Question

You are president of the board of the Theler Community Center in Belfair, WA. Revenues have come from facilities rental, donations, grants, and community classes. The 2014 revenues had been projected to be $71,000. Expenses cover insurance, utilities, supplies, taxes, and payroll. Expenses are projected to be $68,000. On 1/8/14 during the board meeting the interim Executive Director (ED) informs you, the board and the public that the center is faced with $162,000 in debt and back taxes. In addition, there is a criminal investigation into the center’s former ED. The interim ED was hired last month after the former ED was put on suspension and ultimately, fired. The new ED informed the group that the former ED had created a financial mess that dated back to 2008 when the center last filed a tax return. The center owes state unemployment taxes and social security and medicare taxes for the employees to the tune of $97,000. The IRS has additionally levied the center’s bank accounts because of the failure to file for the past 5 years, making it unable to pay its bills this month. What are the ramifications of not having filed the 990 tax forms with the IRS? Besides not being able to pay the bills how will this contribute to the financial situation? What impact does this have on receiving donations and grants from foundations? How may you, and the board members, be held accountable by the IRS? Do the board members have a duty to keep the organization from losing money? Explain.

Answer 1

Q: What impact does this have on receiving donations and grants from foundations?

Answer:

The range of different funding sources that the governing body needs to consider.

The main sources of income are:

• Gifts and donations
• Grants
• Loan financing and equity capital
• Contracts
• Trading

Each source has specific governance issues relating to it. More detail can be found in our funding and income pages.

Gifts and donations

Donations generally come from individuals (e.g. from a fundraising appeal or given as a legacy), from companies, or from charitable trusts and foundations. Unless they have been given in response to a particular appeal you generally have considerable freedom in how to apply them. Gifts and donations are a particularly important source of income for charities and can attract tax relief. Raising funds however can be time-consuming and costly – and you could even lose money.

Key issues for members of the charity or non-profit board body to consider.

• Is your fundraising effective and economic? Have you set cost/income ratios for your fundraising (recognising that some types of fundraising are more expensive than others) and are you achieving them? Are you claiming back tax (eg. through Gift Aid)?
• Is your fundraising legal? The rules about fundraising can be detailed and complex and you may need to seek advice. There are for example rules on data protection, the use of professional fundraisers, and for house-to-house collections and lotteries.
• Is your fundraising ethical? Do you comply with the Institute of Fundraising’s Codes of Fundraising Practice? Have you signed up to the self-regulatory scheme for fundraising?
• Are your fundraising activities likely to damage your reputation in any way? Do you have policies for example on corporate donations?
• Have you made clear what the appeal is for, and what you will do if you raise more or less than target? Have you ensured that the money will be spent on the purpose for which it was given?

The Institute of Fundraising has developed its Codes of Fundraising Practice and Code of Conduct (PDF 316.69KB) to provide a guide to the law and best practice in relation to fundraising activity throughout the United Kingdom.

The Charity Commission sets out its advice in Charities and fundraising.

Grant funding

Grants are typically made by the public sector or by charitable trusts and foundations. The money does not have to be repaid and is usually exempt from tax. Many grant funders will only fund organisations with charitable status. Some grant makers prefer not to fund organisations that have built up significant reserves or generate cash surpluses. This can disadvantage those with a business-like approach to running a sustainable social enterprise. Grants almost always come with conditions, for example:

• particular outputs or outcomes
• achieving agreed milestones
• unspent monies are returned to the funder
• reporting requirements on the progress of the project or use of the money.

Before pursuing grant funding the charity or non-profit board should consider the following.

• Is this an activity consistent with our aims and strategy – or is this grant encouraging us to drift from our mission?
• Can we meet the grant conditions?
• Will the cost of seeking grant monies outweigh the benefits?
• How will the activity be maintained or wound up after grant funding ends?

Loan financing and equity capital

Debt and equity finance are routinely used in the for-profit sector, but are less common in the not-for-profit sector.

Debt finance is essentially loans and overdrafts, which have to be repaid.

Equity finance does not have to be repaid. Instead, the investor takes a stake in the organisation, entitling them to a share in the rewards (and risks) of the organisation.

Both forms of finance are described more fully below.

Loan financing

A loan is simply a sum of money which is borrowed and has to be paid back, usually with interest. Loan finance is potentially useful for a range of non –profits. They are a flexible form of funding that can be quicker and easier to secure than grant funding. However they have to be repaid and may require assets to be offered as security.

Loans are often ‘secured’ against an asset (such as property) but may sometimes be ‘unsecured’. Lenders usually look for a successful track record of operations and income generation. Consequently a small charity or start up social enterprise may find it difficult to get a loan. Providers of loan finance to the non-profit sector include: BIGInvest, CAF Bank, Charity Bank and Co-operative & Community Finance and the Community Development Finance Association.

Members of the charity or non-profit board should consider:

• Is loan finance the best option?
• Does our governing document give us the power to borrow and,
• potentially, to pledge assets as security?
• Do we have the appropriate skills and systems to manage the loan and its repayment?
• Have we appraised the risks and agreed steps to manage those risks?

Equity capital

Equity capital is provided by external investors in return for a (permanent) stake in the organisation and if the organisation is successful, the investors share in the rewards. It does not have to be repaid and does not require security. An equity investor tends to take a long-term view of the organisation and may also want to contribute expertise. Their money is at risk if the organisation fails. Equity finance is most likely to be used by social enterprises.

Only organisations with an appropriate legal structure can raise share capital, typically a company limited by shares, a community interest company (limited by shares), or an industrial and provident society. Charities and companies limited by guarantee cannot raise equity finance.

Conflicts can arise if investors have different objectives and priorities from those of the social enterprise’s founders (for example if they are more interested in financial rather than social returns). Social enterprises may not be attractive to many traditional equity investors.

Members of the charity or non profit board should consider:

• Do you have the power to raise equity finance?
• Do potential investors share your objectives?
• Do you wish to distribute profit to external investors?

The Social Enterprise Coalition has material focusing on non-grant finance.

This is still a relatively new form of finance for the non-profit sector and there are comparatively few sources of equity finance. Sources of venture capital for social enterprises include: Triodos; Venturesome; Bridges Community Ventures Ltd.

Contracts

A contract is a form of trading where there is a formal agreement between two parties. It means that each party has agreed to do something and that if either of them fails to do it they are covered both by the terms of the contract and by contract law.

A contract is a commercial agreement and the income from it may be liable for tax and VAT. An increasing number of non-profits are contracting with the public sector to deliver specific services. But there are potential pitfalls. Delivering public services may distract the organisation from its primary aims or undermine its independence.

There is also a danger that contracts are underfunded so that the organisation can only provide a substandard service or has to use its own resources. Achieving Full Cost Recovery is essential to long term sustainability. And for charity trustees it is against the law to use charitable resources to subsidise public services.

Members of the charity or non-profit board should consider the following.

• Does the contracted service fit your organisation’s aims?
• Can you fulfill all the terms of the contract, and provide evidence that you have done so?
• What would be the consequence of not fulfilling the contract?
• Does the contract price cover all your costs?
• Have the risks been appraised and steps agreed to manage them?

See also The Charity Commission publication Charities and Public Service Delivery – An Introduction and Overview.

Trading

Many non-profits earn income by selling goods and services to members, service users, the general public, or other organisations. Some organisations earn all their income this way. You have flexibility about how to spend your earned income.

Examples of trading by non-profits include:

• selling tickets to events
• selling publications or products
• hiring out a venue
• selling in-house expertise to interested parties e.g. publishing, training, consultancy.

Charities can trade. However, if the trading activity is significant and is not related to your primary purpose there are charity and tax law implications and you should seek specialist advice. You may need to set up a separate trading arm.

Trading is likely to pose particular challenges for charities. Questions to be considered include:

• does your governing document allow you to create and invest in a trading subsidiary?
• will the proposed trading involve significant risk to a charity’s assets?
• would investment in a trading subsidiary be in line with the charity’s current investment policy?

The Charity Commission has specific guidance on Charities and Trading.