Focus on Not-For-Profit Foundations: Private Foundations Penalty Taxes
Good intentions and even profitable transactions can lead to significant tax liabilities when a tax-exempt private foundation is a party to the transaction.
Although private foundations are generally exempt from income tax, they are subject to various forms of excise taxes. Among these are five types of penalty taxes that private foundations can trigger if they engage in certain activities prohibited by the Internal Revenue Code.
Furthermore, the original transaction has to be corrected. Trustees, directors and senior employees of private foundations should familiarize themselves with these penalty taxes and implement controls to avoid transactions that create exposure to these taxes.
While one would expect penalties to apply to abusive transactions, the private foundation rules apply to a much wider range of transactions; good intentions and/or favorable results are not sufficient reasons for avoiding these taxes.
The five penalty taxes which may apply to the foundation, the person involved in a transaction, and foundation managers are as follows:
Taxes on Self-Dealing – 10% Initial Tax
Private foundations are prohibited from entering into self-dealing transactions with a disqualified person. Disqualified persons include:
- Substantial contributors to the foundation (more than $5,000 or 2% of accumulated foundation contributions);
- Foundation managers (officers, directors, trustees, or employees with the responsibility to act on behalf of the foundation);
- Owners of more than a 20% interest in a corporation, partnership, or unincorporated enterprise that is a substantial contributor to the foundation;
- A family member of any of the types of disqualified persons listed above;
- A corporation, partnership, trust, or estate in which any of the types of disqualified persons listed above has a greater than 35% interest; and
- A private foundation controlled by one of the types of disqualified persons listed above or their family members.
Self-dealing transactions include:
- Sale, exchange, or leasing of property;
- Lending of money or extension of credit;
- Furnishing of goods, services, or facilities;
- Payment of compensation;
- Transfer to, or use by, a disqualified person of the income or assets of the foundation;
- Agreement by the foundation to make a payment of money or property to a government official.
The following are two examples of self-dealing transactions:
T is the founder of the Z private foundation and is a substantial contributor. T would like to donate a piece of appreciated rental real estate with a value of $500,000. There is an outstanding mortgage loan balance of $200,000, but the loan payments are covered by the cash flow from the property. The mortgage loan is nonrecourse and was made by an unrelated bank 5 years ago to refinance the property as well as make improvements to the property.
Should the foundation accept the gift subject to the loan? No. Taking the property subject to the loan would be a sale under general tax rules. Since T is a disqualified person, a 10% tax on the $200,000 amount involved in the sales transaction could be assessed. The fact that the foundation would get an asset with a net value of $300,000 does not negate the fact that it is self-dealing.
Company M is a disqualified person with respect to the Z Foundation. Z Foundation makes a donation to a charity having a fundraising event that includes a special dinner. The value of the tickets received for the dinner is $1,000. M reimburses the foundation (Z) for the $1,000 and executives of Company M attend the dinner.
Subject to a complete review of facts and law, it is possible that the company has engaged in a self-dealing transaction whereby the 10% excise tax could be imposed on the entire amount of the donation. Furthermore, correction could involve the company needing to reimburse the foundation for the entire donation (not just the $1,000 value allocated to the dinner).
In at least one instance, the Internal Revenue Service took the position that such a transaction would be self-dealing and subject to the related excise taxes. If a foundation engages in similar transactions, it should consult its tax advisors or consider avoiding such transactions altogether.
The rules provide limited exceptions to the transactions listed above. There is generally an exemption for a disqualified person making a no-interest loan to the foundation. Compensation may be paid for certain professional services. Also, foundation managers may receive reasonable compensation for services provided to the foundation.
If a self-dealing transaction occurs, the disqualified person (other than a foundation manager acting only as a manager) is liable for an excise tax equal to 10% of the amount involved, and a foundation manager who knowingly engaged in such a transaction must pay an excise tax of 5% of the amount involved (up to $20,000).
Also, the transaction usually needs to be reversed or the foundation may need to be compensated for any losses. If the self-dealing transaction is not corrected within the period prescribed by law, the disqualified person is subject to an additional excise tax of 200% of the amount involved, and the foundation manager may be subject to an additional excise tax of 50% of the amount involved (up to $10,000 per act).
Minimum Distribution Shortfall – 30% Initial Tax
Private foundations (other than operating foundations) must distribute 5% of the fair market value of their non-charitable use assets based on an annual calculation. Distributions for this purpose include amounts paid to accomplish the foundation’s charitable purposes, as well as reasonable and necessary administrative expenses.
Non-charitable use assets include all cash and investments (based on an average of the monthly fair market values of these assets) as well as other assets (valued annually) except those held solely for charitable purposes. If a private foundation distributes more than 5% in a given fiscal year, the excess may be carried forward and applied against the distribution requirement for future fiscal years.
The following are two examples of the application of the minimum distribution requirement:
Q, a non-operating private foundation has a minimum distribution requirement of $95,000. Q makes grants of $90,000 and has administrative expenses of $6,000. There will be a carryover of $1,000.
Suppose the $6,000 of expense is allocable to investment expenses instead of administration of charitable activities. If the foundation (Q) only paid $90,000 of grants, there will be an excise tax liability of 30% of $5,000 (or $1,500) because the minimum distribution requirement was $95,000 and only $90,000 of qualifying distributions were paid.
W, a non-operating private foundation has a minimum distribution requirement of $150,000 and has no carryover from prior years. The foundation paid exactly $150,000 in grants, however, it failed to exercise due diligence to confirm that all recipients were qualifying section 501(c)(3) public charities. One grantee received $10,000 but has not filed a Form 990 for more than 3 years (Thus, the grantee’s exempt public charity status is automatically revoked.)
Another grantee (a “friends of....” organization) received $30,000. This grantee is classified by the IRS as a Type III supporting organization that is not functionally integrated with the supported organization. Generally, the two grants totaling $40,000 are not qualifying distributions and will result in an initial excise tax liability of $12,000 (30% of $40,000) on the foundation.
If a private foundation fails to distribute the required 5% by the end of the subsequent tax year, it is subject to a 30% excise tax on the undistributed amount. If the required amounts remain undistributed at the end of a prescribed period, the foundation is subject to an additional 100% excise tax on the undistributed amount.
Excess Business Holdings – 10% Initial Tax
In general, private foundations are not permitted to own an interest of 20% or more in a single business entity. In general, a business enterprise is defined as an active operating entity unrelated to the foundation’s charitable activity.
Entities with passive income might not be classified as a business enterprise for purposes of this tax. For purposes of calculating the percentage interest that the foundation owns of a given business entity, the interests held by all disqualified persons are also included. The rules provide two exceptions to this percentage:
- If a third party has effective control over an incorporated business enterprise, a private foundation and its disqualified persons may own up to 35% of the voting stock in that business enterprise.
- A private foundation may own an interest of 2% or less in a business entity regardless of what interest its disqualified persons own.
In the case of excess business holdings obtained via gift or bequest, the private foundation has five years to dispose of the excess business holdings, and an additional five-year extension may be obtained in certain circumstances.
If a private foundation violates the excess business holding rules outlined above, it is subject to an excise tax equal to 10% of the excess business holdings, based on the largest value of such holdings during the fiscal year. If the excess business holdings have not been liquidated by the foundation by the prescribed period, the foundation is subject to an additional 200% excise tax.
Jeopardizing Investments - 10% Initial Tax
Private foundations are not permitted to own any investments which jeopardize the carrying out of the foundation’s exempt purposes. The tax law does not precisely define what such investments might be; however, generally this section prohibits risky, aggressive, or non-traditional investments, investments for which the foundation has failed to perform appropriate due diligence, investments in which the foundation has placed too large of a share of its portfolio, and/or investments which the foundation has financed by incurring large amounts of debt.
If the private foundation makes a jeopardizing investment as described above, the foundation is subject to an excise tax equal to 10% of the amount of the investment. Additionally, any foundation manager knowingly making a jeopardizing investment is also subject to an excise tax equal to 10% of the amount of the investment, up to $10,000.
If the assets in question are not removed from jeopardy by the end of the prescribed period, the foundation is subject to an additional 25% excise tax, and the investment manager is subject to an additional 10%% excise tax, up to $20,000.
Taxable Expenditures – 20% Initial Tax
In general, all of the foundation’s expenses must be qualifying grants, reasonable administrative expenses or reasonable investment expenses. There are several types of expenditures that private foundations are explicitly prohibited from making. These include:
- Lobbying, or attempts to influence legislation;
- Attempts to influence the outcome of a public election;
- Grants to individuals, unless such grants satisfy specific requirements (which generally include advance IRS approval of the grant procedures);
- Grants to organizations other than domestic public charities, unless such grants satisfy specific requirements. After 2006, Type III supporting organizations that are not functionally integrated with the supported organization are not considered public charities for purposes of this rule.
If the private foundation makes a taxable expenditure such as those described above, the foundation is subject to an excise tax equal to 20% of the amount of the expenditure. Additionally, any foundation manager knowingly making a taxable expenditure is also subject to an excise tax equal to 5% of the amount of the expenditure, up to $10,000.
If the expenditure in question is not corrected by the end of the prescribed period, the foundation is subject to an additional 100% excise tax, and the investment manager is subject to an additional 50% excise tax, up to $20,000.
The five penalty taxes described above can result in material, adverse financial consequences for private foundations and the trustees and senior employees of private foundations who knowingly engage in the activities that trigger these taxes. Accordingly, knowledge of these penalty taxes and the institution of safeguards to prevent these taxes from being incurred are vital for every private foundation. Such safeguards might include:
- Keeping a list of all disqualified persons and referring to that list before signing contracts or making disbursements.
- Having a policy whereby the foundation is billed directly and pays all expenses directly in order to avoid the appearance of a disqualified person being a party to the transaction.
- Having an investment policy which is periodically reviewed and updated.
- Having procedures to verify that grants are qualifying distributions.
- Conducting spot checks that there is documentation that the policies and procedures are being followed.
- When in doubt, check it out with the foundation’s attorneys and financial advisors.
Note that these rules are complex and the above is a summary of portions of the rules. Much has changed since 1969 when these taxes were originally enacted. Thus, in some cases, there may be differing interpretations how the rules apply to a specific situation.
For further information, contact:
Judy Murphy, CPA - St. Louis
Not-For-Profit Services Group
Chip Harris, CPA - Kansas City
Not-For-Profit Services Group
Bert Bondi, CPA - Denver
Not-For-Profit Services Group
Ted Williamson - St. Louis
Manager-In-Charge, Foundations Segment
Not-For-Profit Services Group
Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.
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