Friday, May 22, 2015

Creative Nonprofit Collaboration: Four Basic Principles

Collaborative nonprofit projects are on the rise, such as through new joint venture opportunities, partnering with social enterprises, and even strategically engaging with business to further mutual interests.   But Section 501(c)(3) organizations may not simply give their money or other assets without restrictions.  After all, their resources are charitable:  they held in trust for the “public” benefit and subject to high levels of legal accountability. So, what questions should these nonprofits ask themselves before engaging in these ventures?  

In 1968, the IRS issued a brief but key ruling (Rev. Rul. 68-489), stating that 501(c)(3) organizations will not jeopardize their exempt status if they follow four rules when distributing funds to nonexempt entities. These rules specifically help public charities engaging in activities with nonexempt entities, as well as more broadly as they seek to use their funds safely, effectively, and with accountability.

What’s the Purpose?

Just as 501(c)(3) organizations must operate their programs for tax-exempt purposes, they must also ensure that the funds or other assets they distribute are likewise used exclusively for such tax-exempt purposes (i.e., charitable, religious, and/or educational).  Essentially, they must make sure that their charitable funds further their purposes, whether the funds are used for their own programming or are distributed to other entities or individuals.  This includes ensuring that the funds are not used for activities that are prohibited or restricted under Section 501(c)(3).  For example, charities must limit distributions to prevent the recipient from engaging in political campaign activity or a substantial amount of lobbying.  Charities must also make sure that the funds do not result in more than an incidental amount of private benefit to individuals or privately-owned business (other than fair compensation paid on a quid pro quo basis for goods or services rendered) .     

Are We Funding on a Project-by-Project Basis?

When a public charity decides to distribute funds to another entity, it must do so on a project-by-project basis.  For example, if a US organization wanted to grant funds to an organization overseas, the funds should not simply be distributed to further educational purposes.  Rather, the funds should be provided for a specific project, such as building a school, books and uniforms, or funding tuition for a specific amount of students.  Defining the scope and scale on a project-by-project basis best enables the charity to ensure that the funds are used to further exempt purposes. 

Are We Retaining Control and Discretion?

An exempt organization’s responsibility does not end when the funds exchange hands; instead, the charity must continue to monitor the use of its funds. For example, a best practices approach would be to execute a written joint agreement requiring regular reporting from the business, international organization, or individual about how funds are used and establishing a right to repayment of the funds if they are not used for their exempt purposes.  In addition, once the project is started and funds are received, any modifications to the use of the funds should require approval by the charity.  .

Are We Maintaining Sufficient Records from the Nonexempt Organization?

Charities must maintain financial records and related documentation demonstrating that the funds were used to further their exempt purpose.  This is important for not only an IRS audit or state regulator investigation, but for donors, directors, and other stakeholders with an interest in accountability. Commonly, the charity will require the nonexempt organization to provide a report once the project is completed that accounts how the funds were used.  A charity might also send a director or staff member to visit the nonexempt organization and prepare a report on how the funds are being used.  Photos or other supporting documentation also help the charity memorialize how the funds benefited a specific project. 

For more information on creative nonprofit collaboration and related legal considerations for tax-exempt organizations, please contact one of our law firm’s attorneys at 312.626.1600, or, or visit us on the web at 

Tuesday, May 12, 2015

Better Together: Washington State Expands Self-Insurance Risk Pools to Nonprofits

 Insurance can be expensive, but not having insurance is sometimes even more costly!  One solution within many industries is risk pooling – that is, to join with others and effectively self-insure together, thereby spreading out risk and bringing down overall costs for protecting property and against liability.  The insurance industry itself, however, is highly regulated and therefore requires state authorization for such programs.  State-authorized self-insurance risk pools seem to be gaining traction in the nonprofit sector, with Florida, California and Washington State leading the way.  This article provides highlights of the most recent risk pool expansion to nonprofits – in Washington State. 

Under the new Washington law, nonprofit corporations located there will be permitted to pool resources with other, out of state nonprofits to create self-insurance risk programs/pools (“SIRP”) covering property or liability risks.  A SIRP may be a good option for nonprofits  because they are usually tailored to the unique risk-management needs of nonprofits.  SIRPs often offer specialized training in addition to risk coverage to preemptively reduce nonprofit exposure.  For nonprofits seeking different risk sharing arrangements for moral or other economic reasons, Washington State’s newly expanded SIRPs may provide a cost-effective alternative to traditional insurance solutions.  .


In 2004, Washington State first allowed nonprofit corporations to form self-insurance risk pools.   The 2004 law, however, was limited to Washington nonprofits and government entities.  This year, the legislature received testimony in support of a new bill that would expand self-insurance pools to include out of state nonprofits.  Washington currently has over 600 nonprofit entities in SIRPs.  According to the law’s supporters, making the insurance pools available to out of state entities will further share the risk among more nonprofits and reduce costs. 

In response to its advocates, Washington State Senate Bill 5119 was recently signed into law.  The new law, which will be effective on July 24, allows one or more nonprofits to “jointly self-insure property and liability risks, jointly purchase insurance or reinsurance, and contract for risk management, claims, and administrative services with other nonprofit corporations.”   The new law is designed to permit Washington nonprofits broaden their insurance risk pools and bring down the costs associated with such risk pools.

The new law contains two major provisions.  First the bill creates a separate chapter in the statute to clarify that nonprofit corporations and local governments may not commingle for the purposes of creating SIRPs.  Second, as stated above, the bill allows out of state nonprofits to participate in SIRPs with Washington State nonprofits. 

Requirements and Exclusions

Nonprofits in Washington and other states may participate in the pools if the program satisfies a number of requirements.  For example, ownership interest in the program is limited some or all of the nonprofits that are provided insurance by the program.  Also, the participating nonprofits must elect a board of directors to manage the program.  The programs are subject to prior approval by the State Risk Manager and are subject to extensive reporting and operational requirements.  Nonprofits considering forming or joining a SIRP should consult with qualified legal counsel to fully understand the obligations attending participation. 

Finally, nonprofits should be aware that provisions of this act do not apply to a nonprofit corporation that:

·      individually self-insures for property and liability risks;
·      participates in a risk-pooling arrangement, including a risk-retention group, a risk-purchasing group, or is a captive insurer authorized by its state of domicile;
·      comprises only units of local government or is a group that comprises local governments joined by an interlocal agreement; or
·      is a hospital or entity owned, operated, controlled by, or affiliated with such a hospital that participates in a self-insurance risk pool or other risk-pooling arrangement.

While Washington State’s newly expanded SIRPs do involve substantial operational and reporting requirements, they may provide nonprofits with an economical alternative for the management of their liability risks. 

For further information about Washington State’s new law, or for other information pertaining to risk management in the nonprofit context, please contact one of our attorneys at 312.626.1600 or, or visit us on the web at

Saturday, May 9, 2015

Federal Appeals Court Chimes In: IRS Not Above Constitution

“Pummeled,” “raked over the coals,” and “almost laughed out of court” – these are news descriptions of the recent judicial thrashing of the IRS during oral argument in Z Street v. Koskinen.  It is rare for judges to speak so harshly to government officials, but, then again, the IRS’s argument that it should be allowed to engage in viewpoint discrimination hardly seems worthy of respect.

The case was filed last year by Z Street, Inc., a nonprofit corporation dedicated to educating the public about issues related to Israel and the Middle East.  Z Street filed an IRS Form 1023 application with the IRS, seeking tax-exempt recognition as a Section 501(c)(3) public charity.  An IRS agent later allegedly told Z Street that the IRS was questioning the substance of Z Street’s advocacy efforts, particularly whether and to what extent its views clashed with positions taken by the Obama Administration.  As a result, Z Street’s exemption application was being sent to a special IRS unit in charge of the IRS’s “Special Israel Policy” and therefore would be delayed.

Z Street sued the IRS, claiming the agency violated its First Amendment rights by not processing its application free from consideration of Z Street’s specific positions taken about Israel – i.e., “viewpoint discrimination.”  At the trial court level, the IRS filed a motion to dismiss the case, asserting among other things that it did not have to defend the constitutionality of its internal processes.  The federal district court for the District of Columbia resoundingly disagreed, denying the IRS’s motion and recognizing the IRS’s accountability for potential free speech constitutional violations.  

The next step for the trial court litigation thus should have been discovery, when Z Street would be allowed to ask probing questions about the IRS’s internal processing of its tax-exempt application.  But instead, the IRS appealed the trial court’s denial of its preliminary motion to the D.C. Circuit Court of Appeals. 

During oral argument on May 7, 2015, IRS attorney Teresa McLaughlin argued that, had Z Street simply waited 31 more days at the initial IRS review level, Z Street would have been eligible to sue for judicial approval of tax-exempt status of its application.  Such suit is authorized under Internal Revenue Code Section 7428 for exemption applications that remain pending at the IRS after 270 days.  The IRS attorney argued that such suit should have been an acceptable alternative for Z Street, rather than seeking a constitutionally fair process internally from the IRS.

The three judges on the appellate panel were genteel but obviously incredulous (David Sentelle, David Tatel, Chief Judge Merrick Garland).  Judge Sentelle barely let IRS attorney McLaughlin begin her oral argument before opining that the IRS’s “Special Israel Policy,” if it existed as alleged, would be highly problematic as a First Amendment constitutional matter.  Judge Tatel added that a subsequent tax refund or relief through a Section 7428 “alternative” lawsuit, as proposed by the IRS, could neither satisfactorily resolve the constitutional defect with the IRS’s approach nor remedy the resulting harm to Z Street and other tax-exemption applicants from such viewpoint discrimination. 

Judge Garland continued the grilling on the IRS’s argument that a Section 7428 suit was an acceptable alternative for tax-exemption applicants like Z Street:  “You don’t really mean that, right?  Because the next couple words would be the IRS is free to discriminate on the basis of viewpoint, religion, race [for 270 days].”  He continued:  “Imagine the IRS announces today a policy that says as follows:  ‘No application by a Jewish group or an African-American group will be considered until one day short of the period under the statute . . . Is it your view that that cannot be challenged?”  He then concluded, “I think if I were you I would go back and ask your superiors whether they want us to represent that the government’s position in this case is that the government is free to unconstitutionally discriminate against its citizens for 270 days.” 

In response, IRS attorney McLaughlin pointed out that, indeed, many of her supervisors were in the courtroom.  She also argued, albeit briefly (and incorrectly under binding legal precedent), that tax exemption applicants may not be “unduly biased” in their advocacy.  Thankfully, the appellate panel quickly shot down her viewpoint-related contention and, doing so, expressed great concern over excessive IRS scrutiny of religious beliefs and other areas of conscience rightfully belonging to nonprofit voices. 

The judges also resoundingly rejected the IRS’s back-up argument that, as a procedural matter, the case was precluded under the federal Anti-Injunction Act.  Continuing their concerns, they asked why the government had buried a key legal precedent in a footnote of its brief.  According to that case, such issue was already firmly decided – against the IRS’s position – and therefore should not have been raised.  Under applicable rules, all attorneys – even those from the IRS – must bring to light any adverse authority and are prohibited from engaging in such obfuscation with respect to controlling legal precedent.

The IRS’s apparent indifference to exemption applicants’ constitutional rights are disturbing.  But it is encouraging to witness the judiciary’s capacity for vigorously guarding those rights.  Little doubt exists that the D.C. appellate court will deny the IRS’s appeal, thereby paving the way for Z Street to engage in discovery and search for fuller accountability regarding the IRS’s processing of its tax-exemption application.  But such justice comes at a significant price – money needed to fight the government, extensive delays, and further tarnishing of the IRS’s reputation. 

For more information on IRS considerations affecting tax-exempt organizations and other nonprofit legal matters, please contact one of our law firm’s attorneys at 312.626.1600, or, or visit us on the web at

Thursday, April 30, 2015

An Introduction to Nonprofit Financial Statements

The following article is provided courtesy of Cathedral Consulting Group, LLC, a Milwaukee-based firm that helps small and mid-sized nonprofit organizations and private companies to grow their enterprises through the implementation of best practices.   As growth requires vision for tomorrow and an awareness of today’s needs, Cathedral works alongside clients to identify their organizational needs and to implement both long-term and short-term beneficial strategies.

Perhaps no single operational practice is more impressive to a donor than having timely, accurate financial statements.  It is a reflection of professionalism and accountability.
Successful individuals – that is, your donors – are usually skilled at reading financial statements and find them to be the most important measure of the health of an organization. In fact, most major donors care just as much about the state of your financials as they do about the impact you are making or the service you are providing. 

This article addresses the basics of understanding nonprofit financial reporting.


The financial process begins with bookkeeping.  When an organization is just getting started, its bookkeeping system is often simply an excel spreadsheet, a checkbook register, and an online bank statement. Typically not reviewed until tax season, these spreadsheets are then collected and sent to the accountant, who then returns them in basic statement form and files the 990.

Most organizations, however, keep their records in Quickbooks or a similar accounting software.  For some, the software is not much more functional than a spreadsheet and a bank register.  This is because they keep their books on a cash basis, instead of accrual as explained below.

Larger nonprofits may have a bookkeeper or a full finance department.  While this is helpful, professional staff does not ensure timely, accurate financials. 

A good board treasurer can be a great resource in this area.  While the nonprofit may not be able to afford highly trained accountants, a board treasurer with an accounting background can be well utilized and will help set up and maintain your financials.

Since all board members have a legal fiduciary responsibility for the finances of the organization, it is important for the board to seek a treasurer that will be active in the organization and willing to provide sound advice on bookkeeping and financial reporting.

Cash versus Accrual Accounting Methods

The cash-basis accounting method is perhaps the most familiar to nonprofits, because of its ease and similarity to a checking account. When cash is received, income is recorded and when an expense is paid, an expense is recorded. The weakness in this method is in its simplicity – as a nonprofit organization grows, its financial statements will get more complex.  Eventually, something will need to be accrued, whether it’s a pledge or note payable. Not adapting to the complexity can lead to incomplete and misleading financial statements – most specifically the lack of Accounts Payable and Accounts Receivable.  The question of Accounts Receivable is especially important in a nonprofit, for whom pledges (donations promised but not yet paid) are essentially an asset that, in the cash accounting system, cannot be recognized.

Accrual-based accounting represents all accrued, or “recognized,” income and expenses, regardless of the status of actual receipt or payment.  The easiest way to understand this is to see the various financials exchanges of your enterprise as a series of promises.  This comes in the form of pledges on the revenue side, and in the form of invoices for services on the expense side.  In an accrual-basis system, you post entries as the promises are made.  This is of particular importance with the expense categories, as many bills need to be deferred for cash flow purposes.  Full accrual accounting allows you to keep track of the liabilities within the structure of a financial report.

Because it is so hard to avoid the need to accrue pledges and invoices, many small to mid-sized nonprofits do their bookkeeping a hybrid part cash-basis, part accrual system. The result is a set of financial reports that are more complex and difficult to understand than anything produced by straight accrual accounting.


1.)   Income Statement/Statement of Activities
The Income Statement or Statement of Activities summarizes the activities of the organization over a period of time – monthly, annually or quarterly. It begins by showing total revenue – usually broken up by category or project. Organizations should use a reasonable level of detail in categorizing revenues and expenses. At minimal, revenues must be categorized as follows for the IRS each year:

1.   Public support: Donations considered to come from the general public. This includes individuals, private foundations, businesses, government, and publicly supported granting agencies.
2.   Exempt-purpose activities: Activities that directly advance the organization’s stated mission such as arts groups who sell tickets, schools that charge tuition, etc.
3.   Other Revenue (and UBIT): This category includes the miscellaneous revenue received from unrelated business income (income that does not fall into any other category).  UBIT represents revenue that is taxable because it is not related to the exempt activity of the organization.

While an accurate revenue report is important, the expense side of the Income Statement is scrutinized more carefully by donors. Categorized expenses are a unique aspect of nonprofit accounting.  Donors, board members, and anyone else with an interest in the organization will typically judge an organization’s efficiency on the allocation of their expenses among the following three categories:

1.    Program: Expenses that specifically and directly advance the mission of the organization (e.g., food provided at a homeless shelter);
2.    Fundraising: The costs of raising donations (e.g., marketing efforts that request donations); and
3.   Operations: Expenses that don’t clearly fit under either program or fundraising expenses (e.g., accounting fees).

Note that some expenses may be split up into different categories, such as salaries and rent.  Make sure that all employees keep detailed track of their time spent on program and record it as such so that not all salaries are counted as operations. Taking a few minutes a day to record where time was spent will ease the categorization process, and provide the level of detail and documentation donors, accountants, and the IRS desire.

2.)   Balance Sheet/Statement of Financial Position
The Balance Sheet or Statement of Financial Position is a snapshot of the organization’s financial condition at a given time. It describes what an organization has (assets), what it owes (liabilities), and the difference between the two (fund balance).

Assets are listed in order of liquidity. Current assets come first, and include cash and cash equivalents that can be converted into cash within twelve months. This would include cash in the checking account, inventory and accounts receivable, for example. Fixed assets come next, and include items like equipment, land & buildings.

Liabilities are listed by commitments due with those due soonest listed first. Current liabilities include those that need to be repaid within twelve months such as accounts payable, short-term loans, and grants payable. Long-term liabilities include mortgages, loans, or restricted assets.

Fund Balance
Fund Balance is the nonprofit substitution for Equity.  For nonprofit organizations, the fund balance is your leftover cash (profit). The difference is that profit is not taken out of the organization and distributed to the owners, because there are no owners in a nonprofit organization. The money stays in the organization, and is generally labeled as Retained Earnings or Net Fun Balance. Net Fund Balance is often broken down into three categories: Unrestricted, Temporarily Restricted and Permanently restricted.

3.)   Statement of Cash Flows
When financial statements are kept in full accrual, they should be accompanied by a Cash Flow Statement.  A Cash Flow statement begins with the Net income or loss for the period, then adds or deducts operating, financing and investing activities. The cash flow statement adjusts your accrual-based Income Statement and Balance Sheet back to a cash-based statement, providing you with valuable information on where cash was spent over a given period of time.

Once you have become proficient at producing the three basic financial statements each month (Statement of Income, Statement of Financial Position, Statement of Cash Flows) it is imperative that the statements are reviewed and discussed.  The Executive Director, the Board Chair and Board Treasurer are the key leadership responsible for ensuring the fiduciary integrity of the organization. This is best done through a monthly discussion and analysis of financial statements.

The benefits of this monthly review will help your organization to stay on budget, identify opportunities and target inefficiencies. Get involved with the preparation, production and analysis of the financial statements of your organization, and learn them inside and out. An Executive Director who understands and takes responsibility for the financial statements is a blessing to the organization. The benefits will be reflected within all areas of your organization – program, operations and fundraising.

For specific guidance available to help leaders in nonprofit organizations manage from their financial statements, stay on track with fundraising, and keep their organization strong and growing, please visit

Peter Giersch is a Managing Director and Virginia Zignego is a Senior Associate at Cathedral Consulting Group, LLC.  For more information, please visit us online at