Chris Thompson, BoardSource’s numbers guy (and experienced ATM user) explores what can be learned from our recent financial literacy quiz.
Of the 10 basic board responsibilities, “finance” appears prominently in two of them: “ensuring adequate financial resources” and “protecting assets and providing financial oversight.” Fulfilling both these stewardship roles requires that all directors have at least some knowledge and experience of finance and nonprofit tax laws and regulations, along with basic budget and financial statement reviewing skills. BoardSource is pleased to announce that, on the basis of a recent non-scientific “take five” online quiz, responded to by 1,418 people as of this writing, the level of board financial literacy appears “sound” overall, with an average correct score across five key financial questions being an impressive 81 percent.
The five questions that were asked related to:
- the balance of expenses on program services versus management and fundraising
- buying office supplies from a board member’s company
- general liability insurance
- unrelated business income tax (UBIT)
- the use of purpose-restricted assets for other purposes.
For each question, respondents could read the statement and then select the one option they thought correct out of four or five presented as possibilities. The percentage of respondents guessing correctly for each question is shown in the chart.
It is very reassuring that more than three-quarters of respondents knew the correct answers about the use of purpose-restricted assets, the purchase of office supplies from a member’s company, and the need for general liability insurance. These three are all important bread-and-butter financial issues for nonprofit boards. The two questions where fewer than 75 percent of the respondents guessed correctly related to “spending” and “UBIT,” so let’s go into each of these in more detail.
BoardSource asked whether “Spending 72% of total expenses on program services and 28% on management and fundraising” is too little or too much on one or the other, or about right. Now the way this balance is stated is frequently what people consider to be the “overhead rate”, i.e. how much it costs your organization to do what it does. In spite of that term eliciting sometimes visceral responses (especially if the management and fundraising part is relatively “high”) the truth is, while many people think there is some “correct” percentage to spend on programs versus administration and fundraising, there is not. Every organization is different. As Independent Sector states in Principles for Good Governance and Ethical Practice: A Guide for Charities and Foundations, “A charitable organization should spend a significant amount of its annual budget on programs that pursue its mission while ensuring that the organization has sufficient administrative and fundraising capacity to deliver those programs responsibly and effectively."
As a practical example, a few years ago the fundraising literature rediscovered an early Harvard study on the “cost of fundraising”, which documented that it cost about 18 cents to raise each philanthropic dollar for higher education. For better or worse this figure rapidly became seen as the “benchmark” for cost-to-raise-a-dollar by universities. Presidents became concerned if their fundraising operation was at, say, the 25 cent or higher level, or conversely, boastful if it operated at only 12 cents or so on the dollar. But supposing the 25 cents on the dollar operation raised your nonprofit more than a billion dollars in donations (a level many university capital campaigns now target), while the frugal 12-cent operation raised just half a million dollars: Which operation would you rather have? Clearly, scale, ROI, upfront capital needs, and time-to-realization all have to be factored into any judgement. It may be much better to turn the cost-of-fundraising logic around, and to ask instead: What does a fundraising operation that costs 25 cents on the dollar look like, and what does a 12-cent operation look like? Which one am I capable of mounting? What has to be put in place for it?
The lower score by respondents on the UBIT question is perhaps less surprising, as unrelated business income tax is simply not an issue for many nonprofits, and their board members do not have the opportunity to get educated on it. So here is your primer.
Basically, your nonprofit organization is exempt from tax because it is pursuing a social mission which the private sector would not be able to make a profit doing, or because you are doing it for less than the government would have to spend. But society does not accord that tax-exempt privilege just so unscrupulous entities can engage in money-making business activities at a taxpayer-subsidized cost. So a tax-exempt organization may still be liable for tax on its unrelated business income, i.e. income from a trade or business, regularly carried on, that is not “substantially related” to that charitable, educational, or other purpose which is the basis of the organization's exemption.
Any exempt organization that has $1,000 or more of gross income from an unrelated business must file IRS Form 990-T. All organizations subject to UBIT, except trusts, are taxable at corporate rates on that income (which vary between 15 percent and 35 percent depending on amount of income). All exempt trusts that are subject to these provisions (and that, if not exempt, would be taxable as trusts), are taxable at trust rates on unrelated business taxable income (which also vary from 15 percent to 35 percent but incur an additional varying flat amount at over $1,900 of unrelated business income). An IRS study found that almost 40,000 organizations were required to file a 990-T, and tax-exempt organizations produce a total of $9.5 billion in gross unrelated business income a year.
So is being liable for UBIT a “good” thing or a “bad” thing for your nonprofit? It all depends. It is perfectly acceptable for a nonprofit to generate revenue through activities that do not directly relate to its purpose, provided it fulfills all its IRS requirements. And since only a minority (48 percent) of organizations reporting UBIT state any positive unrelated business taxable income, this suggests that available deductions to reduce tax liability may be very generous. You are then left with the after-tax revenue for putting towards your charitable purposes, supplementing your philanthropic receipts, or helping pay your organization’s overhead. On the flip side, the potential disadvantages are you may incur additional accounting and record-keeping costs, you may have to make estimated tax payments, and the cost of doing this unrelated business may detract from what you can allocate to your primary social purpose. And should this unrelated business income rise to the level of 20 percent or more of the organization’s total gross income, it may be wise to consider spinning off the business activity into a separate taxable subsidiary, lest the sheer scale of unrelated business income attracts IRS attention and threatens your whole tax-exempt status.
Finally, as usual we need to remind ourselves of some caveats about these quiz findings. Since participation in the quiz was voluntary and anonymous, we do not know just who the 1,418 respondents were in terms of their age, experience, “day job,” length of board service, and what kind of nonprofit they serve. Not every tax-exempt organization has any UBIT issues. And not everyone on a board necessarily needs to be a financial guru: Boards certainly need some financially-expert directors, but they also need experts with other occupational backgrounds and mission-related content knowledge that might not be financial in nature.
In uncertain economic times, though, when finances are at the heart of most nonprofits’ practical challenges, it is good to ensure all of your board members are as prepared as possible with the skills and up-to-date information necessary to deliberate effectively on your organization’s financial situation and to decide on its future. And if they are not, well, better luck on the BoardSource literacy quiz next semester, and in the meantime, just send me your board members’ credit card numbers because I have some office supplies I’d like to sell them.
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