Can Nonprofits Write Off Their Expenses?

Nonprofit organizations play a distinct role in society, operating with a primary focus on public benefit rather than generating profits for owners or shareholders. These entities are established to further specific charitable, educational, religious, scientific, or other socially beneficial purposes. Unlike traditional businesses, any revenue exceeding expenses must be reinvested back into the organization to advance its mission. This fundamental difference shapes how expenses are treated and reported within the nonprofit sector.

Understanding Nonprofit Expense Treatment

Nonprofit expense treatment differs significantly from for-profit businesses. For-profit entities deduct expenses to reduce taxable income and lower tax liability. Most nonprofit organizations, particularly those with 501(c)(3) status from the Internal Revenue Service (IRS), are generally exempt from federal income tax on income related to their exempt purpose.

Since their mission-related income is not subject to federal income tax, nonprofits do not “write off” expenses in the traditional sense to reduce a tax burden. Instead, expenses are necessary outlays to achieve their stated objectives and maintain operations. Proper management and allocation of these expenses are crucial for demonstrating financial stewardship, ensuring compliance with IRS regulations, and maintaining their tax-exempt status. These expenditures support programs and services that directly benefit the public. While nonprofits do not pay income tax on qualifying revenue, they are still responsible for other taxes, such as payroll taxes for employees.

Categories of Nonprofit Expenses

Nonprofit organizations incur various expenses, generally categorized by function. These categories demonstrate how an organization’s resources are utilized to fulfill its mission. The three primary functional expense categories are program, administrative, and fundraising expenses. Every expense must be reasonable, necessary, and directly related to the organization’s exempt purpose to be legitimate.

Program Expenses

Program expenses are the direct costs associated with delivering the organization’s mission and services. For instance, a homeless shelter’s program expenses would include the cost of food, temporary housing, and counseling services for its beneficiaries. Examples include:

• Costs of providing direct services
• Salaries and benefits for program staff
• Supplies and materials used in service delivery
• Travel for mission-related work

Administrative Expenses

Administrative expenses, often called management and general expenses or overhead, cover the costs of overall management and operational support. These costs are essential for the organization’s infrastructure and governance. Typical administrative expenses include:

• Executive and administrative staff salaries
• Office rent and utilities
• Accounting and legal services
• Insurance
• Costs related to board meetings

Fundraising Expenses

Fundraising expenses are costs incurred to solicit and collect contributions from donors. While necessary for sustainability, these expenses must be carefully managed for efficiency. Examples include:

• Costs associated with fundraising events
• Marketing and advertising for campaigns
• Salaries of development staff
• Donor management software

These expenditures are distinct from program costs as they focus solely on generating financial support rather than directly delivering services.

Expenses Related to Unrelated Business Activities

While most nonprofit income related to its exempt purpose is tax-exempt, nonprofits can “write off” expenses for Unrelated Business Income (UBI). UBI is defined by the IRS as income from a trade or business regularly carried on by a tax-exempt organization that is not substantially related to its exempt purpose. If an activity meets these three criteria, the income generated is generally subject to federal income tax.

Because UBI is taxable, a nonprofit can deduct ordinary and necessary expenses directly connected with generating this income. These deductions reduce the Unrelated Business Taxable Income (UBTI), similar to how a for-profit business reduces its taxable income. The tax rate applied to UBTI is typically the federal corporate income tax rate, which is 21%. Only expenses directly attributable to the unrelated business activity can be deducted against UBI; exempt purpose expenses cannot offset UBI.

Common examples of UBI include income from advertising in a nonprofit’s publication, operating a gift shop that sells items unrelated to the organization’s mission, or renting out facilities to non-members for events. For instance, if a museum operates a coffee shop open to the public, the income would likely be UBI, and its expenses could be deducted. Nonprofits must maintain separate accounting records for UBI activities to accurately track revenues and expenses. The IRS allows a specific deduction of $1,000 in computing UBTI, and organizations with gross UBI of $1,000 or more must file IRS Form 990-T to report this income and pay any tax due.

Managing and Reporting Nonprofit Expenses

Effective management of nonprofit expenses is essential for accountability, transparency, and compliance. Thorough record-keeping is a key requirement for all nonprofit organizations. This involves maintaining detailed documentation for all financial transactions, including:

• Receipts
• Invoices
• Bank statements
• Canceled checks

These records substantiate reported income and expenses, crucial for potential IRS audits or inquiries.

Implementing strong internal controls is another important aspect of expense management. Internal controls are processes designed to safeguard assets, ensure accurate financial data, and promote operational efficiency. Examples include segregating duties so no single individual controls an entire financial transaction, requiring multiple approvals for significant expenditures, and regularly reconciling bank accounts. These controls help prevent fraud, errors, and mismanagement of funds.

Nonprofits are required to report their expenses annually to the IRS on informational returns, typically Form 990, Form 990-EZ, or Form 990-PF, depending on the organization’s size and type. These forms provide the public and the IRS with an overview of the organization’s financial health and activities. On Form 990, expenses are reported using functional expense reporting, categorizing expenditures by function (program services, management and general, and fundraising) and by natural classification (e.g., salaries, rent, supplies). This detailed reporting demonstrates how funds are utilized to achieve the organization’s mission and ensures transparency. Records should be maintained for at least three years after the tax return due date; some, like organizing documents and tax-exempt status letters, should be kept permanently.