Because I recently worked with a few clients who are seeking 501(c)(3) tax exemption status, I found inspiration to explore and explain the public support test that is a requirement for certain organizations seeking that 501(c)(3) tax-exempt status.
For any nonprofit to obtain tax-exempt 501(c)(3) status, the organization must file an application for recognition of exemption with the Internal Revenue Service (“IRS”) (this is form 1023 or 1023-EZ, depending on annual gross receipts and assets of the organization). The application contains instructions and asks the organization to provide information the IRS uses to determine whether to award it with tax-exempt status. Along with providing information about the structure of the organization and its mission, one of the most important pieces of the application process is determining the public charity status.
In the application, a nonprofit must classify the organization as either a private foundation or public charity. Private foundations and public charities are both types of 501(c)(3) organizations and share certain features – they are both tax-exempt; organized as a corporation, unincorporated association, or trust; cannot engage in political action; cannot use their net earnings to benefit private shareholders; and are organized and operated for one of the charitable purposes established in Section 501(c)(3) of the Internal Revenue Code. Private foundations are the default classification, and are explained here by the IRS. However, most nonprofits would prefer public charity status over being a private foundation because of certain differences that can make the public charity status preferable, including the ability to attract funds from wider sources, more favorable tax deduction features for donors, and less reporting obligations.
A key characteristic to note for this blog post is that private foundations receive funding from a small group of donors and do not typically seek a broad base of support from the public. However, a broad base of funding from public sources is a requirement for the IRS to grant public charity status to a 501(c)(3), and for the organization to receive those preferable features. This broad base of funding, though, must be shown to the IRS by satisfying a test referred to as the “public support test”.[1]
Nonprofit Organizations under Section 509(a)(1) and 170(b)(1)(A)(vi)
When an organization first requests its 501(c)(3) determination from the IRS, the Form 1023 application asks which subcategory the nonprofit is seeking this status under, based on its purpose, programs, and revenue sources. There are several subcategories of 501(c)(3) public charity organizations.[2] This blog will focus on the subcategory of those organizations recognized under Section 509(a)(1) and 170(b)(1)(A)(vi) of the Internal Revenue Code – a public charity that receives substantial support in the form of grants and contributions from governmental units, the general public, and other public charities – as this is one of the most common types of 501(c)(3) organizations we work with and one of the most common classifications that is requested.
Public Support Tests
To qualify as one of these 501(c)(3) organizations under Section 509(a)(1) and 170(b)(1)(A)(vi), the nonprofit must be able to pass one of the IRS’s income-based “public support” tests. The public support test is a way for the IRS to make sure that a nonprofit organization is supported by a broad base of the public. If it cannot meet one of these tests, the organization is likely a private foundation.
The public support test is calculated over five years. New nonprofits without five years of history may claim this public charity status at the outset without a financial track record,[3] but need to be mindful of this income requirement as they move forward because they will need to show they satisfy the test in the future. Otherwise, they will risk losing their public charity status once they begin reporting their five-year income. Existing 501(c)(3) public charities need to maintain their satisfaction of this test, otherwise they risk losing their public charity status.
The One-Third and The Ten Percent and Facts and Circumstances Tests
The public support test compares the ratio of an organization’s public support to its total support. Public support is the financial support it receives in the form of grants and contributions from governmental units, the general public, and other public charities. Meanwhile, total support is all support the organization receives, including that public support, plus other items of support such as net income from unrelated business activities (like rental, dividends, or royalties received by the nonprofit), gross investment income, etc. The test is essentially calculated as a fraction, with the public support being the numerator and the total support being the denominator. The organization’s fraction must meet a certain minimum percentage in order for it to pass. There are two of these public support tests. To be eligible for 501(c)(3) tax exemption status, an organization must receive either:
- At least one third (33 1/3%) of its total support from public support sources – support from governmental agencies, contributions from the general public, and contributions or grants from other public charities[4]; or
- At least ten percent (10%) of its total support from public support sources – governmental agencies, contributions from the general public, and contributions or grants from other public charities; AND also satisfy a “facts and circumstances” test.[5]
When calculating the public support, contributions by an individual, trust, or corporation are counted as public support only to the extent the total amount of the contribution by that donor does not exceed 2% of total support received by the organization.[6] However, contributions by US federal, state, and local government units and other 501(c)(3) organizations that meet the public support test themselves are not subject to the 2% cap,[7] meaning that those contributions will be fully counted in the public support and total support calculations in the fraction. There is one exception to this exception to the 2% rule, though. Contributions received by a nonprofit from such governmental units or from such publicly supported organizations will be subject to the 2% cap if the contributions represent amounts that were either expressly or impliedly earmarked by a separate donor to the governmental unit or publicly supported organization as being for, or for the benefit of, the particular nonprofit ultimately receiving the contribution who is trying to satisfy the public support test.[8]
One-Third Test: Example
A simple example illustrating the one-third test is below:
A nonprofit’s revenue over five years is a total of $1,000,000, consisting of contributions from individual donors, government grants, grants from other 501(c)(3) organizations, and unrelated business income (for this example, renting its property for non-exempt purposes):
Total revenue: $1,000,000
Contributions from individual donors: $200,000***
Government grants: $200,000
Grants from other 501(c)(3) organizations: $400,000
Unrelated business income (property rental): $200,000
Public support: $800,000 = [$200,000 (individual contributions), + $200,000 (government grants) + $400,000 (other 501(c)(3)s)]
Total support: $1,000,000 = $200,000 (individual contributions), + $200,000 (government grants) + $400,000 (other 501(c)(3)s) + $200,000 (unrelated business income)
Public support test calculation: 80%
***This example assumes a wide base of individual donors, none of whose individual contributions exceed 2% of the total support (i.e., all are under $20,000). If, however, there was only one individual donating this total $200,000, that full $200,000 amount would be included in the total support denominator, but only $20,000 (2% of the $1,000,000 total) would be included in the public support numerator. The resulting percentage for that example would be 62%, which is still passing. But for an organization with less income from other public support sources (such as from the government and other 501(c)(3)s), this could be fatal to the organization’s success on this test. This illustrates why having a broad base of support is important. For an extreme example to further this point, a nonprofit receiving only $200,000 of support from one person (and no other sources of support at all) will fail the one-third test because only 2% of that $200,000 ($4,000) can be counted in the public support numerator, while the denominator will include the full $200,000. Its fraction would equal 2% ($4,000 / $200,000).
The one-third test relies solely on the ratio of public support and total support. Thus, a nonprofit aspiring to meet this test likely has, or should have, a broad base of public support. However, if it does not meet this test, the nonprofit may still be able to meet the ten percent public support and facts and circumstances test.
Facts and Circumstances
An organization that does not meet the one-third public support test can still qualify for exemption if at least ten percent (10%) of its total support comes from public support sources, and it satisfies a more subjective “facts and circumstances” test. This test still requires at least ten percent (10%) public support, and is a request to the IRS when the organization is filing its income tax return (Form 990), asking the IRS to allow it to retain its public charity status because it is actively working to get its public support percentage back up to one-third or more. In essence, the organization must demonstrate that the nonprofit is “in the nature of an organization that is publicly supported,” meaning it is organized and operated to “attract new and additional public or governmental support on a continuous basis.”[9] The facts and circumstances relevant to this determination include the percentage of public support the organization receives, whether it has a bona fide program to solicit public support funding, the sources of support, the composition of the governing body and the membership structure (if any) of the organization, the offering of facilities or services to the public, and participation by the public in the organization’s programs.[10]
Failing to Pass the Public Support Test
If a nonprofit fails to pass the public support test (including the one-third and the 10% and fact and circumstances tests), the nonprofit will have its public charity status changed to that of a private foundation – the default classification. As mentioned, this may be a less preferable classification, as the organization will have to comply with more detailed filings, and will have less favorable tax deduction features available to the organization’s donors. Because passing the public support test in any given year automatically carries forward to the following year, defaulting to private foundation status takes at least two consecutive years of failing the public support tests. So, there is hope of maintaining the public charity status if the nonprofit fails the test in only one year. However, failing two years in a row will result in private foundation status starting as of the beginning of the second year.
Conclusion
Obtaining 501(c)(3) tax-exempt status can be very important for a nonprofit. Accordingly, the IRS has created certain requirements to ensure the organizations receiving this status and enjoying the tax-exemption benefits are deserving of such benefits, are serving the public, and are not formed solely for the purpose of the tax benefits. Among these requirements, nonprofits seeking public charity status must satisfy a public support test and continue to satisfy these public support requirements.
Please note, this is not an exhaustive discussion of the tax exemption process for 501(c)(3) organizations or even public charities in particular. Organizations with questions about obtaining 501(c)(3) tax exemption status should reach out to an attorney with expertise in this area before making any definitive decisions and may contact our firm directly.
The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information available on this site is for general informational purposes only. Information on this website may not constitute the most up-to-date legal or other information as laws and regulations may have evolved since it was posted. No reader of this site should act or refrain from acting on the basis of information on this site without first seeking legal advice from counsel.
[1] See Instructions for Form 1023, 14 (Rev. Jan. 2020), available at https://www.irs.gov/pub/irs-pdf/i1023.pdf.
[2] The IRS recognizes different types of 501(c)(3) organizations, each of which may have different requirements for satisfying the 1023 form. For example, there are certain organizations that are public charities based solely upon their activities, without regard to their sources of support. These include churches, schools, hospitals, medical research organizations, and cooperative hospital service organizations and agricultural research organizations (under sections 509(a)(1) and 170(b)(1)(A)(i), (ii), (iii), and (ix) of the Internal Revenue Code). Additionally, public charities who are primarily supported by income earned through performing their nonprofit tax-exempt purpose (e.g., contributions, membership fees, gross receipts from activities related to the nonprofit’s exempt functions) (section 509(a)(2)). Unlike any of these organizations, this blog post focuses on organizations applying for public charity status that normally receive substantial support from grants, governmental units, and/or contributions from the general public (sections 509(a)(1) and 170(b)(1)(A)(iv) and (vi)).
[3] If, at the time of applying for tax-exempt status, an organization is new and can reasonably be expected to meet the public support test during its first five tax years, the organization will qualify as publicly supported for its first five years. The organization will be classified as a public charity for its first five years, regardless of the public support actually received during this period. Beginning with the organization’s sixth tax year, though, the organization will qualify as publicly supported only if it meets one of the public support tests for its sixth year (based on support received in its second through sixth tax years), or as a carryover for its fifth tax year (based on support received in its first through fifth tax years). Publication 557 (01/2024), Tax-Exempt Status for Your Organization).
[4] 26 C.F.R. § 1.170A-9(f)(2).
[5] 26 C.F.R. § 1.170A-9(f)(3).
[6] 26 C.F.R. § 1.170A-9(f)(6).
[7] 26 C.F.R. § 1.170A-9(f)(6)(v).
[8] See Publication 557 (1-2024), 35, available at https://www.irs.gov/pub/irs-pdf/p557.pdf, for more examples regarding exceptions to the 2% cap and earmarked contributions.
[9] See 26 C.F.R. § 1.170A-9(f)(3).
[10] See id.
