The terms of nonprofit entities can be confusing … public charity … private foundation … corporate foundations … private operating foundations … public charities that act as foundations. What are they, and how do you tell which is which?
The word “foundation” can be especially confusing, since different types of tax-exempt entities can use the term foundation in its name.
The Internal Revenue Code distinguishes Section 501(c)(3) nonprofit organizations into various tax categories, including private foundations and public charities. Generally, private foundations and public charities are distinguished but a number of factors, including the level of public involvement in their activities.
Difference between public charity and private foundation
All Section 501(c)(3) Status are Organized and Operated For…
To be eligible for tax exemption under IRS Section 501(c)(3), an organization must be organized and operated for certain purposes, including
- testing for public safety,
- fostering national or international amateur sports competition, or
- prevention of cruelty to children or animals.
These organizational and operational requirements apply to both public charities and private foundations.
The purposes of a public charity and private foundation may be very similar.
What is a Public Charity?
Generally, many organizations that are classified as public charities are those that receive a greater portion of their financial support from the general public or governmental units, and have greater interaction with the public.
There are some categories of public charities that aren’t tied to funding – such as churches, schools, and hospitals.
Many public charities must meet a public support test following the Internal Revenue Code Section 509(a)(1)-(2) — which means that it must receive at least 1/3 of its support from contributions, membership dues, or gross receipts from its activities related to its exempt purpose.
Public charities may receive contributions from different sources, including the general public, governmental agencies, corporations, private foundations, among other sources. Some may hold fundraising events. Others may earn revenue from the conduct of activities in furtherance of the organization’s exempt purposes – such as tuition or fees for services.
However, some public charities are organizations that grant money to other public charities. Community foundations are examples of such organizations. Many of these organizations accept tax-deductible contributions to fund their grantmaking programs.
A public charity is either publicly supported (derives a substantial portion of its support from the public) or functions to support one or more organizations that are public charities.
What is a Private Foundation?
Private foundations are charitable organizations that do not qualify as public charities. Private foundations don’t meet one of the public charity tests under Internal Revenue Code Section 509.
Many are controlled by members of a family or by a small group of individuals, and usually derive much of their financial support from a small number of sources and/or investment income. Some private foundations invest their principal funding, then distribute the income from investments for charitable purposes.
Because they are less open to public scrutiny, private foundations are subject to various operating restrictions and to excise taxes for failure to comply with those restrictions.
The IRS recognizes different types of private foundations: private foundations and private operating foundations. Although the IRS uses a number of criteria to distinguish between the two, in practice, the key differences between a private nonoperating foundation and a private operating foundation are how they distribute their income or conduct activities:
- A private foundation might grant funds to other tax-exempt charitable organizations. It accomplishes its exempt purpose by grant-making to other organizations. These foundations often do not directly perform any charitable programs or services other than grant-making.
- A private operating foundation might distribute funds to its own programs that exist for charitable purposes. It devotes most of its resources to the active conduct of its exempt activities. These organizations are called private operating foundations because they are private foundations that actively conduct their own charitable, educational, or other exempt programs and activities. Examples of operating foundations include museums, zoos, research facilities, libraries, etc. Also, it is important to note that to qualify as operating, the foundation must satisfy an income test and one of three additional tests set forth by the IRS.
Private Foundation Restrictions
Because they may be less open to public scrutiny, private foundations are subject to various operating restrictions and to excise taxes for failure to comply with those restrictions.
Note that there are several restrictions and requirements on private foundations, including:
- No self-dealing – Restrictions on self-dealing between private foundations and their substantial contributors and other disqualified persons. See Internal Revenue Code (IRC) Section 4941.
- Minimum payout requirement – Requirements that the foundation annually distribute income for charitable purposes. See IRC Section 4942.
- Limits on their holdings in private businesses – A foundation cannot have excess business holdings (a controlling interest in a for-profit company, partnership, etc.) with disqualified persons. See IRC Section 4943.
- Jeopardy Investments – Provisions that investments must not jeopardize the carrying out of exempt purposes; and See IRC Section 4944.
- Excise Tax – Internal Revenue Code (IRC) Section 4940 imposes an excise tax on net investment income.
- Provisions to assure that expenditures further exempt purposes. IRC Section 4945 provides a list of various kinds of grantmaking or other expenditures that can subject a private foundation and its manager to penalty for making taxable expenditures. For example, funds spent in support of or in opposition to a political candidate, grants to non-charities and certain supporting organizations without exercising expenditure responsibility, and grants for non-charitable purposes would subject a foundation to taxes
Violations of these provisions give rise to taxes and penalties against the private foundation and, in some cases, its managers, its substantial contributors, and certain related persons.
Public Charities That Act as Grant-Making Organizations
A number of nonprofits that grant money to public charities are actually public charities themselves. Community foundations and the United Way are examples of such organizations. Many of these nonprofits accept tax-deductible contributions to fund their grantmaking programs.
Why is the Word “Foundation” So Confusing?
Not every organization that uses the word “foundation” in its name is a private foundation, and some public charities use the word “foundation” in their name. To look further to discover an organization’s actual tax-category, review the organization’s IRS filings: public charities will file Form 990; private foundations file Form 990-PF.
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