Advising Private Foundations

In the arsenal of estate planning, private foundations have traditionally ranked among the big guns. With their relative formality and extensive tax rules, they have been considered the province of the truly wealthy - people with $1 million or more to dispose of charitably. The belief that lesser largesse could be better served by donor-advised funds and certain types of supporting organizations (see "The Rich Truly Are Different," JofA, April 04, page 32) is changing.

The Pension Protection Act (PPA) of 2006 has curtailed many of the tax and other advantages enjoyed by those two alternative philanthropic vehicles. Today, small family foundations with assets under $1 million make up nearly 60% of all foundations. One factor driving this growth is the unprecedented transfer of wealth to the post-boomer generation that has begun and is likely to accelerate in coming years. Often, these small foundations are administered by family members, who rarely have expertise regarding the complex tax regulations involved.

For all these reasons, developing a niche practice in private foundations poses growth possibilities for CPA firms, according to Holly M. Pantzer, CPA, a partner with BKD LLP, one of the 10 largest CPA and advisory firms in the U.S., where her areas of expertise include advising private foundations. CPA firms are increasingly likely to be advising founding benefactors of family foundations. CPAs can be a valuable resource for monitoring compliance with the many tax laws unique to private foundations. Awareness of the nuances of private foundation laws is especially important now, given the increased scrutiny of all tax-exempt organizations by Congress and the IRS. Advisers can help prevent inadvertent but costly violations of the tax laws peculiar to private foundations. Key issues for benefactors considering a private foundation include:

• Comparisons to other options (donor-advised fund or supporting organization)
• Prohibitions on self-dealing
• Excise taxes on net investment income
• Taxes on undistributed income
• Taxable expenditures and expenditure responsibility
• Jeopardizing investments and excess business holdings

Private foundations operate exclusively for religious, charitable, scientific or similar activities as described in IRC § 501(c)(3) and are exempt from income tax but commonly pay excise taxes on net investment income and, sometimes, as penalties. They are usually funded by a single contributor, such as a family or corporation, rather than by the general public, as with a public charity. They may either directly conduct exempt activities (operating foundations) or make grants and distributions consistent with their exempt status (non-operating foundations).

Although private foundations often support other tax-exempt charitable organizations, a private foundation is not what tax law calls a "supporting organization." A supporting organization exclusively benefits, is controlled by, or operates in connection with a public charity. Nonetheless, CPAs should be familiar with the four types of supporting organizations (see Exhibit 1 for resources) when advising private foundations. Grants made to a Type III non-functionally integrated supporting organization require additional administrative and reporting requirements. In addition, grants to this type of supporting organization are not included in qualifying distributions for purposes of meeting the distribution requirements.

PRIVATE FOUNDATION VS. DONOR–ADVISED FUND
CPAs should assist funders in determining if a private foundation is the best charitable vehicle for their needs. One alternative to establishing a private foundation is to establish a donor-advised fund with a sponsoring organization. Donors make contributions to sponsoring public charities. These funds are separately accounted for and associated with a named donor. The donor then has a reasonable expectation of being able to advise the sponsoring organization as to the distribution of these funds. The donor's role must be advisory, and the sponsoring organization must exercise full control and variance powers over the donated funds.

The conventional wisdom has been that donor-advised funds may offer lower administrative costs than private foundations; however, this is not necessarily true. A remaining benefit of a donor-advised fund is that, unlike private foundations, they are not subject to excise taxes on net investment income. Since passage of the PPA, however, they are sub-ject to penalty taxes similar to those on private foundations (see "Donor-Advised Funds: Preparing for Closer Scrutiny," JofA, Jan. 08, page 28).

Two major advantages of donor-advised funds survived the PPA, however. First, while deductible cash contributions to donor-advised funds are limited to 50% of a taxpayer's adjusted gross income (AGI), deductible cash contributions to a private foundation are limited to 30% of a taxpayer's AGI. Second, the deduction for long-term capital gain property other than publicly traded securities contributed to a private foundation is limited to the donor's basis in the property, while gifts of similar property to a donor-advised fund is not subject to the same limitation. Depending upon the donor's circumstances and assets, these could be major considerations if a substantial portion of a donor's wealth consists of closely held stock.

It is difficult to establish a contribution threshold at which a private foundation is preferable to a donor-advised fund. The fact that two-thirds of family foundations have less than $1 million in total assets indicates that this threshold is below $1 million for many donors.

AVOID CONFLICTS OF INTEREST—TAXES ON SELF–DEALING
CPAs should be aware that private foundations are generally not allowed to engage in transactions with "disqualified persons." Such persons include foundation managers—an officer, director or trustee of the foundation—or substantial contributors. Family members of those persons also may be disqualified. A substantial contributor is one whose cumulative contributions exceed the greater of $5,000 or 2% of the total cumulative contributions received by the foundation from the date of its creation through the end of the tax year. Since the self-dealing rules take effect on the day the person's cumulative contributions become "substantial," it is important for foundations to continually monitor contributions against the threshold. The following transactions with a disqualified person, with certain exceptions, are considered to be "self-dealing acts" subject to potentially high excise taxes under IRC § 4941:

• Sales or exchanges of property
• Leases
• Loans
• Providing goods, services or facilities
• Paying compensation or reimbursing expenses
• Use of income or assets of the foundation by a disqualified person
• Certain payments of money or property to government officials

Excise taxes of 10% and 5% of the amount involved in each act of self-dealing are assessed, respectively, against a disqualified person and, if he or she was aware it was an act of self-dealing, a participating foundation manager. If the transaction is not corrected in a timely manner, additional taxes of 200% and 50% are assessed against the disqualified person and the foundation manager, respectively. Excise taxes are assessed on the "amount involved" in the transaction, which is generally the greater of the fair market value of cash and property either given up or received by the private foundation.

Excise taxes may be imposed even if the self-dealing transaction is at "arm's-length." A disqualified person is allowed to provide property to a private foundation free of charge. However, if a disqualified person provides property for a price to a private foundation, the entire transaction is considered self-dealing.

Disqualified persons are allowed to receive compensation for personal services provided to private foundations if those personal services are reasonable and necessary. An excise tax may be assessed, however, on any compensation or expense reimbursement deemed excessive. Moreover, not all services provided by a person are necessarily considered personal services within the meaning of the exception. Therefore, a foundation should document the job duties and workload of the disqualified person as well as compensation paid to persons with similar duties and workloads at similar foundations. According to Pantzer of BKD LLP, this is particularly important at small family foundations where second- and third-generation family members are being compensated.

The tax laws and regulations applicable to private foundations cannot be navigated by a reasonableness standard. The laws were written to be restrictive and completely eradicate certain practices of wealthy donors. It is often not relevant if a transaction benefits the foundation at the expense of a disqualified person. Almost always, a transaction between a private foundation and a disqualified person will be considered selfdealing. See IRC § 4941 and sources in Exhibit 1 for examples.

MINIMIZE THE TAX CRUNCH—TAX ON NET INVESTMENT INCOME
CPAs can help private foundations minimize taxes by understanding the dual rate structure of the excise tax on net investment income. Net investment income of private foundations is generally taxed at 2%. However, the rate is reduced to 1% if qualifying distributions exceed current-year average monthly FMV of investments, plus or minus certain adjustments, multiplied by the average distribution ratio for the prior five years, plus 1% of current-year net investment income. Net investment income is gross investment income, including capital gains, less ordinary and necessary expenses incurred in the production of the investment income.

Halving your client's tax liability is always a worthy goal, but at least two factors can make it difficult to apply the formula. First, if the foundation's portfolio includes mutual funds, the foundation has little control over timing of realized capital gains and losses, which can make income more difficult to predict. Second, all else being equal, the formula requires a slow but steady year-to-year increase in giving to qualify for the reduced tax on net investment income. This may deter a foundation from making a significantly higher payout in years when special philanthropic needs are especially high.

SPEND IT—TAXES ON UNDISTRIBUTED INCOME
Private foundations are required to pay out their "required distributable amount" each year or pay a 30% excise tax on whatever portion of it has not been distributed within a year. Any portion undistributed after two years is subject to an additional 100% tax. If a foundation distributes more than is required, it may carry forward the excess to offset future amounts for up to five years. The required distributable amount is equal to the foundation's minimum investment return, defined as 5% of the average monthly FMV of total assets, plus or minus certain adjustments.

A foundation may use any reasonable method for valuing total assets, including market quotations and appraisals. Fair market value must be recalculated each year, except for investments in real estate, which must be valued by independent appraisal no less than every five years. Allowed adjustments include reductions for acquisition indebtedness, cash held specifically for charitable activities, and taxes on investment income. See IRC § 4942.

Qualifying distributions are grants to accomplish the foundation's charitable purposes and may include reasonable and necessary administrative expenses and amounts paid to acquire assets used in carrying out the charitable purposes. Depreciation expense, excise taxes, and investment expenses are excluded.

SPEND IT PROPERLY—TAXABLE EXPENDITURES
Taxable expenditures are certain payments inconsistent with a foundation's charitable purposes. Officers of foundations probably understand the prohibitions on funding political propaganda or lobbying of legislators. However, they may not know that a grant to an individual for study, travel or "similar purposes" is also forbidden unless the grant meets any of several conditions of IRC § 4945(g). Taxable expenditures could bring on a 20% excise tax, with an additional 100% if not corrected upon notice or assessment. The penalties might not stop there. Foundation managers who knowingly, willfully and without reasonable cause agree to any taxable expenditure are subject to an initial tax of 5%, up to a maximum aggregate of $10,000.

Foundations must also be careful when making grants to organizations that are not public charities. A foundation must exercise "expenditure responsibility" with regard to grants made to nonpublic charities to avoid classification of the grants as taxable expenditures.

Foundation managers with responsibility for approving expenditures of any type should have a comprehensive understanding of the complex rules associated with taxable expenditures. Expenditure responsibility requires extra administrative and reporting measures (see Exhibit 2) to ensure a grant is spent only for the intended purpose and not for private or political gain.

Private foundations should consider two additional measures to prevent taxable expenditures. First, all expenditures with possible political implications should be carefully scrutinized to ensure they are not associated with lobbying for specific outcomes to legislation. Foundations should be aware of the various exceptions that allow for political expenditures to be excluded from taxable expenditures. Second, foundations should verify the status of public charities requesting a grant by checking the IRS Business Master File, available at no charge at www.irs.gov/taxstats/charitablestats/article/0,,id=97186,00.html. Guidestar has also incorporated information from the Business Master File into its fee-based Charity Check service (available at www.guidestar.org/createUser.do?requestUrl=/services/cc.jsp).

INVEST APPROPRIATELY—TAXES ON JEOPARDIZING INVESTMENTS AND EXCESS BUSINESS HOLDINGS
CPAs with private foundation clients need to understand the investments included in the private foundation's portfolio to prevent excise taxes on jeopardizing investments. A 10% excise tax on each jeopardizing investment may be assessed against both the private foundation and the foundation manager (if the manager is willfully involved) for each year in which the jeopardizing investment is held. If the investment is not removed from jeopardy, additional excise taxes of 25% and 5% may be imposed upon the foundation and foundation manager, respectively.

A jeopardizing investment shows a lack of reasonable business care and prudence in providing for the short-term and long-term needs of a foundation in carrying out its exempt purpose. Although no single investment category is specifically considered jeopardizing, the following investment types should be considered only as part of a well-rounded portfolio:

• Trading in securities on margin
• Trading in commodity futures
• Investing in working interests in oil and gas wells
• Buying puts, calls and straddles
• Buying warrants
• Selling short

Program-related investments made by a foundation are never considered to be jeopardizing investments, even if the investment is income-producing or is considered high-risk. Program-related investments are made primarily to accomplish a foundation's exempt purposes rather than to produce income or capital appreciation.

Example. Two hypothetical private foundations, the Claire Foundation and the Hazel Foundation, recently made high-risk business loans to entrepreneurs interested in opening a shopping center in a very poor neighborhood. The primary exempt function of the Claire Foundation is to provide grants for world health initiatives, while that of the Hazel Foundation is to promote small business growth in economically disadvantaged communities.

The loans are directly related to the exempt purpose for the Hazel Foundation and, therefore, may be considered program-related investments. However, for the Claire Foundation, the loans may be considered jeopardizing investments, since they do not significantly further its specific exempt purpose. The Claire Foundation and its managers need to assess whether reasonable business care was exercised in providing the loans.

Finally, the combined holdings of a private foundation and its disqualified persons are limited to 20% or less of the voting interest of a business enterprise. As a result, private foundations are not allowed to own a voting interest in business enterprises in which disqualified persons own 20% or more of the voting interest. Foundations may be allowed to increase ownership up to 35% if a third person not considered a disqualified person has effective control over the business enterprise in question. A de minimis rule allows a private foundation, together with all other private foundations, to own up to 2% of the voting stock or outstanding shares of all classes of stock of a corporation.

REPORTING REQUIREMENTS
Private foundations are required to file IRS Form 990-PF by the 15th day of the fifth month following the accounting year-end. The 990-PF includes financial and nonfinancial reporting components. The financial reporting component includes an analysis of revenues and expenses, a balance sheet and calculation of excise taxes on net investment income. The nonfinancial reporting component includes disclosures about self-dealing, undistributed income, taxable expenditures, expenditure responsibility, jeopardizing investments and excess business holdings. According to Pantzer, disclosure is crucial on certain items, including compensation, business holdings and self-dealing. Consulting with a client is imperative to determining how much to disclose as well as where best to disclose it on the relevant tax form.

Given the variety of complex tax regulations and reporting requirements faced by private foundations, CPAs can be an important resource in providing valuable expertise and advice. But as this overview shows, many situations could call for a specialist in this area. Thus, setting your clients' foundation on a firm footing—or helping them choose a different vehicle—and keeping it safe from potentially high penalties is a matter for thorough analysis of their philanthropic needs, goals and abilities.

AICPA RESOURCES
Articles
“Donor-Advised Funds: Preparing for Closer Scrutiny,” JofA, Jan. 08, page 28
“The Rich Truly Are Different,” JofA, April 04, page 32
“IRS Bite Beginning to Mirror Its Bark,” The Tax Adviser, Aug. 07

Conference
AICPA Conference on Tax Strategies for the High-Income Individual, May 8-9, Las Vegas.

For more information or to register, go to www.cpa2biz.com , or call the Institute at 888-777-7077.

OTHER RESOURCES
IRS forms and publications
IRS Publication 557, Tax-Exempt Status for Your Organization
IRS Publication 578 (discontinued), Tax Information for Private Foundations and Foundation Managers
IRS Instructions for Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Nonexempt Charitable Trust Treated as a Private Foundation
IRS Instructions for Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code

Publications
Foundation Growth and Giving Estimates: Current Outlook, Foundation Center, 2007
Pension Protection Act of 2006: Law, Explanation and Analysis, CCH Inc., 2006

EXECUTIVE SUMMARY
Small family private foundations are growing at a rate of six per day. This indicates a growing probability that CPA firms will be advising benefactors of family foundations. It is vital that CPA firms understand the complex tax rules related to private foundations.

Private foundations are not allowed to engage in transactions with "disqualified persons," which include foundation managers and substantial contributors, even if the transaction is conducted at fair market value.

Excise tax on the net investment income of private foundations is assessed at 2%. However, the rate is lowered to 1% for years in which the private foundation makes qualified expenditures in excess of the prior five-year rolling average qualified expenditure ratio plus 1% of current-year net investment income.

The minimum annual distribution of private foundations is roughly 5% of the average monthly fair market value of assets. Distributions in excess of this amount may be carried forward for five years to offset future required annual distributions.

Private foundations must pay an excise tax on "taxable expenditures." In general, these expenditures are made for any purpose other than religious, charitable, scientific, literary, educational or other public purposes. To ensure grants made to organizations other than public charities or exempt operating foundations are not classified as taxable expenditures, a private foundation must exercise expenditure responsibility.

Private foundations are not allowed to invest in risky investments, unless the investments are related to the exempt purpose of the foundation. Private foundations are also not allowed to invest in a business enterprise if the combined ownership interest of the private foundation and all disqualified persons exceeds 20% of the business enterprise.

Brian P. McAllister, CPA, Ph.D., is an assistant professor of accounting at the University of Colorado at Colorado Springs. Timothy R. Yoder, CPA, Ph.D., is an assistant professor of accounting at Mississippi State University. Their e-mail addresses, respectively, are bmcallis@uccs.edu and try11@msstate.edu.