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Tax Exempt Organizations - DOC

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Tax Exempt Organizations - DOC Powered By Docstoc
					Tax Exempt Organizations
by David R. York, Esq., CPA and Lee S. McCullough, III, Esq. CALLISTER NEBEKER & McCULLOUGH Gateway Tower East, Suite 900 10 East South Temple Salt Lake City, Utah 84133 (801) 530-7300

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Tax Exempt Organizations 1. Internal Revenue Code Section 501(c)(3) Tax Exempt Organizations 1. Section 501(c)(3) organizations are the most common type of tax exempt organizations. They include organizations which are organized and operated exclusively for one of the following purposes: 1. 2. 3. 4. 5. 6. 7. 8. 2. 2. Religious Charitable Scientific Testing for public safety Literary Educational To foster national or international amateur sports competition For the prevention of cruelty to children or animals

Qualifying under Section 501(c)(3) is only the first half of the tax-exempt status analysis.

Internal Revenue Code Section 509 1. Pursuant to Section 509, all Section 501(c)(3) organizations are deemed to be private foundations (see Section III below) unless they fall under one of the following four exceptions: 1. 2. 3. They are certain “favored organizations” (509(a)(1)); They are publicly supported organizations (509(a)(2)); They are support organizations (509(a)(3));

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4.

They are organized exclusively for testing for public safety (509(a)(4)).

2.

Treatment as a private foundation is disadvantageous because private foundations are subject to excise tax penalties on self-dealing, excess business holdings, jeopardy investments and/or taxable expenditures. Private foundations are also subject to a flat excise tax on net investment income. Cash gifts to non-private foundations are deductible up to 50% of adjusted gross income, as opposed to the lower limits on gifts to private foundations. Favored Organizations - Internal Revenue Code Section 509(a)(1) 1. Section 509(a)(1) borrows the definition of “favored organizations” from Section 170(b)(1)(A) (which deals with limitations on the deductibility of charitable contributions) and include the following: (1) (2) (3) (4) (5) (6) 2. Churches or conventions of churches Educational organizations (see Section II(3)(C) below) Hospitals A university endowment foundation A State or possession of the United Stated Publicly Supported Organizations (see II(3)(D) below)

3.

These “favored organizations” are sometimes also called “50% Charities” because charitable contributions to these entities qualify for a charitable deduction of up to 50% of the donor’s AGI. Educational Organizations (1) The requirements to qualify as a Section 170(b)(1)(A) educational organization are much more strict than those for Section 501(c)(3).

3.

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(1)

Section 501(c)(3) - Defines “educational” as the instruction or training of the individual for the purposes of improving or developing his capabilities, or the instruction of the public on subjects useful to the individual and beneficial to the community. Section 170(b)(1)(A) - Defines “educational organization” as one which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where its educational activities are regularly carried on. Any non-qualifying activities must be merely incidental and growing out of the qualifying activities.

(2)

4.

Publicly Supported Organizations - pursuant to 509(a)(1) (1) Organizations qualify as publicly supported organizations for purposes of Section 170(b)(1)(A)(vi), and thus Section 509(a)(1), if they meet either of the following tests: (1) (2) (2) Mechanical Test Facts and Circumstances Test

Mechanical Test (1) At least 33 1/3% of the total support of the organization must come from the general public and the government (but not from income generated in the performance of its exempt activity, See 509(a)(2) publicly supported organizations below). (1) General Public - Non-disqualified persons (see Section III, Private Foundations, below as the definition of disqualified person for these purposes is borrowed from the private foundation rules) to the extent their

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support does not exceed 2% of the total support of the organization. (2) The one-third requirement is calculated based on a four year moving average. "Unusual grants" may be excluded for purposes of determining the 1/3 requirement if they: (a) come from disinterested parties who are attracted by reason of the publicly supported nature of the organization, (b) are unusual and unexpected and (c) by reason of their size would adversely affect the status of the organization under the one-third public support test. Grants paid over a number of years may be excluded in their entirety if they qualify as "unusual" grants.

(3)

(3)

Facts and Circumstances Test (1) If the facts and circumstances indicate that the organization will normally receive at least 10% of its support from contributions from the public and if the organization is organized and operated so as to attract new and additional public support on a continuous basis, it will satisfy the one-third public support test. Five factors enumerated in the regulations help the IRS to conduct the facts and circumstances test. These factors are as follows: (1) The higher the percentage of support above the 10% requirement from public (or governmental sources) the lesser will be the burden of establishing the publicly supported nature of the organization through other facts. The fact that an organization meets the 10% support requirement through 5

(2)

(2)

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support from governmental units or from a representative number of persons, rather than receiving almost all of its support from the members of a single family, will be taken into consideration in determining whether an organization is publicly supported. (3) The fact that an organization has a governing body that represents the broad interest of the public, rather than the personal and private interests of a limited number of donors will be taken into account. Providing facilities or services directly to the general public on a continuing basis is evidence that an organization is publicly supported. The following factors indicate public participation or involvement in an organization's operations and are considered as evidence that an organization is publicly supported: 1) Participation in or sponsorship of the organization's program by members of the general public who have special knowledge or expertise or who are public officials or community or civic leaders. Maintenance of a definite program by the organization to accomplish its charitable work in the community, such as slum clearance or development of employment opportunities. The receipt of a significant part of an organization's funds from a public charity or governmental agency to which the organization is held 6
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(4)

(5)

2)

3)

accountable in some way as a condition of the receipt of the funds. 4. Publicly Supported Organizations - Internal Revenue Code Section 509(a)(2) 1. The second exception to private foundation status is for organizations which: (1) Normally receive more than one-third of its support from gifts, grants, contributions, and gross receipts from its exempt activities, but not from an unrelated trade or business (See IRC Section 513); and Normally receives not more than one-third (1/3) of its support from gross investment income and unrelated business taxable income.

(2)

2.

Section 509(a)(2) is directed to organizations primarily supported by revenues from the performance of exempt activities. Section 170(b)(1)(A)(vi) is directed to organizations primarily supported by gifts, grants, and contributions. All Section 170(b)(1)(A)(vi) organizations qualify under Section 509(a)(1) as well as Section 509(a)(2), but not all Section 509(a)(2) organizations qualify under 170(b)(1)(A)(vi). A publicly supported organization would rather qualify under Section 509(a)(1) as opposed to Section 509(a)(2) because: (1) Section 509(a)(1) publicly supported organizations can be beneficiaries of a pooled income fund (Section 642(c)(5)); They are not subject to the 33 1/3% limitation on gross investment income imposed by Section 509(a)(2)(B)

3.

4.

5.

(2)

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(3)

Contributions from a single donor are disregarded for purposes of determining public support under Section 170(b)(1)(A)(vi) only to the extent they exceed 2% of an organization’s support for a period whereas under Section 509(a)(2) all contributions from a donor who has contributed $5,000 (or 2%) are excluded from the public support test.

5.

Support Organizations - Internal Revenue Code Section 509(a)(3) 1. Support Organizations must designate one or more public charities which it will support, such as a church, university, or publicly supported charity, and must identify the charity or charities in its organizing instrument as the recipient(s) of the organization's support. There are three broad sets of requirements that must be met in order to qualify as a Supporting Organization rather than a private foundation. (1) (2) (3) 3. Organizational Requirements Operational Requirements Control Requirements

2.

Organizational Requirements (1) The first requirement is that the organization must be "organized, and at all times thereafter . . . operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more specified organizations described in Section 509(a)(1) or (2)." IRC § 509(a)(3)(A). This means that the governing instrument of the Support Organization must contain the following: (1) It must limit the purposes of the organization to one or more of the purposes set forth in Section 509(a)(3)(A). It must not expressly empower the organization to engage in activities not 8

(2)

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in furtherance of the purposes referred to in Section 509(a)(3)(A). (3) It must designate, by class or purpose or by name, the Supported Organizations on whose behalf the organization is to be operated. It must not expressly empower the organization to operate to support or benefit any organization other than the specified Supported Organizations.

(4)

(2)

In other words, the Supporting Organization can only be authorized to make distributions either directly to the Supported Organization or to carry on an independent activity or program which supports or benefits the specified Supported Organizations.

4.

Operational Requirements (1) The second requirement is that the Organization must be "operated, supervised, or controlled by or in connection with one or more Organizations" described in Section 509(a)(1) or (2). Within this requirement, there are three types of Support Organizations: Type I, Type II, and Type III. Type I Support Organizations must be "operated supervised, or controlled by" the Supported Organization, similar to a parent and subsidiary relationship. A majority of the officers, directors, or trustees of the Supporting Organization must be appointed or elected by the Supported Organization. Type II Support Organizations must be "supervised or controlled in connection with" the Supported Organization. This means that, between the two entities, there must exist common supervision or control by the persons supervising or controlling both the Supporting Organization and the Supported Organizations, to ensure that the Supporting Organization will be responsive to the needs and requirements of 9

(2)

(3)

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(4)

the Supported Organization. In other words, the control or management of the Supporting Organization must be vested in the same persons that control or manage the publicly supported organizations. Similar to a brother-sister relationship. Type III Support Organizations must be "operated in connection with" one or more publicly Supported Organizations. To demonstrate this, a Type III Support Organization must meet two tests: the Responsiveness Test and the Integral Part Test. The Responsiveness Test is to insure that the Supporting Organization is responsive to the needs of the Supported Organization. The Integral Part Test is to require that the Supporting Organization will constitute an integral part of the Supported Organization and is designed to ensure that the supported organizations will be attentive to the Supporting Organization and will oversee the operations of the Supporting Organization (Cockerline Memorial Fund v. Comr., 86 T.C. 53, 61 (1986)). (1) Responsiveness Test. In order to meet the Responsiveness Test, the Supported Organization must be able to influence the Supporting Organization. One of the following sub-tests must be met (Regs. §1.509.(a)-4(i)(2)(ii)): (1) The Supported Organization selects one or more Trustees who have significant voice (i.e., who are likely to have influence) over the affairs of the Supporting Organization. The Supporting Organization is a charitable trust established under local law wherein the Supported Organization is designated irrevocably and the Supported Organization under local law has the ability to enforce the payment obligations by the Supporting Organization. 10

(2)

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(2)

Integral Part Test. In order to meet the Integral Part Test, the supporting organization must maintain a substantial involvement in the operations of the supported organizations either by performing an essential function of, or paying a substantial amount of money to, the supported organizations. It consists of one of two sub-tests. (1) “But For” Sub-Test - The Supporting Organization actually conducts activities for the Supported Organization which, but for the involvement of the supporting organization, the activities would normally be engaged by the supported organizations themselves (Regs. § 1.509(a)-4(i)(3)(ii)). The IRS has defined this as an activity which, if discontinued by the Supporting Organization, would be taken over and continued by the Supported Organization. (GCM 38417 (1980)). “Substantially All Income” Test/ “Attentiveness” Test The Supporting Organization must make payments of substantially all its income to or for the use of one or more supported organizations, and that amount of support received by one or more Supported Organizations must be sufficient to ensure the “attentiveness” of that Supported Organization to the operations of the Supporting Organization (Regs. § 1.509(a)-4(i)(3)(iii)(a)). The IRS has ruled that “substantially all income” for purposes of this test means at least 85% (Rev. Rul. 76-208). Income for these purposes consists of interest, dividends, rents, and short-term capital gains (but not long-term capital gains), less direct and indirect investment expenses (PLR 11

(2)

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9714006, PLR 9021060). Accordingly, in order to determine whether the Substantially All Income Test is met you need to analyze the impact of the distributions by the Supporting Organization on the Supported Organizations and determine whether the contributions to any of the Supported Organizations gains that organizations attention. For example, in Cockerline Memorial Fund v. Comr., the Tax Court determined that a fund which provided scholarships for 9% of the full-time students of a particular school was a sufficient amount to gain the attention of the school (86 T.C. 53, 61 (1986)). Other evidences of attentiveness include: 1) Earmarking - The Substantially All Income Test may be met if the support received from the Supporting Organization is earmarked, either by the Supporting Organization or the Supported Organization, for a particular activity or program. Earmarking alone is not enough, and the prong will only be satisfied if the activity or program for which the funds are earmarked is an important and substantial one. Reports - Evidence of actual attentiveness may also include a requirement that the Supporting Organization furnish reports at least annually to the Supported Organizations which include its assets and evidence that the Supporting Organization has not engaged in any activity which would trigger excise tax under Sections 4941 (self-dealing), 4943 (excess

2)

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business holdings), 4944 (jeopardy investments), and 4945 (taxable expenditures) (T.D. 7212, 1972-2 C.B. 250). (3) In other words, the Responsiveness Test guarantees that the supported organizations can influence the activities of the Support Organization, while the Integral Part Test ensures that the supported organizations will be motivated to do so.

5.

Control Requirements (1) The Supporting Organization cannot be controlled by disqualified persons. Disqualified persons include any substantial contributors or any individuals that own more than 20% of the stock of a disqualified person. In essence this means that disqualified persons cannot have 50% or more of the voting power of the Supporting Organization and cannot have a right to veto the actions of the Supporting Organization. Furthermore, the employees of a disqualified person will be considered in determining whether one or more disqualified persons controls 50% or more of the voting power of an Organization's governing body. Other facts which indicate that a disqualified person is in a position to influence the decisions of members or an Organization's governing body will be considered in determining whether an Organization is indirectly controlled by one or more disqualified persons.

6.

Abusive Uses of Support Organizations - What promoters are telling your clients! 1. Assertion #1: Support Organizations can be used to avoid the self dealing rules. (1) Reality: Although support organizations are not subject to the self-dealing rules (described below), support organizations still must not

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(2)

have any substantial non-charitable purposes, nor may there be any private inurement. Treasury Regulation Section 1.501(c)(3)-1(d)(1)(ii) says an organization "is not organized or operated exclusively for exempt purpose under Section 501(c)(3) of the code unless it serves a public, rather than a private interest." Thus, an organization must show it is not organized or operated for the benefit of private interests, such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled by such private interests. Although a 501(c)(3) organization may provide benefits to private individuals, those benefits must be incidental quantitatively and qualitatively. To be quantitatively incidental, the private benefit must be insubstantial, measured in the context of the overall public benefit conferred by the activity. (See eg Rev. Rul. 68-14, 1968-1 c.b. 243). To be qualitatively incidental, it must be impossible for the organization to accomplish its purpose without providing the private benefit. (See e.g. Rev. Rul. 70-186, 1970-1 c.b. 128).

(3)

2.

Assertion #2: You can borrow back all of the assets of your Support Organization. (1) Reality: Support organizations must not have any substantial non-charitable purposes, nor may there be any private inurement. PLR 9812001 involves a public charity that made loans to insiders. As in the case of a support organization, the self dealing rules did not apply. However, the IRS found that "while [the foundation]'s activities may not have been operated primarily for the benefit of [insiders], the evidences of private benefit to [insiders] from [the foundation]'s activities is sufficient to jeopardize [the foundation]'s exempt status." The ruling stated that an organization will not be tax exempt "if more than an insubstantial part of its activities is not in furtherance of an exempt purpose," or "if it has a 14

(2)

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single noncharitable purpose that is substantial in nature." PLR 9812001 took special note of the fact that the loans were made at "bank" interest rates which were lower than the market interest rates for unsecured loans. (3) PLR 9812001 also shed some light on the important question of what is meant by the word "substantial." The ruling cited Best Lock Corporation v. Commissioner, (31 T.C. 620 (1959)) where an organization lost its exemption because of loans made to members of the founder's family, even though the loans were repaid. In Best Lock Corporation, a charity made private loans and expenditures constituting approximately fifteen percent of the total expenditures of the foundation in the taxable years. The court stated that "this is a substantial amount devoted to a personal purpose." There is no clear guideline for what percentage of a support organization's assets may be loaned to an insider.

III.

Private Foundations

1. Section 4940 - Excise Tax on Net Investment Income. Section 4940(a) imposes an excise tax on the net investment income of every foundation exempt from taxation under Section 501(a) for the current taxable year, other than "exempt operating foundations." This is a tax equal to 2% of the net investment income of the foundation for the year. Unlike the other excise taxes included in Chapter 42 that are potentially applicable to foundations as an enforcement or punitive measure, the Section 4940 tax is not based upon a violation of the substantive provision of the Code. The tax is purely an excise tax measured by the foundation’s investment income. Section 4940(e) reduces the tax on investment income from 2% to 1% if the following requirements are met. A. The qualifying distributions, as defined in Section 4942(g), made by the foundation for the year are at least equal to a required amount described below and The foundation was not liable for tax under Section 4942 with respect to any year in the base period.

B.

The required amount referred to in subparagraph A above, is determined by adding two elements. First, the amount of the foundation’s assets for the year is multiplied by the "average 15
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percentage payout for the base period." This refers to the average percentage of assets distributed as qualifying distributions over the five preceding taxable years. Second, the amount determined in the preceding step is added to 1% of the foundation’s net investment income for the current taxable year. If the current year’s qualifying distributions equal or exceed the amount calculated in this fashion, the current years Section 4940 tax on net investment income is assessed at 1% rather than 2%. 2. Section 4941 - Self Dealing. Section 4941(d)(1) provides that the term "self dealing" means any direct or indirect: A. Sale, exchange or leasing of property between a private foundation and disqualified person; Lending of money or other extension of credit between a private foundation and a disqualified person; Furnishing of goods, services, or facilities between a private foundation and a disqualified person; Payment of compensation (or payment or reimbursement of expenses) by a private foundation to a disqualified person; Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation; and Agreement by a private foundation to make any payment of money or other property to a government official.

B.

C.

D.

E.

F.

Transactions with Trusts and Estates Reg. Section 53.4941(d)-1(b)(3) provides an exception to self dealing for this and many other transactions involving a trust or an estate where the transaction is approved by a probate court having jurisdiction over the estate or trust. Assumption of Debt The transfer of real or personal property by a disqualified person to a private foundation is treated as a sale or exchange if the property is subject to a mortgage or a similar lien which the private foundation assumes or if such property is subject to a mortgage or similar lien which a disqualified person placed on the property within the ten year period ending on the date of the transfer.1
1

Section 4941(d)(2)(A)

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No Charge Leases Leasing a property by a disqualified person to a private foundation is not an act of self dealing if the lease is without charge. A lease is considered to be without charge even though the private foundation pays for janitorial services, utilities or other maintenance costs it incurs for the use of the property if the payment is not made directly or indirectly to a disqualified person.2

2

Regs. Section 53.4941(d)-2(b)(2)

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Furnishing of Goods, Services or Facilities Generally, the term self dealing includes any direct or indirect furnishing of goods, services or facilities between a private foundation and a disqualified person.3 This rule applies to the furnishing of goods, services or facilities such as office space, automobiles, auditoriums, secretarial help, meals, libraries, publications, laboratories, parking lots, the possession of collectable objects such as artwork, the furnishing of living quarters. As an exception to the general rule regarding the furnishing of goods, services or facilities, a foundation manager may receive the use of goods, services or facilities from a foundation as reasonable and necessary compensation.4 As a second exception to the general rule regarding the furnishing of goods, services or facilities, a disqualified may furnish goods, services or facilities to a private foundation if such goods, services or facilities are furnished without charge and the goods, services or facilities furnished are used exclusively for Section 501(c)(3) purposes.5 For example, a disqualified person may furnish pencils, stationary and other incidental supplies or building space to a private foundation if such supplies or facilities are furnished without charge. For this purpose, a furnishing of goods is considered without charge, even though the private foundation pays for transportation, insurance or maintenance costs it incurs in obtaining or using the property, so long as the payment is not made directly or indirectly to the disqualified person.6 The service has applied this exception to loans of artwork by disqualified persons to foundations without charge, except for the foundation’s payments for transportation, maintenance and insurance.7 Another exception to the rule regarding the furnishing of goods, services or facilities is that a private foundation may furnish goods, services or facilities to a disqualified person if such furnishing is made on a basis no more favorable than that which such goods, services or facilities are made available to the general public.8 Compensation

3 4 5 6 7 8

Section 4941(d)(1)(C) Regs. Section 53.4941(d)-2(d)(2) Section 4941(d)(2)(C) Regs. Section 53.4941(d)-2(d)(3) PLR 9239024, 8842045 Section 4941(d)(2)(D)

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Self dealing includes any direct or indirect payment of compensation by a private foundation to a disqualified person.9 However, pursuant to Section 4941(d)(2)(e), except in the case of a government official, the payment of compensation (and the payment of reimbursement of expenses) by a private foundation to a disqualified person for personal services which are reasonable and necessary to carry out the exempt purposes of the private foundation is not an act of self dealing if the compensation is not excessive. This exception may include the payment of a pension,10 or the payment of premiums for a split dollar insurance policy on the life of the trustee.11 "Personal services" includes property management services, serving as a broker, but not a dealer (a dealer is one who buys from the private foundation as principal and resells to third parties), and other financial or professional services. In TAM 9008001, the national office advised that a foundation’s directors engaged in self dealing as a result of receiving excessive compensation by comparing the director’s compensation to the average reported for foundations of its size by the Council on Foundations. Use of Foundation Assets The term self dealing includes any direct or indirect transfer to, or use by, or for the benefit of a disqualified person of the income or assets of a private foundation.12 Such prohibited use of foundation assets may include grants to disqualified persons, foundation guarantees of loans made by others to disqualified persons, foundation purchases of fundraising tickets on behalf of disqualified persons, private displays of foundation owned artwork, etc. Examples include the following: (a) Scholarship or fellowship grants paid by a private foundation either directly or indirectly to a disqualified person may constitute self dealing if the benefit provided is not incidental; A private foundation’s indemnification of its foundation managers for liabilities and expenses they may incur individually as a result of serving in that capacity may be acts of self dealing under certain circumstances;13

(b)

9 10 11 12 13

Section 4941(d)(1)(D) Revenue Ruling 74-591, 1974-2 C.B. 385 PLR 9539016 Section 4941(d)(1)(e)

See Section 4941(d)(2)(E); Regs. Sections 53.4941(d)-3(c) and -2(f)

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(c)

A foundation’s payment of premiums for insurance providing liability coverage to its foundation managers may constitute self dealing under certain circumstances;14

14

See Rev. Rul. 82-223, 1982-2 C.B. 301

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(d)

A private foundation’s payment of all or part of the ticket price to a charitable fundraising event may be self dealing if the disqualified person uses the ticket;15 Even where foundation property is conveyed directly to a disqualified person, self dealing may not occur, under special circumstances, e.g., where unmarketable contaminated property is reconveyed by a foundation to the donor of the property who thereby is not benefitted and may actually suffer an economic detriment;16 The display of foundation owned artwork at the private residence of a disqualified person may be self dealing if not effort is made to advertise that the general public is invited to tour the premises to view the artwork;17 Depending upon the specific terms and intended activities with respect to a disqualified person’s joint investment with a foundation, the transaction may or may not constitute a transfer of foundation assets for the benefit of the disqualified person and, thus, be an act of self dealing. For example, the IRS has ruled that the formation and use of a passive partnership for purposes of jointly investing foundation funds and a disqualified person’s funds to achieve greater economies of scale (regarding administrative costs and management fees) for the benefit of both investors is not self dealing.18 On the other hand, the Service has ruled that a proposed development of real property owned by a foundation and a disqualified person as tenants in common would be self dealing where the transaction would involve substantial investment by both parties for the purpose of extensive improvements (utilities, streets, drainage, warehouses, office buildings, and medical buildings) which would be made before the property would be leased to third parties; 19 and

(e)

(f)

(g)

15 16 17

See PLR 9021066 See PLR 8849059

See TAM 8824001; PLR 8842045. See also Rev. Rul. 74-600, 1974-2 C.B. 385
18 19

See PLR 8912061 See PLR 8038049

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(h)

Mere co-ownership of certain property may constitute self dealing. While self dealing does not include the co-ownership and use of property acquired by a foundation and a disqualified person before October 9, 1969 (see discussion of 1969 TRA transition rules at C, below, and TAM 8819007), the IRS has ruled that joint ownership of artworks by a foundation and disqualified person as tenants in common is not self dealing.20 The IRS has also suggested that the mere co-ownership of income-producing property (a deed of trust and related note receivable) by a foundation and a disqualified person is self dealing.21

A private foundation’s payment of an amount that a disqualified person is legally obligated to pay may constitute self dealing.22 Initial and Additional Taxes Tax liabilities imposed under Section 4941 are designed to encourage taxpayers to avoid self dealing transactions and to unwind such transactions if they occur. The tax liabilities arise under a two tier system consisting of an initial tax on both the self dealer and possibly the foundation manager and a second tier tax on both the self dealer and possibly the foundation manager. The initial tax on the self dealer will be applied even though the self dealer had no knowledge at the time of the act that the act constituted self dealing.23 The tax imposed is at the rate of 5% of the amount involved with respect to each act of self dealing for each year.24 In the case of a government official the tax is imposed upon such official only if he knows that such act is an act of self dealing.25 The initial tax is only imposed on foundation managers if: (1) A tax is imposed on a self dealer, (2) The participating foundation manager knows that the act is an act of self dealing, and (3) The participation by the foundation manager is willful and not due to reasonable cause.26 The tax imposed by Section 4941(a)(2) is at the rate of 2.5% of the amount involved with respect to each act of self dealing for each year.
20 21 22 23 24 25 26

See PLR 8842045 See PLR 9127052 See Regs. Section 53.4941(d)-2(f)(1) Regs. Section 53.4941(a)-1(a)(1) Section 4941(a)(1) Regs. Section 53.4941(a)-1(a)(2) Regs. Section 53.4941(a)-1(b)(1)

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In any case in which an initial tax is imposed on a self dealer and the act is not corrected with the taxable period, there is imposed a tax equal to 200% of the amount involved. In any case in which an additional tax is imposed on a self dealer, if a foundation manager refused to agree to part or all of the correction, there is hereby imposed a tax equal to 50% of the amount involved on the foundation manager. Both the initial tax and the additional tax on the foundation manager are capped at $10,000.27 3. Section 4942 - Excise Tax on Failure to Distribute Income. Section 4942 is designed to force a private foundation to distribute at least 5% of the fair market value of the foundation’s non charitable assets annually. This amount is also referred to as a foundation’s "minimum investment return" or "minimum distributable amount." A foundation’s minimum distributable amount may only be satisfied by making "qualifying distributions". A qualifying distribution is any amount (including that portion of reasonable and necessary administrative expenses) paid to accomplish one or more purposes described in Section 170(c)(1) or Section 170(c)(2)(b).28 A qualifying distribution includes amounts directly expended to accomplish these purposes or amounts paid to acquire assets used directly in carrying out one or more of such purposes. A qualifying distribution can also be an amount set aside (i.e., accumulated for future distribution) for such purposes.29 Indirect payments to accomplish charitable purposes by means of a grant to a second organization which will use the funds for such purposes also fall within the definition of qualifying distributions. However, grants to non operating private foundations or organizations controlled by the contributing private foundation or its disqualified persons, will be considered qualifying distributions only if the donee organization is exempt under Section 501(c)(3) and itself makes qualifying distributions equal to the grant from the donor foundation in addition to meeting its own minimum distributions requirements by not later than the close of the taxable year after the year in which the grant was received.30 The "distributable amount" of a private non operating foundation is the amount for each taxable year which the foundation must timely distribute in order to avoid the imposition of the tax on its undistributed income under Section 4942(a). Section 4942(a) imposes an initial excise tax of 15% of a private non operating foundation’s undistributed income that has not been distributed before the first day of the second taxable year following the taxable year for which the income was required to be distributed. There is an additional tax imposed if any portion of the

27 28 29 30

Section 4941(c)(2) Section 4942(g)(1) Section 4942(g)(2) Section 4942(g)(3)

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distributable amount remains undistributed at the close of the taxable period. The additional tax is equal to 100% of the amount remaining undistributed at such time.31

31

Section 4942(b)

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4. Section 4943 - Tax on Excess Business Holdings. The general rule under Section 4943 is that the combined holdings of a private foundation and all disqualified persons in any corporation conducting a business which is not substantially related to the exempt purposes of the foundation are limited to 20% of the voting stock in such corporation, or 20% of the beneficial or profits interest in such business. A private foundation which violates Section 4943 incurs an initial excise tax equal to 5% of the value of its excess business holdings followed by a tax equal to 200% of such excess if the violation is not cured within a stated period.32 The "taxable period", with respect to excess business holdings, ends on the earlier of: (1) the date of mailing of a notice of deficiency; or (2) the date on which the tax is assessed. The term excess business holdings is defined as the amount of stock or other interest in a business enterprise which the foundation would have to dispose of to a non disqualified person in order for the foundation’s remaining holdings in the enterprise to be "permitted holdings". There are three separate rules for determining the extent to which a private foundation may invest in a business enterprise: (1) a general rule; (2) a special 35% rule; and (3) a 2% "de minimis" rule. Section 4943(c)(2)(A) states the general rule that a private foundation’s permitted holdings in a corporation’s voting stock are as follows: 20% of the voting stock reduced by the percentage of the stock actually or constructively owned by all disqualified persons. Special 35% Rule Section 4943(c)(2)(B) provides that where the private foundation and all disqualified persons together do not own more than 35% of the voting stock of the enterprise and it is established to the satisfaction of the secretary that "effective control" is in one or more persons who are not disqualified persons with respect to the foundation, the 20% rule for permitted holdings becomes a 35% rule. 2% De Minimis Rule Section 4943(c)(2)(C) provides generally that a foundation is not treated as having excess business holdings in any corporation in which it owns not more than 2% of the voting stock and not more than 2% in value of all outstanding shares of all classes of stock.

32

Section 4943(a)(b)

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5. Section 4944 - Tax on Jeopardy Investments. Under the terms of Section 4944(a), the penalties provided for in Section 4944 apply "if a private foundation invests any amount in such a manner as to jeopardize the carrying out of any of its exempt purposes." The Treasury Regulations provide that "no category of investments shall be treated as a per se violation of Section 4944."33 Rather than finding a per se violation, the regulations list examples of types of transactions which will be closely scrutinized, including trading on margin, trading in commodity futures, investments in working interests in oil and gas wells, purchase of puts, calls and stradles, purchase of warrants and selling short.34 The standard which must be met by all investments whether they be closely scrutinized or not, is that of a prudent trustee.35 6. Section 4945 - Tax on Taxable Expenditures. Section 4945 imposes a tax on private foundations which expend money on the following purposes: (1) To carry on propaganda, or otherwise attempt to influence legislation; (2) To influence the outcome of any specific public election, or to carry on, directly or indirectly, any voter registration drive, unless certain conditions are met; (3) As a grant to an individual for travel, study or similar purposes, unless the grant meets certain requirements; (4) As a grant to an organization other than a public charity, unless the granting foundation exercises expenditure responsibility; or (5) For any purpose other one specified in Section 170(c)(2)(B), i.e., religious, charitable, scientific, literary or educational purposes, to foster certain amateur sports competitions, or for the prevention of cruelty to children or animals. An initial excise tax of 10% is imposed on each taxable expenditure made by a private foundation. This tax is payable by the foundation.36 If a foundation has made a taxable expenditure for which an initial tax is imposed, another initial excise tax of 2.5% is imposed on any foundation manager who agreed to the making of such expenditure, knowing that it was a taxable expenditure, unless the agreement is not willful and is due to reasonable cause.37 Section 4945(b) imposes upon the foundation an additional excise tax equal to 100% of the amount of the taxable expenditure if it is not corrected within the taxable period. An additional tax of 50% of the taxable expenditure is also imposed on any foundation manager who refuses to agree to any part of the correction. The taxable period begins with the date of the
33 34 35 36 37

Regs. Section 53.4944-1(a)(2)(i) Regs. Section 53.4944-1(a)(2)(i) ID. Section 4945(a)(1) Section 4945(a)(2)

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taxable expenditure and ends with the earlier of the date when (1) a deficiency notice for the first level tax is mailed or (2) the first level tax is assessed. 7. Section 4946 - Disqualified Persons, Section 4946(a)(1) defines the term disqualified person to include the following: (1) (2) Substantial contributors to the foundation; Owners of more than 20% of (1) the total combined voting power of a corporation; (2) the profits interest of a partnership; or (3) the beneficial interests of a trust or unincorporated enterprise, which is a substantial contributor to the foundation; Certain foundation managers; Members of the family of any individual described in paragraphs 1, 2 or 3 above; Corporations, partnerships, trusts or estates in which persons described in paragraphs 1, 2 or 3 above own more than 35% of the total combined voting power, profits interests, or beneficial interests respectively; and Government officials.

(3) (4)

(5)

(6)

In determining who owns the voting power of a corporation or the profits interest of a partnership or the beneficial interests of a trust or unincorporated enterprise, Section 4946 generally applies the attribution rules of Section 267(c), with some modifications. A person is considered a "substantial contributor" pursuant to Section 507(d)(2)(A) if the person contributed or bequeathed more than $5,000 to a foundation; and (i) In the foundation’s taxable year in which the person makes a contribution that exceeds the $5,000 threshhold, his aggregate lifetime and testamentary gifts exceed 2% of the total contributions ever received by the foundation as of the close of that taxable year; or The foundation is a trust and the person is the creator of the trust.

(ii) 9.

Common Uses of Private Foundations 1. Private Operating Foundations. We have set up operating foundations for the following purposes: educating the public about plants and animals, 27

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operating youth leadership camps, operating schools in 3rd world countries, operating a museum, medical research, scientific research 2. 3. Remainder Beneficiary of CRT. Keeps money in family. Family members can take salaries. Income Beneficiary of CLT. Same advantages as above, Keeps a certain asset in the family. If the grantor of an inter vivos charitable lead trust is a member, director or officer of the charitable organization which is the income beneficiary of the trust, the entire corpus may be included in the grantor’s estate pursuant to Section 2036(a)(2), with a charitable deduction permitted for the present value of the income interest. Note, however, that the grantor’s spouse and children may serve as officers and trustees of the charitable income beneficiary without causing inclusion of the trust property in the grantor’s estate. PLRs 9821030, 9822018. Family Benefits. (1) Family traditions, (2) anonymity (safety), (3) generate deductions, (4) genealogy (Rev. Rul. 80-302 - no exemption for purpose of compiling genealogy for a particular family)(Rev. Rul. 71-580 - grants exemption for purpose of compiling genealogy for a particular family in order to perform religious ordinances).

4.

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COMPARISON OF TAX-EXEMPT ENTITIES Public Charity Support Org. Private Non-Operati ng Foundation Yes Donor Advised Fund Practical, not legal control Cash gifts = 50% of AGI; LTCG Prop. = 30% of AGI FMV

Control

Minority vote Cash gifts = 50% of AGI; LTCG Prop. = 30% of AGI FMV

Minority vote Cash gifts = 50% of AGI; LTCG Prop. = 30% of AGI FMV

Limitations on Deductibili ty of Contributio ns Deductible Value of Appreciated Long-Term Gain Property Cost & Complexity Available Grantees

Cash = 30%; LTCG = 20%*

Operating Foundation = FMV Non-Operati ng Foundation = Basis* Significant Any - as long as it accomplishe s exempt purposes, may require expenditure responsibil ity Yes

Significant Any - as long as it accomplishe s exempt purposes

Significant Limited to named organizatio ns or classes

Minimal Generally not private foundations

2% Tax on Net Investment Income Excise taxes for self dealing, excess business holdings,

No

No

No

No

No

Yes

No

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failure to distribute, jeopardy investments

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* Contributions of Qualified Appreciated Stock (stock whose value is readily available on a qualified securities market) to a private foundation may be deducted at FMV, but only to the extent of 20% of the taxpayer's AGI. This exception applies only to the extent that the aggregate value of all prior contributions by the donor (and his family members as defined in Section 267(c)(4)) does not exceed more than 10% of the value of all outstanding stock in the corporation to one or more private foundations.

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