Private and family foundations are subject to more stringent tax laws and regulations than ever before. Understanding the nuances of private foundation laws is especially important now, given increased scrutiny of tax-exempt organizations by Congress and the Internal Revenue Service (IRS). As private foundations transition to successive generations of leadership, the challenges will become even more complicated. The following are four areas from which complications and issues often arise.
We are used to thinking that corporations and those who manage them must deal with each other at arm’s length. There is particular emphasis on arm’s-length dealing between a charity and its managers. The conflict of interest policies that most charities have are generally aimed at disclosing conflicts of interest and having the interested board or staff member not participate in the vote or administration of a conflict transaction.
One of the major differences between public charities and private foundations is the prohibition on many types of transactions between a private foundation and its major donors or managers. Technically, the rules are not prohibitions but rather result in excise taxes. But these excise taxes, if the self-dealing is not unwound, are so high that we generally think of the rules as prohibitions.
The individuals and entities that the foundation is prohibited from dealing with are called “disqualified persons.” The following types of persons count as disqualified:
- Substantial contributors, which includes anyone who gives more than $5,000 at a time when the amount given is more than two percent of all contributions to the foundation—essentially, anyone who creates a foundation;
- Owners of more than 20 percent of the voting power of a corporation that is a substantial contributor, or of more than 20 percent of the profit interests of a partnership that is a substantial contributor or of more than 20 percent of the beneficial interests of a trust that is a substantial contributor;
- Foundation managers, such as officers, directors, trustees or an employee with responsibility for a self-dealing transaction;
- Family members (spouse, ancestors, lineal descendants and spouses of ancestors and lineal descendants) of any individual who is a disqualified person under the previous categories; and
- Corporations, partnerships, trust or estates in which the disqualified persons under the previous categories together own more than 35 percent of the total combined voting power, profits interests or beneficial interests, respectively.
Government officials are also disqualified persons.
What transactions between disqualified persons and foundations are prohibited?
Sales and leases—A foundation may not sell property to a disqualified person and a disqualified person may not sell property to the foundation. For example, a disqualified person may not sell a $1 million painting to a private foundation for $100. That is considered a self-dealing transaction. If the fair rental value of a space is $10,000/month and the disqualified person leases it to the foundation for $50/month, that’s a prohibited transaction. However, the disqualified person could give the painting or lease the space to the foundation rent-free, and those would not be self-dealing transactions. The donation by the disqualified persons of property subject to a lien is considered a sale and a self-dealing transaction unless the lien has existed for more than 10 years.
What if the foundation owns stock in a company that is a disqualified person (because, for example, the company is more than 35 percent owned by a substantial contributor to the foundation) that it must dispose of after five years under the excess business holdings rules? A redemption of the stock by the corporation is a self-dealing transaction unless all stock of the same class is subject to redemption on the same terms.
Loans and extensions of credit—These are self-dealing even if adequately secured and paying market rate interest. Under an exception, a disqualified person can make a loan to the foundation if it is without interest or other charge.
Furnishing goods, services or facilities—A foundation many not provide office space, a car, secretarial help, meals, publications, parking, etc. to a disqualified person unless providing the item is reasonable and necessary to carry out the foundation’s exempt purposes. Think of the founder who, under the exception for compensation for services, has been operating the foundation and now has turned operations over to the next generation, but wants to maintain a personal office in the foundation space. The foundation cannot house the founder’s personal office or provide other goods and services, even if he pays fair market value.
A foundation may provide incidental meals and other items to a foundation manager if providing the item is reasonable and necessary to carry out the purposes of the foundation. It may also provide goods or services to a disqualified person if they are supplied on a basis no more favorable than to the general public and a substantial number of people other than disqualified persons are using such goods and services.
Compensation for Certain Personal Services
The big exception to the prohibition on transactions between a private foundation and a disqualified person is for the foundation’s payment for the performance of personal services that are reasonable and necessary to carry out the exempt purpose of the foundation, provided that the compensation is not excessive. Personal services may be provided by an entity or an individual. Under examples in the regulations, payments to a law firm disqualified person, to an investment manager disqualified person, or to a commercial bank disqualified person for general banking services are not self-dealing.
Under this exception, the reimbursement of a disqualified person’s expenses reasonable and necessary to carry out the exempt purpose of the foundation is not an act of self-dealing, nor is the payment of advances for expenses anticipated in the immediate future.
The tension is around the definition of permitted personal services. In a 1997 case, the disqualified person provided janitorial services to the foundation. The court stated that the exception to self-dealing for payment of compensation for personal services is limited to personal services that are “essentially professional and managerial in nature.” It held that the janitorial services were not within the exception.
Management of various types of investments has been held by the IRS to come within this exception, as has the provision of certain administrative services, such as review of grant proposals and recommendation of grantees. On the other hand, the IRS has held that maintenance, repair, janitorial, cleaning, landscaping, and similar “operational” services are not within the exception. Real estate and insurance brokerage services and certain marketing services have also been held not within the exception. Secretarial services are generally considered not within the exception.
These rulings seem consistent with the regulations permitting a disqualified person to provide rent-free use of space to a foundation. The regulations say that where a disqualified person provides free use of property, there is no self-dealing even if the foundation pays for insurance and maintenance, so long as the payment is not made directly or indirectly to the disqualified person.
So what is the answer when a foundation is housed in the offices of a disqualified person corporation? Can the foundation pay rent? Utilities? Expense of the copying machine? Salary of clerical and secretarial assistants? The foundation cannot pay rent or reimburse any expenses to the corporation. If separately metered, it could pay utilities. It could buy its own copier and hire its own support people.
If we are comfortable that the foundation is paying for personal services that are of the type that may come within the exception, they are only within the exception if the amount paid is reasonable. The regulations refer foundations to the rules for when compensation is reasonable and therefore deductible for a for-profit business. It is probably advisable for the foundation to follow the procedures for obtaining a “rebuttable presumption” that compensation is reasonable under the excess benefits rules that apply to public charities. When a public charity follows procedures, it gets a “rebuttable presumption” that compensation is reasonable. A foundation won’t get that—but it should feel fairly comfortable that the compensation it pays is reasonable.
One teaching of the excess benefits rules is that in determining whether compensation is reasonable, all forms of compensation must be considered: cash compensation, contributions to health and retirement plans, most fringe benefits, club memberships, spousal travel—everything.
To follow the rebuttable presumption procedure, the foundation would have to have an independent portion of its board compare the total amount paid to the total amount paid for comparable services to a comparably sized institution providing comparable services in a similar location. The regulations also say that the experience, education, and particular expertise of the person being compensated must be considered. The independent board members must document contemporaneously their reasoning that the compensation is reasonable, referring to the comparables.
There are excellent comparability data available from the Council on Foundations and other sources, with salaries broken down by geographic region, position and foundation size. However, most databases do not include compensation values other than cash compensation.
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Excess Business Holdings
Prior to 1969, there were instances in which a donor contributed a business to a private foundation and then continued to control the business. The legislative history of the excess business holdings rule recites Congress’s concern that in such a case the private foundation will focus on running the business instead of on the private foundation’s charitable mission.
The general rule is that the combined holdings of a private foundation and all disqualified persons is limited to 20 percent of the voting stock of a corporation conducting a business, or 20 percent of the beneficial or profits interest of any unincorporated business. The rule is enforced through prohibitively high excise taxes when a foundation and its disqualified persons hold excess business holdings in a business enterprise.
A business enterprise does not include, and therefore there are exceptions for, a trade or business related to the private foundation’s exempt purpose (a demonstration farm, for example), program-related investments, and a trade or business for which at least 95 percent of gross income is derived from passive sources such as dividends, interest and rent.
The excess business holdings rule does not apply at all if the private foundation itself does not hold more than two percent of the business enterprise, directly or indirectly. If a private foundation owns two percent or less, disqualified persons can hold any amount—and excise tax doesn’t apply.
If the private foundation can prove that effective control of the business is not in the private foundation or its disqualified persons, the private foundation and disqualified persons can hold in the aggregate up to 35 percent of the business enterprise.
The “excess” business holding is the excess more than 20 percent (or 35 percent, if the special rule applies) held by the private foundation and disqualified persons. A five percent excise tax applies to the value of the excess business holdings, and the tax is increased to 200 percent unless the holding is corrected. If the excess occurs by a purchase by one of the disqualified persons, the private foundation has 90 days to dispose of its holdings so that it no longer has excess business holdings before being subject to tax. The 90 days is extended to include any period in which state or federal securities laws prevent sale. The 90-day period runs from the day the private foundation knows or has reason to know of the event that causes it to have excess business holdings. If the foundation makes the purchase that results in the excess holdings, it is immediately subject to excise tax.
The private foundation has five years to dispose of excess business holdings acquired by gift or bequest (or certain readjustments of the business). If the private foundation receives the business holdings by will or trust, the five years begins when the distribution occurs (not the date of death, for example). The IRS can, by ruling, allow up to an additional five years to dispose of the excess holdings, in the case of an unusually large gift or bequest of diverse holdings or holdings with complex corporate structures.
The issue is squarely presented where a business owner wants to fund a private foundation with interests in the business prior to a sale. Funding a foundation with interests in the business allows the business owner to fulfill a philanthropic goal and not pay tax on a portion of the appreciation in the value of the business, leaving more money for the foundation.
The five-year clock starts ticking when the business interest or stock is contributed. If the proposed sale falls through, there may be a problem. The business cannot redeem shares from the private foundation alone—that would be self-dealing, unless the business offers to redeem from all the owners on the same terms. Also, absent a cash contribution or the foundation’s receipt of dividends, there may be no cash with which to make the required annual distribution for charitable purposes of five percent of the value of the foundation’s net investment assets.
Grants to Charities That Lobby
A 501(c)(3), whether a private foundation or a public charity, may not participate in a political campaign. A public charity is limited in the amount of lobbying it may do, and a private foundation generally may not lobby.
What Is Lobbying?
Direct lobbying is an attempt to influence legislation through communication with a member or employee of a legislative body or with any other government official or employee who may participate in the formulation of legislation. Direct lobbying must refer to specific legislation and reflect a view on it (i.e., for or against it).
Grassroots lobbying is an attempt to influence legislation through an attempt to affect the opinion of the general public. Grassroots lobbying must refer to specific legislation, reflect a view on it, and encourage the recipient to take action either by stating that the recipient should contact government representatives, by including the address or telephone number of a legislator to contact, by providing a petition or postcard, or by identifying legislators who are undecided.
The rule that a private foundation generally may not lobby has narrow exceptions for written invitations to advise governmental bodies or for self-defense (to lobby against a decrease in the charitable contribution deductions for gifts to foundations, for example).
Because public charities are limited in lobbying and because private foundations generally cannot lobby, private foundations have been reluctant to fund public charities that lobby, although in many cases lobbying is the most effective way for a public charity to further its mission. One of my colleagues is fond of referring to an organization with a mission of improving infant nutrition. Through lobbying for a legislative program, this organization helped bring formula worth $18 million a year to city infants. As my colleague says, the organization’s fundraising efforts could never have raised that kind of money.
Helpful Regulations Make It Clear That…
- A general operating grant by a private foundation to a public charity that conducts lobbying is not lobbying by the private foundation so long as the grant is not earmarked for lobbying.A grant is “earmarked” if there is an oral or written agreement that it will be used for lobbying.
- A private foundation’s grant to fund a specific project of a public charity is not lobbying if the grant is not earmarked for lobbying and the amount of the grant (aggregated with other grants for the project by the private foundation in the same year) does not exceed the public charity’s budgeted amount for non-lobbying expenditures.
So, if the project budget is $100,000, and $20,000 is budgeted for lobbying, a private foundation can make an $80,000 grant for the project.
For purposes of this rule, the private foundation can rely on budget documents or other evidence supplied by the public charity, unless the private foundation has reason to doubt their accuracy. Note that it is irrelevant whether other private foundations will provide support for the project. In the example above, the private foundation could make the $80,000 grant, even if it knew that the public charity had received a $20,000 grant for the project from another private foundation.
Although it is not required, many private foundations put a statement in grant letters to public charities that as condition of the grant the public charity agrees not to use grant funds to influence legislation, influence the outcome of any election or conduct a voter registration drive. This type of statement should not be included, because it could prevent the public charity from using the grant funds for lobbying it would otherwise be permitted to use.
A private foundation is not lobbying if it conducts nonpartisan analysis, study or research, i.e., an independent and objective study of an issue. The study can even take a position on the issue—in other words, it can indicate that the foundation is in favor of or against legislation—so long as there is a sufficiently full and fair exposition of pertinent information to enable a reader or listener to form an independent conclusion. The regulations give an example of a foundation that conducts a research study of a pesticide at a time when several state legislatures are considering legislation to ban the pesticide. The resulting report may indicate that the foundation supports the legislation (or does not support it) so long as the factual presentation is sufficiently complete to permit a reader to draw his or her own conclusion about the legislation.
In conclusion, to avoid complications as a result of increased laws and scrutiny, private foundations should be particularly careful with matters involving self-dealing, compensation for personal services, excess business holdings, and grants to charities that lobbies.