How much money can a nonprofit Keep?

It's a myth that your 501(c)(3) nonprofit organization can't make a profit, but some of it may be subject to income tax.

Nonprofit corporations, by definition, exist not to make money but to fulfill one of the purposes recognized by federal law: charitable, educational, scientific, or literary. Under state and federal tax laws, however, as long as a nonprofit corporation is organized and operated for a recognized nonprofit purpose and has secured the proper tax exemptions, it can take in more money than it spends to conduct its activities.

Table of Contents Show

It's a myth that your 501(c)(3) nonprofit organization can't make a profit, but some of it may be subject to income tax.
Making a Profit From Activities Related to Your Nonprofit's Work
Making a Profit From "Unrelated" Business Activities
Nonprofit Sales Activities That Are Not Taxed
FREE Monthly Giving Starter Kit – Unlock the Hidden Treasure of Recurring Gifts

In other words, your nonprofit can make a profit. Whether or not that income is taxable depends on whether the activities are related to the nonprofit's purpose.

Tax-exempt nonprofits often make money as a result of their activities and use it to cover expenses. This income can be essential to an organization's survival. As long as a nonprofit's activities are associated with the nonprofit's purpose, any profit made from them isn't taxable as "income."

Let's take as an example a group called Friends of the Library, Inc. It's a 501(c)(3) (which means it has a federal tax exemption), organized to encourage the appreciation of literature and to raise money to support and improve the local public library. It makes a profit from a lecture series featuring famous authors and from an annual volunteer-run sale of donated books.

Because these activities are educational and literary in nature, they do not jeopardize the group's tax-exempt status, and the proceeds are not taxable. The organization may use this income for its own operating expenses (including salaries for officers and staff) or for the benefit of the local library. What it cannot do is distribute any of the income to the nonprofit's officers, directors, or others connected with Friends of the Library.

Making a Profit From "Unrelated" Business Activities

Sometimes nonprofits make money in ways that aren't related to their nonprofit purposes. While nonprofits can usually earn unrelated business income ("UBI") without jeopardizing their nonprofit status, they have to pay corporate income taxes on it, under both state and federal corporate tax rules. (Generally, the first $1,000 of unrelated income is not taxed, but the remainder is.)

Let's go back to the Friends of the Library nonprofit corporation for an example of unrelated income. People donate thousands of books to Friends of the Library for an annual book sale, one of its major fundraising events. Although the sale is always successful, let's say that one year, thousands of books are left over. The group decides to sell the more valuable of these books by advertising in sources for rare and out-of-print books. The response is overwhelming. Before long, the Friends of the Library has six employees cataloging books for sale. Soon, Friends of the Library finds itself in the business of buying books from other dealers and reselling them to the public. They will have to report these earnings to the IRS, which will tax them as income from unrelated business activities.

Why? In some situations, excessive unrelated business activities can also prompt the IRS to reconsider a nonprofit's 501(c)(3) tax-exempt status. To avoid this, a nonprofit should never let its unrelated business activities reach the point where it starts to look like a regular commercial business. For instance, unrelated business activities shouldn't absorb a substantial amount of staff time, require additional paid staff or volunteers, or produce much more income than that generated by the organization's exempt activities.

Nonprofit Sales Activities That Are Not Taxed

Because the difference between "related" and "unrelated" activities can be confusing, the IRS has said that some nonprofit sales activities will not be taxed, even if they aren't related to the nonprofit's purpose. Here's a quick rundown of the activities that aren't taxed:

activities in which nearly all the work is done by volunteers
activities carried on primarily for the benefit of members, students, patients, officers, or employees (such as a hospital gift shop for patients or employees)
sales of merchandise that has been mostly donated to the nonprofit (such as a thrift store)
the rental or exchange of mailing lists of donors or members, and
the distribution of token or insubstantial items as incentives for donating money (such as stamps or pre-printed mailing labels).

To learn more about the rules that your nonprofit must follow to maintain your tax-exempt status and avoid problems with the IRS, see Every Nonprofit's Tax Guide: How to Keep Your Tax-Exempt Status & Avoid IRS Problems, by Stephen Fishman (Nolo).

For most people, it is common sense to think of having a savings account, or to have money set aside for emergencies. Likewise, most nonprofits need a reserve fund, as well as a separate endowment account that money cannot be drained from at will.

Though the IRS regulations are very clear in stating that profits may not be distributed to board members (as corporate profits are to shareholders), the regulation does not bar nonprofits from generating profits. In fact, any surpluses i.e. (“profits”) are needed by all nonprofits to even out their cash flows.

The obvious way to build a reserve fund is to operate with an annual surplus, generating net revenue that can then be added to reserves. A healthy reserve fund will give a nonprofit the flexibility to either develop new programs or quickly respond to sudden emergencies that constantly seem to appear in this arena. However, The National Charities Information Bureau suggests that charities should not have more than two years’ expenses in reserve.

DISCLAIMER: This information is not intended to provide legal or accounting advice, or to address specific situations. Please consult with your legal or tax advisor to supplement and verify what you learn here.

FREE Monthly Giving Starter Kit – Unlock the Hidden Treasure of Recurring Gifts

Six out of every ten donors will stop giving to your organization next year but you can retain more of your donors with the right fundraising strategy. DonorPerfect created this free Monthly Giving Starter Kit to help you retain more donors and raise more money, year after year.