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Our offices are closed tomorrow 1/7/25 from 8am – 1pm for a firm event. Thank you.
Too few nonprofits keep healthy operating reserves. A study of charities in the Washington, D.C., area, for instance, found that 57% of the organizations had insufficient operating reserves to cover three months of expenses — the minimum level many experts consider necessary to maintain financial stability.
Forgoing reserves leaves your nonprofit vulnerable to rapid or unexpected drops in revenue or jumps in expenses. You may regard such funds as optional or a luxury, but that’s just not the case these days.
The Nonprofit Operating Reserves Initiative Workgroup defines “operating reserves” as the portion of unrestricted net assets that nonprofits designate to sustain financial operations. The assets would be tapped in the event of significant unbudgeted increases in operating expenses or losses in operating revenues. Reserves also should be liquid, or easily converted to cash.
Note that operating reserves and cash on hand are not the same. Cash is often restricted for specific purposes, such as future projects or programs, and is therefore unavailable for other uses, unlike reserves.
Operating reserves also are distinct from endowments. Endowments are restricted, as well, and the organization can typically spend only the interest generated by the principal funds, making that money unavailable for daily operations.
The times are turbulent, and even when the economy gets solidly back on its feet, it won’t stay that way indefinitely. Operating reserves can help nonprofits bridge the gap when revenue streams or donations fall off because of a wobbly economy.
Robust reserves also allow organizations to seize unexpected opportunities, set aside funds for long-term goals and plans, and cover increased expenses after a natural disaster or other emergency hits.
You also can tap reserves to ramp up your staff and deliver services under federal contracts that don’t provide payment for 30 to 60 days. Reserves will come in handy, too, if grants fail to come through, or major fundraising events are delayed or canceled.
There’s no universal operating reserves benchmark that applies to every organization, and the question of an appropriate operating reserves amount can raise some thorny issues among stakeholders. Some may argue, for example, that the nonprofit has an ethical obligation to devote as much of its available resources as possible to carrying out its mission. Others might worry about the appearance or difficulty of soliciting additional donations while sitting on significant reserves.
Reserves, however, aren’t about accumulating wealth. They’re about securing the financial stability necessary to function effectively for the long run.
According to the Workgroup, you need to consider several questions when setting the goal amount, including:
The Workgroup recommends a minimum reserves level of 25% or three months of your nonprofit’s annual expense budget. The adequacy of reserves beyond that amount will depend on specific circumstances.
Organizations without sufficient operating reserves can run into trouble meeting payrolls, paying bills, providing services and retaining qualified staff. Your CPA can help you determine the amount of reserves you need to minimize such risks.
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With election season heating up, not-for-profits must take care not to stray into prohibited political activity that could jeopardize their tax-exempt status. The IRS has addressed the acceptability of several common activities. Knowing the agency’s position on these activities could save you tax trouble down the road. Ban on political campaign interventionThe Internal Revenue Code is clear: For a nonprofit to maintain its status, it can’t “participate in, or intervene in (including the publishing or distributing of statements) any political campaign on behalf of (or in opposition to) any candidate for public office.” But that doesn’t mean your hands are completely tied. If certain conditions are met, not-for-profits can indeed be active — though nonpartisan — players in the political arena. Voter contactNonprofits can conduct voter registration and get-out-the-vote drives if they’re conducted in a neutral, nonpartisan manner. But you can’t, for example, refer to any candidate or party, either in support or opposition. Voter education activities, such as the preparation and distribution of voter guides, are similarly allowed if conducted in a nonpartisan way. The IRS will consider whether the questionnaire used to solicit candidate positions or the guide itself demonstrates a bias or preference in content or structure with respect to the views of a particular candidate. The timing and distribution of voter education materials also could be relevant. Candidate appearancesA not-for-profit can invite a candidate to speak at an event in his or her capacity as a candidate if 1) it provides to all of the candidate’s rivals an equal opportunity to participate, 2) it doesn’t indicate support for or opposition to any candidate (including in introductions and communications about a candidate’s attendance), and 3) no political fundraising takes place. When evaluating whether equal opportunity to participate has been provided, the IRS will consider both the manner of presentation and the nature of the event to which each candidate is invited. You’ll probably violate the prohibition if, for example, you invite one candidate to speak at a heavily attended annual banquet but invite his or her opponent only to a poorly attended general meeting. If you invite a candidate to appear in his or her individual, noncandidate capacity, you must ensure that:
Candidates also may attend a not-for-profit’s event that’s open to the public as long as the organization doesn’t publicly recognize the candidate or invite him or her to speak. Business activitiesAn activity such as selling or renting mailing lists, leasing office space or accepting paid political advertising may constitute prohibited activity. The determination will depend on several factors. These may include whether the good, service or facility is available to rival candidates on an equal basis, whether it’s available to the general public, whether the fees charged are the nonprofit’s usual rate, and whether the activity is an ongoing activity of the organization (as opposed to conducted for only a particular candidate). Proceed with cautionViolation of the ban on political activity could result in the denial or revocation of your nonprofit’s tax-exempt status, as well as the imposition of an excise tax on the amount spent on the prohibited activity. The determination of whether an activity is political will ultimately depend on the specific facts and circumstances. But remember, the underlying criterion for an activity not to be political is generally that the activity clearly be nonpartisan. |
SKR+Co Nonprofit Newsletter
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Meet our Nonprofit Specialists
Steve Hochstetter, CPA, CVA, Audit Partner
Our Nonprofit Services
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Do you bite your nails before your not-for-profit’s external audit each year? Does your staff start showing signs of anxiety in anticipation of the auditors walking in the door?
If this sounds like your situation, take a deep breath. Here are five tips for making the audit experience run more smoothly for you and your auditors.
Ask your auditor for a list of items they’ll need during the audit, with deadlines for each item, if such a list isn’t provided automatically. Talk to your auditor before the fieldwork if you have questions about any of the items, and let your auditor know right away if you won’t be ready by the agreed-upon dates.
Because surprise is a required element in the audit, you’ll also need to produce some information on the spot, such as specific expense reports, journal entry support, or grantor or program reports. But you can still prepare by establishing files during the year to collect the information you may need.
Your expectations of the audit should mirror your contract with the auditing firm. It will spell out what the audit will accomplish and your responsibilities.
Auditors once did accounting “clean-up” work for their clients during the audit, such as preparing year-end journal entries, fixed asset schedules, and various prepaid expense and accrued liability analyses. But today’s professional standards draw a clear line between accounting and auditing services, and your auditor must stay independent of your accounting processes, and as a result may be limited as to what he or she can do.
If there are accounting tasks you can’t do internally due to a lack of expertise, consider hiring a different firm to handle them. But if you’re fully capable and “own” the process, you can engage your audit firm to assist with certain analysis and adjustment information outside of the audit.
Draft and review your accounting and procedures manual. Self-assess inherent internal control weaknesses and determine the necessary internal controls to mitigate such weaknesses. Periodically ascertain whether your organization’s policies and procedures are being followed.
If your operations have changed or evolved, discuss these developments with your auditor during the year and update your policies and procedures accordingly. Waiting until fieldwork begins can delay the audit process.
Your auditor will apply risk standards during the audit. AICPA Statement on Auditing Standards No. 115, Communicating Internal Control Related Matters Identified in an Audit (SAS 115), defines deficiencies in internal control and other “material weaknesses” and “significant deficiencies.”
The auditor, for example, will look to see if there’s:
After reviewing the risk and internal control information you’ve assembled, your auditor could determine there is a “significant deficiency” or the more serious “material weakness.”
For any matter identified in the auditor’s SAS 115 letter, prepare a written response including whether you have taken or intend to take any action in response to the finding. This is important to the audit committee and board as they oversee the audit and the overall system of checks and balances.
Don’t let the annual audit be the only time you talk to your auditor. If you save up all your questions, it’s likely to extend the length of the audit.
Also ask if there are new accounting pronouncements or changes for the year so you and the board aren’t surprised after year end. Be proactive in understanding the new guidance and its impact on your next audit and future financial reporting.
Although the audit — and the preparation that precedes it — requires some work, the benefits are plentiful. The audit not only assesses your overall financial condition, but also can pinpoint problems with financial management and financial reporting, identify ways to reduce risk and strengthen internal controls.
Since the revised IRS Form 990 debuted a few years ago, many nonprofits have been reviewing the policies on their books, improving them, and adding new policies to their collections. Form 990 doesn’t state that these policies are required, but asking about them implies that they should be in place. Form 990 aside, the public — concerned by stories of nonprofit mismanagement — has put more emphasis on nonprofit governance, including policy adoption and enforcement.
There’s good news about this policy-making uptick: Because so many organizations already have policies on the books, you can learn from their successes.
What types of policies do nonprofits need? Form 990 asks nonprofits if they have policies on:
Policies on gift acceptance, investment practices and joint ventures also have become more popular in recent years.
Here is a selected listing of organizations and websites that can help you in developing or improving your nonprofit’s policies:
BoardSource. At http://www.boardsource.org, you can purchase policy samplers on a variety of topics. An extensive policy sampler contains 241 policies on 48 topics under the categories of ethics and accountability, board and board members, chief executive, finance and investments, fundraising, personnel, communications and committees.
Independent Sector. This nonpartisan coalition of approximately 600 national organizations, foundations and corporate philanthropy programs posts model policies at http://independentsector.org under “The Principles for Good Governance and Ethical Practice Resource Center.” You can download them for free.
National Council of Nonprofits. At http://www.councilofnonprofits.org, members have access to a variety of policy-related information, including a Form 990-related “governance practices” checklist and sample policies on conflict of interest, document retention and destruction, board review of compensation policy, joint venture and partnership, and other topics.
Although you should customize your own policies — rather than go with a boilerplate — there’s something to be said about not reinventing the wheel. Just be sure to carefully adjust policies from other sources to fit your operation. Make sure, for example, that the processes are practical for your size and structure, and that the titles and positions listed for policy oversight are correct.
Your CPA can help you customize a policy or review the one you devise. Your lawyer also should review any policy before it’s adopted.
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If your nonprofit needs to finance a project or program, you may be discouraged by reports that credit is still tight. But if you understand the choices available to you, your chances of securing financing will grow.
Bank financing generally comes in two basic forms: line of credit or term loan. Your nonprofit’s underlying cash needs will determine which one you should pursue.
A line of credit is a negotiated amount of financing you can draw against as needed. When the goal is to smooth out cash flows over the year, it’s usually the best option. The maximum amount is available to you, but you use only what you need.
If you obtain a $200,000 credit line, for example, you may use up to the $200,000 limit. Once the line has been paid down to $180,000, you again have $20,000 available to borrow. You can continue this draw-down and repayment cycle until the credit line’s term expires. (But check with your lending officer, because some banks are terminating unused lines of credit.)
Required monthly payments may be limited to interest expense, while principal payments can be made any time cash flow permits. So you have flexibility in how much you repay each month.
When you obtain a term loan, you receive a lump sum, usually for a specific purchase. The term loan application process is usually more complicated, and approval typically takes more time. Repayment is in installments, which means you’ll make equal monthly payments consisting of interest and principal throughout the entire loan term.
An alternative to a traditional bank line of credit or loan is a tax-exempt bond issued by a municipal, county or state government. The interest payments to investors aren’t subject to federal income tax and may be exempt from state and local income tax.
Tax-exempt bond financing may benefit your nonprofit because tax-exempt interest rates are generally two to three percentage points lower than on money raised from other sources. The Internal Revenue Code allows a nonprofit to use the proceeds, which are borrowed from the issuer, to further the organization’s stated charitable purpose.
The first step in planning a bond issue is to identify which local government unit has the ability to issue bonds on a nonprofit’s behalf. This unit (the issuer) then lends the bond proceeds to you.
The next step is selecting a team of specialists to work out the mechanics of the bond issue, including a bond counsel who’ll draft the documents and deliver an opinion. An underwriter advises on the bond issue’s structure and then buys the bonds from the issuer and offers them to investors.
Tax-exempt bonds make the most sense for larger capital investments. Although interest payments over the bond’s term can be significantly lower than on a term loan, the up-front legal and other fees can be substantial.
Also consider that the process may take longer due to more stringent financial disclosure requirements and tighter scrutiny overall. While a line of credit or term loan can be approved in a matter of weeks, bond financing can take six months to a year before the funds are received.
In any economy — whether credit is tight or plentiful — a smart nonprofit will research and weigh its options carefully before seeking financing. Your CPA can assist you in preparing the financial documentation, such as a multiyear cash flow projection and a project budget, which you likely will need to secure financing.
Your 501(c)(3) organization generally is required to pay tax on income that isn’t related to its main purpose — even if that income keeps the not-for-profit afloat. This unrelated business income (UBI) is something to watch closely, because if your nonprofit is ever audited, the IRS will likely scrutinize your records to see whether you’ve accurately reported UBI.
If you haven’t reported UBI correctly, your organization may be responsible for back taxes, interest and penalties that can easily go into the thousands. And worse, if the IRS determines that your not-for-profit has significantly strayed from its mission because of UBI-generating activities, your tax-exempt status could be jeopardized. Fortunately, if you understand and follow the rules, you can avoid such scenarios.
According to the IRS, an activity generally is an unrelated business and its income subject to UBI tax if the activity:
Typically, all three situations must exist for the income to be considered UBI.
The types of activities that can generate UBI sometimes fall under the fundraising umbrella and include the following:
Sale of products unrelated to your purpose. Examples might include sales from a hospital gift shop or a zoo restaurant. To determine if the revenue is UBI, ask:
If you answer “yes” to these questions, you’ll likely need to report the income from the activity as UBI.
Sale of advertising space. Do you sell ad space in your organization’s journal, magazine or newsletter or on its website? Language that induces the reader to buy or use a product or service typically is considered advertising — for instance, a description of the product’s or service’s quality or a favorable comparison to a similar product or service. And the income from that activity is considered UBI. Conversely, a brief acknowledgment — listing, for instance, the supporter’s name and logo in a program — probably isn’t advertising, but rather is sponsorship and considered a donation.
Sale of unrelated services. In an online tutorial, the IRS uses the example of parking lots to explain this type of UBI. If an organization owns a parking lot and opens it regularly to the general public, the parking fee income is taxable. That’s because the activity — charging a fee for public parking — isn’t substantially related to the not-for-profit’s exempt purpose.
But, if only members and visitors use the parking lot while participating in the organization’s activities, the parking fee income isn’t taxable. The excellent tutorial can be found at http://www.stayexempt.org/VirtualWorkshop.aspx.
These are only some of the activities that can generate UBI. Income from certain investments, from selling membership lists and from gaming activities (see the sidebar “It’s all in the game”) also can produce UBI.
Keep in mind that there are many exceptions to the rules — for example, when your volunteers run the activity. According to the IRS, income from any trade or business where uncompensated volunteers perform 85% of the work is exempt from UBI tax.
A transaction’s structure also can exclude the resulting income from taxation. While being paid to directly promote products compatible with your mission probably will result in UBI, receiving royalties for licensing others to use your name or logo to promote such products may avoid it.
Other situations in which your nonprofit’s income may be exempt from tax include when the merchandise you sell is largely donated, such as in a book sale, or when gross income from the activity is less than $1,000. See IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations, for more exemptions.
These examples of activities that produce UBI are straightforward. But your not-for-profit may sponsor activities that seem to fall into a gray area, making them more difficult to evaluate. For instance, an exception that often applies to museum restaurants is when the nonprofit effectively documents that the operation is held for the “convenience of the members or attendees.” Additionally, fundraising activities often are exempt because they aren’t held regularly.
Your CPA can help you to analyze and quantify potential unrelated business activities and allocate expenses against this income. With proper planning, UBI often can be avoided and taxes reduced.
If you’re like many nonprofits, you probably have an accountable plan for employee business expense reimbursements. If you don’t, you’re at risk for having to add reimbursements to your employees’ wages for income tax and Social Security tax purposes. But do you have the necessary policies and procedures in place to comply with IRS requirements? Here are eight tips for making sure that your plan is beyond reproach.
Just because employees submit business expense records, it doesn’t mean the employer can reimburse them tax free. But a nonprofit isn’t required to report the reimbursed expenses as earnings on the employee’s W-2 form if it has an accountable plan in place. The IRS requires that all expenses covered in the plan have a business connection and be “reasonable.”
While an accountable plan isn’t required to be in writing, a formally established plan makes it easier for the nonprofit to prove its validity to the IRS if ever challenged. A written plan also gives the organization a structure for describing its requirements for expense reimbursement.
If an expense qualifies as a business deduction for an employee, it also can qualify as a tax-free reimbursement under an accountable plan. For meals and entertainment, the plan may reimburse expenses at 100% that would be deductible by the employee only at 50%. You must identify the reimbursement or expense payment, and keep these amounts separate from other amounts, such as wages. For 2010, you can reimburse employees up to 50 cents for every mile they put on their vehicles for business purposes.
An accountable plan must reimburse expenses in addition to an employee’s regular compensation. No matter how informal the nonprofit, it can’t substitute tax-free reimbursements for compensation the employees otherwise would have received. For example, assume an employee receives $200 for a day’s work — whether traveling or not — and on a business trip incurs $50 in reimbursable expenses. The employer can’t treat $50 as tax-free reimbursement and report $150 as taxable income.
Even if you give your employees a budget for expenses, if the funds aren’t used for qualified expenses it will invalidate the plan. And an invalid plan means that the employees’ legitimately documented reimbursed business expenses would be taxable.
This begs the question, what isn’t reasonable? Let’s say an organization reimburses an employee at 70 cents per mile, rather than the allowed 55.5 cents per mile. (Note, this rate went into effect July 1, 2011; the rate was 51 cents per mile from Jan. 31, 2011 through June 30, 2011.) The IRS would consider the extra 14.5 cents excessive and treat it as taxable income subject to wage withholding. Also, an employer can’t reimburse the employee more than what he or she paid for any business expense.
The IRS provides three conditions that must be satisfied in an accountable plan. The expense must be 1) ordinary (reasonable) and necessary, 2) incurred while away from the general area of the employee’s tax home for a substantial period, and 3) incurred in the pursuit of business.
The IRS requires that the nonprofit keep these records for business expenses that are reimbursed:
IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses, provides more details on this topic.
Document all lodging expenses with a receipt, unless your nonprofit uses a per diem plan. Require employees to submit receipts for any other expenses of $75 or more and for all lodging. Credit card statements may be used to provide key elements of your documentation, such as the place and date of the expense, and employees must supplement the statement with documentation of other elements.
The IRS has set standard per day amounts that taxpayers may use as an optional deduction for meal expenses incurred while away from home on business travel. U.S. rates are available in IRS Publication 1542, Per Diem Rates, which also includes the IRS per day amounts for combined meal and lodging expenses. When using a per diem for travel — or mileage for vehicle usage — an employer may adopt a lower amount than the IRS maximum.
An account book, diary, log, trip sheet or similar record may be used to substantiate a vehicle’s business use. This is the best way for the employee to maximize and protect this deduction.
SKR Nonprofit Newsletter
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Meet our Nonprofit Specialists!
Steve Hochstetter, CPA, CVA, Audit Partner
Jeff Talus, CPA, Tax Partner Stockman Kast Ryan + CO nonprofit services include:
For more information on any of our nonprofit services, please contact us at (719) 630-1186. We welcome your feedback! Please use this Secure Email link to tell us what you found helpful and what topics you would like to see in the future.
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Do you bite your nails before your not-for-profit’s external audit each year? Does your staff start showing signs of anxiety in anticipation of the auditors walking in the door? If this sounds like your situation, take a deep breath. Here are five tips for making the audit experience run more smoothly for you and your auditors.
There is much talk about accountability, especially financial accountability for charitable and other exempt organizations. Nonprofits need to embrace accountability to protect the organization and its people, to demonstrate openness and forthrightness in external dealings and to support the greater good. Embracing accountability also helps not-for-profits fulfill their fiduciary responsibilities to donors, constituents and the public. But how can nonprofits truly embrace this abstract term?
If you’re like many nonprofits, you probably have an accountable plan for employee business expense reimbursements. If you don’t, you’re at risk for having to add reimbursements to your employees’ wages for income tax and Social Security tax purposes. But do you have the necessary policies and procedures in place to comply with IRS requirements? Here are eight tips for making sure that your plan is beyond reproach.
About two-thirds (67%) of the not-for-profit executive directors who participated in the Daring to Lead 2011 study, sponsored by the Meyer Foundation and CompassPoint Nonprofit Services, said they plan to leave their current jobs within five years. The percentage was somewhat lower than in the prerecession 2006 study, in which 75% of participating executive directors said they’d leave their position within that five-year period.
