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.
- 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, and 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 generally created by a single benefactor, usually an individual or a business. Using this initial seed donation, an endowment, an investment is made to generate income, which is then dispersed as grants to individuals or other charities per the foundation’s charitable purpose.
Many investment products can offer a stable and consistent rate of return as in your own savings account. Therefore, the endowment structure of private foundations provides a consistent and reliable source of continuing funds. Budgeting and funding decisions can be made with greater confidence and ensure timely and efficient access to the aid that the foundation seeks to provide.
A chief benefit of operating a foundation comes from 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 that 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).
What Is a Public Charity?
The “public” in public charity refers to soliciting periodic donations from the 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 circumstances 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 an individual’s contribution.
A board of directors must establish that the public charity is not organized nor operated for the benefit of private interests. It also has a quorum of independent board members to conduct an official board meeting.
Funded by a single large endowment
Makes grants to individuals and organizations
More expensive to start
High degree of individual control
Must distribute 5% of its assets annually
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
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, while 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.
Disbursement of Funds
A second 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.
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.
The board of directors for a private foundation 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.
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.
With a private foundation, to achieve the largest income tax deduction possible, 30% of your pretax income should go into its 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.
What Is 501(c)(3) Status?
The Internal Revenue Service (IRS) provides this tax-exempt status only for organizations with certain purposes. Specifically, they 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 most substantive difference can be found in how they raise funds. A private foundation is usually funded by a single, large endowment of funds that are then used to generate profits through investments. A public charity continually solicits charitable donations from the community. It can even get a donation from a private foundation in the form of a grant, though 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 only of 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 one of the many public charities. If you wish to leave a legacy or have a highly valued estate that you would like sheltered from taxes, then a private foundation may be the way to go. Both public charities and private foundations are useful vehicles for providing charitable services and allow for tax-deductible benefits.