Spend Management and IRS Compliance for 501 (c)(3) Organizations
Federal tax law provides tax benefits to nonprofit organizations recognized as exempt from federal income tax under section 501(c)(3) of the Internal Revenue Code (Code). Organizations recognized as exempt from federal income tax are commonly referred to as charitable organizations and include private foundations as well as churches, educational institutions, hospitals, and many other types of public charities.
Organizations described in section 501(c)(3) are eligible to receive tax-deductible contributions. The code requires that tax-exempt organizations comply with federal tax law to maintain tax-exempt status and avoid penalties.
It’s easy for a nonprofit organization to maintain its tax exempt status—and can be just as easy to lose it. Each year, the IRS revokes the tax-exempt status of more than one hundred 501(c)(3) organizations[1].
501(c)(3) organizations can maintain their tax-exempt status if they heed the rules in six areas:
| Private benefit/inurement | A public charity is prohibited from allowing more than an insubstantial accrual of private benefit to individuals or organizations. This restriction is to ensure that a tax-exempt organization serves a public interest, not a private one.The concept of inurement states that no part of an organization’s net earnings may inure to the benefit of a private shareholder or individual who, because of the person’s relationship to the organization, has an opportunity to control or influence its activities. |
| Political campaign activity | Public charities are absolutely prohibited from directly or indirectly participating in, or intervening in, any political campaign on behalf of (or in opposition to) a candidate for public office. |
| Annual reporting obligation | While 501(c)(3) public charities are exempt from Federal income tax, most of these organizations have information reporting obligations under the Internal Revenue Code to ensure they continue to be recognized as tax-exempt. |
| Lobbying | 501(c)(3) organizations are allowed to do some lobbying. However, if lobbying activities are substantial an organization risks losing its tax exempt status. An organization can elect to have its lobbying activities measured by an “expenditure test” to determine whether or not the activities are substantial. By making this election, an organization agrees to not spend more than a certain percentage of its total expenses on lobbying activities. |
| Unrelated business income (UBI) | Another activity that can potentially jeopardize an organization’s 501(c)(3) tax-exempt status is having too much income generated from activities that are unrelated to the exempt function of the organization. This income comes from a regularly-carried-on trade or business that is not substantially related to the organization’s exempt purpose. |
| Operation in accord with stated exempt purpose(s) | Organizations must remain focused on the exempt activities described in the original application for exemption. Any change in direction needs to be cleared with the IRS. |
This paper will focus on spend controls, approvals, and budgetary controls necessary to ensure compliance with regulations.
Well-managed nonprofit organization will have disciplined and well-documented processes to request, approve, and issue payment for purchases, vendor invoices, and employee expenses. All spending must be controlled with approval workflows based on the type of purchase, department, and spending authority, with complete audit trails and full visibility of actual expenditures and pending commitments. These controls must be enforced in
- Purchase Requisitions and Purchase Orders
- AP Invoice Approval for non-PO invoices
- Travel requests and Expense Reports
Private benefit/inurement:
Spend Management workflows prevent unauthorized and undocumented “backdoor” compensation of individuals or organizations. Examples include purchases, expenses, or compensation that are not directly required for the operations of the charity
- Purchases of goods or services for board members
- Consulting or other fees paid to decision makers in the organization
- Private expenses paid by the charity (e.g. golf outings at conventions).
Approval workflows should be customized to require multiple levels of approvals, and additional reviews based on purchase or expense type, amount, or budget status. Further approvals can be added for disbursements to employees, vendors or board members that could raise the suspicion of a private benefit or inurement.
Public Campaign Activity and Lobbying
As with private benefit/inurement, spend management solutions ensure that all disbursements are approved and documented. Supplemental approvals can be added for certain spending categories or accounts. In addition, any spending on lobbying can be tracked against a budget to comply with the expenditure test to warn against or disallow expenditures above the allowed threshold.
Annual Reporting
In general, a public charity must maintain books and records to show that it complies with tax rules. The charity must be able to document the sources of receipts and expenditures. If an organization does not keep required records, it may not be able to show that it qualifies for tax-exempt status. The ability to monitor income and expenses and ensure that the organization is operating within its budget is crucial to successful stewardship of a public charity[2].
A public charity must keep documentation that supports entries in the books. These would include purchase orders, vendor invoices, expense reports with associated receipts, and payment transactions. For smaller charities, paper forms, spreadsheets, and simple receipts or cashed check storage may suffice. But for larger and more complex organizations, a spend management solution will ensure that all approvals are tracked, documents related to the transaction are accessible, and budgets are monitored.
Unrelated Business Income
Examples of UBI generating activities include the sale of advertising space, some merchandise sales, and even certain fundraising activities that do not have a substantial relationship with the exempt purpose of the organization.
Effective spend management solutions, tightly integrated with fundraising software allow the monitoring of revenue, expenses and net results for events and programs. This integration ties fundraising revenue for a legitimate charitable purpose and the related expenditures of the fundraising event.
Summary and Case Studies
Spend Management is an essential requirement for mid-sized and large nonprofit organizations for two reasons
- To reassure their donors that all expenditures are legitimate, controlled, documented, and approved.
- To comply with IRS 501(c)(3) regulations and retain the tax exempt status.
A Spend Management and Workflow Automation solution like Paramount WorkPlace – seamlessly integrated with the charity’s fundraising and financial systems – helps to manage expenditure approvals and provides audit trails, from requisition to disbursement and financial reporting. For real client examples, see Paramount Technologies Case Studies.
[1] Nonprofit Risk Management Center – How to Lose Your 501(c)(3) Tax Exempt Status (Without Really Trying)
[2] IRS Compliance Guide for 501 c3 Public Charities Publication 4221-PC (Rev. 7-2014) Catalog Number 49829R
About Paramount Technologies
Paramount Technologies is a leading global provider of web-based / mobile spend management and workflow automation solutions for midmarket and enterprise organizations. Our WorkPlace solutions automate Requisition, Procurement, AP Invoice Automation, Materials Management, Project Time, as well as Travel and Expense transactions. The WorkPlace suite of products can be deployed on premise or in the cloud and is universally accessible from any browser-enabled device. WorkPlace 2014 integrates seamlessly with Microsoft Dynamics, Sage, Blackbaud and other financial systems. Established in 1995, Paramount is a private company headquartered in Walled Lake, MI with regional offices across the United States and Canada.
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