By Anna Baumgardner | published 10/01/2020
Not-for-profit organizations face a special IRS reporting requirement – the 990. Within the 990, 501(c)(3) and 501(c)(4) organizations are required to report total expenses according to “function,” which helps the IRS and other 990-readers determine if the organization is expending funds in a manner that supports the organization’s non-profit status and mission. Understanding each of these “function” categories, and the nuances that determine an expense’s function will help you report the most accurate information possible.
What are the Functions?
The three function categories are Program Service, Management & General, and Fundraising.
Program service expenses are expenses incurred to support the non-profit’s mission, and underlying basis of exemption. Examples would be the cost of purchased clothing provided to the residents at a shelter, the cost of food provided to indigent persons at a meal center, or the cost of medications administered and tests performed at a free clinic.
Management and general expenses, which are considered under the larger umbrella “support activities,” are those costs necessary to administer and operate the organization. Examples would be the cost of accounting services, office building lease and office equipment rental payments, payroll expenses for administrative personnel, general liability insurance, and expenses related to executive direction and corporate planning.
Fundraising expenses, which are also “support activities,” are expenditures incurred to help the organization support or finance the non-profit’s mission and administration. This is the category that is often the most confusing and loosely defined. The IRS Form 990 instructions define fundraising expenses as those “incurred in soliciting contributions, gifts, grants, etc.” Similarly, the NFP Audit Guide describes fundraising expenses as those “inducing potential donors to contribute money, securities, services, materials, facilities, other assets, or time.” Fundraising expenses should be separated from program expenses, even though raising funds is technically an inherent mission of a non-profit. Examples of fundraising expenses include the costs of soliciting, the costs of obtaining government grants reportable on Form 990, the costs of advertisements not related to a specific program, expenses of campaign “kick-off” events, and expenses related to maintaining donor information.
Nuances of the Program Service Function
There may be instances where an otherwise management and general or fundraising function expense should be categorized to a specific program. For example, the travel costs associated with a specific grant proposal should be charged directly to that program instead of management and general. Another example, the printing costs to advertise a specific program event should be charged to that program instead of fundraising.
Nuances of the Fundraising Function
Some organizations don’t have a team or activities dedicated to raising funds, and, at a glance, conclude that they do not have any fundraising function expenses. However, expenses related to publications describing the organization and how to donate, advisory services to help with development strategies, and expenses incurred preparing grant proposals should be classified as a fundraising function, so be careful if, at first, you believe you have no fundraising expenses to report.
That said, supporting organizations (such as a non-profit that is separate but intended to provide supporting services to a parent organization) may actually not incur any fundraising expenses. Examples of such supporting organizations would be organizations that have been converted from a private foundation, or created by a trust, family, or individual, where that organization does not handle any contribution solicitations. On the Form 990, it is recommended that organizations reporting $0 in fundraising note why they did not incur or report any fundraising expenses, to avoid further questions from the IRS.
Expenses That Fall Into More Than One Function
Ideally, expenses will be assigned to each type of expense directly. In reality, many expenses may be reasonably classified as more than one type of expense. In these cases, consistent allocation among the functions is considered appropriate. Most allocation methods that can be applied consistently from reporting period to reporting period are acceptable. Recommended allocation methods for functional expenses include:
- Allocation by Payroll or Time Sheet – some organizations use time studies, or analysis of the time spent on each type of activity, to determine how expenses should be allocated. We usually recommend this method because it provides a reasonable and trackable basis of allocation that also accounts for fluctuations in efforts spent in different areas from period to period.
- Allocation by Headcount – very small organizations, and those that have remote employees often find it easiest to allocate overhead-type expenses based on headcount. This method is reasonable, but is limited in that it only accounts for each person performing one type of task.
- Allocation by Square Feet – for regular and recurring costs such as rent and utilities, expenses can be allocated based on the square footage that each department occupies. However, because multiple jobs are often performed by the same person in small non-profits, we usually do not recommend this method of allocation.
The most important factor when allocating expenses is consistency. For simplicity and ease of calculation, we also recommend using one allocation method, rather than a patchwork of methods for different specific expenses. The organization should document the method used to allocate expenses across different functions. Documentation of the allocation method should include:
- a description of the expenses that are typically allocated among functional expense categories
- an explanation of the allocation method used to distribute expenses over more than one functional expense category
- the rationale, or why the organization chose this allocation method
- worksheets demonstrating the overall allocation process
- worksheets showing the calculations behind each allocation entry
We recommend that organizations evaluate, at least annually, the appropriateness of the allocation method selected, to evaluate if the allocation method remains appropriate as the organization grows and changes. This evaluation may be part of the year-end process or performed during the annual audit. If it is determined that the organization’s allocation method should be changed, these changes and the reason behind the changes should be documented. Be aware that auditors will often review changes in allocation methods to determine comparability and reasonability from year to year. If a change in allocation results in a lack of comparability, they may require a restatement of prior years’ financial statements based on the new allocation method, depending on the organization’s reporting requirements.
If you are still uncertain about the functional expense categories, or how certain expenses should be reported, please reach out to us! We will be glad to help you!
Anna Baumgardner is a licensed CPA who advises and provides outsourced accounting and CFO services for tax-exempt clients at RY CPAs.