501c3 questions (was something else)

[Rich Steele]

I am catching up on old emails.  I wanted to respond to some of the tax
issues asked on board.osgeo.org.  There's a lot of boring legal stuff in
here, so go ahead and crack a beer first if you want to read it all.

-Rich

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On Feb 13, 2006, at 15:15, Frank Warmerdam wrote:

> On the issue of "legal framework", I think we have a major decision
> to make on whether to be a 501c3 corporation (ie. charitable).  I am
> concerned that doing so may bind our hands to a significant degree on
> the things we can spend money on, and that it may be difficult getting
> one third of our finances from sources that would qualify as the
> "public" as required to my understanding.  

As has been discussed, qualifying as a "public charity" under 501c3
generally requires broad public support, which means 1/3 of donations
come from dispersed sources.  Any individual donations are capped at 2%
of the total.  So, when computing the 1/3 test, the amount by which an
individual donation exceeds 2% of the total does not go into the
numerator, but it does go into the denominator.  So, for example, if
Autodesk donated $150,000, and there were $50,000 in small donations
from many other sources, the calculation would be:

Cap:       2% x $200,000 = $4,000 (so only $4,000 of ADSK's $150,000
goes into the numerator).
  
1/3 Test:  54,000/200,000 = 27%  FAIL :(

The effect of this rule is that that significant financial support given
by an individual or a corporation could jeopardize the organization's
status as a public charity.

The good news is:

- many charities are initially bootstrapped by a sugar daddy, so the IRS
allows you to go in with a good faith budget and gives you five years to
get your fundraising in order to the point where you can meet the public
support test;

- there is also a 10% (instead of 1/3rd) test if you can show that your
foundation has broad public support through other "facts and
circumstances".  This is the fallback position; and

- if you fail, you don't lose your 501c3 status, you just get
reclassified as a "private foundation", which subjects you to some
excise taxes and burdensome reporting requirements.  Donations to the
organization are still tax deductible, however.

> As well 501c3 status may tie our
> hands in a variety of other regards, such as providing tangible
> benefits to sponsors in return for contributions.

Not sure if I'm reading this correctly.  There is no requirement that
tangible benefits be provided to sponsors in return for contributions.
Quite the opposite actually.  Tangible benefits as quid pro quos for
contributions are actually NOT tax deductible to the extent of that
tangible benefit.  The foundation thus should not provide overt benefits
to contributors, but rather is generally required to have a charitable
purpose.  Fortunately, other open source foundations have laid the
groundwork and the IRS now accepts that offering open source software
free to the public is a charitable purpose.

If you are asking the converse -- ie., we wouldn't be able to provide
tangible benefits to sponsors -- the answer is that we could, but the
contribution from the sponsor *might* be taxable to the foundation as
"unrelated business income tax" (UBIT).  I would have to look into this
in more detail if you gave me more details on the types of arrangements
you would foresee, but the basic rule is that UBIT is designed only to
ensnare profit-seeking activities not related to organization's exempt
purposes.  So if a corporation donated cash as a bounty to develop a
feature to include in the next release of an OSGEO product, that would
probably be OK.  And simple "sponsorships" are OK under IRS regs if
there is no substantial return benefit other than recognition of the
sponsor (logo on the website, etc.)

> My understanding is that the primary benefit of 501c3 status is that
> US private individuals can donate money to the foundation and treat
> it as charitable for tax purposes.  But that this does not benefit
> citizens of any other country, nor businesses who can just treat any
> contribution as a business cost.   Is that right?

This is pretty much right.  501c3 affects only US tax payers (there are
some funky tax treaty rules that apply to Canadians, but only for
certain funds).  Deductibility of funds under local tax regimes is
determined by that tax regime, not the US.  By the same token, I cannot
deduct amounts I would donate to a German charity.  This is why the big
public charities all have local offices in each country to accept local
donations (i.e., the American Red Cross, the German Red Cross, etc.).
So we could set up local charitable adjuncts in each country, but that
would get cost prohibitive in a hurry and is beyond the scope of our low
overhead organization.

Depending on the circumstances, businesses in all likelihood would still
be able to take a business expense deduction for any contributions to
the foundation, so you are correct that 501c3 status may not matter much
for them.

One primary benefit of 501c3 you may be overlooking is that many other
private foundation 501c3's and government entities will only donate to
501c3's.  So if we think we might be eligible to receive grants from
other charities or foundations or governments, 501c3 could provide an
advantage there.

> > I claim that we aren't aiming for substantial amounts of money in
> > personal contributions to support the foundation so 501c3 status
> > will not be a significant benefit.

I can't say this is true or not.  What is true in year 1 may not be true
in years 2-5.  Remember you get five years to get it straight.

On Feb 13, 2006, Allen Doyle wrote:

> Well, I am not a laywer... 

Thank goodness for that :-)

> I think there are subtleties in the
> funding rules for a 501c3 that I am not entirely clear on myself. In
> particular, I'm not sure the 1/3 public support rule is not the only
> way to continue to qualify. There may be some way of also including
> exempt-purpose income and if the funds come from other 501c3's then
> those funds themselves count as public support. 

I think what you may be referring to is that within the 1/3 support
test, contributions from government or other publicly supported
organizations count in both the numerator and denominator when computing
the fraction.  So if you got money from the hypothetical National Center
for Cool Technology, itself a publicly supported organization, this
really helps the public support calculus.

> The obvious attractions of operating as a non-profit are (a) the
> rules on financial disclosure and (b) the lack of stock (i.e. there
> is no "ownership" of the assets).

The lack of stock is a function of the Delaware non-stock corporation,
not the 501c3 status.  We already have no stock and no ownership of
assets by virtue of the corporations code.  501c3 status won't add to or
detract from this.

> I think the only easily acceptable alternative would be a 501c6 but
> that has a different set of baggage, namely that there probably need
> to be corporate members.

There is some baggage there, mostly that there is a "line of business"
requirement.  A 501c6 is really a trade association.  Eclipse is a
501c6, but that is really an industry consortium with mostly corporate
members like IBM.  A more plausible alternative is a 501c4, which is a
community benefit organization.  Donations to this entity would not be
tax deductible, but the entity itself would be tax exempt.  501c4's have
more latitude in what they can do (i.e., political lobbying).  For
example, the Sierra Club is a 501c4, because it takes political
positions.
 
> A possible alternate approach would be to set up a for-profit
> corporation that is owned 100% by a non-profit. The non-profit would
> thus control the assets but would not have to deal with most of the
> money. It could be the source of all incoming donations and could
> probably earmark 2/3 of those donations for use by the projects and
> 1/3 for use by the for-profit corporation for overhead. Any corporate
> donations could go straight to the for-profit corporation and not
> bump up the non-profit's gross revenue, thus it would be easier to
> deal with the support test. If we were to go that route, I would
> suggest that the for-profit corporation's articles of incorporation
> and bylaws require the same level of financial disclosure required of
> a non-profit.

There may be other things that are possible, like having a 501c4 with a
501c3 affiliate.  But honestly, with our limited budget and manpower at
this stage, I can't see us hiring a bunch of tax and corporate attorneys
to conjure up structures, and then have accountants try to track it all.
Mozilla has a more complicate structure, but they are well funded with
many many employees to think about this stuff.
 
Happy to talk more about this or answer additional questions.

-Rich