Many individuals looking to create a nonprofit organization have their sights set on doing good, often overlooking the important decision between seeking classification for their new nonprofit as a public charity versus a private foundation.

By default, a nonprofit applying for tax-exempt status as a Code Section 501(c)(3) organization will be classified as a private foundation. Whether the organization can elect to be treated as a public charity is based on what is known as the public support test.

The public support test requires at least one-third of the nonprofit's total contributions to come from the general public. Public support, however, is limited to those contributions that do not exceed 2% of the nonprofit's total contributions.

For example, assume a nonprofit's total support is $1,000, which is made up of nine hundred $1 contributions and one $100 contribution. As a result of the 2% rule, all contributions are capped at 2% of $1,000, or $20, for the purpose of determining the nonprofit's public support.

Therefore, all nine hundred of the $1 contributions will be counted toward the nonprofit's public support because each contribution is less than 2% of the nonprofit's total support. Conversely, only $20 of the $100 contribution can be counted toward the nonprofit's public support.

The nonprofit's public support would be $920, and the nonprofit's public support percentage would be 92%. Because the nonprofit's public support percentage is more than 33.3%, the nonprofit could qualify as a public charity.

In contrast, if a nonprofit's total support is $1,000, which is made up of two $500 contributions, the nonprofit's public support would be $40 because both $500 contributions would be capped at 2% of the nonprofit's total support, or $20. The nonprofit's public support percentage would be 4%, and the nonprofit would have to be classified as a private foundation.

Keep in mind that there is an alternative test for nonprofits seeking classification as a public charity. This test is known as the facts and circumstances test. The test requires that 10% of the nonprofit's funding come from the general public. If a nonprofit meets this threshold requirement, the IRS will then look to see if the nonprofit operates in the general nature of a public charity.

In sum, if the majority of the nonprofit's funding will be coming from its founders and/or a few individuals or organizations, then the nonprofit will likely be a private foundation. If, on the other hand, the nonprofit will be funded by a large number of sources, the nonprofit may qualify as a public charity.

While both a public charity and a private foundation are generally exempt from paying federal income tax, the distinction between the two classifications will determine the activities in which your nonprofit can engage and the amount of deductions your donors may declare.  Public charities are often easier to administer, whereas private foundations are subject to substantial IRS oversight.  Thus, it is important to consider how your nonprofit will be funded before applying for tax-exempt status with the IRS.

For information on how your tax-exempt status affects your donors, see our previous post titled “Not All Charitable Donations are the Same in Uncle Sam’s Eyes.”

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.