A nonprofit organization is a legal entity that exists to serve a public purpose rather than to generate profit for owners, and understanding how nonprofits work comes down to a single trade: the organization gives up the right to distribute earnings to insiders, and in return the federal government exempts it from income tax. Everything else — the board structure, the disclosure rules, the limits on politics, the paperwork — flows from that bargain. Most organizations people think of as nonprofits are 501(c)(3) charities, named for the section of the Internal Revenue Code that defines them.
The Rule That Defines a Nonprofit
A nonprofit can run a surplus. What it cannot do is hand that surplus to founders, directors, or anyone else with influence over the organization. This is the non-distribution constraint, and it is the line that separates a nonprofit from a business.
Federal law enforces the rule through two concepts. Private inurement targets insiders — someone who channels the organization’s money to themselves through inflated pay, sweetheart contracts, or personal expenses on the books puts the entity’s tax-exempt status at risk.1Legal Information Institute. Inurement Private benefit is broader and reaches outsiders who receive more value from the nonprofit than the public purpose justifies. Any earnings the organization keeps have to go back into the mission.
Who Actually Runs a Nonprofit
There are no shareholders and no owners. Governance sits with a board of directors, usually unpaid volunteers who commit to the mission. The board hires and evaluates the executive leadership, approves budgets, and keeps the organization on the right side of the law.
Three fiduciary duties frame what board members owe the organization. The duty of care means staying informed: reading the financial statements, asking questions, and using reasonable judgment before voting. The duty of loyalty means putting the organization ahead of personal interests — a director whose company might sell services to the nonprofit has to disclose the relationship and stay out of the vote.2Internal Revenue Service. Governance and Related Topics – 501(c)(3) Organizations The duty of obedience means keeping the organization on mission and in compliance.
The IRS strongly encourages a written conflict of interest policy. It is not a legal requirement to obtain tax-exempt status, but the Form 990 asks whether the organization has one and whether it enforces it, so operating without one creates a visible gap.2Internal Revenue Service. Governance and Related Topics – 501(c)(3) Organizations
How Nonprofits Earn and Spend Money
Nonprofits fund themselves through a mix: private donations, government grants, program fees, investment income. A museum can sell tickets and run a gift shop. A social services agency can hold government contracts. All of these revenue streams are legitimate, but the mix determines how the IRS classifies the organization.
To qualify as a public charity rather than a private foundation, a 501(c)(3) generally must draw more than one-third of its total support from public sources such as gifts, grants, and program revenue, and no more than one-third from investment income. The IRS measures this over a rolling five-year period.3Internal Revenue Service. EO Operational Requirements – Requirements for Publicly Supported Charities Falling below the threshold can trigger reclassification as a private foundation, which carries stricter operating rules and additional excise taxes.
Unrelated Business Income
Tax-exempt status does not cover every dollar. Income from a trade or business regularly carried on that is not substantially related to the exempt purpose is subject to unrelated business income tax, or UBIT. A hospital gift shop for patients is related; renting the hospital’s parking garage to commuters is not.
Any organization with $1,000 or more in gross unrelated business income must file Form 990-T and pay tax on it. If the expected tax liability reaches $500 or more, estimated payments are required during the year.4Internal Revenue Service. Unrelated Business Income Tax Newer nonprofits that launch revenue side ventures to reduce donor dependence often miss this.
Donor Receipts and Deductions
For any single cash contribution of $250 or more, the nonprofit must give the donor a written acknowledgment stating the amount and whether the organization provided any goods or services in return. If it did, the acknowledgment needs a good-faith estimate of their value.5Internal Revenue Service. Publication 526 (2025) – Charitable Contributions Donors who itemize can generally deduct charitable contributions up to 50 percent of adjusted gross income for gifts to public charities, with lower limits of 30 percent or 20 percent in certain situations.6Internal Revenue Service. Charitable Contribution Deductions Without proper documentation, donors lose the deduction and the organization loses credibility.
What a 501(c)(3) Can and Cannot Do Politically
The tax code sets two distinct rules. The first is an absolute ban on political campaign activity. A 501(c)(3) cannot contribute to a candidate, endorse or oppose a candidate, or make public statements for or against anyone running for office.7Internal Revenue Service. Restriction of Political Campaign Intervention by Section 501(c)(3) Tax-Exempt Organizations There is no dollar threshold and no safe harbor. Any campaign intervention can cost the organization its exemption.
Lobbying is different. The statute allows it, as long as “no substantial part” of the organization’s activities consists of attempting to influence legislation.8Office of the Law Revision Counsel. 26 USC 501 – Exemption From Tax on Corporations, Certain Trusts, Etc Because that standard is vague, many nonprofits opt into the 501(h) election by filing Form 5768, which replaces the subjective test with an expenditure-based formula. Under 501(h), an organization can spend up to 20 percent of its first $500,000 in exempt-purpose expenditures on lobbying, with the percentage declining on higher amounts, up to a lifetime cap of $1 million. The practical line: talk to legislators about policy, yes; tell voters which candidate to support, no.
What the Public Gets to See
Every tax-exempt organization files an annual information return with the IRS. Which form depends on size:
- Form 990-N (e-Postcard) for organizations with gross receipts normally $50,000 or less
- Form 990-EZ for organizations with gross receipts under $200,000 and total assets under $500,000
- Form 990 (full return) for organizations with gross receipts of $200,000 or more, or total assets of $500,000 or more
The return is due by the 15th day of the 5th month after the fiscal year ends.9Internal Revenue Service. Form 990 Series – Which Forms Do Exempt Organizations File
The Form 990 is public. Anyone can pull it from sites like Candid or ProPublica, and prospective donors and grantmakers frequently do. It shows executive compensation, program versus fundraising spending, governance policies, and board composition. This forced transparency is the check on how leadership uses the money.
How a 501(c)(3) Gets Created
Formation runs on two tracks: state incorporation and federal tax-exempt recognition. They involve different agencies, different documents, and different fees, and neither is optional.
State Incorporation
The process starts with articles of incorporation filed with the state’s Secretary of State. Those organizing documents must include a purpose clause limiting the organization to activities permitted under Section 501(c)(3), and a dissolution clause directing that any remaining assets go to another exempt organization or a government entity if the nonprofit ever shuts down.10Internal Revenue Service. Charity – Required Provisions for Organizing Documents Filing fees vary by state. The organization also needs an Employer Identification Number from the IRS, which serves as its tax ID whether or not it has employees.11Internal Revenue Service. Employer Identification Number
Bylaws are not filed with the state but matter just as much. They set out how directors are elected, how meetings run, and how votes are taken.
Federal Application
After incorporation, the organization applies for 501(c)(3) status using IRS Form 1023. Smaller organizations with projected annual gross receipts of $50,000 or less and total assets under $250,000 may qualify for the streamlined Form 1023-EZ.12Internal Revenue Service. Instructions for Form 1023-EZ (Rev. January 2025) The user fee is $600 for the full Form 1023 and $275 for the 1023-EZ.13Internal Revenue Service. Form 1023 and 1023-EZ – Amount of User Fee Both are filed electronically through Pay.gov; paper filing is no longer accepted. Review takes from a few weeks for the 1023-EZ to several months for the full application. If approved, the IRS issues a determination letter confirming the exemption and the organization’s eligibility to receive tax-deductible contributions.14Internal Revenue Service. Instructions for Form 1023 Institutional donors and grantmakers will ask to see that letter.
How a Nonprofit Keeps Its Status
The determination letter is a starting point, not a finish line. The IRS automatically revokes tax-exempt status for any organization that fails to file its required annual return for three consecutive years. No warning. No appeal. Once revocation takes effect, the organization owes federal income tax on its earnings, donors can no longer deduct contributions, and the entity comes off the IRS’s public list of eligible charities.15Internal Revenue Service. Automatic Revocation of Exemption
Reinstatement means submitting a new application with the full user fee, and retroactive reinstatement is not guaranteed. Small organizations that file the e-Postcard are especially exposed, because the filing is so short people forget about it. Three years of missed e-Postcards ends the same way as three years of missed full returns.
Federal filings are not the whole picture. Roughly 40 states require nonprofits to register before soliciting donations from residents.16Internal Revenue Service. Charitable Solicitation – Initial State Registration Registration fees and renewal deadlines vary. Organizations that fundraise online from donors in multiple states may need to register in each one. Most states also require an annual or biennial corporate report with a modest fee to keep the entity in good standing.
Nonprofits That Are Not 501(c)(3)s
Section 501(c) of the tax code recognizes more than two dozen types of tax-exempt organizations. Alongside 501(c)(3) charities are 501(c)(4) social welfare organizations such as civic leagues and advocacy groups, 501(c)(6) business leagues and trade associations, and 501(c)(7) social and recreational clubs.17Internal Revenue Service. Exempt Organization Types Each category has its own rules on permissible activities, revenue sources, and political involvement. Donations are tax-deductible for the donor only for 501(c)(3) organizations, which is a fundraising advantage the other categories do not fully share. If the organization you are dealing with is not a 501(c)(3), the rules above about lobbying limits, the public support test, and charitable deductibility may not apply the same way.