A common misunderstanding about nonprofit organizations is that they are not supposed to make money. The reality of nonprofit finance is more nuanced, and this article explores what happens when a nonprofit generates more revenue than it spends. It will also cover how these organizations manage their finances to support their missions.
Can a Nonprofit Make a Profit?
While the term “profit” is associated with for-profit businesses, nonprofits can generate revenue that exceeds their expenses. In the nonprofit sector, this financial gain is referred to as a surplus. A surplus indicates that an organization brought in more money than it spent during a specific fiscal period.
Generating a surplus is not illegal; it is often an indicator of a financially healthy and sustainable organization. A consistent ability to generate a surplus demonstrates effective financial management and can enhance an organization’s credibility. This financial cushion allows the organization to plan for the future and ensure its long-term viability.
The distinction lies in how these surplus funds are used. A nonprofit must reinvest any surplus back into the organization to further its charitable purposes. These funds cannot be distributed to individuals for personal enrichment, which is the fundamental difference that distinguishes a nonprofit from a commercial enterprise.
What Nonprofits Do With Surplus Funds
A surplus provides a nonprofit with opportunities to strengthen its operations and expand its impact. A common use for surplus funds is to build an operating reserve. This reserve acts as a financial cushion, providing stability during unexpected economic downturns or periods of reduced donations.
Surplus funds are also used to invest in the organization’s mission-driven activities. This can take the form of expanding successful programs or launching new initiatives to address community needs. For example, a nonprofit might use a surplus to purchase a new vehicle for meal deliveries or upgrade its technology.
Another use of surplus funds is to manage debt. By paying down loans or mortgages, a nonprofit can reduce its interest expenses, freeing up more resources for its programs. A surplus can also be used to invest in employee development and retention, such as providing professional training or modest incentives.
Understanding Unrelated Business Income
Nonprofits can generate income from activities that are not directly related to their tax-exempt purpose, which is known as Unrelated Business Income (UBI). For income to be classified as UBI, it must be from a trade or business, be regularly carried on, and not be substantially related to the organization’s exempt purpose.
An example of UBI is a museum gift shop selling items that are not related to its collections or exhibits. While the sale of art books and prints would be related to its mission, selling general souvenirs could be considered unrelated. Income generated from such sales may be subject to Unrelated Business Income Tax (UBIT).
The purpose of UBIT is to prevent nonprofits from having an unfair advantage over for-profit businesses that offer similar products or services. It ensures a level playing field by taxing commercial activities outside the scope of a nonprofit’s charitable mission. The existence of UBI does not threaten a nonprofit’s tax-exempt status, but the income must be reported and any owed taxes paid.
When Does a Surplus Become a Problem?
A surplus becomes a potential issue when it leads to an unreasonable accumulation of funds. The problem is not the surplus itself, but hoarding money without a clear plan for its use in advancing the organization’s mission. This can create concerns for regulatory bodies and the public.
One of the issues that can arise from an excessive surplus is private inurement. This is a situation where a nonprofit’s earnings are used to benefit private individuals, which is strictly prohibited for 501(c)(3) organizations. An unjustifiably large surplus can be a red flag for this type of financial misconduct.
An excessive surplus can also damage an organization’s reputation and erode donor trust. When stakeholders see a nonprofit accumulating large sums of money, they may question whether their contributions are being used effectively. This can lead to a perception that the organization is more focused on accumulating wealth than on fulfilling its purpose.
Potential Consequences of Excessive Accumulation
When a nonprofit accumulates funds far beyond its reasonable needs without a plan, it can attract the attention of the Internal Revenue Service (IRS). The IRS may initiate an audit to investigate the organization’s finances and determine if it is operating in compliance with tax-exempt regulations.
If the IRS finds that the accumulation of funds is unreasonable or that the organization is operating for a profit-making purpose, it can impose financial penalties and taxes. This can be a significant financial blow to the organization and damage its public standing.
In severe cases, the IRS can revoke an organization’s tax-exempt status. This is a serious consequence, as the nonprofit would lose its ability to receive tax-deductible contributions and would be subject to corporate income taxes. This action is reserved for organizations that have demonstrated a significant disregard for their nonprofit obligations.
How to Evaluate a Nonprofit’s Financial Health
Publicly available resources can provide insights into a nonprofit’s financial situation. The most important of these is the organization’s annual IRS Form 990. This form is a public document that provides detailed information about a nonprofit’s finances, governance, and activities.
When reviewing a Form 990, you can look at the statement of revenues and expenses to see if the organization has a surplus or a deficit for the year. The balance sheet will show the organization’s net assets, which represents the accumulated surplus over time. Comparing the net assets to the organization’s annual expenses gives a sense of its financial reserves.
A healthy nonprofit may have an operating reserve of three to six months of expenses. A reserve larger than this without a clear justification in the Form 990 or other public documents could be a sign of excessive accumulation. This information helps donors and other stakeholders make informed decisions about their support.