Understanding Private Non-Operating Foundations vs. Private Operating Foundations
When establishing a private foundation, it is essential to understand the differences between Private Operating Foundations (POFs) and Private Non-Operating Foundations (PNOFs). While both share the core mission of philanthropy, they differ significantly in their approaches and functions. These differences can greatly influence which structure is more suitable for a philanthropic minded donor.
Private Non-Operating Foundations (PNOFs)
Private Non-Operating Foundations (PNOFs) primarily focus on making grants to other charitable organizations rather than running their own charitable programs. PNOFs are easier to manage and provide flexibility for supporting many different charitable causes. They support other charitable organizations by distributing at least 5% of the total fair market value of their assets annually to charitable causes. These "qualifying distributions" are typically in the form of grants. If PNOFs fail to meet this required distribution, they are subject to an excise tax penalty known as the "Undistributed Income Excise Tax." This tax imposes a penalty of 30% on the undistributed income amount, which can be increased by an additional 100% penalty if not corrected in a timely fashion.
The PNOF structure allows foundations to concentrate on funding other organizations, dedicating their resources primarily to grantmaking without the obligation to conduct their own charitable programs. Consequently, they have great flexibility and the ability to support a wide range of charitable activities and organizations, addressing diverse societal needs.
Private Operating Foundations (POFs)
In contrast, POFs are designed to actively conduct their own charitable activities, such as operating museums, libraries, research facilities, and educational programs. Unlike traditional private foundations, which typically make grants to other organizations, POFs directly engage in charitable work. They must spend a significant portion of their resources directly on their exempt charitable activities rather than simply distributing grants to other entities. Consequently, POFs operate independently without relying on partner charities to achieve their charitable goals.
To maintain their status, POFs must meet the requirements of the income test and at least one of the assets test, endowment test, or support test. These tests ensure that they use the majority of their income and assets to actively conduct charitable programs or services. Although the rules governing these tests are complex, they are manageable for organizations running their own programs.
POFs offer greater control over how funds are ultimately used, allowing for direct involvement in charitable activities. They can sometimes attract additional contributions from the public or other donors, leveraging the founding donor's initial investment. However, POFs are more complex and costly to maintain due to higher administrative and operating costs.
Financial and Operational Requirements of POFs
All private foundations are classified as Non-Operating by default. To be recognized as a Private Operating Foundation (POF), a foundation must demonstrate that its primary function is to operate public charitable programs. The IRS requires that a foundation meet the following criteria to qualify as a POF:
1. Income Test
The foundation must spend at least 85% of its adjusted net income or minimum investment return directly on active charitable programs.
Adjusted net income is a calculated measure used for regulatory and tax purposes. It includes the foundation's gross income from various sources, minus allowable deductions like operating expenses, taxes (excluding those on investment income), and depreciation. Some income types, such as capital gains and unrelated business income, may be excluded from this calculation.
Minimum investment return is a calculation based on 5% of the average market value of a foundation’s investment assets over the course of the year. Importantly, certain assets are excluded from this calculation. For example, assets directly used in the conduct of the foundation's charitable programs, such as office equipment used by foundation staff, are not included in the investment assets.
2. Additional Tests
In addition to the income test, a foundation must satisfy one of the following additional tests:
• Assets Test: At least 65% of the foundation's assets must be used directly for charitable activities or consist of stock in a corporation controlled by the foundation where 85% of the corporation’s assets are used for charitable activities.
• Endowment Test: The foundation must usually spend at least two-thirds of its annual minimum investment return on its charitable activities. This test has significant overlap with the income test.
• Support Test: At least 85% of the foundation’s support must come from the general public and five or more unrelated exempt organizations. No more than 25% of its support can come from any one exempt organization, and no more than 50% can come from investment income.
By meeting these requirements, a foundation can achieve and maintain its status as a Private Operating Foundation. Compliance with these tests is measured over a four-year period. If a foundation meets the tests initially but fails in a future year, it must report as a non-operating foundation on its Form 990-PF.
Expenditures for Active Conduct of Programs
Private Operating Foundations must use most of their resources directly in the charitable programs they operate. Using a museum as an example, here are some examples of qualifying expenditures:
• Construction and Maintenance: Large expenditures like constructing new museum buildings or renovating existing structures to enhance visitor experiences.
• Exhibit Development: Costs associated with designing, creating, and installing new exhibits. This includes purchasing artifacts, artworks, display cases, and interactive technologies.
• Utilities and Maintenance: Expenses for utilities (electricity, water, heating) and routine maintenance of the museum's facilities.
• Office Equipment: Small expenditures such as buying computers, printers, and office furniture for administrative staff who support the museum's operations.
• Salaries and Wages: Compensation for staff members directly involved in the museum's operations, including curators, educators, exhibit designers, and administrative personnel.
• Staff Training and Development: Costs for professional development programs to enhance staff skills and knowledge, ensuring they can effectively manage and present museum collections.
• Technology and Infrastructure: Investments in technology infrastructure, such as website development, ticketing systems, and digital archives.
• Marketing and Promotion: Efforts to raise awareness of museum programs and events, including advertising, public relations, and digital marketing campaigns.
Tax Implications
Private Non-Operating Foundations (PNOFs)
PNOFs have lower deductibility limits for donations: cash contributions are deductible up to 30% of adjusted gross income (AGI), and non-cash donations are limited to 20% of AGI, typically valued at the donor’s cost basis, except for publicly traded securities. All private foundations, including PNOFs, are subject to excise taxes on self-dealing, jeopardizing investments, and taxable expenditures. Additionally, PNOFs are subject to an excise tax on net investment income at a rate of 1.39%. This tax is assessed on standard investment income, such as dividends, interest, and capital gains, less any investment-related expenses.
Private Operating Foundations (POFs)
POFs offer more generous tax-deductibility limits for donations. Cash contributions are deductible up to 60% of a taxpayer’s AGI, while non-cash donations are deductible up to 30% of AGI and typically valued at their fair market value. These favorable deductibility limits often motivate founder-philanthropists to seek POF status. Like PNOFs, POFs generally pay an excise tax on net investment income at a rate of 1.39%. However, some POFs may be exempt from this tax if they meet specific criteria, such as maintaining strong public support, adhering to governance practices that prevent conflicts of interest, and ensuring that the control of the POF is separated from its principal donors.
Similarities Between Private Non-Operating and Private Operating Foundations
Despite their differences, private non-operating and private operating foundations share several commonalities, rooted in their philanthropic missions and regulatory frameworks:
Charitable Purpose
Both types of foundations are dedicated to philanthropic purposes, aiming to support and advance various charitable causes. This shared mission underpins their existence and drives their activities, ensuring that their efforts are directed towards making a positive impact on society. Whether through grant-making or direct program implementation, both types of foundations strive to address societal needs and contribute to the common good.
Tax-Exempt Status
Both private non-operating and private operating foundations are recognized as tax-exempt organizations under Section 501(c)(3) of the Internal Revenue Code. This status provides significant tax benefits, allowing these foundations to allocate more resources to their philanthropic activities rather than to tax obligations. The tax-exempt status is crucial for their financial health, enabling them to maximize their contributions to charitable causes.
Governance
Typically, both types of foundations are governed by a board of directors or trustees. This governance body is responsible for overseeing the foundation’s activities and ensuring compliance with regulatory requirements. The board plays a vital role in strategic planning, decision-making, and maintaining the foundation's integrity and accountability. Effective governance is essential for both types of foundations to achieve their missions and operate within the legal framework.
All private foundations differ from public charities in that their boards may consist of a close group of individuals, including family members, business associates, and major donors. In contrast, public charities are required to have a diverse board of directors, representing a broader cross-section of the public. This diversity helps ensure that the charity operates in the public interest and is free from conflicts of interest.
Additionally, private foundations can be funded by a small group of donors, sometimes even just one, and are often closely held and closely funded. This is in stark contrast to public charities, which must receive funding from a diverse pool of public donors. Public charities rely on contributions from a broad base of supporters, which helps maintain their public support status and ensures that they serve the public good.
Conclusion
Private non-operating foundations and private operating foundations each offer unique approaches to philanthropy, tailored to different charitable objectives and operational preferences. Non-operating foundations excel in grant-making and supporting a broad range of charitable organizations, while operating foundations thrive in directly implementing and managing charitable programs. Understanding the distinctions and similarities between these two types of foundations is essential for philanthropists. This knowledge enables them to make informed decisions that align with their philanthropic goals and maximize their impact on society.
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