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Tax Classification of Charitable Organizations: A Primer

December 2, 2014

PUBLIC CHARITIES AND PRIVATE FOUNDATIONS

Overview of Requirements for Exemption as Charitable Organization. A charitable organization is exempt from federal income tax under section 501(a) of the Internal Revenue Code (the Code) if it is described in section 501(c)(3) of the Code. An organization described in section 501(c)(3) of the Code is one that is organized and operated exclusively for one or more of the purposes set forth in section 501(c)(3) of the Code. These exempt purposes include, but are not limited to, religious, charitable, educational, literary and scientific purposes. Additionally, a 501(c)(3) organization’s earnings may not inure to the benefit of any private shareholder or individual. Also, no substantial part of a section 501(c)(3) organization’s activities may be the carrying on of propaganda, or otherwise attempting to influence legislation, and a section 501(c)(3) organization may not participate in, or intervene in (including the publishing or distribution of statements), any political campaign on behalf of, or in opposition to, any candidate for public office.

Further Classification of Charitable Organizations. Under section 509 of the Code, all section 501(c)(3) organizations are further classified as either “public charities” or “private foundations.” There are essentially four types of section 501(c)(3) organizations:

  • Organizations engaging in inherently public activity
  • Publicly supported organizations
  • Supporting organizations
  • Private foundations

A section 501(c)(3) organization is presumed to be a private foundation, unless it can establish to the satisfaction of the Internal Revenue Service that it meets one of the other classifications. Because private foundations are subject to a number of special rules, most charitable organizations, other than family or corporate foundations, prefer tax classification as other than a private foundation. The private foundation rules limit the allowable income tax charitable deduction for contributions to a private foundation; impose a 2-percent excise tax on a private foundation’s net investment income; impose an excise tax on self-dealing transactions, jeopardy investments, excess business holdings and taxable expenditures; prohibit lobbying activities; and impose a mandatory distribution requirement in each year for charitable purposes. New rules imposed on certain types of supporting organizations by the Pension Protection Act of 2006 and the final and temporary regulations issued by the Internal Revenue Service in 2012 also make certain types of supporting organizations less desirable in many circumstances.

Inherently Public Charities. Inherently public charities are charitable organizations that are considered public because of the nature or type of activity they conduct. Because the activities are inherently public in nature, the organizations are afforded the benefits of public charity classification under Internal Revenue Code section 509(a)(1). Inherently public charities include the following:

  • Churches
  • Qualified hospitals
  • Educational institutions, including private schools, colleges and universities
  • Certain organizations that support a public college or university
  • Governmental units

Publicly Supported Organizations. Certain organizations are afforded public charity classification by virtue of the sources of their support. There are two types of publicly supported organizations. Organizations described in sections 509(a)(1) and 170(b)(1)(A)(vi) of the Code are publicly supported organizations that receive substantial financial support from contributions made by other publicly supported organizations, governmental units, the general public or a combination of such sources. By contrast, organizations described in section 509(a)(2) of the Code are publicly supported organizations that receive more than one-third of their financial support from contributions, membership fees and gross receipts from activities related to their exempt functions, and no more than one-third of their financial support from gross investment income.

Sections 509(a)(1) and 170(b)(1)(A)(vi) Publicly Supported Organizations. An organization described in sections 509(a)(1) and 170(b)(1)(A)(vi) of the Code is treated as publicly supported if the total amount of financial support that it normally receives from governmental units or the general public is at least one-third of the total support received by the organization. The organization’s support for purposes of the test is determined on a five-year aggregate basis.

Sources of “public support” include the following:

  • Gifts, grants (including governmental grants) and contributions
  • Membership fees
  • Gross income from interest, dividends, amounts received from payments on securities loans, rents, royalties and unrelated business taxable income
  • Net income from unrelated business activities, whether or not such activities are carried on regularly as a trade or business
  • Tax revenues levied for the organization’s benefit and paid to or expended on behalf of the organization
  • The value of services or facilities (exclusive of services or facilities furnished to the public without charge) furnished by a governmental unit to the organization without charge

Additionally, direct and indirect contributions from certain sources − such as an individual, trust, business entity, supporting organization or private foundation − are included within the calculation of public support only to the extent that those contributions do not exceed 2 percent of the organization’s total support. This limitation ensures that support will come from a broad cross-section of the general public rather than from a few substantial donors.

An organization will be treated as “publicly supported” if the total amount of support that the organization “normally” receives from the public or governmental sources described above is at least one-third of the total support received by the organization.

If an organization cannot meet the one-third public support test, it may still be treated as a publicly supported organization under sections 509(a)(1) and 170(b)(1)(A)(vi) of the Code if it can meet a “facts and circumstances” test. To meet this test, the organization must satisfy two requirements. First, the organization must show that it normally receives a substantial part of its support from governmental units, contributions given by the general public or a combination of these sources, but the support fraction can be as low as 10 percent. Second, the organization must establish that it is in the nature of a “publicly supported” organization taking into account certain factors. Relevant factors include the following:

  • The percentage of financial support from public or governmental units
  • The sources of support
  • The existence of a representative governing body
  • The availability of public facilities or services and public participation in programs or policies

Section 509(a)(2) Publicly Supported Organizations. An organization that cannot meet either of the public support tests under sections 509(a)(1) and 170(b)(1)(A)(vi) may instead be able to satisfy the public support test under section 509(a)(2). Organizations that meet the section 509(a)(2) support test are usually those that receive some type of fee income in connection with the performance of their exempt functions.

There are two tests that must be satisfied under section 509(a)(2). First, investment income cannot exceed one-third of the organization’s total support. Second, more than one-third of the organization’s total support must be received from one or more of the following sources:

  • Gifts, grants, contributions and membership dues from nondisqualified persons
  • Admission fees to exempt function facilities or performances
  • Fees for the performance of exempt function services
  • Sales of goods related to the organization’s activities

Differences Between Section 509(a)(1) and 509(a)(2) Organizations. While the public support tests under sections 509(a)(1) and 509(a)(2) are similar, there are some important distinctions. First, “support” under section 509(a)(2) includes income derived from activities related to an organization’s exempt purpose, whereas section 509(a)(1) excludes this income. Second, an organization with a large endowment may not be able to qualify under section 509(a)(2) because of the limitation on the amount of gross investment income that can be earned. Section 509(a)(1) has no such restriction. Third, contributions in excess of $5,000 from a single donor are completely disregarded in determining public support under section 509(a)(2), if the donor contributes more than 1 percent of the organization’s support. In contrast, for purposes of the section 509(a)(1) support test, only the portion of a contribution in excess of the 2-percent limit is disregarded if received from an individual or corporation. Generally, there is no limit if such amounts are received from a governmental unit or another section 509(a)(1) public charity. Fourth, there is no “facts and circumstances test” under section 509(a)(2). Finally, under section 509(a)(2), a donor’s payment for goods or services are classified as “gross receipts” and are excluded from support to the extent they exceed $5,000 or 1 percent of an organization’s total support. Under section 509(a)(1), gross receipts are excluded.

Supporting Organizations. A supporting organization is a charitable organization that supports one or more public charities described in sections 509(a)(1) or 509(a)(2) of the Code. Supporting organizations must have a close relationship with a publicly supported charity. Because of this relationship, supporting organizations are not required to meet the public support tests but are treated like public charities for most purposes. Contributions to supporting organizations are given the same favorable income tax treatment afforded to contributions made to other types of public charities. Set forth below is a brief overview of the supporting organization rules. More information can be found in a McGuireWoods white paper available here.

Requirements for Classification as a Supporting Organization. To be classified as a supporting organization, an organization must meet three requirements. The organization must:

  • be organized and at all times thereafter operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more public charities;
  • be operated, supervised or controlled by or in connection with one or more public charities; and
  • not be controlled directly or indirectly by one or more disqualified persons (other than foundation managers) within the meaning of section 4946 of the Code.

Organizational Test. The organizational test requires that supporting organizations be organized for the benefit of one or more public charities that are specified in the organizations’ articles of incorporation. One common method of ensuring compliance with the organizational test is to designate the supported public charity or charities by name in the supporting organization’s governing documents.

Operational Test. The operational test requires that the organization be “operated exclusively” to support one or more specified public charities. An organization will meet the operational test only if it engages solely in activities that support or benefit the specified public charity or charities. Permissible activities may include making payments to or for the use of, or providing services or facilities for, individual members of the charitable class benefited by the supported public charities. However, the organization will not meet the operational test if any part of its activities furthers a purpose other than supporting or benefiting the specified public charity or charities.

Relationship Test. A supporting organization must have one of three types of relationships with the public charity or charities it supports. The key feature of the relationship test is that the relationship must ensure that the organization will be responsive to the needs or demands of the public charity or charities it supports and will constitute an integral part of, or maintain a significant involvement in, the operations of the public charity or charities it supports. The permissible relationships are:

  • a parent-subsidiary relationship in which the supported organization is operated, supervised or controlled by the public charity or charities it supports (Type I);
  • a brother-sister relationship in which the same persons or entities control both the supporting and the supported organizations (Type II); or
  • a relationship in which the supporting organization is operated in connection with the supported organization in a way that satisfies a responsiveness test and an integral part test (Type III).

Type III supporting organizations are subject to stricter regulations than are other supporting organizations. All such organizations must provide to their supported organization an annual report that includes the supporting organization’s most recent Form 990, copies of its governing documents and a description of the support provided to the supported organization for the year. Additionally, all Type III supporting organizations must satisfy a “responsiveness” test and an “integral part” test. The responsiveness test ensures that a supporting organization is responsive to the needs or demands of its supported organization, while the integral part test ensures that the supporting organization maintains significant involvement in the operations of its supported organization. Failure to satisfy these tests may cause a Type III supporting organization to be reclassified as a private foundation.

The Pension Protection Act of 2006 further classified Type III supporting organizations as “functionally integrated” and “nonfunctionally integrated.” Additional restrictions apply to certain “nonfunctionally integrated” Type III supporting organizations. For example, distributions made by private foundations to such organizations will not qualify for purposes of the foundations’ annual distribution requirement. And, nonfunctionally integrated Type III supporting organizations are themselves required to make minimum annual distributions (similar to the distribution requirement imposed on private foundations). They are also subject to the excise tax on excess business holdings that applies to private foundations.

Private Foundations. The federal tax laws do not define the term “private foundation.” Rather, the laws in section 509 of the Code enumerates the types of charitable organizations that are not private foundations (such as public charities and supporting organizations, discussed above) and assumes that a charitable organization is a private foundation unless such organization can establish otherwise. Typically, private foundations are organizations that are unable to satisfy the public support tests under sections 509(a)(1) and 509(a)(2) because they receive most of their revenue from a single individual or family, a corporation, or a small group of private donors. Control over a private foundation is often concentrated in the hands of the foundation’s primary donors. There are two types of foundations: private nonoperating foundations and private operating foundations. Generally, references to “private foundations” refer to private nonoperating foundations. Private operating foundations are briefly discussed below.

Most private foundations carry out their charitable activities by making grants to other charitable organizations rather than by conducting charitable programs and services directly.

Because of the lack of public oversight and participation in these foundations, they are strictly regulated to prevent private benefit and ensure that they operate in furtherance of charitable purposes.

Tax on Net Investment Income. A private foundation must pay an excise tax of 2 percent on its net investment income. The 2-percent excise tax may be reduced to 1 percent for certain tax years in which the foundation’s payout rate is increased. (There are several legislative proposals to simplify this tax by imposing only a 1-percent excise tax on all private foundations regardless of the foundation’s payout rate.)

Self-Dealing. The self-dealing rules prohibit certain direct or indirect transactions between a private foundation and its disqualified persons. Disqualified persons include substantial contributors (generally, anyone contributing more than $5,000 to the foundation); a foundation manager (any officer, director, trustee or employee of the foundation); any 20-percent owner of a business that is a substantial contributor to the foundation; any family member of the persons described above; any corporation, partnership, trust or estate in which persons described above have more than a 35-percent interest; and any government official. Although there are a number of statutory and regulatory exceptions, acts of self-dealing generally include:

  • any sale, exchange or leasing of property between a private foundation and a disqualified person;
  • any lending of money or other extension of credit between a private foundation and a disqualified person;
  • any furnishing of goods, services or facilities by a private foundation to a disqualified person;
  • the payment of compensation or expenses by the private foundation to a disqualified person;
  • any transfer to, or use by, a disqualified person of the private foundation’s income or assets; and
  • any agreement to make any payment of money to a government official.

The major exceptions to self-dealing include payment of reasonable compensation and reimbursement of reasonable expenses by a private foundation to disqualified persons or employees for services rendered and gratuitous transfers of property by a disqualified person to the private foundation.

Minimum Distributions. Private foundations must make annual distributions in the form of qualifying distributions of at least 5 percent of the average fair market value of the foundation’s noncharitable use assets (i.e., the foundation’s investment assets). For purposes of satisfying this requirement, private foundations can make grants to a number of eligible recipients, including public charities, supporting organizations (other than nonfunctionally integrated Type III supporting organizations), certain private operating foundations and government organizations. Distributions to private nonoperating foundations and controlled organizations do not count toward the minimum distribution requirement unless certain requirements are met. The failure to meet the minimum distribution requirement may subject the foundation to excise tax.

Excess Business Holdings. Private foundations and their foundation managers may be subject to an excise tax if the foundation has an excess business holding. The excess business holdings rules can apply only if there is an excess business holding in a “business enterprise.” The term “business enterprise” is not specifically defined, but does not include a functionally related business or a trade or business at least 95 percent of the gross income of which is derived from passive sources. Generally, under the excess business holdings rules, the “permitted holdings” of a private foundation in any incorporated business enterprise are 20 percent of the voting stock of such business enterprise, reduced by the percentage of the voting stock owned by all disqualified persons. In the case of a partnership or joint venture, reference is made to the profits interest held by the foundation and disqualified persons rather than the voting stock. In all other cases, reference is made to the beneficial interest owned by the foundation and disqualified persons.

The term “excess business holdings” means the amount of stock or other holdings that the private foundation would have to dispose of to a person other than a disqualified person in order for the foundation’s holdings in the business enterprise to be “permitted holdings.” There is a de minimis rule that provides that the private foundation will not be treated as having an excess business holding if it does not own more than 2 percent of the voting stock and not more than 2 percent in value of all of the outstanding shares of all classes of stock in a business enterprise.

There are also special rules that apply when a private foundation receives holdings in a business enterprise by gift or bequest. If a private foundation acquires holdings in a business enterprise other than by purchase by the private foundation or disqualified persons with respect to the foundation and the acquisition causes the private foundation to have an excess business holding, the foundation has five years to dispose of sufficient holdings to eliminate the excess business holdings. The rule works essentially by treating the excess business holdings of the private foundation as being held by a disqualified person for this five-year period rather than by the private foundation.

Jeopardy Investments. If a private foundation invests its assets in a manner that jeopardizes the accomplishment of the foundation’s exempt purposes, the foundation and its foundation managers who participated in the investment decision may be subject to excise taxes. While there is no list of investments that are automatically considered to jeopardize a foundation’s accomplishment of its exempt purposes, certain types of investments may trigger extra scrutiny:

  • Trading securities on margin
  • Trading in commodity futures
  • Investing in working interests in oil and gas wells
  • Purchasing puts, calls, straddles or warrants
  • Selling short

Taxable Expenditures. A private foundation that makes a taxable expenditure may be subject to excise taxes. Taxable expenditures include the following:

  • Expenditures to carry on propaganda or otherwise to attempt to influence legislation
  • Expenditures to influence the outcome of any specific public election or to carry on, directly or indirectly, any voter registration drive
  • Grants to an individual for travel, study or other similar purposes unless the grant is awarded on an objective and nondiscriminatory basis and is approved in advance by the Internal Revenue Service
  • Grants to an organization that is not a public charity described in Internal Revenue Code section 509(a)(1), (2), or (3) (other than a nonfunctionally integrated Type III supporting organization) unless the foundation exercises expenditure responsibility over the grant
  • Expenditures for any purpose other than a charitable, religious, scientific, literary or educational purpose

Expenditures that will not be treated as taxable expenditures include the acquisition of investments to generate income to be used in furtherance of the foundation’s charitable purposes as well as reasonable expenses with respect to the foundation’s investment activities.

Private Operating Foundations. A private operating foundation conducts its own charitable programs rather than making grants to public charities. Accordingly, these foundations are not required to meet the minimum distribution requirements imposed on other private foundations. In addition, private operating foundations are treated like public charities for purposes of the income tax charitable deduction rules. To maintain classification as a private operating foundation, however, the foundation must meet an income test, as well as an assets test, endowment test or support test.

Income Test. Under the income test, a private operating foundation must use substantially all (at least 85 percent) of its adjusted net income or its minimum distribution amount (ordinarily 5 percent), whichever is less, directly for the active conduct of its exempt charitable activities. Grants to other organizations do not count as direct expenditures.

Assets Test. The assets test requires that substantially more than one-half (at least 65 percent) of the private operating foundation’s assets are actually used for the active conduct of its exempt charitable activities or functionally related businesses. Stock in a corporation that the foundation controls and of which substantially all of the assets are devoted to charitable purposes will also qualify under the assets test.

Endowment Test. Under the endowment test, a private operating foundation must normally expend at least two-thirds of its minimum distribution amount directly for the active conduct of exempt charitable activities to meet this test.

Support Test. The support test has three requirements. First, substantially all of a private operating foundation’s support must be normally received from the general public and at least five exempt organizations that are not disqualified persons with respect to each other or the private operating foundation. Second, not more than 25 percent of a private operating foundation’s support may be normally received from any one of the five exempt organizations. Finally, not more than half of a private operating foundation’s support may be normally received from gross investment income.

Conclusion. An understanding of the tax classification of charitable organizations is critically important. Publicly supported organizations, whether classified under Code section 509(a)(1) or 509(a)(2), must continue to satisfy a public support test whereas supporting organizations do not. As described above, private foundations face severe penalties for failure to abide by strict rules that generally do not apply to public charities. An organization’s directors and officers should know the organization’s tax classification and the particular requirements imposed on the organization by the Code.

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