Essential Tax Guidelines for Managing a Grant-Making Private Foundation

There’s no doubt the tax code is complex, but it can get even more tricky for private foundations — and the rules are strict. If your private foundation awards grants, consider these important tax guidelines.

What is a 501(c)(3) organization?

When a 501(c)(3) entity is established, it automatically defaults to private foundation status — unless the organization meets the requirements to be classified as a public charity.

All 501(c)(3) entities must meet five tests.

1. The organizational test

The legal entity must be established as a charitable entity either in trust form or corporate form, including a dissolution clause in the document or by state requirement that, upon dissolution, assets will be given to another qualified public charity with a similar mission.

2. The operational test

The private foundation must operate within its charitable mission and follow additional tax requirements.

3. Have no more than an insubstantial amount of lobbying

A private foundation cannot make a grant to a public charity earmarked for its activities to influence legislation, although there are exceptions for certain advocacy activities.

4. Engage in absolutely no political activity

There can be no communication or resources spent or used by the foundation for or against any political candidate for office.

5. Provide no private benefit or private inurement to insiders, or to outsiders, other than to a charitable class

The private benefit and private inurement requirements are complex. See the “self-dealing” rules explained below for details.

Grant-making requirements

A grant-making or “non-operating” private foundation has an annual grant-making requirement. Generally, the organization must distribute at least 5% of the fair market value of the foundation’s noncharitable-use assets each year.

The required distribution amount must be paid out by the end of the following tax year. Charitable grants made to qualified grantees and charitable administrative payments are generally counted as distributions. These must be reported on the cash basis method of accounting. Excess distributions can be carried over for five years.

If the foundation does not make the required distribution by the end of the following tax year, there is a 30% excise tax and then an additional 100% tax may be imposed on any remaining undistributed amount after that.

Specific grant considerations

Private foundations generally must make grants to qualified U.S. public charities. When making grants to other types of recipients, the foundation must follow specific requirements and procedures to avoid being treated as a taxable expenditure under the Section 4945 excise tax.

Grants to individuals for travel, study, or similar purposes

Grants may be made to individuals for travel, study, or similar purposes only if the foundation awards them in an objective and nondiscriminatory manner in accordance with a procedure that has been affirmatively pre-approved by the IRS.

A foundation must apply to the IRS to obtain this approval, including foundations that wish to make scholarship grants to individuals.

Grants to individuals for other purposes, such as for indigent individuals

Grants to individuals for purposes other than travel or study, such as to indigent individuals, are allowed but the grants must further the foundation’s charitable purpose established in its governing documents and must be made to members of a charitable class.

A “charitable class” is a group sufficiently large or indefinite that the grant benefits the community as a whole, rather than a single person or small group of pre-selected people.

To avoid the excise tax on taxable expenditures, the grants must be made for religious, charitable, educational, scientific, literary, or educational purposes.

Grants to organizations other than qualified U.S. public charities

Grants to certain organizations that are not qualified U.S. public charities — such as non-functionally integrated supporting public charities, for-profit entities, foreign charities, or other foreign organizations — are considered taxable expenditures unless proper procedures are followed.

A foundation’s grants to foreign charities must meet either the “equivalency test” or the expenditure responsibility procedures unless the foreign entity has received an IRS determination letter showing that it is a qualified public charity.

The foreign grant “equivalency test” means the foreign grantee is deemed to be equivalent to a qualified U.S. public charity as concluded and documented in written advice by a qualified tax practitioner with knowledge of U.S. tax law of charities.

Expenditure responsibility requirements

Alternatively, the foundation’s foreign grant process may meet the “expenditure responsibility” requirements.

There are four basic steps for the expenditure responsibility requirements, and the first two steps need to be completed before the grant is made. The expenditure responsibility steps are to:

1. Vet the grantee with a pre-grant inquiry
2. Obtain a signed grant agreement containing specific commitments
3. Obtain reports from the grantee
4. Report information about the grant to the IRS on Form 990-PF

The expenditure responsibility requirements are also required when a foundation makes grants to a grantee that is a non-functionally integrated supporting organization or a U.S. or foreign for-profit entity.

A foreign grant that does not have documentation that it meets the equivalency test or has not met the expenditure responsibility requirements will be deemed to be a taxable grant to the private foundation.

Excise tax on net investment income

Non-operating, grant-making private foundations must pay a 1.39% excise tax on net investment income.

Net investment income includes interest, dividends, and realized net capital gain income, but does not include unrelated business taxable income.

For tax purposes, capital gains from appreciated property such as donated stock is calculated using the donor’s tax basis.

Private foundations cannot deduct net capital losses to reduce net investment income and cannot carry net capital losses to any other year, unlike other taxpayers. Expenses that can be allocated appropriately to the investment activity may be deducted to arrive at net investment income.

Foundations must make quarterly estimated tax payments on the net investment income. Those with net investment taxable income of $1 million or more in any of the three preceding tax years need to follow the special “large corporation” estimated tax requirements and pay the quarterly estimates on annualized income during the tax year.

Five specific private foundation tax rules

The Tax Reform Act of 1969 brought several strict requirements for private foundations in an effort to curb tax abuses and regulate how private foundations are managed. The 1969 tax law gave us five more specific private foundation tax rules — and private foundations must include these requirements in their governing documents.

1. Self-dealing (Section 4941)

Foundations are prohibited from having any direct or indirect transactions with its “disqualified persons,” including sales; leases; loans; furnishing goods, services, or facilities; paying compensation; or allowing a disqualified person to use or benefit from the income or assets of a private foundation.

There are some exceptions:

• A loan from a disqualified person to a private foundation if it is without interest and only for charitable purposes
• The disqualified person furnishes goods, services, or use of facilities to the foundation for free
• Payment to disqualified persons of reasonable compensation for personal services provided to the foundation (the most common exception)

The tax imposed on the act of self-dealing between a DP and a private foundation is 10% of the amount involved each year, payable by the DP. The foundation managers are also liable for a 5% tax if they participated in the self-dealing act. If the self-dealing is not corrected, there may be an additional tax of 200% and 50%, respectively.

2. Failure to distribute income (Section 4942)

This is the 5% annual distribution requirement, the most commonly known private foundation requirement, as described above.

3. Excess business holdings (Section 4943)

A private foundation is generally not permitted to hold any part of a proprietorship business enterprise and may hold only 20%, combined with the holdings of all DPs, of any voting stock in a corporation, profits, interest in a partnership, or beneficial interest in any other type of business enterprise.

There are some technical and de minimis exceptions, and generally the foundation has five years to divest itself of the business holdings. The excise tax is 10% of the highest value of the excess business holdings during the tax year, and an additional tax of 200%.

4. Investments that jeopardize charitable purposes (Section 4944)

The rules prohibit a private foundation from making jeopardy investments, which are risky investments that jeopardize the foundation’s ability to carry out its charitable mission. The excise tax is 10% of the invested amount and 10% imposed on the foundation managers. The additional tax, if it is not removed from jeopardy, is another 25% and 5%, respectively.

There is an exception for program-related investments, which may be loans or equity investments that have a charitable purpose. Foundation managers should carefully follow the tax guidance on program-related investments to understand tax treatment opportunities.

For all of these prohibited transactions, the IRS has the private foundation self-report on Form 990-PF. The private foundation must disclose the facts regarding a significant disposition of assets, defined as 25% or more of the fair market value of the net assets as of the beginning of the tax year. A large worthless stock deduction could come to light by this reporting requirement, which could invite IRS scrutiny.

5. Taxable expenditures (Section 4945)

Inappropriate grants and expenditures may result in this tax. The excise tax imposed on private foundations for taxable expenditures is 20% of each taxable expenditure. There is a 5% tax on foundation managers. The additional tax imposed if the transaction is not corrected is 100% and 50%, respectively.

Foundations report prohibited transactions on Form 4720 and calculate the excise tax. Many penalty taxes can be abated if the transactions are corrected, the private foundation is made whole, if possible, and there is an adequate reasonable cause statement.

How we can help

Private foundations have strict and complex tax requirements. This is a high-level summary of some of the potential tax considerations. Foundations should obtain professional tax advice prior to engaging in any transactions or activities. CLA’s private foundation tax professionals can help you break down the rules.