An Introduction to Private Foundation Excise Taxes

“An Introduction to Private Foundation Excise Taxes,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Susan Snyder, ACTEC Fellow from Chicago. Private foundations are an effective vehicle for individuals and families to make charitable gifts, but they are subject to a strict regulatory regime. To educate us on those restrictions, you will be hearing today from ACTEC Fellow, Neil Kawashima from Chicago.

My name is Neil Kawashima and I am going to provide a brief overview of the Private Foundation Excise Tax regime. This is not intended to be a comprehensive discussion, but merely a tool that you can use to identify issues that may arise with respect to private foundations. There are six excise taxes applicable to private foundations.

IRS Section 4940: Excise Tax on Investment Income

First, under Code Section 4940, there is an excise tax on investment income. Even though private foundations are exempt from federal income tax, there is a 2 percent excise tax on the net investment income generated by a private foundation each year. This 2 percent excise tax, under certain circumstances, can be cut in half to 1 percent if the foundation expends more money on charitable activities than it is required to do. In addition, certain private operating foundations, meaning private foundations that are actively engaged in some direct charitable activity, are exempt from this tax.

IRS Section 4941: Excise Tax on Self-Dealing Transactions

Next, Code Section 4941 imposes tax on self-dealing transactions. This prohibition against self-dealing is possibly the most well-known of all of the Private Foundation Excise Taxes. This rule prohibits a private foundation from engaging in most types of transactions with a broad category of related party known as disqualified persons. The concept of a disqualified person is defined in Code Section 4946 and is very important to not only the self-dealing rules, but the excess business holding rules which I will discuss momentarily. The self-dealing rules prohibit the private foundation from engaging in many and most types of transactions with disqualified persons. These transactions can include the sale or exchange or leasing of property, the lending of money or other extension of credit, furnishing of goods, services or facilities, all between a private foundation and a disqualified person. It also prohibits payment of compensation to a disqualified person unless certain requirements are met.

These rules are intended to be broad and sweeping. They are intended to be prohibitive and not based on the impact of the transaction, good or bad, on the foundation. So, for example, if a disqualified person wants to buy an asset from a private foundation for twice the fair market value, which obviously would be a very good deal for the foundation, the transaction would be prohibited. Failure to comply with this rule will result in not only an excise tax imposed on the self-dealer, meaning the disqualified person, at 10 percent of the amount involved, but also an excise tax will be imposed on the foundation managers who approve the self-dealing equal to 5 percent of the amount involved, though this will be capped at $20,000.

Perhaps most important, if a foundation violates the self-dealing rules, it is required to undo or correct the transaction. So, the self-dealing taxes should not be thought of as a toll that simply can be paid and then the disqualified person and the private foundation may proceed with the transaction; rather, it is a strict prohibition on the activity. If the self-dealing act is not corrected, a 200 percent tax is imposed on the self-dealer and a 50 percent tax is imposed on the foundation managers. Because the self-dealing prohibition is so broad, it is very easy to inadvertently run afoul of these rules.

IRS Section 4942: Taxes on Failure to Distribute Income

Next, Code Section 4942 imposes a tax on private foundations that fail to distribute income for any taxable year. This is the so-called 5 percent requirement, under which private foundations are required to distribute a certain amount for charitable purposes each year. The minimum amount is generally thought of as 5 percent of the fair market value of the foundation’s assets valued in the manner described in the code and regs. Of course, a private foundation may always give in excess of the minimum distribution amount if it wishes. Failure to distribute sufficient amounts will result in a 30 percent tax on the amount of undistributed income increasing to 100 percent if not corrected in the required time period.

IRS Section 4943: Taxes on Excess Business Holdings

Next, Code Section 4943 provides for the prohibition against excess business holdings. This is arguably the most complex of all of the private foundation excise taxes. This rule prohibits a private foundation, in combination with all disqualified persons, from owning significant amounts of a business enterprise. Specifically, a private foundation and all disqualified persons may not own in excess of 20 percent of the voting stock of a corporation or profits interest in a partnership. This rule would apply to any business enterprise including limited liability companies, associations and other organizations. Under certain circumstances, the 20 percent threshold is increased to 35 percent if the private foundation and all disqualified persons together do not own more than 35 percent of the voting stock of the corporation or profits interest of a partnership, and it is established, “To the satisfaction of the secretary that effective control of the corporation is in one or more persons who are not disqualified persons with respect to the foundation.”

This means that if the foundation and disqualified persons are significant investors in the business enterprise, but essentially do not run or control the entity, then a 35 percent threshold may be permitted. There also is a safe harbor for private foundations that provides that a private foundation will not be treated as having excess business holdings if it owns no more than 2 percent of the voting stock and no more than 2 percent in value of all outstanding shares of all classes of stock. Excess business holding rules have very complicated rules about attribution and indirect ownership of business ownership of business enterprises, which are important to understand if the issue arises. In addition, it is important to understand what constitutes a business enterprise and also what does not constitute a business enterprise. Typically, this rule deals with operating companies, and it is not intended to draw in business entities for which at least 95 percent of the gross income is derived from passive sources or businesses that are functionally related to the foundation’s exempt purposes. If a private foundation violates the prohibition against excess business holdings, it will be subject to a 10 percent tax on the value of the excess business holdings followed by a 200 percent tax on the holdings if not disposed of in the required timeframe.

IRS Section 4944: Taxes on Investments Which Jeopardize Charitable Purpose

Code Section 4944 imposes a tax on jeopardizing investments. This means that if the foundation invests in a manner that jeopardizes its ability to carry out its exempt purposes, a tax is imposed equal to 10 percent of the amount invested on the foundation managers, as well as the private foundation. If uncorrected, an additional tax of 25 percent is imposed on the foundation and 5 percent on the foundation managers who don’t comply. While there is no specific list of assets that are per se jeopardizing, this is generally thought of as investments that are highly speculative and risky and highly illiquid that would preclude the foundation from engaging in its charitable activities because of the nature of the investments. There is an exception for program related investments, meaning investments that typically might be considered very risky but that the foundation invests in, in furtherance of its charitable purpose.

IRS Section 4945: Expenditure Responsibility

Finally, Code Section 4945 imposes a prohibition on distributions from a foundation known as taxable expenditures. You can think of a taxable expenditure as any foundation expenditure of its funds for improper purposes that are non-charitable. For example, a distribution for the carrying on of propaganda or electioneering or otherwise to attempt to influence legislation would be a taxable expenditure. Grants to individuals, unless they satisfy special rules of the IRS would be considered taxable expenditures. Grants awarded to organizations other than charitable organizations also would be problematic. Perhaps the most frequent issue that arises under 4945 is expenditure responsibility, which is a form of ongoing due diligence in which a private foundation that awards a grant has to exert certain oversight over a grant recipient and in some cases if the expenditure responsibility rules are complied with, a foundation’s grant will not be treated as a taxable expenditure and would be permitted even if it is to an organization that is not charitable or to another private foundation. If this rule is violated, a tax of 20 percent of the amount involved is imposed on the foundation and 5 percent on the foundation managers with an additional tax of 100 percent for the foundation and 50 percent for the foundation managers if uncorrected. This concludes the summary of private foundation excise tax rules. I hope this has been helpful. Thank you for your attention.

Thanks, Neil, for educating us on those very complex private foundation rules.

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