IRS Relaxes Qualification Rules for Public Charities

Client Advisory

October 11, 2011

On September 7, the Internal Revenue Service finalized regulations (initially proposed in 2008) that change the way new tax-exempt organizations are classified, and the way existing tax-exempt organizations maintain their classification. All public charities will be required to calculate their support over a five-year rolling period, instead of over four years under prior law, and will have less flexibility than was previously the case in reporting certain financial data. New organizations wishing to qualify as public charities will be able to achieve that status immediately (subject to the condition that they could lose it after five years) rather than being treated as merely provisional public charities until they could conclusively demonstrate their qualifications in five years.

The tax law recognizes a number of different types of charitable organization, but one of the most important distinctions is between “public charities” and “private foundations.” Both types are recognized as charitable under Section 501(c)(3) of the tax code, and therefore generally are exempt from income tax, and both are eligible to receive tax-deductible contributions. The fundamental difference between them is their sources of support. Public charities receive support from a wide spectrum of the public, while private foundations receive the bulk of their funding from one individual or family. Congress has long imposed extra restrictions and excise taxes on private foundations. For instance, unlike public charities, private foundations are required to make annual distributions of certain amounts, and are prohibited from holding substantial positions in for-profit companies. The new rules substantially revise the way tax-exempt organizations calculate their “public support percentage” and thereby change the procedures by which new organizations are classified as public charities or private foundations.

Under the old rules, a new organization which believed it would receive support from the public at large could request an “advance determination” from the IRS regarding its public charity status. In its application for recognition of tax exemption, the organization would include a projection of its sources of income for four years and, if those figures indicated that it would have an adequate public support percentage over that period, the IRS would issue an advance ruling stating that the organization would be provisionally treated as a public charity for a five-year “advance ruling period.” At the end of that period the charity would be required to show its actual public support percentage over the advance ruling period to demonstrate that it had, in fact, qualified as a public charity. Only at that point would the IRS issue a definitive ruling regarding the organization’s status. If it qualified as a public charity, going forward the organization would have to show that it met the public support test over a rolling four-year period.

Under the new rules, if the organization’s application for recognition of exemption demonstrates that it has a reasonable expectation of having a satisfactory public support percentage, the IRS will issue it a final determination letter to that effect. The organization will then be treated as a public charity for its first five years, regardless of its actual support over that time. However, it will be required to report its actual public support percentage for each year on its tax return. At the beginning of its sixth year, it will be required to calculate its public support percentage based on the five-year period including the reporting year and each of the preceding four years. If it qualifies as a public charity during that period, it will be treated as a public charity for the reporting year and the succeeding year. 

If, during the next year (or any subsequent year) it no longer qualifies as a public charity based on its five-year rolling average of public support, it will become a private foundation. Under the final rules, an organization which determines that it no longer qualifies as a public charity in the middle of a year will be treated as a private foundation from the beginning of that year only with respect to the requirement that it pay the private foundation tax on investment income and the rules relating to reinstatement of public charity status. The other restrictions applicable to private foundations—such as the requirement to make certain distributions and the prohibition on owning certain types of interests in businesses—would not apply until the beginning of the next year.

The final regulations also clarify that calculations of public support must be made using the organization’s overall method of accounting, and that compensation calculations must be made on the basis of the organization’s calendar year. The final regulations are effective immediately. All public charities, including organizations that had received a definitive ruling on their public charity status prior to the effective date of the new regulations, are required to use the five-year computation period to calculate public support for this and all future taxable years.

Questions regarding this advisory should be addressed to Howard J. Barnet, Jr. (212-238-8606,, Jerome J. Caulfield (212-238-8809, and Dan Pittman (212-238-8854,

Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2021 Carter Ledyard & Milburn LLP.
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