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Nonprofit Accounting Basics: Understanding Taxes, Donations, and More

Accounting
Article
05/31/2019

Although nonprofits aren't in business to make money, they still require careful accounting practices. Donors who contribute to nonprofit organizations often want to know that their money is being spent to further the organization's mission. Any signs of irregularity or financial mismanagement can cause an organization to lose monetary backing and community goodwill. For this reason, accurate nonprofit accounting and financial reporting is essential.

Understanding nonprofit accounting basics is a good place to start.

What makes bookkeeping for nonprofits different?

Nonprofits may not be in the business of generating a profit, but that does not remove the importance of bookkeeping. Although there are some similarities, there are distinct differences between nonprofit and for-profit accounting. Facilities must be maintained; payroll, met; and taxes, paid. However, unlike for-profit businesses, accounting for nonprofits must also track volunteer hours, monetary donations, and in-kind donations. Financial records (how resources and assets are distributed) need to uphold the organization's commitments to its stated charitable purpose. If your organization has these or similar obligations, then you are in need of nonprofit accounting.

Considerations when setting up your accounting

Nonprofits share similarities, but that doesn't make them identical. Accounting for a nonprofit organization must accommodate the organization's current and anticipated needs. Things to consider include:

1. Cash vs. accrual: Nonprofit accounting methods

There are two methods for handling your nonprofit accounting, each with its strengths and weaknesses: cash basis accounting and accrual accounting. The size of your not-for-profit organization, plans for growth, and the nature of your operating expenses will determine which is better. The primary difference between the two involves the timing of when expenses and revenue are reported.

  • Cash basis accounting: Considered to be the simpler of the two, cash basis accounting records expenses and revenues only when cash is paid out or received, making it easier to track cash flow. Cash basis accounting can benefit a nonprofit because it recognizes income and expenses when they are actually realized. This can protect the organization from making investments in growth that depend on revenue that exists on paper but has not yet been realized.
  • Accrual accounting: More complicated than cash basis accounting, the accrual method accounts for revenue and expenses when they occur, usually before money changes hands. If, for example, a nonprofit employee provides a fee-based education program, the accrual method identifies that as revenue even before the invoice is paid. Similarly, expenses are accounted for as bills are received, not when they are actually paid. This method gives a nonprofit organization more accuracy for long-term budget planning.

2. Establishing tax-exempt status

Having donations qualify as charitable contributions on a donor's personal tax return is a powerful incentive. This means donations must be contributed to an IRS-designated tax-exempt organization. The first step to setting up your nonprofit's financial reporting system is to file the correct paperwork and attain tax-exempt status. Each state has its own filing rules. Nonprofit owners can file for tax-exempt status, a 501(c)(3) status, with IRS Form 1023.

What is IRS Form 1023?

IRS Form 1023 is a tax form that organizations file to apply for recognition of exemption from federal income tax under section 501(c)(3) — the portion of the IRS code that allows for federal tax exemption of nonprofit organizations. Some nonprofits may be eligible to fill out a streamlined version known as Form 1023-EZ. The IRS provides a worksheet that determines eligibility. Take note: The IRS requires that the Form 1023 and Form 1023-EZ be made available to the public.

3. Filing taxes for a nonprofit

Even though nonprofit organizations are classified as tax-exempt, the IRS still requires a return to be filed, so tax services should be considered. Most charities file a Form 990, the return for organizations exempt from taxes.

What is IRS Form 990?

IRS Form 990 is the most common tax form filed by charities in the United States; however, the amount of financial activity of your nonprofit will determine which IRS form you'll need to file. The longest form, Form 990, according to the IRS, is for "organizations with $200,000 or more in gross receipts or $500,000 or more in total assets." If either condition is met, a nonprofit must file a Form 990. If a not-for-profit has gross receipts of less than $200,000 and total assets of less than $500,000, then a Form 990-EZ may be filed. If donations received total less than $50,000, Form 990-N, or what's known as an e-postcard, may be filed. This short form reconfirms your nonprofit's tax-exempt status and receipts totaling less than $50,000. An exception to these financial distinctions is made for private foundations, all of which, regardless of assets or gross receipts, must file a Form 990-PF.

Forms 990, 990-EZ, 990-N, and 990-PF, like Form 1023, must be made available to the public.

Are there any nonprofits exempt from filing a Form 990?

Every nonprofit is obligated to file a Form 990, with a handful of exceptions. Most of these have religious affiliations, are state institutions, or are organized under acts of Congress. The IRS provides a complete list for exempt organizations.

4. Tracking nonprofit donations

Donations are a critical piece of nonprofit accounting basics. As nonprofit organizations raise funds and solicit donations, tracking and properly recording monetary contributions becomes an important function, as donors require detailed receipts to claim tax deductions. Accounting for donations with customizable line-item entries and reports will ensure that all necessary information is logged for both donors and financial reporting purposes. Kinds of donation data that should be tracked include:

  • Amount of money gifted: How much is being donated? These donations are part of the nonprofit's revenue.
  • Frequency of gift: How often does a particular donor make a donation? This helps a nonprofit track donor loyalty and gauge when to reach, cultivate, engage, or reconnect to donors.
  • Source of the donation: Is it coming from an individual private donor, a corporation, or a foundation? Donors need receipts to track their donations for their own accounting purposes.
  • Method of payment: Did the donor pay with cash, credit, or perhaps an in-kind donation of services or materials? This information needs to be provided on a donor's receipt for their own records and kept for the nonprofit's records of how donations are received.
  • Influence value: How much impact does the donation have in helping the organization fulfill its program and mission? Knowing this helps a nonprofit prioritize fundraising campaign efforts.

5. Nonprofit bookkeeping

Conversely, donors want to know how their money is being spent. To prepare tax returns and financial statements, expenses should be recorded and properly classified as either program or administrative expenses. Many donors look for organizations that funnel as much money as possible into program expenses, ensuring that their dollars are supporting the nonprofit's core mission. A large amount of overhead and administrative expenses, which includes fundraising expenses, could signal inefficiency and affect donors' willingness to contribute.

It's worth noting that tax filings are the main vehicle of transparency. Transparency on a particular year is temporary in that the IRS requests that returns be available to the public for a three-year period beginning on the due date of the return. Nonprofit bookkeeping gives the public (your potential donors) the ability to review your organization's expenses, revenue, and net assets.

  • Expenses: These may include rent, salaries for paid employees, fundraising costs, materials, supplies, and travel.
  • Revenue: In addition to donations, there may be membership dues, investments, grants, pledges, and even donations that entitle the donor to merchandise (from a museum store), a service (an art gallery visit), or an experience (a holiday gala).
  • Net assets: Unlike a business where assets are retained earnings or equity, net assets for a nonprofit are funds. Funds are allocated into three categories:
    • Unrestricted net assets for operations;
    • Restricted net assets for funds received earmarked for certain programs or future efforts; and
    • Permanently restricted net assets containing endowments and other funds not meant to be spent.

6. Financial reporting for nonprofits

In general, accounting for nonprofits requires a great deal of oversight due to the handling of personal donations and to maintain compliance with the tax-exempt status. Financial updates and analyses should be presented to the board of directors on a periodic basis. Also, audits may be necessary to ensure that the proper controls are in place and that funds are being used appropriately to carry out the organization's mission. Reports should include:

  • Balance sheets reporting assets, liabilities, and net assets for a specified period of time.
  • Operations reporting the revenues, expenses, and changes in funds.
  • Cash flows reporting expenses, cash receipts, financing, and investment activities.

Should you use nonprofit accounting software for your organization?

Nonprofits have many unique needs that differ from those of a for-profit organization. Many nonprofits may find cloud-based accounting software useful, which is accessible to a wide range of users, from beginners to the technically savvy. Consider using accounting software to help create customized reports, track donations and expenses, and more.

This website contains articles posted for informational and educational value. Paychex is not responsible for information contained within any of these materials. Any opinions expressed within materials are not necessarily the opinion of, or supported by, Paychex. The information in these materials should not be considered legal or accounting advice, and it should not substitute for legal, accounting, and other professional advice where the facts and circumstances warrant.