One preliminary issue to address when forming a nonprofit organization—and a common source of confusion—is whether the new organization will be a public charity or a private foundation. In my experience, most nonprofit organizers are looking to create public charities, not private foundations. Only when dealing a wealthy individual, family, or large company does the topic of creating a private foundation become a topic of discussion. Here is a basic summary explaining the difference between the two classifications.
A public charity is a charitable organization that either (i) receives most of its financial support from the public, (ii) actively operates to support another public charity (organizations that test for public safety constitute a lesser-known category of public charity and will not be discussed here). Most public charities rely on contributions from the general public, either tax-deductible charitable gifts of money or property or proceeds from fundraising events and programs.
When most people think of nonprofits, they are thinking about 501(c)(3) public charities. FeedMore, Salvation Army, United Way, Shalom Farms, and The Sophie House are examples of public charities. More specifically, a public charity is either “publicly supported” (i.e., derives a substantial portion of its support from the public) or it functions to “support” one or more other public charities (this latter category of nonprofits are referred to as “supporting organizations,” and there are several categories of supporting organizations defined under the Internal Revenue Code).
Private foundations are charitable organizations established with funds from a single source or specific sources, such as family or a corporation, rather than from broad sources of public support.
Contributions to private foundations technically are tax deductible, but private foundations often do not bother soliciting or accepting donations. Instead, they usually invest their principal funding and distribute the income from investments for charitable purposes (i.e., like an endowment) which usually consist of grants or gifts to other nonprofit organizations.
The IRS recognizes two types of private foundations: (i) private nonoperating foundations and (ii) private operating foundations. Basically, the key difference between a private nonoperating foundation and a private operating foundation is how each distributes its income. The more common type of foundation is the private nonoperating foundation, which simply grants money to other charitable organizations and does not directly perform any charitable programs or services. Private operating foundations, on the other hand, uses its funds to support its own programs that it operates for charitable purposes.
Both types of private foundations must comply with special restrictions and requirements that do not apply to public charities. For example, private foundations must distribute a specific portion of their income for charitable purposes each year (approximately 5%), they cannot do business with major contributors, they are subject to excise taxes and can be penalized for self-dealing, making risky investments, and for failing to distribute adequate funds to charitable endeavors, among other requirements.
The default rule is that every 501(c)(3) exempt organization is considered a private foundation unless it demonstrates to the IRS that it is publicly supported. Many large nonprofits branded as “foundations” that grant money to public charities are actually public charities themselves. Community foundations and the United Way are examples of such organizations. Many of these nonprofits accept tax-deductible contributions to fund their grant-making programs.
Not every organization that uses the word “foundation” in its name is a private foundation, and despite its common usage in the nonprofit world, the term “foundation” has no legal meaning in and of itself. To confirm an organization’s actual tax-exempt classification/category, review the organization’s IRS filings: public charities file Form 990 (including Form 990-EZ or Form 990-N); private foundations file Form 990-PF.