Ask people what it means to be a non-profit business organization and you’re likely to get an array of answers, many of them incorrect. For people who aren’t familiar with the ins and outs of how non-profits work, it can be confusing to hear about executive and employee compensation and earnings.

But, guess what? It’s an actual thing!

Because non-profit organizations provide essential services, it’s important for the people who interact with non-profits to understand how they work and especially, how non-profit business owners get paid. Here’s what you need to know.

So, What Does It Mean to Operate as a Non-Profit Business?

 Let’s start at the beginning with an explanation of what it means to be a charitable non-profit organization. According to the IRS, a non-profit charity is:

• In operation for one or more of the exempt purposes set forth in section 501(c)(3) of the tax code, including charitable, religious, educational, scientific, literary, testing for public safety, fostering natural or international amateur sports competition, or preventing cruelty to children or animals.

• Of a charitable nature, using the generally accepted legal sense of the word. Examples include relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erecting or maintaining public buildings, monuments, or works; lessening the burdens of government; lessening neighborhood tensions; eliminating prejudice and discrimination; defending human and civil rights secured by law; and combating community deterioration and juvenile delinquency.

The IRS also states that “no part of a section 501(c)(3) organization’s net earnings may inure to the benefit of any private shareholder or individual.”

A non-profit charity takes in money from donations and other sources. The key part of the IRS definition is that the net earnings may not profit any shareholder or individual.

What’s Included in the Net Earnings of a Charitable Organization?

The area of the IRS definition that confuses people is the bit about net earnings. Let’s talk about what is included in net earnings.

For any business, net earnings (sometimes called net income) are calculated by subtracting operating expenses from revenue. Non-profit charities get revenue from donations, grants, and memberships. They may also get revenue from selling branded products.

A non-profit organization’s expenses may include:

• Rent or mortgage payments
• Purchase of necessary supplies
• Transportation/Gas
• Utilities
• Money for essential services
• Employee salaries and compensation

The last item is one that can cause a great deal of confusion, particularly when some charities are in the news for what seem to be unnecessarily high salaries paid to executives.

How Do Non-Profit Business Founders Earn Money?

The number one question people have about running a non-profit is how non-profit owners – who are usually referred to as founders – get paid. If the IRS rules say that the earnings of a non-profit may not “inure to the benefit of any shareholder or individual,”

…how is it possible that non-profit owners and employees can earn a salary for the work they do?

Let me try to break it down for you.

The IRS differentiates between a benefit and fair compensation for work that is done. A non-profit founder may pay themselves a fair salary for the work they do running the organization. Likewise, they can compensate full-time and part-time employees for the work they do.

Non-profit founders earn money for running the organizations they founded. They often put in long work hours and make far less money than executives at for-profit organizations. When running a non-profit is their sole employment, it is reasonable for them to draw a salary for the work they do.

One of the things that can lead to confusion around the issue of compensation for non-profit owners is that there is no hard-and-fast rule about how much they may be paid. However, the IRS can and does penalize organizations that overpay executives or employees.

You may have seen stories in the news about unscrupulous non-profit charities and their mismanagement of money. One of the most infamous cases was the one involving the United Way, whose former CEO was convicted of fraud in 1995.

The bottom line is that non-profit founders and employees are paid from the gross revenues of the organization. These salaries are considered part of the operating costs of the organization.

What is Considered Reasonable Compensation?

The primary guidelines for both executive compensation and employee compensation at non-profit organizations are that the wages paid must:

1. Meet all local, state, and federal guidelines for the minimum wage; and
2. Be reasonable, fair, and not excessive; and
3. Include all benefits as part of the total compensation package.

Non-profit charities must walk a fine line between keeping their operating expenses low and competing with the for-profit sector for qualified employees; not an easy task. It is the responsibility of every charity to navigate the process of determining fair salaries that also manage to be competitive enough to attract the employees they need.

For executives, the road can be very difficult to travel. The recommended best practices from the Council of Non-Profits says that:

1. Executive salaries must be disclosed to and approved by the non-profit’s executive board on an annual basis.
2. The compensation voted upon must include all benefits.

In other words, a non-profit founder’s compensation package might include:

• An annual salary
• Medical benefits
• Paid time off
• A pre-approved bonus structure

Having the board vote on an executive’s compensation package is one of the best ways to ensure that the payment is not excessive and that it allows the bulk of the charity’s revenue to be put toward the organization’s mission.

How to Check on a Non-profit Business

When you interact with a charitable organization, whether it’s as a donor, member, or recipient of goods or services, it’s important to do some research to determine the charity’s status regarding its financial management, including employee compensation.

There are several organizations that track charities and grade them based on how they operate. They are:

• CharityWatch
• Charity Navigator
• GuideStar
• GiveWell

These organizations track and rate charities based on criteria that may include:

• The charity’s classification
• Its descriptions of its activities and financial management
• In-depth review of financial statements
• In-depth review of tax returns

The goal with the ratings is to provide the public with a tangible way to measure a charity’s financial status and management of funds. The drawback is that in most cases, a charity must have at least seven years’ worth of financial reporting and tax returns to get a rating. That means that newer charities may not yet be rated as in the case with Blue Heart.

Although Blue Heart has been around for 10 years, it’s only been in the last 2-3 years that we have actually been receiving help from grant monies.

If a charity is not rated, there are still some ways to get a feeling for how a charity operates. One popular method is to examine the charity’s overhead percentage. On average, charities spend about 20% of their revenue on overhead.

However, the percentage of overhead being high is not necessarily an indication that the charity is misusing funds or even overspending. In fact, charities that skimp on overhead may not operate as efficiently as they could – and that inefficiency can have a negative impact on their ability to deliver services to the people who need them.

What’s The Point

Before you start coming up with speculative assumptions about how a Non-profit business should get paid, understand that both executives and employees of charitable organization must receive fair compensation for the work they do. Volunteers play a role as well, but people who are employed by non-profit organizations in an official capacity are paid according to their experience and responsibilities. That includes executives and owners, many of whom put in long hours to ensure that the charities they work for meet their obligations to the communities they serve.