The primary difference between private non-operating and private operating foundations is their purpose: operating foundations devote most of their resources to actively conducting programs that directly benefit the public, whereas non-operating foundations function primarily to financially support charity work with few or no public programs. Additionally, to qualify as operating, the foundation must satisfy an income test and one of three additional tests set forth by the Internal Revenue Service (“IRS”). This is not a requirement for non-operating foundations. Also, donors of operating foundations enjoy increased tax deductions for their donations at a rate of up to 50 percent, whereas donors of non-operating foundations can deduct their donations at a rate of up to 30 percent. Operating foundations also are not subject to the excise tax on undistributed income to which non-operating foundations are subject.
Organizational Requirements
All non-profits are governed by their board of directors. This includes public charities, non-operating, and operating private foundations. What makes private foundations unique from public charities, however, is that the board of directors may be a relatively close group of individuals, including family members, business associates, major donors, or other related people, whereas public charities must be diversely funded by public donors. All private foundations can also be funded by a small group of donors, or even just one donor. Private foundations are often closely-held and closely-funded. In terms of their organizational requirements, there is essentially no difference between operating and non-operating private foundations.
Operational Function
The operational function of non-operating and operating private foundations signals the division between them. Operating foundations function primarily to provide public programming in contrast to private non-operating foundations, which are most commonly created solely to distribute funds to other charitable organizations and lack public programming. So what does it take to be categorized as an operating private foundation? Private foundations are, essentially by default, categorized as non-operating unless and until the foundation is able to show that its primary function is to provide public programming.
For the foundation to show that it is operating, it must first meet the income test as set forth by the IRS. No private foundation can be categorized as operating without satisfying this test. In addition, the foundation must pass one of the three following tests also set forth by the IRS: the support test, the endowment test, or the assets test. If the foundation meets both the income test and one of the other three tests, it can be categorized as operating and will benefit from increased tax deductions and other positive tax consequences.
The IRS measures the foundation’s normal operation over a period of years to determine whether the tests are satisfied. Each of the tests mandate compliance with their respective requirements for any three years during a four-year period or an aggregate of all amounts of income or assets held, received, or distributed during the four-year period. The four-year period consists of the tax year in question and the three years immediately preceding that year. The same method of measurement must be used to satisfy both tests in any given year.
A foundation cannot be categorized as operating without satisfying the income test. The income test requires a foundation to spend at least 85 percent of its adjusted net income or its minimum investment return —whichever is less—directly for the active conduct of its charitable activities.
The first relevant question is whether the foundation spends at least 85 percent of its adjusted net income or its minimum investment return directly on programs that benefit the public. These programs must be conducted actively and distribution of funds is not considered a qualified public program, even if it benefits the public. If the answer to this question is yes, the next consideration is whether one of the other three tests can be satisfied.
A private foundation will meet the support test if: (1) at least 85 percent of its support, other than gross investment income, is normally received from the general public and five or more unrelated exempt organizations; (2) not more than 25 percent of its support, other than gross investment income, is normally received from any one exempt organization; and (3) not more than 50 percent of its support is normally received from gross investment income.
A private foundation will satisfy the assets test if 65 percent or more of its assets: (1) are devoted directly to the actively conducting public programming, a functionally related business, or a combination of the two; (2) consist of stock of a corporation that is controlled by the foundation and at least 85 percent of the assets of which are so devoted; or (3) are any combination of (1) and (2).
The endowment test determines whether the foundation normally makes qualifying distributions of at least two-thirds of its minimum investment return directly in actively conducting programs that benefit the public. In most cases, if the foundation satisfies the income test, it will also satisfy the endowment test. Only where the minimum investment return is significantly higher than adjusted net income might the endowment test yield a different result.
Tax Consequences
Because they fall under the umbrella of 501(c)(3) organizations, private foundations of both types are exempt from federal taxation. In addition to this, donors of both types of private foundations benefit from the tax deductibility of their donations. Donors of private operating foundations, however, gain a greater benefit from their donation than do donors of non-operating foundations. Donors of private non-operating foundations can deduct their donations at a rate of up to 30 percent, with a few narrow exceptions. Donors of operating foundations, however, deduct their donations at a rate of up to 50 percent.
Additionally, private non-operating foundations are subject to a 30 percent excise tax on undistributed income. Undistributed income is a certain amount of money or property that is not spent annually for charitable purposes, such as grants to other charitable organizations. The distribution requirement is calculated from the foundation’s distributable amount, equal to the foundation’s minimum investment return, subject to some adjustments as determined by the IRS. If the foundation does not meet the annual distribution, it will be subject to the tax, with a few narrow exceptions. The tax is charged for each year or part of a year in which the distribution deficiency is not corrected. An additional tax of 100 percent will be incurred if the deficiency is not resolved within 90 days of receiving notice of the deficiency of the IRS.
This excise tax does not apply to private operating foundations. This is commonly a benefit to those foundations because operating foundations experience less regulation and requirements on spending, but it is important to consider that the foundation must continue to satisfy the requirements of the income test and another test, so regulations on spending do still exist in that way.
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