Private Foundations Deeper Dive

Transcription

1 Private Foundations Deeper Dive David Lawson, Davis Wright Tremaine November 2, 2017 Seattle, Washington

2 What is a private foundation? Can be a nonprofit corporation or a charitable trust Nonprofit corporation Formed by filing Articles of Incorporation with state Managed by a board of directors Charitable trust Formed by executing a trust document Managed by one or more trustees

3 What is a private foundation? Has 501(c)(3) tax-exempt status Must be organized and operated for charitable, educational, scientific, religious, or literary purposes Assets are irrevocably dedicated to those purposes No inurement or private benefit Cannot engage in political campaign activity Two types of 501(c)(3) organizations Public charities: churches, schools, hospitals, organizations meeting a public support test Private foundations: All 501(c)(3) organizations that do not qualify as public charities

4 Private Foundation Alternatives Donor-advised funds (DAFs) DAFs are maintained by a public charity sponsor The sponsor has permanent and ultimate control, but will follow donor advice in almost all cases Can grant to organizations under very similar rules to grantmaking private foundations Cannot grant to individuals: Scholarship or fellowship grants Less administrative overhead and lower costs than an independent private foundation

5 Private Foundation Alternatives Public charity status The central challenge is fundraising strategy Public support tests: 509(a)(1) + 170(b)(1)(A)(vi) public support = contributions and grants alone 33%, or 10% and pass facts and circumstances 509(a)(2) public support = contributions, grants, and gross receipts from related activity 33%, and <33% from investment and unrelated income 509(a)(3): supporting organizations

6 Deductions: Individual Deduction Limits Public Charities or Private Operating Foundations Private Foundations Cash or Ordinary Income Property: Deduction of up to 50% of donor s contribution base Cash or Ordinary Income Property: Deduction of up to 30% of donor s contribution base Capital Gain Property: Deduction of up to 50% of donor s contribution base to the extent the capital gain property does not exceed 30% of the donor's contribution base Capital Gain Property: Deduction of up to 20% of donor s contribution base

7 Deductions: Corporate Contributions The percentage limitation on charitable contributions by corporations is 10% of the corporation s taxable income, regardless of whether the recipient is a public charity or a private foundation.

8 Governing Instrument Section 508(e) requires that an organization have specific provisions in its governing instrument in order to qualify as a private foundation: prohibit the foundation from engaging in self-dealing subject to tax under 4941, require it to make qualifying distributions each year in amounts sufficient to avoid tax under 4942, forbid it from retaining excess business holdings taxable under 4943, prohibit jeopardizing investments taxable under 4944, and bar the foundation from making taxable expenditures within the meaning of 4945.

9 Types of Private Foundations Operating Direct Charitable Activities Non-operating Grants to Public Charities

10 Types of Private Foundations Non-operating Grantmaking or Checkbook Foundation Primarily makes grants to public charities Operating Foundation Actively engaged in the conduct of charitable activities Annual determination Based on use of income and assets over the most recent four-year period Reported on Form 990-PF, Part XIV

11 Private Foundation Excise Taxes Chapter 42 of the Internal Revenue Code Most of these taxes are punitive in nature; it s easier to consider these the rules governing foundations Section 4940: Investment income excise tax Section 4941: Self-dealing transactions Section 4942: Distribution requirements Section 4943: Excess business holdings Section 4944: Jeopardizing investments Section 4945: Taxable expenditures Grab bag

12 Private Foundation Excise Taxes Tax on Investment Income (Section 4940) 2% on net investment income May be reduced to 1% if the foundation meets certain distribution requirements These are slightly different from those in Section 4942 Does not apply to certain private operating foundations ( exempt operating foundations ) that look like public charities

13 Self-Dealing Transactions Prohibits certain transactions between foundation and disqualified persons (Section 4941) Disqualified persons Officers and directors Staff with responsibilities similar to officers/directors Substantial contributors (status for life!) Spouses, ancestors, descendants of all of the above Entities 35% controlled by all of the above Certain government officials

14 Self-Dealing Transactions Prohibits certain transactions between foundation and disqualified persons (Section 4941) Prohibited transactions Sale or leasing of property (in either direction) Lending (in either direction) Furnishing of goods, services, or facilities (in either direction) Payment of compensation to DQP by foundation Transfer or use by or for the benefit of foundation assets

15 Self-Dealing Transactions Prohibits certain transactions between foundation and disqualified persons (Section 4941) Exceptions: Compensation to DQP for personal services (professional or management services only) Donations by a DQP of goods or services Interest-free lending by DQP to foundation Furnishing of goods or services by foundation if DQP gets them on the same terms as the general public Certain transactions as part of the reorganization of a DQP

16 Distribution Requirements The 5 Percent (Section 4942) Qualifying distributions must exceed distributable amount. What is the Distributable Amount? 5% of fair market value of all assets, except those used directly for exempt purpose A few modifications apply

17 Distribution Requirements The 5 Percent (Section 4942) Qualifying distributions must exceed distributable amount. What are Qualifying Distributions? Amounts paid to accomplish exempt purposes Amounds paid to acquire exempt-use assets

18 Distribution Requirements Some things that are qualifying distributions: Grants to public charities or governments Grants to private operating foundations Permitted scholarship and fellowship grants Amounts spent directly to operate a charitable program Administrative expenses (but not investment management expenses) Program-related investments

19 Distribution Requirements Some things that are not qualifying distributions: Grants to organizations controlled by the foundation or its disqualified persons Grants to other non-operating private foundations (unless timely redistributed by the grantee foundation and made out of corpus ) Grants to individuals not permitted under Section 4945 Investment management expenses

20 Distribution Requirements Taxes under Section 4942 Initially, 30% of undistributed income If uncorrected, 100% of the remaining undistributed amount Timing Distributions for year 1 must happen by end of year 2 To avoid 100% tax on income not distributed by the end of year 2, income must be distributed before either: the return due date for year 2, or the IRS mails a notice of deficiency.

21 Excess Business Holdings Rule (Section 4943) Combined holdings of: a private foundation, and all disqualified persons in any corporation conducting a business enterprise which is not substantially related to the exempt purposes of the foundation are limited to 20% of the voting stock in such corporation. Special rules apply to nonvoting stock.

22 Excess Business Holdings: Elements Business Enterprise The active conduct of a trade or business; and Any activity that is regularly carried on for production of income from the sale of goods or the performance of services which constitutes UBTI under 513 Not a Business Enterprise A business that derives 95% of more of its gross income from passive sources (e.g., dividends, interest, royalties, rents) A business functionally related to the foundation s exempt purposes

23 Excess Business Holdings: Elements Increase of Permitted Holdings to 35% Must establish that effective control is in one or more persons who are not disqualified persons with respect to the foundation Effective Control Having the power, either directly or indirectly, to direct or cause the direction of the management and policies of a business enterprise, whether through the ownership of voting stock, the use of voting trusts, or contractual arrangements, or otherwise

24 Excess Business Holdings: Example Facts Private Foundation owns 7% of voting stock in Corporation and 3% of nonvoting stock Brothers, the founders of Private Foundation, each own 5% of voting stock of Corporation (for total of 10%) Permitted Holdings 20% - 10% (amount owned by Brothers) = 10% Foundation does not have excess business holdings because it holds only 7% of voting interest in Corporation. What if foundation held 20% of nonvoting stock and Brothers held 25% of voting stock of Corporation?

25 Excess Business Holdings De minimis Rule A foundation is not treated as having excess business holdings if it owns not more than 2% of the voting stock and 2% in value of all outstanding shares of all classes of stock.

26 Excess Business Holdings: Tax on Holdings Initial Tax 10% tax imposed on the value of the excess business holdings Value is determined when foundation s holdings are at their highest Additional Tax If foundation fails to dispose of interest, tax of 200% value of excess business holdings imposed.

27 Excess Business Holdings: Special Rules 90-Day Rule Foundation will have 90 days to dispose of excess business holdings and not be subject to tax when: Disqualified person purchases interest causing the excess business holdings, or Foundation purchases additional interest but did not know of disqualified person s interest The 90-day period can be extended if the sale of the business interests is prevented by federal or state securities laws

28 Excess Business Holdings: Special Rules Holdings Acquired by Gift or Bequest Foundation given five years in which to address the excess business holdings No tax assessed during this time Tax assessed if holdings not disposed of by end of five-year period Additional five-year extension may be granted on request if certain criteria are met

29 Jeopardizing Investments (Section 4944) Foundation should not make investments that financially jeopardize the Foundation s ability to carry out its exempt purposes Investments that show a lack of reasonable business care and prudence in providing for the long-term and short-term financial needs of the Foundation No single factor or single investment is determinative of a jeopardizing investment Determination is made when investment is made Investments donated to the Foundation will not be jeopardizing investments

30 Taxes on Jeopardizing Investments Initial Tax Foundation: 10% of amount involved if willful neglect Additional Tax Foundation: 25% of the amount involved

31 Taxes on Jeopardizing Investments Initial Tax Managers: 10% of the amount involved if the manager knowingly, willfully and without reasonable cause participated in making the Jeopardizing investment Managers: Maximum initial tax of $10,000 - joint and several liability Additional Tax Managers: 10% of the amount involved if the manager refuses to correct within correction period Managers: Maximum additional tax of $20,000 joint and several liability

32 Taxable Expenditures (Section 4945) A taxable expenditure is an amount paid or incurred to: Lobby Influence the outcome of public elections Make certain grants to individuals Make grants to organizations other than public charities unless certain steps are taken Carry out any nonexempt purpose

33 Taxable Expenditures Prohibition Against Lobbying Private Foundations may not engage in or fund lobbying

34 Lobbying Direct Lobbying Communications with members or employees of a legislative body designed to influence their opinion with respect to legislation Refers to specific legislation; and Encourages the recipient to take action

35 Lobbying Grassroots Lobbying Communications designed to influence the opinion of the general public with respect to legislation Refers to specific legislation; Reflects a view on such legislation; and Encourages the recipient to take action

36 Political Activity Prohibition Against Political Activity Absolute rule! Private Foundations may not participate or intervene, directly or indirectly, in any political campaign on behalf of or in opposition to any candidate for public office

37 Grants to Individuals Travel, study, or similar purposes IRS pre-approval of grantmaking procedures required Contrast: grants to indigent individuals to enable them to buy food or clothes are not taxable expenditures

38 Grants to Organizations Private Foundations are subject to tax penalties if they make a grant to an organization that is not a public charity unless the Private Foundation exercises expenditure responsibility Public Foundation managers can also be penalized Expenditure responsibility is strictly interpreted by the IRS and courts

39 Expenditure Responsibility Is Expenditure Responsibility Required? NO U.S. public charities U.S. and foreign government units Executive Order organizations Exempt operating foundations Foreign organizations with a 501(c)(3) organization letter or valid equivalency determination YES Private foundations; private operating foundations Non-501(c)(3) exempt organizations For-profit companies Other foreign organizations

40 Expenditure Responsibility Exercise of Expenditure Responsibility Pre-grant inquiry Grant agreement Regular reports Inclusion in Form 990-PF

41 Expenditure Responsibility Step 1: Pre-Grant Inquiry Before any grant payment is made, the Private Foundation must: Make an investigation, based on readily available information, that would assure any reasonable person that the grantee will use the funds for the proper purposes Inquiry should concern identity, experience, history of grantee and its board/key officers; information on management, activities, finances and practices of grantee; experience of the Private Foundation and other foundations with the grantee Document Charitable purpose of the grant Grantee s ability to achieve goal Grantee s ability to report on the use of funds Signed and dated by program officer

42 Expenditure Responsibility Step 2: Written Grant Agreement The grant agreement must: Specify the charitable purpose of the grant Require the grantee to maintain the grant funds in a separate account dedicated to charitable purposes Require the grantee to repay grant funds if not used for the purposes of the grant (even if otherwise charitable) Require the grantee to provide annual reports and a final report on its use of the grant funds Prohibit use of grant funds for lobbying, political activity, regranting (with some exceptions) and non-charitable uses Be signed by the Private Foundation and the grantee

43 Expenditure Responsibility Step 3: Regular Reports The grantee s reports to the Private Foundation must: Describe the grantee s use of the grant funds Verify compliance with the terms of the grant Describe the grantee s progress toward achieving the goals of the grant List equipment purchased with grant funds and confirm its continued use for charitable purposes Be signed and dated by the grantee

44 Expenditure Responsibility Step 4: IRS Form 990PF The Private Foundation must report to the IRS annually on every expenditure responsibility grant made, paid, or for which a report is outstanding during the year Report must include: Grantee name and address The date, amount and purpose of the grant The amounts expended by the grantee based on the most recent grantee report The date of the grantee s reports Whether the grantee has diverted funds Dates and results of any verification of grantee s report

45 Expenditure Responsibility Recordkeeping The Private Foundation must maintain in the grant file and make available to the IRS: Pre-grant inquiry Copy of expenditure responsibility grant agreement Copy of grantee s reports Copy of any reports made as a result of any audit of the grantee by the Private Foundation

46 Expenditure Responsibility Expenditure Responsibility Grants to Private Foundations No separate account required Recording keeping requirements grantee must keep records for four years Out of Corpus to count toward the Private Foundation s payout, the grantee must pay out all grant funds received from the Private Foundation within a short period of time in addition to meeting its own payout Special rules for capital endowment and capital equipment grants

47 Grants to Foreign Charitable Organizations Foreign Equivalency Determination Reasonable judgement that foreign organization is an organization described in Section 501(c)(3) Determination as to whether equivalent to a public charity New special rule: Written advice of tax practitioner Rev. Proc

48 Carrying Out Nonexempt Purposes Examples Unreasonable administrative expenses Operating commercial-type business as primary activity Excessive compensation

49 Taxes on Taxable Expenditures Initial Tax Foundation: 20% of amount expended if involved willful neglect Additional Tax Foundation: 100% of the amount involved

50 Taxes on Taxable Expenditures Initial Tax Managers: 5% of the amount involved if the manager acts knowingly, willfully and without reasonable cause Managers: no liability if acts on advice of counsel given in a reasoned legal opinion in writing Managers: maximum initial tax of $10,000 joint and several liability Additional Tax Managers: 50% of the amount involved if the manager refuses to correct within correction period Managers: Maximum additional tax of $20,000 - joint and several liability

51 More About Private Operating Foundations Advantages Donations are tax deductible under the same rules as donations to public charities Not subject to annual 5% payout requirement for other private foundations

52 Private Operating Foundation Tests The Foundation must meet both an income test and one of three alternative tests: Asset test Endowment test Support test

53 Private Operating Foundation Tests Income Test The Foundation must spend for the active conduct of exempt activities at least 85% of the smaller of: Adjusted net income, or Minimum investment return

54 Private Operating Foundation Tests Asset Test 65% or more of the Foundation assets must be devoted to the direct conduct of exempt activities

55 Private Operating Foundation Tests Endowment Test The Foundation must normally make distributions in the active conduct of its exempt activities in an amount that is two-thirds or more of its minimum investment return

56 Private Operating Foundation Tests Support Test The Foundation normally receives 85% or more of its support from the public

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