Serving Private Foundations by Lorri Dunsmore, Perkins Coie David - PowerPoint PPT Presentation

Serving Private Foundations by Lorri Dunsmore, Perkins Coie David Lawson, Davis Wright Tremaine 1

Deductions: Individual Deductions Limitations Public Charities or Private Private Operating Grantmaking Foundations Foundations Cash or Ordinary Income Cash or Ordinary Income Property: Property: Deduction of up to 50% of Deduction of up to 30% of donor’s contribution base donor’s contribution base Capital Gain Property: Deduction of up to 50% of Capital Gain Property: donor’s contribution base to the Deduction of up to 20% of extent the capital gain property donor’s contribution base does not exceed 30% of the donor's contribution base

Governing Instrument Section 508(e) requires that an organization have specific provisions in its governing instrument in order to qualify as a private foundation: • prohibit the foundation from engaging in self-dealing subject to tax under § 4941, • require it to make qualifying distributions each year in amounts sufficient to avoid tax under § 4942, • forbid it from retaining excess business holdings taxable under § 4943, • prohibit jeopardizing investments taxable under § 4944, and bar the foundation from making taxable expenditures within the meaning of § 4945.

Types of Private Foundations Operating Nonoperating • • Direct Charitable Grants to Public Activities Charities

Private Nonoperating Foundation • Grantmaking Foundation • Checkbook Foundation • Primarily makes grants to public charities

Private Operating Foundation • Actively engaged in the conduct of charitable activities • Annual determination • Based on use of income and assets over the most recent four-year period • Reported on Form 990-PF, Part XIV

Advantages of a Private Operating Foundation • Donations are tax deductible under the same rules as donations to public charities • Not subject to annual 5% payout requirement for private nonoperating foundations

Private Operating Foundation Tests • The Foundation must meet both an income test and one of three alternative tests: • Asset test • Endowment test • Support test

Private Foundation Excise Taxes Chapter 42 of the Internal Revenue Code • Most of these “taxes” are punitive in nature; it’s easier to consider these the “rules” governing foundations • Section 4940: Investment income excise tax • Section 4941: Self-dealing transactions • Section 4942: Distribution requirements • Section 4943: Excess business holdings • Section 4944: “Jeopardizing” investments • Section 4945: “Taxable expenditures” – grab bag

Private Foundation Excise Taxes (cont'd) Tax on Investment Income • 2% on net investment income • May be reduced to 1% if the foundation meets certain distribution requirements • These are slightly different from those in Section 4942 • Does not apply to certain private operating foundations (“exempt operating foundations”) that look like public charities

Self-Dealing Transactions Section 4941 – Prohibits Certain Transactions Between Foundation and “Disqualified Persons” • Disqualified persons: • Officers and directors • Staff with responsibilities similar to officers/directors • “Substantial contributors” (status for life!) • Spouses, ancestors, descendants of all of the above • Entities 35% controlled by all of the above • Certain government officials

Self-Dealing Transactions (cont'd) Section 4941 – Prohibits Certain Transactions Between Foundation and “Disqualified Persons” • Prohibited transactions: • Sale or leasing of property (in either direction) • Lending (in either direction) • Furnishing of goods, services, or facilities (in either direction) • Payment of compensation to DQP by foundation • “Transfer or use by or for the benefit of” foundation assets

Self-Dealing Transactions (cont'd) Section 4941 – Prohibits Certain Transactions Between Foundation and “Disqualified Persons” • Exceptions: • Compensation to DQP for “personal services” (professional or management services only) • Donations by a DQP of goods or services • Interest-free lending by DQP to foundation • Furnishing of goods or services by foundation if DQP gets them on the same terms as the general public • Certain transactions as part of the reorganization of a DQP

Distribution Requirements “The 5 Percent” – Section 4942 • “Qualifying distributions” must exceed “distributable amount.” What is the “Distributable Amount?” • 5% of fair market value of all assets, except those used “directly” for exempt purpose • A few modifications apply

Distribution Requirements (cont'd) “The 5 Percent” – Section 4942 • “Qualifying distributions” must exceed “distributable amount.” W hat are “Qualifying Distributions?” • Amounts paid to accomplish exempt purposes • Amounts paid to acquire exempt-use assets

Distribution Requirements (cont'd) Some Things That Are Qualifying Distributions: • Grants to public charities or governments • Grants to private operating foundations • Permitted scholarship and fellowship grants • Amounts spent directly to operate a charitable program • Administrative expenses (but not investment management expenses) • Program-related investments

Distribution Requirements (cont'd) Some Things That Are Not Qualifying Distributions: • Grants to organizations controlled by the foundation or its disqualified persons • Grants to other non-operating private foundations (unless timely redistributed by the grantee foundation and made “out of corpus”) • Grants to individuals not permitted under Section 4945 • Investment management expenses

Distribution Requirements (cont'd) Taxes Under Section 4942 • Initially, 30% of undistributed income • If uncorrected, 100% of the remaining undistributed amount Timing • Distributions for year 1 must happen by end of year 2 • To avoid 100% tax on income not distributed by the end of year 2, income must be distributed before either: • the return due date for year 2, or • the IRS mails a notice of deficiency.

Excess Business Holdings: Rule and Elements Rule • The combined holdings of a private foundation and all disqualified persons in any corporation conducting a business which is not substantially related to the exempt purposes of the foundation are limited to 20% of the voting stock in such corporation. • Nonvoting Stock • If disqualified persons do not hold more than 20% of the voting stock, nonvoting stock is considered permitted holdings. • If disqualified persons hold more than 20% of the voting stock, then nonvoting stock is considered excess business holdings (unless considered de minimis).

Excess Business Holdings: Elements (cont'd) Business Enterprise • The active conduct of a trade or business; and • Any activity that is regularly carried on for production of income from the sale of goods or the performance of services which constitutes UBTI under 513 Not a Business Enterprise • A business that derives 95% of more of its gross income from passive sources (e.g., dividends, interest, royalties, rents) • A functionally related business

Excess Business Holdings: Elements (cont'd) “Permitted Holdings” • A private foundation may hold 20% of voting stock in a business enterprise, reduced by the percentage of voting stock actually or constructively owned by disqualified persons. Any excess over 20% is excess business holdings. “Disqualified Persons” • Substantial contributors, foundation managers, owners of more than a 20% interest in a substantial contributor, certain family members, and corporations, partnerships, trusts and estates in which disqualified persons own more than a 35% interest.

Excess Business Holdings: Elements (cont'd) Increase of Permitted Holdings to 35% • Must establish that “effective control” is in one or more persons who are not disqualified persons with respect to the foundation “Effective Control” • Having the power, either directly or indirectly, to direct or cause the direction of the management and policies of a business enterprise, whether through the ownership of voting stock, the use of voting trusts, or contractual arrangements, or otherwise

Excess Business Holdings: Tax on Holdings • 10% tax imposed on the value of the excess business holdings Initial Tax • Value is determined when foundation’s holdings are at their highest Additional • If foundation fails to dispose of interest, tax of 200% Tax value of excess business holdings imposed.

Excess Business Holdings: Special Rules 90-Day Rule • Foundation will have 90 days to dispose of excess business holdings and not be subject to tax when: • Disqualified person purchases interest causing the excess business holdings, or • Foundation purchases additional interest but did not know of disqualified person’s interest • The 90-day period can be extended if the sale of the business interests is prevented by federal or state securities laws

Excess Business Holdings: Special Rules (cont'd) Holdings Acquired by Gift or Bequest • Foundation given five years in which to address the excess business holdings • No tax assessed during this time • Tax assessed if holdings not disposed of by end of five-year period