C H A P T E R 1 > F I N A N C I A L A C C O U N T A B I L I T Y
photographs or any other communication which would tend to create a false impression
• 7.2: Communication and Donor Expectations: Fund-raising appeals must not create
unrealistic donor expectations of what a donor’s gift will actually accomplish within the
limits of the organization’s ministry.
• 7.3: Communication and Donor Intent: All Statements made by the Organization in its
fund-raising appeals about the use of the gift must be honored by the Organization. The
donor’s intent is related both to what was communicated in the appeal and to any donor
Instructions accompanying the gift. The Organization should be aware that Communications
made in fund-raising appeals may create a legally binding restriction.
• 7.4: Projects Unrelated to a Ministry’s Primary Purpose: An Organization raising or
receiving funds for programs that are not part of its present or prospective ministry, but
are proper in accordance with its exempt purpose, must either treat them as restricted
funds and channel them through an Organization that can carry out the donor’s intent, or
return the funds to the donor.
• 7.5: Incentives and Premiums: Organizations making fund-raising appeals which, in
exchange for a contribution, offer premiums or incentives (the value of which is not
insubstantial, but which is significant in relation to the amount of the donation) must
advise the donor of the fair market value of the premium or incentive and that the value is
not deductible for tax purposes.
• 7.6: Financial Advice: The representative of the Organization, when dealing with persons
regarding commitments on major estate assets, must seek to guide and advise donors so
they have adequately considered the broad interests of the family and the various ministries
they are currently supporting before they make final decisions. Donors should be encouraged
to use the Services of their attorneys, accountants, or other professional advisors.
• 7.7: Percentage Compensation for Fund-Raisers: Compensation of outside fundraising
Consultants or an organization’s own employees based directly or indirectly on a
percentage of charitable contributions raised is not allowed.
• 7.8: Tax-Deductible Gifts for a Named Recipient’s Personal Benefit: Tax-deductible
gifts may not be used to pass money or benefits to any named individual for personal use.
• 7.9: Conflict of Interest on Royalties: An officer, director, or other principal of the
Organization must not receive royalties for any product that the Organization uses for
fund-raising or promotional purposes.
• 7.10: Acknowledgement of Gifts-in-Kind: Property or gifts-in-kind received by an
Organization should be acknowledged describing the property or gift accurately without a
Statement of the gift’s market value. It is the responsibility of the donor to determine the
fair market value of the property for tax purposes. The Organization may be required to
provide additional information for gifts of motor vehicles, boats, and airplanes.
• 7.11: Acting in the Interest of the Donor: An Organization must make every effort to
avoid accepting a gift from or entering into a contract with a prospective donor which would
knowingly place a hardship on the donor, or place the donor’s future well-being in jeopardy.
Organization receives tax-exempt Status, certain federal taxes may still be imposed. There
may be tax due on the unrelated business income, tax on certain „political“ activities, and
tax on excessive legislative activities.
Tax exemption advantages
Besides the basic exemption from federal income and excise taxes, an Organization that is
recognized as a charitable Organization under the Internal Revenue Code enjoys several
) • Its donors can be offered the benefit of a deduction for contributions.
>• It can benefit from using special Standard nonprofit mail rares.
>• It is in a favored position to seek funding from
foundations and other philanthropic entities,
many of which will not Support organizations
other than those recognized as tax-exempt
organizations under 501(c)(3).
It is eligible for government grants available
only to entities exempt under 501 (c) (3).
It often qualifies for exemption not only from
State and local income taxes but from property
taxes (for property used directly for its exempt
A tax-exempt Organization usually
means the entity is exempt, in whole or
in part, from federal income taxes. The
entity may still be subject to social
security taxes and certain excise taxes.
Nonprofit organizations may be subject
to taxes at the State level on income,
franchise, sales, use, tangible property,
function) and certain sales and use taxes as well. Vj^tan9’^e property, and real property^/
^ It may qualify for exemption from the Federal Unemployment Tax Act in certain
) • Its employees may participate in 403 (b) tax-sheltered annuities.
>» It is an exclusive beneficiary of free radio and television public Service announcements
(PSAs) provided by local media outlets.
X- If it is a church or a qualified church-controlled Organization, it may exclude
compensation to employees from the F I CA social security base. The Organization
must be opposed on religious grounds to the payment of F I C A social security taxes.
The social security liability shifts to the employees of the electing organizations in the
form of SECA social security tax.
Tax exemption limitations
Offsetting the advantages of tax-exempt Status are some strict requirements:
>• An Organization must be engaged „primarily“ in qualified charitable or educational
>• There are limitations on the extent to which it can engage in substantial legislative
activities or other political activities.
>- An Organization may not engage in unrelated business activities or commercial
activities to an impermissible extent.
>• There is a prohibition against private inurement or private benefit.
>• Upon dissolution, the organization’s assets must be distributed for one or more
Tax Exemption for Churches
Tax law and IRS regulations do not define „religious.“ But the courts have defined „religious“
broadly. In part, because of these constitutional concerns, some religious organizations are
subject to more lenient reporting and auditing requirements under federal tax law.
The „religious“ category includes churches, Conventions of churches, associations of
churches, church-run organizations (such as schools, hospitals, orphanages, nursing homes,
Publishing entities, broadcasting entities, and cemeteries), religious Orders, apostolic
groups, integrated auxiliaries of churches, missionary organizations, and Bible and tract
societies. IRS regulations define religious worship as follows: „What constitutes conduct
of religious worship or the ministration of sacerdotal functions depends on the interests
and practices of a particular religious body constituting a church.“
Although not stated in the regulations, the IRS applies the following 14 criteria to decide
whether a religious Organization can qualify as a „church“:
• Distinct legal existence /^^~^\
• Recognized creed and form of worship
>* Definite and distinct ecclesiastical government
j>- Formal code of doctrine and discipline
} • Distinct religious history
Membership not associated with any other
church or denomination
Organization of ordained ministers
• Established places of worship
Literature of its own
>• Ordained ministers selected after completing prescribed courses of studies
>• Regulär congregations
Regulär religious Services
Sunday schools for religious instruction of the young
>• Schools for preparation of its ministers
Churches receive favored Status in that they are not required to file either an application for
exemption (Form 1023) or an annual report (Form 990) with the IRS. A church is still subject
to filing an annual report on unrelated business income (Form 990-T) and Form 5578 for
private schools as well as payroll tax, sales tax, and other forms, if applicable. Individuais
employed by churches qualify more easily for the special ministerial tax treatments, including
a housing allowance.
Churches generally avoid audits because of the highly restrictive requirements of the Church
Audit Procedures Act. While the IRS may begin a „church tax inquiry“ to determine
whether a church qualifies for tax-exempt Status or is carrying on an unrelated business, the
inquiry must be approved by an appropriate high-level IRS official. However, this audit
restriction does not apply to a church that is not filing or paying payroll taxes, to criminal
investigations, to separately incorporated private schools, or to any inquiry relating to the
tax Status or liability of persons other than the church, such as ministers or contributors.
Starting a Nonprofit Organization
The choice of a nonprofit organizational form is a basic decision. Most churches are unincorporated
associations. However, many churches incorporate for the purpose of limiting legal
liability. Most other nonprofit organizations are corporations. While incorporation is usually
desirable for churches and other nonprofit organizations, it is generally not mandatory.
Organizations using the corporate form need articles of incorporation and bylaws. An
unincorporated Organization will typically have the same instruments, although the articles
may be in the form of a Constitution.
Several planning questions should be asked. I f the Organization is
formed for charitable purposes, is public Status desired
or is a private foundation acceptable? Are any business
activities contemplated, and to what degree
will the Organization be incorporated? Is an attorney
competent in nonprofit matters available to
help with the preparation of the legal documents?
What provisions will the bylaws contain? Who
will serve on the board of directors? What name
will be used for the Organization?
The following materials may provide useful information
when starting a church or other nonprofit
Package 1023 Application for Recognition of Exemption with Instructions
Publication 557 Tax-Exempt Status for Your Organization
Obtaining a n employer I d e n t i f i c a t i o n number
All entities, whether exempt from tax or not, must obtain an employer identification number
(EIN) by filing IRS Form SS-4. An E I N is required for a church even though churches are
not required to file with the IRS for tax-exempt Status. This number is not a tax-exempt
number, but is simply the organization’s unique identifier in the IRS’s records, similar to an
individual’s social security number.
When an Organization is approved by the IRS for exemption from federal income tax (not
required for churches), it will receive a „determination letter.“ This letter does not assign
the Organization a tax-exempt number.
I f an Organization is a „central Organization“ that holds a „group exemption letter,“ the IRS
will assign that group a four-digit number, known as its group exemption number (GEN).
This number must be supplied with the central organization’s annual report to the IRS
(updating its list of included subordinate organizations). The number also is inserted on
Form 990 (if required) of the central Organization and the subordinate organizations
included in the group exemption.
When an Organization applies for exemption from State or local income, sales, or property
taxes, the State or local jurisdiction may provide a certificate or letter of exemption, which,
in some jurisdictions, includes a serial number. This number is often called a „tax-exempt
number.“ This number should not be confused with an E I N .
Application for recognition of tax-exempt Status
Although a church is not required to apply to the IRS for tax-exempt Status under Section
501(c)(3) of the Internal Revenue Code and is exempt from filing Form 990, it may be
appropriate to apply for recognition in some situations:
^ National denominations typically file for group
exemption to cover all local congregations. A
copy of the national body’s IRS determination
letter may be used by the local group to
provide evidence of tax-exempt Status.
Independent local churches that are not a
part of a national denominational body often
file for tax-exempt Status to provide evidence
of their Status. The local congregation may
wish to file for group exemption i f it is a
parent church of other local congregations
or separately organized ministries.
If a local congregation ordains, licenses, or commissions ministers, it may be helpful
to apply for tax-exempt Status. Ministers that are ordained by a local church may be
required to provide evidence that the church is tax-exempt. This could be particularly
true if the minister files Form 4361, applying for exemption from self-employment tax.
Organizations desiring recognition of tax-exempt Status should submit Form 1023 (see
pages 27-28 for churches and filing for tax-exempt Status). I f approved, the IRS will issue
a determination letter describing the category of exemption granted.
The IRS must be notified that the Organization is applying for recognition of exemption
within 15 months from the end of the month in which it was organized. Applications
made after this deadline will not be effective before the date on which the application for
recognition of exemption is filed.
Some organizations view the obtaining of an exemption letter from the IRS as an intimidating
process. Organizations faced with the process are typically new, with a general mission in mind.
The mission is often not ftxlly developed, and therefore it may not be clearly articulated. It may
be helpful to have your application reviewed by a CPA or attorney before it is filed.
Organizations that have applied and been approved for tax-exempt Status are listed in
Publication 78, Cumulative List of Organizations, which identifies organizations to which
tax-deductible contributions may be made. However, organizations that do not file
Form 990, such as churches, will not be listed.
Determination letter request
A user fee of $500 (with Form 8718) must accompany applications for recognition of taxexempt
Status where the applicant has gross receipts that annually exceed $10,000. For an
Organization that has had annual gross receipts of $10,000 or less during the past four years,
the fee is $150. Start-ups may qualify for the reduced fee. Group exemption letter fees are $500.
Granting tax exemption
Upon approval of the application for exemption,
the IRS will provide a determination letter. This
letter may be an advance determination or a definitive
(or final) determination. The exempt Status is
usually effective as of the date of formation of the
Organization, if filing deadlines are met.
An advance determination letter provides tentative
guidance regarding Status but is a final determination
relating to Operations and structure of the
Organization. An advance determination is effective
for five years. Before the end of the advance
determination period, the Organization must show
that it qualifies for nonprivate foundation Status.
During the advance determination period, contributors may make tax-deductible donations
to the Organization.
A newly created Organization seeking Status as a publicly supported Organization is entitled
to receive, i f it so elects, a definitive ruling i f it has completed a tax year consisting of eight
füll months as of the time of filing the application.
A definitive (or final) determination letter represents a determination by the IRS that the
organizational and operational plans of the nonprofit entitle it to be classified as exempt.
An affiliated group of organizations under the common control of a central Organization
can obtain a group exemption letter. Churches that are part of a denomination are not
required to file a separate application for exemption i f they are covered by the group letter.
The central Organization is required to report annually its exempt subordinate organizations
to the IRS (the IRS does not provide a particular form for this reporting). The
central Organization is responsible to evaluate the tax Status of its subordinate groups.
Unrelated Business Income
Most Christian ministries are supported primarily from either contributions or revenue from
activities directly related to their exempt purposes. Sales of religious books, tuition
at schools, and campers‘ fees at camp are examples of exempt purpose
revenue. On the other hand, income from activities not directly
related to fulfilling an organization’s exempt purposes may be
subject to the tax on unrelated business income.
All income of tax-exempt organizations is presumed
to be exempt from federal income tax unless the
income is generated by an activity that is
) • not substantially related to the organization’s
exempt purpose or function,
^ a trade or business, and
regularly carried on.
Unrelated business income (UBI) is permitted for \
tax-exempt organizations. However, these organizations
may have to pay tax on income derived from activities unrelated to their exempt
purpose. U B I must not comprise a substantial part of the organization’s Operation. There
is no specific percentage limitation on how much U B I is „substantial.“ However, organizations
with 50% to 80% of their activities classified as unrelated have faced revocation
of their tax-exempt Status.
Form 990-T must be completed to report the source(s) of U B I and related expenses and to
compute any tax. U B I amounts are also reportable on Form 990 (if the filing of Form 990
is required). Organizations required to file a Form 990-T will generally also be required to
make a State filing related to the U B I .
Although exempt from filing Form 990, churches must file Form 990-T i f they have $1,000
or more of gross U B I in a year. There is a specific deduction of $1,000 in Computing
unrelated business taxable income. This specific deduction applies to a diocese, province
of a religious order, or a Convention or association of churches with respect to each parish,
individual church, district, or other local unit.
Unrelated business Income consequences
Some church and nonprofit executives are paranoid about U B I to the point that they feel
it must be avoided altogether. Some people equate U B I with the automatic loss of exempt
Status. A more balanced view is to understand the purpose of the U B I and minimize the
UBI tax through proper planning.
The most common adverse result of having U B I is that all or part of it may be taxed. A less
frequent, but still possible, result is that the Organization will lose its tax exemption. It is
possible that the IRS will deny or revoke the tax-exempt Status of an Organization when it
regularly derives over one-half of its annual revenue from unrelated activities.
Congress recognized that some nonprofits may need to engage in unrelated business
activities to survive. For example, a nonprofit with unused office space might rent the
space to another Organization. Also, nonprofits are expected to invest surplus funds to
Supplement the primary sources of the organization’s income.
A trade or business regularly carried on
A trade or business means any activity regularly carried on which produces income from
the sale of goods and Services and where there is a reasonable expectation of a profit. To
decide whether a trade or business is regularly carried on, the IRS considers whether taxable
organizations would carry on a business with the same frequency and continuity. Intermittent
activities may escape the „regularly carried on“ definition.
EXähiplC I: I f a church sells Sandwiches at an area bazaar for only two weeks,
the IRS would not treat this as the regulär conduct of a trade or business.
Example 2 : A one-time sale of property is not an activity that is regularly
carried on and therefore does not generate unrelated business income
unless the property was used in an unrelated business activity.
Example 3z A church is located in the downtown section of a city. Each
Saturday, the church parking lot is operated commercially to accommodate
shoppers. Even though the business activity is carried on for only one day
Sample Unrelated Business income Checklist
Determination of whether an activity produces unrelated business taxable income can
be made by answering the questions below:
>- Is the activity regularly carried on?
A specific business activity is regularly carried on i f it is conducted with a
frequency, continuity, and manner of pursuit comparable to the conduct of the
same or similar activity by a taxable Organization. An activity is regularly carried
on if it is conducted
• intermittently the year round, or
• during a significant portion of the season for a seasonal type of business.
However, an activity is not regularly carried on i f it is conducted
• on a very infrequent basis (once or twice a year),
• for only a short period of the year, or
• without competitive or promotional efforts.
>• Is the activity suhstantially related to the exempt purposes of the nonprofit?
To be suhstantially related, the business activity must contribute importantly
to the accomplishment of a purpose for which the nonprofit was granted tax
exemption, other than the mere production of income to support such purpose.
>• Is the activity conducted with volunteer Services?
Any business activity in which suhstantially all (85% or more) of the work is
performed by volunteers is specifically exempted from unrelated business
>* Is the activityprimarily for the convenience of clients, patients, faculty, staffi
students, or visitors?
So-called „convenience“ activities are exempt regardless of their nature.
Examples are parking lots, food service, bookstores, laundry, telephone Service,
and vending machines.
>- Is the income derivedfrom debt-financedproperty?
Examples of income from debt-financed property are dividends, interest, rents,
etc., earned from Stocks, bonds, and rental property that have been purchased
with borrowed money.
) • Is the income fom the rental ofrealproperty?
Rental income is generally tax-exempt i f it does not relate to debt-financed
property. But i f significant Services, such as setup, cleaning, and laundry service
are also provided, then the income is usually taxable.
each week on a year-round basis, this constitutes the conduct of a trade or
business. It is subject to the unrelated business income tax.
According to the IRS regulations, a trade or business must „contribute importantly to
the accomplishment of the exempt purposes of an Organization“ i f it is to be considered
„suhstantially related.“ Even i f all the profus from a business go to support the work of
the nonprofit, the profus may still be taxed.
Example: i f a church operates a restaurant and devotes all the proceeds to
mission work, the church will not escape taxation on the restaurant’s income.
Types of income that may be „related“ are
the sale of products made by handicapped individuals as a part of their rehabilitation;
>• the sale of homes constructed by students enrolled in a vocational training course; and
^ a retail grocery störe operated to provide emotional therapy for disturbed adolescents.
Tours conducted by nonprofits usually create U B I . Tours may be exempt from U B I only
if they are strongly educationally oriented, with reports, daily lectures, and so on. Tours
with substantial recreational or social purposes are not exempt.
The definition of „unrelated trade or business“ does not include
activities in which unpaid volunteers do most of the work for an Organization;
activities provided primarily for the convenience of the organization’s members; or
activities involving the sale of merchandise mostly donated to the Organization.
Nonprofits often rent facilities, equipment, and other assets for a fee. Rental income
usually represents U B I with the following exceptions:
Renting to another nonprofit may be termed „related“ i f the rental expressly serves
the landlord’s exempt purposes.
Mailing lists produce U B I , with specific exceptions.
Rental of real estate is excluded from U B I unless the excludable property is acquired
or improved with indebtedness. Rental income from the property becomes U B I to
the extent of the ratio of the „average acquisition indebtedness“ during the year to
the total purchase price. The nonprofit may deduct the same portion of the expenses
directly connected with the production of the rental income. Depreciation is allowable
using only the straight-line method.
To discourage exempt organizations from botrowing money to purchase passive income
items, Congress imposed a tax on debt-financed income. An otganization may have
debt-financed income i f
it incurs debt to putchase ot improve an income-producing asset, and
) • some of that debt remains within the 12 months ptior to when income is teceived
from the asset.
An Organization also may have debt-financed income
accepts gifts or bequests of mortgaged property in
There are exceptions to the debt-financed income
use of suhstantially all (85% or more) of
any property for an organization’s exempt
] • use of property by a related exempt Organization
to further its exempt purposes;
) • life income contracts, i f the remainder
interest is payable to an exempt charitable Organization;
>• neighborhood land rule, i f an Organization acquires real property in its „neighborhood“
(the neighborhood restriction does not apply to churches) mainly to use it for
exempt purposes within 10 years (15 years for churches).
Activities that are not taxed
Income from the following sources is generally not considered U B I :
>• Passive income. Income earned from most passive investment activities is not UBI
unless the underlying property is subject to debt. Types of passive income include
• dividends, interest, and annuities;
• capital gains or losses from the sale, exchange, or other disposition of property;
• rents from real property (some rent is U B I if the rental property was purchased
or improved subject to a mortgage);
• royalties (however, oil and gas working interest income generally constitute UBI).
>• Volunteers. Any business where volunteers perform most of the work without
compensation does not qualify as U B I . To the IRS, „suhstantially“ means at least
85% of total work performed.
LXäWplB: A used-clothing störe operated by a nonprofit orphanage where
volunteers do all the work in the störe would likely be exempt.
) • Convenience. A Cafeteria, bookstore, or residence operated for the convenience of
patients, visitors, employees, or students is not a business. Stores, parking lots, and other
facilities may be dually used (part related and part unrelated).
Donated goods. The sale of merchandise,
mostly received as gifts or contributions, does
not qualify as U B I . A justification for this
exemption is that contributions of property
are merely being converted into cash.
^ Low-cost items. Items (costing no more than
$8.30—2005 adjusted amount) distributed
incidental to the solicitation of charitable
contributions are not subject to U B I . The
amounts received are not considered an
exchange for the low-cost articles, and therefore
they do not create U B I .
) • Mailing lists. Mailing lists exchanged with or rented to another exempt Organization
are excluded from U B I , although the commercial sale of the lists will generally
create U B I . The structuring of the agreement as a royalty arrangement may make
the income exempt from U B I treatment.
Calculatmg the unrelated business income tax
Income tax rules applicable to businesses, such as depreciation method limitations and
rates, apply to the U B I computation. Direct and indirect costs, after proration between
related and unrelated activities, may be used to offset income. The first $1,000 of annual
net unrelated income is exempt from taxation.
For 2005, the corporate tax rates begin at 15% and go up to 39%.
Unrelated business income summary
Be aware of the type of activities that may create U B I in your Organization.
>- Maintain careful records of income and related expenses (both direct and indirect,
including depreciation) for any activities that might be considered unrelated to the
exempt purpose of your Organization. These records should include allocations of
salaries and fringe benefits based on time records or, at a minimum, time estimates.
It may be wise to keep a separate set of records on potential unrelated activities. This
separate set of records would need to be submitted to the IRS only upon audit.
Be sure that board minutes, contracts, and other documents reflect the organization’s view
of relatedness of various activities to the exempt purpose of the entity.
>• If the Organization has over $ 1,000 of gross U B I in a given fiscal (tax) year, file
Private Benefit and Private Inurement
Tax laws and regulations impose prohibitions on nonprofit organizations concerning
private benefit and private inurement. Excise taxes are imposed on „excess benefit transactions“
between „disqualified persons“ and nonprofits. An excess benefit transaction occurs
when an economic benefit is provided by an Organization, directly or indirectly, to or for
the use of a disqualified person, and the value of the economic benefit provided by the
Organization exceeds the value of the consideration received by the Organization in return
for providing the benefit. A disqualified person is any person in a position to exercise
substantial influence over the affairs of the Organization (often referred to as an „insider“).
Nonprofit organizations must serve public, and not private, interests. The private
benefit prohibition applies to anyone outside the intended charitable class. The law
does allow some private benefit i f it is incidental to the public benefits involved. It is
acceptable i f the benefit to the public cannot be achieved without necessarily benefiting
Example: The I R S revoked exemption of a charity as having served the
commercial purposes and private interests of a professional fund-raiser
when the fund-raiser distributed only 3% of the
amount collected to the nonprofit Organization.
Private inurement is a subset of private benefit.
This is an absolute prohibition that generally
applies to a distinct class of private interests.
These „insiders“ may be founders, trustees or
directors, officers, managers, or significant donors.
Transactions involving these individuals are not
necessarily prohibited, but they must be subject to
reasonableness, documentation, and applicable
reporting to the IRS.
Inurement arises whenever a financial benefit
represents a transfer of resources to an individual solely by virtue of the individuals