How Are Private Foundations Taxed? A Deep Dive
Private foundations, despite their tax-exempt status, are not completely immune to taxation. While private foundations generally remain exempt from standard income taxes, they do face unique excise taxes exclusively applicable to private foundations. Additionally, like all tax-exempt organizations, private foundations must adhere to the Unrelated Business Income Tax requirements.
The excise taxes on private foundations have a twofold purpose: to incentivize private foundations to actively pursue their charitable mission and to penalize those that deviate from it. Moreover, the Unrelated Business Income Tax is designed to prevent not-for-profit organizations from unfairly benefiting from commercial activities unrelated to their charitable or tax-exempt objectives. A thorough understanding of these taxes is vital for private foundations to meet their obligations, retain their tax-exempt status, and remain faithful to their charitable mission.
The taxes that private foundations may encounter encompass:
• Excise Tax on Net Investment Income: A tax on the foundation's investment earnings.
• Unrelated Business Income Tax: A tax imposed on the income generated by tax-exempt organizations from unrelated business activities.
• Excise Tax on Failure to Distribute Income: A tax triggered when a foundation fails to distribute the annual requisite income.
• Excise Tax on Taxable Expenditures: A tax applied to expenditures not in alignment with the foundation’s charitable goals.
• Excise Tax on Self-Dealing: A tax levied on transactions that involve private benefits to individuals associated with the foundation.
• Excise Tax on Excess Business Holdings: A tax linked to the foundation's holdings in certain businesses.
• Excise Tax on Jeopardizing Investments: A tax applicable when the foundation engages in high-risk investments.
Excise Tax on Net Investment Income
In general, private foundations are liable for an excise tax on their net investment income. This tax is assessed at a fixed rate of 1.39% of the foundation's net investment income for a given tax year. The purpose of the tax is to cover the government's expenses associated with overseeing private foundations and ensuring they fulfill their charitable missions. Net investment income encompasses a wide range of income sources, such as interest, dividends, capital gains, rents, royalties, and other investment-related earnings. It's important to note that revenues generated from contributions into the foundation and from activities aligned with its charitable mission are not categorized as investment income, and thus are not subject to this tax.
When calculating net investment income, a foundation can deduct all ordinary and necessary expenses related to the production of that investment income.
Deductible expenses encompass specific operating costs of the foundation that are directly tied to the production of investment income. These expenses may include items like officers' compensation, employees' salaries, and fees paid to outside professionals. The most frequent deduction is associated with investment advisory fees paid to portfolio managers. However, it's crucial to recognize that operating expenses unrelated to the production of investment income cannot be deducted. Additionally, it's worth noting that any federal excise taxes paid previously cannot be utilized to offset net investment income.
Private foundations must calculate and pay this excise tax when filing their annual tax return with the IRS on Form 990-PF. The due date for Form 990-PF falls on the 15th day of the fifth month following the foundation's tax year. For the majority of foundations, which operate on a calendar year basis, this deadline falls on May 15th. Private foundations with significant tax liability may need to make estimated tax payments throughout the tax year to avoid penalties and interest. Failing to pay the excise tax on time can result in penalties and interest charges and, in severe cases, may jeopardize a foundation's tax-exempt status.
It's crucial to distinguish the excise tax on net investment income from Unrelated Business Income Tax (UBIT), as both taxes apply to private foundations but address different income streams and activities. While the excise tax on net investment income focuses solely on investment income generated by private foundations, UBIT applies when a tax-exempt organization engages in business activities that generate income unrelated to its charitable mission. Importantly, income that's taxed under UBIT doesn't also face the excise tax on net investment income; only one of these taxes can be applied to the same income.
Unrelated Business Income Tax (UBIT)
Unrelated Business Income Tax (UBIT) applies to all 501(c) tax-exempt organizations, including private foundations. The primary objective of UBIT is to prevent tax-exempt entities from gaining an unfair advantage over for-profit businesses by participating in income-generating commercial activities that are unrelated to their charitable mission or tax-exempt purpose. The IRS defines unrelated business income (UBI) as “income from a trade or business, regularly carried on, that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization's exemption.” UBI occurs when tax-exempt organizations engage in activities that closely resemble regular commercial operations, such as merchandise sales. UBI can arise when private foundations have direct ownership in for-profit businesses or engage directly in commercial activities. However, if a business activity aligns with the organization's mission, such as when a nonprofit museum charges admission fees, UBIT does not apply.
Private foundations seldom engage in commercial ventures, and when they do, the activity almost always relates to their charitable mission. Consequently, direct involvement in unrelated business activities is a rarity among private foundations. Additionally, passive income, such as interest, dividends, capital gains, and royalties, is generally excluded from UBI. As such, common off-the-shelf investments such as stocks, bonds, and mutual funds do not get entangled in the UBIT rules.
It’s worth noting that UBI can also be triggered by debt-financed income. This occurs when investment returns result from assets that were financed through debt. For example, if a foundation borrows money to invest in income-producing real estate and collects rent, that rental income may be categorized as UBI. This situation also occurs when a foundation invests in a limited partnership that utilizes debt to acquire underlying assets or when a foundation borrows funds to purchase securities on margin.
For private foundations, UBI frequently stems from alternative investments, including hedge funds, private equity funds, venture capital funds, and other types of limited partnerships. These investments can generate UBI either directly, as commercial operating income, or indirectly, from assets tied to debt-financed investments. Typically, this UBI income passes through to the investor, leading to the issuance of a Schedule K-1 form that details the UBI earnings
Therefore, private foundations should exercise particular caution when conducting due diligence on alternative investments, as these often hold the potential to generate UBI. Foundation investment managers should determine any UBI exposure before purchasing complex financial instruments. If present, it's advisable to factor in the higher tax rates at the outset. While tax considerations shouldn't be the sole driver of investment decisions, having a solid grasp of the UBIT rules can aid private foundations in their investment planning endeavors.
Private foundations should generally aim to minimize UBI for two significant reasons:
1. Higher Tax Rates: UBI is subject to significantly higher tax rates compared to the standard investment income earned by private foundations. The calculation of UBIT utilizes regular corporate income tax rates or trust rates if the organization is structured as a trust. For 2023, the corporate income tax rate is 21% versus the excise tax on net investment income which is just 1.39%. Furthermore, depending on where UBI is generated, foundations may need to file state income tax returns and pay state income tax, further diminishing investment gains.
2. Risk of Losing Tax-Exempt Status: If UBI becomes a substantial portion of a private foundation's income, the IRS has the authority to revoke its tax-exempt status. The rationale is that significant UBI contradicts the nonprofit nature of these organizations. While there's no fixed percentage to determine how much UBI is too much, foundations should start to exercise caution if UBI reaches 15 to 20% of gross income or higher.
Excise Tax on Failure to Distribute Income
Non-operating foundations, also known as grantmaking foundations, must comply with an annual distribution requirement. This mandates a minimum distribution of 5% of their average net investment assets for charitable purposes. Failure to abide by this rule can result in substantial excise tax penalties. Notably, this regulation does not extend to all private foundations. Operating foundations, which actively participate in direct charitable activities like operating a soup kitchen, are exempt from this 5% distribution mandate.
Most private foundations are categorized as non-operating or grantmaking foundations, and as such, they are required to make qualifying distributions to meet the 5% distribution mandate. Primarily, these qualifying distributions take the form of grants to Section 501(c)(3) public charities. Additionally, qualifying distributions include necessary and reasonable administrative expenses that advance the foundation's charitable mission. These expenses include but are not limited to, employee salaries, grant administration, and legal and accounting fees. By ensuring that qualifying distributions surpass the minimum distributable amount, a foundation can fulfill its annual distribution obligation and avoid excise taxes. Additionally, a private foundation that exceeds this 5% threshold can apply the surplus distribution to counterbalance future years' requirements
Determining the required annual distribution involves a moderately complex calculation based on asset values. This calculation takes into account various valuation requirements, distinguishing between assets held for investment purposes and those used directly for charitable activities. For instance, public securities are valued at their average monthly fair market value, while real estate requires an appraisal every five years. Regular investment holdings are included in the calculation, while assets exclusively dedicated to charitable operations, such as an office printer, are excluded.
The calculation for the minimum distribution requirement begins by deducting 1.5% of the average annual value of the foundation's investment assets, accounted as a cash reserve, along with a deduction for federal taxes paid. This calculation usually yields a requirement just under 5% of the foundation's average portfolio asset value. The calculation is disclosed on the foundation's annual tax return, Form 990-PF. Foundations have a one-year grace period to meet the distribution requirement. Non-compliance triggers a first-tier 30% excise tax on the undistributed income, followed by a 100% excise tax for each additional year of non-fulfillment. Note that these excise tax payments do not substitute the mandated distributions but are additional obligations.
Excise Tax on Taxable Expenditures
The excise tax on taxable expenditures relates to funds not spent on charitable, educational, or similar exempt activities. The aim is to ensure that the funds of private foundations are utilized appropriately and in alignment with their tax-exempt status. A taxable expenditure encompasses any amount paid or incurred by a private foundation for various purposes including:
• Grants to an organization that is not a public charity or an exempt private operating foundation, unless the foundation exercises expenditure responsibility, ensuring the grant funds are utilized solely for a charitable purpose.
• Expenditures for any reason other than the foundation’s exempt purpose (noncharitable expenditure).
• Grants to an individual for travel, study, or other similar purposes, except those awarded on an objective and nondiscriminatory basis.
• Carrying on propaganda or otherwise attempting to influence legislation.
• Influencing the outcome of any specific public election or carrying on, directly or indirectly, any voter registration drive (except nonpartisan voter registration drives).
Despite these general rules, exceptions do exist. For instance, a private foundation can make grants to individuals for travel, study, or similar purposes if the foundation's grant-making procedures receive prior approval from the IRS.
The initial excise tax imposed on the foundation is 20% of each taxable expenditure. Foundation managers, who knowingly agree to make the taxable expenditure, may be subjected to a tax of 5%, with a limit per expenditure. If not remedied, a second-tier excise tax of 100% may be levied on the foundation.
To prevent these significant tax liabilities, private foundations must correct any taxable expenditures within the taxable period. This process can include the recovery of the expenditure or implementing other measures to ensure similar future expenditures are avoided.
Excise Tax on Self-Dealing
Foundations are barred from most transactions with related parties, also known as “disqualified persons” in IRS terms. Generally speaking, a disqualified person can be a manager or significant contributor to the foundation. To avoid unintended violations of self-dealing prohibitions, foundations should keep an up-to-date list of disqualified persons, including any foundation officer, director, trustee, or employee with authority to act on behalf of the foundation, any substantial contributor, as well as certain relatives and entities owned or controlled by the listed people.
The Internal Revenue Code assumes that, in general, all transactions between a private foundation and a disqualified person are prohibited as self-dealing transactions. These prohibitions cover a broad spectrum, including the sale or lease of property, lending of money, furnishing of goods, services, or facilities, transferring of income or assets, and the payment of compensation unless it's reasonable and used for essential personal services.
However, amidst these restrictions, certain exemptions or carve-outs emerge:
1. Hiring Family Members: Family members can be hired and compensated, provided the pay is fair and the services are necessary and further the foundation’s charitable mission. However, these services must be categorized as "personal" services, a term that is narrowly defined to typically encompass white-collar tasks such as legal, accounting, banking, and investment activities. Given these specific conditions, consulting legal counsel is crucial when considering the employment of family members as staff or service providers.
2. Compensating Board Members: Although most foundations do not compensate board members, it is permissible as long as the compensation is reasonable.
3. Renting Space: Paying rent to a disqualified person is considered self-dealing, even at below-market rates. However, leasing space at no cost is exempt from this rule.
Navigating through these regulations, it’s beneficial to highlight some potentially problematic transactions:
4. Paying Family Travel Expenses: Foundations generally cannot finance the travel of spouses and children uninvolved in the foundation.
5. Attending Fundraisers: A disqualified person can only use a ticket purchased by the foundation if attending the fundraising event is part of their oversight responsibility.
6. Providing Scholarships: Foundations cannot provide scholarships or grants to benefit disqualified persons or their family members, such as the grandchildren of a substantial donor.
Self-dealers (i.e., disqualified persons) and foundation management are liable for excise taxes for self-dealing, while the foundation itself remains exempt from these taxes. An initial tax of 10% of the transaction amount is levied on the self-dealer, which can increase to 200% if uncorrected within the taxable period. Foundation managers involved in self-dealing can be taxed 5% of the amount, up to $20,000 for each act, and an additional 50% if not corrected.
Each act of self-dealing and the associated tax liability must be reported on IRS Form 4720, filed annually with Form 990-PF. To correct self-dealing, the disqualified person must undo the transaction as much as possible, ensuring the foundation's financial position is not worse off. Foundations should closely examine transactions and establish robust internal controls to prevent self-dealing.
Excise Tax on Excess Business Holdings
The Internal Revenue Code imposes an excise tax on the excess business holdings of private foundations in certain business enterprises. This provision aims to prevent private foundations and their disqualified persons from excessive ownership and control over businesses, ensuring that the focus remains on their charitable activities.
Excess business holdings arise when a private foundation and its disqualified persons own more than a 20% interest with voting rights (or 35% in certain cases where the business is effectively controlled by unrelated persons) in a for-profit business enterprise, whether directly or indirectly. It's crucial to understand that foundations can hold any amount of nonvoting ownership in a business without facing the excess business holdings classification. Generally, a business enterprise refers to active trade or business activities that are regularly conducted for income from the sale of goods or performance of services, excluding those deriving 95% of income from passive sources like dividends, interest, royalties, and certain real estate rents.
A 10% initial excise tax is imposed on the private foundation’s excess business holdings. If not disposed of within the taxable period, an additional tax, equal to 200% of the excess business holdings, is levied. If a foundation owns only a very small part (up to 2%) of a business, it won’t have to pay this tax. This is true even if disqualified persons own more than 20%.
If a foundation inadvertently acquires excess business holdings through a bequest or gift, it is granted up to five years for their disposal to avoid taxation. In contrast, acquiring excess holdings through other means, such as purchases, may immediately subject the foundation to the tax. Therefore, it's essential for foundations to consistently monitor the business holdings owned by its disqualified persons to prevent unexpected tax obligations.
It is worthwhile to note that there is an exception to the general rules known as the "Newman’s Own Exception" that permits certain private foundations to entirely own a for-profit business. This provision requires the business to donate all net profits to charity and maintain independent operations. Enacted in the 2018 Bipartisan Budget Act, it allows foundations like Newman's Own to sidestep the excise tax on excess business holdings, facilitating substantial charitable contributions through business earnings.
Excise Tax on Jeopardizing Investments
Private foundations are not allowed to make jeopardizing investments, which essentially means they cannot be reckless or imprudent with their invested endowment. The jeopardizing investment rules were implemented to safeguard foundation assets and provide the IRS with an enforcement mechanism in case a private foundation is managing its assets in a reckless or foolish way.
The IRS defines jeopardizing investments as “investments that show a lack of reasonable business care and prudence in providing for the long- and short-term financial needs of the foundation for it to carry out its exempt function.” To steer clear of such precarious investments, foundations should adhere to sound and balanced investment practices. This involves foundation managers and investment advisors abiding by well-established investment strategies. They should focus on key investment principles including expected return, compound growth, risk and return relationships, cost advantages, and the benefit of diversification.
There are no bright line tests that define a jeopardizing investment. To make a determination each investment should be considered on an individual basis by taking into account all the relevant facts and circumstances including the investment's relationship with the foundation’s portfolio as a whole. The determination is made at the moment the investment is purchased—is the investment a reasonable choice at that exact moment? It does not matter if the investment goes on to make a lot of money or lose a lot of money—but rather the focus is on whether the investment was reasonable the day it was made. For example, lottery tickets are universally considered to be terrible investments and are perhaps the epitome of a jeopardizing investment. If a foundation buys a lottery ticket and wins the jackpot this does not change the fact that at the moment the lottery ticket was purchased it was a terrible investment and therefore a jeopardizing one. Because investments are judged based on the facts and circumstances at the moment of purchase, it is very important for foundation managers to maintain records documenting the reasoning behind why the investments were made. There is no specific asset class or type of investment that is instantly treated as an intrinsic violation, but the IRS has historically scrutinized the following investments very closely:
1. Trading in securities on margin,
2. Trading in commodity futures,
3. Investing in working interests in oil and gas wells,
4. Buying puts, calls, and straddles,
5. Buying warrants, and
6. Selling short.
Exceptions to the Jeopardizing Investment Rules
The jeopardizing investment rules do not apply under the following situations:
• The foundation receives an investment as a gift from a third party
• The foundation acquires the investment as a result of a corporate reorganization
• The investment is classified as a program-related investment
Penalties for Violating the Jeopardizing Investment Rules
The penalties for violating the jeopardizing investment rules are designed to punish both the foundation as well as the foundation managers who approve the investment decisions. If a private foundation is found to make a jeopardizing investment, there is a tax levied on the foundation of 10% of the amount invested. This tax can be imposed each year the investment is on the foundation’s books. Additionally, any foundation manager who “knowingly, willfully and without reasonable cause” participated in the making of the investment can also be subject to 10% tax on that investment (up to a maximum of $10,000). This penalty tax is also applied each year the jeopardizing investment is on the foundation’s books. The individual penalty can apply if the foundation manager is negligent in attempting to understand the risks involved of the investment in question.
Furthermore, if the foundation does not take appropriate steps to dispose of a jeopardizing investment, the IRS can impose a second-level tax on the foundation equal to 25% of the amount of the investment. Individual foundation managers who do not allow the disposal of the jeopardizing investment can also be found liable for this second level tax, which is 10% of the investment (up to a maximum of $20,000).
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