The early stages of launching a 501(c)(3) nonprofit can be overwhelming for the first-time nonprofit founder. Once you have figured out your cause, your programs, and have some plan for sustainability, the real work begins. The IRS application for exemption (Form 1023) is long and tedious, and the explanations for what it all means are not always clear. The first issue that can trip up those filling out the application is the distinction between a private foundation and public charity.
The IRS categorizes 501(c)(3) organizations as either private foundations or public charities. By far, the preferred status for most nonprofits is public charity status. Private foundation status is the default, unless your organization fits into the exceptions that provide public charity status. The advantages of public charity status are many and varied, and it is essential to understand the distinction between the classifications and how to fit into public charity (when there is a choice).
Private foundations are subject to far more regulation than public charities and are restricted from acts of self-dealing, maintaining excess business holdings, jeopardizing investments, and making certain expenditures. They also must meet minimum distribution requirements. The reporting requirements are burdensome, as well, with a more complex information return that must be filed annually.
Public charities are exempt from taxation on net investment income and certain federal excise taxes, where foundations must pay. Public charities also are in a better fundraising position due to several factors. First, higher dollar limits apply to contributions made by individuals and corporations to public charities, meaning the philanthropic folks interested in your cause benefit more from giving high dollar donations if you are a public charity. Public charities are also the only classification of 501(c)(3) organizations that may also establish and maintain pooled income funds. And, the expenditure rules that foundations are under make it far more likely that public charities can and will receive grant funding from private foundations.
There are four basic types of 501(c)(3) organizations that qualify as public charities. They are:
1. Organizations that engage in inherently public activities: Typically, churches, schools, hospitals, and governmental units meet this criterion.
2. Publicly supported organizations: Organizations that receive a substantial amount of their financial support from the public or government, or through purpose-related activities. This is the most common exception for 501(c)(3) public charities, and the primary test is the 1/3 support test. That is, at least one-third of the organization's total support must qualify as public support.
3. Supporting organizations: Essentially created to allow foundation-like organizations to qualify as charities as long as they are closely tied to an actual publicly-supported nonprofit, these organizations suffered from abuse at the hand of controlling interests. Recent changes in the law have tightened the oversight and limitations on these opportunities.
4. Organizations that test for public safety: This provision was added for organizations that test consumer products to determine their acceptability of use by the general public.
In most cases, the best route for public charity status is under the publicly supported organizations exception. Whatever your nonprofit idea, planning for a broad base of public support will both allow the highly preferable public charity status and will improve the organization's chances to survive and thrive.
About the Author-K. MacKillop, a serial entrepreneur with a J.D. from Duke University, is founder of LaunchX and blogs about starting a nonprofit. The LaunchX System Nonprofit Edition will help you determine the correct status for your nonprofit organization and will guide you step-by-step through the process of applying for tax-exempt status. Visit LaunchX.com to find out more.
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