Nonprofit vs. Not-for-Profit: Why the Difference Matters
Most people use the terms “nonprofit” and “not-for-profit” interchangeably. In casual conversation, that may not matter. Legally and for tax purposes, however, the distinction can affect how an organization operates, who it is intended to benefit, whether contributions are tax-deductible, and how the IRS regulates it.
This confusion arises because no single legal definition of “nonprofit” and “not-for-profit” applies nationwide. Additionally, State corporation laws, federal tax law, and common usage use these terms somewhat differently.
The Common Goal
Both nonprofit and not-for-profit organizations usually pursue purposes whose objective is not principally to generate profits for their owners or shareholders. Many, like a shared surgery center or a jointly owned public airport fueling center, while not principally operated to generate profits, may operate to assist the business of professionals or airline carriers.
That does not mean either nonprofit or not-for-profit organizations cannot earn a profit. In fact, many such organizations may generate substantial annual surpluses. Universities, hospitals, museums, and charitable foundations often operate with positive cash flow and significant reserves. The critical distinction is what happens to those earnings.
A tax-exempt organization generally must reinvest its surplus to further its exempt mission rather than distribute profits to private owners.
What Is a Nonprofit?
For tax law purposes, the term “nonprofit” commonly refers to tax-exempt organizations; that is, they are not subject to federal and state income taxation on their core activities. The most commonly known are those that qualify under Section 501(c)(3) of the Internal Revenue Code. These organizations are organized and operated exclusively for charitable, religious, educational, scientific, literary, or certain other public purposes.
Examples include:
- Charitable foundations
- Religious organizations
- Educational institutions
- Certain hospitals
- Museums
- Food banks
- Animal rescue organizations
For 501(c)(3) organizations, there are specific requirements both general to all 501(c)(3) organizations to be tax-exempt, and other requirements that may be specific to the type of organization. For example, to be tax-exempt as a hospital or medical clinic, operations must generally be open to assistance of others regardless of the patient’s ability to pay, as they focus on the welfare of all persons within the covered community.
Perhaps the greatest advantage of Section 501(c)(3) tax-exempt status is that donations made to such organizations are generally income tax-deductible by the donors, subject only to limitations imposed on the donors. That income tax incentive has helped fuel charitable giving in the United States for many decades.
In exchange for those benefits, these organizations operate under significant restrictions. For example, they generally may not distribute earnings to insiders; they may not participate in political campaigns on behalf of candidates, and lobbying activities are limited.
What Is a Not-for-Profit?
The phrase “not-for-profit” is also used fairly broadly. It may describe organizations allowed to be tax-exempt, but formed primarily to benefit their members rather than the public at large. Examples include:
- Social clubs
- Recreational organizations
- Homeowners associations
- Business leagues
- Professional associations
- Veterans’ organizations
- Civic organizations
- Mutual water association
Many qualify for federal tax exemption under provisions other than Section 501(c)(3), including Sections 501(c)(4), 501(c)(6), 501(c)(7), and numerous others.
These organizations may enjoy exemption from federal income tax on certain income, but they generally do not receive all of the advantages available to charities. For example, contributions to many not-for-profit organizations are not tax deductible as charitable contributions, although they may qualify as business expenses in appropriate circumstances.
In addition, an organization may describe itself as a “not-for-profit” when it really isn’t. For example, commercial condominiums and certain types of mutual benefit organizations, including cooperatives, operate a commercial enterprise to share costs among their owners and describe themselves as “not-for-profit,” but are not tax-exempt under the Internal Revenue Code. This confusion arises because they may be formed under the same state tax laws for mutual benefit organizations applicable to certain qualified not-for-profit organizations.
Tax-Exempt Does Not Mean Tax-Free
One of the most common misconceptions is that tax-exempt organizations never pay taxes. That is incorrect. First, most tax-exempt organizations pay payroll taxes, property taxes in some jurisdictions, sales and use taxes depending on state law, and employment taxes. They also pay taxes on unrelated business income if they regularly conduct activities unrelated to their exempt purpose.
An exempt organization operating a commercial enterprise unrelated to its mission may owe federal income tax on those activities under the unrelated business income tax (UBIT) rules.
The Importance of Public Benefit
One of the most significant differences between charitable nonprofits and many other tax-exempt organizations is whom they primarily serve. A charitable organization must operate primarily for the benefit of the public. Many other exempt organizations exist primarily to benefit a defined membership. A chamber of commerce advances the interests of local businesses. Likewise, a country club benefits its members. And, a trade association promotes an industry.
Whether each may qualify for tax exemption depends on its operations; many will qualify, but not all. Public policy supporting that exemption differs considerably from the rationale supporting charitable organizations.
The Role of the IRS
Receiving tax-exempt status is not automatic. Most 501(c)(3) organizations must apply to the Internal Revenue Service and demonstrate that they satisfy the requirements of the applicable section of the Internal Revenue Code. Once recognized, they generally must continue filing annual information returns, maintain appropriate governance, avoid impermissible private benefit, and comply with numerous operational requirements. Failure to do so can result in excise taxes, penalties, or even revocation of tax-exempt status.
Why Donors Should Care
For individuals making charitable contributions, understanding an organization’s classification matters. A donation to a Section 501(c)(3) charity is often deductible, subject to applicable tax rules.
Payment to a social club, homeowners association, or trade association generally is not deductible as a charitable contribution, even though the organization itself may be exempt from federal income tax.
Accordingly, before making a significant gift, donors should verify an organization’s status through the IRS Tax Exempt Organization Search or request documentation confirming its classification.
The Bottom Line
The distinction between nonprofit and not-for-profit is less about whether an organization earns money than about why it exists, whom it serves, and how federal tax law treats its activities.
Organizations may generate substantial revenue, employ thousands of people, and build significant financial reserves while remaining tax-exempt. What federal law prohibits is using those earnings for private enrichment when the organization has been granted tax benefits intended to advance public or member-serving purposes.
Understanding that distinction helps donors make informed decisions, enables board members to fulfill their fiduciary duties, and reminds organizations that tax exemption is not simply a label—it is a continuing legal obligation carrying both significant benefits and substantial responsibilities.
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Cameron L. Hess, CPA, Esq., is a Director in Fennemore’s Business and Finance practice, where he advises businesses, families, and nonprofit organizations on tax, business, estate planning, and succession matters. With more than 40 years of experience as both a Certified Public Accountant and attorney, Cameron focuses on helping clients navigate complex federal, state, and local tax issues, including matters involving nonprofit organizations and tax-exempt entities. He can be reached at chess@fennemorelaw.com.