You Do Not Lose Tax-Exempt Status by Becoming a Foundation

Both public charities and private foundations are exempt under section 501(c)(3). The public support test does not decide whether an organization is exempt. It decides which set of operating rules applies, and there are more ways through it than the arithmetic suggests.

“If we fail the public support test, do we lose our 501(c)(3)?”

“We don’t want to be a private foundation because we want to be a nonprofit.”

We often hear variations of this question and this concern when working with nonprofits. Although well-founded, charitable organizations must first understand what the IRS considers a nonprofit and how public charities and private foundations fit into that equation.

Three things clients collapse into one word

An organization does not lose its tax exemption by becoming a private foundation.  Public charities and private foundations are exempt under the same paragraph of the same Internal Revenue Code section.  What differs is classification, and classification determines operating rules, not exempt status.

Where the exemption comes from

Section 501(a) exempts from tax any organization described in subsection (c).  Section 501(c)(3) is the charitable category, covering entities organized and operated exclusively for religious, charitable, scientific, public-safety testing, literary, or educational purposes, subject to the inurement, lobbying, and campaign intervention restrictions.  The organizational and operational tests of Treas. Reg. § 1.501(c)(3)-1(a)(1) are the only tests for that exemption, and they apply to every section 501(c)(3) organization without regard to how it is classified.  A private foundation satisfies the same two tests a public charity does.

What section 509(a) actually does

Section 509(a) defines a private foundation as an organization described in section 501(c)(3) other than one falling within four excluded categories: organizations described in section 170(b)(1)(A), publicly supported organizations under section 509(a)(2), supporting organizations under section 509(a)(3), and public-safety testing organizations under section 509(a)(4).  Treas. Reg. § 1.509(a)-1 restates the same structure.  Public charity status is therefore an exclusion from private foundation status rather than an independent basis for exemption.  Section 508(b) completes the picture by making private foundation status the default: an organization described in section 501(c)(3) that does not notify the Secretary otherwise is presumed to be a private foundation.  The presumption operates on an organization that is already exempt.

Contributions stay deductible

Section 170(a)(1) allows a deduction for a charitable contribution as defined in subsection (c), and the recipient definition at section 170(c)(2) reaches any corporation, trust, fund, or foundation organized and operated exclusively for charitable purposes.  That definition includes private foundations.  Nothing in section 170(a) or (c) withdraws deductibility for a gift to a private foundation.  What changes is the ceiling, addressed below.

Three events that clients treat as one

The distinction that resolves the misconception is that three different things can happen, and only one of them ends the exemption.

Reclassification changes an organization’s classification inside the section 501(c)(3) exemption.  Treas. Reg. § 1.170A-9(f)(4)(vii) provides that an organization failing the support tests is treated as a private foundation as of the first day of the second consecutive failed year for purposes of sections 507, 4940, and 6033, and for all purposes in succeeding years.  The organization remains exempt throughout.  The same regulation confirms the two determinations are independent, providing that revoking the determination that an organization is described in section 170(b)(1)(A)(vi) does not preclude revoking the determination that it is described in section 501(c)(3).  Section 7428 treats qualification under section 501(c)(3) and classification as a private foundation as separately reviewable determinations.

Termination of private foundation status under section 507 is a different mechanism with its own tax, and it does not remove the exemption either.  Section 507(a) permits termination only on voluntary notice to the Secretary or after willful or flagrant chapter 42 acts with the section 507(c) tax paid or abated, and that tax is measured by the lesser of the aggregate tax benefit from section 501(c)(3) status or the foundation’s net asset value.  Section 509(b) provides that an organization treated as a private foundation stays one for all periods unless terminated under section 507, and Treas. Reg. § 1.509(b)-1 takes that to its conclusion: an organization determined not to be exempt and operating as a taxable entity continues to be treated as a private foundation until it terminates that status under section 507.

Revocation of the exemption is the third event and the only one that actually costs an organization section 501(c)(3) status.  Under section 6033(j), failure to file the required return or notice for three consecutive years means the exemption under section 501(a) is considered revoked, and reinstatement requires a new application.  Section 7428(b)(4) confirms the separate footing of that category by excluding section 6033(j)(1) revocations from declaratory judgment review.

The operational point is worth stating plainly to a board.  The support test governs which set of rules an organization operates under.  The filing obligation governs whether it remains exempt at all.  Many organizations worry about the first and administer the second casually, and the exposure runs the other way.

Whether an organization has actually failed the support test is a separate question, and the answer is often no.  We will walk through the four ways an organization can pass the test even if it appears to fail in a future primer.

What actually changes

Reclassification changes the rules an organization operates under.  It does not change whether the organization is exempt, and it does not change whether gifts are deductible.

Year one is narrower than boards assume

The first year of reclassification applies private foundation treatment for purposes of sections 507, 4940, and 6033 only.  In operating terms, the organization files Form 990-PF for that year and owes the section 4940 tax on net investment income, with section 507(c) termination tax exposure where it applies.  For succeeding years, it is treated as a private foundation for all purposes.

The chapter 42 regime arrives in full after that

The rules are the tax on net investment income under section 4940, the minimum distribution requirement of section 4942, and the prohibitions on self-dealing under section 4941, excess business holdings under section 4943, jeopardizing investments under section 4944, and taxable expenditures under section 4945.  Self-dealing is the rule most likely to catch a board off guard, and we will cover that rule in detail in a future primer.

Donor deduction ceilings drop

Gifts that previously fell within the 50 percent limit of section 170(b)(1)(A), or the 60 percent limit for cash under section 170(b)(1)(G), move to the 30 percent limit of section 170(b)(1)(B).  Capital gain property moves to the 20 percent limit of section 170(b)(1)(D).  Separately, section 170(e)(1)(B)(ii) reduces the deduction for appreciated property by the long-term gain a sale would have produced, so a gift of appreciated stock is deductible at basis rather than fair market value.  Treas. Reg. § 1.170A-8 confirms the tiering.  Each of those limits now sits above the floor added at section 170(b)(1)(I), under which contributions are allowed only to the extent the aggregate exceeds 0.5 percent of the taxpayer’s contribution base.  For a donor giving appreciated property at a meaningful level, the combined effect is larger than any single provision suggests.

Donor identities become public

This is the change boards do not anticipate.  Both classifications report the same information to the Service.  Section 6033 requires every section 501(c)(3) organization to furnish the total of contributions received and the names and addresses of substantial contributors, and Treas. Reg. § 1.6033-2 sets the threshold at $5,000, with a private foundation reporting all persons who became substantial contributors during the year.  Both file Schedule B.

The divergence is at public disclosure, and it runs through two provisions of section 6104.  Section 6104(b) withholds authority to disclose the name or address of a contributor to an organization other than a private foundation or a section 527 political organization.  Section 6104(d)(3)(A) applies the same carve-out to the organization’s own inspection obligation.  Treas. Reg. § 301.6104(d)-1(b)(4)(ii) implements the point directly, providing that for a tax-exempt organization other than a private foundation, the annual information return does not include the name and address of any contributor.

A private foundation sits outside both carve-outs.  The same regulation provides that the public annual information return includes Form 990-PF and that each copy must include all information furnished to the Service, together with every schedule, attachment, and supporting document.  The result is that a private foundation’s contributor names and addresses are part of its publicly available return, unredacted.

For an organization whose major donors have relied on the redaction, this is a conversation to have before the second failed year rather than after.

A note on recent history: The changes between 2018 and 2020 concerned what must be reported to the Service, not what is disclosed to the public.  Rev. Proc. 2018-38 relieved exempt organizations other than section 501(c)(3) organizations of the donor name reporting requirement, so neither public charities nor private foundations were ever covered by that relief.  The District of Montana set the revenue procedure aside in Bullock v. Internal Revenue Service, 401 F. Supp. 3d 1144 (D. Mont. 2019), holding that it was a legislative rather than interpretive rule requiring notice and comment.  The Service re-adopted the relief through rulemaking in T.D. 9898, effective May 28, 2020, and the amended Treas. Reg. § 1.6033-2 continues to require reporting by section 501(c)(3) organizations and private foundations.  The public disclosure rules were not touched.

Lobbying becomes a taxable expenditure

A public charity may lobby within limits.  A private foundation cannot lobby at all without paying an excise tax.  Section 4945(d)(1) treats any amount spent to influence legislation as a taxable expenditure, and section 4945(e) reaches both appeals to the general public and direct communication with legislators and government officials who may take part in formulating legislation.

Treas. Reg. § 53.4945-2(d) excludes four categories:  nonpartisan analysis, study, or research; technical advice given to a governmental body in response to its written request; communications about legislation that could affect the foundation’s own existence, powers, duties, tax-exempt status, or the deductibility of contributions to it; and examinations of broad social, economic, and similar problems.  The self-defense exception is narrower than it sounds.  It does not cover legislation that would only change the scope of the programs the foundation funds in the future.

The consequence is a tax, not a loss of exemption.  Section 4945(a) imposes an initial tax of 20 percent of the expenditure on the foundation and 5 percent on any foundation manager who knowingly agreed to it, unless that agreement was not willful and was due to reasonable cause.  If the expenditure is not corrected within the taxable period defined in section 4945(i), section 4945(b) adds a tax of 100 percent on the foundation and, under section 4945(b)(2), 50 percent on any manager who refuses to agree to part or all of the correction.  Section 4945(c)(2) caps each manager’s exposure at $10,000 for the initial tax and $20,000 for the additional tax.

The section 501(h) election does not survive the change.  Only the organizations listed in section 501(h)(4) may elect, private foundations are not among them, and Treas. Reg. § 1.501(h)-2(b)(4) says so expressly.  Under Treas. Reg. § 1.501(h)-2(e), an existing election is revoked automatically, effective at the beginning of the first full taxable year in which the organization is no longer eligible, and no filing is required.  For an organization that failed the public support test, that date lines up with the rest of the regime.  Because the first reclassified year applies private foundation treatment only for sections 507, 4940, and 6033, the loss of the election and the section 4945 rules both take effect with the first full year of private foundation status.  An organization that reaches private foundation status another way, such as a voluntary request, should confirm its own timing.

A foundation can still fund organizations that lobby.  Under Treas. Reg. § 53.4945-2(a)(5) and (a)(6), a general support grant to a public charity is not a taxable expenditure if it is not earmarked for lobbying.  A specific project grant is protected if it does not exceed the non-lobbying portion of the project budget, and the foundation may rely on the grantee’s budget in making that determination.

Election activity is treated the same way.  Section 4945(d)(2) makes spending to influence a specific public election, or to carry on a voter registration drive, a taxable expenditure.  Section 4945(f) excepts nonpartisan voter registration work by an organization that meets five conditions.  An ordinary grantmaking foundation will not usually meet them itself, though it may fund an organization that does.

Private operating foundations receive no different treatment here.  Nothing in section 4945 carves them out, and their special status is confined to the payout rules of section 4942.

State filings barely change

Reclassification does not change whether an organization must register or file annually in Connecticut, the District of Columbia, Massachusetts, or New York.  Each regime turns on charitable purpose, solicitation, or activity in the state, not on the federal classification.  Where a state accepts the federal return, the organization attaches Form 990-PF in place of Form 990.  The differences are narrow.

Connecticut:  nothing changes.  Private foundations are not exempt from registration under Conn. Gen. Stat. § 21a-190d, and neither the fee nor the audit thresholds depend on classification.

District of Columbia:  a reclassification is a change in fact that must be reported to the licensing regulator within 10 days under D.C. Code § 44-1704(b).

Massachusetts:  this is the one substantive change.  Under 940 CMR 2.02(2)(a), a private foundation that attaches its federal Form 990-PF to Form PC is exempt from the state audit requirement.  The regulation has not kept pace with the statute:  it still refers to a $100,000 threshold and to the retired Form 990-AR, while Mass. Gen. Laws ch. 12, § 8F now requires an audit only above $500,000 in gross support and revenue and allows a CPA review report in place of the audit below $1,000,000.  Registration and fee tiers stay revenue-based.

New York:  a change in federal tax-exempt status requires an amended registration, Form CHAR410-A, filed with the Charities Bureau within 30 days under 13 NYCRR § 91.8.  After that, the annual CHAR500 carries Form 990-PF instead of Form 990.

Practical takeaways

1.      Plan for year one as its own event.  The first reclassified year brings Form 990-PF and the section 4940 tax, and the full chapter 42 regime follows the next year.

2.      Find out whether any major donor gave on the understanding that their name stays out of the public copy.  That assumption does not survive reclassification.

3.      If the organization lobbies or holds a section 501(h) election, plan for both to end.  The election is revoked automatically, and direct lobbying becomes a taxable expenditure, though grants to public charities that lobby remain available.

4.      Confirm the annual filing is current.  Three consecutive missed filings revoke the exemption outright, which the support test never does.

Commonlight Legal LLP serves as outside general counsel to public charities and private foundations on classification, governance, and tax-exempt compliance.  If your organization is running its public support numbers, weighing private foundation status, or preparing its board for what reclassification would change, we offer a complimentary 30-minute consultation with a managing partner at commonlight.legal/appointments.

This article is for general informational purposes only and does not constitute legal advice.  Reading this article does not create an attorney-client relationship.  For advice specific to your organization’s situation, contact your attorney or set up a consultation with us at commonlight.legal/appointments.

Lauren Koster is a Managing Partner of Commonlight Legal LLP, based in New York City.  She represents multijurisdictional tax-exempt entities, including public charities, private foundations, and social welfare organizations, as outside general counsel, advising on entity formation, governance, employment, compliance, and grantmaking.  She also leads the firm’s charter and independent school practice.

Lauren’s career has combined litigation and transactional work in public service.  She clerked in the U.S. District Court for the District of New Hampshire and the Massachusetts Supreme Judicial Court, served as a Rappaport Fellow for Law & Public Policy in the Office of General Counsel at the Massachusetts Department of Elementary and Secondary Education, and was a Skadden Fellow representing children as a court-appointed advocate in juvenile court and child welfare matters.  She is admitted to practice in Connecticut, Massachusetts, and New York.