A private operating foundation is a private foundation that conducts charitable activities as opposed to solely making charitable grants. Because of this emphasis on charitable activities, a private operating foundation receives many of the same tax benefits as a public charity without needing to adhere to the public support test requirements.
An organization must meet a number of requirements and restrictions to qualify as a private operating foundation—and to enjoy the numerous benefits associated with this status.
How to Qualify
A foundation must annually meet an income test and one of three other tests to qualify for and retain its status as a private operating foundation. As an exception to this rule, a foundation in its first year of existence may be treated as an operating foundation if it makes a good faith determination that it’ll meet the tests in its first year.
A foundation must make qualifying distributions for the active conduct of the charitable activities for which it received tax-exempt status to meet the income test. A qualifying distribution is defined in Internal Revenue Code Section 4942(g) as one of the following four items:
- Disbursements used to accomplish one or more charitable, religious, educational, or other similar purposes, including reasonable and necessary administrative expenses
- Purchase of assets used or held to carry out its charitable purpose
- Acquisition or operation of program-related investments
- Amounts set aside for certain charitable projects
It’s important to make a distinction between charitable disbursements and grants to public charities. Grants to public charities won’t count toward the charitable disbursement test above.
The income test calculation can be complicated, but the simplified version is that the amount of qualifying distributions must be equal to substantially all, which is 85% or more, of the lesser of the foundation’s adjusted net income or minimum investment return.
Adjusted net income is defined as any adjusted gross income over adjusted deductions. Minimum investment return is calculated as generally 5% of the excess of the average fair market value of a foundation’s assets, not including charitable-use assets, over acquisition indebtedness of those assets.
An organization must also pass one of three other tests—assets, endowment, or support—to qualify and maintain its private-operating-foundation status.
A foundation passes the assets test if at least 65% of the value of its assets are devoted to one or both of the following:
- Active conduct of exempt-purpose activities
- Business activity that’s functionally related to its exempt purpose
A foundation can fulfill this requirement either over a portion of or during the entirety of the four-year period that culminates with the year it’s trying to qualify for private-operating-foundation status.
The endowment test is similar to the income test in that it measures qualifying distributions and minimum investment return. To meet this test, a foundation must make qualifying distributions that directly support the active conduct of the charitable activities for which the foundation was established.
This test also measures minimum investment return, which requires a foundation to make qualifying distributions in excess of two thirds of its minimum investment return.
The crux of this test is revenue support. It requires at least 85% of a foundation’s support to come from the general public and five or more exempt organizations—not including disqualified persons. No more than 25% of its support can be received from any one of those five exempt organizations while no more than 50% of its total support can be received from gross investment income.
It’s important to note that private foundations must meet the income test and one of the three other tests each year. If they can’t, they must report each year as a private nonoperating foundation.
Private operating foundations can be a powerful vehicle for some organizations to achieve their charitable goals.
The donations they receive are eligible for a 50% charitable-contribution deduction limit—instead of the 30% charitable-contribution deduction limit that private foundations have. Additional benefits to obtaining and sustaining status as a private operating foundation include the following:
- Not subject to excise taxes because of a failure to distribute income
- Ability to receive qualifying distributions from other private foundations
- Donors of capital gain property not subject to a reduction of their contribution
Public charities that receive a large amount of donations from limited sources can struggle to maintain healthy public-support percentages. Status as a private operating foundation offers these charities an option to retain some of the benefits of being a public charity while circumventing some of the stringent rules and taxes that private foundations endure.
We’re Here to Help
For more information about qualifying as a private operating foundation, contact your Moss Adams professional.