Question: What happens to a nonprofit corporation's IRC Section 501(c)(3) charitable tax-exempt status at the conclusion of its five-year advance ruling period?

 The short answer to the question is that nothing happens to a corporation's Section 501(c)(3) status at the conclusion of its five-year advance ruling period. Only its status as a public charity might change.

 There are two types of Section 501(c)(3) corporations - private foundations and nonprivate foundations (public charities). The difference is based on a corporation's sources of financial support.  Private foundations are generally supported and controlled by a few persons. Public charities generally receive funds from several sources. Community-based organizations prefer public charity status. One reason is that many private foundations will not make grants to other private foundations. Another is the extra reporting, taxation, and restriction on activities to which private foundations are subject.

 At the time of its application for Section 501(c)(3) status, a corporation requests a ruling on whether it qualifies as a public charity. A corporation which has completed a tax year of at least eight months can request a final ruling. A corporation which is controlled by a public charity can also request a final ruling (often known as a support corporation). Other corporations must obtain an advance ruling that they will be treated as a public charity during their first five tax years. Within 90 days after the end of the corporation's fifth tax year, it must submit information on IRS Form 8734 which the IRS uses to make its final ruling. Most community-based organizations report their sources of support annually on IRS Form 990, Schedule A. IRS Form 8734 is similar to the Schedule A.

 There are two numerical formulas that determine whether a corporation qualifies as a public charity (support corporations qualify based on their relationship with a public charity, and not based on their own sources of financial support). IRC Section 509(a)(1)/170(b)(1)(A)(vi) requires that at least one-third of the support come from public sources, including government grants, member dues, and grants from other public charities. Individual contributions and private foundation grants are also public support, but only up to 2% of total support from any one source. Earned income from fees or other charges, such as rents from low-income housing, are entirely excluded from the calculation.

 The IRS has discretion to reduce the one-third requirement to as low as 10% public support (the "facts and circumstances" test). To meet this test, the corporation must demonstrate that it has a program for solicitation of funds from public sources, that its board of directors is representative, that its programs are available to the public, and that its activities are likely to appeal to persons having a broad common interest or purpose.

 If it meets the other requirements of the facts and circumstances test, a corporation with no government or public charity funds and as few as five private funding sources (5 x 2% = 10%) might still qualify as a public charity.

 IRC Section 509(a)(2) requires that more than one-third of the support come from public sources, but it includes earned income as public support up to the greater of $5,000 or 1% of total support from any one source. Individual contributions and private foundation grants which exceed $5,000 and are more than 2% of total support are included in total support but are not counted as public support. The IRS has no discretion to reduce the one-third requirement. Also, not more than one-third of the support can come from investment income and unrelated business income. For these and other reasons, most community-based organizations prefer to qualify under Section 509(a)(1).

 Under both formulas, unusual (large, nonrecurring) grants are excluded, as are capital gains from the sale of assets.

 At the end of the five-year ruling period, these formulas are applied to the aggregate support received. Thereafter, each year they are applied to the aggregate support received in the immediately preceding four years. Thus, the term "final ruling" is a misnomer. A corporation might lose its status as a public charity in any year after its first five years. However, a corporation which qualifies under either formula in the current year based on its support received in the immediately preceding four years automatically qualifies in the immediately succeeding tax year. For example, a corporation which qualifies in 1998 based on its income in 1994-1997 automatically qualifies as a public charity in 1999.

 What happens to a public charity which is reclassified as a private foundation, whether at the end of the five-year advance ruling period or at a later time? First, until the corporation receives notice of reclassification, its donors generally are treated as having provided support to a public charity, not a private foundation. Second, the corporation might have to pay certain retroactive taxes applicable to private foundations, and must thereafter annually file IRS Form 990PF. However, the corporation can apply for a new five year advance ruling period. If the IRS grants the request, the corporation will be treated as a public charity during the five year period, although it must still file Form 990PF instead of Form 990.

 The new five-year period begins on the first day of the tax year immediately following the date of the new application. Thus, a calendar year corporation which applies in June would begin its five year period the following January 1. To start the five year period sooner, the corporation could change to a July-June fiscal year; the five-year period would then begin on July 1. For most nonprofit corporations, a change in fiscal year can be made once every ten years without IRS approval or payment of a filing fee. The corporation must file a Form 990PF for the short tax year.

 In its application, the corporation must demonstrate how its activities, especially its fundraising activities, will be different than in the past. The corporation will probably want to seek public charity status under Section 509(a)(1), and will most likely rely on the facts and circumstances test. Thus, its application should provide the information required by this test.

 Direct Response is a regular feature addressing commonly asked legal questions from community-based organizations. We encourage you to submit your questions to us. Please contact Brad Caftel at caftel@nedlc.org.

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 This article is from the website of the The National Economic Development & Law Center