Reporting Misuse of Funds
When a nonprofit discovers that misuse of funds has occurred, it’s critical to report the misuse to all appropriate agencies. Not taking the proper steps to report the misuse of funds can lead to financial penalties for the organization and its board members.
As always, we recommend a preventative approach to handling funds to reduce the risk of misuse. Policies and procedures should outline the financial review process for the organization, and the board should ensure that their actions are in line with the written policies. As part of these policies, every organization should designate a board member to review the monthly statements for all accounts — both incoming and outgoing funds — and compare them to the financial reports from the treasurer. This precaution can be a deterrent to fraud and can help catch any accidental misuse in time to correct it.
Even with the best practices in place, sometimes misuse of funds happens. When it does occur, the organization is responsible for reporting it to the appropriate entities, which can include the IRS, federal or local law enforcement if it involves fraud, and the grant-making organization if the misuse involves grant funding.
Reporting to the IRS
Misuse of funds should be reported to the IRS on the organization’s annual Form 990 under the question about diversion of assets. Take note that the misuse of funds is reported the year it is discovered, not through an amended 990 from the year it happened.
Along with answering “yes” to the diversion of assets question, the organization should provide a Schedule O as part of the 990 or include a letter explaining the diversion of assets. This is not a place to be vague about what occurred. Rather, the organization should provide detailed information about the misuse of funds and steps taken to prevent it from occurring in the future. Providing detailed information may help reduce the chance of a full audit from the IRS.
In the Schedule O or letter, include details like how and when the misuse was discovered, the steps the board has taken since discovering the issue, and a police report number or contact information for the law enforcement officers investigating the case. Details of your response to the issue, including any changes to policies or procedures, demonstrate that your organization has done due diligence to resolve the situation and prevent future issues.
“If the misuse involves fraud or embezzlement, do not include the accused individual’s name when reporting to the IRS, as that could be considered defamation.”
If the misuse involves fraud or embezzlement, do not include the accused individual’s name when reporting to the IRS, as that could be considered defamation. Providing the case number of an active investigation or the contact information for the investigating officer should be sufficient in allowing the IRS to gather additional information if needed.
Reporting to law enforcement
If the misuse of funds involves fraud, embezzlement, or other illegal activity, you will need to involve law enforcement at some level. When reporting to law enforcement, consider the source of the funds that were misused.
Funds originating from federal sources must be reported to the FBI. If funds came from the state level, there are more entities to involve. Depending on the situation, you may need to contact the city or county police department, the district attorney, or the state attorney general. Contacting the proper law enforcement agency allows them to investigate and prosecute the situation as necessary. As mentioned, this is an important step in showing due diligence in making every attempt to rectify the situation.
Reporting to the grant-making organization
Grants have rules about how funds may be spent, and any misuse of funds must be reported to the grant-making organization. Most grantors require that misused funds be repaid, so you will want to check the grant guidelines and discuss the appropriate repayment process with the grantor. Misuse of funds could impact the organization’s eligibility for future grants.
Whenever a misuse of funds occurs with grant, state, or federal funds, the board should act quickly to reduce risk to the organization and to all board members. If the misuse of funds involves a disqualified person, it becomes an issue of inurement or self-dealing if within a private foundation. A disqualified person is someone in a position to have substantial influence on the dealings of the organization. If the board does not take the appropriate steps to rectify the issue, they can each be responsible for 25% of the amount designated as misuse in this case.
When it comes to misuse of funds, it’s imperative that nonprofits take quick action to notify the appropriate entities based on the situation and the source of the funds involved. If your organization has identified a misuse of funds and needs legal support through the process, reach out to the Nonprofit Solutions team to schedule a call.
