Nonprofits are fueled by tax-deductible donations—cash from individuals, public grant funding, or money from foundations. As of 2010, nearly 1.3 million 501(c)(3) organizations were registered with the IRS; they raise more than $300 billion in charitable donations a year.

The Classic Example

The American Heart Association was founded in 1924 by six cardiologists seeking to prove that getting a diagnosis of heart disease wasn't the death sentence people assumed it was. In 1948, the association got smart about cause marketing, making its debut as a sponsor on the popular radio show Truth or Consequences. The partnership yielded $1.75 million in donations and propelled the organization into the national consciousness. The American Heart Association continues to use celebrity endorsements, corporate sponsorships, and other high-profile events to secure its spot as one of the country's leading public health education nonprofits. It took in nearly $510 million in public contributions in 2010.

The Model Works Best When

1. The user cannot pay.

2. The organization requires the perception of impartiality. When people donate to support a cause, they want the money to go to that cause, not to shareholders or the CEO's bank account.

The Advantages

Freedom from federal, state, and local taxes is a big plus. Launching a nonprofit also is generally less expensive than starting a for-profit. You don't have to give up equity for money; a nonprofit has no shares to give. Major foundations direct nearly all their funding toward 501(c)(3)s.

The Challenges

If your funders back away, you are in big trouble. (Charitable donations fell 3.6 percent in 2009.) In many cases, donations are restricted to specific projects; that can make it difficult for nonprofits to innovate and expand. And nonprofits don't offer much operating freedom; boards of directors typically control the purse strings and major hiring and firing decisions. Finally, 501(c)(3) groups must report assets, income, expenses, and executive salaries to the IRS; compensation is subject to review by the agency, which has increased the number of nonprofit audits it conducts more than 40 percent over the past two years.

The Tax Implications

Nonprofits are exempt from federal income tax. They can also receive tax-deductible donations of up to 50 percent of an individual's income and up to 10 percent of a corporation's income. Most states honor the IRS's exemption criteria.

The Newcomers

Global Grassroots
Based in Hanover, New Hampshire, Global Grassroots runs a social enterprise incubator for women in Rwanda. Because the incubator participants can't pay (most earn less than $2 a day), Global Grassroots—which raised about $220,000 in 2010—awards grants of $3,000 to $6,000 to cover their start-up costs.

The environmental conservancy group ForestEthics has secured the protection of 65 million acres of forest by helping the likes of Estée Lauder and Nordstrom make their business practices more sustainable. Though it takes in just $300,000 from research contracts with other nonprofits, the San Francisco–based group stays afloat, thanks to more than $2 million in annual charitable contributions.

charity: water
New York City–based charity: water takes in more than $10.7 million a year in public donations and corporate gifts and dedicates 100 percent of that to clean-water projects in 17 developing countries. To keep overhead low, charity: water funds local organizations to build water pumps and wells.