There are many specific requirements that a nonprofit organization must fulfil to be considered a public charity and tax-exempt under section 501(c)(3). One important requirement that can easily be overlooked is ensuring that your organization receives funding from a diverse pool of donors. This is what makes your organization “publicly supported.” To be considered a public charity, at least one-third (33.3%) of your support must be the result of contributions from the general public.
This seems fairly simple, right? Unfortunately, the public support calculation is actually extremely complex. For example, it’s possible for some of your donors to be excluded from that calculation if they give what the IRS considers to be too large of a percentage of your total support. When donors are excluded, it chips away at your public support calculation. The more excluded donors that you have, the more likely it is that your 501(c)(3) public charity status might be imperiled.
What’s the worst thing that can happen if your organization fails to meet the public charity requirements? In a nutshell, you could lose your public charity status and be converted to a 501(c)(3) private foundation instead. Private foundations have a variety of additional tax implications and restrictions on investments, and charitable deductions are limited. The loss of your public charity status can be extremely difficult – and potentially devastating – to any organization that was not originally set up with the intention of operating as a private foundation.
According to the IRS, “an organization will lose its public charity status if it cannot pass the public support test for two consecutive years.” From the first year in which your public support calculation is less than 33.3% (but greater than 10%), you then have one more year to diversify your funding sources and hold onto your public charity status. You will also be subject to a “Facts and Circumstances Test” to demonstrate to the IRS that you have the potential to obtain more public funding.
However – and this is perhaps the most interesting part – your public charity calculation does not need to be calculated for the first 5 years of the organization’s existence. This is quite a double-edged sword. On one hand, this is helpful to new organizations who are working to establish a broad range of donors. But on the other hand, if you are not performing those calculations from the beginning, you may not know how close your organization is to losing its public charity status until your sixth year of operation. And then suddenly, you only have one year to try to fix it. With that in mind, it’s important to monitor your public support throughout the early years of your nonprofit’s existence, to avoid an unpleasant surprise down the road.
Your organization’s exemption letter will indicate whether you are an organization as described in section 509(a)(1) or 509(a)(2) of the Internal Revenue Code. This is based on your application for exemption, your purpose, and your sources of support and revenue. In general, there are two distinct public support tests depending on whether or not your organization holds 509(a)(1) or 509(a)(2) exempt status. It is up to you to monitor your organization’s levels of public support and keep track of large donors to ensure that you meet the threshold to maintain public charity status.
There are many other nuances to the public support calculation that are best discussed with an accounting professional. If you have questions regarding your public support calculation, be sure to reach out to your accountant or other qualified professional for help.
