Updated: Jun 11, 2020
The realm of public charities and private foundations in the Internal Revenue Code (IRC) can be dense, confusing, and, lets be honest, downright boring. In this discussion I hope to bring some levity to the world of IRC 501(c)(3) organizations, and lay out the basic differences and similarities between private foundations and public charities.
Qualifying as a tax-exempt organization under IRC 501(c)(3) is essentially a two-step process. Step one is determining whether your organization is operated for an “exempt purpose”. Operating for an exempt purpose means engaging in activities that further religion, education or prevention of cruelty to animals; or fall into a number of charitable activities including the promotion of social welfare and human rights. If your organization is operating for an exempt purpose, step two is determining whether you qualify as a public charity or private foundation.
Organizations operating for an “exempt purpose” under IRC 501(c)(3) are classified as either a public charity or private foundation. A public charity is typically what you think when you hear the word nonprofit - these are organizations with broad public support that want to be able to solicit public donations.
Public charity is in most cases the more desirable designation, as it offers a number of benefits including higher donor tax-deductibility giving limits, and the ability to attract support for other public charities and private foundation. In addition, public charities have the option of filing less complicated tax returns (form 990-EZ or 990-N) based on annual revenue, where private foundations must always file the exceedingly complex Form 990-PF, regardless of revenue.
So how do you become a public charity? First off, the applicant for 501(c)(3) status must affirmatively prove to the IRS in its application why it should be considered a public charity. Otherwise, you will be considered a private foundation by default. There are a number of different tests that can be used to prove an organization qualifies for public charity status, and the organization must select the test it wishes to use.
Some organizations automatically receive public charity treatment, such as medical research orgs, church associations, or universities. All other organizations seeking public charity status must prove they qualify by showing that they satisfy one of two tests, either by qualifying as a public support organization under IRC 509(a)(1), or by qualifying as a fees and activities support organization under IRC 509(a)(2). The public support test – or the “one-third public support test” - is met if at least 33% of revenue comes from donors who give less than 2% of the organization’s income, other public charities, and/or the government. If you fail all of these tests, you will by default be treated as a private foundation.
Finally, to qualify for and keep public charity status, an organization must include language in its articles of incorporation explicitly stating that it is organized for a specific exempt purpose, and also state that the organization’s assets are dedicated to that exempt purpose upon dissolution. In addition, at least 50% of the organizations board must be unrelated by blood, marriage or outside business relations.
In one sense, private foundations are simply charitable organizations that failed to meet the tests outlined above to become public charities. In reality, it usually means the organization was established with funds from a single source, such as family money or corporate donations, and never intended to qualify as a public charity in the first place.
Private foundations typically use their proceeds to make grants or gifts to other non-profit organizations, such as universities or hospitals. This is why private foundations are often considered organizations that support the work of public charities.
Though often considered the less desirable fallback, there are some advantages to operating as a private foundation. Unlike public charities, private foundations can be controlled by related parties, and can be funded by a much smaller group of donors – even a single family, individual or corporation. This can provide the founders with significantly more control. Whether the increased control is enough to overcome the drawbacks - such as minimum annual asset distributions and deductible limits for donors - is a decision that must be made on a case-by-case basis.
While I hope you found this article helpful, it merely scratches the surface of IRC 501(c)(3) and the many considerations that come in to play for founders deciding whether to apply for tax-exempt status. If you are interested in starting a non-profit organization in or around Portland, Oregon, or simply want to learn more about your options, contact us.