Nonprofits, by their very name are expected to have nothing to do with profit. They are created for social or educational purposes and typically have broad objectives that go beyond simply turning a profit. Based on this premise, most nonprofits do not carry on business, and they ordinarily are not profitable.
However, this conclusion may not operate all the time. There may be circumstances, sanctioned under state and federal laws, where nonprofits may not only do pretty well financially, they may be allowed to turn a profit.
How will these circumstances apply to your nonprofit and are there limitations to when a nonprofit may turn a profit or how much? Here’s all you should know.
Nonprofits can turn a profit
Nonprofits operate, literally, on the charity of others. They are set up to achieve broad organizational objectives that have at their heart, the betterment of society. Whether this is ensuring that people in third world countries can have access to clean water, or helping troubled youth in urban communities, nonprofits have charitable objectives that are in turn helped by charity.
They aim to attract donors for whom these objectives are close to heart, and possibly convince them to part with funds that will help the organization achieve its goals. The government in turn, in consideration of the good work that nonprofits do in society, allows these organizations to register as exempt under the tax laws – specifically section 501(c)(3) of the IRS code.
Due to the fact that nonprofits are generally funded on charity, it is naturally expected that they should not turn a profit. After all, they are not-for-profit organizations. However, US law allows nonprofits to turn a profit.
As long as a nonprofit organization is operated for a recognized nonprofit purpose, they can take in more money than they spend on their activities. By normal accounting standards, when income exceeds expenses, the books indicate a profit. Therefore, by this reasoning, nonprofits may be profitable.
They may receive more donor funds than they need within a calendar year, or even solicit more than they need. In addition, they may be able to earn income from business activities that contribute towards turning a profit. However, they cannot do this without limitation.
The question of “related activities” and other limitations
The first limitation to keep in mind is that, while nonprofits are allowed to make a profit, they cannot distribute this profit to their members, founders or directors. The profit must be ploughed back into the organizations charitable objectives, rather than shared as dividends or bonuses.
They may use the extra income for operating expenses, including salaries for officers and staff (which must be reasonable), and they may utilize these funds for their charitable programs. However, it cannot be distributed as profits.
In addition, none of the profit may be used for personal gain. The founders cannot take this money out of the nonprofit or adapt it to goals that are different from the organization’s or in a manner that is outside the usual financial process of the organization. Acts such as these may expose the nonprofit to an unfriendly IRS investigation.
Another limitation is that the activity from which this profit is made must be related to the organization’s charitable objectives. For instance, if the organization operates youth development programs to help troubled youth, whatever profit it makes, whether from business or non-business activities, must be related to these objectives.
However, it can be difficult to tell exactly what activities are related to the organization’s objectives and which ones are not. According to the IRS, nonprofits will not be taxed for income arising from certain activities, regardless of whether they are related or unrelated to its charitable purposes. These include:
● Activities done primarily by volunteers;
● Activities that are primarily carried on for the benefits of members, students, patients, officers or employees;
● Sales of merchandise that was donated to the nonprofits;
● Rent or exchange of mailing lists of donors or members; and
● Distribution of items that are less than $5 as rewards for donating money to the nonprofit.
Failing to remain within these restrictions can produce unwelcome implications for nonprofits.
What happens if the profit is from unrelated activities?
There are two major implications of making money from unrelated activities – one mild, and the other relatively more serious. The first implication is that the income made from the unrelated activities may become subject to corporate income taxes.
The nonprofit will have an obligation to report these earnings to the IRS and tax will be levied on the income as profit from unrelated business activities. This means the organization’s tax exempt status will not apply in relation to such income.
The second implication is a lot more serious and may result in the loss of the organization’s 501(c)(3) status. When a nonprofit excessively carries on unrelated business activities, it may prompt the IRS to reconsider its tax exempt status, and may be the catalyst of an investigation into the organization’s affairs.
To avoid this, it is important to never let your unrelated business activities subsume your charitable activities so the organization does not begin to look like a regular business. A good way to track this is when unrelated business activities begin to take up a substantial amount of staff time, or require constant expansion to bring in more paid staff and volunteers.
Paying close attention to the mix of activities that make up how your organization operates will help you avoid potential problems. A very good way to do this is to leverage on technology that helps your organization manage finances, charitable programs and your overall financial outlook.
PreciseGrants can provide accurate accounting
At PreciseGrants, we have worked very hard to provide a complete software solution that helps nonprofits clarify, understand and manage their financial health. When it comes to grant reporting and management, there are typically tens to hundreds of activities and obligations that must be undertaken.
Using PreciseGrants, your organization can more easily track expenses, keep records of financial outlay and stay compliant with funders and regulatory organizations. Contact us today to learn how PreciseGrants can help make your reporting smooth and easy.