PRIVATE FOUNDATIONS:
Is it really the right choice?
by Claude R. Schwesig, CPA

EXPLANATORY NOTE:

This outline is meant to be a reference resource, but it is not intended to be exhaustive and technically complete. If the formation of a private foundation is contemplated, specific professional help should be sought. These comments were the basis of a talk given to the Vermont Tax Seminar in South Burlington on December 12, 2000.

  1. What is a private foundation?

    1. A "private foundation" is specifically defined in the Internal Revenue Code as a domestic or foreign organization described in section 501(c)(3), other than:

      1. A church, school, hospital, organization supporting a public college or university, the United States, any state or political subdivision thereof, or a publicly supported organization;
      2. An organization meeting certain public support tests;
      3. An organization which supports an organization described in sections 509(a)(1), 509(a)(2), or 509(a)(3);
      4. An organization which is organized and operated exclusively for testing for public safety.

    2. A charitable trust described in section 4947(a)(1) is treated as an organization described in section 501(c)(3).

    3. A split interest trust described in section 4947(a)(2) is also treated as a private foundation for certain purposes.


  2. An organization described in section 501(c)(3) is presumed to be a private foundation unless it is proved otherwise.

    1. There are some exceptions. In particular, churches and any organization which is not a private foundation, and the gross receipts of which in each taxable year are normally not more than $5000, are not required to apply for non-private foundation status and are not presumed to be a private foundation.


  3. What are the consequences of being classified as a private foundation?

    1. There is a two percent (sometimes one percent) excise tax on net investment income.

    2. There are excise taxes on the following prohibited transactions:

      1. Self-dealing;
      2. Failure to distribute income;
      3. Excess business holdings, usually closely held;
      4. Speculative investments which jeopardize charitable purposes;
      5. Taxable expenditures (UBIT).

    3. A termination tax will be incurred.

    4. There are significant reporting requirements.


  4. In the entire area of taxation of private foundations, "disqualified persons" are treated specially. The following are disqualified persons:

    1. A substantial contributor to the foundation. This means any person who contributed or bequeathed an aggregate amount of more than $5000 to the private foundation, if such amount is more than two percent of the total contributions and bequests received by the foundation before the close of the taxable year of the foundation in which the contribution or bequest is received from such person.

    2. A foundation manager. This means any officer, director, or trustee of the foundation, or any individual having powers or responsibilities similar to those of officers, directors, or trustees of the foundation, and employees of the foundation having authority or responsibility with respect to a particular act.

    3. An owner of more than twenty percent of the following entities, if such entity is a substantial contributor to the foundation: (a) the total combined voting power of a corporation, including attribution rules; (b) the profits interest of a partnership, including attribution rules; (c) the beneficial interest of a trust, including attribution rules; or (d) the beneficial interest of an unincorporated enterprise.

    4. A member of the family of any individual described in section 4946(a)(1). This includes a spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren and great grandchildren. It does NOT include siblings, cousins, nieces, nephews, etc.

    5. A corporation of which persons described in D above own more than 35% of the total combined voting power. The attribution rules do apply.

    6. A partnership of which persons described in D above own more than 35% of the total profits interests. The attribution rules do apply.

    7. A trust or estate of which persons described in D above own more than 35% of the beneficial interest. The attribution rules do apply.

    8. Only for purposes of section 4943, a controlled or related private foundation.

    9. Only for purposes of section 4941, a government official described in section 4946(c).


  5. Broadly supported organizations escape private foundation status.

    1. There is a two-pronged test under section 509(a)(2). Both tests are on the cash basis, even if the foundation is on the accrual basis.

      1. The organization "normally" receives more than one-third of its support in each taxable year from any combination of gifts, grants, contributions, or membership fees, and gross receipts from admissions, sales of merchandise, performance of services, or the furnishing of facilities, in an activity which is not an unrelated trade or business. Receipts from persons and governmental entities are included, except that such receipts are not considered to the extent that they exceed the greater of $5000 or one percent of the organization's support for such taxable year. Receipts from organizations described in section 509(a)(1) are included. Receipts from disqualified persons are excluded. The one-third refers to the amount of support included in these categories, divided by the total support received.
      2. The organization "normally" receives not more than one-third of its support in each taxable year from the sum of (a) gross investment income, and (b) the excess, if any, of the unrelated business taxable income over the tax on that unrelated business taxable income. Again, the one-third refers to the amount of support from these sources, divided by the total support received.

    2. The satisfaction of this broadly-supported test is reported on Schedule A of Form 990.

    3. The concept "normally" means during the four taxable years immediately preceding the current taxable year. For an organization that has been in existence for more than eight months, but less than five years, the number of years for which it was in existence immediately before the current year is substituted for the four taxable years period.

    4. For a newly-created organization, the Internal Revenue Service will generally issue an advance ruling that the organization meets these two tests for a period of up to three years if the requirements of regulation 1.509(a)-3(d) are met. Under certain circumstances, this period may be extended up to six years.

    5. If there are material changes in sources of support in the current year, other than an "unusual grant", the four taxable years period is adjusted.

    6. An "unusual grant" is excluded from both of the broadly-supported tests. An "unusual grant" must be one attracted by reason of the publicly supported nature of the organization, as well as one that is large. The factors to be considered in determining whether a grant is an "unusual grant" are set forth in regulation 1.509(a)-3(c)(4).

    7. "Support" includes the following:

      1. Gifts, grants, contributions, or membership fees;
      2. Gross receipts from admissions, sales of merchandise, performance of services, or furnishing of facilities in any activity which is not an unrelated business;
      3. Net income from unrelated business income activities, whether or not such activities are carried on regularly;
      4. Gross investment income;
      5. Tax revenues levied for the benefit of the organization;
      6. The value of services or facilities furnished by a government unit without charge (unless such services or facilities are generally furnished to the public without charge).

    8. Support does not include the gain from the sale of a capital asset.


  6. Publicly supported organizations are excluded from private foundation status.

    1. A publicly supported organization is one that normally receives from the general public and governmental units at least one-third of its total support. "Support" is defined in regulation 1.170A-9(e)(6), (7) and (8). Note that this is a different one-third test than that described in section 509(a)(2) above.

    2. A publicly supported organization that fails this one-third test may still meet a facts and circumstances test under the regulations.


  7. A supporting organization also escapes private foundation status. A supporting organization is one that:

    1. Is organized, and at all times thereafter, is operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of, one or more specified organizations described in section 509(a)(1) or (2);

    2. Is operated, supervised, or controlled by, or in connection with, one or more organizations described in section 509(a)(1) or (2);

    3. Is not controlled, directly or indirectly, by one or more disqualified persons, other than foundation managers, and other than one or more organizations described in section 509(a)(1) or (2).


  8. In order to be exempt from tax, a private foundation must include in its governing instruments various provisions which:

    1. Require distribution of income in accordance with section 4942;

    2. Prohibit engagement in any act of self-dealing;

    3. Prohibit any excess business holdings;

    4. Prohibit speculative investments which jeopardize its charitable purpose;

    5. Prohibit taxable expenditures under section 4945.

    Most states (including Vermont) have enacted legislation that incorporates these requirements in one fashion or another into the governing instruments by operation of law. Accordingly, it may not be necessary to specifically include these provisions in the instrument.


  9. There are several ways in which the status as a private foundation can be terminated. Specific obligations and requirements should be reviewed for each instance.

    1. The organization can notify the Internal Revenue Service of its intention to terminate.

    2. The organization's private foundation status can be involuntarily terminated if it commits willful repeated acts, or a willful and flagrant act, or failures to act, that cause liability for any of the excise taxes, and the Internal Revenue Service notifies the organization that it is liable for the termination tax, and its pays such tax;

    3. The organization may distribute all of its net assets to one or more bonafide public charities that has been in existence for at least sixty months;

    4. The organization has become a public charity.


  10. The termination tax is the lower of:

    1. The amount, which the private foundation can substantiate by adequate records or other corroborating evidence, is the aggregate tax benefit resulting from the exempt status of the foundation;

    2. The value of the net assets of the foundation.

    The termination tax may be abated by the Internal Revenue Service if the appropriate state officer notifies the IRS that corrective action has been started under state law to ensure the foundation's assets are preserved for charitable or other similar purposes, and later certifies that the action has resulted in the preservation of the assets.


  11. A private foundation may be subject to a 2% tax on net investment income.

    1. The tax is reduced to one percent if the qualifying distributions for the year represent an increase over prior years.

    2. An "exempt operating foundation" is not liable for the tax on net investment income.

    3. Net investment income is gross investment income and capital gain income, less allowable deductions.


  12. An initial tax of 5% is imposed on a self-dealer for each act of self-dealing. The tax is paid by any disqualified person who participates in the act, but is not imposed on a foundation manager who is acting only in that capacity.

    1. There is an additional tax imposed of 200% where the act of self-dealing is not corrected during the taxable period. The taxable period is the period beginning on the date of the act of self-dealing, and ending 90 days after the earlier of (a) the date of mailing of the deficiency notice with respect to the additional tax, (b) the date on which the excise tax is assessed, and (c) the date on which correction of the act is completed.

    2. The tax is the appropriate percentage of the amount involved in the act of self-dealing.

    3. "Correction" means undoing the transaction to the extent possible, but in any case, placing the private foundation in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.

    4. Self-dealing is any direct or indirect transaction of the following types: sale, exchange, or leasing of property, regardless of the amount paid; lending of money or other extension of credit; certain furnishing of goods, services, or facilities; unreasonable compensation or reimbursement of expenses; transfer to, or the use by, a disqualified person of the income or assets; and bribes or related payments to government officials.

    5. It is immaterial whether the transaction results in a benefit or a detriment to the private foundation.


  13. An initial tax of 15% is imposed on the undistributed income of a private foundation.

    1. This tax is imposed on the foundation on that income not distributed before the first day of the tax year following the tax year for which there is a requirement to distribute. If the undistributed income is still undistributed at the beginning of the next succeeding year, there is another tax. This additional tax can reach 100% of the undistributed income.

    2. Undistributed income is the amount by which the distributable amount exceeds the qualifying distributions. The calculation of this is rather complicated and lengthy, but typically would only apply to those organizations which are not using most of their income for charitable purposes.

    3. A qualifying distribution is (a) any amount, including reasonable and necessary administrative expenses, paid to accomplish one or more exempt purposes, (b) any amount paid to acquire an asset used directly in carrying out one or more exempt purposes, and (c) certain "set-asides".


  14. Operating foundations are not subject to the excise tax on undistributed income.

    1. An operating foundation is an organization that makes qualifying distributions directly for the active conduct of the activities constituting the purpose or function for which it is organized and operated, equal to substantially all (85% or more) of the lesser of (a) its adjusted net income, or (b) its minimum investment return, and meets one of three tests.

    2. Assets test: substantially more (65% or more) than half of the assets are devoted directly to the exempt purpose or to functionally related businesses.

    3. Endowment test: normally qualify distributions made directly for the active conduct of the activities constituting the purpose of the organization are not less than two-thirds of its minimum investment return.

    4. Support test: substantially all (85% or more) of the support, other than gross investment income, is normally received from the general public, or through other exempt organizations within certain limits.


  15. Private foundations can be subject to several other excise taxes.

    1. Excess business holdings can be subject to an initial tax of 5%. This tax is often triggered when a foundation invests in closely held businesses.

    2. Investments that jeopardize the charitable purpose of the foundation can be subject to an initial excise tax of 5%. This tax can be imposed on both the foundation and on the foundation manager who participates in the questionable investment. This tax can be increased to 25% if the inappropriate investment is not removed in a timely manner.

    3. Taxable expenditures can attract an initial tax of 10% on the foundation. An additional tax of 2.5% can be imposed on the foundation manager who agrees to the making of a taxable expenditure, and a further tax of 100% can be levied on the foundation (with 50% being levied against the manger) if the taxable expenditure is not appropriately corrected.

    4. Examples of taxable expenditures are:

      1. Carrying on propaganda, or attempting or otherwise influencing legislation;
      2. Trying to influence the outcome of any specific public election;
      3. Carrying on, directly or indirectly, any voter registration drive;
      4. Awarding grants to individuals for travel, study, or other similar purposes by such individual, unless such grant is awarded on an objective and non-discriminatory basis. Specific detailed rules must be followed;
      5. Awarding grants to other organizations, unless (a) the organization is described in section 509(a)(1), (2), or (3), (b) the organization is an exempt operating foundation described in section 4940(d)(2), or (c) the private foundation exercises expenditure responsibility with respect to such grant;
      6. For any purpose other than a charitable one described in section 170(c)(2)(B).


  16. Alternatives to a private foundation:

    1. Creating a supporting organization to a community foundation;

    2. A donor-advised fund within a community foundation.

    These options may not provide the full control and flexibility of a private foundation, but they have the advantage of being relatively simple to establish, they avoid most of the risks and pitfalls associated with private foundations, and they are administratively straight-forward and inexpensive to operate on an on-going basis.

 

© Herrick, Ltd. 2000

This resource outline is current. However, future changes in the Internal Revenue Code and related regulations, rulings, and court cases, may render some of this information obsolete. Current law should be reviewed with the appropriate professionals.