As one of many items to consider when forming or maintaining a not-for-profit organization, public support is arguably one of the most important. Nevertheless, the issue's importance is often drastically underrated, and it is a common source of errors on exempt organization returns. The stakes are high because organizations that do not pass the public support test may be treated as private foundations.
Being a private foundation could be unattractive to donors and may not line up with the charity's operations and strategic direction. In addition, private foundations come with their own requirements, which often are more stringent and costly than those of a public charity. (On the other hand, in some cases, private foundation status may be the better choice and align more closely with the organization's goals.)
Given the consequences of mistakes in this area, it is critical that an organization's staff, board, and advisers know the organization's public support percentage, have an understanding of the special issues that affect the public support test, and learn how to maintain public support in practice and properly prepare Schedule A, Public Charity Status and Public Support, of Form 990, Return of Organization Exempt From Income Tax, to prove its public support to the IRS.
So how does an organization know its public support percentage?
Schedule A serves as the catalyst for the IRS's, the organization's, and the public's record of the public support test. Schedule A is used to indicate an organization's reason for public charity status and to provide the IRS with detailed information about the organization's funding sources. Generally, public support of more than 33⅓% must be maintained to preserve public charity status (Sec. 509(a)(2)(A)). Two exclusive tests exist to facilitate the calculation to determine an organization's public support percentage. These tests are reported on Schedule A, Part II, "Support Schedule for Organizations Described in Sections 170(b)(1)(A)(iv) and 170(b)(1)(A)(vi)," and Part III, "Support Schedule for Organizations Described in Section 509(a)(2)." (For more on how the public support percentage is calculated, see this article.)
Once the organization conceptually knows how to calculate the public support percentage, it should understand the special issues associated with the calculation and the practical considerations for preparing Schedule A.
Special issues and calculations
1. Unusual grants. Generally, unusual grants are donations an organization received that may be significantly large and uncommon. Unusual grants are excluded from the public support and total support definitions for both of the support tests. The criteria for determining whether a grant is unusual (Regs. Secs. 1.170A-9(f)(6)(ii) and 1.509(a)-3(c)(3)) are:
- A substantial contribution or bequest from a disinterested party;
- Attracted by reason of the publicly supported nature of the organization;
- Is unusual or unexpected in amount; and
- Would, by reason of its large amount, result in the organization's not meeting the applicable public support test.
An example of an unusual grant would be a bequest of $100 million from a disinterested party's estate to an animal shelter that has annual revenues of $20 million. If the organization recognizes revenue on an accrual basis, in the year of the bequest all of this money would be included on Form 990 as revenue, even if the cash is paid out over a number of years, or a certain percentage is paid each year.
In analyzing the criteria for an unusual grant, the contribution is substantial, unusual in amount, and would by reason of its amount result in the organization's not meeting the public support test. Assuming the donation was attracted by reason of the publicly supported nature of the organization, this would be considered an unusual grant. Therefore, for Schedule A purposes, the $100 million is excluded from both the numerator and the denominator, and the public support percentage likely remains similar to that of previous years.
2. Excess contributions. For the Sec. 170(b)(1)(A)(vi) test (Part I of Schedule A), excess contributions are not included in the numerator. Excess contributions are contributions by each person included on line 1 of Schedule A, Part II, that exceed 2% of total support for the five-year period (the amount shown on line 11, column (f)). "Each person" includes private foundations but excludes governmental units or publicly supported organizations. As an example, if an organization's total five-year support is $10 million, of any contributions from each person that exceed 2% of $10 million or $200,000 in total for the five-year period, only $200,000 is included in public support. Any amount above the $200,000 is not included in public support.
3. Disqualified persons. For the Sec. 509(a)(2) test, contributions from disqualified persons are not included in the numerator for the public support test. Sec. 4946 defines a disqualified person as:
- A substantial contributor, i.e., a person who gave an aggregate amount of more than $5,000 if that amount is more than 2% of the total contributions the organization received from its inception through the end of the year in which that person's contributions were received. A substantial contributor generally remains a substantial contributor even if he or she did not make any other contributions.
- A foundation manager.
- An owner of more than 20% of the voting power of a corporation, profits interest of a partnership, or beneficial interest of a trust or an unincorporated enterprise that is a substantial contributor (defined in item a) to the organization.
- A family member of an individual described in items a–c. A family member, for this purpose, is the donor's spouse, ancestors, children, grandchildren, great-grandchildren, and the spouses of children, grandchildren, and great-grandchildren.
- A corporation, partnership, trust, or estate in which persons described in items a–d own more than 35% of the voting power, profits interest, or beneficial interest.
Note that the substantial contributor calculation is based on figures from the organization's inception, which in practice may be difficult information to obtain.
4. Becoming a private foundation. If the organization becomes a private foundation after failing the public support test and other tests, the organization should be aware of the result.
- The foundation would be subject to excise taxes of 1%–2% on net investment income.
- Contributions would be limited to 30% of the donors' adjusted gross income (AGI) on their personal income tax return rather than the 50% limit that applies to a public charity.
- Certain types of donations are deductible only to the extent of the donor's basis in the property instead of its fair market value.
- The foundation would be required to file Form 990-PF, Return of Private Foundation, rather than Form 990.
- The organization would be subject to the strict Chapter 42 rules:
- Prohibition on self-dealing with disqualified persons.
- 5% minimum distribution requirement.
- Limit on excess business holdings.
- Additional requirements on grant making to nonpublic charities and to individuals.
Conversely, there are benefits to becoming a private foundation:
- More control by a single entity or family is permitted;
- Public support is a nonissue, so fundraising is perhaps more flexible.
Follow these pointers for maintaining public charity status and preparing Schedule A.
1. An organization's IRS determination letter does not dictate under which test the organization must report. In general, determination letters contain the Code section under which an organization is described, such as, Sec. 170(b)(1)(A)(vi) (Part II of Schedule A) or Sec. 509(a)(2) (Part III of Schedule A). Part I of Schedule A requests the organization's "Reason for Public Charity Status," but the organization is not required to select the option aligned with its IRS determination letter. In other words, the organization should select one of the options under which it could qualify as publicly supported during the tax year. In many cases, for public charities, this means line 7 (an organization that receives a substantial amount of support from the government or the general public) or 9 (an organization that receives 33⅓% support from membership fees, etc.) could be selected. In practice, the best choice may be to select the one providing the most favorable public support percentage.
2. Recognize the complexity and importance of the public support test. The calculation and its components are extremely complex and require the preparer to thoroughly read the applicable parts of the Form 990 and Schedule A instructions. In many cases, it will be necessary to do further research to properly prepare the form. Because of the difficulty in preparing the form, the likelihood the form will be completed improperly is extremely high. If an organization does not understand its public support percentage or improperly calculates it, the organization may become a private foundation and not be aware of it. Furthermore, the IRS monitors the vast majority of Form 990 data and further analyzes them to determine whether organizations are in compliance.
3. The information needed to prepare Schedule A requires detailed records such as:
- Contributor data consistent with the organization's Form 990 accounting method. The accounting method required for Schedule A is the method the organization uses on Form 990. In many cases, this will be the accrual basis of accounting, which may lead to an inconsistency with donor data that may be reported internally on the cash basis for written acknowledgement purposes. Because individual donors are typically cash-basis taxpayers, they require written acknowledgments that reflect the cash basis. Therefore, it is possible that a cash-to-accrual conversion of the data will be needed to properly prepare the form.
- Detailed information regarding the organization's revenue sources. Because Schedule A's two exclusive tests require different information and certain types of revenue, it is critical that there is an understanding of the revenue sources—for example, whether the revenue was exempt function income, donations, or unrelated business income.
- Historical contributor data. Organizations should maintain detailed contributor data from inception and particularly for the five-year period associated with the public support test. Further, the organization should also maintain data about disqualified persons and excessive contributors.
4. Public charity status is attractive to donors. Public charities are the most attractive to donors for several reasons. First, the publicly supported nature of the organization means the donor joins a vast number of others who have contributed. Additionally, the tax deduction available to donors is limited to 50% of the donor's AGI, rather than 30% of AGI for donations to private foundations. When a donor sees that the organization is funded by a smaller group of wealthy individuals or foundations, the donor may be reluctant to support the cause when large foundations or wealthy individuals have contributed so significantly.
5. Monitor public support regularly in the first five years of existence or if the organization is in jeopardy of losing its public charity status. It is important for new organizations to understand and know the public support percentage even though organizations are not required to report the percentage during the first five years of existence. As an example, many organizations may be funded by a select group of individuals in the early days and become more publicly supported in future years. If the organization isn't careful, the sixth year of existence may come with a surprise that the organization does not meet the public support test. Additionally, advisers should consider monitoring an organization's public support if it comes into question. This could provide the organization with the information it needs to make key support decisions or to give it ample preparation time prior to becoming a private foundation.
6. Understand that certain records used in preparing Schedule A are not open to public disclosure. Many tax software programs will generate schedules that are not open to public disclosure, such as the unusual grants list, the excess contributor list, and the disqualified persons list. It is critical that organizations and their advisers produce full public disclosure copies to provide copies to stakeholders or publish on the organization's website.
Organizations should consult with their advisers to ensure the public support test calculation is accurate, addresses the special issues, and reflects the organization's broad public support.
Andrew Gray, CPA, is a tax adviser at Daszkal Bolton in Jupiter, Fla. who specializes in tax consulting and compliance for public charities and private foundations. He often speaks about Form 990, Form 990-PF, unrelated business income, and public support. Andrew is also the Board Chair of Nonprofits First.