Nonprofit Organizations Private Foundations Michael V. Bourland Michelle Coleman-Johnson Bourland, Wall & Wenzel, P.C.

Tax Exempt Organizations – Review I.R.C. Section 501(c) lists organizations that are exempt from federal income tax I.R.C. Section 501(c) lists organizations that are exempt from federal income tax I.R.C. Section 501(c)(3) lists charitable organizations that are exempt from federal income tax, contributions to which are income tax deductible to the donor under I.R.C. Section 170 I.R.C. Section 501(c)(3) lists charitable organizations that are exempt from federal income tax, contributions to which are income tax deductible to the donor under I.R.C. Section 170

Section 501(c)(3) Organizations - Purposes Organized and operated exclusively for Organized and operated exclusively for –Religious, charitable, scientific –Testing for public safety –Literary –Educational purposes; or –To foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment); or –Prevention of cruelty to children or animals

501(c)(3) Orgs – Prohibited Activities No part of net earnings may inure to the benefit of any private shareholder or individual No part of net earnings may inure to the benefit of any private shareholder or individual –Private benefit/inurement doctrine No substantial part of activities may be carrying on propaganda, or otherwise attempting, to influence legislation No substantial part of activities may be carrying on propaganda, or otherwise attempting, to influence legislation –Except as provided in (c)(h)

501(c)(3) Organizations – Prohibited Activities May not participate in, or intervene in (including the publishing or distributing of statements) any political campaign on behalf of (or in opposition to) any candidate for public office. May not participate in, or intervene in (including the publishing or distributing of statements) any political campaign on behalf of (or in opposition to) any candidate for public office.

Charitable Contributions Donors are allowed an income tax charitable deduction for contributions to 501(c)(3) organizations Donors are allowed an income tax charitable deduction for contributions to 501(c)(3) organizations –See sections 170(a)(1) and 170(b)(1)(A) –Some organizations are “charitable” by definition or by the activities carried on

Private Foundation – under section 509(a), an organization is presumed to be a private foundation unless it is demonstrated that it fits an exception, and thus is a public charity Private Foundation – under section 509(a), an organization is presumed to be a private foundation unless it is demonstrated that it fits an exception, and thus is a public charity Further Classification - Private Foundation

There Are Two Types of Private Foundations Private Operating Foundation Private Operating Foundation –Has a stated charitable purpose and carries out its own programs –Generally seeks grants rather than awarding grants to other charitable organizations –Must expend substantially all of its net investment income directly for the purposes of its own charitable activities –Although donors receive the more liberal public charity income tax deduction limitations, this type of foundation remains subject to the private foundation restrictions because its source of funding is generally from one individual, family or corporation

Private Nonoperating Foundation Private Nonoperating Foundation Private Nonoperating Foundation –Most common –Generally receives its funding from one primary source, such as an individual, a family or a corporation –Does not generally actively raise funds or seek grants –Required to distribute approximately 5% of its assets annually to public charities –Donors’ charitable income tax deductions are more limited than when made to a public charity.

Tax Treatment for Donors Gifts of Cash and Nonappreciated Property Gifts of Cash and Nonappreciated Property –Limited to 30% of AGI 50% if to public charity or private operating foundation 50% if to public charity or private operating foundation Gifts of Appreciated Property Gifts of Appreciated Property –Limited to 20% of AGI If gift of qualified stock, donor can write off fair market value If gift of qualified stock, donor can write off fair market value If not qualified stock, donor must write off basis If not qualified stock, donor must write off basis –30% if to public charity or private operating foundation Subject to Itemized Deduction Limitation Subject to Itemized Deduction Limitation

Excise Taxes/Prohibited Transactions Foundations are subject to prohibited transaction rules Foundations are subject to prohibited transaction rules Violation of these rules result in excise taxes, and can arise from Violation of these rules result in excise taxes, and can arise from –Self Dealing –Failure to meet Minimum Distribution Requirements –Excess Business Holdings –Taxable Expenditures

Foundation Excise Taxes On Investment Income (4940(a)) – cannot be avoided, but can be reduced On Investment Income (4940(a)) – cannot be avoided, but can be reduced On Self-Dealing (4941) On Self-Dealing (4941) On Failure to Distribute Income (4942) On Failure to Distribute Income (4942) On Excess Business Holdings (4943) On Excess Business Holdings (4943) On Jeopardizing Investments (4944) On Jeopardizing Investments (4944) On Taxable Expenditures (4945) On Taxable Expenditures (4945) On Termination (507) On Termination (507)

Self Dealing Self dealing – certain actions between a private foundation and a disqualified person – can be direct or indirect, and includes: –Sale or exchange or leasing of property –Lending of money or extension of credit –Furnishing of goods & services (limited exception) –Payment of compensation (limited exception) –See 4941 for comprehensive list

More Acts of Self Dealing Furnishing of goods/services/facilities Furnishing of goods/services/facilities –Unless available to the general public on at least as favorable a basis Compensation Compensation –Payment for personal services, reasonable, necessary and not excessive

Who is a Disqualified Person for Self Dealing? Disqualified Person (IRC Section 4946) Disqualified Person (IRC Section 4946) Substantial Contributor (507(d)(2)) Substantial Contributor (507(d)(2)) Family Member of Substantial Contributor Family Member of Substantial Contributor Persons owning more than 20% of an entity which is a substantial contributor Persons owning more than 20% of an entity which is a substantial contributor If a corporation is a substantial contributor, any officer or director of the corporation If a corporation is a substantial contributor, any officer or director of the corporation Foundation manager Foundation manager Member of family of substantial contributor or foundation manager Member of family of substantial contributor or foundation manager Corporation which a disqualified person own more than 35% of voting power (or 35% of profit/beneficial interest) Corporation which a disqualified person own more than 35% of voting power (or 35% of profit/beneficial interest)

Substantial Contributor Any person who contributes or bequeaths an aggregate amount of more than $5,000 to the private foundation, if such amount is more than 2% of the total contributions and bequests received by the foundation before the close of the taxable year of the foundation in which the contribution or bequest is received by the foundation from such person Any person who contributes or bequeaths an aggregate amount of more than $5,000 to the private foundation, if such amount is more than 2% of the total contributions and bequests received by the foundation before the close of the taxable year of the foundation in which the contribution or bequest is received by the foundation from such person Also means the creator of the foundation Also means the creator of the foundation

Minimum Distribution Requirements PF must generally distribute at least 5% of its assets on an annual basis in qualifying distributions PF must generally distribute at least 5% of its assets on an annual basis in qualifying distributions –Asset base includes those assets not used in furtherance of the foundation’s exempt purposes, such as the foundation’s office building –Generally includes cash, stocks, bonds and other investment assets

MDR – Time Period for Distribution 12 months after close of taxable year to satisfy the minimum payout requirement for that taxable year 12 months after close of taxable year to satisfy the minimum payout requirement for that taxable year Can retroactively satisfy last year’s payout requirements with the current year’s qualifying payment Can retroactively satisfy last year’s payout requirements with the current year’s qualifying payment

MDR – Qualifying Distributions Grants to qualified charitable organizations (other 501(c)(3) organizations) Grants to qualified charitable organizations (other 501(c)(3) organizations) Grants to charities and non-charities for charitable purposes Grants to charities and non-charities for charitable purposes –Special rules for grants to individuals Costs of direct charitable activities Costs of direct charitable activities

Grants to Individuals Grants - Subject to IRC Section 4945 restrictions pertaining to grants for travel, study or any similar purpose Grants - Subject to IRC Section 4945 restrictions pertaining to grants for travel, study or any similar purpose –Requires prior IRS approval Distributions that are not “grants” Distributions that are not “grants” –Distributions to non-charitable organizations are permissible only if the foundation follows expenditure responsibility guidelines

Excess Business Holdings Foundations are limited in business ownership, and may only own Foundations are limited in business ownership, and may only own –20% of voting stock in a corporation, reduced by the percentage owned by all Disqualified Persons –35% of voting interest (reduced by what DP owns) if control is not in DP –De minimis 2% voting stock or value

Excess Business Holdings 5 years to dispose of excess holdings 5 years to dispose of excess holdings Additional 5 years if an unusually large gift or bequest Additional 5 years if an unusually large gift or bequest May not dispose of interest to a disqualified person May not dispose of interest to a disqualified person

Jeopardizing Investments PF cannot make investments which would jeopardize the exempt purpose PF cannot make investments which would jeopardize the exempt purpose –No per se violations in code –“prudent investor” standard of care –Examples: Margins, selling short Margins, selling short Speculative investments Speculative investments –Does not apply to gifts received by the PF

Taxable Expenditures Expenditures not in furtherance of exempt purpose Expenditures not in furtherance of exempt purpose –Carrying on propaganda or political activities –Distributions to non-charities, including grants to individuals Unless distribution is in fact charitable and expenditure responsibility is exercised Unless distribution is in fact charitable and expenditure responsibility is exercised

Awarding of Grants Need prior IRS approval Need prior IRS approval Must be awarded on objective and nondiscriminatory basis Must be awarded on objective and nondiscriminatory basis May not benefit private individual or attempt to influence legislation May not benefit private individual or attempt to influence legislation In furtherance of foundation’s charitable purpose In furtherance of foundation’s charitable purpose Must follow specific guidelines set by IRS Must follow specific guidelines set by IRS

Expenditure Responsibility If a distribution to an individual or non-charity is charitable in nature but not a “grant” under the Code If a distribution to an individual or non-charity is charitable in nature but not a “grant” under the Code –PF must exercise expenditure responsibility Strict guidelines must be followed and thorough records kept Strict guidelines must be followed and thorough records kept PF must monitor the charitable use of the funds PF must monitor the charitable use of the funds

Investment Income Excise Tax Excise tax on investment income (4940(a)) Excise tax on investment income (4940(a)) –Tax of 2% (1% under certain circumstances) on net investment income for a taxable year Does not apply to operating foundations Does not apply to operating foundations –Cannot be avoided - not a penalty for prohibited transactions

Self Dealing Excise Tax st Tier: 1 st Tier: –Disqualified person: 5% of amount involved for each year uncorrected –Foundation manager: 2.5% if willingly participated, knowing prohibited 2 nd Tier: 2 nd Tier: –Disqualified person: 200% –Foundation manager: 50%

Failure to Distribute Income st tier: 1 st tier: –Foundation: 15% on difference of what should have been distributed and what was distributed 2 nd tier: 2 nd tier: –Foundation: 100% of undistributed amount if penalty assessed and correction not made

Excess Business Holdings st tier: 1 st tier: –Foundation: 5% of the excess business holding 2 nd tier: 2 nd tier: –Foundation: 200% of the excess business holding if not timely corrected

Jeopardizing Investments st tier: 1 st tier: –Foundation: 5% of improperly invested assets –Foundation manager: 5% of improperly invested assets 2 nd tier: 2 nd tier: –Foundation: additional 25% –Foundation manager: additional 5%

Taxable Expenditures 1 st tier: 1 st tier: –Foundation: 10% on each taxable expenditure –Foundation manager: 2.5% on each taxable expenditure 2 nd tier: 2 nd tier: –Foundation: 100% –Foundation manager: 50%

Termination Tax A private foundation must take great care in dissolution or merger with another organization so as to avoid a taxable termination under Section 507 A private foundation must take great care in dissolution or merger with another organization so as to avoid a taxable termination under Section 507

Private Operating Foundations Directly carry on charitable activities, instead of making grants to other organizations Directly carry on charitable activities, instead of making grants to other organizations Must meet the “income test” and one of three other tests Must meet the “income test” and one of three other tests –“assets test” –“endowment test” –“support test”

“Income Test” Must distribute substantially all of the lesser of its adjusted net income or its minimum investment return directly for the active conduct of its exempt purposes Must distribute substantially all of the lesser of its adjusted net income or its minimum investment return directly for the active conduct of its exempt purposes –Does not include grants to other organizations

Income test Substantially all – means 85% or more Substantially all – means 85% or more Adjusted net income – gross income less deductions allowable to a corporation Adjusted net income – gross income less deductions allowable to a corporation –Does not include gifts, grants or contributions Minimum investment return – 5% of the assets not used directly in carrying out exempt purposes (same test as minimum distribution for a private foundation) Minimum investment return – 5% of the assets not used directly in carrying out exempt purposes (same test as minimum distribution for a private foundation)

Assets/Endowment/ Support Tests Assets Test Assets Test –Substantially more than ½ of assets be held for use for exempt function activities Defined to be 65% or more Defined to be 65% or more Endowment Test Endowment Test –Direct distributions of at least 2/3 of the foundation’s minimum investment return, or –33 1/3 % of its endowment

Support Test At least 85% of the organization’s support (excluding gross investment income) be from a combination of the general public and 5 or more exempt organizations and At least 85% of the organization’s support (excluding gross investment income) be from a combination of the general public and 5 or more exempt organizations and Not more than 25% of support (other than gross investment income) be from any one exempt organization and Not more than 25% of support (other than gross investment income) be from any one exempt organization and Not more than 50% of support be from gross investment income Not more than 50% of support be from gross investment income

Support Gifts, grants, contributions, Gifts, grants, contributions, Membership fees, gross receipts from admissions, sales of merchandise, Membership fees, gross receipts from admissions, sales of merchandise, Performance of services Performance of services Furnishing of facilities Furnishing of facilities Net income from UBI activities Net income from UBI activities Gross investment income Gross investment income Tax revenues Tax revenues Value of services or facilities furnished by a governmental unit without charge Value of services or facilities furnished by a governmental unit without charge

Computation Period Based upon year in question and the three immediately preceeding years Based upon year in question and the three immediately preceeding years –May be met on an aggregate basis

Tax on Undistributed Income Private Operating Foundations are not subject to the tax on undistributed income Private Operating Foundations are not subject to the tax on undistributed income

Reporting Requirements Private Operating Foundation generally subject to the same reporting requirements as an private nonoperating foundation Private Operating Foundation generally subject to the same reporting requirements as an private nonoperating foundation –Annual return 990-PF