Written by: Jeffrey Haskell | Foundation Source
A guide to critical issues and potential pitfalls
Running a private foundation can be one of life’s most rewarding experiences, a chance for an individual or family to effect real and positive change in the world through philanthropy.
The flexibility, creativity and nearly endless giving capabilities offered by a foundation do come with a dose of administrative complexities, though. It can be challenging for foundations to keep pace with government regulations, which are always changing, as well as IRS filings and required paperwork.
To help private foundations and their advisors steer clear of compliance trouble, here are ten essential rules to remember:
1. Foundations’ annual minimum distribution requirement (MDR) must be calculated carefully.
Generally, a private foundation is required to distribute 5% of the average value of its investment assets for the previous year. The IRS prescribes a specific method for averaging a foundation’s securities and the balances in its savings and checking accounts on a monthly basis. The 12-month average allows for market fluctuations over the year. Special rules apply to the valuation of real estate and all other assets. These calculations can be complex. When performed incorrectly, as is often the case, they can result in under or over payment, so special care must be taken when determining the 5% requirement.
Grants to qualifying organizations and all reasonable administrative expenses necessary for conducting a foundation’s charitable activities—other than investment management or custodial fees or bank charges—count as qualifying distributions toward satisfying the annual 5% payout requirement. Reasonable administrative expenses may include office supplies, telephone charges, consulting fees, certain legal and accounting fees, training and professional development, employee compensation,
publication of the foundation’s annual report, and modest travel expenses associated with foundation business.
2. Unrelated business taxable income (UBTI) will be taxed at the for-profit rates.
Unrelated business taxable income (UBTI) is commonly associated with revenue that a charity generates through an activity that has no direct connection with its charitable mission. To the extent that a foundation has UBTI, it must be taxed as if it were a for-profit organization. The UBTI rules were enacted to ensure that nonprofit, charitable organizations do not compete with for-profit companies, gaining an unfair competitive advantage. Foundation staff often don’t realize that if a foundation borrows money (for example, on margin) to purchase an investment asset (not related to performing its charitable activities), some or all of the income flowing from that asset usually will be deemed UBTI.
In addition to paying taxes at a for-profit tax rate, a private foundation with significant UBTI must also file an additional tax return, Form 990-T, along with its 990-PF. Many professional advisors counsel their foundation clients to avoid engaging in activities that would generate UBTI, unless the potential for profit is considerable.
3. The tax status of charities must continually be validated.
Just because a charity attained tax-exempt status from the IRS at one time does not mean that it maintains that status. For example, if the charity does not continue to maintain its broad public support, it may be reclassified by the IRS as a private foundation.
The IRS lists all tax-exempt organizations in IRS Publication 78. (Although some organizations that are considered public charities, such as schools, houses of worship, and instrumentalities of the government, such as parks and municipalities, aren’t listed in this publication.) Foundations may make grants to public charities listed in this publication without exercising “expenditure responsibility,” a multi-step process to ensure grant funds will be used for a charitable purpose only.
But what if the charity’s status had been revoked in an Internal Revenue Bulletin issued since the date of the last publication? If a private foundation makes a grant to an organization that is not a public charity in good standing with the IRS, and does not exercise expenditure responsibility, the foundation may be subject to a penalty, and the grant will not count toward satisfying its annual distribution requirement.
4. Scholarship grants require IRS approval.
Since universities are 501(c)(3) public charities, and grants made to them do not require the advance approval of the IRS, many foundations believe that they can fund a specific student’s scholarship without advance approval from the IRS – as long as the grant is paid directly to the university and not to the student. This is false. It is the foundation’s act of choosing the scholarship recipient (instead of having the university make that choice) that triggers the need for advance approval, regardless of whether the funds are paid to the individual or directly to the university. It is only when a foundation funds a university’s existing scholarship program and does not involve itself in the selection process that advance approval by the IRS is not required.
If a foundation wishes to take an active role in selecting scholarship recipients, it must apply for advance approval from the IRS. In doing so, the foundation must determine the group of individuals who are eligible to apply for a scholarship and develop an objective and non-discriminatory plan for selecting the final recipients. If the IRS does not contact the foundation within 45 days of the foundation’s submission of its scholarship plan and procedures, the foundation may begin making scholarship grants.
5. Hosting fundraising events requires compliance with federal, state and local laws.
Foundations that host fundraising events seldom realize that they are required to comply with federal, state, and local laws governing charitable fundraising. Many states require foundations to report fundraising events and register with the attorney general’s office of the states where the events are held. Also, the IRS requires foundations to ascribe a value to the benefits provided to attendees as well as provide a tax receipt for each attendee at year-end. This is so the attendee knows what portion of the donation is actually tax deductible.
For example, say an attendee pays $150 for a golf tournament hosted by the foundation, and the usual greens fees are $50. The foundation must provide a tax receipt letter to that attendee stating that the value of goods and services provided was $50 (the value of the greens fees). The proper tax deduction for the attendee to claim is the ticket price minus the value of the greens fees, or $100. If the attendee does not obtain this tax receipt by the time he files his income tax return, the charitable deduction may be lost.
Sometimes foundations raise additional funds at these events by selling merchandise, such as t-shirts or other accessories. Depending on where the event is held and where the foundation conducts its business, the foundation may be required to charge state and local sales tax. Although the foundation itself may be exempt from paying sales tax, that doesn’t necessarily mean it can forgo charging sales tax when it sells merchandise to others. The requirement to charge and remit sales tax varies from one locality to another. Some localities permit a foundation two or three days per year in which it may sell merchandise free of sales tax in connection with a fundraising event. Often, the best solution is to make an arrangement with a local merchant to charge, collect, and remit sales tax to the appropriate taxing authority on behalf of the foundation.
Additionally, if a foundation chooses to raise funds through a live or silent auction, it must clearly document the fair market value of all items for sale before the auction begins. For example, the foundation may attach price tags to items available for bidding or publish a list of such items with their respective values. This is crucial, because only the portion of the amount paid at auction in excess of an item’s fair market value may be treated as a charitable gift.
For example, if a grandfather clock has a fair market value of $1,200 and is purchased at auction for $1,300, the purchaser would be limited to only a $100 charitable deduction. A foundation must record the names and addresses of all attendees of an event, so that it may provide those who pay over $250 with tax receipts at the end of the year. Failure to provide a tax receipt to attendees before they file
their income tax returns may cause the attendees to lose their charitable deductions.
6. Insiders may not economically benefit from the foundation – except for reasonable compensation.
Foundation insiders (essentially anyone who has significant influence over the foundation such as its officers, trustees, family members and substantial donors, and any entities that are substantially owned by such individuals) generally are not permitted to reap economic benefit from their dealings with a foundation. An exception is made for compensation – provided the compensation is reasonable. The reasonableness of compensation is judged on a list of factors, including qualifications, experience, job responsibility, duties, and time dedicated (part- or full-time) by the insiders to their positions. Additional factors can include the size of the foundation, the local labor market, the cost of living in the area, and the salary paid by similarly situated charitable organizations for comparable positions.
7. Insiders’ attendance at charity events must be strictly work-related.
Many private foundations support local charitable institutions that conduct fundraising events. Persons attending or “buying tables” at such events typically receive food and entertainment. If a private foundation purchases tickets for such an event (or is given tickets), a question arises as to whether self-dealing results when a board member, other insider, or their relatives or friends use the tickets to attend.
As a basic rule, all direct and indirect financial transactions between a private foundation and those persons who control and fund it are prohibited. It is immaterial whether the transaction results in a benefit or a detriment to the foundation. However, the foundation is permitted to pay expenses resulting from the participation of its insiders in meetings and events on the foundation’s behalf.
Some argue it is necessary and appropriate for foundation directors, trustees, and staff to attend fundraising events and, therefore, no self-dealing has occurred when its insiders use the tickets. Logically, if a foundation’s board member or officer attends the event to represent the foundation in an official capacity, there should be no private benefit, so long as the attendance is work-related, necessary, and allows the foundation to effectively show support for the organization at a public function.
Impermissible self-dealing may arise, however, if the table seats are given to friends and family members. To remove any question of self-dealing, it is preferable for a private foundation to decline to accept tickets for persons other than board members, trustees, senior staff members and their spouses. A foundation could conceivably furnish the charity with a list of persons to whom tickets may be furnished, but only with the clear stipulation that the charity must decide which individuals are awarded the tickets.
8. Foundations may not fulfill their insiders’ personal pledges.
A common problem arises when a foundation insider makes a personal pledge to a church, synagogue, mosque, etc., and the foundation satisfies that pledge. Since churches are indeed public charities, many foundation personnel incorrectly assume it is perfectly legitimate for the foundation to cover a charitable pledge made by a founder or other board member.
A foundation may make a charitable grant or pledge to a church when that pledge was initiated by the foundation. However, there is a subtle distinction between a foundation making its own charitable grant and a foundation satisfying the personal obligation of a board member or other insider. Insiders are not allowed to obtain a personal benefit from their dealings with the foundation. To the extent that the foundation relieves an insider of such a financial obligation, that person is considered to have benefited.
9. Foundations can make grants to individuals without IRS approval, if it’s for emergency or hardship assistance.
It is commonly believed that a foundation may not make grants to an individual without advance approval from the IRS (such as for a scholarship program). However, grants made to relieve human suffering may be made without advance approval under certain conditions, provided that the foundation makes the grant on an objective and nondiscriminatory basis, complies with basic record-keeping requirements showing how and why a particular individual was selected for assistance, and does not require the recipient to spend the grant funds in a particular way.
The IRS divides such grants into two broad categories in Publication 3833: emergency and hardship assistance. Emergency assistance usually is provided after there has been a natural catastrophe, such as an earthquake, tornado, hurricane or flood. By contrast, hardship assistance is provided based upon established economic need, and may be used, for example, to purchase food or cover health insurance premiums for a low-income family.
10. Foundations can grant to other foundations.
Grantmakers are often unaware that one private foundation may make a grant to another private foundation, as long as the granting foundation exercises expenditure responsibility. This may be desirable when the grantee foundation runs its own special programs (for example, a scholarship program approved by the IRS).
When one foundation makes a grant to another, and the recipient foundation follows by disbursing those funds, the IRS will allow only one of the foundations to count those funds toward satisfying the
annual 5% payout requirement. Unless the foundations agree otherwise, the recipient foundation will be the one that will count the disbursement of the funds toward its 5% payout requirement.
In order for the granting foundation to count the grant proceeds toward its own 5% payout requirement, the recipient foundation must agree to (1) make a special election on its annual return not to count the disbursement of the proceeds toward its 5% requirement; and (2) disburse all of the granted proceeds by the end of its fiscal year following the year in which the funds were received.
Note: This article is not intended as a substitute for legal, tax or investment advice, nor should it be construed as a comprehensive guide to regulations governing private foundations.