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Private Foundation vs Private Operating Foundation: Understanding the Key Differences

private operating foundation

We have talked at length about the differences between the two primary categories of 501(c)(3) – public charities and private foundations. What we haven’t addressed as much is the lesser understood category of private operating foundations. In this article, we going to explain what this entity is, and how it differs in type and use from a typical private foundation.

What Is a Private Foundation?

Private foundations are commonly referred to as non-operating foundations in the philanthropy world. We won’t rehash a lot of details in this article, as we have written extensively about private foundations elsewhere. A key thing to understand about private foundations is that they are rarely established for purposes of conducting a charitable program. Instead, they exist primarily to fund charitable work done by others, usually by public charities.

Some other important factors that differentiate private foundations from public charities are:

  • The ability to have close control by related directors. You often see this in family foundations.
  • The ability to be funded by as few as a single donor. Public charities requires a broad base of public support.
  • Only 5% of a foundation’s non-endowment asset base are required to be distributed for charitable purposes annually.
What Is a Private Operating Foundation?

At first glance, a private operating foundation may seem to be a 3rd broad category of 501(c)(3) organization, but it’s not. It is actually a sub-classification of a private foundation.

In general, a private operating foundation is a private foundation that devotes most of its resources to the active conduct of its exempt activities. More specifically, the IRS defines a private operating foundation as any private foundation that spends at least 85% of its adjusted net income or its minimum investment return, whichever is less, on these program activities. This is known as the income test, and it requires some further definitions to completely understand it.

Adjusted net income is the excess of gross income from operations (not including gifts, grants, or contributions) over total allowable expenses for the same activities.

The minimum investment return is 5% of the excess of the combined fair market value of all assets of the foundation, other than those used or held for exempt purposes, over the amount of indebtedness incurred to buy those assets.

In addition, an operating foundation must also meet one of the three following tests:

  • the Assets Test
    • A private foundation will meet the assets test if 65% or more of its assets:
      • Are devoted to the active conduct of its exempt activity, a functionally related business, or a combination of the two,
      • Consist of stock of a corporation that is controlled by the foundation and at least 85% of the assets of which are so devoted, or
      • Any combination of the above
  • the Endowment Test
    • A foundation will meet the endowment test if it normally makes qualifying distributions directly for the active conduct of its exempt activities of at least two-thirds of its minimum investment return.
  • the Support Test
    • A foundation will meet the support test if
      • At least 85% of its support is normally received from the general public,
      • Not more than 25% of its support is normally received from any one exempt organization, and
      • Not more than 50% of its support is normally received from gross investment income.

Confused yet? It can be tricky to understand without professional assistance, but there are reasons why the rules are very tight in order to qualify as an operating foundation. Those reasons have to do with the benefits associated with private operating foundation status.

Why Private Operating Foundation Status Can Be Attractive

You’ll never see the IRS use the term hybrid to describe a private operating foundation. But in effect, that’s sort of what they are: a mash-up of a private foundation and a public charity. Here’s are 4 reasons why:

(1)  Structure of a private foundation – Private operating foundations can have a closely-held board structure, just like a private foundation. This means that the governing board could all be related by blood, marriage, or outside business co-ownership, unlike a public charity.

(2)  Funded like a private foundation – While most private operating foundations tend to have a broad base of support similar to a public charity, they are not required to.

(3)  Operates programs like a public charity – Inherent to a private operating foundation is the necessity to operate charitable programs. To the outsider, most would actually appear to be public charities.

(4)  Stepped up donation deductibility – Donations to public charities can be tax deductible up to 60% of adjusted gross income. Giving to private foundations, however, limits deductibility to 30% of AGI. Private operating foundations, though they are at their core a private foundation, are allowed a stepped up level of donation deductibility of 50% of AGI.

Why a Private Operating Foundation May Not Be The Best Choice

Despite the benefits, you see relatively few private operating foundations in the nonprofit community. They’re out there, but they are not as common as you might think, given the seeming advantage described above.

The reason for this is rooted in the highly granular nature of qualifying for (and then maintaining) private operating foundation status. The various tests we outlined earlier (the income test, asset test, endowment test, etc.) not only come into play at IRS determination, but continue to play a factor throughout the life the nonprofit. It can difficult enough to understand the rules to start with, and believe me when I say that I dumbed down the explanation a lot. To fully explain the various tests would require a 3,000 word article!

What most organizations that flirt with the idea of a private operating foundation usually discover is that there are better and easier ways to accomplish their goals with either a public charity or a private foundation. The choice of one over the other may not yield the (largely fictional) “best-of-both-worlds” appearance of the private operating foundation, but they inevitably prove easier to maintain over time.

Conclusion

Private operating foundations are unique nonprofit entities that come with very complex rules associated with them. They do serve an important function in the nonprofit world. And for very specific use cases, they may be the best choice. Most nonprofits, however, can probably get where they’re wanting to go much easier with far less complication with the two choices most nonprofits ultimately fall toward.

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Greg McRay, EA

Greg McRay is the founder and CEO of The Foundation Group. He is registered with the IRS as an Enrolled Agent and specializes in 501(c)(3) and other tax exemption issues.

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