Leading a private foundation can be one of life’s most gratifying experiences, a chance for an individual or family to effect real and positive change in the world through philanthropy.
The creativity, flexibility and nearly endless giving capabilities offered by a foundation do come with a dose of administrative complexities, however. 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.
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. Foundation staff often don’t realize that if a foundation borrows money to purchase an investment asset, some or all of the income flowing from that asset usually will be deemed UBTI. Additionally, if a foundation invests in a partnership using leverage, the foundation may be allocated UBTI on its K-1.
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 and the Exempt Organizations Business Master File Extract. Foundations may make grants to listed public charities without exercising “expenditure responsibility,” a multi-step process to ensure grant funds will be used for a charitable purpose only.
If a private foundation makes a grant to a non-IRS-approved public charity, and does not exercise expenditure responsibility, it may be penalized, and the grant may 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 advance IRS approval, many foundations falsely believe that they can fund a specific student’s scholarship without IRS approval – as long as the grant is paid directly to the university and not to the student. 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 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.
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 events to be registered with applicable attorney general’s offices. 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.
Sometimes foundations raise additional funds at these events by selling merchandise, such as t-shirts. 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.
Additionally, if a foundation raises funds through a live or silent auction, it must clearly document the fair market value of all items for sale before the auction begins. 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.
6. Insiders may not economically benefit from the foundation – except for reasonable compensation for certain professional services.
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, which is judged on a list of factors, such as the insiders’ qualifications, the foundation’s size, cost of living in the area, and the salary of similar positions. Additionally, an insider paid compensation must render services that are professional in nature.
7. Insiders’ attendance at charity events must be strictly work-related.
If a private foundation purchases (or is given) tickets to a local fundraising event of a charity, a question arises as to whether self-dealing results when a board member, other insiders, 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. A foundation board member’s or officer’s attendance of an event to represent the foundation in an official capacity, should not result in impermissible 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. To remove any question of self-dealing, it is preferable for a private foundation to decline tickets for persons other than its board members, trustees, senior staff and their spouses.
8. Foundations may not fulfill their insiders’ personal pledges.
A common compliance problem occurs when a foundation insider makes a personal pledge to a public charity – usually a church, synagogue, mosque, etc. – and the foundation satisfies that pledge.
A foundation may make a charitable grant or pledge to a charitable organization only when that pledge is initiated by the foundation. To the extent that the foundation relieves an insider of such a personal financial obligation, that person is considered to have benefited, which is a rule breaker. Insiders are not allowed to obtain a personal benefit from their dealings with the foundation.
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.
The IRS divides such grants into two broad categories of assistance: emergency and hardship. Emergency assistance usually is provided in the wake of a natural catastrophe, such as an earthquake, or after a personal tragedy, such as being the victim of a violent crime or flood. Hardship assistance addresses economic needs, such as providing food or covering 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, as long as the granting foundation exercises expenditure responsibility.
When the recipient foundation disburses grant funds, the IRS allows only one of those foundations to count those funds toward satisfying the annual MDR. Unless the foundations agree otherwise, the recipient foundation will be the one that will count the disbursement of the funds toward its MDR.
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.
