Transaction tax

Briefing Notes for Nonprofits: Accounting Best Practices for Nonprofits | Business

Nonprofit organizations may be exempt from certain taxes, in particular federal income tax and state sales tax. However, the IRS has rules, similar to those for for-profit businesses, regarding accounting and bookkeeping practices.

A 501 (c) (3) organization must keep its books and records over an annual accounting period called a tax year. This is the reference period for compliance with annual reporting requirements.

Tax year

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There are two types of tax year. Both consist of 12 consecutive months. The calendar year is a period of 12 consecutive months beginning on January 1 of a year and ending on December 31 of the same year.

A fiscal year is a period of 12 consecutive months ending on the last day of any month except December. For example, if a nonprofit organization begins its fiscal year on July 1 of any year, the last day of that fiscal year is June 30 of the following year.

Accounting methods

There are two forms of accounting methods. One method is called the cash basis of accounting and the other the accrual method of accounting. Both record transactions in the tax year they chose to use. Postings document when and how income and expenses arise.

After one year of existence, a nonprofit organization must file an annual information return known as 990. At that point, the organization must choose the accounting method it will use.

There are some variations in the communication of information in the two methods. Differences are usually based on the source and amount of income received in the first year.

Cash accounting versus accrual accounting

If cash accounting is chosen, income is recorded on the date it is deposited into a current account or otherwise. Expenses are recorded on the date of their payment. In some cases, an invoice can be received within a month and paid the following month.

This method does not lend itself well to matching the income with the expenses incurred to generate the income.

If the organization opts for the accrual method, the income is recorded when it is earned even if it is not yet received. For example: when a commitment, a donation or a subsidy is made (via a written notice) but not yet (made) received.

The expenses are recorded on the date of receipt of the invoice, but not yet paid. Even if the invoices are not paid in the same month received, they are compared to the income that created the expense during the same period. The practice of matching income to related expenses provides the margin (profit) of income over expense or the converse (loss) of expense over income.

Best choice and convenient

As a general rule and suggestion, the IRS prefers the calendar year over the 990 annual information return. And it works well using cash accounting and bookkeeping. Keeping the books on an accrual and fiscal year basis will require more entry work and can lead to problems with errors.

In addition, nonprofits can use simpler accounting practices to match costs and income received for an event or program that is part of the mission and the goal.

Recording of transactions and documentation

All financial matters should have documents describing and justifying each transaction. On the income / revenue side there will be donations, rewards, gifts, grants, functions that generate income supported by checks, deposit receipts, written pledges and grants. Everything must be saved.

On the expense side, canceled checks, receipts, paid invoices and invoices should be kept. These documents represent the flow of income and expenditure. They should be entered in a journal so that all transactions are recorded, backed up in detail and ready for the reporting process.

There are charts of accounts unique to nonprofit organizations that can be used to organize all transactions. It is best to always keep the records in a safe place so that if the IRS calls you, they are readily available.

Few IRS agents will accept thinly veiled excuses for why documentation is not available, especially during an audit. If and when a nonprofit is audited, you can be sure that there is a justifiable reason that something doesn’t look right in the annual reports.

Final considerations

The rules and practices of bookkeeping and accounting have undergone a wide range of changes due to the age of digital reporting and especially accounting programs. The best choice for nonprofit agents is to have trained a professional who recommends the way forward.

Dr. Frederick J. Herzog is the Founder / Executive Director of the NonProfit Resource Center in Citrus County. He can be reached at 847-899-9000 or by email at [email protected] Need help for your association? Visit www.TheNonProfitResourceCenter.com.


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