A 501(c)(3) nonprofit can still generate earned income. And plenty do. The National Center for Charitable Statistics estimates that nearly 70 percent of the $1.4 trillion generated by nonprofits in 2008 came from the sale of goods and services.

The Classic Example

The Girl Scouts of the USA is synonymous with cookies—thanks to a troop in Oklahoma that began selling cookies in 1917 to raise funds. The Girl Scouts was founded in 1912, with the goal of teaching girls practical life skills. The cookie business did just that, while giving the organization a financial boost as well. Now the Girl Scouts, which has 3.3 million members, generates more than $700 million in annual revenue from the cookie program.

The Model Works Best When

1. The nonprofit has a valuable product or expertise. An education nonprofit, for instance, could sell tutoring services. As long as the product or service is directly related to the mission, the income remains tax exempt.

2. The user has some ability to pay.

3. The nonprofit's mission is job training or skill building. According to IRS regulations, organizations that help certain classes of individuals—refugees or homeless people, for example—find jobs are permitted to become employers themselves.

The Advantages

Generating income frees an organization from total dependence on philanthropic dollars. At the very least, the income is a safety net; it also means more money to invest in the mission. Unlike many grants, earned income is unrestricted and can be used however the organization chooses. Finally, nonprofits with earned income retain all the advantages of pure nonprofits—including tax exemptions, ability to receive tax-deductible donations, and eligibility for nonprofit-exclusive grants from major foundations.

The Challenges

Nonprofits with substantial earned income usually have two staffs: one to work on philanthropic goals; the other to handle tasks like sales, marketing, and customer service for the business side. This makes them more costly to run and poses the risk of conflict of interest. All 501(c)(3) organizations must give priority to the nonprofit's stated mission. That can often make it difficult for income-generating arms to pursue opportunities.

The Tax Implications

If the IRS decides that a nonprofit's business efforts are not "substantially related" to its mission, the earned-income is subject to taxes. The nonprofit's 501(c)(3) status is jeopardized, too. To qualify as substantially related, the business has to specifically accomplish the nonprofit's goals. Say a women's shelter opened a bakery to supplement grants and donations. That would likely be considered unrelated to the organization's mission—unless it was staffed by women from the shelter. The question is so subjective, though, that nonprofits have found themselves tied up in legal squabbles with the Feds for years.

The Newcomers

Founded in 1999, this Austin nonprofit offers low-cost spay and neuter services. It generates more than $1.7 million a year, performing about 1,400 surgeries a month—which gives Emancipet enough money to offer free spay and neuter services to 60 percent of its clients.

Living Goods
Taking a cue from Avon's direct selling structure, San Francisco–based Living Goods employs rural Ugandans to sell health products, like deworming pills, at a fraction of the market cost. The so-called health promoters pay Living Goods for the products and sell them at a profit—a model known as microfranchising.

Digital Divide Data
Digital Divide Data trains poor Cambodians and Laotians in basic computer skills—and then hires them to perform tech services for major U.S. corporations, universities, and government agencies. Income from these contracts now amounts to $2.7 million, double the New York City–based group's charitable funding.