By Anthony Diosdi
This article has two subsections. The first part of this article discusses the penalties associated with incorrectly operating a private foundation. The second part of this article provides an overview of the declaratory judgment process involved in the litigation of the tax-exemption status of a private foundation.
Promoters of private foundations make private foundations sound like the perfect tax planning option. Here is how one promoter describes private foundations-
“Private Foundation or Family Foundation (PF) can let you control your legacy, reduce your income taxes and impact your values to future generations. Family foundations provide living donors with flexibility as to the trimming of gifts. For instance, a donor may in one year have particularly high income and wish to take full advantage of the income tax deduction for a cash gift to a foundation (individual taxpayers may deduct up to 30% of their adjusted gross income for cash gifts), without deciding in that same year on the final charitable recipients. In a subsequent lean year, the foundation will have available additional funds for giving that, in the meantime, have been earning virtually tax-free income. First of all, a private foundation is a special, not-for-profit entity. It is organized exclusively for charitable, educational, religious, scientific and literary purposes under Section 501(c)(3) of the Internal Revenue Code. It is a flexible entity that enables you to engage in a variety of innovative charitable strategies. You can attend local and national associations and fundraising meetings to learn best practice models and compare practices in the field.”
This explanation greatly oversimplifies how a private foundation operates and neglects to mention the stiff penalties the Internal Revenue Service (“IRS”) will assess against individuals who incorrectly operate private foundations. Private foundations are suitable for many situations, and are generally governed by some of the same rules that govern public charities. However, the activities of private foundations are subject to certain requirements and restrictions which, if violated, can result in the imposition of very harsh penalties. Consequently, if you established a private foundation or are involved with a private foundation, you must have a working knowledge of the tax laws governing private foundations. This article provides an overview of the tax laws governing private foundations.
Background- The 1969 Tax Reform Act
Charities were investigated by Congress, Treasury, and the IRS from 1961 until the 1969 Tax Reform Act. Actually, the investigations began in 1952, with the study of unrelated business income. All of the investigations culminated in 1969 with the 1969 Tax Reform Act. The conclusion of the various investigations was that family or closely held foundations needed to be regulated. The investigations found that there was unchecked 1) self-dealing; 2) failure to make distributions for charitable purposes; 3) excessive business involvement; 4) use of foundations to control closely held businesses; 5) non charitable activity, including politics; and 6) closed management. These were commonly accepted perceived abuses. In response, recommendations were made from the elimination of family foundations or limiting the time period they could exist to imposing excise taxes as was ultimately done. Congress concluded these abuses do not exist in publicly supported organizations or in organizations carrying on certain activities, such as universities and hospitals. The 1969 Tax Act therefore established two concepts. First, the concept (definition of) of a private foundation and, secondly, the concept of excise taxes that would prohibit/tax the abuses found to exist by Congress.
As indicated, Congress found that the abuses in the charity areas did not occur in charities supported by the public or charities involved in certain activities. Those public type charities had been eligible for favorable treatment for income tax deduction purposes in Internal Revenue Code Section 170. In other words, a contribution to a public type charity as defined in Section 170 is entitled to an enhanced income tax deduction.
Private Foundation
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.
Foundation Revocation Litigation
Should the IRS audit a private foundation, the fall out of an IRS audit of a foundation may not be limited to the penalties discussed above. The IRS may also seek to revoke the tax-exempt status of the organization. If the IRS revokes the tax-exempt status of a private foundation (or any other tax-exempt organization) and the foundation does not agree with the IRS’s decision to revoke its tax-exempt status, the foundation’s only option is to seek a declaratory judgment in federal court.
Internal Revenue Code Section 7428 provides the United States Tax Court, the United States Court of Federal Claims, and the United States district court for the District of Columbia with concurrent jurisdiction to issue a declaratory judgment with respect to the “initial or continuing qualification” of an organization as exempt from taxation under Section 501(c)(3) or as described under Section 170(c)(2), or the “initial or continuing classification” of an organization as a private foundation under Section 509(a) or as a private operating foundation under Section 4942(j)(3). Once a case is filed in one of these three courts, the other courts are permanently deprived of jurisdiction to hear the case.
A federal court can only adjudicate a declaratory judgment proceeding when: 1) when the action is commenced by a proper party (this means only the organization that is the subject of the declaratory judgment action can bring an action in court); 2) there is an actual controversy; 3) the IRS has made, or has failed to make, a “determination;” 4) the individual or organization bringing the case has exhausted all administrative remedies; and 5) the action is timely filed.
In order to bring an action in court within the parameters of Section 7428, the controversy must relate either to a determination made by the IRS or the failure by the IRS to make a determination as to the initial or continuing qualification or classification of the organization in question. For this purpose, a determination must be final, and the IRS must have issued the foundation a formal notice of determination. See Treas. Reg. Section 601.201(a)(3). A notice of deficiency does not constitute a final determination for this purpose.
An organization must exhaust the administrative remedies available to it prior to commencing an action in court. These administrative remedies are discussed in detail in the income tax regulations and Revenue Procedures. The rules discussed in the Regulations and Revenue Rulings require a foundation to request the IRS to make a determination, to provide the IRS with information it requests, and to exhaust all administrative rights. In the case of a proposed revocation, the obligation to request a determination from the IRS can generally be satisfied by a properly filed protest. The issuance of an adverse determination letter on the merits by the IRS will generally be considered by the courts as evidencing that the exhaustion requirements have been satisfied by a foundation.
When a foundation satisfies these administrative requirements, but the IRS fails to make a determination within 270 days after the date of the original request for determination, the foundation will be deemed to have exhausted its administrative remedies. See 7428(b)(2). Following the issuance of an adverse determination letter by the IRS, the foundation has 90 days from the mailing date of the letter within which to file a proceeding under Section 7428 in court. See IRC Section 7428(b)(3). If the IRS fails to issue a determination letter within 270 days after an initial request, the requesting foundation is permitted to file a Section 7428 action any time thereafter. To the extent the IRS does not issue a determination letter, the statute of limitations for filing suit in court remains open indefinitely.
Conclusion
Any disqualified persons who engage in acts of “self-dealings” or managers of foundations that do not make proper distributions can find themselves in deep trouble with the IRS. An audit of a foundation can also result in the seeking to revoke the tax-exempt status of a foundation. In many cases, this can trigger a significant tax liability to the individual or individuals that established the foundation. In certain cases, a foundation may seek a declaratory judgment in court regarding the IRS’s determination to revoke the tax-exempt status of a foundation. If you have established a private foundation that is being audited by the IRS, make sure you consult a tax attorney that understands the complexities of the laws governing foundations and significant experience litigating tax controversies in federal court..
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. He has more than 20 years of experience with tax-related matters, focusing on federal and state tax disputes. His experience covers a broad range of engagements at all stages of the IRS administrative process, including assisting with audits and litigation in the federal courts. Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in domestic and international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.