What Every CPA Needs to Know ... 2nd Edition

Essential Nonprofit Compliance: What Every CPA Needs to Know about Federal Filing Requirements

By Monika Briggs, CPA, June 3, 2024

This series is designed to serve as a foundational guide for CPAs who are new to the nonprofit space. It aims to help them navigate this sector confidently at the outset and gradually deepen their understanding as they progress in their journey. As the series unfolds, each installment will delve into an aspect of nonprofit management, offering essential information, practical advice, and expert insights. The goal is to demystify the complex regulatory landscape. This series will empower CPAs with the knowledge necessary to thoughtfully manage nonprofit finances and adeptly handle the myriad regulatory and compliance challenges they will encounter.

Last month, we launched the series with "Essential Nonprofit Compliance: What Every CPA Needs to Know about Nonprofit Status," exploring the distinctions between nonprofit and tax-exempt status. This month, we shift the focus to understanding the federal filing requirements that tax-exempt nonprofits must navigate. As CPAs integrate into nonprofit roles, mastering federal filing requirements becomes one of their first and most daunting challenges. Strict adherence to these requirements is crucial, not only for legal compliance but also for demonstrating the organization's transparency and integrity.

This article delves into the essentials of federal filing for nonprofits, focusing on key forms and concepts, common pitfalls, and strategic practices that ensure compliance and enhance organizational effectiveness. Understanding these requirements is more than just satisfying IRS demands; it’s about leveraging compliance to strengthen trust and engagement with donors, volunteers, and the communities served.

Key IRS Filings: The Form 990 Series

Nonprofit organizations with tax-exempt status are bound by strict IRS reporting requirements, primarily through the Form 990 series. Far more than just a tax return, Form 990 is a crucial tool for compliance, financial transparency, and public trust.? It demands detailed disclosures about an organization's finances, operations, and activities, allowing the IRS, donors, and the public to closely examine a nonprofit's financial health and effectiveness.

This information not only helps stakeholders make informed decisions but also supports state regulatory oversight and sector wide analyses, thereby enhancing accountability, facilitating charitable giving, and shaping policy within the nonprofit sector.

The specific Form 990 needed depends on an organization’s financial activity, total assets, and gross receipts during the fiscal year:

• Form 990: For organizations with gross receipts greater than $200,000 or total assets over $500,000 at the end of the year.
• Form 990-EZ: For organizations with gross receipts less than $200,000 and total assets at the end of the year less than $500,000.
• Form 990-N (e-Postcard): For small organizations with gross receipts normally $50,000 or less.
• Form 990-PF: Required for all private foundations, regardless of financial status.
• Form 990-T: Filed by organizations that generate gross income from unrelated business activities (discussed in greater detail below).

Form 990 filing exemptions apply to certain organizations, such as churches and some state-funded institutions.

Typically, a Form 990 is due by the 15th day of the fifth month following the end of the organization's fiscal year. So, for organizations operating on a calendar year, this deadline falls on May 15 (or the next business day if May 15 is a weekend or holiday). However, it’s common for nonprofits to have fiscal year ends on June 30 or Sept. 30, which alters the filing deadline accordingly. It is important to note that the filing obligations commence from the tax year the organization is considered legally formed, which coincides with the application for an employer identification number. This is not always in the same year that an entity receives its determination letter from the IRS.

The consequences of late or incorrect filings can be significant. Late or incorrect filings can result in penalties ranging from $20 per day (up to $10,000 or 5% of the year's gross receipts) and increasing to $100 per day with a maximum of $51,000 for larger entities. Failure to file for three consecutive years results in automatic revocation of tax-exempt status. Furthermore, inaccuracies can trigger IRS audits and precipitate severe legal and financial consequences, damaging the organization’s reputation and operational capabilities.

Alongside the Form 990 and its variants, several schedules and additional forms may need to be filed, depending on the specific activities, financial circumstances, and characteristics of the nonprofit organization:

• Schedule A: Verifies public charity status through public support tests (discussed below).
• Schedule B: Lists contributors who donate above a certain threshold.
• Schedule C: Reports political campaign and lobbying activities.
• Schedule D: Provides detailed financial statements.
• Schedule E: Required for schools to detail educational programs.
• Schedule F: Reports activities conducted outside the United States.
• Schedule G: Details fundraising and gaming activities.
• Schedule H: Applicable to hospitals reporting on community benefits and operations.
• Schedule I: Details grants and other assistance within the United States.
• Schedule J: Reports compensation for certain officers and employees.
• Schedule K: For organizations with tax-exempt bond liabilities.
• Schedule L: Discloses transactions with interested persons.
• Schedule M: Reports noncash contributions.
• Schedule N: For organizations that have undergone significant changes, such as dissolution or asset disposition.
• Schedule O: Provides additional information for responses on Form 990.
• Schedule R: Details relationships and transactions with related organizations and partnerships.

Each schedule helps paint a more complete picture of the nonprofit’s activities, governance, and financial situation, ensuring transparency and compliance with IRS regulations.

Public Support Test for Public Charities

In the first article of our series, we discussed the key differences between public charities and private foundations. The Public Support Test, calculated on Schedule A of Form 990, is crucial for determining whether an organization qualifies as a public charity. Maintaining public charity status is highly beneficial because it enhances eligibility for grants, increases donor confidence due to the perceived transparency and accountability, and usually results in more favorable tax treatment compared to private foundations. Additionally, public charity status offers more favorable deduction limits for donors.

The Public Support Test quantifies the diversity of an organization's funding sources, with calculations performed in two separate schedules, Part II and Part III.

• Part II applies to organizations defined in IRC Sections 170(b)(1)(iv) and 509(a)(1), which are typically charitable entities like social welfare organizations. These organizations must demonstrate that at least one-third of their support comes from public sources, such as contributions from governmental units or the general public, excluding income from activities unrelated to their primary exempt purposes. Should they fail to meet the 33 1/3% threshold, they may still qualify as a public charity under the 10% "facts and circumstances" test, which considers various factors, such as diversity of the donor base and the nature of the public support.
• Part III applies to organizations that are described in IRC Section 509(a)(2), such as cultural institutions and museums. These entities can include a larger portion of their support from earned revenue directly related to their exempt purposes. These organizations must normally receive more than 33 1/3% of their support from contributions, membership fees, and gross receipts related to their exempt functions (subject to certain exceptions) and no more than 33 1/3% of their support from gross investment income and unrelated business income.

For the purpose of completing Schedule A, qualifying public support includes grants from government entities, contributions from other public charities, and gifts from donor-advised funds. Membership fees and revenues from activities closely related to the nonprofit’s mission, as well as proceeds from fundraising events, also count toward public support. Finally – with some limitations – direct donations from individuals constitute public support and are crucial for demonstrating community and public backing.

Per Stacy Cullen, nonprofit tax director at Aprio, the Schedule A public support calculations are some of the most nuanced and miscalculated portions of Form 990. A misstep on Schedule A could land an organization in private foundation status. If your public support percentage is getting below 40% or you anticipate changes in your organization’s funding, it is important to reach out to a nonprofit tax specialist who can model what your public support may look like over the next few years while there is time to make necessary changes to retain your public charity status.

Regulatory Requirements and Compliance for Private Foundations

If an organization fails to meet the Public Support Test, it is classified by the IRS as a private foundation. Unlike public charities, private foundations typically have a limited number of donors, often centered around a single individual, family, or corporation. The concentration of control and funding raises concerns about the potential misuse of assets or influence for personal gain, which is not aligned with the charitable purposes for which tax exemptions are granted.

Given their significant investment assets and the potential for funding nontraditional grantees – including those that are not tax-exempt – private foundations undergo stringent regulatory oversight. This includes rules against self-dealing, mandatory asset distribution requirements, and detailed reporting on all financial transactions and grant-making activities. Such measures are essential, not only to prevent the misuse of substantial financial resources but also to ensure that private foundations contribute effectively and positively to societal welfare.

Private foundations face filing requirements and regulatory obligations different than those of public charities. Here are some key differences:

• Filing Requirements: Private foundations are required to file Form 990-PF annually, regardless of financial status. This form is more comprehensive than Form 990s filed by public charities and includes detailed financial information, activities, grants given during the year, and names and addresses of substantial contributors.
• Excise Tax on Net Investment Income: They are subject to an excise tax on net investment income, which includes interest, dividends, rents, royalties, and capital gains. This tax rate was historically 2%, but was adjusted to 1.39% in 2019.
• Minimum Distribution Requirements: To ensure that assets are used for charitable purposes and not hoarded, private foundations must annually distribute at least 5% of the average market value of their assets. Distributed funds include grants to charities and expenditures for administrative expenses directly connected to carrying out its charitable activities.
• Disclosure Responsibilities: Private foundations must make their filed Form 990-PF available for public inspection, either on their website or providing copies upon request. This form also details the grants awarded, including recipients and purposes.

Unrelated Business Income Tax

Tax-exempt entities generally do not pay federal income tax on most income, but they may be subject to unrelated business income tax (UBIT) for revenue not substantially related to their primary exempt purpose. UBIT was enacted as part of the Revenue Act of 1950, largely in response to concerns that tax-exempt organizations were unfairly competing with taxable businesses. It ensures that tax-exempt status is not used to avoid taxation inappropriately and encourages nonprofits to focus on their primary missions.

The following key criteria determine if income is subject to UBIT:

• Trade or Business: The activity must be considered a trade or business.
• Regularly Carried On: The activity is carried on regularly, similar to how a comparable for-profit entity would operate.
• Not Substantially Related: The activity does not substantially contribute to the organization's exempt purpose, other than through the production of funds.

Some nonprofits engage in activities that can generate income that subjects them to UBIT. A typical example is when a nonprofit sells advertising space on its website, in newsletters, or other publications. The revenue generated from these activities is usually considered unrelated to the organization’s exempt purpose. Similarly, providing fitness or recreational facilities to the general public for a fee (common among organizations like YMCAs or university gyms) produces income that does not align directly with educational or charitable purposes, thereby constituting taxable income. In my own experience, I’ve seen youth sports organizations generate revenue through the sale of branded apparel and other merchandise on their websites. Since their primary mission is promoting youth sports, not retail, the income from these sales is classified as unrelated business income.

Tax-exempt entities file Form 990-T, Exempt Organization Business Income Tax Return, to calculate and report UBIT. This form must be filed if gross income from unrelated businesses totals $1,000 or more during the fiscal year. The first $1,000 is exempt from tax. Organizations must deduct directly connected business expenses from gross income to calculate UBIT, and losses from one unrelated business can offset income from another. The tax rate applied is the same as corporate or trust tax rates, depending on the nonprofit's structure.

The timely and accurate filing of Form 990-T is crucial, and noncompliance can lead to penalties and jeopardize the nonprofit's tax-exempt status. Nonprofits engaged in any business activity should closely monitor these ventures and consult with tax professionals to ensure compliance with UBIT regulations and avoid potential financial liabilities.

Common Tax Compliance Pitfalls

Tax compliance is critical to nonprofits preserving their integrity and tax-exempt status. Unfortunately, many organizations encounter compliance challenges. Some of these issues were discussed earlier in this article, but they are worth emphasizing again due to their critical impact. Here are key pitfalls to avoid:

• Late Filing of Form 990: Failing to file the required Form 990 series by the deadline can lead to penalties and, after three consecutive years, automatic revocation of tax-exempt status.
• Incorrect or Incomplete Forms: Errors such as incorrect financial details, omission of activities, or incomplete disclosure of key employee compensation can trigger IRS scrutiny.
• Poor Record Keeping: Inadequate records can complicate substantiating expenses or donations during an IRS audit, undermining proof that funds are used according to the nonprofit’s mission.
• Underreporting of Unrelated Business Income: Nonprofits sometimes inadvertently underreport income from activities not directly related to their exempt purpose, resulting in potential UBIT liabilities.
• Violating Lobbying or Political Activity Restrictions: Excessive lobbying or engaging in political campaign activities can lead to severe penalties and threaten tax-exempt status for 501(c)(3) organizations.
• Failure to Maintain Public Charity Status: Not accurately tracking or reporting public support figures can lead to reclassification as a private foundation, subjecting the organization to stricter regulations and higher taxes.
• Not Reporting Changes in Organizational Structure or Activities: Significant operational, activity, or governance changes must be reported to the IRS. Failure to do so can affect the organization’s tax-exempt status.
• Misunderstanding of Tax Exemptions: Incorrect applications for, or failure to apply for, eligible exemptions, such as sales or property tax, can lead to unnecessary costs.
• Neglecting State and Local Tax Requirements: Compliance isn’t only federal. State and local regulations also demand attention, including registration, exemptions, and tax filings.

By being aware of these pitfalls and proactively addressing compliance issues, nonprofits can safeguard their tax-exempt status and continue to operate effectively and transparently.

Communicating Your Nonprofit’s Story

Form 990 often elicits mixed feelings within the nonprofit sector. Many view it solely as an administrative task – a checkbox to be ticked off each year. Thus, it’s not uncommon for organizations to delay addressing their Form 990 until the deadline looms, forcing them to scramble and treat the process as a last-minute chore.

This perspective overlooks the Form 990's strategic potential, and can lead to missed opportunities for strategic communication and storytelling. Form 990 is publicly accessible through platforms like GuideStar and the IRS website, making it a primary source of information for donors, grant makers, and other stakeholders who are evaluating an organization's credibility and effectiveness. Here are some strategic ways to use Form 990 to effectively communicate with donors, stakeholders, and the general public:

• Transparency and Trust Building through Detailed Financial Reporting (Parts VIII and IX): By providing a clear breakdown of revenues and expenses, along with specific allocations to program services versus administrative or fundraising expenses, nonprofits can showcase prudent financial management and commitment to their mission. This transparency builds trust with donors and stakeholders by demonstrating exactly how resources are being used and emphasizing the organization’s dedication to directing funds toward mission-critical activities.
• Mission and Impact Explanation (Part III): The Statement of Program Service Accomplishments offers a dedicated space for organizations to detail their missions and describe their major program services and accomplishments. Using clear, impactful language to outline key achievements and milestones provides a narrative that both informs and engages donors and the public, showcasing the organization's effectiveness and the tangible impact of its activities over the fiscal year.
• Governance and Practices (Parts VI and VII): Reporting on governance practices and listing board members and key staff helps reinforce an organization's integrity and accountability. Part VI, in particular, provides insight into the organization’s governance structure, including board oversight, ethical guidelines, and conflict-of-interest policies. Additional narrative should be provided in Schedule O to highlight how the organization adheres to high standards of governance and accountability and to communicate the strength and expertise of the team, which can reassure stakeholders about the organization’s direction and management.
• Fundraising and Donor Engagement (Parts VIII and IX): While Form 990 does not list individual donors, total contributions are included in Part VIII, which can be highlighted in communications to thank donors. Additionally, detailing fundraising expenses versus amounts raised in Part IX demonstrates the cost-effectiveness of fundraising efforts, appealing to donors interested in efficiency and maximizing the impact of their contributions.
• Strategic Planning and Future Goals (Various parts): Historical financial data and program achievements reported throughout Form 990 can be used for strategic planning, showing growth trends and financial stability. This data supports the organization's narrative about its path and potential future, helping to engage and reassure stakeholders of the organization’s continued relevance and impact.

By leveraging Form 990 as a communications tool, nonprofits can enhance their credibility, attract and retain donors, and effectively showcase their mission and impact. It's crucial to approach each section of the form, not just as a compliance requirement but as an opportunity to tell the organization’s compelling story. Here are some tips for maximizing the strategic use of Form 990:

• Start Early: Allow ample time to gather comprehensive information and consider how each piece of data reflects on the organization.
• Collaborate Across Departments: Engage multiple departments in the preparation of Form 990 to ensure that the information presented is accurate and reflects the organization’s collective achievements.
• Consult with Experts: Work with professionals to ensure that Form 990 not only meets compliance standards but also strategically communicates the organization’s story.
• Review and Update Regularly: Treat Form 990 as a living document that evolves with the organization to ensure that it remains an accurate and dynamic reflection of the nonprofit’s operations and goals.

By shifting the perspective on Form 990 from a burdensome chore to a valuable communications asset, nonprofits can significantly enhance their credibility, attract and retain donors, and effectively showcase their mission and impact.

Conclusion

This exploration into the federal filing requirements for tax-exempt nonprofits has highlighted the critical role that compliance plays, not only in maintaining legal status but also in building transparency and trust within the nonprofit sector. Clearly, the Form 990 series is not merely a regulatory requirement – it's vital to providing a window into a nonprofit's financial health, strategic direction, and overall impact.

As CPAs and nonprofit leaders navigate this complex landscape, it’s essential to approach filing requirements with diligence and strategic foresight. Proper management of Form 990 and its schedules can transform a routine filing obligation into an opportunity to showcase the organization’s dedication to its mission and accountability.

Your insights and engagement are invaluable to this series. I have enjoyed connecting with many of you since the first article's publication, and I invite you to share your experiences, questions, or challenges related to these topics. Your input enriches our discussions and helps tailor this series to your needs, fostering a more informed nonprofit community.

Next Weeks Issue

The next installment of this series, "What Every CPA Needs to Know about State Regulatory Compliance," the focus will shift to state-level regulatory compliance for nonprofits, highlighting the requirements for registration, reporting, and charitable solicitations. The discussion will also address the complexities faced by organizations operating across multiple jurisdictions and delve into the Charleston Principles and related disclosures on solicitation materials.

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Specific data in this blog was provided for the Pennsylvania Society of CPAs PICPA.

Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.