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Nonprofit Taxes: When Nonprofits Make a Profit

Despite the name, nonprofits do sometimes make a profit.

Unlike for-profit businesses, nonprofit corporations aren't designed to make money for owners or shareholders. Instead, nonprofits are formed to serve a government-approved purpose. So, they are given special tax treatment. Whether a nonprofit's profit is taxed is based on whether the profit was generated from activities that are “related" or “unrelated" to the nonprofit's purpose.

This article explains how these organizations handle making money and taxes. We'll talk about:

  • Different kinds of profits and what the law says about them
  • Why it's important for nonprofit owners to follow Internal Revenue Code (IRC) rules
  • How nonprofit organizations work with taxes

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Profit Made From 'Related' Activities

When nonprofits do something that aligns with their main purpose, this is called a “related" activity. For example, consider a charitable organization whose mission is to sell books to help animals. The money made here is okay because it supports the nonprofit's goals.

This income is usually safe from federal income tax. This is due to exemption rules in the IRC. The nonprofit's board of directors must also ensure these activities align with their articles of incorporation and bylaws. This way, they stay true to their mission and maintain their tax-exempt status.

Like any business, a nonprofit must 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.

Profit Made From 'Unrelated' Activities

Sometimes, nonprofits make money from activities that don't fit their tax-exempt purpose. For example, a public charity running a café is an “unrelated" business activity. This kind of income can be tricky. Unlike profits from related services, this income might be subject to income tax by the Internal Revenue Service (IRS).

The IRS has rules about this in the IRC. Nonprofits need to file a tax return for this income. They might have to pay federal income tax, state tax, and maybe sales tax. It's important for nonprofits to know these rules and avoid problems.

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 remains a small part of the nonprofit's operation. To avoid losing tax-exempt status, a nonprofit should:

  • Keep any unrelated activities that generate profit small
  • Avoid spending staff time on unrelated activities
  • Never hire someone dedicated to performing unrelated activities

Learn more about maintaining your tax-exempt status with FindLaw's Keeping Your Nonprofit Tax Exempt Status article.

Exempt 'Unrelated' Activities

Some “unrelated" activities can still be tax-exempt. If these activities are small or only happen once in a while, the IRS might not tax them. Also, if volunteers mostly do the work or it benefits the organization's members, it may be tax-free. This is great for things like occasional bake sales or small fundraisers.

But each nonprofit must check if its activities meet these criteria. They must also keep good records and possibly file an annual report with the secretary of state or other government entities.

The IRS realized that distinguishing between related and unrelated activities is often difficult. So, it created a list of activities that aren't likely to be related to a nonprofit's purpose, but that 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 primarily benefitting members, patients, students, officers, or employees of the nonprofit
  • Activities where volunteers do nearly all of the work
  • The sale, rental, or exchange of donor mailing lists

Unrelated business income tax (UBIT) is a key concept for nonprofits that engage in regular business activities unrelated to their exempt purpose. Understanding UBIT helps nonprofits determine whether their income is subject to federal income tax. A nonprofit generating substantial income from unrelated business activities may have its tax-exempt status affected. So, understanding UBIT for the financial health and compliance of a nonprofit is essential.

Managing Nonprofit Finances and Tax Obligations

Nonprofits, just like any business entity, must manage their finances carefully. This includes keeping track of all charitable contributions, expenses, and income. They need to maintain clear records to show they are using their funds for the nonprofit's purpose.

These organizations also must understand their obligations regarding different taxes. They should know about their jurisdiction's sales tax, property tax, and state taxes. By sticking to these practices, nonprofits ensure they meet the eligibility criteria for maintaining their federal tax-exempt status. They also stay compliant with state law as a tax-exempt nonprofit.

Protect Your Non-Profit Organization: Get Professional Tax Help

Running a nonprofit, especially one just getting off the ground, can be challenging. Because of ongoing issues with compliance, it's critical to have the expert counsel of a small business attorney to ensure that your organization is on solid ground.

Get in touch with an experienced tax law attorney near you today.

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