The Trouble with Tipping: How Big Donations Can Affect Public Charities

Have you ever heard the term "tipping" in relation to charities?  It’s a crucial concept that can impact a nonprofit’s charitable status, especially when big donations are involved. Let’s break it down.

What is Tipping?

In the nonprofit world, "tipping" is when a charity no longer passes the public support test. The IRS sets specific criteria that must be met in order to separate a public charity from a private foundation. One key criteria is called the "public support test." This test ensures that a charity receives a significant portion of its funding from the general public, rather than from a small group of wealthy donors. If a public charity fails the public support test for two consecutive years, then the charity “tips” over into being classified as a private foundation.  

Why Does Tipping Matter?

If a public charity is reclassified as a private foundation after failing the public support test, this could result in significant changes to the operations of the nonprofit. While reclassification does not revoke a nonprofit’s tax-exempt status, it will subject the nonprofit to new regulations, tax compliance issues, excise taxes, minimum distribution requirements and donor considerations. 

Donations to private foundations have different tax benefits, which might make donors hesitant to contribute as their deduction would be limited to 30% of the donors' adjusted gross income on their personal income tax return rather than the 50% limit that applies to a public charity. There is also the fact that for private foundations certain types of donations are deductible only to the extent of the donor's basis in the property instead of its fair market value. Finally, donor advised funds are prohibited from making grants to most types of private foundations.

What is the Public Support Test?

The public support test evaluates where a charity’s funding comes from. To pass, a charity must show that at least 33 1/3% of its support comes from public sources. This test is presented on Schedule A of the charity’s Form 990. Schedule A is used to indicate an organization's reason for public charity status and to provide the IRS with detailed information about the organization's funding sources.

There are many exceptions that could prevent some funds from being factored into the public support test that will work in favor of the charity. For example, gifts from other public charities count in full towards the public support percentage. Another beneficial exemption pertains to "unusual grants" which can be excluded from the public support calculation altogether

Are Unusual Grants Safe to Accept?

Generally, unusual grants are donations an organization received that may be significantly large and uncommon. Unusual grants are excluded from the public support and total support definitions for both of the support tests. The criteria for determining whether a grant is unusual include:

• The contribution must be substantial and from a disinterested party;

• It should be unusual or unexpected in amount; and

• The size of the grant should be large enough that it would affect the public support test.

Omitting unusual grants allows the public support percentage to remain similar to that of previous years.

What Happens After Failing the Public Support Test?

If a charity doesn’t pass the public support test, it might still pass the "facts and circumstances" test, which requires a minimum of 10% public support. The charity must show characteristics of a publicly supported organization, such as:

• Public support percentage above 10%

• Broad public participation and financial support

• A diverse and independent board of directors

• Programs and facilities open to the public

• Significant support from other public charities or governmental agencies to which the charity is accountable

Which Records Are Needed to Complete the Public Support Test?

The complexity and importance of the public support test requires the nonprofit to maintain accurate and detailed records. This includes: 

• Contributor data consistent with the organization's accounting method. 

• Information regarding the organization's revenue sources. For example, whether the revenue was exempt function income, donations, or unrelated business income.

• Historical contributor data, especially for the five-year period associated with the public support test. 

How Can Charities Avoid Tipping?

Charities can take several steps to avoid tipping:

• Diversify Funding: Relying on a mix of individual donors, grants, and earned income helps spread the risk.

• Careful Planning: If a large donation is expected, the charity can plan ahead to manage the impact on its public support ratio.

• Understanding the Rules: Charities should be familiar with the public support test and consult with a tax advisor if necessary.

While receiving a large donation is exciting, it's essential for charities to maintain their public charity status to continue serving their community effectively. By understanding the concept of tipping, donors and charities can work together to keep things running smoothly.