With the exception of schools, religious organizations, and hospitals, tax-exempt organizations are not considered public charities by default. To qualify as a public charity, a 501(c)(3) tax-exempt organization, nonprofits must pass what’s known as the public support test.
The public support test demonstrates that a certain ratio of a nonprofit organization’s total income is derived from the general public. To calculate this ratio accurately, leaders must both understand the variables that make up this calculation and accurately track their organization’s different sources of income.
In this guide, we outline the two different types of public support tests: the 509(a)(1) test and the 509(a)(2) test. We explore the variables included in the calculation and outline the key definitions and considerations that organizations must keep in mind. Finally, we share an update on proposed new rules that could affect existing public support ratios for tax-exempt organizations.
The public support test is a calculation submitted on IRS Form 990 that proves an organization is a public charity, receiving a substantial percentage of its overall support from the general public. This matters when it comes to attracting donors because individuals receive a greater benefit on their personal Form 1040 tax filings when contributing to a public charity versus a private foundation.
The public support test works based on a ratio calculated over the five years preceding the Form 990 filing. There are two components:
To pass the public support test, an organization’s public support must be over one-third (33.3%) of its total support over a five-year period. As an example, if an organization had an average gross income of $1 million, an average of $333,333.33 of this must come from public support each year. Any unusual, unexpected, or unsolicited grants may be omitted from the calculation.
In an organization’s first five years of existence, it does not have to pass the public support test to be considered a 501(c)(3) tax-exempt organization.
As noted, there are two versions of the public support test. The first, the 509(a)(1) Public Support Test, is computed on Part II of Form 990, Schedule A. It is the preferable option for nonprofits and is primarily meant for organizations that receive most of their revenue from donations and charitable contributions.
To pass this public support test, organizations must show that over one-third of their total support comes from public sources: individual/corporate donors, other charities, and government funding. This ratio is calculated over five years. However, there are a couple of caveats to watch out for.
If a single donor contributes over 2% of your organization’s total support, they are considered an Excess Contributor. These contributions are no longer counted toward your organization’s public support total, but are still counted toward your total support – therefore diluting your public support ratio. It’s important to note that contributions from other public charities and government agencies are not subject to the Excess Contributor limitations, even if they exceed the 2% threshold.
Tax-exempt organizations must report their public support ratio each year. If an organization fails the public support test one year, it still remains a public charity but must disclose it failed the test. If the organization fails the test again the following year, it may fall back on the 10% facts and circumstances test.
To pass this test, an organization must demonstrate that its public support ratio was above 10%, and also submit a letter to the IRS outlining its plans to work back toward the 33.3% ratio. Some organizations remain in this status for years. However, if an organization dips below 10% public support for two consecutive years, it loses its public charity status and becomes a private foundation.
Organizations that receive the majority of their support from program revenue (such as ticket sales, membership dues, or tuition payments), must pass the 509(a)(2) Public Support Test, which is computed on Form 990, Schedule A, Part III.
This test is less favorable for most organizations as it is a two-hurdle test. To pass, organizations must have a public support ratio greater than one-third and also have less than one-third of their total support come from investment income.
The Part III test, as it’s sometimes referred to, also has the excess contributor limitations that apply to the Part II test. In addition, the Part III test has the Substantial Contributor Limitation. A Substantial Contributor is an entity that has contributed more than 2% of all support since the organization’s inception. Once a contributor qualifies as a Substantial Contributor, they are no longer considered part of an organization’s public support but remain a part of the organization’s total support. They remain in this status indefinitely, which may cause long-term impacts to the organization’s public support ratio.
In addition to this, organizations must also consider the excess receipts limitation. If more than 1% of an organization’s gross receipts come from one entity, support from this entity would no longer be characterized as public support, but would remain part of the total support, lowering an organization’s public support ratio.
Accurately calculating an organization’s public support ratio demands a firm grasp of the various definitions and concepts that impact this calculation. This is a definition-driven field, and it’s important nonprofit executives understand and proactively track their organization’s public support ratio.
A key element of this is building the framework to be able to effectively track where the organization’s income comes from. An important component of this is determining whether any donors are close to becoming excess contributors. The likelihood of this can be alleviated by a concerted effort to grow the organization’s fundraising and development efforts.
Organizations should track their public support ratio on a regular basis. The ratio is calculated over a five-year period, so there is plenty of time for leaders to adapt their organization’s strategy if their public support ratio is continually trending downward.
Currently, donors may transfer funds to a Donor Advised Fund (DAF), claim a charitable contribution deduction, and then distribute funds from the DAF to a public charity. From the perspective of the receiving organization, they are receiving funds from another public charity (the DAF), and therefore do not have to consider excess contributor limitations.
Under new regulations proposed in IRS Notice 2017-73, the IRS proposes that contributions from DAFs should be treated as if they came directly from an individual donor. If adopted, these regulations could damage the public support ratio of many nonprofit organizations. These regulations would also create an additional administrative burden since nonprofit organizations would have to determine the identity of the donor who funded the DAF.
Legitimate tax-exempt organizations should not be overly concerned about failing the public support test, although it is important to approach it with precision. This is a technical field and it’s important for nonprofit organizations to have the support of an experienced nonprofit accounting partner.
At Smith + Howard, our nonprofit accounting and tax professionals are well-versed in helping nonprofit organizations accurately complete the public support test. We take an educational approach, helping our clients understand the different definitions, correctly categorize different types of revenue, and proactively manage their public support ratio over the long term.
With a rich depth of knowledge and a decades-long track record of assisting leading nonprofit organizations across the country, our team is here to help. To learn more about Smith + Howard’s services for nonprofit organizations, contact an advisor today.
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