Since 2011, Princeton University has been fighting a lawsuit that challenges the institution's nonprofit designation and tax-exempt status. The lawsuit, filed by four Princeton, New Jersey, residents, could have widespread ramifications for nonprofits across the United States.

Why should Princeton lose its nonprofit status? The plaintiffs note that the university makes millions in royalties on patents, including a cancer drug discovered by a faculty researcher, which it shares with faculty. The university should also pay property taxes, the plaintiffs allege, because 19 campus buildings are used for commercial purposes, including McCarter Theatre, which charges admission to performances. The institution reports paying $10.8 million in property taxes and voluntarily contributed $2.5 million to its hometown in 2014. That's not enough to cover the university's fair share for public services, which shifts an unfair tax burden to local residents, plaintiffs say.

Nonprofits are not above scrutiny, but the criticism over their tax status stems from a misunderstanding of why and how they operate. People learn that a nonprofit earns millions and think, "That's a charity? Why shouldn't it pay taxes?" Such opinions are not about an organization's mission or effectiveness but its bank account. This lawsuit is the latest volley in a long-standing argument against charitable wealth. The salaries of executive directors at major national charities are routinely condemned as too high. In 2008, critics attacked U.S. universities for their large endowments, and Congress considered mandating that universities spend at least 5 percent of their endowments each year. That proposal died when the economy tanked and the largest endowments lost significant funds.

As a culture, we're ambivalent about high-revenue nonprofits. We accuse wealthy institutions of hoarding money in their endowments, yet these organizations routinely receive more and larger gifts than their low-revenue peers. We argue that nonprofit professionals should accept slim salaries to keep overhead low in order to do the most good, but we shame the poor for not earning enough money. Now, some contend that tax-exempt organizations with lucrative revenue streams are not really nonprofits.

But nonprofit status has never been determined by revenue. The logical conclusion of such an argument is that the more a nonprofit struggles, the more worthy it is. Charitable organizations have bills to pay, and insisting they struggle leads to low-quality services. Starvation diets are no better for an organization than they are for your body.

A world without nonprofits

Nonprofit status means several things. It symbolizes that an organization is trustworthy, signifies quality to customers or clients, and is—most important—a source of tax breaks both for the organization and its donors.

Nonprofits don't receive tax breaks out of some kind-hearted government sentiment. The U.S., like many other governments, recognizes that without nonprofits, it would need to provide more services to citizens. Whether that's educating more than 21 million college students in the U.S. annually or stocking food banks that feed 46.5 million people each year, the government is scarcely prepared to take over the work of the nonprofit sector.

What would happen if we removed the charitable status of Princeton and other financially successful nonprofits? If Princeton is vulnerable, so are charities such as the Red Cross, United Way, and others that generate resources through retail sales, like the World Wildlife Fund, which sells plush animals.

Perhaps the government could take over higher education, in which case Princeton would continue to not pay taxes as it would become a government agency. Given the decline of higher education funding, this isn't realistic. (Nor does the government seem inclined to increase spending for social services.)

Or perhaps institutions like Princeton could become for-profit entities. They would give up their tax advantages and much of their philanthropic income in exchange for greater freedom. For-profit colleges have been growing in the United States, as have for-profit hospitals. Such colleges have been accused in the popular press and by political leaders of poor-quality education, unethical recruitment, and burdensome student debt levels. Some derive more than 90 percent of their income from the government via federal grant and loan programs, hardly representing a savings to the taxpayer. Do we really wish to push more institutions to that model?

Amend it, don't end it

Certainly the government should exercise some influence over nonprofits. In 1983, the U.S. Supreme Court ruled 8-1 that the IRS was right to strip Bob Jones University of its tax-exempt status because of the institution's racially discriminatory admissions policies. The justices held that Bob Jones was fulfilling a charitable purpose (education) but that nonprofits' purposes and practices cannot be "so at odds with the common community conscience as to undermine any public benefit that might otherwise be conferred."

U.S. courts have repeatedly held it unlawful to penalize nonprofits based on the amount of revenue that goes to services versus administration. For example, in Schaumburg v. Citizens for a Better Environment, the Supreme Court held that an Illinois town ordinance that prohibited certain types of charitable solicitation by organizations that didn't spend at least 75 percent of funds on charitable operations was unconstitutional. There is simply no legal precedent for arguing that high income means a loss of charitable status. (Yes, that even applies to the NFL, a tax-exempt trade association of for-profit football teams. Critics of the NFL's nonprofit status rightly argue that the group is not serving any public need.)

Revisiting tax policy seems reasonable. Before resorting to the blunt "fix" of eliminating an organization's nonprofit status, many intermediate steps could be taken.

If a local government wished to eliminate non-federal tax breaks for nonprofits, that would likely be legal and equitable. It would also result in higher costs for nonprofits and could drive some out of business, placing a larger burden on governments to provide service. We may argue that feeding the hungry or clothing the poor is government's rightful job, but a cost-benefit analysis should be conducted to see whether tax breaks or the provision of these services results in lower government costs. Eliminating local tax breaks is a bad idea, but it's not illegal.

A more realistic option for local governments is to increase the use of payments in lieu of taxes (PILOTs are payments nonprofits make to local governments to offset tax revenue loss) to capture revenue from successful nonprofits, particularly those that own large plots of land. Government could also expand the use of unrelated business tax income. While scientific knowledge is rightly considered a charitable purpose, legislators should reconsider their reluctance to levy taxes on patent revenue. To the extent Princeton or any other nonprofit earns revenue on an activity outside its core purpose, we should consider taxing that revenue. But withdrawing the institution's exempt status over profits from a socially useful cancer drug seems like an extreme solution.

While it may be tempting to target organizations that earn large amounts of non-donative revenue, I'm not sure where we would draw the line. Charities will cut back on revenue-generating activities to avoid taxation, and we will create a climate in which only struggling nonprofits are deemed worthy. Unfortunately, poorly funded organizations tend to offer poor services.