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You are here: Home / Blog / What are Functional Expenses and Why Do They Matter to Nonprofits?

What are Functional Expenses and Why Do They Matter to Nonprofits?

April 6, 2021 by Casey Crowell

By: Susan Rosati                               

The IRS requires nonprofits to divide their expenses into three categories that include program, management and general, and fundraising for filing the 990 tax return. Essentially, functional expenses describe the purpose of any expense. This is different as compared to natural expenses, which are based on the type of payment such as supplies or insurance.

Program expenses are the expenses needed to run the core mission of the nonprofit and are usually the biggest group. These are the costs that are delivered through programs or services. They also include direct or indirect program expenses. Direct expense are tied directly to the program, such as staff who deliver your services. Indirect expenses, such as utilities or billing services, are often allocated because they do not tie to any one particular program. Traditionally, donors prefer nonprofits that spend most of their money on programs and do not like funding “overhead.” However, during the pandemic we have seen a significant shift away from that perspective as more donors rely they need to support the entire organization if they want their nonprofits to survive and thrive.

Management and general expenses are supporting expenses that cannot directly tie to your programs. These expenses can include insurance, human resource management, or rental space allocated for administration.

Fundraising expenses are those costs incurred raising contributions for the organization. This could include expenses related to fundraising events, direct mailers requesting donations, and wages of fundraising personnel.

It is important that nonprofits understand how to categorize functional expenses so that they are following IRS guidelines. However, there are no specific IRS requirements given on determining them. Nonprofits need to develop a functional allocation plan and document it. If your Executive Director is spending time thinking and planning how to grow a new service to meet a growing need in the community, that should be considered a program expense. However, if the Executive Director is meeting with a donor, that time is fundraising costs. And if time is spent planning a new hire orientation, then that would fall under Management and General Expenses.

Functional expenses are broken down in a matrix on the 990. They are also critical because of the audience reviewing them. Funders, donors, grantors, regulators, board members and the press all look to the 990 functional expenses as a way to understand how well the nonprofit is spending towards fulfilling their mission. So your organization should pay attention as well as to how your expenses are allocated in order to give the most accurate picture of your organization’s investment in your mission and your community.

Filed Under: Blog, Finance, Members

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