By Deb Nelson
October 17, 2017
The public support test, filed as part of an organization’s annual tax filing, is commonly an area management and boards don’t focus on because it’s lengthy and complicated. However, many readers don’t understand the importance it plays in relation to maintaining public charity status or why public charity status matters. There are key factors readers can review without having to be an expert on public support test calculations to better understand the impact.
Know why foundation status matters. When an organization initially applies to the IRS for tax-exempt status under section 501(c)(3), it is presumed to be a private foundation unless it can satisfy requirements for public charity status under sections 509(a)(1), 509(a)(2), 509(a)(3), or 509(a)(4).
Private foundations are more strictly regulated, subjected to a number of rules and excise taxes that don’t apply to public charities. Donors to private foundations can take charitable contribution deductions up to 30 percent of their adjusted gross income.
Donors to public charities can take charitable contribution deductions up to 50 percent of their adjusted gross income. There is also a difference in the amount that can be deducted as charitable contribution for certain types of assets between the two entities. Therefore, in order to obtain the public charity status (and the benefits that go with it), the organization needs to be able to show it is broadly supported by the general public. This broad support shows the general public is holding it accountable to act in accordance with its exempt purpose.
An organization indicates which public charity status it intends to operate under as part of its exemption application and then files Schedule A with its annual tax filing to show the IRS it is maintaining that public charity status. While there are a number of different types of public charities, there are two primary types that must complete a public support test calculation to show they are publicly supported. These organizations include:
There are two different public support tests, depending on whether an organization is classified under section 509(a)(1) or 509(a)(2). In general, the tests look at an organization’s percentage of public support compared to its total support. Public support is defined differently between the two tests and different limitations must be applied to payments from contributors, disqualified persons and payments for services depending on the test. However, in both tests the organization must be more than 33.33 percent publicly supported.
Public Charity Under 509(a)(1)
Under this test, public support is defined as gifts, grants and contributions and total support includes revenue sources other than payments for services. There is a limit to the amount of public support that can be included in the test from any one donor. Gifts, grants and contributions received from donors other than governmental entities or other publicly supported 509(a)(1) organizations must be limited over a rolling five-year period to 2 percent of total support. This effectively means the organization cannot be supported by a small group of donors unless those donors are governmental entities or other publicly supported entities.
Key things to consider when looking at the 509(a)(1) support test:
Public charity under 509(a)(2)
Under this test, public support is defined contributions, membership fees, and gross receipts from related activities and total support includes all revenue sources. In this test, amounts from disqualified persons and payments for services from any source in excess of $5,000 or 1 percent of total revenue is limited. This effectively means the organization must be supported by payments from a broad class of payors. In addition, the organization cannot receive more than a third of its income from investment activities.
Key things to consider when looking at the 509(a)(2) support test:
Your organization should have processes in place to track substantial contributors (once an individual is a substantial contributor they are always a substantial contributor) and other disqualified persons.
An organization that fails the public support test for two consecutive years will automatically convert to a private foundation in that second year. As mentioned above, this change in status can have a significant impact on an organization and its activities, such as being subject to a 1-2 percent excise tax on net investment income, required minimum distributions, and potential excise taxes for self-dealing, excess business holdings, and taxable expenditures. In addition, converting to a private foundation may adversely impact an organization’s ability to receive contributions from donors due to less favorable tax deductions and additional reporting for private foundation donors.
Organizations who qualify to file the Form 990-N e-Postcard are not required to file Schedule A with the IRS, but they should be completing the calculation as part of their internal support showing how they continue to satisfy requirements for public support status.
These key questions provide a place to start discussions and allow management and the board to proactively address any potential public charity status issues before being automatically converted to a less favorable private foundation tax status.