Study Examines Causes Behind Reporting Errors on Federal Tax Returns

More than a third of nonprofit groups that collected $50,000 or more in 2000 told the federal government they did not spend anything on fund raising even though that was often not the case, according to a new study that examined the informational tax returns charities must file.

Many other organizations understate what they spend to raise money, the report found — sometimes in deliberate attempts to hide those expenses, but just as often because many small and medium-size charities lack the resources they need to accurately keep track of their costs.

Researchers from the Urban Institute’s Center on Nonprofits and Philanthropy and the Center on Philanthropy at Indiana University spent three years on the report, examining the tax returns of more than 125,000 nonprofit groups, conducting surveys of overhead costs and accounting practices at about 1,500 of them, and conducting in-depth studies of nine organizations.

The study’s findings are similar to a Chronicle report published in 2000 that found that more than one-quarter of nonprofit groups receiving $500,000 or more in contributions reported no fund-raising costs (The Chronicle, May 18, 2000).

Ratings Skewed

Many watchdog groups, donors, and grant makers rely on the overhead expenses reported in nonprofit organizations’ tax returns to judge how efficiently the groups are run, often using the cost figures to calculate what percentage of a charity’s budget it spends on its essential programs.

The researchers concluded, however, that in many cases groups that receive the best ratings from such measures actually are not as efficient as they appear, either because they have reported inaccurately low expense figures or they are spending so little on administering their programs that they are not run effectively.

Charities whose tax returns show that a high percentage of their spending goes for fund-raising and administrative costs not only face criticism from watchdogs and the news media, but also can actually lose out on grants. The Combined Federal Campaign, which solicits government workers, will not give any money that it receives to charities that spend more than 25 percent on overhead. Several United Ways and foundations also restrict grants based on charities’ administrative spending.

While the report’s authors acknowledge the need to discourage nonprofit groups from spending too much on overhead, they also argue that charities should likewise be discouraged from spending too little.

“We recommend that the watchdog groups and others not only put a ceiling on overhead, but that they also add a floor,” said Thomas H. Pollak, a senior research associate at the Center on Nonprofits and Philanthropy and one of the study’s leaders.

That suggestion is not likely to go very far.

Trent Stamp, executive director of Charity Navigator, a New Jersey watchdog group that publishes ratings of nonprofit groups’ financial efficiency on the Internet, said he did not see a need for changes in how his organization evaluates charities. Charity Navigator groups charities in its rankings within percentile ranges, so that an organization that spends 1 percent of its funds on overhead, for example, gets the same rating as one that spends 9 percent.

That system, Mr. Stamp said, means “we already have a floor.” He added that Charity Navigator does not include in its rankings organizations that report no fund-raising expenses.

New Systems Needed

The researchers found that many charities simply do not have the capacity to track their costs accurately. Of the nine organizations they studied closely, only three had any system — whether computerized or on paper — of keeping tabs on how much time their workers spent on raising funds, doing other administrative duties, or carrying out program operations.

The study concluded that one important reason why charities cannot afford the computers and staff expertise they need to keep better records is that government, foundation, and other grant makers rarely pay for them.

The chief executive at a large human-services provider — one of the groups included in the report’s case studies — told researchers that foundations usually refuse to pay any administrative costs. “Worse still,” he added, “are those that simply make an award for 85 percent of the amount requested” on the assumption that any grant proposal has administrative expenses of about 15 percent hidden in it.

The researchers proposed several changes aimed at fixing the reporting errors on the federal tax forms. They called on the Internal Revenue Service to increase its monitoring of tax returns to help catch obvious mistakes and inconsistencies.

They also recommended that government and foundations allow charities to include more overhead expenses in grant requests; that accountants take a more active role in helping nonprofit clients manage their finances; that boards of small charities consider merging with other organizations so they can afford the administrative structure they need; and that donors and watchdog groups stop using “simplistic overhead ratios” to measure nonprofit efficiency.

The researchers said that some of the reporting problems are caused by defects in the federal tax form nonprofit groups use to file their returns. Among the changes they recommended:

• Require charities to file a consolidated return that would reflect the expenses of its affiliates. Currently many large nonprofit groups are composed of numerous affiliated entities, each of which files its own tax return. In many cases, one of the organizations conducts the fund raising for all the rest, making it appear that the others spend virtually nothing to solicit contributions. While this arrangement is usually established to make fund raising more efficient rather than to deceive watchdogs or donors, the result is that many of the affiliates’ tax returns are misleading, said Mr. Pollak.
• Allow the value of volunteer hours to be counted as a program expense on the tax forms, as is already permitted under accounting rules. Under current tax-form rules, groups must record the expenses they incur in staff time overseeing volunteers, but the benefit of volunteer service is not recorded. For groups that oversee many volunteers, this can make their overhead costs appear unusually high on the form. One organization studied by the researchers, which uses volunteers to tutor students, was denied funds by a local United Way because its tax return showed that a large share of its spending went to salaries for the full-time staff who administer the program. Had the value of the volunteer services been added in, the portion spent on overhead would have fallen from 30 percent to 12 percent.

Improving the quality of charities’ expense accounting not only would be valuable to the public, donors, and grant makers, Mr. Pollak said, but also would help the nonprofit organizations themselves.

“A good manager would want to know how his staff is spending their time,” he said. “What return are you getting for the time spent on fund raising? There are a lot of benefits in knowing how efficiently your organization is being run.”

The “Nonprofit Overhead Cost Study” is available online at http://www.coststudy.org by selecting the section labeled “research briefs.”