It’s generally assumed that nonprofit businesses with a 501(c)(3) status, (particularly churches,) don’t have to pay taxes on – well, anything. While that is mostly true, there are definitely exceptions to the rule. Not fully understanding those exceptions could cost your nonprofit organization money and, in extreme cases, your organization’s 501(c)(3) status.
If you do the bookkeeping for or manage a nonprofit, it’s important to remember that your charitable status does not give you a license to never be taxed on any of the money you bring in. As a nonprofit entity, it is crucial for you to understand the nuances of taxable vs. nontaxable income.
Let’s talk about what it looks like to maintain a charitable status and what situations your nonprofit might face where funds received need to be classified and reported as profit.
Maintaining Charitable Status
First, to be deemed a nonprofit an organization must file for and receive 501(c)(3) status from the IRS. A non-profit also needs to obtain a state business license. Rules can vary from state to state, but generally, your state business license will need a renewal occasionally. The 501(c)(3) status does not need to be renewed but can be revoked by the IRS if they determine it is being exploited for profit.
Every nonprofit organization must file a Form 990 each year. While this form isn’t reporting taxable income, it does report your organization’s income and expenditures to the IRS each year. This transparency with the IRS is as much for your organization’s protection as it is for the IRS’s. As we’ll see ahead, there are many “gray” areas nonprofits can find themselves in where the line between donations and for-profit transactions can get blurry. The 990 form helps a non-profit prove that it is following the rules and not abusing its charitable status.
What qualifies as non-profit taxable income?
The most basic way to determine whether or not your nonprofit’s income is taxable or not is to consider if it’s actually a freewill donation or if it is a transaction of goods for money. Anything not purely a donation needs to be taxed as profit.
Let’s look at some situations an organization might find itself in where these questions might arise:
It is not uncommon for large churches to have a coffee shop, bookstore, or thrift shop under their organization’s umbrella. Even if the profits from these stores go directly to fund the church’s charitable work, they still need to be taxed the same as any independent coffee shop or bookstore would be.
In a coffee shop, gift shop, or thrift store, customers exchange money for a product sold for a specific price. Ultimately, this is a for-profit business functioning within a non-profit.
The same policy applies to the exchange of services for money. Let’s say a church runs a daycare center out of its facility. If parents and guardians are paying the church for the service of caring for their children, this is an exchange of services for profit. Even if a church is renting space out to another non-profit organization or renting out its resources, (like a parking lot), that rent income still needs to be reported as profit.
Reporting Taxable Income as a Nonprofit
If your nonprofit organization engages in transactions like the ones mentioned above and is receiving any income that doesn’t qualify as purely donation, it will need to take extra steps to ensure that income is accounted for properly.
The 990T (990 Taxable) form is specifically for nonprofits to report any income that needs to be taxed as profit. This is a separate form than the 990, which every nonprofit needs to file, and does not account for taxable income.
Situations that Fall Under “Donations” and Do Not Need to be Taxed
What about more nuanced situations like fundraisers, you might ask? What organization doesn’t occasionally host a raffle, a “spaghetti dinner,” or a bake sale to raise money for a charitable cause or mission?
As long as the money raised goes directly to the advertised cause, an organization can have a “suggested donation amount” or “pay what you can” policy that keeps it under the “donation” bracket, thus avoiding taxes. In this instance, there isn’t a consistent revenue stream being built under a non-profit umbrella; it is a one-off event.
Similarly nuanced are situations where an organization is refunded for products/services. Perhaps a youth group wants to have t-shirts with their group’s logo, or a small group wants to host a catered dinner event. An organization can ask participants to pitch in a set amount of money to cover those costs, and because it is a one-time, low-volume transaction with direct ties to a net-zero profit, it does not need to go under the “profit” bracket.
Consequences of not following the rules:
Conceivably, if your organization has 501(c)(3) status and the IRS determines that you are not properly following their rules, they retain the right to revoke your charitable status.
Unfortunately it is totally feasible and possible for an organization to start a fraudulent non-profit simply to get around income and property taxes. The IRS is fully aware of that, which is why the 990 and 990T forms are necessary to keep transparency and accountability between a non-profit and the government.
In the same vein, it is also possible for a nonprofit with good intentions to appear to the IRS as if it has been acting fraudulently, simply by not understanding and distinguishing correctly between what income falls under “donations” and what income falls under “profit.”
If you are a bookkeeper for a nonprofit, it’s important to tread wisely as you make these distinctions. Your charitable status and your organization’s reputation hang on it!
At System Six, we want you to know that you don’t have to do this work alone. We have years of experience helping churches and nonprofits manage their bookkeeping, and we also can make referrals to vetted, experienced nonprofit-specialty CPAs as resources for 501(c)(3) companies.
Want to learn more? Contact us today!
Welcome to the final part of our three part series on bookkeeping and finance specific to churches. This third part of the series covers budgeting. Just like I mentioned in part two, I recommend reading the previous parts (on Helpful Tools and Program Spending) of the series since this final edition of the series builds on what was previously covered.
In part three we will be discussing budgeting and the various aspects of the process to consider while walking your clients through building a budget.
The biggest challenge to budgeting is making sure that the appropriate people are involved in the process. Usually the primary champion of the budgeting process is whoever is sitting in the board treasurer or church operations role. Unfortunately, this most often ends up as the only person that cares about having a budget.
It may seem simplistic, but it’s important to start with the basics: “What is a budget?” Throughout my years of helping with budgets, and even working on my own household budget, I have learned that a budget is a plan for how to spend money. With a church, that money belongs to the churchgoers who donated those funds. In a church, a budget is a plan for how to spend other people’s money and that plan should support the ministry goals and objectives of the church.
Who Should Make the Budget?
Since these ministry goals and objectives are often discussed and set by church leadership, a budget should support those goals. Because of this it is vitally important that other members of leadership contribute to, or assist with budgeting. In most cases, pastors and lay leaders are not financially minded so their natural inclination is to avoid the budgeting process altogether. In their minds that is the reason they hired or appointed an operations or finance director.
As outsourced bookkeepers and consultants, the goal here is to advise our church clients that the budget committee should consist of ministry leaders, operations staff, and ministers. During the process the question of “Does this budget support the ministry goals and objectives of our church?” should be at the forefront of everyone’s minds, and the committee consists of all the right people that can answer that question.
The Mechanics of a Balanced Budget
Now that all the right people are at the table, it’s okay for the operations and financially minded leaders to lead the process. The best place to start is with income.
Income for a church can be a challenge due to the following:
- How many church attenders are giving?
- Will those church attenders continue to give at the rate they are giving?
- If the church is growing, how much will the revenue grow?
- If the church is getting smaller, are the people leaving regular givers?
- Of the people leaving, how much are they giving?
- Is there a plan to encourage increased giving in the upcoming period?
In part two of this series some of the donor management and church management tools that I listed can help to answer these questions. Other questions are better answered by pastors and ministry leaders, which is why it’s important that they are involved in the process.
Once all these questions are answered it’s important that the revenue budget is set based on practical expectations and not on the amount that is desired. The revenue can be divided evenly across all twelve months of the year, or allocated differently to each month based on previous year giving trends. If using the latter method, make sure that the monthly cash flow can handle particular months where expenses may exceed revenue. This situation may arise since most expenses are the same month-to-month, but monthly revenue can fluctuate. Once revenue is determined, expenses naturally follow.
The first pass through expenses can be accomplished without looking at revenue, and based only on the needs of the church and ministries. It’s important that expenses are then compared to the overall projected revenue. If total expenses exceed total revenue for the year, that means the church likely can’t accomplish everything that it wants to that year. This is again why it is important to have a budget committee made up of ministry leaders and pastors because at this point, hard decisions will have to be made about where to reduce expenses. These decisions should be guided by the ministry goals of the church, and if expenses are cut in certain areas, it’s a collective decision instead of a financial director simply moving numbers around on a spreadsheet.
At the end of the process the difference between total expenses and total income ideally should be zero. If expenses exceed revenue, that means there will be an expected cash burn (disregarding any balance sheet considerations). If revenue exceeds expenses, there is the potential that the extra money can be put towards a reserve for future savings.
Bookkeeping to Serve the Church
As stated earlier, budgeting is important and because it is important, needs to involve many stakeholders. Since churches are made up of many people, many people should be involved. In our role as trusted advisors we can encourage the churches we are serving in this direction.
Since this wraps up the three part series on outsourced church bookkeeping, our hope is that we have helped to provide clarity on some of the potential pitfalls of serving churches. The intention is that this will help to increase the value that we are providing, and ensure the success of the churches and non-profit ministries we are serving.
If you are an outsourced bookkeeper looking for further ideas, or a church that is in need of outsourced bookkeeping, we are glad to serve, and we can be reached at firstname.lastname@example.org.
Welcome to part two of our three part series on bookkeeping and finance specific to churches. This second part of the series covers program spending, restricted funds, and taxes. If you haven’t read part one it covers SAAS tools and services, I recommend reading that first since this part of the series builds on what was covered in part one, and you can look forward to the final part about budgeting.
Here in part two we will cover the aspects of church bookkeeping that often get overlooked as churches grow and operations and activities become more complex.
As a church grows, various ministries and programs start to take shape that require expenses, and sometimes income, to be tracked separately. Good examples of this are kids ministry, worship, building/operations — things that would often be considered “departments,” or “business segments” in the for-profit world. One option is to simply create new accounts for them, which works most of the time. However, what happens when the church wants to see supplies used by the kids ministry and the worship band separately? What if there are other accounts (food supplies, small equipment, etc.) that need to be tracked separately as well?
As this complexity grows we recommend creating “Classes” (a Quickbooks term) for each of the ministries. Terms for this vary across the accounting world but it’s essentially a way to show each ministry or program as a distinct column on the income statement. That way, it’s easier to see the goldfish crackers consumed (and sometimes inhaled) by the kids ministry separately from the muffins and croissants bought for the worship band’s Sunday breakfast.
The word of caution here is to only create “classes” for ministries where this type of separation is needed. It’s okay for other programs to exist as only an account since it’s easier to read an income statement containing three columns versus ten columns. As outsourced bookkeepers and solutions providers, this is a great opportunity for us to advise on what works best for each church’s specific needs and goals.
Most bookkeepers cringe when they hear the term “restricted funds,” and for good reason. In accounting this prompts potentially bitter memories of releasing expenses, changes to net assets, and tracking restricted income. This is usually a fair reaction because it can quite literally cause a headache with the multitude of accounting rules that dictate these funds.
Fortunately, all these requirements are only needed if the church is regularly audited according to U.S. GAAP standards. Since most churches do not fall under these standards, the process can be simplified more than you might realize!
What are “restricted funds” exactly? As with every non-profit in the country, each donation is given with an intent on how that donation will be used and organizations are bound by that donor intent. However, if churches are clear on how donations will be spent, and create a “general fund” with clear language that it will be used for general church operations and ministries it can safely be assumed that donors understand and are providing donations for that purpose. For this reason it is important that these expectations are clearly displayed or stated.
Problems arise when a donor states they would like their donation to be spent on a more specific purpose (i.e. choir robes, kids ministry, sprinkler repair, etc.). If the donation is accepted, then the donation is legally restricted to be used for that purpose. In most cases a quick conversation with the donor can convince them to change their designation to the general fund, but if not, that donation is now restricted and has to be tracked that way in the books.
It’s also perfectly normal for churches to intentionally set up a restricted fund especially if they need to raise funds for a special purpose. The most common example is a building fund set up to pay for a new roof or replace a furnace. This is most often associated with a special giving drive.
Whatever the case, the church needs to easily demonstrate two things in the books:
- How much money was collected for this purpose?
- How much money has been spent for this purpose?
Going back to the first section in this article the most effective way to answer these two questions is to set up a Class for the fund, especially if the expenses need to go to multiple accounts on the income statement. For almost all churches, using Classes will ensure that the expenses and income for the specific purpose are not mixed in with other general church giving and expenses and those two questions can be easily answered.
I often hear the phrase “churches don’t pay taxes,” and while this is generally true there are some exceptions. These exceptions appear when churches start to engage in activities more commonly associated with for-profit companies. Here is a quick list of the more common exceptions:
- Selling books or merchandise
- Hosting a concert with paid public admission
- Collecting royalties for published content
- Receiving rent for parking lot spaces
- Fee income for a church-operated daycare
The term for these activities is “unrelated business income,” meaning they are unrelated to the normal operations of a church. All churches are required to fill out a 990 form to the IRS every year, but if they collect business-type income they are required to fill out a 990T form.
It’s important to note that just like with for-profit business some expenses related to these activities can be deducted against the income received, so it may be worth tracking the associated income and expenses using Classes, as mentioned above. Also, these types of income may be taxable to state government agencies. As outsourced bookkeepers it is important to be aware of all the income our church clients are receiving, and be able to advise them on if they are liable to pay taxes on some of their activities even if we are not the ones actually preparing the tax filings.
Currently, churches are coming under more and more scrutiny as we diversify our traditional institutions and as they change the scope and variety of ministries and services they offer. Because of this, it is important that churches stay under compliance with all tax and business laws. Keeping a clean set of books where it is easy to demonstrate how money is spent is crucial to building a healthy church.
It may seem complex to answer the many questions about how money is spent, but this process can be simplified immensely by working within the structure of a well thought out and organized budget. With clear, well formatted intentions, categories, and processes for delegating funds the process for reporting them only gets easier! Stop by next week for the final part of the series on church bookkeeping — budgeting!
Oftentimes church bookkeeping can be a lot more difficult than for-profit bookkeeping due to the extra regulatory requirements placed on churches by the IRS and state government. We understand that these nuances can be incredibly difficult to navigate. As outsourced bookkeepers, it is our job to be experts on how to address the unique challenges of churches, and advise them on how to address those challenges in the most streamlined and efficient way possible.
We want to help relieve the sense of complexity with a three part series on bookkeeping and finance specific to churches. The three topics you can look forward to learning more about are:
Part 1 – SAAS Tools and Services
Part 2 – Program Spending, Restricted Funds, and Taxes
Part 3 – Budgeting
Let’s begin the first part of this series by taking a close look at the tools required for accurate and efficient church bookkeeping.
SAAS (software-as-a-service) Tools and Services
System Six believes that “outsourced” and “cloud bookkeeping” are dependent on each other. Even more than before, it is crucial that records and accounting be accessible no matter where people are working. Choosing cloud-based programs is not only convenient, but wise for security, availability, and quality of service for a much affordable price. Every recommendation is based on this premise.
The first decision is to select a good bookkeeping/accounting tool. In almost all situations, I recommend Quickbooks Online (QBO) for its integration potential with other SAAS (software-as-a-service) tools, and the ability to directly connect to the activity feed for most banks and credit card companies. If the books are currently stored on a complicated collection of Excel spreadsheets, it’s probable that there is only one person who can help troubleshoot the system if there is a problem. QBO allows for multiple user access, and in turn allows for separation of duties between different bookkeeping roles spread across in-house church staff and you as the outsourced bookkeeping solution. It supports a team approach to bookkeeping that allows openness, checks and balances, and transparency across accounts. At just $20-40 per month, the benefits of choosing a “one stop shop” tool are well worth the investment.
Donor Management System (or DMS)
Each year churches and non-profit organizations scramble to provide year end statements to their donors. While the IRS does not require end-of-year statements to be sent by non-profit organizations, what they do require is that any donor claiming a charitable deduction on their taxes must provide proof of their donation, and a “written acknowledgement” by the organization fulfills this requirement. Since many church/non-profit donors will likely ask for this “acknowledgement” early in the year when they are working through their taxes, it is smart for all churches to be proactive. It is more efficient to prepare and send all the statements at once, rather than generate a single statement in response to every email or phone call from a donor.
Most churches start out small, so it is tempting to track donor information as well as donations within QBO. However it is most beneficial to be able to provide a donor statement upon request at any given moment. While there are some workarounds in QBO, most DMS’ are equipped to easily generate such a statement.
Here are some additional features common to most donor management systems:
- Providing a login to every donor so that they can view their donation record online.
- Batch reports providing a breakout of amounts contributed to each church fund.
- Ability to upload a letter template (for example, a year-end letter from the pastor), and insert a total amount given to every fund, where specified, and then email from the system along with the donor statement.
- Built-in merchant account or integration with one where donors can pay using ACH/credit card, and those donations are automatically posted to their donor account.
Each of these features by themselves offer significant savings in both time and capacity for everyone involved! Here is a good starting list of systems that we most commonly work with:
If you are interested in additional merchant accounts that integrate with some of these systems:
At this point, you likely have a burning question running through your mind, and that is “if I am tracking donations in a separate system, how do I get that information into QBO?” Oftentimes churches will try to double up their records in QBO and DMS, but generally this is unnecessary.
All you really need from QBO is financial reports because the DMS is tracking donor data. In QBO, all you need to track is the amount deposited and the breakout of the income.
It’s worth noting that NeonCRM (listed above) actually has an integration with QBO that will batch the donations and create a deposit entry in QBO that matches both the credit card and bank deposits. If the church you are working with receives a lot of ongoing donations, this is a huge time saver!
It’s important to note the unique relationship between a church and it’s donors. Primarily, that almost all donors regularly attend that church, and can visibly see how the money is spent and the results of their contribution. At any time, it is smart for a church to be ready to answer financial questions from their regular attendees, and they need to have the tools in place to quickly and easily answer those questions. As outsourced bookkeepers, we are in a great position to advise and manage the tools and solutions that remove financial pain points for the churches we serve.
We understand that there are similar frustrations in regards to budgeting, taxes, and spending, so look forward to the next two parts of this series. Church bookkeeping can be complicated, but with help from dedicated experts, it doesn’t have to be.