The excess business holding rules prevent private foundations from owning large controlling stakes in businesses, but still allow foundations to have small non-controlling stakes as passive investors. Essentially, if a private foundation and its disqualified persons (foundation insiders) own too much of a business, the foundation is in violation of the rules and potentially faces financial penalties. The most common reason foundations find themselves owning too much of a given business is that they receive a large ownership stake as a bequest from the estate of deceased business owner. However, any acquisition, regardless of form, can cause the foundation to own too much of a given business. The excess business holding rules apply to the ownership of all business entities including corporations, partnerships, and LLCs.
The excess business holding rules check to see if a private foundation, along with its disqualified persons, collectively own voting control of a business enterprise in excess of certain thresholds. As a general rule, a foundation and its disqualified persons are allowed to own up to 20% of the voting ownership of a business enterprise. Any voting ownership inexcess of 20% violates the rules, which typically triggers financial penalties. Note that the testing is in regards to voting ownership interests; the nonvoting ownership interests do not count toward violating the threshold. What’s more, if a foundation and its disqualified persons stay below the voting ownership threshold, then the foundation can own an unlimited amount of the nonvoting ownership in that company. The IRS has laid out detailed rules for the attribution of business holdings when complex ownership structures are in play (i.e., when there are complex org charts involved), but this is beyond the scope of this article.
There are two important exceptions to the general rule outlined above:
(1) If an unrelated third party has effective control of a given business, the private foundation and its disqualified persons are allowed to own up to 35% of the voting ownership of that company. Effective control means having direct or indirect power over the direction, management, and policies of a business—it does not matter whether the power is actually exercised.
(2) There is also a de minimis exception to the general rule. A private foundation does not violate the excess business holding rules if, for a given business, the foundation owns less than 2% of the voting ownership and less than 2% of the overall value ownership. If the foundation meets the de minimis exception it does not matter how much ownership is held by the associated disqualified persons.
Certain Businesses Excluded from the Excess Business Holding Rules
Certain types of businesses are exempt from the excess business holding rules. The exempted businesses include:
Passive Income Businesses: A private foundation is not subject to any ownership restrictions for businesses that derive 95% or more of their gross income from passive sources such as interest, dividends, royalties, and capital gains. A family investment partnership is a good example of this kind of business.
Functionally Related Businesses: A private foundation is not subject to any ownership restrictions for businesses whose operations substantially relate to the exempt charitable mission of the private foundation. For example, if a foundation’s charitable mission is to help mentally handicapped adults operate in regular society, it should be permissible for the foundation to own a large stake in a for-profit business like a car wash that primarily employs the mentally handicapped.
Newman’s Own Type Businesses: This exception is narrow and is informally named after the grocery product company Newman’s Own. Paul Newman started Newman’s Own as a for-profit company but he chose to donate all profits to charitable causes. The company grew and became very successful. After Paul Newman passed away, the company was transferred to a private foundation. The United States Congress crafted this exception to allow private foundations to wholly own a for-profit company as long as specific requirements are met. In order to qualify the company must be 100% owned by the foundation and must donate 100% of its profits to the foundation. Furthermore, the company and the foundation must be operated independently from each other with distinct boards of directors. There are a few other minor requirements beyond the scope of this article.
How to Avoid Noncompliance
Excess business holding issues can be easy to overlook, especially if the financial affairs of the foundation and the associated disqualified persons are managed in a similar way with overlapping investments. It is advisable for foundations to set up careful procedures to mitigate the chances of inadvertent violations. Note that these rules normally pertain only to privately held businesses. Mainstream investments like mutual funds and publicly traded stock mostly fall outside of the domain of the excess business holding rules because of the structure of the investment funds and the massive market capitalization of publicly traded companies. So private foundations can, by and large, pay almost no attention to the excess business holding rules if their endowments are invested in standard vehicles like stocks, bonds, mutual funds, and ETFs.
Private foundations should focus their safeguards and monitoring programs on privately owned businesses instead of publicly traded investments. If a foundation is considering making an investment in a privately owned business, it should first check with all its associated disqualified persons to verify there are no excess business holding ownership issues. Foundations should also keep an updated list of their investments in privately owned companies and regularly circulate the list with their associated disqualified persons. When circulating such a list, foundations should always ask for certification from all disqualified persons on whether any private business holdings overlap. Information must flow both ways—from the foundation to the disqualified persons and vice versa.
Potential Grace Period
Private foundations on the wrong side of the excess business holding rules may benefit from a grace period to address the excess holdings. Generally, foundations have a grace period of 90 days to sell or otherwise dispose of an excess business holding. The grace period starts after the sooner of (1) the foundation realizes it has an excess holding, or (2) the foundation has reason to know of the excess holding. Negligence and lack of internal controls are not a justification for not knowing about a holding. Also, there is no grace period if the violation occurs because a foundation directly buys an ownership interest (as opposed to receiving an ownership interest as a gift or if an associated disqualified person acquires the holding). If a foundation directly buys an ownership interest in violation of the applicable threshold, then the foundation is immediately subject to a financial penalty.
On the other hand, there are situations where the grace period can be extended. If the excess holding results from a gift or bequest, the Internal Revenue Code gives foundations up to five years to take care of the issue. Furthermore, the IRS has the authority in some special cases to extend the five-year period if the foundation can demonstrate its good faith efforts to dispose of a holding have been unsuccessful due to circumstances beyond its control. The IRS can also extend a grace period if federal or state law somehow prevent a foundation from disposing of an excess holding.
Penalties for Noncompliance
Private foundations that do not reduce their excess business holdings to permissible levels within any applicable grace period are subject to the penalty regime. The initial tax is equal to 10% of the highest value of the excess holdings during the period. An additional tax of 200% can be imposed if the foundation fails to dispose of the excess holding in a timely manner.
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