Will Your Institute Pass the IRS’ P.S. Test?

By Richard L. Hendershot, C.P.A
Published on Sunday, June 01, 2008
ARTICLES

The IRS can change your nonprofit status. Why? One possible reason: failure to meet what is referred to as the "public support test," which is described below. This test applies to all nonprofit organizations that attain the age of five years, and then can be applied every year thereafter. Though the following may seem laborious, bear with me, because if your institute fails the test, your think tank's life will become exciting in a way you may not want.

Institutes that have been accepted as not-for-profit organizations are exempt under Section 501 (c) (3) of The Internal Revenue Code. The 501 (c) (3) exemption allows the organization to avoid taxes on its revenues in most cases. Furthermore, donors receive a deduction for the contributions they make.

There are two categories of exempt organizations under this section of the code - public and private. Private foundations are much less desirable since certain transactions are prohibited and the foundations pay a one to two percent tax on net investment income. Additionally, donor information is open to public disclosure.

The key to being classified as a publicly supported organization under Section 170 (b) (1) (A) (vi): the organization must "normally" receive "a substantial part" of its financial support from government units or from "direct or indirect contributions" from the general public. This is important because Section 509 of the code states, every organization qualifying for tax exemption under Section 501 (c) (3) is a private foundation unless it can demonstrate that it meets the requirements of Sections 509 (a) (1) through (3).

The general public refers to monies from individuals, businesses, other public charities and government. To meet the "substantial" support test, the organization must receive either one-third of its financial support from the general public (this is a computation discussed below), or receive at least 10 percent from public support and meet other facts and circumstance test. The facts and circumstance test is on a case-by-case basis and it's not defined within the code. However, the types of items the IRS may consider are the product/service that is actually delivered to the general public, whether the organization has broad representation on the board, how active is the organization in finding monies from multiple sources and the like. Additionally, "normally" means the organization meets the support test on the basis of a rolling four-year average.

So, how does an organization compute the financial support for the purposes of ascertaining whether or not it has met the one-third support test? The rules are located at Treasury Regulation Section 1.170a-9(e). However, before determining what constitutes permissible support from governmental units or from the general public, which forms the numerator of the support test, it is necessary to define the term "support," the denominator of the fraction.

First, income secured from the performance of particular activities that are related to the tax-exempt purpose of the organization (such as sale of the organization's publications) is totally excluded from the numerator and the denominator.

Second, support includes gifts, grants, contributions, and membership fees as well as net income from unrelated business activities, tax revenues and investment income. Support does not include gain or losses on sale of capital assets.

Third, contributions from individuals, trusts and estates, and businesses can be counted towards the one-third support test fraction only to the extent that the total of all donations from any one such source does not exceed two percent of the organization's total support. Therefore, while the total donation will be included in the denominator of the fraction, only that portion that does not exceed the two-percent limitation can be included in the numerator.

For example:

Donor A gives $ 200 Total support $22,000

Donor B gives $ 200 Limitation limit x 2%

Donor C gives $ 600 Allowable limit $ 440

Donor D gives $20,000

Investment Inc $ 1,000

Total Support $22,000

Numerator: Donor A $ 200 Public Support Calculation:

Donor B $ 200

Donor C $ 440 Numerator $ 1,280

Donor D $ 440 Denominator $ 22,000

Investment $ 0

Total $1,280 Support Test Ratio 5.8 %

In this example, the organization would fail both the one-third and 10 percent support tests.

There is one important consideration. If Donor D above was a "publicly supported organization," then the entire $20,000 would be included within the numerator. In this case, the fraction would be $20,840/$22,000 giving you a 94 percent rating. However, if the monies are passing through contributions that their donors have specifically earmarked as being made for, or for the benefit of, an organization, the monies can't be included within the numerator for the purposes of this calculation.

Organizations should monitor their public support test to ensure they do not lose their publicly supported organization status. Remember, if the organization loses its publicly-supported organization status, it does not lose its "tax exempt" status. Instead, the organization is reclassified as a private foundation and must comply with those regulations until public support can be re-established.

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