Non-Distribution Constraint

by Jonathan Collier

Definition 

The definition of non-distribution constraint has two elements to it. Firstly ‘non-distribution’ which is a negative definition in terms of telling us what cannot be done rather than what can be. In this element, the definition concerns the inability to distribute. Distribute meaning giving out or spreading resources or capital. If someone was told not to distribute something they would have to hold on to whatever they are being told they could not distribute. In this case it is commonly profit or money made by the organization. ‘Non-distribution’ in more simple terms means something that cannot be given to another person, group, organization or cause. 

The second element is ‘constraint’ which gives a negative impression of imposed limits to how a person, organization or cause can act. Combining the two elements makes the ‘constraint’ element more evident. The limitation on distribution means that an organization that identifies as nonprofit will not have as much freedom in how they operate.  

Therefore together the idea of a ‘non-distribution constraint’ can be applied to non-profit organizations as they are not allowed to freely distribute their profits or capital. This concept does not however, say that they must not make a profit and more specifically does allow some distribution but only related to the organizations cause or mission (Hansmann, 1980). The non-distribution constraint effectively means that such organizations are not allowed to distribute profits to stakeholders or employees. This is seen to increase trust as the constraint limits the ways in which companies could be seen as potentially wasteful. 

Historic Roots 

The emergence of the non-distribution constraint aligns with the growth of official structured non-profit organizations. The concept allows academics and theorists to better understand why non-profits may have an advantage in certain environments than for-profit counterparts (Anheier, 2014. Payton & Moody, 2008). Academics commonly cite the non-distribution constraint as a beneficial concept for non-profit organizations even though it does have negative associations within its definition. 

Henry Hansmann is often noted as coining the concept as part of a wider non-distribution theory in 1980 (Hansmann, 1980). The concept has always been present however, the idea that charities and foundations would have to use their resources to help their cause has existed as long as philanthropic activity and associations have existed. Hansmann addresses this concept by stating that non-profit organizations are established noting that they are not intending or being operated for financial gain (Hansmann, 1980). 

As the concept is very related to finance, it has also been defined under other terms in law. The Internal Revenue Code which governs tax rules sees the non-distribution constraint in the Inurement Prohibition. This prevents the use of organizations profits or resources benefiting individuals close to or involved in the organization. Organizations known as 501(c)3’s in the US are the most common form of organization ruled by these constraints. The inurement prohibition places the same limitations on such organizations as the non-distribution constraint but is effectively the legal definition of the non-distribution constraint (Fishman, 2015). These codes are the more contemporary developments of the non-distribution constraint while the concept emerged from common understandings of what good charitable or philanthropic organizations would do with donations or gifts. 

Importance 

The non-distribution constraint should be seen as very important simply because it is relevant to all forms of organization that are established as a non-profit. It also governs a large amount of philanthropic activity in the sense that donations or gifts to good causes, people or organizations are given in the faith that they will be used toward the achievement of the objectives that were set out (Anheier, 2014. Payton & Moody, 2008). This is why more donations and gifts go toward non-profit organizations than for-profit competitors. This also raises the importance of understanding that the non-distribution constraint can develop trust for organizations. In the sense that the constraint limits how much donations or gifts could be misused or simply given to high ranking employees or interested individuals in the organization. 

By doing so it also is a factor in encouraging donations to the organization as donors are more likely to give as a result of knowing that the organization is not as motivated by a profit (Mori, 2018). This is created through the fact that most financial support has to be utilized for its cause and it cannot maintain a surplus.  

While non-profits can indeed pay salaries and wages to workers, this has to be reasonable and this factor works within the non-distribution constraint to ensure that donor money is not used to simply pay higher wages to staff. Furthermore if the money is more than needed for a specific program it must be utilized toward another similar cause that is aligned with the wider purpose or goals of the non-profit organization. 

This concept and wider theory is based on the assumption that it is enforced perfectly across all non-profits. Examples where this is not the case irreparably damage the trust in such nonprofit organizations (Mori, 2018. Valentinov, 2008). While it is therefore not a perfect concept or one that can be perfectly enforced across the large number of nonprofit organizations it is still a significant influence on the greater trust the nonprofit sector sees for certain causes when compared to its for-profit counterparts. 

Ties to the Philanthropic Sector 

The non-distribution constraint has clear ties to the philanthropic sector since the concept itself influences how the sector operates. In addition to these ties however are the importance of the ideas that created the concept itself which are fundamental to philanthropic activity. The main idea of the non-distribution constraint is that giving should be used for its proper or intended purpose rather than personal gain (Anheier, 2014. Payton & Moody, 2008). 

Perhaps understanding the basis of the non-distribution constraint as the desire to ‘do good’ as best as possible highlights why it is so influential in the philanthropic sector and for non-profit organizations. If the constraint did not exist then for-profits and non-profit organizations would in effect be the same. 

Key Related Ideas 

• Non-Profit Organizations - Organizations that operate with the non-distribution constraint and cannot distribute a profit to stockholders or employees 
• Inurement - private benefit from donations or gifts to a non-profit organization in terms of employees taking from funds for their own gains and reducing the ability for the organization to complete their own mission. 
• Self-Dealing - the idea of taking actions that would benefit the individual rather than the business 
• Non-Profit Taxation - non-profit organizations are often taxed differently due to being judged on their mission rather than profit. The non-distribution constraint is part of what creates the different objectives of non-profit organizations. 

Important People related to the Topic 

• Henry Hansmann - originator of the non-distribution constraint concept 
• IRS (Agency) - More so than one individual, the IRS is important as it has a significant impact on the imposing of the non-distribution constraint 

Related Nonprofit Organizations 

All nonprofit organizations are related to the concept through the definition of their work. All nonprofit organizations are in effect governed by the nondistribution constraint and should be studied with relation to this concept. 

• IRS and IRC code regulations section, https://www.irs.gov/  The Internal Revenue Service is the federal branch that governs taxation and therefore governs the certification and regulation of nonprofit organizations. The following link is the exemption requirements for 501c3 organization which includes the non-distribution constraint laws. https://www.irs.gov/charities-non-profits/charitable-organizations/exemption-requirements-501c3-organizations  
• State Attorney Generals: https://www.justice.gov/ag  
  Indiana Specific: https://www.in.gov/attorneygeneral/ 
  Attorney Generals operate at both the federal and state level and legally enforce the laws and regulations for nonprofit organizations. If a nonprofit broke the nondistribution constraint the attorney general would be brought in to either stop the organization or enforce compliance. 
• Charity Navigator https://www.charitynavigator.org/  Regulating and overseeing organizations charitable activity, allowing the public more easy access to both giving and information. 
• CharityWatch https://www.charitywatch.org/  A watchdog for charities keeping such organizations accountable and overseeing activity. 

Reflection Question 

What are the drawbacks and benefits to operating under the non-distribution constraint for non-profit organizations when compared to for-profit companies? 

Bibliography 

• Hansmann, Henry. 1980. ‘The Role of Nonprofit Enterprise’. Faculty Scholarship Series. 5048 
• Valentinov, Vladislav. 2008. ‘The Economic of non-distribution constraint: A critical reappraisal’. Annals of Public and Cooperative Economics 79:1. 
• Mori, Pier Angelo. 2018. ‘Non-Profits and the Profit Non-Distribution Constraint with Selfish Entrepreneurial Motivations’. Euricse Working Papers, No.100/18 
• Anheier, Helmut. 2014. Nonprofit Organizations: Theory, Management, Policy, 2nd edition. Routledge 
• Payton, Robert, and Michael Moody. 2008. Understanding Philanthropy: Its Meaning and Mission, Indiana University Press 
• Fishman, James et al. 2015. Nonprofit Organizations. Cases and Materials, 5th edition. LEG Inc. 

This briefing paper was authored by a student taking a philanthropic studies course in 2019 at The Lilly Family School of Philanthropy