Non-Distribution Constraint

By Kate Korslin

Graduate Student, Center on Philanthropy at Indiana University

The Non-Distribution Constraint states that a nonprofit organization is prohibited from distributing its net earnings among individuals who oversee the organization. This includes board members, staff and directors.

The Non-Distribution Constraint, as explained by Henry Hansmann, "A nonprofit organization is, in essence, an organization that is barred from distributing its net earnings, if any, to individuals who exercise control over it, such as members, officers, directors, or trustees. By 'net earnings' I mean here pure profits—that is, excess of the amount needed to pay for services rendered to the organization; in general, a nonprofit is free to pay reasonable compensation to any person for labor or capital that he provides, whether or not that person exercises some control over the organization. It should be noted that a nonprofit is barred from earning a profit. Many nonprofits in fact consistently show an annual accounting surplus. It is only the distribution of these profits that is prohibited. Net earnings, if any, must be retained and devoted entirely to financing further production of the services that the organization was formed to provide." (Hansmann 1980, 835)

Historic Roots

The idea of non-distribution constraint and taxation differences in nonprofit versus for-profit organizations first emerged with the passage of the sixteenth amendment.

The sixteenth amendment reads that "Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration." This amendment created the federal income tax. Shortly thereafter the U.S. Tariff Act of 1913 was passed, which excluded public benefit nonprofits such as churches from paying federal income tax. Specifically this act exempted organizations in which "no part of the net income of which inures to the benefit of any private shareholder or individual" was exempt from the federal income tax. (Hopkins 1998, 32)

These organizations were made exempt due to the fact that they operated under the non-distribution constraint. This idea put into effect in 1913 remains in effect today. However, it was not formally referred to as the non-distribution constraint until 1980 in Henry Hansmann´s Yale Law Review article, "The Role of Nonprofit Enterprise." During this era and into today the nonprofit sector has become more widely recognized, studied and legalized.

Importance

The non-distribution constraint is essentially what makes an organization non-profit and sets it apart from government and business organizations. Nonprofit organizations are unique in that they are prohibited from distributing their net earnings to any stakeholders. However this does not mean that nonprofit organizations are solely comprised of volunteers. A nonprofit is free to pay its staff and directors a just compensation. What is deemed just can vary from organization to organization. Ideally, a just compensation should be comparable to other compensations in similar nonprofit organizations.

There are many theories as to why the nonprofit sector exists and works in America. Many point to the fact that the non-distribution constraint creates greater service and accountability since nonprofits have no profit motive. Hence nonprofits are only interested in reinvesting their assets in their mission and increasing the quality or availability of the service(s) they are providing.

Ties to the Philanthropic Sector

The non-distribution constraint creates incentives for Americans to donate to nonprofits in two major ways. First of all, the non-distribution constraint assures donors that their donations are supporting the mission of their chosen nonprofit. Due to the non-distribution constraint, their donations cannot support frivolous salaries or spending. Second of all, the non-distribution constraint, by qualifying an organization for tax-exempt status (one of many criteria to achieve tax-exempt status), creates a tax incentive for donors. Donors that chose to support these organizations are permitted to deduct these donations from their taxes.

Nonprofits are held accountable by the non-distribution constraint on their tax form, the 990. On this form nonprofit tax-exempt organizations are required to list salaries of executives as well as complete income statements for the fiscal year.

Key Related Ideas

Six Characteristics of a Nonprofit

1. Organizations are institutionalized to some extent
2. Private or not a part of government
3. Non-profit-distributing
4. Self-Governing
5. Voluntary or noncompulsory and involving some meaningful degree of voluntary participation
6. Serve some public benefit and contribute to the public good (Salamon 1999, 10-11)

The Contract Failure Theory developed by Henry Hansmann explains that nonprofits exist based on the trust inherent in nonprofits versus their for-profit counterparts. Due to the fact that nonprofits are mission driven versus profit driven people are more apt to trust a nonprofit organization. The non-distribution constraint also provides added insurance in their work. An example of this theory can be seen in a for-profit versus nonprofit daycare. Consumers of a nonprofit center may find the fact appealing that their money can only be reinvested in the daycare center. And as a result, that the nonprofit center will provide a better daycare for their children. (Hansmann 1980)

"According to the Internal Revenue Code, to qualify as a 'Charity' and thus be tax exempt from taxation and eligible to receive tax-deductible donations, an organization must (1) serve some charitable purpose, (2) not distribute net profits to individuals who control the organization, and (3) refrain from certain kinds of political activity." (O´Neil 2002, 5)

Important People Related to the Topic

• Henry Hansmann (Born 1945): He developed the term "non-distribution constraint" in his 1980 Yale Law Review Article entitled "The Role of Nonprofit Enterprise" to describe a nonprofit´s inability to distribute profits among stakeholders. He is currently a Professor of Law at Yale University.
  

• The State Attorney General oversees the complete workings of nonprofit organizations on a state-by-state basis. Nonprofit law varies on a state-to-state basis.
  

  The oversees the complete workings of nonprofit organizations on a state-by-state basis. Nonprofit law varies on a state-to-state basis.

• Woodrow Wilson (1856-1924): President Wilson put the 1913 Tariff Act up for consideration in his appearance before congress. He brought special attention to the appeal by appearing before congress himself. (U.S. History)

Related Nonprofit Organizations

• National Association of Attorney Generals whose mission is "To facilitate interaction among Attorneys General as peers. To facilitate the enhanced performance of Attorneys General and their staffs." The State Attorney General holds nonprofits accountable for their actions and their adherence to the non-distribution constraint (http://www.naag.org/).
  
  
• The National Council Nonprofit Associations (NCNA) is a membership-based organization of state and regional associations that represent thousands of nonprofits throughout the country. They work at the state and local level to provide training and technical assistance to improve the operations and effectiveness of organizations while promoting the value and accountability of the nonprofit sector (http://www.ncna.org/).
  
  
• The Independent Sector is an organization that seeks "to advance the common good by leading, strengthening, and mobilizing the independent sector." They help to strengthen nonprofits, citizen action and democracy. (http://www.independentsector.org/about/about-is.htm)

Related Web Sites

Due to the non-distribution constraint, non-profit organizations must report their financial information to the government on their 990 Form. This allows government to make sure that the organization is adhering to the non-distribution constraint. A page on the website of the Nonprofit Coordinating Committee of New York, http://www.npccny.org/Form_990/Working_a_990.htm, explains how to read and understand a 990 form.

The Exempt Organizations Division of the Internal Revenue Service has a website that offers information on how to file for exemption, how to do tax filing for already established nonprofits and much more. This division of the IRS works to enforce the non-distribution constraint. More information can be found on their webpage, http://www.irs.gov/charities/index.html.

Some believe that the IRS is not working hard enough in their enforcement and policing of nonprofit organization. Quality 990´s website explores current activities and projects to increase IRS action, http://www.qual990.org/index.html.

Bibliography and Internet Sources

Hansmann, Henry. "The Role of Nonprofit Enterprise". The Yale Law Journal, Volume 89, Number 5 (1980): 835-902.

Hopkins, B.R. The Law of Tax-Exempt Organizations. New York: Wiley, 1998. ISBN: 0471196290.

O´Neil, Michael. Nonprofit Nation. San Francisco: Jossey-Bass, 2002. ISBN:07879514144.

Quality 990: Increase IRS Form 990 Reporting. Nonprofit Accountability: The Sector's Response to Government Regulation. Accessed 23 October 2004. http://www.qual990.org/index.html

Salamon, Lester. America's Nonprofit Sector: A Primer. New York: Foundation Center, 1999. ISBN: 0879548010.

U.S. History. Tariff of 1913. Accessed 23 October 2004. http://www.u-s-history.com/pages/h1053.html