Substantial Contributors to Public Charities: With Reward comes Some Risk
Charitable organizations are created and operated for a public good and not for purposes of making a profit for investors. But there is a cost to operating and carrying out a charity’s goals. The cost is covered by a portion of the contributions received by the charity.
It’s great when a charity is the potential recipient of an unusually large contribution. It will help the charity carry out its objectives and pay the expenses necessary to do so. But such a large gift may place the organization in jeopardy of losing its tax-exempt status, as described in this article.
Impact of Substantial Contributor on Governance and Taxation
If a donor makes a large contribution to an organization, the donor may be classified as a “substantial contributor” to the charity. A substantial contributor impacts the charity in two important ways: (i) determining whether the substantial contributor is a disqualified person, and (ii) determining whether the charity meets the public support test for IRS purposes. The tentacles of a substantial contributor classification reach very long lengths.
Identifying a Substantial Contributor
A substantial contributor is any person or entity (other than a 501(c)(3) pubic charity or government entity) who contributes or bequeaths a total amount of more than $5,000 to the charity if the amount is more than 2% of the total contributions and bequests received prior to the end of the year. Substantial Contributor Private Foundation | Internal Revenue Service (irs.gov).
If an officer or director’s family member makes a substantial contribution, that officer or director is considered to be a disqualified person.
A corporation or partnership is a disqualified person if a substantial contributor has a 35% interest in the corporation (i.e., total voting power) or partnership (i.e., ownership of profit interest in partnership). In addition, if a corporation/partnership is a substantial contributor, then any person who has an interest of 20% or more therein is also a disqualified person. This includes employees of the substantial contributor.
Once a person meets substantial contributor status, she remains a substantial contributor for 10 years, even if she does not meet substantial contributor status in subsequent years.
(i) Disqualified Person
Most charities understand that a director of officer has a special relationship with the organization and are aware to avoid any conflicts of interest. In the IRS’s view, these persons are considered “disqualified persons,” such that they must recuse themselves from certain actions or decisions that may create a conflict of interest.
The IRS also considers a substantial contributor to be a disqualified person.
A substantial contributor may be on a charity’s Board, but too many substantial contributors may place the charity’s tax-exempt status in jeopardy. The voting power of a disqualified person (whether as a substantial contributor, director, officer or key person) must be a MINORITY (i.e., specifically 49% or less, of the board’s total voting power). Further, the combination of the voting power of multiple disqualified persons must be 49% or less.
Any disqualified person is deemed to have control over the Board if her voting power, in combination with the voting power of another disqualified person, exceeds the 49% rule.
This is a big deal when you combine it with the 10-year rule mentioned above.
(ii) Public Support Test
A charitable organization, unlike a private foundation, must be publicly supported. Although there are various formulas to satisfy the public support test, a commonly used formula is that at least 1/3 of annual contributions received are received from the general public.
In determining the contributions that are counted toward the 1/3 calculation, contributions received from disqualified persons is excluded. This may impact the organization’s ability to satisfy the public support test and be treated as a private foundation for tax purposes.
Consider the following simple examples for a charity that has annual contributions of $100,000.
Example 1. Satisfies Public Support Test. Of the $100,000 received, a contribution of $10,000 was from one disqualified person (i.e., a director, officer, or family member), which is 10% of the total contributions received. A portion of the contribution must be excluded from the total support test because it is greater than $5,000 and the amount is more than 2% of the total support received (i.e., $2,000). The amount excluded from the total support test is $8,000, which is the contribution in excess of 2% of total contributions ($2,000) (i.e., $10,000 minus $2,000). Total support for the 1/3 test is $92,000 (i.e., $100,000 minus $8,000). The charity satisfies the public support test because 92% of its contributions are from the general public.
Example 2. Fails Public Support Test. Of the $100,000 received, a contribution of $10,000 was from one disqualified person (i.e., a director, officer, or family member), $15,000 was from a partnership in which an officer’s family member has at least 35% income interest, and various $50,000 substantial contributions carried over from the prior 5-year period. A portion of all these contributions must be excluded from the total support test because they are more than 2% of the total support received for the year ($2,000). The amount excluded is approximately $69,000 ($10,000 minus $2,000 = $8,000; $15,000 minus $2000 = $13,000; $50,000 minus $2000 = $48,000). Total support for the 1/3 test is $31,000 (i.e, $100,000 minus $69,000). The charity fails the public support test because 31% of its contributions are from the general public.
2-Year Rule for Failure to Satisfy Test
Although it is beyond the scope of this article, the IRS provides that a public charity fails to meet the public support test for 2 consecutive years loses its public charity status and must file as a private foundation. This is important to note in order to forecast when and what amount of substantial contributors a charity can receive to safeguard its charitable tax status. 26 CFR § 1.509(a)-3(c)(1)(i).
Final Thoughts
An excise tax may be imposed for a charity that fails the public support test after two consecutive years. It is advisable for a charity to take note of who is a disqualified person and whether any substantial contributor rules may impact the charity’s fundraising effort.
A charity should work closely with their CPA to monitor the organization’s finances and charitable tax calculations.