Non-profit organizations are enterprises that focus on fulfilling a public purpose rather than on making money for its own sake. The formation of non-profit corporations is treated by the federal Internal Revenue Code (IRC), which grants them tax-exempt status. Of course, the IRC can take away an organization’s nonprofit if it should make a profit or devote too much of its efforts to the wrong kind of activities.
States also have state tax laws that grant nonprofit status to certain enterprises, and a nonprofit entity should concern itself with the tax laws in the state where it has formed and operates.
Generally speaking, a nonprofit corporation can make a limited profit as long as it does so as a result of engaging in activities that are closely related to its public purpose, and the making of a profit is only incidental to its main activities.
While there are many designations for various kinds of nonprofits under the federal Internal Revenue Code section 510(c), the three most common types of nonprofits include 501(c)(3), 501(c)(4) and 501(c)(7) organizations.
The most common of these types of nonprofit organizations is the 501(c)(3) organization. Examples of 501(c)(3) nonprofits are organizations that work to address global concerns.
The concerns most often addressed by nonprofits are education, religious support, and medical research. Private foundations, which fund other nonprofits through making grants to them, are also 501(c)(3) organizations.
There are restrictions on the kinds of public service in which 501(c)(3) organizations can be involved. For example, they cannot participate in political activities. There are limitations on the lobbying activities they can participate in. They can devote only 10% of their operational budgets to lobbying. If they exceed the 10% limit, they would risk losing their tax-exempt status.
How Can a Nonprofit Remain a Nonprofit for Tax Purposes?
Generally, nonprofits can best maintain their tax-exempt status by only using profits to support their charitable or other goals, holding regular board meetings, and maintaining detailed records of their activities and accounting.
The term “nonprofit” is something of a misnomer to the extent that a nonprofit organization is allowed to make a profit to a limited extent. A nonprofit can make a profit on its operations. However, it is legally required to use its extra income to either pay off expenses or further the public purpose that it works to accomplish.
In order for the nonprofit to hold onto its tax-exempt status, if a nonprofit should earn a profit, it would not want to hand the extra money over to the officers of the organization as some sort of “bonus” or otherwise use the money to enrich anyone.
Whether the profit may be taxable depends on how the profits were made. If the extra income was made when the nonprofit was engaged in an activity that is closely related to its public purpose, it remains tax-exempt.
However, if the profit was made from an activity that was unrelated to the purpose of the nonprofit, federal income tax may have to be paid to the Internal Revenue Service (IRS). In addition, the nonprofit may have to pay tax on its profit to its state tax authority.
What Are “Related” and “Non-related” Activities?
Any profit that is made from an activity related to the purpose of the nonprofit group is considered to be exempt from taxation. For example, a nonprofit is working towards the promotion of science education or some field of science.
The nonprofit might decide to put on a science fair to promote children’s interest in science. It decides to charge visitors an admission fee to cover the costs of renting space and other expenses. The organization might make a profit if the money it collects from admission fees exceeds the costs it incurred in staging the science fair.
If the organization should happen to make a profit as a result of this event, that money would be tax-exempt because the fair furthered the purpose of promoting science.
If the non-profit organization engages in an activity unrelated to their public purpose and ends up making a profit from it, that profit could be subject to taxation. If the same group promoting science decided to sell lab equipment produced by a major labware manufacturing corporation and made extra income, the profit would be taxable. This is not an activity that directly promotes science education.
While it is perfectly acceptable for a nonprofit to make money from a non-related activity, the organization should not devote a lot of resources to the non-related activity and should not be earning much more from this activity than from its related activities.
If a nonprofit begins to shift its main focus to a non-related, profit-making activity over nonprofit-related activities that serve its public purpose, the organization could have its non-profit status revoked by the federal Internal Revenue Service (IRS).
If an organization should lose its nonprofit status, it would then have to pay taxes on the profit earned, just like any other business. While a nonprofit does not have to worry about losing its tax-exempt status if it makes a small profit from unrelated activities, it is important that such profit remains only a small part of the nonprofit’s operation.
A nonprofit should do the following to avoid risking the loss of its federal tax-exempt status:
- Limit its unrelated activities that generate profit and do not allow unrelated activities to become a major occupation of the organization;
- Avoid having staff members devote their time solely to unrelated activities;
- Never hire someone whose time is to be dedicated only to unrelated activities.
Another example of how a nonprofit might earn a profit from unrelated activities would be a nonprofit that holds a number of charity events every year. It decides to buy a facility for that purpose. They think that they could then rent the space to other nonprofits and even businesses when it is not using the facility itself. In this way, the nonprofit could earn income from renting the space.
If the nonprofit were to do this, the profit they earned from renting out their space would be taxed as income.
The IRS has issued a list of activities that it is likely to consider unrelated to the purpose of a nonprofit because it understands that telling the two kinds of activities apart might prove challenging. They are as follows:
- Selling merchandise that has mostly been donated to the nonprofit;
- Distribution of items worth less than $5 as a “gift” for donations;
- Activities whose benefit mostly accrues to members, patients, students, officers, or employees of the nonprofit;
- Activities for which most of the labor was provided by volunteers;
- Selling, renting, or exchanging mailing lists of donors.
Should I Consult an Attorney When Trying to Form a Non-profit Organization and Determining What Its Activities Will Be?
If you are running a nonprofit or want to start one, you want to consult an experienced business lawyer.
LegalMatch.com can advise you how to set up a nonprofit, how to run so it stays on the right side of the IRC, and how to manage any profits so you do not put your nonprofit status at risk. It is wise to start with the best advice and not to wait until problems develop. This will ensure the success of your nonprofit enterprise.