Aren’t Nonprofits Penalized for Having a Reserve?
This is a question, and many times, a forceful statement I hear at least once a month. My clients and members of nonprofit boards I belong to have a deep misconception that nonprofits are not allowed to accumulate savings (aka reserves). Several years ago, I did an extensive search and asked various experts in the field, only to arrive at the same conclusion – nonprofits are not penalized for having savings. Most importantly, there is no reserve level at which the elusive penalty kicks in. So why do people hold so firmly to this misconception? If you’ve ever had a conversation with an inquisitive 6-year-old (the “but why?” loop), you will understand the conversations I have when trying to explain this conundrum.
“But aren’t we supposed to operate at breakeven?” The term “nonprofit” refers to a legal entity type (corporation), defined by state law, that prohibits the entity from operating at a profit that will benefit an individual or another entity. Nonprofit corporations do not have owners to which profits can be distributed. There are also controls at the state and federal level (through IRS regulations) to limit excessive salaries, which could be a form of personal benefit. The main point is that there is no legal prohibition from operating at a surplus and keeping that surplus within the organization for use in future programs or as a reserve to create financial stability.
“But then won’t our profits be penalized or taxed?” This is the most common question I hear after I explain the term “nonprofit.” It’s one thing for reinvested or reserved profits to be considered legal, but how much profit is acceptable before an organization gets penalized? And who will penalize them? The most obvious answer would be for the IRS to impose a penalty tax on excess reserves. This type of tax does not exist. The less obvious answer is for potential funders to turn away a grant request because the organization appears to not need it based on its healthy reserves. These reserves obviously result from years of unused profits. If true, lost funding could be a hefty penalty.
“So, will having reserves hurt our fundraising abilities?” Funding organizations receive many grant requests and your organization needs to compete with some robust proposals. Most funding organizations review your financial statements and your financial stability when reviewing your grant request. They are, after all, making an investment in your organization in hopes that you will continue taking care of the problem addressed in your mission. Reserves are a key indicator of fiscally responsible management and a good indicator that you will be around to continue doing the work for which you are being funded.
“But at what point are the reserves considered excessive?” The Standards for Excellence Institute sets a range of three to six months of working capital, and state that “Organizations also risk having reserves that are too large. Nonprofits are in the business to deliver services in furtherance of their missions, not to accumulate wealth.” The Better Business Bureau’s Wise Giving Alliance ‘Standards for Charity Accountability’ allows you to meet their standards with three years or less of current operating expenses. So, is anywhere between six months to three years excessive? Many organizations struggle to have three months of working capital and the few that have six months are way ahead of the curve. However, if an organization purposely plans to have more than six months of reserves with a board-approved policy that specifies the logic behind the relatively high reserve amount, I am willing to bet funders and the standards quoted above will be highly impressed.
I wonder… how many organizations have actually been turned down for funding for having too much in reserves?
Maribel Torres, CPA is CEO and Director of Client Accounting Services at Lumix CPAs and Advisors. She is a member of the Advisory Board for CPA.com and the AICPA Digital CPA Conference. She also serves as a peer reviewer for the Maryland Association of Nonprofits Standards for Excellence Institute®. Follow Lumix on Twitter, Facebook, and LinkedIn for the latest insights, news, and updates in accounting and advisory services.