Nonprofit organizations play a crucial role in our society, addressing various social, environmental and humanitarian needs. More fundamentally, nonprofits represent the long-standing tradition of Americans joining together voluntarily in associations outside of government to meet the needs of our communities.
A constitutionally protected right to associate is part of the fabric of our society. However, recent proposals, such as those outlined in a Tax Foundation report, have suggested taxing nonprofits’ net income and investment earnings.
Recommendations like these overlook the distinct mission-driven focus and reinvestment practices of nonprofits. Imposing broad tax burdens on the nonprofit sector could disproportionately harm smaller organizations and diminish their capacity to serve communities effectively. Punishing American citizens by taxing their constitutionally protected right to freely associate is the wrong way to address government’s rampant overspending.
Unlike for-profit businesses, nonprofits are mission-driven entities focused on benefiting the public interest or specific causes. Their primary goal is not to generate profits for shareholders but to reinvest any surplus funds into supporting the mission. This fundamental difference sets nonprofits apart from commercial enterprises and shapes their financial practices.
As the report states, there are large, successful nonprofits that operate similar to for-profit entities. That’s how nonprofits can compete in a landscape where individual donations to charities are down. But the revenue does not flow back to shareholders’ bank accounts, as it does with for-profits.
Nonprofits are legally obligated to serve the public good and operate exclusively for exempt purposes under Section 501(c)(3) of the Internal Revenue Code. This designation ensures revenue generated is used to sustain and expand programs that benefit society at large rather than enriching private individuals.
How Nonprofits Can and Cannot Use Net Income
It’s important to note nonprofits face strict regulations on how they can use their net income. For example, they are prohibited from distributing income to individuals. Nonprofits cannot distribute any of their income to officers, directors or other individuals connected with the organization.
Nonprofit organizations typically use their net income, or surplus, in several ways:
- Building reserves: Many nonprofits allocate surplus funds to build operating reserves, providing financial stability and helping them weather unexpected expenses or revenue shortfalls. Experts recommend having sufficient reserves to cover six months of operating expenses.
- Reinvesting in programs: A significant portion of net income is often reinvested into expanding or improving existing programs that further the organization’s mission. This could involve upgrading equipment, launching pilot projects or investing in research and development.
- Upgrading infrastructure: Net income can be allocated to improve facilities, technology or other infrastructure that supports the organization’s operations.
- Staff development and retention: Some surplus may be used for staff training, professional development or improving compensation to retain talented employees.
- Debt repayment: Nonprofits may use net income to pay down debts and reduce interest expenses, freeing up cash flow for charitable expenditures.
- Future growth: Organizations may set aside surplus funds for planned future expansion or long-term strategic initiatives.
- Compliance with donor restrictions: Some net income may be restricted by donors for specific purposes and must be used accordingly
A More Balanced Approach
It’s clear there are some questionable nonprofits that compete with for-profit entities and may not be following the laws and regulations designed to ensure they are operating to further their missions. Perhaps there is reason to look deeper into the small minority of entities that generate over $1 billion in revenue each year, for example.
But it’s crucial to keep in mind the Tax Foundation found 325 groups of this size – out of nearly two million groups. Those of us concerned with the overreach of a muscular central government surely cannot support a new tax on nonprofits to target 0.02% of the groups that may raise eyebrows. Rather than implementing sweeping tax changes, a more nuanced approach is needed to address specific concerns without jeopardizing the invaluable contributions of the charitable sector.
Why, for example, would the government continue to fund these large nonprofits at staggering levels, only to turn around and take some of their funding back through a tax on all nonprofits? Such a scheme would make our current system even less efficient, and only serve to further grow the bureaucracy needed to administer a tax.
Instead of punishing Americans by making association more expensive, some potential areas for review include:
- Examining federal funding practices for large nonprofits, particularly those with substantial endowments.
- Strengthening enforcement of community benefit standards, especially for large nonprofit hospitals.
- Reviewing overhead funding caps for federal grants to nonprofit organizations.
- Ensuring large nonprofit hospitals are meeting charity care standards commensurate with the value of their tax exemption.
Nonprofit organizations play a vital role addressing societal needs and fostering innovation in service delivery. While it’s important to ensure accountability and proper use of resources in the nonprofit sector, broad tax reforms risk undermining the essential work of countless organizations. There are legitimate questions about organizations receiving substantial government funds.
This raises fundamental questions about whether such groups are in fact outside the realm of government. But taxing a dog shelter because it sells flying discs at a farmers’ market is not going to get to the root of the problem: government is spending too much money.
By preserving the autonomy and financial health of nonprofits, we can ensure continued innovation and impactful service delivery in addressing societal needs. A balanced approach that focuses on specific areas of concern while recognizing the unique nature and contributions of nonprofits will better serve both the sector and society as a whole.
