Demystifying Form 990: A Guide for Nonprofit Financial Leaders
Most nonprofit leaders know they need to file Form 990 annually, but they might not realize how important it is to their mission. Major donors review 990s before making gifts, foundations compare your ratios against similar organizations, and charity watchdogs generate public ratings based on your filing. We understand the pressure that comes with that scrutiny, and how much you care about getting it right—not just for compliance, but for the mission you serve. With strong nonprofit accounting systems, you’ll file cleaner 990s and make better strategic decisions year-round for sustainable growth.
What the Form 990 Really Is (And Why It Matters)
At its core, the Form 990 is the story of your nonprofit told through numbers and checkboxes. It's the primary way the IRS ensures you're operating as a legitimate tax-exempt organization, but it serves a much broader purpose for nonprofits.
Your Most Important Audiences
When you file your 990, you're not just checking a nonprofit compliance box. You're communicating with multiple stakeholders who will make decisions based on what they read:
Major donors and foundations increasingly require 990 reviews before making significant gifts. They're looking for warning signs: Are administrative expenses unreasonably high? Has revenue declined for multiple years? Is the organization sitting on excessive reserves while claiming an urgent need?
Charity watchdogs scan every 990 filed. Charity Navigator and GuideStar create ratings that appear in Google searches for your nonprofit. A low rating because of incomplete or concerning 990 data can redirect thousands of dollars in donations to your competitors.
State regulators use 990 data to flag organizations for closer scrutiny. States like California and New York compare 990s against state filings, looking for discrepancies that trigger audits.
Building Financial Systems That Support Accurate 990s
Organizations that handle 990s smoothly share one characteristic: they maintain clean, organized financial records through proper nonprofit accounting practices. This isn't about perfection. It's about having accounting systems that catch and correct errors before they compound.
Monthly Reconciliation: Your Early Warning System
Reconciliation is a fundamental nonprofit accounting practice that goes beyond matching bank statements. For growing organizations, you're managing multiple bank accounts, investment accounts, credit cards, and merchant services. Each needs monthly attention.
Restricted Fund Management: Where Many Nonprofits Stumble
Restricted funds represent promises to donors. Most organizations choose to report the split between Net Assets with and without donor restrictions, which requires proper tracking. Yet many growing nonprofits track restrictions in spreadsheets disconnected from their nonprofit accounting systems.
This disconnect between development tracking and proper nonprofit accounting creates problems. Organizations often discover during 990 preparation that their development database shows different restriction balances than their accounting system. This discrepancy signals weak internal controls and can trigger audit adjustments.
Your accounting system must track:
Each restriction's purpose and amount
When and how funds were used
Documentation supporting the release
Remaining balances by restriction type
Real impact: A nonprofit organization discovered that it had over-released funds and was using restricted funds to cover unrestricted expenses. The implications: 1) They either had to ask donors for permission to redirect the funds or cut other programs to make up the difference. 2) They had to recode over a year of expenses, a time-consuming and costly process.
Navigating Critical Reporting Areas
Functional Expense Allocation: Telling Your Efficiency Story
How you allocate expenses between program, management, and fundraising directly impacts how funders perceive your efficiency.
Direct expenses are straightforward: A grant to another organization is 100% program. Your audit fee is 100% management. But shared expenses require more thought. For example, salaries are best allocated by actual time spent (e.g., through timesheets).
Red flag: Using the same allocation percentages year after year. As your organization evolves, your allocation methods should too.
Executive Compensation: The Most Scrutinized Section
Part VII (compensation) and potentially Schedule J draw intense scrutiny and are now under increased federal review. The IRS is actively looking at compensation practices as grounds for revoking 501(c)(3) status.
Protect your tax-exempt status with proper governance:
Compensation committee: Board members without conflicts must formally review and approve executive compensation
Market data: Document comparable salaries from peer organizations (similar size, location, complexity)
Contemporary documentation: Record the entire decision process in board minutes, including data reviewed, performance considerations, and rationale for the amount
Annual review: Don't set and forget—reassess compensation each year
Growth consideration: As budgets expand, executive compensation may need to be increased to keep top talent. But these increases must be justified through this formal process—informal decisions or retroactive approvals won't protect your tax-exempt status.
Board Governance: More Than Just Names
The 990's governance section shows your organizational maturity. Sophisticated funders read this section first, looking for evidence of strong oversight and proper policies.
What strong governance looks like on the 990:
Active and independent board: Typically 7-15 independent board members meeting at least quarterly.
Financial expertise: An audit or finance committee with demonstrated financial knowledge.
Conflict of interest management: Annual review of conflict of interest policies with documented disclosures from all board members.
Key policy oversight: Regular review of crucial financial and documentation retention policies.
Emerging policy considerations: Proactive review of policies for new areas, such as crypto donations and AI use.
Pre-filing review: The board formally reviews the 990 before filing.
Adherence to bylaws: Ensuring bylaws and policies are consistently followed by both the Board and senior management.
Common mistake: Checking "yes" to having policies without implementing them. During audits, reviewers request these policies and evidence of implementation. Empty checkboxes can trigger penalties and damage your reputation.
Common Pitfalls For Growing Nonprofits
Schedule B: Donor Reporting Complications
Schedule B requires listing major donors, but the threshold isn't always $5,000. Most 501(c)(3) organizations that meet the public support test can use the "2% rule". This rule means you only report donors who gave more than 2% of total contributions. For growing nonprofits, this typically raises the threshold.
Example: If your organization raised $500,000, you'd only report donors who gave more than $10,000 (not $5,000).
Where things can get tricky:
All gifts from one source must be combined, including related entities
Donor-advised funds require reporting the fund name, not individual advisors
The value of non-cash gifts needs to be documented
Monthly donations need to be summed for the year to assess if they have breached the reporting threshold
Practical advice: Don't wait until December. Find a way to flag donors as they approach the threshold. This could be in your CRM or if you use Google Sheets, try conditional formatting.
Unrelated Business Income: The Hidden Compliance Risk
Many nonprofits don't realize they're generating unrelated business taxable income (UBTI) until 990 preparation. This often comes from advertising revenue, rental income with services, and sales unrelated to your exempt purpose.
UBTI over $1,000 requires filing a separate 990-T and paying corporate taxes. Failure to file the 990-T can result in substantial taxes, penalties, and professional fees.
Red flag: The IRS may revoke 501(c)(3) status if UBTI becomes substantial. If you have any UBTI, consult a nonprofit tax professional to ensure it won't risk your C3 status.
Related Party Transactions: Transparency Is Essential
The IRS requires detailed reporting of financial transactions with board members, officers, and their family members. These are allowed, but require full disclosure and careful documentation.
Common scenarios:
Renting office space from a board member
Purchasing services from a director's company
Loans to or from insiders
Best practice: Document the business need and show it’s at fair market value. Keep conflicted board members out of decisions. Mistakes here can trigger penalty taxes on your leaders.
The Role of Professional Nonprofit Accounting
As organizations grow, the complexity of 990 preparation often outpaces internal capacity.
Professional nonprofit accounting support works best when:
Internal staff maintain clean books throughout the year
Your accounting firm understands nonprofit-specific requirements
There's clear communication about who handles which components
You invest in the relationship before crisis hits
The sweet spot often involves a hybrid approach: strong internal nonprofit accounting practices for day-to-day management, complemented by specialized expertise for complex areas like cost allocation, UBTI analysis, and multi-state filing requirements.
Consider bringing in nonprofit accounting expertise when:
You're jumping to a new filing threshold (990-EZ to 990)
Multiple funders are requesting specific financial presentations
Your first audit is approaching (which typically involves two years of balance sheets)
You're expanding programs across state lines or internationally
Building Your Organization's 990 Process
Year-Round Preparation Beats Year-End Scramble
The most successful nonprofits treat 990 preparation as an ongoing process:
Monthly: Review and code transactions properly. Investigate unusual items immediately.
Quarterly: Analyze functional expense allocations. Review restricted fund balances. This regular rhythm prevents year-end surprises and allows time for corrections.
Annually: Allocate ample time to complete the document. The narrative component is your opportunity to tell your organization's story, but keep it brief.
When crafting your narrative:
Review the prior year's narrative to ensure it's still relevant.
Remember, potential donors read 990s and often use them to make a preliminary assessment of your alignment as a grantee.
Be specific about your overall goals and methods, but not so specific that it could be used to rule you out.
Consider using keywords that might be flagged during an AI search, such as one of the 17 UN Sustainable Development Goals (e.g., 'Reduce Inequalities').
Your Path Forward
The 990 can be a way to showcase what is important to you and how your organization is making the world a better place. When done well, it shows donors and grantmakers that you're professionally managed and financially responsible. That builds trust.
Take Action Today:
Pull up your last 990. Ask yourself:
Are the numbers accurate and complete?
Does it show responsible financial management?
Would it raise red flags for a potential funder?
If you're not confident in your answers, it's time to start planning improvements for next year.
At Sutro Li, we know that nonprofit work is about heart, grit, and a vision for a better world. We’re not just here to crunch numbers—we’re here because we care about the same things you do. We listen, we ask questions, and we want to understand what really matters to your organization. If you’re looking for accountants who get why you do what you do, and who want to help you keep doing it, let’s connect to see how we can support your mission.