Choosing the wrong tax-exempt structure at formation is a mistake that can take years and significant legal costs to unwind. Public charities that fail the public support test face automatic reclassification to private foundation status. Private foundations that misunderstand the five percent distribution rule rack up penalties that can reach 100 percent of the undistributed amount. Both mistakes force organizations to divert resources away from their mission and into compliance cleanup. 

The IRS doesn’t let you switch structures easily. Once you’ve filed your Form 1023 or 1024, changing course requires a new application, legal fees, and months of uncertainty. Understanding the difference between a public charity and a private foundation before you file can save you compliance headaches and protect your mission from unnecessary risk. 

Here’s what you need to know to get it right from the start. 

What Defines a Public Charity? 

A public charity raises money from the public and uses those funds to create programs that serve the public. Think food banks, youth development programs, arts councils, and community health clinics. The funding model is broad-based: donations come from individuals, corporations, grants, and events. 

Public charities aren’t required to distribute a specific percentage of assets each year, giving you flexibility to build reserves or weather economic downturns. But you still need to demonstrate that your activities primarily benefit the public, not private interests. If a significant portion of your income benefits insiders or fails to advance your exempt purpose, you risk losing your tax-exempt status. 

Public charities operate in the open. Your Form 990 is available to donors, watchdog sites like Charity Navigator and GuideStar, and the press. Organizations that understand this use their 990 as a trust-building tool, demonstrating financial health, program impact, and governance strength to current and prospective supporters. 

Depending on your size, you may qualify for a simpler filing. Organizations with average gross receipts under $50,000 can file the 990-N, an electronic postcard. Those with gross receipts under $200,000 and total assets under $500,000 may file the 990-EZ, which requires substantially less detail than the full Form 990. Larger organizations file the standard 990, which includes detailed schedules on governance, compensation, and program accomplishments. Even with the above thresholds, there may be other reasons to file one form vs. another that should be discussed with your tax advisor. For example, you may qualify to file the 990-EZ, but perhaps filing the standard 990 provides better donor opportunities.  

Public charities don’t pay excise tax on investment income. However, if your organization earns income from activities unrelated to your exempt purpose, such as selling merchandise, renting property, or running advertising, you may need to file Form 990-T and pay unrelated business income tax (UBIT). 

What Defines a Private Foundation? 

A private foundation takes a different approach. It’s typically funded by a single source: a family, an individual, or a private endowment. Instead of running public programs directly, most private foundations make grants to other organizations or fund scholarships that benefit the public. 

Private foundations face mandatory spending requirements. You must distribute at least five percent of your investment assets each year. That five percent can go toward grants or qualifying operating expenses, but the IRS definition of “qualifying” is narrower than most boards realize. Direct charitable expenditures and approved grants count. General administrative salaries, overhead, and investment management fees typically don’t. If you fall short, the IRS assesses a 30 percent excise tax on the undistributed amount. If you don’t correct the shortfall within a specified period, the penalty jumps to 100 percent. There are opportunities to establish set aside funds under a private foundation for certain major projects. This is a planning opportunity to be discussed with your tax advisor. 

Private foundations also face self-dealing restrictions that public charities don’t encounter. Self-dealing occurs when a foundation engages in financial transactions with disqualified persons, including substantial contributors, foundation managers, and their family members. Even a loan to a board member at market rate or paying fair market value rent to a foundation trustee can trigger penalties. The IRS doesn’t consider intent. The transaction itself is the violation. 

Your internal documents stay private. Unlike public charities, private foundations aren’t required to disclose financials to the public beyond their annual tax return. 

Every private foundation must file the full Form 990-PF, regardless of size. There’s no streamlined option. The 990-PF also includes a 1.39 percent excise tax on net investment income. 

What They Have in Common

Both public charities and private foundations are exempt from federal income tax. Donors who contribute to either type of organization can claim a tax deduction, though deduction limits may differ. Both may be required to file Schedule B for contributions.  The reporting requirements are similar, in terms of the financial information for each tax filing as well as exempt-purpose reporting and board member listings. 

Three Red Flags Your Structure Might Not Fit Anymore

Even if you made the right choice at formation, funding models and donor bases shift. Here’s how to know if your current structure still works: 

• You’re classified as a public charity, but most of your funding comes from one or two donors.  The IRS measures public support over a rolling five-year period using either the one-third support test or the 10 percent facts-and-circumstances test. If you fail both tests for two consecutive years, you lose your public charity status automatically. You’ll be reclassified as a private foundation, inheriting the five percent spending mandate and 1.39 percent excise tax retroactively. The cost of that reclassification includes amended returns, legal fees, and potential penalties. 

• You’re a private foundation and you’re reinvesting all your earnings without making grants.  If you’re not distributing at least five percent of your assets annually, you’re accruing penalties. The IRS doesn’t accept “we’re growing the endowment for future impact” as an excuse. The distribution requirement exists every single year, regardless of market conditions or long-term plans. 

• You’re filing a 990-EZ, but your gross receipts just crossed $200,000. Once your gross receipts reach $200,000 or your total assets exceed $500,000, you must file the full Form 990. The reporting burden increases significantly. You’ll need to disclose executive compensation, board governance policies, program service accomplishments, and functional expense breakdowns. If your accounting systems aren’t prepared for that level of detail, you’ll struggle to meet the filing deadline and risk submitting incomplete information. 

Which Structure Fits Your Funding Model and Mission? 

If you’re raising money from multiple donors, hosting fundraisers, applying for foundation grants, and building broad community support, a public charity structure makes sense. If you’re managing a single large gift, spending down a family endowment, or making grants from private funds, a private foundation is the better fit. 

Public charities face transparency requirements but gain flexibility in how they manage reserves and respond to funding fluctuations. Private foundations maintain privacy and control but must navigate stricter spending mandates, self-dealing prohibitions, and excise taxes. 

The structure you choose shapes your compliance workload, your relationships with donors, and your ability to adapt when circumstances change. 

Get Your Structure Right Before You File 

Choosing between a public charity and a private foundation isn’t about what sounds more impressive on letterhead. Your legal structure needs to match your funding reality. The key is understanding the compliance obligations that come with each choice and avoiding costly reclassifications down the road. 

Rea’s not-for-profit advisory team works with organizations at every stage, from formation to growth to restructuring. We review your funding sources, your governance documents, and your most recent filings to confirm you’re structured correctly and filing the right forms. We’ll tell you if your current setup doesn’t match your funding model, if you’re at risk of failing the public support test, or if you’re leaving compliance gaps that could trigger penalties. 

Reach out to Rea’s not-for-profit team. We’ll assess your formation documents, your donor base, and your filing history to confirm you’re on solid ground.