrate that it exercised ordinary business case and prudence. Probably much to dismay of the American Friends, its own accountant’s submission in the case was cited by the court as the basis for finding the absence of reasonable cause. The court states:
Accountant Strauss represented in his submissions to the IRS that the loss of the files during the move to Chicago was Fishman’s fault, and that Fishman was also responsible for the late filings in 1996 and 1997.
The IRS has been much criticized for some of the so-called governance questions in Part VI of the Core Form 990. One question that is clearly relevant to tax administration is the one asking whether the organization has a record retentions policy in place. The following description of the American Friends’ record retention practices from the court’s opinion borders on the comical:
Plaintiff states in its answers to interrogatories that Fishman sent 40 boxes to Chicago, 20 of which were returned to Mrs. Fishman’s home residence after Kogan refused delivery. Mrs. Fishman returned from a trip some time later to find the boxes waterlogged on her porch. Instead of making any efforts to salvage the financial records, Mrs. Fishman simply disposed of them.
So here are the lessons that can be drawn from the court’s opinion:
A. The Board Must Exercise Oversight. We saw no reference to the American Friends board in the court’s opinion, suggesting little involvement by the board. Once the bookkeeping and tax return preparation problems surfaced following the 1996 and 1997 failures to file, the board should have been demanding reports and proof that returns were timely filed. Those demands may have been made, but there is no evidence of it in the opinion. Boards need to exercise oversight once problems become known. Regulators often give organizations a second chance, but rarely a third one.
B. Record Retention is Critical. Too many organizations view accountants and recordkeeping costs as needless overhead. The outcome in this case demonstrates why shirking on recordkeeping systems and accountants are false economy. One can only begin to wonder how the board oversaw and management managed this organization given what the interim financial statements must have looked like, if there were interim financial statements.
C. Incomplete Returns. The instructions to the redesigned Form 990 carry the implication that an incomplete return will be treated as a late one. Organizations should honor the IRS’s admonition that all questions on the return and required schedules be answered unless the instructions specifically direct that the filer is to leave a space blank. As the American Friends case demonstrates, the penalties for filing a late return can be high. More importantly, even though the Form 990 is an information return, the IRS is taking late filing of these returns seriously.
D. Take Classification of Transactions Seriously. The American Friends misclassified tuition payments as income. This had the effect of pushing the organization’s revenues above $1 million. As a consequence, the organization was subjected to a more punitive penalty schedule. The court refused to let the organization adjust its income downward after the fact. This is just one example of why properly classifying transactions is important.
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