The public support test: staying a public charity

This explainer is for treasurers and founders of 501(c)(3) charities that raise money from donors, grants and program fees. Most small charities are public charities, and they want to stay that way. To do it, many must show the IRS, year after year, that their money comes from a broad base of people and not just a few. That is the public support test. After reading, you'll understand why it matters, how the two main versions of the test work, and how to keep an eye on your numbers long before the IRS asks.

Public charity or private foundation?

IRS Publication 557 says something that surprises many founders: every 501(c)(3) organization is a private foundation unless it falls into one of the categories the tax code excludes. Those excluded categories are the public charities. Publication 557 says they are generally organizations that have broad public support, or that actively support other public charities.

The IRS's public charities page lists the usual kinds: churches, hospitals and schools; organizations with an active fundraising program that receive contributions from many sources, including the public, government, companies, foundations and other charities; organizations that earn income from activities that further their mission; and supporting organizations. A private foundation, by contrast, typically gets most of its money from one family or company and mainly makes grants.

Why it matters: the IRS says private foundations pay an excise tax on their net investment income, and face extra rules, including limits on dealings with insiders, a requirement to pay out income for charitable purposes each year, and limits on business holdings. Most small charities are not set up for that.

Publication 557 also says a charity is presumed to be a private foundation unless it tells the IRS otherwise on its exemption application (Form 1023 or 1023-EZ). That is where you first chose your public charity status.

The two public support tests

Your IRS determination letter names the code section your public charity status rests on. Most community charities that rely on donations and grants fall under section 170(b)(1)(A)(vi), which goes with section 509(a)(1). Charities that earn much of their money from fees for their programs, like admissions or classes, often fall under section 509(a)(2). You report your numbers on Schedule A of Form 990 or 990-EZ: Part II for the first test, Part III for the second.

Both tests look at a five-year period: the current tax year and the four before it.

Section 170(b)(1)(A)(vi): the donation-based test

The Schedule A instructions say an organization qualifies if either:

• 33 1/3 percent or more of its total support comes from governmental units, contributions from the general public, and contributions or grants from other public charities; or
• 10 percent or more of its total support comes from those sources and the facts and circumstances show it is publicly supported.

For the 10 percent route, you explain in Schedule A, Part VI how you meet the facts-and-circumstances test. The instructions ask, for example, whether you run a continuous, genuine program to raise money from the public, government or other charities; whether your board represents the broad interests of the public; and whether you provide facilities or services directly to the public on a continuing basis.

The instructions also warn that you won't meet either test if almost all your support comes from gross receipts from related activities (such as fees for your programs) and only an insignificant amount comes from government and the public. That's what the second test is for.

Section 509(a)(2): the fee-friendly test

The Schedule A instructions say an organization qualifies under section 509(a)(2) if:

• more than 33 1/3 percent of its support normally comes from gifts, grants, contributions, membership fees, and gross receipts from admissions, sales of merchandise, performance of services or furnishing of facilities in activities that aren't unrelated businesses; and
• no more than 33 1/3 percent of its support normally comes from gross investment income and certain net unrelated business income.

This test has its own limits on what counts. Amounts from disqualified persons, such as board members, major donors and their families, don't count as public support. Gross receipts from related activities from any one person or government agency count only up to the greater of $5,000 or 1 percent of total support for that year. Check the Part III instructions for the details.

The 2 percent limit on large gifts

Under the 170(b)(1)(A)(vi) test, big gifts from one donor count only partly. The Schedule A instructions say you count each individual, trust or corporation's contributions as public support only up to 2 percent of your total support for the five-year period. Anything above that is subtracted. Gifts from a donor and certain related people, such as a spouse, other family members, and businesses they control, are treated as coming from one person.

The 2 percent limit doesn't apply to support from governmental units or from charities that are themselves publicly supported under 170(b)(1)(A)(vi). Some other public charities, such as churches, schools and hospitals, are also exempt from the limit, but only if they also qualify under 170(b)(1)(A)(vi). So a grant from a community foundation that is publicly supported under 170(b)(1)(A)(vi) can count in full.

The instructions ask you to keep, for your own records, a list of every donor whose total gifts over the five years exceeded 2 percent, and not to file that list with your return, because returns can be made public.

Here is a simple illustration with made-up numbers. If your total support over five years is $500,000, 2 percent is $10,000. A board member who gave $40,000 over those years counts as $10,000 of public support; the other $30,000 still counts in total support but not in public support.

There is also a narrow exception for unusual grants: substantial, unexpected gifts from disinterested donors, attracted by your public nature, that are large enough to endanger your status. These can be left out of the calculation entirely. The rules are strict, so ask an accountant before relying on it.

Your first five years

New charities get breathing room. The Schedule A instructions say that for each of its first five tax years as a 501(c)(3), an organization that the IRS classified as a 170(b)(1)(A)(vi) public charity checks a box on Schedule A (Part II, line 13) and doesn't complete the rest of the support schedule. Part III has the same arrangement for 509(a)(2) organizations.

That doesn't mean you can ignore the test. The IRS tells new organizations to do the calculation on a copy of Schedule A they keep for themselves, and to monitor public support on an ongoing basis so they will pass in the sixth year and after. In year six, the test covers your first five years together.

What happens if you fail

The Schedule A instructions explain what happens. If a charity meets the 33 1/3 percent test for the current five-year period, it qualifies for that year and the next. If it falls short this year but passed in the prior period, it still qualifies for this year. If it fails under every test and has no other public charity status, it is treated as a private foundation from the start of that tax year for filing purposes. It then files Form 990-PF, the private foundation return, instead of Form 990 or 990-EZ, and checks "Initial return of a former public charity."

From then on the private foundation rules described above apply. Before that happens, look at whether you qualify under the other test. The instructions point a charity that fails Part II to try Part III, and the other way round.

Practical tips

• Know your code section. Find your IRS determination letter and note which section your public charity status rests on.
• Code gifts as they come in. Your bookkeeping should separate individual gifts, government grants, grants from public charities, grants from private foundations, program fees and investment income. The test can't be worked out from a single "donations" line.
• Widen your base early. Many small gifts from many people do more for the test than one large gift. A yearly appeal, a membership program or a modest peer-to-peer campaign all help.
• Don't refuse large gifts. A big gift still counts up to the 2 percent limit and still pays for programs. Just plan to balance it with broader fundraising.
• Get help in year five. Before you file your sixth return, ask an accountant to check the five-year numbers.

For help with the return itself, see filing your first Form 990.