If you think we’re capitalizing on the excitement of Top 10 Lists in order to make a tax topic more exciting … you’re right! This Top 10 List is designed to highlight the differences between private foundations and public charities, the two possible designations for a 501(c)(3) organization. Making this decision is not just a matter of checking a couple of boxes on your exemption application, but an important dive into the fundamentals of your organization—from whom will the money come, what activities will the organization engage in, and what will your compliance burden be?
Before we dive in, remember that 501(c)(3) entities will be private foundations by default. If you want status as a public charity, your nonprofit has to prove its eligibility.
The rules around public charities and private foundations are complex, but this list provides an overview of the key differences. Now let’s get started!
- Sources of Support Public charities “normally” receive a substantial part of their income, directly or indirectly, from the public or from the government in the form of donations or grants. “Normally” is measured based on an aggregation of the four years preceding the current tax year plus the current tax year, for a total of five years. Public charities have to meet one of two tests to prove their public support—a 331/3 % public-support test or a 10% facts-and-circumstances test. In practice, an organization doesn’t know for certain whether it qualifies as a public charity until five years after it’s formed (fun!).
Private foundations, by contrast, receive a substantial part of their income from investments and endowments, and all of a private foundation’s funding may come from a single source (like one family or one company).
- Activities Private foundations generally use their funds to make grants to individuals or other charities, as opposed to directly funding their own programs.
Public charities, in contrast, tend to carry out more so on-the-ground activities, such as operating a homeless shelter.
Note: Just to clarify the issue, private foundations sometimes do directly operate their own programs, and public charities can also make grants.
- Impact of Public Opinion Public charities have to solicit donations from the community on a regular basis, and thus have to appeal to public opinion and sentiment. Additionally, because there is competition for dollars among public charities, each organization strives to capture the same individual’s contribution.
Since private foundations have private, limited funding sources, foundations have a greater ability to ignore public opinion and support socially contentious projects. In addition, without the guiding influence of the market, private foundations may generate less-than-optimal outcomes by focusing efforts inefficiently.
- Expenditures Private foundations must annually distribute at least 5% of their net investment assets for charitable purposes (assets held by the foundation don’t count—only distributions out of the foundation are included).
Public charities don’t have any annual distribution requirements.
- Board Relationships Private foundation boards are subject to no composition requirements; in fact, many private foundation boards are made up entirely of family members.
Public charity boards should generally be drawn from a broader field, with no more than 50% of board members related by family or business relationships.
- Information Returns Private foundations are required to file annual information returns with the IRS—regardless of the amount and source of their income.
Public charities aren’t required to file a full annual information return until they have annual gross receipts exceeding $25,000. When a public charity has $25,000 or less in gross receipts, they can file a Form 990 “postcard”—super short, super easy.
- Donor Deduction Limitations Private foundations have a maximum deduction of up to 30% of their contribution base.
Public charities allow for a higher level of deduction for their donors. The maximum deduction is up to 50% of the contribution base.
- Extra RestrictionsPrivate foundations operate under many additional restrictions: (i) restrictions on self-dealing between private foundations, substantial contributors, and “disqualified persons” (a complex topic that’ll be the subject of its own blog post); (ii) limits on equity holdings in private businesses; and (iii) a prohibition from making investments for economic return that jeopardize the foundation’s ability to carry out its charitable purposes.
- Excise Taxes Public charities can celebrate—they’re not subject to excise tax.
Private foundations incur an excise tax in the event that they voluntarily terminate their private foundation status. Note that this excise tax is why it’s not great to convert from a private foundation to a public charity.
- The Word “Foundation” This is a tricky difference. If a 501(c)(3) entity has “foundation” in its name, it doesn’t necessarily mean that it is a private foundation. Many states allow public charities to use “foundation” in their name. Confusing? Yes, both for the organization and the people it interacts with.
Call your friendly neighborhood nonprofit tax lawyer; we’re eager to help you understand and navigate the benefits and obligations that come along with choosing and complying with either status, especially how these organizations can fit into a broader hybrid structure.