Five Key Facts of Life for Non-Profits
Introduction
This article is addressed primarily to the officers and directors of non-profit organizations, but has important information for donors as well.
Here I’m going to present some key facts for non‐profit organizations. Non‐profits provide vital services to many people including the disabled, the sick, the homeless, retirees, veterans, children, abused animals and others. There are significant tax advantages for donors who contribute to charities, and there are many ways for such gifts to be structured so that everyone, including the wider community, benefits.
Physics teaches us that for every action there is an equal and opposite reaction. For every act of harm there is a healing reaction which non-profits are a major part of achieving.
Many of our reactions to harm and trauma are instinctive and spontaneous, like the responses of the people who converged on the scene of the Twin Towers in New York immediately after the September 11, 2001 terrorist attacks. I was there the Saturday after the attacks on September 15th and saw a large crowd of volunteers working tirelessly to try (even then, four days later) to rescue victims, clear debris, and restore order. The stench of unburned jet fuel lingered in the air. The tragedy of trauma can be healed only by courageous caring.
Non‐profits represent approximately 14% of Maine’s economy. According to the IRS there were 1,080,130 charitable and religious non-profit organizations nationwide in September 2012. The non‐profit sector of the workforce employs 10% of all Americans.
One of the greatest problems confronting non‐profits is that few officers and directors of these types of organizations receive appropriate training. Idealistic, highly motivated and caring people just go out and try to run a non‐profit. This is both admirable and dangerous. Knowledge of how non‐profits are taxed, what their accounting reports look like, and how they should be operated is crucial.
Here then is a handful of five very important Facts of Life your non-profit organization MUST understand and deal with. Somebody needs to know this information. Why not you? You may be the last line of defense for your organization.
(1) You Get Tax Exempt Status by Giving Up Privacy
This is one of the most misunderstood facts of life for non‐profits. Yes, it’s true non‐profits are usually exempt from paying income taxes on most types of income. But in exchange for getting tax exemption you must give up a significant degree of financial privacy regarding your organization.
Pursuant to Internal Revenue Code (IRC) Section 6104(d) non‐profit organizations must provide copies of their annual IRS Form 990 or 990‐EZ to the public on demand. The top right corner of page one of Form 990 and 990‐EZ specifically states “Open to Public Inspection.”
If a stranger shows up at the main office of your non‐profit organization and demands to see a copy of your IRS Form 990 you are required by law to provide him or her with a copy “immediately” pursuant to IRC Section 6104(d)(1)(B). See:
The purpose of this disclosure rule is to promote financial transparency so that current and potential future donors can see where their contributions are going.
Be aware that the stranger who shows up unexpectedly and demands a copy of your Form 990 might be an IRS agent checking to see if your organization is complying with the law.
If you are a non‐profit organization under IRC Section 501(c) your books are open to the world. In my next Fact of Life for Non‐Profits I discuss how your organization can use this to advantage.
(2) The Advantages of Financial Transparency: IRS Form 990 is a Marketing Tool
You shouldn’t be upset that your organization lost financial privacy when the IRS gave it tax‐exempt status. IRS Form 990 describes in detail who your organization is, how you conduct your business, where you get your money from and, finally and most important, what you spend your money on.
Form 990 can be used as a marketing tool to show potential donors and existing contributors how well your organization is handling money.
Potential donors will look at how much of your revenue is spent on administration and executive salaries. If this percentage is reasonable (hopefully well under 60%) this is a good fact that distinguishes you from the ‘bad apples’ out there who take money from donors and spend it almost entirely on administration, executive pay and benefits. See here for an example of a non‐profit organization that spends almost 100% (maybe even more!) of its revenue on administrative costs:
Donors and the public evaluate non‐profit organizations on how well and efficiently they deliver public goods: The Give‐Back Percentage. If an organization raises $100 from contributions and spends $40 on scholarships, charity, public service and similar public goods this is a pretty good ratio. Such an organization is giving back 40 cents on the dollar. Well done! Applause is appropriate.
Many non‐profits will actually publish IRS Form 990 on their website. I highly recommend this. They take pride in what they achieve and in how efficient they are at delivering public goods.
The ratio of delivered public goods to total donor contributions is called “Give‐Back” and is a great measure of how well a non‐profit is performing its core functions, regardless of what type of non‐profit it might be. (There are 27 major types of non‐profit organization.)
On the other hand if the Give‐Back percentage is near zero this is terrible and means the organization is probably doing a lousy job delivering public goods: corrective action is needed.
It is important, however, to evaluate non‐profits using non‐financial measures of performance by looking at what they achieve in the real world. An obsessive focus only on administrative costs and dollars can lead to incorrect conclusions about a non‐profit.
The Better Business Bureau (among others) evaluates non‐profits on their financial AND non‐financial performance. See:
Better Business Reviews of Charities
Another marketing tool for non‐profits is to be able to say to the public and to current and potential donors that your financial statements are prepared by an independent CPA. The IRS specifically asks this question on Form 990.
Using an independent Certified Public Accountant to prepare your financials inspires public confidence and trust in your organization and in how well it manages and accounts for its money. Trust and accountability go hand in hand.
Perhaps the most important marketing tool of all for charitable non‐profit organizations is to leverage the power of the charitable contribution for potential donors. Contributors can accomplish a great deal of good for their community while at the same time saving significantly on their taxes by donating to a charity.
Every charitable non‐profit should use their tax‐exempt status as a marketing tool to acquire donor contributions. Qualified professionals including attorneys and CPA’s can perform a vital task in helping non‐profits utilize their tax‐exempt status to attract donors. While taxes are indeed the price of civilization you can be sure the IRS is the worst charity of all to donate money to.
(3) Think About the Future or You Won’t Have One
Smart non‐profits will think not only about current donors, members and supporters, but also about who their donors will be five years from now. Those who don’t think about the future may not have one.
Social media (Facebook, LinkedIn, etc.) is a great way to reach out to the next generation of donors. Younger people may not have financial assets to contribute, but you can recruit their volunteer labor, a crucial source of support for most non‐profits. And you will help these younger people gain the experience they need to build their resumes and improve their skills. You can help build their future and your own at the same time.
Non‐profits are about people helping people in all the countless ways this can be done. This type of activity inherently inspires and motivates many people to get involved.
Writing a check is only one way to help and not always the most important. Volunteer service, time and skill can be just as valuable to non‐profits as money. People who volunteer today may contribute money or property in the future. The relationships your non-profit develops with people, including donors, volunteers, and the wider community will define the future success of your organization.
Non‐profits must be aware of current disturbing social trends discussed in important books like Robert Putnam’s Bowling Alone. Fewer and fewer people are gathering together in public places to engage in mutual activities like bowling. Membership in social groups, churches, charities and non‐profits of all kinds is declining and has been for years. This is a very sad and negative fact for our country (among many other sad and negative facts.)
Harvard Business School professor Niall Ferguson discussed this depressing phenomenon in his recent book The Great Degeneration and cites Putnam’s statistics on how people are withdrawing from the society they live in. The percentage changes in social participation shown below are for the U.S. comparing the 1960’s/1970’s to the late 1990’s (you can be sure things are worse today in 2013):
Attendance at a public meeting on town or school affairs: down 35%
Service as an officer of a club or organization: down 42%
Service on a committee for a local organization: down 39%
Membership of parent‐teacher associations: down 61%
The average membership for thirty‐two national chapter‐based associations: down almost 50%
Membership rates for men’s bowling leagues: down 73%
(Source: Niall Ferguson, The Great Degeneration, 2013, The Penguin Press, p. 117). See:
Non‐profits in Maine and nationally must combat this trend by inspiring people to get out of their homes and away from their computer screens and smart phones. The Internet is NOT a good substitute for normal human face‐to‐face interaction. (See the movie “Surrogates.”)
Failure to combat current trends will eventually result in the severe decline and perhaps the end of many non‐profits. Our country will be poorer as a result, and we will all be more alone.
(4) Basics of Non-Profit Accounting
Non‐profits follow very different accounting rules than private business. They are taxed differently and their financial statements are different. One key source of guidance for non‐profit accounting is Statement on Financial Accounting Standard (“SFAS”) No. 117 (now called ASC No. 958) issued by the Financial Accounting Standards Board. Here is a brief summary:
Here are some key points if your non‐profit chooses to follow SFAS No. 117 (I recommend that it does):
>>No Retained Earnings. Non‐profits don’t use this equity account.
>>All revenue is classified by the stipulations donors impose on the money they give you. If the donor imposes no stipulations then the donation is unrestricted. Spend the money as needed.
>>If the donor wants his contribution designated for a particular use then it is temporarily restricted until you fulfill the obligation by spending the donation as required.
>>And if the donor gives you money and states that only the income earned on it may be spent for a designated purpose then such a contribution gives rise to a permanently restricted fund or endowment.
>>Non‐profits following SFAS No. 117 have three sources of funds:
Unrestricted
Temporarily Restricted
Permanently Restricted.
Your equity accounts must follow this structure.
>>Financial statements of non‐profits look different from the financial statements of businesses. A non‐profit balance sheet is called the Statement of Financial Position; their income statement is called the Statement of Activities. And some non‐profits must provide further details of expenses on a Statement of Functional Expenses.
For further information on non‐profit financial statements see:
Accounting Guidance for Non-Profits
(5) Not All Non‐Profit Income is Tax Exempt: UBIT, Payroll & Sales Taxes
Here is another widespread and potentially devastating misunderstanding about non‐profits: that they are exempt from ALL taxes.
FALSE!
Revenues earned by non‐profits that directly relate to their exempt function are tax‐exempt. But the IRS states that income is TAXABLE if it arises from a business not substantially related to the accomplishment of the non‐profit’s primary exempt purpose. E.g., a church opens a store that is operated at a profit. The store’s profit is likely to be classified as taxable income because a store is an activity that has nothing to do with the church. (There are some exceptions to this rule).
If non‐profits have so‐called unrelated business income then they will indeed be taxed on it. The tax is called the Unrelated Business Income Tax (UBIT). Non‐profits report taxable income and UBIT on IRS form 990‐T and similar state tax forms (Form 1120ME for Maine.) See:
Also see IRS Publication 598 for more information on UBIT:
And non‐profits do indeed have to report and pay payroll taxes. Tax‐exempt status applies to INCOME TAXES, NOT payroll taxes. Non‐profits with employees must report and pay payroll taxes the same as everyone else.
As for Maine sales tax, it is not automatically true that just because your organization is a non‐profit then it doesn’t have to pay sales tax. This is a false assumption. Maine has very specific exemptions for sales tax. If you qualify for a sales tax exemption you must pro‐actively apply for exemption from Maine and receive an exemption certificate. If your organization does not qualify for one of these exemptions then you are subject to both sales and use taxes. Here are Maine’s sales tax exemptions:
Know and respect these Facts of Life so your organization stays out of trouble.
Philosophical Musings on Non‐Profit Organizations
Non‐profits comprise approximately 1/7th of Maine’s economy. They consist of people helping people in countless different ways including education, sports, fraternal lodges, health care, and general charity.
Consider the disaster that would occur if the functions performed by caring and motivated volunteers were taken over and performed by government.
Non‐profits build the social capital that enriches our society through voluntary cooperative action. Profit is payment to entrepreneurs and businesses for taking risks and investing time, skill and ideas. Non‐profits replace private profit for a few with social capital for many without any government involvement (usually).
One of the strengths of most non‐profits is that they typically engage in actions at a small scale. According to recent IRS statistics 82.3% of all non‐profits had annual expenditures under $1 million. Action within the scope of direct personal knowledge is what makes most non‐profits the antithesis of large impersonal bureaucratic institutions and big government.
The scale of informed and effective human action is limited by our brain capacity. Anthropology proves, through the DUNBAR LIMIT (click here for further information), that a typical person can keep track of about 150 personal relationships. Beyond this limit you lose the ability to truly know who you are dealing with. In this sense we can say that bureaucracy begins at the 151st relationship and grows ever more impersonal beyond this.
Smaller non‐profits acting within the Dunbar Limit can make informed and knowledgeable decisions about the people they interact with in a way bureaucrats cannot. The Dunbar Limit has profound implications for all forms of human interaction and proves indeed that all politics is (and should be) local.
Classification of Donor Contributions to Non‐Profits
This is one of the most frequently asked questions I receive as a CPA from my non‐profit clients: Are donor contributions to a non‐profit treated as charitable contributions? The correct answer is: Sometimes.
Contributions will be classified as charitable in nature if made to a qualifying organization (usually an IRC Section 501(C)(3) entity) and otherwise satisfying the requirements of IRC Section 170(C). Here is a great summary from IRS Publication 526 on when contributions will be classified as charitable in nature:
Deductible As Charitable Contributions
Money or property you give to:
Churches, synagogues, temples, mosques, and other religious organizations
Federal, state, and local governments, if your contribution is solely for public purposes (for example, a gift to reduce the public debt or maintain a public park)
Nonprofit schools and hospitals
The Salvation Army, American Red Cross, CARE, Goodwill Industries, United Way, Boy Scouts of America, Girl Scouts of America, Boys and Girls Clubs of America, etc.
War veterans' groups
Expenses paid for a student living with you, sponsored by a qualified organization
Outofpocket expenses when you serve a qualified organization as a volunteer
Not Deductible As Charitable Contributions
Money or property you give to:
Civic leagues, social and sports clubs, labor unions, and chambers of commerce
Foreign organizations (except certain Canadian, Israeli, and Mexican charities)
Groups that are run for personal profit Groups whose purpose is to lobby for law changes Homeowners' associations
Individuals
Political groups or candidates for public office
Cost of raffle, bingo, or lottery tickets
Dues, fees, or bills paid to country clubs, lodges, fraternal orders, or similar groups
Tuition
Value of your time or services
Value of blood given to a blood bank
See IRS Publication 526 for further information:
>>If the contribution is classified as charitable then your organization must issue a receipt to the donor if the value of the gift (cash or property) is $250 or more. The receipt must describe the property given and the date. Special rules apply to donations of vehicles, stock, art, etc. See IRS Publication 526 for information on how to handle contributions of these types of assets.
>>Responsibility for valuing the property donated is with the donor. If the donation is quid pro quo (i.e., the donor gets something valuable in exchange) your non‐profit must disclose the fair market value of the goods or services the donor receives. This rule applies to donations of $75 or more. (Here's an interesting question: how does the non-profit apply the $75 threshold for this rule when the donor is responsible for valuation? My answer is to use good judgment.)
>>If the contribution is NOT classified as charitable the donor may still be able to deduct it as an ordinary and necessary business expense. But the non‐profit organization MUST disclose that the donation is not deductible as a charitable contribution. Non‐profits that fail to observe this rule may be fined by the IRS up to $10,000 per year.
>>Political contributions and lobbying are NOT tax deductible. Non‐profits who spend money on political and lobbying activities must disclose to donors the pro-rated percentage of the donor’s contribution that is non‐deductible.
>>Maine (and many other states) require a license to solicit charitable contributions. See:
Maine Licensing of Charitable Solicitations
Charitable non‐profit organizations must always remember that they have a valuable financial benefit to offer to donors beyond the innate good they do: the value to the donor of a tax‐deductible charitable donation. This message should be present on all major communications with the public and with potential donors.
Here are Some of the Ways We Help Each Other
“…let us cultivate our garden.”
Voltaire
Candide
(The concluding sentence)
Further Resources for Non‐Profits
Maine Secretary of State Site:
National Association of Non‐Profit Organizations Site:
National Association of Non-Profit Organizations
IRS Non‐Profit Site:
IRS Site
George Adams
Certified Public Accountant Master of Business Administration
Tel: (207) 989-2700 E-Mail: GeorgeAdams@IntelligenceForRent.com
450 South Main Street: The HQ of IQ
Brewer, Maine 04412-2339
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