Nonprofit Taxes: When Non-profits Make a Profit
Despite how the name sounds, non-profits can and do sometimes make a profit. Non-profit corporations, unlike other forms of business, are not designed to make money for owners or shareholders. Instead, non-profits are formed to serve a government-approved purpose, and are accorded special tax treatment as a result. Whether or not the profit a non-profit makes is taxed is based on whether the profit was generated from activities that are "related" or "unrelated" to the non-profit's purpose.
Profit Made from "Related" Activities
Like any business, a non-profit has to cover operating costs and pay its employees. To pay employee salaries, keep the lights on and expand, a non-profit needs to generate revenue. Sometimes the non-profit generates revenue that exceeds the amount of its expenses, resulting in a profit. How it generates that profit matters tremendously. To avoid having to pay taxes on any profits it creates, a non-profit must make money on activities "related" to its non-profit status.
For example, suppose there was a non-profit group called Clothes for Kids that went around collecting old clothing, cleaning and repairing the items, and then giving the refurbished clothes away to children in need. The non-profit generates income by conducting charity dinners, raffles and fundraisers. The non-profit could properly use the income it generates from these activities to pay operating expenses and employee salaries. The non-profit won't have to pay taxes on any profits it receives, because the activities that generated the profits were directly related to its mission: providing children in need with clothing.
Profit Made from "Unrelated" Activities
Sometimes, however, non-profits earn money on activities unrelated to their tax exempt purpose. In that case, the non-profit must pay taxes on the profit earned, just like any other business. While a non-profit doesn't have to worry about losing its tax exempt status if it makes a little profit from unrelated activities, it's important that such profit remain a small part of the non-profit's operation. To avoid losing tax exempt status, a non-profit should:
- Keep any unrelated activities that generate profit small
- Avoid spending staff time on unrelated activities
- Never hire someone dedicated to performing the unrelated activities
As an example of how a non-profit might earn profit from unrelated activities, imagine that Clothes for Kids has decided that, in order to reduce costs, it should own and operate its own facility for putting on charity events. When not in use by Clothes for Kids, the non-profit often rents out the space to other charities and businesses, earning rental income on the facility. Any profit generated from renting the facility would likely be taxed as normal business income.
Exempt "Unrelated" Activities
The IRS realized that distinguishing related and unrelated activities might often be difficult, so it set out a list of activities that are likely not related to a non-profit's purpose, but nevertheless will not be taxed:
- Sales of merchandise that has largely been donated to the non-profit
- Distribution of items worth less than $5 in return for donations
- Activities that primarily benefit members, patients, students, officers or employees of the non-profit
- Activities where nearly all of the work is done by volunteers
- The sale, rental or exchange of donor mailing lists