Charitable Foundation Basics
As seen on Council on Foundations
What is a charitable organization?
Charities are a large and diverse group of nonprofit institutions that play a key role in American society and help to form and strengthen communities. With the help of millions of volunteers and the generosity of countless donors, they provide many services and perform many functions that in some countries are largely performed by government. Organizations that only operate charitable activities are classified under Section 501(c)(3) of the Internal Revenue Code.
Many types of organizations are tax-exempt, but not all qualify for 501(c)(3) status. The 501(c)(3) designation is a legal designation reserved for organizations that are exclusively charitable. Other organizations exempt from federal income tax can be found under Section 501(c) of the Tax Code, but they do not qualify as 501(c)(3) organizations because they are permitted to operate programs that are both charitable and non-charitable.
A few basic legal characteristics of 501(c)(3) organizations:
Contributions to 501(c)(3) organizations are generally tax deductible.
Grants and activities may not assist election campaigns that support or oppose candidates for public office.
Grants, compensation, and other payments must be made within specific guidelines, and for a charitable purpose, not for personal or private benefit.
The IRS classifies all 501(c)(3) organizations into two distinct types: private foundations and public charities.
The IRS is a good source of general information on the different types of tax-exempt organizations, all of which are under 501(c) of the Tax Code.
In the nonprofit sector, the term foundation has no precise meaning. The Council on Foundations defines a foundation as an entity that supports charitable activities by making grants to unrelated organizations or institutions or to individuals for scientific, educational, cultural, religious, or other charitable purposes. While foundations are often primarily engaged in grantmaking activities, some may engage in their own direct charitable activities or programs. When thinking about foundations in the charitable context, it is helpful to see how the IRS describes private foundations and public charities.
What is a foundation?
In the nonprofit sector, the term foundation has no precise meaning. The Council on Foundations defines a foundation as an entity that supports charitable activities by making grants to unrelated organizations or institutions or to individuals for scientific, educational, cultural, religious, or other charitable purposes. While foundations are often primarily engaged in grantmaking activities, some may engage in their own direct charitable activities or programs. When thinking about foundations in the charitable context, it is helpful to see how the IRS describes private foundations and public charities.
What is a private foundation?
Private foundations are generally financially supported by one or a small handful of sources—an individual, a family, or a corporation. There are a few different kinds of private foundations: independent, family, and corporate. These categories are not legally defined. Rather, they are commonly used in the field of philanthropy to distinguish the different kinds of private foundations. Private foundations must pay out at least 5 percent of their assets each year in the form of grants and operating charitable activities. A private operating foundation is a kind of private foundation and must operate under similar rules. However, it does not have to pay out 5 percent or more of its assets each year in grants. Instead, it must carry out its own charitable purposes. All private foundations are 501(c)(3) organizations. Under the Internal Revenue Code, a charity is presumed to be a private foundation unless it can prove that it is a public charity.
What is a public charity?
Public charities include a wide variety of charitable organizations, including hospitals, schools, churches, and organizations that make grants to others. Charities that primarily make grants are commonly referred to as public foundations. Most of these foundations are publicly supported charities, meaning they receive their funds from multiple sources, which may include private foundations, individuals, government agencies, and fees they charge for charitable services they provide. Some foundations are public charities because they meet at least one of the IRS tests for qualifying as a public charity. One kind of public charity, known as a supporting organization, is recognized by the IRS as charitable simply because of its legal relationship to one or more other public charities. A community foundation is yet another kind of public charity. In some cases, corporate foundations are set up as public, rather than private, foundations.
The IRS’s “Compliance Guide for Public Charities” provides an overview of the compliance requirements public charities must meet in order to stay tax-exempt.
Do charities pay taxes?
Charities generally do not pay state or federal income tax. They also may be exempt from paying state sales tax on their purchases and from local property tax on property they use to carry out their charitable activities. The extent and nature of exemptions from state taxes will vary from state to state. These generous exemptions recognize the important principle that organizations that act voluntarily to further the public good should be freed from the obligation to support government through the payment of taxes. Exemptions maximize the ability of charities to help others.
Key differences between a public charity and a private foundation?
The distinction between public charities and private foundations is a matter of federal tax law.
Public charities, unlike private foundations, are heavily supported by the public. For this reason, public charities are more subject to public scrutiny, which can help ensure adherence to appropriate standards of conduct in the absence of the more strict rules and regulations governing private foundations.
Since 1969, private foundations have been subject to stricter and more extensive federal rules than public charities, including strict prohibitions on self-dealing, and limits on the amount of stock they can hold in any one company. Examples of the various regulated private foundation activities include:
financial transactions between the foundation and its largest contributors, officers, and other insiders
amounts paid out toward operating costs, grants, and charitable programs
reasonableness of the types and amounts of expenses incurred to operate the foundation
compensation of foundation staff and board members
business holdings of the foundation
engaging in overly risky investments with charitable assets
grants or other payments to individuals, other private foundations, certain kinds of charities, and organizations that are not charities
These more stringent rules were less applicable in the public charity context, but in recent years have been applied in some degree to charities that administer funds that are considered donor advised. Although public charities were traditionally not as heavily regulated as private foundations, it has been and is still recommended that charities follow the private foundation rules closely as guidance. Indeed, more and more, the IRS is requiring that public charities adhere to many of the private foundation rules when making certain kinds of grants or payments to individuals, charities, and non-charities. In addition, private foundations, supporting organizations, and organizations that administer donor advised funds or scholarship funds must also stay in compliance with the charitable grantmaking provisions of the Pension Protection Act of 2006.
