The distinction between for-profit and non-profit organizations ("NPO's") is often misunderstood. Contrary to conventional wisdom (which is often more convention than wisdom), the difference between the two types of entities is not about the existence or non-existence of profit, but rather, how that profit is used.
In reality, the primary difference between NPO's and for-profit entities is based on what each does with those profits. When an NPO's revenues exceed its expenses, we don't refer to it as profit, but rather as an "increase in net assets." However, to simplify this discussion, regardless of whether I'm referring to a non-profit or a for-profit, I will use the term "profit."
Although widely accepted in use, the term "non-profit organization" is actually somewhat misleading. For-profit entities are taxable – they pay income taxes on their earnings. Non-profit entities are tax-exempt – they pay no income taxes on their earnings. Over the years, the term "non-profit" has become a proxy for the term "tax-exempt."
Internal Revenue Service regulations generally prescribe requirements for approval and maintenance of an organization's tax-exempt status. These regulations state that none of the earnings of a tax-exempt entity (i.e. a non-profit) "may inure to any private shareholder or individual." In short, you and I have no legal right to the organization's profits. Obviously, this provision does not prohibit an organization from paying reasonable salaries and benefits to employees. Notice, however, that this provision (or any other provision in the Internal Revenue Code), does not prohibit profits. Rather, it places restrictions of the use of those profits.
Unlike NPO's, for-profit entities have the legal right to use their earnings for any purpose at their sole discretion, which includes the right to distribute those profits to owners and investors. A good example is when a corporation uses excess profits to pay dividends to shareholders.
In exchange for the benefits granted to NPO's as a result of their tax-exempt status, i.e. exemption from income and other taxes, NPO's must use their earnings for their tax-exempt purpose, a purpose which has been previously approved to further the public good. In essence, as part of its agreement with the NPO, the IRS says: "Because of the good you're doing for society, we'll give you the benefit of exemption from taxation. In exchange for that privilege, you have to follow our rules, one of which is that, no one can be personally enriched as a result of your existence."
Of course, over the years, less than honorable organizations have found ways to get around the laws which bar private enrichment. Examples include purchasing property for personal use with organizational funds, and excessive payments to affiliated service providers, to name a few. Of course, the vast majority of NPO's do not engage in these practices, and, in fact, most maintain strict policies, procedures and controls to ensure that such practices do not occur.
So, is it wrong, then, for a non-profit to earn profits? My answer is a resounding "NO." I would take it one step further by stating that, not only is it not wrong, it is often vital for an NPO to generate profits. This is particularly true in the current economy, where government programs are chronically underfunded, or even face elimination altogether, while foundations and other donors have become more discriminate in their giving. Guidestar, which maintains a database of non-profit organizations, estimates that there are approximately 1.8 million IRS-approved NPO's operating in the United States, many of which, to one degree or another, are competing for the same scarce dollars.
The notion that non-profits shouldn't earn profits, which is often based on the misconceptions I have described, is misguided. I would venture to guess that proponents of this point of view have never witnessed an organization scrambling to find enough money to make payroll every few weeks.
I should point out that, quite often, NPO's are funded by contracts and grants received from governmental and other agencies, which stipulate that 100% of the funding under that agreement must be used for a specific purpose – i.e. no profit is permitted. Although quite common, this applies to that specific grant or contract only, and should not be confused with profits earned by the agency as a whole.
Unlike the Federal government, non-profits cannot simply print money or sell Treasury securities to China when money is tight. Most NPO's are independent and self-sufficient, no different from any other business entity in that respect. To an NPO, as well as any organization, profits and cash flows are the fuel that keeps the organization running. If you drive around with your tank near empty, eventually you're going to run out of gas – and it will most likely be on a dark, deserted road in the middle of the night.
In the world of non-profit organizations, profits are used to sustain, maintain, and grow. Yes, growth is as important to NPO's as it is to for-profit entities. Growth expands the organization's ability to impact more of those who benefit from its programs and services. Growth also enables the organization to diversify its programs and funding sources to minimize risk, such as, the risk that a particular program will be discontinued or the risk of losing an important source of funding.
In addition to mere survival, non-profit executives will be the first to tell you that there is no shortage of good uses for profits, including:
- Enhancing existing programs, most of which operate on shoestring budgets;
- Building the organization's capacity to provide quality programs and manage effectively, by recruiting, hiring and training talented employees;
- Minimizing the financial impact of any number of unexpected expenditures, which are, by definition, beyond the organization's control;
- Initiating and/or enhancing fund-raising efforts, a necessity for any organization that relies on public funding to sustain its existence; and
- Functioning as a self-funded line of credit, or cash reserve, to protect against the down-side of cyclical cash flow periods.
These are just a few examples of the endless number of reasons why it is crucial for NPO's to generate profits. Because the term "non-profit" is a tax status, not an operating goal, it is by no means illegal, or even immoral, for them to do so.
