Those unfamiliar with the term "tipping" in the nonprofit context may be wondering why as a funder we are advising how much you should leave on your restaurant bill. While tipping fortunately may not be a very common occurrence with nonprofits, it has significant consequences on the legal/tax status for an organization that may be in jeopardy of being tipped (and ultimately its ability to attract funding). As the majority of our grantees are public charities who are responsible for maintaining their tax-exempt status, Meyer wants our organizations to be aware of this issue — and discuss ways to avoid the unintended consequences of tipping.
What is tipping and why does it matter to Meyer grantees?
One of the key elements reviewed for 501(c)(3) determination (the most common tax exempt classification by the IRS) is an organization's sources of revenue and diversity of its funding. A 501(c)(3) organization is then further classified as a private foundation or a public charity. A public charity follows more flexible IRS rules since it's considered to be more accountable to the public as a widely, publicly supported organization. This is in contrast to private foundations, most of which have just a single source of funding and therefore more strictly monitored by the IRS.
Tipping occurs when a large contribution from a single donor to a 501(c)(3) public charity causes that organization to fail the IRS public support test and is therefore "tipped" out of public charity status. The organization will then become reclassified by the IRS as a private foundation and will need to comply with more restrictive and complex legal and financial regulations.
The other huge impact of being tipped is that the organization may then face losing future funding. Since it's more difficult for funders to give funds to private foundations (many foundations only give grants to organizations with public charity status), fundraising and receiving grants could become significantly more challenging for the nonprofit.
What is public support and how does it get calculated?
The IRS requires a public charity to annually submit a Form 990 — which provides the organization's financial information — which is then made available to the public. As part of this form, the organization needs to calculate both its public support (income from the public) and total support (income from tax revenues, membership fees, government grants and contracts, gifts and grants from private foundations, public charities, individuals, corporations, etc.) over a five-year period (current year and prior four years). While there are complex rules around calculating public support percentages and the different options for doing so (additional information can be found via the resource list at the end of this article), it is crucial to maintain this support to ensure continued public charity status.
How does a nonprofit avoid tipping?
First and foremost, a nonprofit should be highly aware of its overall funding situation and the portion of its income derived from the public. Do you have a low public support percentage (or barely meeting the 33.3 percent threshold)? Are you currently receiving funding from just one or two sources? Are you expecting to receive a significant grant from a private foundation soon — how will this impact your overall revenue?
The most important thing that a nonprofit must do to avoid tipping is to diversify their funding to include substantial public support. That means securing funding from multiple sources and more than one private foundation, such as government funding, donor-advised funds and of course the general public/individuals. While this may be easier said than done for some organizations — particularly for new or smaller organizations with limited fundraising capacity — this will be key to maintaining the organization's status and overall long-term financial health. In certain cases, a potential large grant by a funder may ultimately need to be restructured (decreasing the grant amount, changing payout timeline, etc.) so as not to tip the organization.
An alternative option used in some circumstances is for an organization to apply to the IRS to classify an award as an "unusual grant." While this is a somewhat complex process, getting an "unusual grant" ruling (which completely omits a single substantial grant from the organization's public support test) may be a possible solution.
While nonprofits operating with small budgets and/or with a narrow base of funding, as well as newly formed nonprofits with seed funding, may be more vulnerable to tipping, any public charity can be tipped if their funding is not carefully and regularly monitored.
Below is a list of resources as a starting point. Organizations concerned about being at high risk for tipping are strongly recommended to consult their accountants, tax advisors or lawyers with nonprofit expertise for further guidance.
- IRS Schedule A (Form 990 or Form 990-EZ) Public Charity Status and Public Support and IRS Instructions for Schedule A
- Information about public support test from the Foundation Center
- Council on Foundations - Foundation Basics