Paul Horton: Nonprofit Entities and Taxes

Nonprofits can and do sometimes make a profit. Nonprofit corporations, nonprofit organizations or other exempt legal entities, unlike other forms of business, are not designed to make money for owners or shareholders. Instead, nonprofits are formed to serve a government-approved purpose, and are accorded special tax treatment as a result. Whether or not the profit a nonprofit makes is taxed is based on whether the profit was generated from activities that are “related” or “unrelated” to the nonprofit’s purpose.

Related Activities Profit

Like any business, a nonprofit has to cover operating costs and pay its employees. To pay employee salaries, keep the lights on and expand, a nonprofit needs to generate revenue. Sometimes the nonprofit 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 nonprofit must make money on activities “related” to its nonprofit status.

For example, suppose there was a nonprofit 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 nonprofit generates income by conducting charity dinners, raffles and fundraisers. The nonprofit could properly use the income it generates from these activities to pay operating expenses and employee salaries. The nonprofit 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.

Unrelated Activities Profit

Sometimes, however, nonprofits earn money on activities unrelated to their tax exempt purpose. In that case, the nonprofit must pay taxes on the profit earned, just like any other business. While a nonprofit 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 nonprofit’s operation. To avoid losing tax exempt status, a nonprofit should (1) Keep any unrelated activities that generate profit small; (2) Never hire someone dedicated to performing the unrelated activities; and (3) Avoid spending staff time on unrelated activities.

As an example of how a nonprofit 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 nonprofit 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.

Exemptions For 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 nonprofit’s purpose, but nevertheless will not be taxed:

Sales of merchandise that has largely been donated to the nonprofit;
Distribution of items worth less than $5 in return for donations;
Activities that primarily benefit members, patients, students, officers or employees of the nonprofit;
Activities where nearly all of the work is done by volunteers;
The sale, rental or exchange of donor mailing lists.

Free Consultation with a Nonprofit Corporation Lawyer

If you are here, you probably have a not for profit entity or tax issue you need help with. If you do, call Ascent Law for your free consultation (801) 676-5506. We want to help you.