10 THINGS TO KNOW ABOUT

10 THINGS TO KNOW ABOUT PRIVATE FOUNDATIONS JOHN E. CHRIsToPHER MANLEY BURKE LPA CINcINNATI, OHIO BACKGROUND Private foundations are charities descr...
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10 THINGS TO KNOW ABOUT PRIVATE FOUNDATIONS JOHN E. CHRIsToPHER MANLEY BURKE LPA CINcINNATI, OHIO

BACKGROUND

Private foundations are charities described under Internal Revenue Code (“IRC”) Section 501(c)(3) that are funded by contributions from a limited pool of donors’. Normally, donors to private foundations have substantial wealth. Their donations result in a substantial current tax benefit in the form of a charitable contribution deduction for Federal income, estate and gift taxes. 2 Over the life of the foundation, the foundation receives the ongoing substantial tax benefit of an exemption from income tax liabilities under Subtitle A of the Internal Revenue Code. After making the contributions, donor(s) will normally retain substantial control over the contributed assets and the income and appreciation generated thereon by occupying positions of authority with respect to the foundation. Often, those in control of a private foundation choose to defer for as long as possible the distribution of the foundation’s tax-benefit-leveraged-assets into the stream of charitable commerce. As a result of the financial status of private foundation donors, the retained control over the contributed assets and the relatively slow distribution of the foundation’s tax-benefit-leveraged-assets, private foundations have for decades been viewed with skepticism by those in political power and by private citizens alike. 3 As a result of actual and perceived abuses, the federal government, state governments and the charitable sector have undertaken efforts to regulate charities in general and private foundations specifically. The federal regulatory scheme is perhaps the most broad-reaching and involved of the three. It certainly seems to have the most teeth. At the core of the federal regulatory scheme are the required disclosure of the identities of donors and amounts donated, disclosure of grant recipients and amounts distributed, and penalty taxes applicable to those foundation insiders that gain unwarranted economic benefit from the foundation, and those of the foundation management that allow the flow of unwarranted economic benefit. 1

See IRC § 509(a) See IRC § 170(a) th 7 . See, Chairman of the House Select Committee on Small Business, 8 Cong., 2d Sess., Tax-exempt Foundations and Charitable Trusts: Their Impact on Our Economy. See also, Fremont-Smith, Marion R., Governing Nonprofit Organizations: Federal and State Law and Regulation, pp. 67-77, Troyer, Thomas A., The 1969 Private Foundation Law: Historical Perspective on Its Origins and Underpinnings, Exempt Organization Tax Review, Vol 27, No. 1, January 2000. Current compliance efforts of the IRS regarding Private Foundations are described in the IRS Exempt Organizations FY 2012 Annual Report and FY 2013 Workplan at page 19. 2

In addition to federal regulatory authority, the states, through their Attorneys General, continue their historical oversight and enforcement role with respect to foundation activities and board member fiduciary obligations. Finally, particularly, over the last decade or so, the charitable . 4 sector itself has sought to self regulate foundation governance and transparency Despite the burden imposed by the various regulatory schemes, private foundations continue their historically important role in the charitable segment of the United States economy by making grants, loans and other distributions supporting the accomplishment of substantial and important 5 Where properly conceived, private charitable endeavors benefiting all segments of society. implemented and managed, a private foundation may be the most appropriate and efficient structure through which private wealth, leveraged by foregone income tax, may support and further charitable purposes. The goal of this writing is to add my thoughts to the constantly developing analytical framework regarding whether a private foundation will appropriately and efficiently serve the purposes and goals of the budding philanthropist in a particular set of circumstances. 1.

What are the Philanthropist’s Philanthropic Goals?

Perhaps the most important of all of the considerations discussed herein is the initial understanding of a donor’s goals and how his or her level of commitment and resources match those goals. After he signed the bulk of his fortune over to the Bill and Melinda Gates Foundation, Warren Buffett is reported to have said “It is far easier to make money than to give it away effectively.” To paraphrase another purported Buffett quote, philanthropy can deal in tough questions and issues that historically have resisted both intellect and money. Buffett is clearly a person who understands business, but his actions show he also understood the unique complexities of engaging in substantial philanthropy. The lesson to be taken from Buffett is that a potential philanthropist should honestly examine his or her philanthropic goals and understand how best to achieve them before taking on the challenge of entering into the fray. Clearly, if all that is desired is a charitable deduction during life or at death, then there are much simpler means to achieve that end than starting and operating a private foundation (See Alternatives, below). Similarly, it may be that the amount of resources (time, money, effort) the donor intends to commit to his or her philanthropic goals may be more efficiently utilized by an existing charitable organization. Finally, even if the donor is extremely sophisticated and is ready to devote substantial assets to his or her philanthropy, he or she may find that the resources may be more efficiently utilized by an existing organization, just as Mr. Buffet did. I would argue that a private foundation is most clearly indicated where the donor’s philanthropic goals require: (i) a substantial amount of capital; (ii) retained control in the donor and his or her family or close associates; and (iii) flexibility (e.g., to accommodate evolving charitable See, e.g., Independent Sector “The Principles for Good Governance and Ethical Practice” which lists 33 principles of good governance practices. There were 97,941 private foundations as of February 2013 (nccs.urban.org/statistics/quickfacts.cfm) (accessed 5/1/2013). Private foundations distributed $46.9 Billion in furtherance of charitable purposes in 2011. Id. Private foundations held $618.1 Billion of assets in 2010. www.foundationcenter.org/gainknowledge/research/nationaltrends.html. (accessed 5/10/2013) ‘

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focus). Where one or more of these attributes are not present, it may be that a different approach would best accomplish the philanthropist’s goals. Thus, exploring the cost/benefit ratio of establishing a private foundation structure in the context of the donor’s philanthropic goals may well head off an unsatisfying experience for your donor and his or her successors. Assuming the donor desires to be actively engaged in philanthropy in a substantial way and the private foundation structure appears to be the appropriate vehicle, helping that donor identify with some specificity his or her vision will be beneficial not only to the donor in gaining a sense of purpose and focus, but also to you as the advisor in confirming the private foundation structure as the best solution. One exercise that may help your donor in this regard is the development of a vision statement for his or her philanthropy. The vision statement will succinctly describe what the donor hopes to accomplish, what activities will be undertaken, where, and for whom. In addition to helping your donor identify his or her intended goals and to focus upon how to accomplish those goals, a thoughtful vision statement will allow you to further tailor your legal structure recommendations to the donor’s vision. Further, the vision statement may be adopted by the foundation as a mission statement to provide the current and future management of the foundation to make the best use of its resources by focusing grants and activities on the founder’s specific area of emphasis and increasing the impact of the foundation’s resources. For example, the mission statement will help guide the managers in creating grant-making guidelines that communicate the focus of the foundation for potential grant seekers, prioritize grant requests and train the next generation of managers by communicating the founder’s values, hopes and aspirations, among other things. The vision statement will also help you determine, and advise your donor with respect to, the 6 The private foundation sub-classification the organization’s intended activities will most likely yield. type of private foundation sub-classification that will result from the donor’s philanthropic activities may impact the tax benefit received by the donor and will impact the tax/regulatory burden experienced by the foundation. As we know, whether a charity is a private foundation or a public charity depends in large measure upon the source of the funds received by the foundation. The sub-classification of a private foundation depends upon its activities. Private foundations may engage in the active conduct of philanthropic activities as well as the passive making of grants to other charities for use in fulfilling their philanthropic purposes. A typical family private foundation engages in grant-making and usually funds its grants through an endowment created from one or more substantial gifts from the founding donor(s). This type of private foundation is often referred to as an endowed private foundation. Some grant-making private foundations are, at least on occasion, funded annually and “pass7 Other private foundations, however, engage in through” all of their annual funding to grant recipients. 8 That is, they have the active conduct of charitable activities much like the typical public charity. operations and may be classified as an “operating foundation”. Normally, pass-through foundations and operating foundations provide better income tax deduction outcomes then endowed private 6

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See, IRC 170(b)(1)(F), 4942(j)(3). IRC 170(b)(1)(F) IRC 4942(j)(3).

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foundations. Further, operating foundations are subject to a slightly less stringent federal tax regulatory scheme. 2.

Federal Tax Deduction Rules.

Having determined that the budding philanthropist is willing to commit the resources to reach some substantial goals, it is important to next reflect upon the various philanthropist, governmental, sector and societal expectations that accompany entering into philanthropy. The philanthropist will expect, among other things, a tax benefit for the assets he or she permanently dedicates to charitable 9 estate tax’° and gift tax” deductions for activities. The federal tax law provides for income tax, contributions to charities, including private foundations. With respect to the income tax, the amount and timing of the utilization of the charitable deduction depends in part upon the sub-classification of the foundation receiving the contribution. The tax deduction is also dependent in part upon the type of assets contributed. Endowed Private Foundations. The tax deduction for contributions of cash and nonappreciated property to an endowed foundation is more limited than similar contributions to a public 12 Specifically, cash donations are limited to an amount equal to 30%’ of the donor’s adjusted charity. 14 in the taxable year, as opposed to 50% for gifts of cash and other non-appreciated gross income 5 The deductibility for gifts of appreciated property to an endowed property to public charities.’ foundation (e.g. capital gain property) are even more limited. The deduction is limited to 20% of the 6 as opposed to 30% for gifts of appreciated property to public donor’s adjusted gross income,’ . More importantly, the deduction for gifts of appreciated property is limited to the donor’s 7 charities’ 8 basis in the asset, unless the asset is publicly traded stock.’ ,

Further, the tax law prefers contributions falling within the 50% limitation. As a result, contributions falling within the 50% deduction limitation (e.g., cash and non-appreciated property contributions to public charities) are counted first for limitation purposes. That is, such contributions to a public charity will be applied to the 50% deduction limitation first. As a result, the deduction for a cash contribution to a private foundation will be reduced to the extent contributions subject to the 50% limitation exceed 20% of the donor’s adjusted gross income. For example, if the donor’s contributions to a 50% charity equal 40% of the donor’s adjusted gross income, then the donor’s current year deduction for the contribution to the private foundation is limited to 10% of the donor’s

IRC 170 IRC 2055 IRC 2522 12 Compare IRC 170(b)(1)(A) with IRC 170(b)(1)(B) and 170(b)(1)(D). 13 IRC 170(b)(1)(B) 14 Technically, it is the donor’s adjusted gross income not reduced by any net operating loss carryback. IRC 170(b)( 1)(G). 15 IRC 170(b)(1)(A) 16 170(b)(1)(D). 17 170(b)(1)(C). 170(e)(1)(B)(ii) 10

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9 To the extent any gift exceeds the applicable limitations, the excess can be adjusted gross income.’ carried forward for the following five years. ° will be treated for 2 Pass-Through Foundations. A contribution to a pass-through foundation limitation purposes as if it were made to a public charity. That is, deductions will be limited to 50% of the donor’s adjusted gross income except for contributions of appreciated property subject to the special 30% limitation. As mentioned earlier, a pass-through foundation is a private foundation which makes qualifying distributions in an amount equal to 100% of contributions received by the foundation for the tax year before the fifteenth day of the third month following the close of the foundation’s ’ Whether a foundation meets the requirements of a flow-through foundation is 2 taxable year. determined on a year by year basis. That is, the foundation has some control over whether it qualifies as a pass-through foundation for a particular period. In order to substantiate the higher deduction limitations, the donor is required to obtain evidence from the private foundation that it did, indeed, make sufficient qualifying distributions. Operating Foundations. Operating foundations are subject to the same deduction limitations as 22 As mentioned earlier, operating foundations are private foundations that pass-through foundations. 23 The active conduct of are substantially engaged in the active conduct of charitable activities. charitable activities means that the foundation engages in activities in its own name rather than making grants to other organizations that engage in charitable activities. Whether a private foundation qualifies as an operating foundation depends in large measure on the amount expended during a year in the active conduct of charitable activities. In essence, if a private foundation expends at least 85%24 26 then it will qualify as an 25 or its minimum investment return, of the lesser of its adjusted net income maintain assets used directly in the or to acquire paid amounts For example, 27 foundation. operating conduct of the foundation’s exempt activities, such as the operating assets of a museum, public park, or historic site qualify as being expended in the active conduct of charitable activities. Further, reasonable administrative expenses (such as staff salaries and traveling expenses) and other operating costs necessary to conduct the foundation’s exempt activities qualify as being used in the active conduct of charitable activities.

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See, IRS Publication 526, page 15 for an example showing the hierarchy of contribution limits. IRC 170(b)(1)(F)(ii)

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IRC 170(b)(1)(F)(i) IRC 4942(j)(3) Treas. Reg. 53.4942(b)—1(c) 24 25 IRC 4942(f)(1). Adjusted net income is gross income less deductions allowed to corporations subject to tax under IRC 11, with certain modifications to income and deductions. 26 IRC 4942(e). Generally, minimum investment return means 5% of the fair market value of the foundation’s assets, other than assets used (or held for use) directly in the foundation’s exempt functions, 27 IRC 4942(j)(3)(B)(ii). There are actually three alternative subtests in addition to the income test for operating foundations. However, in most cases, where the foundation satisfies the income test, then it will also satisfy one of the three alternative subtests (the endowment test). Only where the minimum investment return is markedly higher than adjusted net income does the endowment test (and thus the other alternative tests as well) have independent significance. 23

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Estate and Gift Tax Deductions. Unlike the income tax deduction, the charitable deduction for a valid, effective transfer for gift and estate tax purposes is unlimited and is measured by the value of the property being transferred. 3.

Regulation.

Ohio Regulation. The Ohio Attorney General, like most state’s Attorneys General, is charged 28 with ensuring that assets dedicated to charitable purposes are, indeed, utilized for those purposes. from its parens patriae charitable assets comes The Attorney General’s duty to oversee and protect role as representative of the indefinite members of the public who are the beneficiaries of property 29 Under this authority, Attorneys General oversee registration and devoted to charitable purposes. annual reporting statutory requirements and enforce state fiduciary duty obligations of the managers 30 of charitable organizations. Registration. Ohio, like most other states, requires all charities, including private foundations, organized or operating within the state to register and to file an annual report with the Attorney Genera 1.31 The registration and reporting process in Ohio is now exclusively online at www.ohioattorneygeneral.gov/charitableregistration. Registration must be completed within 6 months of the charity’s formation. A copy of the trust instrument, articles of incorporation, bylaws, and constitution and any subsequent amendments of these instruments that created or funded the charitable trust, and pursuant to which it is administered must be provided along with a copy of the 28

ORC 109.24 states: “The powers of the attorney general under sections 109.23 to 109.33 of the Revised Code shall be in addition to and not in limitation of his powers held at common law. The attorney general may investigate transactions and relationships of trustees of a charitable trust for the purpose of determining whether the property held for charitable, religious, or educational purposes has been and is being properly administered in accordance with fiduciary principles as established by the courts and statutes of this state. The attorney general is empowered to require the production of any books or papers which are relevant to the inquiry.” “The attorney general shall institute and prosecute a proper action to enforce the performance of any charitable trust, and to restrain the abuse of it whenever he considers such action advisable or if directed to do so by the governor, the supreme court, the general assembly, or either house of the general assembly. Such action may be brought in his own name, on behalf of the state, or in the name of a beneficiary of the trust, in the court of common pleas of any county in which the trust property or any part of it is situated or invested, or in which the trustee resides; provided that in the case of a charitable trust created by, arising as a result of, or funded by a will, such action may be brought in either the court of common pleas of any such county, or the probate division of it, at the election of the attorney general. No such action shall abate or discontinue by virtue of the discontinuance in office of the attorney general in whose name such actions may be brought. This section is intended to allow the attorney general full discretion concerning the manner in which the action is to be prosecuted, including the authority to settle an action when he considers that advisable.” 29 See generally Scott on Trusts, Fourth Edition § 391.See also, 107. See also, State of Ohio v.Drobnick, Complaint of Ohio Attorney General Mike Dewine at para. 107” The Ohio Attorney General, in his role as parens patriae, protects charitable trusts and their beneficiaries who should have benefitted from charitable trust assets, including the assets raised or held on behalf of the charitable beneficiaries.” °

“The Charitable Law Section is committed to honoring the important role of non-profits in Ohio. Oversight is critical: One of the section’s most important tasks is to make sure that funds are used for charitable purposes, not private interests. This duty, rooted in common law and reinforced through many statutory provisions, is one of the Attorney General’s oldest 31

ORC 109.26, ORC 109.31. 6

Internal Revenue Service determination letter if available. 32 The annual report must be submitted contemporaneously with the submission of a timely filed Form 990-PF and must be completed online. The internal Revenue Code requires that a copy of the foundation’s Form 990-PF be filed with the 33 state. Ohio Nonprofit Corporation Law Requirements. In addition to the registration and annual reporting requirements, private foundations in corporate form are required to record with the Secretary of State a statement of continued existence within each five years after the date of incorporation or of the last corporate filing. 34 Additionally, the Ohio Nonprofit Corporation Law requires any charity, operating as a nonprofit corporation, to obtain consent, either from its Court of Common Pleas or the Attorney General, prior to transferring more than 50% of its assets. 35 State Regulation of Investments. Ohio codified and clarified the common law fiduciary principles applicable to those responsible for investing a private foundation’s assets by adopting the Ohio Uniform Prudent Investment of Institutional Funds Act (“OUPMIFA”). 36 OUPMIFA requires each person responsible for managing and investing an institutional fund shall manage and invest the fund in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances 37 and must incur only costs that are appropriate and reasonable in relation to the assets, the purposes of the institution, and the skills available to the institution, and shall make a reasonable effort to verify facts relevant to the management and investment of the fund. 38 OUPMIFA sets forth the circumstances to be considered when the persons responsible for investing seek to fulfill their duty of care. These include: (a) General economic conditions; (b) The possible effect of inflation or deflation; (c) The expected tax consequences, if any, of investment decisions or strategies; (d) The role that each investment or course of action plays within the overall investment portfolio of the fund; (e) The expected total return from income and the appreciation of investments; (f) Other resources of the institution; (g) The need of the institution and of the fund to make distributions and preserve (h) An asset’s special relationship or special value, if any, to the charitable purposes of institution

capital; the

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OAC 109:1-1-02. IRC Section 6033(c)(2). ORC 1702.51 ORC 1702.39 1(B) ORC 1715.51 ORC 1715.52(B) ORC 1715.52(C) ORC 1715.52 7

OUPMIFA requires that management and investment decisions about an individual asset not be made in isolation but rather in the context of the foundation’s portfolio of investments as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the foundation. Under these rules, the responsible parties are permitted broad discretion to invest in any kind of property or type of investment so long as it is consistent with the standards set forth in OUPMIFA. Federal Regulation. Due to the financial benefit of the tax advantages offered under the Internal Revenue Code, it has been argued that the Internal Revenue Service, through Congress’ taxing authority, occupies the role of the primary regulator of charitable organizations. The role of the Internal Revenue Service arose out of years of congressional investigations into charitable organizations, with an emphasis on private foundations. th 20 century. The U.S. Endowed family foundations attracted congressional scrutiny early in the Commission on Industrial Relations of the U.S. Congress (also known as the Walsh Commission) first investigated private foundations in 1915. The investigation focused upon charges that wealthy ° In the 1950s, the Select 4 capitalists were using the foundation form to protect their economic power. Committee to Investigate Foundations and Other Organizations (the Cox Committee) in 195241 and then the Special Committee to Investigate Tax-Exempt Foundations and Comparable Organizations (the Reece Committee) in 195442 looked into allegations that the large foundations were promoting “un-American activities” and Communist subversion of the capitalist system.

In the 1960s, Congressman Wright Patman, chairman of the Select Committee on Small Business, engaged in an extensive investigation of private foundations and their impact on the 43 Patman’s investigation and a 1965 Treasury Department study of foundations resulted in economy. the legal and regulatory framework applicable to private foundations adopted by Congress and signed into law as part of the Tax Reform Act of 1969. This Act created the private foundation designation, set forth special rules that, among other things, prohibit certain activities deemed abusive by Congress and assigned enforcement of these private foundation rules to the Internal Revenue Service. Penalty Taxes. Unlike public charities which receive funding from a broad segment of the population or otherwise serve certain purposes traditionally held to be charitable in nature, private foundations receive their funding from a limited base of support. A private foundation’s financial stability is not dependent upon pleasing a broad segment of society and, as such, it is not answerable to a broad segment of society. It has been said that “[ut is the intimate fiduciary structure, the lack of serious attention to formal protocol, and the under-regulated nonprofit sector environment that 44 enables the possible abuses to occur.”

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Marion R. Fremont-Smith, Governing Nonprofit Organizations Federal and State Law and Regulation at 68. Id. at 70. 42 Id. at 71. Id. at 72-76. Nina J. Crimm Emory Law Journal, Vol. 50, 2001 A Case Study of a Private Foundation’s Governance and Self Interested Fiduciaries Calls for Further Regulation 8

In light of this, Congress adopted as part of the Tax Reform Act of 1969 five Internal Revenue Code provisions that impose excise taxes on private foundations, foundation managers, or other persons closely involved with the foundation that engage in certain prohibited acts. These are (1) taxes on self-dealing between private foundations and their substantial contributors, directors or other disqualified persons ; (2) requirements that the foundation annually distribute a minimum amount of 45 its assets for charitable purposes ; (3) taxes on certain business holdings 46 ; (4) taxes designed to 47 discourage behavior detracting from a foundation’s ability to further charitable purposes ; and (5) 48 taxes on certain foundation expenditures . These penalty excise taxes are self-reported and paid on 49 Form 4720. Violation of these provisions gives rise to taxes and penalties against the private foundation and, in some cases, its managers, its substantial contributors, and certain related persons. Each of the excise taxes is divided into two tiers. The first tier (initial) tax is imposed if the foundation engages in one of the prohibited acts described in the excise tax provisions. The first tier tax is, in essence, a warning shot across the bow to the unwary. The Internal Revenue Service has the discretionary authority to abate and refund or not assess first tier taxes (other than self-dealing taxes under IRC 4941) if the foundation establishes to the satisfaction of the Service that the violation: (1) was due to reasonable cause; (2) was not due to willful neglect; and (3) has been corrected within the appropriate correction period. 50 The second tier of excise taxes (called “additional taxes”) are punitive and are imposed where the party at fault continues to fail to correct the event. In all events, the event causing the excise taxes must be corrected. Corrective action depends upon the event. Repeated willful failure to correct the event or a willful and flagrant violation of the private foundation excise taxes could lead to the £

IRC 4941 IRC 4942. Disqualified persons are defined as 1.All substantial contributors to the foundation, 2.All foundation managers of the foundation, 3.An owner of more than 20 percent of-a. The total combined voting power of a corporation, b. The p rofits interest of a partnership, or c. The beneficial interest of a trust or unin-corporated enterprise, which is, during the ownership) a substantial contributor to the foundation, 4.A member of the family of any of the individuals described in (1), (2), or (3), 5.A corporation of which more than 35 percent of the total combined voting power is owned by persons described in (1), (2), (3), or (4), 6.A partnership of which more than 35 percent of the profits interest is owned by persons described in( 1), (2), (3), or (4), 7.A trust, estate, or unincorporated enter-prise of which more than 35 percent of the bene-ficial interest is owned by persons described in (1), (2), (3), or (4) IRC 4943 48 IRC 4944 IRC 4945 ° IRC 4962 46



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’ It can also result in a penalty equal to the 5 imposition of the private foundation termination tax. 52 amount of the tax. The termination tax, as it sounds, is a substantial penalty which, in essence, requires the foundation to deliver a substantial amount of the assets of the foundation, up to all of the assets, to the Internal Revenue Service. Thus, the excise taxes are not “cost of doing business taxes”. These are taxes intended to prevent certain behaviors which may divert the foundation’s assets away from the charitable class to be served and toward the private interests of those executing substantial influence over the foundation. Self-Dealing. Section 4941 of the Internal Revenue Code imposes an excise tax on certain transactions (acts of self-dealing) between a private foundation and persons determined to be capable of exerting substantial influence over the foundation. An initial excise tax of 10 percent of the 53 other than a amount involved in the act of self-dealing is imposed on the disqualified person, year a in the taxable period. An or part of each year for as a manager, acting only manager foundation excise tax of 10 percent of the amount involved is imposed on a foundation manager who knowingly participates in an act of self-dealing, unless participation is not willful and is due to reasonable cause, 54 for each year or part of a year in the taxable period. An excise tax of 200 percent of the amount involved is imposed on the disqualified person, other than a foundation manager acting only as a manager, who participated in the act of self-dealing, 55 The additional tax will not be if the act of self-dealing is not corrected within the taxable period. assessed, or if assessed will be abated, if the act of self-dealing is corrected in a timely manner. If the additional tax described above is imposed on the disqualified person, an excise tax of 50 percent of the amount involved is imposed on any foundation manager who refuses to agree to part or all of the 56 correction of the self-dealing act. The maximum initial tax imposed on the foundation manager is $20,000 and the maximum 57 There is no maximum on the liability of the self-dealer, additional tax is $20,000 for any one act. including one who is a foundation manager. If more than one person is liable for the initial and additional taxes imposed for any act of self-dealing, all parties will be jointly and severally liable for 58 those taxes. Generally, providing goods, services or facilities between a private foundation and a disqualified person is an act of self-dealing. This applies to providing goods, services or facilities--for example, office space, cars, auditoriums, secretarial help, meals, libraries, publications, laboratories or parking lots. However, it is not self-dealing if a disqualified person provides them to a foundation without 51 52



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IRC 507(c) IRC 6684 IRC 4941(a)(1) IRC 494 1(a)(2) 1RC4941(b)(1) IRC 4941(b)(2) IRC 4941(c)(2) IRC 4941(c)(1) 10

charge and the goods, services or facilities are used exclusively for purposes specified in section 501(c)(3) of the Code. Also, providing goods, services or facilities to a foundation manager, employee, or unpaid worker, is not an act of self-dealing if the value of the items provided is reasonable and necessary to the performance of the tasks involved in carrying out the exempt purpose of the foundation and is not excessive. 59 IRC 4941(d) provides that the following transactions are generally considered acts of selfdealing between a private foundation and a disqualified person: A. Sale, exchange, or leasing of property, B. Lending money or other extension of credit, C. Furnishing of goods, services, or facilities, D. Paying compensation or paying or reimbursing expenses to a disqualified person, E. Transferring foundation income or assets to, or for the use by or benefit of, a disqualified person, F. Certain agreements to make payments of money or property to government officials. For self-dealing purposes, it is immaterial whether the transaction results in a benefit or a detriment to the private foundation. Common Self-Dealing Transactions. Where the foundation satisfies a pledge made by disqualified person. ° Where the foundation receives tickets to a fundraising event in exchange for its 6 support and the directors, officers, founder, etc., use the tickets. ’ Any direct or indirect sale or 6 exchange of property between a private foundation and a disqualified person. 62 The sale of a private foundation’s art objects to a disqualified person at a public auction conducted by an auction gallery to which the items were consigned for sale constitutes an act of self-dealing. 63 If a family member has no duties or responsibilities for the operation of the foundation, paying such family member’s travel expenses is a violation of the self-dealing rules. Excise Taxes on Failure to Distribute. Private foundations are required to spend annually a certain amount of money or property for charitable purposes. 64 These expenditures may be

Providing-Goods,-Services-or-Facilities 60 Treas. Reg. § 53.4941(d)-2(f)(1). 61 See PLR 8449008; PLR 9021066. 62 IRC 4941(d)(1)(A) 63 Rev. Rul. 76-18 IRC 4942 11

in the form of grants to other charitable organizations, administrative expenses attributable to charitable activities and expenditures for activities directly fulfilling charitable purposes. The amount that must be distributed annually is, in essence, equal to 5% of the monthly average fair market value 65 The distributable amount of the foundation’s assets that are not used directly in charitable activities. must be distributed as a “qualifying distribution”, which is defined as: “Any amount (including program-related investments) paid to accomplish religious, charitable, scientific, literary, or other public purposes. Qualifying distributions do not include contributions to organizations controlled by the contributing foundation or by one or more disqualified persons with 66 respect to the foundation or to private non-operating foundations.” In general, a distribution to a public charity described in section 509(a)(1), (2), or (3) to accomplish a religious, charitable, scientific, literary, educational, or other permitted public purpose is a qualifying distribution. If a foundation distributes more than the required amount in a particular year, 67 then the excess of the required amount may be carried forward for a period of five years. A foundation that fails to pay out the distributable amount in a timely manner is subject to an 68 The tax is charged for each year initial 30 percent excise tax measured by the undistributed amount. or partial year that the deficiency remains uncorrected. An additional 100 percent tax measured by the remaining undistributed amount is triggered if the foundation fails to make up the deficient 69 distribution by the end of the taxable period. Excess Business Holdings. Private foundations are not permitted to own a substantial 70 Generally, the combined holdings of a private foundation and all amount of a closely held business. of its disqualified persons are limited to 20 percent of the voting stock in a business enterprise that is a ’ The 20 percent limitation also applies to holdings in business enterprises that are 7 corporation. 72 For a partnership or joint venture, partnerships, joint ventures, or other unincorporated enterprises. profits interest is substituted for voting stock, and for any other unincorporated enterprise, beneficial interest is substituted for voting stock. A private foundation that has excess business holdings in a 73 business enterprise may become liable for an excise tax based on the amount of the excess holdings. An initial excise tax often percent of the value of the excess holdings is imposed on the 74 The amount of the excess holdings is determined as of the day during the tax year when foundation. the foundation’s excess holdings in the business were the greatest. The initial tax may be abated if the foundation can show that the excess holdings were due to reasonable cause and not to willful neglect, 65 66 67 68 69 70 71 72

IRC 4942(d); 4942(e) IRC 4942(g) IRC 4942(i) IRC 4942(a) IRC 49429b) IRC 4943 IRC 4943(c)(2) IRC 4943(c)(3) RC 4943(c)(3)(A) IRC 4943(a)(1) 12

and that the excess holdings were disposed of within the correction period. Where a private foundation receives “excess” closely held business interests under a will or trust, the private 75 After the initial tax foundation has a five year period within which to dispose of the excess holdings. has been imposed, an excise tax of 200 percent of the excess holdings is imposed on the foundation if 76 The it has not disposed of the remaining excess business holdings by the end of the taxable period. additional tax will not be assessed, or if assessed will be abated, if the excess business holdings are reduced to zero during the correction period. Jeopardizing Investments. The jeopardizing investments excise tax is a multi-level tax 77 If a private foundation designed to deter private foundations from making jeopardizing investments. makes any investments that would financially jeopardize the carrying out of its exempt purposes, both the foundation and the individual foundation managers may become liable for taxes on these jeopardizing investments. 78 An investment is a jeopardizing investment if it is determined that the foundation managers, in making the investment, have in providing for the long- and short-term financial needs of the foundation to carry out its exempt purposes failed to exercise ordinary business care and prudence under the facts and circumstances prevailing at the time of making the 79 investment. In exercising the requisite standard of ordinary business care and prudence, private foundation managers may take into account the: expected return (including both income and appreciation of capital); risks of rising and falling price levels; and the need for diversification within the investment portfolio (e.g., with respect to type of security, type of industry, maturity of company, degree of risk, and potential for return). The determination should be made on an investment-by-investment basis, in ° In other words, if it can be 8 each case taking into account the foundation’s portfolio as a whole. shown that the foundation managers fulfilled their fiduciary duty of care by engaging in an informed decision making process, then the likelihood of an investment being characterized as a jeopardizing investment decreases significantly. Jeopardizing investments do not include an investment made by any person which is later ’ 8 gratuitously transferred to a private foundation. The first tier is an excise tax of ten percent of the amount of the jeopardizing investment which 82 The is imposed on the foundation for each tax year, or part of a year, in the taxable period. foundation will not be liable for the tax if it can show that the jeopardizing investment was due to reasonable cause and not willful neglect, and that the jeopardizing investment was corrected within the correction period. An excise tax often percent of the amount involved is also imposed on any

1RC4943(c)(6) IRC 4943(b) IRM 7.27.18.6 (04-30-1998) 78 IRC 4944 RM 7.27.18.2 (04-30-1998) 80 Treas. Reg. 53.4944—1(a)(2)(i) 81 Treas. Reg. 53.4944-1(a)(2)(ii)(a) 82 IRC 4944(a)(1) 76

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foundation manager who knowingly, willfully, and without reasonable cause participated in making the jeopardizing investment. If a private foundation is liable for the initial tax and has not removed the investment from jeopardy within the taxable period, an additional excise tax of 25 percent of the amount involved will 83 The additional tax will not be assessed, or if assessed will be abated, if be imposed on the foundation. the investment is removed from jeopardy within the correction period. An investment is removed from jeopardy when it has been “sold or otherwise disposed of, and the proceeds of such sale or other 84 In each case disposition are not investments which jeopardize the carrying out of exempt purposes.” often percent of the tax excise additional an where this additional tax is imposed on the foundation, amount involved is imposed on any foundation manager who refuses to agree to all or part of the 85 If more than one individual manager is liable for removal from jeopardy within the correction period. 86 In addition, the excise tax on jeopardizing investments, all parties will be jointly and severally liable. repeated willful or flagrant violations of IRC 4944 by a private foundation may result in the termination of its private foundation status as well as the imposition of excise tax pursuant to 1RC 507. Also, the foundation managers may be subject to an excise tax under IRC 6684. Taxable Expenditures. The taxable expenditure excise taxes are designed to discourage private foundations from engaging in legislative and political activities, making grants to individuals without prior approval of the Internal Revenue Service (Service), making grants to organizations (other than public charities) without exercising adequate control and supervision over the use thereof, and providing grants for noncharitable purposes.87 Congress enacted the taxable expenditure provisions in 88 an effort to curb perceived abuses of private foundations. The Internal Revenue Code identifies specific types of expenditures that Congress sought to curb taken from the results of its various investigations. Under the Code, a taxable expenditure is any amount paid or incurred by a private foundation: (1) to carry on propaganda, or otherwise to 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; (3) as a grant to an individual for travel, study or similar purposes, unless the foundation approves such a grant in accordance with procedures preapproved by the Internal Revenue Service; (4) as a grant to any other organization (except a public charity under IRC 509(a)(1), 509(a)(2) or a 509(a)(3) organization closely related to its supported organization) unless the private foundation exercises expenditure responsibility with respect to the 170(c)(2)(B). If a grant; or (5) for any purpose other than the charitable purposes listed in Code Sec. 89 ° The taxes 9 private foundation makes a taxable expenditure, it is liable for taxes on the expenditure. are imposed on both the foundation and on any foundation manager who knowingly and willfully agrees to the expenditures. 83 84 85 86 87 88

90

IRC 4944(b)(1) IRC 4944(e)(2) IRC 4944(b)(2) IRC 4944(d)(1) IRM 7.27.19 (02-22-1999) IRM 7.27.19.1.1 (02-22-1999) IRC 4945(d). IRC 4945 14

The initial tax on the foundation is 20 percent of the amount expended. ’ The foundation is not 9 liable for the tax if it can show the expenditure was due to reasonable cause and not to willful neglect, and the expenditure was corrected within the correction period. If a foundation manager knowingly, willfully, and without reasonable cause agrees to the taxable expenditure, the initial tax on the management is five percent of the amount expended , up to a maximum tax of $10,000 for any 92 93 A foundation manager who acts on advice of counsel, given in a reasoned legal opinion expenditure. in writing, is not liable for the tax. 94 If the taxable expenditure is not corrected within the taxable period, an additional tax of 100 percent of the amount expended is imposed on the foundation. 95 The tax will not be assessed, or if assessed will be abated, if the expenditure is corrected within the correction period. Any foundation manager who refuses to agree to any part of the correction must pay an additional tax of 50 percent of the expenditure, 96 up to a maximum tax of $20,000. If more than one foundation manager is liable for either the initial or additional tax, all are jointly and severally liable. 98 Investment Income Tax. There is an excise tax on the net investment income of most private 99 This tax must be reported on Form 990-PF, Return of Private Foundation, and must be foundations. paid annually at the time for filing that return or in quarterly estimated tax payments if the total tax for the year is $500 or more.’°° Under current law, a private foundation is subject to a 2 percent tax on its net investment income.’°’ The tax is reduced to 1 percent if the foundation’s charitable distributions for the year exceed the average distributions over the five preceding tax years. The Administration’s budget proposal calls for a replacement of the current two-tier tax on the net investment income of a private foundation with a single tax rate of 1.35 percent.’° 2 Organizing the Foundation.

4.

Choice of Entity. Under Section 501(c)(3), charities may take the structure of a trust, corporation or unincorporated association.’ 03 Normally, private foundations are structured as either nonprofit corporations or trusts. In determining whether to select a trust or corporate structure for a private foundation, considerations that need to be taken into account include: (1) ease/speed of formation; (2) limitation of liability for members and directors; (3) financial resources; (4) type and scale of activities to be conducted; (5) governance requirements; (6) capacity to own property and

91 92

IRC 4945(a)(1) IRC 4945(a)(2) IRC 4945(c)(2)

1d. 94 IRC 4945(b)(1) IRC 4945(b)(2) IRC 4945(c)(2) 98 IRC 4945(c)(1) IRC 4940 100 IRC 6655(c) 101 IRC 4940(a) 102 See General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals, p 180. 103 IRC 501(c)(3) 15

contract; (6) capacity to sue and be sued; (7) liabilities to third parties; (8) permanence of the organization; and (9) ease of dissolution. 105 A charitable . The charitable trust is the oldest form of nonprofit entity. 104 Charitable Trust and the charitable trustee between the existing property to respect with trust is a fiduciary relationship beneficiaries. Ohio law defines a charitable trust as a trust, or portion of a trust, created for the relief of poverty, the advancement of education or religion, the promotion of health, governmental or 106 municipal purposes, or other purposes the achievement of which is beneficial to the community. A trust is formed in Ohio when a settlor with capacity to create a trust indicates an intention to do so and either transfers property to another person or declares himself or herself to be trustee with 7 Normally, trusts are evidenced by a written document respect to property that the owner holds.’° containing the terms of the trust, and it is clear that the Internal Revenue Service expects a copy of a 8 Charitable trusts are written trust document as part of the application for exemption process.’° managed by trustees who have the legal authority to do all things necessary to administer the trust. Ohio law does not require the trustees to have periodic meetings or to keep minutes of any meetings held by the trustee. A charitable trust may be managed by a single trustee, including the settlor of the 9 When three or more trustees are serving, the decision of a majority of the trustees serving trust.’° controls.”° A trustee must administer a trust in good faith, in accordance with its terms and purposes and ’ A trustee must 1 the interests of the beneficiaries, and in accordance with the Ohio Trust Code.’ ,” beneficiaries as a prudent person would and must administer the trust solely in the interests of the 2 consider the purposes, terms, distributional requirements, and other circumstances of the trust. In The settlor of a satisfying this standard, the trustee shall exercise reasonable care, skill, and trust is granted standing to enforce a charitable Nonprofit Corporation. The nonprofit corporation is the predominant form of charitable organization in the United States. Nonprofit corporations are governed by the Ohio Nonprofit 104

In Ohio, the statutes authorizing Attorney General oversight refer to all charitable organizations as “charitable trusts”. CRC 109.23 provides charitable trusts are not limited to formal trust agreements; a charitable trust can include corporations, associations, and other business organizations. Charitable trusts encompass both property and entities vested with responsibility for property held for any charitable, religious, or educational purpose. 105 See Trust created by William Payne in 1660, an early Massachusetts settler, who decreed in his will that the trust was for the “benifitt of the said scoole of lpswitch, for euer...and therefore the sayd land not to bee sould nor wasted.” http://ipswichtrust.files.wordpress.com/2012/01/probate-feoffees-101202-summary-judgment-memo.pdf 106 CRC 580 1.01(E) 107 ORC 5804.01 108 See Form 1023 Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, Part II, Item 4a. CRC 5804(E) 110 CRC 5807.03 CRC 5808.01 112 CRC 5808.02 113 CRC 5808.04 114 ORC 5804.05(C) 16

5 A nonprofit corporation is a corporation that is formed otherwise than for the Corporations Law.” pecuniary gain or profit of, and whose net earnings or any part of them is not distributable to, its 6 Formation of a nonprofit corporation begins members, directors, officers, or other private persons.” 7 The Articles of with filing of Articles of Incorporation with the Secretary of State of Ohio.” Ohio where the principal office of in the place corporation; Incorporation must contain the name of the A the corporation is located and the purpose or purposes for which the corporation is .” Incorporation written appointment of a statutory agent must also be filed with the Articles of 9 A nonprofit corporation may have members having the authority to elect directors and approve ° Where the corporation has members, an annual meeting of 2 organic changes to the corporate form.’ ’ All of the authority of an Ohio nonprofit corporation is exercised 2 the members is required to be held.’ 22 The directors of an Ohio nonprofit corporation by or under the direction of its board of directors.’ must perform the duties of a director in good faith, in a manner the director reasonably believes to be in or not opposed to the best interests of the corporation, and with the care that an ordinarily prudent circumstances.’ The Ohio nonprofit corporation law person in a like position would use under similar 23 allows directors to enter into transactions with the corporation without violating a duty of loyalty circumstances.’ under certain 24 Important differences. Perhaps the most important difference between the trust form and the corporate form is that corporate directors appear to have the benefit of the business judgment rule. The business judgment rule protects nonprofit directors by providing that directors will not be liable for harm to the corporation for the exercise of their judgment so long as they exercised care in the decision making process. That is, a director shall not be found to have failed to perform the director’s duties in accordance with Ohio law, unless it is proved, by clear and convincing evidence, in an action brought against the director that the director has not acted in good faith, in a manner the director reasonably believes to be in or not opposed to the best interests of the corporation, or with the care circumstances.’ Further, a that an ordinarily prudent person in a like position would use under similar 25 director is liable in damages for any act that the director takes or fails to take as director only if it is proved, by clear and convincing evidence, in a court with jurisdiction that the act or omission of the director was one undertaken with a deliberate intent to cause injury to the corporation or was one 26 undertaken with a reckless disregard for the best interests of the corporation.’

115 116 117

CRC Chapter 1702 CRC 1702.0 1(C) CRC 1702.04(A)

118

119 120 121 122 123 124 125 126

CRC CRC CRC CRC CRC CRC CRC CRC

1702.04(C) 1702.14 1702.16 1702.30(A) 1702.30(B) 1702.301. Note, however, that IRC 4941 may impose excise taxes on such transactions. 1702.30(D) 1702.30(E) 17

Further, a trust clearly may have only a single level of management, the trustee, and a single person serving in that role. In order to have a single level of management, an Ohio nonprofit corporation must have at least three directors. A nonprofit corporation may have a single director, but must also have a single member, thus requiring two levels of participation in the governance of the corporation. Further, corporate directors are specifically empowered to form committees of one or more directors and may rely upon committee reports in their decision making processes. Finally, if the private foundation becomes subject to unrelated business income tax, the marginal tax rates applicable to the trust may result in a higher average tax rate than the same unrelated business income 27 earned by a corporation.’ Application for Recognition of Exemption. Form 1023, Application for Recognition of Exemption Under § 501(c)(3) of the Internal Revenue Code should be filed within 15 months from the end of the month of the foundation’s organization. An automatic extension allows filing within 27 months of the foundation’s organization. Further extension may be granted for reasonable action, good faith, and a showing of no prejudice to the government. If Form 1023 is timely filed, exempt status will relate back to the date of organization. Otherwise, exempt status relates back only to the date of filing of Form 1023. If Form 1023 is approved, the IRS will issue a “determination letter” as evidence that the foundation is exempt as organized under Code § 501(c)(3). Copies of the approved 28 Once exempt status is Form 1023 and related correspondence must be made publicly available.’ 129 granted, Ohio similarly grants exemption from state income tax. 5.

Governance Practices.

It is the intimate fiduciary structure, the lack of serious attention to formal protocol, and the under-regulated nonprofit sector environment that enables the possible abuses to occur in private ° Starting in the early 2000’s, immediately following the Enron saga and the legislative 3 foundations.’ response in the Sarbanes-Oxley Act, the charitable sector (notably through Independent Sector), the Internal Revenue Service and the states began assessing the governance practices of charitable organizations generally. The results of many of these assessments can be seen in the Independent Sector’s “Principles for Good Governance and Ethical Practice: Guide for Charities and Foundations” released in 2007, the Internal Revenue Service’s Form 990 released in 2008 and in Ohio Attorney General Mike DeWine’s “Guide for Charity Board Members.” From these resources it can be seen that the three regulators of the charity sector, the sector itself, the Internal Revenue Service and the states’ Attorneys General believe that prudent and good faith management of a charity, including a private foundation, requires substantial attention to governance practices and procedures. Thus, while the stewards of charitable assets have always had the legal obligation to act in accord with their fiduciary duties, the prominent failures of corporate and 127

See, Rev. Proc. 2013-15 showing that the 2013 the highest marginal rate of 39.6% applies to trusts having taxable income in excess of $11,950. In contrast, the first $50,000 of corporate taxable income is taxed at 15% and the highest rate of 39% becomes effective for amounts of taxable income in excess of $100,000. IRC 11. 128 IRC 6104(a)(1) 129 CRC 5747.02(E) regarding trust income tax. See, 575 1.01(E)(8) which excludes all nonprofit corporations. 130 Nina J. Crimm Emory Law Journal, Vol. 50, 2001 A Case Study of a Private Foundation’s Governance and Self Interested Fiduciaries Calls for Further Regulation

18

charitable leaders to so abide have resulted in heightened scrutiny of their actions. Much of the results of the various governance examinations and reports may be encapsulated as follows : 131 Trustees or board members should: •

Prepare for board meetings by reading and reviewing reports, minutes, and other materials distributed for the meeting.



Attend board and committee meetings and record all actions taken or decisions made.



Ask questions and obtain the information necessary to make informed decisions.



Review the performance of the charity’s executive director or chief executive officer.



Exercise independent judgment rather than blindly follow the staff’s requests.



Oversee the executive director and ensure that the charity’s purposes are fulfilled efficiently and follow sound business standards.



Establish a written policy for dealing with conflict-of-interest situations, including procedures for written disclosures from board members concerning business dealings with the charity or those seeking to do business with the charity.



Not engage in any transaction that hurts the charity or in any activities that compete with the interests of the charity or result in any personal advantages based on the charity’s business dealings.



Use caution when entering into any business relationship between the organization and a board member. Avoid this scenario entirely unless the board determines that the transaction is in the best interest of the charity.



Establish and comply with a written policy for disclosing conflicts of interest, appearances of impropriety, and business dealings involving board members.



Disclose any financial interest and abstain from discussions and votes on transactions when the charity proposes to enter into a business relationship in which a board member holds an interest.



Avoid diverting opportunities available to the charity for personal gain.



Understand the charity’s articles of incorporation, constitution, bylaws, codes of conduct, codes of ethics, and any other governing documents.

131

Ohio Attorney General Mike DeWine, Guide for Charity Board Members available at

19



Be familiar with state and federal laws relating to nonprofit entities, fundraising, and taxrelated issues as well as legal issues connected with the organization’s charitable purposes and operations.



Comply with state and federal registration and reporting requirements, including filings with the Ohio Attorney General, the Ohio Secretary of State, and the Internal Revenue Service.



Develop policies and procedures that protect the organization’s business interests and operations.



Develop annual budgets that provide clear direction for all organizational spending. The budget should be a blueprint of the board’s program plans and should be routinely monitored, tracked throughout the year, and revised as necessary.



Ensure maintenance of accurate records of all income, expenditures, transactions, and for the board and in all organizational operations. activities throughout the year —

6.



Establish appropriate internal accounting systems, including checks and balances, so one staff member or volunteer does not have total control over finances and so theft and improper spending can be identified quickly.



Prudently invest and reinvest assets.



Develop fundraising goals and policies and assist the organization in acquiring resources for its programs.



Make certain that fundraising appeals are presented honestly and fairly by monitoring the performance of fundraising professionals and volunteers.



Insist upon getting the best value for goods and services through comparisons and an informed bidding process.



Ensure board minutes are kept to indicate board approval of expenditures and investments and to show that informed discussions were held prior to approval of such transactions.

Tax Compliance.

Form 990-PF, Return of Private Foundation. Private foundations generally are required to file Form 990-PF, Return of Private Foundation, annually whether or not they have any taxable income for, or activity during, the year. Section 4940 of the Code imposes an excise tax of 2% on the net investment income of most domestic tax-exempt private foundations, including private operating foundations. This tax must be reported on Form 990-PF and paid annually at the time for filing that return or in quarterly estimated tax installments if the total tax for the year is more than $500. Some

20

exceptions apply. Exempt operating foundations are not subject to the tax. Further, some foundations are only required to pay a 1% tax. The Form 990-PF must be filed by the 15th day of the fifth month after the end of the private foundation’s annual accounting period (May 15 for calendar year taxpayers). If the private foundation receives money, securities, or other property valued at $5,000 or more directly or indirectly from any person during the year, it must complete Schedule B, Schedule of Contributors and attach it to Form 990-PF. Schedule B sets forth the identities of the contributors required to be listed. Filing Penalties for Form 990-PF. An organization that fails to file a timely complete Form 990PF (taking into account any extensions) is subject to penalties of $20 per day for each day the return is late ($100 per day for large organizations with annual gross receipts in excess of $1 million), not to exceed the lesser of $10,000 ($50,000 for large organizations) or 5 percent of the organization’s gross receipts unless the failure to file was due to reasonable cause. The person or persons responsible for the failure to file will be subject to a penalty of $10 per day (not to exceed $5,000) if the return is not filed by the date specified by the IRS in a written demand for payment unless such failure to file is due to reasonable cause. Penalties also apply to failures to provide required return information or incorrect information. Form 990-PF is also a tax return because it is used to report the tax on investment income imposed by section 4940 (or 4948 if an exempt foreign organization). Accordingly, the penalties imposed by section 6651 for not filing a return (without reasonable cause) also apply. The penalty is generally 1/2 of 1 percent of the unpaid tax for each month or part of a monththe tax remains unpaid, not to exceed 25% of the unpaid tax. If there was reasonable cause, the penalty may be waived but interest is charged on any tax not paid on time. If the organization fails to file Form 990-PF for three consecutive years, then its 501(c)(3) status will be automatically revoked and it will be a taxable private foundation that must file income tax returns as well as Form 990-PF. Form 990-T. A private foundation that has $1,000 in gross income from an unrelated trade or business must file a Form 990-T, Exempt Organization Business Tax Return. Net income from income producing activities is taxable if the activities constitute a trade or business, are regularly carried on, and are not substantially related to the organization’s exempt purpose. Examples of unrelated business income may include income from advertising in publications, income from gaming, and other income from the sale of goods or performance of services unrelated to the organization’s exempt purposes. Whether an income-producing activity is an unrelated trade or business activity depends on all the facts and circumstances. Private foundations must pay quarterly estimated tax on unrelated business income if the organization expects its tax for the year to be $500 or more. Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Code. A private foundation and its managers may be liable for two-tier excise taxes and be required to file Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code, if they violate 21

certain restrictions and requirements imposed on private foundations. If a private foundation is required to file Form 4720, the return must be filed by the 15th day of the fifth month after the end of the organization’s annual accounting period (May 15 for calendar year taxpayers). Public Disclosure. As described below, Form 990-PF and its schedule of contributors is required to be publicly disclosed. An organization’s filed Form 990-PF can easily be found and accessed on www.guidestar.org.’ Thus, all interested parties including the press, skeptics, critics, websites such as 32 researchers, donors, state and Federal regulators, and elected officials all have essentially immediate access to the information on Form 990-PF. Thus, any error or inconsistency may result in negative publicity or unwanted attention from regulating agencies. In contrast, a well prepared Form 990-PF can tell a compelling story about the charitable activities undertaken by the organization, the assistance it has provided and the lives it has changed. 7.

Transparency Expectations.

As mentioned previously, private foundations utilize private funds, leveraged by public tax dollars, for privately selected charitable activities. The ongoing debate over how to balance the public’s interest in the expenditure of their tax dollars with the privacy interests of the donors to a private foundation is far from resolved. Currently, private foundations are required to disclose certain information on a yearly basis to the IRS in their 990-PF forms which are then required to be made 33 Broad access to filed Forms 990-PF is made possible through websites such as publicly available.’ www.guidestar.org. However, the desires of some groups for increased transparency in private 34 It is reasonable to expect that the philanthropy go well beyond that provided by the Form 990-PF.’ next big charity scandal may result in further governmental regulation requiring additional disclosure of internal private foundation information. 8.

Succession.

After the years of hard work of the founders to organize and operate the foundation and comply with the various regulatory bodies, continuing the foundation’s work in fulfilling the founder’s vision will become a priority. Planning early for an orderly transition of leadership will enhance the likelihood of the foundation’s continued existence and successful operation. A foundation that develops a reasoned and workable succession plan early and shares that plan with the next generation of interested parties will have a much better chance to engage the next generation in controlled foundation experiences early on, thereby both training and engaging the next pool of leaders while the founder is still capable of passing on his or her philanthropic vision. Where a 35 family foundation is involved, such early planning will help prevent family difficulties later on.’ 132

Other websites are described here http://grantspace.org/Tools/Knowledge-Base/Funding-Research/Forms-990and-990-PF/Finding-990-990-PFs 133 IRC 6104(b) 134 See, e.g,, www.glasspockets.org. See also, http://www.philanthropyroundtable.org/file_uploads/Transparency_Companion_Guide.pdf 135 Facing Forever: Planning for Change in Family Foundations,” Gast, Elaine C., 11

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Without a plan, a family may move toward an arbitrary selection process that can cause resentment or frustration on the part of those not included.’ 36 Young members of the family, for example, may be denied the opportunity to serve the foundation at a time when they are most likely to provide a source 37 of vitality and renewal for the foundation.’ Even the best succession plans may not work where the human family dynamic is involved. Plans are normally made with the assumption that all interested parties will act rationally and in the best interests of the foundation. Where outside factors such as damaged family relationships, divorce of the founders, substantial disagreement between the generations involved and mental or physical illness enter into the equation, it may be impossible to reach a suitable compromise particularly after the founder(s) are no longer involved. Charitable activities reach a standstill, compliance with tax reporting and payment requirements may falter resulting in substantial penalties imposed upon the foundation. Alternatives to succession should be considered. 9.

38 Termination’

Why do Foundations Terminate? There are two parts to the termination of a private foundation; why and how. With respect to why, from my experience and what I have learned anecdotally, foundations terminate for a number of reasons. Specific examples I have dealt with include: the founder does not believe the next generation will respect and further one or more aspects of his charitable vision; a lack of trust among the second (or third) generations resulting in stagnation; and the cost in time, labor and money to effectively manage the foundation is too much. I am sure there are many other examples of circumstances leading to the termination of a private foundation. How is Private Foundation Status Terminated? With respect to how to terminate aprivate foundation, both state and federal requirements must be satisfied. It is important to note that the termination of a private foundation for federal tax purposes does not necessarily mean the termination of the foundation as an entity. An organization whose status as a private foundation is terminated will be treated as an organization created on the day after the day of the termination. An organization whose private foundation status has been terminated under the provisions of section 507(a) will, if it continues to operate, be treated as a new organization and must, if it wants to be classified under section 501(c)(3), apply for recognition of section 501(c)(3) status.

For federal tax purposes, once an organization is classified as a private foundation, it may only terminate that status under the provisions of Internal Revenue Code section 507. Under section 507, there are four ways to terminate private foundation status, two of which involve tax liability: Voluntary Termination. Voluntary termination by notifying the IRS of intent to terminate and paying a termination tax. To voluntarily terminate under section 507(a)(1), the organization must send a statement to the Manager, Exempt Organizations Determinations (Internal Revenue Service, Exempt Organizations Determinations, P.O. Box 2508, Cincinnati, OH 45201) of its

136 137 138

Id. Id. See

23

intent to terminate its status under section 507(a)(1). The statement must provide, in detail, the computation and amount of private foundation termination tax. Unless the organization requests abatement, it must pay the tax at the time the statement is filed. Involuntary Termination. Involuntary termination occurs where either willful repeated violations or a willful and flagrant violation of the private foundation excise tax provisions occurs. Private foundations under involuntary termination are subject to the termination tax. Distribution of All Assets to Public Charity. A private foundation may terminate its status under section 507(b)(1)(A) by distributing all its net assets to one or more organizations with a ruling or determination letter described in section 509(a)(1) without being subject to the termination 139 However, the organization to which the distribution is made must have been in existence and so tax. described for a continuous period of at least 60 months before the distribution. A private foundation that terminates its status in compliance in this manner is not required to notify the IRS of its intent to terminate. Thus, this is perhaps the easiest approach from a tax compliance standpoint. A foundation may request a determination regarding the termination. One use of this particular exception from the termination tax would allow the terminating private foundation to transfer its assets to a community foundation (a public charity under 509(a)(1)) to create a donor advised fund. While private foundations may not impose material restrictions or conditions on the recipient charity’s use of the funds under this exception, the private foundation may define a specific charitable purpose for the assets so long as the recipient’s governing body is independent of the terminating foundation. If the community foundation receives complete ownership and control of the transferred assets and the income they produce then it is likely that a charitable purpose restriction would not be characterized as an improper material restriction. Under such circumstances, the foundation’s board members may be named as advisors to the fund. A private foundation that distributes all its net assets to one or more public charities, at least one of which is described in § 509(a)(1) and has been so described for fewer than 60 calendar months immediately preceding the distribution or is described in § 509(a)(2) or (3), does not terminate its private foundation status unless it gives notice under § 507(a)(1). If the private foundation does not provide notice and does not terminate, the private foundation is not subject to tax under § 507(c). If the private foundation chooses to provide notice, and therefore terminates, it is subject to the tax under § 507(c) on the date notice is given; however, if the private foundation has no net assets on the day it provides notice (e.g., it provides notice at least one day after it distributes all its net assets), the ° 4 tax imposed by § 507(c) will be zero.’ Convert to Public Charity. An organization may terminate its private foundation status under section 507(b)(1)(B) without becoming liable for the termination tax if it meets the requirements of section 509(a)(1), (2), or (3) for a continuous 60-month period beginning with the first day of any tax year, and notifies the Service before beginning the 60-month period that it is terminating its private

139 140

IRC Section 507(b)(1)(A) Revenue Ruling 2003-13

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foundation status.’ ’ The notice of termination of private foundation status via operation as a public 4 charity should include: The name and address of the private foundation, Its intention to terminate its private foundation status, The Code section under which it seeks classification (section 509(a)(1), (2), or (3)), If section 509(a)(1) applies, the specific type of section 170(b)(1)(A) organization for which it seeks classification, The date its regular tax year begins, and The date the 60-month period begins. The organization also must establish immediately after the end of the 60-month period that it has met the requirements of section 509(a)(1), (2), or (3). Distribute Assets to Another Private Foundation. A foundation may also transfer its assets to another private foundation, commence voluntary termination, and pay no termination tax because it has no assets. 142 That is, since the termination tax is based upon the value of the assets owned by the private foundation, if it owns no assets, then the tax liability is zero. As a result of such a termination, the transferee private foundation acquires all of the aggregate tax benefits of the transferor associated with the transferred assets.’ 43 For example, a person who was a substantial contributor of the transferor will continue to be a substantial contributor of the transferee. Further, it means that the future measure of the termination tax will include the tax benefits conferred by the predecessor foundation. This approach is useful to divide an existing private foundation among family factions. It can also be used to convert trust-form foundations into corporations. Termination Tax. The most significant consideration in terminating a private foundation, at least financially, is the “termination tax” applicable to certain “voluntary” and “involuntary” terminations (see below) under IRC Section 507(c). The tax imposed under section 507(c) on the termination of a private foundation is the lesser of: 1. The combined tax benefit resulting from the section 501(c)(3) status of the organization, or 2. The value of the net assets of the organization. The combined tax benefit resulting from the section 501(c)(3) status of any private foundation is the sum of’ : 44 1. The combined increases in income, estate, and gift taxes that would have been imposed on all substantial contributors if deductions for all contributions made by those contributors to the foundation had been disallowed, and

141 142 143 “

IRC Section 507(b)(1)(B) See Rev. Rul. 2002-28 IRC Section 507(b)(2) http://www.irs.gov/Charities-&-Non-Profits/Private-Foundations/Private-foundation-termination-tax 25

2. The combined increases in income tax that would have been imposed on the private foundation’s income if— a. The foundation had not been tax exempt, and b. In the case of a trust, its charitable deduction had been limited to 20 percent of its taxable income, and 3.

Amounts received from private foundations to which transferee liability applies, and

4. The interest on the tax increases in (1), (2), and (3) from the first date the increase would have been due or payable to the date the organization ceases to be a private foundation. In figuring the combined increases in tax under (1), all deductions for a particular contribution for income, estate, or gift tax purposes must be included. For example, if a substantial contributor had taken income tax and gift tax deductions for a charitable contribution to the foundation, the amount of each deduction must be included. The combined tax benefit may be more than the fair market value of the property transferred. The value of the net assets of the organization is generally the greater of: 1. The value on the first day action was taken to terminate private foundation status, or 2. The value on the date the organization ceased to be a private foundation. The valuation date in (1) is the date the organization gave notice it was terminating private foundation status. 10.

Easier Alternatives to Private Foundations.

Outsourcing Administrative Activities. A search of the Internet reveals a number of organizations offering back office support for private foundations and at least one news report 145 Similarly, a foundationsource.org study identifies savings in the range of 25 percent to 40 percent. found that, depending upon the asset level of the foundation, savings in the range of 38 percent to 58 46 percent are possible.’ Donor-Advised Funds. A donor-advised fund is a fund or account (1) that is separately identified by reference to the contributions of a donor or donors; (2) that is owned and controlled by a sponsoring organization; and (3) with respect to which the donor or person appointed or designated by the donor has, or reasonably expects to have, advisory privileges with respect to distributions or

145

Small foundations get edge by “back-office” outsourcing, Reuters, Manuela Badawy, July 11, 2012 http://www.fou ndationsource.com/press-releases/second-annual-study-confirms-Iower-operating-costs-for private-foundations-that-outsource-administration/#. UYgBZrVwgM4, accessed May 6, 2013. 146

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147 Donor-advised funds have historically been considered a better alternative to a private investments. foundation. As discussed above, private foundations are subject to federal, state and sector oversight, press and private individual review and scrutiny, substantial tax and other regulatory compliance requirements, possible penalties imposed upon foundation managers and other unsavory prospects. In addition, the charitable deduction limits for contributions to a private foundation are lower than those for comparable contributions to a public charity. As donor-advised funds are held and ultimately controlled by a public charity, many of the parade of horribles described in this writing will not apply, or at least not to the donor. In addition, there are no formation costs, and contributions are deductible according to the public charity deduction limits. Importantly, there are no administrative, investment, fiduciary or governance responsibilities nor is there any requirement to engage in oversight over grants. The cost for the foregoing is that the donor lacks legal control over the management, utilization and investment of the contributed assets after making the contribution. While the donor may provide recommendations or may advise the sponsoring organization about potential recipients of grants from the donor-advised fund, the donor does not have legal control over the donor advised fund. In my experience, sponsoring organizations generally make every effort to fulfill the donors’ recommendations so long as such grants would be consistent with the sponsoring organization’s exempt purposes and in compliance with the law. Clearly, a sponsoring organization that does not fulfill a donor’s recommendations will likely lose goodwill among its donors and the potential contributors in the community. Fiscal Sponsorship. A similar relationship with a public charity may also serve as a viable alternative to the private foundation. A “fiscal sponsorship” is a relationship between an individual or group of individuals who have a vision for a charitable project and an existing charitable organization that has agreed to support the project.’ 48 While there are a number of different models under which this may occur, the most straight-forward model is where the sponsor undertakes the project under its own organizational umbrella by its employees or volunteers.’ 49 The sponsor accepts contributions restricted to use for the project. The project visionaries will likely become affiliated with the sponsor as either employees or volunteers and will be charged with the responsibility of operating the project. The exact relationship, and any administrative fees charged by the sponsor, should be carefully considered and set forth in writing prior to the project being initiated. Once the project commences in the sponsor’s organization, it will become the sponsor’s own.

147

IRC 4966 See Gregory Colvin, Fiscal Sponsorship: Six Ways To Do It Right Review, April 1993 149 Id. This model is identified as the Direct Project Model. 148



A Synopsis

—,

The Exempt Organization Tax

27

MANLEY BuRKE A LItGAL PROFESSIONALASSOCIATCON tvvw.nianI,j,fjurhc.cont

John E. Christopher 225 West Court Street Cincinnati, OH 45202 (o) 513-721-5525 (direct) 513-763-6750 (c)5 13-633-0875 [email protected] manleyburke.com www. manleybjirke. corn

John E. Christopher is a partner at Manley Burke, LPA where he primarily practices in the area of nonprofit organizations. John’s tax focused education and his years of experience in working with a broad variety of nonprofit organizations (both charities and non-charities) allow him to provide focused, relevant and usable legal advice to his nonprofit clients in all phases of their operations, from creation and start up through termination. More specifically, he represents operating and nonoperating private foundations ranging from those affiliated with Fortune 1 00® listed companies to small family foundations. His public charity representation covers all varieties of public charities. He has represented hospitals and hospital-supporting organizations, national church foundations, college and university-affiliated organizations, museums, arts organizations, cultural organizations, community organizations, ministries, youth sports organizations and national fraternal organizations and their related foundations, among many other mission-driven organizations. John’s experience in representing nonprofit clients includes corporate governance and fund stewardship, domestic and foreign grant-making, maintaining the corporate integrity of affiliated organizations, policy and procedure drafting and review, self-dealing and excess benefits transactions review and guidance, and representation of organizations facing IRS audit. He is a frequent author and has presented at numerous seminars, institutes and client training programs. Before joining Manley Burke, John was a partner in the Cincinnati office of Dinsmore & Shohl LLP. John is listed in the Best Lawyers in America® in Non-Profit I Charities Law.

Recent Publications and Presentaticrs • • • . . •

States Ramp Up Regulation of Nonprofits With Help From the Feds, July 2011 IRS Posts Automatic Revocation List: Are You and Your Chapters Still Exempt?, June 2011 What’s New With CHIA?, February 2011 Deadline Extended for 2010 Charitable IRA Rollover, January 2011 IRS modifies Filing Thresholds, January 2011 New Private Letter Ruling Disregards Separate Existence of a Charity and Related Noncharity, —

January 2011 • •

Legal Update at THE Foundation Seminar August 2010 IRS Denies Exemption to Local Fraternity Foundation Providing Scholarships to Chapter

Members, August 2010 • • • •

IRS Gives Some Non-Filers One Last Chance, August 2010 Loss of Exemption Under Group Ruling Requires Full Re-Application, January 2010 Whether and Where to Register Your Foundation, January 2010 THE Foundations Seminar Annual Legal Update, August 2009 and Follow-Up to Annual Legal Update, September 2009

Education • • •

1994, LL.M. (Taxation), University of Florida 1993, J.D., Northern Kentucky University Salmon P. Chase College of Law (cum laude) 1990, B.A., University of Kentucky