Not-for-profits must recognize funds earlier

When do funds left to you from an estate actually become yours? This issue is fraught with meaning for not-for-profit organizations for numerous reasons. First, and importantly, many future grants or bequests are dependent upon an entity's financial statements, which are directly impacted by the timing of incoming funds. Next, new Federal Accounting Standards Board (FASB) updates were issued to go into effect as of 2018 in August 2016 titled Not-for-Profit-Entities (Topic 958) No. 2016-14, building on FASB Statement No. 117, Financial Statements of Not-or-Profit Organizations, which became effective starting in 1994.

Basically, these new standards address the presentation of financial statements of not-for-profit entities, while accelerating the recognition of incoming funds. Different financial standard reporting needs have been created which require a legal analysis of underlying bequests and the valuation process itself. The final opinion issued will require a mix of tax and probate law, along with a strong grasp of accounting.

The FASB Accounting Standards Update No. 2016-14 covers and updates numerous areas of recognition and disclosure. The stated goal is to provide more relevant information about resources, and changes in them. Previously, the standards had been inconsistently applied, weren't transparent, and thus were of limited usefulness. Now, not-for-profit entities must be more forthcoming regarding true liquidity. A main provision includes presenting two classes of net assets, replacing the prior three, so net assets either have donor restrictions or do not. Restrictions can no longer be released over the estimated useful life of an acquired asset. Those without restrictions are recognized immediately regardless of when payment is expected or received.

For tax purposes, ownership of an asset that is recognized is addressed frequently and in many contexts. The basic legal definition is "the full and complete right of dominion over property." The "benefits and burdens" of ownership test for property has been a factor in case law for over 100 years. In Burnet v. Guggenheim (53 S. Ct. 369 1933) reserving a right of revocation when transferring a gift to a trust was held not to be a true transfer. The Supreme Court stated with respect to a true transfer that, "it is aimed at transfers of the title that have the quality of a gift, and a gift is not consummate until put beyond recall." Under Probate Codes Sections 7000 and 7001, title passes on death when a will exists, subject to administration costs and other rights.

The relevant new FASB provisions instead refer to a "promise to give," or an "unconditional promise," which is a lesser standard. A promise to give is now defined as "a written or oral agreement to contribute cash or other assets." Words such as "subscriptions," "awards," "appropriations" or "grants" can indicate a promise. The word "pledge" encompasses other intentions that aren't promises. Verifiable documentation is required, and an oral promise that can likewise be verified is adequate for recognition. Title or control do not need to pass, and word choice matters.

Therefore, less certainty with respect to the timing and likelihood of a donation is required before an amount must be recognized on the balance sheet. Entities will need to use offsetting entries should the amount change or not get paid, despite having been "certain" when the entity learned of the amount forthcoming. Also necessary is a valuation, which we can expect will frequently be only a best estimate. For example, if the bequest is the residue of an estate, then when the entity learns of the gift they must account for the expected amount. Anyone who has worked on the administration and distribution of an estate knows that getting estimates of value takes time, and sometimes the market changes dramatically before all assets are liquidated and sums due paid. Unexpected expenses of administration and creditors can arise after an initial accounting has been done, but before the statutory time period for such claims has passed. Further, an estate might be contested by an unhappy heir or by the Internal Revenue Service. All such factors could have a material impact on funds paid.

So when is a bequest or other payment likely to trigger immediate recognition by being unconditional enough? Some factors include: if a donor has made payments under a promise; if a fixed payment schedule exists; if the amount of the payment can be determined with certainty; if the grant or bequest includes words such as "binding" or "promise"; if the donor has the financial ability to make the payment(s); and if the grant or bequest includes conditions that are certain. True conditions over which the entity has no control can delay recognition, though less so than before.

How best to counsel clients going forward with respect to these new rules, still subject to clarification, court determination and practicality? Lawyers will need to determine the type of bequest or devise, title of asset, timing of payment, amount of payment or the valuation certainty of payment and discount factors.

Property donated to not-for-profit organizations by will or trust can vary greatly. A general bequest is a gift of money. A specific devise is a gift of real property or other tangible or intangible asset. These gifts range from an outright and immediately vested, specifically named asset to a portfolio of securities whose value fluctuates daily. They can include a limited partnership share or a corporate minority interest. They can also include a life estate in a property or annuity stream. Very frequently, not-for-profit organizations are named as the default inheritor to an estate residue after all other assets are distributed and debts paid. Liabilities can attach to certain types of assets such that the entity might decide not to accept them. For example, environmental liabilities or carrying costs can be inherent in a real estate asset, or an ongoing business might be too much work for the entity to liquidate or manage.

The title of the asset in question must be determined. Did the donor have clear title such that they can grant that interest? Is the interest a whole interest so the not-for-profit entity gets full ownership or is it a fractional share? Does the interest need to vest? Do conditions attach to such ownership? For example, co-op board approval is required for a cooperative apartment share to pass to another entity. Certain types of trusts can also vest only a partial interest, such as a charitable remainder trust in which the charity gets a remainder interest in the trust assets. That remainder interest could be valued based on an attached lifetime payment stream payable to a currently living individual, something hard to estimate with certainty. Or, with other trust structures, the not-for-profit entity might get the life estate with the underlying assets passing elsewhere after a set time period. If the trust generates UBTI (unrelated business tax income), tax could accrue to the (otherwise) not-for-profit entity, changing the true value.

When the payment or asset distribution is to be paid should be determined with as much certainty as the estate administrator can provide. Under the new rules, if a promise to give has a present value element attached, then that reality must be disclosed. Accrual of these discounts is detailed, and related losses are considered bad debt.

The amount of payment to be received or asset valuation is documented currently on the balance sheet so clarity is necessary. An estate accounting can take time, and there is typically a lag between the accounting and payments from the estate. This lag can impact the ultimate total sum paid due to fluctuating values, unexpected costs and expenses, or an inaccurate appraisal.

The certainty of payment also determines when the not-for-profit entity must report the incoming amount. Clarity of contingencies should be requested from the estate administrator, especially those that qualify as donor restrictions under the new rules.

Discount factors include a minority interest, a fractional interest, lack of control, precipitating events, multiple owners, diminishing market value, a lack of liquidity and legal restrictions. In estate valuation, getting a 40 or 50 percent discount on the value of an asset due to a combination of these factors is common.

Documentation that clarifies the factors listed above can help delay recognition such that the bequest or devise is accurately reflected as to true value and timing. If the amount to be paid is still subject to potential litigation or IRS challenge, these risks should be documented. As always when dealing with valuation, documenting reasonable assumptions is key. Having a clear paper trail with respect to the actual value of a bequest can lead to more accurate financial accounting and fewer adjustments and restatements.

For residuary gifts from a trust or estate beneficiary entities will now need to request the entire estate planning document(s), whether will or trust, not just the bequest pages. Reviewing ongoing accountings is also important as the sum paid will be based on the net property on hand after payment of debts, taxes, costs of administration and general or specific bequests.

Valuation and recognition can be controlled to an extent, even under these new rules. Not-for-profit entities and their accountants need legal guidelines regarding regulatory requirements to create accurate financial reports. The provisions related to trust and estate administration and their reporting under the new standards are highly ambiguous. The Rule was simply not written with the different types of bequests and estate administration in mind.