This information was originally published in a post by the Foundation Group.
Many people have a layman’s understanding of the difference between public charities and private foundations: Public charities are understood to perform charitable work, while private foundations support the work of public charities. That grassroots definition is, in practice, mostly true. The specifics, however, are slightly more complicated.
Public charities. Public charities represent the largest share of active, 501(c)(3) organizations. Those starting a new organization usually prefer public charity status, not just because it better describes the organization’s purpose. Public charities also enjoy some advantages over private foundations: higher donor tax-deductible giving limits, the ability to attract support from other public charities and private foundations, as well as a $25,000 income threshold to trigger annual Form 990 filing (private foundations file Form 990-PF regardless of income). In fact, an applicant for 501(c)(3) status must prove why it should be considered a public charity, lest they be considered a private foundation by default.
Like the layman’s definition, public charities typically carry out some type of direct, charitable activity. Examples include churches, private schools, homeless shelters, etc…the list of possibilities is nearly endless. The true definition of a public charity, though, goes well beyond the programs and into the realm of structure and revenue source. As for structure, in order to qualify for (and keep) public charity status, a 501(c)(3) must be organized for exclusively 501(c)(3) purposes. The IRS requires certain language to be in a public charity’s articles of incorporation explicitly restricting its activities to such. In addition, a public charity must represent the public interest by having a diversified board of directors. More than 50% of the board must be unrelated by blood, marriage or outside business co-ownership and not be compensated as employees of the organization. We are often asked where that is in the “code” and, frankly, it isn’t there…at least not verbatim. It is an extrapolation of the IRS’s requirement that governance of a public charity be at arms-length and without private benefit (inurement) to insiders. As such, the IRS requires that a quorum of board members be possible who have no personal stake, either directly or potentially through relationship. Finally comes the income, or source of revenue, test. Public charities must be supported by the general public. For that to be true, a significant amount of revenue, at least 33%, must come from relatively small donors (those who give less than 2% of the organization’s income), from other public charities or the government. While that is significant, that leaves 67% to potentially come from other, less diverse sources.
Private foundations. While being considered a private foundation could simply be a fall-back position of not qualifying for public charity status via either the organizational or income test (or both), it is most often a choice that is made. There are reasons why someone would choose foundation status over public charity. Chief among those is control. In exchange for somewhat disadvantaged deductibility limits to donors, mandatory Form 990-PF filings, and minimum annual asset distributions (5% each year), private foundations can be controlled by related parties and be funded by a relatively small group…even one individual or family (think Bill and Melinda Gates Foundation). This is often more than enough trade off for those starting a foundation. One thing that is not different for private foundations is the requirement that it be organized for exclusively charitable purposes.
There is even a third type of 501(c)(3), the private operating foundation. This is best thought of as a hybrid of the other two, most often a private foundation with direct program services like that operated by public charities. The rules are strict, as control can be like that of private foundations, but with some of the benefits of public charities. There are relatively few of these organizations around. You typically only see these under rather unique circumstances.