How To Help Foundations From Being Madoffed

If private foundations losing billions to Bernard Madoff's Ponzi scheme and going out of business weren't enough of a cautionary tale for private foundations everywhere,¹ add this: At least two state attorneys general are examining the actions of the foundation boards that were caught flatfooted by the Madoff disaster.² And, of course, the glare of these bad headlines and state investigations comes after a decade of the federal government's increasing scrutiny of how charities handle their money and a recent doubling of the federal excise tax rates on private foundations.

Clearly, now is an excellent time for foundation managers and those who advise them to review the laws and latest decisions governing their investment decisions.

Are all your “T”s crossed and “I”s dotted? If not, the consequences, and penalties, can be severe.

Many Masters

An investment can subject a foundation and its managers to penalties under both federal tax law and state law.

Under federal tax law, investments that jeopardize a foundation's ability to carry out its tax-exempt purposes are subject to a significant excise tax, as are a foundation's excess business holdings.³ Transactions that are the result of self-dealing are likewise subject to hefty penalties.⁴ Foundations also will pay corporate tax on unrelated business income (UBTI).⁵

In many states, managers of foundations established as corporations or trusts with charitable trustees also must comply with the Uniform Management of Institutional Funds Act (UMIFA)⁶ or the more recent Uniform Prudent Management of Institutional Funds Act (UPMIFA).⁷

Trusts with non-charitable trustees (such as individuals or banks) are governed by the Uniform Prudent Investor Act (UPIA) in virtually all states.

The Federal Rules

Looking to discourage the wealthy from using foundations for non-charitable personal gain, Congress back in 1969 enacted a web of taxes and penalties in Internal Revenue Code Sections 4940 through 4948 (the Chapter 42 Excise Tax Rules). These focus on certain of a private foundation's activities (including investments) and relationships (with “disqualified persons”). The thinking is: with private foundations, donors get to exert the greatest amount of control than they would with any type of charitable entity — but they also may be subject to the strictest penalties for abusing that privilege. Control is the carrot to the wealthy to establish private foundations. The Chapter 42 rules are the stick that keeps everyone in line.

The most important of these rules applicable to foundation investments are:

1. the IRC Section 4944 prohibition against jeopardizing investments,
2. the IRC Section 4941 prohibition against self-dealing and
3. the IRC Section 4943 prohibition against excess business holdings.

But, to understand how the Chapter 42 rules apply to private foundation investments, it's necessary to understand which individuals and entities are covered. Collectively, they are known as “disqualified persons.” Specifically, they are⁸:

• Substantial contributors to the foundation, including an individual, trust, estate, partnership or corporation whose contributions total more than $5,000 — if that $5,000 exceeds 2 percent of all the contributions received by the foundation from its creation through the close of the taxable year in which the contribution is made. An individual's total contributions include the contributions made by his or her spouse.

• Foundation managers, including officers, directors, trustees and certain employees of the foundation. (The definition of a “foundation manager” is particularly important for the Section 4944 rules regarding jeopardizing investments.)

• Persons holding more than a 20 percent interest in corporations, partnerships or trusts that are substantial contributors to the foundation.

• Family members of any person described in the previous categories, including that person's spouse, ancestors and descendants, and spouses of such person's descendants.

• Corporations, partnerships and trusts in which persons described in all the previous categories hold more than a 35 percent interest.

Certain family attribution rules apply for purposes of determining whether a disqualified person holds more than a 20 percent or 35 percent interest in a corporation, partnership or trust.⁹

With this background in mind, let's turn to how a foundation and its foundation managers can run afoul of the Chapter 42 rules through the foundation's investments.

Jeopardizing Investments

The jeopardizing investments excise tax (Section 4944) is the federal equivalent of state prudent investor statutes. The purpose is to discourage foundations from taking too much risk when investing their assets. The idea is that the feds want to guarantee that the maximum amount of a foundation's wealth is available for charitable purposes.

Unfortunately, this rule has been the least enforced among the excise taxes. The Internal Revenue Service typically has relied on state enforcement in this area. In fact, according to the Spring 2006 IRS Statistics of Income Bulletin, there were no jeopardizing investment taxes collected in 2004 and 2005.

But in the wake of the disaster that befell 147 private foundations invested in Madoff, some of which lost all of their assets,¹⁰ lawmakers and regulators in Washington are suggesting that federal neglect of oversight for jeopardizing investments is about to end — big time.

So, what, precisely, is a “jeopardizing investment”? The IRC defines it somewhat vaguely as the investment by a foundation of “any amount in such a manner as to jeopardize the carrying out of any of its exempt purposes.”¹¹ An investment will be deemed to jeopardize the foundation's exempt purposes if, when the foundation managers made the investment, they failed “to exercise ordinary business care and prudence, under the facts and circumstances prevailing at the time of making the investment, in providing for the long- and short-term financial needs of the foundation to carry out its exempt purposes.”¹²

The determination of whether an investment is jeopardizing is to be made “as of the time that the foundation makes the investment and not subsequently on the basis of hindsight.”¹³ Such determination is to be made on an investment-by-investment basis, taking into account the foundation's overall portfolio.¹⁴ When considering how to invest a foundation's funds, a foundation manager may take into account the need for diversification within the foundation's investment portfolio, the risks of rising and falling price levels, and the expected return of the investment, including both income and the appreciation of capital.¹⁵

No type of investment is automatically regarded as jeopardizing under the IRC or Treasury Regulations.¹⁶ Still, Treasury Regulations indicate that the following categories of investments merit close scrutiny: trading in securities on margin; trading in commodity futures; investments in working interests in oil and gas wells; the purchase of “puts,” “calls,” and “straddles;” the purchase of warrants; and selling short. This list of closely scrutinized investments was made at a time when some of the investments on the list were considered more risky than they would be today.¹⁷

The Internal Revenue Manual (IRM) lists the following “more recent strategies that deserve close scrutiny:” investment in “junk” bonds, risk arbitrage, hedge funds, derivatives, distressed real estate, and international equities in third world countries.¹⁸ The IRM also highlights guarantees and collateralizations as investment activities warranting close scrutiny.¹⁹

The notion of what constitutes a jeopardizing investment has evolved over time such that an investment that would have been viewed as jeopardizing when Section 4944 was added to the IRC in 1969 might not be regarded as such today. For example, the IRS found in 2003 that a foundation's investment of most of its assets in the general partner of a hedge fund was not a jeopardizing investment even though the hedge fund engaged in such investment techniques such as puts, calls, straddles, margin purchases and short selling. The IRS determined that the underlying assets of the hedge fund were “sufficiently diversified so that the indirect investment by [the foundation] would meet the requisite standard of care and prudence which would not jeopardize the carrying out of the foundation's exempt purposes.”²⁰

Private Letter Ruling 9723045 offers another example of a non-traditional investment that the IRS found not to be jeopardizing. In that ruling, the IRS held that a foundation would not make a jeopardizing investment by investing less than 30 percent of its assets in six different funds that invested, respectively, in high technology partnerships and companies, hedge funds, companies being restructured or reorganized, equity and convertible instruments of companies, commercial forests and leveraged acquisitions.²¹

Other investments that the IRS has regarded as not jeopardizing include an investment in a managed commodities trading program²² and an investment in a futures market trading limited partnership.²³

An investment may be deemed jeopardizing for reasons other than its inherent risk. If, in making an investment, a foundation and its managers fail to seek out the information that a prudent investor would require before making the investment, that investment may be deemed jeopardizing.²⁴ Also, an investment that prevents a foundation from diversifying its portfolio may be regarded as jeopardizing. For example, the IRS has ruled that a private foundation's exchange of stock was a jeopardizing investment because “the investment did not allow for diversification of [the foundation's] investments,” even though the foundation received more than fair market value for the stock exchanged.²⁵ Likewise, the IRS has found that a foundation's purchase of stock in a publically traded company was a jeopardizing investment because, among other reasons, the purchased stock constituted 75 percent to 85 percent of the foundation's investments.²⁶

Once an investment is deemed not to be jeopardizing, the investment will not subsequently be considered jeopardizing, even if the investment results in a loss to the foundation.²⁷ But, a change in the terms or form of an investment will cause the investment to be regarded as a new investment, requiring a new analysis as to whether it's jeopardizing.²⁸

If a foundation holds an interest in another entity, a change in that entity's underlying investments may not constitute a change in the foundation's investment requiring a new evaluation of the investment under Section 4944. For example, the IRS has held that a change in the underlying assets of a limited liability partnership in which a private foundation held a limited partnership interest would not be regarded as a change in the terms or form of the foundation's investment in the LLP.²⁹

Penalties Are Painful

A private foundation found to have made a jeopardizing investment is subject to an excise tax equal to 10 percent of the amount of such investment.³⁰ If the foundation does not remove the investment from jeopardy during the “taxable period” in which the investment was made (as defined in the IRC)³¹ the foundation will be subject to an additional tax of 25 percent of the jeopardizing investment.³²

Managers themselves may be penalized if a private foundation is deemed to have made a jeopardizing investment. A foundation manager who knowingly participates in making a jeopardizing investment is subject to an excise tax of 10 percent of the amount so invested.³³ The only saving grace there is that the excise tax that may be incurred by a manager with respect to any one jeopardizing investment is capped at $10,000.³⁴

In the highly unlikely event that a foundation manager actually refuses to agree to remove an investment from jeopardy within the taxable period as defined in the IRC,³⁵ the manager will be subject to an additional fine of 5 percent of the jeopardizing investment. But that fine is capped at $20,000 per jeopardizing investment.³⁶

For a foundation manager to “refuse to agree” to remove an investment from jeopardy, a fellow manger or the IRS must first ask the manager to effect the removal.³⁷ The U.S. Tax Court has held that receipt by a foundation manager of an IRS auditor's report and an initial deficiency notice does not constitute a request for removal, nor does an IRS auditor's oral discussion of removal of a jeopardizing investment with a foundation manager's personal representatives during an audit.³⁸

If more than one foundation manager is found to have knowingly participated in a foundation's jeopardizing investment, the liability of the managers with respect to such investment is joint and several.³⁹

Managers Are Personally Liable

As painful as the penalties can be, it does take some doing for foundation managers to be deemed liable. They're subject to the penalties imposed by Section 4944 only if they “participated” in making an investment on behalf of a foundation “knowing” that the investment was jeopardizing unless the managers' participation was not “willful” and was “due to reasonable cause.”⁴⁰

A foundation manager is deemed to have knowingly participated in a jeopardizing investment if:

• he made “any manifestation of approval of the investment” and, at the time of manifesting approval, the manager had “actual knowledge of sufficient facts so that, based solely upon such facts, [the manager understood that] such investment would be a jeopardizing investment[;]” and

• the manager was “aware that such an investment under [such] circumstances [might] violate the provisions of federal tax law governing jeopardizing investments[;]” and

• the manager “negligently fail[ed] to make reasonable attempts to ascertain whether the investment [was] a jeopardizing investment, or [was] aware” that the investment was a jeopardizing investment.⁴¹

In other words, if a manager thinks there's some possibility, however tiny, that an investment might qualify as a jeopardizing investment, he should act to ensure that it's not. If he doesn't act, and the investment is later found to be jeopardizing, he may be liable.

But, even if a foundation manager knowingly participates in a jeopardizing investment, he won't be subject to the Section 4944 penalty if his participation wasn't “willful” or was “due to reasonable cause.” A manager's participation is deemed willful if it was “voluntary, conscious, and intentional.”⁴² If he didn't know that an investment was jeopardizing, his participation in the investment will not be deemed willful.⁴³ The manager's participation in a jeopardizing investment is deemed to have been “due to reasonable cause” if the manager “exercised his responsibility on behalf of the foundation with ordinary business care and prudence.”⁴⁴

A foundation manager may avoid liability for a jeopardizing investment if he “after full disclosure of the factual situation to legal counsel … relie[d] on the advice of such counsel expressed in a reasoned written legal opinion that a particular investment” was not jeopardizing.⁴⁵ Also, a manager may not be liable for a jeopardizing investment if “after full disclosure of the factual situation to qualified investment counsel” the manager relied on the advice of such counsel “that a particular investment [would] provide for the long and short term financial needs of the [manager's] foundation.”⁴⁶

Exceptions

There are three exceptions to the rules regarding jeopardizing investments.

The most frequently encountered: an investment will not be considered a jeopardizing investment if it is a “program-related investment” (PRI). The use of PRIs is the primary way that foundations engage in venture philanthropy. To qualify as a PRI, an investment must meet three criteria, which we'll refer to as the “charitable-purpose requirement,” the “not-for-profit requirement,” and the “Section 170(c)(2)(D) requirement.”

To pass the charitable-purpose requirement, the primary purpose of an investment must be the accomplishment of at least one of the purposes described in IRC Section 170(c)(2)(B).⁴⁷ An investment is deemed to satisfy the charitable-purpose requirement if it “significantly furthers the accomplishment of the private foundation's exempt activities and if the investment would not have been made but for such relationship between the investment and the accomplishment of the foundation's exempt activities.”⁴⁸

An investment will not meet the “not-for-profit requirement” if a “significant purpose” of the investment is the production of income or the appreciation of property.⁴⁹ In deciding whether a significant purpose of an investment is the production of income or appreciation of property, the Service may consider “whether investors solely engaged in the investment for profit would be likely to make the investment on the same terms as the private foundation.”⁵⁰ But an investment will not automatically fail the not-for-profit requirement if the investment happens to produce income or capital appreciation.⁵¹

Finally, for an investment to satisfy the Section 170(c)(2)(D) requirement, the purpose of the investment must not include “attempting to influence legislation, and … pariticipat[ing] in, or interven[ing] in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.”⁵²

Once an investment is deemed to be a PRI, it will retain that status so long as future changes to the terms or form of the investment are made “primarily for exempt purposes and not for any significant purpose involving the production of income or the appreciation of property.”⁵³ If a foundation changes the terms of an investment for the “prudent protection of the foundation's investment,” the change ordinarily will not cause an investment to lose its designation as a PRI.⁵⁴

An investment loses its PRI status if there is a “critical change” in the terms of the investment (for example, if the terms of the investment change such that it serves an illegal purpose or the private purpose of the foundation or its managers). If an investment loses its designation as a PRI because of such a critical change, the foundation that made the investment will not be penalized so long as it acts to correct its position with regard to the investment within 30 days.⁵⁵

There are two other exceptions to the rules regarding jeopardizing investments.

First, an investment made by any person that is later gratuitously transferred to a private foundation will not be deemed a jeopardizing investment.⁵⁶ For example, in PLR 200548026, the IRS found that the transfer of an interest in an LLP from a charitable remainder unitrust to a private foundation established by the settlor of the unitrust would not constitute a jeopardizing investment because the transfer would be made without consideration.⁵⁷

Second, an investment obtained by a private foundation solely as a result of a corporate reorganization within the meaning of IRC Section 368(a) is not considered a jeopardizing investment.⁵⁸

Self-Dealing

Although the IRS has rarely imposed the jeopardizing investment excise tax, it has regularly imposed the self-dealing excise taxes under IRC Section 4941 during the past 40 years.

The basic principle underlying Section 4941 is that all financial transactions between a private foundation and a disqualified person should be prohibited, whether or not the transaction benefits the private foundation — unless it satisfies a specific exception to the self-dealing rules.

The tax came into existence in 1969 after wealthy donors were found to be using their private foundations as personal piggy banks. Congress responded through Section 4941 by saying, essentially: If you can't play nice, you can't play at all (with a few exceptions).

Among the transactions Section 4941(d) considers self-dealing are:

1. any sale, exchange or leasing of property between a private foundation and a disqualified person;
2. any lending of money or other extension of credit between a private foundation and a disqualified person;
3. any furnishing of goods, services, or facilities between a private foundation and a disqualified person; and
4. any payment of compensation (or payment or reimbursement of expenses) by a foundation to a disqualified person.

Section 4941 prohibits both direct and indirect self-dealing. Direct self-sealing involves transactions between a foundation and a disqualified person. Indirect self-dealing involves transactions between a disqualified person and an entity that the foundation controls.

The transactions covered by the term “indirect” self-dealing are those that would have been acts of self-dealing, if entered into between the disqualified person and the foundation directly. The indirect self-dealing rules are byzantine in their complexity and easily missed. But make no mistake about it, the IRS has mastered these rules during the last 40 years and has issued dozens, if not hundreds of rulings. So, practitioners and donors take note: When even the possibility of indirect self-dealing arises, it's best to take out a piece of paper and chart out the various relationships to identify transactions that may involve indirect self-dealing.

The self-dealing tax itself has a dual purpose:

1. to discourage disqualified persons from engaging in acts of self-dealing, and
2. to require them to unwind (or correct) any self-dealing transactions.

A disqualified person who participates in such an act (knowingly or unknowingly) is subject to an excise tax of 10 percent of the amount involved in the act of self-dealing for the year in which the act of self-dealing occurs, and then again in each subsequent year until the self-dealing is corrected.⁵⁹ An additional tax of 200 percent (rarely, if ever, imposed) of the amount involved in the act of self-dealing will be assessed on the disqualified person if the self-dealing is not unwound or corrected within the applicable “taxable period,” as defined in the IRC.⁶⁰

A foundation manager who knowingly and willfully participates in an act of self-dealing is subject to an excise tax of 5 percent of the amount involved in the act of self-dealing; the total tax assessed on a foundation manager per act of self-dealing is not to exceed $20,000.⁶¹ An additional tax of 50 percent of the amount involved in the act of self-dealing will be assessed on the manager if the manager does not agree to correct the self-dealing within the applicable “taxable period.”⁶²

A foundation manager is subject to penalties for an act of self-dealing only if the manager knowingly participated in the act of self-dealing and the manager's participation was “willful” and not “due to reasonable cause.”⁶³

The definitions of “knowing,” “willful” and “due to reasonable cause” under the self-dealing regulations are similar to those under the jeopardizing investment regulations.⁶⁴

Beware, though, the definition of “participation” is substantially different. For the purposes of the regulations regarding self-dealing, “participation” includes “silence or inaction on the part of a foundation manager where he is under a duty to speak or act, as well as any affirmative action by such manager.”⁶⁵ But if a foundation manager opposes an act of self-dealing “in a manner consistent with the fulfillment of his responsibilities to the private foundation,” the manager will not be deemed to have participated in the act of self-dealing.⁶⁶

A manager may avoid liability for an act of self-dealing if the manager relied “on the advice of such counsel expressed in a reasoned written legal opinion” that the sanctioned act did not constitute self-dealing.⁶⁷

Section 4941 contains specific exceptions to the definition of “self-dealing” which apply to both direct and indirect acts of self-dealing. Several of these exceptions are relevant in the context of foundation investments. Under the self-dealing regulations, a disqualified person may be paid for performing personal services for a foundation, such as legal, investment advisory and banking services, if the services are reasonable and necessary to carry out the foundation's charitable purposes.⁶⁸

For example, in PLR 200318069, the IRS permitted the investment by a private foundation in a hedge fund controlled by a disqualified person under the self-dealing rules, because the services provided by the disqualified person were considered to be brokerage services and therefore fell under the personal services exception to the self-dealing rules.

In contrast, the IRS in PLR 9325061 held that certain services provided by disqualified persons to entities controlled by a private foundation would not qualify for the “personal services” exception and therefore constituted acts of self-dealing. The IRS based its holding on the fact that the disallowed services were not necessary to carry out the foundation's charitable purposes. Those services included management of real estate, real estate brokerage, construction and mill work, marketing and advertising services, and insurance brokerage.⁶⁹

The compensation paid to a disqualified person to perform exempted personal services must be reasonable. Compensation generally qualifies as reasonable “if it reflects amounts that ordinarily would be paid for like services by like enterprises under like circumstances.”⁷⁰

The amount of compensation a disqualified person can charge for personal services must be that which are reasonable based on comparable practices in the particular industry. So, in PLR 9237035, a fee based in part on a percentage of the increased equity of an investment fund was deemed reasonable compensation because it was standard in the industry.

In another example, the IRS in PLR 9008001 compared the compensation a private foundation paid its directors for their services with the compensation other foundations paid to their directors for similar services. In making this comparison, the IRS relied on the 1986 Foundation Management Report by the Council on Foundations (a non-profit membership association of more than 2,100 grant-making foundations and corporations, now based in Arlington, Va.) and the 1986 Corporate Directors' Compensation Guide, by the Conference Board (a non-profit business membership and research organization based in New York City). Based on the comparison, the IRS held that the private foundation's directors had been unreasonably compensated, and that the directors therefore had engaged in acts of self-dealing.⁷¹

Excess Business Holdings

The Section 4943 tax on excess business holdings penalizes foundations for holding too large an ownership interest in certain business entities when the foundation's holdings are aggregated with those of disqualified persons. This tax was adopted in 1969, because wealthy families had regularly used private foundations to maintain control of a business but dramatically reduce the family's burden of income, gift and estate taxes. Families were accomplishing this feat in one of two ways:

1. The family contributed voting stock in a corporation that the family controlled to a private foundation that the family also controlled. This approach allowed the family to obtain income and gift tax charitable deductions for the contribution, eliminate estate taxes on the contributed stock, and achieve a tax-free transfer of control of the business to the younger members of the family by subsequently shifting control of the foundation to them.
2. The second approach was to recapitalize the family business into voting and non-voting stock. By contributing the non-voting stocks to the foundation, the senior generation would obtain a current income tax charitable deduction, then transfer the voting stock (now representing a significantly diminished proportion of the value of the corporation) to the younger generation with significantly reduced estate and gift tax consequences.

These types of structures were resulting in significantly reduced revenue to the Treasury. The excise tax on excess business holdings stopped the bleeding.

Now, under Section 4943, a private foundation is deemed to have “excess business holdings” if the foundation and its associated disqualified persons own more than 20 percent of a “business enterprise”⁷² — unless the foundation can demonstrate that its ownership of such interests qualifies for an exception.

Under the “35 percent rule,” a private foundation and its disqualified persons may own up to 35 percent of a corporation or other unrelated business enterprise if the foundation can demonstrate that this corporation or enterprise is controlled by a non-disqualified person or an entity other than the foundation.⁷³

Under the “2 percent de minimis rule,” if a private foundation owns no more than 2 percent of a corporation's voting stock and no more than 2 percent of all of the outstanding shares of such corporation, the foundation won't be treated as having excess business holdings.⁷⁴

Certain business interests are not subject to the excess holding rules. A “functionally related business” won't be regarded as a “business enterprise” for the purposes of the excess business holdings statute.⁷⁵ A foundation therefore may own any amount of a functionally related business without incurring a penalty for possessing excess business holdings. A business can qualify as a “functionally related business” if it does not qualify as an “unrelated trade or business” under IRC Section 513 or if it's an activity “carried on within a larger aggregate of similar activities or within a larger complex of other endeavors” related to the exempt purposes of the organization.⁷⁶ So, if a private foundation operates a museum, the museum gift shop would likely be considered a functionally related activity or business.

A trade or business also is excluded from the definition of “business enterprise” if at least 95 percent of the gross income of such trade or business is derived from passive sources.⁷⁷ The rules regarding excess business holdings also include a five-year grace period for a foundation to dispose of a gift or bequest that causes it to have excess business holdings.⁷⁸ If a foundation is experiencing difficulty disposing of such a gift or bequest, the foundation can request another five years to get rid of it.⁷⁹

However accommodating those deadlines may seem, the penalties for not complying are stiff: A foundation is subject to an excise tax of 10 percent on such holdings.⁸⁰ Once a foundation has been penalized for possessing excess business holdings, it must dispose of such holdings by the end of the applicable “taxable period” or face an additional tax of 200 percent of the value of such holdings.⁸¹

UBTI

We all know the general rule that charities, including private foundations, don't pay income tax. But there is one important exception: Foundations do pay taxes on their “unrelated business income tax” (UBTI).⁸² Income is consider “unrelated” if it comes from an activity that constitutes a trade or business, the trade or business is regularly carried on — and that activity is not substantially related to the foundation's charitable purposes.⁸³ Income is not considered substantially related to a foundation's charitable purposes simply because the foundation uses the funds derived from the activity to support its charitable activities.⁸⁴

A crucial exception to UBTI exists for most passive income, including rents, royalties, dividends, interest and annuities.⁸⁵ Take note, though: passive income is considered UBTI if it is derived from “debt-financed property.” Debt-financed property generally means any property that's held to produce income (including gain from the sale of such property) for which there is “acquisition indebtedness” at any time during the year (or during the 12 month period before the date of the property's disposal, if it was disposed of during the year).⁸⁶

Acquisition indebtedness is the unpaid amount of debt incurred under three circumstances:

1. when acquiring or improving the property;
2. before acquiring or improving the property if the debt would not have been incurred except for the acquisition or improvement; or
3. after acquiring or improving the property if (a) the debt would not have been incurred except for the acquisition or improvement, and (b) incurring debt was reasonably foreseeable when the property was acquired or improved.⁸⁷

The scope of the unrelated business income tax is vast and the ways that a foundation investment can be subject to the tax are numerous. A few areas that commonly trigger tax are mortgaged real estate, investments in a corporation and investments in hedge funds and private equity.

If a foundation has UBTI, the income is subject to tax at regular corporate tax rates. Such taxation can significantly reduce the economic return on a foundation investment that is determined to be UBTI.

STATE LAW

As if all those federal laws weren't enough, foundations and their managers also must take care to comply with state law. Most states have passed uniform acts governing private foundations' investments.

The three big uniform laws are UMIFA, UPMIFA and the UPIA. That's the Uniform Management of Institutional Funds Act (UMIFA), approved by the uniform law commissioners in 1972, and the more up-to-date Uniform Prudent Management of Institutional Funds Act (UPMIFA), approved in 2006 and designed to replace UMIFA, which apply to foundations established as corporations or as trusts with a trustee who is itself a charity (a “charitable trustee.”) The Uniform Prudent Investor Act (UPIA) applies to foundations established as trusts with a trustee that is not itself a charity.

It is under these three uniform laws that most of the activity regulating foundation's investments occurs. That's because state attorneys general (who are the protectors of charitable assets) have been far more likely to bring claims against foundations than the IRS for improper investing.⁸⁸

As of March 31, 2009, every state except Alaska and Pennsylvania had enacted UMIFA or UPMIFA in some form.⁸⁹ By 2006, 47 states and the District of Columbia had enacted at least some portion of UMIFA.⁹⁰ By the end of March 2009, 30 states and the District of Columbia had adopted UPMIFA, and bills regarding UPMIFA had been introduced in 15 states.⁹¹ In several respects, UPMIFA's rules regarding institutional investments are more detailed than UMIFA's.⁹² UMIFA imposes a general obligation on members of a governing board to “exercise ordinary business care and prudence” in making and retaining investments and delegating investment management of institutional funds.⁹³ In contrast, UPMIFA enumerates precise guidelines.⁹⁴

UPMIFA provides that “every person responsible for managing and investing an institutional fund” must manage and invest such fund with “good faith” and “with care that an ordinarily prudent person in a like position would exercise under similar circumstances.”⁹⁵ “Subject to the intent of a donor expressed in a gift instrument,” an institution that manages and invests an institutional fund must consider “the charitable purposes of the institution and the purposes of the institutional fund.”⁹⁶

UPMIFA also stipulates that in managing an institutional fund, an institution should “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.”⁹⁷ The institution should make a “reasonable effort to verify facts relevant to the management and investment of the fund.”⁹⁸

UPMIFA requires certain factors be considered in managing and investing an institutional fund (unless a donor provides otherwise in a gift instrument):

• “general economic conditions;

• the possible effect of inflation or deflation;

• the expected tax consequences, if any, of investment decisions or strategies;

• the role that each investment or course of action plays within the overall investment portfolio of the fund;

• the expected total return from income and the appreciation of investments;

• the institution's other resources;

• the needs of the institution and the fund to make distributions and to preserve capital; and

• an asset's special relationship or value, if any, to charitable purposes of the institution.”⁹⁹

UPMIFA also provides that management and investment decisions about an asset should be made “not in isolation” but rather “in the context of the institutional fund'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 fund and to the institution.”¹⁰⁰ An institution may invest in any kind of property or type of investment consistent with these requirements.¹⁰¹

UPMIFA imposes on an institution an affirmative duty to diversify the investments of its institutional fund unless the institution “reasonably determines that, because of special circumstances, the purposes of the fund” would be better served without diversification.¹⁰² UPMIFA also requires that an institution, “within a reasonable time after receiving property,” decide whether to retain or dispose of the property and/or rebalance its portfolio of investments in order to bring the fund in compliance with UPMIFA and the “purposes, terms, and distribution requirements” of the institution.¹⁰³

Both laws discuss delegation of the investment authority. UMIFA simply allows such delegation (unless otherwise provided by a gift instrument or another applicable law) without providing express standards.¹⁰⁴ UPMIFA is more prescriptive, introducing standards for the appointment of an agent by incorporating the delegation rule found at Section 9 of the UPIA.¹⁰⁵

Subsection 5(a) of UPMIFA requires that a delegation of investment authority be made in good faith, “with the care that an ordinarily prudent person in a like position would exercise under similar circumstances” with regard to certain activities:

• “selecting an agent;

• establishing the scope and terms of the delegation, consistent with the purposes of the institution and the institutional fund; and

• periodically reviewing the agent's actions in order to monitor the agent's performance and compliance with the scope and terms of the delegation.”¹⁰⁶

Private foundations and their advisors should pay particularly close attention to Section 5(a). If an institution complies with this subsection, it won't be liable for the decisions or actions of an agent to which (or to whom) the institution has delegated investment authority.¹⁰⁷

In addition to standards for a delegating institution, UPMIFA includes guidelines for an agent exercising investment authority on behalf of an institution. In exercising such authority, an agent has a duty to take “reasonable care to comply with the scope and terms of the delegation.”¹⁰⁸ By accepting a delegation of investment authority from an institution subject to the laws of a state that has enacted UPMIFA, an agent submits to jurisdiction of the courts in such state.¹⁰⁹

UPIA

The UPIA, approved by the uniform law commissioners in 1994,¹¹⁰ is now the law in 44 states, the District of Columbia and the U.S. Virgin Islands.¹¹¹ It's the act that UPMIFA is largely based on, so most of the two laws' principals are identical.

What practitioners need to know is that you look to the UPIA (rather than UMIFA or UPMIFA) as the guide for investing if the foundation is established as a trust with a non-charitable trustee. The banks are one of the most common non-charitable trustees of foundations and through acting as trustee of non-charitable trusts they have become extremely comfortable with the provisions of the UPIA and did not want to become subject to another set of laws when administering charitable trusts.

Under the UPIA, a trustee's prudence in making a particular investment is evaluated in the context of a trust's entire “portfolio,” as a component of “an overall investment strategy having risk and return objectives reasonably suited to the trust.”¹¹² The UPIA regards “tradeoff in all investing between risk and return” as a fiduciary's “central consideration.”¹¹³

The UPIA permits a trustee to invest in anything “that plays an appropriate role in achieving the risk/return objectives of the trust and that meets the other requirements of prudent investing” under the UPIA.¹¹⁴ Also, the UPIA allows a trustee to delegate investment authority, provided the trustee exercises “reasonable care, skill, and caution” in choosing an agent, “establishing the scope and terms of the delegation, consistent with the purposes of the trust,” and monitoring the agent.¹¹⁵

The UPIA imposes on fiduciaries an explicit obligation to diversify their investments, “unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.”¹¹⁶

On the Straight and Narrow

If foundations, their managers and their advisors keep these guidelines in mind, they will go a long way towards helping their clients from being “Madoffed” — and certainly help them withstand increasing governmental scrutiny. Also, be advised: Although the sleeping giant of the jeopardizing investments excise tax has yet to rise, there is little doubt that it will. This is a good thing. The jeopardizing investments taxes provide an excellent backstop to state enforcement of foundation investing. The rules are there, now it is up to the IRS to enforce them.

Endnotes

1. In January 2009, Nicholas Kristoff of The New York Times posted on the newspaper's website a list of 147 foundations that were invested with Madoff at the time of their most recent tax filings. “What is staggering is how many of these 147 foundations had all their assets invested with Mr. Madoff and may have been wiped out as a result. For example, the Avery and Janet Fisher Foundation, which supported everything from various museums to meals-on-wheels programs, appears to have been fully invested with Mr. Madoff… The Picower Foundation of Palm Beach, Florida, with nearly $1 billion in assets and a major contributor to non-profits across the nation, has already announced that it will close down because of its Madoff investments.” Nicholas Kristoff, “Madoff and America's (Poorer) Foundations,” On the Ground Blog (Jan. 29, 2009), available athttp://kristof.blogs.nytimes.com/2009/01/29/madoff-and-americas-poorer-foundations/?apage=6.

2. In December 2008, Richard Blumenthal, the Attorney General of Connecticut, announced that his office would investigate whether the governing boards of non-profit organizations that invested with Bernard Madoff recklessly neglected their fiduciary responsibilities. In January 2009, Andrew Cuomo, New York's Attorney General, revealed that his office was looking into frauds perpetrated on charities as part of the Ponzi scheme. As part of the inquiry, Cuomo's office has subpoenaed 15 non-profit organizations and schools. J. Ezra Merkin, a fund manager who may have served as a middleman in the Madoff scandal, served on the boards and, in some cases, the investment committees of several of these organizations. Merkin apparently encouraged the organizations to invest in his fund, Ascot Partners, which then invested in Madoff's funds. See Carrie Coolidge, “Blumenthal May Investigate Charities Ripped Off By Madoff,” Forbes.com (Dec. 22, 2008); Ben Gose, “Connecticut Attorney General Examines Liability of Charity Trustees in Madoff Scandal,” Chronicle of Philanthropy (Dec. 23, 2008); Martha Graybrow, “NY Attorney General launches Madoff investigation,” Reuters (Jan. 13, 2009); Douglas Feiden and Greg B. Smith, “State investigation exposes Bernie Madoff middleman J. Ezra Merkin's charity conflicts of interest,” New York Daily News (Jan. 17, 2009).

3. Internal Revenue Code Sections 4943 through 4944.

4. IRC Section 4941.

5. IRC Section 511.

6. Uniform Management of Institutional Funds Act (1972), 7A U.L.A. 11 (2006).

7. Uniform Prudent Management of Institutional Funds Act (2006), 7A U.L.A. 9 (Supp. 2008).

8. IRC Section 4946(a)(1); Treasury Regulations Section 53.4946-1.

9. Treas. Regs. Section 53.4946-1(d).

10. Nicholas Kristoff, “Madoff and America's (Poorer) Foundations,” On the Ground Blog, (Jan. 29, 2009), available at http://kristof.blogs.nytimes.com/2009/01/29/madoff-and-americas-poorer-foundations/?apage=6.

11. IRC Section 4944.

12. Treas. Regs. Section 53.4944-1(a)(2)(i).

13. Ibid.

14. Ibid.

15. Ibid.

16. Ibid.

17. See, for example, Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1969 (JCS-16-70), Dec. 3, 1970 at p. 46. “Under prior law a private foundation manager might invest [the foundation's principal] in warrants, commodity futures, and options, or might purchase on the margin or otherwise risk the corpus of the foundation without being subject to sanction.” (Emphasis added).

18. Internal Revenue Manual Section 7.27.18.2.3(3).

19. IRM Section 7.27.18.2.3(4) “Guarantees or collateralizations are a type of a lending of money or an extension of credit and, thus, are forms of investment activity. Such investments also deserve close scrutiny.” (Citing Janpol v. Comm'r, 101 T.C. 518 (1993)).

20. Private Letter Ruling 200318069.

21. PLR 9723045.

22. PLR 9237035.

23. Technical Advice Memorandum 200218038.

24. See, for example, PLRs 8206036, 8101007. In relying on an unaudited balance sheet, foundation managers did not meet IRC Section 4944's standard of care and prudence.

25. PLR 9205001.

26. General Counsel Memoranda 39537 (Jul. 18, 1986) and TAM 8631004.

27. See supra note 12.

28. Treas. Regs. Section 53.4944-1(a)(2)(iii).

29. PLR 200548026. The terms of the foundation's interest in the LLP precluded the foundation from participating in the management of the LLP. See Ibid.

30. IRC Section 4944(a)(1); Treas. Regs. Section 53.4944-1(a)(1); Pension Protection Act Section 1212. The rate of the excise tax for jeopardizing investments was 5 percent until the Pension Protection Act of 2006 increased the rate to its current level.

31. IRC Section 4944(e)(1) (definition of “taxable period”); IRC Section 4944(e)(2) (definition of “removal from jeopardy”).

32. IRC Section 4944(b)(1).

33. IRC Section 4944(a)(2); Treas. Regs. Section 53.4944-1(b).

34. IRC Section 4944(d)(2).

35. See supra note 31.

36. IRC Sections 4944(b)(2) and 4944(d)(2); PPA Section 1212. Until the PPA, this additional penalty was limited to $10,000 with respect to any jeopardizing investment.

37. Thorne v. Commissioner, 99 T.C. 67, 97 (1992).

38. Ibid, at 93-97 (1992).

39. IRC Section 4944(d)(1).

40. Treas. Regs. Section 53.4944-1(b)(1).

41. Treas. Regs. Section 53.4944-1(b)(2)(i) (definition of “knowing”); Treas. Regs. 53.4944-1(b)(2)(iv) (definition of “participation”).

42. Treas. Regs. Section 53.4944-1(b)(2)(ii). “No motive to avoid the restrictions of the law or the incurrence of any tax is necessary to make such participation willful.” See Ibid.

43. Treas. Regs. Section 53.4944-1(b)(2)(ii).

44. Treas. Regs. Section 53.4944-1(b)(2)(iii).

45. Treas. Regs. Section 53.4944-1(b)(2)(v).

46. Ibid.

47. IRC Section 4944(c); Treas. Regs. Section 53.4944-3(a)(1)(i).

48. Treas. Regs. Sections 53.4944-3(a)(2)(i) and 53.4944-3(a)(1)(ii). An investment in an activity described in IRC Section 4942(j)(5)(B) and the regulations thereunder will satisfy the purpose requirement..

49. IRC Section 4944(c); Treas. Regs. Section 53.4944-3(a)(1)(ii).

50. Treas. Regs. Section 53.4944-3(a)(2)(iii).

51. Ibid.

52. Treas. Regs. Sections 53.4944-3(a)(1)(iii) and 53.4944-3(a)(2)(iv); IRC Section 170(c)(2)(D). “An investment shall not be considered as made to accomplish one or more of the purposes described in section 170(c)(2)(D) if the recipient of the investment appears before, or communicates to, any legislative body with respect to legislation or proposed legislation of direct interest to such recipient, provided that the expense of engaging in such activities would qualify as a deduction under section 162.”

53. Treas. Regs. Section 53.4944-3(a)(3)(i).

54. Ibid.

55. Treas. Regs. Section 53.4944-3(a)(3)(i). For examples of PRIs, see Treas. Regs. Section 53.4944-3(b).

56. Treas. Regs. Section 53.4944-1(a)(2)(ii)(a).

57. PLR 200548026; see also PLR 200621032 where a foundation's acceptance of a gift of one percent working interest in an oil and gas exploration and development venture was not a jeopardizing investment provided the venture's costs and expenses did not become an encumbrance against foundation's other assets.

58. Treas. Regs. Section 53.4944-1(a)(2)(ii)(b).

59. IRC Section 4941(a)(1); Treas. Regs. Section 53.4941(a)-1(a).

60. IRC Section 4941(b)(1) (regarding 200 percent tax); IRC Section 4941(e)(1) (regarding the definition of “taxable period”).

61. IRC Section 4941(a)(2); Treas. Regs. Section 53.4941(a)-1.

62. IRC Section 4941(b)(2) (regarding excise tax of 50 percent); IRC Sec-tion 4941(e)(1).

63. Treas. Regs. Section 53.4941(a)-1(b)(1).

64. Treas. Regs. Section 53.4941(a)-1(b)(3) (definition of “knowing”); Treas. Regs. Section 53.4941(a)-1(b)(4) (definition of “willful”); Treas. Regs. Section 53.4941(a)-1(b)(5) (definition of “due to reasonable cause”).

65. Treas. Regs. Section 53.4941(a)-1(b)(2).

66. Ibid.

67. Treas. Regs. Section 53.4941(a)-1(b)(5). See ibid for guidance regarding the standard for a “reasoned written legal opinion.”

68. Treas. Regs. Section 53.4941(d)-3(c) (regarding legal and investment services); Treas. Regs. Section 53.4941(d)-2(c)(4) (regarding banking services); see also Treas. Regs. Section 53.4941(d)-3(c) and Treas. Regs. Section 53.4941(d)-2 for further examples of exceptions to the rules and regulations governing self-dealing.

69. PLR 9325061.

70. See, for example, Kermit Fisher Foundation v. Commissioner 59 T.C.M. 898 (1990); see also Treas. Regs. Section 1.162-7(b)(3).

71. PLR 9008001.

72. IRC Section 4943(a) and (c)

73. IRC Section 4943(c)(2)(B).

74. IRC Section 4943(c)(2)(C).

75. IRC Section 4943(d)(3)(A).

76. IRC Section 4942(j)(4). Examples of functionally related businesses can be found at Treas. Regs. Section 53.4942(a)-2(c)(3)(iii)(b).

77. IRC Section 4943(d)(3)(B).

78. IRC Section 4943(c)(6).

79. IRC Section 4943(c)(7).

80. IRC Section 4943(a).

81. IRC Section 4943(d)(2).

82. IRC Section 511

83. IRC Section 512

84. IRC Section 513(a)

85. IRC Section 511(b)(1), (2) and (3)

86. IRC Section 511(b)(4)

87. IRC Sections 514 (b) and (c)

88. Uniform Prudent Management of Institutional Funds Act (UPMIFA) was modeled in many respects on the Uniform Prudent Investor Act (UPIA). Prefatory Note, UPMIFA, 7A U.L.A. 4 (Supp. 2008). In addition to provisions regarding investment conduct and delegation of investment authority, UPMIFA includes updated provisions regarding expenditure of institutional funds. Compare the earlier Uniform Management of Institutional Funds Act (UMIFA) Section 2 with the more up-to-date UPMIFA's Section 4. UPMIFA's most important development with regard to expenditures may be the elimination of the concept of historic dollar value from the endowment spending rule. See Prefatory Note, UPMIFA, 7A U.L.A. 5 (Supp. 2008). UPMIFA also includes more expansive provisions than UMIFA regarding release of restrictions imposed by donors. Compare UMIFA Section 7 with UPMIFA Section 6.

89. A bill adopting UPMIFA was making its way through Alaska's state legislature as of March 31, 2009.

90. Alaska, Arizona and Pennsylvania are the three states that never enacted some part of UMIFA. See “Table of Jurisdictions Wherein Act Has Been Enacted,” UMIFA, 7A U.L.A. 1 (2006); see also “General Statutory Note,” UMIFA, 7A U.L.A. 1 (Supp. 2008).

91. This information is taken from the “Enactment Status” page of the official UPMIFA website, www.upmifa.org/DesktopDefault.aspx?tabindex=5&tabid=68. The status of each bill regarding UPMIFA then making its way through a state legislature was confirmed by a search for the legislative history of each such bill as of March 31, 2009. The bills regarding UPMIFA introduced in the Mississippi legislature died in committee on Feb. 3, 2009, so as of March 31, 2009, 14 states were still considering enacting of UPMIFA. See Mississippi Legislature, 2009 Regular Session, House Bill 419, available athttp://billstatus.ls.state.ms.us/2009/pdf/history/HB/HB0419.xml; Mississippi Legislature, 2009 Regular Session, Senate Bill 2335, available athttp://billstatus.ls.state.ms.us/2009/pdf/history/SB/SB2335.xml.

92. The Uniform Law Commission has published a brief comparison of UPMIFA and UMIFA, available atwww.upmifa.org/DesktopDefault.aspx?tabindex=4&tabid=71.

93. UMIFA Section 6. UMIFA defines “governing board” as “the body responsible for the management of an institution or of an institutional fund. UMIFA Section 1(4).

94. UPMIFA Section 3.

95. UPMIFA Section 3(b). UPMIFA also requires every such person to comply with the duty of loyalty otherwise imposed by law. Ibid.

96. UPMIFA Section 3(a).

97. UPMIFA Section 3(c)(1).

98. UPMIFA Section 3(c)(2).

99. UPMIFA Section 3(e)(1).

100. UPMIFA Section 3(e)(2).

101. UPMIFA Section 3(e)(3).

102. UPMIFA Section 3(e)(4).

103. UPMIFA Section 3(e)(5).

104. UMIFA Section 5.

105. UPMIFA Section 5.

106. UPMIFA Section 5(a).

107. UPMIFA Section 5(c).

108. UPMIFA Section 5(b). UPMIFA also provides that an institution may delegate investment authority to its own committees, officers, and employees. UPMIFA Section 5(e).

109. UPMIFA Section 5(d).

110. Uniform Prudent Investor Act (1994), 7B U.L.A. 15 (2008). See also Restatement (Third) of Trusts, Prudent Investor Rule Section 389, Comment b, at 190-91. Absent a contrary statute or other provision, the prudent investor rule applies to investment of funds held for charitable corporations.

111. See “Table of Jurisdictions Wherein Act Has Been Enacted,” UPIA, 7B U.L.A. 1 (Supp. 2008). Delaware, Georgia, Kentucky, Maryland, Louisiana and South Dakota have not enacted the UPIA. Ibid.

112. UPIA Section 2(b). “In the trust setting the term ‘portfolio’ embraces all the trust's assets.” Prefatory Note, UPIA, 7B U.L.A. 3 (2006).

113. UPIA, Section 2(b).

114. UPIA, Section 2(e).

115. UPIA Section 9.

116. UPIA, Section 3.

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David T. Leibell is a partner in the Stamford, Conn. office and Phyllis Maloney Johnson is an associate in the New Haven office of Wiggin and Dana LLP.