The author of this article is a legal expert on foundations and the benefits they bring to users and beneficiaries alike. In the US, this sector is an important part of the philanthropy landscape. Here are some rules to follow.
In the tools and structures that high net worth indviduals and families use to support philanthropy is the private foundation. These come with a number of complexities that advisors to such HNW clients must be aware of. To that end, here is an article about the territory from Jeffrey Haskell, chief legal officer, of Foundation Source (more on the author below). We hope readers find this content useful. As ever, the editors don’t necessarily endorse all views of guest contributors. Email email@example.com
Running a private foundation can be one of life’s most rewarding experiences, a chance for an individual or family to effect real and positive change in the world through philanthropy.
The flexibility, creativity and nearly endless giving capabilities offered by a foundation do come with a dose of administrative complexities, though. It can be challenging for foundations to keep pace with government regulations, which are always changing, as well as IRS filings and the required paperwork.
To help private foundations and their advisors steer clear of compliance trouble, here are 10 essential rules to remember:
1. Foundations’ annual minimum
distribution requirement (MDR) must be calculated
Generally, a private foundation is required to distribute 5 per cent of the average value of its investment assets for the previous year. The IRS prescribes a specific method for averaging a foundation’s securities and the balances in its savings and checking accounts on a monthly basis. The 12-month average allows for market fluctuations over the year. Special rules apply to the valuation of real estate and all other assets. These calculations can be complex. When performed incorrectly, as is often the case, they can result in under or over payment, so special care must be taken when determining the 5 per cent requirement.
Grants to qualifying organizations and all reasonable administrative expenses necessary for conducting a foundation’s charitable activities – other than investment management or custodial fees or bank charges – count as qualifying distributions toward satisfying the annual 5 per cent payout requirement. Reasonable administrative expenses may include office supplies, telephone charges, consulting fees, certain legal and accounting fees, training and professional development, employee compensation, publication of the foundation’s annual report, and modest travel expenses associated with foundation business.
2. Unrelated business taxable income
(UBTI) will be taxed at the for-profit rates.
Unrelated business taxable income (UBTI) is commonly associated with revenue that a charity generates through an activity that has no direct connection with its charitable mission. To the extent that a foundation has UBTI, it must be taxed as if it were a for-profit organization. The UBTI rules were enacted to ensure that nonprofit, charitable organizations do not compete with for-profit companies, gaining an unfair competitive advantage. Foundation staff often don’t realize that if a foundation borrows money (for example, on margin) to purchase an investment asset (not related to performing its charitable activities), some or all of the income flowing from that asset will usually be deemed UBTI.
In addition to paying taxes at a for-profit tax rate, a private foundation with significant UBTI must also file an additional tax return, Form 990-T, along with its 990-PF. Many professional advisors counsel their foundation clients to avoid engaging in activities that would generate UBTI, unless the potential for profit is considerable.
3. The tax status of charities must
continually be validated.
Just because a charity attained tax-exempt status from the IRS at one time does not mean that it maintains that status. For example, if the charity does not continue to maintain its broad public support, it may be reclassified by the IRS as a private foundation.
The IRS lists all tax-exempt organizations in IRS Publication 78. (However, some organizations that are considered public charities, such as schools, houses of worship, and instrumentalities of the government, such as parks and municipalities, aren’t listed in this publication.) Foundations may make grants to public charities listed in this publication without exercising “expenditure responsibility,” a multi-step process to ensure that grant funds will be used for a charitable purpose only.
But what if the charity’s status had been revoked in an Internal Revenue Bulletin issued since the date of the last publication? If a private foundation makes a grant to an organization that is not a public charity in good standing with the IRS, and does not exercise expenditure responsibility, the foundation may be subject to a penalty, and the grant will not count toward satisfying its annual distribution requirement.
4. Scholarship grants require IRS
Since universities are 501(c)(3) public charities, and grants made to them do not require the advance approval of the IRS, many foundations believe that they can fund a specific student’s scholarship without advance approval from the IRS – as long as the grant is paid directly to the university and not to the student. This is false. It is the foundation’s act of choosing the scholarship recipient (instead of having the university make that choice) that triggers the need for advance approval, regardless of whether the funds are paid to the individual or directly to the university. It is only when a foundation funds a university’s existing scholarship program and does not involve itself in the selection process that advance approval by the IRS is not required.
If a foundation wishes to take an active role in selecting scholarship recipients, it must apply for advance approval from the IRS. In doing so, the foundation must determine the group of individuals who are eligible to apply for a scholarship and develop an objective and non-discriminatory plan for selecting the final recipients. If the IRS does not contact the foundation within 45 days of the foundation’s submission of its scholarship plan and procedures, the foundation may begin making scholarship grants.
5. Hosting fundraising events requires
compliance with federal, state and local laws.
Foundations that host fundraising events seldom realize that they are required to comply with federal, state, and local laws governing charitable fundraising. Many states require foundations to report fundraising events and register with the attorney general’s office of the states where the events are held. Also, the IRS requires foundations to ascribe a value to the benefits provided to attendees as well as provide a tax receipt for each attendee at year-end. This is so that ethe attendee knows what portion of the donation is actually tax deductible. For example, say an attendee pays $150 for a golf tournament hosted by the foundation, and the usual greens fees are $50, the foundation must provide a tax receipt letter to that attendee stating that the value of goods and services provided was $50 (the value of the greens fees). The proper tax deduction for the attendee to claim is the ticket price minus the value of the greens fees, or $100. If the attendee does not obtain this tax receipt by the time he files his income tax return, the charitable deduction may be lost.
Sometimes foundations raise additional funds at these events by selling merchandise, such as t-shirts or other accessories. Depending on where the event is held and where the foundation conducts its business, the foundation may be required to charge state and local sales tax. Although the foundation itself may be exempt from paying sales tax, that doesn’t necessarily mean it can forgo charging sales tax when it sells merchandise to others. The requirement to charge and remit sales tax varies from one locality to another. Some localities permit a foundation two or three days per year in which it may sell merchandise free of sales tax in connection with a fundraising event. Often, the best solution is to make an arrangement with a local merchant to charge, collect, and remit sales tax to the appropriate taxing authority on behalf of the foundation.
Additionally, if a foundation chooses to raise funds through a live or silent auction, it must clearly document the fair market value of all items for sale before the auction begins. For example, the foundation may attach price tags to items available for bidding or publish a list of such items with their respective values. This is crucial, because only the portion of the amount paid at auction in excess of an item’s fair market value may be treated as a charitable gift.
For example, if a grandfather clock has a fair market value of
$1,200 and is purchased at auction for $1,300, the purchaser
would be limited to only a $100 charitable deduction. A
foundation must record the names and addresses of all attendees
of an event, so that it may provide those who pay over $250 with
tax receipts at the end of the year. Failure to provide a tax
receipt to attendees before they file their income tax
returns may cause the attendees to lose their charitable