Worth Knowing: Obey The Rules... Or Pay The Price

Private foundations that fail to abide by certain regulations can be subject to financial penalties.

Background

Although "private charity" has always been with mankind, "private foundations" as we know them today came into existence with federal income tax reform legislation enacted in 1969. The rules that are the topic of this paper were enacted in response to perceived abuses of the tax-exempt status conferred upon certain charities.

The Tax Reform Act of 1969 created two broad categories of charity: public charities, which, as the name implies, derive most of their support from the general public; and private foundations. This article examines provisions relating only to private foundations classified as "private nonoperating foundations."

A private nonoperating foundation (hereafter referred to as a private foundation) is a charitable organization created, funded and often run by a single donor or members of the donor's family. Foundations are typically established to institutionalize and perpetuate the family's charitable legacy, to instill a sense of "giving back," and sometimes to help educate future generations about financial and philanthropic matters.

Private foundations do not directly perform charitable programs or services, but instead make monetary grants to other operating charities. Because donors are able to maintain a high degree of control over their activities, private foundations are more susceptible to mismanagement, whether intentional or unintentional, than public charities. This is why the 1969 Act established a set of restrictive rules designed to penalize potential abuses. These rules are enforced by various excise taxes, which may be imposed on both the foundation and its foundation managers.

This article will discuss each of these rules and the excise taxes imposed to enforce them. These rules constitute much of the governance of private foundations. Another article in this series will go beyond these rules to discuss the "best practices" foundations should adopt to achieve operational excellence.

WHO PAYS WHAT?

Private foundations are subject to six categories of federal excise tax. Five of these are completely avoidable "penalty taxes" that may be levied against both the foundation and anyone the government considers to be "disqualified persons."

A disqualified person broadly encompasses any individual and his or her family members who have a vested financial interest in the private foundation. They are generally prohibited from conducting financial transactions with the foundation because of the risk of self-dealing. Disqualified persons can include:

  • A substantial contributor, which is someone who contributes more than $5,000 to the foundation and whose contributions represent more than 2% of the total contributions to the foundation. A substantial contributor also includes a creator of a private foundation that is a trust.
  • A foundation manager, which is generally an officer, director or trustee.
  • An owner of more than 20% of a substantial contributor to the foundation.
  • An organization of which any one of the above individuals owns more than 35% of the organization's voting power, profits interest or beneficial interest.

Certain government officials are also deemed to be disqualified persons.

SIX KINDS OF TAXES

All private foundations must pay annual excise taxes on net investment income. This tax is paid directly from the foundation's assets. The other five excise taxes are "penalty taxes" for errant practices. Such a tax is imposed on:

  • Self-dealing
  • Failure to distribute income
  • Excess business holdings
  • Jeopardy investments
  • Taxable expenditures

We will examine these six taxes separately.

TAX ON NET INVESTMENT INCOME

A private foundation is subject to a 2% excise tax on its net investment income. The rate is reduced to 1% if the foundation's qualifying charitable distributions reach a certain level and the foundation has met its minimum required distribution obligations over the previous five years.

Several things should be noted about this excise tax. First, it's not as bad as it sounds. Let's look at a hypothetical example.** The Smith Foundation, started in 2004, is worth $5 million in fully investable assets and generates annual net investment income of $250,000 in 2017. For the year, it would owe $5,000 in taxes (2% of $250,000), less than one-tenth of a percent of its total net worth.

Second, unlike the other excise taxes, it is unavoidable. A foundation must calculate and report this tax on its income tax return, Form 990PF.

Finally, this tax was not designed as a penalty, but rather to provide specific funding for the IRS to use to monitor activities of private foundations. That specific use has since stopped, and money raised from this tax goes straight into the government's general kitty.

TAX ON SELF-DEALING

Private foundation "self-dealing" was probably the greatest concern leading to charitable reforms in 1969 — and still is today. Unfortunately, a few people have abused the benefits available from private foundations, leading to strict rules that apply to all private foundations and related persons.

The basic rule is that a private foundation and its foundation managers are subject to an excise tax if a disqualified person participates in a "prohibited transaction."

A prohibited transaction includes any direct or indirect sale or lease of property, loans, furnishing of goods or services, payment of excessive compensation, or any other direct or indirect transfer between a private foundation and a disqualified person.

Examples of prohibited transactions could include:

  • A real estate developer who established the foundation wants to lease office space to the foundation. Even at a market rental rate, this would be a prohibited transaction.
  • A foundation manager who owns a small biotech firm wishes to make grants to a university research center to develop products that might financially benefit the firm.
  • A foundation set up by a business owner makes a contribution to his local symphony orchestra and receives season tickets to the symphony in return. The business owner uses these tickets for client entertainment purposes and does not report the value of the tickets as income.

The definitions of the various prohibited transactions are very broad, and if transactions fit within the definitions, they are prohibited, period. It is generally not a defense that the terms of a transaction are fair, or that the same terms could be obtained from an independent party. They are prohibited — and the taxes are steep.

Several exceptions exist, the most common being for reasonable and necessary compensation paid for personal services (such as legal and accounting services) performed to carry out the foundation's exempt purposes. Any compensation paid by a private foundation should be carefully determined and reviewed periodically.***

Compensation, direct or indirect, continues to be the greatest area of abuse in the foundation world.

Taxes on prohibited transactions:

  • The first level of tax is 10% of the amount involved and is imposed on the disqualified person who engages in the transaction for each year that the transaction remains uncorrected. Further, a foundation manager who willfully participates in a prohibited transaction is personally subject to a tax of 5% of the amount involved (not to exceed $20,000), again for each year that the transaction remains uncorrected.
  • If the self-dealing is not corrected within the tax period, it gets even worse. At that point, an additional tax of 200% is imposed on the disqualified person, and an additional 50% tax is imposed on the foundation manager (up to $20,000).

What does this mean? Let's look at a hypothetical situation, based on the Smith Foundation scenario. Let's say the executive director of the foundation paid himself $1 million in compensation, and the two other foundation managers looked the other way. Let's postulate that in this case, based on all the facts and circumstances, "reasonable compensation" would have been $100,000, so $900,000 constituted self-dealing.

  • The first level of tax would be 10% of the $900,000, or $90,000 on the executive director and 5% or a maximum of $20,000 on each of the other foundation managers.
  • An additional $1.8 million would be levied on the executive director, as well as an additional $20,000 on each of the other foundation managers, if the self-dealing situation wasn't corrected before the IRS assessed or issued a notice of deficiency for the 10% tax.

Great caution must be used in this area. Intent is irrelevant. Actual conduct, according to strict rules, will determine when the tax applies.

TAX ON FAILURE TO DISTRIBUTE INCOME

Private foundations are supposed to be charitable. That means distributing funds to other operating charities, not hoarding money within a largely tax-exempt entity.

Specifically, private foundations must make qualifying distributions (generally, grants to qualified charitable organizations, certain payments to noncharities for charitable purposes, and other specified expenses) of at least 5% of their investment assets each year. Distributions must be made by the close of the following taxable year. Failure to do so results in an excise tax being applied to the amount of the shortfall. Again, intent is irrelevant.

  • The first level of tax is 30% of the shortfall.
  • The tax then rises to 100% of the amount that remains undistributed by the earlier of the time that the IRS mails a notice of deficiency or the time the initial excise tax is imposed.

Using the Smith Foundation as an example, let's assume that in 2017 the foundation is required to make $250,000 in qualifying distributions, based on 5% of its $5 million net worth. Of this amount, $50,000 can be applied to pay for legitimate operating expenses, leaving a balance of $200,000 that must be made in grants to other operating charities or noncharities for charitable purposes by the end of the following year.

  • If the Smith Foundation distributed only $100,000 in grants by the end-of-year deadline, it would have to pay $30,000 in excise taxes.
  • If the IRS sent the foundation a notice of deficiency before the foundation distributed the remaining $100,000, it would have to pay an additional $100,000 in taxes.

The results? More than 2% of the foundation's value would be given to the government — instead of to charity. Although the formulas involved can be complicated for some foundations, most foundations can easily calculate and monitor their required distributions so that this never becomes a problem.

TAX ON EXCESS BUSINESS HOLDINGS

The United States economy and our capitalist system are all about competition. Allowing a business to operate without paying income taxes would give it an unfair edge over its competitors. For that reason, private foundations are not allowed to own more than 20% of the voting stock in a corporation (or ownership interest in other business entities), or 35% where it can be established that an independent third party has effective control over the business. Stock (or other business interests) owned by disqualified persons is generally included in calculating the permissible limits.

Excess business holdings are the amounts owned by the foundation and disqualified persons in excess of the permissible limits. For example, let's say the Smith Foundation owned 15% of the voting stock of Smith International, which would be permissible by itself, but disqualified persons owned another 25% of Smith International voting stock, bringing the total ownership to 40%. Twenty percent of this amount would be considered excess, subject to the excise tax.

  • The first level of tax would be 10% of the amount of the excess business holdings. In certain situations, tax may be avoided if the foundation disposes of the excess amount within 90 days of learning of the excess holdings.
  • Failure to dispose of the excess business holdings by the time the first level of tax is imposed or a deficiency notice was mailed would result in an additional 200% tax.

A special rule exists for foundations that receive the excess business holding by gift or bequest, which allows for a five-year disposition period before the tax is imposed. This five-year period may be extended for an additional five years if the business interest is received from an unusually large gift or bequest or involves a complex business structure. In any case, foundations must be careful not to dispose of the excess business holding in a self-dealing transaction.

TAX ON JEOPARDY INVESTMENTS

Those who manage a foundation's investment portfolio are expected to manage it according to the prudent investor standard. Simply put, the prudent investor standard gives foundation managers the flexibility to diversify a portfolio of traditional equity and fixed income securities with other kinds of investments.

Even with this flexibility to look at an overall portfolio rather than just individual investments, foundation managers are not permitted to purchase anything that would be deemed a "jeopardy investment," and this is determined on an investmentby- investment basis.

The main problem is that there is no clear definition of jeopardy investments. The Treasury regulations target trading securities on margin, trading in commodities futures, buying working interests in oil and gas, puts, calls, straddles and warrants, and selling securities short. Even though many followers of modern portfolio theory would specifically use some of those techniques or strategies to maximize return characteristics while minimizing risk characteristics in the foundation portfolio, a private foundation should carefully consider whether the risk of scrutiny is worth the rate of returns using those techniques or strategies.

If the IRS deems that a foundation has invested in a way that jeopardizes its charitable purpose, both the foundation and its foundation managers may be penalized.

  • The initial tax is now 10% on both the foundation and the foundation managers with knowledge of the jeopardizing investment (maximum of $10,000 per foundation manager).
  • If the foundation fails to correct the investment, the penalty increases to 25% on the foundation and 5% on each foundation manager (maximum of $20,000).

This tax applies only to jeopardy assets purchased by the foundation, not those received by gift or bequest (in the absence of the private foundation paying any consideration).

Once again, using the Smith Foundation as an example, let's say that its foundation manager bought $250,000 worth of warrants in a public company that purported to engage in silver straddle transactions with foreign investors in non-U.S.-recognized jurisdictions. The IRS subsequently discovered this investment when investigating offshore tax shelters and determined that it was, among other things, a jeopardy investment.

  • The foundation would be taxed $25,000, and the foundation manager would be taxed the maximum $10,000.
  • If not corrected in time, the additional taxes would be $62,500 on the foundation and $12,500 on the foundation manager.

For most foundations, maintaining a diversified portfolio of stocks and bonds with small allocations to risk-appropriate alternative investments will keep them from running afoul of this provision. Exotic investments, such as hedging foreign currencies, should be carefully evaluated and avoided if possible. Better still, a foundation should have a clearly defined investment policy statement that broadly describes its asset allocation, portfolio structuring and rebalancing guidelines.

TAX ON TAXABLE EXPENDITURES

A foundation is supposed to make grants to organizations that benefit the common good, not their political or personal agendas. Public and governmental scrutiny has recently centered on foundations established by politicians who make grants to ideological think tanks or their own tax-exempt political action committees. Grants such as these run the risk of being characterized as taxable expenditures — those that are not in furtherance of the foundation's exempt purposes.

Taxable expenditures generally fall into two categories:

  • First, foundations cannot distribute any amount to influence legislation or to participate in political campaigns. There are some limited exceptions for industry-wide lobbying, but these must be carefully monitored.
  • Second, foundations can make grants to individuals or noncharitable organizations only under certain conditions that are established to provide objective criteria and are used for certain approved purposes or goals, such as a scholarship award to an individual to permit that person to achieve a certain objective or talent.

For this second category, foundations are often required to either obtain preapproval from the IRS for these types of program expenditures or to conduct what is referred to as "expenditure responsibility." This is basically a detailed record keeping process to ensure that foundation money is going toward a charitable purpose. Detailed regulations govern this process, and they must be closely followed.

If a private foundation is subject to excise taxes on taxable expenditures:

  • The foundation must pay an initial excise tax of 20% of the taxable expenditure, with an additional tax of 5% imposed on foundation managers who willingly participate in making such distributions without reasonable cause or IRS permission.
  • These taxes increase to 100% on the foundation and 50% on foundation managers (with a $20,000 maximum) if these taxable expenditures are not corrected.

GOOD GOVERNANCE AND STRONG ETHICS — A PROVEN PENALTY-AVOIDANCE STRATEGY

While all excise taxes imposed on the foundation must be paid by the foundation itself, foundation managers must pay these penalties out of pocket — in other words, the foundation cannot pay for their errant practices.

With all these restrictive rules, why would so many families still elect to create private foundations rather than another option, such as a donor-advised fund or donor-directed fund with a community foundation, or simply make outright gifts?

The answer is that of all of the various options available, private foundations provide the greatest degree of long-term control and flexibility to a donor in terms of how a substantial charitable gift will be used for charitable purposes. Family legacy, family unity, and family involvement and control over investments and charitable distributions are maximized with the use of a private foundation, even with the restrictions discussed above.

Fortunately, foundation managers can minimize the risk of five out of these six excise taxes if they follow these general guidelines:

  • Avoid the temptation to use the foundation's assets for personal financial or political gain.
  • Meet the foundation's annual distribution requirements.
  • Invest the foundation's assets responsibly.
  • Make grants only to legitimate charitable organizations.
  • Codify these guidelines in the foundation's mission and adopt good governance policies that cover the topics discussed above.

It's really that simple to minimize the risk of excise taxes. For more information on this topic, please contact your U.S. Trust advisor.

Institutional Investments & Philanthropic Solutions (Philanthropic Solutions) is part of U.S. Trust, Bank of America Private Wealth Management (U.S. Trust). U.S. Trust operates through Bank of America, N.A., and other subsidiaries of Bank of America Corporation (BofA Corp.). Bank of America, N.A., Member FDIC. Trust and fiduciary services and other banking products are provided by wholly owned banking affiliates of BofA Corp., including Bank of America, N.A.

Bank of America, N.A., makes available investment products sponsored, managed, distributed or provided by companies that are affiliates of BofA Corp.

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