Disqualified Persons Under Section 509(a)(2) and Section 509(a)(3)

As discussed in a previous post, a nonprofit organization that is organized and operated exclusively for charitable purposes may be deemed a public charity (and not a private foundation) under section 501(c)(3) of the Internal Revenue Code (IRC) in one of three principal ways.

  1. It meets certain requirements based on the nature of its activities.
  2. It qualifies as a "publicly supported charity" based on a mathematical public support test.
  3. It is a "supporting organization" to another public charity.

A "publicly supported charity," described under section 509(a)(2), and a "supporting organization," described under section 509(a)(3), take into consideration the role of "disqualified persons." This is to ensure that the charities are responsive to the public rather than to the interests of a limited number of donors or other insiders.

In this post, we will discuss the meaning of "disqualified persons" as the term relates to both a 509(a)(2) publicly supported charity and a supporting organization.

Disqualified Persons Under Section 509(a)(2)

A publicly supported charity described under section 509(a)(2) must pass a public support test demonstrating that it is primarily supported through income earned from conducting activities in furtherance of its charitable purposes. Specifically, to qualify, an organization must receive "almost all of its support … from gross receipts from related activities."  See Treas. Reg. § 1.170A-9(f)(7)(iii). As part of this test, the organization is subject to certain limitations on amounts received from disqualified persons.

The section 509(a)(2) public support test is complicated, and not covered in detail here. For a more detailed description of the test, see our list of additional resources below.

The IRS defines a disqualified person as "any person who was in a position to exercise substantial influence over the affairs of the applicable tax-exempt organization. …  It is not necessary that the person actually exercise substantial influence, only that the person be in a position to do so." For purposes of this definition, a corporation or entity can be a disqualified "person."

The disqualified person designation is important because income from disqualified persons is completely excluded from an organization's public support in the public support calculation. As a result, significant contributions from a disqualified person will lower an organization's public support. Notably, governmental units and public charities are not considered to be disqualified persons, regardless of the size of their contributions to an organization. See Treas. Reg. § 53.4946-1(a)(7).

As it relates to a publicly supported organization under section 509(a)(2), disqualified persons include all of those listed below:

  • Substantial Contributors. Any person who contributed more than the greater of $5,000 or 2 percent of the organization's total contributions since its inception. As noted above, governmental units and public charities are excluded from this definition.
  • Managers. Officers, directors, and trustees, and individuals with similar powers or responsibilities. A person is an officer if he or she is designated as such under the governing instruments or regularly makes policy or administrative decisions. An employee who has authority merely to recommend such decisions but must have approval from a superior to implement those decisions is not an officer. 
  • Owners of a Business That Is a Substantial Contributor. A person who owns more than 20 percent of the voting power of a corporation, the profits interest of a partnership, or the beneficial interest of a trust or unincorporated enterprise that is a substantial contributor during the person's ownership.
  • Family Members of Disqualified Persons. The family members of a substantial contributor, manager, or 20 percent owner. This includes a disqualified person's children, grandchildren, and great-grandchildren; their spouses; a disqualified person's spouse; and a disqualified person's ancestors. 
  • Corporations Owned by Disqualified Persons. Corporations where substantial contributors, managers, 20 percent owners, or their families own more than 35 percent of the combined voting power.
  • Partnerships Owned by Disqualified Persons. Partnerships where substantial contributors, managers, 20 percent owners, or their families own more than 35 percent of the profits interest.
  • Entities Owned by Disqualified Persons. A trust or estate if a substantial contributor, manager, 20 percent owner, or their family owns more than 35 percent of its beneficial interest.

Disqualified Persons Under Section 509(a)(3)

As described in a previous post, section 509(a)(3) supporting organizations must meet an organizational test, operational test, control test, and relationship test as they relate to their supported charities. The control test mandates that a supporting organization cannot be controlled directly or indirectly by disqualified persons.

Supporting organizations apply the same definition of disqualified person described above, with a couple of exceptions. First, disqualified persons include creators of trusts that are substantial contributors to a supporting organization. Second, managers are not disqualified by virtue of their position as managers unless they are disqualified persons for a reason independent of their position, such as being a substantial contributor.

Below are examples of each principle listed above (PDF).

  • A four-person board of directors is made up of one disqualified person, two persons appointed by the supported charity, and a fourth director paid by disqualified persons for accounting, legal, or investment advice apart from the supporting organization's affairs. The disqualified person can influence the fourth director's decisions, so this evidences control.
  • A five-person board of directors is made up of two disqualified persons, two appointed by the supported charity, and a fifth director appointed by the disqualified persons. The disqualified persons' ability to appoint the fifth director represents control.
  • A five-person board of directors includes three disqualified persons. They control the organization.
  • A five-person board of directors includes two disqualified persons. The organization is not controlled by disqualified persons.
  • Same as in the previous paragraph; however, the disqualified persons have veto power over the activities or operations of the organization. The organization is controlled by disqualified persons.
  • A disqualified person holds 85 percent of the stock of a closely held corporation and transfers 5 percent of such stock to the supporting organization, which constitutes its only or primary asset. The disqualified person's 80 percent ownership of the corporation allows it to influence the economic rights associated with organization's ownership of the minority interest in the corporation.

Disqualified Persons and Equivalency Determinations

Non-U.S. organizations may qualify for an equivalency determination (ED) under any of sections 509(a)(1), 509(a)(2), or 509(a)(3). For this reason, NGOsource sometimes requires information on an organization's disqualified persons. The rules around disqualified persons are complicated and unique to U.S. tax law. It helps to remember that their underlying purpose is to ensure that charities remain independent from private interests and accountable to the general public.

Other Resources

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.