The Revised 990: provides opportunity to reconsider expense allocation.(TAXING ISSUES)

By now, you are probably deep into figuring out how the "new" Form 990 will affect you and your organization. It is true that you will have to compile numerous pieces of information to complete the form. However, an item that can have a dramatic impact has been around for many years and is often given short shrift by the preparers of Form 990. It's your allocation of expenses among program services, management and general, and fundraising.

Form 990 for 2008 moves the Statement of Functional Expenses from Part II (990, page 2) to Part IX (990, page 10).While this might lead you to think that the allocation of functional expenses is less important than it used to be, that is not the case. Many prospective donors look closely at your types of expenses and their respective proportions in making funding decisions. Watchdog groups also monitor expenses in making their recommendations.

Organizations exempt under Section 501(c)(3) or (4) are required to allocate expenses among program services, management and general, and fundraising. If your organization is exempt under a Code section other than 501(cX3) or (c)(4), you are not required to allocate your expenses on Form 990 (although your auditors will probably do so on your financial statements).

The instructions for Form 990 offer little help as to how to report your expenses. In fact, the instructions do not appear to have changed much from prior years in this area. The instructions still define the three categories of expenses as follows:

1. Program services--Expenses for those activities that further the organization's exempt purposes.

2. Management and general--Expenses related to the organization's overall operations and management, rather than fundraising activities or program services.

3. Fundraising--Expenses incurred in soliciting contributions, gifts and grants.

DIRECT COSTS V. INDIRECT COSTS

The instructions further provide that you should allocate expenses that relate to a specific activity or project to the appropriate category. For example, if you operate a school, you can allocate all teacher salaries and related costs to program services, as that is your exempt purpose. Contrarily, the costs of your development department generally are allocable to fundraising. These are referred to as direct costs, and are relatively easy to handle for Form 990 reporting purposes.

Program service expenses are often primarily direct expenses, but the expenses are always related to the exempt function of the organization. The 990 instructions provide examples of direct costs. Program service expenses may also include the costs of activities that generate unrelated business income, such as advertising in your organization's periodicals. Costs related to work done under grants are considered to be program services, even if the grants are included as contributions in Part VIII.

Certain expenses are classified as management and general. These include the costs of managing investments, board and committee meetings, general legal services, accounting, liability insurance, office management, and human resources.

Fundraising costs include those incurred to solicit contributions, grants and bequests, distribute fundraising manuals and other materials, and conduct fundraising events.

Indirect costs present a more complicated issue than direct costs. Indirect costs are the costs of functions that benefit program services and fundraising as well as management. Because of the expenses' multi-functionality, you must allocate these costs among the various categories using a consistent "reasonable method of allocation. "In addition, the IRS requires you to report the amounts accurately and also document your method of allocation.

ALLOCATIONS USING ACCOUNTING SYSTEMS

Some organizations use an accounting system that classifies expenses in significant detail, including allocation as costs are incurred. For example, under these systems, staff members who spend time performing program services and management may turn in detailed time sheets so that their salaries can be allocated between both functions.

Some systems allow supplies to be categorized depending on how they are used by the organization. However, even these detailed methods are likely to have some expenditure that requires further allocation by you using your "reasonable method."

Contrary to the intent of those who de signed or purchased these detailed accounting systems, this allocation method may make completing Form 990 more complicated. You may have salary accounts in various places on your trial balance .To complete the appropriate lines on Form 990, you will have to aggregate all of them on one line and use the separate categories to allocate the expenses among the three columns. If categories are broken down into sub-categories (e.g., various grants or programs), you may have even more cost centers to consider.

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TIPS FOR ALLOCATING FUNCTIONAL EXPENSES

If you do not allocate expenses as you progress through the year, you will have to do it after year-end. First, you should determine all of the expense types that are not directly allocable. Then you need to determine an appropriate allocation factor for each type.

In general, salaries and related costs (payroll taxes, benefits, etc.) are usually allocated based on the time spent by each individual. Time sheets are often helpful in calculating this allocation. Occupancy costs are usually allocated based on the square footage used by various departments and individuals. Supplies may be allocated based on the number of employees in each department. These are merely suggestions of commonly used methods; any method you choose that results in a reasonable result for your organization will be acceptable.

Direct expenses should go in the appropriate columns in Part IX. You can handle indirect expense allocations in one of two ways: (1) You can allocate each line in Part IX among the categories after doing the allocations; or (2)You can also report the total expenses in the appropriate column (usually management and general) and then use a separate sub-line of line 24 to allocate them by reducing the management column and increasing the others. The "total" column will be zero in most cases.

We are often asked what the "optimal" expense ratios are. This question is often driven by the arbitrary percentages used by watchdog groups in rating charities for efficiency. However, there is no "right" answer. Your ratios may be affected by numerous factors that might tilt the appearance of how your contributions are spent.

For example, if you begin a capital campaign during the year, your fundraising expenses will be unusually high. If you start new programs, you may have to incur more administrative costs in order to get it started. If you use a reasonable method to allocate costs, these anomalies should be relatively easy to explain.

At the present time, many organizations are revising their governance procedures due to the expanded questions on Form 990. Consequently, their management and general costs may be higher than usual. From a donor standpoint, this may not be a bad thing, as the new procedures will ensure better use of charitable dollars in the future.

If your ratios appear abnormal, you can attach an explanation on Schedule O of Form 990. You might also want to address the abnormality in your annual report to donors. However you handle it, you should be sure that your methods are reasonable and defendable if you are asked about them.

In any case, while you are getting ready to file the new 990, you might want to review your methods for allocating expenses. Your returns this year are likely to receive more scrutiny than ever, and you should present the most accurate picture possible of your organization.

Harvey Berger is a retired tax partner with Grant Thornton and currently serves as a consultant on nonprofit tax issues. His email is harvey.berger@gt.com. Greg Goller is Grant Thornton's national partner-in-charge of Not-for-Profit Tax Services and is based in the Washington, D.C. area office. His email is greg.goller@gt.com. Mary Torretta is a senior associate in Grant Thornton's corporate tax practice in McLean, Va. Her email is marytorretta@gt.com

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