Notes - Zondervan 2020 Church and Nonprofit Tax and Financial Guide

November 20, 2024

Chapter 1: Faithful Administration

Accountability

Accountability is an important concept that relates to the responsibilities associated with managing a ministry. For many, it's embraced, but others misunderstand it or even fear it.

Biblical Foundation

The Bible underscores the importance of accountability and financial integrity. Verses from Ezra, Job, Psalms, Proverbs, Matthew, Luke, John, Romans, Colossians, 1 Thessalonians, and 1 Peter emphasize the importance of:

• Accurate record-keeping
• Honesty
• Integrity
• Justice
• Planning
• Transparency
• Using gifts for their intended purposes

Independent Board

An independent board is crucial. The board helps determine the mission, set goals, provide financial oversight, establish policies, and ensure adherence to those policies.

Key Issue: Board Self-Evaluation

Boards need to regularly assess their own performance. This helps them improve both individually and collectively. Tools and templates for self-evaluation are available from the Evangelical Council for Financial Accountability (ECFA).

Key Questions for Board Effectiveness

To gauge effectiveness, boards should consider these questions:

• Are there robust discussions on key issues?
• Are the ministry's values and policies clearly stated?
• Does the board evaluate the ministry leader based on goals?
• Does the board evaluate itself with the same rigor as it evaluates the leader?

Board Meetings and Minutes

Boards should meet at least twice per year, and many meet more frequently. All board and committee actions should be recorded in meeting minutes, which need to be signed by the secretary. Ministries that file Form 990 must document whether their board minutes are maintained contemporaneously.

Managing Conflicts of Interest

Conflicts of interest can undermine trust. Here are some key points:

• Disclose any real or potential conflicts.
• Address conflicts of interest directly through a written policy.
• Understand state laws governing conflicts of interest.
• Undertake significant transactions involving conflicts of interest only when the organization's best interests are prioritized and adequate transparency measures are taken, such as board approval, exclusion of related parties from decision-making, consideration of bids and valuations, and full disclosure in audited financial statements.

Compensation Review and Approval

Compensation for ministry leaders, especially those in top positions, should be reasonable and well-documented. Excessive compensation can lead to penalties.

Key Considerations for Compensation

• Use comparable data to determine appropriate pay for similar positions.
• Make compensation decisions independently, meaning the person whose compensation is being considered should not be part of the process.
• Document all elements of pay (both taxable and nontaxable), including salary, housing allowances, benefits, and any perks.
• Review compensation regularly, taking into account factors such as responsibilities, goals achieved, and available resources.

Proper Stewardship Practices

Communicating with Givers

• Honor all statements made about how gifts will be used. The giver's intent matters.
• Provide full, fair, and accurate explanations about all aspects of a proposed gift. Be transparent about limitations on the use of the gift.

Key Points to Include in Communications

• Proposed use of the gift: Set realistic expectations about what the gift will accomplish.
• Representations of fact: Ensure accuracy and avoid omissions, exaggerations, misleading visuals, or anything that could create false impressions.

Key Issue: Truthfulness

It's essential for Christ-centered organizations to be truthful when communicating with givers because donors rely on that information to make decisions about their support.

Additional Points to Include in Communications

• Valuation issues: If an appraisal is needed, the giver should understand the procedures and who will pay.
• Tax consequences: Explain the tax implications, but don't present a gift as a tax shelter.

Reporting for Incentives and Premiums

If fundraising appeals offer incentives with substantial value, the ministry should tell the giver the fair market value and clarify that the value is not tax-deductible.

Transparency

Churches and nonprofits should be open about their governance, finances, programs, and activities. This includes providing financial statements upon request and complying with public disclosure rules for charities.

The Role of CPAs and Audits

Churches and nonprofits of significant size should utilize the services of an independent CPA annually. Larger organizations should have an annual audit. Smaller ones might opt for an annual review or compilation.

Types of CPA Services

• Audits: Formal examination to assess the accuracy of financial records and provide an opinion based on GAAP.
• Reviews: Less in-depth than an audit; provides limited assurance on the financial statements.
• Compilations: Gathering financial information and creating statements without providing any assurance.
• Agreed-upon procedures: Focuses on specific issues or procedures as determined by the organization.

Internal Audits

Larger churches and ministries may have staff dedicated to internal audits, in addition to using external auditors. Smaller organizations may form an audit committee to perform internal audits.

Choosing a CPA Firm

When selecting a firm, consider these factors:

• Knowledge of accounting standards and the organization's niche.
• A track record of providing value-added management letters.
• Fee structure.
• Understanding of the organization's accounting system.

Preparing for a CPA Engagement

• Start early.
• Communicate clearly and often with the CPA.
• Reconcile accounts regularly throughout the year.
• Prepare all requested items before the CPA's work begins.

Chapter 2: Tax Exemption

Advantages and Limitations of Tax Exemption

• Tax exemption for churches and nonprofits recognizes their contributions to society's common good in the voluntary or civil society sector outside of government agencies.
• Exempting these organizations from taxes protects their identities and diverse contributions.

Tax Exemption for Churches

• Churches are generally not required to apply to the IRS for recognition of tax-exempt status.
• However, churches should obtain an Employer Identification Number (EIN) by filing IRS Form SS-4.

Starting a Church or Other Nonprofit Organization

• Organizations desiring recognition of tax-exempt status (except churches) should submit Form 1023 or the streamlined Form 1023-EZ to the IRS.
• Form 1023-EZ can be used by organizations with annual gross receipts of $50,000 or less and total assets with a fair market value of $250,000 or less.
• Organizations must apply for recognition of exemption within 27 months from the end of the month in which they were organized.

Unrelated Business Income

• Income from activities not substantially related to an organization's exempt purpose is called Unrelated Business Income (UBI).
• UBI is subject to taxation, and churches and nonprofits should be aware of activities that may create UBI.
• Organizations with over $1,000 of gross UBI in a fiscal year must file Form 990-T.

Private Benefit and Private Inurement

• Private benefit occurs when an organization's transactions benefit individuals rather than the organization's charitable purpose.
• Private inurement, a subset of private benefit, is an absolute prohibition, primarily applying to transactions with insiders like founders, directors, officers, and significant donors.
• Excessive compensation is a common example of private inurement.
• Penalties, including excise taxes, are imposed on insiders and organization managers involved in excess benefit transactions.

Filing Federal Returns

• Several federal tax forms apply to churches and nonprofits, including Form 990, Form 990-T, Form 1120, and Form 5500.
• Form 990 should be filed using the same accounting method used for the organization's books.

Postal Regulations

• Churches and nonprofits may qualify for reduced postal rates for bulk mailings by filing Form 3624 with the U.S. Postal Service.

State Taxes and Fees

• Many states impose sales taxes and require churches and nonprofits to register and file returns.
• Churches may be exempt from property taxes, while nonprofits may qualify for exemptions based on property use and ownership.

Political Activity

• Churches and nonprofits are prohibited from participating in political campaigns or endorsing candidates.
• They can engage in nonpartisan activities like voter registration and education.

This chapter emphasizes the importance of understanding tax exemption, unrelated business income, and private benefit/inurement. It also highlights the necessity of proper financial management and reporting to maintain tax-exempt status and avoid penalties.

Chapter 3: Compensating Employees

Challenges in Compensating Employees

This chapter focuses on the topic of employee compensation for churches and nonprofits, identifying three primary issues:

• Setting Appropriate Compensation: Balancing the requirements of the Fair Labor Standards Act with the potential tax implications of excessive compensation requires careful consideration. Comparability data, along with the employee's qualifications and performance, are crucial in establishing appropriate compensation levels.
• Documentation and Reporting: Compensation, including fringe benefits, should be documented thoroughly, especially for leadership positions. Taxable portions must be reported to the relevant tax authorities.
• Maximizing Fringe Benefit Advantages: Effective structuring of fringe benefits, utilizing tax-free or tax-deferred options, can significantly enhance an employee's take-home pay without requiring the organization to spend more.

Reasonable Compensation

The chapter emphasizes the concept of "reasonable compensation," which is vital for maintaining the organization's tax-exempt status. Excessive compensation can trigger "private inurement" issues. To determine "reasonable compensation," consider what similar organizations would pay for comparable positions in similar circumstances. The IRS provides guidelines to avoid penalties related to excessive compensation. These guidelines emphasize the role of an independent body in approving compensation arrangements.

Key Considerations for Ministers

• Housing Allowance: This section highlights the unique tax benefits available to "qualified ministers," specifically the housing allowance exclusion. It emphasizes the importance of a "dual tax status" for ministers, allowing them to receive a portion of their compensation tax-free for housing expenses while also being subject to self-employment tax.
• Proper Assignment: The chapter stresses the necessity of clear documentation when assigning a minister to a specific role within the church, going beyond just the process of assignment. It details the need to provide evidence that the church is actively engaging in ministry through the assigned individual.
• Special Speakers: Churches often engage special speakers, and this section outlines how to properly compensate them. A sample board resolution demonstrates how to allocate an honorarium, travel expenses, and a housing allowance.

Fringe Benefits

The chapter discusses various fringe benefits and the tax implications associated with them:

• Cell Phones: With the prevalence of cell phones, the IRS has provided guidance on their use as a fringe benefit. Demonstrating a clear business purpose for employer-provided cell phones is essential to avoid tax implications.
• Vehicles: When a ministry provides a vehicle to an employee, proper documentation of its use is required. The chapter outlines different valuation rules to determine the taxable value of personal use, emphasizing the importance of maintaining a mileage log.
• Social Security Reimbursement: Churches often reimburse ministers for their self-employment tax liability. The chapter explains the effective rates of SECA reimbursement and how it varies based on marginal tax rates.
• Sabbaticals: The tax implications of sabbaticals are addressed, noting that paid leave during a sabbatical is taxable.

Legal Requirements and Best Practices

• Workers' Compensation: The importance of Workers' Compensation insurance is highlighted, noting that it is generally obtained through private carriers but might be provided by the state in some cases.
• Overtime and Minimum Pay: The chapter discusses the Fair Labor Standards Act (FLSA) and its relevance to churches and nonprofits. It stresses the importance of adhering to minimum wage and overtime regulations, particularly for employees engaged in interstate commerce.
• Employee Classification: Distinguishing between employees and independent contractors is crucial for proper tax reporting. The chapter provides guidance on determining exempt employee status, specifically outlining the duties test for executive, administrative, and professional employees.
• Nondiscrimination Rules: This section underscores the need for fair and equitable treatment of employees, particularly in fringe benefit plans. Discriminatory practices, such as limiting benefits to high-ranking employees, are strictly prohibited.

Paying Employee Expenses

The chapter details the use of accountable plans to reimburse employee expenses:

• Accountable Plan Requirements: It lists the three key elements of an accountable plan: business purpose, expense substantiation, and the return of excess reimbursements.
• Timeliness: Timely submission of expense documentation is crucial. While the IRS provides a safe harbor of 60 days, demonstrating a "reasonable time" for documentation is important even beyond this period.
• Sample Board Resolution: A sample board resolution illustrates the practical implementation of an accountable expense reimbursement plan, including guidelines for substantiating expenses.
• Per Diem for Volunteers: While per diem payments to volunteers are permissible within IRS limits, volunteers must include any excess amounts exceeding their deductible travel expenses in their taxable income.

Steps for Excellent Compensation Practices

The chapter concludes by summarizing key steps for establishing effective compensation practices:

• Compensation Philosophy: A clear statement outlining the organization's approach to compensation should be developed, taking into account goals for attracting, retaining, and motivating employees.
• Independent Decision-Making: Compensation for leadership positions should be determined by an independent body, not by the individual whose compensation is being decided.
• Transparency: Open communication about family member compensation is important to maintain board awareness and transparency.
• Comparability Data: Research and analysis of compensation for similar roles in comparable organizations are essential.
• Comprehensive Review: All forms of compensation, including taxable, nontaxable, and tax-deferred benefits, should be considered. This includes elements like debt forgiveness, bonuses, and deferred compensation.
• Compliance: Utilizing an accountable reimbursement plan and maximizing tax benefits like the minister's housing exclusion are important steps.
• Fairness: Ultimately, ensuring compensation is fair and reasonable is paramount.

Additional Insights

Beyond the steps listed above, the chapter provides additional insights:

• Integrity in Ministerial Status: The chapter discusses the complexities of determining ministerial status, particularly for organizations beyond local churches. Applying integrity and a deep understanding of ministry practices are crucial in this process.
• Stewardship and Compliance in Fringe Benefits: The selection and implementation of fringe benefits reflect the organization's stewardship and commitment to compliance. Maximizing tax-free and tax-deferred opportunities while accurately reporting taxable benefits demonstrate responsible stewardship.

Chapter 4: Employer Reporting

In This Chapter

This chapter covers the following:

• Classification of workers
• Reporting compensation
• Payroll tax withholding
• Depositing withheld payroll taxes
• Filing quarterly payroll tax forms
• Filing annual payroll tax forms

Employers must comply with complicated withholding and reporting requirements. The special tax treatment of qualified ministers adds another level of complexity. Churches and other nonprofits are generally required to withhold and pay federal (and state and local, as applicable) income taxes and social security taxes on wages paid to full-time or part-time employees (except qualified ministers).

The classification of ministers

Organizations must decide if their employed ministers qualify for special tax treatment as ministerial services. Most ordained, commissioned, or licensed ministers serving in local churches are eligible for six special tax provisions:

• Social security taxes: Ministers are considered self-employed for Social Security purposes even though they are employees of the church.
• Federal income tax withholding: Churches are not required to withhold federal income tax from a minister's salary, though ministers may voluntarily elect to have income tax withheld.
• Housing allowance: Ministers may exclude from gross income a designated housing allowance to the extent used to provide a home.
• Parsonage: Churches may provide a tax-free parsonage to a minister, or if a parsonage is not provided, a housing allowance may be designated.
• Self-employment tax: Ministers are responsible for paying their own self-employment tax on ministerial income, and it is calculated on Schedule SE of their individual income tax return.
• Deduction for self-employment tax: Ministers may deduct one-half of their self-employment tax on their individual income tax return as an adjustment to income.

Filing Quarterly Payroll Tax Forms

Form 941

Church and nonprofit employers who withhold income and social security and Medicare taxes must file Form 941 quarterly. Organizations do not need to file Form 941 if they haven't withheld payroll taxes even if they have one or more minister-employees. If the only employee is a minister and voluntary federal income tax has been withheld, the employer must file Form 941.

Tips for filing Form 941:

• Do not file more than one Form 941 per quarter, even if you deposit payroll taxes monthly.
• Use the pre-printed form sent by the IRS.
• Use the exact business name printed on the form sent by the IRS.
• Do not include titles or abbreviations (e.g. "Dr.", "Mr.", or "Mrs.") in the name line.
• On Line 2, do not include housing allowances for qualified ministers.
• On Lines 5a and 5c, report taxable Social Security wages and taxes and taxable Medicare wages and taxes separately.

Filing Annual Payroll Tax Forms

Form W-2

Employers must provide Form W-2 to each employee by January 31st. Before distributing Forms W-2 to employees, be sure to reconcile the data reflected on Forms W-2, W-3, and 941. The IRS will send a letter to the employer if these forms do not reconcile, requesting additional information. Make all entries without a dollar sign or comma, but with a decimal point and cents.

Tips for completing Form W-2:

• Box 1: Report total wages, taxable fringe benefits, business expenses under nonaccountable plans, payments for business expenses exceeding IRS-specified rates, and payments made to an employee's IRA.
• Box 3: Report total wages subject to Social Security tax. The amount must not exceed $132,900 in 2019. Include nonaccountable employee business expenses and 403(b) salary reduction contributions.
• Box 4: Leave blank for qualified ministers.
• Box 5: Report wages subject to Medicare tax, which are the same as those subject to Social Security tax in Box 3. There is no wage limit for the Medicare tax.
• Box 6: Enter total employee Medicare tax withheld. Leave blank for qualified ministers.
• Box 9: Report advance earned income credit payments.
• Box 10: Report dependent care benefits, including amounts over $5,000.
• Box 11: Report total distributions from non-qualified deferred compensation plans.
• Box 12: Report group-term life insurance over $50,000 (code C), cost of employer-provided health coverage (code DD), 403(b) voluntary salary deferrals for pre-tax amounts (code E) and for Roth amounts (code BB), and per diem or mileage allowance exceeding the IRS-specified rate (code L).
• Box 14: Report any other information (for example, health insurance premiums deducted). You may include the housing allowance in Box 14 or on a separate statement. Do not include payments under an accountable plan if the total reimbursement is less than or equal to the amount substantiated.

Form W-3

Form W-3 is a transmittal form submitted to the IRS with Forms W-2. Submit Form W-3 and all attached W-2s to the Social Security Administration Center by January 31. Do not send any money with Form W-3.

Form 941-X

Employers use this form to correct information previously reported on Form 941 for income tax, Social Security (FICA), and Medicare. Employers may need to issue Form W-2c to employees for prior year data. Form 941-X has three pages.

Integrity Points

Employers must apply tax rules with integrity. For example, they should not withhold and match FICA-type Social Security taxes from a minister's pay, because the matched portion would then escape income tax.

Chapter 5: Information Reporting

In This Chapter

This chapter, from the "Zondervan 2020 Church and Nonprofit Tax and Financial Guide," covers general filing requirements, reporting on the receipt of funds, reporting on the payment of funds, and includes a summary of payment reporting requirements. Beyond the employer reporting issues discussed in the previous chapter, this chapter outlines additional information reporting requirements to the IRS that apply for almost all churches and other nonprofit organizations.

Key Information Reporting Issues

• Classifying payments to workers: This section focuses on helping organizations classify workers to ensure they are reporting information properly to the IRS. An organization will make many payments to individuals providing services; some of these individuals are employees (discussed in chapter 4) and some are independent contractors. Payments of $600 or more in a calendar year to an independent contractor trigger filing Form 1099-MISC.
• Backup withholding: The chapter discusses the importance of backup withholding and how to avoid it. Backup withholding applies when payments are made to individuals who have not provided the payer with a correct taxpayer identification number. To avoid this, an organization should require all individuals receiving payments to complete Form W-9, Request for Taxpayer Identification Number and Certification. This form requires the individual to:
  • Provide their taxpayer identification number (Social Security Number or Employer Identification Number).
  • Certify that the number provided is correct.
  • Certify that they are not subject to backup withholding.

Reporting on the Receipt of Funds

This section discusses the types of funds received that require reporting to the IRS.

• Receipt of interest on mortgages: This section explains that an organization must use Form 1098, Mortgage Interest Statement, to report mortgage interest of $600 or more received by the organization during the year from an individual. However, there is no requirement to file Form 1098 for interest received from a corporation, partnership, trust, estate, or association. Additionally, a transmittal Form 1096 must accompany one or more Forms 1098.

Reporting on the Payment of Funds

This section covers which payments made by an organization require reporting to the IRS. The following payments should be reported on Form 1099-MISC:

• At least $10 in royalties or broker payments in lieu of dividends or tax-exempt interest.
• At least $600 in:
  • Rents.
  • Prizes and awards.
  • Other income payments.
  • Medical and health care payments.
  • Crop insurance proceeds.
  • Payments to an attorney.
  • Cash payments for fish (or other aquatic life) purchased from anyone engaged in the trade or business of catching fish.
• Any fishing boat proceeds.
• Golden parachute payments.
• Direct sales of at least $5,000 of consumer products to a buyer for resale anywhere other than a permanent retail establishment. The following are not required to be reported on Form 1099-MISC:
• Payments to a corporation.
• Payments for merchandise.
• Payments of rent to real estate agents or property managers.
• Wages paid to employees (report on Form W-2).
• A canceled debt. Canceled debts reportable under section 6050P must be reported on Form 1099-C.
• Advances, reimbursements, or expenses for traveling and other business expenses of a self-employed person for income tax purposes that are not substantiated to the paying organization.
  • Example 1: ABC Ministry organizes a seminar and engages a speaker. The speaker is paid a $750 honorarium, and ABC reimburses the travel expenses of $200 upon presentation of proper substantiation by the speaker. Form 1099-MISC should be issued to the speaker for $750.
  • Example 2: Same facts as Example 1, except $250 of the $750 payment is designated for travel expenses and the speaker substantiates to ABC for the travel. Since the honorarium is $500, after excluding the substantiated payments, and therefore is less than the $600 limit, there is no requirement to issue a Form 1099-MISC to the speaker.

This section also instructs organizations to use Form 1099-MISC to report royalty and nonemployee services payments.

• Example: ABC Ministry pays a musician $500 in royalties for the use of copyrighted music at a summer youth camp. No Form 1099-MISC would be required since the royalty is less than the $600 limit. However, if ABC paid an honorarium to the same speaker during the same calendar year of $100 or more, bringing the total for the year to the $600 level, a Form 1099-MISC should be issued.

INTEGRITY Points

• Obtaining a completed Form W-9: This section stresses the importance of obtaining a properly completed Form W-9 before the applicable payments are made by the church or nonprofit to ensure accurate completion of forms in the 1099 series. Organizations may find it very difficult to obtain the form at a later date which could complicate the filing of the appropriate 1099 form.
• Payments to nonresident aliens: The authors point out that payments to nonresident aliens are subject to special rules and reporting requirements and these rules can be very complex. While reimbursements made under an accountable expense reimbursement plan are not reportable, other payments must be reported on Form 1042-S, and some payments are even subject to federal income tax withholding.

Chapter 6: Financial Management and Reporting

Importance of Sound Financial Records

Sound financial recordkeeping is critical for churches and nonprofits because it:

• Allows for informed decision-making: By accurately reflecting the financial condition of the organization, quality financial records enable the board and staff to assess financial health, spot trends, measure outcomes, and project future needs, leading to more informed decisions.
• Ensures accountability and transparency: Comprehensive and accurate financial records serve as a testament to the organization's commitment to accountability and transparency to its stakeholders, including the governing body, congregation or constituents, and donors.
• Facilitates compliance with regulations: Maintaining organized financial records is essential for complying with various tax and regulatory requirements.

Recordkeeping of Income and Expenses

• Chart of Accounts: A well-structured chart of accounts is the foundation for recording income and expenses, providing a systematic way to categorize and track financial transactions. It's important to find a balance between too few and too many accounts to ensure efficient recording and reporting.
• Income Handling: Robust internal controls are crucial to protect income, especially in the case of churches where offerings are a primary source of funding. Guidelines for handling offerings, found on pages 128-135 of the source, emphasize the importance of security, segregation of duties, and proper documentation.
• Disbursement Controls: It is highly recommended to pay expenses primarily by check or electronic means, with a petty cash fund being the only exception. Using cash from deposits for expenses is strongly discouraged. Checks should be pre-numbered, and spoiled checks should be marked "void" and retained.
• Authorization and Documentation: Depending on the organization's control environment, requiring two signatures on checks exceeding a certain amount may enhance security. Access to checking accounts should be restricted, and supporting documentation should be maintained for all disbursements, including honoraria payments.

Accounting Records

• Selection Criteria: The choice of an accounting system should be based on its ability to meet the organization's needs for financial measurement, control, and reporting, while considering the capabilities of the individuals responsible for recordkeeping.
• Cash vs. Accrual Methods: Smaller organizations often opt for the cash or modified cash basis due to their simplicity, recording revenue upon receipt and expenses upon payment. The accrual method, aligning with GAAP, recognizes revenue when earned and expenses when incurred, providing a more accurate representation of the financial position, particularly for larger organizations.
• Modified Cash Method: Combining elements of both cash and accrual, the modified cash method offers a middle ground, often recording payables upon receipt but not necessarily other receivables, providing a more precise financial picture than the pure cash method.
• Depreciation: Accrual-based statements necessitate the presentation of property and equipment assets and associated depreciation, calculated over the asset's useful life. This information can inform budgeting for replacement reserves, minimizing reliance on external financing for significant repairs or replacements.
• Fund Accounting: This system, accounting by classes of net assets, promotes transparent stewardship reporting by segregating resources restricted by donors for specific purposes. While not requiring multiple bank accounts, it emphasizes tracking and reporting based on donor restrictions.

Records Retention and Destruction

• Importance: Maintaining corporate documents and records is essential for management, legal compliance, audit preparedness, and protection against loss.
• Sample Policy: A sample record retention and destruction policy, spanning pages 112 to 117 of the source, provides recommended retention periods for various record types, emphasizing the need to retain both electronic documents and the means to access them, as well as maintaining backups.

Financial Reports

• Tailoring to Audience: The guiding principle for financial reporting is to create different reports that cater to the specific needs and understanding of various audiences.
• Dashboard Reporting: Increasingly popular among nonprofits, dashboard reporting offers a concise and visual overview of financial health, highlighting key indicators and potential problems.
• Characteristics of Effective Reports: Financial statements should be easily understandable, concise, comprehensive, comparable (often to a budget or prior period), and timely to facilitate prompt corrective action.
• Statement of Financial Position (Balance Sheet): Reflects the organization's assets, liabilities, and net assets at a specific point in time, showcasing the fundamental accounting equation.
• Common Statement of Financial Position Errors: These errors include neglecting to categorize net assets by donor restrictions, displaying negative balances in restricted net assets, and failing to accurately present various asset and liability components.
• Statement of Activities: Summarizes the organization's revenue, expenses, and changes in net assets over a period, highlighting sources of income and resource allocation. It can be presented in various formats but must adhere to GAAP requirements for larger organizations, including the functional classification of expenses.
• Common Statement of Activities Errors: Errors encompass misclassifying exchange transactions as restricted revenue, reporting fundraising activities on a net basis, failing to recognize in-kind gifts or volunteer services, omitting fundraising expense disclosures, and improperly allocating expenses functionally.
• Statement of Cash Flows: Tracks the organization's cash inflows and outflows, categorized by operating, investing, and financing activities. The direct method directly lists cash sources and uses, while the indirect method reconciles changes in net assets to cash flows.
• Statement of Functional Expenses: Provides a detailed breakdown of costs associated with different program services and supporting activities, enhancing transparency regarding resource allocation.

Budgeting

• Purpose: A budget serves as a roadmap for allocating financial resources, planning expenditures, and controlling spending, even for smaller organizations.
• Approaches: Budgeting often involves separate budgets for different funds, including capital and debt-retirement funds, which are then combined into a unified budget. Line-item budgets detail projected costs for specific expense categories, while program budgets present costs by program area.
• Key Considerations: Effective budgeting necessitates a thorough understanding of revenue and expense trends, the conversion of program plans into estimated costs, and a balanced approach to projecting both income and expenses.
• Planning for Reserves: Incorporating reserve funds into the budget is essential for financial stability and flexibility, allowing for unexpected expenses and future opportunities.

Audits and Other Related Services

• Importance of Transparency: External audits, reviews, or compilations, conducted by independent CPAs, enhance transparency, both internally and to external stakeholders, promoting accountability and aligning with biblical principles of openness and integrity.
• External Services: The choice between an audit, review, or compilation depends on the organization's needs and resources. Audits provide the highest level of assurance, reviews offer limited assurance, and compilations focus on assembling financial statements without assurance. Agreed-upon procedures engagements allow for focused testing of specific areas.
• Choosing a CPA Firm: Key considerations include the firm's knowledge of accounting standards and the nonprofit sector, experience in providing value-added management letters, fee structure, understanding of the organization's accounting system, and ability to communicate effectively.
• Preparing for External Services: Early preparation, clear communication with the CPA firm, regular reconciliations, and timely completion of requested items are essential for a smooth and efficient engagement.
• Internal Audits: Internal audits, typically conducted by an audit committee composed of organizational members, assess the validity of financial statements and internal controls. Focusing on sampling techniques rather than reviewing every transaction can be an effective approach.

Fraud

• Internal Controls and Prevention: Establishing and maintaining strong internal controls, including segregation of duties, proper authorization, physical safeguards, and regular reconciliations, can significantly reduce the risk of fraud.
• Response to Fraud: A well-defined fraud response plan should outline the steps to be taken upon discovery of fraud, including gathering evidence, notifying appropriate individuals, correcting the situation, implementing preventive measures, and potentially involving law enforcement.

Key Takeaways:

• Robust recordkeeping is paramount: Comprehensive and accurate financial records are fundamental to responsible stewardship, informed decision-making, and compliance with regulations.
• Internal controls are crucial: Implementing and consistently enforcing internal controls, especially for handling cash and disbursements, is essential to mitigate the risk of fraud and financial mismanagement.
• Transparency is a cornerstone: Churches and nonprofits should strive for transparency in their financial practices, reporting, and governance, fostering trust and accountability among stakeholders.

Chapter 7: Charitable Gifts

Overview of Charitable Giving

This chapter focuses on charitable giving, examining various aspects such as gift options, limitations, disqualifying factors, timing, acknowledgment, reporting, and disclosure requirements for quid pro quo contributions. It emphasizes the importance of understanding the tax implications of charitable giving, ensuring both the giver and the receiving organization are aware of the rules and regulations surrounding charitable contributions.

Understanding Charitable Gifts

A "gift," in tax law, is defined as an unconditional transfer of cash or property without any personal benefit to the giver. A simple transfer of funds to a church or nonprofit doesn't automatically qualify as a gift. For instance, paying a child's college tuition, while contributing to a tax-exempt educational institution, isn't considered a gift or eligible for a charitable deduction. However, a donation earmarked for a specific ministry goal or a future time period fits the definition of an unconditional transfer.

Acknowledging Charitable Gifts

The IRS mandates that charitable organizations provide written acknowledgments for single donations of $250 or more to substantiate the giver's claim for a tax deduction. Here’s what should be included in the acknowledgment:

• Giver’s name
• Amount of cash contributed (if applicable)
• Description of the property contributed (if applicable), but not the value
• If the gift is an automobile, boat, or airplane, the organization must generally provide Form 1098-C to the giver
• A statement clarifying whether the organization provided any goods or services in exchange for the contribution
• If goods or services were provided to the giver, a description and good-faith estimate of their value and a statement that the giver’s charitable deduction is limited to the amount of the payment exceeding that value
• If services provided consisted solely of intangible religious benefits, a statement to that effect
• If no goods or services were provided to the giver, the acknowledgment must state this clearly
• Date of the donation
• Date the acknowledgment was issued (recommended but not required)

The sources provide examples of a charitable gift acknowledgment, a sample letter to non-cash givers, and a table summarizing charitable contribution substantiation requirements.

Key Considerations and Best Practices

• Consecutively number all acknowledgments for control and accounting purposes.
• Provide acknowledgments to givers by January 31 each year, or earlier if possible, to assist them in tax preparation.
• Issue Form 1098-C within 30 days of selling a donated vehicle or within 30 days of the donation date if the organization retains the vehicle.
• Issue receipts or acknowledgments at a frequency that suits the organization, such as gift-by-gift, monthly, quarterly, or annually. For better communication and administration, many charities acknowledge all gifts, irrespective of the amount.

Quid Pro Quo Contributions

The IRS requires specific disclosures for "quid pro quo" contributions, where givers receive something of benefit in return for their donation, particularly if the payment exceeds $75. In such cases, the organization must:

• Inform the giver that their deductible contribution is limited to the amount exceeding the value of the goods or services received
• Provide a good-faith estimate of the value of the goods or services provided

Additional Points to Note

• The disclosure can be made during solicitation or upon receipt of the contribution.
• To calculate the net charitable contribution, deduct the fair market value of any benefit received by the giver, such as premiums or incentives, from the donation amount.
• Unsolicited, low-cost articles given as part of the ministry's stewardship efforts may allow givers a full tax deduction.

INTEGRITY Points

• Issue gift acknowledgments in the correct tax year, avoiding backdating unless specific criteria are met.
• Provide proper acknowledgments for non-cash gifts to avoid disqualification of charitable deductions.
• Ensure transparency in "quid pro quo" transactions, providing givers with the necessary information to claim the correct charitable contribution amount.

Chapter 8: Special Charitable Gift Issues

In This Chapter

This chapter covers giver-restricted gifts, contributions to support missionaries and other workers, contributions to support short-term mission trips, and other special charitable contribution issues.

Giver-Restricted Gifts

This section explains the tax implications for a donor when they give a gift to a charitable organization, but the use of that gift is restricted in some way, for example, for use in supporting a specific missionary or program.

A donation is only deductible as a charitable contribution if the donor gives up control of the gift to the charitable organization. If the donation is earmarked for a specific individual, then this rule may be violated, and the donation may not be deductible. There are two specific tests that the IRS uses to determine if the donee organization has sufficient control of the gift. These are the "intended benefit" and "control" tests.

• The intended benefit test requires the donee organization to be the intended beneficiary of the contribution.
• The control test mandates that the donee organization, not the donor, must have control over the donated funds.

There are several ways a charitable organization can ensure that a donation passes these tests:

• Include in the organization's solicitation materials a statement like:

  "Contributions are solicited with the understanding that [insert name of donee organization] has complete discretion and control over the use of all donated funds."

• Include similar language in the gift receipt, such as:

  "This contribution is made with the understanding that [insert name of donee organization] has complete control and administration over the use of the donated funds."

This section gives the example of a missionary raising financial support for their work. If a donor gives money to the missionary's sponsoring organization with the understanding that the money will be used to support the missionary, then the donation should pass both IRS tests as long as the organization retains discretion over how the money is used. If the missionary leaves the organization, then any money left over in their account remains an asset of the organization. It would not be transferred to the missionary.

Ministries using this "deputized fundraising" approach should consider several factors when determining how to maintain discretion and control of the donations:

• Ensure that all communications with donors clearly state that the organization will exercise discretion and control over donations. This includes solicitations, receipts, and training materials for the missionary or other individual raising support.
• Terminology should be chosen carefully to avoid the implication that donated funds will be directly used for a particular missionary's salary, benefits, and expenses. Instead, language should emphasize the organization's discretion and control.

Contributions to Support Short-Term Mission Trips

Churches and other non-profit organizations often sponsor short-term mission trips. There are special rules for claiming tax deductions for travel expenses incurred on such trips. The cost of travel is only deductible if the participant is on duty in a "genuine and substantial sense" for the entire duration of the trip. If the participant only has nominal duties, or if there are significant portions of the trip when the participant is not on duty, then the travel expenses are not deductible.

To substantiate their service, participants should keep an hour-by-hour itinerary of the trip detailing when they are on duty for the organization and when they are free to choose their own activities.

Other Special Charitable Contribution Issues

This section reviews some other issues related to special charitable gifts, such as gifts of inventory, scholarships, and how to communicate with donors about restricted gifts.

Gifts of Inventory

The retail value of donated inventory cannot be used to calculate a charitable contribution. Instead, the donor can only deduct the cost of the inventory. Churches and non-profit organizations should not include the dollar value of donated inventory on gift acknowledgments.

Scholarship Programs

This section briefly reviews issues related to establishing a scholarship program in a church or other non-profit organization. Scholarship programs should be set up so that the organization has complete discretion and control of how scholarship funds are used.

• Applications must be submitted to the organization, not to the individuals who will receive the scholarship.
• The scholarship program should have established criteria that determine who is eligible to receive a scholarship, the amount of the scholarship, and how many scholarships will be awarded.
• The criteria should be in writing.

INTEGRITY Points

The final section of this chapter reiterates some important points related to integrity when churches and non-profit organizations receive charitable donations.

• Always clearly communicate with givers. This is especially important when a gift includes restrictions on its use. The communication should make it clear that the organization has discretion and control over how the funds are used, even if the giver has a preference.
• Avoid duplicity in communication. If a giver has the option to designate their donation for a specific fund, then do not also state that the church or organization can use the funds for any purpose. This type of language is confusing for givers.
• Make wise decisions when restricted funds cannot be used for their intended purpose. While there is no specific timetable, organizations should decide reasonably promptly how these funds will be used.