Serving Private Foundations by Lorri Dunsmore, Perkins Coie David - - PowerPoint PPT Presentation

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Serving Private Foundations

by Lorri Dunsmore, Perkins Coie David Lawson, Davis Wright Tremaine

Deductions: Individual Deductions Limitations

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 Grantmaking 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

Governing Instrument

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.

Types of Private Foundations

Operating

• Direct Charitable

Activities

Nonoperating

• Grants to Public

Charities

Private Nonoperating Foundation

• Grantmaking Foundation
• Checkbook Foundation
• Primarily makes grants to public charities

Private Operating Foundation

• Actively engaged in the conduct of

charitable activities

• Annual determination
• Based on use of income and assets over

the most recent four-year period

• Reported on Form 990-PF, Part XIV

Advantages of a Private Operating Foundation

• Donations are tax deductible under the

same rules as donations to public charities

• Not subject to annual 5% payout

requirement for private nonoperating foundations

Private Operating Foundation Tests

• The Foundation must meet both an

income test and one of three alternative tests:

• Asset test
• Endowment test
• Support test

Private Foundation Excise Taxes

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 (cont'd)

Tax on Investment Income

• 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

Self-Dealing Transactions

Section 4941 – Prohibits Certain Transactions Between Foundation and “Disqualified Persons”

• 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 (cont'd)

Section 4941 – Prohibits Certain Transactions Between Foundation and “Disqualified Persons”

• 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 (cont'd)

Section 4941 – Prohibits Certain Transactions Between Foundation and “Disqualified Persons”

• 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

Distribution Requirements

“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 (cont'd)

“The 5 Percent” – Section 4942

• “Qualifying distributions” must exceed

“distributable amount.”

What are “Qualifying Distributions?”

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

Distribution Requirements (cont'd)

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 (cont'd)

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 (cont'd)

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 of

year 2, income must be distributed before either:

• the return due date for year 2, or
• the IRS mails a notice of deficiency.

Excess Business Holdings: Rule and Elements

Rule

• The combined holdings of a private foundation and all

disqualified persons in any corporation conducting a business which is not substantially related to the exempt purposes of the foundation are limited to 20% of the voting stock in such corporation.

• Nonvoting Stock
• If disqualified persons do not hold more than 20% of the voting

stock, nonvoting stock is considered permitted holdings.

• If disqualified persons hold more than 20% of the voting stock,

then nonvoting stock is considered excess business holdings (unless considered de minimis).

Excess Business Holdings: Elements (cont'd)

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 functionally related business

Excess Business Holdings: Elements (cont'd)

“Permitted Holdings”

• A private foundation may hold 20% of voting stock in a

business enterprise, reduced by the percentage of voting stock actually or constructively owned by disqualified

• persons. Any excess over 20% is excess business

holdings.

“Disqualified Persons”

• Substantial contributors, foundation managers, owners
• f more than a 20% interest in a substantial contributor,

certain family members, and corporations, partnerships, trusts and estates in which disqualified persons own more than a 35% interest.

Excess Business Holdings: Elements (cont'd)

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

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.

Excess Business Holdings: Special Rules

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 (cont'd)

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

Excess Business Holdings: Special Rules (cont'd)

Additional Five-Year Extension

• Foundation establishes that it made diligent efforts to dispose of such

holdings during the initial five-year period

• Foundation establishes disposition within the initial five-year period

has not been possible by reason of such size and complexity or diversity of holdings

• Foundation submits to the IRS a plan for disposing of all of the excess

business holdings involved in the extension

• Foundation submits the plan to appropriate state official having

administrative or supervisory authority or responsibility with respect to the foundation's disposition of the excess business holdings

• IRS determines that such plan can reasonably be expected to be

carried out before the close of the extension period

Jeopardizing Investments

• Foundation should not make investments that

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

• Jeopardizing investments are 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

Jeopardizing Investments (cont'd)

• No single factor or single investment is

determinative of a jeopardizing investment

• Determination is made at the time the investment is

made

• Investments donated to the Foundation will not be

jeopardizing investments

Impact Investing

• In 2015, IRS issued guidance to facilitate

mission-related investments (MRIs).

• Private foundation can align its general

investment activities with its mission.

• Notice clarifies that if MRIs are consistent with

prudence standards in UPMIFA then would not be jeopardizing investments.

Taxes on Jeopardizing Investments (Foundation)

Initial Tax

• Foundation: 10% of amount involved

if willful neglect

Additional Tax

• Foundation: 25% of

the amount involved

Taxes on Jeopardizing Investments (Managers)

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

Additiona l 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

Taxable Expenditures – Code Section 4945

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

Lobbying

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 (cont'd)

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

Political Activity

Prohibition Against Political Activity

• 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

Grants to Individuals

• 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 Organizations

• 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

Expenditure Responsibility

NO

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

equivalency affidavit

YES

• U.S. exempt organizations that are

not public charities

• Private foundations; private
• perating foundations
• For-profit companies
• New public charities
• Foreign organizations without a

U.S. determination letter or equivalent affidavit

Expenditure Responsibility (cont'd)

What is Expenditure Responsibility?

• Private Foundations must make all reasonable

efforts and establish procedures to

• see that the grant is spent solely for its

charitable purpose;

• btain full and complete grantee reports on

how the funds are spent; and

• make full and detailed reports to the IRS

with respect to such expenditures.

Expenditure Responsibility (cont'd)

Exercise of Expenditure Responsibility

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

Grants to Foreign Charitable Organizations

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

• Affidavit of foreign organization
• Opinion of counsel

Carrying Out Nonexempt Purposes

Examples

• Unreasonable administrative expenses
• Excessive compensation

Taxes on Taxable Expenditures (Foundation)

Initial Tax

• Foundation: 20% of amount

expended if involved willful neglect

Additional Tax

• Foundation: 100% of

the amount involved

Taxes on Taxable Expenditures (Managers)

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

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