Choosing a Public Charity or Private Foundation for Your Nonprofit
If you are able to be a charitable organization under Section 501(c)(3), you must determine whether your organization is a public charity or a private foundation.
All new charitable organizations are presumed to be private foundations unless they can pass certain tests and become public charities. There are three ways to be classified as a public charity qualifying automatically, passing the public support test, or passing the facts and circumstances test. These are spelled out in detail in IRS Publication 557 and are summarized below.
A charity automatically qualifies as public if it is one of the following types of organizations:
- a church
- a school with formal instruction and a regularly enrolled student body
- a hospital
- a medical research facility
- a public safety organization
- an organization that supports one of the above
Public Support Test
If a charity does not qualify automatically for public charity status, it can qualify if it receives broad public support. For this, the IRS requires an organization to receive a substantial amount of its total financial support from public support sources, such as donations from the public.
If a nonprofit organization cannot qualify for public charity status through any of the above tests, it will be classified as a private foundation. As a private foundation, it must comply with the rules under the I.R.C. It must:
- distribute income each year so as not to be subject to Section 4942 tax
- avoid any self-dealing as defined in Section 4941(d)
- avoid retaining business holdings as defined in Section 4943(c)
- refrain from any investments taxable under Section 4944
- refrain from any expenditures as defined in Section 4945(d)
- pay an excise tax on its investment income
Donors who give to a private foundation can only deduct up to 30% of their adjusted gross income, whereas for a public charity, they can deduct up to 50%.
Private Operating Foundations
If a private foundation can become classified as a private operating foundation, it can qualify for donors to be able to deduct up to 50% of their contributions, and it can be relieved of the requirement to distribute funds received from private foundations within one year. To qualify, it must meet the asset test, the support test, or the endowment test, and it must distribute 85% of its income each year.
Under the assets test, 65% or more of assets are devoted directly to exempt activity or a related business, or consist of stock in a corporation that is 80% controlled by the foundation, and at least 85% of assets are devoted to exempt activity or related business. Under the support test, at least 85% of support comes from the general public, not more than 25% comes from one exempt organization, and not more than 50% of support comes from investments. Under the endowment test, at least two-thirds of its minimum investment return is distributed directly for exempt functions. (Minimum investment return is 5% of excess of value of exempt assets over the indebtedness to acquire those assets. For more information, see IRS Publication 557.)
Exempt Operating Foundations
A third possibility for a private foundation is to qualify as an exempt operating foundation. As an exempt operating foundation, an organization does not have to pay the excise tax on net investment income. A private operating foundation can qualify as exempt if it has been publicly supported for at least ten years, has a governing body that broadly represents the public, and has no officers and no more than 25% of the governing board as disqualified individuals (major donors or their family members). You can see IRS Publication 557 for more details about these rules.