Philanthropy
Top 10 Compliance Rules For Private Foundations

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 tom.burroughes@wealthbriefing.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
carefully.
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
approval.
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
deductions.
6. Insiders may not economically
benefit from the foundation – except for reasonable
compensation.
Foundation insiders (essentially anyone who has significant
influence over the foundation such as its officers, trustees,
family members and substantial donors, and any entities that are
substantially owned by such individuals) generally are not
permitted to reap economic benefit from their dealings with a
foundation. An exception is made for compensation – provided the
compensation is reasonable. The reasonableness of compensation is
judged on a list of factors, including qualifications,
experience, job responsibility, duties, and time dedicated (part-
or full-time) by the insiders to their positions. Additional
factors can include the size of the foundation, the local labor
market, the cost of living in the area, and the salary paid by
similarly situated charitable organizations for comparable
positions.
7. Insiders’ attendance at charity
events must be strictly work-related.
Many private foundations support local charitable institutions
that conduct fundraising events. Persons attending or “buying
tables” at such events typically receive food and entertainment.
If a private foundation purchases tickets for such an event (or
is given tickets), a question arises as to whether self-dealing
results when a board member, other insider, or their relatives or
friends use the tickets to attend.
As a basic rule, all direct and indirect financial transactions between a private foundation and those persons who control and fund it are prohibited. It is immaterial whether the transaction results in a benefit or a detriment to the foundation. However, the foundation is permitted to pay expenses resulting from the participation of its insiders in meetings and events on the foundation’s behalf.
Some argue that it is necessary and appropriate for foundation directors, trustees, and staff to attend fundraising events and, therefore, no self-dealing has occurred when its insiders use the tickets. Logically, if a foundation’s board member or officer attends the event to represent the foundation in an official capacity, there should be no private benefit, so long as the attendance is work-related, necessary, and allows the foundation to effectively show support for the organization at a public function.
Impermissible self-dealing may arise, however, if the table seats are given to friends and family members. To remove any question of self-dealing, it is preferable for a private foundation to decline accepting tickets for persons other than board members, trustees, senior staff members and their spouses. A foundation could conceivably furnish the charity with a list of persons to whom tickets may be furnished, but only with the clear stipulation that the charity must decide which individuals are awarded the tickets.
8. Foundations may not fulfill their
insiders’ personal pledges.
A common problem arises when a foundation insider makes a
personal pledge to a church, synagogue, mosque, etc., and the
foundation satisfies that pledge. Since churches are indeed
public charities, many foundation personnel incorrectly assume
that it is perfectly legitimate for the foundation to cover a
charitable pledge made by a founder or other board member.
A foundation may make a charitable grant or pledge to a church when that pledge was initiated by the foundation. However, there is a subtle distinction between a foundation making its own charitable grant and a foundation satisfying the personal obligation of a board member or other insider. Insiders are not allowed to obtain a personal benefit from their dealings with the foundation. To the extent that the foundation relieves an insider of such a financial obligation, that person is considered to have benefited.
9. Foundations can make grants to
individuals without IRS approval, if it’s for emergency or
hardship assistance.
It is commonly believed that a foundation may not make grants to
an individual without advance approval from the IRS (such as for
a scholarship program). However, grants made to relieve human
suffering may be made without advance approval under certain
conditions, provided that the foundation makes the grant on an
objective and nondiscriminatory basis, complies with basic
recordkeeping requirements showing how and why a particular
individual was selected for assistance, and does not require the
recipient to spend the grant funds in a particular way.
The IRS divides such grants into two broad categories in Publication 3833: emergency and hardship assistance. Emergency assistance is usually provided after there has been a natural catastrophe, such as an earthquake, tornado, hurricane or flood. By contrast, hardship assistance is provided based upon established economic need, and may be used, for example, to purchase food or cover health insurance premiums for a low-income family.
10. Foundations can grant to other
foundations.
Grantmakers are often unaware that one private foundation may
make a grant to another private foundation, as long as the
granting foundation exercises expenditure responsibility. This
may be desirable when the grantee foundation runs its own special
programs (for example, a scholarship program approved by the
IRS).
When one foundation makes a grant to another, and the recipient foundation follows by disbursing those funds, the IRS will allow only one of the foundations to count those funds toward satisfying the annual 5 per cent payout requirement. Unless the foundations agree otherwise, the recipient foundation will be the one that will count the disbursement of the funds toward its 5 per cent payout requirement.
In order for the granting foundation to count the grant proceeds toward its own 5 per cent payout requirement, the recipient foundation must agree to (1) make a special election on its annual return not to count the disbursement of the proceeds toward its 5 per cent requirement; and (2) disburse all of the granted proceeds by the end of its fiscal year following the year in which the funds were received.
Note: This article is not intended as a substitute for legal, tax or investment advice, nor should it be construed as a comprehensive guide to regulations governing private foundations.
Jeffrey Haskell, J.D., LL.M. is chief legal officer for Foundation Source, which provides comprehensive support services for private foundations. The firm works in partnership with financial and legal advisors as well as directly with individuals and families.