We have seen many instances where public charities that were initially established with public support have built up their savings and investments, while public support has diminished. While they can survive and support operations with investment income, they are in danger of losing their classification as a public charity. If the organization does not pass the various public support tests for two consecutive years, the IRS will reclassify the public charity to be a private foundation. If your organization finds itself in this situation, there are some steps that you may be able to take in order to minimize the effect that the reclassification will have on your organization.

There are three different types of private foundations that are each treated differently from the others for tax purposes. The first type is the Private Non-operating Foundation. This is the type of foundation that your non-publicly supported organization will become automatically if you do nothing. You can file to request the change ahead of the two years, but we generally do not recommend doing so. There is a $400 filing fee to request a change, and there are significant disadvantages to this type of organization. There is a tax of either 1% or 2% charged on the net investment income each year.

There is also an excise tax assessed if a minimum amount is not donated to public charities each year. We generally estimate the amount that private foundation clients have to give away to charities each year so that they can avoid being assessed the excise tax. While as a public charity, donors were generally limited to a deduction equal to 50% of their adjusted gross income, donors to a private non-operating foundation are limited to a deduction equal to 30% of their adjusted gross income each year. Other private non-operating foundations face restrictions when donating and some public charities, such as community foundations, refuse to donate to these organizations at all.

The best option for an alternative classification is an Exempt Operating Foundation. This alternative most closely resembles the public charity status. This classification needs to be requested and certain requirements need to be met. The Foundation needs to have been publicly supported for 10 years, have a governing board of more than 75% non-disqualified individuals which displays a broad representation of the general public, and all officers must be non-disqualified individuals.

There are a number of advantages to becoming an Exempt Operating Foundation. An Exempt Operating Foundation is not subject to tax on net investment income paid by other private foundations. In addition, Private Foundations may make grants to these Exempt Operating Foundations without complying with the expenditure responsibility rules, and they also share the advantages of Private Operating Foundations (non-exempt).

Many organizations in this situation do not qualify for Exempt Operating Foundation status; however, there is a third alternative that we have had success in obtaining. The third option is called the Private Operating Foundation. We have recently helped one of our clients apply for this classification. The application was approved without any additional correspondence in six weeks.

A Private Operating Foundation must show that it devotes most of its resources to the active conduct of furthering its exempt purposes. The advantages to this classification include the fact that these organizations are not required to distribute a calculated amount of each year's income in order to avoid an excise tax. Tax deductible donations made to these types of private foundations are limited to 50% of a donor's adjusted gross income, the same as donations to public charities.

In addition, a private operating foundation may receive contributions from private foundations which it does not control. One disadvantage that distinguishes this classification from the Exempt Operating Foundation is that these organizations are generally still subject to net investment income tax of 1% or 2%.

If you choose to apply for reclassification of your public charity status, you should file before the IRS converts your organization to a private non-operating foundation upon failing the public support test for the second year. Feel free to contact us with any questions.