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CHAPTER 15: NOT-FOR-PROFIT ORGANIZATIONS – REGULATORY,

TAXATION AND PERFORMANCE ISSUES


Answers to Questions

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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immediately, and within 30 days f a request made by phone or mail. The NPO may be able to meet
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 .

15-10. 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 $ 70,000


Grant from Agawa County 5,000
(the excess over $5,000 is not counted)
Contributions:
small contributions 100,000
large contributions:
5 gifts @ $5,000 (the limit) 25,000
Public Support $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 5,000
Contributions:
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 5th 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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