Form 990-PF: Latest Compliance Strategies

Transcription

1 Presenting a live 120-minute teleconference with interactive Q&A Form 990-PF: Latest Compliance Strategies Meeting IRS Demands for Fiscal, Grant and Other Data From Private Foundations WEDNESDAY, NOVEMBER 28, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Brian Yacker, Partner, YH Advisors, Huntington Beach, Calif. Candice Meth, Senior Manager, EisnerAmper, New York Amanda Adams, Tax Partner, Blazek & Vetterling, Houston Milton Cerny, Counsel, McGuire Woods, Washington, D.C. For this program, attendees must listen to the audio over the telephone. Please refer to the instructions ed to the registrant for the dial-in information. Attendees can still view the presentation slides online. If you have any questions, please contact Customer Service at ext. 10.

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5 Form 990-PF: Latest Compliance Strategies Seminar Nov. 28, 2012 Amanda Adams, Blazek & Vetterling Milton Cerny, McGuire Woods Brian Yacker, YH Advisors Candice Meth, EisnerAmper

6 Today s Program Form 990-PF Review [Amanda Adams] Slide 8 Slide 28 Critical Compliance Issues With Form 990-PF [Milton Cerny, Amanda Adams and Brian Yacker] Slide 29 Slide 81 Best Practices With Future Form 990-PF Filings [Candice Meth] Slide 82 Slide 96

7 Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. 7

8 Amanda Adams, Blazek & Vetterling FORM 990-PF REVIEW

9 Part I: Analysis Of Revenue And Expenses Column (a) reflects revenue and expenses per books cash or accrual. Column (b) reflects revenue and expenses that are subject to the 4940 excise tax on net investment income. Column (c) reflects revenue and expenses that are included in the calculation of adjusted net income. For private operating foundations, this column is relevant to determining the spending requirement. For non-operating foundations, this column is generally not completed unless the foundation has income from a charitable activity. Column (d) reflects expenses which are treated as qualifying distributions. This column is relevant to determining satisfaction of both operating and non-operating foundations minimum spending requirements. 9

10 Part II: Balance Sheets This section of the return presents the balance sheet of the foundation at the beginning of the year and the end of the year. The FMV of assets held at the end of the year is also reported. A detailed listing of investments held at the end of the year (other than mortgage loans) is required. Lines 6 and 20 report receivables/payables occurring between the foundation and disqualified persons. Having an entry on either of these lines could be a sign that impermissible self-dealing has occurred. 10

11 Part III: Analysis Of Changes In NA Or FB This section of the return demonstrates the components of the change in net assets from the beginning of the year to the end of the year. For many cash-basis foundations, current income is the only change. For foundations that follow the accrual method and report their investments at fair market value, unrealized gains and losses are reported here. Returned grants are also reported in this section rather than as a reduction of expense or income in Part I. 11

12 Part IV: Capital Gains And Losses After the passage of the Pension Protection Act of 2006, capital gains and losses from the sale of virtually all capital assets became subject to the 4940 tax on net investment income. Two important exceptions still exist: 1. Capital gains and losses subject to unrelated business income tax are not also subject to 4940 tax. 2. Gains and losses from charitable-use assets held for at least one year are not subject to 4940 tax, if the proceeds from sale are used to purchase similar charitable-use assets, in much the same way as the like-kind exchange rules of Remember that all sales of publicly traded securities can be reported on a single line. Details are only required for non-publicly traded securities. 12

13 Part V: Qualification For Reduced Tax The normal rate of 4940 tax on net investment income is 2%. This section of the return provides a calculation that may enable the foundation to reduce the tax percentage to 1%. A ratio of qualifying distributions to non-charitable-use assets is calculated based on a five-year history. If current year qualifying distributions equal or exceed the amount determined by multiplying the five-year ratio by the current year s average of non-charitable-use assets plus 1% of net investment income, then the foundation qualifies for the 1% tax rate for the year. 13

14 Part VI: Excise Tax This section reports the tax due on the return as well as any payments made towards the tax. If the foundation was erroneously subject to back-up withholding, such amounts can be reported here as credits toward the foundation s tax liability. Foundations whose tax liability exceeds $500 for the year must make quarterly tax payments (which must be deposited electronically), and those whose net investment income has exceeded $1 million in the past three years must base their 2Q-4Q payments using annualization calculations, which use actual income earned during the year. This can be problematic for those foundations with partnership investments and that do not have timely information. 14

15 Part VII-A: Statements Regarding Activities Although questions 1(political activities), 6 (governing instrument) and 13 (public inspection) search for possible non-compliance with the requirements of 501(c)(3), the bulk of the questions in this part ask for information that does not necessarily have a negative impact on the foundation. Changes in activities, organizing documents, new substantial contributors and similar information are required to be reported. A new question is asked for 2011: Did the foundation make a distribution to a donor-advised fund over which the foundation or a disqualified person had advisory privileges? If Yes, attach statement. The statement must report whether the foundation treated the distribution as a qualifying distribution and how the distribution will be used for 170(c)(2) purposes. One wonders whether the IRS plans to restrict grants to DAFs, as they have grants to supporting organizations. 15

16 Part VII-B: Statements Regarding Activities For Which Form 4720 May Be Required Care should be taken in answering the questions in this section, as Yes answers may indicate that Form 4720 (a penalty return) is required to be filed. Questions 1-5 seek information to determine if the foundation is subject to one of the Chap. 42 excise taxes on self-dealing, under-distribution, excess business holdings, jeopardizing investments and taxable expenditures. Questions 6 and 7 relate to non-chap. 42 excise taxes. 16

17 Part VIII: Information About Officers, Etc. All officers, directors, trustees and foundation managers that served during the year are reported along with their compensation and average hours per week devoted to the foundation. The top five highest-paid employees compensated >$50,000 are reported. The top five highest-paid independent contractors compensated >$50,000 are reported. 17

18 Part IX-A: Summary Of Direct Charitable Activities Many foundations conduct direct programs in conjunction with, or instead of, making grants to other organizations. Even if the foundation is a non-operating foundation, it has the opportunity to describe its four largest activities and provide the total expenditures related to each. Some foundations are concerned about the appearance of a large percentage of expenses coming from non-grant sources, because it may seem that administrative expenses are too high. Describing direct activities in this part can help indicate when expenses are related to a charitable program rather than being administrative. 18

19 Part IX-B: Summary Of Program- Related Investments Program-related investments are made primarily to accomplish a charitable purpose of the foundation, rather than to produce investment income or capital gain from the sale of the investment. Examples include educational loans to individuals and lowinterest loans to other 501(c)(3) organizations. Only the top two PRIs made during the year are reported, so that ongoing investments are not reported on succeeding returns. 19

20 Part X: Minimum Investment Return This section of the return reports the average fair market value of non-charitable use assets including cash, securities and other assets. This calculation is the first step in determining the amount the foundation is required to spend for charitable purposes. 20

21 Part XI: Distributable Amount The minimum investment return (5% of investment assets) is reduced in this section by the excise tax on investment income for the year, as well as the income tax (990-T) for the year. Recoveries of amounts previously treated as qualifying distributions (i.e., returned grants) are added to the MIR to determine the distributable amount. 21

22 Part XII: Qualifying Distributions This section calculates the total amount of qualifying distributions for the year by combining the expenses paid from Part I, Col. (d) with amounts spent to purchase program-related investments or charitable use assets and any amounts set aside for charitable purposes. Set-asides: Type I: Suitability test straightforward and applicable to foundations of any age; must request in advance and may not receive approval until after deadline for return to be filed Type II: Cash distribution test generally applicable to foundations in their first few years of existence; complex rules which are difficult to understand; advance approval not required 22

23 Part XIII: Undistributed Income This section illustrates satisfaction or failure of a non-operating foundation s payout requirements. It is important to remember that the amount shown on Line 6f, Col. (d) is not required to be distributed until the tax year after the tax year covered by the return. Normal ordering of application of distributions: 1. Current-year payout requirement (calculated on prior return) 2. Next year s payout requirement (calculated on current return) 3. Excess distribution carryover Elections can be made to divert distributions after Step 1 in order to satisfy requirements from a prior year (penalty situation) or to meet redistribution requirements. 23

24 Part XIV: Private Operating Foundations This section illustrates satisfaction of a private operating foundation s payout requirements. The test can be met on an aggregate basis (i.e., total for all four years), or on a three-out-offour-year basis. Two-part test: 1. Income test (based on lesser of adjusted net income or MIR) 2. One of the following: I. Asset test (65%-plus are charitable-use) II. Endowment test (spend 2/3 of MIR) III. Support test (certain required percentages of support from public) Failure of test means the foundation becomes a non-operating foundation that completes Part XIII. 24

25 Part XV: Supplementary Information This section provides information about grant programs. Foundation can describe what kinds of organizations/individuals it supports or attempt to forestall submission of unsolicited applications by checking the box. Details regarding grants paid during the year and those approved for future payment are presented. Importantly, the public charity status (on the return, this is referred to as foundation status) must be reported for each grantee [e.g., 509(a)(1)]. 25

26 Part XVI-A: Analysis Of Income- Producing Activities This section analyzes the sources of revenue during the year to show how much revenue was unrelated business income that is taxable, unrelated business income that is not taxable, and related/exempt function income. 26

27 Part XVI-B: Relationship Of Activities For exempt function revenue reported in Col. (e) of Part XVI-A, a description is reported in this section explaining how the incomeproducing activity contributed to the foundation s exempt purposes. 27

28 Part XVII: Information Regarding Transfers To, And Transactions And Relationships With, Non- Charitable Exempt Organizations As the title implies, this section reports information about transfers and other transactions with non-charitable exempt organizations, as well as relationships with such organizations. It is important to demonstrate that such transactions, etc. do not result in the improper use of charitable funds for non-charitable purposes. 28

29 Milton Cerny, McGuire Woods Amanda Adams, Blazek & Vetterling Brian Yacker, YH Advisors CRITICAL COMPLIANCE ISSUES WITH FORM 990-PF

30 Current Developments I IRS work plan A. Based on information reported on Form 990-PF, the Exempt Organization Division is examining a selection of the largest private foundations. 1. Proposed regulations a. Reliance standards for making good faith determinations of foreign organization s charitable status (Reg ) b. Sections 4942 and 4945 require a determination, based on an affidavit of the foreign organization or an opinion of counsel (equivalency letter), to the grantor foundation that the grantee is a charitable organization. Now includes in the list of qualified tax practitioners an enrolled agent 30

31 Current Developments (Cont.) c. Other changes under consideration by the IRS: Time limitation, during which foundation could rely on equivalency written advice Revision of Rev. Proc to take into account changes in public support test for public charities Elimination of the good faith determination based on grantee affidavit 3. New examples regarding program-related investments under Sect of the regulations were revised. The new examples include the following investments: a. The purchase of stock in a business that will develop a vaccine to prevent a disease that predominantly affects poor individuals in developing countries 31

32 Current Developments (Cont.) b. The purchase of stock, or the provision of a loan with below-market interest rates accompanied by the acceptance of stock, in a business in a developing country that collects recyclable solid waste and delivers such waste to recycling centers that would otherwise be inaccessible to a majority of the population c. A loan with below-market interest rates to a business in a rural area that employs a large number of poor individuals, where the business has sustained damage from a natural disaster d. A loan with below-market interest rates to individuals in a developing country that was damaged by natural disaster, for the purpose of starting small businesses 32

33 Current Developments (Cont.) e. A loan with below-market interest rates to a company that purchases coffee from farmers in a developing country, for the purpose of training poor farmers about water management, crop cultivation, pest management and farm management f. A loan with below-market interest rates to an organization described in IRC Sect. 501(c)(4) that develops and encourages interest in painting, sculpture and art by conducting weekly community art exhibits, for the purchase of a large exhibition space g. A deposit as security, or a guarantee and reimbursement agreement, for a loan to a charitable organization described in IRC Sect. 501(c)(3) that provides childcare services in a low-income neighborhood, for the construction of a new childcare facility 33

34 Current Developments (Cont.) 4. Guidance on charitable donations to disregarded single-member LLCs a. The IRS announced in Notice that a contribution to a domestic single-member LLC that is wholly owned and controlled by a U.S. charity and disregarded for federal tax purposes is deductible, because the IRS will treat the gift as being made to a branch or division of the charity. The charity will be treated as the recipient of the gift, for purposes of meeting the substantiation and disclosure requirements. b. Before this notice, foundations had no definitive guidance as to whether a charitable contribution to a disregarded LLC owned by a public charity would be a charitable grant. Now, foundations will be able to direct their grants directly to the LLC without uncertainty over the charitable deductibility of the grant. 34

35 Disclosing Operational Activities: Part VII-A, Question 2 Has the foundation engaged in any activities that have not been previously reported to the IRS? 1. Generally, any substantially different activities that have not previously been reported (Form 1023 or 990-PF) should be reported here. The foundation will not receive a letter from the IRS approving of such activities as a result. However, it may protect the foundation from retroactive challenges to exempt status by putting the IRS on notice of new activities. 2. Certain new activities require advance approval from the IRS: I. Grants to individuals for study, travel, similar purposes II. Termination of private foundation status through operation as a public charity 35

36 Disclosing Operational Activities: Part IX-A, Direct Charitable Activities The top four programs are reported. Statistical data such as the number of persons served, classes taught, books distributed, etc. enhance the descriptions. The expenses reported include capital expenditures for related assets but not depreciation. A reasonable and consistent allocation of overhead expenses is permitted. Unless there is significant involvement in the foundation s grant programs, they are typically not reported as direct charitable activities. This section is critical for private operating foundations. 36

37 Minimum Distribution Requirements (Sect. 4942) Definitions o Undistributed income Distributable amount exceeds qualifying distributions for any given year o Distributable amount Overview Two years to make qualifying distributions Calculation Essentially, the private foundation s minimum investment return, with certain adjustments Private foundation s grants that are returned to the private foundation ( 4942(f)(2)(C)(i)) Amounts received or accrued from the sale of property, to the extent that the acquisition of the property was considered a qualifying distribution ( 4942(f)(2)(C)(ii)) Any amount set aside for a specific project, to the extent the amount set aside was not necessary for the purposes for which it was set aside ( 4942(f)(2)(C)(iii)) Prepared by YH Advisors, Inc. 37

38 Minimum Distribution Requirements (Sect. 4942), Cont. Definitions (Cont.) o Minimum investment return 5% of fair market value of non-charitable assets (net total assets less exempt purpose assets) Examples of exempt purpose assets Art owned by private foundation that is displayed in museum Desks in classroom of school operated by private foundation Fair market value calculations Cash Calculate average monthly cash balances See regulations ( (a)-2(c)(4)(ii)) Securities Readily available market quotations + NYSE or NASDAQ + Any city or regional exchange on which quotations appear on a daily basis + Any other exchange (foreign, national, regional) on which quotations appear on a daily basis + Regularly traded in a market for which published quotations are available + Locally traded in a market for which quotations can be obtained from established brokerage firms Consistently calculate average monthly fair market value Marketability discounts permitted (Sec. 4942(e)(2)(B)) See five examples in regulations ( (a)-2(c)(4)(i)(e)) Prepared by YH Advisors, Inc. 38

39 Minimum Distribution Requirements (Sect. 4942), Cont. Definitions (Cont.) o Minimum investment return (Cont.) Real estate Five-year optional reliance, if written appraisal prepared by unrelated (Reg (a)-2(c)(4)(iv)) Written, certified and independent appraisal of the fair market value of any real estate Qualified person may not be disqualified person or an employee of the private foundation. Commonly accepted valuation methods must be used in making the appraisal. Valuation based upon acceptable methods of valuing property for federal estate tax purposes will be considered acceptable. Appraisal must include a closing statement that, in the appraiser s opinion, the appraised assets were valued according to valuation principles regularly employed in making appraisals of such property, using all reasonable valuation methods. Private foundation must keep a copy of the independent appraisal for its records. IRS will continue to accept the appraisal for a five-year period, even if actual FMV changes. Planning opportunity: When the FMV of real estate is increasing, the private foundation should utilize the independent appraisal for determining the value of its real estate investments. When it is decreasing, consider obtaining another independent appraisal, even if the five-year period has not yet concluded for the original appraisal of the real estate. Real estate valuation planning will help the private foundation minimize its minimum distribution requirements, by minimizing the value of total non-charitable assets. Prepared by YH Advisors, Inc. 39

40 Minimum Distribution Requirements (Sect. 4942), Cont. Definitions (Cont.) o Minimum investment return (Cont.) Valuation of other assets Fair market value consistently determined annually (see Reg (a)-2(c)(4)(iv)(a)) Valuation can be conducted by a private foundation insider. May be valued as of any day in PF s tax year, provided that the PF values the asset as of that date in all tax years Exempt purpose assets are not considered for the minimum investment return calculation. Reg (a)-2(c)(3): Asset is used directly in carrying out the foundation's exempt purpose only if the asset is actually used by the foundation in the carrying out of the charitable, educational or other similar purpose that gives rise to the exempt status of the foundation. Assets held for production of income or for investment are not being used directly in carrying out the foundation's exempt purposes, even though the income from such assets is used to carry out such exempt purposes. Whether an asset is held for the production of income, rather than used directly to carry an exempt purpose, is a question of fact. For example, an office building used for the purpose of providing offices for employees engaged in the management of endowment funds of the foundation is not being used directly by the foundation to carry out its exempt purposes. Where property is used both for exempt purposes and for other purposes, if the exempt use represents 95% or more of total use, such property shall be considered to be used exclusively for an exempt purpose. Prepared by YH Advisors, Inc. 40

41 Minimum Distribution Requirements (Sect. 4942), Cont. Definitions (Cont.) o Minimum investment return (Cont.) Exempt purpose assets not considered for minimum investment return calculation (Cont.) Examples (in the IRS regulations) of assets that are used directly in carrying out exempt purposes Administrative assets, such as office equipment and supplies, that are used to the extent such assets are devoted to and used directly in the administration of the foundation's exempt activities Real estate used by the foundation directly in its exempt activities Paintings or other works of art owned by the foundation and which are on public display, fixtures and equipment in classrooms, research facilities and related equipment Any interest in a functionally related business or in a program-related investment Property leased by a private foundation in carrying out its exempt purposes at no cost (or at a nominal rent) to the lessee or for a program-related purpose, such as the leasing of renovated apartments to low-income tenants at a low rental as part of the lessor foundation's program for rehabilitating a blighted portion of a community Prepared by YH Advisors, Inc. 41

42 Minimum Distribution Requirements (Sect. 4942), Cont. Definitions (Cont.) o Minimum investment return (Cont.) Reasonable cash balances for administrative expenses (Reg (a)- 2(c)(3)(iv)) 1.5% of total assets (less exempt purpose assets) Exclude 1.5% amount, even if greater than average cash balances (see Rev. Rul ) May exceed 1.5% amount under certain limited circumstances Attach statement to Form 990-PF Short tax years Minimum investment return percentage is reduced based on number of days in period PLR IRS ruled that a private foundation may re-compute its minimum investment return for several years, in order to take into account an adjustment to the value of real property donated to the foundation. Prepared by YH Advisors, Inc. 42

43 Minimum Distribution Requirements (Sect. 4942), Cont. Definitions (Cont.) o Qualifying distributions (Sect. 4942(g)) Any amount, including reasonable/necessary admin expenses, paid to accomplish charitable purposes; and any amount paid to acquire asset used directly in carrying out charitable purposes Expenses incurred directly in carrying out the private foundation s charitable purposes Grants and gifts made by the private foundation to qualifying recipients Exercise expenditure responsibility for grants and gifts made to non-public charities NOT including amounts paid to directly or indirectly controlled charitable organizations (see Sec. 4942(g)(1)(A)) or paid to non-functionally integrated Type III charitable support organizations (see also Reg (a)-3(a)(3)) Acquisition of exempt purpose assets Reasonable and necessary administrative expenses (Cont.) Examples Expenses attributable to soliciting grants Expenses related to inspecting determination letter of public charities NOT expenses related to the management of an investment endowment fund Prepared by YH Advisors, Inc. 43

44 Minimum Distribution Requirements (Sect. 4942), Cont. Definitions (Cont.) o Qualifying distributions (Cont.) Reasonable and necessary administrative expenses (Cont.) Internal Revenue Service rulings Rev. Rul : Legal fees paid in a lawsuit to determine the proper beneficiary of part of the private foundation s income PLR : Reasonable legal and accounting expenses incurred by a private foundation in obtaining an IRS ruling with respect to transfer of assets for purposes of furthering charitable purposes PLR : Reasonable and necessary legal, accounting, and other expenses incurred to implement the transfer of assets from one private foundation to another were considered qualifying distributions Rev. Rul : Depreciation expense generally will NOT be considered a qualifying distribution EO CPE Text Other qualifying distributions include expenses attributable to soliciting grants or contributions to the foundation; preparing Form 990-PF making the return available for public inspection or providing copies... Prepared by YH Advisors, Inc. 44

45 Verifying Grant Recipients Grants to small exempt organizations o Grants made to small exempt organizations whose exempt status was revoked Not taxable expenditure until the IRS published revocation list on June 8, 2011 See for the Auto-Revocation List Would be taxable expenditure if make grant to a revoked entity thereafter Key for the private foundation to check the Auto-Revocation List and IRS Select Check before making grants to smaller exempt organizations Can avoid classification as a taxable expenditure if exercise expenditure responsibility o Grants made to single-member LLCs of public charities See IRS Information Letter : Grant to single-member LLC owned by public charity is considered to be a qualifying distribution and as such, the exercise of expenditure responsibility is not required. Prepared by YH Advisors, Inc. 45

46 Verifying Grant Recipients (Cont.) Grants to supporting organizations o o o Controlled supporting organizations Not a qualifying distribution if private foundation makes grant to any supporting organization, if a disqualified person directly or indirectly controls the supporting organization or a supported public charity of the supporting organization Grant to controlled supporting organization will be considered a taxable expenditure if expenditure responsibility is not exercised Non-functionally integrated Type III supporting organization Even if exercise expenditure responsibility, grant to non-functionally integrated Type III supporting organization will NOT be considered a qualifying distribution (see Sect. 4942(g)(4)) Grant to non-functionally integrated Type III supporting organization will be considered a taxable expenditure, if expenditure responsibility is not exercised. Check status before making contribution Publication 78 does not indicate whether organization is a supporting organization, or if so, what type Required analysis when make grants to certain supporting organizations Who are the private foundation s disqualified persons? Which supporting organizations does the disqualified person control? To which supporting organizations does the private foundation make grants? Was expenditure responsibility exercised for grants made to organizations listed, in response to the two questions immediately above? Prepared by YH Advisors, Inc. 46

47 Verifying Grant Recipients (Cont.) Grants to supporting organizations (Cont.) Is donee a supporting organization (SO)? YES Is donee SO a Type I, Type II or Type III? Type III Type I or II Is the Type III SO functionally integrated or not? Does a DQP control the SO or a charity it supports? YES NO YES Has the PF exercised expenditure responsibility? NO Grant will be considered a qualifying distribution + No violation of Sect re taxable expenditures Violation of Sect excise taxes imposed Prepared by YH Advisors, Inc. 47

48 Verifying Grant Recipients (Cont.) Grants to foreign charities o Expenditure responsibility Take responsibility for the funds granted to the foreign charity Granting private foundation conducts specific oversight and monitoring procedures Takes lots of ongoing effort and energy Necessary steps Pre-grant due diligence that foreign recipient is a bona fide charity Ensure that grant is actually spent only for the purpose for which it is made Obtain full and complete reports from the foreign grantee organization on how funds were spent Make full and detailed reports on the expenditures to the IRS on Form 990-PF Private letter rulings See PLR for IRS guidance when making grants to foreign charities See also PLR See PLR for IRS guidance regarding when expenditure responsibility should be exercised for grants made to domestic non-charitable entities Prepared by YH Advisors, Inc. 48

49 Verifying Grant Recipients (Cont.) Grants to foreign charities (Cont.) o Expenditure responsibility (Cont.) Pre-grant inquiry Investigate, based on readily available information, that the grantee will use the granted funds from the private foundation for proper purposes Inquiry should include identity, experience, history of grantee and its governing body, information on management activities, finances and practices of the grantee. Private foundation must document the purposes of the grant, assessment of the grantee s ability to achieve goal, and assessment of grantee s ability to report on the use of the funds. Please me for examples of pre-grant inquiry forms Written grant agreement Specify the charitable purpose Require the grantee to maintain grant funds in separate account Require grantee to maintain records of receipts and expenditures and make such records available to the private foundation for inspection Require the grantee to repay grant funds, if they were not utilized for purposes of the grant Require the grantee to provide annual reports and a final report on its use of the grant funds Prohibit the use of the grant funds for lobbying, political activities, re-granting and non-charitable uses Must be executed by the private foundation and the grantee Please me for a copy of the sample agreement letter Prepared by YH Advisors, Inc. 49

50 Verifying Grant Recipients (Cont.) Grants to foreign charities (Cont.) o Expenditure responsibility (Cont.) Annual reports (must be received in all years that grant funds expended) Detailed breakdown of how grant funds were expended during the relevant period, in comparison to the initial budgets of the grantee Narrative description of the grantee s progress in achieving the purposes of the grant during the year Statement whether the grantee has fully complied with the terms of the grant agreement Signature of the authorized officer of the grantee Please for a sample grantee report form Final reports Must be received within a reasonable period of time after the close of the grantee s annual accounting period in which all the grant funds were expended or the grant was terminated (generally, 90 days) Reports to the IRS Must annually report to the IRS on every expenditure responsibility grant made Please see the example of the Form 990-PF attachment in the course materials Investigate problems with grant Private foundation must take corrective measures, if a diversion of grant funds has taken place. Take all reasonable and appropriate steps to recover the grant funds Withhold further payments to the grantee until receive assurances that further diversions will not occur Prepared by YH Advisors, Inc. 50

51 Verifying Grant Recipients (Cont.) Grants to foreign charities (Cont.) o Expenditure responsibility (Cont.) How to fail expenditure responsibility Fail to conduct sufficient pre-grant inquiry Fail to include required terms in grant agreement Fail to receive annual or final reports Fail to attach required support documents to the Form 990-PF Disadvantages of expenditure responsibility Tougher to make general support grants under expenditure responsibility Required periodic reporting could be tough to obtain from certain countries Probably not the preferred method if the private foundation grantor expects to fund the foreign charity over a long-term period Prepared by YH Advisors, Inc. 51

52 Types Of Self-Dealing I. Sale between PF (private foundation) and DP (disqualified person) A. Foundation holds charitable auction and sells item to DP. B. Foundation makes bad investment; DP wants to buy from foundation at more than FMV. C. Foundation manager retires, and PF sells him the car owned by the PF that he used for site visits. II. Lease transaction between PF and DP A. DP leases office space larger than needed; sublets space to foundation. III. Loan between PF and DP A. Foundation needs money to make distributions, DP loans. B. Foundation loans money to DP s business at an aboveaverage interest rate. 52

53 IV. Types Of Self-Dealing (Cont.) Furnishing of goods, services, or facilities between PF and DP A. PF provides office space to DP at no charge. B. DP uses PF s office supplies. V. Payment of compensation by PF to DP A. DP receives directors fees. B. DP receives payment for serving as PF s investment manager. VI. Use of PF s income or assets by a DP 53 A. DP uses PF s deposits in a bank as collateral for a loan. B. DP uses PF s accounts with an investment manager to reduce the amount of fees paid on his personal account. C. PF purchases table at charity gala; DPs and friends attend.

54 Tips To Prevent Self-Dealing I. Know who the PF s DPs are. This includes family members, businesses owned by DPs, etc. II. Carefully scrutinize any financial transaction between the PF and a DP, to assure yourself whether an exception to self-dealing applies. Self-dealing is different from a conflict of interest. III. DPs should clearly identify PF checkbooks/credit cards, so that they are not inadvertently used when making a personal purchase. Similarly, when making account transfers, care should be taken. IV. Consider whether grants to charities that include membership benefits, event tickets and similar quid pro quos result in selfdealing when a DP uses the benefits. If a claim is made that the benefits are incidental to accomplishing a charitable purposes, then written documentation should be maintained. 54

55 Alternative Investments I. Alternative investments A. Alternative investments include notional contracts, hedge funds, fund of funds, private equity funds and other investment partnerships. B. Generally, income from such investments is not subject to federal income tax. Sect. 512(b)(5) C. If the fund borrows to make investments and generates income from leveraged funds, the foundation will have to pay its share of income attributable to the debt financed property. Sect. 514 D. Option: Establish a blocker corporation, created offshore in a jurisdiction that does not impose income tax at the corporate level and avoids the corporate level tax for the foundation the blocker distributes dividends to the foundation that are not taxed as UBIT to the foundation. See PLR

56 Alternative Investments (Cont.) E. U.S. anti-deferral regime for passive foreign investment companies (PFICs) F. Seventy-five percent of PFIC s income comes from passive income. G. No taxes are due until there is a distribution of accumulated dividends. H. Reported income is taxed as ordinary income, and an interest penalty must be paid. See IRC 297(c) and

57 Revenue Included In Net Investment Income I. Interest II. Dividends III. Rents IV. Royalties V. Payments with respect to securities loans VI. Income from sources similar to those above (????) VII. Capital gain (special exclusion is listed on next slide). Remember that for donated assets, the donor s tax basis carries over to the foundation. 57

58 Revenue Excluded From Net Investment Income I. Revenue subject to unrelated business income tax II. Inventory sales III. Income from sources not similar to those listed on the previous slide 1-5 (????) IV. Capital gain from the sale of charitable use assets held for at least one year, when the proceeds are used to purchase similar charitable assets V. Net capital loss cannot be used to offset other investment income, carried forward or carried back. VI. Tax-exempt income (interest on municipal bonds) 58

59 Deductions Included In Net Investment Income I. Ordinary and necessary expenses related to the production or collection of gross investment income II. Ordinary and necessary expenses related to the management, conservation or maintenance of property held for the production of investment income III. Depreciation of investment assets must be straight-line. IV. Cost depletion of investment assets is permitted, but percentage depletion is not. V. Overhead expenses can be allocated based on a reasonable and consistent allocation. VI. Deductions related to income earned from a charitable activity cannot exceed the income. VII. Documentation for allocations of joint activities is critical. Example: Foundation manager s compensation, which is allocated between investment and charitable activities (timesheets!) 59

60 Tips For Qualifying For The 1% Tax Rate I. Check calculation before year-end, to determine estimate of spending needed to qualify; accelerate the payment of grants that would have been paid in the following year anyway II. Alternate years between 1% and 2% and coordinate distributions, so that they are as low as possible in 2% years in order to drive the historical ratio down III. In initial year of existence, make no qualifying distributions. This will ensure the 1% for the second year, as the historical ratio will be 0. IV. Consider not accelerating distributions, in order to qualify for the 1% rate when the tax savings is immaterial (i.e., spending $100,000 in grants to save $1,000 in tax.) This will improve the ratio for future years when capital gains might increase tax savings. 60

61 Excess Business Holdings Rules I. General overview (Sect. 4943) A. Generally, holdings not permitted in excess of 20% B. Combine the holdings of the private foundation and disqualified persons II. Definitions A. Business enterprises 1. Not including functionally related business 2. Trade or business conduct that is substantially related to exercise of charitable functions 3. Trade or business in which substantially all work is performed without compensation 4. Business carried on primarily for the convenience of members, students, patients, officers or employees (such as a cafeteria operated by a museum) 61

62 Excess Business Holdings Rules (Sect. 4943), Cont Business that consists of selling of merchandise, substantially all of which was received as gifts or contributions 6. Activity carried on within larger combination of similar activities related to exempt purpose B. Not including passive businesses (95% of income from passive sources) 1. For example, a business that generated only royalty income 2. See PLR (activity deemed not to be a business enterprise) 3. IRS rules that a private foundation s ownership of 100% of the stock of a company would not be classified as excess business holdings, because at least 95% of the company s gross income came from passive sources. See PLR

63 Excess Business Holdings Rules (Sect. 4943), Cont. 4. See Sect. 4943(d)(3) and Reg (c)(1) for the 95% rule C. Excess business holdings (Sect. 4943(c)(2)) 1. General rule: Hold no more than 20% of voting stock D. Exceptions a. PLR : Cannot convert voting stock to nonvoting stock by agreeing not to vote the stock b. No limit on the amount of non-voting stock that private foundation can own 1. Increase to 35% when unrelated owner has effective control (Reg (b)(3)(ii)) 63

64 Excess Business Holdings Rules (Sect. 4943), Cont. 64 a. Effective control is the power to direct the management and policies of a business enterprise E. Private foundation can own 2% of voting stock of business enterprise, regardless of what is owned by disqualified persons. F. Ownership of the stock of a functionally related business (Reg (b)) 1. General rule: Hold no more than 20% of voting stock a. Business related to the exempt purposes of the private foundation b. See Sect. 4942(j)(4) and Reg (a)-2(c)(3)(iii) c. See PLR Private foundation s program-related investments

65 Excess Business Holdings Rules (Sect. 4943), Cont. G. Disposition of excess business holdings day period (knows or reason to know of the excess business holdings) a. Private foundation acquires ownership other than by purchase b. For example, disqualified person acquires additional holdings H. Gifts and bequests 1. Five-year time period (ability to obtain another five years under certain circumstances) a. See Sect. 4943(c)(7)(A) b. PLR : Private foundation received five-year extension when making best efforts to dispose of interest in farm 65

66 Excess Business Holdings Rules (Sect. 4943), Cont. c. PLR : Private foundation received five-year extension when making best efforts to dispose of interest in farm. d. PLR : Private foundation received five-year extension for publicly traded stock (thin volume/sales restrictions). e. PLR : IRS granted a private foundation an additional five years under Sect. 4943(c)(7) to dispose of excess business holding that resulted from an unusually large bequest. III. PLR A. Voting stock gifted to non-functionally integrated Type III supporting organization was treated as subject to 4943, due to redemption from ESOP. B. IRS permitted a five-year extension for disposition of the stock. 66

67 Jeopardizing Investments I. Consider gifts of excess stock/securities, as opposed to just selling A. Potentially reduces capital gain subject to the net investment income excise tax II. Rules for the application of the extension of five-year holding period A. Request for an extension to the IRS before the expiration of the initial disposal period B. Diligent efforts to dispose of the holdings within the five-year period C. Submission to the IRS of a plan for disposition D. Submission of the plan to the attorney general of such plan, and the attorney general s response to the plan 67

68 Jeopardizing Investments (Cont.) E. IRS determination that such plan can reasonably be expected to be carried out before the close of the extension period. F. IRS may grant an additional period up to five years to dispose of stock III. Options for disposition of excess business holdings A. Sale of stock B. Liquidation of the corporation when the foundation is the sole owner of the stock C. Reorganization of the corporation through conversion of voting stock to non-voting stock D. Transfer of shares of stock to one or more public charities 68

69 Jeopardizing Investments (Cont.) E. Conversion of foundation to a supporting organization affiliated with a public charity IV. Jeopardizing investments A. What are jeopardizing investments? 1. Sect provides that if a private foundation invests its assets in such a manner that will jeopardize the accomplishments of its exempt purposes, the foundation and possibly its managers are subject to certain excise taxes. 2. Foundation managers failed to exercise ordinary business care and prudence under the facts and circumstances at the time of mailing the investment. Knowingly and willing engages in a transaction when manager is aware that transaction may violate Sect IRS decision is made on an investment-by-investment basis. No category of investments are treated as a per se violation of Sect Transaction may be protected by a reasoned opinion of counsel. 69

70 Jeopardizing Investments (Cont.) 3. IRS will closely scrutinize trading in securities on margin, commodity futures, puts calls and straddles. B. Program-related investments exempted from jeopardy investment rules 1. The primary purpose is to accomplish one or more tax exempt purposes, and no significant purpose is the production of income or the appreciation of property. 2. PRIs are not subject to excess business holdings rules under Sect and may be treated as qualifying distributions under Sect

71 Jeopardizing Investments (Cont.) 1. An investment can be made to either a charity, non-profit or commercial business that is carrying out the charitable purposes of the foundation. 2. Investment would not have been made but for the investment and the accomplishment of the exempt purpose. a. Examples: Low-interest or interest-free loans to needy students High-risk investments in non-profit/low-income housing Low-interest loans to small businesses in economically distressed areas, owned by disadvantaged groups where commercial loans are not available 71

72 Jeopardizing Investments (Cont.) Investment in businesses in deteriorated urban areas Investments combating community deterioration Purchase of stock or loans to businesses in a developing country Loans to businesses in rural areas that employ large numbers of poor people Guarantee for a loan to charitable organization engaged in charitable activities 72

73 Jeopardizing Investments (Cont.) V. Each program related investment must be made subject to a written commitment that includes: A. An agreement by the recipient to use the funds only for the purposes of the investment B. Submit at least once a year a full and complete financial report ordinarily required by commercial investors C. Keep adequate books and records D. Funds must not be used for legislative or political activities 73

74 Jeopardizing Investments (Cont.) VI. General observations on program-related investments A. Take responsibility for the funds granted to the foreign charity B. Granting private foundation conducts specific oversight and monitoring procedures C. Necessary steps to take 1. Pre-grant due diligence that foreign recipient is a bona fide charity 2. Ensure that grant is actually spent only for the purpose for which it is made 3. Obtain full and complete reports form the foreign grantee organization on how funds were spent 74

75 Jeopardizing Investments (Cont.) 4. Make full and detailed reports on the expenditures to the IRS on Form 990-PF D. Private letter rulings 1. See PLR for IRS guidance when making grants to foreign charities Also see PLR See PLR for IRS guidance regarding when expenditure responsibility should be exercised for grants made to domestic non-charitable entities 3. See PLR for IRS guidance on the receipt of royalty payments resulting from funding hospital research program 75

76 Reporting Self-Dealing On Form 4720 I. For self-dealing transactions that involve the use of money (loan), the amount involved is the FMV of the use of the money, not the amount of money borrowed. With today s interest rates, that amount is usually pretty small. II. The self-dealer must file a separate Form 4720 if his tax year is different from the foundation s (typically an issue if the foundation is on a fiscal year that is other than the calendar year). III. No abatement of the penalty is permitted. IV. Penalty is 10% of the amount involved and is owed by the self-dealer. If the PF pays a penalty, this results in another self-dealing transaction. V. Correction involves undoing the transaction to the extent possible, but not putting the PF in a worse position than if it had engaged in the transaction with a non-insider. If terms are favorable to the PF and must be rescinded, the DP has to make the PF whole. 76

77 Reporting Taxable Expenditure On Form 4720 I. Remember that a taxable expenditure may still be a qualifying distribution. A scholarship grant that is a taxable expenditure because an approved plan is not in place, was still made for charitable purposes. II. Abatement of the penalty can be requested as long as the taxable event was due to reasonable causes and not willful neglect, and the event was corrected within the prescribed correction period. III. Correction is generally accomplished by recovering part or all of the expenditure, to the extent recovery is possible. When full recovery is not possible, additional corrective action includes one or more of the following: Requiring that any unpaid funds due to the grantee be withheld Requiring that no further grants be made to the particular grantee Requiring reports regarding the use of the funds Requiring improved methods of exercising expenditure responsibility Requiring improved methods of selecting recipients of individual grants 77

78 Form 4720: Foundation Manager Liability Remember that foundation managers who approve of certain transactions (listed below) reported on Form 4720 may personally be subject to a penalty. The tax is imposed only when the foundation manager knew that the expenditure was improper and agreed to the making of the expenditure willfully and not due to reasonable causes. The following types of penalty transactions could result in FM liability: Self-dealing Taxable expenditure Jeopardizing investment Political expenditure 78

79 Form 990-PF: Red Flag Items Receivables/payables with insiders (Part II) Capital gains not computed properly for donated securities (Part IV) Undertaking political activities (Part VII-A) Undertaking of transactions with disqualified persons (Part VII-B) Exercising expenditure responsibility without required Form 990-PF attachment (Part VII-B) Compensating disqualified persons (Part VIII) Reporting grants to certain types of recipients (Part XV) Generating unrelated business income (Part XVI-A) Prepared by YH Advisors, Inc. 79

80 IRS Audits Of Private Foundations General overview o Have experienced marked increase in IRS audits of our private foundation clients IRS referenced such in their 2012 EO work plan o Audit selection Appear to be targeted audits, to the best of our knowledge o Audit procedures Interestingly, the majority of audits of our private foundation clients are being conducted by out-of-state auditors. Prepared by YH Advisors, Inc. 80

81 IRS Audits Of Private Foundations (Cont.) Common IRS audit issues o Self-dealing Reimbursement of personal expenses Loans Unreasonable compensation o Employment tax issues Failure to file 1099s Failure to undertake required back-up withholding o Under-reported unrelated business income K-1s o Foreign reporting FBAR o Expense allocations Form 990-PF, Part I Prepared by YH Advisors, Inc. 81

82 Candice Meth, EisnerAmper BEST PRACTICES WITH FUTURE FORM 990-PF FILINGS

83 Lessons Learned From Self-Dealing Leases: Don t pay rent to disqualified person Special events: A private foundation cannot purchase tickets to a charitable fundraising event and then provide the tickets to disqualified persons or to third parties, if doing so benefits a disqualified person. There is an exception that permits foundation managers to use the tickets, if attending the event furthers their duties for the foundation. 83

84 Lessons Learned From Self-Dealing (Cont.) Investment management services might be okay. Loan to disqualified person bad idea (exception for qualified disaster super-storm Sandy) Using credit cards: If a disqualified person uses a foundation credit card for personal expenses and later reimburses the foundation for the expenses, this is considered a loan and a form of self-dealing, even if the person reimburses the full amount within a month of the transaction. 84

85 Providing Investment Management Services For A Fee Is Okay Per Private Letter Ruling , it was determined that payment for fees by a private foundation for investment services provided by a disqualified person, as described in Sect (d)-3(c)(2), will not be an act of self-dealing. 85

86 Pro-Bono, Please! As stated in the IRS Publication 578 Tax Information for Private Foundations and Foundation Managers providing goods, services, or facilities between a private foundation and a disqualified person is not self-dealing if a disqualified person provides them to the foundation without charge and the goods, services, and facilities are used exclusively for purposes specified in section 501(c)(3) of the Code. 86

87 Lessons Learned With Respect To Qualifying Distributions IRS revocation: Keep a record of tax status based on when you made the grant Foreign grants: Expenditure responsibility or equivalency determination (pay attention to new rules) Giving to donor-advised fund: A good option if you are trying to target the 1% tax Scholarships/honorariums: Might need to create a 1099; special IRS rules! 87

88 Concerns About Compensation Executive compensation is a hot topic in the press. Are you doing compensation studies? Do you have a compensation-setting committee? Can you show that compensation is reasonable in comparison to that of other foundations? The box for payment to disqualified person should be checked Yes (Part VII-B Question 1(a)4), since the executive director is a disqualified person and is paid (if no compensation was paid, it s possible this box would get checked No ). 88

89 Concerns About Compensation (Cont.) Does it look bad if the directors or trustees receive stipends? A private foundation may pay reasonable compensation to a disqualified person for providing necessary professional services to the foundation. Example: A foundation can pay a member of its board of directors, who also provides accounting services to the foundation, as long as the fees are reasonable. W-2 vs. 1099: An individual receives one or the other, but never both! Remember, in a family foundation, your relative or spouse should not be the person setting your compensation best practices! 89

90 Problems With The Current Form The form has not been significantly revised since the 1970s, yet private foundations have evolved significantly and are diverse in size, mission and endowment structure. The information about private foundations is extremely delayed due to the fact that many foundations are still paper-filing their returns, and therefore benchmarking and better understanding of the sector are hampered. There are no governance questions on the form. The current excise tax structure, which varies from 1% to 2%, is confusing, unpredictable and needs to be reviewed. 90

91 The number of U.S. foundations has grown by 246%, and the total assets of U.S. foundations by 395%, since 1975 while the 990-PF regulatory structure has remained static. Number of U.S. Foundations 80,000 70,000 71,095 75,595 60,000 56,582 50,000 40,000 40,140 32,401 30,000 20,000 21,877 22,088 25,639 10, Source: The Foundation Center 91