Nonprofit organizations with Section 501(c)(3) tax-exempt status that do not fit into any of the public charity categories found in Section 509(a) may be private operating foundations. Whether a private foundation is a private operating or direct charitable foundation or a private non-operating or grant-making foundation, private foundations raise complex tax issues. The California Center for Nonprofit Law can ensure that your private operating foundation or other nonprofit organization is aware of and complies with all requirements to remain tax-exempt at all times.
Understanding Private Operating Foundations
Private operating foundations benefit from some of the same advantages as a public charity but, in all other respects, is treated as a private foundation. These foundations actively conduct activities that meet charitable, educational, or other exempt purposes.
Organizations qualify as private operating foundations if they meet an income test and one of three alternative tests: an asset test, an endowment test, or a support test. An organization must meet these tests each year, and different rules apply for an organization that has existed for less than one year, between one and four years, and four or more years.
The Income Test
To satisfy the income test under Section 4942(j)(3)(A), a private foundation must make qualifying distributions toward the activities to further its primary purpose that is equal to or substantially all of the lesser of its adjusted net income or its minimum investment return. The foundation generally must use the distributions itself and can use them to purchase or maintain assets to further its exempt activities. Likewise, qualifying distributions may be used for reasonable administrative expenses, operating costs for conducting exempt activities, and reasonable and necessary legal fees. On the other hand, payments to individual or corporate beneficiaries are only permissible as qualifying distributions only if the foundation maintains substantial involvement in the programs it funds.
The Assets Test (Alternative 1)
A private foundation meets the assets test under Section 4942(j)(3)(B)(i) and Treas. Reg. 53.4942(b)-2(a)(1) if substantially more than half of the fair market value of its assets is:
- Devoted directly to the active conduct of activities constituting the foundation’s exempt purpose or to functionally related businesses,
- Stock of a corporation that is controlled by the foundation and substantially all the assets of which are so devoted, or
- Some combination of the above.
A functionally related business is any trade or business that is not unrelated or an activity carried on within a larger aggregate of similar activities or a larger group of other endeavors related to the organization’s exempt purpose. To be “devoted directly,” the foundation must use at least 95% of the asset to conduct its activities that constitute its exempt purpose.
The Endowment Test (Alternative 2)
Under the endowment test outlined in Section 4942(j)(3)(B)(ii), a private foundation must normally make “qualifying distributions directly for the active conduct of activities constituting its exempt purpose in an amount not less than two-thirds of its minimum investment return.” These distributions amount to 3 1/3 percent of the excess of the fair market value of the foundation’s assets over the amount of acquisition indebtedness concerning those assets.
The endowment test alternative is designed for foundations that actively engage in charitable activities but also need large endowments to fund their personal services. In most cases, a foundation that satisfies the income test also satisfies the endowment test.
The Support Test (Alternative 3)
A private foundation must meet the following three eligibility requirements to satisfy the support test under Section 4942(j)(3)(B)(iii):
- Substantially all of its support (other than gross investment income as defined in Section 509(e)) must normally be received from the public and from five or more exempt organizations that are not related to each other or the recipient foundation per Section 4946(a)(1)(H);
- Not more than 25% of its support other than gross investment income may normally be received from any single exempt organization; and
- A maximum of half of its support may normally be received from gross investment income.
Support includes a wide range of income, including gifts, grants, gross receipts from admissions or memberships, net income from unrelated business activities, gross investment income, tax revenues levied for the benefit of the organization, and the value of services or facilities furnished by a governmental unit to an organization free of charge.
The support test is geared primarily toward private operating foundations with special purposes and expertise in specialized substantive areas. However, any organization may meet the support test standard.
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The California Center for Nonprofit Law dedicates its efforts to the daily legal matters that nonprofit organizations face, including maintaining tax-exempt status. Call us today at (949) 892-1221 and schedule a time to discuss your case. Get your questions answered and learn more about how we can help.
