You may have a vision and a passion to make a difference in the world, be it in your own backyard or halfway around the world. These days, profound changes can result from the efforts of a single person. To get started, you might want to set up a nonprofit organization.
The two most common types of nonprofit organizations started by individuals are private foundations and public charities. And within those two broad categories, there are different subtypes. This article will help you understand the differences among them as a first step in deciding which charitable vehicle is best suited to what you want to accomplish.
Private Foundations
Private foundations are established for charitable purposes and to provide donors with a tax deduction for their contributions. These entities receive most of their support from a small number of contributors and are normally controlled by their founders or substantial donors. Amongst other requirements, foundations must make charitable distributions throughout their taxable year. Private foundations can be subdivided into two categories: “non-operating foundations” and “operating foundations.”
A. Non-Operating Foundations
These foundations must distribute annually an amount equal to 5% of their net investment assets in the form of qualifying distributions. Qualifying distributions include grants to qualified charities as well as all necessary and reasonable administrative costs (including Foundation Launch’s fees) to make those grants. Non-operating foundations do not typically provide services or conduct charitable activities themselves—instead, they make grants to public charities of their choice that do provide such services or conduct such activities.
B. Operating Foundations
Operating foundations are subject to the same rules applicable to non-operating foundations, except with respect to the annual distribution requirement. An operating foundation is a charity that “does its own thing,” or, in the language of the Internal Revenue Code, “actively conducts activities constituting the purpose or function for which it is organized and operated.” Essentially, an operating foundation makes qualifying distributions by sponsoring and managing its own charitable projects rather than by making grants to other organizations. An operating foundation must make annual expenditures for its active programs under an income test and also meet one of three different assets tests.
Income Test - This test requires an operating foundation to spend the lesser of (1) 85% of its annual “adjusted net income” or (2) 4.25% of its investment assets on its self-initiated charitable programs.
Adjusted Net Income = A – B – C – D
- A = Gross income of all types for the year
- B = Long-term capital gains
- C = Contributions received
- D = Ordinary and necessary expenses paid or incurred for the production or collection of gross income or for the management, conservation or maintenance of property held for the production of such income
Different Asset Tests - In addition to the income test, an operating foundation must meet any one of an “asset test,” an “endowment test,” or a “support test.”
Asset Test - Basically, the asset test measures the portion of the foundation’s assets devoted to the active conduct of its charitable activities. To meet this test, at least 65% of the fair market value of the operating foundation’s assets must be program related: an art collection, buildings, etc.
Endowment Test - Under the endowment test, an operating foundation’s annual distributions must equal at least 3% of its investment assets (compared to 5% for a non-operating foundation).
Support Test - Under the support test, an operating foundation’s revenues must come from donations from the general public and from five or more non-controlled charitable organizations, with none giving more than 25% of the operating foundation’s support.
The income and asset tests are applied each year for a four-year period that includes the current and past three years. An operating foundation has a choice of methods to calculate its compliance with the tests, but it must use the same method for both the income and asset tests:
- All four years can be aggregated, so that the distributions for four years are added together. An operating foundation must use only one of the asset, endowment, or support tests for all four years.
- For three of the four years, an operating foundation meets the income test and any one of the asset, endowment, or support tests.
If an operating foundation fails to qualify for a particular year, it is treated as a non-operating foundation
for that year. However, it can return to operating foundation classification as soon as it again qualifies under both the income test and the assets, endowment, or support test. New organizations generally must meet the test in their first year.
The most distinguishing characteristic of an operating foundation often is the most difficult quality to possess: the foundation must be significantly involved in its own projects in a continuing and sustainable fashion. To be involved might mean the foundation purchased goods and services to operate a museum, to conduct scientific research, to develop low-income housing, or to conduct some other charitable program. An operating foundation maintains a staff of researchers, teachers, curators, or other program specialists. Significant involvement of an operating foundation and its staff exists when the individual grants are part of a comprehensive program.
Public Charities
Public charities generally are organizations that: (1) by their very nature conduct inherently public activities regardless of their sources of support, (2) have broad public support, or (3) actively function in a supporting relationship to other charitable organizations that have broad public support.
A. Inherently Charitable Organizations
This first type of public charity includes:
- Churches or conventions or associations of churches
- Educational organizations
- Hospitals and medical research organizations
- Organizations that normally receive a substantial part of their support from the government or from the general public and that are organized for the benefit of state and municipal colleges and universities
- Governmental units (federal, state, county, city, etc.)
Each of the above types of organizations is inherently charitable and is deemed a public charity regardless of its source of support.
B. Publicly Supported Charities
The second type of public charity, which receives broad public support, can be subdivided into two categories: “donative charities” and “service-providing organizations.”
1. Donative Charities - Donative charities normally receive at least 33% of their annual support in the form of donations from members of the general public. “Normally” is based on an aggregation of the four years preceding the tax year in question and the tax year, for a total of five years. The 33% support formula does not include revenues the organization receives from performing its exempt activities–student tuition or patient fees, for example.
2. Service-Providing Organizations - This type of public charity includes entities that provide services to the public, such as museums, libraries, community centers, and the like. Like donative charities, service- providing organizations must meet public support tests. Unlike donative charities that disregard “fee for service” revenue in calculating public support, service-providing organizations count exempt function revenues and donations and grants as public support. Thus, this public charity category usually includes organizations receiving a major portion of their support from fees and charges for activity participation, such as day care centers, animal shelters, theaters, and educational publishers.
A two-part support test must be met to qualify as a service-providing organization:
a. Investment income cannot exceed 1/3 of the total support. Total support here means the organization’s gross revenue except for capital gains.
b. More than 1/3 of the total support must be received from exempt function sources made up of a combination of:
- Gifts, grants, contributions, and membership dues.
- Admissions to exempt function facilities or performances, such as theater or ballet performance tickets, museum or historic site admission fees, movie or video tickets, seminar or lecture fees, and athletic event charges.
- Fees for performance of services, such as school tuition, day care fees, hospital room and laboratory charges, psychiatric counseling, testing, scientific laboratory fees, library fines, animal neutering charges, athletic facility fees, etc.
- Merchandise sale of goods related to the organization’s activities, including books and educational literature, pharmaceuticals and medical devices, handicrafts, reproductions and copies of original works of art, by-products of a blood bank, and goods produced by disabled workers.
C. Supporting Organizations
The third listed type of public charity is commonly known as a “supporting organization.” Supporting organizations have been compared to barnacles: they attach themselves to (or support) one or more public charities and, in effect, acquire the public charity status of the organizations they support. The supporting organization must be carefully constructed to meet the complex tests required by the law and regulations. The two essential tests are a purpose test and a control test. The purpose test requires the supporting organization to benefit or carry out a purpose of the supported organization, ordinarily a public charity. The control test requires that the supported organization control the supporting organization. Here, the definition of “control” is fairly broad and can be satisfied applying one of several different approaches.
Two other important limitations on supporting organizations worth mentioning are:
Specified Public Charities - Normally it is expected that the charity or charities that will be supported will be specifically identified in the governing instruments by name. However, under some circumstances, specific identification can be avoided by identifying beneficiary organizations by class or purpose so long as other more technical tests are also met.
Limitation on Control - A supporting organization may not be controlled directly or indirectly by one or more disqualified persons, meaning substantial contributors to the foundation and their families. In this context, “control” means having 50% or more of the voting power of the organization or the right to exercise veto power over the activities of the organization.
