How Noncompliance Reports Can Turn into IRS Audits
Regardless of how well you run your tax credit site, your state housing agency may cite you for noncompliance with the tax credit law. If that happens, your state housing agency must notify your site’s owner of the violation and report it to the IRS using IRS Form 8823 (Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition).
If the state housing agency issues the owner a Form 8823, the owner will be aware that it’s likely to be under IRS scrutiny. Although a site’s tax return can be selected independently for a number of reasons and audited by the IRS for any large, unusual, or questionable issue, a single Form 8823 puts any return much closer to an IRS audit simply because, by definition, it has identified an owner that’s not in compliance with Section 42 of the Internal Revenue Code.
Four Steps that Lead to Audit
We’ll explain the four steps that need to occur for a noncompliance notice to result in an IRS audit.
Step #1: The state agency sends a Form 8823 to the IRS and a copy to the owner. When a Form 8823 is issued by the state agency, it is generally not an instant decision on the part of any agency unless the form is issued because of one defining event, such as a building disposition. The overall process of monitoring project compliance is ongoing between each state agency and owner. The state agency may make numerous contacts with the building owner and property managers to resolve noncompliance issues identified through their reviews of the tenant files and inspections of the property.
State housing agencies must file Form 8823 with the IRS no more than 45 days after the deadline for correcting a violation (known as the “correction period”). Agencies usually wait until sites have had a chance to correct the noncompliance before filing this form. At that point, the agency would send Form 8823 to the IRS, with a copy sent to the owner. If the noncompliance was corrected, the agency will indicate this on the form (line 9). That way, the IRS will learn up front that you acted diligently in correcting noncompliance.
At the IRS, Forms 8823 are initially screened, and may be immediately selected for further audit consideration. The IRS will match the Form 8823 with the owner’s tax return for the year of noncompliance. The IRS then determines whether the owner’s tax return should be audited.
Step #2: The IRS reviews the owner’s tax return, even if the owner corrected the noncompliance after the Form 8823 was issued. Receiving a Form 8823 gives the IRS a reason to look at a tax return. The IRS will interpret it as a notice that something is wrong with respect to IRC Section 42, the Low-Income Housing Credit. At this point, the IRS not only analyzes the owner’s return for IRC Section 42 issues, but will also consider any other item that appears large, unusual, or questionable.
A corrected Form 8823 may be a good thing for the state agency, but it may arrive at the IRS a couple of days, weeks, months, or even years after the original Form 8823 was received, and perhaps long after the original Form 8823 and corresponding tax return have been reviewed for audit consideration.
A corrected Form 8823 won’t reverse the IRS’ process for identifying tax returns for audit. Even though the noncompliance may have been corrected, the potential still exists for a portion of the current year credit to be disallowed and for the recapture of prior year credit. This is especially true when a portion of the building was found not to qualify for IRC Section 42 credits and the noncompliance wasn’t corrected until after the close of the tax year.
Step #3: The IRS weighs certain factors to determine whether an audit is warranted. The number of Forms 8823 issued by the agency on a LIHTC site, or the type of noncompliance item checked on the form, or the number of noncompliance items checked on the form are considered to determine if an IRS audit is warranted.
Owners may believe that the IRS considers the number of Forms 8823 issued on a LIHTC project as indicative of either how isolated, or how widespread, the noncompliance may be. For example, if a project consists of 10 different buildings, and a noncompliance issue for each building is reported to the IRS, it indicates a high level of widespread noncompliance. On the other hand, an owner may also worry when a Form 8823 is filed for noncompliance with a single requirement, which could result in some type of credit adjustment or recapture, such as when a household’s income was above the income limit upon initial occupancy, the project failed to meet its minimum set-aside requirement, or the project is no longer in compliance or participating in the IRC Section 42 program. Noncompliance issues are not only tough to correct, but they can be widespread and significantly reduce the amount of credit an owner can claim.
Of course, an owner might also be concerned about repetitive noncompliance. Even if a tax return isn’t selected for audit, all Forms 8823 issued by the agency are retained by the IRS and can be associated with any future Forms 8823 received from the state agency.
These factors are all logical and have some bearing on the decision of whether to audit a site or not. But there’s no way of knowing for sure how much weight these factors are given when the IRS reviews a specific tax return for audit.
Step #4: The IRS reviews the tax return for all other items that are large, unusual, or questionable. Once the IRS has the tax return, it’s not good business sense to simply analyze the return for IRC Section 42 issues. There are hundreds of other code sections that potentially could impact the owner. So, in addition to IRC Section 42 issues that originated with Form 8823, the IRS will take the time to see if any other large, unusual, or questionable issues warrant examination. The issue may not pertain to the LIHTC program, but the issue may warrant an audit just the same.