The non-profit sector has steadily grown over the last several years. In fact, the non-profit sector accounted for over 5% of the United States’ Gross Domestic Product (“GDP”) in 2016. As the sector grows, so does the public’s awareness of non-profit organizations, what they do and how they continue to positively impact local communities. You may know that non-profits are 501(c)(3) organizations, but you may not know that there are different 501(c)(3) models—and choosing the proper model is crucial to the organization’s success. Read on to learn about the differences between a private foundation and a public charity, both of which are 501(c)(3) organizations!
Private foundations and public charities differ based primarily on each entities source of financial support and the resulting tax treatments. A private foundation is the default model for tax-exempt charities in the United States— that is, at least until the organization files a form 1023 and properly demonstrates to the IRS that it qualifies within another category, such as a public charity.
A small number of donors and private investors typically fund a private foundation, and sometimes it’s entirely funded by a single individual or entity. In other words, private foundations generally do not solicit funds from the general public. In fact, a person or a family often establishes the foundation as a way to make a tax-deductible charitable contribution, while also allowing family members to work together in philanthropic projects for generations to come. These foundations, however, often do not run charitable activities but instead funnel capital to “operating” charities by means of grants, scholarships, and sponsorship agreements.
Private foundations must pay an annual 2% tax on its net investment income (income from investment assets such as shares, bonds, and mutual funds), and must distribute at least 5% of its investment assets for charitable and administrative purposes, or otherwise pay an excise tax on undistributed income. The IRS also gives private foundation donors less of a tax break. These donors can deduct up to 30% of their adjusted gross income, whereas donors to a public charity may deduct up to 50% of their adjusted gross income.
Despite these less favorable tax consequences, some organizations prefer the foundation model over the public charity model because its creators enjoy greater control over how the organization operates in comparison to other 501(c)(3) models. Additionally, a small group or even a single individual can fund the foundation without running afoul IRS requirements and family members can pursue philanthropy, while also getting a tax deduction.
Public charities represent the largest portion of active, 501(c)(3) organizations. In contrast to private foundations, public charities primarily derive funding or support from the general public (e.g. individual donations and government grants). Specifically, at least 33% of a public charity’s annual support must come in the form of small donations from members of the general public. The IRS, however, will not require an organization to prove this 33% in its first five years. But after five years, if a nonprofit does not meet this 33% benchmark the IRS will automatically convert the public charity into a private foundation.
Public charities enjoy some advantages over private foundations: the ability to garner support from other public charities and private foundations, and high tax deductions for its donors. To qualify and keep the status of public charity, the organization must restrict its activities to 501(c)(3) purposes, and the IRS requires this be written in the articles of incorporation. A public charity must also have a diversified board of directors.
Practice Note: The IRS primarily looks at one thing when it decides whether a non-profit qualifies as a private foundation or public charity—the source of funding. Nonprofits funded more than 33% by the public (including government grants) will be classified as public charities, even if these organizations primarily make grants and provide funding to other organizations, rather than conduct its own charitable activities.
Private Operating Foundations (the hybrid)
A private operating foundation combines elements of both private foundations and public charities. As with private foundations, the bulk of a private operating foundation’s income usually comes from a small number of donors. However, unlike private foundations, (and as with public charities) private operating foundations use their income to directly operate charitable programs or services. Thus, in essence, a private operating foundation sponsors and manages its charitable activities.
Private operating foundations are still taxed on their net investment income and also must comply with many of the same restrictions and regulations that apply to private foundations. However, a private operating foundation will not be taxed if it fails to distribute its investment income. Additionally, donors to private operating foundations may deduct up to 50% of their adjusted gross income (same as donations to public charities), rather than the 30% limit applicable to private foundations. Finally, a private operating foundation may receive donations from private foundations, provided the private foundation does not control the private operating foundation.
What does this all mean to you before you start your own non-profit? It means you need to know where your funding will come from and how the funding will be distributed. It also means you should understand how you want to organize and operate your non-profit. Without this foresight, you may find yourself taxed more than you expected, even as a “tax-exempt” organization.
- Are You Ready to Start a Nonprofit?
- Nonprofit FAQs – Getting to Tax Exemption
- Nonprofit Board of Directors FAQs
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