 |
Providing the Quality Legal Services You Require
| Copyright 2007 by Kelley, Scritsmier & Byrne, P.C. All rights reserved. You may reproduce materials available at this site for your own personal use and for non-commercial distribution. All copies must include this copyright statement. Website designed and created by Todd D. Turner. Click here to report any problems. |
 |  |  |  |
 |  |  |  |  |  |
 |
| |
 |
| |
 |
| |
 |
| |
 |
| |
 |
| |
 |
| |
 |
| |
 |
| |
 |
Private Foundations:
INTRODUCTION
A private foundation is a charitable organization exempt from Federal income tax under I.R.C. Section
501(c)(3). This is the same provision under which churches, schools & universities, hospitals, and
similar organizations [called “public charities” to differentiate them from “private foundations”] are
exempted from Federal income taxes. This is not a blanket tax exemption. Charitable organizations
must still pay sales taxes and property taxes [and possibly state income taxes], unless the organization
obtains specific approval for exemption from these taxes from the State. Nebraska income taxation
generally follows Federal taxation, so an organization exempt from Federal income tax will normally be
exempt from Nebraska income tax. This is not necessarily true for every state, so it is important to
know in advance which state you intend to operate under. In addition, if the organization operates a
business that is not substantially related to the organization’s charitable purpose, the net income from
the business is subject to the Unrelated Business Income Tax (UBIT).
A charitable organization is presumed to be a private foundation. Private foundations are typically
controlled by only a few people, often family or close friends of the founder. They are also generally
funded almost exclusively by these same people. This small control group makes private foundations
more susceptible to abuse of the advantages of tax-exempt status than a public charity, such as a
church or college. In order to prevent private foundations from being used improperly, Congress has
enacted several Federal excise taxes that specifically apply to private foundations, despite the tax
exemption of § 501(c)(3).
ESTABLISHING TAX-EXEMPT STATUS
Tax-exempt status is not automatic. An Application for Recognition of Exemption [Form 1023] must
be filed within 15 months after the private foundation is organized. Filing within this period will permit
tax-exempt status from the date the foundation is formed. A late-filed application will be effective as
of the date it is filed. Contributions to the foundation are tax-deductible only if made after the
effective date of the application. Therefore, any contributions to the foundation before the filing date
of a late-filed application are not tax-deductible.
REPORTING REQUIREMENTS
Private foundations are required to file annual information returns, Form 990-PF, somewhat similar to
the tax returns required of individuals and business entities. A copy of this form must be sent to the
State Attorney General. For calendar-year organizations, which most private foundations are, this
return is due May 15. If the foundation, or any person or other entity, is liable for one of the excise
taxes discussed below, the foundation or person (or entity) must file a Form 4720 reporting the excise
tax. Private foundations with employees are required to withhold Social Security and Income taxes
from the employees’ wages, file quarterly returns, and make any required deposits. Charitable
organizations, including private foundations, are required to make available for public inspection its
exemption application, the IRS determination letter, and its annual information return for the
preceding three years.
TYPES OF PRIVATE FOUNDATIONS
There are several different types of private foundations, with the distinguishing characteristics
primarily in how the foundation is funded, the purpose of the foundation, and the distribution of
management and control. The standard private foundation is the most common because this form
permits the founder to retain control of the foundation, within limits, and does not require a
substantial amount of time and effort to comply with the applicable requirements. The most important
fact that the founder of a private foundation, or anyone in a management position of a private
foundation, must keep in mind is that the tax-exempt status of the foundation comes at the price of
limitations on the use of the foundation’s assets. The assets effectively belong to the public and must
be dedicated to use in some qualifying charitable purpose. This dedication of purpose includes the
requirement that if the private foundation terminates its tax-exempt status, all of its assets must be
transferred to another tax-exempt organization, or the foundation will be subject to a “termination
tax”, generally equal to 100% of the value of the foundation’s assets.
DISQUALIFIED PERSON
The basic concept underlying the restrictions imposed on private foundations is the prevention of
improper tax benefits being obtained by a “disqualified person”. In general, a disqualified person is a
person [including an individual, corporation, partnership, trust, or estate] that has a particular, usually
intimate, relationship with the private foundation and thus stands in a position to exert influence over
the foundation. Categories of disqualified persons include: Substantial Contributors; Foundation
Managers; Twenty-percent Owners; Family Members; and Corporations, Partnerships, Trusts, and
Estates.
A Substantial Contributor is a person whose aggregate contributions to the private foundation, during
its entire existence, exceeds both $5,000 and 2% of the total contributions received by the private
foundation.
A Foundation Manager is any director, officer, or trustee of a private foundation, or any person having
similar powers or responsibilities.
A Twenty-percent Owner is any person who owns more than 20% of a corporation, partnership, trust, or
other enterprise that is a substantial contributor with respect to the private foundation.
A Family Member of any substantial contributor, foundation manager, or 20 percent owner is also a
disqualified person. A family member of a disqualified person includes a spouse, ancestor, child,
grandchild, great-grandchild, or spouse of a child, grandchild, or great-grandchild.
If one or more disqualified persons own an aggregate of 35% or more of a Corporation, Partnership,
Trust, or Estate, it also is a disqualified person.
EXCISE TAXES ON PROHIBITED ACTS
There are six excise taxes that are specifically applicable to private foundations. These excise taxes
are imposed with respect to a private foundation:
terms of more than one tax, each of the applicable taxes may be imposed. The tax on net investment
income, although technically an excise tax, is in essence an income tax. The remaining five excise taxes
are imposed on “prohibited acts”. As stated previously, the latter taxes were enacted to prevent
foundations from obtaining improper advantages from their tax-exempt status. In addition to the taxes
imposed on a prohibited act, the foundation is required to “correct” the transaction, which generally
means the foundation must reverse the transaction to the extent possible. The tax imposed does not
reduce the amount by which the transaction must be corrected. However, apart from the tax on acts of
self-dealing, the tax will generally be abated if the transaction is reversed within a prescribed period of
time.
NET INVESTMENT INCOME [§ 4940]
An excise tax of two-percent is imposed on the net investment income of the private foundation. This
2% rate may be lowered to 1% if the private foundation meets certain distribution requirements in the
current and preceding taxable years. In general, the taxable amount is the foundation’s investment
income [i.e., interest, dividends, rents, royalties, and certain capital gains or losses] less the expenses
incurred in producing this income. The tax due under this provision is subject to the estimated tax
deposit rules, so quarterly estimated payments must be made. The tax, along with any amount due or
to be refunded, is reported on the Form 990-PF.
SELF-DEALING [§ 4941]
An excise tax may be imposed if the foundation engages in any “act of self-dealing” with a disqualified
person. In general, any transaction between a foundation and a disqualified person [with respect to
that foundation] is an act of self-dealing, regardless of whether the transaction is at fair market value
or even of greater benefit to the foundation. Specifically, any sale or exchange of property between a
foundation and a disqualified person is prohibited. A foundation may pay a disqualified person who is a
foundation manager or employee reasonable compensation for services performed, and also may
reimburse such a person for other reasonable expenses of the disqualified person incurred in
performing services for the foundation. A no-interest loan [or furnishing goods, services, or facilities
without charge] may be made from a disqualified person to the foundation, but only if the loan [or
goods, services, or facilities] is used exclusively for a charitable purpose. A loan charging any interest
is prohibited, whether to or from a disqualified person. A disqualified person may receive goods,
services, or facilities from a foundation only if: 1) the terms are no more favorable than given to the
general public; 2) there is a substantial number of non-disqualified persons who actually utilize the
relevant goods, services, or facilities; and 3) the goods, services, or facilities furnished are functionally
related to the foundation’s charitable purpose.
The tax is imposed on both the disqualified person who engaged in the self-dealing act and any
foundation manager who approved the self-dealing act. Each tax is based on the value of the self-
dealing act and is in two parts – an initial tax, and a second-tier tax that is imposed only if the self-
dealing act is not reversed within a prescribed period. Even if the second-tier tax is imposed, it may be
abated if the self-dealing act is reversed within an certain period of time.
MANDATORY DISTRIBUTIONS [§ 4942]
Private foundations are required to distribute funds annually, rather than retain all of its income, in
an amount generally equal to 5% of the fair market value of the foundation’s assets that are not
directly used in accomplishing its exempt purposes. These required distributions cannot be for any
purpose, but must either be directly spent in accomplishing the foundation’s exempt purposes or paid
to acquire assets that are directly used to accomplish its exempt purposes. Expenditures related to
investment activities are not qualified distributions, even if the investment income is used to fund the
foundation’s exempt activities. The foundation must make the required distributions for a year by the
last day of the following year. Thus, the foundation has two years in which to make the distributions
required for any particular year.
An initial tax is imposed on the amount by which the required distributions exceed the actual
distributions. A second-tier tax of 100% of this excess required distribution is imposed if the excess is
not distributed within a prescribed period. Even if this second-tier tax is imposed, it may be abated if
the amount remaining undistributed is properly distributed within an additional period of time. Both
the initial tax and second-tier tax are imposed on the foundation and are imposed for each year in
which an amount remains undistributed. This means that the same undistributed income may be taxed
multiple times if it remains undistributed for two or more years beyond the allowable period. No tax is
imposed on a foundation manager or any other person for not making the required distributions. The
taxes imposed on undistributed income are in addition to the required distributions. This means that
even if the foundation pays the tax, it still must make the distributions in the amount initially required.
RETAINED EXCESS BUSINESS HOLDINGS [§ 4943]
Private foundations are only permitted to hold relatively small interests in businesses [whether a
corporation, partnership, or other type of entity], in order to prevent the private foundation from being
used to operate the family business while deriving the tax-exempt benefits of private foundation
status. In addition to the interest in a business directly held by a private foundation, the interests held
in that business by any disqualified persons are included in determining whether there are retained
excess business holdings. In general, a foundation may own a maximum interest of 20% in a business,
less the aggregate amount of any interests owned by all disqualified persons. Thus, if one disqualified
person owns 7% of a corporation’s stock and another disqualified person owns 10% of that corporation’
s stock, the foundation can own no more than 3% of that corporation’s stock. If the business entity is
in fact controlled by one or more people, none of who are disqualified persons, the 20% figure is
increased to 35 percent. If a foundation receives a gift or bequest of an interest in a business entity
that either creates or increases the amount of the excess business holdings of a foundation, the
foundation has a 5-year grace period to dispose of the excess business holding caused by the gift or
bequest without incurring this tax.
An initial tax of 5% of the value of the excess business holdings is imposed on the foundation. The
valuation of the excess holdings in each business enterprise is made as of the date on which the excess
holdings in that enterprise were the greatest. Thus, if there are excess holdings in 2 or more business
enterprises, the valuation of each may occur on different days. In addition, this tax is imposed for each
year in which there is a retained excess business holding as of the last day of the year. Thus, if the
same excess business holding is retained for more than one year, it may be subject to taxation more
than once. A second-tier tax of 200% of excess business holdings is imposed if the excess amount is
not disposed of within a prescribed period. Even if this second-tier tax is imposed, it may be abated if
the excess holdings are properly disposed of within an additional period of time. Both the initial tax
and second-tier tax are imposed on the foundation. No tax is imposed on a foundation manager or any
other person for retaining the excess business holdings.
JEOPARDIZING INVESTMENTS [§ 4944]
In order to protect the foundation’s ability to fund its exempt purposes, investments that jeopardize
the assets of the foundation are prohibited. In general, a jeopardizing investment is an investment
that, in the context of the foundation’s portfolio as a whole, is not a prudent investment that provides
for the foundation’s long- and short-term financial needs to accomplish its charitable purposes. While
no type of investment is strictly prohibited, there are certain investments that will be closely
scrutinized by the IRS. These include: trading in securities on margin; trading in commodity futures;
investments in working interests in oil and gas wells; the purchase of puts, calls, and straddles; the
purchase of warrants; and selling short. However, even one of the preceding investments will not be
deemed jeopardizing in a sufficiently large and properly diversified portfolio.
There are two major exceptions to this tax. First, if a foundation gratuitously receives an investment,
that investment is not jeopardizing. However, if the foundation transfers any property in consideration
for the investment, the value of the property transferred must be evaluated as potentially
jeopardizing. The second exception is for “program-related investments”. A program-related
investment is an investment with a primary purpose of accomplishing the foundation’s charitable
purposes and that has no significant purpose as an income-producing investment. Examples of
program-related investments may include low-interest loans to disabled people to enable them to
purchase and convert vehicles suitable to their disabilities, providing low-interest loans to minorities to
aid them in establishing their own businesses, or providing low-interest loans or scholarships to enable
low-income people to attend college.
The tax is imposed for each year in which there is an amount deemed to be a jeopardizing investment.
Thus, if the same jeopardizing investment is retained for more than one year, it may be subject to
taxation more than once. A second-tier tax may be imposed on the foundation if the jeopardizing
investment is not disposed of within a prescribed period. A second-tier tax is imposed on any
foundation manager who knowingly participated in making the jeopardizing investment if the
jeopardizing investment is not disposed of within a prescribed period. Even if these second-tier taxes
are imposed, they may be abated if the jeopardizing investment is properly disposed of within an
additional period of time.
TAXABLE EXPENDITURES [§ 4945]
In order to prevent the use of the tax-exempt funds of a private foundation in non-exempt activities, a
tax is imposed on distributions and expenditures that fall within certain categories, called “taxable
expenditures”. These categories are: 1) attempts to influence legislation; 2) attempts to influence
specific elections; 3) grants to individuals for study, travel, and similar purposes; 4) grants to
organizations other than certain public charities; and 5) grants for any purpose other than religious,
charitable, scientific, literary, or educational purposes, or to foster national or international amateur
sports competition [but only if no part of its activities involve the provision of athletic facilities or
equipment], or for the prevention of cruelty to children or animals. Each of these categories contains
exceptions that permit expenditures that would otherwise be prohibited, if certain requirements are
met. For example, a foundation may expend funds in the performance of certain limited acts intended
to influence legislation, if the legislation would affect its existence or rights. Grants to individuals and
organizations may also fall within an exception to the general prohibitions if the foundation imposes
specified restrictions on the recipient’s use of the grant funds and performs certain “supervising”
responsibilities to verify that the funds are properly used. Many grants that meet the definition of
“program-related investments” would be prohibited as for a non-exempt purpose but for a specific
exception for program-related investments. There are several other exceptions, each of which contains
detailed requirements that must be met in order to qualify for the exception.
An initial tax of 10% of the amount of the taxable expenditure is imposed on the foundation. An
initial tax of 2½ percent of the amount of the taxable expenditure is imposed on any foundation
manager who knowingly agreed to the taxable expenditure. A second-tier tax of 100% of the amount
of the jeopardizing investment is imposed on the foundation if the taxable expenditure is not corrected
within a prescribed period. A second-tier tax of 25% of the amount of the jeopardizing investment is
imposed on any foundation manager who knowingly agreed to the jeopardizing investment if the
jeopardizing investment is not corrected within a prescribed period. Even if these second-tier taxes are
imposed, they may be abated if the jeopardizing investment is properly disposed of within an additional
period of time.
PENALTY TAX [§ 6684]
A person who becomes liable for any of the preceding taxes, after having been previously liable for any
of the taxes, is also subject to a penalty equal to the amount of the tax currently imposed.
TERMINATION TAX [§ 507]
A foundation may voluntarily terminate its tax-exempt status by notifying the IRS. The IRS may
involuntarily terminate the tax-exempt status of a foundation if the foundation is abusing its tax-
exempt status. Unless the foundation transfers all of its assets to a qualified organization, which is
generally limited to certain types of public charities, the foundation is subject to a tax which will
normally be equal to 100% of the value of its net assets at the time of the termination. The
terminating foundation’s assets may also be transferred to certain other private foundations, but only
if numerous conditions are met. The termination tax was mentioned in the introduction, under
“Creating and Ending Private Foundations”. The purpose for this tax is the same as each of the
preceding taxes [except for the tax on net investment income] ― the prevention of abuse by the
foundation, and its managers, of its tax-exempt status.
SUMMARY
It is essential to keep in mind that, although called a “private” foundation, it is really a “public”
organization and must be operated accordingly. Thus, once assets are placed in a foundation, they
must be dedicated to some public benefit and not for personal gain. However, because the private
foundation organization does permit control over the assets, within limits, the donor/founder is able to
provide a public benefit, but still largely determine how to go about doing so. In conclusion, the private
foundation permits the donor/founder to gain the satisfaction of personally doing something good for
his or her neighbor, and obtain a tax benefit at the same time.
INTRODUCTION
A private foundation is a charitable organization exempt from Federal income tax under I.R.C. Section
501(c)(3). This is the same provision under which churches, schools & universities, hospitals, and
similar organizations [called “public charities” to differentiate them from “private foundations”] are
exempted from Federal income taxes. This is not a blanket tax exemption. Charitable organizations
must still pay sales taxes and property taxes [and possibly state income taxes], unless the organization
obtains specific approval for exemption from these taxes from the State. Nebraska income taxation
generally follows Federal taxation, so an organization exempt from Federal income tax will normally be
exempt from Nebraska income tax. This is not necessarily true for every state, so it is important to
know in advance which state you intend to operate under. In addition, if the organization operates a
business that is not substantially related to the organization’s charitable purpose, the net income from
the business is subject to the Unrelated Business Income Tax (UBIT).
A charitable organization is presumed to be a private foundation. Private foundations are typically
controlled by only a few people, often family or close friends of the founder. They are also generally
funded almost exclusively by these same people. This small control group makes private foundations
more susceptible to abuse of the advantages of tax-exempt status than a public charity, such as a
church or college. In order to prevent private foundations from being used improperly, Congress has
enacted several Federal excise taxes that specifically apply to private foundations, despite the tax
exemption of § 501(c)(3).
ESTABLISHING TAX-EXEMPT STATUS
Tax-exempt status is not automatic. An Application for Recognition of Exemption [Form 1023] must
be filed within 15 months after the private foundation is organized. Filing within this period will permit
tax-exempt status from the date the foundation is formed. A late-filed application will be effective as
of the date it is filed. Contributions to the foundation are tax-deductible only if made after the
effective date of the application. Therefore, any contributions to the foundation before the filing date
of a late-filed application are not tax-deductible.
REPORTING REQUIREMENTS
Private foundations are required to file annual information returns, Form 990-PF, somewhat similar to
the tax returns required of individuals and business entities. A copy of this form must be sent to the
State Attorney General. For calendar-year organizations, which most private foundations are, this
return is due May 15. If the foundation, or any person or other entity, is liable for one of the excise
taxes discussed below, the foundation or person (or entity) must file a Form 4720 reporting the excise
tax. Private foundations with employees are required to withhold Social Security and Income taxes
from the employees’ wages, file quarterly returns, and make any required deposits. Charitable
organizations, including private foundations, are required to make available for public inspection its
exemption application, the IRS determination letter, and its annual information return for the
preceding three years.
TYPES OF PRIVATE FOUNDATIONS
There are several different types of private foundations, with the distinguishing characteristics
primarily in how the foundation is funded, the purpose of the foundation, and the distribution of
management and control. The standard private foundation is the most common because this form
permits the founder to retain control of the foundation, within limits, and does not require a
substantial amount of time and effort to comply with the applicable requirements. The most important
fact that the founder of a private foundation, or anyone in a management position of a private
foundation, must keep in mind is that the tax-exempt status of the foundation comes at the price of
limitations on the use of the foundation’s assets. The assets effectively belong to the public and must
be dedicated to use in some qualifying charitable purpose. This dedication of purpose includes the
requirement that if the private foundation terminates its tax-exempt status, all of its assets must be
transferred to another tax-exempt organization, or the foundation will be subject to a “termination
tax”, generally equal to 100% of the value of the foundation’s assets.
DISQUALIFIED PERSON
The basic concept underlying the restrictions imposed on private foundations is the prevention of
improper tax benefits being obtained by a “disqualified person”. In general, a disqualified person is a
person [including an individual, corporation, partnership, trust, or estate] that has a particular, usually
intimate, relationship with the private foundation and thus stands in a position to exert influence over
the foundation. Categories of disqualified persons include: Substantial Contributors; Foundation
Managers; Twenty-percent Owners; Family Members; and Corporations, Partnerships, Trusts, and
Estates.
A Substantial Contributor is a person whose aggregate contributions to the private foundation, during
its entire existence, exceeds both $5,000 and 2% of the total contributions received by the private
foundation.
A Foundation Manager is any director, officer, or trustee of a private foundation, or any person having
similar powers or responsibilities.
A Twenty-percent Owner is any person who owns more than 20% of a corporation, partnership, trust, or
other enterprise that is a substantial contributor with respect to the private foundation.
A Family Member of any substantial contributor, foundation manager, or 20 percent owner is also a
disqualified person. A family member of a disqualified person includes a spouse, ancestor, child,
grandchild, great-grandchild, or spouse of a child, grandchild, or great-grandchild.
If one or more disqualified persons own an aggregate of 35% or more of a Corporation, Partnership,
Trust, or Estate, it also is a disqualified person.
EXCISE TAXES ON PROHIBITED ACTS
There are six excise taxes that are specifically applicable to private foundations. These excise taxes
are imposed with respect to a private foundation:
- 1) Net investment income [§ 4940];
2) Acts of self-dealing [§ 4941];
3) Undistributed income [§ 4942];
4) Retained excess business holdings [§ 4943];
5) Jeopardizing investments [§ 4944]; and
6) Taxable expenditures [§ 4945].
terms of more than one tax, each of the applicable taxes may be imposed. The tax on net investment
income, although technically an excise tax, is in essence an income tax. The remaining five excise taxes
are imposed on “prohibited acts”. As stated previously, the latter taxes were enacted to prevent
foundations from obtaining improper advantages from their tax-exempt status. In addition to the taxes
imposed on a prohibited act, the foundation is required to “correct” the transaction, which generally
means the foundation must reverse the transaction to the extent possible. The tax imposed does not
reduce the amount by which the transaction must be corrected. However, apart from the tax on acts of
self-dealing, the tax will generally be abated if the transaction is reversed within a prescribed period of
time.
NET INVESTMENT INCOME [§ 4940]
An excise tax of two-percent is imposed on the net investment income of the private foundation. This
2% rate may be lowered to 1% if the private foundation meets certain distribution requirements in the
current and preceding taxable years. In general, the taxable amount is the foundation’s investment
income [i.e., interest, dividends, rents, royalties, and certain capital gains or losses] less the expenses
incurred in producing this income. The tax due under this provision is subject to the estimated tax
deposit rules, so quarterly estimated payments must be made. The tax, along with any amount due or
to be refunded, is reported on the Form 990-PF.
SELF-DEALING [§ 4941]
An excise tax may be imposed if the foundation engages in any “act of self-dealing” with a disqualified
person. In general, any transaction between a foundation and a disqualified person [with respect to
that foundation] is an act of self-dealing, regardless of whether the transaction is at fair market value
or even of greater benefit to the foundation. Specifically, any sale or exchange of property between a
foundation and a disqualified person is prohibited. A foundation may pay a disqualified person who is a
foundation manager or employee reasonable compensation for services performed, and also may
reimburse such a person for other reasonable expenses of the disqualified person incurred in
performing services for the foundation. A no-interest loan [or furnishing goods, services, or facilities
without charge] may be made from a disqualified person to the foundation, but only if the loan [or
goods, services, or facilities] is used exclusively for a charitable purpose. A loan charging any interest
is prohibited, whether to or from a disqualified person. A disqualified person may receive goods,
services, or facilities from a foundation only if: 1) the terms are no more favorable than given to the
general public; 2) there is a substantial number of non-disqualified persons who actually utilize the
relevant goods, services, or facilities; and 3) the goods, services, or facilities furnished are functionally
related to the foundation’s charitable purpose.
The tax is imposed on both the disqualified person who engaged in the self-dealing act and any
foundation manager who approved the self-dealing act. Each tax is based on the value of the self-
dealing act and is in two parts – an initial tax, and a second-tier tax that is imposed only if the self-
dealing act is not reversed within a prescribed period. Even if the second-tier tax is imposed, it may be
abated if the self-dealing act is reversed within an certain period of time.
MANDATORY DISTRIBUTIONS [§ 4942]
Private foundations are required to distribute funds annually, rather than retain all of its income, in
an amount generally equal to 5% of the fair market value of the foundation’s assets that are not
directly used in accomplishing its exempt purposes. These required distributions cannot be for any
purpose, but must either be directly spent in accomplishing the foundation’s exempt purposes or paid
to acquire assets that are directly used to accomplish its exempt purposes. Expenditures related to
investment activities are not qualified distributions, even if the investment income is used to fund the
foundation’s exempt activities. The foundation must make the required distributions for a year by the
last day of the following year. Thus, the foundation has two years in which to make the distributions
required for any particular year.
An initial tax is imposed on the amount by which the required distributions exceed the actual
distributions. A second-tier tax of 100% of this excess required distribution is imposed if the excess is
not distributed within a prescribed period. Even if this second-tier tax is imposed, it may be abated if
the amount remaining undistributed is properly distributed within an additional period of time. Both
the initial tax and second-tier tax are imposed on the foundation and are imposed for each year in
which an amount remains undistributed. This means that the same undistributed income may be taxed
multiple times if it remains undistributed for two or more years beyond the allowable period. No tax is
imposed on a foundation manager or any other person for not making the required distributions. The
taxes imposed on undistributed income are in addition to the required distributions. This means that
even if the foundation pays the tax, it still must make the distributions in the amount initially required.
RETAINED EXCESS BUSINESS HOLDINGS [§ 4943]
Private foundations are only permitted to hold relatively small interests in businesses [whether a
corporation, partnership, or other type of entity], in order to prevent the private foundation from being
used to operate the family business while deriving the tax-exempt benefits of private foundation
status. In addition to the interest in a business directly held by a private foundation, the interests held
in that business by any disqualified persons are included in determining whether there are retained
excess business holdings. In general, a foundation may own a maximum interest of 20% in a business,
less the aggregate amount of any interests owned by all disqualified persons. Thus, if one disqualified
person owns 7% of a corporation’s stock and another disqualified person owns 10% of that corporation’
s stock, the foundation can own no more than 3% of that corporation’s stock. If the business entity is
in fact controlled by one or more people, none of who are disqualified persons, the 20% figure is
increased to 35 percent. If a foundation receives a gift or bequest of an interest in a business entity
that either creates or increases the amount of the excess business holdings of a foundation, the
foundation has a 5-year grace period to dispose of the excess business holding caused by the gift or
bequest without incurring this tax.
An initial tax of 5% of the value of the excess business holdings is imposed on the foundation. The
valuation of the excess holdings in each business enterprise is made as of the date on which the excess
holdings in that enterprise were the greatest. Thus, if there are excess holdings in 2 or more business
enterprises, the valuation of each may occur on different days. In addition, this tax is imposed for each
year in which there is a retained excess business holding as of the last day of the year. Thus, if the
same excess business holding is retained for more than one year, it may be subject to taxation more
than once. A second-tier tax of 200% of excess business holdings is imposed if the excess amount is
not disposed of within a prescribed period. Even if this second-tier tax is imposed, it may be abated if
the excess holdings are properly disposed of within an additional period of time. Both the initial tax
and second-tier tax are imposed on the foundation. No tax is imposed on a foundation manager or any
other person for retaining the excess business holdings.
JEOPARDIZING INVESTMENTS [§ 4944]
In order to protect the foundation’s ability to fund its exempt purposes, investments that jeopardize
the assets of the foundation are prohibited. In general, a jeopardizing investment is an investment
that, in the context of the foundation’s portfolio as a whole, is not a prudent investment that provides
for the foundation’s long- and short-term financial needs to accomplish its charitable purposes. While
no type of investment is strictly prohibited, there are certain investments that will be closely
scrutinized by the IRS. These include: trading in securities on margin; trading in commodity futures;
investments in working interests in oil and gas wells; the purchase of puts, calls, and straddles; the
purchase of warrants; and selling short. However, even one of the preceding investments will not be
deemed jeopardizing in a sufficiently large and properly diversified portfolio.
There are two major exceptions to this tax. First, if a foundation gratuitously receives an investment,
that investment is not jeopardizing. However, if the foundation transfers any property in consideration
for the investment, the value of the property transferred must be evaluated as potentially
jeopardizing. The second exception is for “program-related investments”. A program-related
investment is an investment with a primary purpose of accomplishing the foundation’s charitable
purposes and that has no significant purpose as an income-producing investment. Examples of
program-related investments may include low-interest loans to disabled people to enable them to
purchase and convert vehicles suitable to their disabilities, providing low-interest loans to minorities to
aid them in establishing their own businesses, or providing low-interest loans or scholarships to enable
low-income people to attend college.
The tax is imposed for each year in which there is an amount deemed to be a jeopardizing investment.
Thus, if the same jeopardizing investment is retained for more than one year, it may be subject to
taxation more than once. A second-tier tax may be imposed on the foundation if the jeopardizing
investment is not disposed of within a prescribed period. A second-tier tax is imposed on any
foundation manager who knowingly participated in making the jeopardizing investment if the
jeopardizing investment is not disposed of within a prescribed period. Even if these second-tier taxes
are imposed, they may be abated if the jeopardizing investment is properly disposed of within an
additional period of time.
TAXABLE EXPENDITURES [§ 4945]
In order to prevent the use of the tax-exempt funds of a private foundation in non-exempt activities, a
tax is imposed on distributions and expenditures that fall within certain categories, called “taxable
expenditures”. These categories are: 1) attempts to influence legislation; 2) attempts to influence
specific elections; 3) grants to individuals for study, travel, and similar purposes; 4) grants to
organizations other than certain public charities; and 5) grants for any purpose other than religious,
charitable, scientific, literary, or educational purposes, or to foster national or international amateur
sports competition [but only if no part of its activities involve the provision of athletic facilities or
equipment], or for the prevention of cruelty to children or animals. Each of these categories contains
exceptions that permit expenditures that would otherwise be prohibited, if certain requirements are
met. For example, a foundation may expend funds in the performance of certain limited acts intended
to influence legislation, if the legislation would affect its existence or rights. Grants to individuals and
organizations may also fall within an exception to the general prohibitions if the foundation imposes
specified restrictions on the recipient’s use of the grant funds and performs certain “supervising”
responsibilities to verify that the funds are properly used. Many grants that meet the definition of
“program-related investments” would be prohibited as for a non-exempt purpose but for a specific
exception for program-related investments. There are several other exceptions, each of which contains
detailed requirements that must be met in order to qualify for the exception.
An initial tax of 10% of the amount of the taxable expenditure is imposed on the foundation. An
initial tax of 2½ percent of the amount of the taxable expenditure is imposed on any foundation
manager who knowingly agreed to the taxable expenditure. A second-tier tax of 100% of the amount
of the jeopardizing investment is imposed on the foundation if the taxable expenditure is not corrected
within a prescribed period. A second-tier tax of 25% of the amount of the jeopardizing investment is
imposed on any foundation manager who knowingly agreed to the jeopardizing investment if the
jeopardizing investment is not corrected within a prescribed period. Even if these second-tier taxes are
imposed, they may be abated if the jeopardizing investment is properly disposed of within an additional
period of time.
PENALTY TAX [§ 6684]
A person who becomes liable for any of the preceding taxes, after having been previously liable for any
of the taxes, is also subject to a penalty equal to the amount of the tax currently imposed.
TERMINATION TAX [§ 507]
A foundation may voluntarily terminate its tax-exempt status by notifying the IRS. The IRS may
involuntarily terminate the tax-exempt status of a foundation if the foundation is abusing its tax-
exempt status. Unless the foundation transfers all of its assets to a qualified organization, which is
generally limited to certain types of public charities, the foundation is subject to a tax which will
normally be equal to 100% of the value of its net assets at the time of the termination. The
terminating foundation’s assets may also be transferred to certain other private foundations, but only
if numerous conditions are met. The termination tax was mentioned in the introduction, under
“Creating and Ending Private Foundations”. The purpose for this tax is the same as each of the
preceding taxes [except for the tax on net investment income] ― the prevention of abuse by the
foundation, and its managers, of its tax-exempt status.
SUMMARY
It is essential to keep in mind that, although called a “private” foundation, it is really a “public”
organization and must be operated accordingly. Thus, once assets are placed in a foundation, they
must be dedicated to some public benefit and not for personal gain. However, because the private
foundation organization does permit control over the assets, within limits, the donor/founder is able to
provide a public benefit, but still largely determine how to go about doing so. In conclusion, the private
foundation permits the donor/founder to gain the satisfaction of personally doing something good for
his or her neighbor, and obtain a tax benefit at the same time.
 |