501(c)(3)s: Private Foundation versus Public Charity

Every section 501(c)(3) organization is classified as either a private foundation or a public charity. Both private foundations and public charities 501(c)(3) public charities are organized and operated exclusively for the following exempt purposes: charitable, religious, educational, scientific, literary, testing for public safety, amateur athletic organizations, and organizations that prevent cruelty to children or animals. 

Private Foundation Versus Public Charity - What is the Difference?

Public charities have greater freedom to pursue their mission and face far fewer restrictions than do private foundations. Private foundations and public charities are distinguished primarily by the level of public involvement in their income generating activities.

Public charities generally receive a greater portion of their financial support from the general public or governmental units, and have greater interaction with the public. Public policy assumes that a charity dependent on raising money, either directly or indirectly, from the general public has greater incentives toward transparency, competence, and good government (in other words, that the “market” for public donations will keep public charities honest).

A private foundation, on the other hand, is typically supported by members of a single family or by a small group of individuals, and derives much of its revenue from a small number of sources and from investment income. Because private foundations generally are less open to public scrutiny, they are subject to various operating restrictions and to excise taxes for failure to comply with those restrictions.

Under the tax law, a section 501(c)(3) organization is presumed to be a private foundation unless it requests, and qualifies for, a ruling or determination as a public charity.  Organizations that qualify for public charity status include churches, schools, hospitals, medical research organizations, publicly-supported organizations (i.e., organizations that receive a specified portion of their total support from public sources), and certain supporting organizations.

501(c)(3) Public Charities:

501(c)(3) public charities benefit the community at large, and receive funding from diverse public sources.

To be tax-exempt under section 501(c)(3) of the Internal Revenue Code, none of a corporation’s earnings may “inure” to any private shareholder or individual.  This means that the organization must benefit the community broadly, and all revenues left over after expenses are paid must be reinvested into the nonprofit corporation for its charitable purposes.  Any payment(s) to a private individual must be made in fair exchange for a good or service provided.  If the organization engages in a lopsided transaction that benefits a private individual and harms the organization, especially if that private individual has substantial influence over the organization as an officer or director, an excise tax may be imposed on the individual and any organizational leadership agreeing to the transaction.

501(c)(3) public charities must receive their funding from diverse, broad-based public sources.  An organization will qualify as publicly supported if it normally receives at least one-third of its total support from governmental units, from contributions made directly or indirectly by the general public, or from a combination of these sources. If the organization fails the one-third support test, it may qualify under the facts and circumstances test. If it fails both tests, the organization will be reclassified as a 501(c)(3) private foundation.

In addition, 501(c)(3) public charities may not be action organizations, i.e., they may not attempt to influence legislation as a substantial part of their activities and may not participate in any campaign activity for or against political candidates.

Examples of public charities tax-exempt under section 501(c)(3) of the Internal Revenue Code are: Youth athletic organizations, churches, historical societies, community centers, environmental groups, private/charter schools, hospitals, dog rescues, and cancer prevention organizations.

The IRS has put together a compliance guide for 501(c)(3) public charities

501(c)(3) Private Foundations:

On the other hand, private foundations receive funding from a single family or by a small group of individuals. Private foundations are generally non-operating, meaning they do not serve individual members of the community directly; rather, they function to benefit public charities who carry out those charitable programs.

501(c)(3) private foundations are prohibited from any form of political activity.

Private foundations are subject to various operating restrictions and taxes:

• There is an excise tax on the net investment income of most domestic private foundations. Public charities are not subject to this tax.

• There are restrictions on self-dealing between private foundations and their substantial contributors and other disqualified persons. Click here to read our blog article about these restrictions. Public charities are permitted to engage in limited self-dealing transactions (also called conflict-of-interest transactions) so long as the transaction is in the best interest of the organization and the board votes to waive the conflict.

• There are strict provisions to assure that the private foundation's expenditures further its exempt purposes and requirements that the private foundation annually distribute its income for charitable purposes (minimum distribution requirements).

• There are limits on a private foundation's holdings in private businesses.

• There are provisions that investments must not jeopardize the carrying out of a private foundation's exempt purposes.

• There is a termination tax. Public charities are not subject to this tax.
  

Violations of the provisions discussed above give rise to excise taxes and penalties against the private foundation and, in some cases, its managers, its substantial contributors, and certain related persons.

The IRS has put together a compliance guide for 501(c)(3) private foundations

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