Q&A #78 – What’s the difference between a private operating foundation and a private non-operating foundation?

Question: My 501(c)(3) organization will soon be reclassified as a private foundation. We have had good success running programs, but we have not been able to satisfy the public support tests based on how we receive funding. I have heard that “private operating foundation” status may be an option. What is a private operating foundation and how is it different from a regular private foundation?

Answer: Private operating foundations are a special type of private foundation that generally devote most of their earnings and assets to running charitable programs directly, in contrast to standard private foundations that mainly make grants (technically referred to as “private non-operating foundations”). Private operating foundations are generally subject to more favorable rules than other types of private foundations, so this status is usually preferable if your organization qualifies.

There are three main benefits of private operating foundation status as compared to other types of private foundations: (1) a private operating foundation’s donors have more generous charitable deduction limits, generally on par with the limits applicable to public charities; (2) a private operating foundation is eligible to receive “qualifying distributions” from other private foundations (and a subset of private operating foundations called “exempt operating foundations” may receive these grants without the grantor foundation exercising “expenditure responsibility”); and (3) a private operating foundation is not subject to the same payout rules as standard private foundations, which generally must pay out at least 5% of their net investment assets per year in the form of grants or eligible administrative expenses.

Rather than the 5% payout rule, private operating foundations are subject to rules that ensure that a certain minimum amount is expended in furtherance of the private operating foundation’s own programs. These rules are technical and difficult to understand, but in practice are usually not hard for organizations that primarily run their own programs to satisfy. It is common for museums, libraries, and similar organizations that run their own programs to have private operating foundation status.

A private operating foundation must satisfy an “income” test, requiring that the organization spend at least 85% of its “adjusted net income” or “minimum investment return” (whichever is less) directly for the conduct of its exempt activities. The term “minimum investment return” generally means 5% of the combined fair market value of all foundation’s assets, subject to certain exclusions and modifications. Grants to other organizations do not count toward this test.

Additionally, a private operating foundation must satisfy one of the following tests: (1) the “assets” test; (2) the “endowment” test; or (3) the “support” test. Like the income test, the “assets” and “endowment” tests generally seek to ensure that most of the foundation’s assets are used directly for the conduct of its exempt activities. In contrast, the “support” test generally seeks to ensure that the organization’s revenue does not come from only a handful of donors. These tests are technical and detailed, and the IRS website provides a good overview.

Private operating foundations may satisfy these tests based on either an aggregate 4-year period or on a year-by-year basis in at least 3 out of the past 4 tax years.

Planning Tip – For any organization that will be reclassified as a private foundation, it is important to confer with your organization’s tax advisors as early as possible to begin planning for restructuring operations, governing documents and policies as necessary to comply with the private foundation rules. Notably, the Form 990-PF is vastly different and more complex than the Form 990. It is crucial to gain an understanding of the different information required in the Form 990-PF, make sure your tax preparer is experienced with this form, and adjust your recordkeeping systems to meet these new and expanded requirements. Additionally, it is generally recommended that organizations seeking private operating foundation status submit a Form 8940 (request for miscellaneous determination) to the IRS.

Lastly, be aware that private operating foundations still must comply with most of the rules that apply to private foundations. This includes the Form 990-PF requirement, the self-dealing rules, the excess business holdings rules, the total restriction on lobbying or political activities, and the tax on net investment income (however, “exempt operating foundations” are exempt from the tax on net investment income).

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