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CHAPTER 15:

Answers to Questions

NOT-FOR-PROFIT ORGANIZATIONS – REGULATORY, TAXATION AND PERFORMANCE ISSUES

15-1.

Auditors are asked to express an opinion not only on whether an entity presents financial statements that are fair and in accordance with generally accepted accounting principles, but also as to whether the organization has complied with laws and regulations. Apart from the audit function, accountants may be engaged for other attestation services or for the preparation of specialized financial reports to oversight bodies, such as the state and federal governments.

15-2.

A state government grants legal existence to a not-for-profit entity in the form of a nonprofit corporation or a charitable trust. With that right comes the responsibility for the government to monitor the actions of the NPO’s managers, and for the agency to report to the government. The

public looks to the state to monitor the charitable organization so it operates for the public good. A tax-exempt entity is only exempt from federal income taxes because it has applied to the Internal

Revenue Service for that privilege.

Congress gave the I.R.S. the power to grant tax-exempt status to

qualifying nonprofit organizations, and with that power, the responsibility to monitor organizations’

managers to ensure that the assets the public entrusts to the tax-exempt group are safeguarded and funds are spent for tax-exempt purposes.

15-3.

Note: Not all of these are examples of "real" organizations.

a. Peace and Quiet Cemetery

IRC Sec. 501(c)(13)

b. Midwest Society of CPAs

IRC Sec. 501(c)(6)

c. Eastville Rotary Club

IRC Sec. 501(c)(8)

d. Rolling Hills Country Club

IRC Sec. 501(c)(7)

e. American Heart Association

IRC Sec. 501(c)(3)

f. Cornell Elementary PTA

IRC Sec. 501(c)(3) or sometimes (4) or (5)

g. Time for Tots Child Care Center

IRC Sec. 501(k)

h. League of Women’s Voters

IRC Sec. 501(c)(4)

 

Note: Their goals are to foster voter education and participation in the electoral

process.

 

i. National Basketball Association

IRC Sec. 501(c)(6)

15-4.

If a not-for-profit organization is organized primarily to influence legislation or carry on propaganda,

it

will not qualify for tax-exempt status under any classification. Legislation is generally actions by

Congress or a state or local government body and propaganda is information skewed toward a particular belief, with little factual basis. If an NPO participates in a political campaign, either

directly or indirectly, it may lose its tax-exempt status.

15-5.

A public charity is in the not-for-profit (or “third sector”) and not in the public sector, which is the phrase commonly used to include governmental entities supported by public tax revenues. Public charities, however, are broadly supported by the general public in the form of contributions, dues, or charges for services which is why the adjective “public” is appropriate. Private foundations are funded by gifts from a small set of donors, usually a family or corporation. A private foundation makes grants to public charities, which then operate programs. Both are tax-exempt under IRC Sec. 501(c)(3), but public charities receive the most preferred tax treatment because it is assumed that the public, both donors and beneficiaries of the programs, will monitor the actions of the organization.

A private foundation is subject to many excise taxes for prohibited behavior because there is a higher

risk that this type of organization will serve the interests of a small set of donors at the expense of the

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public. For example, a wealthy donor could establish a private foundation, receive a charitable income tax deduction for a contribution of appreciated stock in the current period, place family members on the board who make spending decisions, rent office space to the foundation, and pay out relatively small amounts to charities over time. Students may remember from an introductory taxation course that the charitable contribution itemized deduction is more generous for gifts given to public charities than private foundations.

15-6.

Congress, through the Internal Revenue Code, requires that the amount a tax-exempt organization spends on influencing legislation be insubstantial. For example, less than 5% of total expenses might

be considered insubstantial. The organization cannot participate in political campaigns or be involved

in

propaganda. If the organization engages in excess political activities, then it is subject to a tax on

that excess. The organization may elect under IRC Sec. 501(h) to make limited expenditures on influencing legislation. The ceiling on allowable political expenses is a function of direct and grass roots lobbying, and cannot exceed $1 million in one year. The IRS also has the sanction of revoking the tax-exempt status of an organization if it engages in partisan political campaigns.

A

political action committee is an organization created for the express purpose of soliciting public

contributions that will be used to support a political party or candidate for public office. These organizations, along with political parties and campaign committees, apply for exemption under IRC Sec. 527.

15-7.

A gift shop that is considered unrelated to the tax-exempt mission of the museum and regularly carries on business activities will be subject to the unrelated business income tax (UBIT) if its net income is greater than $1,000. The UBIT rate is equal to corporate income tax rates. In order to ensure that the museum does not incur a UBIT liability, the managers should carefully review the incorporating documents to determine if the tax-exempt mission of the organization includes selling items related to exhibits. The museum can also escape this tax if the gift shop is staffed by volunteers, if the entire inventory is donated, or if its net income is less than $1,000.

Ch. 15, Answers, (Cont’d)

15-8.

Intermediate sanctions refers to the power given to the IRS in IRC Sec. 4958 to assess a tax on excess benefit transactions. Transactions in which a substantial benefit is given to a disqualified person (i.e., one who has the ability to influence the organization, such as an officer or manager)

result in a tax on the person receiving the benefit and possibly an additional tax on the organization, if

it

knew the transaction was improper. Examples include excess compensation and sales of goods at

bargain prices to managers. Prior to the introduction of this tool in the 1996 Taxpayer Bill of Rights

2,

the only sanction the IRS had against NPO abuses was to revoke their tax-exempt status. This

harsh penalty often hurt the public beneficiaries who lost the services of the charity, more so than the abusive officers.

15-9.

The Form 990 which is filed by all tax-exempt organizations (except private foundations which file a Form 990-PF) each year contains (1) descriptive information about the NPO; such as address, type of exempt organization, method of accounting, list of officers, (2) financial information; such as balance sheet, statement of revenues, expenses, and changes in net assets, and functional expenses, and (3) additional information; such as extent of political activity, compensation to highest paid employees and independent contractors, unrelated business income, related party transactions, and program service accomplishments. See also Illustration 15-3.

Form 990 must be available for public inspection at the organization’s office for three years and can also be obtained directly from the IRS for a fee. The 1999 IRS public disclosure regulations require that an organization honor a request for Form 990 and the exempt application made in person

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15-10.

immediately, and within 30 days f a request made by phone or mail.

this requirement by making the documents widely available on the Internet. The National Center for Charitable Statistics at the Urban Institute is a partner with Guidestar at the Philanthropic Research Institute (PRI-Guidestar) that make nonprofit organizations’ Form 990s available on this website http://www.guidestar.org . Other information about the Quality of Form 990s is available at http://nccs.urban.org/990 .

The NPO may be able to meet

Board members have a high degree of public responsibility to hold the NPO managers accountable for the safety of the tax-exempt assets and the effective operation of the programs. Inside board members, who are also employees, may have the most working knowledge of the organization, and yet they may have incentives to favor short-term results over long term-goals, in part because their compensation may be tied to current operating results. An incentive compensation plan that translates the overall organization’s long and short-term goals into measurable outcomes may curb a manager’s self-serving actions.

Solutions to Cases

15-1.

a.

The memo should clearly point out that there is a two step process: (1) apply to become a nonprofit corporation or charitable trust with a particular state by filing

Ch. 15, Solutions, Case 15-1, (Cont’d)

articles of incorporation, and (2) apply to the IRS for tax-exempt status under a particular exempt subsection of IRC Sec. 501. Explain how important it is that the mission or purpose statement in the articles of incorporation and tax-exempt application (Form 1023 or 1024) clearly describe the purpose for which the organization is to be organized and who will benefit from its existence. If the organization merely collects donations from neighbors that are spent on improvements that benefit those neighbors, then the organization will not be considered a charitable or educational exempt organization under IRC Sec. 501(c)(3), the most advantageous of all the exempt sections. The incorporating officers may want to discuss the advantages and disadvantages of broadening their focus to solicit funds and benefit the public at large. The group should also carefully review the plans and amount of resources directed to lobbying and affecting local legislation.

 

b.

There are numerous websites on the Internet of management support organizations that provide information for new nonprofit entities. For example, www.accountingaidsociety.org , www.boardsource.org , and www.independentsector.org and www.mapfornonprofits.org .

15-2.

a.

This country club is most likely exempt under IRC Sec. 501(c)(7) based on the mission of providing social and recreational benefits to members. This purpose should also be articulated in the articles of incorporation. Sales to nonmembers, if conducted as a regular business, would constitute unrelated business income.

b.

The Supreme Court of the United States seldom hears tax cases; however, in Portland Golf Club v. Commissioner of Internal Revenue (1990) it spent a considerable amount of time discussing the methods of allocating fixed or indirect expenses against gross revenue from nonmember revenue in order to determine whether there is unrelated business income. Fixed costs relating to the building, such as depreciation and utilities, could be allocated based on the square footage used in serving members and nonmembers, and fixed costs, such as

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manager’s salaries, can be allocated based on the percentage of total salaries related to serving nonmembers. If a systematic and rationale allocation scheme is used and a loss results, the IRS may claim that there really wasn’t a profit motive for sales to nonmembers, and limit expenses to revenue. Unrelated business income does not include investment income, so business losses should not be deducted against that income.

Note to instructor: Although the issues in this case are primarily taxation issues and students may not have had enough tax background to locate a Supreme Court case, this case can be used to point out that federal regulation over nonprofit entities is primarily through the tax code; and to adequately address whether an organization has complied with all rules and regulations, an auditor must have enough familiarity with tax law to know when he or she needs to consult with a tax specialist.

15-3.

Students will choose different sets of charities. Although Internet addresses may change, the current homepages of the organizations listed in Illustration 15-5 are:

Lutheran Services in America

www.lutheranservices.org

National Council of YMCAs

www.ymca.net

United Jewish Communities

www.uja.org

Salvation Army

www.salvationarmy.org

American Red Cross

www.redcross.org

Catholic Charities USA

www.catholiccharitiesusa.org

Goodwill Industries International

www.goodwill.org

Fidelity Investments Charitable Gift Fund

www301.charitablegift.org

Shriners Hospitals for Children

www.shrinershq.org

Boys & Girls Club of America

www.bgca.org

American Cancer Society

www.cancer.org

Students may need to search a website to find financial information. Very few organizations include their audited annual financial statements at this point in time, although under sections such as “Disclosures” the organization may direct you to write the organization or some state office to obtain a copy of the annual report. The BBB Wise Giving Alliance (at http://www.give.org) provides reports that contain financial measures of performance for a fee, and Form 990s are available at www.guidestar.org . The most common performance measure that is publicized is the percentage of total expenses spent on the programs as opposed to supporting the programs (general and administrative and fund-raising expenses).

15-4.

a. On June 5, 2002 the American Red Cross issued a press release entitled “Donor DIRECT Program Sets New Standards for Honoring Donor Intent” (available at www.redcross.org under Press Room). DIRECT is an acronym for Donor, Intent, Recognition, Confirmation, Trust. Students should examine this for the issues of importance to accountability; that is, internal controls, relevant information, documentation, and accounting for “restricted” contributions.

b. The IRS produced an addendum to Pub. 78, the Cumulative List of Exempt Organizations, called “Disaster Relief, September 11, 2001.” Students may be surprised to see that almost 300 new tax-exempt organizations were created to meet the needs of victims of this disaster. Each organization will have administrative costs to establish accounting information systems, regularly

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record receipts and disbursements, prepare compliance reports, and report to the Board. Students will estimate different costs for these activities, but should recognize some inefficiencies

Ch. 15, Solutions, Case 15-4, (Cont’d)

in administering many small organizations for seemingly the same purpose. Organizations with a narrow focus may dissolve after a few years or choose to merge its charitable assets and programs into another organization with similar values and mission.

Solutions to Exercises and Problems

15-1.

1.

a.

6.

d.

2.

c.

7.

b.

3.

b.

8.

c.

4.

a.

9.

d.

5.

a.

10.

a.

15-2.

a.

United Way support Grant from Agawa County

 

$ 70,000

 

5,000

(the excess over $5,000 is not counted) Contributions:

small contributions large contributions:

 

100,000

gifts @ $5,000 (the limit) Public Support

5

25,000

$200,000

 

b.

The organization is a public charity because it passes both the external and the internal support tests. More than 1/3 of its revenue comes from the public at large

 

($200,000/495,000 = 40%) and less than 1/3 comes from investment income $45,000/$495,000 = 10%).

 

c.

No. Now the organization fails the external support test because $205,000/$635,000 ($495,000+$140,000) = 32% which is less than 1/3 of total support.

 

United Way contribution

 

$ 70,000

Grant from Agawa County Contributions:

5,000

small contributions

100,000

6

gifts @ $5,000

30,000

Total Public Support

 

$205,000

15-3.

a.

LearnMore, Inc. is in violation of the requirement that prohibits public charities from spending a substantial portion of their total expenses in an attempt to influence legislation. Although substantial is not defined in the tax code, 19 percent ($250,000/$1,350,000) would probably be considered significant. In addition, LearnMore, Inc. is subject to a tax on the lobbying expenditures. If the

Ch. 15, Solutions, 15-3, (Cont’d)

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organization’s management knew that the lobbying expenditures were likely to result in LearnMore, Inc. no longer qualifying as a public charity, then an equal amount of tax would be assessed on the organization’s management.

 

b.

If LearnMore, Inc. elected to participate in lobbying activities under IRC Sec. 501(h), then, it would have to calculate the ceiling on permitted lobbying expenses. This step requires that the organization identify its direct lobbying expenses and grass roots lobbying expenses. The calculation of the tax is beyond the scope of this text; however, interested students may want to review the “Exempt Organizations” chapter in a comprehensive income taxation book.

15-4.

a.

The Tax Court ruled in the Sierra Club case (77 TCM 1999-86 (March 23, 1999) that revenues from selling a mailing list are royalties from licensing the use of an intangible asset under IRC Sec. 512(b)(2). The IRS lost a similar case in the Sixth Circuit and did not appeal the adverse decision in the Mississippi State Alumni Association in the 5 th Circuit. The IRS may stop pursuing these cases; however, that is yet to be seen.

b.

Neither the Tax Court ruling nor the Internal Revenue Code section on Unrelated Business Income indicates that the dollar amount is a factor. The organization should check each year to see that this type of revenue is still exempt; for example, if the sales appear to constitute a trade or business regularly carried on for profit, the tax consequences may be different.

15-5.

a.

Unrelated business income tax is $600 (15% of the net income of the gift shop, $5,000 less $1,000). The organization may not be subject to UBIT if the youth it is training work in the gift shop.

b.

The UBIT would be the same. UBI depends primarily on the nature of the money received, and not how it was used.

15-6.

1.

Yes. This is a classic example of excess economic benefit transactions. Jane is a disqualified person because she is an officer with substantial influence over the organization; and she receives more than the fair market value for the building. The organization can avoid sanctions by getting other appraisals that document that the building is really worth $250,000, or purchasing the building for $200,000.

2.

Yes; however, only when the excess benefit is paid out. The organization could avoid a problem, by putting a cap on the amount of compensation the president could receive.

3.

No; however, the law is silent on this particular example. She is probably receiving the tickets as a member, if all members receive the same amount of admission tickets. If the organization intended it to be compensation, then it needs

Ch. 15, Solutions, 15-6, (Cont’d)

to explicitly say so in a Board resolution. Forthcoming IRS regulations may clarify this example.

4. Possibly. If the incoming president’s duties are similar to the outgoing president and comparable organizations, then the compensation may be unreasonable. If the duties are similar, however, he is able to perform them more efficiently, then the higher salary may be reasonable. The organization should be sure his other offers are written and that he did not

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influence them so that they substantiate his “worth.” The NPO should also survey for comparable salaries and document the nature of his duties and how they may differ from the previous president, as well as any difficulty in finding a candidate as qualified as this person.

15-7.

The benefits of reorganizing should be compared to the costs of doing so. For example, cost savings may arise from reducing staff and consolidating offices; however, extra costs may arise if consultants are employed to evaluate the financial and operations systems. Merging two accounting information systems requires that adequate internal controls be developed in the surviving system, new operating procedures are documented, and the old systems are run parallel to the newly combined system for a period of time long enough to ensure that the data are reliable.

If one organization is dissolved, then the proper forms for dissolution of a corporation must be filed

with the state, all creditors must be paid (or they must approve transferring the liability to the

surviving organization), and all charitable assets must be transferred to another exempt organization, presumably the surviving organization. The auditor of the new organization may have to rely on the prior year’s audit done by another auditor.

A useful resource is Thomas A. McLaughlin’s Seven Steps to a Successful Nonprofit Merger,

National Center for Nonprofit Boards (now Boardsource), 1996.

15-8. a.

First, note that the American Red Cross is the fifth largest tax-exempt not-for-profit entity in the United States as can be seen in Illustration 15-5. Note, also that the example financial statements presented are for the year ending June 30, 2001 which is before the tragedy of September 11, 2001 which resulted in a huge inflow of contributions to this charity and tremendous public attention on this organization’s accountability for the use of those contributions.

The organization is liquid and can meet its short-term obligations as evidenced by the current ratio for the unrestricted net assets of 2.52 times (unrestricted current assets/unrestricted current liabilities or $994,718,000/$393,969,000). This NPO has more than two and one-half times the amount it needs to pay off current liabilities. Of course, current assets include inventory and, perhaps, prepaid expenses that cannot be quickly converted to cash to pay off current liabilities. The current ratio is not a meaningful measure for the restricted net assets.

Ch. 15, Solutions, 15-8, (Cont’d)

b. The organization had a decrease in unrestricted net assets of almost $50 million from operations ($2,662,425,000 - $2,712,302,000), and a decrease of more than $100 million after nonoperating losses which brought net assets to approximately $1.5 trillion. The managers should decide whether a decrease in unrestricted net assets of 7% in one year is material and whether they should take action to reverse this trend by increasing revenues or decreasing expenses in future years. However, when increases to restricted net assets are considered, the organization merely had a 1% decrease in total net assets ($31,071,000/$2,195,208,000).

c. This organization spent about 90 percent ($2,448,960,000/$2,712,302,000) of all its expenses on the programs (e.g., disaster services, biomedical services, and health and safety services) and approximately 10 percent ($263,342,000/$2,712,302,000) on supporting the programs

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(e.g., management and general and fund-raising expenses). This ratio meets that suggested by watchdog agencies, such as the BBB Wise Giving Alliance (www.give.org ).

d. The cost of fund-raising could be computed as total public support for the year divided by total fund-raising expenses. This means that $7.02 is contributed for every dollar spent on fund-raising (total public support/fund-raising expenses or $762,668,000/$108,616,000). It is positive, and in general, the higher the amount, the better. A finer analysis would compare the specific type of contributions raised with the fund-raising expenses that generated those funds. For example, “other contributions” may result from the efforts of federated fund- raising organizations and not from the fund-raising dollars spent by this organization.

e. Investment performance is complicated as the organization may have different investment pools or portfolios that have different investment objectives. For example, an endowment or permanently restricted fund may be invested for long-term capital growth, while other funds may be invested in cash equivalents or short-term money market funds for income to meet current operating needs. One measure might be total investment income/total investments. For this organization, that performance measure is 6% ($81,405,000/$355,090,000 + $1,120,773,000), a good starting point from which to investigate further.

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