Nonprofit Organizations: Classifications And Traps For The Unwary

The Tax Court once stated, “trying to understand the various exempt organization provisions of the Internal Revenue Code is as difficult as capturing a drop of mercury under your thumb.”

501(c)(3) Organizations

A 501(c)(3) organization is an entity organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, testing for public safety, the prevention of cruelty to children or animals, or promotion of national or international amateur sports competition. Section 501(c)(3) requires that: (1) the organization be organized and operated exclusively to further a proper exempt purpose; (2) no part of the net earnings of the organization inure to the benefit of any private shareholder or individual; and (3) no substantial part of the organization’s activities consist of carrying on propaganda or otherwise attempting to influence legislation. The underlying concept behind these requirements is that the exempt organization must serve a public rather than a private benefit, and cannot, except to an insubstantial amount, engage in activities that do not further its exempt purposes.

There are generally two classes of 501(c)(3) organizations: public charities and private foundations. Public charities receive a greater portion of its support from public sources and have greater interaction with the public, whereas private foundations receive the bulk of their support from investment income and are typically controlled by single families or small groups of individuals. To assure that private foundations employ their resources for charitable purposes and do not misuse them, restrictions and various excise taxes are imposed on private foundations to compensate for their lack of public accountability. Public charities, on the other hand, must be accountable and responsive to the public and the government in order to maintain their support base. Therefore, Congress did not impose the same restrictions and excise taxes on public charities since their donors and those they interact with are presumed to provide the necessary oversight.

It is more advantageous for an organization to be classified as a public charity than a private foundation for several reasons: (1) as noted above, public charities are subject to less rules and restrictions than private foundations, (2) public charities are not subject to the net investment income tax that private foundations are subject to (discussed below), (3) public charities are more donor friendly, as donors can deduct a larger portion of their income for donations to public charities than private foundations, (4) the annual tax return for public charities, Form 990, is generally considered less burdensome than the annual tax return for private foundations, Form 990-PF, and (5) public charities can perform an insubstantial amount of lobbying activities, whereas private foundations have a total prohibition on lobbying.

Private Foundations

The default tax classification of a 501(c)(3) organization is the private foundation classification. Unless an organization can otherwise qualify as a public charity, classification as a private foundation will be presumed.

Private foundations are subject to an annual 1.39% excise tax on the net investment income of the private foundation. In addition, private foundations (and the directors and officers that were involved) are subject to an excise tax if a private foundation invests any of its assets in such a manner that will jeopardize the carrying out of its exempt purposes. These are referred to as “jeopardizing investments.”

Private foundations are also subject to restrictions on self-dealing that may apply if the private foundation enters into a transaction with a disqualified person (i.e., insiders and substantial contributors). These self-dealing rules are intended to limit perceived abuses involving the private foundation and to restrict the benefits available to private persons closely involved with the private foundation. The self-dealing rules can encompass transactions that are actually favorable to the private foundation, so generally private foundations should avoid transactions with disqualified persons or seek legal counsel to review the terms of the transaction to ensure it will not run afoul to the self-dealing rules. The excise tax on self-dealing can get hefty, including a 200% tax on the amount involved imposed on the disqualified person.

Additionally, private foundations are subject to an excise tax on its excess business holdings. The general rule is the combined holdings of a private foundation and all its disqualified persons is limited to 20% of the voting stock of a corporation (or 20% of the beneficial or profits interest if the business is not a corporation). Otherwise, the private foundation is subject to excise tax on the value of its excess business holdings.

Private foundations are also subject to minimum distribution requirements. Generally, the annual minimum distribution requirement is 5% of the aggregate fair market value of all of the foundation’s investment assets. If a private foundation does not meet its minimum distribution requirements for the year, an excise tax is imposed on its undistributed income.

Public Charities

Public charities include organizations such as churches, schools, hospitals, and “public” organizations. There are two types of public organizations, “donative” public organizations and “service-provider” public organizations.

To be considered a “donative” public organization, one-third of the organization’s total support must be considered public support. Total support includes gifts, grants, and contributions, net income from unrelated business activities, and gross investment income. Public support includes gifts, grants, and contributions, but only to the extent that the donation from any one contributor does not exceed 2% of the total support received by the organization in the previous five years. However, donations from other donative public organizations and governmental units are not subject to this 2% cap.

The test to be a “service-provider” public organization is similar, except that exempt function income (e.g., gross receipts from admissions) is included in calculating both total support and public support. Additionally, donations from disqualified persons are all together excluded from public support (not just subject to a 2% limit). Service-provider public organizations are subject to an additional requirement, which is that not more than one-third of the organization’s total support can come from gross investment income.

Failure to Meet the Public Support Test

The public support tests described above for donative public organizations and service-provider public organizations is performed over a five-year period. For example, an organization will determine whether it met the public support test for 2022 when it prepares its tax return for the year in 2023 by looking at all support received from 2018-2022. If the organization satisfies the test for 2022, it will be a public charity for years 2022 and 2023. However, if the organization fails the public support test in 2022, and then again in 2023, it will be considered a private foundation as of January 1 of 2023. Even if the organization failed the support test in 2022, if it passed the test in 2021, it would still be considered a public charity for 2022.

To aid against the harsh result of receiving private foundation status unexpectedly once the tax year has ended, if an organization fails to meet the public support test, it still has a couple tools in its toolbox to secure public charity status. The first is the exclusion for unusual grants. If an organization performs its public support analysis over a 5-year period and it fails to meet the test because of one particularly large grant, that grant can be excluded from support as an unusual grant. A factors test is used to determine if the grant is “unusual.” Factors that generally tend to favor unusual grant status include the grant being unexpected in amount, if it was attracted by reason of the publicly supported nature of the organization, and if it was from a disinterested party. Unusual grants also tend to be cash, marketable securities, or an asset to further the organization’s exempt purpose (such as a painting to a museum). Also, we look to see how frequently the organization needs to rely on excluding a grant as an unusual grant. It is more favorable if the organization rarely has to do this.

If the organization still fails the public support test, it may still qualify as a public charity under an alternative test known as the facts and circumstances test. Under this test, at least 10% of the organization’s support must be considered public support (as opposed to one-third). In addition, the organization must demonstrate that it operates in such a way to attract public support on a continual basis by carrying on activities designed to attract support and maintaining a program to solicit funds.

Supporting Organizations

Supporting organizations are another type of public charity. Supporting organizations essentially borrow public charity status from another organization because of the relationship between the two organizations. There are three categories of supporting organizations: Type I, Type II, and Type III. Type I supporting organizations are operated, supervised by, or controlled by a public charity. This requires a majority of the officers or directors of the supporting organization to be appointed by the public charity. Type II supporting organizations are supervised or controlled in connection with a public charity. This requires the control or management of the supporting organization to be vested in the same persons that control or manage the public charity. Type III supporting organizations are operated in connection with a public charity. There are various notification and distribution requirements for an organization to be considered a Type III supporting organization designed to assure the public charity has a significant voice on how the supporting organization manages and uses its assets.

Private Operating Foundations

Private operating foundations are a hybrid classification between private foundations and public charities. For some purposes they are treated as public charities, most notably for purposes of the charitable contribution deduction. On the other hand, they are treated as private foundations for most of the various rules and excise taxes imposed on private foundations. Private operating foundations are typically organizations that devote their assets or income to the active conduct of charitable operations, rather than making grants to other organizations, but have difficulty meeting the public support tests.

There are various other rules and restrictions that are applicable to non-profit organizations such as prohibitions on private inurement and private benefit, lobbying guidelines, unrelated business income tax, and fiduciary duties imposed on an organization’s officers and directors. If you operate a non-profit and have compliance concerns, or are interested in forming a non-profit organization, please contact any member of the McGrath North Tax and Estate Planning Practice Group.