For nonprofits that file Form 990, particularly 501(c)(3) public charities, changes in how the organization earns, spends, or receives money can create reporting and compliance issues that aren’t always obvious from the financial statements alone. New business activities, expense allocations, and increased reliance on a small number of donors can all affect tax reporting and, for some organizations, public-charity status.
These are several areas worth reviewing before year-end rather than waiting until the return is being prepared.
Using expense classifications that can’t be supported
Form 990 divides expenses among program services, management and general, and fundraising. For organizations required to report expenses by function, these classifications become part of the organization’s publicly available Form 990 and can affect how readers understand its use of resources.
A common mistake is assigning nearly every shared cost to programs or placing all shared costs in management and general simply because no allocation method exists. Neither approach necessarily reflects how the organization operates.
Let’s say your executive director spends approximately 60% of their time supervising programs, 25% fundraising, and 15% on administration. Their compensation may need to be allocated among all three functions in roughly those proportions, assuming the estimate is reasonable and supportable.
Other shared expenses may require different methods. Depending on the expense and the organization’s circumstances, reasonable allocation methods might include square footage for certain occupancy costs or usage for certain technology costs. Other expenses may require a different basis that reflects how the cost actually supports each function.
The goal is to create a consistent, documented method that reasonably reflects how the expense was used. At a minimum, the methodology used for significant shared costs should be documented, and the supporting information should be updated periodically. Some organizations formalize those methods in a written allocation policy.
New income-producing activities
New revenue can be good news, but it can also create tax and filing questions. A tax-exempt organization can have unrelated business taxable income when it regularly carries on a trade or business that isn’t substantially related to its exempt purpose. Using the profits to support charitable programs doesn’t, by itself, make the activity related.
For example, an environmental nonprofit may begin selling advertising in a monthly publication. Although the proceeds fund conservation programs, the advertising activity may still require unrelated-business-income analysis. Depending on the facts, merchandise sales, facility rentals, services provided to outside parties, and income from debt-financed property can raise similar questions.
The details matter. Sponsorship payments may be treated differently from advertising. Rent from real property is often excluded, but the result may change when the organization provides substantial services, rents personal property, uses debt-financed property, or leases to a controlled entity.
An organization with $1,000 or more of gross income from unrelated trades or businesses generally must file Form 990-T, even if deductions eliminate taxable income. Leaders don’t need to classify every revenue source themselves, but they should alert the preparer whenever the organization starts, expands, or materially changes an income-producing activity.
Donor concentration and public support
Public-support status also deserves attention. Many public charities must satisfy one of the public-support tests reported on Schedule A. Those tests generally look at the organization’s sources of support over a rolling five-year period, but the rules differ depending on which public-charity classification applies.
Suppose an organization normally receives $500,000 annually from a broad donor base, then receives a $750,000 contribution from one donor while smaller-donor support declines. A highly concentrated contribution can affect the public-support calculation because the rules limit how some large contributions are treated as public support. However, certain large and unexpected contributions may qualify for “unusual grant” treatment and be excluded from the calculation. The result depends on the applicable public-support test and the facts surrounding the contribution.
If an organization fails to qualify under the applicable public-support test for two consecutive years and doesn’t qualify under another public-charity category, it generally becomes a private foundation for federal tax purposes. That changes the organization’s filing obligations and subjects it to the private-foundation rules, including additional excise-tax, distribution, and transaction requirements.
When donor concentration is increasing, or the revenue mix is changing, model the public-support calculation before year-end. Bring unusual grants, government funding, program-service revenue, and related-party contributions to your advisor’s attention early. Different types of support are treated differently, so don’t assume that a grant, government payment, or program-service payment will fall into a particular category based only on its label.
Don’t wait for Form 990 preparation
The common thread in each of these issues is timing. An expense-allocation problem is easier to address while supporting records are current. A new revenue activity is easier to evaluate before it has operated for a full year. And a changing public-support percentage is more useful to know before year-end than after the return is already being prepared.
Consider adding these items to your year-end Form 990 and tax-compliance review: significant new revenue sources, changes in how shared expenses are allocated, unusually large contributions, greater donor concentration, and changes in government or program-service revenue.
Get guidance tailored to your organization
If your nonprofit has launched a new revenue-generating activity, experienced a significant change in its funding mix, or has questions about expense allocations or public-support status, contact our office. We can review the facts with you, identify potential Form 990 or Form 990-T implications, and help address issues before they become filing-season surprises.
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