MAINTAINING TAX EXEMPT STATUS FOR YOUR FAMILY FOUNDATION

Transcription

1 MAINTAINING TAX EXEMPT STATUS FOR YOUR FAMILY FOUNDATION Below is a brief overview of the basic rules for compliance and governance requirements in order to maintain tax exempt status for your family foundation. A. RECORDKEEPING. You must maintain copies of the following documents in your records: (1) copies of the declaration of trust or corporation formation documents for the foundation, (2) the letter of determination from the IRS, (3) the recognition of state tax-exempt status (if any), (4) IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code and (5) the state application for exemption (if any). Additionally, foundations are required to keep copies of the three most recent IRS Form 990-PF, Return of Private Foundation or 4947(a)(1) Trust Treated as a Private Foundation, and such permanent books of account or records as are sufficient to establish its items of gross income, receipts and disbursements, and to substantiate the information on the IRS Form 990-PF. Copies of the IRS Form 990-PF and supporting materials are generally required to be maintained for at least three years from date of filing; although it is advisable, in the case of an exempt organization such as the foundation, to retain the returns and supporting materials for the entire period of the organization's existence. All of the foregoing documents must be kept available for public inspection. B. ANNUAL FILINGS. Each year, the Foundation will be required to file IRS Form 990-PF, Return of Private Foundation or 4947(a)(1) Trust Treated as a Private Foundation. Form 990-PF must be filed by the 15th day of the fifth month after the end of the trust's annual accounting period. In addition, many states have annual state filing requirements. You should speak to your accountant about whether he or she has experience with these filings. If the Foundation hires employees, it must withhold and pay employment tax, including federal income tax withholding and Social Security and Medicare (FICA) taxes. A foundation must withhold federal income tax from employee wages and pay FICA on each employee who is paid $100 or more in wages during a calendar year. To know how much income tax to withhold, the foundation should have a completed IRS Form W-4, Employee s Withholding Allowance Certificate, on file for each employee. Employment taxes are generally reported on IRS Form 941, Employer s Quarterly Federal Tax Return, or if instructed by the IRS, IRS Form 944, Employer s Annual Federal Tax Return. Any foundation that fails

2 to withhold and pay employment tax may be subject to penalties. You should speak to your accountant about whether he or she has experience with these filings. C. OPERATING RULES FOR PRIVATE FOUNDATIONS. For your general information, the following is a summary of special rules applicable to private foundations that are exempt from tax under 501(c)(3) of the Internal Revenue Code of 1986, as amended ("the Code"). 1. Tax on Net Investment Income. Section 4940 of the Code imposes an excise tax of 2% (1% under certain circumstances) on the net investment income of a private foundation during a taxable year. In any year in which a foundation's distributions (measured as a percentage of assets) exceed the average payout rate of the foundation calculated over the preceding five years by at least 1%, this excise tax is reduced to 1%. The net investment income of a foundation includes income from interest dividends, rents, payments with respect to securities loans and royalties, less the expenses attributable to such income. It also includes the gains and losses from the sale or other disposition of property, such as stock, used for the production of interest dividends, rents or royalties. Your accountant should be able to advise you as to the amount of the distribution that would be required to qualify for the reduced 1% rate. With proper tax planning, a foundation can maximize the benefit of this reduced rate by timings its distributions and sales of any highly appreciated investments. 2. Prohibited Transactions. Five provisions of the Code impose two-tier excise taxes on private foundations, foundation managers, and other "disqualified persons" that engage in certain prohibited acts or transactions. 1 The first-tier tax (initial tax) is automatically imposed if the foundation engages in a prohibited transaction. A second-tier tax is imposed if the prohibited transaction is not corrected within a certain period of time. There is a potential third-tier tax that may be imposed directly on the private foundation under 507 of the Code (a so-called "termination tax"). Under 507(a)(2), a private foundation's status will be involuntarily terminated if there have been willful repeated acts (or failures to act) or a willful and flagrant act (or failure to act) giving rise to liability for tax under one of the prohibited transaction provisions, and the Secretary of the Treasury notifies the foundation that, by reason of the act or acts, the organization is liable for the termination tax. This tax is potentially confiscatory and would be imposed only in the most flagrant situations See Code Cf. Regs (c)(1) and (c)(2). 2

3 Each of the five prohibited transactions is briefly discussed below. (a) Self-Dealing. Section 4941 of the Code imposes the series of taxes described above on "disqualified persons" and foundation managers who engage in certain types of prohibited business transactions with a private foundation. The term "self-dealing" includes the direct or indirect sale or exchange or leasing of property between the private foundation and disqualified persons; lending of money or other extension of credit between a private foundation and a disqualified person; furnishing of goods, services or facilities between a private foundation and a disqualified person; payment of compensation by a private foundation to a disqualified person; transfer to or use by or for the benefit of, a disqualified person of the income or assets of a private foundation; and the agreement by a private foundation to make any payment of money or other property to a government official during the period of his government service. There are exceptions to each of these prohibitions, as, for example, the exception that a private foundation may pay a disqualified person reasonable compensation for personal services without engaging in an act of self-dealing. However, legal counsel should be consulted prior to agreeing to the payment of compensation. As noted above, the tax on self-dealing is imposed on "disqualified persons" who engage in certain business dealings with the foundation. "Disqualified persons" include substantial contributors to the foundation and foundation managers as well as members of the family of disqualified persons and businesses in which family members hold a substantial interest. 3 If you should ever contemplate any dealings with the foundation other than to make contributions, we advise that you check with us or with other legal counsel in advance. It is important to remember a family foundation cannot satisfy a pre-existing pledge made by a disqualified person to a public charity because to the extent that the foundation relieves the person of the financial obligation, he or she has received a prohibited personal benefit. 4 However, a private foundation may make a charitable grant or pledge to a public charity, including a church or other religious institutions, if that grant or pledge was initiated by the foundation itself. Additionally, as a general rule, the receipt of goods by a disqualified person from the private foundation constitutes an act of self-dealing under 4941 of the Code. 5 Where a family foundation is given tickets for a fund-raising event hosted by a public charity that the family foundation supports, the question arises of whether self-dealing results when disqualified persons attend the event and partake of the food, beverages and entertainment. No self-dealing should arise if board members, officers or trustees of the foundation attend an event that is related to the foundation's stated exempt purposes in an official capacity to monitor the use of Code Reg (d)-2(c). Reg (d)-2(d)(1). 3

4 one or more grants made to that public charity. 6 However, there is no exemption to the selfdealing rules for tickets to the events that are given to friends and family members that are not board members, officers or trustees of the foundation. The self-dealing rules do not prohibit a foundation manager from purchasing tickets to an event entirely with his or her personal funds. 7 (b) Failure to Make Required Minimum Distribution. Under 4942 of the Code, a private foundation is required to make "qualifying distributions" equal to 5% of the excess of the aggregate fair market value of all assets of the foundation (other than those used directly in carrying out the foundation's exempt purposes) over the acquisition indebtedness with respect to such assets, reduced by the taxes imposed on net investment income and unrelated business income. The aggregate fair market value of the foundation's assets is generally computed for this purpose as an average of the monthly fair market values of cash and marketable securities on hand over the course of the prior taxable year, plus the fair market value of all other assets computed as of a consistently used valuation date occurring on that taxable year. Excess qualifying distributions made in any one taxable period may be carried over to reduce the amount distributable in the five tax years immediately following the tax year in which the excess of qualifying distributions is created. In general, "qualifying distributions" consist only of amounts the foundation has paid or set aside to accomplish one or more of its purposes described in 170(c)(2)(B) of the Code (i.e., religious, charitable, scientific or other defined public purposes). 8 Qualifying distributions also include amounts paid for administrative expenses that are reasonable and necessary to accomplish or support qualified activities. 9 Reasonable administrative expenses include overhead costs such as office supplies, telephone charges, certain legal and accounting fees, training and professional development, costs of publication of an annual report and reasonable travel expenses associated with foundation business. 10 i. Grants to a Public Charity. Grants to public charities under 501(c)(3) of the Code are qualifying distributions. However, before distributing a grant, the foundation should confirm that the donee is the public charity by either (i) requesting a copy of the organization's IRS determination letter or (ii) checking IRS Publication 78, Cumulative List of Organization Described in 170(c) of the Code (available online at Some organizations, such as churches or other religious institutions, government instrumentalities or municipalities that are a political subdivision of a state, are public charities, but are not listed in IRS Publication 78. While other organizations, such as fire departments, rotary clubs, libraries 6 7 TAM The IRS has taken the position that it is not possible to divide the price of a ticket into its charitable and noncharitable components. PLR Accordingly, it is not possible for the individual attendee to pay the fair market value of tangible benefit received and thereby avoid the self-dealing rules. 8 Code 4942(g). 9 Regs (a)-3(a)(2)(i). 10 Regs (a)-3(a)(8), ex. 1. 4

5 or policemen benevolence funds, may be tax-exempt under 501(c)(4) or 501(c)(6) of the Code instead of being public charity and, accordingly, grants to such organizations would require the foundation to exercise expenditure responsibility (discussed in more detail below). ii. Grants to a Private Operating Foundation. Grants to a private operating foundation that is not controlled by the grant-making foundation are a qualifying distributions. 11 A private operating foundation is a foundation that spends at least 85% of its adjusted net income or its minimum investment return, whichever is less, directly for the active conduct of its exempt activities (referred to as the "income test" and also meets one of the following tests: (i) the assets test, (ii) the endowment test or (iii) the support test. 12 As with grants to public charities, prior to distributing a grant, the foundation should confirm the status of an organization as a private operating foundation either (i) requesting a copy of the organization's IRS determination letter or (ii) checking IRS Publication 78. iii. Grants to Another Private Foundation or Controlled Entity. As a general rule, a grant by a private foundation to another private, non-operating foundation, or to any organization, public or private, controlled by the grant-making foundation or by any of its disqualified persons, will not constitute a qualifying distribution. 13 However, a private foundation may make a grant to another private foundation if the granting foundation exercises expenditure responsibility. 14 To exercise "expenditure responsibility," the foundation must use all reasonable efforts and establish adequate procedures (i) to assure that its grant is spent solely for the exempt purpose for which made, (ii) to obtain full and complete reports from the grantee on how the funds were spent and (iii) to make full and complete reports regarding the grant to the IRS. 15 The required procedures also include a pre-grant inquiry to assure that the recipient foundation will utilize the grant for proper purposes and the execution of a written grant agreement requiring the grantee to maintain records and submit complete reports. 16 iv. Grants to Individuals. As a general rule, a private foundation may not make a grant to an individual without advance approval from the IRS. However, grants made to individuals to "relieve human suffering" may be made without advance approval under certain conditions, provided that the foundation (i) makes the grant on an objective, nondiscriminatory basis, (ii) complies with recordkeeping requirements, including documenting how and why the particular recipient was selected, and (iii) does not restrict how the recipient spends the grant. The IRS divides such grants into two broad categories: (i) emergency assistance (e.g., assistance to victims of a natural disaster) and (ii) hardship assistance (e.g., an established need to purchase food for a low-income family). For more information on grants to individuals to "relieve human suffering," see IRS Publication 3833, Disaster Relief: Providing Assistance Through Charitable Organizations Regs (a)-3(a)(2)(i). Code 4942(j)(3). Code 4942(g)(1)(A); Regs (a)-3(a)(2)(i)(a), (b). Code 4945(d)(4), (h). Regs (b)(1). Code 4945(h). 5

6 v. Expenditure Responsibility Grants. A grant to (i) for-profit entity, (i) an organization tax-exempt under a section of the Code other than 501(c)(3), (iii) to Type III non-functionally integrated supporting organizations and (iv) to Type I and Type II "controlled" supporting organizations, will only be treated as a qualifying distribution if the foundation exercises expenditure responsibility. 17 If the expenditure responsibility rules are not complied with, the grant will be treated as a taxable expenditure (discussed below). You should contact us prior to undertaking your first expenditure responsibility grants as this is a complex area of law. vi. Program Related Investments. Program related investment (PRIs) are an exception for the jeopardy investment rules (discussed below) and are treated as qualifying distributions. 18 An investment will generally qualify as a PRI, if (i) the primary purpose of the investment is to accomplish one or more of the foundation's exempt purposes; (ii) a return on investment is not a significant purpose of the investment; and (iii) no political or legislative purposes is a purpose of the investment. 19 PRIs include, without limitation, loans, loan guarantees, linked deposits, and even equity investments in for-profit ventures. If a PRI is repaid, in whole or in part, to a foundation that treated such PRI as a qualifying distribution, then the foundation must include such amounts received in the foundation's distributable amount for the year of repayment. 20 You should contact us prior to undertaking your first PRI as this is a complex area of law. (c) Retention of Excess Business Holdings. Section 4943 of the Code imposes an excise tax on the "excess business holdings" of any private foundation in a business enterprise during any taxable year. A foundation's interest in an incorporated business enterprise is considered to be an "excess business holding" if it exceeds 20% of the voting stock reduced by the percentage of the voting stock owned by all disqualified persons. 21 In the case of a partnership or joint venture, the terms "profits interest" and "capital interest" are to be substituted for voting stock in determining whether a foundation has an excess business holding in an enterprise. 22 The term "business enterprise" for purposes of the excess business holdings provisions does not include "functionally related businesses", 23 which generally may include businesses related to the exempt function of the foundation or "a trade or business at least 95% of the gross income of which is derived from passive sources." 24 Income from passive sources, in turn, Regs Regs (a)-3(a)(2)(i).. Regs (a)(1). 4942(d)(1), (f)(2)(c). Code 4943(c)(2)(A). This percentage is increased to 35% of the voting stock where it is established that one or more persons who are not "disqualified persons" with respect to the foundation have effective control of the enterprise. 22 Code 4943(c)(3) and Regs (c)(2). A private foundation may have no "permitted holdings" in a sole proprietorship. Code 4943(c)(3)(B) and Regs (c)(3). 23 Code 4943(d)(3)(A). 24 Code 4943(d)(3)(B). 6

7 includes interest dividends, rents and royalties, as well as capital gains from the disposition of property which is not stock in trade held primarily for sale to customers in the ordinary course of a trade or business. 25 Although a foundation that acquires excess business holdings by gift, or under the terms of a will or trust, is given a 5-year period (with a 5-year extension permitted in certain circumstances) after the receipt of such holdings to dispose thereof, during which period no excise tax will be imposed, the self-dealing rules restrict how the foundation may dispose of the stock and, therefore, make a direct gift or bequest of a substantial interest in a closely-held business to a foundation unadvisable. However, with respect to a bequest of business holdings at death, under the "estate administration exception," self-dealing (i.e., a transaction between the foundation and a disqualified person) is permitted during the administration of an estate (or revocable trust) provided that: (1) the personal representative is permitted to enter into the transaction pursuant to state law, (2) the private foundation will receive an interest at least as valuable as the business holdings it would have received and (3) the transaction is approved by a court of competent jurisdiction. The most commonly used variation of the estate administration exception is the grant of an option to specified disqualified persons to purchase the business interests at their fair market value. If you are considering leaving a business interest to your foundation at death, please contact us to assist you with structuring. (d) Jeopardy Investments. Section 4944 of the Code imposes penalties "if a private foundation invests any amount in such a manner as to jeopardize the carrying out of any of its exempt purposes..." 26 A jeopardizing investment generally may be considered as one lacking in the requisite standard of ordinary business care and prudence under the facts and circumstances prevailing at the time of making the investment. 27 Foundation managers may take into account the expected return (including both income and appreciation of capital), the risks of rising and falling price levels and the need for diversification within the investment portfolio. No category of investment is treated as a per se violation of Section 4944(c) of the Code provides an exemption from the jeopardy investment rules for PRIs. The PRI exemption allows private foundations to make an investment in a forprofit entity without incurring excise tax. You should contact us prior to undertaking any program related investments as this is a complex area of law. A private foundation that violates 4944 of the Code will incur an initial excise tax equal to 10% of the jeopardy investment. 29 An excise tax of an equal amount will also be imposed Code 4943(d)(3). Code 4944(a). Regs (a)(2). Id. Code 4944(a)(1). 7

8 on any foundation manager who knowingly made such jeopardy investment. 30 If the violation is not cured by the close of the taxable period with respect to such holdings, then an excise tax of 25% of such investment will be imposed on the foundation and an additional excise tax of 5% of such foundation managers will be imposed on those who refuse to agree to part or all of the removal of the investments from jeopardy. (e) Taxable Expenditures. Section 4945 of the Code is designed to prohibit foundations from using charitable funds in a manner that does not further the foundation's exempt purposes. The rules governing taxable expenditures are extremely technical and too complex to explain, other than in a summary fashion, within the confines of this summary. "Taxable expenditures" include amounts paid or incurred by private foundations: (i) To carry on propaganda, or otherwise attempt to influence legislation; (ii) To influence the outcome of any specific public election, or to carry on, directly or indirectly, any voter registration drive unless certain conditions are met; (iii) As a grant to an individual for travel, study or other similar purposes, unless the grant meets certain requirements; (iv) As a grant to an organization, other than a public charity, unless the granting foundation exercises expenditure responsibility (discussed above); or (v) For any purpose other than one specified in 170(c)(2)(B) (i.e., religious, charitable, scientific, literary or educational purposes), or to foster certain amateur sports competitions, or for the prevention of cruelty to children or animals. Grants to individuals that are not for the purpose of travel or study do not come within the rules of 4945, and are not taxable expenditures. An example of such a grant would be a grant to an indigent individual to enable him to purchase furniture. Please do not hesitate to contact us at any time if you have any questions. Elizabeth Carrott Minnigh, Counsel Buchanan Ingersoll & Rooney PC 1700 K Street, NW, Suite 300 Washington, DC elizabeth.minnigh@bipc.com 30 Code 4944(a)(2). 8

9 TAX ADVICE DISCLAIMER: Any federal tax advice contained in this communication (including attachments) was not intended or written to be used, and it may not be used, by you for the purpose of (1) avoiding any penalty that may be imposed by the Internal Revenue Service or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein. If you would like such advice, please contact us. 9