The Internal Revenue Service (IRS) has allowed for the creation of tax-exempt charitable organizations through the granting of 501(c)(3) status. These groups exist as private foundations or public charities. There are a number of important differences between two.
An organization that has been granted tax-exempt status doesn't pay federal income tax on income gained from activities that are substantially related to the purpose for which the organization was formed.
Key Takeaways
- Tax-exempt charitable organizations don't owe federal income tax on income made from their activities.
- A private foundation is a nonprofit charitable entity that is generally created by a single benefactor, usually an individual or a business, through an endowment of funds.
- A public charity uses publicly collected funds to directly support its initiatives.
- The most substantive difference between the two is how funds are acquired.
Understanding 501(c)(3) Status
To qualify for tax-exempt charitable status, both private foundations and public charities must exist for one of the following purposes, as stated by the IRS:
- Charitable
- Religious
- Educational
- Scientific
- Literary
- Testing for public safety
- Fostering national or international amateur sports competition
- Preventing cruelty to children or animals
The IRS defines “charitable” purposes as “relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erecting or maintaining public buildings, monuments, or works; lessening the burdens of government; lessening neighborhood tensions; eliminating prejudice and discrimination; defending human and civil rights secured by law; and combating community deterioration and juvenile delinquency.”
What Is a Private Foundation?
A private foundation is a nonprofit charitable entity normally created and funded by a single benefactor, usually an individual, family, or business.
Income From Investments
Using the initial seed donation, or endowment, an investment is made to generate income. This income is then dispersed as grants to individuals or other charities per the foundation’s charitable purpose.
Many investment products, including a savings account, can offer a stable and consistent rate of return. The endowment structure of a private foundation provides a consistent and reliable source of continuing funds.
Because of this, budgeting and funding decisions can be made with greater confidence. And the foundation can ensure timely and efficient distribution of the aid that it was organized to provide.
Control Remains With the Donor
A chief benefit of operating a foundation is the degree of control available. The person responsible for running the foundation can decide whom or what to support and make investment decisions. The organization’s board of directors can consist entirely of the members of a single family.
However, a chief criticism of private foundations stems from this operational independence. Their funding source allows them to ignore public opinion and possibly support socially contentious projects.
In addition, they may generate less-than-optimal outcomes by focusing their efforts incorrectly. Private foundations also have mandatory paperwork to ensure the appropriate use of funds and minimum asset distribution requirements (5% each year).
$2.68 Trillion
The revenues of all reporting nonprofit organizations in the United States in 2020 (the latest data provided by the IRS).
What Is a Public Charity?
A public charity solicits periodic donations from a community. The IRS requires that a public charity receive at least one-third of its contributions from the general public or meet the 10% facts and circ*mstances test. The charity uses the publicly collected funds to directly support its initiatives, such as operating a homeless shelter or providing medical care to the indigent.
Some might consider public charities more desirable than private foundations because they must appeal to public sentiment. A “market for charity” is created as each organization strives to capture contributions from donors.
A board of directors must establish that the public charity is neither organized nor operated for the benefit of private interests. It also has a quorum of independent board members to conduct official board meetings.
Key Differences
Acquisition of Funds
The most substantive difference between a private foundation and a public charity is how funds are acquired. A private foundation is generally funded by an endowment from a single source (an individual, family, or corporation). A public charity must continually solicit donations from individuals and organizations. Also, a public charity can receive funds from a private foundation, but not vice versa.
Disbursem*nt of Funds
Another difference is in how the funds are used. Private foundations make grants to individuals or other charities, while public charities use their money to carry out direct activities.
Establishment
Establishing a private foundation usually requires an up-front commitment of income, both to start the foundation and to pay legal fees.All charitable organizations at birth are deemed private foundations by default. A public charity then must prove to the IRS that it qualifies to be one.
Control
The board of directors for a private foundation can be determined by the donor(s) who funded it. For example, it can consist solely of the members of a single family. The IRS reviews the composition of the board of a public charity to ensure that the members are independent and represent a broad public interest. Public charities must also field a quorum to conduct official business.
Tax Deductions
Public charities generally have higher donor tax-deductible giving limits than private foundations. From an individual perspective, giving to public charities is desirable due to the flexibility in making donations. This allows for the customization of tax strategies tailored to personal preference.
Regarding donations to a private foundation, to obtain the largest income tax deduction possible, 30% of a donor's pretax income should go into the endowment. Through regular contributions, an individual could save up to 46% on their estate taxes, with any excess allowed to carry over for up to five years.
Private Foundation vs. Public Charity
Private Foundation
Funded by a single large endowment from an individual, family, or corporation
Makes grants to individuals and organizations
More expensive to start
High degree of individual control
Must distribute 5% of its assets annually
Public Charity
Funded by continual donor solicitations
Funds direct activities
Must prove to the IRS that it is not a private foundation
Must be responsible to a diverse board of directors
Must receive one-third of its funds from public donations
What Is 501(c)(3) Status?
The Internal Revenue Service (IRS) designates the 501(c)(3) tax-exempt status only for organizations with certain purposes. Specifically, these purposes are “charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals.”
What Is the Main Difference Between a Private Foundation and a Public Charity?
The biggest difference is in how they raise funds. A private foundation is usually funded by a single individual, family, or business providing a large endowment of funds. These funds are then used to generate profits through investments. A public charity continually solicits charitable donations from members of the community. It can also receive a donation from a private foundation in the form of a grant (though the reverse does not apply—public charities do not contribute to private foundations).
Do Both Public Charities and Private Foundations Have a Board of Directors?
Yes, but the organization of the board is different for each. A private foundation can have a small board that consists of people determined by the donor. That might mean only family members, with one person, usually the donor, making decisions. A public charity should have a composition of members where the majority is unrelated.
The Bottom Line
If you want to get the most out of your tax-deductible giving, donate to public charities. If you wish to leave a legacy or have a highly valued estate that you would like sheltered from taxes, then giving to a private foundation may be the way to go.
Both public charities and private foundations can be useful organizations that provide charitable services and allow for tax-deductible benefits.
