Most businesses are first and foremost concerned with generating profit—it’s how they stay afloat in an ever-changing, fast-moving economy. But the pursuit of profit almost always entails the use of state-funded infrastructure and resources—like roads, an educated workforce, and utilities. Businesses must help fund these in the form of taxes.
For businesses not chiefly concerned with generating profits—who instead seek to advance a social cause or promote the public good—even moderate tax responsibility can be prohibitive to their mission. To protect these special entities from being eaten up by tax obligations, the United States and individual state governments offer nonprofit status.
What is a nonprofit?
Officially speaking, a nonprofit organization (NPO) is a business that has been granted tax-exempt status by the US Internal Revenue Service (IRS) on the basis that it advances a social cause benefiting the public in some way. (Think: historical preservation, scientific research, animal welfare, economic development.) These entities are prohibited from distributing profits they generate toward anyone or anything other than advancing the organization.
Nonprofits are sometimes referred to as non-stock corporations, or 501(c)(3) organizations—depending on the subsection of the tax code’s Section 501 that provides for their tax-free status. While enjoying federal tax exemption status on income, nonprofits typically must pay employment taxes for hired staff. Individual states may offer even more tax benefits to nonprofit organizations, such as exemption from paying sales taxes on items they purchase for use by the business.
Nonprofits run with the purpose of maximizing revenues for the causes they support—a key point of distinction from other types of tax-exempt organizations, which may not necessarily run with the goal of generating revenues but simply maintaining an ability to pay overhead.
What are the qualifications to be a nonprofit?
Because a nonprofit must serve the public benefit in some way, they are required to make financial and operating data public so that potential donors are informed as to how contributions are being used.
Before receiving tax-exempt status, an organization must request recognition from the IRS as a 501(c)(3) or other types of nonprofit. Once the organization is registered, it must comply with the rules set by state charity authorities in addition to IRS protocols:
- Promoting welfare. Nonprofits should first and foremost promote social good and public benefit, whether their mission involves educating the public, feeding the hungry, advocating criminal justice reform, funding research to cure diseases, and more.
- Political activity. Nonprofits must avoid political involvement. While some 501(c) organizations can engage in political campaigning or making expenditures for political purposes (such as a labor union donating to a candidate’s campaign), organizations with 501(c)(3) status are prohibited from engaging in these activities.
- Adherence to mission. To receive 501(c)(3) tax treatment, a nonprofit organization may not deviate from its core purpose or mission.
- Fair pay. 501(c)(3) status organizations must pay all employees fair market value wages.
Nonprofit vs. not-for-profit
The term “nonprofit” is often used interchangeably with “not-for-profit”—neither generates profits for its owners. All money earned by either format goes back into operating the organization. But unlike nonprofits, not-for-profits are not required to operate for the benefit of the public—they can simply serve the personal purposes of its members. A sports team, for example, might operate as a not-for-profit.
Benefits enjoyed by nonprofits
Forming and operating a nonprofit can be an immensely rewarding experience. And the benefits can match—both in terms of emotional and spiritual fulfillment, as well as concrete financial advantages.
- Tax exemption. The most obvious benefit of forming and running a nonprofit organization is that it does not pay federal income tax under the Internal Revenue Code. Tax exemptions on the state level vary by state. For example, a nonprofit in Florida that purchases office supplies may be exempt from paying sales tax on those items, while a nonprofit in California is not exempt from paying sales tax.
- Limited liability. When formed as a nonprofit limited liability corporation (LLC), directors, officers, and members of a nonprofit are protected against being held personally liable for the organization’s debts or legal liabilities. Informally organized nonprofits—that is, those that don’t take the form of a corporation—will generally not enjoy this liability shield.
- Access to grants. Some nonprofits are eligible to receive public and private grants. However, access to grants may be limited based on the type of nonprofit applying for it—for example, some grants are only available to 501(c)(3) organizations.
- Fundraising. Nonprofits can also generate operating capital from donations made by individuals. Individuals can be incentivized to make such donations, depending on the type of nonprofit receiving the gift. For example, donations to 501(c)(3) organizations are federally tax-deductible for the donor. Some states also offer benefits to the receiving organization, such as exemption from sales or property taxes on the gift.
- Helping others. A commitment to promoting social good can lend a deep sense of purpose and personal satisfaction to those involved. While it is entirely possible to earn a comfortable living from the operation of a nonprofit, the intangible rewards of doing so often outstrip any material benefits.
Types of nonprofit organizations
The IRS recognizes about 30 different types of nonprofit organizations—ranging in specificity from the general charitable organization with a broad mission to support a community to benefit trusts for coal miners to teachers’ retirement fund associations. Note that while all nonprofits enjoy an exemption from federal income tax, not all types are able to extend tax deductions to their donors.
Five common types of nonprofits include:
How to start or become a nonprofit
A nonprofit can be designated as such from the point of the organization's birth. Alternatively, a for-profit organization can be converted into a nonprofit.
Starting a nonprofit from scratch
The process for founding a nonprofit varies state by state, but generally speaking, organizers must:
Converting a for-profit into a nonprofit
The rules for converting a for-profit organization to a nonprofit will vary state by state. But generally speaking, organizers must: