Did you know there are two types of 501(c)(3) organizations described in the Internal Revenue Code (IRC)? Along with the local not-for-profits that help those in need in your city, there are also private foundations that hold and distribute funds according to tax-exempt regulations.
And to make matters more confusing, if an organization isn’t paying attention, they may find themselves suddenly reclassified from one to the other.
The Tipping Point of a Charitable Organization
For most not-for-profit organizations, their financial health is improved with large donations from generous people or organizations. However, if one donor consistently contributes too much of your total revenue, you’re at risk of becoming a private foundation rather than a public charity. The line between the two is known as the tipping point.
The tipping point is when one third of the organization’s total receipts comes from a single source — whether a company, other charity, or independent donor. For some not-for-profits, the IRS may also stipulate that the organization may not receive more than one third of total receipts from taxable business income or investments.
Both of these tests (called “public support tests”) consider financial information over a five-year period. In order to change from public to private, an organization would have to fail the public support tests two years in a row.
Private Foundation vs. Public Charity
For run-of-the-mill not-for-profits who provide services or products in pursuit of their mission, flipping from public to private status under 501(c)(3) won’t change everything about the organization, though it will have a few effects. Private foundations are different from public charities in that they:
- Must pay 2% excise taxes on their net investment income.
- File form 990-PF instead of 990.
- Are governed by a single company or individual.
- Must disburse at least 5% of their financial assets to other charitable organizations each year.
And while there are many private foundations who operate programs, the far more common organization for a private foundation is simply to make and disburse grants to others in need.
In other words, if your mission is to directly impact people through specific, mission-focused products or services, it is easier to do so as a public charity rather than a private foundation.
Strategies to Maintain Public Charity Status
Avoiding the tipping point isn’t always easy if your organization has been granted an unexpectedly large amount of money, but there are a few safety nets you can put in place now to help keep the organization’s mission on track.
Though it goes without saying, having a broad and diverse set of annual donors is the number one way to ensure your not-for-profit doesn’t reach the tipping point. Organizations should always be looking for ways to engage new donors and to encourage repeating givers.
Monitor Public Support
You will report your organization’s public support test on Schedule A of IRS form 990 each year, so meeting with your tax preparer to evaluate your public support each year is a key way to identify the risk of reaching the tipping point, and begin the conversation to change course if necessary.
Discuss Strategies for Large Donations
Regardless of whether a significant donation will send your organization over the tipping point, it’s worth meeting with the development team and/or your accountant to strategize how best to utilize those funds. Sometimes the mission can be served just as well by shifting the not-for-profit into a private foundation, and your team and board of directors are the key stakeholders in that conversation.
Plan For the Long-Term Mission
For some organizations, reaching the tipping point is inevitable due to massive changes in donor giving. But in others, gradual changes over time lead to a panicked moment down the line when a lack of public support suddenly puts the organization’s public status in jeopardy.
That’s why it’s always important to think long-term about how to best serve the organization’s mission. Keep in contact with the board of directors and the staff to gauge effectiveness and impact, and always pay close attention to the audited financial statements and 990s that are issued annually.
It always helps to have financial statements that are prepared accurately, timely, and clearly. Even better is to have a friendly partner to present the statements to the board and answer any questions they may have. The auditors at Donovan CPAs are ready to partner with you. Don’t hesitate to contact us at any time to start the conversation.