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The Great Resignation, Talent Shortages, Inflation, Recession … Maybe Bonuses Can Help!

Aug 28, 2023

It will come as no surprise that bonuses (includes all forms of variable pay for purposes of this discussion) are far more prevalent in the for-profit than the nonprofit sector. For many people, bonuses are believed to be appropriate, or perhaps unavoidable, among for-profits but often viewed as inappropriate or unnecessary for nonprofits. Quite simply there is a school of thought that nonprofits shouldn’t have bonuses or just don’t need them to carry out their missions.

Many nonprofit boardrooms have struggled with the “b-word”. There’s been uncomfortable squirming as they wrestle with “should we, could we, ever pay a bonus?” That kind of uneasiness inhibits many nonprofit organizations from considering a bonus pay-for-performance option in favor of the same old flat percentage across-the-board salary increase for everyone.

Some allege the use of bonuses could distract attention from the organization’s good work or, worse yet, motivate staff to maximize bonuses at the expense of the organization’s mission. Others mistakenly harbor a belief that nonprofits are not allowed to pay bonuses. Some believe nonprofit status precludes the ability to meaningfully measure performance upon which a bonus could be based. Finally, some board members may just not have enough familiarity with compensation practices to properly consider the use of bonuses.

Contrary to some of the comments above, bonuses of one sort or another are already in use and rather prevalent in several nonprofit sectors. And there is a trend, albeit a slow one, by others to start using them as well.

Hospitals, health systems and professional trade associations were early adopters of bonus plans. Most often the plans covered executive-level positions. Over the years, the prevalence of plans and the award opportunities associated with them have grown as well. This is particularly true among the larger and ever more complex hospitals and health systems. Larger academic institutions, human services and philanthropic organizations have also been instituting bonus plans. No doubt, the competition for executive talent and increasing prevalence of bonus plans among competitors for that talent have, and will, promote adoption of plans by others.

Why limit bonuses to management alone? I believe that a case can be made for considering the use of bonuses not just for executives but other staff positions in nonprofits as well. I am not referring to just the occasional one-off “thanks for the great job” award, I am talking about formally incorporating a bonus plan into the organization’s compensation program.

The COVID crisis and related employment and economic disturbances associated with it have negatively impacted many types of organizations and nonprofits are no exception. Mandated shutdowns, work from home requirements, inflation and recession fears have left many nonprofits scrambling to get help, desperately clinging to experienced staff members and fretting over a range of possible recession scenarios.

Organizations have shared stories of valued employees leaving for more compensation elsewhere or the new hires who are “no shows,” or worse yet, “short stays!” Not surprisingly, more pay has frequently been viewed as a solution, or at least a partial one, for addressing these tumultuous times.

Budgeting for 2023 compensation expenses has been strained by pressures to respond to competitive pressures in the job market, the highest levels of inflation in 40 years, plus the highest average salary increases in more than a decade. Recession worries raise questions about the advisability of budgeting large payroll increases, especially fixed ones. Year-over-year increases, particularly for those organizations opting to target pay above mid-market levels, build in higher cost for the future. A healthy increase in salary, whether in response to tumultuous times like these or simply a banner year of performance, becomes an ongoing annuity.

This might be an excellent time to consider the adoption of a bonus plan if you do not have one or expanding participation to other staff members if you do. Think of the bonus as replacing all or at least some of the traditional annual increase for positions participating in a plan or even a way of boosting the competitiveness of your pay program.

As a first step, make a determination about the competitiveness of the compensation you now offer your positions. You must know the answer to this to responsibly proceed with exploring the feasibility of offering a plan as a formal part of your compensation program.

Next consider the impact of a bonus on your competitive position. Generally, a minimum of 5% of salary is considered sufficient to impact employee behavior. Reflect on that in relation to the expected 4.25% +/- average salary increase many now project for 2023 (likely for 2024 as well if inflation persists). That 5% amount should allow the organization to maintain its current position in relation to competitive pay levels. Obviously, a higher or lower amount will either improve or erode the relationship to market pay levels. Many would suggest that the bonus target should be set higher than the expected average increase percentage. This offers a higher potential opportunity in return for making it contingent on the organization’s performance, a risk adjustment of sorts.

The bonus plan could be added as a formal component of the compensation program to maintain competitiveness and offset cost escalation caused by year-over-year salary increases. Doing so would introduce some elasticity into the organization’s compensation costs. The organization’s results for the year will determine how much of the bonus is earned and can be paid. As mentioned previously, this may also be a way to improve the competitiveness of your current pay. This also adds a performance-basis component to the compensation program as well.

The use of a bonus plan will not preclude the need for periodic salary increases. Competitive pay of covered positions will need to be monitored and adjustments made if the bonus is no longer sufficient to maintain the organization’s desired position versus the competitive market. But the year-over-year increase to salaries can be slowed.

If a bonus plan appears feasible, its success will be heavily dependent on effective communication for a number of important topics, including:

Overall objective of the plan (e.g., “will allow us to offer more competitive pay while controlling our expenses,” “will allow us to maintain our above-average compensation and carefully manage our costs,” etc.)
Participation criteria – levels or positions to be covered by the plan (often introduced at senior-level positions and lower levels later)
Eligibility criteria – minimum employment/position tenure, employed at time of award, etc.
Performance factors – identify the criteria that will be used to determine the decision about payment of the bonus (i.e., yes/no and size of award)
Periodic progress reports – updates to employees on the organization’s actual results in relation to the performance factors

This is not an approach that will be appropriate for every organization nor for every position within an organization. The promise of a future bonus does little for employees struggling to manage higher prices now. In the same way, the presence of a bonus opportunity will have marginal ability to overcome a salary that is not competitive.

The presence or absence of a bonus plan is certainly not the sole determinant of a nonprofit’s ability to attract and retain executive talent. That said, if two employment opportunities were essentially comparable for an applicant or an employee targeted by a competitor, might a bonus opportunity make a difference? I submit it could, especially among the most capable and sought-after employees. Great talent is always in demand, and this may be a helpful tool in the competition for talent.

For more information, contact Mike Conover, Managing Director, Specialized Tax Services – Global Employer Services.

Global ERP Considerations for International Organizations

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Aug 21, 2023

Modern Enterprise Resource Planning (ERP) systems empower organizations of all sizes, structures and industries when it comes to financial and operational management. However, some industries suffer unique challenges, particularly those that provide goods and services worldwide. International non-governmental organizations (INGOs) are typically nonprofit organizations established to serve a purpose and achieve objectives on a global scale. Such goals can include aiding or advocating for a humanitarian cause, protecting an environment and its wildlife, as well as providing healthcare or financial services to developing nations. The missions of these organizations span international borders, sometimes requiring operations in either remote, underdeveloped or even high-risk areas. Due to the unpredictable nature of INGO work, business transformation through ERP system modernization can be challenging for these organizations.

The world’s most impactful organizations utilize ERP systems to streamline operations across industry-standard business cycles, such as opportunity to cash, procure to pay, record to report, plan to deliver and hire to retire. In fact, according to a survey of INGOs, which BDO recently conducted, 80% of respondents indicated that they have already invested or are planning to invest in modern ERP technology. ERP system implementation stands to provide myriad benefits to these organizations, including process automation and workflow standardization, data analytics and benchmarking through dashboarding, enforcement of internal controls and flexible management, and regulatory reporting capabilities. However, for INGOs, realizing these benefits can come at a significantly higher level of effort and cost compared to other industries and nonprofit sectors. Difficulties often emerge with the integration of headquarter and country office operations under a single, holistic ERP solution.

Although implementation of a modern ERP system provides organizations with long-term return on investment through cost and resource savings, INGOs face unique challenges in the deployment of ERP solutions across country offices. The nature of INGO missions generally results in decentralized organizational structures and siloed operations, with each country managing its own procedures and maintaining its own statutory reporting requirements. Challenges arise when organizations require streamlined business processes between headquarters, regional and country offices that help the organization operationalize its mission and goals. Examples of these challenges, according to BDO’s latest INGO CFO survey and roundtable discussions, include the need for organizations to:

Implement organization-wide process controls to mitigate risks
Maintain a comprehensive source of employee information for domestic and international offices
Roll up country office transactions for donor- or funder-specific reporting requirements
Comply with localization and statutory reporting requirements
Have real-time access to organization financial data and the ability to easily create dynamic reports with that data
Mitigate risks for regional and field finance teams that lack adequate human capital
Fill in gaps when there is a lack of reliable IT infrastructure to provide adequate bandwidth for modern day enterprise-wide tools to function properly
Adapt to turnover of leadership and staff personnel
Calculate accurate indirect cost rates to recover maximum reimbursable funds
Automate reconciliation processes during month, quarter or year-end close
Track organization-wide commitments and encumbrances

To address the ERP challenges above, INGOs have primarily two options to successfully dismantle the financial and operational silos between headquarters, regional and field offices:

Implement one universal ERP solution: a holistic, global solution that can handle country, regional and headquarters offices within a single system; or
Implement a two-tier ERP solution: a core ERP system at the headquarters that fully integrates with a second distinct ERP system utilized only at the regional or country offices.

There is not a one-size-fits-all ERP solution and implementation approach for complex organizations such as INGOs. The correct choice between the above options is dependent on each individual organization’s business model. However, it is ultimately more beneficial to maintain a single source of truth for financial data either through a single ERP system or a fully integrated two-tier ERP model. Aside from evaluating the performance of a core ERP system to meet organizations’ needs, other factors that INGOs should take into consideration when exploring ERP solutions include but are not limited to:

Integration ability with supplemental tools
Ease of use and user interface
Simplicity and flexibility in the system design
Footprint and customer satisfaction in the INGO market and similar organizations
Low bandwidth capability
Modular design to enable scalability
License and implementation costs
Simplified application architecture
Business process design and definition
Organizational change management
Flexibility of reporting and analytics capabilities

The right collaborator can help INGOs navigate ever-changing ERP system needs and help organizations develop their global enterprise applications strategy, assess the current state of processes and controls, gather and develop future state requirements, identify gaps, evaluate various available solutions and implementation partners, and recommend a holistic global solution that best fits organization-specific needs.

Managing Pay for Disqualified Individuals

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Aug 14, 2023

The title of this article might have caught the eye of some readers, who may have thought it provides tips on managing pay for poor performers or offers a rationale for employing individuals without proper job qualifications. However, this article focuses on “disqualified individuals” in the context of IRS intermediate sanctions — IRC Section 4958 — and the management of compensation paid to those individuals. It is an area that receives considerable attention from the IRS and the general public. Failure to manage it well can result in lingering reputational damage, as well as punitive taxes and penalties for all involved.

The term “disqualified individuals” is defined as individuals in a position to exercise considerable influence or control over the affairs of an IRC Section 501(c)(3) or Section 501(c)(4) tax-exempt organization. They are singled out as individuals who might be in a position to exercise their influence or control over the organization for personal benefit at the expense or to the detriment of the organization with which they are associated. This personal benefit, defined as an excess benefit transaction by IRC Section 4958, could arise in almost any type of transaction involving the organization and a disqualified individual. Some examples include the purchase or sale of goods and services and the provision of special personal benefits. This article explores IRC Section 4958, disqualified individuals and excess benefit transactions as they apply to compensation.

Most commonly, questions regarding compensation for disqualified individuals will arise in the context of pay for an organization’s executive-level positions. These disqualified individuals, both individually and collectively, exercise great control over the affairs of an organization, including its financial resources. The organization’s principal executive officer (e.g., CEO or executive director) and principal financial officer (e.g., CFO or finance director) are almost always deemed disqualified individuals. There are, however, individuals in the management hierarchy of some organizations that might qualify as well, such as chief operating officer and top program executive. These other positions must be determined on a facts-and-circumstances basis to determine whether the individuals meet the criteria to be considered disqualified individuals.

The Section 4958 definition of disqualified individual is considerably broader than executive roles for the organization. The types of individuals and relationships that qualify and may be associated with compensation include:

Other influential persons such as voting members of the governing body
Family members of a disqualified individual, such as siblings, spouse, children, grandchildren, great grandchildren and the spouses of each.

Managing all forms of pay for disqualified individuals is the responsibility of the tax-exempt entity’s governing board (i.e., organization manager(s)). Section 4958 defines these individuals as any officer, director, trustee of an organization or individual (i.e., board members) who serve in that capacity. As stewards of the organization and its financial resources, board members are accountable for ensuring that pay for any individual is not unreasonable (i.e., results in an excess benefit transaction).

In the event of an excess benefit compensation transaction, the consequences are potentially costly for all involved, specifically:

The individual receiving the excess benefit must repay the gross amount of the excess benefit (not just the net amount they were paid) to the organization with interest, to make the organization “whole.” An excise tax on the benefit amount ranging from 25% to 225% may also be levied on the individual.
Members of the organization’s governing body (the organization managers) and management (disqualified individuals) who knowingly authorized the transaction may also be personally subject to penalties of up to $20,000 per occurrence.

These penalties are commonly referred to as “intermediate sanctions.” The intermediate sanctions provisions provide guidance to exempt organizations to avoid excess benefit transactions and offer possible protection from excise taxes and penalties that could arise from them. The guidelines, known as the rebuttable presumption of reasonableness, provide that if an organization meets the listed requirements, any payments it makes to a disqualified person under a compensation arrangement are presumed to be reasonable, and a transfer of property or the right to use property is presumed to be at fair market value. In other words, the organization will be presumed to have met the test for a reasonable transaction and the burden of proof will be placed on the IRS to prove it was not reasonable.

The requirements to meet the rebuttable presumption of reasonableness are:

The transaction must be approved by an authorized body of the organization, composed of individuals who do not have a conflict of interest in the transaction (outside/independent board members). Many boards have a subcommittee focused on compensation composed of outside directors.
Before authorizing the compensation, the authorized body must obtain and rely on comparable data and/or expert advice as to the reasonableness of the transaction. Board members may rely on published compensation surveys or Form 990 filings by other organizations for comparable positions in similar organizations as the basis for their decision.
The authorized body must adequately document the proceedings that were the basis for its determination in a timely manner. Meeting minutes that meet this requirement must be thorough and include the following information:
The comparability data obtained and relied on by the authorized body and how the data was obtained;
The basis for any determination that reasonable compensation is higher or lower than the range of comparability data obtained;
The members of the authorized body who were present when the transaction was debated;
The identity of the members who voted on the transaction;
The terms of the compensation and the date it was approved;
Any actions taken with respect to consideration of the transaction by a regular member of the authorized body who had a conflict of interest (for example, the conflicted party was excused from the meeting during the discussion);
Information related to the date the minutes were drafted as well as approved by those in attendance.

It should be noted that the organization’s Form 990 and Schedule J filings include annual declarations about an organization’s adherence to each of the three broad requirements of the rebuttable presumption of reasonableness.

The most common difficulties in complying with these factors include:

Maintaining appropriate and timely documentation and not simply “checking the box” on the organization’s 990 filings; and
Insufficient information about competitive compensation practices for similar positions among comparable organizations.

BDO has recently undertaken a significant campaign to create a special compensation survey covering the CEO and CFO positions for nonprofit organizations of all types. These two positions are where disqualified individuals are found in nearly all exempt organizations. If we obtain a high level of participation, this survey could become a valuable and pertinent source of information for use in the compensation governance process.

Judy Canavan has provided the following information about the survey. Organizations that complete the online questionnaire for their CEO and CFO positions will receive a complimentary copy of a report with the compiled survey results for the nonprofit participating organizations. Of course, individual data submitted will be kept confidential and only participating organizations will receive the report. The survey will accept completed questionnaires from June 15 through August 15 with a report in mid- to late October pending timely participant submission of information. More details about the survey and the online questionnaire for participation can be found here.

ESG: An Opportunity for Nonprofits

khunt August 2023, Newsletter Tags:

Aug 10, 2023

In the for-profit world (and particularly among SEC-regulated companies), environmental, social and governance (ESG) planning has largely focused on compliance and risk mitigation. Given the mission-based orientation of nonprofits, ESG can be approached as an opportunity to grow their mission and impact in a rapidly changing world. The integration of environmental and social sustainability principles into nonprofits’ operational lifecycles will be key to ensuring donor retention and programmatic success for years to come.

The Rise of ESG Standards and Reporting
Over the past few years, multiple global ESG frameworks and standards have emerged to encourage sustainability strategies and provide guidance on sustainability reporting and disclosure. In the for-profit space, ESG reporting is often used to inform investment decisions, comply with regulations and/or give a company a competitive edge. At present, there is no universally followed standard in place, but there is movement toward consolidation of frameworks and standards. The International Sustainability Standards Board (the ISSB) recently merged with the Sustainability Accounting Standards Board (SASB). In addition, the Global Reporting Initiative (GRI) is a leading framework guiding corporate ESG transparency. Together, they are collaborating in an attempt to establish universal metrics for reporting greenhouse gas emissions, human rights protections, diversity, equity and inclusion (DEI) progress, and linkages to the United Nations Sustainable Development Goals.

In a few short years, the private sector has evolved beyond the early adopters who have expanded their corporate social responsibility efforts into broader ESG reporting. Today, companies understand the risk of being left behind if they do not adopt comprehensive ESG programming. ESG reporting is becoming the new normal, even for entities not beholden to SEC regulations. In the corporate space, ESG adoption is often a reactive response to the demands of investors, customers and other stakeholders. That said, nonprofit organizations will ultimately face demands from their stakeholders; however they are uniquely positioned to leverage ESG to enhance their mission and brand.

The Social License and Increasing Call for Transparency
Nonprofit organizations exist to serve individuals and communities where gaps in the market are unaddressed by the private sector or government. Their social license to operate comes with the benefit of tax exemption in exchange for providing services and transparency (e.g., IRS Form 990). As the nonprofit industry has evolved, so have reporting expectations. In addition to reporting to the IRS, nonprofits self-report an ever-increasing amount of impact and operational data to third-party evaluators such as Charity Navigator, GuideStar and Candid. ESG reporting is the next evolution of transparency reporting for nonprofits.

As nonprofit organizations are adept at reporting financials and an increasing amount of impact data, they must now navigate the evolving expectations related to ESG stakeholders. For stakeholders focused on the bottom line of mission impact, it must not come at the expense of unaddressed (or uncalculated) negative environmental impacts. For example, stakeholders expect nonprofits to understand their environmental footprint and develop strategies to mitigate it. BDO’s Nonprofit Benchmarking Report shows that 18% of nonprofits surveyed report evaluating their vendors, partners and/or funders for their alignment to ESG policies and actions. If that expectation has not been set for an organization today, it is only a matter of time before corporate donors or other stakeholders will expect to see disclosure and alignment. Donors who are accustomed to evaluating their own investments utilizing ESG indexes will be asking questions about the investment portfolios for endowments that fund a nonprofit organization’s programs. Foundations are increasingly aligning their endowments to ESG metrics utilizing the Global Impact Investing Network’s (GIIN) IRIS+ for measuring, managing, and optimizing their impact. Lastly, stakeholders who expect an organization to embody expectations of DEI will also expect reporting on established metrics that demonstrate evidence of progress.

An Opportunity to Grow the Mission
As nonprofit executives examine the industry landscape and their organization’s opportunity to thrive in the future, sustainability must become a key focus in all aspects of management. From attuning to evolving stakeholder priorities to ensuring continued access to donations and capital, and amplifying the impact of their mission, the integration of ESG principles into all facets of the nonprofit lifecycle will contribute to continued success. Indeed, leading industry organizations such as the American Red Cross have exhibited this imperative by incorporating formal ESG programs into their strategic plans.

Establishing ESG expectations at the leadership level can also drive adoption throughout the organization. Program staff can seize the opportunity to further integrate ESG elements and frameworks into program design, delivery and measurement. Development professionals can utilize ESG reporting to articulate insights attractive to individual, corporate and foundation donors. Communication and marketing professionals can tell a truly holistic story of impact. Finance leaders can ensure that their investments reinforce the organization’s mission.

Endowment Woes! Navigating The Nuances With Endowments

khunt August 2023, Newsletter Tags:

Aug 10, 2023

An endowment is a pool of funds donated or set aside to be preserved over time in order to support an organization’s mission. Nonprofits establish endowments for a variety of reasons, usually as part of their long-term strategic plan. Donors may contribute assets, such as cash and securities, and make pledges for future contributions to a nonprofit for creating an endowment.

While an endowment is a great idea for long-term planning and may provide continuous funding for charitable activities, it comes with some nuances that must be carefully navigated to ensure it is successfully managed and fulfills the intended purpose for the organization.

The main types of endowments are as follows:

Type	Period	Description
Perpetual (donor restricted)	Perpetuity	Principal (corpus) preserved perpetually, while earnings may be expended based on donor stipulations.
Term (donor restricted)	Varies	Principal preserved for a specified period or until the occurrence of an event, specified by the donor.
Board designated	Varies	Principal usually retained, while earnings may be expended. Principal may be utilized upon board approval.

Potential Challenges

Understanding what they are and how to account for endowments
“I received an endowed gift. Now what?” Nonprofits that never had an endowment may not know where to start. Endowments are governed by guiding documents, which may come in various forms such as a trust instrument, other written agreements from the donor or a board resolution. Identifying the right key words in these documents becomes crucial to ensuring that endowments are set up and accounted for correctly. Additionally, recognizing the type of endowment is also important to ensure the appropriate accounting guidance is applied.

Stipulations plus governing laws
Endowment operations are not only governed by the gift instruments but also by state law. Nonprofits may not appropriately prioritize these. The Uniform Prudent Management of Institutional Funds Act (UPMIFA) is a uniform act that provides guidance on investment decisions and endowment expenditures for nonprofit and charitable organizations. Except for Pennsylvania, all states and the District of Columbia have enacted their version of UPMIFA. Pennsylvania has its own endowment law not based on UPMIFA. Nonprofits may not realize that the donor’s stipulations take precedence over UPMIFA, albeit at times the donor stipulations are not explicit enough to override UPMIFA. This can create confusion.

Unclear donor intent
It is not uncommon for donor agreements to be vague when it comes to conveying the intent and purpose of the gift. These documents can be written by various persons who are not accountants, which can create challenges when determining the appropriate financial statement classification and operating mechanics of the endowment.

Managing endowments
Endowment management can be complex and time consuming without proper resources and knowledge. Nonprofits need to track endowment activity in detail, and retain adequate supporting documentation for all gifts and any investment returns. Funds are often commingled in investment pools, which can create allocation challenges for nonprofit accounting teams. Various levels of expertise and strong internal controls are required for effective management.

Donor changes
Over time, donors can submit modifications to their original gift instruments that are not correctly applied on a prospective basis. Nonprofits need to retain support from donors who make modifications to their endowment agreements as a record for any changes made to the accounting and treatment of an endowment from a donor.

Balancing the objectives
Under UPMIFA, applying prudence to the fund to preserve value is the goal, not just retention of the dollar amount of the initial corpus. This is due to the time value of money. A gift of $100 in 1990 is not worth the same today; thus, to preserve the purchasing power of the fund’s principal, prudent investment and spending policies must be applied, while considering the donor’s stipulations for the fund’s use. Funds with deficiencies (where the fund value drops below the corpus) require special considerations related to spending and estimating future recovery. Many of these challenges also apply to a board-designated endowment fund. A board-designated endowment fund is created by a nonprofit organization’s governing board by designating a portion of its net assets without donor restrictions to be invested to provide income for a long but not necessarily specified period. Proper management and investment tracking are also applicable to this type of endowment fund. The board of the organization establishes the purposes for the endowment fund and this should be documented in the board minutes.

Navigating the Challenges
To effectively manage endowments, nonprofits need to be proactive, sophisticated and careful. They must be willing to make the required investment to educate their team and put the right processes and controls in place. Here are some tips to help organizations navigate the challenges discussed above:

Adopt formal gift acceptance, endowment and investment policies. Policies should clearly address how funds are to be invested, spent and used (purpose).
Use consistent templates for gift/endowment agreements to standardize the language and avoid misinterpretation. It is important to have personnel from various areas of the organization review and approve these templates including legal, finance, operations and the board.
When in doubt, clarify intent! Reach out to donors or their representatives, especially for unusual gifts that come into the organization from trusts and bequests.
Maintain detailed documentation for all gifts. Accurate and detailed recordkeeping is crucial to the success of endowment operations. Documentation should include certain key information on the donor, assets transferred, specified use, spend rate, investment policy and any modifications.
Monitor endowment assets regularly and compare to donor agreements often.
At minimum, organizations should analyze investment returns, spending rates and fund balances throughout the year to ensure funds are being managed in accordance with the gift instrument and state law, if applicable.
Organizations can go back to donors and discuss modifications, if needed. Seek legal advice before any significant changes are considered and obtain written approval from donors.
Be mindful that the goal is to preserve the overall purchasing power of the endowment over time. Deficient funds should be tracked separately and monitored more frequently. Elevate these to the board or investment committee for review and a plan of action.
Nonprofits should consider short- and long-term needs when accepting gifts to ensure it is the right strategic decision. Some organizations may need more short-term liquidity to fulfill their mission; thus, it may not be wise to accept endowments that must be maintained in perpetuity and do not generate adequate income for operations. Overly large endowments have been likened to hoarding in the public eye in some cases. Readers of financial statements may not understand how endowments work and see the large balances and question why the entity needs additional resources. Nonprofits may want to consider more flexibility to ensure the immediate needs of the organization are being met. Outside of perpetual endowments, nonprofits can consider term/quasi endowments or include variance power language in their agreements. This will grant the organization some flexibility in redirecting the use of the assets.
Proper internal controls are imperative to ensure accuracy and completeness of endowment funds. Nonprofit finance personnel should stay abreast of the latest accounting guidance through research and training.
Before establishing endowments, nonprofits should examine and quantify the costs to manage an endowment, in terms of time and resources. This may be in the form of investment managers, bank charges and other fees, and additional staff time required to reconcile and track activity.

Over the past three years, nonprofits have had to navigate some turbulent times with the disruption of the world’s economic and political environments due to the COVID-19 pandemic, inflation, and political unrest. Endowments and other reserves may be an opportunity for nonprofits to boost liquidity and permanently support their philanthropic goals and survive in an unstable economic climate. Nonprofits should weigh the benefits and costs of establishing and running an endowment. Organizations should also be mindful of the nuances described above and plan how to navigate these. With proper planning and the right resources, nonprofits can avoid improper classification of gifts and financial statement errors when it comes to accounting for endowments. Nonprofits can also lower reputational risk by ensuring compliance with applicable state law and donor stipulations.

Is that a Lease? A Focus on Nonprofit Lease Considerations under ASC Topic 842

khunt August 2023, Newsletter Tags:

Aug 10, 2023

While Accounting Standards Codification (ASC) Topic 842 is applicable to all entities, the adoption of the new leasing standard by nonprofit organizations is bringing into focus some unique considerations that may impact the conclusion of whether a contract actually contains a lease.

What is a Lease?
To set the stage for some of the nonprofit-specific lease considerations to follow, it is important to understand the definition of a lease under Topic 842. A lease is defined as follows: “A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”[1]

Free or Reduced Rent
A nonprofit organization may be given space, equipment or other assets to use free of charge, or be charged below-market rates for these items. For these types of transactions, a nonprofit organization must consider whether to apply ASC Topic 842, Leases, ASC Topic 958-605, Not-for-Profit Entities Revenue Recognition – Contributions, or a combination of both standards. Let’s illustrate these concepts with some specific examples.

Example 1: Free Rent

Company A provides Nonprofit B with the right to use office space free of charge for five years. Company A retains legal title to the office building but allows Nonprofit B to use the space in furtherance of Nonprofit B’s mission. If Company A had rented the space to another entity, Company A would have charged $1,000 per month for the first year of the lease with a 3% annual escalation of rent for each additional year of the five-year term, which is considered to be the market value.

What’s the accounting for that?
On day one of the arrangement, Nonprofit B would record a contribution receivable, and related contribution revenue, for the full amount of rent payments over the five-year period ($63,710), discounted to present value using an appropriate discount rate.

The revenue is donor-restricted due to time and is released from donor restrictions as the contributed asset (the office space) is used each period. On a straight-line basis each reporting period, Nonprofit B reduces the contribution receivable balance and records rent expense representing its use of the office space.

What is the basis for the accounting?
The transaction in this example falls within the scope of contribution accounting under Topic 958-605 but not lease accounting under Topic 842, because Topic 842 requires an exchange of consideration.

In other words, because Nonprofit B does not pay Company A cash (or other assets) for the use of the office space, the transaction falls outside of Topic 842. If the contributed assets are being provided for a specific number of periods (in this example, the period is five years), the contribution revenue (and related receivable) should be recorded in the period received for the market value of the lease payments discounted to present value.[2]

If the arrangement in this example had not specified the period of use, Nonprofit B would have recorded contribution revenue and the related rent expense each reporting period based on the fair value of the space for that period.

Example 2: Below-Market Rent

Company C provides Nonprofit D with the right to use office space for $250 per month for five years. Company C retains legal title to the office building, but allows Nonprofit D to use the space in furtherance of Nonprofit D’s mission. If Company C had rented the space to another entity instead, Company C would have charged $1,000 per month for the first year of the lease with a 3% annual escalation for each additional year of the five-year term, which is considered to be the market value. For purposes of this example, there is no variable lease cost, no non-lease components, no prepaid rent, no initial direct costs, and no lease incentives. We will assume a 3.5% risk-free rate for the calculation of the lease liability. We will also assume Nonprofit D will use 3.5% as the discount rate for the contribution.

What’s the accounting for that?
On the commencement date of the lease, Nonprofit D would record a lease liability equal to the present value of the lease payments totaling $13,550 (rounded) and a right-of-use asset in the same amount. For simplicity purposes, the present value calculations in this example are based on annual rather than monthly payment amounts. The contribution portion of this arrangement is calculated as the difference between the fair market value of rent ($63,710) and lease payments ($15,000) over the lease term totaling $48,710. Nonprofit D should record contribution revenue and a related contribution receivable[3] at present value of $43,870 on the commencement date of the lease.[4] Similar to the first example, the revenue is donor restricted due to time and would be released from donor restrictions as the contributed asset (the office space) is used each period. On a straight-line basis each reporting period, Nonprofit D reduces the contribution receivable balance and records rent expense representing its use of the office space. This example assumes a known fair market value for the rental payments. When such information is not known, organizations need to obtain such information directly from the lessor or find comparable market data for a similar asset with a similar rental term.

What is the basis for the accounting?
The transaction above falls within the scope of both Topic 842 and Topic 958-605. Because ASC 842 defines consideration as cash or other assets exchanged, as well as non-cash consideration (subject to certain exceptions), only the portion of the transaction requiring payment is considered to be a lease within the scope of Topic 842. The fair value of the lease minus the cash payments made represents the contribution revenue and related receivable.[5]

In both of the illustrative examples above, the contribution of free or reduced-rate office space represents a non-financial asset. Nonprofit organizations must consider the revised presentation and disclosure requirements for contributed non-financial assets as outlined in Accounting Standards Update 2020-07, Not-for-Profit Entities (Topic 958): Presentation and Disclosures by Not-for-Profit Entities for Contributed Nonfinancial Assets. This standard is effective for periods beginning after June 15, 2021.

Embedded leases

As nonprofit organizations review their activities and agreements to determine the universe of lease transactions, in both the year of adoption of Topic 842 and in subsequent periods, management should be aware that there may be leases “hiding” within service or other contracts. These types of contracts are referred to as contracts with embedded leases. The following chart provides some examples of service or other contracts where embedded leases may be present:

Information Technology

Advertising

Inventory Management

Shipment of Goods or Materials

Food Service

May contain embedded assets like phones, computers, copies, servers, etc.

May contain embedded assets such as the use of a billboard.

Third parties may be engaged to assist a non-profit organization with inventory management. Use of warehouse space could be an embedded asset.

Use of a rail car or semi-truck.

Some organizations provide on-site cafeterias or vending machines. The use of the vending machines, freezers, refrigerators, soft-drink dispensers, etc. could represent an embedded lease.

As part of internal policies and procedures related to accounting for leases, management should document, in the year of adoption and annually, how the universe of leases was determined, as well as how management considered the possible existence of embedded leases. While embedded leases may not be material to a nonprofit organization’s financial statements, an analysis to determine the relative value of such transactions should be performed nonetheless.

Use of the risk-free rate
As an accounting policy election, Topic 842 permits nonprofit organizations (specifically entities that are not public business entities) to use a risk-free discount rate for leases instead of an incremental borrowing rate, determined using a period comparable with that of the lease term.[6] The use of the risk-free rate may be a more expeditious approach for organizations that do not have a readily available incremental borrowing rate. As a reminder, Topic 842 defines the incremental borrowing rate as “the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to lease payments in a similar economic environment.” If an organization has a real estate lease with lease payments totaling $700,000 over the 10-year lease term, it would not be appropriate for the organization to use its $5 million, one-year, line-of-credit borrowing rate as the incremental borrowing rate because the term and amount of the borrowing is not similar. Organizations wishing to use an incremental borrowing rate that do not have such a rate readily available may need to use external parties such as banks or other lending institutions or valuation professionals to determine an appropriate collateralized rate for certain lease agreements.

In summary, nonprofit organizations should take the time to examine all their agreements to assess whether they have any embedded leases or other arrangements that are subject to lease accounting.

[1] See ASC 842-10-15-3.

[2] See ASC 958-605-25-2 and 958-605-55-24.

[3] See ASC 958-605-55-24.

[4] See ASC 958-605-24 and 958-605-25-2.

[5] See ASC 958-605-55-24.

[6] See ASC 842-20-30-3.

Best Practices in Subrecipient Risk Assessments and Monitoring for Federal Grant Recipients

khunt August 2023, Newsletter Tags:

Aug 10, 2023

Subrecipient risk assessments and monitoring are critical aspects of federal grants management. These practices ensure that funds are used in accordance with federal regulations, that grant objectives are met and that the risk of fraud, waste and abuse is minimized. The federal government has set forth guidelines in the Uniform Administrative Requirements, Cost Principles, and Audit Requirements for Federal Awards (Uniform Guidance) found in 2 Code of Federal Regulations (CFR) 200, which outlines the requirements and responsibilities of grant recipients and their subrecipients. This article will delve into common pitfalls around performing subrecipient risk assessments and monitoring, and the best practices for organizations looking to improve their processes in these areas.

Background
The Uniform Guidance addresses the requirements that subrecipients must comply with in section 2 CFR 200.332. This section describes the required procedures for performing monitoring and risk assessments to evaluate the likelihood of noncompliance, fraud or other issues when selecting subrecipients that could impact the performance and success of the grant.

Effective risk assessments and monitoring are crucial for various reasons, including:

Compliance with federal regulations: Adhering to 2 CFR 200 requirements is essential to avoid penalties, such as disallowed costs or even suspension or termination of the funding.
Mitigating risks: Timely identification and addressing risks can reduce the potential for mismanagement, waste or fraud, ensuring that federal funds are used effectively and efficiently.
Performance and outcome achievement: Proper monitoring helps grant recipients track progress, confirm that milestones are met and determine if adjustments are necessary to achieve desired outcomes.

Common Pitfalls
Below are some of the common pitfalls that plague pass-through entities (prime recipients) that work with subrecipients:

Inadequate risk assessments: Failing to perform a comprehensive risk assessment prior to executing the subaward agreement or relying solely on historical information may result in an incomplete understanding of a subrecipient’s risk profile.
Insufficient monitoring: Not allocating enough resources to monitor subrecipients or only relying on self-reporting can leave gaps in understanding that can allow certain risks to go unaddressed.
Lack of documentation: Inadequate documentation of risk assessments, monitoring activities and communications with subrecipients can hinder an organization’s ability to demonstrate compliance with federal regulations and address potential issues effectively.
Ineffective communication: Poor communication between grant recipients and subrecipients can lead to misunderstandings, missed deadlines and noncompliance with grant requirements.

Best Practices for Subrecipient Risk Assessments
Below are some of the best practices that we recommend:

Develop a risk assessment framework: Create a structured process that outlines risk categories, scoring criteria, and the frequency of risk assessments. This framework should consider factors such as prior audit findings, debarment, financial stability and the subrecipient’s experience managing federal funds.
Conduct pre-award evaluations: Before entering into a subaward agreement, assess the subrecipient’s capacity to manage the grant, considering its technical expertise, financial management systems and internal controls. Performing this required risk assessment in the pre-award phase allows for the determination and inclusion of the monitoring procedures as part of the subaward agreement.
Implement ongoing risk assessments: Regularly reassess subrecipient risk throughout the grant period to identify any changes in circumstances that may affect its ability to meet grant requirements.

Best Practices for Subrecipient Monitoring

Develop a monitoring plan: Establish a systematic approach to subrecipient monitoring that includes a schedule, tools and documentation requirements. This plan should consider the risk level of each subrecipient and the nature of the grant activities.
Provide training and technical assistance: Offer support to subrecipients in the form of training, resources and guidance on federal grant requirements, financial management and performance reporting.
Conduct regular communication and site visits: Maintain open lines of communication with subrecipients and schedule site visits as deemed appropriate to review progress, verify compliance and address any concerns.
Review financial and performance reports: Regularly analyze subrecipient financial and performance reports and included data to identify potential issues, ensure compliance with grant terms and track progress toward grant objectives.
Tailor monitoring efforts to risk level: Allocate resources for monitoring based on the risk profile of the subrecipient, with higher-risk subrecipients receiving more oversight and attention.
As mentioned above, incorporate monitoring procedures directly into subaward agreements.

Conclusion
Effective subrecipient risk assessment and monitoring are essential for federal grant recipients to ensure compliance with 2 CFR 200, mitigate potential risks and achieve desired outcomes. By implementing best practices and avoiding common pitfalls, organizations can strengthen their grant management processes and ensure the responsible stewardship of federal funds.

Demystifying Nonprofit Cost Allocations

khunt August 2023, Newsletter Tags:

Aug 10, 2023

When asked what is at the top of their finance department “to-do” list, many nonprofits name the need for an updated cost allocation plan. An effective cost allocation strategy is essential to organizations’ understanding of how their resources are being deployed. It is also integral to performing cost analyses, such as evaluating funding requirements and comparing actual versus budgeted costs.

Allocations are an efficient and effective way to distribute costs across activities, including programmatic, administrative and fundraising work. However, many find the practical application of allocation concepts challenging to navigate. While some costs are easily assigned to specific activities and do not need to be allocated at all, there are certain costs that need to be proportionately distributed across activities and the organization, magnifying the potential for complexity and errors.

Allocation Methods
When determining an organization’s allocation strategy, limiting the number of different methods utilized can avoid overcomplication, although most organizations use at least two different allocation methods based on the type of cost.

Payroll and related costs are typically a nonprofit’s most significant expense. Organizations determine employee time worked and how that information is documented and substantiated in different ways. However, the goal is ultimately the same: to report these costs in a way that reflects where employees spend their time—that is, where resources are actually being deployed.

For costs other than payroll, or other than personnel service (OTPS) costs, allocation can be accomplished via various methods, including:

Full-time equivalent (FTE): The FTE method allocates OTPS in the same proportion as employee time worked in different activities.
Percent of salary dollars: The salary dollars method allocates OTPS in the same proportion as payroll dollars assigned to different activities.
Square footage (SF): The SF method, typically applied to occupancy costs, allocates costs proportionate to an activity’s share of facility space.
Per participant: The participant-based method, typically applied to OTPS across programs, allocates costs proportionate to the ratio of participants in each activity.

Allocating Grant Costs
Grant agreements add a layer of complexity to nonprofit cost allocation. Commonly, grants require related costs to adhere to funder-approved, line-item budgets and conform to defined terms and conditions. That is true regardless of whether the funding is from another nonprofit, an individual or a government entity. Adopting and implementing both a consistent organizational cost allocation methodology and a consistent grant allocation methodology is critical. Special attention to grant allocations helps organizations:

Understand progress against each grant’s budget
Avoid the risk of double charging (charging the same cost to two different grants)
Avoid potential consequences of violating such agreements

To provide an example of how an organizational cost allocation methodology interacts with grant allocations, let’s consider the allocation of program supplies expense for a nonprofit with two different grants supporting a certain program:

The nonprofit has chosen to allocate OTPS using the FTE approach. Under this approach:

The program’s share of personnel time and effort is 20%, so the program also is allocated 20% of shared supply costs.
The program’s supply expense can be further assigned to the two grants, barring any limitations based on grant budgets and related allowability of those costs per the contracts.

Costs allocated to grants need to be done so with a consistently applied methodology.

From a practical perspective, nonprofit financial systems need to accommodate such multi-dimensional expense tracking. The ability to automate allocation calculations, as opposed to calculating allocations using spreadsheets, is a significant efficiency opportunity. In any case, generating financial reports at different levels of detail, by both activity and grant, directly from the financial system is key.

Once an organization has effectively applied these concepts, the result should be a fair representation of the costs incurred in each program area and in each supportive service. This information is valuable for a variety of reasons. Knowing the cost of programs and the costs covered by grants allows organizations to make more informed choices when evaluating funding opportunities, planning for operational changes and monitoring ongoing activities.

Data Quality for Nonprofits

khunt August 2023, Newsletter Tags:

Aug 10, 2023

Data quality is a critical factor for organizations of all sizes, and nonprofits are no exception. Poor data quality can lead to inaccurate business decisions, missed opportunities and even financial losses. Further, poor data quality can impact contributions negatively in several ways. It can obfuscate the nonprofit’s achievements year after year, which can erode donors’ trust or describe fewer accomplishments to its contributors. Poor data quality can lead to marketing campaigns that fail to appeal to first-time donors or are insufficient to recapture previous donors.

Why Data Quality is a Challenge
If data quality is a pervasive issue with real consequences, why have most organizations not solved it? This is the case because assessing and remediating data quality is fraught with challenges, such as:

Data is an intangible asset and, unlike other assets, does not give detectable signals, such as changing color, giving off smoke or changing smell. In fact, a single erroneous record normally can only be detected when a knowledgeable individual notices the value is not correct in the data.
It is not cost effective to confirm the accuracy of every data record. It requires real-world observations or corroboration by another source. These are expensive endeavors.
So much data is collected and processed so quickly now that bad records are not perceived as worth the effort to correct, as they will just be replaced soon.
Unless the root cause of data quality issues is discovered and resolved, organizations will continue to admit poor data quality into their systems.

Another challenge to data quality is defining what it means for data to be fit for purpose. That definition can change not only across different nonprofits, but within a single nonprofit’s departments as well. In general, high-quality data tends to be defined as:

A data record presents what is found in reality without distortion (e.g., the ZIP code is the correct ZIP code for a donor).
The data values follow the correct format (e.g., a U.S.-based ZIP code has five digits with no letters or special characters).
A data record has no missing values where values are mandatory (e.g., a ZIP code is present for all donor address records).
There are no duplicate data records for the same entity or event (e.g., the list of valid ZIP codes in a system presents each ZIP code only once per entity).
There are no contradictions within a data record or across data records (e.g., a ZIP code is the correct ZIP code for the city and state in a donor record).
The data record represents the most current known information (e.g., the ZIP code in a donor record exists for the donor’s current address, not the prior one).
The parentage of the record can be traced so that the user knows whence the value was derived (e.g., the donor’s ZIP code was pulled from the contributions database after a donation was made last week).

What Can Be Done
Nonprofits can take one of three stances with regard to data quality:

Do nothing. Consider poor data quality a cost of doing business and accept the inherent risk.
Reactive remediation. When data quality problems are discovered—often too late to prevent a damaging business outcome—fix the problem and the class of problems it represents. Over time, data quality will improve.
Proactive remediation. Pick the data records that are most critical to the nonprofit, usually meaning they are used by more than one department more than once. Define the data quality rules for those data records. Codify those rules into a dashboard that searches for data record violations and aggregates them into a scorecard. When a rule breaks a threshold value —say 15% or more data records have missing values —take action and fix that class of problems.

The proactive remediation approach requires resources and should be taken if the perceived cost of data quality issues is greater than its remediation. In this vein, the approach should not treat all data as equal, but instead consider only the critical data of the entity.

What Questions to Ask
Nonprofits’ leadership should find out what they can about their data quality. Some questions leaders should ask include:

Is the nonprofit’s data considered trustworthy overall?
How much time do staff spend cleaning data in preparation for a business analysis exercise?
No organization has perfect data. Do the managers know where the data quality problems lie? Do they know why the problems occur?
What steps have the managers taken to detect poor data quality? When found, do the managers fix the data record, fix the problem at the source or both?

The answers to these questions may suggest that leadership devote resources toward not only the assessment and remediation of data quality issues, but in identifying the root cause of those issues and remediating them as well.

Parting Thoughts
Data quality is a critical component of good governance and effective oversight. Nonprofits need accurate and timely information to make informed decisions about their donors and strategy. Poor data quality can distort decision-making, lead to missed opportunities, lower fundraising outcomes and even cause compliance issues. Data quality is also important for risk management, as poor data quality can increase the risk of fraud and cyberattacks and create other business disruptions. Nonprofits should support data quality programs that identify the most critical data records, monitor those records for problems and address problems at the source when they occur.

Retirement and Employee Benefit Plans

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Aug 10, 2023

How do the new rules apply to retirement and benefit plan filings? Different aggregation rules apply, depending on the type of form being tested for whether electronic filing is required, which can be confusing.

Form 5500. Filers of Form 5500 must file electronically for plan years that begin on or after Jan. 1, 2024, if they (together with any member of a controlled or affiliated service group) are required to file at least 10 returns of any type, including information returns (such as Forms W-2 and Forms 1099), income tax returns, employment tax returns and excise tax returns, during the calendar year that includes the first day of the plan year. Thus, Form 5500 filers are subject to an additional controlled group aggregation rule that does not apply to other types of filings. This means that Form 5500-EZ (plans that cover only the owner or owner and spouse) may need to be filed electronically depending on the number of Forms W-2, Forms 1099, etc. filed by the plan sponsor and affiliated businesses. Most Forms 5500s (but not Form 5500-EZ) are already filed electronically through the U.S. Department of Labor’s EFAST2 filing system.

Form 8955-SSA. Forms 8955-SSA (identifying retirement plan participants who terminated employment but left vested benefits in the plan) that are required to be filed for plan years that begin on or after Jan. 1, 2024, must be electronically filed if the filer is required to file 10 or more returns of any type, including information returns (such as Forms W-2 and Forms 1099), income tax returns, employment tax returns and excise tax returns, during the calendar year that includes the first day of the plan year. But if the Form 8955-SSA filer is a member of a controlled or affiliated service group, the filer would count only the number of its own returns being filed and would not count the number of returns being filed by others in the group.

Form 5330. Forms 5330 (for certain employee benefit plan excise taxes) required to be filed for tax years ending on or after Dec. 31, 2023, must be filed electronically if the filer is required to file 10 or more returns of any type, including information returns (such as Forms W-2 and Forms 1099), income tax returns, employment tax returns and excise tax returns, during the calendar year in which the Form 5330 is due.

Forms 1094, 1095, 1099 and 5498. Forms 1094 and 1095 series (Affordable Care Act coverage reporting), Form 1099 series (including 1099-R for retirement plan benefit payments) and Form 5498 Series (for IRA contributions) required to be filed after Dec. 31, 2023, must be filed electronically if the filer is required to file 10 or more “specified information returns” during the calendar year that includes the first day of the plan year.

Counting Rules for Each Form. When determining whether a filer for a retirement plan’s Forms 1099-R must file those forms electronically, the filer would count only its “specified information returns” (like Forms W-2, 1099 series, 1094 series and 1095 series). The requirement to include filings by entities in the sponsor’s controlled or affiliated group applies only to electronic filing of the plan’s Form 5500.

Example 1: If a retirement plan filer is required to file eight Forms 1099-R, one Form 5500 and one Form 8955-SSA, the filer is not required to file the Forms 1099-R electronically. However, it is required to file Forms 5500 and 8955-SSA electronically, because all returns, including Forms 1099-R, must be taken into account for determining Forms 5500 and 8955-SSA electronic filing status under the aggregation rules.
Example 2: In 2023, Company A (the plan sponsor and plan administrator of Retirement Plan B) is required to file a 2023 Form 5330 for its nondeductible contribution to Plan B. Company A and Plan B both operate on a calendar-year basis. In 2024, Company A (as plan administrator) is required to file 21 returns for 2023, including nine 2023 Forms 1099-R (for plan benefit payments), 10 2023 Forms W-2, one 2023 Form 5500 and one 2023 Form 1120 (federal corporate income tax return). Because Company A is required to file at least 10 returns of any type during the 2024 calendar year, Company A must file the 2023 Form 5330 for Plan B electronically.
Example 3: Assume plan sponsor A, who maintains retirement plan B, is required to file one Form 1099-R, one Form 5500 and one Form 8955-SSA. Assume plan sponsor A is not a partnership with 100 or more partners, and is required to file one Form W-2, four Forms 941, one Form 940 and one Form 1120 (federal corporate income tax return). Assume also that plan sponsor A owns 100% of entity C, which files 20 Forms W-2, four Forms 941, one Form 940 and one federal income tax return. The Form 1099-R for the plan and the Form 8955-SSA can be filed on paper (because the controlled and affiliated service group rules do not apply to those filings), but the Form 5500 for the plan must be electronically filed due to the aggregation rules.

What about corrected returns? Generally, if an original return is required to be filed electronically, any corrected return corresponding to that original return must also be filed electronically. If an original return is permitted to be filed on paper and is filed on paper, any corrected return corresponding to that original return must be filed on paper.

Are there any waivers or exemptions? Filers that are required to file fewer than 10 returns during the calendar year when counting all types may use IRS paper forms, but only if the paper form is machine-readable.

In cases of undue hardship, the IRS may waive the mandatory electronic filing requirement. The main factor in determining hardship is the amount, if any, by which the cost of electronic filing exceeds the cost of paper filing. Religious waivers will also be considered. Waiver requests must be made in accordance with applicable IRS revenue procedures and must specify the type of filing and the period to which it applies. Electronic filing is also generally waived if the IRS’s system does not support it for a particular form or situation.

Example: If an employer is required to file a final return on Form 941 (Employer’s Quarterly Federal Tax Return), or a variation thereof, and expedited filing of Forms W–2 (or applicable versions for Puerto Rico, the U.S. Virgin Islands, Guam or American Samoa) is required, but the IRS’s systems do not support electronic filing, filers will not be required to file electronically.
What are the penalties for noncompliance? A failure to file in the required manner (for example, electronically or on machine-readable paper forms) is considered a failure to file. The penalties differ based on the type of return. For information returns, such as Forms W-2 and Form 1099 series, the penalty under Internal Revenue Code Section 6721 would apply, which is up to $310 per information return (for 2023 information returns required to be filed in 2024) with an annual maximum penalty of $3,783,000 ($1,891,500 for small businesses with annual gross receipts of no more than $5 million). Penalty amounts are indexed and change annually.

When are the new rules effective? The new mandate is generally effective for 2023 tax year returns that must be filed with the IRS on or after Jan. 1, 2024.

Insight
Even if filers are not required to file electronically under the new rules, they may want to consider doing so, as electronic filing has become more common, accessible and economical. Electronic filing may reduce administrative efforts compared to paper filing, can increase accuracy and improve record retention.

The new mandatory electronic filing rules are complicated and penalty exposure may be significant.

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