With the recent online trend of the ALS “Ice Bucket Challenge” and this Saturday’s Fredericksburg Walk to End Alzheimer’s event, many people have been flooded with requests for charitable donations. Most people are willing to donate to a charitable organization without any questions asked. However, very few realize the actual legal implications of their donations, as well as the charitable organization’s corporate structure and regulations.
Most people tend to think of charitable organizations as a non-profit organization or public charity, such as American Red Cross, Smithsonian Institute, Alzheimer’s Association, etc. In order to become a non-profit organization, these businesses must be structured under specific regulations by the Internal Revenue Service (IRS). The IRS has specifically outlined these regulations in 26 U.S. Code 501(c)(3).
Section 501(c)(3) is the portion of the US Internal Revenue Code that allows for federal tax exemption of nonprofit organizations, specifically those that are considered public charities, private foundations or private operating foundations.
Entities that can seek 501(c)(3) determination from the IRS include corporations, trusts, community chests, LLCs, and unincorporated associations. The overwhelming majority of 501(c)(3) organizations are nonprofit corporations. The purpose of becoming a 501(c)(3) organization is to receive “tax-exempt” status from the IRS. In order to qualify for 501(c)(3) status, an entity must be organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals.
One of the most distinct provisions unique to Section 501(c)(3) organizations as compared with other tax exempt entities is the tax deductibility of donations. 26 U.S.C. § 170 provides a deduction, for federal income tax purposes, for some donors who make charitable contributions to most types of 501(c)(3) organizations. Other unique provisions tend to vary by state. Like federal law, most states allow for deductibility for state income tax purposes. Also, many states allow 501(c)(3) organizations to be exempt from sales tax on purchases, as well as exemption from property taxes. Furthermore, 501(c)(3) organizations fall into one of three primary categories: public charities, private foundations, and private operating foundations.
1. Public Charity – A public charity is generally defined by the IRS as “not a private foundation”. It receives a substantial portion of its revenue from the general public or from government. In order to remain a public charity (and not a private foundation), a 501(c)(3) must obtain at least 1/3 of its donated revenue from a fairly broad base of public support. Public support can be from individuals, companies and/or other public charities. Donations to public charities can be tax deductible to the individual donor up to 50% of the donor’s income. Corporate limits are generally 10%. In addition, public charities must maintain a governing body that is mostly made up of unrelated individuals.
2. Private Foundation – A private foundation is often referred to as a non-operating foundation, as in it typically does not have active programs. Revenue may come from a relatively small number of donors, even single donors. Private foundations are usually thought of as nonprofits which support the work of public charities through grants, though that is not always the case. Donations to private foundations can be tax deductible to the individual donor up to 30% of the donor’s income. Governance of a private foundation can be much more closely held than in a public charity. A family foundation is an example of a private foundation.
3. Private Operating Foundation – The least common of the three types, these organizations often maintain active programs similar to public charities, but may have attributes (such as close governance) similar to a foundation. As such, private operating foundations are often considered hybrids. Most of the earnings must go to the conduct of programs.
501(c)(3) organizations are highly regulated entities. Strict rules apply to both the activities and the governance of these organizations. No part of the activities or the net earnings can unfairly benefit any director, officer, or any private individual, and no officer or private individual can share in the distribution of any of the corporate assets in the event the organization shuts down. Additionally, lobbying, propaganda or other legislative activity must be kept relatively low. Intervention in political campaigns or the endorsement/anti-endorsement of candidates for public office is strictly prohibited.
In order for a corporation or other qualifying entity to receive 501(c)(3) status, it must apply to the IRS for recognition by filing Form 1023, Application for Recognition of Tax Exemption. The application is a thorough examination of the organization’s structure, governance and programs. 501(c)(3) organizations generally have to adhere to strict state compliance regulations as well.
So remember, when you are making a donation to a charity, pouring an ice bucket on your head, or walking with us on Saturday, September 27 at the Alzheimer’s Association Walk to End Alzheimer’s, please remember that there are strict compliance requirements for these charitable organizations. Additionally, if you are looking to set up a charity event or organization, it is important to know what regulations and rules you will be required to follow. As always, please feel free to stop by our office if you have questions about charitable organizations and we hope to see you tomorrow!