Our nonprofit is very close to the 33.3% public support threshold on the most recent Form 990 tax information return. Our auditors indicate that one year under this amount won't cause us to no longer qualify as a publicly supported organization. However, we don't want to fail this test two years in a row. We are trying to understand the implications of failing this test. What are the practical issues that a public charity must face if it is reclassified as a private foundation? —From the Website.
Your auditors are probably correct that having public support under 33.3% for a single five-year period (and maybe several more) will not cause you to convert to private foundation status as long as you still meet the 10% minimum under the “facts and circumstances” test. You also have ways to increase your public support for the next period by getting additional small contributions or, if the shortfall is caused primarily by too much investment income, changing your investments to securities that pay less in interest and dividends while still keeping the potential benefit of capital gains. (See Ready Reference Page: “Calculating Public Support”)
But having public charity status allows you substantially greater opportunities for your program than being a private foundation. The greatest practical difference is probably the loss of grants from private foundations. Private foundations are required to spend 5% of the value of their net investment assets each year for charitable purposes and grants to public charities qualify toward meeting that requirement. For one private foundation to make a grant to another private foundation is considered a “taxable expenditure” unless the granting foundation goes through a process called “expenditure responsibility” to justify the grant and report it to the IRS on its annual Form 990-PF. Because foundations often don’t want to go through that effort, and perhaps risk personal liability for their managers if they do it wrong, many private foundations simply don’t make grants to organizations that are not public charities. If private foundation grants are a major source of your support, your change in status could put you out of business.
That same private foundation limitation could make it more difficult for your own operations. As a public charity, you can make grants to other organizations for charitable purposes without needing to go through expenditure responsibility. You could make a grant to a for-profit electric utility to pay for heat for residents who couldn’t afford it during the winter, for example. You could also serve as a fiscal sponsor for a start-up group that has a great charitable program but is not recognized as a public charity by the IRS.
If part of your activity is advocacy and occasional lobbying for legislation affecting your issues, you would probably be prohibited from lobbying as a private foundation. While a public charity may lobby on legislation so long as it is not a substantial part of its activity, it is a taxable expenditure for a private foundation to lobby unless the legislation deals directly with the foundation’s rights and obligations, such as legislation to increase the required 5% minimum annual payout. (See Ready Reference Page: “Lobbying Rules Create Opportunities for Charities”)
The biggest personal risk to foundation managers comes from the draconian rules against self-dealing for private foundation managers compared to public charity managers. Public charity managers are subject to taxes on “excess benefits,” if they get more from the charity than they give in return. Excessive compensation, for example, would be taxed on the difference between what was paid and what was excessive. For a private foundation manager guilty of “self-dealing,” the tax would be based on the entire value.
Self-dealing for a private foundation includes not only excessive compensation, but also most furnishing of goods, services or facilities. A foundation manager could sell vans to a public charity for use in its program so long as the price is reasonable, but not to a private foundation, even if the sale was at cost from the manufacturer, because a sale for any amount would be an automatic self-dealing transaction taxed on the basis of the total value involved. It would be permissible for a private foundation only if the manager gave the vans to the charity without charge. (See Ready Reference Page: “Private Foundations Must Avoid Self-Dealing”).
Because the self-dealing rules cover “disqualified persons” of the foundation and because “disqualified persons” include family members of different generations, a parent or child who is a disqualified person could create a self-dealing transaction without the foundation knowing anything about it.
For more distinctions between public charities and private foundations, listen to our webinar on “Understanding Private Foundations, DAFs and Other Forms of Philanthropy.” To summarize the response to your basic question, however, it is much better to be qualified as a public charity than as a private foundation if you can.
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