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Part II - Private Foundations - what can go wrong?

Many private foundation tax missteps can be corrected on Form 4720. Some very high profile and large foundations have recently filed Form 4720 to report and correct errors and noncompliance with tax rules, including those that can afford sophisticated tax and legal resources. The private foundation rules can be quite complex and inadvertent missteps can certainly happen to anyone.

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Many private foundation tax missteps can be corrected on Form 4720. Some very high profile and large foundations have recently filed Form 4720 to report and correct errors and noncompliance with tax rules, including those that can afford sophisticated tax and legal resources. The private foundation rules can be quite complex and inadvertent missteps can certainly happen to anyone.

Recently we met with Joe and Marie Bete, truly lovely philanthropic, family-oriented people. They ran a successful family business for many years, then established the Bete Family Foundation with a $1 million gift several years ago.

What is particularly special is that, in addition to the foundation’s normal grant-making, the couple allows each of their grandchildren, when he or she turns 12 years old, the privilege of recommending a small grant to a charity. The grandchild’s amount goes up each year by $100 until he or she reaches age 22.

Each grandchild accepting this privilege needs to do research and write a summary request on why the foundation should make the grant. One of the grandchildren visited another country and befriended a young girl with an untreated cleft palate.

As Marie and Joe were telling the story about the granddaughter who befriended the young girl we thought for sure the ending would be a recommendation for a foreign grant. As mentioned in Part I of this article series, private foundation grants to a foreign grantee can be very tricky. They’re often not done correctly.

We braced ourselves, in case we were going to discover an inadvertent tax mishap in this beautiful, loving story.

To our relief, the grandchild’s grant recommendation was to a U.S. public charity that provides needed medical care to children internationally. And even better, we found that Marie and Joe keep current by attending well-respected foundation tax seminars and reading; have meticulous records; and understand there are complex rules about running a foundation.

Several years ago, The Boston Globe spotlight team did an investigative series that uncovered several foundations that paid trustees huge salaries overshadowing their grants given to charities. They uncovered “numerous instances of money earmarked for charity being used to fund travel and lavish perks for foundation trustees – the people charged with protecting foundation assets.” (Healy, Beth. “Charity money funding perks,” The Boston Globe, November 9, 2003.) Their investigation included one foundation that bought extravagant jets for the trustees and another that increased a director’s compensation to pay for his daughter’s $200,000 wedding.

So, aside from obvious and egregious mishandling of funds, what else can go wrong with private foundations?

As mentioned, private foundations occasionally make foreign grants without understanding the onerous administrative requirements. There are two approaches for a private foundation to appropriately make foreign grants, and neither one is hassle-free.

The foundation’s foreign grantee may meet the “equivalency test.” This means the foreign grantee is deemed to be equivalent to a qualified U.S. public charity. The conclusion must be documented in written advice by a qualified tax practitioner with knowledge of U.S. charity tax law. Or the foundation’s foreign grant may meet the “expenditure responsibility requirements.”

Expenditure responsibility procedures are needed when a foundation’s grantee is not a qualified U.S. public charity, such as a foreign grantee that the IRS hasn’t determined is a qualified public charity. There are four basic steps in the expenditure responsibility requirements. Since two of the steps need to be done before the grant is made, it will be too late if the foreign grant is made before these steps are taken. 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, and
  4. Report information about the grant to the IRS on Form 990-PF.

A foreign grant that does not have documentation that it meets the equivalency test as a qualified U.S. public charity and has not met the expenditure responsibility requirements will be treated as a taxable grant to the private foundation.

Surprisingly, a grant to another U.S. tax-exempt organization can also cause a problem.

A private foundation made a grant to the state bar association to support the bar association’s educational programs. The purpose was fine – it was for charitable, educational purposes. However, because the grant was made to a Section 501(c)(6) professional association (rather than to a Section 501(c)(3) charity), and since the foundation did not have a signed grant agreement with the bar association – unfortunately, it was not fine.

The pre-grant inquiry step was not necessarily violated, because the foundation was familiar with the bar association, a very well-known and reputable entity, and no further inquiry was needed in this case. However, because the private foundation did not have a signed grant agreement with the grantee before the grant was made, there was a technical violation of the expenditure responsibility rules. Therefore, the grant was taxable to the private foundation.

A new small private foundation was set up by a family to support a large national charity whose mission is to cure a disease that had afflicted a family member. Their foundation held an annual golf fundraiser. Some family members did not pay but received personal benefit from the day of golf and lunch. In

addition, the fundraiser invitations and the family told participants that all payments for the golf fundraiser and all raffle money could be taken as charitable deductions since the foundation would send all proceeds to the national charity. The family meant well and did send all net proceeds to the national charity. They were unaware, however, that their foundation had a responsibility to provide a good faith estimate on a written notice of the value of golf and lunch their friends and family received, the amount which really should not be taken as charitable tax deductions.

Operational expenditures may also cause issues.

A very small private foundation dissolved recently – which was probably not a bad idea, since it seemed to be treated somewhat like a personal account. It had paid a $1,000 grant as a political campaign contribution and paid for many personal meal expenses of the founding trustee, all of which have since all been corrected.

A third-generation trustee of a large foundation found himself in charge of running the family foundation. He was about to send his first of three children to college and had recently started a new business venture. His business needed some cash and he decided to have the foundation make a relatively modest loan of $100,000 to his business, with a written loan agreement including arms-length interest rate and terms. He also decided to have the foundation sublease an office from his business – again, with similar market terms the business was paying on its lease and a written one-year lease agreement. Fortunately, neither of these transactions took place because the trustee consulted advisors before finalizing. Transactions that appear reasonable in a normal business setting, and are even allowable with public charities, are not necessarily permitted in the private foundation world.

Some large private foundations have alternative investments in their portfolios: investment partnerships; funds of funds, oil and gas, hedge funds and private equity. Holding these types of investments can result in various tax issues for tax-exempt organizations, including for private foundations. Since a partnership investment is considered a “flow-through” entity for tax purposes, the partner – in our case, the private foundation – is deemed to be carrying on the activities of the partnership. The character of the partnership income flows through to the partner for tax purposes.

Investment partnerships may have debt-financed income or business activities, for example, operation of a shopping mall, and these activities flow through to the partner. In the case of a tax-exempt organization, they usually result in taxable income or loss as unrelated business income. One foundation trust held a small interest in a New York hotel through such a partnership investment. This investment was just a tiny portion of the foundation’s entire investment portfolio. For years the partnership investment resulted in minor unrelated business losses that the foundation did not report. When the hotel shut down and the partnership interest terminated, it resulted in a surprise to the foundation for nonresident New York tax purposes.

Investment portfolios may also result in international tax disclosure requirements for U.S. taxpayers, including tax-exempts. If a foundation has investments in foreign financial assets, such as foreign corporations, foreign partnerships or foreign bank or other financial accounts, it may have filings for U.S. tax purposes that carry serious penalties for any noncompliance. Sometimes these filings are

overlooked, or foundation managers are unaware of the filing requirements, and then need to file the delinquent forms.

For successful entrepreneurs and family business owners who are charitably-inclined, it’s tempting to donate a portion (or all!) of their successful business into a foundation to get a tax deduction and use the business profits for their foundation to support charitable causes. However, there are strict rules regarding private foundations that have certain business holdings. Great care should be taken to follow the complex rules to avoid draconian penalties.

As outlined in the previous section of this article series, private foundations are in focus of the Internal Revenue Service. Although IRS resources are limited, the Service is now doing more with less by using technology to identify noncompliance. Not since The Boston Globe spotlight investigative series from several years ago has there been such focus on foundations as now.

Many private foundation tax missteps can be corrected on Form 4720. Some very high profile and large foundations have recently filed Form 4720 to report and correct errors and noncompliance with tax rules, including those that can afford sophisticated tax and legal resources. The private foundation rules can be quite complex and inadvertent missteps can certainly happen to anyone.

In the next section of this article series we discuss how the private foundation rules are anything but simple!

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