Private Foundations vs. Donor Advised Funds

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1 The Path of Least Resistance Converting Private Foundations to Donor Advised Funds Cherie Evans Evans & Rosen LLP Berkeley, California Evans & Rosen LLP Private Foundations vs. Donor Advised Funds 1

2 Map of Nonprofits O O O California Nonprofit Corporations O Public Benefit Corporation (Corporations Code Sections ) O formed for public or charitable purposes O may not distribute corporate assets to members O Religious Corporation (Corporations Code Sections ) O formed for religious purposes O may not distribute corporate assets to members O subject to less state regulation O Mutual Benefit Corporation (Corporations Code Sections ) O formed for any lawful purpose O may distribute corporate assets to members on dissolution Nonprofit Unincorporated Associations Charitable Trusts Map of Tax Exempt Entities O Federal and State Tax Law numbers below refer to Internal Revenue Code sections O 501(c)(3) - charitable organizations O Public Charity O Private Foundation O 501(c)(4) - social welfare organizations O 501(c)(5) - labor & agricultural organizations O 501(c)(6) - business leagues O 501(c)(7) - social clubs O There are other code sections; these are the most common. 2

3 Donor Advised Fund Definition O Separately identified by reference to contributions of a donor or donors O Owned and controlled by a sponsoring organization O As to which a donor or donor advisor has advisory privileges with respect to the distribution or investment of the fund Comparison Private Foundation Donor Advised Fund Use Tax Benefits Founder wants to make grants for charitable purposes; usually funded by a small number of people Donor receives a charitable deduction, but it is subject to the private foundation limits Donor wants to make grants for charitable purposes but does not want administrative burdens Donor receives a charitable deduction subject to the public charity limits 3

4 Charitable Contribution Income Tax Deduction for Individuals Public Charity Private Foundation Gift Valuation Limit on Amount of Deduction as % of Adjusted Gross Income Valuation Limit on Amount of Deduction as % of Adjusted Gross Income Cash FMV 50% FMV 30% Qualified appreciated stock Real estate long term capital gain FMV 30% FMV 20% FMV or Basis 30% or 50% Basis 20% Private Foundation Comparison Donor Advised Fund Control Controlled by a Board of Directors or Board of Trustees The public charity owns and controls the fund; however, the donor advisor may advise the charity on investment of the fund or preferred charitable beneficiaries Mainten ance Private foundations have to comply with both state and federal laws, including annual filing requirements The public charity is responsible for all the administration 4

5 Private Foundation Rules O IRC Section 4940: 2% annual excise tax on net investment income O IRC Section 4941: severe sanctions on most financial transactions between private foundation and disqualified persons O IRC Section 4942: annual qualifying distributions of at least 5% of value of investment assets In Depth Self-Dealing Federal tax law prohibits self-dealing transactions between a disqualified person and a private foundation. (IRC Section 4941) 5

6 Excess Benefit Transactions Compared O Unlike transactions between public charities and disqualified persons, the transactions are prohibited even if they provide no excess benefit. O There are some exceptions. Disqualified Persons O Substantial contributor O Foundation manager O One who owns more than 20% of an entity which is a substantial contributor O Family member of anyone in the above categories O Corporation, partnership or trust in which persons described above own more than 35% of the total combined voting power, profit interest, or beneficial interest O Government officials 6

7 Self-Dealing A self-dealing transaction includes the following whether direct or indirect: O Sale, exchange, or lease of property O Lending money or extension of credit O Furnishing of goods, services, or facilities Self-Dealing O Payment of compensation or payment or reimbursement of expenses O Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation 7

8 Exceptions O A disqualified person can provide free use of property, goods, services, or facilities to a private foundation. O A private foundation may furnish goods, services, or facilities to a disqualified person if it is on a basis no more favorable than that on which they are provided to the general public. More Exceptions O A disqualified person may loan money to a private foundation if the loan is without interest or other charge. 8

9 Exceptions for Compensation O A private foundation may pay compensation or pay or reimburse expenses of a disqualified person if it is for personal services which are reasonable and necessary to carrying out the foundation s exempt purpose and the amount is reasonable and not excessive. O This exception does not apply to government officials. Penalties on Disqualified Person O An excise tax equal to 10% of the amount involved is imposed. O If the disqualified person does not correct the transaction, an additional excise tax of up to 200% of the amount involved is imposed. 9

10 Penalties on Foundation Manager O An excise tax of 5% of the amount involved may be imposed on any officer, director, trustee or senior executive employee who knowingly and willingly participated in the transaction. Private Foundation Rules O IRC Section 4943: prohibits a private foundation and its disqualified persons together from owning more than 20% of a business enterprise O IRC Section 4944: prohibits investments that jeopardize the private foundation O IRC Section 4945: prohibits expenditures for lobbying, political activities, and unless expenditure responsibility is exercised, grants to individuals and organizations that are not public charities 10

11 Donor Advised Fund Rules O IRC Section 4943: applies the private foundation excess business holdings rules except that disqualified persons include a donor, a donor advisor, certain relatives of either, or a 35% controlled entity of any such persons O IRC Section 4958: treats a grant, a loan, compensation, or other similar payment from a donor advised fund to a donor, donor advisor, or person related to either as an automatic excess benefit transaction Donor Advised Fund Rules O IRC Section 4966: prohibits distributions to: (1) any individual or (2) any organization unless expenditure responsibility is exercised O distributions to most public charities are excepted from the expenditure responsibility requirement O IRC Section 4967: prohibits advice as to a distribution that results in a donor, donor advisor or certain related persons receiving, directly or indirectly, a more than incidental benefit 11

12 Termination of Private Foundation Option 1 O Under IRC Section 507(a)(1) and 507(c), a private foundation may voluntarily terminate if it notifies the IRS and pays a termination tax equal to the lesser of all the tax benefits it and its substantial contributors ever received or the net fair market value of its assets. O These taxes may be abated if the private foundation can secure abatement through a private letter ruling. IRC Section 507(g). 12

13 Option 2 O Alternatively, a private foundation may voluntarily terminate its private foundation status by distributing all its net assets to one or more public charities, each of which has been so described for a continuous period of at least 60 calendar months. IRC Section 507(b)(1)(A). O A private foundation terminating in this manner does not need to notify the IRS and does not incur a termination tax. Distribution to DAF O A distribution to a donor advised fund will not qualify as a tax free terminating distribution if there is a material restriction on the transferred assets. The following do not constitute a material restriction: O (1) The fund is given a name which is the same or similar to that of the transferor private foundation. O (2) The income and assets of the fund are to be used for a designated purpose or for one or more particular public charities, and that use is consistent with the transferee public charity s charitable purpose. O (3) The transferred money or property is administered in an identifiable or separate fund, some or all of the principal of which is not to be distributed for a specified period. Treas. Reg. Section (a)(7)(iii). 13

14 Factors Considered a Material Restriction O O The donor (which includes the private foundation, a disqualified person with respect thereto, or any other person designated by such persons) reserves the right to name (other than by designation in the instrument of transfer of particular Section 509(a)(1) or (2) organizations) the organization to which the public charity must distribute or to direct the timing of such distributions (other than by direction in the instrument of transfer that some or all of the principal, as opposed to specific assets, not be distributed for a specified period). The terms of the transfer agreement require the public charity to take or withhold action with respect to the transferred assets which is not designed to further one or more of the exempt purposes of the public charity and such action would, if performed by the private foundation, have subjected it to tax under Chapter 42, except with respect to the minimum investment return requirement of Section 4942(e). Factors Considered a Material Restriction O The public charity assumes contractual obligations or liabilities of the private foundation for purposes inconsistent with the purposes of the public charity, other than the payment of the private foundation s Chapter 42 taxes incurred prior to the transfer to the public charity to the extent of the value of the assets transferred. O The public charity is required by any agreement to retain any securities or other investment assets transferred to it by the private foundation. O An agreement grants the private foundation or any disqualified person a right of first refusal with the respect to transferred property if and when disposed of by the public charity. 14

15 Factors Considered a Material Restriction O An agreement is entered into between the private foundation and the public charity which establishes irrevocable relationships with respect to the maintenance or management of assets transferred to the public charity such as continuing relationships with banks, brokerage firms, investment counselors, or other advisors. O Any other condition is imposed on action by the public charity which prevents it from exercising ultimate control over the assets received from the private foundation. Treas. Reg. Section (a)(7)(iv). Dissolution of a California Nonprofit Public Benefit Corporation Steps Description Performed by 1 Determine who will receive assets upon dissolution 2 Approval by Board and Members (if any) of the plan of dissolution 3 File Certificate of Election to wind up and dissolve 4 Notify Attorney General and request a written waiver of objections 5 Notify Members (if any) who did not vote for dissolution The assets must be distributed in accordance with the corporation s Articles of Incorporation. This can either be approved by unanimous written consent or at a duly called and noticed meeting at which a quorum is present. This is required unless dissolution is approved by 100% of the members or if there are no members, 100% of the directors. This includes submitting the federal tax returns for last three accounting periods plus the current financial statements. Board Counsel prepares resolutions Counsel Counsel Board 6 Notify creditors All the corporation s liabilities should be satisfied in full or Board otherwise provided for. 7 Wind up operations and distribute Board assets 8 File Certificate of Dissolution This officially dissolves the corporation. Counsel 9 File final tax returns and attach copy of stamped Certificate of Dissolution to final returns 10 Send a copy of final federal return and Certificate of Dissolution to the California Registry of Charitable Trusts For the final partial year, federal and California returns must be filed. Accountant Accountant 15

16 Disclaimer These materials have been prepared for informational purposes only and do not constitute legal advice, nor are any of these materials intended to be a substitute for obtaining legal advice. You should not rely or act upon any information provided in these materials without seeking the advice of an attorney regarding the facts of your specific situation. These materials are general in nature and are intended, but not guaranteed, to be upto-date. 16