Charitable giving has been a part of our society since ancient times, dating back to when the Egyptians built the pyramids. But it was only in 1954 that the modern tax code caught up and began recognizing public charitable organizations — vehicles bringing critical aid to those in need — as tax-exempt entities, otherwise known as 501(c)(3) organizations.
As a public charity, you benefit from your rightful tax-exempt status, but you also must understand and remain compliant with certain rules to maintain it — primarily the public support test. If you don’t, the IRS could change your status to a private foundation and key tax benefits will be lost.
What are the Benefits to Being a Public Charity?
Maintaining your public charity status is important, as this designation provides donation-related and other key benefits:
- It’s easier to support a public charity, meaning more donations to your cause. Enhanced tax deductions and less regulatory restrictions for donors make public charities a prime choice for charitable giving — whether coming from individuals, other public charities, governmental entities or private foundations.
- Regulatory and tax concerns for the public charity itself are also advantageous. Public charities have shorter and less complex tax filings than what’s required of private foundations. And public charities are not subject to net investment income (NII) excise tax, minimum distribution requirements and other restrictive regulations applicable to private foundations.
What Does the IRS Consider a Public Charity vs. a Private Foundation?
It’s important to note that every organization that qualifies for tax-exempt status is classified as a private foundation unless it meets certain exceptions. The primary difference between a public charity and private foundation is its level of public involvement.
Public charities generally have many different donors and directly operate a charitable program or programs. Entities organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, educational or other specified purposes can apply for and receive tax-exempt status under Internal Revenue Code Section 501(c)(3). Public charities also must pass, and maintain requirements for, the critical public support test (more on that in a bit).
Various types of entities, noted below, can qualify as public charities. Most are required to file Form 990 and Schedule A (as applicable) to maintain their public charity status:
- 509(a)(1) organizations - Those that receive a significant portion of their revenues from contributions.
- 509(a)(2) organizations – Those that receive a significant portion of their revenues from program revenues.
- 509(a)(3) organizations - Supporting organizations that pass all four tests and are classified as below based on how they satisfy the relationship test:
- Type I (supervised or controlled by the supported organizations)
- Type II (supervised or controlled in connection with the supported organizations)
- Type III (operated in connection with the supported organization)
Private foundations, on the other hand, typically have a single major source of funding, generally gifts from one family or corporation rather than funding from many sources. Most make grants to other charitable organizations as their primary activity, rather than directly operating charitable programs themselves.
What is the Public Support Test a Public Charity Must Pass?
Generally, an organization must have 33.33% or more in financial support from the general public to be deemed a public charity. This is known as the public support test and is critical to your organization’s ongoing tax status. See the examples below on how to calculate your percentage. Note that 509(a)(3) organizations are supporting entities and, therefore, do not have to pass a public support test.
The numerator should consist of grants and contributions, not including program revenue or any amounts contributed by a single donor in excess of 2% of organization’s total support over a five-year window. The denominator is your organization’s total support for the five-year period, including investment, unrelated business income and other income.
For these organizations, you do include the program revenues to determine your numerator. The denominator is the same as above — your organization’s total support for the five-year period, including investment, unrelated business income and other income.
A newly formed organization has five years to reach the threshold. Any organization that fails the public support test for two consecutive years will lose its public charity status and will be reclassified as a private foundation.
Note that a facts and circumstances test can potentially help organizations prove their public charity status if they fail to qualify under the public support test.
How Can Your Organization Regain Its Tax-Exempt Status?
Once this coveted status is lost, your organization will need to file Form 990-PF and pay any excise tax during this five-year period. After the five-year period, you will need to file Form 8940 — Request for Miscellaneous Determination — to attempt to regain public charity status, assuming your organization is able to pass the public charity tests at that time.
As a public charity, it’s important to pay attention to your public support percentage throughout the year; it will be a long road back to attain public charity status once it’s lost. Work with your tax advisers closely to ensure your public charity status is preserved. If your percentage begins declining, your officers and trustees should work to adjust your organization’s strategy before losing this valuable designation.
Contact Pargat Singh at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.