A section 501(c)(3) organization is a private foundation unless it fits a public charity category. Many nonprofits rely on being publicly supported under section 170(b)(1)(A)(vi). The test is computed on Schedule A of Form 990 over five years, and a large gift from a single donor can pull an organization below the line without anyone noticing. The nonprofit auditor does not opine on tax status, but a change would affect the Form 990, donor deductions and the going concern discussion, so the computation belongs in the planning file.
The two tests
Under Treas. Reg. 1.170A-9(f), an organization is publicly supported if it meets either:
- the 33 1/3 percent support test, under which at least one-third of its total support normally comes from governmental units, other qualifying public charities and contributions from the general public; or
- the facts and circumstances test, which requires at least 10 percent public support plus other factors, such as a continuous and bona fide program to attract new and additional public or governmental support.
"Normally" has a specific meaning. An organization normally meets the 33 1/3 percent test for a year and the following year if, for the test year and the four preceding years, it meets the test on an aggregate basis. The same five-year window applies to the facts and circumstances test. An organization that has normally met the 33 1/3 percent test but cannot do so for a later year does not lose the chance to qualify under the facts and circumstances test for that year.
A new organization is treated as normally meeting either test during its first five taxable years as a section 501(c)(3) organization if it can reasonably be expected to meet it. For its sixth year, the general five-year definition applies, or it can rely on passing for its fifth year using support from its first five years.
What counts as support
Regulation 1.170A-9(f)(7) defines support by reference to section 509(d). Support includes gifts, grants, contributions and membership fees, net income from unrelated business activities, gross investment income, tax revenues levied for the organization's benefit and the value of services or facilities a governmental unit furnishes free. It excludes gain from the sale of capital assets and the value of tax exemption. Amounts received from performing the exempt purpose, such as fees for related program services, and contributed services for which no deduction is allowable, are left out of both the numerator and the denominator. An organization that receives almost all of its support from related-activity receipts and an insignificant amount from government and the public cannot meet either test.
The 2 percent cap
The regulation limits how much one donor counts as public support. Contributions by an individual, trust or corporation count as support from the general public only to the extent the total from that donor during the computation period does not exceed 2 percent of the organization's total support for the period. A gift is included in full in the denominator but only up to the cap in the numerator. Gifts from a donor and persons in the relationships described in section 4946(a)(1)(C) through (G) are treated as made by one person.
The 2 percent limit does not apply to support from governmental units described in section 170(c)(1) or to contributions from organizations described in section 170(b)(1)(A)(vi), with an exception noted in the regulation. Earmarking matters: amounts a donor earmarked for the particular organization, passed through a governmental unit or another public charity, remain subject to the 2 percent limit.
The regulation also allows an exclusion of unusual grants from both the numerator and the denominator. The exclusion is meant for substantial contributions or bequests from disinterested parties that are attracted by the organization's publicly supported nature, are unusual or unexpected in amount, and would by their size adversely affect the organization's status. All pertinent facts and circumstances are considered, and no single factor is determinative. A grantee may ask the IRS for a determination before the grant is made.
Worked example
Over the five-year period, an organization has total support of $2,000,000:
- Government grants: $400,000.
- Gifts from many donors, none above the cap: $700,000.
- One donor family, treated as one person, giving $500,000.
- Investment income: $400,000.
The cap is 2 percent of $2,000,000, or $40,000.
- Public support in the numerator: $400,000 plus $700,000 plus $40,000 (the capped major donor), or $1,140,000.
- Test: $1,140,000 divided by $2,000,000 is 57 percent.
- Result: 57 percent exceeds 33 1/3 percent, so the test is met.
Now suppose government grants fall to $100,000 and the family gives $800,000, so total support is still $2,000,000 and the cap is still $40,000. Numerator: $100,000 plus $700,000 plus $40,000 is $840,000, or 42 percent. Still passing, but the cushion shrank from 23.7 points to 8.7 points. A cushion that small is a signal to the board.
Second example: an unusual grant
Over five years, an organization has total support of $2,000,000:
- Government grants: $100,000.
- Gifts from many donors, each under 2 percent of total support: $400,000.
- Investment income: $500,000.
- One bequest from a disinterested party: $1,000,000.
Without the exclusion, the cap is 2 percent of $2,000,000, or $40,000. Numerator: $100,000 plus $400,000 plus $40,000 is $540,000, or 27 percent. That is below 33 1/3 percent.
If the bequest qualifies as an unusual grant, it comes out of both sides. Total support is $1,000,000 and the numerator is $100,000 plus $400,000, or $500,000, which is 50 percent. The test is met. The difference between failing and passing is whether the unusual grant requirements are documented.
If the organization fails
An established organization that fails both the 33 1/3 percent test and the facts and circumstances test for two consecutive taxable years is treated as a private foundation from the first day of the second year for purposes of sections 507, 4940 and 6033. It must file Form 990-PF and owes the section 4940 net investment tax for that year. A new organization that fails for both its fifth and sixth years is treated the same way from the first day of its sixth year. For later years it is a private foundation for all purposes.
What to do in the engagement
- Obtain the five-year Schedule A, Part II, and tie each year's contributions to the audited statements. The reconciliation steps are in Form 990 reconciliation to audited financial statements.
- List all donors above 2 percent of five-year support and group related donors.
- Identify unusual grants and the support for treating them as such.
- Model next year's roll-forward, dropping the oldest year and adding the new year.
- If the cushion is thin, discuss the facts and circumstances test and its documentation requirements, or the section 509(a)(2) tests, which Schedule A reports in Part III.
For contributions accounting itself, see nonprofit contributions and grants under ASC 958-605.
Common errors
- Putting the full amount of a large gift in the numerator instead of limiting it to 2 percent of total support.
- Treating a donor and related persons as separate donors when section 4946(a)(1)(C) through (G) relationships make them one person.
- Applying the 2 percent limit to government grants or to grants from other public charities that were not earmarked for the organization.
- Counting program service fees from related activities in support.
- Testing one year alone instead of the aggregate of the test year and the four preceding years.
- Excluding an unusual grant without the facts that support it.
Sources
- Legal Information Institute, 26 CFR 1.170A-9, Definition of section 170(b)(1)(A) organizations: https://www.law.cornell.edu/cfr/text/26/1.170A-9
- Internal Revenue Service, Public charities: https://www.irs.gov/charities-non-profits/charitable-organizations/public-charities
- Internal Revenue Service, Instructions for Schedule A (Form 990), Part II support schedule: https://www.irs.gov/instructions/i990sa
- Legal Information Institute, 26 U.S.C. 509, Private foundation defined (subsection (d), definition of support): https://www.law.cornell.edu/uscode/text/26/509
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