What is a Nonprofit Organization (NPO)?
A nonprofit organization (NPO) is an entity, often tax-exempt, that seeks to serve the public good rather than make a profit.
🤔 Understanding nonprofit organizations
Nonprofit organizations (NPOs) exist for the sake of doing some form of public service rather than seeking profits. Certain NPOs approved by the Internal Revenue Service are exempt from paying federal income taxes, and donations to them may be tax-deductible. NPOs can include churches, hospitals, schools, political organizations, volunteer service providers, research institutes, and professional organizations. NPOs typically fund their operations with donations and grants rather than sales. While employees of an NPO can receive a reasonable paycheck (and pay income taxes), its members, directors, and officers do not receive dividends or any other share of profits.
The American Red Cross is an example of a nonprofit organization. Its mission is to serve as a group that “prevents and alleviates human suffering in the face of emergencies by mobilizing the power of volunteers and the generosity of donors.” Its disaster relief efforts are well-publicized following earthquakes, floods, fires, and hurricanes. The organization does not seek profit in exchange for providing these services to the public.
A nonprofit organization is like a Good Samaritan…
When someone is in need, bystanders often offer assistance. That could mean helping an elderly person cross the street, holding the door for someone with their arms full, or pulling someone out of a ditch. Good Samaritans don’t do these things because they are trying to get a reward — They do them out of a deeper sense of responsibility and kindness. Similarly, nonprofit organizations exist for a purpose other than profit.
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- How does an NPO work?
- What are the qualifications for NPO status?
- What are the operating rules of a nonprofit?
- How does an NPO pay its employees?
- Where do nonprofits get their money?
- What is the difference between a nonprofit, a not-for-profit, and a charity?
- What are the advantages and disadvantages of an NPO?
- How big is the nonprofit sector?
How does an NPO work?
A nonprofit organization is established by an individual or group of people interested in accomplishing a goal other than making money. NPOs can take many forms, including a corporation, foundation, partnership, and more. Most are managed by a board of directors, who are typically volunteers, and run by an executive director. Board members are usually considered fiduciaries (someone with a legal and ethical duty to look out for the organization’s best interest). The executive director generally manages day-to-day operations, as directed by the board.
An NPO may have paid staff, but many are run primarily by volunteers. NPOs may raise money through fundraisers, individual donations, corporate sponsorships, grants, membership fees, entry fees, and sometimes merchandise sales. For non-profits that want to stay compliant under Section 501(c)(3) of the federal tax code, the money they raise must be used to accomplish the mission of the organization. No funds can go toward the personal gain of a founder, member, employee, or individual. This includes excessive pay for employees. Many nonprofits are exempt from paying federal taxes. However, only donations to charitable organizations with 501(c)(3) status are eligible as federal tax deductions against the giver’s adjusted gross income.
What are the qualifications for NPO status?
A nonprofit organization (NPO) can be recognized by the Internal Revenue Service as tax-exempt under Section 501(c) of the federal tax code.
The most popular status is 501(c)(3), which classifies the organization as a charitable NPO eligible to receive tax-deductible donations. To qualify, the NPO must fall under one of the following categories:
- Testing for public safety
- Fostering national or international amateur sports competition
- Preventing cruelty to children or animals
- To be considered for the general classification of “charitable,” the mission of the NPO must provide some public good, which includes:
- Relief of the poor, distressed, or underprivileged
- Advancement of religion
- Advancement of education or science
- Erecting or maintaining public buildings, monuments, or works
- Lessening the burdens of government
- Lessening neighborhood tensions
- Eliminating prejudice and discrimination
- Defending human and civil rights secured by law
- Combating community deterioration and juvenile delinquency
Other NPOs can be tax-exempt, but the donations they receive generally cannot be deducted on the donor’s federal income taxes. Some examples are fraternal societies, community associations, social clubs, labor unions, trade associations, and political parties.
What are the operating rules of a nonprofit?
The primary rule of operating a nonprofit organization (NPO) is that it can’t dish out profits to any private individual. Despite its name, a nonprofit can make a profit, as well as reasonably compensate people for goods and services. But it can’t distribute the profits to anybody associated with the NPO.
For example, if your NPO brings fresh water to disaster victims, it’s reasonable to use donations to purchase water bottles. You also probably need to pay to transport the water and volunteers. But it would not be acceptable to pay $100 per bottle to your brother that gets them from Costco. Or to pay someone $10,000 a day to hand out those bottles. Nor can you collect $100,000 in donations, spend $30,000 in pursuit of your mission, and distribute the rest to the board members.
There are also limitations on using donations to influence political outcomes. Generally, a tax-exempt charitable nonprofit organizations cannot use donations for partisan political activity, like supporting a political candidate. However, it can spend a small share of its budget on lobbying, as long as it’s nonpartisan. Other types of nonprofits, such as a 501(c)(4), can work to influence politics, as long as it’s not the primary purpose of the organization. Other NPOs that are primarily formed as political organizations have special regulations found in Section 527 of the federal tax code.
Nonprofits organizations also must file annual reports with the IRS to maintain tax-exempt status. If a nonprofit doesn’t file on time, it can get charged a penalty. If a nonprofit fails to file a tax return for three years, it can lose tax-exempt status.
How does an NPO pay its employees?
No organization can operate without people. While many nonprofit organizations (NPOs) rely on volunteers to get things done, others hire employees. Nothing prevents an NPO from paying staff to accomplish its mission, as long as it pays them reasonably. In fact, there are a lot of people working for NPOs in the US. As of 2019, over 12 million Americans receive a paycheck from a nonprofit. Some of the donations, grants, and other revenues the NPO collects go toward paying wages and other operating expenses, like rent and utilities.
Where do nonprofits get their money?
Some people assume that nonprofits are primarily funded by large private foundations. In reality, only about 3 percent of the money American nonprofits get comes from foundation grants.
The largest source of revenue (49 percent) is fees nonprofits collect for services they provide. The next largest is government grants (32 percent). Another 10 percent or so comes from private donors, about 1.5 percent of which comes through gifts left in a will. Corporate donations make up 1 percent of funding.
Most nonprofits don’t actually have big budgets. In fact, 92 percent of 501(c)(3) nonprofits (not including private foundations) have annual revenues under $1M.
What is the difference between a nonprofit, a not-for-profit, and a charity?
The words nonprofit, not-for-profit, and charity are often used interchangeably. In all three cases, the organization does not set out to make a profit, but they differ in subtle ways.
A charity, or a charitable organization, is the narrowest of the terms. It refers specifically to an organization recognized by the Internal Revenue Service as existing to perform a charitable purpose. That generally includes improving society, helping people in need, and making the world a better place. It extends to things like churches, food pantries, homeless shelters, as well as many organizations advancing education, literacy, and science. A recognized charity is registered with the IRS under code 501(c)(3). These organizations are tax-exempt, and the donations they receive are tax-deductible.
The word “nonprofit” extends beyond charities. Nonprofit organizations (NPOs) can fall under any of the 29 IRS classifications in code 501(c), while charities exclusively fall under 501(c)(3). Nonprofits can include social clubs or fraternal societies that do not seek a profit but provide a benefit exclusively to members. A trade organization, labor union, homeowners association, and community bank are other organizations that may have nonprofit status but are not charities.
For most people, “not-for-profit” and “nonprofit” are synonymous. Both terms describe organizations that do not exist for the purpose of earning profits for the owners. Sometimes, “nonprofit” refers to an organization, while “not-for-profit” refers to the activities it performs. The IRS uses the term “nonprofit” to refer to those organizations recognized as tax-exempt.
Many groups of people can come together to accomplish something other than earn money —. a neighborhood watch, community garden, or even a book club. But only by creating a legal entity and meeting criteria for being tax-exempt would the group be considered a nonprofit by the IRS.
What are the advantages and disadvantages of an NPO?
The biggest advantage of registering as a nonprofit organization (NPO) is that it is generally exempt from federal income taxes. In a for-profit business, profit is taxable income that belongs to the owners of the business. If an NPO collects more revenues than it has expenses, it does not pay taxes on that surplus. Instead, it carries those funds forward to do more good in the future. 501(c)(3) nonprofits can also motivate people to donate to their cause, since contributions are tax-deductible.
NPOs are allowed to make money. However, they can’t distribute those surplus revenues to the people that make them successful. So if you have a great idea, an NPO is not a good way to get rich off of it. Your reward comes strictly from personal fulfillment and not from increased wealth.
Many NPOs attract people who believe in the mission of the organization. That can lead to a great work environment, a fulfilling career, and committed employees. Of course, it can be difficult to raise money, which can lead to stress about how to keep the doors open. And, sometimes running a nonprofit requires a lot of paperwork and activities that aren’t quite as fulfilling. All in all, the advantage of a nonprofit tends to be the things they accomplish. And being a good person is often its own reward.
How big is the nonprofit sector?
As of Sept. 2019, there were nearly 2.5M nonprofit organizations listed in the Internal Revenue Service directory. Those nonprofits employ over 12M people and leverage many more volunteers. And they pay more than $826B out in salaries, benefits, and payroll taxes. For context, that’s more than some of the larger sectors in the US economy. That includes the construction industry ($554B), the retail trade sector ($627B), the financial industry ($817B).
In addition to wages paid out, the nonprofit sector spends another $1T on goods and services to accomplish its mission.
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