Understanding Private Not-for-Profit Organizations

Key Takeaways

• Private not-for-profits, or private foundations, are primarily funded by individuals or small groups rather than the public.
• These organizations are subject to stricter IRS regulations and must meet specific payout requirements.
• They do not have owners; instead, they are governed by boards or trustees and are accountable to the IRS and their charitable mission.
• Myths about nonprofits often confuse private foundations with public charities and misrepresent their goals and operations.
• Not-for-profits, including private foundations, may generate revenue, but all earnings must support their exempt purposes.
• Clear legal distinctions exist between private not-for-profits and other entity types, particularly regarding taxation, governance, and funding sources.

What does private not-for-profit mean? Private not-for-profit refers to a private foundation that is engaged in social or public benefit activities and is registered as such with the IRS. It derives its revenue from a small group of donors.

Not-for-Profit Meaning

A not-for-profit is an organization that is engaged in some activity of public benefit without any intention of earning income for its owners. All the profits and donations of a not-for-profit organization are used in operating the organization as per its objectives (i.e., charity or public service).

Most not-for-profit organizations are exempt from tax due to their contribution to the well-being of the society. Donors may also be able to claim deductions for donations made to not-for-profit organizations.

Different nonprofit organizations have different objectives and may employ different strategies to obtain them. For instance, a nonprofit educational institution may charge fees and then use that money to impart education. It may also use the money to pay salaries to the faculty, conduct research, and maintain the campus. In other words, the institution puts back all the money earned into educational activities.

On the other hand, the primary objective of a for-profit school is to earn profits for its owners. It charges you fees but instead of putting the money back into education, it may spend the money on marketing, recruiting, and other activities. A for-profit school is answerable to its stockholders rather than its students.

The IRS differentiates between various nonprofit organizations based on the involvement of the public in their operations. Thus, nonprofit organizations can be broadly grouped into two categories:

• Public nonprofit organizations or public charities
• Private nonprofit organizations or private foundations

Common Myths About Not-for-Profit Organizations

There are several misconceptions about not-for-profit organizations, particularly private not-for-profits. It's important to separate fact from fiction to better understand how these entities operate:

• Myth: Not-for-profits can’t earn a profit.
  While they are mission-driven and do not distribute profits to owners or shareholders, not-for-profits can generate revenue. The key is that all revenue must be reinvested in furthering their charitable or public-interest mission.
• Myth: Not-for-profits are run entirely by volunteers.
  Many not-for-profits, including private foundations, have paid staff and professional leadership teams. These individuals are often essential for fulfilling the organization’s complex operational and regulatory responsibilities.
• Myth: Private foundations serve only the interests of their founders.
  Although they are often funded and led by families or individuals, private not-for-profits must meet IRS standards and pursue charitable activities to retain tax-exempt status.

Public Nonprofit Organizations or Public Charities

When we talk about nonprofit organizations, public charities come to mind. A nonprofit organization must meet certain conditions of the Internal Revenue Code (IRC) to qualify as a public charity or a public nonprofit organization.

While organizations like churches, hospitals, and orphanages are common examples of public charities, the IRC definition is quite broad and includes various other types of organizations. Entities like educational and medical research institutions also fall under the category of public charities and are usually known as statutory public charities.

Some charitable organizations may play a supportive role and help other public charities carry out their programs or reach out to the public.

Unlike private foundations, the board of directors of public charities must be diversified enough to represent public interest. Additionally, more than 50 percent of directors must be non-employees and unrelated to the organization.

To qualify as a public charity:

• At least 33 percent of the organization's income must be from the government, small donors, or other charities.
• The funds of the organization must be used in activities directly associated with its initiatives.

Previously, nonprofit organizations had to wait for a certain period of time before being approved as public charities by the IRS. However, as per current provisions, a new nonprofit organization can also get approval as a public charity if the IRS is convinced that it can garner enough public support.

Public nonprofit organizations are usually less regulated than private foundations. However, due to their reliance on public contributions, they are more open to public scrutiny.

Private Nonprofit Organizations or Private Foundations

By default, the IRS considers a nonprofit organization to be a private foundation unless it applies for and is approved as a public charity.

Private foundations need not have outside directors. They can be controlled by friends and family. The trustees or directors manage the funds of such organizations. Most of the private foundations fund their operations through investment income.

Private foundations usually get their funds from a limited number of donors and are subject to a higher degree of restrictions than public charities. For example, private foundations must pay out a minimum of five percent of their investments every year and can't make certain types of risky investments. Also, most of the contributions made to private foundations are not tax-deductible for donors.

Private foundations must be careful in complying with regulations since any failure can result in serious penalties. However, private foundations are not accountable to the public and can operate quite independently.

Ownership and Accountability in Private Not-for-Profits

One unique characteristic of private not-for-profit organizations is that they do not have owners. Unlike for-profit entities, no individual or group holds equity or receives profits. Instead:

• Governance Structure:
  These entities are governed by a board of directors or trustees responsible for ensuring the foundation fulfills its mission. Board members have fiduciary duties to act in the best interest of the organization.
• IRS Oversight:
  The Internal Revenue Service monitors private foundations closely, requiring detailed reporting through Form 990-PF. This includes information about grants, investments, and administrative expenses.
• Asset Lock:
  Assets of private foundations are permanently dedicated to charitable purposes. If the organization dissolves, its assets must be distributed to other tax-exempt entities.

Setting Up a Not-for-Profit Organization

Almost anyone can establish a nonprofit organization following a few simple rules:

• For tax exemption, you must request the IRS for section 501(C)(3) status.
• You can also choose to incorporate your organization.
• Once registered, you must comply with the relevant state agency.

Private Not-for-Profit vs. Public Charity: Key Differences

When deciding on a structure for a not-for-profit, it's essential to distinguish between a private not-for-profit foundation and a public charity:

Choosing between the two depends on funding plans, governance preferences, and the type of charitable work intended. An attorney on UpCounsel can help evaluate your goals and ensure compliance with relevant legal standards.

Frequently Asked Questions

1. What is the main difference between a public and private not-for-profit?
   A public not-for-profit relies on public donations and has a broader board, while a private not-for-profit (foundation) is typically funded by a few individuals and has more IRS restrictions.
2. Can private not-for-profits earn income?
   Yes, but all income must support the organization’s charitable purpose. Profits cannot be distributed to individuals.
3. Who owns a private not-for-profit organization?
   No one. These entities are not owned by individuals but are managed by a board of directors or trustees.
4. Are private foundations tax-exempt?
   Yes, if they qualify under IRS Section 501(c)(3). However, they must meet specific operational and reporting requirements to maintain this status.
5. Can a private not-for-profit pay its directors?
   It can compensate directors for their services, provided compensation is reasonable and complies with IRS guidelines.

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