Nonprofit Organization (NPO): Definition and Example

What Is a Nonprofit Organization?

A nonprofit organization is a business that has been granted tax-exempt status by the Internal Revenue Service (IRS) because it furthers a social cause and provides a public benefit. Donations made to a nonprofit organization are typically tax-deductible to individuals and businesses that make them, and the nonprofit itself pays no tax on the received donations or on any other money earned through fundraising activities. Nonprofit organizations are sometimes called NPOs or 501(c)(3) organizations based on the section of the tax code that permits them to operate.

Qualifications for NPO Status

A nonprofit designation and tax-exempt status are given only to organizations that further religious, scientific, charitable, educational, literary, public safety or cruelty-prevention causes or purposes. Examples of nonprofit organizations include hospitals, universities, national charities, churches, and foundations.

A nonprofit must serve the public in some way, whether through the offering of goods, services, or a combination of the two. They're also required to make financial and operating information public so that donors can be informed about how—and how well—their contributions have been used. Nonprofits may also exist to collect income to dispense to other qualifying charities.

Before it can receive a tax exemption, an organization needs to request 501(c)(3) status from the IRS. Once registered and running, the organization has to maintain compliance with the appropriate state agency that regulates charitable organizations. This often requires a dedicated CIO and accounting team.

NPOs cannot be political, which helps explain why so many of them actively seek a non-partisan tone in their communications. Organizations seeking 501(c)(3) status must state explicitly in their organizing papers that they will not participate in any political campaign on the behalf of any candidate or make expenditures for political purposes. There are 501(c) groups that can engage in these activities, but not 501(c)(3) organizations.

Operating Rules for NPO Status

While some not-for-profit organizations use only volunteer labor, many large or even medium-size non-profits are likely to require a staff of paid full-time employees, managers, and directors. Despite having special tax advantages in other respects, nonprofits typically must pay employment taxes and abide by state and federal workplace rules in the same way as for-profit organizations.

Nonprofits are allowed to provide assets or income to individuals only as fair compensation for their services. Indeed, the organization must explicitly state in its organizing papers that it will not be used for the personal gain or benefit of its founders, employees, supporters, relatives, or associates.

Nonprofit Funding Sources

Nonprofits may receive income or donations from a variety of sources. Below are the most common ways nonprofits fundraise and earn revenue.

Individual Donations

Nonprofits often rely on individual donors who contribute money, goods, or services to support their mission. Donors can give one-time or recurring donations, and they may give through various channels, including online platforms, direct mail, or events. Some individuals may also coordinate with their company and have donations automatically pulled from their paychecks.

Grants

Nonprofits may receive grants from foundations, corporations, or government agencies. Grants are typically awarded for specific projects or programs, and may require the nonprofit to meet certain conditions or reporting requirements. Nonprofits usually have to apply for the grant which requires an extensive application process.

Corporate Gifts

Corporations may donate money, goods, or services to nonprofits as part of their corporate social responsibility initiatives or to support causes that align with their values or mission. In addition, if companies have matching programs, corporations may match individual donations that are automatically withdrawn from paychecks.

Major Events

Nonprofits often host events such as galas, auctions, or charity runs to raise money and awareness for their cause. These events may involve ticket sales, sponsorships, or auctions of goods or services.

In-Kind Donations

Nonprofits may receive donations of goods or services such as office supplies, equipment, or professional services. Instead of individuals or companies donating money, it may be more efficient to have specific goods donated instead. Not only can this help reduce their expenses and free up resources for other activities, the donating party may receive favorable tax benefits as gifting in-kind items opposed to having sell a good to donate the cash may be favorable.

Nonprofit vs. Not-for-Profit

The terms nonprofit organization (NPO) and not-for-profit organization (NFPO)are sometimes used interchangeably. There are, however, key distinctions between the two types of enterprise.

A key one is their purpose. As mentioned, nonprofits must offer some social benefit and provide goods or services. Not-for-profits need not have such an orientation and may exist simply to serve their membership rather than society at large.

The sections of the IRS's 501(c) code that governs each of NPOs and NFPOs serve to further delineate their differences. Nonprofits operate under 501(c)(3), for corporations, funds or foundations that operate for religious, charitable, scientific, literary or educational purposes. NFPOs, by contrast, primarily do so under other sections, such as 501(c)(7), for recreational organizations. One classic example of an NFPO, then, is a sports club that's jointly owned by its members and sustained simply for their enjoyment.

In turn, the code sets out different tax treatment for NPOs and NFPOs. In general, both organization types are tax-exempt, as in the income they earn is not subject to tax. But only with NPOs is the money people give to the organization, as dues or donations, deductible from their taxable income.

Nonprofits and Form 990

Nonprofits are tax-exempt entities. However, they are still required to file informational returns to the IRS using Form 990. This tax form provides information about the organization's finances, programs, and activities to the public and the IRS. The form is used by charitable, religious, educational, and other types of tax-exempt organizations. Private foundations, charitable trusts, and political organizations also must file a form 990.

The form 990 requires organizations to provide detailed information about their revenue, expenses, assets, and liabilities. The form is also very different from an individual's tax form as there are many governance questions to ensure IRS compliance.

Many companies post their 990 on their website. The form is also available to the public, which allows donors, stakeholders, and members of the public to review the organization's financial information and assess its operations and impact. For this reason, it's incredibly important to ensure the information reported is correct as it may indirectly negatively impact public perception on the use of donated funds.

Advantages and Disadvantages of Nonprofits

Pros of Nonprofits

Nonprofits are typically focused on a specific mission or cause. Because they operate around a central vision such as addressing a social issue, promoting education or the arts, or providing healthcare to underserved populations, this vision can foster a greater sense of purpose for staff. As opposed to a for-profit entity primarily driven by increasing profit and market share, there is often greater intrinsic value within nonprofits.

Because nonprofits are exempt from federal and state income taxes, they can allocate more of their resources towards achieving their mission and serving their communities. Nonprofits also have access to the greater range of funding sources discussed above. Similar to how an investor might attempt to diversify their portfolio, nonprofits can aim to diversify their income and donation streams.

In many ways, nonprofits can capitalize on cheaper or free labor to support their operations. Volunteer-run organizations may have small-to-no labor costs, and these individuals may be driven by a strong sense of community as opposed to individuals striving for personal profit.

Cons of Nonprofits

Nonprofits rely on donations, grants, and other sources of funding to operate, which can be unpredictable and inconsistent. This can make it difficult for nonprofits to sustain their programs and operations over the long term. As opposed to companies that generate products that may meet daily necessities, donating is an optional expense for households and may easily be reduced or eliminated.

Nonprofits often have limited scalability. They may have limited staff, expertise, and technology resources, which can make it challenging to implement programs and achieve their goals effectively. In addition, due to limited resources, nonprofits are often known for lower compensation scales compared to for-profit entities.

Nonprofits may also face accountability hurdles. Like other forms of organization, nonprofits face certain levels of regulation and oversight. On one hand, it must maintain requirements to maintain its nonprofit status via the IRS. On the other hand, it must demonstrate to donors it is being fiscally responsible and deploying successful programs that benefit the community. Last, management of a nonprofit may report to the board and must answer to more strategically-driven motivations.

The Bottom Line

Nonprofit organizations are entities that are tax-exempt and operate to better the community. By receiving funds from individuals, corporations, and governments, nonprofits deploy programs and strategies for public good. Nonprofits must meet a number of regulatory compliances to operate, and they often have the most passionate, loyal volunteers helping operate their mission.