Nonprofit Accounting Basics: Understanding Taxes, Donations, and More

Although nonprofits aren't in business to make money, they still require careful accounting practices. Donors who contribute to nonprofit organizations often want to know that their money is being spent to further the organization's mission. Any signs of irregularity or financial mismanagement can cause an organization to lose monetary backing and community goodwill. For this reason, accurate nonprofit accounting and financial reporting is essential.

Understanding the basics of nonprofit accounting is a good place to start. Let's explore how you can set up a system that supports your nonprofit's mission seamlessly.

What Makes Bookkeeping for Nonprofits Different?

Although there are some similarities, there are distinct differences between nonprofit and for-profit accounting. From keeping facilities in top shape to paying your team on time and ensuring taxes are filed properly, these essential responsibilities are the foundation of smooth operations. However, unlike for-profit businesses, accounting for nonprofits must also track volunteer hours, monetary donations, and in-kind donations. Financial records (how resources and assets are distributed) need to uphold the organization's commitments to its stated charitable purpose. If your organization has these or similar obligations, then you need nonprofit accounting.

Considerations When Setting Up Your Accounting

Nonprofits share many similarities, but that doesn't make them identical. Accounting for a nonprofit organization must accommodate the specific organization's current and anticipated needs. Things to consider include:

1. Cash vs. Accrual: Nonprofit Accounting Methods

There are two methods for handling your nonprofit accounting, each with its strengths and weaknesses: cash-basis accounting and accrual accounting. The size of your nonprofit organization, plans for growth, and the nature of your operating expenses will determine which method is better. The primary difference between the two involves the timing of when expenses and revenue are reported.

• Cash-basis accounting: This method is often considered to be the simpler of the two. Cash-basis accounting records expenses and revenues only when cash is paid out or received, making it easier to track cash flow. Cash-basis accounting can benefit a nonprofit because it recognizes income and expenses when they are actually realized. This can protect the organization from making investments in growth that depend on revenue that exists on paper but has not yet been realized.
• Accrual accounting: Often more complicated than cash-basis accounting, the accrual method accounts for revenue and expenses when they occur, usually before money changes hands. If, for example, a nonprofit employee provides a fee-based education program, the accrual method identifies that as revenue even before the invoice is paid. Similarly, expenses are accounted for, as bills are received, not when they are actually paid. This method gives a nonprofit organization more accuracy for long-term budget planning.

2. Establishing Tax-Exempt Status

Having donations qualify as charitable contributions on a donor's personal tax return is a powerful incentive. This means donations must be contributed to an IRS-designated tax-exempt organization. The first step to setting up your nonprofit's financial reporting system is to file the correct paperwork and attain tax-exempt status. Each state has its own rules regarding tax filing. Nonprofit owners can file for tax-exempt status, a 501(c)(3) status, with IRS Form 1023.

What Is IRS Form 1023?

IRS Form 1023 is essential for nonprofit organizations seeking federal tax-exempt status under section 501(c)(3). This form helps organizations qualify as tax-exempt, allowing them to focus on their mission while offering donors the benefit of tax-deductible contributions. Certain nonprofits may qualify for a simplified version, Form 1023-EZ. The IRS provides a worksheet to determine eligibility for this shorter form. It's important to note that both Form 1023 and Form 1023-EZ must be made available to the public, ensuring transparency and accountability for nonprofit operations.

3. Filing Taxes for a Nonprofit

Even though nonprofit organizations are classified as tax-exempt, the IRS still requires a tax return to be filed. Tax services can be considered in order to minimize errors and ensure the nonprofit remains in compliance. Most charities will file a Form 990, this is the tax return for organizations that are deemed exempt from taxes.

What Is IRS Form 990?

IRS Form 990 is the most common tax form filed by charities in the United States; however, the amount of financial activity conducted by your nonprofit will determine which IRS form you'll need to file. The longest form, Form 990, according to the IRS, is for "organizations with $200,000 or more in gross receipts or $500,000 or more in total assets." If either condition is met, a nonprofit must file a Form 990. If a nonprofit has gross receipts of less than $200,000 and total assets of less than $500,000, then a Form 990-EZ may be filed.

If donations received total less than $50,000, Form 990-N, or what's commonly known as an e-postcard, may be filed. This short form reconfirms your nonprofit's tax-exempt status and receipts totaling less than $50,000. An exception to these financial distinctions is made for private foundations, all of which, regardless of assets or gross receipts, must file a Form 990-PF.

Remember, Forms 990, 990-EZ, 990-N, and 990-PF, like Form 1023, must all be made available to the public.

Are There Any Nonprofits Exempt From Filing a Form 990?

Every nonprofit is obligated to file a Form 990, with a handful of exceptions. Most of these have religious affiliations, are state institutions, or are organized under acts of Congress. The IRS website provides a complete list of exempt organizations.

4. Tracking Nonprofit Donations

Donations are an integral part of nonprofit accounting. As nonprofit organizations raise funds and ask for donations, tracking and properly recording monetary contributions becomes an important function, as donors require detailed receipts to claim tax deductions. Accurately tracking and recording contributions ensures you’re meeting both financial reporting requirements and your donors’ needs. With the right tools—such as customizable line-item entries and comprehensive reporting—you can ensure every donation is properly logged, helping maintain transparency and trust.

When tracking donations, it’s important to capture essential details, including:

• Amount of money gifted: How much is being donated? The total financial contributions from donors play a significant role in shaping a nonprofit’s revenue stream and provide the essential support needed to drive the organization forward.
• Frequency of gift: How often does a particular donor donate? This helps a nonprofit track donor loyalty and gauge when to reach, cultivate, engage, or reconnect to donors. Understanding donation patterns helps nurture relationships with loyal donors and identify opportunities to re-engage lapsed supporters.
• Source of the donation: Is it coming from an individual private donor, a corporation, or a foundation? Donors will need receipts to track their donations for their own accounting purposes. And nonprofits can benefit in future fundraising efforts by keeping track of donation sources.
• Method of payment: Did the donor pay with cash, credit, or an in-kind donation of services or materials? This information needs to be provided on a donor's receipt for their own records and kept for the nonprofit's records of how donations are received.
• Influence value: How much impact does the donation have in helping the organization fulfill its program and mission? By evaluating how each donation directly supports its mission, the nonprofit can highlight its meaningful impact on donors and organize targeted campaigns.

By implementing effective donation tracking practices, the nonprofit can build accountability and strengthen relationships with donors, ensuring it continues to fulfill its mission effectively while fostering long-term communal support.

5. Nonprofit Bookkeeping

Donors care deeply about how their contributions are used. They want reassurance that their money is making a meaningful impact. To prepare tax returns and financial statements, it's vital to accurately record and classify expenses as either program or administrative.

Most donors prefer to see their funds invested directly into program expenses, ensuring their support drives the nonprofit’s core mission. A large amount of overhead or administrative expenses, including fundraising expenses, could signal inefficiency and affect donors' willingness to contribute in the future.

It's worth noting that tax filings play a huge role in providing that transparency. These filings give nonprofits a chance to showcase how funds are managed, though it's worth noting that the public availability or transparency of these records only extends for three years after the initial filing date, as mandated by the IRS. Solid bookkeeping not only fulfills this requirement but also empowers potential donors to gain insight into your nonprofit’s financial health, including detailed information about expenses, revenue, and net assets.

• Expenses: These may include essentials like rent, staff salaries, fundraising costs, materials, supplies, and travel.
• Revenue: In addition to donations, there may be membership dues, investments, grants, pledges, or even benefits like merchandise sales, event services (like art gallery tours), or exclusive experiences (like member only events or holiday galas).
• Net assets: Unlike a business where assets are retained earnings or equity, net assets for a nonprofit are funds. Funds are allocated into 3 categories:
  • Unrestricted net assets: Funds available for general operations.
  • Restricted net assets: Funds dedicated to specific programs or future initiatives.
  • Permanently restricted net assets: Endowments and other funds intended to still be untapped.

6. Financial Reporting for Nonprofits

Financial management for a nonprofit comes with its unique challenges. It’s not just about accurate recordkeeping—it’s about ensuring every dollar of donor support is managed responsibly and goes toward advancing your mission. Maintaining your tax-exempt status also requires strict oversight and transparency.

To keep everything on track, regular financial updates and analyses should be conducted and shared with your board of directors. These updates provide clarity and ensure everyone is aligned with the organization's goals. Additionally, audits might be necessary to evaluate whether the right financial controls are in place and confirm that resources are being used effectively to support the organization's mission.

Reports should include:

• Balance sheets: Highlight your organization’s financial position by reporting assets, liabilities, and net assets over a specific period.
• Operations reporting: Offer a snapshot of revenues, expenses, and any changes in funds to measure performance.
• Cash flows: Report expenses, cash receipts, financing, and investment activities.

Should You Use Nonprofit Accounting Software for Your Organization?

Nonprofits have many unique needs that differ from those of a for-profit organization. Many nonprofits may find cloud-based accounting software useful, which is accessible to a wide range of users, from beginners to the technically savvy.

Consider using accounting software like Paychex Flex^® to help create customized reports, track donations and expenses, and more. It’s our all-in-one solution that can be tailored to the needs of your nonprofit organization.