As an advisor to private foundations, I have seen them run afoul of the Internal Revenue Service time and again. Many of the missteps are inadvertent, but the penalties are no less severe. At the extreme, violations can lead to foundations losing their not-for-profit status. Sanctions also can take the form of additional excise taxes, as much as 200 percent of the amount in dispute.
While not all pitfalls can be predicted, foundation leaders should at least be aware of the most frequent mistakes. Here are 10 areas where foundations make potentially costly mistakes, in order of what we see most frequently:
- Scholarship grants and IRS approval.
Many foundation personnel mistakenly believe they can fund a specific person's scholarship without advance approval from the IRS, as long as the grant is paid directly to the university and not the student. Wrong.
It is the foundation's act of choosing the scholarship recipient — instead of having a university make that choice — that triggers the need for advance approval. This requirement exists regardless of whether the funds are paid to an individual or directly to a university.
Advance approval is not required when a foundation funds a university's existing scholarship program and does not involve itself in selecting scholarship recipients.
If a foundation wishes to take an active role is selecting scholarship recipients, it must determine the group of individuals who are eligible, develop an objective, nondiscriminatory plan for selecting the final recipients and submit this information to the IRS. If the IRS does not contact the foundation within 45 days of this submission, the foundation may begin making scholarship grants.
- Paying pre-existing charitable pledges incurred by foundation staff.
A common problem arises when foundation insiders make a personal pledge to a church, synagogue, mosque, etc., and the foundation satisfies that pledge. Because religious organizations are public charities, many foundation personnel incorrectly believe a foundation can legitimately cover a charitable pledge made by a founder or other board member.
A foundation may make a charitable grant or pledge to a religious institution — when that pledge was initiated by the foundation. But there is a distinction between the foundation making its own charitable grants and satisfying the personal obligation of a board member or other insider.
Insiders are not allowed to derive a personal benefit from their dealings with the foundation. To the extent that the foundation relieves that insider of such financial obligations as a pledge to a charity, that person is considered to have received a benefit.
- Hosting fundraising events.
Foundations hosting fundraising events, such as golf tournaments and bike-a-thons, seldom realize that they are required to ascribe a value to the benefits provided to attendees as well as provide a tax receipt for each attendee at year end. This receipt helps inform the attendee what portion of the donation is actually tax deductible.
For example, say an attendee pays $150 for a golf tournament hosted by the foundation, and the usual greens fees are $50. The foundation must provide a tax receipt letter to that attendee, stating that the value of goods and services provided was $50 (the value of the greens fees). The proper tax deduction for the attendee to claim is the ticket price minus the value of the greens fees, or $100. If the attendee does not obtain this tax receipt by the time he files his income tax return, the charitable deduction may be lost.
Sometimes foundations raise additional funds at these events by selling merchandise, such as T-shirts, sweatshirts or other accessories. Depending on where the event is held and where the foundation conducts business, the foundation may be required to charge state and local sales taxes. Although the foundation itself may be exempt from paying sales tax, it still may have to charge a sales tax when selling merchandise to others.
The requirement to charge and remit sales tax varies from one locality to another. Some localities permit a foundation to sell merchandise tax-free for two or three days a year in connection with fundraising events. Often, the best solution is to make an arrangement with a local merchant to charge, collect and remit sales tax to the appropriate taxing authority on behalf of the foundation.
When giving away memorabilia or tokens to attendees of a fundraising event, such as coffee mugs, calendars, posters or T-Shirts, foundations are well-advised to ensure that the total value of all such tokens is modest on a per person basis. If the cost of these items is about $7 per person or less, adjusted annually, it will not count in calculating the total amount of the attendee's charitable deduction. For example, if the ticket price for a golf tournament is $150, the green fees are valued at $50, and each attendee is provided with a T-shirt that costs the foundation $5 per shirt, the attendee's charitable deduction would remain $100. But if each T-shirt costs the foundation $12, the charitable deduction would be reduced to $88.
A foundation must record the names and addresses of all attendees of an event, so that it may provide those who pay over $250 with tax receipts at the end of the year. Failure to provide a tax receipt to an attendee before he files his income tax return may cause the attendee to lose the charitable deduction.
While fundraising events can be an effective way to raise additional funds, foundations commonly fail to develop a budget for the event and therefore tend to lose money, break even or raise much less than hoped. It's worth consulting with a professional event planner or advisor to develop realistic financial projections.
- Validating the tax status of charities before making grants.
A favorable determination letter from the IRS doesn't necessarily remain in effect forever, especially if the charity bases its public charity status on broad public support. If such a charity does not continue to maintain this support, the IRS removes its favored status, turning it into a private foundation.
In IRS Publication 78, issued on a quarterly basis, the Service lists all exempt organizations. Foundations may make a grant to a public charity listed in this publication without concern, provided the charity's status has not been revoked in any Internal Revenue Bulletin issued between the date of the last publication and the date of the grant. If a private foundation makes a grant to an organization that is not considered a public charity, it may be subject to a penalty, and the grant will not count towards satisfying the foundation's annual distribution requirement.
Some organizations are considered public charities even though they are not listed in Publication 78. For example, religious institutions, such as churches, synagogues and mosques, instrumentalities of the government, such as the parks department or municipalities that are political subdivisions of a state, fall into this category. But a private foundation must ensure that a church not registered with the IRS as a public charity is genuine. The personnel of many foundations often assume that certain types of organizations, such as fire departments, Rotary Clubs, libraries, veterans funds or policemen benevolence funds are public charities. In fact, such organizations may be tax-exempt (for example a 501(c)(4) or (c)(6)), but still may not be recognized by the IRS as a public charity.
- Self-dealing when buying tables at charity events.
Many private foundations support local charitable institutions that conduct fundraising events themselves. People attending or buying tables at such events typically receive food and entertainment. What happens when a private foundation purchases tickets for such an event (or is given tickets) and board members, their friends or relatives attend the event and enjoy the food and benefits in their place? As a basic rule, all direct and indirect financial transactions between a private foundation and those who control and fund it are prohibited. But the foundation is permitted to pay reasonable compensation to insiders for participating in meetings and events on the foundation's behalf.
Some argue it is necessary and appropriate for foundation directors, trustees and staff to attend fundraising events, so no self-dealing occurs when insiders use the tickets. Logically, if a foundation's board member or officer attends the event to represent the foundation in an official capacity, there should be no private benefit, so long as the attendance is work-related and allows the foundation to show support for the organization at a public function.
Impermissible self-dealing may arise, however, if seats are given to friends and family. To remove any question of self-dealing, it is preferable for a private foundation to decline to accept tickets for anyone other than board members, trustees, senior staff members and their spouses. A foundation could conceivably furnish the charity with a list of those to whom tickets might be furnished, but only with the clear stipulation that the charity must decide which individuals are awarded the tickets.
- Calculating the minimum distribution requirement.
Generally, a private foundation must distribute in one year 5 percent of the average value of its investment assets for the previous year. The IRS prescribes a specific method for averaging a foundation's securities and balances in its savings and checking accounts on a monthly basis. The 12-month average allows for market fluctuations over the year. Special rules apply to the valuation of real estate and all other assets.
Grants to qualifying organizations along with reasonable costs of administering charitable activities — other than investment fees — count toward the 5 percent payout requirement. Reasonable administrative expenses may include office supplies, telephone charges, consulting fees, certain legal and accounting fees, training and professional development, publication of the foundation's annual report and modest travel expenses associated with foundation business.
- Making grants to individuals for hardship assistance.
It is commonly, but wrongly, believed that a foundation may not make grants to individuals without advance approval from the IRS. Actually, grants made to relieve suffering may be made without advance approval under certain conditions, provided the foundation makes the grant on an objective and nondiscriminatory basis, complies with basic record keeping requirements regarding selection and does not require the recipient to spend the grant funds in a particular way.
The IRS divides such grants into two broad categories in Publication 3833: emergency and hardship assistance. Emergency assistance “may be provided” after there has been a natural catastrophe, such as an earthquake, tornado, hurricane or flood. Hardship assistance is provided based upon established economic need, and may be used to purchase food or cover health insurance premiums for a low-income family.
- Calculating appropriate compensation.
Board members and other insiders generally are not permitted to reap any economic benefit from their dealings with a foundation. There's an exception for compensation — provided the compensation is reasonable. This determination is made based on a list of factors, including qualifications, experience, responsibilities, duties and time dedicated (part- or full-time) by the insider. Additional factors can include the size of the foundation, the local labor market, the cost of living in the area and the salary paid by similarly situated charitable organizations for similar positions. It is common to have an attorney draft an opinion letter on the reasonableness of compensation to help insulate the foundation and its insiders from penalties and other repercussions.
- Dealing with unrelated business taxable income.
Unrelated business taxable income (UBTI) is commonly associated with revenue that a charity generates through an activity that has no direct connection with its charitable mission. To the extent that a foundation has UBTI, it must be taxed as if it were a for-profit organization. The UBTI rules were enacted to ensure that non-profit charitable organizations do not compete with for-profit companies, gaining an unfair competitive advantage. Foundation staff often don't realize that if a foundation borrows money (for example, on margin) to purchase an investment asset (not related to performing its charitable activities), any income flowing from that asset is usually deemed UBTI.
In addition to paying taxes at a for-profit tax rate, a private foundation with significant UBTI also must file an additional tax return, Form 990-T, along with its 990-PF.
Many professional advisors counsel their foundation clients to avoid engaging in activities that would generate UBTI, unless the potential for profit is considerable.
- Making a grant to a second foundation.
Grant makers are often unaware that one private foundation may make a grant to another private foundation. This may be desirable when the grantee foundation runs its own special programs (for example, for a scholarship program approved by the IRS).
When one foundation makes a grant to another and the recipient disburses those grant funds, the IRS will allow only one of those foundations to count those funds toward satisfying the annual 5 percent payout requirement. Unless the foundations otherwise agree, the grantee will be the foundation that will count the disbursement of the funds toward its 5 percent payout requirement.
In order for the granting foundation to count the grant proceeds toward its own 5 percent payout requirement, the grantee foundation must follow two conditions: It must make a special election on its annual return not to count the disbursement of the proceeds toward its 5 percent payout requirement. It also must disburse all of the granted proceeds by the end of the following fiscal year after funds were received.
Of course, foundations can stumble in numerous other ways. But advisors who at least keep in mind the most common pitfalls will be a step ahead in helping them stay in compliance, so that clients can spend less time cleaning up messes and more energy on charitable giving.
Note: This article is not intended as a substitute for legal, tax or investment advice, nor should it be construed as a comprehensive guide to regulations governing private foundations.
“The Hen Egg” was commissioned by Czar Alexander III as an Easter gift to his wife in 1885. Inside the simple enamel egg was a golden yolk; inside the yolk a golden hen; inside the hen a ruby crown; and inside the crown a dangling pendant.