501(c)(3) vs. 501(c)(4) Organizations

Tax News You Can Use | For Professional Advisors

Jane Ditelberg, Director of Tax Planning
Hilary Leav, Associate Director Philanthropic Advisory Services

501(c)(3) vs. 501(c)(4) Organizations

In the United States, there are many types of organizations that qualify as “exempt” from federal income tax. Section 501(c) of the Internal Revenue Code lists 28 separate types of organizations that can be exempt, each with its own set of rules for qualification. Examples include scientific or educational institutions, veteran’s organizations, chambers of commerce, credit unions, trade associations, labor unions, horticultural societies, professional sports leagues, fraternal organizations, employee benefit plans and churches. Because of the nuances in the requirements for each type, it is often not possible to tell which status an organization has just from its name, or the cause associated with it. Donors need to be aware of the categories of organizations, the types of activities they can conduct and the limits on which contributions generate an income tax deduction.

What is a 501(c)(3) organization?

Organizations that qualify for tax exemption under section 501(c)(3) are corporations, trusts, or associations operated solely for charitable, religious, educational, scientific, or literary purposes, or for the prevention of cruelty to animals, testing for public safety, or fostering of amateur sports. A 501(c)(3) organization must not serve any private interests, and if it ceases operating, all its remaining assets must be distributed for a permitted charitable purpose. 501(c)(3)s include public charities, private foundations and donor advised funds (DAFs), and community trusts, and may be either operating entities that conduct these activities directly or grant-making institutions that raise money for other organizations to use to conduct these activities. Churches, universities, homeless shelters, food banks, art museums and programs for at-risk youth are all examples of 501(c)(3) organizations.

What is a 501(c)(4) organization?

501(c)(4) is the category for social welfare organizations. The entity must not be organized for profit, and it must be operated exclusively to promote social welfare. According to the IRS, social welfare encompasses certain organizations formed for political advocacy, civic leagues that promote social benefit, local groups of employees that use their profits for charitable, educational, or recreational purposes, and certain volunteer fire companies. The National Organization for Women, the Sierra Club and the ACLU are well-known social welfare organizations, as are teachers’ unions and social groups like Kiwanis, Lions or Rotary.

Why does the category matter to the organization?

All organizations that wish to qualify as tax-exempt under section 501(c) need to apply for a determination letter that will list the type of exemption the organization qualifies for. The category of tax-exempt status impacts the organization in several ways. First, it determines the types of activities the organization can undertake. Furthermore, the status can impact what other types of organizations or activities the entity can support with financial contributions. A 501(c)(3) organization that wants to make contributions to a 501(c)(4) must make restricted donations that are used for specific charitable purposes and not for general support of the 501(c)(4) or its fundraising activities. On the other hand, a 501(c)(4) can make contributions or financially support all the activities of a 501(c)(3). The category also determines whether all of the organization’s income is exempt from tax or only certain portions of it. The net investment income of private foundations (one type of 501(c)(3) organization) is subject to tax, while the investment income of a social welfare organization (a 501(c)(4)) is not.

What about lobbying and political advocacy?

Political advocacy is one area in which permitted activities differ. For this purpose, 501(c)(3) organizations are divided into two groups – Private foundations and DAFs on one hand, and public charities on the other. Private foundations and DAFs may not engage in lobbying or political advocacy, and may not contribute to other organizations for those purposes. 501(c)(3)s that qualify as public charities may engage in some advocacy on legislation or issues within prescribed limits. This includes:

• Educating lawmakers or the public about their mission or programs, or supporting their grantees’ efforts to do so.
• Educating the public on specific social issues that do not include a call to action (like voting or lobbying for the issue).
• Funding partnerships between public and private entities.
• Funding portions of a grantee organization’s budget that do not support lobbying.
• Signing an amicus brief or funding litigation to challenge a law’s constitutionality.

However, neither a private foundation nor a public charity can engage in direct lobbying of lawmakers to act on specific legislation or make campaign contributions.

A 501(c)(4) organization can conduct all the activities listed above, and also may not make campaign contributions. 501(c)(4)s can also engage in lobbying activities directly related to promoting a specific point of view on legislation for a social issue. Permitted lobbying can take two forms:

• Direct: communicating with a member of any level of legislature or government expressing a point of view on specific legislation.
• Grassroots: communicating with the general public expressing a point of view on specific legislation, with a call to action.

How does the type of exempt status impact potential donors?

From the perspective of potential contributors to the organization, only donations to 501(c)(3) organizations generate a charitable tax deduction for the donor. Contributions to any of the other types, such as 501(c)(4) organizations, do not qualify as charitable contributions. That is not surprising when the organization is the National Hockey League (a 501(c)(6) organization) or a credit union (exempt under 501(c)(15)), but it may be surprising that it includes the Sierra Club (a 501(c)(4) social welfare organization) or a garden club (a 501(c)(5) agricultural, horticultural, or labor organization). Taxpayers who believe they are making charitable contributions that qualify for a tax deduction should obtain confirmation that the organization qualifies under 501(c)(3) before donating.

Creating a holistic approach to giving

Often donors who support a charitable cause may also want to support advocacy on specific legislation that furthers their charitable purposes and perhaps even candidates who will vote in favor of that legislation. Some taxpayers choose to create a 501(c)(4) and allow it to fund both 501(c)(3) and 501(c)(4) activities and organizations. This will work, but it does not maximize the tax deductions available for donations to 501(c)(3)s. A multichannel approach has tax advantages.

Example:

Aidan and Bret are passionate about education reform and interested in making financial donations to further their goals to change the elementary school reading curriculum in the schools in their state. Aidan and Bret are willing to contribute $1 million to support this cause. They have been approached by the following organizations seeking donations:

• A university conducting research on reading scores in different schools;
• A local teacher’s union that wants to provide supplemental training for its members on reading strategies;
• An organization dedicated to lobbying Congress for legislation in support of charter schools;
• The League of Women Voters that wants to host a forum for local school board candidates to discuss their points of view on education; and
• A candidate running for governor on a platform that includes school reform.

Aidan and Bret have considered creating a private grant-making foundation or a 501(c)(4) social welfare club, but they realize that the donation to the private foundation will limit the purposes that the funds can be used for, and that a donation to the social welfare club will not generate an income tax deduction. After consultation with their advisors, Aidan and Bret contribute $250,000 to a DAF, $500,000 to their own 501(c)(4) organization, and retain $250,000. This generates a $250,000 income tax charitable deduction for the contribution to the DAF, which at a 37% income tax rate can save up to $92,500 in income tax.

Using this approach, Aidan and Bret can request that the DAF distribute to the university. They can use the cash retained to make a campaign contribution to the candidate. And their 501(c)(4) can support all the other requests. The 501(c)(4) could also make contributions to the DAF. This flexible approach allows Aidan and Bret to fund all the work that is important to their cause, and to get a charitable deduction for the portion related to charitable activities. Had Aidan and Bret given all the assets to either a 501(c)(3) or a 501(c)(4), they could not have made grants for this range of purposes.