Understanding a Charitable Organization’s Exempt Purpose

2021-11-24T21:06:05-05:00

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.

About the Author(s)

Amy is a Principal and the Chair of the Tax Advisory Group at HBK CPAs & Consultants. The Tax Advisory Group is a group of highly specialized professionals who provide tax training to our team members, oversee compliance with tax policies in order to mitigate risk to the firm, and provide tax planning and consulting services for our clients.

Amy is the Co-National Director of the Nonprofit Solutions group. She also leads the HBK's diversity and inclusion initiative.

Amy specializes in estate, gift, trust, individual, and nonprofit taxation. She is skilled at researching complicated tax issues, consulting on complex estate plans, and providing guidance for our clients to ensure they are in compliance with their tax filing responsibilities.

Amy enjoys sharing her knowledge and passion for tax planning with clients and other professionals. She is a frequent speaker at bar association and estate planning council events, and has authored many articles discussing tax planning techniques and compliance issues.

Hill, Barth & King LLC has prepared this material for informational purposes only. Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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