FIN 48 and Not-for-Profits

Ready for FIN 48?

A look at the tax positions that must be considered.

Joseph S. DeTrane, CPA
It’s hard to believe that it’s been almost three years since FASB first issued its Interpretation Number 48 (FIN 48). Yet, 2009 will be the first time that most not-for-profit [IRC 501(c)(3)] organizations will have to address the tax positions and approaches that can be taken to meet the FIN 48 requirements.

The Rundown
FIN 48 was first adopted to be applicable for financial statements issued in accordance with generally accepted accounting principles, beginning with the GAAP financial statements for the fiscal year beginning after Dec. 15, 2006. Subsequent FASB staff positions allowed for a deferral of the effective date for non-public not-for-profit organizations until the GAAP financial statement first issued for the fiscal year beginning after Dec. 15, 2008. Note that public not-for-profit organizations, such as those that issued tax exempt bonds, were not granted the deferral and were required to adopt FIN 48 for the fiscal year beginning after Dec. 15, 2006.

A not-for-profit organization’s perspective on FIN 48 is unique in that most did not usually have to give much consideration to taxes when preparing their financial statements in the past. In prior year financial statements, a not-for-profit organization likely had a very succinct tax footnote indicating that the organization was tax-exempt under IRC Sec. 501(c)(3). In California, the organization would note a similar tax exemption from the FTB.

Upon hearing about FIN 48, the natural first reaction of many not-for-profit organizations was that FIN 48 does not apply to them since they are tax-exempt. Another reaction could be that, since they have filed their Information Return Form 990 with the IRS and Form 199 with the FTB, what uncertain tax positions have they taken?

While FASB has indicated that it will issue guidance and examples to help clarify the application of FIN 48 to not-for-profit organizations, the guidance is still forthcoming.

One thing that is clear is that the status of a not-for-profit as tax-exempt is in and of itself a tax position. This will be particularly challenging for organizations that claim exemption under IRC Sec. 501(c)(3) as this particular section is the most stringent for exemption qualification and many of the qualifications for this status are based on facts and circumstances, rather than a compendium of case law or a collection of IRS settlement history.

Definitions and Tax Positions
IRC Sec. 501(c)(3) provides that an organization is generally exempt from
income tax if:

Organized and operated exclusively for religious, charitable, scientific, educational or certain other purposes.
No part of the net earnings inures to the benefit of any private shareholder or individual.
No substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation.
It does not participate in, or intervene in, any political campaign on behalf of or in opposition to any candidate for public office. Note: the organization is subject to tax on unrelated business income activities.

Based on the above, it’s apparent there are primarily two types of tax positions to be considered in FIN 48. The first and most critical is the continued qualification as a tax-exempt organization.

As can be seen from the above four requirements for exemption, there is little room for error and, as mentioned earlier, many determinations of continued tax exemption qualification are based on facts and circumstances. Consider the following questions:

What does it mean to operate exclusively for the listed purposes?
What types of transactions can result in an inurement of benefit that could jeopardize tax exemption? Inurement can occur when a charity’s assets are used by an organization’s insider.
How much lobbying is substantial?

The second tax position is whether there are unrelated business income (UBI) activities conducted that would be taxable. These activities are also based on facts and circumstances, and what is UBI for one organization may not be UBI for another. In addition to considering whether a type of revenue is UBI or not, a follow-on tax position is determining the expenses allocable as a deduction against the UBI income. Also, how much UBI would be too much and jeopardize exempt status?

While the continued qualification of the organization as tax-exempt and potential UBI are the primary tax positions, others to consider include:

Do employee benefit plans continue to qualify as tax-exempt?
If there are international activities, have the appropriate international filings been made, including Form 5471 for ownership of a foreign entity and Form 926 for contributions to the capital of a foreign entity, as well as other required filings?
If there are investments such as partnerships that have invested internationally, have the appropriate international tax return filings been made?
If there are activities in multiple state jurisdictions, is the organization qualified as exempt everywhere and is it filing appropriate tax returns in each state as required?

The decision to file or not file tax returns is itself a tax position under FIN 48.

A Word to the Wise
Not-for-profit organizations, because of their tax-exempt status, may be inclined only to do the bare minimum to comply with FIN 48. However, a best practice would be to view FIN 48 as an opportunity to provide the board of directors and executive management with a fresh look at the tax positions taken, and inventory the positions along with their relevant authority so that they can know where they have tax exposures, if any.

Non-public not-for-profit organizations can learn from the experience of public not-for-profits that have adopted FIN 48—much like the lessons that for-profit private organizations learned from public for-profit organizations’ adoption of FIN 48.

For example, Daughters of Charity Health System adopted FIN 48 for its fiscal year ended June 30, 2008. Mike Stuart, CFO of Daughters of Charity, advises not-for-profit organizations that have not yet adopted FIN 48 to “start the process early. It will take longer you than you think to complete the analysis. In addition, there are a number of constituents to involve in the process, including your external auditors, your tax advisers and others, as needed, so that you know each constituents’ expectations.”

Stuart suggests following a process that includes:

Determining your level of materiality for financial statement purposes;
Determining the open tax years;
Developing a complete inventory of tax positions taken;
Understanding what is necessary to reach a more likely than not level of comfort with the tax positions taken; and
Keeping your FIN 48 analysis current once it’s completed.

The Process to Inventory Tax Positions
Key to the adoption of FIN 48 is the process of identifying uncertain tax positions, which should include reviewing:

All sources of revenue, including underlying investments, on each tax filing in all significant jurisdictions for all tax years in which the statute of limitations remains open (generally three or four years). Recognize that the statute is open in cases where a return was not filed.
The organization’s activities, including those performed by volunteers and board members.
Financial statements and trial balances for all legal entities for all open years.
The board of directors’ and board committee meeting minutes for all open years.
The application for tax-exemption and any related correspondence to and from the IRS for consistency with current operating activities.
With human resource, legal, and financial and accounting personnel the existence of any transactions with officers, directors and significant influencers of the organization and each transaction for consistency with the organizations’ tax-exempt status.
The results of prior year income tax audit.

The results of each of these reviews should be summarized and categorized in one of the following categories: highly certain (virtually no tax risk), uncertain (along with its level of certainty) and immaterial. The rationale or tax authority for the certainty should be listed, as well. The tax benefit for each material tax position can be reflected in the organization’s financial statements only if the position can meet the more likely than not threshold for both the recognition and measurement steps.

Recognition and Measurement
The recognition step for each tax position evaluates whether it meets the more likely than not standard—that is, whether there is a greater than 50 percent chance
that the position will be sustained on examination by the taxing authorities, assuming that the tax authority will examine the technical merits of each tax position.
If a position will be below that threshold, 100 percent of the position’s tax benefit will be unrecognized, which means that a tax liability for the position will be recorded for financial statement purposes.

In determining whether a position meets the more likely than not standard, prior tax research can be considered if it concludes at the more likely than not level and at the appropriate “unit of account” detail, which is a new concept under FIN 48.

For example, assume that the organization’s total unrelated business income activities include some that generate net income, and some that usually generate a tax loss and a net of no taxable income. If each of the activities is a “unit of account,” the result could be that the activity generating income is certain and the activity generating a loss is uncertain. In this case, the organization would have to consider recording a tax liability for the benefit claimed by the loss activity.
Tax research may also have to be updated to reflect recent technical developments and any changes in facts. Also, the research may need to be enhanced to be sure that it meets the more likely than not standard.

Only after meeting the recognition step can the organization measure the greatest amount of the tax position that meets the more likely than not threshold.
This is perhaps the most subjective aspect of FIN 48. Many tax positions relating to UBI versus exempt function income and tax-exemption itself are likely to be all-or-nothing positions. Further, the tax precedents are few, so guidance is limited compared to taxable organizations where tax positions have greater guidance and audit history, along with specific documentation in support of a tax position can greatly impact its measurement.

Footnote Disclosure
Upon the adoption of FIN 48, and in subsequent GAAP financial statements, the footnotes to the financials are required to disclose the impact of FIN 48. For a not-for-profit organization, this will require a disclosure of the FIN 48 impact upon adoption and the detail changes to the FIN 48 reserve during the current year,
as well as any changes expected in the subsequent 12 months—such as expiration of the statute of limitations.

In addition, the revised Form 990 for 2008 has a new requirement that the text of the FIN 48 footnote in the financials be included on the form. Recall that Form 990 is publicly available and the footnote may contain greater detail than an organization may like to disclose. Imagine if an organization could not reach a more likely than not conclusion on its tax-exempt status. It would have to record a tax liability on its income for all open tax years and calculate potential penalties and interest on the tax liability.

Monitoring FIN 48 Tax Positions
Once FIN 48 has been adopted and the tax positions have been inventoried, not-for-profit organizations will need to continue to monitor the positions to determine if there have been changes in tax law, technical interpretations of the law or changes in facts that could result in a change to the FIN 48 liability. This will be a challenge due to the lack of in-house resources, and will require a greater reliance on outside advisers.

Conclusion
The adoption of FIN 48 by a not-for-profit organization will require a fresh look at its tax-exempt status and evaluation of the risk to the UBI tax on its activities and revenue sources. Documenting and monitoring its tax positions will enable an organization to be prepared for an eventual tax audit or other scrutiny and manage the tax risk.

Joseph S. DeTrane, CPA is a partner in Grant Thornton’s Greater Bay Area tax practice specializing in not-for-profit and corporate tax matters.