Many nonprofit organizations with which you may be familiar have names that contain the word “Foundation”. However, in many cases these organizations are not foundations in the legal sense, but rather are public charities. While both private foundations and public charities are 501(c)(3) organizations, there is quite a substantial difference between the two types of entities.

 Traditionally, the Internal Revenue Service classifies an organization described in Section 501(c)(3) of the Code as a private foundation unless the organization can demonstrate that it qualifies as a public charity. Because there are different rules that apply to public charities and private foundations, it is important to be able to identify whether an organization is a public charity or a private foundation.

 Unlike private foundations, which normally receive substantially all of their contributions from relatively few sources, such as a wealthy individual or corporation, and often rely on investment earnings as their source of ongoing support. A public charity, on the other hand, is either “publicly supported” (deriving a substantial portion of its financial support from the public) or functions to support one or more organizations that are classified as public charities. Specifically, an organization may qualify as a “publicly supported” organization because it does one or more of the following:

•Carries on specific exempt activities, which are religious, educational, scientific, or charitable in nature

•Is supported substantially by financial support from government agencies and/or the general public.

•Is supported substantially by contributions and gross receipts from its exempt activities, and does not receive more than one-third of its support from investment income.

•Is organized and at all times thereafter operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more specified publicly supported organizations. Organizations described in this paragraph are called “supporting organizations”.

 Because the private funding and private control of a private foundation increase the likelihood that the foundation will improperly benefit those who control the foundation, the Code subjects a private foundation to certain requirements and restrictions that are not applicable to public charities. For example, private foundations are subject to a tax on net investment income. In addition, private foundations are subject to excise taxes for failing to take certain required actions or for taking certain prohibited actions.

 Most notably, private foundations are required to make annual distributions equal to 5 percent of the aggregate fair market value of all assets of the organization, and are prohibited from the following:

•Engaging in acts of “self-dealing” with certain persons
•Having excess business holdings
•Making jeopardizing investments
•Making certain prohibited international expenditures

 Finally, the deductibility for federal income tax purposes of contributions to a private foundation is subject to certain limitations that do not apply to contributions to public charities. For example, the amount of contributions to private foundations that may be deducted for any year generally may not exceed 30 percent of an individual′s adjusted gross income for the year, while contributions to public charities may be deducted up to 50 percent of the AGI.

 Since the elimination of the advance ruling period, the IRS will review annual information returns annually and make bi-annual status rulings. Thus, nonprofits will have to be extra diligent in monitoring their funding sources and activities if they wish to retain their specific classification as either a private foundation or public charity.