Nonprofits enjoy a special tax status that is conferred to them by the government. In order to maintain and uphold the agreements involved with this special status, they must appropriately report any and all revenue generated and any profits made throughout the year. One of the main differences between a for-profit entity and a nonprofit is that nonprofits do not intend to gain funds for shareholders or those involved in managing the company. However, a nonprofit must still make enough funding to be able to compensate its employees and cover its overhead expenses. Sometimes, a case will arise wherein a nonprofit has actually generated a profit beyond the amount that is necessary to cover these bare minimum costs of doing business. In these instances, nonprofit accountants must be vigilant in making sure these profits are reported correctly to the Internal Revenue Service. Here are the things you will need to remember when dealing with this kind of situation.
Determining What Type of Profit You Made
For general tax purposes, a nonprofit can generate two different types of monies: those that are related to its purpose and those that are unrelated. The purpose of a nonprofit is formally established with the federal government when the nonprofit is given its status, and this purpose is what enables it to have special tax treatment. Some common nonprofit purposes are animal rescuing, collecting items for low-income adults and promoting sustainability or environmental health. What does the purpose of a nonprofit have to do with how it is taxed? Nonprofits who make excess funds in a way that is closely tied to their specified purpose are not responsible for paying taxes on this income. However, if an organization generates extra revenue in a way that is not supportive of its purpose, this income is taxable. Therefore, the first step in determining how to handle your taxes is classifying your profit as either related or unrelated to the mission of the nonprofit.
- Related activity profits: These types of tax exempt profits result from actions that the nonprofit takes to support its mission, such as an animal rescue charity that holds a walk-a-thon to raise money for its dogs and cats.
- Unrelated activity profits: These types of unrelated activity profits come from actions that the nonprofit takes that do not directly support its missions, such as hiring a full-time employee to sell non-animal related products out of the building that the animal rescue uses during the day. Any profits made from this endeavor would be subject to the regular tax structure that businesses must observe.
- Unrelated but tax exempt activity profits: Certain activities that might seem unrelated to the purpose of the nonprofit remain tax exempt in the eyes of the law. These include exchanging donations for the giving away of items that have a value of five dollars or less, events that are run by volunteer work or engage those who are already involved with the organization, selling or trading contact information of donors and selling products that were donated to the nonprofit.
Retaining Your Nonprofit Status
As you can see from the examples above, it is extremely important to know the difference between related and unrelated profit-generating activities so you can keep your tax exempt status as a nonprofit and avoid paying taxes on any extra revenue you might make. Make sure your accountant distinguishes carefully between types of activities so that it will be easy to tell at a glance whether a certain source of funding is taxable or not. This practice will help you keep your nonprofit status without having to wonder whether certain revenue is tax exempt.
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