Most people have heard the term “private foundation,” and know vaguely that it somehow relates to philanthropic organizations. But beyond that, most people are lost when pressed for more details about these organizations. A 501(c)(3) tax-exempt organization is either a public charity or a private foundation. The default is that an organization will be classified as a private foundation unless it can demonstrate that it falls into one of the categories specifically excluded from the definition of a private foundation. These rules are found in section 509(a). Generally, it is to the advantage of the organization to be classified as a public charity as there are fewer restrictions on the operations of the organization under this category.
A private foundation is typically a legal entity set up by an individual, a family, or a group of people for a specified philanthropic purpose. It does not typically solicit funds from the public, but is funded by the founders of the organization. Some well-known private foundations include the Bill and Melinda Gates Foundation, the Howard Hughes Medical Institute, the Ford Foundation, the Lilly Endowment, the Andrew W. Mellon Foundation, and the Pew Charitable Trusts. The Gates foundation is by far the largest in the world, with a reported endowment of $42.3 billion in 2014.
Private foundations must file a Form 990-PF with the IRS. The form is similar to a 990 filed by a public charity with one notable exception. Schedule B is a list of contributors to the organization donating more than $5,000 in a given year. These names and amounts are redacted on a 990 filed by a public charity. However, these are not redacted on the Schedule B of a private foundation.
The primary test for being classified as a public charity is the source of support. The organization must pass one of two tests in order to be classified as a public charity. Under the first test, an organization must show that it receives at least one-third of its support from the general public. This is the purpose behind the Form 990, Schedule A. The second test is a facts and circumstances test that has a 10 percent threshold. If the organization has between 10 and 33 1/3 percent of its support from the general public, it can qualify as a public charity if it can demonstrate to the IRS that it normally receives a substantial portion of its support from the general public or governmental units.
A new 501(c)(3) organization will be classified as a public charity when it applies for tax-exempt status if it can show that it can reasonably be expected to be publicly supported. This is done be providing financial and other information on the exemption application. It would keep this status for its first five years, regardless of the public support it actually receives. 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. A part of the annual Form 990 or 990-EZ is Schedule A, which involves a calculation to determine the percentage of support that is public. If it passes the test, the IRS will continue to monitor its public charity status after the first five years based on the Schedule A numbers.
In addition, there are several restrictions and requirements on private foundations, including:
1. Restrictions on self-dealing between private foundations and their substantial contributors and other disqualified persons.
2. Requirements that the foundation annually distribute income for charitable purposes;
3. Limits on their holdings in private businesses.
4. Provisions that investments must not jeopardize the carrying out of exempt purposes of the organization.
5. Provisions to assure that expenditures further exempt purposes of the organization.
Obviously, there are definitions and much more detail to these restrictions that go beyond what can be discussed here. Violations of these provisions can give rise to significant penalties on the organization as well as managers of the foundation.
Any 501(c)(3) organization, whether a public charity or a private foundation should carefully monitor its support, its activities, and the activities of it officers in order to assure compliance with the applicable tax laws.
Subscribe to TaxConnections Blog
Enter your email address to subscribe to this blog and receive notifications of new posts by email.