Tax-Exempt and Nonprofit Organizations

We provide advice to tax-exempt and nonprofit organizations. Anyone considering establishing a tax-exempt organization or nonprofit organization should understand this area of tax law is full of minefields. Advisors often tell clients to utilize private foundations for tax purposes. Congress chose to define private foundations as follows. All Section 501(c)(3) organizations that are not described in Section 509(a)(1)-(4) are private foundations. In other words, a Section 501(c)(3) organization is a private foundation unless it meets a certain test or definition. An organization described in Internal Revenue Code Section 170(b)(1)(A)(i) through (vi) is not a private foundation. Those organizations are:

1. Church or convention of churches;
2. School, i.e., an educational organization which maintains a regular faculty and student body;
3. Hospital or a medical research organization engaged in medical research in conjunction with the hospital;
4. Foundation of state supported by a college or university;
5. State possession or political subdivision;
6. Organization that receives substantial support from the public or the government.

Private Foundation Excise Tax

Private foundations are subject to a set of excise tax rules designated to stop the abuses perceived by Congress to exist in 1969. The excise taxes range from 10 percent to 200 percent of the amount involved. If a private foundation or disqualified person (discussed below) engages in one of the acts Congress sought to prohibit, the Internal Revenue Code imposes an excise tax on either or both the foundation and the disqualified person. Below is a summary described of each of the excise taxes and the mechanics or application of the excise taxes.

There are two tiers of each tax. Level one is the tax imposed on the initial transaction. For example, the self-dealing (discussed below) 10 percent tax is imposed when it is discovered by the IRS. The organization and self-dealer are required to correct, or undo, the prohibited act of self-dealing within the correction period. If the act is not corrected, then a second level tax of 200 percent self-dealing tax is imposed. This means, if you receive a notice of a 10 percent tax for an act of self-dealing, you must act immediately in order to avoid a very serious second-tier 200 percent penalty.

Also, the organization’s board of directors or trustees can be subject to excise tax. For illustration purposes, the first level of tax imposed on foundation managers in self-dealing transactions is 5 percent and the second level of tax is 50 percent. The tax on foundation managers applies only if the foundation manager “knowingly” participates in the transaction or permits the transaction. Knowingly means the foundation manager understood the transaction was prohibited and continued to move forward with it.

There is a correction period that applies to the second tier tax. The correction period is the period of time within which the taxable event must be corrected to avoid the second tier tax. The correction period is the period beginning with the date of the event giving rise to the tax and ending 90 days after the mailing under Section 6212 of the notice of deficiency with respect to the second tier tax.

Disqualified Persons

A key player for purposes of the private foundation rules is a “disqualified person.” Internal Revenue Code Section 4946(a)(1) defines a disqualified person as follows:

1. a foundation manager (board member), officer, etc;
2. A substantial contributor (contributes more than 2 percent of the foundation’s total contributions);
3. 20 percent owners of substantial contributions, e.g., a corporate substantial contributor;
4. Family members of foundation managers or substantial contributors;
5. Government officials.

Foundation Manager Defined

A foundation manager is anyone who has the ability to participate in a decision with respect to the transaction in question. The term includes officers, directors, and trustees of the foundation, as well as employees who have authority or responsibility with respect to the transaction.

“Substantial Contributor” Defined

A “substantial contributor” means any person who has contributed or bequeathed an aggregate amount of more than $5,000 to the foundation, provided that this aggregate amount was more than 2 percent of the total contributions and bequests ever received by the foundation.

20 Percent Owners of Substantial Contributors

An owner of more than 20 percent of substantial contributors is defined as more than 20 percent of: 1) the total combined voting power of a corporation; 2) the profits interest of a partnership, or 3) the beneficial interest of a trust or unincorporated enterprise, which is a substantial contributor to the foundation.

Family Members of Foundation Managers or Substantial Contributors Defined

Family members of a manager or substantial contributors is defined as a spouse, ancestor, child, grandchild, or great-grandchild.

Acts of Self-Dealing

If the donor contemplates that any dealings between the foundation and disqualified persons will occur after the foundation is funded, other than 1) the payment of reasonable compensation for services and 2) the furnishing of goods and services to the foundation without charge, a private foundation will be an unsuitable vehicle for the donor’s needs.

Any disqualified person who participates in a self-dealing transaction must pay a tax of 10 percent of the amount involved for each year that the transaction remains uncorrected. A penalty of 200 percent of the amount involved is also imposed on the disqualified person engaging in the self-dealing if the initial 10 percent tax was assessed and the transaction is not timely corrected.

Generally, self-dealing occurs when:

A disqualified person and the private foundation enter into a transaction with each other (e.g., selling, exchanging or leasing property; lending money; or furnishing goods, services, or facilities);

The private foundation compensates or pays the expenses of a disqualified person;

The private foundation’s income or assets are used by or for the benefit of a disqualified person.

Self-dealing can occur in the following example:

Foundation, which owns artwork, allows a disqualified person to display the art work at his home in exchange for the disqualified person’s agreement to bear the cost of properly maintaining the art. This is self-dealing.

“Permissible” Self-Dealing

There are some exceptions to the self-dealing prohibitions. For example, a private foundation can pay reasonable compensation to a disqualified person. Hence, Child can work for Dad’s foundation, if the work is appropriate and the compensation is reasonable. See IRC Section 4941(d)(2)(E).

Can a Private Foundation Hold a Family Business

An individual may be tempted to place his or her closely held business in a foundation. If so, he or she must be aware of Internal Revenue Code Section 4943, which generally prohibits a private foundation from holding substantial interest in active businesses. Subject to a 2 percent de minimis rule, a private foundation is prohibited from holding more than 20 percent of the voting stock in any corporation holding an active business.

Investment Income Taxes

A private foundation is required to distribute each year an amount equal to 5 percent of the value of its non-charitable assets, for the most part, its investment assets. A private foundation that fails to make the minimum charitable distributions, the excise tax is 15 percent of the under distribution, and 100 percent of the under distribution if it is not corrected. As with most adjustments to a private foundation by the IRS, corrections must be made immediately to avoid a more significant second layer penalty. The amount required to be distributed is based on year end values. The distribution is required to be made prior to the end of the year following the year with respect to the distribution. A foundation that distributes more than the minimum may carry over the excess for a period of five years. The private foundation information return (Form 990PF) contains a schedule for keeping track of excess distributions. A qualifying distribution is generally any grant for a charitable purpose. Additionally, an organization can treat a reasonable portion of its expenses related to charitable activities as a qualifying distribution.

Jeopardizing Investments

In 1969, Congress believed that foundations were making speculative investments with foundation assets and thereby jeopardizing the existence of the foundation. Congress believed that foundations should invest prudently and, therefore, imposed an excess tax on any jeopardy investment. In general, a jeopardy investment is an investment made that does not adhere to the Prudent Investor Rules. In other words, although as not stated as such, Section 4944 imposes an excise tax on any investment that is not “prudent.”

Taxable Expenditures

A private foundation generally cannot: 1) make grants to individuals for travel, study, or similar purposes without advance IRS approval; 2) try to influence legislation or the outcome of any specific public election; 3) carry on a voter registration drive; 4) make a grant to an organization which is not a non charitable purpose. See IRC Section 4945.

These expenditures are known as taxable expenditures. A foundation that makes a taxable expenditure will be taxed on 10 percent of the amount of the expenditure, and the foundation manager who agrees to a payment knowing it was a taxable expenditure will incur a tax equal to 2.5 percent of the amount of the expenditure. Failure to timely correct the taxable expenditure will result in the imposition of a penalty tax on the foundation of 100 percent of the amount of the expenditure and a penalty of 50 percent of the amount of the expenditure on a foundation manager who refused to agree to part or all of the correction. “Timely” means the earlier of the date of mailing a deficiency with respect to the initial tax or the date the initial tax is assessed. This means, if the IRS challenges the expenditures of a private foundation, corrections must be done immediately to avoid a second more serious penalty.

The penalties discussed above are similar if tax-exempt organizations or other charitable organizations are not correctly established or operated. If you are considering establishing any type of nonprofit organization, we can profit you with guidance to avoid harsh penalties.