When deciding where to make donations, potential donors rely on the information in a nonprofit’s tax return. When making their decision, many donors heavily weight the information included in the statement of functional expenses. Because of this, it is important for organizations to be aware of how to correctly classify expenses between program expenses, management & general expenses, and fundraising expenses.
Expense Allocation for Non-Profit Organizations The allocation of expenses between functional categories in a non-profit organization is an important part of preparing its tax return. A non-profit organization’s expenses are classified as program service expenses, management and general expenses, and fundraising expenses. Correctly classifying expenses in these three categories is an essential part of preparing tax filings and presenting potential donors with the intended image of the non-profit organization.
Program Service Expenses are expenses incurred to further the organization’s exempt purpose as outlined in the organization’s articles of incorporation. One example of a program service expense is a teacher’s salary at a school.
Fundraising expenses are expenses incurred in soliciting contributions. They include costs of preparing and distributing fundraising materials to solicit contributions.
Management and General Expenses is a general category for expenses that are neither a program service expense nor fundraising expense. Examples of some costs that are included in this category are office management, legal services, executive planning, investment management, mail distribution, telecommunication, accounting, etc.
How to allocate
Not all expenses fit neatly into one of these three categories; some expenses may be related to multiple activities or functions. One of the reasons it is important to correctly allocate these expenses to the correct category is that donors want to know the extent to which their contributions are being used for charitable purposes. When accounting systems do not segregate expenses into these categories, non-profit organizations are allowed to use any reasonable method of allocation.
It is important to properly allocate expenses related to more than one activity or function because, in addition to informing donors, these expenses allow the IRS and state governments to verify that the organization is operating primarily for an exempt purpose in order to continue to qualify for its tax exempt status. As stated in the IRS instructions to Form 990, the organization should use its normal accounting method to allocate the expenses into the appropriate categories. If the accounting method does not provide this level of detail, the return preparer must determine an appropriate allocation method. You may allocate indirect expenses based on how the activity relates to one function versus another, or based on the amount of time spent on each separate function within the activity. Included below is detail on how a couple of common mixed used expenses are allocated between functional categories:
- Salary – based on number of hours spent in each functional expense category.
- Occupancy Costs – based on square footage of space dedicated to each functional category.
- Interest – based on how the borrowed funds were used.
Please keep in mind the importance of correctly allocating expenses between the functional categories and how this impacts a donor’s perspective of the non-profit. If you need help allocating expenses or setting up a system to allocate expenses, please contact your L&B professional at 858-558-9200.