July 2nd, 2021
Key Issues to Consider Before Forming a 501(c)(3) Organization
Author: Rebecca A. O'Neill, Mark W. Schweighofer
Many philanthropic individuals looking to further their charitable endeavors, while also creating a meaningful legacy that can span generations, explore the possibility of forming a charitable 501(c)(3) organization. The term “501(c)(3)” refers to that section of the Internal Revenue Code, and encompasses several different types of tax-exempt charitable organization. This article provides a summary of key issues to consider prior to forming a 501(c)(3).
501(c)(3) organizations essentially fall into two principal categories for federal income tax purposes: the “public charity” and the “private foundation”. Private foundations typically engage in passive grantmaking and do not receive significant public funding, whereas public charities usually engage directly in their own charitable activities and must be substantially publicly-funded.
The first step toward creating a 501(c)(3) organization is to form an entity. Typically, these entities will be non-profit/non-stock corporations, formed by submitting a filing with the applicable state agency. Further, the entity must be organized and operated exclusively for appropriate religious, charitable, scientific, literary, or educational purposes pursuant to Code §501(c)(3).
Once formed, the non-profit/non-stock corporation must then apply for 501(c)(3) tax-exempt status with the Internal Revenue Service (“IRS”) by filing a Form 1023 application.
The default classification for all 501(c)(3) applicants is private foundation status. To opt for public charity status instead, an organization must elect such status on its Form 1023 application. But, the election alone is not enough – the organization must also demonstrate to the IRS’ satisfaction that it will meet the applicable funding and operational criteria. For this purpose, the applicant must provide information on the Form 1023 application regarding its proposed operations and finances, and good faith projections of its sources and amounts of donations and other revenue. If the application is accepted, the IRS will issue a determination letter specifying the new 501(c)(3)’s classification.
The primary factor the IRS analyzes determining 501(c)(3) classification is the source(s) of funding for the organization. Under the Code and Regulations, public charities must be substantially supported by donations from the general public, whereas private foundations typically receive their funding from a smaller group of donors, even from a single individual or family.
Most public charities rely on one of two tests in determining whether the organization is considered publicly supported:
- Either an organization must receive at least one-third of its funding from the general public; or
- It must receive at least 10% of its funding from the general public, so long as the facts and circumstances indicate it is a publicly-supported organization (there are additional factors in this analysis).
While many organizations expect to satisfy one of the public support tests, the rules are quite nuanced and require careful analysis and planning; in our experience, many organizations fall short of the necessary threshold. As discussed below, the distinction between public charity and private foundation status impacts not only the organization’s ability to raise money, but determines the operational rules that must be followed in order to maintain tax-exempt status.
While both private foundations and public charities afford donors a tax deductions for contributions made, donations made to a public charity are generally deductible to a greater extent than donations to private foundations. Although public charities are subject to certain restrictions and prohibitions on transactions that benefit insiders or other individuals1, private foundations are subject to a separate, more onerous regime of restrictions. For example, under the punitive “self-dealing” rules – private foundations are prohibited from engaging in many types of transactions with “disqualified persons”, essentially any founders, substantial contributors, board members, officers, or persons or entities related to such people. Such transactions include sales of property, certain leases of property and certain loans. Further, self-dealing includes excessive compensation paid to disqualified persons. Violating these rules, even unintentionally, can trigger significant penalties to the insiders and the organization and, in extreme cases, may cause the organization to lose its tax-exempt status.
Private foundations must satisfy certain operational rules as well. For example, private foundations are required to make charitable grants equal to roughly 5% of the value of their assets on an annual basis and will be subject to excise taxes on any undistributed amounts. Further, private foundations must pay an excise tax of 1.39% on their annual net investment income.
Finally, many philanthropic business owners wish to make donations of their closely-held business interests to their own private foundations, either as lifetime gifts or as part of their estate plans. While this is permitted to an extent, private foundations are prohibited from owning, in conjunction with disqualified persons, more than 20% of the voting/ownership interests of most types of active business enterprise. Excess business holdings are subject to excise taxes.
Non-profit /501(c)(3) organizations are a powerful tool to further an individual’s philanthropic endeavors and, if properly structured, can provide significant income and estate tax benefits. That said and as noted above, the regulatory regime applicable to non-profit/501(c)(3) organizations is highly complex and, without careful planning and diligence, can lead to significant penalties and administrative headaches for the organization’s founders. It is crucial that anyone considering establishing a 501(c)(3) organization work with knowledgeable tax and business advisors to ensure the objectives are achieved.
1Such as the excess benefit transaction rules and the prohibition against private inurement. Compensation in excess of fair market value paid to a disqualified person is a common example of an excess benefit transaction and can subject the disqualified person and public charity managers to intermediate sanctions.