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Public charities vs. private foundations: a practical guide.

In 1969, Congress subdivided Sec. 501(c)(3) organizations into two distinct classes, commonly referred to as "Public charities" and "private foundations." Because of the patchwork way in which Congress implemented the 1969 changes and because of some complex terminology, this subject continues to be a mysterious and vexing area of the tax law.

Public charities: the upper class

In reforming the rules for charitable organizations in 1969, Congress clearly intended to favor public charities - in general, organizations that draw their support from a broad base within the community, as well as certain traditionally favored institutions (such as schools, churches and hospitals). Conversely, Congress sought to restrict and regulate private foundations - usually family or corporate foundations engaged in charitable activities.

The most obvious advantage of public charity status is the more generous contribution limitations for individual donors. Under Sec. 170(b)(1)(a), an individual donor's deduction for contributions to public charities cannot exceed 50% of the individual's adjusted gross income (AGI), while contributions to private foundations are generally limited to 30% of AGI (Sec. 170(b)(1)(B)). Similarly, deductible contributions of appreciated capital gain property are generally limited to 30% of AGI if the recipient is a public charity (Sec. 170(b)(1)(c)), but only 20% if the recipient is a private foundation (Sec. 170(b)(1)(D)).

These basic contribution limits may be the most important distinction to donors. From the exempt organization's point of view, however, there are many other disadvantages to private foundation status, including the following.

[] A 2% excise tax is imposed under Sec. 4940 on the investment income of private foundations, including capital gains.

[] A penalty excise tax is imposed under Sec. 4945 on certain "taxable expenditures." Well-intentioned, but technically incorrect, grants to individuals or other foundation may run afoul of these restrictions. For example, grants to individuals for college scholarships pursuant to procedures that have not been approved in advance by the IRS are taxable expenditures. Similarly, grants to other private foundations can result in penalties if the granting foundation fails to exercise "expenditure responsibility" over the recipient foundation. (For this reason, large private foundations generally will not make grants to other private foundations.)

[] A penalty excise tax is imposed under Sec. 4941 on "self-dealing." This provision may come into play solely because of the relationship between the foundation and the other party to a particular transaction. The existence of a real advantage or benefit to the exempt organization from the transaction is generally not a defense to a violation (see, e.g., Regs. Sec. 53.4941(d)-2(a)(1)).

[] Other penalty exercise taxes apply in various circumstances described in Sec. 4942 (failure to distribute income), Sec. 4943 (excess business holdings) and Sec. 4944 (investment that jeopardize the entity's charitable purpose).

In contrast, the primary limitations on the activities of public charities are much more general. They include (1) a duty to carry out the organization's exempt purpose (Sec. 501((c)(3)); (2) a prohibition against "inurement" of benefit to private individuals (Sec. 501(c)((3)); and (3) a prohibition against political activity and lobbying (Sec. 501(c)(3) and Regs. Sec. 1.501(c)(3)-1(c)). All of these limitations also apply to private foundations.

Because of these differences, foundation managers frequently expend great effort to enable their foundations to be classified as public charities, and to protect that status once it is attained.

The determination of status

The legislative approach to the 1969 changes was unfortunate. Instead of simply revising Sec. 501(c)(3) to create two distinct classes of charitable organizations, the writers created a web of exceptions and special provisions, with numerous cross-references between the charitable contribution rules of Sec. 170, the private foundation rules of Secs. 507-509 and the excise tax or penalty rules of Secs. 4940-4948. The result can be befuddling. The statutory scheme creates three different groups of tests to qualify for public charity status. The organization must satisfy at least one of these tests to avoid being classified as a private foundation.

Public charities per se: Certain types of organizations need only meet the basic statutory definition to qualify as public charities - notably, churches (Sec. 170(b)(1)(a)(i)), schools (Sec. 170(b)(1)(a)(ii)), hospitals (Sec. 170(b)(1)(a)(iii) and governmental units (Sec. 170(b)(1)(a)(v)). However, the regulations construe these terms narrowly. For example, a nursing home that is not a "skilled nursing facility" does not qualify as a hospital (Regs. Sec. 1.170A-9(c)).

The mechanical tests: Many organizations qualify for public charity status under one of two very similar mechanical tests that measure the percentage of "support" received from "public" sources, as opposed to contributions from a few large donors. (Note: The historical revenue information that must be reported annually on Schedule A of Form 990, Refund of Organization Exempt From Tax, is needed to apply these two tests). The two tests are described below in general terms.

1. Public charities (Sec. 170(b)(1)(a)(vi)): Under the basic test for for charity status, an organization will qualify if at least one-third of its aggregate income for the four preceding years was receive from individual contributions or governmental sources, and not more than one-third consists of investment income and unrelated business income.

An important restriction is that qualify contributions do not include contributions from any individual that exceed 2% of the charity's total income. Thus, when a substantial contributor makes a donation, only the portion of the contribution less than 2% limit qualifies as public support. This restriction often causes family-funded foundations to fail the support test and become private foundations.

Special rules apply to new organizations, and alternative standards may be met in certain circumstances.

2. Organizations with broad public support (Sec. 509(a)(2)): Congress wisely provided an alternative test for exempt organizations that survive on revenue derived from their exempt function (museums, social work agencies, nursing homes, home health agencies, etc.). An organization will generally meet this alternative test if, for the last four years, at least one-third of its income was received from a combination of contribution and revenue from the performance of its exempt function, and not more than one-third of its income consisted of investment income and unrelated business income.

Other nonprivate foundations

There are a number of other categories of public charities that have narrower applicability than those discussed. One example is an organization controlled by a public charity and operated to help further its exempt purpose (Sec. 509(a)(3)). A typical example is a scholarship foundation operated in connection with an exempt hospital or university.

Also, some private foundation are treated the same as public charities for certain purposes. For instance, a private foundation that actively pursues its exempt function can qualify as a "private operating foundation." Contributions to private operating foundations qualify for the same 50% of AGI contribution limit that applies to public charities. They also escape the 2% excise tax on investment income by virtue of Sec. 4949(d). Private operating foundations are still subject to the other prohibited transaction and penalty rules of Secs. 4941 through 4947.

Conclusion

Since the inception in 1969 of the two-class system for Sec. 501(c)(3) organizations, public charities have clearly held preferred status for Federal tax purposes when compared to private foundations. While the more liberal contribution limitations available to public charities are familiar to most tax practitioners, the many operational disadvantages of private foundation status, which are typically of much greater significance than the contribution limits to the organization themselves, remain somewhat of a mystery. With careful planning, however, the harsh rules applicable to private foundation status can be avoided in many instances.
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Author:Lewis, Forrest G.
Publication:The Tax Adviser
Date:Dec 1, 1992
Words:1284
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