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A Taxonomy of Tax-Exempt Organizations

Planned Giving Today

Originally Published in Planned Giving Today.


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Ask a representative of a charitable organization what type of charity he or she represents, and the correct, if incomplete, answer will often be, “We’re a 501(c)(3) organization.” This basic qualification will likely be only part of the answer sought. Most tax-exempt charitable institutions–private foundations, public charities and the variety of hybrids between–share this basic qualification under Internal Revenue Code (“Code”) Section 501(c)(3), which exempts them from most of the income tax provisions of the Code, excluding, for example, the unrelated business taxable income provisions of Code Sections 511-514.

Exactly where does your own organization fit into this taxonomy of tax-exempt charitable organizations? The answer will be important to donors and their advisors, who frequently will want to ensure that contributions to the institution qualify for the highest, “public charity” deductibility thresholds: 50 percent of adjusted gross income (“AGI”) for cash, and 30 percent of AGI for appreciated assets. Similarly, grant-making organizations such as private foundations, which are generally prohibited from making grants to other private foundations at the risk of loss of their own exempt status, are highly motivated to determine whether or not a grant candidate is a public charity.

Private Foundations

On the lower rungs of the tax-exempt hierarchy are private foundations, which qualify under Code Section 501(c)(3) and do not fall within one of the public charity exceptions under code Sections 509(a)(1), (2) or (3). The “private” designation arises due to the fact that the foundation receives most or all of its support from a single donor or family. Because of perceived past abuses, private foundations are subject to close scrutiny through a series of penalty taxes, euphemistically termed “excise taxes,” designed to keep them on the straight and narrow. These taxes–imposed on acts of self-dealing, failure to distribute income, excess business holdings, jeopardy investments and taxable expenditures–are familiar to many planned giving officers to the extent they also apply to charitable remainder trusts.

In order to discourage gifts to private foundations, Congress has mandated that a contribution of cash to a private foundation may be deducted only up to 30 percent of AGI, and that a contribution of an appreciated asset must be reduced to its cost basis, and even then may be deducted only up to 20 percent of AGI. A temporary exception to this harsh “reduce-to-basis” rule applies to publicly traded stock, and is set to expire on May 31, 1997. Contributions which cannot be used in the year of transfer qualify for a five-year carryover.

Typically, the private foundation must refrain from carrying on its own activities, and has to be content with the relatively passive role of making grants “upstairs” to public charities. Even a scholarship grant or a grant to an individual for special research is generally not permitted, except with the Service’s prior approval of “grant-making procedures” conforming to the regulations issued by the Treasury Department.

Private Operating Foundations

Occupying a special domain between the realms of private foundations and public charities, private operating foundations, described in Code Section 4942(j), may carry on their own activities, with the prior blessing of the Service. The private operating foundation remains “private,” in the sense that it usually receives contributions from a single donor or family, but it enjoys some of the status of a public charity–including the higher deductibility thresholds which apply to such institutions.

In order to receive these enhanced blessings, the private operating foundation must expend substantially all its income directly for charitable purposes. In addition, it must meet any one of the following requirements: (a) It must devote at least 65 percent of its assets to charitable purposes; (b) It must normally distribute at least two-thirds of its “minimum investment return” (i.e., 5 percent of the value of its investment portfolio) to qualified public charities; or (c) It must receive substantially all its support from the general public, and not more than half of its support from gross investment income.

Public Charities

In contrast to private foundations are public charities—the institutions to which most planned giving officers owe their allegiance. Because they are perceived as enjoying “public” support in one form or another, these public charities have traditionally enjoyed a lower threshold of IRS scrutiny than their private foundation cousins. “The public is watching the public charity,” so goes the theory, “so the IRS doesn’t have to.” In addition to qualifying under Code Section 501(c)(3), these public charities also qualify under Code Sections 509(a)(1), (2) or (3). It is also rather important to know which of these parenthetical numbers applies to a particular institution.

“Automatic” Public Charities. Some types of charitable institutions manifest their “public”-ness simply by their very nature. For example, churches, conventions or associations of churches; certain hospitals and medical institutions; certain educational institutions; and governmental units are “automatic” public charities. Other institutions are not quite so fortunate.

“Support Test” Public Charities. Other public charities must demonstrate affirmatively and regularly that they enjoy the support of the general public. Code Section 509(a)(1) “support test” public charities, which generally include community foundations for example, must show that they ordinarily receive at least 1/3 of their total support from contributions from the general public. An organization which finds this test too rigorous may seek to qualify under an alternate 10 percent “facts and circumstances” test, under which it can receive as little as 10 percent of its total support from the general public, so long as other factors, including the public nature of its board of directors for example, demonstrate its essentially “public” nature.

The other variety of “support test” public charities are those which are defined in Code Section 509(a)(2). These charities often enjoy a combination of gifts from and purchases by members of the general public, as does a symphony orchestra, for example. In addition to demonstrating that it normally receives at least 1/3 of its total revenue from the general public, the Code Section 509(a)(2) organization must also show that not more than 1/3 of its revenue comes from its investments.

Supporting Organizations. Yet another type of public charity is, strangely enough, one which bears many similarities to a private foundation–it usually enjoys the support only of a single donor or family, after whom or which it is named. On the other hand, this last type of public charity, the supporting organization, enjoys “automatic” public charity status, so long as it meets certain tests. The supporting organization must not be “controlled” by the founding family; that is, the number of independent trustees or directors must always exceed the number of family trustees or directors, according to the Service.

In addition, the supporting organization, as its name implies, must “support” one or more Code Section 509(a)(1) or (2) public charities through direct grants, or by carrying on activities in which the supported institution engages. With the increasingly dim prospect for private foundations, the supporting organization is currently enjoying something of a renaissance and re-evaluation.

Sources

How should the planned giving officer go about determining exactly where his or her institution fits into the taxonomy of tax-exempts? The best source is the letter (or letters) of determination issued to the organization by the IRS. In some cases, the organization’s letter of determination will indicate that the organization is in an “advance ruling period,” a sort of trial-run for fledgling would-be public charities. At the end of the advance ruling period, the organization must demonstrate that it qualifies under the “support test” public charity rules. If it cannot, it is relegated to private foundation status (or worse).

The other source is IRS Publication 78, which lists charitable institutions and uses a number code to indicate where they fit into this taxonomy. For example, if an entry in Publication 78 shows no number after an organization’s name, the organization is a public charity; a “3” after the name indicates a private operating foundation; a “4” indicates a private foundation, and so forth.

Conclusion

The planned giving officer is frequently the first representative of a charity who will be asked what type of charity the organization is, and for all of the reasons summarized above, it would be best if the officer can supply a complete, accurate answer to this important question.

IRS Circular 230 Disclosure: To the extent this message contains tax advice, the U.S. Treasury Department requires me to inform you that any such advice, whether in the body of the message or in any attachment, is not intended or written by my firm to be used, and cannot be used by any taxpayer, for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code. Advice from my firm relating to tax matters may not be used in promoting, marketing or recommending any entity, investment plan or arrangement to any taxpayer.

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