People thinking about starting a 501(c)(3) nonprofit organization may choose between two types: public charities and private foundations. While both can qualify for tax-exempt status at the federal and state levels, they differ in terms of their purpose, functions, and operations. This guide outlines those key differences to help you decide which type makes the most sense for your nonprofit’s purpose and needs.
What’s a Public Charity?
Public charities are the most common type of 501(c)(3) organizations. These nonprofits generally obtain most of their funding from the public via individual donations or grants from the government or private foundations. Public charities typically carry out some direct form of charitable activity, such as operating schools, arts programs, churches, sports organizations, and shelters. To grant public charity status to a nonprofit, the Internal Revenue Service (IRS) must understand how that public charity benefits the public interest. If the IRS believes a charity doesn’t benefit the public interest enough, then it automatically classifies that organization as a private foundation.
Many nonprofit organizations choose the public charity option because public charities enjoy certain advantages unavailable to private foundations. Yet, alongside those key benefits, public charities also face greater public scrutiny and the need to rely primarily on public funding.
Public charities enjoy many benefits, including:
Higher Tax-Deductible Limits
Donors to public charities enjoy higher tax-deductible giving limits. For example, individuals may deduct cash contributions to public charities worth up to 50% of their adjusted gross income (AGI). In contrast, people contributing to private foundations may only deduct cash donations worth up to 30% of their AGI.
More Sources of Funding
Because public charities have the ability to raise funds through public donations as well as private foundations, they have a broader set of potential funding sources.
Simpler Tax-Filing Process
All private foundations must file the complex and lengthy Form 990-PF with the IRS each year. However, public charities have a simpler tax-filing process in which they file one of three forms based on their revenue. Those generating more than $200,000 in annual revenue must fill out Form 990 while those with between $50,000 and $200,000 in annual revenue should complete Form 990-EZ. Public charities with annual revenue of less than $50,000 may use Form 990-N.
No Income or Corporate Taxes
Public charities are exempt from federal and state income and corporate taxes.
Public Recognition for Meeting and Representing Community Needs
By establishing a nonprofit as a public charity, founders create an organization designed to meet certain community needs. Shelters, for example, fill a need for safe housing while nonprofit arts programs fill a need for arts education. By providing such services or programs, public charities also demonstrate an understanding of specific needs and the ability to represent and fill them based on their purpose.
Nonprofits may continue to exist long after their founders pass away, so their good work and service can carry on in perpetuity.
Discounted Employee Benefits
Public charities that employ a certain number of people may qualify for discounts on health and/or life insurance programs.
All incorporated nonprofits benefit from limited liability protection. That means any trustees, directors, elected officers, staff, and volunteers enjoy protection from limited liability of their personal assets should someone sue the organization.
Lower Start-Up Costs
Public charities tend to have lower start-up costs than private foundations because foundations require a larger upfront income commitment. Foundations also must pay fees for ongoing legal support. Public charities, on the other hand, can determine their budgets and financial needs based on the revenue required to support their programs and cover their operational costs.
While starting and running a public charity offers many benefits, it also poses several key challenges you should consider. Those challenges include:
Greater Public Scrutiny
Because the public provides most of a public charity’s funding and the charity’s work must directly serve the public interest, these nonprofits face a high level of public scrutiny. Public charities also face higher expectations and more requirements for transparency so donors, grantors, and other third parties know what they’re supporting and how the charity will use their funds.
Ongoing Fundraising Needs
Unlike private foundations that tend to derive a steady income from investment returns, public charities primarily rely on donations. Public charities must, therefore, dedicate a lot of time and resources to planning and conducting their fundraising activities. This can prove challenging for many public charities — especially those just starting out.
Public Support Criteria Tests
In order for the IRS to consider a nonprofit as a public charity, the organization must pass one of two tests to prove it receives a certain amount of public support. The first test — called the 33.3% test — requires a nonprofit to demonstrate it receives at least 33.3% of its funding from public support. If a charity receives between 10% and 33.3% of its funding from public support, it must pass a second test called the “facts and circumstances” test. In this test, a nonprofit must prove it receives at least 10% of its funding from public support and explain why the IRS should consider it a publicly supported organization and how it plans to increase its level of public support going forward. The IRS bases results for both tests on the aggregation of a nonprofit’s public donations in the current and previous four years.
Required Public Disclosures
Public charities must make certain public disclosures and provide timely responses to any information requests from donors, such as for annual returns or the charity’s application and determination letter for tax-exempt status. This requires public charities to operate with extra diligence and maintain detailed records.
Proof of Eligibility Requirements
By default, the IRS considers 501(c)(3) nonprofit organizations as private foundations. To earn a public charity designation, nonprofits must qualify as public charities. This typically requires a nonprofit to clearly state in its purpose that it exists for public charity purposes and provide some form of proof to support that claim, such as an outline of its programs and services or copies of its educational resources.
What's a Private Foundation?
Just because an organization’s name includes the word “foundation” that doesn’t always mean it’s a private foundation. Unlike public charities, private foundations typically don’t run any direct charitable activities or programs and instead support public charities through grants. With their funding coming from an individual, family, or corporation, private foundations also operate in a more closely held manner. Foundations enjoy tax-exempt status as long as they meet certain state and federal requirements. You may set up a private foundation as a not-for-profit corporation or a trust and then invest its funds in order to generate income for grants and the foundation’s operations.
Private foundations require a substantial amount of time, work, and money to establish and maintain. While it’s much easier to write a check to a charity you’d like to support, starting your own private foundation does offer many benefits alongside the challenges.
Starting a private foundation provides a range of benefits, including:
More Effective Philanthropy
If you just want to write a check and send it to your favorite charity, that’s a fairly simple and quick process. While you can easily donate to one organization this year and then to another the next, this approach doesn’t require you to keep track or have a formal plan. In contrast, foundations provide a more organized, strategic, and targeted way of giving. They encourage founders to carefully determine how they want to use their resources to make a positive impact and then implement a practical plan to achieve that goal.
Expanded Giving Opportunities
Foundations provide more options in terms of how — and to whom — you may give your charitable contributions. An individual cannot claim tax deductions on a donation to another individual, foreign nonprofit, or a non-charitable organization. However, foundations may make grants to such recipients just like public charities. That means if you donate to your foundation, your foundation can then give grants to this wider set of recipients.
Greater Financial Control
With a private foundation, the founding individual, family, or corporation maintains financial control because this small group of donors provides the nonprofit’s funding. In contrast, a public charity depends on public support and its board of directors or trustees to make decisions.
Like public charities, private foundations benefit from four major tax incentives in order to encourage charitable giving. Those incentives include:
- Income Tax Deductions: Private foundation donors can claim tax deductions on both their federal and state tax returns. Donors may deduct the value of cash donations up to 30% of their AGI as well as the value of appreciated property up to 20% of their AGI.
- Tax-Free Asset Growth: All investment returns — whether from interest, dividends, capital gains, or other forms of investment returns — remain tax-free if earned within a foundation.
- No Gift or Estate Taxes: Generally, assets transferred to family foundations are not subject to gift or estate taxes.
- Double Capital Gains Benefits: Because foundations invest all donor contributions, those donors may claim a charitable deduction for the full market value of appreciated stocks held in publicly traded companies. Furthermore, as property owned by a foundation increases in value that added value doesn’t count as a capital gain and so doesn’t incur a capital gains tax.
Consistency in Giving
Many people start private foundations because they want a consistent way to support their favorite charities. Foundations also enable them to continue giving even after they’re gone.
Reasonable Compensation for Your Services
While members of a public charity’s board of directors typically can’t receive compensation for their work, a foundation’s board members or trustees can receive reasonable compensation for services rendered to the foundation under normal circumstances.
Reimbursement of Travel and Other Expenses
A foundation’s board of directors, trustees, and founding family members may receive reimbursement for reasonable and direct costs of services rendered to the foundation. If you must travel to your foundation’s board meetings, for example, you can receive reimbursement for your travel expenses.
Stronger Public and Community Relationships
Foundations can create strong, well-recognized relationships throughout the community and with the general public. For example, Bill and Melinda Gates are well-known for their business leadership. However, their work with the Bill & Melinda Gates Foundation further elevates their public image and community relationships because people recognize all the good they do for the community. Heightened public recognition also can help foundations bring more attention to a specific cause.
Foundations make it easy for people who regularly receive requests for charitable donations and fundraising appeals to refer all such inquiries to their foundation. This can prove especially beneficial in protecting the privacy of a high-profile figure.
Private foundations can provide a great way to leave a legacy — or to honor a friend or family member — by supporting a cause important to you or your loved ones. Because most founders set up private foundations to operate in perpetuity, this type of nonprofit enables them to continue supporting a cause indefinitely. Family foundations, in particular, help donors engage generations of family members in a specific cause or charitable work, deepening their social consciousness and creating a true family legacy.
Greater Freedom to Take Action
Private foundations do more than simply enable founders to leave legacies and gain tax benefits. They also allow founders to create organizations that address specific needs in specific ways they deem appropriate. That means you can take risks and pursue actions that others — even the government — can’t or won’t do.
Starting a private foundation also involves several challenges you should be sure to consider, including:
Substantial Time Commitment and Costs
Starting a foundation involves a substantial amount of time and money because of the work required to incorporate or establish the organization in another acceptable way. Setting up a foundation typically also requires engaging outside professionals — such as attorneys, accountants, and others — who can provide expert advice on how to form and run your foundation.
Annual Excise Tax Payments
Private foundations must pay a 1% to 2% annual excise tax on their net income. The exact percentage depends on a foundation’s annual grantmaking.
Detailed Record-Keeping Requirements
Foundations must maintain good records to provide evidence of regulatory compliance and grantmaking, document board and committee meeting minutes, and create financial reports. A foundation also should create and store other important documentation that shows how its work meets its charitable purpose and proves there’s no misuse or abuse of funds.
Greater Regulatory Requirements
Private foundations must distribute at least 5% of their investment income each year through charitable grants. Foundations also face greater scrutiny by state and federal governing bodies than public charities because only a few trustees manage them under much less public scrutiny.
Mandatory Annual Reporting
While different states may have different annual reporting requirements, the IRS mandates annual reporting by all private foundations. This process typically takes four to eight hours to complete and often requires an accountant or attorney to finalize and submit the necessary paperwork.
Lower Deductibility Caps
Individuals may make cash contributions worth up to 30% of their AGI and appreciated property donations valued at up to 20% of their AGI to private foundations. That’s significantly lower than the limits set for public charities to which individuals may contribute cash donations worth up to 50% of their AGI and appreciated property worth up to 30% of their AGI.
Less Favorable Treatment of Some Capital Gain Gifts
While public charities may deduct the fair market value of any gifts of appreciated property they receive, foundations may only make deductions for such gifts on a cost basis. Publicly traded stocks represent an exception to this rule, and foundations may deduct stocks at their fair market value.
Overall, the key differences between public charities and private foundations relate to their:
- Funding Sources: Public charities receive their funding from individual donations, government funding, and grants. In contrast, a sole individual, family, or corporation typically provides funding for a private foundation. Foundations then invest that money to provide income for the organization via investment returns.
- Tax-Deductible Giving Limits: The value of tax-deductible, charitable contributions a donor may claim on their annual tax return depends on the donation recipient. Donations made to public charities have higher tax-deductible limits than those made to private foundations.
- Start-Up Costs: Private foundations cost more to set up and run than public charities because they require a higher initial income commitment and must pay for ongoing legal support.
- Programs: Public charities tend to operate their own activities and programs while private foundations instead support public charities.
- Expenditures: Private foundations must distribute at least 5% of their net investment income each year while public charities have no such requirement.
If you’re deciding on whether to start a public charity or a private foundation, carefully consider the benefits and challenges of each type of organization. You also may want to consult an attorney to help you determine the best option for your nonprofit. When you're ready to get started, head over to our How to Form a Nonprofit guide.