Public Charity vs. Private Foundation

Every organization classified under section 501(c)(3) is categorized as either a private foundation or a public charity. The main distinction between the two lies in the level of public involvement in their activities.

Public charities typically receive a larger portion of their funding from the general public or government entities and engage more actively with the community. In contrast, a private foundation is usually overseen by family members or a small group of individuals, relying heavily on limited funding sources and investment income. Due to their lower level of public transparency, private foundations are subject to various operational restrictions and may incur excise taxes if they do not comply with these regulations.

Under tax law, an organization categorized under section 501(c)(3) is generally assumed to be a private foundation unless it formally requests and obtains a ruling to be recognized as a public charity. Organizations that qualify as public charities include schools, hospitals, churches, publicly supported organizations (which receive a specified portion of their total support from public sources), and certain supporting organizations. Churches, along with their integrated auxiliaries and conventions or associations, that fulfill the requirements of section 501(c)(3) of the Internal Revenue Code are automatically recognized as tax-exempt and do not need to apply for or obtain recognition of their exempt status from the IRS. 

Private foundations are categorized into two types: private non-operating foundations and private operating foundations, which are discussed and distinguished further below.

Public Charity

Public charities hold the most advantages among the three primary types of 501(c)(3) organizations. This is why many organizations aim to qualify as public charities to access the full benefits of this designation. These organizations typically engage in direct service or other tax-exempt activities but can also participate in grant-making initiatives. Their funding is obtained from diverse sources, including individual donations, government contributions, and private foundations.

An organization must meet one of three “public support” tests to obtain and maintain public charity status. The IRS considers an organization to have met the “public support” test if it satisfies either the (1) one-third (1/3) support test or the (2) ten percent (10%) facts and circumstances test.

One-Third Public Support Tests
To meet one of the two “one-third public support tests,” an organization must fulfill one of the following criteria: 

1. It must receive at least one-third of its support through contributions from other public charities, governmental agencies, and/or the general public. 
2. Alternatively, it can receive no more than one-third of its support from gross investment income while obtaining more than one-third of its support from contributions, membership fees, and gross receipts from tax-exempt activities.

It is important to note that any grant or contribution received from sources other than governmental entities or another public charity—provided that they meet the “one-third” test—counts as public support only up to a limit of 2% of the total support received over a five-year assessment period. 

For example, if an organization receives a total support of $100,000 over five years and obtains a grant of $40,000 from a private foundation, the entire $40,000 will count towards total support. However, only $2,000 (which is 2% of $100,000) of that grant will be counted as public support.

This limitation can create what is known as a “tipping” problem. A large contribution from a private foundation or an individual is capped at the 2% limit, which can increase the overall total support figure without a corresponding increase in the public support amount. As a result, this may lead the organization to fail the “one-third” test.

Ten-Percent Facts and Circumstances Test
If an organization cannot demonstrate that it is likely to meet the one-third support test, it can still qualify as a public charity by meeting the following criteria: (1) at least ten percent (10%) of its total support must come from a variety of public sources, (2) there must be widespread public interest in its programs, (3) it should have a continuous fundraising program aimed at reaching a diverse segment of the public, and (4) its board of directors must represent public interests effectively.

Advantages of Public Charity Status

Higher Tax-Deductibility Limits
One of the biggest advantages of being a public charity is that donors can deduct cash contributions in full up to 60% of their adjusted gross income.  This advantage means that individual donors have a greater tax benefit from contributing to public charities than private foundations (as further explained below).

Easier to Receive Grants from Private Non-Operating Foundations
Due to specific tax regulations, private foundations typically prefer to grant funds to public charities instead of other private foundations. As a result, if your organization is set up as a public charity, it is likely to receive more grants from private foundations compared to being structured as a private foundation.

Not Subject to Stricter Regulations Applicable to Private Foundations
Public charities have several advantages over private foundations, primarily because they are exempt from many of the stringent requirements that private foundations face. For example, public charities are not required to spend a specific minimum amount of their funds each year, known as “qualifying distributions,” which is mandatory for private foundations. However, in practice, most public charities tend to spend more than the minimum required to support their charitable activities. Public charities are not subject to the strict self-dealing rules that apply to private foundations; they do not have to pay a tax on their net investment income.

Ability to Engage in Limited Lobbying Activities
Public charities may also engage in a certain limited number of lobbying activities, as compared to private foundations and private operating foundations, which are completely prohibited from engaging in any lobbying activities.² 

Disadvantages of Public Charity Status

There are technically no disadvantages to public charity status, except for the requirement that the organization meet the IRS’s public support test. This means the organization needs to receive funding from a diverse range of sources. However, organizations that secure sufficient funding from limited sources—such as a small group of dedicated donors or an endowment—may not find it necessary or beneficial to focus on continuous fundraising efforts. Consequently, public charity status might not be the best tax-exempt option for organizations that prefer to avoid ongoing fundraising activities.

Private Non-Operating Foundation

When an organization does not qualify as a public charity, the IRS automatically classifies it as a private non-operating foundation. Private foundations are usually funded by a small group of individuals, such as family members, or a single primary source, like a corporation. Most private non-operating foundations focus primarily on grantmaking to fulfill their charitable objectives and typically do not run their own charitable programs. However, it is important to note that non-operating foundations are not prohibited from conducting direct charitable activities if they choose to do so.

Advantages of Private Non-Operating Foundation Status

No Requirement to Fundraise
Private foundations do not need to ensure that they receive their funding from broad “public support.” This alleviates the administrative burden of making sure donations are not primarily from a limited number of donors.

Disadvantages of Private Non-Operating Foundation Status

Tax-Deductibility
Donors face a significant disadvantage in terms of tax deductibility when compared to public charities. Cash donations made to private foundations are only tax-deductible up to 30% of a donor’s adjusted gross income. As a result, many large donors tend to prefer donating to public charities instead.

Qualifying Distributions
The IRS mandates that private foundations adhere to several additional requirements that do not apply to public charities. One specific requirement is that private foundations must make “qualifying distributions” to eligible public charities or other tax-exempt organizations. These distributions must be equal to 5% of the average fair market value of their assets from the previous year.

Grantmaking Oversight
Private foundations that make grants to other private foundations, foreign organizations, or any entities that are not 501(c)(3) public charities must ensure proper oversight of these grants. This can be achieved through one of two methods: 

1. “Equivalency Determination” The foundation determines that the grantee organization is equivalent to a U.S. public charity. 
2. “Expenditure Responsibility” The foundation implements measures to ensure that the grant funds are used for charitable purposes.

The rules surrounding expenditure responsibility require detailed accounting and documentation to confirm that grants given to private foundations and other organizations not classified as public charities are spent appropriately—specifically, for charitable purposes rather than for private benefit or political gain. Due to these additional oversight requirements, private foundations may be discouraged from making grants to organizations that are not public charities. As a result, they typically concentrate their grantmaking efforts on supporting public charities.

Tax on Net Investment Income
Private foundations face additional taxes that public charities do not, including a 1.39% excise tax on their net investment income.

Prohibition on Self-Dealing Transactions
Private foundations are generally prohibited from engaging in financial transactions with insiders associated with the foundation. These transactions are referred to as “self-dealing transactions.” The following activities are typically considered self-dealing between a private foundation and a disqualified person: 

1. Sale, exchange, or leasing of property.
2. Leasing agreements.
3. Lending money or extending credit.
4. Providing goods, services, or facilities.
5. Paying compensation or reimbursing expenses to a disqualified person.
6. Transferring foundation income or assets to, or for the benefit of, a disqualified person.
7. Certain agreements to make payments of money or property to government officials.

The prohibition on self-dealing means that members of the foundation’s board and other disqualified persons, including significant contributors, are not allowed to personally benefit from any transactions that the foundation conducts. In contrast, public charities can engage in these types of transactions as long as the board determines that the transactions are in the charity’s best interest. The ban on self-dealing is quite extensive; even payments made to a disqualified person for goods or services rendered at or below fair market value are prohibited. Therefore, avoiding financial transactions between disqualified persons and the foundation is crucial.

Tax on Excess Business Holdings
Private foundations are subject to a tax on their excess business holdings. This tax effectively prohibits a foundation and its disqualified persons from owning more than 20% of the voting stock of a business enterprise in total.

Tax on Jeopardizing Investments
Private foundations are also subject to a punitive tax on certain risky investments, known as “jeopardizing investments.” Jeopardizing investments are those that generally show a lack of reasonable business care and prudence in providing for the foundation’s long- and short-term financial needs to carry out its exempt function. No single factor determines whether an investment should be deemed a jeopardizing investment; rather, the determination must be made on an investment-by-investment basis, taking into account the foundation’s portfolio as a whole. The foundation managers may consider expected returns, risks of rising and falling prices, and the need for diversification within the portfolio.

Private Operating Foundation

A private operating foundation is a special type of private foundation. It is typically established if an organization cannot achieve public charity status but can satisfy certain other criteria.

The primary distinction between private operating foundations and private non-operating foundations lies in their activities. Private operating foundations actively conduct their own charitable programs, whereas non-operating foundations do not. Because of this essential difference, private operating foundations must adhere to regulations similar to those governing public charities, which tend to be more favorable than those that apply to non-operating foundations.

Advantages of Private Operating Foundation Status

Grants from Private Non-Operating Foundations Count Towards the Grantor’s Qualifying Distributions
Private operating foundations are eligible to receive “qualifying distributions” from other private foundations in the same way that public charities are eligible to receive them for the conduct of their own charitable programs. This benefit makes it more likely that a private foundation would grant to a private operating foundation than to a private non-operating foundation.

Higher Tax-Deductibility than Contributions to Non-Operating Foundations
Private operating foundations are subject to the more generous donation deductibility limits applicable to public charities (whereas donations to non-operating foundations have lower deductibility limits). Because wealthier donors are sensitive to the deductibility cap, the more generous tax-deductibility limits available to private operating foundations is typically the primary motivation for founder-philanthropists to seek private operating foundation status over non-operating foundation status.

Cash contributions made to operating foundations are deductible for taxpayers up to 60% of their adjusted gross income (AGI), similar to the deduction limit for public charities. In contrast, for non-operating foundations, the limit is 30%. 

Donations of long-term capital gain property—such as artwork or real estate—are also deductible when given to operating foundations, with a limit of 30% of the taxpayer’s AGI, akin to donations made to public charities. However, this deduction is limited to 20% of the donor’s AGI for non-operating foundations. 

Additionally, the deduction for long-term capital gain property donated to an operating foundation is generally based on the property’s fair market value on the date of the contribution. Conversely, for non-operating foundations, the deduction for long-term capital gain property (excluding qualified appreciated stock) is limited to the donor’s tax basis in the property.

Disadvantages of Private Operating Foundation Status

Compliance with Strict Financial Tests
A private operating foundation must allocate most of its resources—either its earnings or assets—toward actively pursuing its tax-exempt activities. Specifically, it must spend at least 85 percent of its adjusted net income or its minimum investment return (whichever is less) directly on these exempt activities. This requirement is known as the income test. 

In addition to passing the income test, the foundation must also meet one of the following tests: (1) the assets test, (2) the endowment test, or (3) the support test. Together, these tests constitute the qualifying distribution requirement for private operating foundations. 

Private operating foundations must demonstrate compliance with these tests every year by providing information in the annual Form 990-PF filed with the IRS.

Restrictions applicable to non-operating foundations
Private operating foundations are also subject to taxes on self-dealing, excess business holdings, jeopardizing investments, and net investment income.

Conclusion

Choosing the right 501(c)(3) classification—whether as a public charity, a private non-operating foundation, or a private operating foundation—depends largely on the specific goals of the organization and its planned sources of funding. While it is relatively easy to switch from a public charity to a private non-operating foundation, it is a much more complex process to seek reclassification from a private foundation to a public charity. Therefore, it is crucial to understand the differences between these classifications in order to select the most suitable one for your goals from the start.

1   A 501(c)(3) refers to the federal tax code section granting tax-exempt status to certain organizations.

2  A narrow exception to the lobbying prohibition exists in connection with lobbying in “self-defense” on legislation that would affect the existence, powers, duties, or tax-exempt status of a private foundation or its ability to receive deductible contributions.

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Under the Internal Revenue Code, all 501(c)(3) organizations are prohibited from participating in any political campaign on behalf of or in opposition to any candidate for elective public office.  This includes contributions to political campaigns or public statements of position made on behalf of the organization in favor of or in opposition to any candidate for public office.  The IRS explains on its website that non-partisan voter registration and get-out-the-vote drives may be permissible as long as they do not bias, favor or oppose one candidate over another, or have the effect of favoring a candidate or group of candidates.   For private foundations, there are more specific rules restricting their grantmaking for voter registration activities.  

Although public charities are prohibited from engaging in political campaign activities on behalf of or in opposition to candidates, the IRS states that “The political campaign intervention prohibition is not intended to restrict free expression on political matters by leaders of organizations speaking for themselves, as individuals. Nor are leaders prohibited from speaking about important issues of public policy. However, for their organizations to remain tax exempt under section 501(c)(3), leaders cannot make partisan comments in official organization publications or at official functions of the organization.” (IRS Rev. Rul. 2007-41).

If you lead or work for a public charity and plan to get involved in political activities in a personal capacity, you should keep the following guidelines and best practices in mind.    

• Employees who endorse or support candidates, make public comments in person, express themselves in writing or online, or engage in other electioneering activities, should refrain from using organizational titles or the organization’s name while making such endorsements or expressing such support.  
• If an employee is identified by name or title in public communications, the employee should include this statement: Titles and affiliations of each individual are provided for identification purposes only and do not reflect the views of the organization or imply an endorsement by the organization. 
• Organization leadership and employees who use personal email communications, personal social media platforms, and any online platforms not affiliated with the organization to communicate about or engage in political campaign activities should include the following disclaimer in the ‘About/Bio’ section and where possible, at the end of such communications:  All personal views and opinions expressed are my own and do not represent or reflect the views of any organization.  Although this disclaimer will not provide absolute cover, its inclusion helps to draw a clearer line between the individual’s affiliation with an organization and their rights as a private citizen.
• Organization representatives cannot support or oppose candidates at organization-sponsored events.  For example, an employee should not, while attending a charity-sponsored event, wear any political t-shirts, buttons, hats, etc. 
• Employees should not use organizational resources, including phones, copiers, computers, office space, email addresses, office addresses, organization name, organization online and social media platforms, donor or mailing lists, for supporting or opposing candidates.  

If you lead or work for a public charity, consider the following tips to help keep your organization in compliance during election season.   

• Organization leaders should provide written notice to members of the Board, staff, and volunteers of its policy against using organizational resources for political campaign activity.  In addition to developing a policy on political activities, leaders should regularly update the policy and train the Board, staff, and volunteers.

• Charities should not report or comment on staff and volunteer personal campaign intervention activities in the charity’s newsletter, on its websites, or any social media accounts.  
• When dealing with the public on issues relating to an election, charity spokespersons should regularly include disclaimers that the charity cannot and does not endorse political candidates (The organization can post a disclaimer on the charity’s website to this effect). While such disclaimers will not excuse partisan activity, they can help explain that a charity’s public communications are not intended to support or oppose candidates, particularly where members of the public might construe certain communications to involve political campaign intervention. 

When it comes to political campaign activities, public charities have different restrictions than the individuals who lead and work for them have in their personal capacities.  That said, to help keep your organization out of trouble, the best thing you can do is to understand the rules and make sure there is a clear line between what you do in your personal capacity from that of the organization you work for.

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While a nonprofit entity is the most typical structure for an organization seeking to create positive social impact, many mission-driven entrepreneurs are choosing for-profit vehicles to achieve their goals. To determine if a nonprofit organization is the right structure for your vision, you must understand what is required to obtain and maintain nonprofit (and tax-exempt) status. 

What Does It Mean to be a Nonprofit Organization? 

First, it is critical to understand the core legal requirements and restrictions of being a nonprofit to determine if it is the right fit for your venture.¹  You may be wondering if “nonprofit organization” and “tax-exempt organization” are interchangeable terms. Although most nonprofit organizations are also tax-exempt, these terms do have different meanings. 

The term ‘nonprofit’ is typically used to refer to an organization’s legal form under state law. Most often, nonprofits are formed as corporations, but other legal forms, such as trusts or unincorporated associations, can be used. A corporation is the most popular legal structure for nonprofits, however, and offers many benefits to mission-driven ventures, including greater liability protection for the incorporated nonprofit’s directors and officers. 

A key distinguishing feature of nonprofit entities from for-profit entities is that nonprofit entities cannot distribute profits to individuals who control the organization. Unlike a for-profit corporation, a nonprofit corporation is not owned by anyone and does not have shareholders. 

Federal Tax-Exempt Status

The purposes and activities of the nonprofit will help determine whether it will qualify for exemption from federal income tax. Many nonprofit organizations are tax-exempt under section 501(c)(3) of the Internal Revenue Code (“Code”), which is the designation for charitable organizations. 501(c)(3) organizations are classified as either public charities or private foundations, depending mostly on whether they are diversely funded (public charity) or primarily funded by one or a few sources (private foundations). Other sections of the Code provide tax-exempt status to non-charitable nonprofits, the most common of which are 501(c)(4) social welfare organizations, 501(c)(6) business leagues, and 501(c)(7) social clubs. For this article, we will focus on the requirements of the 501(c)(3) public charity.

To obtain 501(c)(3) public charity status, an organization must be organized and operated exclusively for exempt purposes. Exempt purposes under section 501(c)(3) of the Code include those that are charitable, educational, religious, scientific, literary, fostering national or international sports competition, preventing cruelty to children or animals, and testing for public safety. To be organized exclusively for exempt purposes means that the organization’s governing documents must describe its exempt purposes and limit the use of its assets exclusively to those exempt purposes. To be operated exclusively for exempt purposes is, in large part, a negative test, i.e. an organization will not be considered to be operated exclusively for exempt purposes if (1) more than an insubstantial part of its activities is in furtherance of a non-exempt purpose, or (2) its net earnings inure in whole or in part to the benefit of private individuals. 

If more than an insubstantial part of the organization’s activities is not in furtherance of an exempt purpose, the IRS may deny or revoke the organization’s exempt status. To maintain 501(c)(3) status, an organization must do the following. 

• Not participate in political campaigns of candidates for local, state, or federal office
• Restrict its lobbying activities to an insubstantial part of its total activities
• Ensure that its earnings do not inure to the benefit of any private shareholder or individual;
• Not operate for the benefit of private interests such as those of its founder or the founder’s family
• Not operate for the primary purpose of conducting a trade or business that is not substantially related to its exempt purpose

Key Reasons Why You Should, or Should Not, Form a 501(c)(3) Nonprofit Organization

Deciding on whether a 501(c)(3) nonprofit entity is the right legal structure requires consideration of both the advantages and constraints of this legal form and tax status. While any decision should ideally be made in consultation with legal counsel, here are a few practical considerations that may help guide your assessment. 

Advantages of 501(c)(3) Nonprofit Status

Tax-Deductibility of Donations and Eligibility for Grants or Government Contracts 

Tax-deductibility is an important incentive for donors. Donations made to a 501(c)(3) nonprofit are generally tax-deductible for the donor, whereas donations to for-profit entities or most other types of exempt organizations are not. Similarly, many institutional funders only make grants to 501(c)(3) organizations, and 501(c)(3) status may be a prerequisite for certain government contracts. If you envision donations or grants being a significant source of funds for your organization, and the requirements of public charity status don’t unduly limit the core activities you seek to engage in to accomplish your mission (e.g., lobbying activities), then 501(c)(3) status may be beneficial for your organization. 

Exemption from Income Taxes

Generally, the income generated by a nonprofit organization from revenue-generating activities is exempt from federal income taxation if the generation of that revenue actually accomplishes the organization’s tax-exempt purposes (e.g., college tuition or hospital service fees). It’s important to understand when revenue is “substantially related” to accomplishing an exempt purpose, an evaluation that’s heavily driven by facts and circumstances, and best undertaken with advice of legal counsel. 

Public Transparency/Accountability 

Choosing the nonprofit form can signal trustworthiness, in part, because a nonprofit is legally required to operate exclusively in furtherance of the organization’s charitable purposes and is subject to regulatory scrutiny. In fact, studies have shown that nonprofits are among the most trusted institutions in the U.S. and are relied upon to shape better policies and deliver better results in local communities.² A 501(c)(3) nonprofit is subject to significant operational requirements and restrictions as well as public disclosure obligations under both state and federal laws. At the federal level, 501(c)(3) tax-exempt nonprofits must annually file Form 990 financial informational returns, which are publicly available on the IRS’s website. At the state level, most states require charitable organizations which are soliciting or otherwise conducting charitable activities in the state to register annually. Many of the state charity regulatory databases make even more information available to the public than the IRS makes available, such as organizations’ governance documents, IRS tax-exempt application, Form 990s, and audited financial statements. 

Disadvantages or Constraints of 501(c)(3) Nonprofit Status

Limits on Leveraging Commercial Market Strategies

If you want to use a more traditional market approach to accomplish a social impact objective, e.g., leveraging investor capital to expedite innovation and growth, a tax-exempt nonprofit vehicle may not be an ideal structure. However, there are creative structuring options that can involve tax-exempt entities, including joint venture or subsidiary structuring options.

Limits on Ability to Maximize Profit and Compensation

If your goals involve simultaneously maximizing profit and social impact (even if the profit generated does not benefit any insiders or investors), a tax-exempt vehicle that’s subject to numerous regulatory restrictions may limit the organization’s strategic options when trying to maximize profit, as you must simultaneously ensure that those strategic options do not require the organization to engage in activities that may jeopardize its tax-exempt status. Nonprofit 501(c)(3) organizations must also pay “reasonable compensation” for services, which may limit the organization’s ability to compete with for-profit entities for talent in certain fields. 

Limits on Founder Control

If founder control is paramount, a nonprofit may not be ideal. No individual(s) can “own” a nonprofit or its assets. A founder may be voted out of their position by the board of directors if the board does not agree with the direction of the founder. In addition, while rare, if a state attorney general (“AG”) determined that a founder was failing to uphold their fiduciary duties, the AG could petition the court to remove the founder from any leadership roles with the organization. 

Limits Based on What the IRS Considers a “Charitable” Purpose

There are a number of groups that genuinely believe that their organizational purposes are “charitable” because they provide a significant benefit to the community or the world at large. However, the IRS, which is the gatekeeper of 501(c)(3) status, does not always agree. This difference in perspective has been seen in a number of areas, ranging from farmer’s markets to open-source software initiatives to, most recently, NIL Collectives, as highlighted in tax-exempt application denials and other IRS-issued guidance. Seeking legal counsel is especially important when an organization is seeking to operate in areas where the IRS has previously scrutinized (and denied) qualification for 501(c)(3) tax-exempt status. 

In our experience we have found that a 501(c)(3) tax-exempt nonprofit corporation is a good fit for most parties seeking to establish a new charitable project, and that the benefits of nonprofit tax-exempt status outweigh the burden of the regulatory requirements and restrictions. However, given the increasingly creative approaches taken to optimize social impact through charitable initiatives, in order to best achieve your goals, before moving forward it is important to understand the fundamental structural requirements of a tax-exempt nonprofit.

1 For organizational leaders to benefit from the protections of the corporate form, they must maintain appropriate corporate formalities, including properly maintaining corporate records of meetings, and not commingling personal and organizational funds.

2 See “Trust in Civil Society,” a report prepared by Independent Sector in partnership with Edelman Data & Intelligence, published on May 19, 2022.

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I. Federal Tax Code Limitations on Public Charity Lobbying and Political Campaign Activities

Advocacy
A public charity can engage in an unlimited amount of advocacy in furtherance of its exempt purposes as long as that advocacy does not constitute lobbying or political campaign activity. This type of unrestricted advocacy may take many forms, including public education, nonpartisan research, and nonpartisan voter education, and can lay the groundwork for future lobbying activity.

Lobbying
What is Lobbying?
The Code recognizes two types of lobbying – direct lobbying and grassroots lobbying. In order for advocacy to be considered direct or grassroots lobbying, the communication must reflect the organization’s view on specific legislation.  “Legislation,” in this context, includes action by Congress, a state legislature, local council or similar governing body, and the general public in a referendum, initiative, constitutional amendment, or similar procedure. It generally does not include action by an executive branch of government or independent regulatory agencies.

Direct lobbying refers to attempts to influence specific legislation through communication with a member or employee of a legislative body or a government official who participates in the formulation of legislation.  A “member of a legislative body” generally includes members of Congress, state legislators, county supervisors and commissioners, city council members, members of international bodies with legislative power, legislative staffers, and the general public when voting on a ballot measure. Communication with other government employees, such as executive or administrative officials and staff, will be considered lobbying if those officials participate in the formulation of legislation and the purpose of the communication is to influence legislation. However, in general, communication with judges, executive branch officials, school board members, members of other similar local special purpose bodies, and members of the public when not voting on ballot measures do not qualify as communication with a member of a legislative body, and are therefore excluded from  the definition of “direct lobbying.”

Grassroots lobbying refers to attempts to influence specific legislation by urging the public to take action with respect to the legislation. Common actions that constitute grassroots lobbying include: (1) directing the public to contact a legislator for the purpose of influencing legislation, (2) providing the contact information for a legislator, (3) providing a means to contact the legislator (e.g., a petition or postcard), or (4) publicly identifying a legislator as being opposed to or undecided about the organization’s view on the legislation.

Public Charity Lobbying Limits
A section 501(c)(3) public charity may engage in direct or grassroots lobbying as long as it does not devote a substantial part of its overall activities to lobbying activities (the “substantial part test”). There is no bright line rule stating what constitutes a “substantial” amount of lobbying activity. Whether an organization has devoted a substantial part of its activities to lobbying depends on all facts and circumstances, including the time of both compensated and volunteer workers devoted to lobbying activity and lobbying expenditures. If a public charity engages in a substantial amount of lobbying activity in any one year, the Internal Revenue Service (IRS) can revoke its tax-exempt status causing all of the organization’s income to be subject to tax. In addition, the IRS may impose a tax equal to 5% of lobbying expenditures on the organization and, separately, on any manager who agreed to make the expenditures knowing the organization would likely lose its tax-exempt status.

There is little guidance about what constitutes “substantial” lobbying activity and the consequences resulting from a violation of the substantial part test are severe. As a result, many organizations desire a more definite set of rules. Fortunately, Congress responded in 1976 when it enacted Code Sections 501(h) and 4911 setting forth the “expenditure test” as an alternative to the substantial part test. Charities seeking clearer limitations for their lobbying activities may elect to be subject to the “expenditure test” instead of the substantial part test by filing Form 5768 with the IRS (also known as making “a 501(h) election”).

While the substantial part test takes into consideration all facts and circumstances, including time spent by volunteers on lobbying activity, the expenditure test is concerned only with an organization’s lobbying expenditures. Under the expenditure test, lobbying will not jeopardize a charity’s tax-exempt status unless the organization’s lobbying expenditures exceed 150% of the lobbying expenditure allowance set by the Code taking into account the current year and the previous three years. For the first three years of its first election an organization need only take into consideration the years in which the election has been in effect as long as its lobbying expenditures do not exceed 150% of the lobbying expenditure allowance for those years . A public charity that has made a 501(h) election can spend up to twenty-five percent (25%) of its lobbying expenditure allowance on grassroots lobbying or up to the entire amount on direct lobbying. Lobbying expenditures in excess of this allowance will be subject to a 25% tax. Also, for electing charities, the Code exempts certain activities from the definition of lobbying including nonpartisan analysis or research, discussions of broad social, economic, and similar problems, requests for technical advice, and certain “self-defense” communications made by the organization to a legislative body or its representatives.

Political Campaign Activity
In addition to placing limits on lobbying activity, the Code prohibits a public charity from engaging in political campaign activity. An organization engages in political campaign activity when it participates or intervenes, directly or indirectly, in any political campaign on behalf of or in opposition to any candidate for public office. Whether an organization is participating or intervening in a political campaign depends on all of the facts and circumstances of each case. The IRS often looks for whether the communication, in content, structure, or distribution, evidences a bias or preference with respect to the views of any candidate or group of candidates. A “candidate for public office” is anyone who offers himself or herself, or is proposed by others, as a contestant for an elective office at the federal, state or local level. Participation in a political campaign might include actions such as endorsing or supporting financially a candidate for public office, a political party or a political action group or making statements in favor of or in opposition to a candidate. Certain voter education activities, such as releasing voter guides or legislative scorecards can, if structured appropriately, be conducted in a non-partisan manner and not constitute political campaign activity. A public charity that engages in any political campaign activity will lose its tax-exempt status.

II. Creating an Affiliated 501(c)(4) Organization

The limitations placed on public charity lobbying and political campaign activity may not allow a charity to engage in the level of advocacy necessary to achieve a desired policy outcome.  One option in this instance is to establish a 501(c)(4) social welfare organization. Contributions to a 501(c)(4) are not deductible as charitable contributions, but 501(c)(4)s may engage in an unlimited amount of lobbying as long as the issues relate to the exempt purpose of the organization. In addition, 501(c)(4) organizations may engage in limited political campaign activities, subject to campaign finance laws, as long as these activities are not its primary activity. Charities should consider the operational and strategic implications of this decision, including:

• if there is a sufficient donor base to support a new 501(c)(4) organization;
• if additional advocacy tools will complement the 501(c)(3)’s advocacy efforts;
• whether the organization’s policy issue has been politicized in a way that makes it difficult to discuss in a non-partisan manner; and
• the effect of establishing an affiliated 501(c)(4) on the organization’s reputation.

Below are a few more considerations for public charities that plan to establish an affiliated 501(c)(4) organization.

Legal Separation
The 501(c)(4) must be a separate legal entity from the 501(c)(3). Usually, 501(c)(4) organizations are established as corporations under state law and, as such, are required to observe corporate formalities. The two organizations should maintain their own books and records, bank accounts, mailing addresses, and file their own tax returns and applications for tax-exempt status.

The board of directors of the 501(c)(4) organization must operate independently from the 501(c)(3), including holding distinct meetings. The 501(c)(3) and 501(c)(4) may have board members in common. If the boards completely overlap, careful attention must be paid to keep meetings and decisions separate so that it is clear which board is acting at a given moment. Even with careful recordkeeping, there are reasons to keep board overlap to a minority of the board. Minority overlap will allow the disinterested majority of the board of each entity to approve financial transactions (e.g., grants or loans) between the entities and protect the interests and separate existence of both entities. Further, if the 501(c)(4) will engage in any political campaign activity, it is often advisable to increase the separation between the two entities to reduce the risk that any political activity of the (c)(4) may be attributed to the 501(c)(3).

Financial Separation
A 501(c)(3) must not subsidize the day-to-day operations of an affiliated 501(c)(4). If the two entities will share office space, equipment, and/or staff, the (c)(4) must pay its share of the cost. Typically, this arrangement is memorialized in a written cost-sharing agreement.

Shared employees should keep written time records in order to support allocation of salary between the two organizations. This is critical if the (c)(4) will engage in political campaign activity since the (c)(3) may not directly or indirectly support the political activity of the (c)(4).

As in the case with employee time, the (c)(4) should pay its fair share for any office space or equipment used so that the (c)(3) is not subsidizing the (c)(4)’s activities. The (c)(4) might sublease office space from the (c)(3) at fair market value, pay its share of the rent to the landlord directly, or even pay the full amount of rent and allow the (c)(3) to occupy the space free of charge.

Operational Separation
The charity may not control or give the appearance that it controls the everyday activities of the (c)(4). The (c)(3)’s and (c)(4)’s purposes may align, but each organization should maintain and document its own levels of authority and responsibility in day-to-day operations. Set up good legal compliance systems from the beginning and train staff so they know these systems and can make sure they function effectively.

There are a number of other considerations when establishing an affiliated 501(c)(4) organization, including issues related to applying for tax-exempt status, startup costs, joint fundraising, grants or loans between the organizations, and whether the two entities can share other resources, such as donor lists or a website.  To navigate these issues, it is helpful to seek qualified counsel.

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