IRS Charity Classification: Private Foundation or Public Charity?

This IRS 501(c)(3) classification has a significant impact on how a charity can operate and the rules it must follow.

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Twenty-eight different types of nonprofit organizations are recognized by the tax law. But by far the most common type of nonprofits are Section 501(c)(3) organizations; (Section 501(c)(3) is the part of the tax code that authorizes such nonprofits). These are nonprofits whose mission is charitable, religious, educational, or scientific. Section 501(c)(3) organization have one huge advantage over all other nonprofits: contributions made to them are tax deductible by the donor.

Every Section 501(c)(3) organization is classified by the IRS as either a private foundation or a public charity. This classification is important because private foundations are subject to strict operating rules and regulations that don’t apply to public charities. For example, deductibility of contributions to a private foundation is more limited than for a public charity, and private foundations are subject to excise taxes that are not imposed on public charities. Public charities and private foundations also file different annual information returns with the IRS: Public charities file Form 990 or Form 990-EZ, foundations file Form 990-PF.

The bottom line is that private foundations get much worse tax treatment than public charities.

The main difference between private foundations and public charities is where they get their financial support. A private foundation is typically controlled by an individual, family, or corporation, and obtains most of its income from a few donors and investments--a good example is the Bill and Melinda Gates Foundation. Because they are controlled by such a small group, private foundations can easily be misused and abused. This is why the tax law is so tough on them. Most foundations just give money to other nonprofits. However, some—called “operating foundations”—operate their own programs. As a practical matter, you need at least $1 million to start a private foundation; otherwise, it’s not worth the trouble and expense. It’s not surprising, then, that a private foundation has been described as a large body of money surrounded by people who want some of it.

Most Section 501(c)(3) organizations are public charities. They have a much broader base of financial support than private foundations and have more interaction with the public. Certain organizations, such as churches, schools, hospitals, and medical research organizations, automatically qualify as public charities. Others must prove that they are publicly supported, which generally means they must be able to show they receive at least one-third of their support from contributions, membership fees, or gross receipts from activities related to their exempt functions.

Schools, churches, hospitals, medical research organizations, and nonprofits that support them are automatically classified as public charities by the IRS. Other nonprofits are not so lucky. The IRS initially presumes that they are private foundations.

However, a new 501(c)(3) organization will be classified as a public charity (not a private foundation) when it applies for tax-exempt status if it can show that it reasonably can be expected to be publicly supported. This is done be providing financial and other information on the exemption application. If the IRS classifies the nonprofit as a public charity, it keeps this status for its first five years, regardless of the public support it actually receives during this time. Beginning with the nonprofit’s sixth tax year, it must show that it meets the public support test, which is based on the support it receives during the current year and previous four years. The nonprofit must file Schedule A along with its annual information return on Form 990 or 990-EZ, containing detailed information about its sources of financial support. If a nonprofit passes the test, the IRS will continue to monitor its public charity status after the first five years by requiring that a completed Schedule A be filed each year.

Find out more about your nonprofit's tax status with Nolo's book, Every Nonprofit's Tax Guide.

August 2013

by: , J.D.

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