When Should a 501(c)(3) Consider Creating an Affiliated 501(c)(4)?

Closeup of businessman making decision whether to accept or deny a suggestion or employee.

501(c)(3) organizations have numerous tools at their disposal for achieving their charitable purposes, and also have the distinct advantage of being able to receive contributions that are generally tax-deductible for donors.  However, in exchange for tax-exemption and the ability to receive deductible charitable contributions, the law places some limitations on the permissible advocacy-related activities of 501(c)(3) organizations.  These limitations have led some 501(c)(3) organizations to make use of affiliated 501(c)(4) social welfare organizations, which are generally subject to fewer limitations and restrictions, to best further their common primary mission.

The limitations associated with 501(c)(3) exempt status include a complete prohibition on engaging in any activities that constitute intervention in a political campaign and a requirement that no more than an insubstantial amount of a 501(c)(3)’s activities constitute lobbying.  While we unfortunately do not have a clear definition of “insubstantial” in this context, as we’ve previously written about on this blog, many 501(c)(3) organizations have the option of making the election under IRC Section 501(h) to have their lobbying activities measured based solely on expenditures.  Section 501(h) also offers fairly generous thresholds for permissible lobbying expenditures by an electing organization.

Nonetheless, some 501(c)(3)s find that they could more effectively pursue their missions through lobbying or election-related activities beyond those permissible for 501(c)(3)s.  In that case, forming an affiliated 501(c)(4) organization may be an attractive option.

Unlike 501(c)(3)s, 501(c)(4) organizations are permitted to engage in an unlimited amount of lobbying activities, provided such activities are in furtherance of the organization’s social welfare purposes.  They may also engage in a limited amount of political campaign intervention activities, so long as such activities are secondary to their general social welfare activities.  Because of the greater flexibility that 501(c)(4)s have in these areas, they can be a great tool for effectively furthering a social welfare mission.

Once you’ve decided to form an affiliated 501(c)(4), you may find our post on the step by step process for creating a 501(c)(4) helpful.  However, before launching into forming a new entity, here are a few things to consider:

  • Capacity – In creating a separate 501(c)(4), you are creating a separate legal entity with its own filing, registration, and compliance obligations, and operational needs. The 501(c)(3) should carefully assess whether it has access to the additional capacity necessary to create and run a separate entity.
  • Funding – While 501(c)(4)s are exempt from federal income taxes, donations to them are typically not deductible for donors. Accordingly, finding funding for a 501(c)(4)’s activities can be challenging.  Before beginning the process of forming an affiliated 501(c)(4), it would be wise for a 501(c)(3) to ensure that the 501(c)(4) will be able to attract sufficient funding to set it up for success, and that the pursuit of such funding will not negatively impact the 501(c)(3)’s ability to fundraise from common donors.
  • Affiliation Structure – Because nonprofits do not have any owners, it is not possible to a create a 501(c)(4) “subsidiary” of a 501(c)(3). However, if close affiliation between the two organizations is desired, there are a few options for structuring such affiliation.  These structures are usually created in the 501(c)(4)’s Bylaws, which will be subject to the laws of the state in which the entity was incorporated.  In California, one option may be to create a voting membership structure with the 501(c)(3) as the sole voting member of the 501(c)(4).  Alternatively, the 501(c)(3) could be given the right to designate some or all of the Directors of the 501(c)(4).  However, in setting up such an affiliation, the 501(c)(3) will need to be mindful of the need to maintain appropriate separation between the entities, for the purposes of both ascending liabilities and to ensure it does not jeopardize its own tax-exempt status.
  • Exemption/Registration – Another distinction between 501(c)(4) and most 501(c)(3) organizations is that 501(c)(4)s may self-declare as exempt from federal income taxes without needing to file an application with the IRS. Many 501(c)(4)s nonetheless choose to file a Form 1024 and obtain recognition of tax-exemption in order to have the assurance that comes with such recognition.  In addition, as of mid-2016, organizations intended to operate as exempt under Section 501(c)(4) must file IRS Form 8976 with the IRS no later than 60 days after the organization is formed (see our earlier blog post on this requirement here).
  • Maintain Appropriate Separation – Because 501(c)(4)s can engage in activities that 501(c)(3)s may not, it is important that appropriate separation between two such affiliated organization be maintained and that the 501(c)(3) not allow its assets to be used to subsidize the activities of the 501(c)(4) that are prohibited for the 501(c)(3). For example, if the 501(c)(3) wishes to make a grant to an affiliated 501(c)(4), it should be made pursuant to a written grant agreement that clearly requires the funds to be used solely for 501(c)(3)-consistent purposes.  Accordingly, a general operating grant from a 501(c)(3) to a 501(c)(4) would not be permissible, even for startup costs, as such a grant could serve to further activities not permissible for the 501(c)(3).  A grant made for the stated purpose of supporting the 501(c)(4)’s lobbying activities must be accounted for as a lobbying activity and/or expenditure of the 501(c)(3), and a grant that does prohibit its use for lobbying may also be attributed as a lobbying expenditure by the 501(c)(3).  If the two entities will share resources, such as staff or facilities, such sharing should be pursuant to a resource sharing agreement that ensures that the 501(c)(4) pays at least its fair share for the costs of the day-to-day operations of the 501(c)(4).
  • Political/Election Laws – Finally, if a 501(c)(4) does engage in lobbying or election-related work, it may be subject to additional election and political laws beyond the tax laws generally discussed in this post. A 501(c)(4) will need to be aware of any such applicable laws in advance of engaging in lobbying or election-related activities in order to ensure compliance.  Note that a 501(c)(3) may also be subject to some political and election laws if it engages in certain activities, particularly permissible nonpartisan election-related activities.

In summary, in many instances, creating an affiliated 501(c)(4) can be a highly effective means of furthering an organization’s mission.  However, it is important to think through the various considerations in advance to ensure that such an affiliation is proper under the particular circumstances, and will be set up for success.

20th Annual Western Conference on Tax-Exempt Organizations

los-angeles-biltmore

The 20th annual Western Conference on Tax-Exempt Organizations (WCTEO) will take place at the Millennium Biltmore Hotel in downtown Los Angeles this Thursday and Friday, December 1-2, 2016. The WCTEO has been my top go-to conference every year since starting NEO Law Group, and I’m particularly excited about this year, my first as a member of the planning committee. With a schedule that features panels led by some of the country’s top tax-law experts (no hyperbole!), I highly recommend the WCTEO to all of my professional colleagues serving or working in the nonprofit sector and am happy to talk with anybody considering attending. You can submit your name on the waitlist for registration here and you’ll be contacted by the staff to complete your registration.

Some Highlights from the Schedule:

  • Exempt Organization Practice: A Twenty Year Retrospective – Marcus Owens (former Director of the IRS Exempt Organizations Division).
  • Current Developments – Bruce Hopkins
  • Investing in the Future: What Does Mission Have to Do with It? – Jeffrey R. Hom,  David A. Levitt
  • Funding Through Exploitation – The Life Cycle of Nonprofit IP and Other Desirable Assets – Ofer Lion,  Michael I. Sanders 
  • A Twenty Year Prospective – Exempt Organizations Through 2036 – Ofer Lion,  Alexander L. Reid,  Jean L. Tom,  Stephanie Wilkinson

In addition, there are sessions on tax compliance issues, property tax exemption, private foundations, charitable solicitations, charitable giving, accelerators and incubators, and international activities, and an update from the IRS and Treasury. I’m looking forward to moderating an informative and fun session on crowdfunding with panelists Jeanette Lodwig, Arthur M. Rieman, and Jean L. Tom.

Check out this profile on WCTEO Co-Chair Ellen April: Loyola Tax-Law Leadership Exemplified in Conference.

Washington Update

Compliance Issues – Not Just Your 990

  • Form 990: Much more than financial information. Also mission, program services, governance, compensation, transactions with insiders, related organizations.
  • Who cares? IRS, media, individual donors, watchdog organizations (and state charity officials, state revenue authorities, potential board members, private foundations, corporate sponsors and donors, etc.).
  • Disclosures of uncertain items on Form 990 may be important to start statute of limitations (e.g., potential unrelated business taxable income).
  • IRS moving from a subsector-driven compliance model (e.g, universities and hospitals) to data-driven compliance model (from information submitted on the Form 990). Panel discussed several possible triggers of examination (audit) on the Form 990.
  • IRS TE/GE FY 2017 Work Plan – reinforces 5 issue areas of focus: (1) exemption; (2) protection of assets; (3) tax gap (e.g., employment taxes, unrelated business income taxes); (4) international (e.g., conduit to foreign persons or entities, inadequate oversight of grants); and (5) emerging issues (e.g., 501(r)).
  • For independence of directors, be careful if director has a material financial transaction with a related organization – nonprofit or for-profit (can blow her or his independence as a director).
  • Form L of the Form 990 – identifying business transactions with interested persons can be very challenging. Consider using a negative confirmation letter with no need to respond if the “interested person” (including any Schedule B contributors) has no disclosures to make.

Expanding Your International Footprint

  • Regulatory Trends: shifting enforcement of tax-related regulations, stricter immigration, linking immigration to tax reporting, NGO registration and reporting.
  • Many issues with operating outside of the United States, including unfamiliar laws of foreign countries, no existing legal structure in foreign country, different health and safety considerations.
  • War stories include independent contractors in foreign countries claiming to be employees, foreign parter non-compliance, detention of employees or volunteers.
  • Forms of international activities: grant to an existing overseas entity, collaboration with a partner organization. branch office, new NGO, new for profit subsidiary.

Exempt Organization Practice: A Twenty Year Retrospective

Former head of the IRS Exempt Organizations Division Marcus Owens provided a twenty-year retrospective and included some insightful thoughts for the future, including a forecast of problems for the IRS hidden by use of the Form 1023-EZ.

Expecting the Unexpected in Property Tax Exemption (California)

  • Even if you haven’t received an Organizational Clearance Certificate (OCC) yet, file with the County Assessor before the February deadline.
  • The court in the Jewish Comm Center Dev. Corp v. LA case in 2016 held that an operator of a property does not need to file an exemption claim with the assessor or hold an OCC issued by the Board of Equalization (BOE). The BOE has revised (but not yet released) BOE-267, Claim For Welfare Exemption (First Filing), and BOE-267-A, 20__ Claim For Welfare Exemption (Annual Filing), to remove instructions requiring that both the owner and operator must file a separate exemption claim form and each must hold a valid OCC issued by the BOE. In addition, the BOE has created a supplemental affidavit, BOE-267-O, Welfare Exemption Supplemental Affidavit, Organizations Operating On Claimant’s Real Property, for the property owner to demonstrate that the property is used exclusively for welfare exempt purposes by an operator that is organized and operated for an exempt purpose.
  • The “exclusive” use requirement for property tax exemption remains elusive to define. There are precedents both for a fairly strict interpretation  (“incidental use must be directly connected with, essential to, and in furtherance of the primary use”) and a more permissive interpretation (allowing for some non-qualifying uses).

Investing in the Future: What Does Mission Have to Do with It?

Funding Through Exploitation – The Life Cycle of Nonprofit IP and Other Desirable Assets

  • Traditional intellectual property (IP): patents, copyrights, trademarks/servicemarks, trade secrets
  • Non-traditional IP: provision of assets to captive audiences, corporate sponsorships, naming opportunities, endorsements
  • IP license income or royalties (excluded from unrelated business income tax or UBIT) vs. service income (which, if unrelated, may be subject to UBIT)
  • Where IP is being transferred to a related organization, additional issues may arise, including conflicts of interest, resource-sharing, fair market value, and taxable subsidiary issues.
  • Fascinating discussion of National Geographic Society (nonprofit) – 21st Century Fox (for-profit) joint venture from Michael Sanders – 73% Fox; 27% NG equity split but 50:50 representation on board (based on IRS Revenue Rulings and seminal cases on joint ventures)
  • Big challenge is how to value nonprofit’s contribution to the joint venture if it involves non-traditional IP
  • Negotiating issues on behalf of nonprofit to joint venture with for-profit involves educating for-profit counsel regarding control requirements and critical provisions in the operating agreement to protect the nonprofit’s exempt status; also consider exit strategies in advance

Current Developments

 

Crowdfunding

  • About $16.2 billion was raised globally through crowdfunding in 2014 , and that number has been projected to reach $34 billion in 2015 . According to a 2013 study commissioned by the World Bank, crowdfunding is projected to become a $90-96 billion industry by 2025, almost twice the size of the current global venture capital industry.
  • Donation crowdfunding can be hosted on a site/platform owned and operated by either a nonprofit or for-profit organization.
  • Donation crowdfunding campaigns can be run by charities or individuals who may not may not be operating with a charity’s authority.
  • For fundraising campaigns run by charities, issues include mission-consistency, charitable class, conduit (jeopardizing a donor’s ability to deduct her contribution), registered vs. unregistered professional fundraisers, restricted gifts, and substantiating contributions; and, if rewards are involved, unrelated business income, commerciality, seller’s permit and sales tax, and quid pro quo written disclosures.
  • For fundraising campaigns run by individuals, issues include charity vs. charitable class vs. private beneficiaries, charitable trust jurisdiction, characterization of income, diversion of assets, charitable trust vs. consumer protection laws, delegation of authority with due care (including terms and limitations), and registration requirements.
  • Cautionary tales regarding over-reliance on an annual crowdfunding campaign. See, e.g., Technology Glitch Results in Day of Giving Fiasco (Nonprofit Quarterly).

Charitable Giving Update

 

Accelerators and Incubators

  • The terms “incubator” and “accelerator” are not defined in the law. However, according to UC Senior Counsel Thomas Schroeder, “these terms are commonly understood to refer to programs designed to nurture and accelerate the growth and success of private start-up companies by providing resources such as physical space in a collaborative environment with other start-ups, shared office equipment, technology and administrative services, mentoring and management training, networking opportunities, and, in some cases, capital or access to some other form of financing.”
  • There is still little guidance from the IRS regarding university incubators and accelerators and the circumstances under which they further 501(c)(3) educational purposes. For colleges and universities, they may want to tie the incubator to the students’ curricula. They must differentiate themselves for for-profit incubators in their exemption application and operations.
  • Other possible 501(c)(3) exempt purposes: scientific, charitable (relief of the poor, economic development, lessening the burdens of government)
  • Some of the tax issues for a 501(c)(3) incubator include: related or unrelated business activities, private benefit, in-kind payments of equity, and joint venture.

A Twenty Year Prospective – Exempt Organizations Through 2036

  • Ofer Lion: Nonprofits looking to access capital markets, high brow arts organizations tax-exempt status will be questioned (populist movements). 501(c)(3) hospitals will still be around (not all will convert or be forced to convert to for-profits) but there will be more consolidation. IRS will still be around to provide tax law enforcement over charities and other exempt organizations (perhaps doing less with less). More mission-related investments and shareholder activism (with 70% of U.S. equities being held by tax-exempt organizations).
  • Stephanie Wilkinson: Tax reform under Trump may severely and detrimentally impact charitable contributions (changes to standard deduction, limiting number of people who can get tax benefit of charitable contributions to 5%; elimination of estate tax). IRS will operate picking a few select areas of enforcement on which to focus; practitioners will specialize accordingly.
  • Jean Tom: Artificial intelligence (AI) using big data to help charities target particular prospective donors, virtual reality used in communications and fundraising, self-driving cars, drone deliveries, laws trying to catch up. With the devaluing of tax benefits associated with charitable contributions, despite the Trump-supported Johnson Amendment, which would blur difference between 501(c)(3)s and 501(c)(4)s (it would allow 501(c)(3)s to engage in electioneering), more 501(c)(4)s formed in place of 501(c)(3)s. More use of for-profit vehicles (instead of private foundations) to engage in charitable and other social good activities (like Omidyar Network and Chan Zuckerberg Initiative). Tech tools will help improve public accountability and self-regulation (where the public sector may fail).
  • Alex Reid: Increase in corporate civil rights, leadership by AI. Some DAF regulations! Challenge to charitable grantmaking as a charitable activity. Consumption tax in the form of exempting savings from income tax. Possible move of charitable contribution deduction moving ‘above the line” so not impacted by increase in standard deduction (but would only a type or part of charitable contributions move above the line?).

Starting a Nonprofit: Environmental as a 501(c)(3) Charitable Purpose

Green Globe On Moss - Environmental Concept

An environmental purpose is not one of the seven exempt purposes specified in Section 501(c)(3) of the Internal Revenue Code (the “Code”). However, many environmental organizations qualify for exemption under 501(c)(3) because their activities further charitable, educational, and/or scientific purposes.

Although there is no explicit mention of environmental purposes in the statutes or regulations defining what is charitable under Section 501(c)(3) of the Code, the IRS has said that efforts to preserve and protect the environment for the benefit of the public serve a charitable purpose. However, not every activity directed at advancing environmental benefits is recognized as charitable. Additional factors may be required to show that the environmental activities are “lessening the burdens of government” and/or “combating community deterioration.” (See Starting a Nonprofit: What is “Charitable” under 501(c)(3)).

IRS rulings reveal that the IRS looks for activities that have a “significant” and “direct” impact on the environment when determining if an activity qualifies as charitable. In addition, the charitable aspects of the activity must outweigh any commercial or private benefits. Any private benefit conferred upon individuals or for-profit businesses that is more than incidental, quantitatively and qualitatively, to the environmental preservation activities will defeat the exemption. Some rulings suggest that credible studies and research should be provided to the IRS to demonstrate the direct and significant impact of the proposed activities.

Examples of environmental organizations that served charitable purposes according to the IRS include:

  • an organization that planted trees in public areas when the city did not have sufficient funds to do so, thus lessening the burdens of government and combating community deterioration (Rev. Rul. 68-14, 1968-1 C.B. 243);
  • an organization that acquired and maintained ecologically significant land, the IRS noting that the benefit to the public was guaranteeing “future generations … the ability to enjoy the natural environment” (Rev. Rul. 76-204, 1976-1 C.B. 152).

Examples of organizations that did not qualify for exemption because the impact on the environment was determined to be too indirect or resulting in too much private benefit, include:

  • an organization that provided particular solar panels to low and middle class income households, where the impact on the environment was “indirect and tangential” and the benefits flowed to a select group of homeowners rather than the general community (Priv. Ltr. Rul. 201210044 (2012);
  • an organization whose primary activity was beta testing green residential housing products to make those products market-ready, because the direct and primary beneficiaries were the private business manufacturing the products (Priv. Ltr. Rul. 201149045 (2011).

In Example 12 of IRS’s final regulations for program related investment (PRIs), effective April 2016, the IRS illustrates another instance where furthering an environmental interest is recognized as charitable so long as the private benefit is only incidental to the overall charitable nature of the activity. In the example, a private foundation is permitted to make an investment in a new business enterprise in a developing country whose only activity would be to collect recyclable solid waste and deliver those materials to recycling centers. Although the investment was benefiting a private business, the primary purpose for making it was to combat environmental deterioration, in furtherance of the foundation’s exempt purposes. The facts show that the business was unable to attract other funding because the expected rate of return was low, and thus, the IRS reasons, the foundation would not have made the investment but for its charitable purpose.

As more nonprofits are created to address new and continuing environmental concerns, it will be interesting to see how such activities are characterized as charitable or not by the IRS. Alternative energy, segments of the sharing economy, and eco-friendly products all pose several questions for the future.

IRS TE/GE FY 2017 Work Plan

Last week, the IRS Tax Exempt and Government Entities (TE/GE) division issued their 2017 work plan. The document summarizes strategy and compliance from fiscal year (FY) 2016, as well as a plan for the coming FY 2017. As covered by the Nonprofit Law Blog last year, TE/GE currently focuses on 5 strategic areas for continuous improvement within the exempt organizations (“EO”) division: exemption, protection of assets, tax gap, international, and emerging issues. Here are some notable points from the work plan:

  • Issue Snapshots: In order to increase the technical knowledge of EO employees and the general public, the IRS prepares and posts technical “Issue Snapshots” that provide analysis regarding a particular tax issue. Five issue snapshots were completed on EO topics including IRC Section 4946’s definition of a disqualified person, and currently, over 20 are in development. The in-process snapshots will include private foundation qualifying distributions and 501(c)(4) and determining primary activity.
  • Examinations/Revocations: As of June 30, 2016, the IRS completed 4,984 examinations of annual returns. The largest issue area examined was “Filing, Organizational, Operational”, which focused on verifying the exempt activities of the organization or its filing requirements. Many of these examinations involved the IRS securing delinquent returns. Within the IRS’s post determination compliance examinations of 1,400 exempt organizations that filed Forms 1023 or 1024, 39% had issues “ranging from amendments to organizational documents and failure to file returns.” Lastly, of the 43 organizations that had their exempt status revoked in FY 2016, the majority were revoked for not operating for an exempt purpose.
  • Form 1023-EZ: Form 1023-EZ constituted roughly 60% of all Form 1023s received by the IRS in the third quarter of FY 2016. Ninety-four percent of 1023-EZ applications were approved, and approximately 5% were rejected. The IRS anticipates the reduction of the user fee, which went into effect on July 1, 2016, will result in an increase in the percentage of 501(c)(3) applicants using Form 1023-EZ. Despite widespread criticism from state regulators, the National Taxpayer Advocate, and many commentators, the IRS also noted its belief that the 1023-EZ form and process has proven to be efficient and effective through pre- and post-determination review processes.
  • Determination Results: In late 2015, the IRS began rejecting incomplete Form 1023 applications by returning the application packages, along with any user fee paid and a letter explaining why the application was rejected. This process is meant to educate applicants as to the requirements of a complete application and ensure that once the application is assigned to a review agent, it can be expedited and reviewed efficiently. Overall, the IRS approved 93.6% of applications in FY 2016, and denied less than one percent. The most common reasons for denial of exempt status were private benefit and private inurement, having a substantial non-exempt purpose, and commerciality issues. Additionally, since the implementation of the new requirement for social welfare and civic organizations to submit notice to the IRS of intent to operate as a 501(c)(4), Form 8976, the IRS has received and processed over 400 notifications.

Donor-Advised Funds: What You Should Know

woman listening to gossip

Introduction

A donor-advised fund (“DAF”) is a charitable vehicle housed within a 501(c)(3) public charity that allows a donor to make a gift, take an immediate charitable deduction, and recommend, typically with strong persuasive authority, future grants made from funds in the DAF. Unlike private foundations that require a minimum annual distribution, a DAF has no distribution requirements and can allow investment funds within the account to build up for years or even decades. This is one reason why DAFs have come under fire by philanthropists and academics like Lewis B. Cullman and Ray Madoff, who together wrote The Undermining of American Charity published by The New York Review of Books (“Donor-advised funds (or DAFs) give donors all of the tax benefits of charitable giving while imposing no obligation that the money be put to active charitable use.”).

Growth

DAFs are growing ever faster, according to The Nonprofit Quarterly. The 2015 Donor-Advised Fund Report released by the National Philanthropic Trust in November 2015 and cited by The Nonprofit Quarterly provides:

Grants from donor-advised fund accounts to charitable organizations reached a new high at $12.49 billon …. This is a 27.0 percent growth rate compared to a revised total for 2013 grants of $9.83 billion.

 

Contributions to donor-advised fund accounts in 2014 totaled $19.66 billion, also an all-time high. This number surpasses the revised 2013 value of $17.23 billion by $2.4 billion …, an increase of 14.1 percent.

 

Charitable assets under management in all donor-advised fund accounts totaled $70.70 billion in 2014, an all-time high …. The increase in total charitable assets can logically be attributed to the growth in the number of funds (an 8.8 percent increase) and contributions (a 14.1 percent increase).

 

The number of donor-advised fund accounts increased by 8.8 percent in 2014, to 238,293 ….

 

Grant payout rates from donor-advised fund accounts annually exceeded 20 percent for the eighth consecutive year.

 

The 2014 average donor-advised fund account size reached $296,701, which is also an all-time high ….

Definition

A donor-advised fund is defined in the Internal Revenue Code as a fund or account:

  1. which is separately identified by reference to contributions of a donor or donors,
  2. which is owned and controlled by a sponsoring organization, and
  3. with respect to which a donor (or any person appointed or designated by such donor) has, or reasonably expects to have, advisory privileges with respect to the distribution or investment of amounts held in such fund or account by reason of the donor’s status as a donor.

– IRC Sec. 4966(d)(2)(A)

The first prong of this definition may be met by (1) naming the fund after a donor, or (2) treating a fund on the books of the sponsoring organization as attributable to funds contributed by a specific donor or donors. Contrary to popular myth, giving a fund a generic name (e.g., “The Human Fund” (Seinfeld alert)) doesn’t result in a fund falling out of the DAF definition. The second prong requires ownership and control by a sponsoring organization, which generally includes most domestic public charities. The third prong may be met even if a donor doesn’t have advisory privileges codified in a written agreement so long as the donor has reasonable reason to expect to have advisory privileges with respect to distribution or investment of amounts held in the fund. For more information, see our earlier post What is a Donor Advised Fund?

Exceptions: Even if a fund meets three prongs required of a DAF, it may still be excepted from the definition if:

  1. it make distributions only to a single identified organization or government entity; or
  2. the donor or donor advisor provides advice regarding grants to individuals for travel, study, or other similar purposes, provided that:
    1. the donor’s, or the donor advisor’s, advisory privileges are performed in his capacity as a member of a committee, all the members of which are appointed by the sponsoring organization;
    2. no combination of donors or donor advisors (or related persons) directly or indirectly control the committee; and
    3. all grants are awarded on an objective and nondiscriminatory basis pursuant to a procedure approved in advance by the board of directors of the sponsoring organization that meets the requirements of IRC 4945(g)(1), (2), or (3) (scholarship or fellowship grant to be used for study at a qualifying educational organization; prize or award to recipient selected from the general public; or grant with a purpose to achieve a specific objective, produce a report or other similar product, or improve or enhance a literary, artistic, musical, scientific, teaching, or other similar capacity, skill, or talent of the grantee; respectively).

Restrictions

No Distributions to Natural Persons

A sponsoring organization and its fund managers (including directors, officers, trustees, and employees having authority or responsibility related to any act or failure to act resulting in the prohibited distribution) may be subject to excise taxes if they engage in “taxable distributions” with respect to the DAF’s grants. A taxable distribution includes any distribution from a DAF to any natural person.

A taxable distribution imposes an excise tax of 20% on the sponsoring organization and 5% (with a $10,000 cap) on any fund manager who knowingly agrees to the distribution.

Unfortunately, the meaning of a “distribution” within the context of this rule has not been clarified by the IRS. A conservative view would suggest that payments to any individuals, even if goods or services of equal value were provided in return, are prohibited as a form of distribution. Under this interpretation, DAFs could only make payments to business entities for goods or services and not to any individuals or sole proprietorships.

Conditional Distributions to Organizations

A taxable distribution also includes any distribution from a DAF to any entity if:

  • the distribution is not for a religious, charitable, scientific, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals purpose; or
  • the sponsoring organization does not exercise expenditure responsibility with respect to such distribution.

However, excepted from the definition of a taxable distribution are distributions from a DAF to:

  • any organization described in section 170(b)(1)(A) (which includes most public charities and private operating foundations) other than a disqualified supporting organization (e.g., non-functionally integrated Type III supporting organizations, other supporting organizations controlled directly or indirectly by the donor or any donor advisor),
  • the sponsoring organization of such DAF;
  • any other DAF.

Accordingly, distributions from a DAF to most public charities (other than disqualified supporting organizations and public safety organizations) and private operating foundations will not be taxable distributions.

As noted above, a taxable distribution imposes an excise tax of 20% on the sponsoring organization and 5% (with a $10,000 cap) on any fund manager who knowingly agrees to the distribution.

No Prohibited Benefits to Donors, Donor Advisor, or Related Persons

A donor, donor advisor, or related person* may be subject to a tax penalty if they advise a distribution, or receive, directly or indirectly, more than an “incidental benefit” resulting from a distribution. The penalty tax is 125% of the prohibited benefit, and any prohibited benefit must be returned to the DAF. As an example, a distribution from a DAF to a college for payment of a donor’s child tuition would be a prohibited benefit warranting a penalty tax.

* A related person includes a member of the donor or donor advisor’s family (spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren) and any 35-percent controlled entity (i.e., entity in which the donor and donor advisors own more than 35% of the total combined voting power of a corporation, the profits interest of a partnership, or the beneficial interest of a trust or estate).

Furthermore, any fund manager (e.g., director, officer, or employee having authority or responsibility with respect to the act in question) who knowingly agrees to make a distribution that confers a prohibited benefit faces a 10% tax amount of the benefit amount, not to exceed $10,000 per transaction. Note, though, that taxes for a prohibited benefit will not be imposed if the taxes for an excess benefit transaction are imposed instead on the same transaction.

No Excess Business Holdings

Generally, a DAF and its disqualified persons together may own no more than 20% of the voting stock, profits interest, capital interest, or beneficial interest in a business enterprise. For these purposes, a disqualified person includes the donor, donor advisor, and related persons. The penalty for a violation of the excess business holdings rule is a first-tier tax of 10% of the value of such excess business holdings and a second-tier tax of 200% if the foundation still has excess business holdings at the end of the taxable period. The amount of excess holdings is determined as of the day during the tax year when the foundation’s excess holdings were the greatest.

There are a few exceptions to this general rule, including:

  • Where the DAF (together with certain related DAFs) owns less than 2% of the voting stock and 2% of the value of all outstanding shares of all classes of stock.
  • Where the DAF and disqualified persons with respect to the DAF own up to 35% of the business enterprise but one or more persons who are not disqualified persons have effective control of the business enterprise.

No Excess Benefit Transactions

An excess benefit transaction is defined as any transaction in which an economic benefit is provided by the organization directly or indirectly to or for the use of any disqualified person, and the value of the economic benefit provided exceeds the value of consideration (including the performance of services) received for providing the benefit. For these purposes, a disqualified person is a person in a position to exercise substantial influence over the affairs of the organization at any time during the five-year look back period from the date of the excess benefit transaction, and, with respect to a DAF, includes the donor, donor advisor, and related persons (which also includes for these purposes, the donor’s and donor advisor’s brothers and sisters (whether by the whole or half blood) and their spouses).

If an excess benefit transaction has occurred, the IRS can levy taxes, commonly referred to as intermediate sanctions, on both the disqualified person who received the excess benefit and the organizational manager(s) who knowingly approved the excess benefit transaction:

  • 25% excise tax of the excess benefit on the disqualified person who received the excess benefit; and an additional 200% excise tax of the excess benefit if the violation is not corrected within the taxable period.
  • 10% excise tax of the excess benefit on the organizational manager who knowingly participated in the transaction (maximum of up to $10,000).

Resources

Donor-Advised Fund Guide Sheet Explanation (IRS)

Donor-Advised Funds (Council on Foundations)

Is the Fund a Donor-Advised Fund? (Council on Foundations)

What are the issues with donor-advised funds? (Urban Institute)

Discerning the True Policy Debate over Donor-Advised Funds (Urban Institute)

An Analysis of Charitable Giving and Donor Advised Funds (Congressional Research Service, 2012)

Regulations

Well, we’ve been waiting for regulations on DAFs for almost a decade since a DAF was first defined in the Pension Protection Act of 2006. DAF guidance has been on the IRS priority guidance list for years. The Treasury Department completed and released a study on DAFs in 2011, though it was criticized as “disappointing and non responsive” by Senator Chuck Grassley, Senate Finance chairman at the time of the 2006 legislation, and I can no longer access the report from the link on the IRS site.

You can read comments about prospective regulations from the American Bar Association’s Charitable Planning and Organizations Group of the Section of Real Property, Trust and Estate Law (“RPTE Section”) here and download comments from the RPTE Section in a letter to Treasury dated August 18, 2016 here. My personal view is not to expect proposed regulations before the Presidential election because of the growing controversy with DAFs, whether they should be treated more like private foundations with minimum annual distribution requirements, and how this all fits in with broader tax policies.

Benefits to Donors

  • An immediate income tax deduction
  • Avoidance of capital gains taxes if the gift is appreciated property
  • Reduction of the gross estate by the amount of the excluded asset

Advantages Over Setting Up a Private Foundation:

  • Donations to a donor-advised fund qualify for the more favorable charitable deduction treatment of a gift to a public charity than donations to a private foundation
  • Donor-advised funds are not subject to the self-dealing and payout rules applicable to private foundations
  • Sponsoring organization generally takes care of all the administrative work
  • Typically, low contribution minimums
  • Ease and relative low-cost in establishment
  • Privacy, if donor desires
  • Ability to receive donations from private foundations, charitable remainder trusts, charitable lead trusts

Disadvantages Over Setting Up a Private Foundation:

  • Lack of control over distributions (grant-making)
  • Lack of control over investments
  • Less visibility and prestige than family-named private foundation
  • Lack of flexibility (e.g., grant-making areas)
  • No ability to hire staff (such as the donor and his or her family members)
  • No distributions to individuals

Program-Related Investments

Goodness

Program-related investments (PRIs) are investments (different from strictly donative grants) made by private foundations in which:

  1. The primary purpose is to accomplish one or more of the foundation’s 501(c)(3) exempt purposes (other than testing for public safety),
  2. Production of income or appreciation of property is not a significant purpose, and
  3. Influencing legislation or engaging in political campaign intervention is not a purpose.

While PRIs are not used widely by the vast majority of private foundations, PRIs can be an effective alternative strategy to grantmaking in advancing the foundation’s charitable purpose and meeting its minimum distribution requirements. One reason why PRIs are not used more broadly is the difficulty in interpreting whether a particular investment would qualify as a PRI and not subject a foundation to penalties for making a jeopardizing investment or failing to meet its distribution requirements (if it relied on the investment being part of its qualifying distributions). Some foundation rely on legal opinions to mitigate such risks, but this may not always be cost-effective, particularly for smaller investments. But legal opinions are not always necessary provided that the the foundation has a sufficient understanding of the PRI rules and how they are applied and is comfortable accepting and managing a modest amount of risk. The trade-off can be key in allowing a private foundation to use PRIs to “get more bang out of their buck.”

The following examples and principles are listed on the IRS webpage on program-related investments:

5 Examples of PRIs

  1. Low-interest or interest-free loans to needy students,
  2. High-risk investments in nonprofit low-income housing projects,
  3. Low-interest loans to small businesses owned by members of economically disadvantaged groups, where commercial funds at reasonable interest rates are not readily available,
  4. Investments in businesses in low-income areas (both domestic and foreign) under a plan to improve the economy of the area by providing employment or training for unemployed residents, and
  5. Investments in nonprofit organizations combating community deterioration.

7 PRI Principles

  1. An activity conducted in a foreign country furthers an exempt purpose if the same activity would further an exempt purpose if conducted in the United States,
  2. The exempt purposes served by a PRI may include any of the purposes described in section 170(c)(2)(B) are not limited to situations involving economically disadvantaged individuals and deteriorated urban areas,
  3. The recipients of PRIs need not be within a charitable class if they are the instruments for furthering an exempt purpose,
  4. A potentially high rate of return does not automatically prevent an investment from qualifying as program-related,
  5. PRIs can be achieved through a variety of investments, including loans to individuals, tax-exempt organizations and for-profit organizations, and equity investments in for-profit organizations,
  6. A credit enhancement arrangement may qualify as a PRI, and
  7. A private foundation’s acceptance of an equity position in conjunction with making a loan does not necessarily prevent the investment from qualifying as a PRI.

Two Sticky Issues

  1. When a private foundation makes a particular investment, like a loan to a for-profit, can the foundation reasonably justify that such investment was made primarily to advance the foundation’s specific exempt purpose? According to the regulations: “An investment shall be considered as made primarily to accomplish one or more of the purposes described in section 170(c)(2)(B) if it significantly furthers the accomplishment of the private foundation’s exempt activities and if the investment would not have been made but for such relationship between the investment and the accomplishment of the foundation’s exempt activities.”Beyond the PRI rules, can the foundation also show that any private benefit it provides to the for-profit is incidental, quantitatively and qualitatively, to furthering its exempt purpose? An interesting example of an investment target would be a local for-profit newspaper. If the private foundation makes a high risk $1 million loan to the newspaper company at below market interest, is that consistent with the foundation’s educational goals? Is the newspaper company only incidentally benefited by the loan primarily extended to help assure the local public remain informed of important issues?
  2. If the production of income or appreciation of property is a secondary purpose for making the loan (the primary purpose being to advance the foundation’s exempt purpose), how can the foundation tell if such secondary purpose is significant? According to the regulations: “In determining whether a significant purpose of an investment is the production of income or the appreciation of property, it shall be relevant whether investors solely engaged in the investment for profit would be likely to make the investment on the same terms as the private foundation.”Using the newspaper example above, what if, in lieu of a loan, the foundation purchased a $1 million equity stake in the newspaper company? Such purchase may be at below the stock’s market value (particularly if the foundation accepted non-preferred stock), but it could help leverage additional equity investments from other investors seeking more preferential terms, which could ultimately result in a high return for all shareholders. While a high rate of return in and of itself does not signal that the foundation had a significant profit motive at the time it made the investment, how can one tell?

Resources

Program-Related Investments: Will New Regulations Result in Greater and Better Use? Nonprofit Quarterly

Strategies to Maximize Your Philanthropic Capital: A Guide to Program Related Investments TrustLaw, Thompson Reuters Foundation for Mission Investors Exchange

Examples of Program-Related Investments – Final Regulations  Federal Register

 

Economic Development as a 501(c)(3) Activity

Economic prosperity financial concept as a group of green trees shaped as growing finance pie chart as a metaphor for gradual gains in company stock or competitive wealth success.

 

Economic development may not immediately come to mind as an activity that furthers a charitable purpose, but it doesn’t take long to think of circumstances where helping a depressed community in its economic development can help in the relief of poverty and distress, and in the combat of community deterioration, all of which are regarded as charitable purposes. Accordingly, it is possible for a 501(c)(3) organization to provide funds and other resources to for-profit businesses to advance the purposes of economic development consistent with its charitable purpose. However, such support is limited by the 501(c)(3) restrictions against private inurement, prohibited private benefit, substantial lobbying, and political campaign intervention. For private foundations, additional rules and restrictions apply with respect to self-dealing, excess business holdings, jeopardizing investments, and taxable expenditures.

Economic Development Corporations and Incubators

Public charities that focus on charitable economic development are sometimes referred to as economic development organizations or incubators. According to a 1990 EO CPE Text (Economic Development Corporations: Charity Through the Back Door) published by the IRS:

Economic development corporations generally are established to assist existing and new businesses located in a particular geographic area through a variety of activities including grants, loans, provision of information and expertise, or creation of industrial parks. Incubators are a type of economic development corporation generally formed to provide assistance to induce new businesses to locate in communities whose economies are depressed or deteriorating, or to provide assistance to existing, emerging businesses so that they may remain in such communities. Incubators provide low-interest loans, facilities and equipment to new and emerging businesses as well as clerical and technical services in an effort to encourage such businesses to locate in the depressed areas. The services provided to the new businesses are offered by the incubator at reduced rates or even free of charge. Incubators may be set-up and/or sponsored by local and state governments, they may be affiliated with universities, or they may be an offshoot of an existing tax-exempt organization. In many cases, incubator organizations operate a “technology center” where businesses can be assisted (nurtured) through provision of business expertise, lower rental rates or pooled or shared services.

Serving a Public Interest

In addition to having a stated charitable purpose and consistent activities, a 501(c)(3) economic development organization or incubator must serve a public rather than an private interest. Any private benefit conferred upon an individual or for-profit business that is more than incidental, quantitatively and qualitatively, to the furthering of its exempt purposes is prohibited. Grants of funds or other resources to for-profit businesses must be justified as incidental to advancing the 501(c)(3) organization’s charitable purposes, which may include relief of the poor and distressed and combat of community deterioration.

The 1990 EO CPE Text stated that the following factors “are necessary” for an agent to conclude that an economic development corporation is primarily accomplishing charitable purposes despite the element of private benefit present.

Assistance is targeted (1) to aid an economically depressed or blighted area; (2) to benefit a disadvantaged group, such as minorities, the unemployed or underemployed; and (3) to aid businesses that have actually experienced difficulty in obtaining conventional financing (a) because of the deteriorated nature of the area in which they were or would be located or (b) because of their minority composition, or to aid businesses that would locate or remain in the economically depressed or blighted area and provide jobs and training to the unemployed or underemployed from such area only if the economic development corporation’s assistance was available.

It’s been more than 25 years since the above guidance was released, and additional guidance, including a more definitive test and/or examples of acceptable charitable activities that reflect the current needs and economic climate in many communities, has recently been requested by the Council of Michigan Foundations (CMF):

CMF urges Treasury to consider updating previous guidance regarding economic development as a charitable activity by providing a more definitive test and/or examples of acceptable charitable activities that reflect the current needs and economic climate in many communities. Here are two examples encountered by CMF foundation members that illustrate the requests for foundation support.

 

• The Chamber of Commerce is sponsoring an initiative to encourage small businesses to locate in a deteriorating section of downtown and ask the local community foundation about collecting charitable contributions from individuals and businesses. The community foundation will then make grants to assist individuals with expenses associated with establishing new small businesses provided they agree to locate in this particular area.

 

• A rural municipality in the Upper Peninsula desires to expand internet services to its citizens and wants to collect charitable donations to build infrastructure through a fund at the local community foundation.

Lessening the Burdens of Government

It’s possible for an economic development organization to be exempt under 501(c)(3) based on the charitable purpose of lessening the burdens of government. This involves a two part test:

  1. There is an objective manifestation by a governmental unit that it considers the activities of the organization to be its burden; and
  2. The organization’s activities actually lessen such burden of the government.

The 1990 EO CPE Text lists 7 factors that favor a lessening of governmental burdens rationale for an economic development corporation (but also states that extreme caution should be exercised before employing a lessening the burdens rationale ):

(1) There is a state statute specifically authorizing government funding of an economic development corporation to operate by assisting fledgling businesses within the state as a means to help alleviate severe unemployment.

(2) The economic development corporation was established to specifically qualify under the statute and was funded under the statute.

(3) The state statute provides that the funding is more than a mere grant but provides the state with approval authority over projects to be financed by the corporation and approval must be obtained from the state on an ongoing basis.
(4) As part of its assistance, the economic development corporation operates in conjunction with a state university. (5) The specific cities which will be the corporation’s primary beneficiaries provide officials who sit on the corporation’s board of directors in their official capacity.

(6) The commissioner of the state’s Department of Economic Development utilizes the corporation as an extension to carry out services formally conducted by the Department. The Department was unable to continue such services because of budgetary constraints and is not otherwise prohibited from providing such services.

(7) The corporation is required to provide annual reports of its activities and finances to the state government.

Resources

Obtaining 501(c)(3) Status for Economic Development Organizations (Community Economic Development Law Project)

Economic Development Organizations, Trickle Down Charity and the Private Benefit Doctrine (American Bar Association)

Johnson Amendment: 501(c)(3) Prohibition on Political Campaign Intervention

Church

The Johnson Amendment refers to the law codified in Section 501(c)(3) of the Internal Revenue Code prohibiting organizations exempt from taxes under 501(c)(3) from participating in any political campaign on behalf of (or in opposition to) any candidate for elective public office. Churches & Political Activity: The Call to Repeal the Johnson Amendment, an article written by our senior counsel Erin Bradrick, was published by The Nonprofit Quarterly yesterday.

The most significant call for repealing the Johnson Amendment is from the Republican Party in its official 2016 Platform:

We value the right of America’s churches, pastors, and religious leaders to preach and speak freely according to their faith. Republicans believe the federal government, specifically the IRS, is constitutionally prohibited from policing or censoring the speech of America’s churches, pastors, and religious leaders. We support repeal of the Johnson Amendment, which restricted First Amendment freedoms of all nonprofit organizations by prohibiting political speech.

Additional Resources:

Know the law: Avoid political campaign intervention (IRS)

The Rules of The Game: A Guide to Election-Related Activities for 501(c)(3) Organizations (Alliance for Justice)

Republican Platform Calls for Repeal of Ban on Political Organizing by Churches (TIME)

New IRS Notification Requirement for 501(c)(4) Organizations – Form 8976

Treasury

On July 8, 2016, the IRS issued final and temporary regulations and published Revenue Procedure 2016-41 relating to the immediately effective requirement that organizations notify the IRS of their intent to operate under section 501(c)(4) of the Internal Revenue Code (“IRC”).

Form 8976, “Notice of Intent to Operate Under Section 501(c)(4),” is the electronic notification required to be submitted to the IRS no later than 60 days after the date the organization is organized (e.g., its date of incorporation). Form 8976 is available for completion and submission here. A draft of the Form is available download here.

The new rules are the result of the Protecting Americans from Tax Hikes (“PATH”) Act of 2015, which added section 506 to the Internal Revenue Code, requiring an organization to notify the IRS that it is operating as a section 501(c)(4) organization. The PATH Act also amended IRC section 6652(c) to impose penalties for failure to submit Form 8976 by the date and in the manner prescribed. The penalty is equal to $20 per day for each day such failure continues, up to a maximum of $5,000.

The notification requirement generally applied to organizations formed after December 18, 2015, but there were transition relief provisions to reflect the absence of regulations until July 8. According to Journal of Accountancy:

Organizations that were established between Dec. 18, 2015, and July 8, 2016, that either applied for a determination of tax-exempt status or filed at least one required annual return or notice (Form 990 series) are relieved from the notification requirement. Organizations formed during that interim period that do not qualify for that relief have until Sept. 6 to submit the notification.

501(c)(3) Electioneering Rules: Voter Guides & Candidate Questionnaires

 

Closeup of businessman making decision whether to accept or deny a suggestion or employee.

 

In this next post in our series on election-related activities and 501(c)(3) organizations, we are taking a closer look at nonpartisan voter guides and candidate questionnaires.  Despite the fact that such guides and questionnaires are election-related, 501(c)(3) organizations can prepare and distribute them without fear of jeopardizing their exempt status (if done properly!).

A voter guide or candidate questionnaire is typically a printed guide comparing the positions of candidates for a particular office.  The information used to compile a voter guide is often gathered from questionnaires sent to the candidates soliciting their responses and from public sources, such as campaign materials and incumbent legislative records.  While other types of entities may be able to prepare voter guides that instruct the recipient who to vote for, 501(c)(3) organizations may not prepare such guides for the purpose of influencing the outcome of an election or benefitting a particular candidate or political party.  Rather, it would be appropriate for a 501(c)(3) organization to distribute a voter guide merely for impartial educational purposes.

The IRS has indicated that, in determining whether the preparation and distribution of a voter guide constitutes impermissible campaign intervention, the following factors are key considerations:

  • “Whether the questions and any other description of the issues are clear and unbiased in both their structure and content.”
  • “Whether the questions posed provided to the candidates are identical to those included in the voter guide.”
  • “Whether the candidates are given a reasonable amount of time to respond to the questions.  If the candidate is given limited choices for an answer to a question (e.g. yes/no, support/oppose), whether the candidate is also given a reasonable opportunity to explain his position in his own words and that explanation is included in the voter guide.”
  • “Whether the answers in the voter guide are those provided by the candidates in response to the questions, including whether the candidate’s answers are unedited, and whether they appear in close proximity to the question to which they respond.”
  • “Whether all candidates for a particular office are covered.”
  • “Whether the number of questions, and the subjects covered, are sufficient to encompass most major issues of interest to the entire electorate.”

As with other election-related activities, the IRS will look at all of the facts and circumstances in reviewing a voter guide prepared by a 501(c)(3) organization.  This includes the guide’s format, its content, and the method of distribution used.  In designing a questionnaire to send to candidates, 501(c)(3) organizations must be careful to draft neutral questions—ones that do not hint at the “correct” answer or indicate the organization’s position on the issue being discussed.  They should also avoid separately stating the organization’s position on any of the issues covered in the guide, which would likely be viewed by the IRS as an invitation for recipients to compare the views of candidates to those of the organization.

Also, as with other election-related activities (and activities in general), a 501(c)(3) organization is not able to do indirectly what it would be prohibited from doing directly.  Accordingly, the distribution by a 501(c)(3) organization of a voter guide prepared by a third party that it could not have prepared itself will likely constitute impermissible political campaign intervention.