November 22, 2021
To be a public charity, an organization must meet one of the Internal Revenue Code (Code) Section 509(a) tests. This article focuses on the first listed test, Section 509(a)(1), and the ramifications for a charitable organization described in this section. However, to understand 509(a)(1), it is helpful to understand the alternative 509(a)(2) test.
Please note that, unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations.
509(a)(1) vs. 509(a)(2) Tests
Generally speaking, the public support tests under 509(a)(1) and (a)(2) are designed to make sure that a 501(c)(3) organization has a sufficiently broad base of support to be classified as a public charity (PC) and not a private foundation.
There are several benefits to qualifying as an (a)(1) organization rather than as an (a)(2) organization, including:
- In calculating public support, an (a)(1) organization excludes only excess contributions, as explained below, from substantial donors;
- There is an exception from the 2 percent cap, as explained below, for government and certain other 509(a)(1) donors;
- There is an alternative 10 percent “facts and circumstances” test, which acts as a “safety net” in achieving PC status but does not apply under 509(a)(2); and
- There is no separate PC calculation restriction on investment income.
The criteria for being a 509(a)(1) public charity are not included in Code Section 509(a)(1). 509(a)(1) simply refers to organizations described in Section 170(b)(1)(A)(i)-(vi).
Code Section 170(b)(1)(A)(i)-(v) includes subsections for churches, schools, hospitals, and governmental units. These organizations are treated as public charities based upon the nature of their activities.
Section 170(b)(1)(A)(vi) determines public charity status based upon an organization’s sources of support. Going forward, we will refer to 509(a)(1) when describing these 170(b)(1)(A)(vi) entities.
There are two applicable tests under 509(a)(1). First, if the entity’s public support is greater than 33.33 percent, it is automatically classified as a PC. However, even if public support is less than 33.33 percent, it may still qualify as a PC under the subjective 10 percent facts-and-circumstances test.
Because the 509(a)(1) test does not include fees from the performance of activities related to an organization’s exempt purpose (referred to interchangeably as fees, fees for services or gross receipts) in the support calculation, it is often necessary to first determine whether certain revenues, which may be labeled as “grants,” are even included in the calculation.
To distinguish whether a grant is a contribution or a fee (and therefore excluded in the calculation), the regulations state that contributions confer no/limited benefit to the donor, while fees demonstrate a primary benefit to the donor. A grant is defined as an amount given to an organization that is intended to encourage the grantee organization to carry on its exempt purpose, whereas fees serve direct and immediate needs of the payor rather than conferring a benefit upon the general public. Fees would include sales or services, while a grant would be utilized specifically to help the organization in executing its exempt purpose or mission.
Thus, a grant could state that the recipient must produce 1 million educational booklets. If the booklets are then distributed by the charity to the general public, the primary benefit is to the non-grantor (the general public), and the revenues are considered to be contributions. If the booklets are to be delivered back to the grantor, who will then decide what to do with the booklets, then the primary benefit has been provided to the payor, and the revenues are treated as fees.
‘Good’ vs. ‘Bad’ Support
As noted above, fees are not included in either the numerator or the denominator of the calculation. Described below is the treatment of contributions in computing the public support of a 509(a)(1) entity.
The testing period for the 509(a)(1) public support test is five years: the current filing year and the preceding four years. In determining whether an entity has sufficient “public support,” the calculation requires that the entity identify those contributions that are not considered “good” support. To arrive at the desired greater than 33.33 percent threshold, only this “good” money goes into the numerator, while all contributions go into the denominator.
The amount from a single donor received during the five-year testing period that exceeds 2 percent of the total support of an organization over the five-year period is not “good” money. Importantly, the regulations provide that amounts from the US government or political subdivisions (states, cities, etc.) and other 509(a)(1)/170(b)(1)(A)(vi) organizations are not subject to this 2 percent limit. These amounts are all “good” money and are included in both the numerator and denominator when calculating the public support percentage. It should also be noted that loan money received through the Paycheck Protection Program (PPP) is treated as government contributions, and therefore all “good money”, in the year the loan is forgiven.
Assume that an organization had $50 million in support over a five-year test period. Two percent of that is $1 million. If an individual, corporation or private foundation donor gave $3.5 million over the testing period, all of the donor’s contributions would go into the denominator, but only $1 million would be “good” money and be included in the numerator.
Thus, large amounts from single donors can have a very significant negative impact on the percentage of public support. However, if the $3.5 million contribution came from a US governmental unit or 509(a)(1) organization, the entire amount would be classified as good money.
Although the Code and regulations specify domestic governments, Revenue Ruling 75-435 concludes that foreign government support to a foreign charity is treated as government support for the (a)(1) test. It is unclear whether, based on the ability to exclude foreign government funding, one might consider the ability to exclude organizations made up of foreign governments, such as the United Nations, the World Bank or the International Monetary Fund. However, contributions from foreign charities appear to be subject to the 2 percent limit, unless treaty provisions provide otherwise.
This determination of public support is made on Part II of Schedule A of Form 990. If Section C, line 14 (current year) or line 15 (prior year) is 33.33 percent or more, then the organization is deemed to have sufficient public support to be deemed a PC. Thus, an organization that passes the test in one year is considered a PC for that year and the following year.
In this article, we have covered the benefits of qualifying as a PC as a 509(a)(1) rather than a 509(a)(2) organization. In addition, we looked in some detail at the mechanics of the objective 33.33 percent public support test, including an examination of “good” vs. “bad” support.
However, an organization may not meet the 33.33 percent public support test but may still qualify as a 509(a)(1) PC under the subjective facts-and-circumstances test.
For more information about the public support test for 509(a)(1) charities, contact a CPA who specializes in tax-exempt organizations.
Richard J. Locastro, CPA, JD
Partner and Director, Nonprofit Tax