As the year draws to a close, many of our client conversations are about gifts—not so much about Christmas presents, but gifting to charities and other philanthropic organizations. The subject arises as we discuss year-end deadlines and planning. Considering the strong stock market performance of 2021, most of my clients are dealing with capital gains and how to plan around them, which is where gift-giving conversations begin.

Donating is one of the few options to decrease your tax responsibilities. Giving money to a charity also corresponds nicely with the season and the spirit of doing good for others. However, when I ask customers about their favorite organizations and programs to support, I discover that many of them have reservations. They are concerned about how some charities use their donations, particularly put off by the seven-figure salaries of some nonprofit organization executives. My interactions with my nonprofit foundation and charity clients, on the other hand, frequently revolve around annual receipts that fall short of income predictions and strategies to increase their donation receivables.

This is where taxpayers looking for deductions and nonprofits looking for donations can come together for their mutual benefit. An endowment can be the solution to both concerns.

The endowment double solution

For the donor, an endowment can perpetuate their gift by producing gifts for many years. In addition, an endowment can provide assurance the donated funds are used for programs they specify. For example, a donor might endow a certain position within an organization, like a chaplain in an assisted living facility who helped the donor’s mother adjust to her new way of life. Or an endowment could be used to fund educational scholarships for the donor’s field of study that allowed him to earn money during his career that he can now use to help others.

As an endowment is a way to ensure the funds gifted will be used only as the donor intends, it is also a powerful tool for charitable organizations looking to increase their donation receivables. The endowment is a permanently invested pool of money that provides a reliable source of income in perpetuity. The organization can count on the distributions annually to support its charitable work. The value of endowments was particularly evident in 2020 when making donations and supporting local charities was challenged by local lockdowns and the COVID- 19-related financial uncertainties, when the pandemic prevented charities from staging events and gathering people together to raise money. As the needs served by charitable organizations didn’t diminish with the pandemic—in fact, they increased—endowment income was for many organizations a lifesaver.

The endowment can hedge inflation and increase future spending power by implementing sound investment and spending practices. An endowment can generate a pipeline of gifts. Many endowment gifts are intended to be used at a later date, usually after the donor’s death. We frequently use life insurance to make small gifts during a donor’s lifetime and a substantial gift after they pass away. As a result, the endowment provides long-term financial security to the organization through delayed gifts. It can also position the organization for larger gifts in the future, as endowments frequently attract new contributors who want to support the endowment’s mission. Because of their long-term and future focus, endowments can attract committed visionaries, which can add to the endowment other assets, like real estate and cash. Their commitment to the project’s future often makes them annual donors.

In summary, the endowment is a powerful, donor-centered fundraising tool for givers and charitable organizations:

• As the gift is controlled by the donor and limits the use of the assets, the endowment solves concerns over the mishandling of donations.
• By assuring donors that their gifts will be used as they designate, an endowment can attract new donors and donations by specifically targeting projects or programs as well as by giving them the opportunity to designate the use of the funds.
• An endowment can provide perpetual income to help flatten gifting curves during economic downturns by reliably providing ongoing income.

An endowment can solve many concerns for both givers and receiving organizations this time of year when gift-giving and helping others is top of mind.

Read the full Winter issue of Insights, the HBK Nonprofit Solutions quarterly newsletter.

IMPORTANT DISCLOSURES

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The HBK Nonprofit Solutions Group is often approached by individuals who wish to establish a charitable organization. In our first meeting, we try to understand their ultimate goals, what they hope to accomplish with their charitable organization. Sometimes it involves tax planning. They wish to make annual contributions that will provide them an income tax deduction, and they wish to then use those funds to support local organizations in their community. Other times, the individuals are engaged in an activity that significantly benefits their community, and they wish to formalize the activity in a charitable organization. The latter of these two situations generally provides the greatest flexibility in how the charitable organization can apply for its exempt status.

How a charitable organization applies for exemption, specifically under Internal Revenue Code (IRC) § 501(c)(3) as an organization that benefits the general public, can have a significant impact on how the organization ultimately approaches fundraising and overall operations. And because often there are several categories of exemption that an organization qualifies for, we often consult with similar organizations subject to vastly different reporting requirements. This article will review some of the ways an organization can claim an exemption under IRC § 501(c) (3) and walk through an example demonstrating the differences in reporting requirements and the impact on the organization’s operations.

Exemption under Internal Revenue Code (IRC) § 501(c)(3)

In order to qualify for exemption under IRC § 501(c)(3), an entity must be organized and operated exclusively for one or more exempt purposes:

• The organizational portion of this requirement focuses on the entity’s governing documents: how it is organized, the exempt purpose, and what happens to the entity’s assets if it were to terminate. Some types of organizations, like churches, are considered tax-exempt without needing to apply for the exemption, though in most instances, an organization that is organized as a charitable entity for state purposes will still need to apply for tax-exempt status with the Internal Revenue Service.
• The operational portion focuses on the activities of the entity and whether they are performed to further the exempt purpose.

Private Foundation vs. Public Charity

When an entity applies for exemption under IRC § 501(c)(3), it will generally be considered a private foundation unless it meets one of the exceptions qualifying it as a public charity. Private foundations normally receive their support from one individual or family, are generally subject to an excise tax on net investment income, and may be required to make annual distributions if they are not considered operating foundations. In addition, private foundations are generally subject to greater restrictions on self-dealing, business holdings, and noncharitable expenditures. Most organizations look to avoid private foundation status through the following exceptions:

• Public Charity Status based on the Nature of the Exempt Activities: Organizations that have exempt activities that meet the requirements of the following categories will generally be considered a public charity:

  -Churches

  -Schools, colleges, universities, and their supporting organizations

  -Hospitals

  -Medical research organizations

  -Governmental units

  -Testing for public safety

• Public Charity Status: Publicly Supported: To be considered publicly supported, a charitable organization generally must pass one of two support tests:

  One test applies to organizations that receive a substantial portion of their support from governmental units and direct or indirect contributions from the general public. The organization does not need to generate revenue from the performance of its exempt activities.

  The second support test applies to organizations that receive at least one-third of their support from gifts, grants, contributions, membership fees, and exempt function income. Investment income and unrelated business income cannot make up more than one-third of the organization’s total support.

Same Activities, Different Classification

When an entity completes its application for exemption under IRC § 501(c)(3), it will need to explain its exempt purpose, its activities, and what its projected financials will be. In addition, the application asks whether the entity will be classified as a private foundation or a public charity and, if a public charity, how it qualifies as a public charity. It is how these questions are answered and how the exempt purpose and activities are framed that will ultimately dictate what the annual reporting requirements will be for the charitable organization and what restrictions the organization will be subject to. Because there are organizations that inherently qualify as both a private foundation and a public charity, it is vitally important that the organization understands the distinction when applying for exemption.

Example: Dolly’s Jazz Studio

Dolly’s Jazz Studio teaches jazz to children and adults, and its students perform in local jazz competitions. Its exempt purpose is to promote the art of jazz. While it will rely on tuition payments as support, it will also be receiving substantial annual contributions from Dolly, a wealthy patron who sits on the board and has dedicated her life to the arts. Dolly’s Jazz Studio has three options for claiming exemption:

• Private Foundation: Because Dolly’s Jazz Studio will be funded primarily by Dolly, it is possible that the organization will not meet one of the two support tests. Contributions received by Dolly will be subtracted from total support, which may mean that the organization cannot meet the “substantial portion” requirement of the first support test, or the “one-third” requirement of the second support test.
• Public Charity – School: If Dolly’s Jazz Studio has established a curriculum and classes, it is possible that the organization could meet the requirements of a school. The Internal Revenue Service has recognized that a cultural organization devoted to the promotion of the arts may qualify as an educational organization and therefore qualify as a public charity.
• Public Charity – Publicly Supported: Depending on the level of tuition charged and any additional contributions received from the general public, Dolly’s Jazz Studio may meet the requirements of one of the two public support tests.

As the example demonstrates, there is often some crossover in aspects of the different categories of exemption an organization can claim under IRC § 501(c) (3). This crossover means that similar organizations could claim exemption differently, which means they may be operating differently, and subject to different reporting requirements.

For example, suppose Dolly’s Jazz Studio decides to claim exemption as a private foundation. In that case, it will not need to focus on fundraising activities unless Dolly’s financial contributions and the tuition charged are insufficient to pay the ongoing operating costs. However, it will also be subject to increased regulation, in-depth annual reporting on Form 990- PF, and potential excise tax and distribution requirements if it does not qualify for an exception.

In contrast, if Dolly’s Jazz Studio instead chooses to be a publicly supported organization, it will need to put significant emphasis on tuition levels and additional fundraising activities to ensure it meets one of the public support tests.

Finally, if Dolly’s Jazz Studio meets the requirements of a school, less emphasis is placed on the source of funds, but it will be subject to nondiscrimination requirements and reporting. The annual reporting requirements for a public charity relate to the level of revenue and assets, so it is possible that Dolly’s Jazz Studio would only be required to file the more simplified Form 990-EZ or postcard, Form 990-N, instead of Form 990 each year.

If you are looking to establish a charitable organization—even if you have been operating a charitable organization for years— it is vitally important that you understand the exempt purpose and the activities that are or will be performed to determine how the organization should apply for exemption—or whether your existing organization would benefit from a change in how it is exempt. The HBK Nonprofit Solutions Group is skilled at consulting on these topics, and we encourage you to reach out to us to see how we can support you in your charitable endeavors.