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 will take an in-depth look at the differences between private foundations and public charities to help you understand the classifications, benefits, and limitations of each one.
It covers the following topics:
What Is the Difference Between a Private Foundation and a Public Charity?
Discerning the difference between public charities and private foundations can be confusing because many public charities refer to themselves as foundations, even though there are technical differences between the two.
The most common type of charitable organization is a public charity. Some institutions are automatically classified as public charities, for example universities, churches, and research organizations. For other tax-exempt organizations to qualify as a public charity, they must meet one of the following criteria:
- Have broad public support, demonstrated by passing a public support test in the current or prior year
- Pass stringent organization and operation tests to be classified as a supporting organization
Public Support Tests
These types of organizations are publicly supported by receiving donations or program service revenue from a broad base of donors, clients, or customers. In general, a public charity needs to receive at least 33.3% of its funds from the general public to qualify; in certain circumstances, a charity can pass the test with only 10% public support. Each test is calculated over a 5-year period.
There are two public support tests, and each test has its own definitions of what is considered the general public:
- The first test is for organizations that rely on donations as their main source of support.The test is passed when donations come from a broad base of donors, government grants, and other donation-based public charities.
- The second test is for organizations that have significant program revenue. The test is passed when this program service revenue comes from a broad base of clients or customers, rather than a handful of payors or contracts.There’s also a limitation on how much investment income can be received.
If a public charity fails its support test, it has the option of qualifying under the other test, or as a supporting organization if those tests can be met. If no public support or supporting organization test can be met for two years in a row, the organization becomes a private foundation. It’s still a tax-exempt charity under Section 501(c)(3) and contributions remain deductible for donors, but they’re subject to the private foundation limitations.
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 projections, it can terminate its private foundation status to become a public charity over a 60-month period.
The supporting organization must be organized and operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of another public charity. In some circumstances the supporting organization can also support non-charitable tax-exempt organizations such as a Section 501(c)(4) social welfare organization, a Section 501(c)(5) labor, agricultural, or horticultural organizations, or a Section 501(c)(6) trade association.
These types of public charities don’t need to pass a public support test, but must meet the following tests:
- Be organized and operated exclusively for the benefit of, perform the functions of, or carry out the purposes of its beneficiary organizations
- Be operated, supervised, controlled by, or in connection with the beneficiary organization
- Not be controlled directly or indirectly by a disqualified person
A disqualified person is any person in a position to exercise substantial influence over the affairs of the applicable tax-exempt organization. The disqualified person could be an individual, corporation, partnership, trust, estate, or other foundation.
In contrast to public charities, some private foundations don’t conduct charitable programmatic activities themselves and instead distribute grants to public charities. Others do conduct charitable programmatic activities, but don’t meet a public support test.
Private foundations typically are set up and funded by an individual, family members, or corporations. They generally administer grants to organizations that are important to the founders, and they’re subject to different restrictions than public charities.
All private foundations have a prohibition against private inurement. With very limited exceptions, such as reasonable compensation for services provided, private foundations may not conduct any financial transactions with insiders. An insider can be a foundation manager, board member, significant donor, family member, or entity owned by of any aforementioned persons. If a transaction is deemed to occur, the foundation and the person or persons who received a benefit could be subject to hefty excise taxes.
Private foundations also have rules regarding expenditure responsibility. Expenditure responsibility is a term to describe the establishment of adequate procedures to ensure grants were spent for intended purposes, and reporting is required of the grantee in certain circumstances.
When expenditure responsibility is required, a full and detailed report must be given to the IRS via the organization’s tax return. In addition, a private foundation is subject to rules regarding taxable expenditures, jeopardizing investments, and excess business holdings.
There are two main types of private foundations, which are briefly described below.
Private Nonoperating Foundation
A private nonoperating foundation typically is a grant-making-only foundation. These foundations must meet a minimum distribution requirement or be subject to an excise tax. They’re also subject to a net investment income tax of 1.39% for tax year 2020 and beyond, and there are rules regarding additional paperwork when a grant is made to an organization other than a public charity.
Private Operating Foundation
A private operating foundation is a foundation that conducts charitable activities as opposed to solely making charitable grants. Since there’s a dual emphasis, private operating foundations share similarities with both public charities and private grantmaking foundations.
Private operating foundations aren’t subject to the minimum distribution requirements described above. These types of foundations also enjoy charitable deduction treatment for their donors similar to that of a public charity.
Private operating foundations are subject to a net investment income tax at a rate of 1.39% for tax year 2020 and beyond.
A private operating foundation must qualify for this status annually by passing two different tests—an income test and an assets, endowment, or support test.
For a more detailed look at the tests, and how to qualify for and retain your status as a private operating foundation, please see our article.
Why Is the Term Foundation Potentially Confusing?
There are many charitable organizations with the term foundation in their name; including that term is often meant to inspire a call to action. However, the IRS has very specific definitions for its use.
IRS Regulation Section 1.509(a)-1 defines a private foundation as any domestic or foreign organization described in IRC Section 501(c)(3) other than an organization described in IRC Section 509(a)(1), (2), (3), or (4). Organizations that fall into the categories under IRC Section 509(a) generally are publicly supported, and therefore called public charities.
The only foolproof way to know what type of charitable organization a foundation is would be to check the IRS database search tool.
Benefits from a Donor's Perspective
Whichever charitable vehicle is used to conduct philanthropy, it’s important to choose the right one to accomplish your philanthropic goals.
Contributions to public charities and private foundations are both tax deductible. However, public charities have higher tax-deductible giving limits and are more likely to allow for a fair market value deduction rather than tax basis.
Donations to private non-operating foundations are generally limited to 30% adjusted gross income (AGI) limitation for cash donations and 20% AGI limitation for all others. Noncash donations are generally subject to the donor’s tax basis, except for publicly traded stock for which market value is deductible.
Donations to public charities and private operating foundations, on the other hand, generally use market value to determine the tax deduction and higher AGI limits—50% to 100% for cash and 30% for noncash donations. Contributions of personal property to public charities are also allowed a market value as long as contributed properties are used by the charity in its exempt purpose.
Public charities aren’t required to publicly 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.
Benefits from an Organizational Perspective
An organization that is 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.
Many public charities are heavily supported by the public, which means they’re subject to more public scrutiny than private foundations to help encourage appropriate conduct. There are many different types of public charities, not all are required to be supported with public money.
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 allow 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 aren’t ever 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 nonoperating foundations are required by law to distribute approximately 5% of the average market value of their nonexempt use assets, typically investments, each year.
Unrelated Business Income Tax
There are select times when tax-exempt organizations are subject to income tax, known as the unrelated business income tax (UBIT).
Congress created the UBIT rules to avoid giving tax-exempt organizations an unfair advantage over their corporate and trust counterparts. The rules require tax-exempt organizations to pay income taxes when engaged in 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 choosing one over the other can affect your organization—contact your Moss Adams professional.