Violations of these rules can result in taxes and penalties not only for the foundation itself, but also its governing body and management.
As of 2017, U.S. private foundations reportedly held more than $1.7 trillion in endowments in total. That is a lot of money that can be put to a lot of good. But it also represents a lot of money from which the IRS sees very little tax revenue. Naturally, the government wants to be very sure all those funds are truly being used to serve the public good, so in exchange for their beneficial tax status, one trade-off is these organizations are required to adhere to a complex set of tax rules. Many of these rules can be non-intuitive to those not already familiar with them, so even if you are not an accountant, it is important private foundation managers, officers, contributors and trustees at least acquaint themselves with the tax issues that private foundations tend to run afoul of the most. To that end, here are seven biggest tax rule violations that can damage a private foundation’s finances.
While it will seem obvious to most that private foundations should avoid transactions that could be construed to be benefitting foundation officers or other associates, the rules surrounding acts of self-dealing encompass more than you might think. Specifically, these seven types of transactions are considered acts of self-dealing between a private foundation and a disqualified person:
— Sale, exchange or leasing of property
— Leases (with certain exceptions)
— Lending money or other extensions of credit
— Providing goods, services or facilities
— Paying compensation or reimbursing expenses to a disqualified person
— Transferring foundation income or assets to, or for the use or benefit of, a disqualified person
— Certain agreements to make payments of money or property to government officials
A “disqualified person” is anyone who is in a position to exert substantial influence over the affairs of the foundation. This category includes substantial contributors to the foundation, foundation managers, government officials, other private foundations that are controlled by the same individuals that control the foundation in question, and the family members of these individuals, among other disqualified persons and entities.
There are certain exceptions to self-dealing transactions. But in general, remember that private foundations enjoy their tax beneficial status because their purpose is to serve a cause, not to enrich its benefactors or their associates. Mistakes with regard to self-dealing can lead to steep penalties, including an initial tax of 10% of the amount involved imposed on the disqualified person and a second-tier tax of 200% if the matter is not resolved — as well as an initial and second-tier tax of 5% and 50%, respectively, for the foundation manager on the amount involved. That is why if you suspect there may be even an appearance of impropriety with regard to a given transaction, it is so important that you speak to your tax advisor in advance.
2. Impermissible (taxable) expenditures
Certain kinds of expenditures are not allowed by private foundations; if the foundation does make one of these taxable expenditures, they are subject to taxes on these expenditures under Section 4945 of the Internal Revenue Code. Impermissible expenditures include amounts spent on lobbying, influencing public elections, grants to individuals without advance approval from the Internal Revenue Service, grants to organizations that are not public charities, expenditures for non-charitable purposes, and grants to Type III non-functionally integrated supporting organizations.
Taxes arising from impermissible expenditures are levied on both the foundation and any foundation manager who knowingly and willfully agreed to the expenditures. The initial tax on the foundation is 20% of the amount expended; if not corrected within the allowed correction period, an additional tax of 100% is applied to the foundation. If a foundation manager is found to have knowingly and willfully approved the expenditure, he or she is subject to a 5% initial tax up to a maximum of $10,000 and, failing to correct it, an additional 50% tax up to $20,000.
3. Failing grant expenditure responsibility
Making grants to organizations is one of the most common types of expenditures for private foundations. However, if it wishes to make a grant to organizations that are not 501(c)(3) organizations, a foundation must exercise expenditure responsibility. Expenditure responsibility means that the organization exerts reasonable efforts and establishes adequate procedures for ensuring that the recipient organization spends the grant only for its intended purpose, that it obtains full and complete reporting from the recipient organization, and that it makes full and complete reports to the IRS regarding the grant. If the grant is found to have failed to exercise expenditure responsibility, the grant is considered a taxable expenditure subject to the taxes described above.
4. Making jeopardizing investments
Private charities have a responsibility to not make investments that place the foundation’s short- and long-term financial needs at unnecessary risk. Each investment from the foundation’s endowment requires “reasonable business care and prudence.” There is no single criterion that determines whether an investment shows reasonable business care and prudence; such a determination will require taking into account the rest of the foundation’s investment portfolio. However, certain activities can draw extra scrutiny from the IRS, including trading securities on margin, trading commodity futures, investing in oil or gas wells, buying puts or calls, buying warrants, and selling shorts. These investments fall under the mantle of “alternative investments,” and while alternative investments can represent a legitimate element in a diverse investment portfolio, they do require extra caution, and definitely call for a discussion with your tax advisor.
5. Failing mandatory payout requirements
A private foundation, being by its very nature dedicated to some cause, is not unreasonably required to pay out at least 5% of its noncharitable assets each year towards charitable purposes, such as grants to charitable organizations. Calculating the fair market value of noncharitable assets can be fairly complex; the calculation takes into account the value of securities, cash, real estate, dual-use property, exclusions and recoveries. Cash and marketable securities are valued monthly; most other assets must be valued annually. Real estate assets may be appraised once every five years.
If in one year the foundation distributes amounts in excess of its 5% obligation, they can carry forward that excess and apply it toward future year requirements for up to five years. The penalty for failing to adhere to the mandatory payout requirement is an excise tax of 30% of the minimum amount failed to be distributed.
6. Excess business holdings
The tax code is designed to prohibit private foundations from controlling for-profit businesses. Substantial control is generally considered to be an ownership stake in excess of 20%, minus any voting stakes owned by any of the disqualified persons described above. However, if the corporation, partnership or trust is effectively controlled by non-disqualified individuals, then the foundation may legally possess an ownership stake of up to 35%. As with self-dealing, the foundation’s penalty for excess business holdings is a 10% tax on the excess business holdings and a second 200% tax if the business holdings are not dispossessed in the allowed time period.
7. Unreasonable compensation
Private foundations are strictly regulated with regard to how much they may pay to officers, directors and trustees. For instance, there are strict rules around paying family members — family members being considered disqualified persons, as discussed above. However, there is an exception for compensation paid for personal services to the disqualified person as long as those services are “reasonable and necessary” to the foundation. There is no single standard for what amount is considered reasonable compensation, and a rigorous compensation study that takes into account the specific facts and circumstances should be performed before paying any disqualified persons, even for what appear to be reasonable and necessary services.
BPM Tax Preparation for Private Foundations
Private foundations aim to make a difference in the world, and one of the founding goals of BPM’s Nonprofit Industry group more than three decades ago was to make a significant difference in the way nonprofits are served by those in our industry. At BPM, we understand the unique operational and financial challenges faced by private foundations. With a strong commitment to the community — many of us having served on nonprofit boards ourselves — we have aided hundreds of nonprofit organizations. This firsthand experience allows BPM to offer nonprofits the highest value and the best service available in the marketplace today. For more on our tax preparation services for nonprofit organizations, contact Elena Serebriakova, managing director, or Tami McInerney, partner, today.
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