Nonprofit Accounting Basics

Be Careful What You Ask For

Topics: 

This article illustrates how accounting decisions or judgments can affect taxes - on an organization or on its donors, and vice versa. Expense allocation and revenue recognition are especially judgmental areas.

Expense allocation

Allocation of expenses among functions is often subjective. There are rules, but application of them to specific situations generally requires judgment. A frequent example is how much of a given employee's compensation and related occupancy costs should be charged to various functions, since many people perform multiple functions. Especially challenging is a person who performs two functions simultaneously, such as someone who creates a brochure to be used for both public education - say, about symptoms of a disease, and for fundraising.

Three ways this expense allocation can have tax consequences are as follows:

  1. When one of the functions involved generates unrelated business income, the way in which expenses are allocated to that function will affect the amount of deductions allowed against that income when computing the organization's tax on the net unrelated income;
  2. When expenses are related to conduct of a fundraising event (such as a dinner), whether and how much the expenses are considered to provide a direct benefit to the participants (e.g., diners) may affect their personal tax deduction for the payments they make to participate;
  3. When an organization engages in an activity that might be construed as lobbying, the amount of expenses allocated to that activity may affect the organization's compliance with strict tax rules about how much lobbying is permissible for some exempt organizations. Violation of those rules can cause monetary penalties and/or loss of exemption.

Keep in mind nonprofit organizations have four goals relevant to expense allocation:

  1. Minimizing the organization's unrelated business income tax;
  2. Maximizing the charitable contribution tax deductions available to its donors;
  3. Reporting a high percentage of the organization's expenses as program expenses, while minimizing amounts reported as management and fundraising;
  4. Complying with tax laws related to limitations on lobbying.

Sometimes these four goals conflict with each other.

Consider some examples:

  • More expenses charged against unrelated business income will reduce the tax on that income. But 'unrelated' activities often are not program activities (if they were, they might not be unrelated). So charging more expenses to them will adversely affect the percentages reported in the financial statements as program versus other expenses, thus making it appear the organization isn't using as much of its resources for direct conduct of its programs. 
  • Accounting rules for the costs of so-called 'special events' permit the costs of 'direct benefits to participants' to be reported in the organization's financial statements as deductions from the revenue generated by the event, rather than as fundraising expenses. This has the desirable effect of reducing the organization's reported fundraising expenses, thus increasing the reported ratio of program expenses to total expenses. But judgment is often required to determine just what costs relate to benefits to participants, versus other costs of the event. So for accounting purposes why not try to allocate as much of the event cost as possible into the 'direct benefit' bucket? Because that would push the donor up against the tax rule that requires donors to a charity, who receive a benefit in exchange for their donation (e.g., dinner), to reduce the amount of their personal tax deduction by the value of the benefit. Tax rules also require the organization to inform donors of larger amounts what part of their payment is not deductible due to the value of benefits received. So if more costs are considered to provide benefits to donors, their tax deductions will be lower - which will not please donors. But if less of the event costs are treated as provision of donor benefits, so donors can take a bigger deduction, more of those costs will end up being reported by the charity as fundraising, thus hurting its expense ratios.
  • An activity involving lobbying is probably a program activity, so an organization would like to charge more 'overhead' expenses to it, rather than to management and general. However, the more expenses that are charged to this activity, the higher the risk of violation of IRS limitations on allowable lobbying activities.

In all of these examples, think of 'rocks' and 'hard places'.

 

Revenue recognition

The issue here is unrelated business income, and judgment also plays a role. One important judgment is whether a particular item of revenue is in fact a contribution, or whether it is properly an 'exchange transaction', where the payer is receiving goods or services roughly commensurate in value with the amount of the payment. Examples of exchange transactions for nonprofits include tuition, membership dues, conference fees, ticket sales, bookstore and gift shop sales, and some research grants. The characterization of revenue as either a contribution or exchange can have tax consequences to the nonprofit recipient.

It is often not clear how some items should be classified. This is especially true with government and foundation grants. The AICPA audit guide for not-for-profit organizations (Chapter 5; ASC 958-605) includes a list of indicators (Table 5-1) to consider in making this accounting judgment. If an item can be justifiably characterized as a contribution, it will not be unrelated business income. But if it is characterized as an exchange transaction, it will be reported on one of Lines 2 to 11 of IRS Form 990, Part VIII, and is now at risk of the IRS alleging it is unrelated to the organization's exempt purpose, thus taxable - which the organization would not like. In addition, Form 990 requires that for each non-contribution revenue item, the organization explain why it should not be considered unrelated; the burden of proof of relatedness is on the organization. Again, an accounting judgment can lead to tax consequences if the judgment is not: (1) made appropriately and (2) the logic behind it adequately documented in case it is challenged.

***

So, be careful which accounting and reporting practices you choose and what judgments you make, because sometimes they can have tax consequences you might not like. And don't automatically make choices to minimize taxes, because the accounting results might not always be what you want.