501(c)(3)s are not all the same - what's your nonprofit's foundation classification

While most starting out in the nonprofit community are aware what 501(c)(3) means, many are unaware that there are different classifications, or types, of 501(c)(3) nonprofits. Specifically, there are two main 501(c)(3) nonprofit types: public charity or private foundation, each of which with their own subclassifications. In practice, the classification and subclassification of a 501(c)(3) is known as its “foundation status.”

Determining the foundation status of an organization is important because the type of a 501(c)(3) nonprofit dictates what a nonprofit can do, cannot do and must do. In general, being classified as a private foundation is less tax advantageous than being classified as a public charity. The purpose of this blog post is to provide an overview of the different foundation statuses available to a nonprofit.

A breakdown of 501(c)(3) nonprofit types is as follows:

Public Charities

In order for a 501(c)(3) nonprofit to be classified as a “public charity,” it needs to be an organization described in Section 509(a)(1), (2), (3) or (4) of the Internal Revenue Code. These correspond, respectively, to the four main sub-types of 501(c)(3) nonprofit: per se and donation based publicly supported nonprofits, publicly supported revenue based nonprofits, supporting organizations, and testing for public safety organizations.

509(a)(1) Public Charities: Per Se and Donation Based Publicly Supported Nonprofits

509(a)(1) of the Internal Revenue Code deems all organizations described in Sections 170(b)(1)(A)(i)-(vi), and (ix), to be public charities. In case you are wondering, Section 170 of the Internal Revenue Code addresses tax-deductions for charitable contributions to 501(c)(3) nonprofits, as well as limitations on tax-deductions. Section 170(b)(1) limits the annual charitable tax-deduction amount of a human donor to organizations described in a subsection of Section 170(b)(1)(A) to 50% of the donor’s annual adjusted gross income. Section 170(b)(1)(A)(vii) and (viii) are excluded from 509(a)(1) because the former describes private operating foundations and exempt operating foundations, which are special sub-types of private foundations that are entitled to the same deduction privileges (the limitation on private nonoperating foundations is 30% instead of 50%), and the latter describes 509(a)(2) and 509(a)(3) public charities.

509(a)(1) public charities are described by those of us who practice nonprofit law as either per se public charities (i.e., public charities because of a nonprofit’s general character) or publicly supported charities (i.e., because of a nonprofit’s support from the general public).

509(a)(1) Per Se Public Charities

Organizations described in Sections 170(b)(1)(A)(i), (ii), (iii), (v) and (ix) are called per se public charities because these organizations are considered public charities solely by virtue of their character, irrespective of the source of donations. They consist of the following organizations:

170(b)(1)(A)(i) Houses of Worship: Churches, temples, mosques and other houses of worship, and groups, conventions and associations of houses of worship.
170(b)(1)(A)(ii) Educational Institutions: Schools, colleges, universities and other educational organizations that have a regular faculty, curriculum and enrolled student body.
170(b)(1)(A)(iii) Medical Institutions: Hospitals, clinics, and medical education and medical research organizations.
170(b)(1)(A)(v) Government Units: States and territories of the United States, and political subdivisions of such states and territories.
170(b)(1)(A)(ix) Agricultural Research Institutions: Agricultural research organizations directly engaged in the continuous active conduct of agricultural research in conjunction with certain educational institutions.

509(a)(1) Publicly Supported Donation Based Public Charities

Organizations described in Sections 170(b)(1)(A)(iv) and (vi) are called publicly supported charities because these organizations are considered public charities by virtue of a significant portion of their donations coming directly or indirectly from the general public. They consist of the following organizations:

170(b)(1)(A)(iv) University Related Organizations: Organizations that receive significant support from donations from government or the general public, that administer property and make expenditures for the benefit of public universities and colleges.
170(b)(1)(A)(vi) Generally Publicly Supported Organizations: Organizations that are envisioned to receive significant support from donations from government or the general public.

The Section 170(b)(1)(A)(vi) public charity is one of the most common foundation statuses for public charities. To qualify, and continue to qualify, as a public charity, 170(b)(1)(A)(vi) nonprofits must satisfy what is called the 33⅓-percent public support test, and failing that, the 10-percent facts and circumstances test. The percentage values are indicative of the threshold percentage of the amount of donations deemed directly or indirectly received from the general public or government sources, in relation to the gross revenue of the nonprofit other than mission-related program sales, over a 5-year period.

509(a)(2) Public Charities: Publicly Supported Revenue Based Nonprofits

509(a)(2) of the Internal Revenue Code describes another type of publicly supported charity, in addition to those described in Section 170(b)(1)(A)(vi). Unlike the nonprofits described in Section 170(b)(1)(A)(vi) which can only use donations to determine public support, 509(a)(2) nonprofits are allowed to use mission-related income from sales of goods and services, in addition to donations, to determine public support. An example of a 509(a)(2) public charity would be a 501(c)(3) theatre that receives significant support from ticket sales.

To qualify, and continue to qualify, as a public charity, 509(a)(2) nonprofits must satisfy both a more than 33⅓-percent public support test and a less than 33⅓-percent investment income test. The first percentage value is indicative of the threshold percentage of the amount of donations and mission-related program sales deemed directly or indirectly received from the general public or government sources, in relation to the gross revenues of the nonprofit, over a 5-year period. The second percentage value is indicative of the threshold percentage of the amount of investment income and non-mission-related income, in relation to the gross revenues of the nonprofit, over the same period.

509(a)(3) Public Charities: Supporting Organizations

509(a)(3) of the Internal Revenue Code describes nonprofits that are considered public charities by virtue of their role in supporting other public charities. They are called “supporting organizations” because they must be organized and operated, exclusively for the benefit of, to perform the functions of, or to carry out the purposes of a 509(a)(1) or 509(a)(2) public charity. Specifically, 509(a)(3) public charities can be subclassified into Type I, Type II, Functionally Integrated Type III, and Non-Functionally Integrated Type III, supporting organizations, as follows:

Type I: Organizations operated, supervised, or controlled by one or more eligible supported organizations. The relationship between the supported organization and a Type I supporting organization is often structured as a parent-subsidiary relationship, for example, where the supported organization is the sole member of the supporting organization.
Type II: Organizations supervised or controlled in connection with one or more eligible supported organizations. The relationship between the supported organization and a Type I supporting organization is often structured as a sister relationship, for example, where the supported organization and the supporting organization either share a significant number of board members, or where a third organization is the sole member of both organizations.
Functionally Integrated Type III: Organizations operated in connection with one or more eligible supported organizations, where the supporting organization either conducts or supports a program related function of the supported organization, or where the supporting organization is a the parent of the supported organization and exercises a substantial degree of direction and control over the supported organization.
Non-Functionally Integrated Type III: Organizations operated in connection with one or more eligible supported organizations, where the supporting organization distributes the greater of 85 percent of its adjusted net income or 3.5 percent of the fair market value of its non-program related assets, to the supported organization, and which is sufficiently attentive to the needs of the supported organization and its operations.

509(a)(4) Public Charities: Testing for Public Safety Organizations

509(a)(4) of the Internal Revenue Code describes nonprofits that are considered public charities because they are organized and operated exclusively for testing for public safety. This is a relatively uncommonly used foundation status.

Private Foundations

When a 501(c)(3) nonprofit does not qualify, or ceases to qualify, as a public charity, it will be classified as a “private foundation.” Private foundations are “private” because they are envisioned to be supported by one or a small number of people, families or businesses, rather than by the general public.

As private foundations have, in the past, been implicated with many abusive tax practices, private foundations are subject to more restrictions than public charities. These restrictions include absolute prohibitions on lobbying activities and on certain transactions between the nonprofit and its insiders (such as directors, officers and substantial contributors), restrictions on certain business holdings, investments and expenditures, and annual requirements to use or distribute certain assets.

Private Nonoperating Foundations

The default type of private foundation is the private nonoperating foundation. A 501(c)(3) nonprofit that is not a public charity is automatically subclassified as a private nonoperating foundation unless it specifically receives a different subclassification determination. Private nonoperating foundations are “nonoperating” because they are envisioned to advance their 501(c)(3) purposes primarily by disbursing funds to other organizations, rather than by running their own programs internally (although they are not prohibited from doing so).

The private nonoperating foundation sub-type is the least tax-advantageous subclassification a 501(c)(3) nonprofit can have. Compared with a public charity, a private nonoperating foundation:

Is subject to harsh “self-dealing” rules which restrict many transactions between an insider and the nonprofit (even when the transaction will be beneficial to the nonprofit), in addition to the more forgiving “excess benefit transaction” rules that public charities are subject to;
Is subject to “minimum distributable amount” rules, which require the use or distribute a minimum amount of its asset value each year for 501(c)(3) purposes;
Is subject to “excess business holdings” rules which, except in extremely limited circumstances, prohibit ownership for-profit subsidiaries, or significant portions of for-profit companies;
Is subject to “jeopardizing investment” rules, restrict both the type and manner of investments that a private foundation can make;
Is subject to “taxable expenditure” rules, which restricts certain expenditures a private foundation can make, including absolute prohibitions on lobbying activity, due diligence requirements for certain grants, and restrictions on certain grants to individuals;
Is subject to lower tax-deduction ceilings than public charities (for cash donations,30% of a human donor’s adjusted gross income compared to 50% for public charities and private operating foundations);
Cannot receive grants from other private foundations to satisfy the donor foundation’s “minimum distributable amount” requirements, unless special due diligence procedures are utilized; and
Is subject to tax on investment income.

Private Operating Foundations

Another sub-type of private foundation is the private operating foundation. A private operating foundation is “operating” because, unlike the nonoperating foundation, is envisioned to advance its 501(c)(3) purposes primarily by running its own programs and initiatives.

In order to be subclassified as a private nonoperating foundation, a private foundation must use either 85% of 5% of its total non-program assets value, or 85% of its net income (subject to certain adjustments), each year, on its own 501(c)(3) program related operations and activities. In addition, to be subclassified as a private nonoperating foundation, a private foundation must also fulfil one of the three following tests:

Assets Test: At least 65% of the private foundation’s assets must be used in its own 501(c)(3) programs related operations and activities, either by itself or through an entity controlled by the foundation (it is important to understand that this test is generally not dependent on distributions, but rather the foundation’s use of assets such as real estate and intellectual property).
Endowment Test: The foundation must spend at least 2/3 of 5% of the combined fair market value of all of its non-program related assets on its own 501(c)(3) program related operations and activities.
Income Test: At least 85% of the support received by the private foundation comes from the general public and 5 or more unrelated exempt organizations, not more than 25 percent of support is received from any one exempt organization, and not more than 50% of its support is from gross investment income.

The benefit of qualifying as a private operating foundation is that unlike nonoperating foundations, private operating foundations

have the same tax-deduction ceiling as public charities;
exempt from punitive taxes levied for violation of the “minimum distributable amount” rules (although it is still subject to the spending rules necessary to maintain the private operating foundation classification); and
can receive grants from other private foundations to satisfy the donor foundation’s “minimum distributable amount” rules on the same basis as public charities

the tax-deduction ceiling available to donors is similar to those of public charities, are exempt from punitive taxes levied for violation of the “minimum distributable amount” rules (although it is still subject to the spending rules necessary to maintain the private nonoperating foundation classification), and can receive grants from other private foundations to satisfy the donor foundation’s “minimum distributable amount” requirements on the same bases as public charities.

Exempt Operating Foundations

The exempt operating foundation is a rare subtype of private nonoperating foundation. In general, it is a private nonoperating foundation that has been publicly supported for a minimum of 10 years, has a board where 76% of all directors are independent directors, and has no officer that is not independent.

In addition to the benefits of other private operating foundations, the exempt operating foundation is also exempt from the tax on investment income. That being said, very often, an exempt operating foundations can also qualify for reclassification as a public charity.

This blog post is provided for general informational purposes only. It is not legal advice, and should not be a substitute for legal advice. If you have questions or comments about the post, or would like to learn more about something in the post, please feel free to contact me.

Additionally, you may be interested in taking a look at my New York nonprofit law services.

501(c)(3) Nonprofit Types: Public Charity & Private Foundation Classification