Tax law allows nonprofit organizations to be exempt from paying income tax on the money they bring in, if they meet certain conditions. Nonprofits must apply for tax exempt status under section 501(c) of the IRS code. Sometimes nonprofits are referred to as 501(c) organizations. This simply means they have been granted tax exempt status.
There are 29 different types of tax exempt organizations under 501c. Of which the most common type is 501c3 organizations. These include public charities and private foundations.
The IRS is extremely strict about the requirements for obtaining any 501c tax exempt status. The organization must serve a public good. It must not declare a profit, and instead must use its revenues to serve the public interest. It is allowed to use those revenues for operational expenses.
What are Public Charities?
Most 501c3 nonprofits are considered public charities. The term “public charity” is generally understood to mean an organization that helps or serves the public in some way.
Most nonprofits want to be considered public charities because they not only get tax exempt status, but they also have more tax filing options and they have higher donor tax-deductible giving limits.
In order to qualify as a public charity, a nonprofit must:
- Be organized exclusively for 501(c)(3) purposes
- Have language in the articles of incorporation that limit the organization’s activities to things in the public interest
- Have a diversified board of directors
- More than 50% of the board must by unrelated by blood, marriage, or outside business co-ownership
- The board must not be compensated as employees of the organization
- Has broad public support and receive at least 33% of its revenues from small donors
- Small donors are individuals whose contribution is less than 2% of the organization’s income
What are Private Foundations?
Some private foundations are simply nonprofits that hoped to be considered public charities, but for one reason or another did not qualify. Funding for Private Foundations is primarily derived from a single source. And, although they can, they usually do not accept outside donations.
The major motive for starting a private foundation instead of a public charity is control. Private foundations can be controlled by related individuals, or even a single person. Additionally, foundations are able to have their primary function to be to fund and support public charities. While most charitable foundations primarily engage in issuing grants, they are able to also fund and operate their own charitable programs.
Foundations have limitations charities do not:
- Cannot do business with contributors
- Required to donate at least 5% of its annual income
- Investment income is taxed
- Deductible value of a donation is limited.