Private Foundations Deeper Dive David Lawson, November 2, 2017 - - PowerPoint PPT Presentation

November 2, 2017 Seattle, Washington David Lawson, Davis Wright Tremaine

Private Foundations Deeper Dive

Can be a nonprofit corporation

• r a charitable trust

Nonprofit corporation

• Formed by filing Articles of Incorporation with state
• Managed by a board of directors

Charitable trust

• Formed by executing a trust document
• Managed by one or more trustees

What is a private foundation?

Has 501(c)(3) tax-exempt status

• Must be organized and operated for charitable,

educational, scientific, religious, or literary purposes

• Assets are irrevocably dedicated to those purposes
• No “inurement” or private benefit
• Cannot engage in political campaign activity

Two types of 501(c)(3) organizations

• Public charities: churches, schools, hospitals,
• rganizations meeting a “public support test”
• Private foundations: All 501(c)(3)
• rganizations that do not qualify

as public charities

What is a private foundation?

Donor-advised funds (DAFs)

• DAFs are maintained by a public charity “sponsor”
• The sponsor has permanent and ultimate control, but

will follow donor advice in almost all cases

• Can grant to organizations under very similar rules to

grantmaking private foundations

• Cannot grant to individuals:
• Scholarship or fellowship grants
• Less administrative overhead and lower costs

than an independent private foundation

Private Foundation Alternatives

Public charity status

• The central challenge is fundraising strategy
• Public support tests:
• 509(a)(1) + 170(b)(1)(A)(vi)
• “public support” = contributions and grants alone
• 33%, or 10% and pass “facts and circumstances”
• 509(a)(2)
• “public support” = contributions, grants, and gross receipts

from related activity

• 33%, and <33% from investment and

unrelated income

• 509(a)(3): supporting organizations

Private Foundation Alternatives

Deductions: Individual Deduction Limits

Public Charities or Private Operating Foundations

Cash or Ordinary Income Property: Deduction of up to 50% of donor’s contribution base Capital Gain Property: Deduction of up to 50% of donor’s contribution base to the extent the capital gain property does not exceed 30% of the donor's contribution base

Private Foundations

Cash or Ordinary Income Property: Deduction of up to 30% of donor’s contribution base Capital Gain Property: Deduction of up to 20% of donor’s contribution base

The percentage limitation on charitable contributions by corporations is 10%

• f the corporation’s taxable income,

regardless of whether the recipient is a public charity or a private foundation.

Deductions: Corporate Contributions

Section 508(e) requires that an organization have specific provisions in its governing instrument in order to qualify as a private foundation:

• prohibit the foundation from engaging in self-dealing subject to

tax under § 4941,

• require it to make qualifying distributions each year in amounts

sufficient to avoid tax under § 4942,

• forbid it from retaining excess business holdings taxable under §

4943,

• prohibit jeopardizing investments taxable under § 4944, and
• bar the foundation from making taxable

expenditures within the meaning of § 4945.

Governing Instrument

Types of Private Foundations

Operating

• Direct Charitable

Activities

“Non-operating”

• Grants to Public

Charities

“Non-operating”

• Grantmaking or “Checkbook” Foundation
• Primarily makes grants to public charities

Operating Foundation

• Actively engaged in the conduct of charitable

activities

• Annual determination
• Based on use of income and assets
• ver the most recent four-year period
• Reported on Form 990-PF, Part XIV

Types of Private Foundations

Chapter 42 of the Internal Revenue Code

Most of these “taxes” are punitive in nature; it’s easier to consider these the “rules” governing foundations

• Section 4940: Investment income excise tax
• Section 4941: Self-dealing transactions
• Section 4942: Distribution requirements
• Section 4943: Excess business holdings
• Section 4944: “Jeopardizing” investments
• Section 4945: “Taxable expenditures”
• Grab bag

Private Foundation Excise Taxes

Tax on Investment Income (Section 4940)

• 2% on net investment income
• May be reduced to 1% if the foundation meets

certain distribution requirements

• These are slightly different from those in Section 4942
• Does not apply to certain private operating

foundations (“exempt operating foundations”) that look like public charities

Private Foundation Excise Taxes

Prohibits certain transactions between foundation and “disqualified persons” (Section 4941) Disqualified persons

• Officers and directors
• Staff with responsibilities similar to officers/directors
• “Substantial contributors” (status for life!)
• Spouses, ancestors, descendants of all of the above
• Entities 35% controlled by all of the above
• Certain government officials

Self-Dealing Transactions

Prohibits certain transactions between foundation and “disqualified persons” (Section 4941) Prohibited transactions

• Sale or leasing of property (in either direction)
• Lending (in either direction)
• Furnishing of goods, services, or facilities (in either direction)
• Payment of compensation to DQP by foundation
• “Transfer or use by or for the benefit of”

foundation assets

Self-Dealing Transactions

Prohibits certain transactions between foundation and “disqualified persons” (Section 4941) Exceptions:

• Compensation to DQP for “personal services”

(professional or management services only)

• Donations by a DQP of goods or services
• Interest-free lending by DQP to foundation
• Furnishing of goods or services by foundation if DQP

gets them on the same terms as the general public

• Certain transactions as part of the reorganization
• f a DQP

Self-Dealing Transactions

“The 5 Percent” (Section 4942) “Qualifying distributions” must exceed “distributable amount.” What is the “Distributable Amount?” 5% of fair market value of all assets, except those used “directly” for exempt purpose

• A few modifications apply

Distribution Requirements

“The 5 Percent” (Section 4942) “Qualifying distributions” must exceed “distributable amount.” What are “Qualifying Distributions?”

• Amounts paid to accomplish exempt purposes
• Amounds paid to acquire exempt-use assets

Distribution Requirements

Some things that are qualifying distributions:

• Grants to public charities or governments
• Grants to private operating foundations
• Permitted scholarship and fellowship grants
• Amounts spent directly to operate a charitable

program

• Administrative expenses (but not investment

management expenses)

• Program-related investments

Distribution Requirements

Some things that are not qualifying distributions:

• Grants to organizations controlled by the

foundation or its disqualified persons

• Grants to other non-operating private

foundations (unless timely redistributed by the grantee foundation and made “out of corpus”)

• Grants to individuals not permitted under

Section 4945

• Investment management expenses

Distribution Requirements

Taxes under Section 4942

• Initially, 30% of undistributed income
• If uncorrected, 100% of the remaining undistributed

amount Timing

• Distributions for year 1 must happen by end of year 2
• To avoid 100% tax on income not distributed by the end
• f year 2, income must be distributed before either:
• the return due date for year 2, or
• the IRS mails a notice of deficiency.

Distribution Requirements

Rule (Section 4943)

• Combined holdings of:
• a private foundation, and
• all disqualified persons
• in any corporation
• conducting a business enterprise
• which is not substantially related to the exempt purposes
• f the foundation
• are limited to 20% of the voting stock

in such corporation. Special rules apply to nonvoting stock.

Excess Business Holdings

Business Enterprise

• The active conduct of a trade or business; and
• Any activity that is regularly carried on for production of

income from the sale of goods or the performance of services which constitutes UBTI under 513

Not a Business Enterprise

• A business that derives 95% of more of its gross income

from passive sources (e.g., dividends, interest, royalties, rents)

• A business functionally related to

the foundation’s exempt purposes

Excess Business Holdings: Elements

Increase of Permitted Holdings to 35%

• Must establish that “effective control” is in one or more

persons who are not disqualified persons with respect to the foundation

“Effective Control”

• Having the power, either directly or indirectly, to direct or

cause the direction of the management and policies of a business enterprise, whether through the ownership of voting stock, the use of voting trusts, or contractual arrangements, or otherwise

Excess Business Holdings: Elements

Facts

• Private Foundation owns 7% of voting stock in Corporation and 3%
• f nonvoting stock
• Brothers, the founders of Private Foundation, each own 5% of

voting stock of Corporation (for total of 10%)

Permitted Holdings

• 20% - 10% (amount owned by Brothers) = 10%

Foundation does not have excess business holdings because it holds only 7% of voting interest in Corporation. What if foundation held 20% of nonvoting stock and Brothers held 25% of voting stock of Corporation?

Excess Business Holdings: Example

De minimis Rule

A foundation is not treated as having excess business holdings if it owns not more than 2% of the voting stock and 2% in value of all

• utstanding shares of all classes of stock.

Excess Business Holdings

Excess Business Holdings: Tax on Holdings

Initial Tax

• 10% tax imposed on the value of the

excess business holdings

• Value is determined when foundation’s

holdings are at their highest

Additional Tax

• If foundation fails to dispose
• f interest, tax of 200%

value of excess business holdings imposed.

90-Day Rule

• Foundation will have 90 days to dispose of excess business

holdings and not be subject to tax when:

• Disqualified person purchases interest causing the excess

business holdings, or

• Foundation purchases additional interest but did not

know of disqualified person’s interest

• The 90-day period can be extended if the sale of the business

interests is prevented by federal or state securities laws

Excess Business Holdings: Special Rules

Holdings Acquired by Gift or Bequest

• Foundation given five years in which to address

the excess business holdings

• No tax assessed during this time
• Tax assessed if holdings not disposed of by end
• f five-year period
• Additional five-year extension

may be granted on request if certain criteria are met

Excess Business Holdings: Special Rules

• Foundation should not make investments that financially

jeopardize the Foundation’s ability to carry out its exempt purposes

• Investments that show a lack of reasonable business

care and prudence in providing for the long-term and short-term financial needs of the Foundation

• No single factor or single investment is determinative of

a jeopardizing investment

• Determination is made when investment is made
• Investments donated to the Foundation

will not be jeopardizing investments

Jeopardizing Investments (Section 4944)

Taxes on Jeopardizing Investments

Initial Tax

• Foundation: 10% of amount involved

if willful neglect

Additional Tax

• Foundation: 25% of

the amount involved

Taxes on Jeopardizing Investments

Initial Tax

• Managers: 10% of the amount involved if the

manager knowingly, willfully and without reasonable cause participated in making the Jeopardizing investment

• Managers: Maximum initial tax of $10,000 -

joint and several liability

Additional Tax

• Managers: 10% of the

amount involved if the manager refuses to correct within correction period

• Managers: Maximum

additional tax of $20,000 – joint and several liability

A taxable expenditure is an amount paid or incurred to:

• Lobby
• Influence the outcome of public elections
• Make certain grants to individuals
• Make grants to organizations other than public

charities unless certain steps are taken

• Carry out any nonexempt purpose

Taxable Expenditures (Section 4945)

Prohibition Against Lobbying

• Private Foundations may not engage in or fund

lobbying

Taxable Expenditures

Direct Lobbying

• Communications with members or employees
• f a legislative body designed to influence their
• pinion with respect to legislation
• Refers to specific legislation; and
• Encourages the recipient to take action

Lobbying

Grassroots Lobbying

• Communications designed to influence the
• pinion of the general public with respect to

legislation

• Refers to specific legislation;
• Reflects a view on such legislation; and
• Encourages the recipient to take action

Lobbying

Prohibition Against Political Activity

• Absolute rule!
• Private Foundations may not participate or

intervene, directly or indirectly, in any political campaign on behalf of or in opposition to any candidate for public office

Political Activity

• Travel, study, or similar purposes
• IRS pre-approval of grantmaking procedures

required

• Contrast: grants to indigent individuals to

enable them to buy food or clothes are not taxable expenditures

Grants to Individuals

• Private Foundations are subject to tax penalties

if they make a grant to an organization that is not a public charity unless the Private Foundation exercises “expenditure responsibility”

• Public Foundation managers can also be

penalized

• Expenditure responsibility is strictly interpreted

by the IRS and courts

Grants to Organizations

Is Expenditure Responsibility Required?

Expenditure Responsibility

NO

• U.S. public charities
• U.S. and foreign government units
• Executive Order organizations
• Exempt operating foundations
• Foreign organizations with a

501(c)(3) organization letter or valid equivalency determination

YES

• Private foundations; private
• perating foundations
• Non-501(c)(3) exempt
• rganizations
• For-profit companies
• Other foreign organizations

Exercise of Expenditure Responsibility

• Pre-grant inquiry
• Grant agreement
• Regular reports
• Inclusion in Form 990-PF

Expenditure Responsibility

Step 1: Pre-Grant Inquiry

• Before any grant payment is made, the Private Foundation must:
• Make an investigation, based on readily available information, that

would assure any “reasonable person” that the grantee will use the funds for the proper purposes

• Inquiry should concern identity, experience, history of grantee and its

board/key officers; information on management, activities, finances and practices of grantee; experience of the Private Foundation and

• ther foundations with the grantee
• Document
• Charitable purpose of the grant
• Grantee’s ability to achieve goal
• Grantee’s ability to report on the use of funds
• Signed and dated by program officer

Expenditure Responsibility

Step 2: Written Grant Agreement

• The grant agreement must:
• Specify the charitable purpose of the grant
• Require the grantee to maintain the grant funds in a separate

account dedicated to charitable purposes

• Require the grantee to repay grant funds if not used for the

purposes of the grant (even if otherwise charitable)

• Require the grantee to provide annual reports and a final report on

its use of the grant funds

• Prohibit use of grant funds for lobbying, political activity, regranting

(with some exceptions) and non-charitable uses

• Be signed by the Private Foundation and the grantee

Expenditure Responsibility

Step 3: Regular Reports

• The grantee’s reports to the Private Foundation must:
• Describe the grantee’s use of the grant funds
• Verify compliance with the terms of the grant
• Describe the grantee’s progress toward achieving the

goals of the grant

• List equipment purchased with grant funds and confirm

its continued use for charitable purposes

• Be signed and dated by the grantee

Expenditure Responsibility

Step 4: IRS Form 990PF

• The Private Foundation must report to the IRS annually on

every expenditure responsibility grant made, paid, or for which a report is outstanding during the year

• Report must include:
• Grantee name and address
• The date, amount and purpose of the grant
• The amounts expended by the grantee based on the most

recent grantee report

• The date of the grantee’s reports
• Whether the grantee has diverted funds
• Dates and results of any verification
• f grantee’s report

Expenditure Responsibility

Recordkeeping

• The Private Foundation must maintain in the

grant file and make available to the IRS:

• Pre-grant inquiry
• Copy of expenditure responsibility grant agreement
• Copy of grantee’s reports
• Copy of any reports made as a result of any audit of

the grantee by the Private Foundation

Expenditure Responsibility

Expenditure Responsibility Grants to Private Foundations

• No separate account required
• Recording keeping requirements—grantee must keep

records for four years

• “Out of Corpus”—to count toward the Private

Foundation’s payout, the grantee must pay out all grant funds received from the Private Foundation within a short period of time in addition to meeting its own payout

• Special rules for capital endowment

and capital equipment grants

Expenditure Responsibility

Foreign Equivalency Determination

• Reasonable judgement that foreign
• rganization is an organization described in

Section 501(c)(3)

• Determination as to whether equivalent to a

public charity

• New special rule:

Written advice of tax practitioner

• Rev. Proc. 2017-53

Grants to Foreign Charitable Organizations

Examples

• Unreasonable administrative expenses
• Operating commercial-type business as

primary activity

• Excessive compensation

Carrying Out Nonexempt Purposes

Taxes on Taxable Expenditures

Initial Tax

• Foundation: 20% of amount

expended if involved willful neglect

Additional Tax

• Foundation: 100% of

the amount involved

Taxes on Taxable Expenditures

Initial Tax

• Managers: 5% of the amount involved if the manager

acts knowingly, willfully and without reasonable cause

• Managers: no liability if acts on advice of counsel

given in a reasoned legal opinion in writing

• Managers: maximum initial tax of $10,000 – joint and

several liability

Additional Tax

• Managers: 50% of the amount

involved if the manager refuses to correct within correction period

• Managers: Maximum additional

tax of $20,000 - joint and several liability

Advantages

• Donations are tax deductible under the

same rules as donations to public charities

• Not subject to annual 5% payout

requirement for other private foundations

More About Private Operating Foundations

• The Foundation must meet both an

income test and one of three alternative tests:

• Asset test
• Endowment test
• Support test

Private Operating Foundation Tests

Income Test

• The Foundation must spend for the active

conduct of exempt activities at least 85% of the smaller of:

• Adjusted net income, or
• Minimum investment return

Private Operating Foundation Tests

Asset Test

• 65% or more of the Foundation assets

must be devoted to the direct conduct of exempt activities

Private Operating Foundation Tests

Endowment Test

• The Foundation must normally make

distributions in the active conduct of its exempt activities in an amount that is two-thirds or more of its minimum investment return

Private Operating Foundation Tests

Support Test

• The Foundation normally receives 85% or

more of its support from the public

Private Operating Foundation Tests

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