Where Funding Comes From Matters
Your nonprofit is pretty new and still small. It’s been operating on about $5,000 a year. Now a funder wants to give you a grant for $20,000. Or, it’s a mature charity, but an offer of unusually large support arrives from one wealthy individual.
Great, right? Of course we’ll take it! Time to slow down and think about what it means to be a 501(c)(3) “public charity,” and what impact your funding sources may have on that status.
Failure to meet the Public Support test over a five-year period may result in reclassification of the organization as a private foundation, so it’s important to keep this issue in mind and discuss significant funding opportunities with your accountant before accepting them.
- Does your nonprofit have legal questions? Join Pro Bono Partnership on April 6 in Basking Ridge for a Q&A session
If you retain a professional to help prepare your annual Form 990, they will likely raise these issues, but you should be aware of the funding percentages before the point of preparing the 990. (This is not the most exciting stuff, but it’s important to maintain public charity status — so bear with me.)
The IRS required you to demonstrate in your organization’s application for tax-exemption that it would meet one of the public support standards. This is why the IRS asked your nonprofit to estimate how much money you’d be raising and from what types of sources.
Which set of standards applies to your organization depends on where you expected to get most of your funding at the time you applied. Do you know whether your organization is tax-exempt under Internal Revenue Code section 509(a)(1) or 509(a)(2)? That information is specified in your Determination Letter from the IRS — the one that confirmed that the nonprofit qualified for federal tax-exempt status.
If your Determination Letter states that your organization qualifies under 509(a)(1), then your nonprofit is subject to a requirement that it receive at least one-third of its support from contributions from the general public, or meet the 10 percent “facts and circumstances” test. Public support generally includes funding from governmental agencies and contributions or grants from the public and/or other public charities. Grants from other single sources, such as private foundations or individuals, count towards public support, but only up to 2 percent of the organization’s total support. Note that the percentage is calculated using a five-year period.
For example, if an organization’s total support over the five-year period is $2 million, including $200,000 of total contributions from one foundation, the amount of that foundation’s contributions that can be included as public support is limited to 2 percent of $2 million, or $40,000. Because $40,000 is only 2 percent of $2 million, the organization would need another $626,666 of public support (from government grants, individual contributions, etc.) to meet the 1/3 test.
Instead, the alternative “facts and circumstances” test for a 509(a)(1) organization is met if the nonprofit has a public support ratio of 10 percent or more; the organization is organized and operated so as to attract new and additional public or governmental support; and the facts and circumstances indicate it is a publicly supported organization. The “facts and circumstances” are analyzed using the “Five Factor Analysis,” which includes analysis of sources of support, corporate structure and governance, and programs and services.
Section 509(a)(2) organizations are those that generally receive more than one-third of their support from contributions from the general public and/or from gross receipts from activities related to their tax-exempt purposes, and no more than one-third from gross investment income and unrelated business taxable income. Examples of a 509(a)(2) might include theaters or schools that receive most of their support from ticket sales or tuition payments.
The takeaway is that you don’t need to be an expert in nonprofit accounting, but you do need to keep in mind that new or potential funding sources must be evaluated in light of your organization’s total support.
Failure to pay attention to relative percentages of funding sources has led many nonprofits into private foundation status — escape from which requires several years of effort! If a particularly large gift or grant is being considered, or there are any doubts about meeting the public support test, you should contact the nonprofit’s accountant or another financial professional familiar with public charities.
For more information and examples, please see the following articles:
- Exempt Organizations Annual Reporting Requirements – Form 990,
- Schedules A and B: Public Charity Support Test
- What is the “public support” test? How do I calculate it?
- Public Charity: Public Support Tests Part I: 509(a)(1)
- Public Charity: Public Support Tests Part II: 509(a)(2)
Do you have a question you’d like to us to address? Leave it in the comments below.
Nancy Eberhardt is New Jersey director of Pro Bono Partnership and a regular contributor to the Dodge Blog. Pro Bono Partnership provides free business and transactional legal services to nonprofits serving the disadvantaged or enhancing the quality of life in neighborhoods in New York, New Jersey and Connecticut. Learn more here.