16. Private Foundations and Donor Advised Funds, Part 3 of 3

16. Private Foundations and Donor Advised Funds, Part 3 of 3

Article posted in General on 5 October 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 6 October 2016

An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

16. Private Foundations and Donor Advised Funds, Part 3 of 3

Links to previous sections of book are found at the end of each section.

The general rule is that a non-operating private foundations must make qualifying distributions of at least 5% (reduced by payments for net investment income tax or unrelated business income tax) of its net non-charitable investment assets.  However, private foundations are allowed to accumulate funds instead of distributing them as a means of saving up for a later large qualifying distribution in certain cases.
Saving up these charitable distributions is referred to as a “set aside,” following the idea that these funds are set aside for future qualifying distributions.  This is permitted only if the project would be better accomplished through saving up these distributions than by making them immediately and if the qualifying distributions are made within 60 months of the first set aside.  These sets asides are typically used for very large single purchases, such as the purchase or construction of a building.
Not only may a nonoperating private foundation save up qualifying distributions through a set aside plan, but it may also do the reverse and make a large qualifying distribution today which will reduce the requirement for future qualifying distributions.  Thus, any amount paid by the private foundation in excess of the 5% minimum requirement can be carried over for up to 5 years.  During this carry over period, the excess amount can be used to reduce any remaining required qualifying distributions not paid during any year.  The carry forward amounts are used much like charitable tax deductions carried forward due to exceeding the income giving limitations in that transfers made during the tax year are counted first and only then can carry forward distributions be used with the oldest non-expired carry forward distributions being used first.
As with the other violations, failure to distribute the minimum required amount to charity results in a tax penalty.  The penalty begins at 30% of the undistributed amount.  An additional tax of 100% of the undistributed amount is charged if the distribution is not made within 90 days of the IRS notice of the violation.  Payment of these penalties does not substitute for the payments to charity.  Persistent failure to distribute could result in the revocation of the foundation’s tax exempt status.
The next type of prohibited transactions is excess business holdings where the private foundation, combined with insiders, holds too large of a share of a business entity.
Prior to the legislation preventing excess business holdings an owner could transfer his or her business into the private foundation, take a tax deduction for the transfer, and still continue to control the business precisely as before with no functional changes.  This level of control created a number of opportunities for abuse. 
The problems with excessive business holdings come because the donor receives a tax deduction, but continues to control the business.  This control means that the donor can decide if any profit is distributed to the foundation, which was particularly important under previous legislation where charitable distributions were based upon income rather than assets.  Further, the donor – as controller of the business – would continue to control his own personal compensation as well as all other employees.  A donor could thus transfer a business into a foundation, take a large tax deduction, and then extract the value out of the business through salaries paid to the donor and the donor’s family members as employees of the business.  This payment of salary (or, e.g., “sweetheart” deals benefitting others in exchange for reciprocal treatment in the donor’s other non-charitably-owned operations) could be used to cause the company to incur losses, reducing the value of the company, and thus reducing the foundation’s required charitable grants based on the company’s value.  The various schemes for taking a large deduction at transfer and then subtly extracting the value from the company without benefitting the private foundation are nearly limitless, but all are predicated upon the donor being able to control the underlying business entity.  Thus, the tax code was changed to eliminate the use of private foundations as a means to control an operating business.
A private foundation is allowed to own up to 2% of a company regardless of the ownership interests of other insiders.  Thus, a private foundation could own 2% of a corporation that was otherwise entirely owned by the founding donor.  A private foundation may not own more than 2% of a business entity if the foundation and all insiders combined own more than 20% of a business entity.  Ownership can refer to voting stock ownership in a corporation, beneficial interests in a trust, or profit interest in a partnership.  (Thus, e.g., a private foundation may own 100% of non-voting shares in a corporation where it and all disqualified persons combined own fewer than 20% of the shares.)  This permitted ownership percentage will increase to 35% where the foundation can demonstrate that an unrelated person or “cohesive group of third parties” does, in fact, exercise control over the business.  In this case, the risk of abuse is likely reduced by the influence of an outside controlling person or group.
An exception to the prohibition against private foundations controlling a business is allowed when the business entity is engaged in activity directly related to the private foundation’s charitable purposes, and not simply earning profits for the foundation’s use.  Thus, a private foundation could have full control of a school or hospital and thereby further its charitable purposes in education or healthcare.  Other allowed businesses include thrift shops selling donated items, a business operated by volunteers, or a business primarily for the convenience of the employees or customers of its charitable business, such as a hospital gift shop or museum cafeteria.
Additionally, a private foundation is allowed to have full ownership of a “passive” business entity that merely collects payments from assets such as dividends from stock holdings, interest from investments, royalties from intellectual property or rent from real estate.  So long as this type of income constitutes at least 95% of the business entity’s gross income, full ownership of the entity is allowed.  Similar to the rules for unrelated business income, borrowing money to purchase real estate will cause such investments to no longer be passive.
The private foundation finding itself in the circumstance of owning excess interest in a business must sell or transfer those interests.  This sale must occur within 90 days if the foundation acquired the business interests by purchase or within five years if the foundation receives the business interests by gift.  This five year limitation allows time for a business owner to transfer all or part of his or her business to his or her private foundation prior to a sale (thus avoiding the capital gains taxes that would otherwise be due at sale) and still have sufficient time to market and sell the asset, even in a difficult market.  Indeed, if the five years is not sufficient to achieve an appropriate sale, the foundation may go through a procedure to request an extension of the time from the IRS, allowing for up to five additional years.
As with other violations, a private foundation having excess business holding is subject to tax penalties.  The foundation must pay a tax of 10% of any excess holdings, based upon the highest excess business holdings occurring during the tax year.  If the excess business holdings are not removed from the foundation within 90 days of the IRS notice of the violation an additional 200% penalty may be imposed.
In order to preserve the charitable function of the private foundation, the tax code prohibits the foundation from investing in jeopardizing (excessively risky) investments.
Without this restriction, there is a risk that the private foundation’s assets could be squandered, thus eliminating any further charitable benefit.  In such a case, the taxpayer would have received a large charitable tax deduction, but with no resulting charitable activity.  Issuing charitable tax deductions in return for little or no charitable activity violates charitable tax policy principles and, consequently, such risky investments are prohibited.
There is no “black and white” rule to determine what a jeopardizing investment is.  Instead, it occurs when the manager “fails to exercise ordinary business care and prudence.”  Although a particular investment may be highly risky, it will be considered in the context of the entire portfolio.  For example, the purchase of 60-day out-of-the-money options could be a reasonable part of a hedging strategy taken in the context of other asset holdings, but would clearly be a jeopardizing investment if such options constituted the foundation’s entire investment portfolio.  Because of the potential for excessive risk, the IRS will pay particular attention to investments in options, margin trading, short selling, commodity futures, and oil and gas interests.  Nevertheless, each of these may be a perfectly appropriate investment in the context of the risk profile of the overall investment portfolio.
Because the purpose of the jeopardizing investment rule is to ensure that charitable activity will ultimately occur, rather than the assets being squandered, the rule will not apply to high risk investments that are primarily intended to advance charitable goals.  Thus, investments in college loans for needy students or low-income housing may indeed by highly risky, but will not constitute jeopardizing investments.  In this case even if the foundation loses its investment, the funds would still have been used to advance charitable purposes and so the underlying tax policy goals would not have been violated. 
As a penalty for making a jeopardizing investment the foundation must pay a tax of 10% of the amount invested in the jeopardizing investment.  Because the foundation manager is directly responsible for managing the foundation’s assets, he or she will also be charged a penalty of 5% of the amount invested up to a $10,000 penalty if he or she willingly and knowingly participated in making the investment without any reasonable cause for doing so.  As with other violations, an additional tax applies if the violation is not corrected within 90 days of the IRS notice of violation.  If the foundation has not divested itself of the jeopardizing investment within this time, the foundation is subject to another tax of 25% of the amount invested in the jeopardizing investment, and the manager may pay an additional 5% of the amount invested up to an additional $20,000 penalty.
The final way in which the private foundation rules attempt to protect charitable purposes is to prohibit and penalize non-charitable grants from the foundation.  These non-charitable grants are referred to as taxable expenditures.

Any grant made by the foundation that does not qualify as an appropriate charitable grant is a prohibited taxable expenditure.  This is not a problem for typical grants made to public charities.  However, prior to the current law some private foundations were being used to further political campaigns, which is not a charitable purpose.  Thus, the use of funds for campaigning and lobbying are now prohibited as taxable expenditures.  Non-partisan research is allowed, but there is careful oversight of such activities.  For example, support of voter registration drives is not allowed if such drives are limited to specific geographical regions as this may advantage one party or candidate.

Grants to individuals are not charitable gifts, because an individual is not a charity.  However, in certain cases a private foundation may fund a grant to individuals for travel, study, or similar purposes.  This may be done only with advanced approval of the granting procedures by the IRS.  In seeking such approval, the foundation must show that the grant is (1) a scholarship to a nonprofit educational institution, (2) a prize made primarily in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement, [note that these awards may be made without prior approval by the IRS if there are no restrictions on or expectations regarding the use of the prize money] or (3) the purpose of the grant is to achieve a specific objective, produce a report or other similar product, or improve or enhance a literary, artistic, musical, scientific, teaching, or other similar capacity, skill, or talent of the grantee.  In addition to grants for travel, study, or similar purposes, the foundation may also make grants to impoverished individuals or those who experience catastrophic medical expenses or property loss.  These poverty-relief or catastrophe grants do not require advanced approval from the IRS.

Grants made to most charitable entities other than public charities, e.g., private foundations, labor unions, trade associations, fraternal orders, veterans groups, type III non-functionally integrated supporting organizations, or other supporting organizations controlled by a disqualified person, are taxable expenditures.  The exception to this rule is that if the private foundation exercises “expenditure responsibility” on grants made to such organizations then the grant is permitted.  Expenditure responsibility requires a variety of tasks including a written agreement of the specific charitable tasks the entity will accomplish, segregation of funds, regular reports from the recipient, and special reports to the IRS. 
If a private foundation makes grants that do not qualify as appropriate charitable grants it will be penalized initially by a 20% tax on the amount of the taxable expenditure.  The foundation manager is subject to a 5% tax, up to a $10,000 maximum, if there was no reasonable cause to believe the expenditure would be appropriate.  The foundation must recover the expenditure or, where full recovery is not possible, the foundation must recover as much as possible and take any corrective action directed by the IRS within 90 days of the IRS notice of the violation or the foundation will receive an additional penalty of 100% of the taxable expenditure.  Absent such timely correction, the foundation manager may also be penalized another 50% penalty, up to $20,000.
As briefly summarized above, the rules for establishing and managing a private foundation are extensive.  There is, however, an alternative to a private foundation that is much cheaper and easier for the donor.  This simple substitute for the private foundation is the donor advised fund.
The simple concept of a donor advised fund is that the donor gives money to a public charity which the public charity sets aside in a separate account.  The public charity then typically follows the advice of the donor regarding when and where to distribute those segregated funds to other public charities.  The charity has legal control of all of the donor advised funds and could choose to ignore the donor’s advice.  This legal reality does not impact the practical reality that donor advised funds do follow donors’ advice (so long as the advice is for legally permissible distributions), because failure to do so would discourage other donors from using the charity for their donor advised funds.  Nevertheless, this legal control of the accounts by the public charity owning the donor advised funds means that the donor has made a completed gift to a public charity immediately upon transfer of funds or assets into the donor’s account.

Whether the private foundation or donor advised fund is the best instrument will depend upon the gifts and goals of the donor.  Donor advised funds are remarkably simple for the donor to establish.  No legal documents need to be specially drafted and there are no annual meetings or required filings.  Depending upon the organization, donor advised funds may be started with only $5,000.  Annual costs vary with the size of the account, but typically range from 1% to 0.1% of the account value.  Donor advised funds meeting certain minimum account sizes (e.g., $250,000), often permit management of assets by the donor’s own qualified financial manager and allow for these managers to charge fees to the fund for this management.  Large donor advised funds are often comfortable with accepting not just cash, but also complex assets such as privately-held C- and S-corporation stock, limited partnership interests, real estate, and even valuable personal property.  Donor advised funds do not expire at the death of the donor.  Managing charities typically allow for the appointment of new advisors at death.  These new advisors can appoint others during life or at death, indefinitely continuing the passage of control.  Further, there are currently no minimum payout requirements for these funds, meaning that no charitable distributions would ever have to occur.  Donor advised funds have several tax advantages over private foundations.  Gifts to public charities (such as donor advised funds) may have higher valuations and generate deductions that can be used up to a higher percentage of the donor’s income than gifts to private foundations.  Additionally, donor advised funds are not subject to the 2% excise tax on net investment income as are private foundations.

With all of these advantages of the donor advised fund, why would a donor ever use a private foundation?  There are several reasons.  Private foundations offer a much higher degree of multi-generational control of assets.  The founding donor can create legally enforceable trust rules that limit the charitable purposes of the foundation, limit the trust expenditures, and dictate who may – and may not – be trustees and board members.  The rules for private foundations are quite old and legislatively stable, suggesting a high likelihood for multi-generational stability.  Although donor advised funds are not new, the massive growth of funds from charities affiliated with financial institutions is new, and consequently many of the rules have only been recently established.  This legislative newness combined with the complete lack of any enforceable legal rights to control the funds in the donor advised account make donor advised funds a less certain option for long-term planning.  Although convenient, donor advised funds lack the ability to directly benefit friends or family members through travel reimbursements and employment in professional and managerial tasks.

Donor advised funds have a much higher average payout rate than private foundations, reflecting their common use as a short-term place to park charitable funds.  It often makes sense for donors to estimate their giving for the upcoming year and then transfer that money to a donor advised fund at the end of December.  This allows for the charitable deductions to be taken earlier, even though the ultimate distributions to charities will not take place until the following tax year or later.  This type of short-term planning corresponds perfectly with the convenience and simplicity of the donor advised fund. 
Many of the same type of limitations on private foundations also apply to donor advised funds.  For example, there can be no benefits going to the donor, the donor’s family, or organizations controlled by either.  Grants from a donor advised fund cannot be used to fulfill a legally enforceable pledge by the donor to a charity.  This would provide a benefit to the donor by reducing his or her legally-enforceable obligations.  Similarly, grants from a donor advised fund cannot result in the charity giving benefits, such as donor event tickets, to the donor.  Donor advised fund grants that generate such benefits are subject to a tax of 125% of the amount of the benefit, payable by either the donor/advisor or the benefit recipient, and a 10% tax on the donor advised fund manager who knowingly made such a transfer (up to $10,000).  Donor advised funds are also subject to the same rules preventing excess business holdings as private foundations are.  Unlike private foundations, donor advised funds may make distributions to other donor advised funds.  However, donor advised funds may not make distributions to individuals.  Donor advised funds may not make distributions to private foundations, unless the managing charity follows the rules for “expenditure responsibility,” and even then distributions to a private foundation controlled by the donor or donor’s family may result in excess donor control leading to the fund be reclassified as a private foundation.  Any distributions to private foundations may also create the opportunity for challenges to the higher deduction taken for a gift to a public charity upon transfer to the donor advised fund, rather than for a gift to a private foundation.
Private foundations and donor advised funds offer opportunities to take an immediate tax deduction for a transfer where the donor and donor’s financial advisors can continue to manage the funds for the indefinite future.  Once transferred, the funds can grow in a tax-free or tax-minimal environment.  Although private foundations are typically used for long-term holding of more significant wealth, and donor advised funds are more commonly used for short-term holding of less significant wealth, finding the best fit will depend upon the specific values and goals of each particular donor.

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