Through an arrangement with TechSoup, PND is pleased to offer a series of articles about the effective use of technology by nonprofits.
Welcome to a new blog series from TechSoup's general counsel and legal team. In the series, the team hopes to shed light on basic concepts in nonprofit law as well as thorny legal issues in the sector that arise from time to time. The first installment in the series addresses some of the legal differences between nonprofits, charities, public charities, and private foundations.
Q: Is a nonprofit the same thing as a charity?
A: No. Nonprofits come in many forms and serve multiple functions, from schools, hospitals, and food banks to business leagues, political action committees, and labor unions. All of these entities can be nonprofit, and most of them are eligible for exemption from income tax. However, not all of them are charities.
In the U.S., an organization incorporates at the state level as one of several entity types — for example, an LLC, a joint stock company, or a nonprofit corporation. The designation determines the entity's corporate structure. For example, a joint stock company issues shares to the public, whereas a nonprofit corporation does not.
No special recognition is required to identify as a nonprofit. All an organization has to do is incorporate as that entity type in accordance with directions provided by the state regulator (typically, the secretary of state's office).
A nonprofit corporation will owe taxes on its income unless it applies to the Internal Revenue Service for a tax exemption. Without exempt status, it is a taxable nonprofit. That is, it does not operate for the purpose of profit and does not distribute profits among shareholders, but it still owes taxes because it has not sought or qualified for exemption under a specific section of the Internal Revenue Code.
Tax exemption is available for a number of nonprofit entity types, including (in addition to those listed above) social welfare organizations, labor unions, agricultural organizations, fraternal societies, social clubs, political action committees, homeowners' associations, civic leagues, and trade associations. While all these nonprofit entities may qualify for exemption from having to pay income tax, most are not able to offer donors a deduction for their charitable donations. The privilege of tax-deductible charitable donations is limited to 501(c)(3) organizations (and in certain other limited situations).
Q: What is the difference between a 501(c)(3) public charity and a 501(c)(3) private foundation?
A: Public charities are charitable organizations that are supported by a diverse set of donors or constituents and that engage in direct charitable programs. In contrast, private foundations are funded by either one or a limited number of donors — such as a company or family — and typically engage primarily in grantmaking. A 501(c)(3) organization is deemed a private foundation by default unless it can prove to the IRS that it qualifies as a public charity.
The IRS considers public charities to be inherently accountable to the public, whereas it views private foundations as having guaranteed funding, making them less dependent on public approval. Accordingly, the IRS imposes an array of regulations and restrictions on private foundations to ensure that they operate withing state and federal guidelines. Any violations of private foundation rules may result in additional taxes and penalties on the foundation and its management.
Public charities have the benefit of operating under more flexible rules and being able to offer more generous tax deductions for their donors. For example, public charities may give more freely to non-U.S. entities, as long as the funds are not expended for non-charitable purposes. Private foundations, on the other hand, must either exercise expenditure responsibility or obtain an equivalency determination before they make a grant to a non-U.S. entity.
Note that just because an organization has "foundation" in its name does not necessarily mean that it is a private foundation. Most community foundations, for example, are public charities. Many community foundations also act as sponsoring organizations for donor-advised funds (DAFs). In recent years, a number of large financial institutions have also created DAF affiliates as a way to serve the charitable (and tax) needs of their clients. Although DAFs qualify as public charities, they are subject to some of the same restrictions on their grants as private foundations because of their unique hybrid nature.
For more on the differences between public charities and private foundations, check out NGOsource's LegalEASE blog.
Martha Lackritz-Peltier is associate general counsel at TechSoup, a global charity based in San Francisco, and serves as chief counsel at NGOsource, a project of TechSoup and the Council on Foundations.