Excise Tax on Investment Income
Net investment income (dividends, interest, royalties, net operating gains LESS directly related expenses) is taxed at 2%, unless foundations make additional distribution for charitable purposes, then it is taxed at 1%.
Self-Dealing
This provision penalizes almost ANY transaction between the foundation and its ”disqualified person” (which we will discuss later), even if the transaction was at arm’s length and benefits the foundation. The penalty is 5% of the amount involved in self-dealing imposed on the self-dealer and 2-1/2% (with $10,000 maximum) on foundation managers who knowingly participate in the transaction. However, the IRS will allow the organization to correct the problem (i.e. the self-dealer to pay the organization back) and will assess the tax only if the situation is not remedied.
Minimum Distribution Requirements
Private foundations must make annual “qualifying distributions” in the amount of 5% of the fair market value of their net investment assets. If the organization fails to do so, the IRS will assess 15% penalty on the undistributed income and if the funds are not distributed within a specified period, the IRS will assess 100% penalty.
Qualifying distributions are:
- grants for charitable purposes;
- reasonable administrative costs related to the grantmaking process
- payments to purchase assets used in conduct of the foundation’s activities
- expenses of conducting direct charitable activities
- amounts set aside for future projects
- program-related investments
Excess Business Holdings
The rationale for this penalty tax is the position of Congress that it is inappropriate for a private foundation to hold a substantial share of the principal donor’s family business.
If the percentage is owned by disqualified persons – the holding allowable for the foundation is determined as follows: 20% minus the percentage owned by disqualified person. For example, if a disqualified person owns 4%, the foundation can own 16% of the business.
If the percentage is owned by not disqualified persons – the 20% above is substituted for 35% – i.e. the combined share allowable is 35%.
The foundation is allowed to own less than 2% of any business regardless of the percentage held by disqualified persons – this is known as the de minimus rule.
The amount of tax imposed is 5% of the value of the excess holdings. If the foundation fails to divest the unallowed shares within the specified period (which can be between 5 to 10 years), the penalty becomes 200%.
Jeopardy Investments
If an organization invests its funds in a manner that jeopardizes the carrying out of its exempt purposes, the penalty is 5% on the amount invested. There is also 5% penalty ($5,000 maximum) on foundation managers who knowingly participate in the jeopardy investments. If the organization fails to make necessary correction, there is an additional 25% penalty against the foundation and 5% penalty (with $10,000 maximum) against managers.
Taxable Expenditures
Any expenditures for noncharitable purpose, such as lobbying, electioneering, voter registration, grants to individuals, grant to any organization that is not a public charity. The penalty of 10% of the prohibited expenditure is imposed on foundation and 2-1/2 % on foundation’s managers ($5,000 maximum). If the action is not corrected, additional tax of 100% is imposed on foundation and 50% on the managers ($10,000) maximum.
March 27th, 2010
Operating foundations do more than only distributing grants for charitable purposes – they also are involved in their own charitable programs. The regulatory rules applicable to the private operating foundations are similar to private foundations. There are significant advantages enjoyed by private operating foundations:
- Donors may take advantage of the favorable income tax charitable deduction rules – similar to the ones for public charities – 50% AGI limitation for charitable contributions deducted on Schedule A.
- Operating foundations are NOT subject to the income distribution requirement for private foundations under 4942.
How to qualify for the private operating foundation status? Satisfy two tests:
- Income test – 85% or more of foundation’s income is used for “active conduct of charitable activities” (not just for grantmaking)
- One of three tests:
The assets test – at least 65% of the foundation’s asset are devoted to the active conduct OR to functionally-related businesses
The endowment test – the foundation must spend at least 3-1/3% of net investment assets on the active conduct
The support test – 85% of its support must come from the general public and five or more unrelated non-profits.
March 27th, 2010
A supporting organization attaches itself to another public charity and gains the exempt status that way. The two essential tests that must be satisfied are:
- purpose test – requires the organization to carry out a purpose of the supporting organization;
- control test – the supported organization must control the supporting organization.
March 27th, 2010
To qualify under this exception for a public charity status, two tests must be met:
1. public support test (different from the First Exception: Traditional Public Charity) – in the prior 4 years, the organization must have received more than 1/3 of its total support from any combination of:
- qualifying gifts, grants, contributions or membership fees, AND
- gross receips from admissions, sales of merchandise, performance of services or other activities related to its exempt functions.
2. investment income test – total of the organization’s investment income and net unrelated business income is NOT MORE than 1/3 of the total support.
March 27th, 2010
There are two ways for an organization to qualify under this exception:
1. By definition – if an organization is:
- churches
- colleges
- universities
- schools
- nonprofit hospitals
- medical research institutes
- support organizations to schools and governmental unit.
2. By the amount of public support the organization receives. There are 2 tests under which the organization may qualify as a public charity:
- mechanical test - look to the most recent 4 years - if public support >= 1/3 of total support – the charity is a public charity. Let’s talk about definitions involved in this test:
public support – generally the support will fall in one of these categories:
- contributions from individuals, foundations, trusts and corporations.
- support from governmental units.
- membership dues, if the purpose of such payment is to support the organization and NOT to purchase admissions, use facilities, etc.
total support – everything included in public support PLUS:
- gross investment income
- contributions and dues from individuals, foundations, trusts or corporations that are MORE than 2% of total support
- net income from unrelated business activities.
- facts and circumstances test – if the organization fails to qualify under the mechanical test, it can still try to qualify under the facts and circumstances test. For this, evidence of three elements must be demonstrated:
- the total amount of government and public support = or > than 10% of total support for the applicable period.
- the organization continuously tries to attract new and additional public and governmental support.
- the organization is entitled to be recognized as public rather than private. Most often, two factors are considered:
a. To what degree the board of directors represents the general public (and not just donors)
b. To what extent services or facilities of the organization are available to the general public.
March 27th, 2010
