By Diane Burks
Assume you would like to start a nonprofit for your favorite charitable cause, which will ultimately raise funds from the general public for its operations.
Because public-charity status provides many advantages over private-foundation status, including higher tax-deductible contribution limits for donors, exemption from certain federal taxes and regulations, and less burdensome annual reporting requirements, you ideally would structure your organization as a public charity.
However, you also wish to fund your organization with stock in your family-owned business.
In donating assets to your own nonprofit, you should carefully consider how to classify this organization.
Typically, to qualify as a public charity, an organization must either receive a third of its support from the general public, or a tenth of its support from the general public if facts and circumstances indicate the charity serves the public interest.
The “general public” includes individuals, trusts or entities, but only to the extent that contributions from the donor do not comprise more than 2 percent of the organization’s total support for the current and prior four years.
Contributions by people in a “special relationship” with the donor, such as family members, also are included in this 2 percent limitation.
Unfortunately, an organization with an endowment from a generous donor – such as you – may be unable to meet these tests.
However, your organization still could receive certain favorable treatment if it qualifies as a private operating foundation.
Like public charities, private operating foundations typically devote their assets and income to the active conduct of charitable operations.
To qualify as an operating foundation, an organization must expend at least 85 percent of its annual income directly for the active conduct of charitable activities.
These expenditures may include payments to accomplish charitable purposes, expenditures for assets used in carrying out the organization’s charitable purposes, set-asides for charitable purposes approved by the IRS, and grants to individuals, but not organizations, if the nonprofit is significantly involved in active programs for which the grants were made.
The nonprofit also must satisfy one of the following tests:
- An asset test, under which the organization must devote at least 65 percent of its assets to charitable activities.
- An endowment test, under which the organization must distribute at least two-thirds of its minimum investment return.
- A support test, under which the organization must receive 85 percent of its non-investment support from the general public, and not more than half its support from gross investment income .
Although operating foundations are treated as private foundations for most purposes, they receive several important benefits from their public-charity status:
- Percentage deduction limitations — Donors generally may deduct a charitable contribution to operating foundations to the same extent as to public charities, up to 50 percent of the donor’s adjusted gross income, while donors to private foundations may only deduct contributions up to 30 percent of the donor’s adjusted gross income.
- Minimum distribution requirements — A private foundation must distribute at least 5 percent of its investment assets annually in order to avoid a tax on undistributed income. However, in some cases, it may not be practical for nonprofits with largely illiquid endowments to distribute this percentage of assets annually as a way of meeting that requirement.
A nonprofit funded solely with a closely-held business interest, for example, may not want to distribute stock to an outsider, a move that could give an outsider an ownership interest and possible voting authority in the business.
Operating foundations are not subject to this minimum distribution requirement or the related tax.
- Receipt of qualifying distributions — Private foundations may satisfy their annual minimum distribution requirement by making distributions for exempt functions or to certain nonprofits such as operating foundations. Unlike private foundations, operating foundations and public charities are eligible to receive qualifying distributions from private foundations. This creates an incentive for private foundations to make grants to operating foundations, and opens up a potential donor pool.
- Net investment income — Certain operating foundations are exempt from federal excise tax.
Operating foundations may qualify as “exempt operating foundations” if:
- They have been publicly supported for at least 10 taxable years.
- At least 75 percent of the governing body consists of individuals who are not “disqualified individuals” such as a substantial contributor, a partial owner of an entity which is a substantial contributor, or a family member of either, as well as the governing body is broadly representative of the general public
- And no officers are “disqualified individuals.”
Diane Burks is an associate with Katten Muchin Rosenman, a Charlotte-based law firm, who focuses her practice on trusts and estates.