Nonprofit Accounting Basics

Accounting for Uncertain Tax Positions: A Requirement for Nonprofit Financial Statements

FIN 48, Accounting for Uncertain Tax Positions (now codified as ASC 740-10) was made a requirement for any entity with financial statements prepared in accordance with generally accepted accounting principles (GAAP) for years beginning after December 15, 2006. However, this requirement was deferred by the Financial Accounting Standards Board (FASB) for all but "public" entities until years beginning after December 15, 2008. A few nonprofits with certain tax-exempt bonds were considered to be public entities but the vast majority of nonprofits are implementing FIN 48 for the 2009 calendar year or fiscal years ending in 2010.

FIN 48 requires entities to examine all tax positions and to determine if it is more likely than not that these positions would stand up under audit by the taxing authorities. If there are uncertain, material (as defined by the auditor) tax positions, the organization must accrue an expense and a liability on its balance sheet as well as describe the uncertainty in a footnote. To add insult to injury, organizations must disclose its FIN 48 footnotes on the new Form 990 so if there are uncertain tax positions, the IRS will be so informed.

This provision applies to any tax based upon income (but not taxes such as sales/use, payroll or unclaimed property, or most excise taxes). It is also applicable to federal, state, local, and foreign jurisdictions for the current year and any prior years that are open. Not only does the organization have to accrue an expense and liability for taxes, but it must also include estimated amounts for interest and penalties. In making this assessment, the organization must assume that the IRS will discover all uncertain positions in an audit.

The first reaction to this from many exempt organizations is that this is a "no-brainer": they state they are exempt from tax and therefore don’t have any tax positions. At that point, we have to inform them that their very exempt status is a tax position even if there is no unrelated business income.

The approach to the FIN 48 analysis requires a careful inventory of all tax positions and then a determination if any of these are uncertain. A close look at each revenue stream is a must for the inventory of positions. If there are uncertain positions, then estimated tax, penalties, and interest are calculated on these; and, if material, an accrual and disclosure must be made on the financials.

Measurement of the dollar values of uncertain positions is somewhat complex and beyond the scope of this article and requires the services of tax experts. We will, however, discuss some of the more common areas of uncertain positions that nonprofits should analyze.

Exemption issues: Is there any reason to believe the organization’s exempt status might be at risk? This analysis requires looking at the activities of the organization to first see if they are in agreement with the purposes for which the organization received its exemption (from its exemption application). Next, it should look at other rules which may impact exemption: Political activity (for charities), too much lobbying (for public charities), private inurement, illegal activity, etc. If exemption issues are discovered, it is obvious that major uncertain tax positions might exist which go back for many years. Some states (and the District of Columbia) do not necessarily follow the federal exempt status but rather require a state exemption application to be filed. If this was not done, then a sizable state tax liability for many years may have accrued.

Unreported Unrelated Business Income (UBIT): Organizations may have significant revenue streams that have been reported as related or excluded income but which the IRS might consider as UBI. Some of the more common areas include:

  • Royalties which do not meet the passive standards of the Internal Revenue Code
  • Corporate sponsorship payments which include payments for advertising or other taxable activities
  • Sale of merchandise not related to exempt purpose
  • Rental income from debt-financed real estate
  • Alternative investments reported on K-1s with significant elements of UBI
  • Certain payments from controlled taxable subsidiaries
  • Provision of services to members for a fee

Non-filing of state returns: Organizations with operations in more than one state or with pass-through investments originating in other states, may never have filed UBIT state returns in other than the home state, thus creating a possible liability going back many years.

Foreign taxes: Organizations with foreign operations or foreign investments have to be sure that these activities do not generate income taxes in foreign jurisdictions.

UBIT Calculations: Unreasonable, overly aggressive allocations of expenses used to create losses which the IRS could overturn.

Long loss generating activities: If an activity has only been generating losses for years, the IRS can take the position that the activity was never entered into with a profit motive and thus cannot be used to create a Net Operating Loss or be used to offset other activities which do have taxable income.

Implementation of FIN 48 is now a requirement that cannot be postponed. Done properly, it requires a significant amount of work in its first year. Subsequent years should be easier, as the organization only has to update its inventory of positions for anything new and analyze the additions. FIN 48, in our experience, does provide a much needed UBIT and operational review for organizations and has helped many to become aware of a wide variety of tax issues and to get their tax houses in order before the IRS comes knocking on doors.