A primer on private foundations

Within the realm of charitable organizations, private foundations, such as the Bill and Melinda Gates Foundations, are one of the most highly-regulated. Congress’ rationale for imposing strict requirements on private foundations is that the funding primarily comes from a single or small number of supporters. The small number of supporters are less likely to scrutinize their own foundation’s activities than public charities that have a diverse array of supporters, who, presumably, scrutinize the public charity’s use of funds. Knowing this, Congress has imposed a myriad of requirements and limitations on private foundations. 

To begin, it is worth noting that a 501(c)(3) organization is presumed to be private foundation unless it meets one of the “public support” requirements in IRC section 509(a). If it fails to meet the public support requirements, the 501(c)(3) is deemed to be a private foundation and must comply with complex rules set forth in IRC sections 4940 through 4946. The following explains, in very general terms, the requirements and limitations imposed on private foundations and the penalties associated with failure to comply.  

Disqualified Persons

Who is and is not a disqualified person is an essential concept that flows through all aspects of the private foundation regulatory regime. A transaction between the private foundation and a disqualified person may trigger a significant penalty, so it is important to understand the rules defining disqualified persons. The rules defining who is a disqualified person are complex and lengthy. Non-exhaustive examples of disqualified persons include “substantial contributors” to the private foundation, managers of the foundation, or anyone who owns more than 20 percent of an entity that is a substantial contributor; family members of any of the three preceding examples are also disqualified persons, with “family members” being defined very broadly.  

Self-Dealing Transactions

IRC section 4941(d)(1) lists self-dealing transaction that take place between the private foundation and a disqualified person.  “Self-dealing” includes, among other transactions, direct or indirect transactions between private foundation and a disqualified person such as sales or exchange, or leasing, of property; lending of money or other extension of credit; furnishing of goods, services or facilities; and payment of compensation or payment or reimbursement of expenses.  

Of course, as with any good tax statute, there are many exceptions to these self-dealing transactions. For example, a private foundation may furnish facilities to a disqualified person if the furnishing is made on a basis no more favorable than that which the facilities are made available to the general public

Penalty: Five- to 200-percent of the amount involved.

Mandatory Distribution

IRC section 4942 requires private foundations to distribute a certain amount of its assets on a yearly basis. That statute, which is a labyrinth of definitions and math equations, generally requires a private foundation to make “qualified distributions” in an amount equal to five-percent of the fair market value of the foundation’s non-charitable assets.

The methodology for calculating the fair market value of the foundation’s non-charitable assets varies depending on the nature of the asset (e.g., securities are valued differently than land). Qualified distributions include reasonable administrative expenses, amounts paid to accomplish one of the charitable goals of the foundation, and amounts paid to acquire an asset used directly in carrying out the foundation’s charitable goals. Qualified distributions in excess of five-percent requirement can be carried over to five subsequent years.  

Penalty: Thirty- to 100-percent of the amount that should have been distributed.  

Excess Business Holdings

IRC section 4943 provides that a private foundation and its disqualified persons may not—together—own more than 20 percent of voting stock in a business enterprise. Again, there are exceptions to this rule. The two-percent de minimis rule provides an exception to the excess business holdings rules if the private foundation owns 2 percent or less of the voting stock and 2 percent or less in value of all outstanding shares of all classes of stock. Additionally, a private foundation and its disqualified persons may own up to 35 percent of a business enterprise if it can be shown that one or more persons who are not disqualified persons have effective control of the enterprise. 

Penalty: Sale of investment to comply with requirements; possible 10-percent tax on the value of excess business holdings.

Jeopardizing Investments

IRC section 4944 provides private foundations may not invest in a manner as to jeopardize the carrying out of any of its exempt purposes. While there is no hard and fast rule as to what type of investments would run afoul of this rule, prudent investments would tend to not “jeopardize the carrying out of any” of the private foundation’s exempt purposes.

Penalty: Removal of investments “from jeopardy”; ten-percent tax on the jeopardizing investment.

Taxable Expenditures

IRC section 4955 precludes private foundations from making “taxable expenditures.” Taxable expenditures include, among others, amounts paid or incurred to lobby; to influence the outcome of a specific public election; or as a grant to an individual for travel, study, or other similar purpose (unless certain procedures are put in place).

Penalties: Five- to 50-percent of the taxable expenditure.

Excise Tax on Net Investment Income

As with other tax-exempt organizations, private foundations generally do not pay income tax. Private foundations do, however, pay an annual 1- or 2-percent excise tax on their net investment income. This tax is used to offset the Federal government’s expenses incurred to regulate private foundation.

The material in this blog is not intended, nor should it be construed or relied upon, as legal advice. Please consult with an attorney if specific legal information is needed.