25 TXNEXEMPT 24 Page 1 (Cite as: 25 TXNEXEMPT 24, 2014 WL ()) Taxation of Exempts March/April, 2014

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1 25 TXNEXEMPT 24 Page 1 A ROAD MAP FOR FOUNDATION ADVISORS Taxation of Exempts March/April, 2014 Navigating Chapter 42 Copyright (c) 2014 RIA Sharon W. Nokes [FNa1] The critical task for private foundations and their advisors is to identify, as early as possible, the transactions, actions, and omissions that could give rise to taxes and penalties. *24 Private foundations comprise a relatively small percentage of tax-exempt charitable organizations. Their impact on global society, however, exponentially exceeds their number. Recently released statistics confirm that, in 2013, foundations comprised roughly 9% of all Section 501(c)(3) organizations (private foundations and public charities), but held nearly 18% percent of their combined assets. [FN1] Further, through grants and the direct conduct of charitable programs, they gave nearly $47 billion to charitable organizations and causes (both in the United States and abroad) in [FN2] The distinction between private foundations and public charities derives from federal tax law. Private foundations are subject to the fundamental tax rules that apply to public charities, such as the prohibitions against private inurement and politicking, that are set out in Section 501(c)(3) itself. But because foundations are frequently funded and controlled by a small number of private persons (such as a corporation or members of a family), they are subject to additional tax rules to ensure that foundations operate in furtherance of their charitable purposes. These rules are highly technical, sometimes counterintuitive, and not always well-understood by practitioners who are new to the exempt organizations field or who do not specialize in the area. A road map through these complex tax rules is set out in the discussion below. Introduction A 501(c)(3) refresher As exempt organizations' advisors are well-aware, Section 501(c)(3) provides for exemption from federal income tax for entities that are (1) organized and operated exclusively for religious, charitable, scientific... literary, or educational purposes, and (2) meet the other requirements for exemption set out in Section 501(c)(3), such as the prohibitions against private inurement and campaign intervention. The federal tax law further divides Section 501(c)(3) organizations into two broad classes public charities and private foundations. Many new charitable enterprises strive to qualify as a public charity because this status offers several advantages to the organizations and their donors. For example, the rules governing fundraising are more generous to public charities. Individual gifts to public charities are generally subject to higher deductibility limitations than individual gifts to private *25 foundations, public charities can more easily receive grants from private foundations than can other private foundations, and donors to public charities enjoy more privacy than donors to private foundations. In addition, and as detailed below, private foundations are subject to much more stringent restrictions on the sorts of activities and transactions in which they can engage and both the foundation and

2 25 TXNEXEMPT 24 Page 2 certain of its fiduciaries may incur penalty taxes if these restrictions are breached. The Code provides several options for qualifying as a public charity, each with different operational requirements. Some organizations (e.g., schools, churches, and organizations that provide health care or conduct medical research) are specifically identified in the Code as public charities. [FN3] Other organizations known as publicly supported charities qualify as public charities because they are organized and operated for one or more exempt purposes and satisfy one of two mathematical tests that measure their breadth of public financial support. [FN4] A third group of public charities, called supporting organizations, are entitled to public charity status by virtue of their close relationship with one or more publicly charities (their supported organizations ). [FN5] All other Section 501(c)(3) organizations are classified as private foundations. Private foundations, in turn, are classified as either nonoperating foundations or operating foundations. In general, private nonoperating foundations support charitable activities primarily through grants to other organizations. Private operating foundations, by contrast, support charitable activities primarily through direct charitable operations much like public charities, but without the broad base of public support that would entitle them to public charity status. Congress created the distinction between public charities and private foundations in 1969 to address actual and perceived abuses by organizations that are now classified as private foundations. Specifically, Congress was concerned that the activities of foundations were not subject to public scrutiny (and that foundations were not sufficiently accountable to the public) because foundations neither relied on the public for financial support nor engaged in activities that required significant public involvement. Thus, private foundations are subject to the fundamental legal rules that apply to Section 501(c)(3) public charities such as the prohibitions against private inurement and campaign intervention, and the unrelated business income tax regime as well as additional tax rules that were enacted by Congress to ensure that foundations operate in furtherance of their charitable purposes.these latter restrictions are codified in Chapter 42 of the Code, at Sections 4940 through [FN6] These rules are quite nuanced and complex. Accordingly, the following discussion does not indeed, could not provide a full explication. Organizations should consult their tax counsel for a deeper understanding of how these rules may apply to a specific foundation and its circumstances. Private nonoperating (grantmaking) foundations A private nonoperating foundation must satisfy the broad requirements of Section 501(c)(3) e.g., that it be organized and operated at all times for purposes that are charitable, educational, etc. as well as a set of more specific restrictions applicable to private foundations. These include: 1. A tax on net investment income. 2. Regulation of a foundation's charitable activities by (a) requiring a minimum level of distributions for charitable purposes and (b) imposing special procedures for grants to individuals and to certain organizations. 3. Regulation of other foundation activities, including (a) dealings with individuals and entities whose relationship to the foundation makes them disqualified persons, (b) the extent of the foundation's ownership of any business enterprise, (c) the extent to which the foundation may invest its funds in investments that expose a foundation's assets to excessive risk of loss, and (d) expenditures for electioneering and lobbying. *26 The IRS enforces these rules through a system of initial penalty taxes, which may also be imposed on foundation managers (e.g., the organization's officers and members of its board of directors) involved in certain vi-

3 25 TXNEXEMPT 24 Page 3 olations. Additional taxes at increased rates can be imposed if the violations are not timely corrected. This section discusses the main features of each of these rules. It bears emphasis that, in a number of instances, there are detailed requirements for procedures, computations, and recordkeeping, as well as special exceptions and penalty provisions that have not been detailed in this summary. Rule #1 Excise tax on net investment income. Section 4940 imposes a tax on the net investment income earned by a private foundation. This tax, which is normally 2%, applies both to investment income, such as dividends and interest, and to realized capital gains from the sale or other disposition of property held for investment purposes. Giving appreciated stock as a grant does not constitute realization of capital gain and, thus, such appreciation gain is not subject to this tax. In computing its net investment income, the foundation may deduct capital losses (to the extent of capital gains) during the year. The foundation may also deduct expenses associated with its investment income and assets. Deductions for depreciation and depletion are subject to special limitations. The tax rate may be reduced from 2% to 1% for any tax year during which the foundation maintains its level of distributions for charitable purposes in accordance with certain requirements. [FN7] Broadly speaking, a foundation is eligible for this reduction in tax if both of the following are true: The amount of its qualifying distributions for the tax year equals or exceeds the sum of (1) an amount equal to the assets of such foundation for the tax year multiplied by the average percentage payout for the base period, and (2) 1% of its net investment income for that year. It was not liable for tax under Section 4942 with respect to any of the five preceding tax years. In effect, this rule enables the foundation to distribute 1% of its net investment income as grants to charitable organizations instead of paying the corresponding amount in tax to the federal government. In planning its distributions for charitable purposes, the foundation may want to consider whether to make the additional distributions necessary to qualify for the lower tax rate. The foundation must make estimated tax payments in accordance with these rules. Further details and instructions regarding the calculation and payment of the estimated tax appear in the instructions to the Form 990-PF annual information return that private foundations must file with the IRS. Rule #2 Prohibition against self-dealing. Section 4941 establishes a set of penalty taxes designed to eliminate certain direct and indirect self-dealing transactions between a foundation and certain insiders, known as disqualified persons. Disqualified persons subject to the self-dealing tax. A foundation's disqualified persons are defined in Section 4946 and include the following: Substantial contributors and certain members of their families. A foundation's substantial contributors include its founders and any donors whose contributions to the foundation (1) total more than $5,000 and (2) represent more than 2% of the total contributions received by the foundation. If any entity is a substantial contributor to the foundation, both that entity and persons who hold more than a 20% interest in the entity are also disqualified persons. Certain family members of a foundation's substantial contributors i.e., their ancestors, spouses, lineal descendants (through great-grandchildren), and spouses of such descendants are also disqualified persons of the foundation.

4 25 TXNEXEMPT 24 Page 4 *27 Foundation managers and certain members of their families. Directors, trustees, and officers of the foundation are disqualified persons because they are foundation managers, as are any senior staff employees with authority to make administrative or policy decisions on behalf of the foundation. During an individual's tenure as a trustee, officer, or manager, the foundation's disqualified persons also include that individual's spouse, ancestors, and lineal descendants (through great-grandchildren), along with the spouses of these descendants. Government officials. Certain federal, state, and local government officials, regardless of any connection with the foundation, are also disqualified persons. 35%-controlled entities. Any corporation, partnership, trust, or estate in which disqualified persons as a group hold more than a 35% interest is a disqualified person. However, Section 501(c)(3) organizations (private foundations, public charities, and supporting organizations, for example) are not considered disqualified persons. [FN8] Private foundations should consider maintaining a complete and up-to-date list of all disqualified persons (other than government officials) and monitor transactions that could involve such persons to ensure there are no inadvertent violations of the self-dealing rules. Definition of self-dealing. The regulations define self-dealing quite broadly. The concept includes virtually all direct and indirect transactions between the foundation and disqualified persons except outright gifts from disqualified persons to the foundation. For example, self-dealing includes (1) direct or indirect sales, leases, and loans between the foundation and disqualified persons and (2) any other payments by the foundation to, or transfers or use of foundation assets for the benefit of, disqualified persons. The fact that a given transaction is negotiated at arm's length for fair market value and benefits the foundation does not prevent that transaction from being treated as self-dealing. Only those transactions that fall within a limited number of specific exceptions are protected. For example, exceptions exist for interest-free loans or rentfree leases from disqualified persons to the foundation, but not for fair-market (or even above-market) loans and leases from the foundation to the disqualified person. Three exceptions to the definition of self-dealing, are likely to be of particular relevance to most foundations: Director and officer compensation and expense reimbursement. A private foundation may compensate a disqualified person (other than a government official) for personal services and reimburse his or her expenses, provided that (1) the compensation or reimbursement is not excessive in amount meaning that it is comparable to what similar organizations pay similar positions for similar services and (2) the services for which the person is being compensated are reasonable and necessary to carry out the exempt purposes of the private foundation. [FN9] Both the IRS and courts have specifically recognized that officers and senior executives responsible for managing a private foundation's business and program activities render personal services for purposes of this rule. [FN10] Thus, private foundations may pay their trustees and officers reasonable salaries or directors' fees and reimburse them for reasonable expenses they incur in attending meetings and performing other duties on behalf of the foundation. Indemnification of directors and other foundation managers. Subject to certain restrictions, a private foundation may provide insurance and indemnification protection to its trustees and officers. Thus, the foundation is permitted to indemnify a trustee or other foundation manager directly for certain expenses of defending a proceeding arising from service to the foundation after the trustee or other manager is successful, or the case is settled, and the indemnitee has not acted willfully and without reasonable cause. [FN11] The

5 25 TXNEXEMPT 24 Page 5 foundation cannot, however, directly indemnify a trustee or other manager for expenses or liabilities resulting from an unsuccessful defense; neither can it advance funds to pay the costs of defense while the proceedings are still unresolved. The foundation may, however, purchase insurance to provide such protection. If it does so, for purposes of the self-dealing rules, a portion of the premiums must be treated as compensation paid to the trustee or other manager, and the total compensation including the premium payment along with any other salary or fee must not be excessive. [FN12] Grants to charities. Because a charity cannot be a disqualified person with respect to a private foundation for purposes of the self-dealing rules, foundation grants to (or other dealings with) another charity are unlikely to trigger any self-dealing tax, unless it results in a disqualified person receiving a financial benefit. Intangible benefits, such as public recognition, do not trigger the self-dealing excise tax. *28 Self-dealing excise tax regime. A self-dealing transaction results in an initial tax on the disqualified person involved (the self-dealer ) equal to 10% of the amount involved in the transaction. [FN13] If the act of self-dealing is not corrected in a timely manner, a second-tier tax of 200% is assessed. [FN14] Both taxes fall on the disqualified person, not the foundation. Unless the self-dealer is a government official, there is a strict liability quality to the taxing regime the self-dealing tax will be imposed even if the self-dealer was not aware that the transaction constituted self-dealing. [FN15] Finally, if more than one self-dealer is liable for tax with respect to a single act of self-dealing, all of them will be held jointly and severally liable for the tax, and the Service may collect the tax from any one of them. [FN16] To avoid imposition of the more onerous second-tier tax, an act of self-dealing must be corrected. This requires reversing the transaction and taking such additional action as is needed to protect the foundation from any loss due to the transaction, and doing so in a timely manner. [FN17] Specifically, the act of self-dealing must be corrected by the earlier of the date on which the IRS mails a deficiency notice with respect to the firsttier tax or the date on which the IRS assesses the first-tier tax. [FN18] In most circumstances, a single transaction will generate a single act of self-dealing. That is not the case, however, if the transaction is a loan of foundation money, a leasing of foundation property, or some other use of foundation property. In these situations, the transaction is treated as potentially giving rise to more than one act of self-dealing. The first act of self-dealing takes place on the day the transaction occurs. An additional act of self-dealing occurs on the first day of each subsequent year (or part of a year) until the transaction is corrected or the second-tier tax is imposed. [FN19] Because the 10% tax applies to each such transaction until the initial transaction is corrected, there is a pyramiding effect. Example 1. On 6/1/12, PF, a private foundation, sells a building to DP, one of PF's disqualified persons. Under these circumstances, the transaction between PF and DP would be a single act of self-dealing that occurred on 1/1/12. Example 2. Assume that, instead of selling the building to DP, PF leases the building to DP for a term of four years beginning 7/1/12 for a fair-market annual rental of $20,000. On 9/30/14, the transaction is corrected and PF made whole. Under these circumstances, the lease between DP and PF constitutes three separate acts of selfdealing, treated for purposes of Section 4941 as occurring on 6/1/12, 1/1/13, and 1/1/14. Consequently, there are three tax periods. The first tax period runs from 7/31/12 to 12/31/12; the second from 1/1/13 to 12/31/13; and the third from 1/1/14 to 9/30/14. *29 For purposes of the initial self-dealing tax to be imposed on DP, the amount involved is $10,000 for the first tax period, $20,000 for the second, and $15,000 for the third. The initial taxes to be paid by A are thus $3,000 for the first act ($10,000 X 10% tax X 3 tax years or partial tax years in the tax period); $4,000 for the second act ($20,000 X 10% X 2); and $1,500 ($15,000 X 10% X 1) for the third

6 25 TXNEXEMPT 24 Page 6 act a total initial tax of $8,500. [FN20] Tax on foundation managers. It bears emphasizing that the self-dealing penalties do not necessarily fall solely on the disqualified person. Any foundation manager who agreed to the transaction knowing that it was an act of self-dealing, or who refuses to require correction, will be subject to initial and additional excise taxes as well, albeit at lower rates. Specifically, the initial manager's tax is equal to 5% of the amount involved in the transaction; if the act is not timely corrected, the foundation manager will be liable for an additional tax of 50% of the amount involved in the transaction. [FN21] Reliance on a written, reasoned opinion of legal counsel that a given act does not constitute self-dealing will protect a foundation manager (but not a self-dealer) from the excise taxes. [FN22] The tax on managers is imposed on only those foundation managers who approve or participate in the act of self-dealing, knowing that it is an act of self-dealing, and whose participation is willful and not due to reasonable cause. [FN23] A manager will be considered to have participated in a transaction knowing it to be an act of self-dealing only if he or she (1) has actual knowledge of sufficient facts so that, based solely on those facts, the transaction would be an act of self-dealing; (2) is aware that such an act under these circumstances may violate the federal tax law provisions on self-dealing; and (3) negligently fails to make reasonable attempts to ascertain whether the transaction is an act of self-dealing (or is, in fact, aware that this is the case). [FN24] A manager's participation is due to reasonable cause if the manager has exercised his or her responsibility on behalf of the foundation with ordinary business care and prudence. [FN25] The maximum amount of first-tier tax that may be imposed on a manager is $20,000 for any one act of selfdealing. [FN26] A similar $20,000 cap applies to the second-tier tax. [FN27] As with the tax on disqualified persons, liability for the managers' tax is joint and several. [FN28] Rule #3 Mandatory charitable distributions. In general, Section 4942 requires a private nonoperating foundations to make annual charitable distributions of, at a minimum, an amount equal to [its] minimum investment return, reduced by the sum of the taxes imposed the foundation under subtitle A of the Code (e.g., capital gains taxes) and section 4940 (discussed above), and increased by the amounts of certain trust distributions. [FN29] In general, the foundation's minimum investment return equals at least 5% of the fair market value of their its net investment assets for the prior year. [FN30] If the foundation fails to make the required minimum distribution, it generally must pay a 30% tax on the shortfall and, to avoid a further tax of 100%, the must distribute the shortfall within a statutorily defined period. [FN31] Definition of qualifying distributions. Distributions that count toward this requirement, called qualifying distributions, include: Grants to charitable organizations (including private operating foundations). Program-related investments (discussed below). Direct payments to accomplish a charitable purpose (including the purchase of assets and payment of individual grants such as scholarships). Administrative expenses of the foundation's charitable programs. Grants to other private nonoperating foundations or to any other organization controlled by the foundation or by its disqualified persons, count as qualifying distributions only if the grantee meets certain pass-through requirements. [FN32] Specifically, before the end of the tax year following the year of receipt of the grant, the

7 25 TXNEXEMPT 24 Page 7 grantee must itself do all of the following: Redistribute the full amount of the grant for charitable purposes (i.e., makes a qualifying distribution in the same amount) not later than 12 months after the close of the tax year in which the grant was received. Treat that redistribution as having been made out of corpus, rather than from undistributed income. (In other words, the recipient must make the redistribution in addition to its normal 5% payout requirement.) Provide sufficient documentation to the initial grantor foundation that these conditions have been satisfied. [FN33] Grants to foreign organizations. Many nonoperating foundations seek to accomplish their charitable purposes through making grants to *30 foreign organization. These grants may be counted as qualifying distributions if any of the following is true: The foreign organization has received an IRS determination letter classifying it as a public charity or an operating foundation under U.S. tax law. The foundation has made a good-faith determination that the organization qualifies as a public charity or operating foundation. [FN34] The foundation's good-faith determination may be based on an affidavit of the grantee, an opinion of counsel (either counsel to the foundation or the grantee), [FN35] or, under certain circumstances, an affidavit prepared by the grantee for another grantor. [FN36] The foundation exercises expenditure responsibility (discussed below) over the grant. To the extent the foreign organization is controlled by the foundation or its disqualified persons, however, the pass-through rules discussed above will apply. Amounts set aside for future charitable projects. Under certain circumstances, a private nonoperating foundation may treat amounts it has reserved for a particular project, but has not yet actually paid over to a grantee, as a qualifying distribution. [FN37] To take advantage of this set aside rule, the foundation must obtain advance approval from the IRS. It also must establish that the amount set aside will be paid for the specific project within 60 months after it is set aside and, with a few exceptions, that the specific project for which the amount is set aside is one that can be better accomplished by the set-aside than by the immediate payment of funds. [FN38] The set-aside exception to the annual distribution requirement is intended to apply in instances in which relatively long-term grants or expenditures must be made in order to assure the continuity of particular charitable projects or program-related investments... or where grants are made as part of a matching-grant program. [FN39] Determining the amount to be distributed. The amount a nonoperating foundation must distribute (its distributable amount ) is defined as its minimum investment return, less certain taxes. [FN40] For a foundation with no acquisition indebtedness, the minimum investment return is 5% of the aggregate fair market value of all [its] assets other than those used (or held for use) directly in carrying out [its] exempt purpose. [FN41] To determine the fair market value of a foundation's noncharitable assets and calculate *31 its minimum investment return, its publicly traded securities must be valued on a monthly basis and these monthly values averaged to determine the annual value. Cash balances must be valued on a monthly basis by averaging the amount of cash on hand as of the first and the last day of each month. These monthly values are then averaged to determine the annual value. If the foundation owns a participating interest in a common trust fund in which the participating interests are valued periodically throughout the year and the value of the interests is reported to the

8 25 TXNEXEMPT 24 Page 8 participants, the value of the foundation's interest in the fund can normally be based on the average of the valuations reported to the foundation during its tax year. All other investment assets must be valued once each year, on a consistent and reasonable basis, except for (1) real estate, which may be valued once every five years, and (2) the voting stock of an issuer of unlisted securities, which are subject tospecial rules. Assets held during only part of the year are included in proportion to the number of days held during the year. [FN42] The foundation's minimum investment return is then reduced by two taxes; the tax on investment income imposed by Section 4940 and the tax (if any) imposed on unrelated business income. The result is the foundation's distributable amount for a particular year. [FN43] Timing of distribution requirement. A nonoperating foundation must meet its minimum distribution requirements for a given year by the end of the following year. [FN44] Thus, for example, the foundation may wait until the end of 2015 to satisfy the distribution requirement relating to the value of its assets in If the foundation makes qualifying distributions in excess of the required amount for a given year, the excess can be carried over and applied against subsequent distribution requirements for up to five years. [FN45] The practical effect of this requirement is that if the foundation wishes to avoid gradually spending itself out of existence, it must achieve a total rate of return (including capital gain as well as interest and dividend income) commensurate with the 5% distribution requirement plus inflation. Rule #4 Limitations on the foundation's 'business holdings.' Section 4943 contains a complex set of rules that prohibit a private foundation from owning more than specified percentages of any business enterprise. Generally, any active business operation will be considered a business enterprise subject to these rules. However, the term does not include either: A trade or business that derives 95% or more of its gross income from passive sources (such as dividends and interest). [FN46] Any functionally-related business. [FN47] A functionally-related business is either (1) a trade or business that is not an unrelated trade or business [FN48] or (2) an activity that is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors that is related (aside from the need of the organization for income or funds or the use it makes of the profits derived) to the exempt purposes of the foundation. [FN49] The statute defines the permitted levels of holdings for private foundations. Broadly speaking, a foundation, together with its disqualified persons, may hold no more than 20% of the voting stock of a corporation or 20% of the profits interest of a partnership. [FN50] When the IRS is convinced that effective control of a business enterprise lies in persons other than disqualified persons, the level of permitted holdings increases to 35%. [FN51] The excess business holdings rules preclude the foundation operating a business enterprise as a sole proprietorship. [FN52] An important de minimis rule allows the foundation to own up to a 2% interest in a corporation or partnership regardless of the holdings of disqualified persons. [FN53] In determining whether holdings exceed the 2% limit, the foundation must aggregate its holdings with those of related private foundations. If the combined holdings of the foundation and related foundations are near the 2% level, the foundation should establish procedures to insure that the combined holdings do not cross 2% (e.g., by purchases or as a result of reductions in total outstanding interests), unless the foundation is certain that the combined holdings of the foundation and its disqualified persons will not exceed the overall permitted level, which generally will be 20%. If the holdings of the

9 25 TXNEXEMPT 24 Page 9 foundation and related foundations exceed 2%, the foundation must monitor both its own holdings and those of its disqualified persons to ensure that the combined holdings remain within the permitted level. The excess business holdings tax regime. Excess business holdings (those in excess of the 20% or 35% limitation) trigger an initial tax on a private foundation of 10% annually of the value of the excess holdings. [FN54] Although the tax is imposed on the last day of the foundation's tax year, the amount of tax is calculated based on the highest level of the foundation's excess business holdings during that year. [FN55] *32 If the foundation's holdings are not reduced to the permitted levels before the earlier of the mailing of a notice of deficiency with respect to the initial tax on those holdings or the assessment of the initial tax on those holdings, an additional tax of 200% of the value of the excess business holdings is imposed. [FN56] The excess business holdings excise taxes are imposed on only the foundation; no penalty is imposed on foundation managers for permitting a foundation to acquire or retain excess business holdings. Time to dispose of excess business holdings. If a private foundation acquires excess business holdings other than by its own purchase of such holdings, no penalties will apply if it disposes of such excess holdings within 90 days from the date on which it knows or has reason to know that it has such excess holdings. [FN57] The 90-day period also applies if a foundation purchases holdings that constitute excess holdings only because of prior acquisitions of disqualified persons of which the foundation neither knew nor had reason to know. [FN58] The 90-day period is automatically extended to include the period during which federal or state securities laws prevent the foundation from disposing of its excess business holdings. [FN59] To take advantage of the 90-day period, the disposition must not have any restrictions or conditions that prevent the recipient of the interest from freely using or disposing of the interest in the business enterprise, except for restrictions or conditions required by federal or state securities laws or by the gift or bequest through which the foundation acquired the interest. [FN60] If a foundation has excess business holdings because it or a disqualified person receives an interest in a business by gift or bequest, or in any way other than by the foundation or one of its disqualified persons purchasing an interest in a business, the foundation has five years to dispose of the excess holdings before any penalties will apply. In the case of a gift or bequest by a will or trust, the five-year period will not start until the date on which such holdings are distributed to the foundation. However, any excess business holdings held by the foundation before the receipt of the gift or bequest remain subject to immediate penalty. [FN61] The IRS may also allow an additional five years to dispose of excess business holdings acquired by a large gift or bequest if the foundation applies to the Service seeking an extension of the five-year period. Very specific procedural requirements apply to such requests. [FN62] Rule #5 Prohibition against jeopardizing investments. Section 4944 prohibits a private foundation from making speculative investments that place the assets of the foundation at excessive risk, and thereby jeopardize the carrying out of [the foundation's] exempt purposes. [FN63] An investment will be considered to jeopardize the foundation's exempt purposes if the foundation's managers, in making the investment, fail to exercise ordinary business care and prudence under the circumstances existing at the time the investment was made. The prudence of making a particular investment is evaluated in relation to the foundation's portfolio as a whole. The statute does not prohibit per se any category of investments, but the IRS will closely scrutinize certain investment practices, such as trading securities on margin, trading commodity futures, or purchasing put and call options. [FN64]

10 25 TXNEXEMPT 24 Page 10 In general, an investment program based on the advice of responsible investment counselors and conducted within normal institutional investment practices will run no risk of being held to involve jeopardizing or jeopardy investments. Any proposals for aggressive or novel investment strategies, however, or for investments involving investment practices that are subject to scrutiny by IRS, should be *33 reviewed for compliance with the standards of Section Exceptions from the jeopardizing investment rules. The jeopardizing investment rules do not apply to investments acquired by the foundation without payment of any consideration. [FN65] Consequently, the foundation need not determine whether investments received as gifts or bequests could prudently have been made by the foundation itself. Nor do these rules apply to investments, known as program-related investments (PRIs), that are made by the foundation primarily to accomplish its charitable purposes (as opposed to being made primarily for financial reasons). [FN66] Broadly speaking, a foundation investment will qualify as a PRI if three requirements are met: First, the primary purpose of the investment must be to accomplish one or more of the purposes described in Section 170(c)(2)(B) e.g., charitable, educational, literary, or scientific purposes. An investment will satisfy this requirement if (1) it significantly furthers the accomplishment of the private foundation's exempt activities and (2) the investment would not have been made but for the relationship between the investment and the accomplishment of the foundation's exempt activities. [FN67] Second, the production of income or the appreciation of property may not be a significant purpose of the investment. To determine whether a proposed foundation investment satisfies this requirement, it is relevant whether investors engaged in the investment solely for profit would be likely to make the investment on the same terms as the private foundation. [FN68] However, the fact that an investment produces significant income or capital appreciation is not, by itself, conclusive evidence of a significant purpose involving the production of income or appreciation of property. [FN69] Generally, if the private foundation is receiving rates of return that are below the market rate for an investment of comparable economic risk, this fact is sufficient to demonstrate that an investor engaged in an investment solely for profit would not be likely to make the investment on the same terms as the private foundation. [FN70] Third, influencing legislation, or participating or intervening in any political campaign on behalf of (or in opposition to) any candidate for public office, as described in Section 170(c)(2)(D), may not be a purpose of the investment. [FN71] PRIs can take many forms, including below-market loans and loan guarantees, extensions of credit, and equity investments in for-profit entities. Significantly, both the regulations that describe program-related investments and numerous IRS rulings make it clear that investments in non-charitable entities that accomplish charitable purposes may qualify as program-related expenses. [FN72] This principle is echoed in proposed regulations issued by the Treasury in April [FN73] The proposed regulations offer nine additional examples or program-related investments that reflect current investment practices and illustrate certain principles, including that... (5) [program-related investments] can be achieved through a variety of investments, including... equity investments in for-profit organizations. [FN74] Jeopardy investment tax regime. Jeopardy investments trigger an initial tax payable annually by a private foundation of 10% of the amount of the investment for each year (or part thereof) until the earliest of (1) the removal of the investment from jeopardy, (2) the mailing of a notice of deficiency with respect to the initial tax on that investment, or (3) the assessment of the initial tax on that investment. [FN75] Failure to remove the investment from jeopardy (by sale or gift of the investment) before either the mailing of a notice of deficiency or the

11 25 TXNEXEMPT 24 Page 11 assessment of the initial tax results in an additional tax of 25% of the amount invested on the foundation. [FN76] Foundation managers who knowingly agree to a jeopardizing investment or who refuse to agree to its removal from jeopardy are themselves subject to initial and additional taxes, though at lower rates than those that apply to the foundation. Specifically, if one or more foundation managers participates in making an investment and does so willfully, without reasonable cause, and knowing that it will jeopardize the carrying out by the foundation of its exempt purposes, a tax is imposed on the manager(s) involved. The tax is equal to 10% of the amount invested for each year (or part thereof) until the earliest of the removal of the investment from jeopardy, the mailing of a notice of deficiency with respect to the initial tax, or the assessment of the initial tax. [FN77] The initial tax may not exceed $10,000 per investment. [FN78] Generally, for a manager to act without reasonable cause, he or she must have failed to exercise ordinary business care and prudence. [FN79] *34 Reliance on either (1) a written, reasoned legal opinion that a particular investment would not jeopardize the carrying out of any of the foundation's exempt purposes or (2) written advice of qualified investment counsel that the investment will provide for the long- and short-term financial needs of the foundation will protect foundation managers from being subject to these taxes. [FN80] If the additional tax is imposed on a private foundation, and a foundation manager refuses to agree to part or all of the investment being removed from jeopardy, an additional tax equal to 5% of the amount invested is imposed on the foundation manager. [FN81] This additional tax may not exceed $20,000 per investment. [FN82] Note that this tax may be imposed on a manager even if the initial tax was not for example, because the manager's initial decision to make the investment was not willful and was due to reasonable cause. [FN83] For both the initial and additional taxes imposed on foundation managers, if more than one manager is liable for the tax the managers will be held jointly and severally liable for the tax. [FN84] Rule #6 Prohibition against taxable expenditures. Section 4945 restricts the purposes and activities for which private foundations may expend their funds. Payments that violate those restrictions called taxable expenditures include expenditures for the following purposes: Attempts to influence legislation (with certain exceptions). [FN85] Attempts to influence the outcome of any specific public election (with an exception for certain voterregistration support). [FN86] Payments for any purpose that is not a charitable purpose. [FN87] Grants to individuals for travel, study, or other similar purposes unless the grantor foundation meets standards of objective and non-discriminatory selection, purpose, and character of grant, with IRS approval of procedures in advance. [FN88] Grants to organizations other than public charities unless the grantor foundation exercises expenditure responsibility. To satisfy the expenditure responsibility requirement, the grantor foundation must make reasonable efforts and establish adequate procedures to (1) ensure that the funds are spent for the purpose of the grant, (2) obtain reports from the donee as to the use of the grant funds, and (3) report to the IRS on these grants. [FN89]

12 25 TXNEXEMPT 24 Page 12 A grant made by the foundation to a public charity for its general support or for specific non-prohibited purposes is not a taxable expenditure, even if the public charity uses its own funds, including those given by the foundation, for purposes that would be prohibited to the foundation itself. The grant must not, however, be earmarked that is, designated by oral or written agreement for such purposes. [FN90] Moreover, if the grant is earmarked for any organization that is not a public charity, the foundation must exercise expenditure responsibility (discussed below) as though the grant had been made directly to such organization. Proper documentation of grants. The nature of a particular grant and the identity of the grantee will dictate the contents of the foundation's grant files. Grants to public charities. Grants to public charities do not require formal documentation. Nevertheless, as a matter of sound management, the foundation will likely want to obtain for its files (1) evidence sufficient to document the public charity status of grantees, (2) at least a brief letter agreement covering all grants, and (3) some record of the charity's use of the grant funds. The foundation must report grants to public charities to the IRS on the foundation's annual information return (Form 990-PF). Conversely, public charities are required to report the grants they receive from private foundations on Schedule B of their annual information returns (Form 990). Expenditure responsibility grants. As noted above, the foundation may make a grant to an *35 organization that is not a public charity, but only if the foundation exercises expenditure responsibility. The expenditure responsibility requirements are set out in detail in the regulations and require the foundation to: Make a reasonable inquiry, before transferring the funds, to confirm that the grant will be used for proper purposes (the pre-grant inquiry ). Make the grant subject to a written agreement specifying the purpose of the grant and committing the grantee (1) to repay any portion of the grant not used for the purposes of the grant, (2) to submit full and complete reports on the manner in which grant funds are spent, (3) to maintain records of receipts and expenditures and to make its books and records available to the foundation at reasonable times, and (4) not to use any of the funds granted for activities prohibited to the foundation itself (such as lobbying and electioneering). Obtain annual and final reports from the grantee on how the funds were spent. List the grantees and the amounts and purposes of such grants in its Form 990-PF annual information return. Take specified follow-up action if it fails to receive required reports or learns that its grant funds have been diverted to improper purposes. [FN91] In making an expenditure responsibility grant, however, the foundation is not required to ensure grantee compliance and may rely on information received from the grantee unless the foundation has reason to doubt the reliability or accuracy of such information. Foreign grantees. As noted above, nonoperating foundations are also permitted to make grants to foreign charities. If the foreign charity does not have an IRS ruling or determination letter classifying it as a public charity, it nevertheless will be treated as a public charity (and therefore not subject to the expenditure responsibility rules) if the foundation has made a good-faith determination that the foreign grantee qualifies as a public charity. In making the determination, the foundation must apply the same standards and procedures as it would in making a good-faith determination of public charity status under Section 4942 (when considering whether a grant to the foreign organization would constitute a qualifying distribution). The foundation may also make grants to other foreign grantees as well, as long as the foundation exercises expenditure responsibility over the

13 25 TXNEXEMPT 24 Page 13 grants. Grants to individuals. Foundations frequently wish to establish a program of grants to individuals for scholarships, fellowships, awards for distinguished accomplishments, or the performance of particular research or study. Foundation grants to individuals in these programs must be made, on an objective and nondiscriminatory basis, [FN92] for: Scholarships or fellowships to be used for study at an educational institution. Prizes or awards in recognition of specific achievement. Funding to achieve a specific objective, produce a report or similar product, or improve or enhance a literary, artistic, musical, scientific, teaching, or like capacity, talent, or skill of the grantee. [FN93] In these situations, the foundation must secure advance approval by the IRS of the procedures under which the individual grant programs are administered. [FN94] To secure such approval, a private foundation must demonstrate the following to the satisfaction of the IRS: Its grant procedure includes an objective and nondiscriminatory selection process. The procedure is reasonably calculated to result in performance by grantees of the activities that the grants are intended to finance. The foundation plans to obtain reports to determine whether the grantees have performed the activities that the grants are intended to finance. [FN95] After obtaining initial approval from the IRS, the foundation does not need further IRS approval for particular awards or grants made in accordance with those procedures. [FN96] The foundation must report all grants to individuals to the IRS on the foundation's Form 990-PF annual information return. Penalties for taxable expenditures. Here, as under other sections of Chapter 42, taxes may be imposed on both the foundation and its managers. Taxes imposed on the foundation. If a private foundation makes a taxable expenditure, it must pay an initial tax equal to 20% of the amount of that expenditure. [FN97] If the expenditure is not corrected before the earlier of (1) the mailing of a notice of deficiency with respect to the initial tax on the expenditure or (2) the assessment of the initial tax on that expenditure, the foundation must pay an additional tax equal to 100% of *36 the expenditure. [FN98] An expenditure is corrected by taking all reasonable measures to recover the funds and to prevent a repetition. [FN99] If recovery of the expenditure amount, plus interest, is not possible, the IRS may require additional corrective action on a case-by-case basis. [FN100] For grants to individuals for travel, study, and similar purposes, if the only failure on the part of the foundation is a failure to obtain advance approval for its grantmaking procedure from the IRS, the foundation may not need to recover grants already paid. It can avoid having to recover the grants if it can demonstrate to the IRS that (1) no grant funds have been diverted from the stated purposes of the grants, (2) the grantmaking procedures used by the foundation would have been approved if the foundation had requested approval from the IRS, and (3) if and when advance approval of additional grant-making procedures is required, the foundation will request such approval. [FN101] For grants to organizations other than public charities, if the only failure is a failure to exercise expenditure responsibility because the foundation either did not receive a required report from the grantee or failed to make the required report to the IRS, the grant is corrected simply by obtaining or making the needed report. [FN102]