A nonprofit’s source of revenue can greatly affect its potential IRS classification of 501(c)(3) status. Often, an organization’s purpose determines any sub-classification. In this article, we’re going to take a look at what happens when it is revenue that determines the outcome.
In the world of 501(c)(3) organizations, the public charity is the kind that first comes to mind for most people. It is typically the type of nonprofit that actively conducts programs that provide a charitable impact to its chosen community.
But, not all public charities are the same. The IRS sub-classifies many based on their purpose. For example, there is a specific sub-classification of public charity status that is exclusively for churches. There is another one for schools, and yet another for charity hospitals, and so on. For those who really like details, here’s the breakdown of the most common examples:
- Churches and associations of churches – 509(a)(1) and 170(b)(1)(A)(i)
- Schools – 509(a)(1) and 170(b)(1)(A)(ii)
- Hospitals and similar orgs – 509(a)(1) and 170(b)(1)(A)(iii)
- Supporting organization – 509(a)(3)
- Testing for public safety – 509(a)(4)
So what about a 501(c)(3) public charity that isn’t so specific that it falls under one of the above sub-classifications? These are nonprofits with less laser-focused purposes, such as general education, arts, youth sports, assisting the poor, etc. Far more 501(c)(3) public charities fall under this fuzzier description than those listed above.
With these, the IRS sub-classifies them by source of revenue, specifically those that receive most of their revenue from donor support, and those that receive a combination of donor support, program revenue, and investment income. They are sub-classified as a 509(a)(1) and 170(b)(1)(A)(vi) public charity and a 509(a)(2) organization respectively.
Let’s dig a little deeper.
NOTE: For the remainder of this article, we’re going to simplify things and refer to a 509(a)(1) and 170(b)(1)(A)(vi) organization as simply a 509(a)(1).
The IRS defines a 509(a)(1) as:
an organization that receives a substantial part of its financial support in the form of contributions from publicly supported organizations, from a governmental unit, or from the general public.
In other words, it is a charitable nonprofit funded primarily through gifts and contributions. But there is deeper meaning behind some of the phrases. They are not as generic as they sound.
To qualify as a public charity under sub-section 509(a)(1), the nonprofit must still pass the public support test. We won’t go into extreme detail here, due to the in-depth evaluation in the other article. Suffice it to say that at least 1/3 of the organization’s support must come from other similarly supported public charities, a governmental source, and/or from smaller individual donations.
A public charity recognized under sub-section 509(a)(2) is one that,
normally receives not more than one-third of its financial support from gross investment income and receives more than one-third of its financial support from contributions, membership fees, and gross receipts from activities related to its exempt functions (subject to certain exceptions).
Similar to the 509(a)(1), a 509(a)(2) likely receives donation support. In addition, a portion of its revenue comes from investment income (limited to 33% of total income), membership dues, and/or program revenue, the latter being money earned from the sale of goods and/or services that are directly related to the nonprofit’s exempt purpose.
A nonprofit receives 501(c)(3) status by filing an application called Form 1023. To be considered a public charity, the IRS asks which sub-section your proposed organization qualifies under. We stated earlier that your purpose and programs may determine the choice. But, if you are among the many that must choose 509(a)(1) vs. 509(a)(2), how do you know which to choose?
If your organization is going to raise money almost exclusively through donations, 509(a)(1) is the only choice that makes sense. Likewise, you will most likely want to choose 509(a)(2) if you expect any substantial part of your revenue base to be something other than donations, like the nonprofit’s programs.
Interestingly, Form 1023 allows you to choose a third option: let the IRS pick for you. If you expect your nonprofit to be publicly supported, but don’t really know which one to pick, you can let the IRS decide which one makes the most sense based on your projected income sources in your included budget.
Let’s go back to the public support test for a moment. The IRS requires all 501(c)(3) organizations to file Form 990 each year. For the first 5 years of a public charity’s existence, it is not required to substantiate a public support threshold yet. The IRS allows the organization that long to get on its feet and diversify its income stream.
Starting in year 6, however, every public charity that files a Form 990-EZ or greater must complete the public support test calculation on Schedule A. Your nonprofit’s classification as a 509(a)(1) or 509(a)(2) determines how the calculation is performed. In fact, there are two separate spreadsheets on Schedule A, one for each classification. And, both versions of the test averages together the most recent 5 tax years, not just the current one.
If your revenue in year 6 and beyond is consistent with your original expectations, then the calculation of public support will be fairly straightforward. But what happens if things are substantially different? For example, let’s say you originally expected all of your income to be from donations, but by the time year 6 rolls around, most of your revenue is coming from the sale of services. If you complete the public support test based on the spreadsheet required of a 509(a)(1), none of the program revenue will count toward your public support percentage. What now?
Fortunately, the IRS allows nonprofits classified under 509(a)(1) and 509(a)(2) to switch from one to the other if the switch better reflects your revenue and assists in maintaining public support. In fact, a nonprofit could theoretically jump back and forth every year, though that would hardly ever be necessary. No advance permission of the IRS is required. Simply complete the public support test spreadsheet that best reflects your situation, and the IRS will automatically reclassify the organization from one sub-section to the other.
Given the relative ease of moving back and forth between the two sub-classifications, it sort of begs the question of why it even matters. The best answer I can give is that it gives the IRS an initial heads-up as to the nature of your proposed nonprofit’s revenue picture. Ultimately passing and maintaining the public support test isn’t optional, but the way you maintain it can evolve right along with your organization’s method of raising financial support.
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