Part III - Private Foundation Rules - Anything But Simple!

To start with understanding tax rules for private foundations, we first look at tax requirements for all Section 501(c)(3) entities. When a Section 501(c)(3) entity is established, it automatically defaults to private foundation status unless it meets the requirements to be a public charity.

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Insights  <  Part III - Private Foundation Rules - Anything But Simple!

To start with understanding tax rules for private foundations, we first look at tax requirements for all Section 501(c)(3) entities. When a Section 501(c)(3) entity is established, it automatically defaults to private foundation status unless it meets the requirements to be a public charity.

Most foundation managers are aware of two private foundation tax rules – the 5% annual distribution requirement and the 1% or 2% excise tax. One is a very strict requirement and the other is a nice-to-meet requirement.

The 5% annual distribution requirement is calculated each year using the average monthly fair market value of cash and securities, plus year-end fair market value of other noncharitable assets. The required distribution must be paid by the end of the following tax year. Distributions include charitable grants to qualified recipients and charitable administrative payments. Excess distributions can be carried over for 5 years.

If the foundation doesn’t distribute the required distribution by the end of the following tax year there is a 30% excise tax and an additional 100% tax may be imposed on any remaining undistributed amount! So, this is the strict requirement.

Grant-making private foundations are also required to pay a 2% excise tax on net investment income. After a foundation’s initial year, this tax rate may be reduced to 1% if the foundation meets a certain payout test. The test is generally met if the foundation pays out a higher percentage of its net value of noncharitable assets than the average payout percentage over the last five years. This is a moving target, however, since the foundation cannot know its final average fair market investment value until the end of the tax year. Foundation managers hoping to obtain this lower tax rate need to estimate the amount of charitable distributions to make in order to ensure the lower tax rate. And unfortunately, the distributions for this test need to be made in the current year; excess charitable carryovers from prior years will not count.

And as you may expect, there is much more!

Congress and the public had noticed many tax abuses on how private foundations were run. So, the Tax Reform Act of 1969 resulted in several very strict requirements for private foundations, which continue to restrict them to this day.

To start with understanding tax rules for private foundations, we first look at tax requirements for all Section 501(c)(3) entities. When a Section 501(c)(3) entity is established, it automatically defaults to private foundation status unless it meets the requirements to be a public charity.

All 501(c)(3) entities must meet five tests: 1) the organizational test, 2) the operational test, 3) may have no more than an insubstantial amount of lobbying, 4) strictly no political activity, and 5) no private benefit to insiders, or to outsiders, other than to a charitable class.

The organizational test is generally met with establishment of a legal entity, either in trust or corporation form, as a charity. It must include a clause either in the document or by state law that assets will go to another qualified charity with a similar mission upon dissolution.

The lobbying restriction is strict for private foundations. Although there’s an exception for advocacy, a foundation can’t make a grant to a public charity earmarked for lobbying.

The private benefit restriction generally means for a 501(c)(3) entity there can be no excess benefit transactions. That is, excessive compensation and “sweetheart deals” to foundation insiders, like officers and directors and trustees – and their family members.

But the private foundation tax rules include much more.

The 1969 tax law gave us five more specific tax rules – which are in Sections 4941 through 4945 of the Internal Revenue Code and must also be part of a private foundation’s governing documents.

Taxes on self-dealing (Section 4941)

This restriction prohibits the foundation from having 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 asset of a private foundation. There are some exceptions, such as for a loan from a disqualified person to a private foundation only for charitable purposes and without interest; if the disqualified person furnishes goods, services or use of facilities to the foundation for free; and – the most common exception – payment to disqualified persons of reasonable compensation for personal services provided to the foundation.

Disqualified persons (“DPs”) are generally the founders, substantial donors, certain owners of substantial donors that are entities, board members, directors, trustees, officers and foundation managers, including their family members and related businesses.

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 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.

Taxes on failure to distribute income (Section 4942)

This is the commonly known 5% annual distribution requirement that is described above.

Taxes on 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 up to 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 technical exceptions. Generally, a foundation will have 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% if not corrected.

Taxes on investments that jeopardize charitable purposes (Section 4944)

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

There’s an exception for “program-related investments” (“PRIs”), which may be loans or equity investments that have a charitable purpose. Foundation managers should carefully follow the tax guidance on PRIs to ensure favorable treatment.

For all prohibited transactions, the private foundation must self-report to the IRS on Form 990-PF. One question on Form 990-PF asks, “Did the foundation invest during the year any amount in a manner that would jeopardize its charitable purposes?” An additional question asks if there’s been a “substantial contraction during the year,” which may “bubble up” this jeopardy investment issue. A statement is needed 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 certainly come to light inviting IRS scrutiny.

Taxes on taxable expenditures

Inappropriate grants and expenditures, inadvertent or not, 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 would report prohibited transactions in Sections 4941 through 4945 on Form 4720 and calculate the tax. Most times a penalty tax can be abated if the transaction is corrected, the private foundation is made whole, if possible, and there is an adequate reasonable cause statement.

There are other traps for the unwary.

For example, the net investment excise tax calculation includes interest, dividends and capital gain income. The capital gains for appreciated property, such as donated stock, is calculated for tax purposes using the donor’s tax basis. This may be much lower than the fair market value of the stock when it was donated into the foundation.

A private foundation can’t deduct net capital losses against its other types of investment income. And, unlike for other taxpayers, there is no capital loss carryforward.

There are also important tax tidbits to be aware of for private foundation donors.

  • Donors need receipts from the private foundation to take tax deductions for these charitable contributions. This is frequently overlooked.
  • Donors may deduct the fair market value of their appreciated stock donations to private foundations, but may only deduct their tax basis, if lower, for other types of noncash contributions.
  • Donors who give $5,000 or more are listed on Schedule B of Form 990-PF filed with the Internal Revenue Service. Unlike Schedule B for public charities, donor information is available for public inspection and is not confidential.
  • Lastly, donor’s tax deductions to private foundations are generally more limited than to public charities; generally limited to 30% of AGI for cash donations and 20% of AGI for publicly traded securities versus 60% and 30%, respectively, for public charities.

As you can see, the private foundation rules are very complex and restrictive, and the administration is burdensome, especially if the foundation is not just plain vanilla.

Foundation managers of many smaller foundations have been weighing the administrative time and costs against the benefits of keeping the family foundation name or the company foundation name.

Many have been dissolving their foundations and transferring the assets to commercially sponsored

donor advised fund charities, which is usually a much easier route. But for the families and companies that want to continue nurturing, expressing and passing along a legacy of charitable values and opportunities to children, grandchildren, or employees, a private foundation is a wonderful charitable vehicle.

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