When starting a 501(c)(3) organization, there are generally two choices of how the organization will be classified. It can be a public charity or a private foundation. Though greatly outnumbered by public charities, private foundations bring a lot to the table. Many people have a layman’s understanding of the difference between public charities and private foundations: Public charities are understood to perform charitable work, while private foundations support the work of public charities. That grassroots definition is, in practice, mostly true. The specifics, however, are slightly more complicated. Let’s take a closer look at the differences, and similarities, between these classifications:
Public charities. Public charities represent the largest share of active, 501(c)(3) organizations. Those starting a new organization usually prefer public charity status, not just because it better describes the organization’s purpose. Public charities also enjoy some advantages over private foundations: higher donor tax-deductible giving limits and the ability to attract support from other public charities and private foundations. Also, public charities have 3 possible tax filing requirements, depending upon annual revenue (listed in order of complexity): Form 990 (> $200,000), Form 990-EZ ($50,000 – $200,000), and Form 990-N e-postcard (<$50,000). All private foundations, regardless of revenue, must file Form 990-PF each year. It is a lengthy and complex return much like Form 990 for public charities. It should also be pointed out that an applicant for 501(c)(3) status must prove why it should be considered a public charity, lest they be considered a private foundation by default.
Like the layman’s definition, public charities typically carry out some type of direct, charitable activity. Examples include churches, private schools, homeless shelters, etc…the list of possibilities is nearly endless. The true definition of a public charity, though, goes well beyond the programs and into the realm of structure and revenue source. As for structure, in order to qualify for (and keep) public charity status, a 501(c)(3) must be organized for exclusively 501(c)(3) purposes. The IRS requires certain language to be in a public charity’s articles of incorporation explicitly restricting its activities to such. In addition, a public charity must represent the public interest by having a diversified board of directors. More than 50% of the board must be unrelated by blood, marriage or outside business co-ownership and not be compensated as employees of the organization. We are often asked where that is in the “code” and, frankly, it isn’t there…at least not verbatim. It is an extrapolation of the IRS’s requirement that governance of a public charity be at arms-length and without private benefit (inurement) to insiders. You can read more about that here. As such, the IRS requires that a quorum of board members be possible who have no personal stake, either directly or potentially through relationship. Finally comes the income, or source of revenue, test. Public charities must be supported by the general public. For that to be true, a significant amount of revenue, at least 33%, must come from relatively small donors (those who give less than 2% of the organization’s income), from other public charities or the government. While that is significant, that leaves 67% to potentially come from other, less diverse sources.
Private foundations. While being considered a private foundation could simply be a fall-back position of not qualifying for public charity status via either the organizational or income test (or both), it is most often a choice that is made. There are reasons why someone would choose foundation status over public charity. Chief among those is control. In exchange for somewhat disadvantaged deductibility limits to donors, mandatory Form 990-PF filings, and minimum annual asset distributions (5% each year), private foundations can be controlled by related parties and be funded by a relatively small group…even one individual or family (think Bill and Melinda Gates Foundation). This is often more than enough tradeoff for those starting a foundation. Another significant reason may simply be operational. If the organization has as its primary purpose the financial support of public charities, as opposed to operating a particular program, a private foundation is likely more appropriate.
There is even a third type of 501(c)(3), the private operating foundation. This is best thought of as a hybrid of the other two, most often a private foundation with direct program services like that operated by public charities. The rules are strict, as control can be like that of private foundations, but with some of the benefits of public charities. There are relatively few of these organizations around. You typically only see these under rather unique circumstances.
There really is no right way to go between operating as a public charity or a private foundation. It completely depends on each organization’s programs, plans and intentions.