A private operating foundation could be a great tool to direct funding to a specific cause while affording a donor a larger charitable donation deduction. But first, a private foundation has to qualify for this status.
Below, learn how to qualify for operating status, why it’s beneficial to do so, and how you can retain that status over time.
What Is a Private Operating Foundation?
A private operating foundation is a private foundation that conducts charitable activities as opposed to solely making charitable grants. Because of this emphasis on charitable activities, a private operating foundation receives many of the same tax benefits as a public charity without needing to adhere to the public support test requirements.
An organization must meet a number of requirements and restrictions to qualify as a private operating foundation—and to enjoy the numerous benefits associated with this status.
How Do You Qualify as a Private Operating Foundation?
A foundation must annually meet an income test and one of three other tests to qualify for and retain its status as a private operating foundation. As an exception to this rule, a foundation in its first year of existence may be treated as an operating foundation if it makes a good-faith determination that it’ll meet the tests in its first year.
How Can a Private Foundation Become a Private Operating Foundation?
If a private foundation’s main activity is running one or more charitable programs, it can be classified as a private operating foundation.
For a more detailed overview of private foundations, including distribution rules and income classifications, please read our article.
Income Test Requirements and Calculation
A foundation must make qualifying distributions for the active conduct of the charitable activities for which it received tax-exempt status to meet the income test. A qualifying distribution is defined in Internal Revenue Code (IRC) Section 4942(g) as one of the following four items:
- Disbursements used to accomplish one or more charitable, religious, educational, or other similar purposes, including reasonable and necessary administrative expenses
- Purchase of assets used or held to carry out its charitable purpose
- Acquisition or operation of program-related investments
- Amounts set aside for certain charitable projects
It’s important to make a distinction between charitable disbursements and grants to public charities. Grants to public charities won’t count toward the charitable disbursement test above.
The income test calculation can be complicated, but simply stated, the amount of qualifying distributions must be equal to substantially all, which is 85% or more, of the lesser of the foundation’s adjusted net income or minimum investment return.
Adjusted net income is defined as any adjusted gross income over adjusted deductions. Minimum investment return is calculated as generally 5% of the excess of the average fair market value of a foundation’s assets, not including charitable-use assets, over acquisition indebtedness of those assets.
Asset, Endowment, and Support Tests
An organization must also pass one of three other tests—assets, endowment, or support—to qualify and maintain its private-operating-foundation status.
Assets Test
A foundation passes the assets test if at least 65% of the value of its assets are devoted to one or both of the following:
- Active conduct of exempt-purpose activities
- Business activity that’s functionally related to its exempt purpose
A foundation can fulfill this requirement either over a portion of or during the entirety of the four-year period that culminates with the year it’s trying to qualify for private-operating-foundation status.
Endowment Test
The endowment test is similar to the income test in that it measures qualifying distributions and minimum investment return. To meet this test, a foundation must make qualifying distributions that directly support the active conduct of the charitable activities for which the foundation was established.
This test also measures minimum investment return, which requires a foundation to make qualifying distributions in excess of two thirds of its minimum investment return.
Support Test
The crux of this test is revenue support. It requires at least 85% of a foundation’s support to come from the general public and five or more exempt organizations—not including disqualified persons. No more than 25% of its support can be received from any one of those five exempt organizations while no more than 50% of its total support can be received from gross investment income.
It’s important to note that private operating foundations must meet the income test and one of the three other tests each year. If they can’t, they must report each year as a private nonoperating foundation.
What Are the Benefits of Using a Private Operating Foundation?
Private operating foundations can be powerful vehicles for some organizations to achieve their charitable goals.
The donations they receive are eligible for a 50% charitable-contribution deduction limit—instead of the 30% charitable-contribution deduction limit that private foundations have. Additional benefits to obtaining and sustaining status as a private operating foundation include the following:
- Not subject to excise taxes because of a failure to distribute income
- Ability to receive qualifying distributions from other private foundations
- Donors of capital gain property aren’t subject to a reduction of their contribution
Public charities that receive a large amount of donations from limited sources can struggle to maintain healthy public-support percentages. Status as a private operating foundation offers these charities an option to retain some of the benefits of being a public charity while circumventing some of the stringent rules and taxes that private foundations endure.
Another benefit is private operating foundations can use their distributions to fund their charitable programs instead of only making distributions outside the organization.
Are Private Operating Foundations Required to Follow the 5% Minimum Investment Return?
No. Private operating foundations aren’t subject to IRC 4942(a)(1) and IRC 4942(b), which require private foundations to distribute a calculated minimum amount of their income for charitable or other exempt purposes.
Private operating foundations must still calculate their minimum investment return to meet the rules described above, but they aren’t subject to tax on a failure to distribute that income.
Can a Private Operating Foundation Accept Donations from the General Public?
Yes, all 501(c)(3) charitable organizations may receive tax deductible donations from a wide variety of sources, and public charities must receive donations from the general public in order to maintain their public charity status.
Private foundations typically don’t attract donations from the general public as they tend to be family or corporate foundations that pool their wealth and fund charitable ventures to meet their personal or corporate philanthropic goals. However, private operations foundations don’t need to meet a public support threshold. Since they operate at least one charitable program, they may be more successful at generating revenue from donors outside the family.
With the generous charitable deduction available to donors of private operating foundations, these types of organizations could be a strong option for those looking to make a substantial donation.
We’re Here to Help
For more information about qualifying as a private operating foundation, contact your Moss Adams professional.