Nonprofits

Using 501(c)(3) Accounting to Maximize Your Nonprofit Mission

While all organizations typically have similar accounting needs, certain organizations are in a class of their own: those tax-exempt under section 501(c)(3) of the IRS. These can include charitable or religious organizations, churches, and certain private foundations.

Organizations that fall under this category are typically excused from certain types of federal income taxes, may have access to certain grants and funding, and can even earn more credibility from donors. But 501(c)(3) accounting is very particular, and tax-exempt organizations need to understand what that means, the key principles, and the legal and regulatory considerations.

Due to the nuances of 501(c)(3) accounting and the requirements that come with it, many turn to outside professionals to help them with their accounting and financial needs. Here at hiline, it’s one of the things we do best.

Here’s everything you need to know about 501(c)(3) accounting and how proper tax-exempt financial management and best practices can help you maximize your organization’s impact.

What is 501(c)(3) Accounting?

Firstly, earning 501(c)(3) status means your organization falls under this section of the IRS’s code, meaning it’s tax-exempt from federal income taxes and unemployment taxes. Additionally, donors can claim their contributions as tax deductions. Nonprofits and other charitable organizations must earn and maintain this status (if applicable) to take advantage of the benefits.

Defining 501(c)(3) Organizations

As we mentioned, 501(c)(3) organizations are those which fall under section 501(c)(3) of the IRS code. There are several parameters an organization needs to meet to learn this title.

For example, they need to be a charitable organization and cannot be “operated for the benefit of private interests.” Employees need to be paid a fair wage (consistent with market value), and additional net earnings must be used to advance the organization’s charitable cause.

There are a few other requirements that an organization needs to meet to be applicable for 501(c)(3) status. For example, these organizations typically aren’t permitted to engage in political lobbying, and after they earn 501(c)(3) status, they need to stay aligned with their original mission.

Key Principles of 501(c)(3) Accounting

For nonprofit organizations, it’s crucial to maintain accurate financial records and comply with IRS guidelines. Aside from the basic requirements to qualify for 501(c)(3) accounting, there are some key principles tax-exempt organizations should be aware of.

Accrual Basis Accounting

Nonprofits follow Generally Accepted Accounting Principles (GAAP) issued by the Financial Accounting Standards Board (FASB). GAAP principles dictate that tax-exempt organizations should use accrual basis accounting, which requires them to record sales when they occur instead of receiving the payments.

Accrual basis accounting is the standard in the 501(c)(3) space, and it is considered to give a more complete view of an organization’s finances, which can be useful for stakeholders and donors.

Fund Accounting: What it is and Why it Matters

Depending on the 501(c)(3) organization you’re part of, you might also use fund accounting. Nonprofit organizations use this system of tracking and managing financial resources to ensure they’re used for specific purposes or activities.

It operates by separating financial resources into different groups called funds. There are several different types of funds, and they might be separated based on their purpose, use restrictions, or revenue sources.

Fund accounting can play a big role in the financial operations of nonprofit organizations. First, it can facilitate financial accountability, ensuring financial resources are used for their intended purposes. It can also help with the transparency of finances, providing clear ways to track funds, their sources, and how they’re used. This accounting system also allows nonprofits to easily manage grants separately and evaluate the financial performance of individual programs.

Net Assets Classification

When it comes to assets, nonprofits are also required to classify them (which is also required by the GAAP). These guidelines dictate that nonprofits classify an organization’s net assets into one of three categories:

Unrestricted net assets –These are the financial resources not subject to donor-imposed restrictions or limitations. Nonprofits can use these assets for any purpose deemed appropriate by the organization's management, including general operating expenses, program development, or strategic initiatives.
Temporarily restricted net assets – These represent funds designated by donors or other external entities (such as grantmakers) for specific projects, programs, or time-limited purposes. Nonprofits are required to use these assets following the donor's restrictions until they are met or expire.
Permanently restricted net assets – These assets are subject to restrictions by donors or governing authorities that stipulate they must be maintained in perpetuity.

Understanding the 501(c)(3) Audit Process

While your organization is up and running, it might undergo an audit process. This process will be different depending on what type of audit it is.

For example, your organization may receive a letter or phone call from the IRS saying it’s been selected for a field or office/correspondence audit. If this is the case, the IRS might want to visit your organization’s premises or ask you to deliver documents via mail.

If so, they will require your financial records and books to complete their audit. They might assess whether your organization’s activities align with its stated exempt purpose, scrutinize any income related to activities, examine the compensation and benefits provided to executives and employees, and review the accuracy and completeness of your records.

It’s also possible for a 501(c)(3) organization to face another type of external audit. This might be performed by an independent body and conducted in certain situations, such as by a specific grantmaking organization, as a condition for funding.

Additionally, it’s also possible for a 501(c)(3) to go through an internal audit. When this is the case, the organization's internal auditors or an independent audit committee assess the effectiveness of internal controls, ensure compliance with policies and procedures, and identify any potential risks or areas for improvement.

Legal and Regulatory Considerations

When it comes to 501(c)(3) accounting, there are many legal and regulatory considerations to keep in mind, including:

IRS regulations – 501(c)(3) organizations must comply with IRS regulations, including filing the appropriate annual information returns to report financial activity. Compliance with IRS regulations ensures the organization retains its tax-exempt status and remains in good standing.
State and federal regulations – Nonprofits are also subject to state and federal laws and regulations that govern their operations, reporting requirements, and fundraising activities. Compliance with regulations is essential to maintain legal standing.
Reporting requirements – 501(c)(3) organizations must adhere to certain reporting obligations. These can include annual information returns and certain public disclosures readily available. This can include information about the organization's finances, operations, and governance.
Compliance with GAAP – While certain laws vary regarding the legal requirements surrounding GAAP, most nonprofits do adhere to GAAP guidelines, and they are considered the gold standard of accounting for nonprofits.

Taxes and Accounting Built for Nonprofits

Let’s face it, a lot comes with 501(c)(3) accounting. From initially earning your 501(c)(3) status to mastering the fundamental accounting principles, it can be a full-time job to follow all the necessary processes and requirements.

But that’s where Hiline can help. We provide tax-exempt organizations like yours with all the key financial and accounting services you need for organizations of all sizes.

Here’s how:

Bookkeeping – With our nonprofit bookkeeping services, we’ll ensure your books are accurate, up-to-date, and error-free while handling things like reconciliations, employee expense management, and A/P management.
Tax – While your organization might be tax-exempt, you must still file certain paperwork with the IRS to maintain your status. And in the event of an audit, we’ve got your back.
Accounting management – With our accounting management services, you get an all-star team of cloud accounting specialists, managers, and directors who can help you maximize your financial resources and, therefore, your impact.
Financial reporting – Don’t let your financial reporting requirements suck up your valuable time or your team’s manpower. With our financial reporting and analysis services, you can make data-driven decisions to steer your nonprofit in the right direction.
Cash management – Your cash resources are vital to accomplishing your mission. We’ll monitor your cash flows, process and collect payments, and manage your bank accounts.

These are the things we do best and are most passionate about. Let our team of financial experts handle your tax-exempt nonprofit's financial and accounting needs so you can focus on doing the most good.