A Section 501(c)(3) exempt organization is presumed to be a private foundation unless it qualifies as a public charity. The distinction between the private foundation and public charity classification may be critical for organizational leaders to understand, as public charity status is generally far more advantageous when there is a choice.
Since private foundations are generally governed by a smaller, more insular group of individuals and receive funds from only a few sources, they are subject to many more burdensome rules, regulations, and potential penalties to help assure proper operation. Private foundations must also complete the lengthy annual information return, Form 990-PF, and cannot make use of the short-form options (Form 990-EZ and Form 990-N). Further, as compared to public charities, private foundations face significant disadvantages in terms of fundraising opportunities from other private foundations (due to the expenditure responsibility rules of Section 4945 of the Internal Revenue Code (the “Code”)) and major donors (due to the smaller charitable deduction limits applicable to gifts made to a private foundation).
Private foundations are also subject to a set of federal tax laws that impose monetary penalties on the organization and its managers for various infractions and activities. These rules regulate areas such as self-dealing, minimum distributions, excess business holdings, jeopardizing investments, and taxable expenditures. Leaders of private foundations should know how to manage their compliance with these laws and understand the potential consequences of a violation.
Private Foundation Excise Taxes
Self-Dealing – (IRC § 4941)
In general, a private foundation is constrained from having any financial transactions with persons who create, control, or fund the organization. These individuals are known in the Code as disqualified persons. A disqualified person may be a director, officer, substantial contributor, family members, or a 35% controlled entity. The Code identifies six specific transactions that, if engaged in by the foundation and a disqualified person, constitutes an act of self-dealing:
- Lending money or credit;
- Payment of compensation;
- Furnishing goods, services, or facilities;
- Selling, exchanging, or leasing property; and
- Agreeing to pay a government official.
If such a transaction occurs, the disqualified person benefiting from the transaction will be subject to a 10% first-tier tax and 200% second-tier tax if the violation is not corrected within the taxable period. Generally, the tax is measured by the “amount involved,” which is defined as the “greater of the amount of money and the fair market value of the other property given [to the disqualified person] or the amount of money and the fair market value of the other property received [by the disqualified person].” Treas. Reg. § 53.4941(e)-1. To avoid the second-tier tax, the self-dealing error must be corrected between the date of the transaction and the date on which the tax is assessed or a notice of deficiency with respect to the tax is mailed, whichever is earlier.
Foundation managers (including directors) who knowingly approve a self-dealing transaction may also be subject to a 5% first-tier tax and 50% second-tier tax.
Additionally, there are several exceptions to self-dealing, where certain transactions are permitted between private foundations and disqualified persons. These include:
- Payment of reasonable compensation for personal services (professional services reasonable and necessary to carrying out the mission); and
- Furnishing of goods, services, or facilities to a disqualified person on a basis no more favorable than that on which such goods, services, or facilities are made available to the general public.
For more information on exceptions to the self-dealing rules, see Exceptions – Self-Dealing by Private Foundations.
Minimum Distribution Requirement – (IRC §4942)
A private foundation must spend a minimum amount for grants, administration, and other charitable distributions annually. The minimum disbursement required in order to avoid excise taxes, also known as a qualifying distribution, is 5% of the organization’s assets, not including those which are used (or held for use) directly in carrying out the foundation’s exempt purpose. The purpose behind this mandatory payout is to ensure private foundations are actively funding charitable programs and not simply hoarding charitable funds in perpetuity. Note that, a private foundation in its first year of existence has no distribution requirement.
For some grantmaking private foundations whose sole charitable activity is related to grantmaking, the minimum distribution requirement is equal to 5% of its investment assets. Qualifying distributions include grants to charities and reasonable and necessary administrative expenses paid to accomplish the foundation’s charitable purposes.
Failure to make the required distribution may subject the foundation to a first-tier tax equal to 30% of the amount of undistributed income at the beginning of subsequent taxable year. If uncorrected by the close of the taxable period, a second-tier tax of 100% of the undistributed portion remaining may be imposed.
Excess Business Holdings – (IRC §4943)
Generally, a private foundation and its disqualified persons together may own no more than 20% of the voting or ownership interest in a business enterprise. The term “business enterprise” includes partnerships, joint ventures, or other unincorporated enterprises. 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 private foundation (together with certain related private foundations) owns less than 2% of the voting stock and 2% of the value of all outstanding shares of all classes of stock.
- Where the private foundation and its disqualified persons own up to 35% of the business enterprise but a third party effectively controls the management and policies of the enterprise.
Also note that the initial tax may be abated if the private foundation can demonstrate that the excess holdings were due to reasonable cause and not willful neglect, and that the excess holdings were disposed of within the correction period.
Jeopardizing Investment – (IRC §4944)
A private foundation’s managers must exercise prudence and good business judgment in investing the foundation’s assets. If a private foundation invests in a manner that jeopardizes its ability to carry out its exempt purposes, the foundation may be subject to a first-tier tax of 10% of the relevant amount so invested for each year in the taxable period. A 25% second-tier tax may be imposed if the violation is not corrected within the taxable period. Foundation managers (including directors) who knowingly participated in making that investment may also be subject to a first-tier tax of 10% and a second-tier tax of 5% of the relevant amount.
The general approach to avoiding the tax on jeopardizing investments is to look at the entire investment portfolio of the foundation rather than at individual investments. A diverse portfolio of investments may be characterized as prudently invested without looking to whether individual investments are jeopardizing, but that may not be the case where one single highly speculative investment dominates the investment portfolio.
There is a specific exclusion from the jeopardizing investment prohibition for program-related investments (PRIs). Generally, a PRI is an investment in which (1) the primary purpose is to accomplish one or more charitable purposes; (2) the production of income or the appreciation of property is not a significant purpose; and (3) lobbying or electioneering is not a purpose. A PRI might take the form of a loan to a charity or a loan to, or equity investment in, a business entity for a charitable purpose, such as, to develop or distribute a lifesaving drug for use in developing countries that would not otherwise be commercially viable.
Taxable Expenditures – (IRC §4945)
A private foundation must devote its income and principal exclusively to the charitable purposes for which it was created. Any payment made by the foundation for a non-charitable purpose is therefore a taxable expenditure. Examples of taxable expenditures include payments used for:
- Political intervention;
- Grants to individuals for travel, study, or similar purposes unless such grants are awarded on an objective and nondiscriminatory basis pursuant to a procedure approved in advance by the IRS and otherwise meet certain statutory requirements;
- Grants to domestic organizations that are not public charities, unless the foundation exercises expenditure responsibility over the grant; and grants to foreign charities, unless the foundation exercises expenditure responsibility or the grantee meets determines that the grantee passes an equivalency determination (i.e., is determined to be the foreign equivalent of a U.S. public charity); and
- Other than charitable purposes.
If a private foundation makes such an improper expenditure, the foundation is subject to a first-tier tax of 20% of the amount and a 100% second-tier tax if the violation is not corrected within the taxable period. Foundation managers (including directors) who knowingly participated in making that taxable expenditure may also be subject to a first-tier tax of 5% and a second-tier tax of 50% of the relevant amount.
Excise Tax on Investment Income – (IRC §4940)
Private foundations must pay an excise tax of 2% annually on the income earned on its investments, including dividends, interests, royalties, rents, and capital gain from properties producing such income. In certain cases, the tax amount may be reduced to 1% in a year during which the foundation’s percentage of charitable giving in relation to its total assets increases.
For more information about payment and calculation of this tax, see the Instructions for Form 990-PF.
[UPDATE (December 24, 2019): For all tax years beginning after December 20, 2019, the private foundation excise tax on net investment income is 1.39 percent. The complicated and burdensome dual tax regime described above has been eliminated.]