Have you ever wondered what the differences are between a private foundation and a public charity?
Most people are familiar with charities from which they receive a tax deduction, but they often don’t know charities are classified into two types: private foundations and public charities. Understanding the major differences between the two is critical, given the way they affect donor-contribution limits, minimum distributions, public scrutiny, and more.
This article is the first in a series taking an in-depth look at topics important to private foundations. Other issues that will be explored:
- Net investment income tax and minimum distribution requirement
- Excess business holdings
- Grant-making, including who foundations can grant to and expenditure responsibility
- Program-related investments compared to mission-related investments
- Private operating foundations
Discerning the difference between public charities and private foundations can be confusing because many public charities refer to themselves as foundations, even though they aren’t private foundations. Even though the term foundation can describe either type of organization, there are technical differences between the two.
Some institutions are automatically classified as public charities, such as universities, churches, and research organizations. For other tax-exempt organizations to qualify as a public charity, they must meet one of the following criterion:
- Have broad public support, demonstrated by passing a public-support test in the current or prior year
- Pass stringent organizational and operational tests (this only applies to supporting organizations that aren’t required to pass the public-support test)
A public charity subject to the public-support test must pass the test to retain its public classification. In general, a public charity needs to be 33.33% publicly supported. The test is complicated, however, and in certain circumstances a charity can still pass the test with only 10% public support. A public charity that fails the public-support test two years in a row is automatically reclassified as a private foundation.
The good news is that if a public charity fails the public-support test two years in a row and becomes a private foundation, it’s still a tax-exempt charity, which means contributions remain deductible for donors. If a public charity is reclassified as a private foundation but later shows it’s being greatly supported by the general public with future revenue projected to come from the general public, it can terminate its private foundation status to become a public charity over a 60-month period.
In contrast to public charities, most private foundations don’t conduct charitable programmatic activities themselves and instead distribute grants to public charities.
However, if a private foundation actively runs one or more charitable programs, it might be classified as a private operating foundation, which is a unique hybrid blend of a public charity and a private foundation that allows donors the same donation thresholds as public charities.
From a Donor's Perspective
Contributions to public charities and private foundations are both tax deductible. However, public charities have higher tax-deductible giving limits, as demonstrated in the table below.
Noncash contributions to private foundations are generally limited to a donor’s tax basis, except for publicly traded stock for which market value is deductible. Noncash contributions to public charities, on the other hand, use market value to determine the tax deduction while contributions of personal property to public charities is also allowed a market value as long as the contributed property is used by the charity in its exempt purpose.
Public charities aren’t required to publically disclose the names and addresses of their contributors, which means the annual tax filings available on GuideStar don’t disclose donor names or addresses.
In contrast, private foundations are required to make their donor information available to the public, so their tax returns, which are also available on GuideStar, list every donor and address for contributions greater than or equal to $5,000.
From an Organizational Perspective
An organization that’s classified as a public charity has great potential for receiving grants from the government, private foundations, and the general public.
A private foundation can also receive grants, but donors may be more reluctant to give because the governing board is typically made up of a close group or family instead of various community representatives.
Public charities are heavily supported by the public, which means they’re subject to more public scrutiny than private foundations—helping to ensure appropriate conduct.
Private foundations are generally governed by a smaller group, which means they’re subject to burdensome rules and regulations—as well as potential excise taxes—to help ensure proper operation. These rules regulate areas such as:
- Minimum distributions
- Excess business holdings
- Jeopardized investments
- Taxable expenditures
If a foundation discovers it’s failed to follow regulations, excise taxes are payable by the organization and possibly by foundation managers or founders if the act was known. Often, excise taxes are abatable if there’s reasonable cause, but self-dealing penalties are always paid by the person who committed the act and are never abatable.
Public charities generally spend their money on running charitable programs or providing grants for charitable purposes. They don’t have a required expenditure amount each year and are instead regulated by the general public. For example, the general public is often reluctant to donate to a public charity that isn’t making enough charitable expenditures, unless it’s building up money for a specific program or asset, such as a capital campaign.
Private foundations are required by law to distribute approximately 5% of the average market value of their nonexempt use assets (typically investments) each year.
Private foundations pay an excise tax on net investment income at a rate of 1% to 2%. Public charities don’t share this tax burden.
Unrelated Business Income Tax
There are select times when tax-exempt organizations are subject to income tax, such as the unrelated business income tax (UBIT).
Congress created the UBIT rules to help ensure tax-exempt organizations aren’t given an unfair advantage over their corporate and trust counterparts by requiring tax-exempt organizations to pay taxes when engaged in commercial activities outside the scope of their exempt purposes.
Both private foundations and public charities can have unrelated business income, which means either organization type may be required to pay UBIT.
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To learn more about the differences between private foundations and public charities—and how they can affect your organization—contact your Moss Adams professional.