Generally, ever since 1968, Section 501(c)(3) organizations have been divided into two categories for tax purposes: public charities and private foundations.
Public Charities.Public charities generally depend on outside funding. Some organizations, including churches, schools, and hospitals, are, by their very nature, considered “publicly supported.” Other organizations must pass one of two mathematical public support tests to qualify as a public charity. These tests require charities to obtain funding from many sources rather than one funding source or a small group of related funders. This requires public charities to conduct their affairs in a manner that attracts donor support.
Private Foundations.In contrast, private foundations are usually privately created and funded by an individual, a family, a company, or a small group. As a result, private foundations are generally not dependent upon the support of outside donors. For this reason, private foundations are not subject to the same degree of scrutiny from the public as public charities that depend on donor support for their survival.
Private foundations are subject to a more strict regulatory regime than public charities. There are penalties for “self-dealing” transactions, failure to distribute sufficient income for charitable purposes, holding concentrated interests in business enterprises, making risky investments, and for making certain types of expenditures. Public charities are exempt from these penalty regimes, however, public charities are prohibited from conferring excessive benefits on private interests.
In essence, when a charity passes one ofthe public support tests, it is demonstrating to the IRS that a sufficiently broad segment of the general public (non-insiders) have evaluated the charity’s performance and found it worthy of their support. As a result, Congress treats such charities as having received the public’s stamp of approval, reducing the need for the strict IRS scrutiny applied to private foundations.