Nonprofit 101: Avoiding the Most Common IRS Pitfalls for Tax-Exempt Organizations

Running a nonprofit comes with both meaningful mission work and complex regulatory responsibilities. At K. Galloway & Co., CPA P.C., we help tax-exempt organizations navigate tricky compliance areas so they stay focused on impact — not IRS issues. This article breaks down the most common nonprofit IRS pitfalls  and provides clear examples to help your organization stay compliant.

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Understanding Unrelated Business Income (UBI)

Unrelated business income is one of the biggest sources of trouble for nonprofits. The IRS defines unrelated business income as revenue from a trade or business that is regularly carried on and not substantially related to the organization’s exempt purpose.

A Classic Example:

A youth-development nonprofit operates a thrift store to support its programs. The store is open year-round and functions like a typical retail business. Because selling donated goods generally qualifies for an exception, this may not produce UBI. But if that same nonprofit began selling new merchandise purchased wholesale, the IRS could classify the revenue as taxable UBI.

Common scenarios that create UBI problems include:

• Running a café or gift shop that does not directly align with your charitable mission
• Selling advertising space in event programs or on your website
• Charging fees for services unrelated to your exempt purpose

Nonprofits may earn some UBI, but they must report it on Form 990-T and pay tax on the profit. Repeatedly failing to do so places your exempt status at risk.

For more background, visit the IRS’ official UBI overview .

Inurement and Private Benefit: A Critical Compliance Zone

Inurement — when a nonprofit’s earnings improperly benefit insiders like board members, founders, or key employees — is strictly prohibited. Even a single act of inurement can cause the IRS to revoke tax-exempt status.

Examples of inurement include:

• Paying unreasonable compensation to executives
• Allowing board members to use organizational property for personal gain
• Giving loans or financial perks to insiders

Suppose a nonprofit pays its founder double the market rate for their position without documentation or a board-approved compensation study. This could be viewed as an excess benefit transaction, triggering IRS penalties and potential jeopardy to exempt status.

Private benefit is broader. It includes benefits to individuals or businesses outside the organization that are more than incidental. For instance, if a nonprofit awards scholarships but disproportionately favors the children of board members, the IRS may classify this as providing a prohibited private benefit.

To stay on the safe side, document compensation decisions, create conflict-of-interest policies, and follow strong governance procedures recommended by credible nonprofit governance authorities such as the National Council of Nonprofits .

Nonprofit Filing Deadlines: Avoiding Penalties & Automatic Revocation

One of the easiest, but most damaging, nonprofit compliance pitfalls is missing filing deadlines. Every tax-exempt organization must file some version of Form 990 annually:

• Form 990-N (e-Postcard)
• Form 990-EZ
• Form 990
• Form 990-PF for private foundations

These forms are due the 15th day of the 5th month after the organization’s fiscal year ends. For a calendar-year nonprofit, that means May 15 .

Missing the deadline comes with consequences:

• Late fees, which increase the longer the return is overdue
• Loss of public confidence due to missing filings on publicly searchable databases
• Automatic revocation of tax-exempt status after three consecutive missed years

Example:

A small arts nonprofit, run entirely by volunteers, forgets to file its Form 990-N for three straight years. The IRS automatically revokes its tax-exempt status, forcing the organization to reapply — a lengthy and sometimes expensive process.

Create internal calendars, assign return oversight to a responsible board member, and consider professional support to reduce filing risks.

Program- vs. Fundraising- vs. Administrative Expenses

While not a formal IRS “pitfall,” misunderstanding nonprofit expense categories can create audit red flags and public perception issues. Program expenses relate directly to the mission. Fundraising expenses relate to raising money. Administrative expenses support organizational infrastructure.

Problems arise when nonprofits:

• Misclassify fundraising expenses as program expenses
• Fail to document shared costs using allocation methods
• Drastically fluctuate in reported categories year over year

Example:

A nonprofit runs an annual gala and labels the entire event as a program expense because “it promotes mission awareness.” However, because the primary purpose is fundraising, most costs must be categorized accordingly. Misreporting could trigger IRS scrutiny and donor mistrust.

Accurate and consistent reporting helps nonprofits stay compliant and strengthens transparency.

Recordkeeping: A Nonprofit’s Best Defense

Maintaining strong financial and governance records is deeply important. While this may sound basic, many nonprofits fall short because they rely on volunteers or part-time staff.

Important records include:

• Board minutes and governance documents
• Receipts, invoices, and donor acknowledgment letters
• Grant agreements and program documentation
• Payroll and compensation records

These records become crucial during an audit or compliance review. They also support accurate Form 990 reporting and safeguard your organization from allegations of mismanagement.

Putting It All Together: Practical Tips to Help Stay Compliant

Below are actionable practices to help nonprofits stay out of IRS trouble:

• Regularly review revenue streams for potential UBI
• Adopt written conflict-of-interest and compensation policies
• Train board members on governance fundamentals
• Use a compliance calendar for federal and state filings
• Perform periodic internal financial reviews
• Work with qualified nonprofit tax professionals

These habits can help maintain good standing and support a strong organizational foundation.

Nonprofit compliance can be complex, but organizations do not need to navigate it alone. With guidance from experienced experts like K. Galloway & Co., CPA P.C., your nonprofit can maintain tax-exempt integrity, protect its mission, and operate for years to come.

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