Fair Game
New accounting standard may affect your financial statement.

By Renee Ordeneaux

If you thought the new accounting standard that requires organizations to measure assets at fair value doesn’t apply to your nonprofit, think again. It’s likely your organization will need to use it starting with your next financial statement.

Does it Apply to You?

FASB Statement No. 157, Fair Value Measurements (SFAS No. 157), defines fair value, provides for tools to measure it and expands footnote disclosures required under Generally Accepted Accounting Principles (GAAP) in financial statements. It applies to fiscal years starting after Nov. 15, 2007, and interim periods within those fiscal years, if your nonprofit has any of the following:

• Noncash contributions
• Financial assets held as an agent, such as cash or investments held by your organization when you agree to distribute those assets to a specified beneficiary
• Beneficial interests in trusts
• The contribution portion of split-interest agreements
• Certain investments, such as the fair value of restricted stock acquired without a readily available quoted market price
• Derivative instruments, such as interest rate swaps
• Accounts receivable and other financial instruments
• Long-lived assets.

The pronouncement is delayed until fiscal years beginning after Nov. 15, 2008, for fair value measurement of most nonfinancial assets and liabilities, such as assets measured at fair value in a business combination whose fair values are not remeasured in subsequent periods.

How is “Fair Value” Defined?

Fair value is the price that market participants would settle on to transfer an asset or liability on a particular measurement date. SFAS No. 157 dictates that fair value measurement take into account the asset’s value “in-use” (if the asset is used in conjunction with other assets) or “in-exchange” (if the asset is used on a standalone basis). In addition, the fair value measurement of a liability should reflect the risk that the obligation won’t be fulfilled — for example, that an entity will default on payment.

How Can You Value Assets at Fair Value?

More than likely, your organization has been using valuation techniques to value assets and liabilities. If you’ve entered into a charitable gift annuity agreement, the present value of the liability to the donor is calculated using a discount rate at each year end. This is an example of the income approach, as defined in SFAS No. 157. The income approach is a valuation technique that takes into account current market expectations about those future amounts.

Two other techniques are the market approach and the cost approach. The market approach uses prices in market transactions for comparable assets or liabilities. This approach is similar to the way that a real estate agent compares recently sold and currently listed homes to find a market price.

The cost approach is based on the asset’s current replacement cost. Think of the amount for which your engagement ring, home or car is insured. The amount that you’d receive if anything should happen to one of those assets is its current replacement cost. It takes into account wear and tear and, particularly in the case of a home, the money that you’ve put into it.

Of course, the appropriate valuation technique must be used. Your organization most likely uses the income approach on a continuing basis to value certain assets or liabilities due to its widespread use in the accounting community. The present value of the asset or liability is calculated using an applicable discount rate (often the risk-free rate or an applicable Treasury bill rate). Whatever the case may be, the American Institute of Certified Public Accountants’ Audit and Accounting Guide for Not-for-profit Organizations notes that “a fair value measurement is the point within that range that is most representative of fair value in the circumstances.”

How Can You Prepare for the Change?

SFAS No. 157 expands the required disclosures for assets and liabilities measured at fair value. As your year end audit approaches, it’s time to get ready to use the new measurement. If you haven’t already, you should meet with your accountants to discuss the effect of this standard on your audited financial statements. Finally, prepare your users, such as your board of directors, for the change.

Renee Ordeneaux
Principal
Nonprofit Services Group

For more information about this article, click here to send Renee an email.

With traditional investments having lost a lot of their luster in today’s environment, many nonprofits are turning to alternative investments for a better return. But before you put part of your nest egg into investments such as venture capital funds, hedge accounts or private equity funds, be sure you fully understand their possible tax consequences.

Realizing How They Are Different

Alternative investments can be U.S. or international investments. They are commonly organized as partnerships or limited liability companies (LLCs), with income passing through to the investors and taxes levied at the partner level, which creates a tax dilemma for you.

Here’s why: Traditional investments typically produce interest, dividends or capital gains — and none of these are generally taxable as unrelated business taxable income (UBTI). But when alternative investments are made in a partnership (as they typically are), your nonprofit is taxed as if it were performing the activities itself. So if the partnership is involved in a business activity unrelated to your exempt purpose, your portion of the partnership income as reported on Schedule K-1 will be taxed as UBTI.

Reading Form K-1

If you’ve made the alternative investment through a brokerage firm, your monthly and year-end statements should report the investment and what appears to be its income. But don’t be misled: The statement only reports the distributions you receive from the partnership. You must wait for a Form K-1 (sent out by partnerships to investors) to get an accurate reporting of the investment activity.

The K-1 for a typical alternative investment reports income from a business activity (most often unrelated to your exempt purpose and thus taxable). It also reports interest income, dividends — and perhaps some capital gains. In most cases, these latter amounts will be tax-exempt. The K-1 also reports the income that is subject to unrelated business tax (reported on a separate line, identified as UBTI).

One exception to the tax-exempt treatment is debt-financed property. If you take out a loan to purchase the alternative investment, all of the income from the investment becomes taxable to the extent it’s debt-financed. If capital gains are produced by the sale of partnership property that is debt-financed, those capital gains are taxable.

Weighing the Pros and Cons

Although alternative investments carry more risk than traditional investments, they also can produce more favorable returns. But the tax consequences can lower these returns, and you may need to make additional filings as well. (See “Extra tax filings”.) In addition, there’s an accounting issue for organizations that prepare financial statements according to Generally Accepted Accounting Principles (GAAP): Statement of Financial Accounting Standards No. 157, Fair Value Measurements, can create additional costs because the nonprofit will need to be able to support fair market value using specific methodology, which can be difficult and, thus, expensive. Related costs — appraisals, information gathering and the drafting of disclosures — can add to the expense.

As with any investment decision, you’ll need to weigh the pros and cons of alternative investments. And if you truly understand what you’re getting into — their nature and the tax consequences — alternative investments could be a sound choice for your organization.

Extra Tax Filings

Additional filings that could be required as a result of alternative investments include:

• Form 990-T: filing for unrelated business taxable income (UBTI)
• Estimated tax payments: quarterly payments of current year tax
• Foreign filing: informational filing to report foreign activity, commonly Form 8865 for involvement in a partnership with foreign activity
• Form 8886 for reportable transactions — informational filing for involvement in a transaction with the potential for tax evasion (the partnership should advise you if this applies)
• State filings, as required for UBTI: Watch for partnerships that do business in multiple states; your nonprofit could be subject to tax in multiple states.

Thomas Leaper
Partner-in-Charge
Entrepreneurial Services Group

For more information about this article, click here to send Thomas an email.

Nonprofits often ask their advisors how to look at an operating reserve: Is it cash set aside for a rainy day? Is it the same as an organization’s net worth? How much is too little — or too much?

What an Operating Reserve is — and isn’t.

An operating reserve is a portion of an organization’s net assets that is unrestricted in nature and relatively liquid. But it shouldn’t be defined so narrowly that only cash or cash equivalents can meet its definition. That would make it a working capital reserve created to ease routine cash flow swings. Funds that shouldn’t be considered part of an operating reserve include:

• Endowments and temporarily restricted funds that your organization doesn’t have the prerogative to use as it sees fit
• Net assets tied up in illiquid fixed assets used in operations, such as your buildings and equipment.

Rather, an operating reserve is more long-term in nature. It generally spans a period of years and usually comes from operations that create a surplus. Receiving unrestricted contributions, generating investment income and budgeting for a surplus are all ways to create unrestricted net assets. And that, in turn, can be considered your operating reserve.

Who Should be in the Loop?

Involve your board in determining your nonprofit’s policy on building an operating reserve, the desired fund amount, and the circumstances under which it can be drawn down. Many organizations have the board designate a portion of their unrestricted net assets as an operating reserve, implying that they must authorize any of the fund’s releases.

Determining how much should be in your operating reserve depends on your organization and its operations. Generally, if you depend heavily on only a few funders or government grants, your nonprofit would benefit from a larger reserve. Likewise, if personnel costs make up a significant part of your expense budget, your organization could use the cushion a healthy operating reserve provides.

How Much is Right?

On the other hand, there are nonprofits that need less in reserve: for example, those with diverse funding, or whose expense budgets are less personnel-intensive. Also included are nonprofits whose expenses are more heavily pass-through expenditures that can shrink with a reduction in funders’ awards.

If there is any generally accepted benchmark for operating reserves, it’s usually three to six months of operating expenses. Three months is typically considered a minimum accumulation and six months a more sought-after amount. But rather than thinking of this as a benchmark, it’s better to consider it a safe-harbor range established to cover any emergency. This would enable an organization to continue its operations only for a relatively brief transition in operations or funding. Or, in the worst-case scenario, it would allow for an orderly winding up of affairs.

An operating reserve of more than six months of expenses provides more flexibility. For example, it might give your nonprofit funds to pursue a new program initiative that’s not fully funded, or to leverage debt funding for needed facilities or equipment.

Accumulating more than a year’s worth of expenses in reserves, not designated by the board for specific purposes, must be approached carefully. You should look at it through the eyes of your donors and the general public: How would they perceive that kind of nest egg?

What’s Next?

As your nonprofit establishes its operating reserve, it’s important to consider all factors that impact your organization’s finances. What’s right for one organization might not be right for another. Take into account the variables mentioned above and tailor-make an operating reserve that’s right for you.

Tom Schulte
Partner-in-Charge
Nonprofit Services Group

For more information about this article, click here to send Tom an email.

When Fiscal Sponsorship is Right

By Mike Cantrill

Imagine this: A family member is afflicted with a strange new disease that no one is studying. You want to take action immediately to support a group of scientists willing to research it. But you don’t have time to form your own nonprofit and build the infrastructure to run it.

You do, however, have people willing to donate to your cause. What can you do? Finding a fiscal sponsor could be the answer. A nonprofit with 501(c)(3) status can act as a fiscal sponsor for a group that hasn’t obtained its own 501(c)(3) status but has a charitable project to pursue. And for many nonprofits, serving as a fiscal sponsor can be beneficial.

Agent vs. Sponsor

Some relationships that portray themselves as fiscal sponsorships are merely fiscal agencies. In a fiscal sponsorship, the 501(c)(3) sponsor is responsible for the funds and is legally responsible for the project. The sponsor acts as a “guardian” for the donations and grants the project receives. Donations are made to the fiscal sponsor, qualifying the donors for a charitable deduction. The employees working on the project are employed by the sponsor, not the project. The project must be consistent with the sponsor’s mission, and the sponsor controls the project.

In a fiscal agency arrangement, the 501(c)(3) organization is merely the project’s conduit. The conduit accepts the donations and transmits them to the intended recipients. The IRS considers the donations to be made from the donors directly to the intended recipients.

The danger with a fiscal agency structure is that, if the recipient isn’t a charity, the donations won’t qualify for a charitable deduction. For example, if a family’s house is destroyed by fire, and an individual uses a church as the fiscal agent to donate money to the family, the donation isn’t deductible because the family isn’t a charity.

Benefits for Sponsorees

Obtaining a fiscal sponsorship can be advantageous for projects that are too small to have staff or much infrastructure for pilot projects where longevity is in question. Groups waiting to secure 501(c)(3) status, but that want to operate now, also are good candidates.

A fiscal sponsorship relationship can provide much-needed infrastructure and fiscal management to a project. By making it possible to receive charitable donations, the sponsorship can make more funds available. Associating with an established charity also can enhance the project’s credibility.

Benefits for Sponsors

The fiscal sponsor can gain from the relationship as well. The project can provide more exposure to that organization, possibly resulting in new funders for established programs.

Often the sponsor will charge a nominal fee for the sponsorship to offset some of its overhead costs. The project under sponsorship could give the sponsor a more competitive edge by providing a service that other similar agencies aren’t providing. For example, your nonprofit may provide medical services to the underprivileged, but no organization in town offers dental services to the same group. You are approached by a group that doesn’t have 501(c)(3) status, but wants to start offering dental services to the indigent. Becoming its fiscal sponsor can broaden your reach and increase your profile in attracting donations.

This example also points out an additional benefit — by becoming a fiscal sponsor, your organization can enhance its own program offerings with minimal monetary outlay.

Both parties must understand the key responsibilities in the relationship. First and foremost, the fiscal sponsor is ultimately responsible because the project and the sponsor are legally one entity. This arrangement requires proper oversight by the sponsor. See the sidebar, “Forming the relationship,” for specific factors to consider.

Just as important as these start-up considerations is the plan for terminating the relationship. This would include defining the project’s life, if desired, and determining how the project’s assets and activities will be severed from the sponsor.

A Favorable Union

Fiscal sponsorship can be a win-win situation for both parties involved, but the devil is in the details. The relationship must be thoughtfully designed with mutual understanding and agreement on the key factors.

Forming the Relationship

The terms of the fiscal sponsorship relationship should be mutually agreed upon before the relationship begins. Some factors to consider:

• When will the relationship begin?
• How and when will the relationship be evaluated?
• Who is authorized to make decisions?
• How will disbursements be handled?
• Who will handle any reporting requirements, such as an audit and reporting to funders?
• What fee will the sponsor charge? (Up to 10% is typical.)
• What are the major business decisions that need to be made, such as staffing and insurance?

Mike Cantrill
Director
Nonprofit Services Group

For more information about this article, click here to send Mike an email.