Private grant-making foundations and nonprofit organizations operate like bees and pollen. Without pollen, bees would have no contribution as they buzz from flower to flower. And without bees, pollen would lack the necessary means of transportation for pollination to occur. Similarly, nonprofit organizations need the financial resources private grant-making foundations can provide. And to meet their own missions, grant-making foundations rely on nonprofit grantees to use the funds to perform the necessary work. And just as pollination occurs inside a structured ecosystem, grant-making occurs inside a regulatory framework. To avoid the sting of excise taxes and penalties, private grant-making foundations have to adhere to certain requirements.
In general, the IRS requires grant-making foundations to establish procedures and make reasonable efforts to ensure grants are spent only for their intended purpose. To do so, foundations have to obtain the information on how the funds were spent from the grantee and report these expenditures to the IRS. However, grants made to exempt operating foundations and public charities are excluded from these requirements.
Among other things, grants made to influence an election or voting rights, gifted to individuals, or supporting a non-charitable cause may result in a taxable expenditure. In this case, the IRS will impose an initial tax on your foundation equal to 20% of the expenditure. If you don’t correct the issue within the taxable period, the IRS will impose an additional tax equal to 100% of the expenditure. If foundation managers “knowingly” and “willfully” agree to the taxable expenditure, they may be liable for an initial 5% tax (up to a max of $10,000) and an additional 50% tax (up to a max of $20,000) for the expenditure.
If your foundation transacts with disqualified persons, including insiders like directors and officers, the IRS may consider the transaction self-dealing. The IRS restricts self-dealing between private foundations, their substantial contributors, and other disqualified persons.
The tax the IRS imposes on the disqualified person is equal to 10% of the amount involved each year. If the self-dealing is not corrected, the IRS may impose an additional tax of 200%. If foundation managers participate, they may be liable for a 5% tax and an additional 50% tax. Reasonable compensation paid for necessary services is not considered self-dealing. For example, if your foundation’s manager is an investment advisor, it is acceptable to provide non-excessive compensation for their service in managing the foundation’s investment portfolio.
Private Business Holdings
In general, private foundations cannot hold any part of a proprietorship business enterprise and must adhere to the limits on holdings in private businesses. The combined holdings of the foundation and its disqualified persons must not exceed 20% of the voting stock in a corporation, interest in a partnership, profits, or beneficial interest in any other type of business enterprise.
While there are some technical and de minimis exceptions, typically, unless the foundation can show reasonable cause, it may be subject to an excise tax equal to 10% of the value of the excess holdings if they are not disposed of promptly. And the value of excess holdings is determined based on the day during the tax year when they were at their highest. Private foundations generally have five years to divest their business holdings. If the foundation has not disposed of the excess holdings by the end of the taxable period, the IRS may impose an additional 200% tax.
Annual Distribution Requirements
Private grant-making foundations must meet an annual grant-making requirement. Generally, the foundation must distribute at least 5% of the fair market value of its noncharitable-use assets each year. The required distribution must be paid by the end of the following tax year. Charitable administrative payments and charitable grants made to qualified grantees typically count as distributions. Foundations may carry forward excess qualifying distributions across the five tax years immediately following the tax year in which the excess originated.
If your foundation fails to pay out the distributable amount on time, it may be subject to a 30% excise tax on the undistributed income. The IRS may impose an additional 100% tax if the foundation fails to correct a deficient distribution within 90 days of receiving notice.
Except for certain program-related investments, investments of income or principal must not jeopardize your foundation’s ability to carry out its mission. Private foundations are required to report prohibited transactions when filing Form 990-PF.
Unless the jeopardizing investment was due to reasonable cause and corrected on time, the foundation may be subject to an excise tax equal to 10% of the amount involved. The foundation may be liable for an additional 25% tax if it fails to remove the investment from jeopardy within the taxable period. The IRS may also impose a 10% excise tax (up to $10,000 per investment) on foundation managers who were a part of the investment without reasonable cause. If the manager does not agree to the correction promptly, the IRS may impose an additional tax (up to $20,000 per investment).
Private grant-making foundations must pay a 1.39% excise tax on net investment income (NII), which includes dividends, interest and realized net capital gain income. NII does not include unrelated business taxable income (UBTI). And unlike other taxpayers, private foundations cannot deduct net capital losses to reduce NII, nor can they carry net capital losses to any other year.
Private foundations must make quarterly estimated tax payments on NII. Those with taxable NII of $1 million or more in any of the three preceding tax years must follow the same special estimated tax requirements the IRS has designated for large corporations.
When you set up a grant-making foundation, you have to consider how the content of your organizing documents affects your foundation’s tax status. A grant-making foundation’s organizing documents must include special provisions to be tax-exempt from federal income tax, avoid certain excise tax liabilities, and ensure contributions made to the foundation may be deducted as charitable contributions. In Publication 557, the IRS provides examples that illustrate these requirements. For example, regarding self-dealing, the IRS suggests the organizing documents state, “The corporation won’t engage in any act of self-dealing as defined in section 4941(d) of the Internal Revenue Code, or the corresponding section of any future federal tax code.”
The foundation’s organizing documents may conform with these special requirements based on provisions in the applicable state laws. The IRS periodically updates its list of states with these statutes. All six New England states have enacted such statutory provisions, “except where otherwise provided by a court of competent jurisdiction.”
Contact Smith, Sullivan & Brown
For private grant-making foundations, compliance is complex, and noncompliance can be costly. Smith, Sullivan & Brown has an experienced nonprofit team with members who focus on your unique needs. Whether your foundation is a seedling or fully bloomed, we’re here to help with everything from formation, accounting, tax planning, and compliance to grant-making strategies and other advisory needs. Contact us today!
by Sandra Brown, CPA
Sandra Brown, CPA, is a Partner at Smith, Sullivan & Brown, where she co-supervises nonprofit accounting, auditing, and tax engagements. Sandy graduated from the University of Oklahoma and began her career in public accounting at Price Waterhouse. She is licensed in Oklahoma and Massachusetts.