Public Charity: Section 509(a)(2) limits investment income


The IRS has four categories under Sec. 509 that allow an organization to be a public charity, but the two most common are 509(a)(1) and 509(a)(2).


The characteristics of an (a)(1) public charity were discussed in previous articles. This article focuses on (a)(2) public charities, whose public support test calculations present a few more complexities than that of an (a)(1) public charity.

The test to classify an organization as a 509(a)(2) public charity is strictly a mechanical test. The organization must have more than 33.33 percent public support and may not have more than 33.33 percent of its support from investment income.

This investment income test can be difficult for some organizations to pass, such as those having a large endowment that generates a lot of investment income. Unlike for the 509(a)(1) test, no “facts and circumstances” test is available if the 33.33 percent test is not met.

Public Support Test

To properly calculate the support percentage, one must understand how support is defined for this type of organization. The 33.33 percent support test includes the following in the numerator:

1. Gifts and grants

2. Membership fees

3. Gross receipts from admissions, sales of merchandise, performance of services or furnishing of facilities in an activity that is not unrelated business income

Similar to the 509(a)(1) test, there are limits on what support is included in the numerator as “good” support. However, the 509(a)(2) limits are calculated a bit differently.

First, all amounts received from “disqualified persons” are excluded from the numerator. This limit applies not only to contributions but also to membership fees or other gross receipts. Disqualified persons are officers, directors, trustees or substantial contributors (defined below).

An additional limitation is applied to gross receipts from carrying out the organization’s exempt purpose from all payers who are not disqualified persons. Any amounts received from any non-disqualified payer, including a person, corporation, private foundation, public charity or governmental unit, in excess of the greater of $5,000 or 1 percent of the support for the year will be excluded from the numerator.

This limit is applied annually based on total support for that year (and not on the total support over a five-year test period as with the 509(a)(1) test). Also, unlike the 509(a)(1) test, not all governmental money is “good” support as it is subject to the 1 percent limitation just as other payers are.

However, not all federal government money is aggregated for purposes of this limitation. Money from different federal agencies or bureaus can be treated as separate payers.

As mentioned above, no amounts from substantial contributors are included in the numerator in calculating the test. “Substantial contributors” are defined as persons who contribute more than $5,000 if the amount is more than 2 percent of contributions received through the end of the taxable year from the inception of the organization.

There are three important implications here. First, a new small organization will have a very low dollar threshold for a donor becoming a substantial contributor. Second, an organization, in theory, must be able to track its donations by donor since inception. Finally, once a donor is classified as a substantial contributor, it is difficult for a donor to lose that status.

To cease being a substantial contributor, there are two hurdles to overcome. First, there must be no contributions from the individual (or persons related to the individual) for a period of 10 years, and the contributor cannot be a foundation manager (e.g., an officer, director or trustee). Second, the aggregate amounts contributed must be insignificant when compared to at least one other person.

As with the 509(a)(1) test, the distinction between gross receipts and contributions is an important one, as all contributions are “good” support except those from disqualified persons, while all gross receipts are subject to the $5,000/1 percent support rule.

If the payment to the organization is serving the immediate and direct needs of the payer, it is classified as gross receipts. If the payment is primarily to provide a direct benefit to the general public, it is a grant.

Gross receipts from activities that are not unrelated activities under Sec. 513 are also included in public support. Sec. 513 includes four exceptions from the definition of unrelated trade or business – volunteer labor, donated goods, convenience and trade shows. Therefore, gross receipts for activities that, but for these exclusions, may be unrelated business income are included in the numerator.

Investment income (excluding capital gains and losses), net unrelated business taxable income (UBTI) from businesses acquired after June 30, 1975, net income from unrelated activities that are not regularly carried on (e.g., fundraising events) and other income are included in total support.

Investment Income Test

The investment income test limits the organization’s investment income to 33.33 percent of total support. Included in investment income is the total of interest, dividends, rents, royalties, and net UBTI from businesses acquired after June 30, 1975. This total is divided by total support to determine the percentage of support represented by investment income. This test is applied on an annual basis.

Finally, it should be noted that both tests are applied on the basis of the organization’s normal sources of support. An organization will be considered as normally meeting these tests for its current taxable year and the taxable year immediately succeeding its current taxable year, if, for the four taxable years immediately preceding the current taxable year it meets both tests based on an aggregate of the results in the four-year taxable period.