e-Newsletter: Training & Resource Update
Other Side of the Coin: The Perils of Top-Line Capacity Building
By Thomas Hastings, CPA – Director, BCG Nonprofit Practice Group
Click here to download a printable version of the article. [pdf]
As nonprofits have come to play such a critical role in our communities, there has developed a need for them to become even more effective, and often with fewer available dollars. One response to this need has been the concept of capacity building, and has become a major topic among nonprofit managers as well as the consultants who advise these organizations in this endeavor. Capacity building can take many forms and mean different things. A basic definition is “actions that enhance an organization’s ability to fulfill its mission.” Those actions, if conducted properly, will provide a catalyst for greater organizational effectiveness, making them stronger, more sustainable and better equipped to serve their stakeholders. This can encompass a broad range of activities performed in the many different functional areas within the organizations themselves.
Given the current economic and funding crisis in which we find ourselves, capacity building might tend to take a more defensive stance. Nonprofits are now focused largely on the financial management areas of their organizations, including formulating strategies to enhance current funding models, particularly in programs for which funding has been reduced or lost all together. Some organizations are embracing certain social entrepreneurship strategies, or seeking grants from sources they would not have otherwise pursued. Nonprofits are also revisiting budgets, and identifying areas for cost control, which, is contrary to the end objective of capacity building. Nonetheless, to some extent, this is unavoidable.
This article will focus primarily on building capacity in the financial management area of the organization with a focus on the revenue side. Although my purpose here is not so much to provide guidance on the how; rather, my focus will be on the strings that may attach to such activities. Here are a few scenarios where I often find myself in client discussions along with considerations that should surface as part of your organization’s due diligence process.
Planning for (or Borrowing from) Your Future – Use of Endowment and Investment Funds
Although most endowments have become significantly devalued over the course of the last year, the need to tap into endowment funds may seem unavoidable. Issues to consider abound in this area, probably the most critical being assurance you’re maintaining compliance with donor restrictions. The State of Ohio recently enacted into law the Uniform Prudent Management of Institutional Funds Act (“UPMIFA”), which sets forth guidelines and restrictions for prudent endowment management and expenditure, but also provides for some flexibility for the use of those funds in underwater situations (the fair value has declined below the original contribution). The emphasis here is on the prudent use of funds, which may restrict the organization as to the use and amount of allowable or required distributions.
If the organization is fortunate to be in the good graces of a funder willing to establish an endowment on their behalf, these funds are often established by the donor at the local community foundation. In such a case, distributions from the endowment will be limited to the extent of the foundation’s spending policy, which generally ranges between 4 and 6 percent. In fact, UPMIFA provides a safe harbor spending policy at 5 percent. This isn’t required, but it may lead to foundations further limiting their distributions, which has already been occurring due to the economic environment and consequential investment losses. Keep in mind many foundations may exercise variance power, which means in certain rare instances, the foundation could redirect those funds to another organization. The lesson here – read the entire agreement.
Another issue related to the use of investment funds has to do with liquidity. Some organizations have come to invest a portion of their assets in less liquid alternative investments. For example, a fund investing in private equity or commercial real estate won’t be immediately available for distribution, and, in some cases, months later.
State and Federal Grants
Most organizations have experienced declines in the level of governmental grants they’re receiving. For organizations who have won the heart and the purse strings of a government agency with a unique service solution or who have shown an ability to provide services at a lower cost, there are several considerations. Most state and federal grants come with restrictions and more regulations, for example, over the allowability or timing of the expenditures. Or there may be regular reporting requirements. Failing to meet the grantors’ requirements could result in returning the funds (which have already been spent) to make the government whole. Organizations expending federal funds (even funds passed through the State) in excess of $500,000 face expanded audit requirements, and are expected to have sufficient accounting and internal control procedures. This is particularly relevant for those organizations now receiving American Recovery and Reinvestment Act (ARRA) funds, which were established as part of the President’s stimulus program. The requirements attached to ARRA funds are much more stringent than other federal dollars. An audit report disclosing certain internal control weaknesses or a violation of compliance requirements creates a nightmare for the organization and most assuredly puts the kibosh to future funding. Management’s awareness and attention to all grant requirements is critical to ensuring compliance. The lesson here – read the entire agreement (and do what it says).
He is the Tax Man – IRS Compliance
Contributions
Many organizations rely considerably on philanthropic giving, i.e. gifts and contributions. With state and federal dollars shrinking, some may be shifting their funding models to a greater reliance on individual, corporate and foundation gifts. Since donors presumably will receive a tax benefit from their gifts, the Internal Revenue Service wants to make sure generous taxpayers aren’t abusing the system. Organizations must provide adequate and timely substantiation to donors, including those for which the donor received some form of benefit, for example, a meal at a charity event. For non-cash gifts valued over $5,000 an appraisal is required. Organizations are prohibited from providing an appraisal value to the donor, so this falls on the shoulders of the donor. If the donee organization subsequently sells the asset for less than the original gift value, the donor must be provided a form as notification of this. This reduces the value of the donor’s tax deduction.
Unrelated Business Income
In the quest to become more entrepreneurial, organizations may have identified a new business venture as a way to replace lost funding. While the business model may make sense and sound exciting here are some issues to consider. If the new business is (1) considered a trade or business activity, (2) is not substantially related to the exempt purpose of the organization, and (3) is regularly carried on, the activity is considered an unrelated business, and could subject you to a corporate tax on the income generated. Basically, this is the IRS’s way of leveling the playing field between for-profit businesses and the nonprofit organizations that compete with them. The fact that you may use the proceeds from the business activity toward your charitable purpose doesn’t help avoid this issue.
Political and Lobbying Activities
The current political climate is such that sharp lines have been drawn between competing views over support of federal programs. This creates a desire among organizations to support candidates who are more likely to favor their interests. Organizations that perform activities in support of a certain candidate over another expose themselves to the wrath of the IRS, which, could lead to loss of their tax-exemption. Political activities are prohibited – end of story.
However, organizations may engage in lobbying, but it cannot be a significant part of their activities. With governmental funding shrinking, organizations may consider engaging a consultant or lobbyist to help them, particularly if they have an interest in larger earmark funds. The point here is lobbying in moderation is allowable and perhaps appropriate. A special election is available which can be made with the IRS to provide an organization a greater amount of lobbying activity before subjecting themselves to penalty.
The Urge to Merge – Conducting Sufficient Due Diligence
Another popular strategy is collaboration with other nonprofits. Sometimes this means sharing resources or staff to operate a program. Sometimes it means sharing back-office operations. Sometimes, it means a merger. Unfortunately, some organizations come to this realization too late, when a potential suitor is looked upon to save a sunken ship. In the situation where two viable organizations come together for good reasons to create one combined organization, there are still considerations in the form of due diligence. Fortunately for nonprofit organizations, they have greater flexibility in terms of the level and timing of information-sharing allowed during the feasibility stage as opposed to for-profit companies who must make the decision first then begin the due diligence work later. This could keep professional fees down. The process, nonetheless, creates significant costs, requires detailed financial analysis and budgeting, not to mention, dealing with issues that arise over cultural compatibility. Much work is to be done and none of it can be taken lightly.
In each of the situations described above, you may need to turn to your professionals for direction. Having the right accounting systems and procedures in place is critical. Having an engaged board and executive team who are supportive of the organization’s capacity building endeavors is critical to its success.
Permission to post the above article was granted to CNE by Mr. Hastings. Please click here to learn more about Mr. Hastings.
