Satisfaction of one of the public support tests under Section 509(a) of the Internal Revenue Code is one way that an organization can qualify as a public charity rather than a private foundation. There are two types of public support tests under Section 509(a)(1) for organizations seeking public charity status under this Section – the “one-third support test” and the “ten percent facts and circumstances test” – both of which rely on an initial computation of public support.   There is an alternative and different “one-third support test” under Section 509(a)(2) for organizations seeking public charity status under this Section.

Prior to the redesigned Form 990 (which took effect in 2008), a nonprofit qualified under either one of the Section 509(a)(1) public support tests or the Section 509(a)(2) public support test for the current year and the subsequent year only if its public support ratio over a measurement period of the four years preceding the current year satisfied the applicable public support test as computed with a cash method of accounting. With the redesigned Form 990 came new rules that affected 501(c)(3) tax-exempt organizations for tax years beginning in 2008 or later, and those with advanced ruling letters that expired after June, 8, 2008. In filing the redesigned Form 990, these organizations are also required to fill out Schedule A which has changed some elements of the public support tests:

• The measurement period is extended to five years (current year plus the four years immediately preceding); and
• The accounting method for computing public support must be the same method used in keeping the organization’s books and preparing its annual Form 990 return.

The redesigned Form 990 also eliminated the advance ruling requirement for nonprofits seeking 501(c)(3) tax-exemption (note that the printed Form 1023 has yet to reflect this change). Now, if an organization is granted 501(c)(3) tax-exempt status, the IRS will not evaluate the actual public support received for the organization’s first five-years. This is not, however, a permanent “free pass” because in the sixth year, the organization will need to show it satisfied the public support test based on years two through six in Schedule A of its Form 990. Failure to do so will result in a change of organization’s status from a public charity to a private foundation.

In general, an awareness of these changes is important not only for proper compliance but also to address any related concerns.  For example, organizations that use an accrual method of accounting for keeping its books and preparing its Form 990 must be sure to re-calculate their support for 2007 and prior years (due to the previous requirement to use a cash method of accounting).

Additionally, as Quarles & Brady LLP points out, “a change in the information reported on the schedule [due to re-calculations to comply with the required accounting method] could result in significant changes to the organization’s public support percentage.” For example, a $500,000 grant from a private foundation paid in equal installments over five years will be reported as $100,000 each year it is received under the cash method, but $500,000 in the year approved under the accrual method. Thus, conversations about the public support tests could lead to consultations with tax attorneys about which accounting method – cash, accrual, or other – makes the most sense for an organization.

Finally, similar to the concern about the five-year grace period with newly formed public charities, the two year qualification as a public charity should not invite ignorance about whether the organization will meet the public support test after the two year period. Although failing to satisfy the public support test in the year following the reporting year will not change an organization’s public charity status, failure to satisfy the public support test the next year when the organization must re-qualify will tip the organization into private foundation status.

The tax-exempt organizations update from Quarles & Brady LLP on changes to the public support tests, “PUBLIC SUPPORT CALCULATIONS: IMPORTANT CHANGES IN STORE IN THE 2008 FORM 990,” is available here.

Adler & Colvin provides an informative summary on the public support tests, “QUALIFYING FOR PUBLIC CHARITY STATUS: The Section 170(b)(1)(A)(vi) and 509(a)(1) Test and the Section 509(a)(2) Test,” available here.

The IRS publication on the final and temporary regulations regarding the redesigned Form 990 (released on Sept. 9, 2008) is available here.

For additional information, please view the previous posts “IRS Eliminates Advanced Ruling Process,” as well as a summary of the public support tests prior to the release of the redesigned Form 990, “Public Support Tests – Public Charities.”