Insights

A few years ago, IRS Revenue Procedure 2018-15 changed the rules regarding not-for-profit restructuring. If you’ve participated in a restructuring in the past, you’ll be relieved to know that in many cases it’s now easier. Even so, if recent challenges have led your organization to consider restructuring, it’s important to work with a professional advisor, such as a CPA.

That was then

Under previous IRS rules, tax-exempt organizations were required to file a new exemption application when they made certain changes to their structure. Filing this application created a new legal entity.

To apply for new exempt status, nonprofits had to file a final Form 990 under their initial Employer Identification Number (EIN), obtain a new EIN and apply for exemption for the new entity. In addition to being a time-consuming and often expensive process, the new nonprofit risked failing to receive its tax-exempt status. The process also required changing the EIN on all bank and investment accounts.

This is now

Now in many situations restructuring nonprofits are required only to report significant organizational changes on their Forms 990. To be eligible, the restructuring must satisfy certain conditions. Your organization must be:

1. A U.S. corporation or an unincorporated association,
2. Tax exempt as a 501(c) organization,
3. In good standing in the jurisdiction where it was incorporated or, in the case of an unincorporated association, formed.

And your reorganization must do one of the following: change from an unincorporated association to a corporation; reincorporate a corporation under the laws of another state after dissolving in the original state; file articles of domestication to transfer a corporation to a new state without dissolving in the original state; or merge a corporation with or into another corporation.

The “surviving” organization must carry out the same exempt purpose that the original organization did. For a 501(c)(3) organization, the new articles of incorporation must continue to satisfy the IRS’s organizational test that requires your nonprofit’s organizing documents to limit its purposes and use of its assets to exempt purposes.

Special circumstances

Note that there are additional limitations. For example, the new rules don’t apply if your surviving organization is a “disregarded entity,” limited liability company (LLC), partnership or foreign business entity. Also, surviving organizations still have reporting obligations — for instance, to report the restructuring on any required Form 990 for the applicable tax year. And, these rules apply only to federal income tax exemptions. Your state’s laws could require you to file a new exemption application.

For more information and guidance, contact us.

Since the beginning of the pandemic, financial markets have been riding a roller coaster. This volatility is a good reminder that if your nonprofit has an endowment, it could benefit from management by a professional investment advisor. Here’s how to find a qualified advisor.

Nonprofit experience required

Finding the right investment advisor for your organization starts with identifying a pool of qualified candidates with proven track records. Ask for referrals from local private foundations (possibly ones that have funded you in the past) or other area nonprofits. Also, members of your board may know investment advisors they can recommend. Qualified candidates should have experience working with nonprofit endowments.

Request detailed proposals from candidates on how they’d manage your investments — as well as the fee structure for their services. Generally, investment advisors charge clients based on one (or a combination) of three structures:

1. Fees or commissions on trades,
2. A percentage of the asset values they’re managing, or
3. An hourly rate.

After reviewing the candidates’ proposals and checking their references, allow search committee members to talk to other nonprofit leaders to gauge their satisfaction level with your short list. Then select two or three people to interview.

Grow without incurring excessive risk

Members of your board’s investment or finance committee should interview candidates. They should look for someone who closely follows market movements and trends and is capable of creating and managing a balanced portfolio that can grow without incurring excessive risk. Understanding the candidates’ investment processes, along with their long-term results, is essential.

Other desirable qualities include experience assisting investment committees in drafting and changing investment policies and an ability to clearly explain the processes behind their investment decisions. Committee members might ask candidates, based on what they know of your organization, what changes to your endowment’s current investment strategy they might propose.

Good candidates should express empathy toward the kinds of problems your organization faces and suggest investment solutions specific to your nonprofit. And they should have the time to properly manage your investments. Ask how many hours per month they anticipate spending on your account and whether they’d be able to attend off-hour meetings, if necessary.

Finally, consider how much you trust the candidate. Don’t engage an investment advisor for your nonprofit unless you’d wholeheartedly trust the person to handle your own money.

Referral source

If you’re not sure where to look for a qualified investment advisor, contact us for referrals. Also contact us if you don’t yet have an endowment but would like to establish one.

No not-for-profit looks forward to annual audits. But regular maintenance and preparation specific to an impending audit can make the process less disruptive. We recommend taking the following steps.

1. Reconcile routinely

You shouldn’t wait until audit time to reconcile accounts — for example, cash, receivables, pledges, payables, accruals and revenues. Reconcile general ledger account balances to supporting schedules (bank reconciliation, receivables and payable aging) monthly or at least quarterly. And don’t forget to reconcile database information provided and maintained by nonaccounting departments, such as contributions, events revenue, registration revenue and sponsorships.

2. Prepare supporting documentation

Collect all supporting documentation before your audit and, if anything is missing, alert auditors immediately. It might be necessary to request duplicate invoices from vendors or ask donors for copies of letters describing restrictions on contributions.

3. Assemble the PBC list items

As part of their planning process, auditors typically compile a Provided by Client (PBC) list of materials they expect you to produce. The list includes a timeline indicating when the auditors need each type of material. Submit everything on the list according to the timeline. If you don’t, you could push back the audit itself and miss your board deadline for completion. Also, to ensure accuracy, perform a self-review of all information before you send it.

4. Be ready to explain variances

Before the auditors arrive, identify major fluctuations in your account balances compared to the previous year. Your auditors will inquire into significant variances in revenues and expenses. Make sure you’re ready to explain them — as well as budget variances — promptly and clearly.

5. Review earlier audits

Audits from previous years provide useful guidance. Check prior years’ audit entries and confirm that you didn’t make the same errors this year. Also confirm that you posted all of the audit entries from the last audit. If you didn’t, your financial statements might be distorted.

Year-long relationship

Don’t think of audits as a once-a-year obligation. Keep in touch with auditors throughout the year. For example, if you land a new grant or contract and aren’t certain how to properly record it, don’t hesitate to ask your auditors.

As mitigation measures related to COVID-19 ease, it will be interesting to see which practices and regulatory changes taken in response to the pandemic remain in place long-term. One of them might be relief from a sometimes-inconvenient requirement related to the administration of 401(k) plans.

A virtual solution

In IRS Notice 2021-40, the IRS recently announced a 12-month extension of its temporary relief from the requirement that certain signatures be witnessed “in the physical presence” of a 401(k) plan representative or notary public.

The original relief, which appeared in IRS Notice 2020-42, was provided primarily to facilitate plan loans and distributions under the CARES Act. However, the relief could be used during 2020 for any signature that, under regulations, had to be witnessed in the physical presence of a plan representative or notary public. This included required spousal consents. The relief was subsequently extended through June 30, 2021, under IRS Notice 2021-03.

Under the notices, signatures witnessed remotely by a plan representative satisfy the physical presence requirement if the electronic system uses live audio-video technology and meets four requirements established under the original relief:

1. Live presentation of a photo ID,
2. Direct interaction,
3. Same-day transmission, and
4. Return with the representative’s acknowledgment.

Signatures witnessed by a notary public satisfy the physical presence requirement if the electronic system for remote notarization uses live audio-video technology and is consistent with state-law requirements for a notary public.

Comments requested

As mentioned, IRS Notice 2021-40 further extends the relief — subject to the same conditions — through June 30, 2022. The notice also requests comments regarding whether permanent modifications should be made to the physical presence requirement. Comments are specifically requested regarding:

• The costs and other effects of the physical presence requirement and its temporary waiver,
• Whether the relief has resulted in fraud, coercion or other abuses,
• How the witnessing requirements are expected to be fulfilled as the pandemic abates,
• What procedural safeguards should be instituted if the physical presence requirement is permanently modified, and
• Whether permanent relief should use different procedures for witnessing by plan representatives or notary publics.

Comments should be submitted by September 30, 2021.

More information

Going forward, the need for a signature may often relate to spousal consents. If your business recently established a 401(k), the plan may be designed to limit or even eliminate the need for spousal consents.

However, plans that offer annuity forms of distribution are still subject to the spousal consent rules. And other 401(k) plans must require spousal consent if a married participant wants to name a nonspouse as primary beneficiary. Feel free to contact our firm for more information on the latest IRS guidance addressing employee benefits.

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As the COVID-19 pandemic finally seems to be fading in the United States, your not-for-profit organization may be making plans for its post-pandemic future. Is a merger with another nonprofit part of these plans?

A merger can provide your organization with greater stability and resilience so that you can survive any new challenges that comes your way. But a merger isn’t always the best solution if, for example, you’re looking for a financial rescue. Here’s a rundown of good — and bad — reasons to join forces.

Solid motivations

Successful mergers are based on a foundation of solid motivations. You might decide to merge to establish the stability that will make it easier to pursue your mission. Such a union could lead to a stronger organization that’s better able to survive difficult times. You also might want to merge to reduce the competition for funding, which could intensify as cash-strapped state governments cut back on their nonprofit grants and contracts in the wake of the pandemic.

A merger can help nonprofits achieve economies of scale that will make the merged organization more efficient, too. This might come, for example, from combining infrastructures — everything from staffing and board leadership to administration, information systems, human resources and accounting. A merger could also give you access to a wider network, as well as more perspectives and experiences to base decisions on. And it might enable you to provide more programming or add physical locations.

Unexpected expenses

For all of the worthwhile reasons to consider a merger, it’s important to remember that mergers do sometimes fail. One common reason is that the merger itself, as well as the new organization, can cost much more than expected. In the short term, for example, you’ll need to finance transactional and integration costs.

Arrangements intended to rescue a failing organization are another red flag. In this scenario, you usually see a larger, more stable nonprofit swoop in to save a smaller counterpart that, despite its weaknesses, has something to offer. But a merger isn’t likely to solve problems such as poor leadership or business practices. The better approach in such a situation is for the larger nonprofit to acquire assets, or viable pieces, of the smaller organization.

Potential partners

If you do decide to proceed with a merger, be careful about choosing a partner. It should share a similar mission, values and work culture. That doesn’t mean you have to offer duplicative services, but they should at least complement each other.

Contact us for more information about the benefits and risks of a merger. We can review your financial situation and help determine whether your plans make sense or whether there are better alternatives.

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If your not-for-profit organization accepts contributions of nonfinancial assets, such as land, services and supplies, you should know about Financial Accounting Standards Board (FASB) rules approved last year. Accounting Standards Update (ASU), Not-for-Profit Entities (Topic 958): Presentation and Disclosures by Not-for-Profit Entities for Contributed Nonfinancial Assets is intended to increase transparency around gifts in kind.

Inflated values

The updated rules were generated in response to concerns about U.S. wholesale market prices being used to determine the value of donated pharmaceuticals that can’t legally be sold in the United States. A donor, for example, could contribute such drugs for use only outside the country.

Stakeholders worried that the values will be inflated, which could increase an organization’s revenue and program expenses. The nonprofit might, therefore, appear larger and more efficient than a smaller organization or one with lower values for its gifts-in-kind donations.

New procedures and disclosures

The most dramatic change from previous gifts-in-kind rules is that donations should be reported by type of asset (for example, building, food or pharmaceuticals), rather than reported in aggregate. The rules also require you to report gifts-in-kind donations as a separate line item in the statement of activities.

Further, you must disclose:

• Your organization’s policies for monetizing in-kind donations (such as by selling them), rather than actually using the donations in your operations,
• Any donor restrictions,
• The valuation techniques and data used to calculate a gift’s value, and
• The principal market or most advantageous market used to calculate the gift’s value.

This last disclosure is necessary if donor restrictions prohibit your nonprofit from selling or using the donation in the principal or most advantageous market. The principal market has the highest volume of activity for the donated asset. The most advantageous market generally maximizes the amount that would be received if the donation were sold.

Compliance required soon

If you aren’t already following the rules, prepare to comply with them. They take effect for annual reporting periods starting after June 15, 2021, and interim periods within fiscal years starting after June 15, 2022. Contact us if you have questions or need help.

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If your not-for-profit periodically prepares internal financial statements for your board, you may have noticed that your auditors propose adjustments to these interim statements at year end. Why do auditors do this? Generally, it reflects differences due to cash basis vs. accrual basis financial statements. But you can help minimize the need for such adjustments. Here’s how.

Cash basis accounting

Under cash basis accounting, income is recognized when you receive payments and expenses are recognized when you pay them. The cash “ins” and “outs” are totaled (generally by accounting software) to produce the internal financial statements and trial balance you use to prepare periodic statements. Cash basis financial statements are useful because they’re quick and easy to prepare and they can alert you to any immediate cash flow problems.

The simplicity of this accounting method comes at a price, however: Accounts receivable (income you’re owed but haven’t yet received, such as pledges) and accounts payable and accrued expenses (expenses you’ve incurred but haven’t yet paid) don’t exist.

Accrual basis accounting

With accrual accounting, accounts receivable, accounts payable and other accrued expenses are recognized when they occur, allowing your financial statements to be a truer picture of your organization at any point in time. If a donor pledges money to you, you recognize it now when it’s pledged rather than waiting until you receive the money — which could be next month or next year.

Generally Accepted Accounting Principles (GAAP) require the use of accrual accounting and recognition of contributions as income when promised. Often, year-end audited financial statements are prepared on a GAAP basis.

Reasonable estimates

Internal and year end statements also may differ because your auditors proposed adjusting certain entries for reasonable estimates. This could include a reserve for accounts receivable that may be ultimately uncollectible. Another common estimate is for litigation settlement. Your organization may be the party or counterparty to a lawsuit for which there’s a reasonable estimate of the amount to be received or paid.

We can help you reduce disparities between monthly or quarterly statements and those prepared at year end by maximizing your accounting software’s capabilities. Also, we can work with you to improve the accuracy of estimates. Contact us.

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Not-for-profit organizations are different from for-profit businesses in many vital ways. One of the most crucial differences is that under Section 501(c)(3), Sec. 501(c)(7) and other provisions, nonprofits are tax-exempt. But your tax-exempt status is fragile. If you don’t follow the rules laid out in IRS Publication 557, Tax-Exempt Status for Your Organization, the IRS could revoke it. Be particularly alert to the following common stumbling blocks.

Lobbying and campaign activities

There are many categories of tax exemption — each with its own rules. But certain hot-button issues apply to most tax-exempt entities — such as lobbying and campaign activities. Having a Sec. 501(c)(3) status limits the amount of lobbying a charitable organization can undertake. This doesn’t mean lobbying is totally prohibited. But according to the IRS, your organization shouldn’t devote “a substantial part of its activities” trying to influence legislation.

For nonprofits that are exempt under other categories of Sec. 501(c), there are fewer restrictions on lobbying activities. Lobbying activities these groups undertake must relate to the accomplishment of the group’s purpose. For instance, an association of teachers can lobby for education reform without risking its tax exemption.

The IRS considers lobbying to be different from campaign activities, which are completely off limits to Sec. 501(c)(3) organizations. This means they can’t participate or intervene in any political campaign for or against a candidate for public office. If you’re not a 501(c)(3) organization, campaign restrictions vary.

Excess profit and unrelated revenue

The cardinal rule about excess profits is that a nonprofit can’t be operated to benefit private interests. If your fundraising is successful and you have extra income, you must put it back into the organization through additional services or by creating a reserve or an endowment. You can’t use extra income to reward an individual or a person’s related entities.

If you’re generating income through a trade or business you conduct regularly and it’s outside the scope of your mission, you may be subject to unrelated business income tax (UBIT). Examples include a college that rents performance halls to noncollege members of its community or a charity that sells advertising in its newsletter. Almost all nonprofits are subject to this provision of the tax code, and, if you ignore it, you could risk your exempt status. That said, losing an exempt status from unrelated business income is rare.

Notice from the IRS

The best way to preserve your organization’s exempt status is to refrain from risky activities. But if you receive notice from the IRS of a violation, please contact us. We can help you respond and get your nonprofit back on track.

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Many not-for-profits are just starting to emerge from one of the most challenging environments in recent memory due to the COVID-19 pandemic. Even if your organization is in good shape, don’t get too comfortable. Financial obstacles can appear at any time and you need to be vigilant about acting on certain warning signs. Consider the following.

Budget variances

Once your board has signed off on a budget, you should carefully monitor it for unexplained variances. Although some variances are to be expected, staff should be able to provide reasonable explanations — such as funding changes or macroeconomic factors — for significant discrepancies. Where necessary, work to mitigate negative variances by, for example, cutting expenses.

Also make sure you don’t:

• Overspend in one program and funding it by another,
• Dip into operational reserves,
• Raid an endowment, or
• Engage in unplanned borrowing.

Such moves might mark the beginning of a financially unsustainable cycle.

Messy financials

If your financial statements are untimely and inconsistent or aren’t prepared using U.S. Generally Accepted Accounting Principles (GAAP), you could be heading for trouble. Poor financial statements can lead to poor decision-making and undermine your nonprofit’s reputation. They also can make it difficult to obtain funding or financing.

Insist on professionally prepared statements as well as annual audits. Members of your organization’s audit committee should communicate directly with auditors before and during the process, and all board members should have the opportunity to review and question the audit report.

Declining donations

Let’s say you’ve noticed a decline in donations. Then you start hearing from long-standing supporters that they’re losing confidence in your organization’s finances or leadership. Investigate immediately.

Ask supporters what they’re seeing or hearing that prompts their concerns. Also note when development staff hits up major donors outside of the usual fundraising cycle. These contacts could mean your nonprofit is scrambling for cash.

Faulty leadership

Even the most experienced and knowledgeable nonprofit executive director shouldn’t have absolute power. Your board needs to step in if an executive tries to ignore expense limits and breaks other rules of good fiscal management. The board also should question an executive who attempts to choose a new auditor or makes strategic decisions without the board’s input.

Don’t ignore the signs

If one of these danger signs appears, it’s important to act swiftly. Financial problems don’t disappear on their own. Contact us for help evaluating the situation and for advice on how to get your organization back on track.

Events of the past year put a dent in many not-for-profit’s reserves. Perhaps you tapped this stash to buy personal protective equipment or to pay staffers’ salaries when your budget no longer proved adequate. As the pandemic wanes and economic conditions improve, you’ll need to start thinking about rebuilding your operating reserves.

Back on steady ground

Assembling an adequate operating reserve takes time and should be regarded as a continuous project. Obviously, it’s nearly impossible to contribute to reserves when you’re under financial stress. But once you feel your nonprofit is on steadier ground, your board of directors needs to determine what amount to target and how your organization will reach that target. It’s also a good time to review circumstances under which reserves can be drawn down.

Reserve funds can come from unrestricted contributions, investment income and planned surpluses. Many boards designate a portion of their organizations’ unrestricted net assets as an operating reserve. On the other hand, funds that shouldn’t be considered part of an operating reserve include endowments and temporarily restricted funds. Net assets tied up in illiquid fixed assets used in operations, such as your buildings and equipment, generally don’t qualify either.

Protection and flexibility

Determining how much should be in your operating reserve depends on your organization and its operations. Generally, if you depend heavily on only a few funders or government grants, your nonprofit probably will benefit from a larger reserve. Likewise, if personnel costs are high, your organization could use a healthy reserve cushion.

Three months of reserves is typically considered a minimum accumulation. Six months of reserves provides greater security. A three-to-six-month reserve should enable your organization to continue its operations for a relatively brief transition in operations or funding. Or, in the worst-case scenario, it would allow for an orderly winding up of affairs.

An operating reserve of more than six months provides greater protection if, for example, something similar to the COVID-19 lockdown occurs again. And a bigger reserve can give you financial flexibility. For example, you might have the funds to pursue a new program initiative that’s not fully funded, or to leverage debt funding for needed facilities or equipment.

No hoarding

Note that it’s generally not a good idea to put aside more than 12 months of expenses. Increasingly, donors want to see the nonprofits they support put funds to work, not hoard them. Contact us for more information about operating reserves and setting policies that are appropriate for your organization.

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