Over the years, we have found the public support test to be one of the least understood topics by nonprofits, especially smaller organizations. But, it is absolutely critical to understand how it works, lest your nonprofit lose its public charity status.
Public Charity vs. Private Foundation
Before getting into the specifics of the public support test itself, it helps to step back and talk briefly about private foundations vs. public charities. Both are considered tax-exempt 501(c)(3) nonprofits, but the requirements regarding donor support are very different. Private foundations are typically closely-governed nonprofits, and the purpose of most private foundations is to fund the work of public charities. In addition to being allowed to have close control, private foundations also can be closely funded, even by just one individual. Many family foundations are governed and funded by members of a single family.
Public charities, on the other hand, are expected to have both diverse control and diverse funding. On the control side, the IRS expects charity boards to have a majority of members who are unrelated by blood, marriage, and outside business ownership. As for funding sources, charities are required to have a broad base of public support. That is where the public support test comes in.
There Is More Than One Public Support Test
One reason this area causes so much confusion is that there is not just one public support test. Most 501(c)(3) public charities that have to prove public support do so under one of two different tests. One is the one-third support test that applies to organizations supported primarily by gifts, grants, and contributions. The other is the gross receipts test that applies to organizations supported by a mix of contributions and revenue from exempt activities. That distinction matters because public support is not defined exactly the same way under both tests.
The Traditional Test Looks Mostly at Contributions
For organizations trying to qualify under the traditional one-third support test, public support generally consists of gifts, grants, contributions, and certain membership fees, along with government support and support from certain other public charities. This is the test most often associated with organizations that depend primarily on charitable giving rather than earned revenue. This is also the test where people usually hear about the 2 percent rule. Under this approach, support from an individual donor, company, or private foundation generally counts as public support only up to 2 percent of the organization’s total support. The rest still counts as support overall, but it does not count on the favorable side of the public support fraction. That is why a nonprofit can receive a large gift and still have a public support problem if too much of its support is concentrated in too few hands. So, under this test, the issue is not whether the charity can receive a major gift. Of course it can. The issue is how much of that gift helps the organization demonstrate broad public support.
The Gross Receipts Test Uses a Different Definition
For organizations trying to qualify under the gross receipts test, public support is broader in one sense and stricter in another. It is broader because public support can include not only gifts, grants, and contributions, but also gross receipts from related exempt activities. That is why this test is often a better fit for nonprofits such as museums, cultural organizations, and similar charities that receive a significant part of their support from admissions, tuition, program fees, or other exempt-function revenue. But it is also stricter in certain ways. Under this test, no more than one-third of total support can come from investment income and unrelated business income. In addition, gross receipts from related activities are subject to a separate limitation when too much comes from one source. That is why it is not enough to say that both tests look for one-third public support. They do, but they define qualifying support somewhat differently.
The 2 Percent Limit Is Not the Same Under Both Tests
This is probably the single most misunderstood point. For a charity being measured under the traditional one-third support test, the 2 percent limitation applies to how much support from one contributor can count as public support. That is the familiar donor concentration rule.
For a charity being measured under the gross receipts test, the limitation works differently. Under that approach, donative support from permitted sources is treated one way, while gross receipts from related activities are treated another way. The related-activity receipts from any one payer are includable only up to the greater of $5,000 or 1 percent of total support for the year. So, while both tests are trying to prevent over-concentration, they do not do it the same way. The difference is critical. A nonprofit can get into trouble by assuming the same 2 percent rule applies mechanically across the board when it does not.
Breadth of Support Is the Real Point
The public support test is not really asking whether the organization has enough money. It is asking whether the organization is supported broadly enough to be treated as a public charity rather than a private foundation. That can happen through a large number of smaller donors. It can also happen, depending on the test, through a combination of charitable giving and exempt-function revenue. But the precise definition of good support depends on which test the organization is trying to satisfy. That is why the same revenue mix may help one organization and hurt another, depending on how the organization is classified.
The Facts and Circumstances Test Is Limited
Another area that often gets overstated is the 10 percent facts and circumstances exception. If an organization is trying to qualify under the traditional one-third support test and falls short of the full one-third threshold, it may still be able to qualify under the facts and circumstances test if it has at least 10 percent public support and can show that it is organized and operated to attract public support on a continuing basis. Factors include whether support comes from a representative number of persons, whether the governing body is representative, and whether the organization is actively conducting programs that serve the public. That is not a cure-all, and it does not generally apply to organizations trying to qualify under the gross receipts test.
Large Gifts Can Sometimes Be Excluded
One additional wrinkle is the unusual grant exception. In some cases, an unusually large and unexpected contribution can be excluded from both the numerator and denominator of the public support calculation. This can matter when a very large gift would otherwise distort the organization’s support ratio and unfairly push it toward private foundation status. Whether a gift qualifies depends on several facts and circumstances, including the identity of the donor, the size of the gift, and whether the organization can reasonably be expected to attract broad public support apart from that contribution. That exception can be extremely important in the right case, especially for newer organizations or charities that receive a one-time major grant or bequest.
The Calculation Is Based on Multiple Years
Another point that nonprofits often miss is that the public support test is calculated over a rolling multi-year period, not just for one year standing alone. That means an organization can look fine in the current year while its cumulative public support percentage is moving in the wrong direction. It also means one large grant can affect the organization for years. For that reason, this is not something to think about only when Form 990 is due.
What Happens If a Nonprofit Fails
The consequences of failing the public support test can be severe. If the organization cannot qualify under another public charity classification, it may be treated as a private foundation instead of a public charity. That means becoming subject to the stricter private foundation rules. It also means donors may face less favorable charitable deduction limitations. And, because many private foundations will only make grants to public charities, reclassification can cut off access to foundation funding.
For many nonprofits, that is not just a technical issue. It is a real operational and fundraising problem.
Failing the Test Does Not Always Mean Immediate Reclassification
One point that often causes confusion is timing. In most cases, failing the public support test does not mean the organization is immediately reclassified as a private foundation for that same year. If the charity passed the test in the prior year, that result generally carries forward for one additional year. As a result, a single bad year will not usually trigger an immediate change in status.
That said, two consecutive failures are a different matter. Once that happens, the organization can lose public charity status.
There is an important wrinkle for newer organizations. A charity that has been operating under its initial advance public charity period may not have the benefit of that same extra cushion once it reaches the first year in which actual public support must be demonstrated. If it fails at that point and does not qualify under the facts and circumstances test where applicable, the change in status can begin with that year.
Wrapping Up
The public support test is critically important. But one of the biggest mistakes nonprofits make is talking about it as though there is only one test with one set of rules. There are different ways to qualify. The limits are different. The definition of public support is different. And what counts as healthy support under one test may not count the same way under the other.
That is why nonprofits need to understand not only whether they are passing, but which test they are trying to meet and how that particular test works. Otherwise, it is very easy to misread the numbers and discover the problem only after public charity status is already at risk.
Ellis Carter is a nonprofit lawyer with Caritas Law Group, P.C. licensed to practice in Washington and Arizona. Ellis advises nonprofit and socially responsible businesses on federal tax and fundraising regulations nationwide. Ellis also advises donors concerning major gifts. To schedule a consultation with Ellis, call 602-456-0071 or email us through our contact form.Â