From Insight to Impact: Examining Proposed Tax Changes for Nonprofits

Nonprofit organizations form the bedrock of civil society, representing a long-standing tradition of voluntary associations that operate independently from government control to meet community needs.
A constitutionally protected right to associate is part of the fabric of our society. The tax-exempt status of nonprofit organizations allows charities to operate with a degree of independence from government control.
Recent proposals to tax nonprofits like for-profit businesses overlook fundamental differences between the sectors, such as nonprofits’ mission-driven focus and reinvestment requirements and could harm smaller organizations providing vital services.
Nonprofits use their net income to build reserves, reinvest in programs, upgrade infrastructure, develop staff, repay debt, plan for future growth and comply with donor restrictions, all of which support their charitable missions.
Rather than imposing broad tax reforms on nonprofits, a more nuanced approach should focus on reviewing federal funding for large nonprofits with substantial endowments and reviewing existing community benefit standards for nonprofit hospitals.

Civil Society and the Independence of Nonprofit Organizations

Nonprofit organizations form the bedrock of a vibrant civil society. From health care and education to environmental protection and artistic expression, countless causes and organizations rely on the generosity of individuals and institutions. 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.

The clear distinction between civil society and the private sector is why associations of civil society and charity have been exempted from the types of taxation that often apply to profit seeking businesses of the private sector. The tax-exempt status of nonprofit organizations allows charities to operate with a degree of independence from government control. This also allows charities to prioritize causes that may not be politically popular but are still vital for society, such as advocacy or research into controversial topics.

Calls to Treat Nonprofits Like Businesses

However, recent reports, such as the Tax Foundation’s report, “Reining in America’s $3.3 Trillion Tax-Exempt Economy,” bring attention to several significant issues within the nonprofit sector.¹ It highlights that a small fraction of nonprofits (325 out of 1.8 million) generate substantial revenue and points out instances of organizations overly reliant on government aid, as well as the presence of “quasi-government entities.”

While these observations are important, the policy recommendations proposed by the report are overly broad and risk causing significant harm to the broader charitable sector. The suggested measures could undermine the essential work of countless nonprofits that rely on tax-exempt status to fulfill their charitable missions.

Nonprofits Are Not Profit Seeking Corporations

Subsequent opinion articles have suggested “the corporate income tax should be levied on net program service income, and nonprofits’ investment income should be taxed at the same rate other businesses pay.”² The author notes this would be the “the fairest way to level the playing field.” However, comparing businesses and nonprofits is not an apples-to-apples comparison. Businesses distribute their profits to shareholders and investors seeking investment returns, while nonprofits reinvest net income into programs, services, and initiatives that support their mission.

Sweeping changes to tax policies could disproportionately affect smaller organizations, which play a crucial role addressing local and national needs. For example, a small nonprofit pet shelter should not be subject to corporate income taxes because they offer spaying and neutering services. Nor should a nonprofit theater company charging for tickets to performances, or a conservation organization offering guided nature tours for a small fee.

Furthermore, the notion of redirecting funds from organizations dedicated to charitable missions to the bureaucratic mechanisms of an already bloated federal government is misguided. Such a shift would likely result in inefficiencies and reduce the effectiveness of social support systems that rely on nonprofit interventions. The vibrancy of civil society depends on the strength and independence of these organizations, which operate more efficiently and innovatively than government programs.

The fiscal case for imposing undue tax burdens on charitable organizations is also unconvincing. The estimated $39 billion in new revenues from the proposed policy changes is a drop in the bucket compared to the annual federal budget deficit of $2 trillion.³ This approach is akin to trying to bail out a sinking boat with a teaspoon. The financial impact on the nonprofit sector, however, could be devastating, leading to reduced services and support for vulnerable populations.

The Dual Role of Tax-Exempt Status

Aside from the tax revenue discussion, the exempt status of the charitable sector has a more significant consequence: fostering a robust nonprofit sector with a degree of independence from government control. 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. The tax-exempt status of nonprofit organizations allows charities to operate with a degree of independence from government control. Unlike government-funded programs, charities reliant on donations are not subject to the same level of political bureaucracy and budgetary constraints. This allows them to be more agile, responding quickly to emerging needs and pursuing innovative solutions without waiting for legislative approval.

Additionally, charities can prioritize causes that may not be politically popular but are still vital for society, such as advocacy or research into controversial topics. In other words, the tax status of the nonprofit sector plays a dual role—it fosters donor generosity, ultimately leading to a greater flow of resources to worthy causes. But equally important, it fosters a vibrant nonprofit sector with a degree of autonomy from government control.

While recent reports have identified critical issues within the tax-exempt sector, a one-size-fits-all approach is problematic. Rather than implementing broad, punitive measures, a more nuanced approach is needed to address the specific problems without jeopardizing the invaluable contributions of the larger charitable sector. For instance, reviewing the billions of dollars in federal funding that many large nonprofits (some with vast endowments) receive would be a better place to start.

Fundamental Differences Between Nonprofits and for- Profit Organizations

Some critics of the nonprofit sector have claimed nonprofit organizations increasingly resemble for-profit businesses in their operations. While this assertion may draw parallels in certain superficial aspects, a closer examination reveals profound and fundamental differences that distinguish nonprofits from their commercial counterparts.

At the core of nonprofit organizations lies their mission-driven purpose to benefit the public interest or a specific community or cause. Unlike for-profit businesses, whose primary goal is to generate profits for shareholders or owners, nonprofits reinvest any surplus funds to support their mission. Whether it’s a charity supporting medical research, a social service agency aiding disadvantaged populations, or an environmental organization advocating for conservation, nonprofits channel their resources toward advancing their stated charitable, educational, scientific, or literary purposes.

Nonprofits: Serving Public, Not Shareholders

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 any revenue generated is used to sustain and expand programs that benefit society at large rather than enriching private individuals.

Unlike for-profit businesses, nonprofits must make all their financial information readily available to the public. This transparency ensures donors, beneficiaries, and stakeholders can review how funds are used and assess the organization’s effectiveness in fulfilling its mission. Annual filings such as Form 990, required by the IRS for most tax-exempt organizations, provide detailed insights into a nonprofit’s financial health, governance practices, and programmatic achievements. This level of transparency fosters trust and confidence among supporters, reinforcing the nonprofit sector’s commitment to ethical stewardship of charitable resources.

In contrast to for-profit businesses, which have shareholders or investors seeking financial returns on their investments, nonprofits do not have equity ownership. Rather, nonprofits may have members, volunteers, or beneficiaries who are integral to their operations and mission fulfillment. The absence of profit distribution to shareholders means any surplus generated by a nonprofit is reinvested into programs, services, or initiatives that directly benefit the community or advance the organization’s mission. This reinvestment strengthens the nonprofit’s capacity to serve its constituents and achieve long-term impact, aligning with its charitable objectives.

How Do Nonprofit Organizations Use Net Income?

While recent reports have highlighted the significant net income generated by nonprofits, it’s crucial to consider the unique nature of these organizations and how they utilize their financial resources. Unlike for-profit entities, nonprofits do not distribute their net income to shareholders or executives as personal profits. Instead, these organizations typically reinvest their surplus funds into expanding charitable programs, improving services, or building financial reserves to ensure long-term sustainability and resilience.

This reinvestment approach allows nonprofits to further their missions, respond to community needs, and weather economic uncertainties. By focusing solely on the net income figures without accounting for how these funds are utilized, recent analysis fails to fully capture the societal benefits and long-term impact of nonprofit organizations’ financial practices.

Nonprofits use their net income, also referred to as surplus, for several key purposes:

Building reserves: Nonprofits often allocate surplus funds to build operating reserves, which provide financial stability and help the organization weather unexpected expenses or revenue shortfalls. Experts advise nonprofit organizations to have sufficient reserves to cover six months of operating expenses.⁴ Survey data suggests almost one-in-four nonprofit organizations fail to accumulate even three months worth of cash on hand, while 45 percent of organizations report not having an emergency fund altogether.⁵ Allocating net income toward building reserves is vitally important to the long-term sustainability of nonprofit organizations.
Reinvesting in programs: A significant portion of net income is typically reinvested into expanding or improving existing programs that further the organization’s mission. This could involve upgrading equipment or materials used in service delivery, launching pilot projects, testing new program ideas, or investing in research and development. Small and medium sized organizations with plans to grow their charitable mission and organizational reach typically invest the bulk of their net income into program expansion and improvement.
Upgrading infrastructure: Net income can be allocated to improve facilities, technology, or other infrastructure that supports the organization’s operations. For example, a homeless shelter which regularly reaches full capacity may choose to reinvest its net income into purchasing or leasing a larger facility or buying more beds to accommodate the growing need.
Staff development and retention: Some surplus may be used for staff training, professional development, or improving compensation to retain talented employees. Merit-based salary increases, bonuses, and benefits packages are important investments for a nonprofit to retain and reward its staff for their contributions. Meanwhile, in-house training programs tailored to the specific needs of the organization ensure staff can immediately apply what they learn to their work.
Debt repayment: For many nonprofits, taking on debt can be a necessary step to finance significant projects or manage cash flow during periods of fluctuating revenue. However, carrying debt can also be a financial burden that impacts the organization’s overall financial health and stability. Net income may be used to pay down debts and reduce interest expenses which would otherwise crowd out charitable expenditures. With less money tied up in debt service, an organization can free up cash flow, expand program services, and prepare for future growth.
Future growth: Nonprofits may set aside surplus funds for planned future expansion or long-term strategic initiatives. Planning for future growth is essential for nonprofits aiming to expand impact and sustain operations over the long term. Setting aside surplus funds for future expansion or strategic initiatives ensures the organization is well-prepared to seize new opportunities and address emerging challenges.
Compliance with donor restrictions: Some net income may be restricted by donors for specific purposes and must be used accordingly. For example, 55 percent of net assets held by the American Red Cross are restricted funds.⁶ Therefore, a large share of net income must be used in compliance with donor restrictions. Donors often give charitable gifts with specific intentions reflecting the principles and beliefs of the donor. The recipient nonprofit organization must uphold donor intent to maintain trust between donors and beneficiaries.

While nonprofits can and should aim to generate a surplus, their primary goal is not to make a profit but to further their mission. The surplus should be used to ensure the organization’s sustainability and enhance its ability to serve its constituents.

What Nonprofits Cannot Use Net Income For

Unlike for-profit entities, nonprofits cannot distribute their net income to shareholders or executives. Instead, they must adhere to specific guidelines that ensure the funds are used to further their charitable missions. These constraints ensure nonprofits remain focused on their mission-driven activities and maintain the trust of their donors and the public.

Nonprofits cannot use their net income or surplus for the following purposes:

Distribution to individuals: Nonprofits are prohibited from distributing any of their income to officers, directors, or other individuals connected with the organization. Internal Revenue Code 501(c)(3) makes clear that “no part of the net earnings of which insures to the benefit of any private shareholder or individual.”⁷ Additionally, the corresponding Treasury regulations Section 1.501(c) (3)-1(c)(2) says “An organization is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals.”⁸ This is a key distinction between nonprofits and for-profit entities.
Excessive unrelated business activities: While nonprofits can engage in some unrelated business activities, they should not let these activities become a substantial part of their operations. Excessive unrelated business activities can jeopardize a nonprofit’s tax-exempt status.⁹ The IRS uses the “substantiality test” to determine if the unrelated business activities are a substantial part of the nonprofit’s operations.¹⁰ If these activities are deemed substantial, the organization risks losing its tax-exempt status. The test considers factors such as the amount of time and resources dedicated to unrelated activities compared to the overall operations.
Personal benefit: Net income cannot be used for the personal gain or benefit of the organization’s leaders or members. Paying excessive salaries, benefits, or providing unreasonable perks to executives or employees can be considered private inurement. Compensation must be reasonable and commensurate with the services provided. The IRS has strict regulations regarding private inurement and private benefit.¹¹ Nonprofits must comply with these regulations to avoid penalties, excise taxes, and potential revocation of tax-exempt status.
Activities Outside the Organization’s Mission: Nonprofits must use their income to further their stated charitable, educational, scientific, or literary purposes. Nonprofit organizations define their missions in their founding documents, such as articles of incorporation and bylaws.¹² For example, a wildlife conservation nonprofit focuses on preserving endangered species and their habitats, while a medical research foundation conducts studies to advance treatments for a specific disease. Using funds for activities unrelated to the organization’s mission could trigger taxes on unrelated business income or put their tax-exempt status at risk.
Accumulating Excessive Reserves: While building reserves is important, nonprofits should be careful not to accumulate excessive funds without a clear purpose, as this could raise questions about their nonprofit status. There is no specific IRS threshold for what constitutes “excessive” reserves, but the general guidance suggests reserves should be reasonable in relation to the organization’s needs and future plans. Candid, an information service specializing in reporting on U.S. nonprofit organizations, recommends reserves should not exceed the amount of two years’ budget.¹³

Nonprofits are expected to use their income primarily to further the mission and support programs. While they can and should aim for financial stability, their primary goal is not profit-making but rather serving constituents and fulfilling their stated purpose.

Federal Funding Changes May Offer More Efficient Reform

Rather than implementing sweeping changes to tax policies that could disproportionately affect smaller organizations and the vulnerable populations they support, reviewing the billions of dollars in federal funding that many large nonprofits receive might reveal some opportunities for reform. For example, Ivy League colleges with multi-billion-dollar endowments should not be receiving taxpayer funded subsidies in the form of government aid. Columbia University, with its $14 billion endowment, received $1.2 billion in federal funding in 2021, while Stanford University, with its $37 billion endowment, received almost $1.4 billion in federal funding in the same year.¹⁴

Research on federal funding of Ivy League colleges also finds a large chunk of this government aid is used to cover “overhead costs,” with research overhead costing more than five times federal student aid and loan subsidies.¹⁵ Reimposing an overhead funding cap at 15 percent of direct costs, as was the law until the 1960s, would limit some of the excessive government funding to large nonprofit colleges.

Critics of the nonprofit sector have also raised the concern that most of the nonprofits with more than $1 billion in revenues are hospitals, including 55 percent of all nonprofit income. Under existing law, nonprofit hospitals must use surplus revenues for “community benefit,” which includes the provision of free or reduced-cost care to individuals within Federal Poverty Guidelines (typically below 200-400%).¹⁶

To ensure large nonprofit hospitals are meeting these standards of charity care, they could be required to allocate sufficient resources to the provision of free and discounted care to match or exceed the value of their tax exemption. To this end, some have proposed setting thresholds for community benefit spending based on the hospital’s size, revenue, and the value of its tax exemption to standardize expectations and ensure a baseline level of community investment.

To avoid applying a sledgehammer to an issue that requires a scalpel, those concerned with fiscal matters should first look to government funding of multi-billion-dollar organizations that already raise sufficient revenues to operate effectively. Better enforcement of existing rules on community benefit standards and charity care would be preferable to imposing tax burdens broadly on all organizations. Dealing with the nuanced problems highlighted in recently published reports in a way that doesn’t harm small and medium-sized nonprofits providing vital services and support for vulnerable populations would be a more prudent approach.

Targeting the Problem, Not Blanket Burdens on Civil Society

While recent criticisms and reports shed light on some important issues, many of the broad policy recommendations risk undermining the essential work of countless nonprofits. Proposals to tax net income and investment earnings of nonprofits overlook their distinct mission-driven focus and reinvestment practices. Such measures would disproportionately harm smaller organizations and diminish their capacity to serve communities effectively.

Rather than imposing blanket tax reforms, a more balanced approach that reviews federal funding practices for large nonprofits and strengthens enforcement of community benefit standards would better address the report’s concerns without jeopardizing the broader charitable sector. By preserving the autonomy and financial health of nonprofits, we can ensure continued innovation and impactful service delivery in addressing societal needs.

Mentioned on this page

Americans Internal Revenue Service Stanford University Columbia University Ivy League The Heritage Foundation American Red Cross Internal Revenue Code