LegalEASE: Notes from the Legal Experts - Tipping from Public Charity to Private Foundation Status

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As discussed in previous posts, a nonprofit organization that is organized and operated exclusively for charitable purposes may be deemed a public charity and not a private foundation under section 501(c)(3) of the Internal Revenue Code (IRC) in one of three principal ways.

  1. It meets certain requirements based on the nature of its activities.
  2. It qualifies as a publicly supported charity based on a mathematical public support test.
  3. It is a supporting organization to another public charity.

The majority of public charities in the U.S. — as well as foreign public charity equivalents — fall under the second category. That is, their income comes from a diverse range of sources, as opposed to a single or limited number of contributors.

Publicly supported charities must demonstrate that they continually meet a minimum threshold of public support over a 5-year reporting period. A single substantial and material change in the income of a publicly supported charity can cause the organization to lose its public charity status and convert to a private foundation. This is called "tipping." Both U.S. charities and foreign public charity equivalents can tip out of public charity status, although the rules for determining when an organization tips are slightly different.

By default, once a public charity tips, it becomes a private foundation and loses the benefits associated with its former classification as a public charity. In the U.S., broadly speaking, this means more restrictions on its activities and expenditures, as well as lower limits on deductions from donors. For foreign public charity equivalents, it means that grantmakers — private foundations and donor advised funds — must exercise expenditure responsibility when making grants to them. Tipping can potentially trigger the out of corpus rules (PDF) as well.

A grantmaker's failure to recognize an organization's change in status can negatively impact both the organization and the grantmaker. For these reasons, it is in the best interest of the organization and its funders to avoid tipping when possible.

What Causes Tipping?

Tipping occurs when a grant by a single private source — meaning an individual, business, or private foundation, and not a public charity or government — is large enough to bring a publicly supported charity's public support percentage below the required minimum threshold.

As described in our post on the public support test, donations from private sources may only be counted toward a charity's public support in an amount up to 2 percent of the charity's total income. Therefore, a single large donation could substantially increase the denominator of the public support calculation while only incrementally increasing the numerator. The result is a smaller percentage of public support.

Example of Tipping

Charity A receives a total of $100 each year for 5 years, totaling $500. Twenty different private foundations each give $5 a year, totaling $25 per grantmaker over the 5-year period. Because two percent of $500 is $10, each individual donation over the entire 5-year period is only counted up to $10 for purposes of public support. Therefore, the public support percentage is 10 x 20 / 100, or 40 percent.

Now let's imagine that Charity A in its fifth year received a gift of $10,000 from one of its regular donors, instead of just $5. Its total income is now $10,495. 2 percent of $10,495 is $209.90. Therefore, the public support percentage is (25 x 19) + 209.9 / 10,495, or, 6.5 percent. In other words, a single generous gift caused the organization's public support to drop from 40 percent to just over 6 percent — below the minimum threshold of 10 percent.

How Public Charities May Avoid Being Tipped

Tipping is the unfortunate result of a fortunate event. While an organization would typically be thrilled to receive such a significant contribution, it may — by virtue of a single donation — lose the benefits of being a public charity if its public support drops below 10 percent.

In the U.S., a public charity will only default to private foundation status if it fails the public support test for two consecutive years over a 5-year reporting period. A foreign organization seeking an equivalency determination (ED), however, is tested on a single 5-year reporting period. Therefore, the consequences of tipping in one year can mean that the organization will fail to qualify as a public charity equivalent.

Although an organization cannot entirely control its public support, there are steps it can take to proactively help prevent tipping. For example, an organization can

  • Actively seek donations from public sources, meaning other U.S. public charities, foreign public charity equivalents, and government agencies, which count in full toward an organization's public support calculation.
  • Seek to diversify funding sources by attracting donations, either from the general public through fundraisers or online donation mechanisms or from other grantmakers.
  • Consider whether a payment may be more properly classified as gross receipts for mission-related activities. For example, see if a grant may actually be properly restructured as a payment for specific services rendered. Gross receipts from mission-related activities are removed from both the numerator and the denominator of the public support calculation.
  • Determine whether a single large grant or bequest might qualify as an unusual grant and thus not count toward either the numerator or the denominator of the public support calculation.

How Grantmakers Can Avoid Tipping Their Grantees

Grantmakers should avoid tipping their grantees, as doing so complicates a grantmaker's freedom to make unrestricted grants. Here are a few tips for grantmakers wishing to avoid this problem.

  • Collaborate with other grantmakers to diversify funding.
  • Advise the grantee on ways to seek additional sources of income.
  • Work with the grantee to determine whether separate installments of the grant over time may help shift the funds from all falling within a single 5-year period.
  • Consider whether a payment may be more properly classified as gross receipts for mission-related activities. For example, see if a grant may actually be restructured as a payment for specific services rendered.

As indicated, even foreign public charity equivalents may tip out of public charity status when they receive a substantial contribution from a U.S. funder. At NGOsource we do our best to help both grantmakers and grantees understand the implications of tipping and help them prepare accordingly.

Feel free to contact us if you have questions related to this or other topics on our blog. Stay tuned for our next post which will cover unusual grants.