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Wednesday, March 22, 2023

What Even Is a Non-profit?

Ask an Economist #10

Image Credit: Flickr - Sam Beebe | CC BY 2.0

For “Ask an Economist” this week I have a question from Hal who asks, “What is the difference between a ‘non-profit’ and a ‘not for profit’?”

In order to address this question, I think it’s important to discuss what separates a for-profit business from these two forms of organization.

To understand the former, we first have to think about what it means to own something at all.

Economic Ownership

When we think of owning something, we usually think of it in the binary. Either you own something or you don’t. This categorization might be true and useful in some sort of legal or normative sense, but it isn’t the only useful way to think about ownership.

Economist Armen Alchian conceived of economic ownership as having multiple attributes. The first attribute of ownership is the ability to decide how a good or service is used. We can summarize it as:

1. Economic owners have the right to determine how an asset is used.

When you scroll through this story with your phone or mouse, you’re determining how it is used. This means you have some control over the asset. Economists call this “control rights.”

It’s not necessarily the case that control rights are morally legitimate. It’s possible for people to control property that is not legally their own. But the fact remains that to be the true owner of an asset, in an economic sense, you must be able to determine how it is used.

One important note about control rights is they are not optional. When anti-capitalist idealists talk about a society “without property,” they’re merely talking about a world where the law says that no one is the owner.

Nonetheless, it’s inconceivable that there will ever be a world where goods and services are not used at all. So long as they are used by someone, that person is exercising an economic property right.

A world without property rights is a world without people. We cannot live without controlling things like food, water, and shelter.

The next two attributes of property rights are:

2. Economic owners have the right to receive a stream of income from their property.

3. Economic owners have the right to sell their property.

Unlike the first attribute of property, these two attributes can be removed entirely. It’s possible to make someone unable to sell or receive a stream of income from an asset. This possibility is central to understanding for-profit, non-profit, and not-for-profit businesses.

Profit vs. Non-profit vs. Not-for-Profit

So what makes a for-profit business distinct? To put simply, in for-profit businesses, owners have, for the most part, all three of the attributes of property rights. The owner of a for-profit business can use the business’s assets (and hire others to use them), they can receive a stream of income from the operation of the business, and they can sell the business.

At the end of the year, when the books are done and the company receives more revenue than cost, they earn a profit. The owners can decide to take the profit themselves, or they can reinvest the profit into the business (thereby increasing the value of the business they own and can sell).

What about non-profits? In the US, the law claims non-profits have no owners (or sometimes that they are owned by the public). In some sense though, this is not true. Insofar as non-profits have assets, those assets are used by someone. So whether it’s the board of directors or the employees, someone does own the right to use the property of the non-profit.

However, it’s true that no one in a non-profit has the legal right to sell the assets of the organization in part or as a whole. So there is ownership (in terms of control rights) in non-profits, but there are no sale rights. Ownership is attenuated.

So what happens when revenues exceed costs in non-profits? In these cases, the organization is legally required to use the excess revenues to improve the non-profit or fulfill its mission. Excess revenues must be re-invested.

But this is where we need to dispel a common myth about non-profits. You might think that being a non-profit means the chief executive is paid less than the CEO of a for-profit company. This belief, though understandable, is wrong.

The chief executive of a non-profit is paid a salary which counts as a business expense. As such, when revenues are higher than costs, the non-profit could always choose to increase the salary of the executive.

Technically, the board of directors of the non-profit would be responsible for avoiding situations where executives receive exorbitant salaries which expand to fill every revenue surplus, but due to knowledge and incentive problems this may not always happen.

This brings us to our last form of organization and the center of Hal’s question—what about a not-for-profit. Note a non-profit and a not-for-profit are different forms of business organization. Confusing, I know.

Generally non-profits are classified as 501(c)(3)’s by the IRS whereas not-for-profits are classified as 501(c)(7)’s. Let’s call this new type of organization an NFP to make the discussion more clear.

An NFP, in theory, has one primary difference from a standard non-profit. The language varies by state, but generally non-profits are supposed to be created for the benefit of society as a whole. In contrast, NFP’s are created for the benefit of the members of the NFP, but the organization does not provide benefit to the members via profit.

So just like standard 501(c)(3) non-profits, the members of an NFP are unable to sell the organization as a whole. They are also limited in particular ways on how much income they can draw from the organization.

So the main difference between a non-profit and an NFP, from an economic perspective, is regarding control rights. Non-profits are expected (at least by the legal system) to use assets to forward some socially aimed goal. They are not meant to be treasure troves for the board, the chief executive, or other employees.

On the other hand, NFPs are meant to use assets specifically for members.

Because of this difference, the legal system treats them differently. Non-profits, for example, have more tax advantages and the ability to create subsidiary organizations. But, on the flip side, these benefits come with strings attached. Non-profits also have more rigorous financial reporting requirements with the IRS than NFPs do.

There are several other differences between non-profits and NFPs, but, as far as I can tell, most of them seem to follow the logic that non-profits are supposed to be more constrained in the control rights of assets and therefore there is higher accountability to match the better tax incentives.

  • Peter Jacobsen is a Writing Fellow at the Foundation for Economic Education.