Part 3: Presumed Private until Proven Public

In our first installment in this series on nonprofit formation, we discussed what organizations and activities can qualify for tax exemption and what to consider before starting a nonprofit. In Part 2, we discussed selecting your organization’s initial directors and officers and drawing up your organization’s governance documents.

In this post, we will discuss the different categories of nonprofit organizations that the IRS recognizes as tax-exempt under Section 501(c)(3). These include public charities, private foundations, and private operating foundations. When you apply for exempt status from the IRS, you will need to specify which of these categories your organization fits into. Misclassifying your organization can result in significant problems down the road and converting from one category to another can take up to five years. So it’s important to understand these categories up front so that you can be confident which of them best fits your organization.

Nonprofits With Legs: Public Charities

Most active 501(c)(3) organizations are public charities. Public charities are nonprofits that do things. They engage in tax-exempt activities. Public charities include churches, hospitals, aid and relief organizations, Little League clubs, private schools, and other nonprofit organizations that conduct religious, educational, and/or charitable activities.

Because public charities do important things that help society, the IRS generally allows donors to these organizations to deduct donations to public charities up to 60% of their gross adjusted income. Public charities also generally have easier annual reporting requirements compared to private foundations.

If your nonprofit organization idea is in the realm of doing things (which most are), then you need to make sure that it can and will meet the requirements for being a public charity. First, in order to be a public charity, an organization must show that it receives (or will receive) a substantial part of its funding from a broad base of public support or government sources and not from just a handful of large donors. This is known as the “Public Support Test.” Second, the board of a public charity must be mostly comprised of directors who are not related to one another by blood, marriage, or outside business relationship.

The gist of these requirements is that a public charity cannot be closely-governed or closely-funded by family members or business partners. Each of these requirements have lots of nuanced exceptions, caveats, and criteria under the tax code and IRS regulations. Organizations should consult with knowledgeable legal counsel or a tax professional to make sure they comply with these rules for obtaining and maintaining public charity status.

Nonprofits With Pockets: Private Foundations

Not all nonprofits do things. Some of them just have things, particularly money for grants to public charities. These are private foundations. The main function of a private foundation is to hold assets tax-free for the purpose of distributing its assets to other nonprofits.

Unlike public charities, private foundations can be governed by directors who are family members or business partners. Moreover, private foundations do not need to meet the Public Support Test. Private foundations can be closely controlled and closely funded.

However, there are significant drawbacks to private foundation status. First, private foundations are generally required to distribute at least 5% of their assets to charitable purposes each year. Second, there are strict rules on self-dealing and transactions that involve directors and their family members. Third, private foundations are subject to an excise tax on their net investment income. Fourth, donors to private foundations can generally only deduct up to 30% of their income for such donations (which is less incentivizing than the deductibility for public charity donations). Finally, private foundations typically have more onerous annual reporting requirements to the IRS.

Despite the substantial limitations associated with being a private foundation, many nonprofits elect this status for the purpose of forming a source of funding and support for one or more charitable purposes, controlled by a single family or corporation.

Tertium Quid: Private Operating Foundations

One subclassification of private foundations is known as a “private operating foundation” (POF). POFs and the rules that govern them are too complex to explain in detail in this post. But what you should know is that they are essentially a hybrid between private foundations and public charities, and they have many of the perks of both without some of the drawbacks.

However, before you go thinking that a POF is the obvious “best-of-both-worlds” option, you should know that maintaining POF status is very complicated and should only be done with guidance from a knowledgeable attorney or tax professional.

Why It Matters: Rebutting the Presumption

It is important to understand that the IRS presumes that an organization applying for 501(c)(3) exemption is a private foundation unless it proves that it meets the criteria for being a public charity (the Public Support Test, board diversity requirements, etc.).

When you apply for 501(c)(3) exempt status, the IRS will send you a determination letter that will specify your organization’s foundation status classification, that is, whether it is a private foundation or a public charity. The basis on which the IRS makes that determination is whether your application demonstrates that you overcome the presumption of private foundation status. The default status is private foundation. To obtain public charity status, the burden is on the applicant to show that the requirements for that status are met.

Also, while a public charity may very easily convert to a private foundation, it is very difficult to convert a private foundation into a public charity. Indeed, it is a five-year process that involves extensive reporting to the IRS. Therefore, you should confirm up front whether you want your organization to be a public charity. And you should complete your application for exemption to the IRS in a way that will ensure that you rebut the presumption of private foundation status and get classified as a public charity.

More on the Way

In this third installment in this series, we’ve looked at the different categories of tax exempt organizations under 501(c)(3). In Part 4, we will look at restrictions on private inurement and political activities and how to avoid getting into trouble with the IRS on those issues. Finally, in Part 5, we will examine the process of applying for 501(c)(3) status and how to maintain that status going forward.

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Featured Image by Rebecca Sidebotham.