When a nonprofit organization receives funding, it’s important for it to know if it should classify those incoming funds as receipts from a contract, or receipts from a grant. How the funds are categorized can lead to very different outcomes for the nonprofit organization. For example, the characterization will affect the category of expense or revenue under which the payment appears on the nonprofit’s financials, the timing in which the revenue may be recognized, and potentially trigger an organization’s obligation to perform various monitoring procedures.
Whether an agreement is treated as a contract or a grant is also important for calculating whether or not certain public charities meet their public support test—and a misunderstanding in this area could adversely affect a charity’s public charity status. Grant classification, as opposed to contract classification, may also affect the application of Section 1981 of the Civil Rights Act of 1866, which specifically applies to contracts, but may not apply to grants. The details of Section 1981 will be discussed in a separate post coming soon.
Primary Distinctions between Contracts and Grants
In general, a contract can be defined as an agreement between two parties creating mutual obligations enforceable by law. Among other requirements, contracts must have adequate consideration provided by both parties, often money from one party in exchange for services or property by the other. Grants or Grant Agreements, on the other hand, are closer in nature to gifts and are generally intended to be transfers of money or property by a “Grantor” without adequate consideration (i.e., with little to no obligation to provide anything in return) from the other party, the “Grantee”. Note that the fact that an agreement is titled as a contract or grant does not control its classification. Instead, it is the substance of the agreement that controls how it will be classified.
Another main difference between the two types of agreements is that with a contract, the party purchasing the goods or services generally has control over the output or item (i.e., the purchaser is in control of determining how it wants the services it bought to be performed), but with grants, the Grantee-recipient generally has control over its own output or performance. The Grantee, however, rarely has complete control of its performance, as it still may be subject to a certain degree of oversight from the Grantor, such as ensuring that the funds go towards the nonprofit’s charitable purposes and not towards any 501(c)(3) impermissible purpose, as well as following certain accounting procedures, reporting, and potentially expenditure responsibility.
Treasury Regulations (the “Regulations”) provide additional guidance on how to classify funds. For example, the Regulations relating to publicly supported nonprofit organizations state that grants are typically characterized as funds given to encourage an organization to carry on activities in furtherance of its exempt purposes. Grants may contain certain terms and conditions imposed by the Grantor to ensure that the Grantee’s programs or activities are conducted in a manner compatible with the Grantor’s own programs and policies and are beneficial to the public. Alternatively, the Regulations state that “gross receipts” (which typically derive from a contractual type of arrangement) are defined as amounts received in exchange for the performance of an activity to serve the direct and immediate needs of the funder, including providing the funder with some type of economic or physical benefit, such as products or services. Of course, a grant also provides a certain degree of economic benefit to a Grantee, which is why these distinctions can get tricky. But if the funds end up primarily conferring a direct benefit upon the general public, as opposed to the nonprofit itself, it’s a good sign that it’s a grant.
The Regulations also provide additional insight for private foundations: expenditures such as scholarships, fellowships, internships, prizes, program-related investments, loans for certain enumerated purposes, as well as payments to exempt organizations to be used in furtherance of that organization’s exempt purposes, are all generally characterized as grants. And note that although these characterizations are provided in the context of private foundations, they have broader application to other nonprofit organizations as well.
The Regulations set out examples to help elucidate some of the foregoing:
Example 1. A nonprofit research organization engages in contract research and receives funds from the government to develop a specific electronic device needed to perfect articles of space equipment. The initiative for the project came solely from the government and the government could have contracted with for-profit research companies that carry on similar activities. The funds received by the nonprofit organization for this project are considered to be gross receipts and do not constitute grants. The nonprofit organization provided a specific product at the government’s request and thus was serving the direct and immediate needs of the payor.
Example 2. A government agency makes a community action program grant to a nonprofit organization. As part of this program, the nonprofit organization signs an agreement with an educational organization to carry out a housing program for the benefit of poor families. Pursuant to this agreement, funds provided by the government agency are provided by the nonprofit organization to the educational organization to build or rehabilitate low-income housing and to provide advisory services to other nonprofit organizations in order for them to meet similar housing objectives, all on a nonprofit basis. The payments under this agreement constitute grants because the program is carried on primarily for the direct benefit of the community.
The following list of considerations can serve as a preliminary checklist when determining whether a contract or grant agreement is in place:
- Was anything provided to the funder in return for the payment? Funds provided with the expectation of little to nothing in return (i.e., no substantial consideration), is an indication that a grant agreement is in place. Note that a Grantee may still perform some type of service or produce a work product, but in such cases, these outputs should only provide an incidental benefit to the Grantor (e.g., a Grantee may produce a scientific report for the Grantor). Funding with an obligation to provide a service or product, usually of similar or equal value, in return, typically indicates the presence of a contract.
- Control over output. Contracts typically involve the purchaser mandating a certain output, whereas grants usually involve the recipient determining how they’ll create an output or use the funds that they receive. As noted above, grants are rarely made without oversight, however, and Grantors usually, at minimum, ensure that funds are spent for their exempt purposes.
- Type of work being funded. If the recipient was planning to perform that type of work anyway, this indicates that the funds are from a grant (e.g., the nonprofit was planning to feed needy children anyway, the funds only made it so that the size and scope of the service could be expanded). If the work is instead being performed solely as a result of a payment being received, this indicates that the funds may be provided pursuant to a contract (e.g., as in Example 1 from the Regulations listed above).
- Does the work under the agreement support the recipient’s mission or exempt purpose? A grant is normally provided in order to further both the Grantor’s and the Grantee’s missions. When funds are given for the purpose of advancing both the funder’s and the recipient’s (usually charitable) missions, this indicates that such funds are from a grant. When an agreement is solely supporting the funder’s goals, this indicates that a contract is present.
- Ownership of work product. If, as a result of receiving funds, a recipient creates a work product (e.g., intellectual property), and the recipient is entitled to keep ownership of such work product, it is more likely that the funds were given in the form of a grant. When a funder retains ownership rights of the work product, this is a sign that the payment was pursuant to a contract.
- How was the funding amount determined? The amount of a grant is often determined by the funder in response to a request by an organization asking for funding. Contracts typically involve amounts that have been calculated at fair market value, often as a result of negotiations, to be exchanged for services or work product being provided.
These considerations can help guide nonprofit organizations when trying to determine whether a contract or grant agreement is in place. However, terms and conditions of grant agreements and contracts can overlap, and it is often unclear whether a payment was received pursuant to a contract or to a grant. Seeking the advice of an accountant or legal advisor is important under such uncertain circumstances, to ensure, among other things, that the nonprofit organization can adequately maintain its books and records, avoid penalties (if a private foundation) and/or avoid a revocation of its public charity status (when relying on the public support test).