All nonprofit organizations recognized by the IRS as exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code (known as 501(c)(3) organizations) are charitable. However, not all 501(c)(3) organizations are subject to the same rules.
The two categories of 501(c)(3) organizations are private foundations and public charities. A 501(c)(3) organization is deemed a private foundation by default unless it can prove to the IRS that it qualifies as a public charity.
(For a discussion of the difference between "charitable" and "nonprofit," see our previous post on this topic.)
What Is a Private Foundation?
A private foundation is a charitable organization that typically has the following characteristics.
• It is funded from one or a limited number of sources.
• Its ongoing revenue is derived from investments.
• It invests and manages its assets and makes grants to other charitable organizations.
Examples of private foundations include the Bill & Melinda Gates Foundation, the J. Paul Getty Trust, and the Ford Foundation. Note that just because an organization has "foundation" in its name does not necessarily make it a private foundation. For example, most community foundations (such as the Silicon Valley Community Foundation or the Cleveland Foundation) are in fact public charities.
Private foundations are subject to stricter regulations by the IRS than are public charities. These broadly include:
• Restrictions on self-dealing between foundations and their substantial contributors and other insiders;
• Minimum annual distribution requirements;
• Limits on their holdings in private businesses;
• Prohibitions against jeopardizing investments;
• Certain requirements and protections against expenditures that may be deemed non-charitable (such as lobbying expenditures or grants to non-U.S. charities).
What Is a Public Charity?
A public charity is a 501(c)(3) organization that qualifies as such through one of three principal ways.
(1) Because it is specifically defined by the nature of its activities as a qualifying charity in the Internal Revenue Code.
(2) Because, in addition to being organized and operated for charitable purposes, it meets a mathematical public support test.
(3) Because it qualifies as a supporting organization.
Specifically Defined Charities
Those charities that are specifically defined in the Code include churches (not limited to any particular religion), schools, hospitals, medical research institutions, and support arms of state universities and governmental units. If an organization fits into the definitions of one of these organizations, it may qualify as a public charity without satisfying any mathematical support test.
Publicly Supported Charities
The majority of charities in the U.S. qualify as public charities because at least one-third of their income comes from public sources. Organizations like this include food banks, human rights organizations, housing organizations, think tanks, and any other number of charitable nonprofits. Generally speaking, public sources include other charities, government grants, small donations from the general public, and mission-related income. These mathematical support tests are fairly complicated and will be the topic of our next blog post.
Supporting organizations are deemed public charities because they exist for the benefit of, to perform the functions of, or to carry out the purposes of one or more other qualified public charities. One common example of a supporting organization is an organization that raises funds for a university or hospital or otherwise fully supports it.
Even if an organization falls within one of the above categories, it will be presumed to be a private foundation unless it applies to the IRS for recognition as a public charity using IRS Form 1023, Application for Recognition of Exemption. There are some exceptions to this rule, notably, churches.
What’s the Difference?
The IRS considers public charities to be inherently accountable to the public. Most public charities are either publicly supported or, by the nature of their activities, directly serve the public interest. In contrast, private foundations are typically funded by either one or a limited number of donors. The IRS imposes an array of rules and regulations on them to ensure compliance in their operations.
Any violations of private foundation rules may result in additional taxes and penalties, assessable against the private foundation and its management, substantial contributors, and related persons. Public charities have the benefit of more flexible rules governing their operations and more generous tax deduction limits for donors.
The following table summarizes the primary differences between these two types of 501(c)(3) organizations.
|Private Foundation||Public Charity|
|Less favorable donor tax-deductible giving limits.||Higher donor tax-deductible giving limits.|
|Must file a Form 990-PF each year (regardless of size).||Three possible tax filing requirements depending on gross receipts: (i) 990, (ii) 990-EZ, or (iii) 990-N (e-postcard).|
|Cannot engage in or fund any lobbying activity.||Can engage in an insubstantial amount of lobbying activity.|
|Cannot make a grant to an organization other than a U.S. public charity or government entity unless it exercises ER or has an ED (see below).||Can generally make a grant to anyone or any organization as long as it furthers its exempt purpose.|
|A number of unique rules and restrictions applicable only to private foundations.||Fewer restrictions on transactions with potential insiders and no minimum payout requirements or taxes on net investment income.|
What's NGOsource/ED Got to Do with It?
As noted above, private foundations cannot make grants to organizations that are not themselves public charities without potentially being taxed on the grants. Because most foreign organizations have not sought recognition from the IRS as 501(c)(3) public charities, grants to them (even ones that are clearly charitable) are subject to penalizing taxes.
In order to avoid penalties on such grants, private foundations can exercise expenditure responsibility (ER). They can also seek a determination from a qualified tax practitioner that the foreign organization is the equivalent of a U.S. public charity, which is known as an equivalency determination (ED). Many foundations find ED a simpler and more efficient method to make grants to foreign organizations.
Stay tuned for forthcoming blog posts on the public support test, specific types of charities, expenditure responsibility, and other useful concepts in tax-exempt law.
This article is for general informational purposes only and does not represent legal advice as to any particular set of facts. Please seek legal counsel as you deem necessary.