When you want to start a non-profit organization with the 501c3 status (that is exempt from federal taxes), you have to think about how it will be classified: as a public charity or as a private foundation.
In this case, the Internal Revenue Code (IRC) separates non-profit organizations according to its purpose, fundraising, and annual declaration. However, these concepts tend to be extremely confusing.
So, to help you clarify these terms, we summarized the most important things you need to know to differentiate and understand them.
Public Charity
Public non-profit organizations represent the bulk of active organizations that have the benefit of 501c3 status. Those who start a new organization usually choose the classification of “public charity” because they receive some advantages over private non-profit organizations, for example:
- The ability to find more support from donors and other corporations.
- A higher tax deduction.
Also, these organizations have three types of forms to make their annual report or declaration, which will depend on their annual income:
- 990 (more than $ 200.00 per year)
- 990-EZ (between $ 50,000 and $ 199,999 per year)
- 990-N (less than $ 50,000 per year)
➡ You can read more about these forms here: What is form 990, and who can file 990ez
Public charity is typically related to charitable activities such as the ones from churches, schools, shelters, among others. But in reality, what categorizes it as “public” is its structure and its source of income.
Structure of Public Charities
For a non-profit organization to qualify as a public charity according to the Internal Revenue Service (IRS), it requires particular conditions in its incorporation.
These conditions include very explicit restrictions in certain economic activities, and it must have a diversified board of directors.
This means that there cannot be consanguinity or family affiliations of any kind (or external commercial joint ownership) between more than 50 percent of the board.
Income of Public Charities
Public non-profits must have the support of the general public, so at least 33 percent of its funds must come from relatively small donors, who give less than 2 percent of their income to the organization.
This is a significant number since it is about a third of the organization’s income; however, it allows the remaining 67 percent to potentially come from less diverse sources, for example, large companies.
Private Foundation
Although public charities far outnumber them across the United States, private foundations also contribute a lot.
In practice, private organizations are established with funds from a single source or specific sources, with family or corporate money, and without contributions from the general public.
Many of these organizations do not accept donations; they generally invest their main funds and then distribute the investment income to charitable purposes.
They are best know for giving grants to causes related to charity, education, religion, sports, among others, to contribute to the community.
In the case of private foundations, regardless of the amount of their income, they must file Form 990-PF annually, a very lengthy and complicated document, similar to Form 990 for public charities.
Types of Private Foundations
The IRS establishes two types of private foundations; the main difference between both of them is the way to distribute its income:
- Non-operative private foundation: They fulfill their purpose by designating their money to other charities. Also, they usually do not organize charitable programs or activities to serve the community; its focus is giving grants to other groups.
- Operative private foundation: They distribute their funds to realize programs and activities for specific purposes.
Also, both types are subject to restrictions and legal requirements, such as:
- They cannot do formal business with their primary contributors.
- They are subjects to private taxes.
- They are exposed to face fines for self-negotiation when making risky investments.
- They are exposed to criminal charges for not distributing funds appropriately.
It is important to clarify that any American and foreign organization that qualifies under 501c3 status will be considered a private foundation unless it demonstrates that it belongs to a public charity.
If you want more official information about private foundations, click here.
How to identify the classification of a foundation?
The IRS determines whether an organization is a public charity or a private foundation in a letter called an “organization determination letter.”
This letter is delivered when the non-profit completed the application for tax-exemption. But, if the IRS requests it, the organization must return this letter for review or cancellation.
Another way to determine the type of organization is to check its annual income, as we explained before. Depending on the number, they will fill a specific annual declaration (Form 990, 990ez or, 990n).
We must clarify that not all the organizations that have “foundation” on its name are private foundations. The word “foundation” does not have a legal meaning or concept, according to the North American legal system.