Primer for Operating a Private Foundation
The purpose of this memo is to provide a brief summary of the legal and tax aspects relating to the organization and administration of charitable New York not-for-profit corporations.
- What is a Private Foundation?
The term 'private foundation' is a tax designation rather than a description of a type of legal entity. The Internal Revenue Code designates any tax exempt organization not called something else (e.g., a public charity, a school or a religious institution) as a private foundation. There are two kinds of private foundations. The usual plain vanilla kind whose principle activity is to make grants to other tax exempt organizations, and the private operating foundation which spends its money by running a charitable service (e.g., a clinic or research center). It is possible to change from a private foundation to a private operating foundation upon filing the appropriate application with the Internal Revenue Service. Private foundations are usually supported by family and friends and do not engage in public fund-raising activities.
- Legal Entity
There are four types of not-for profit corporations in New York. Type A, Type B, Type C and Type D. Type B corporations are formed for charitable, educational, religious and scientific purposes. Types A, C and D are used for political, social, quasi-public, athletic or other purposes specified by law. Type B corporations do not have to have members.
Under New York law (and in order to maintain its tax exempt status), a not-for-profit corporation may not use its funds for propaganda, to support or oppose a political candidate, attempt to influence legislation (with certain exceptions) and no funds can inure to the benefit of any director, officer or related individual.
A not-for-profit corporation is managed by a Board of Directors (there must be at least three). The Board will adopt by-laws which will provide how the entity will be governed.
- Tax Exempt Status
Once the not-for-profit corporations have been organized, the first order of business is to apply for tax exempt status under Section 501(c) (3) of the Internal Revenue Code by filing a Form 1023 with the Internal Revenue Service. Being classified as a tax exempt entity is important for two reasonsâ€”first because all contributions to the organization qualify as charitable deductions for income and estate tax purposes and second, because the income earned by the entity will not be subject to income tax (as discussed below, a private foundation is subject to a 1â€“2% excise tax, which is still significantly less than regular income tax rates). It usually takes about three months (if there are no snags) for the Internal Revenue Service to process the application. Upon acceptance of the application, the IRS will issue a determination letter acknowledging the organization's tax exempt status. This should be kept in the files at all times. If the application is timely filed (within fifteen months of organizing), tax exempt status is retroactive to the day of incorporation. The organization must also register as a tax exempt entity with New York State after the determination letter is received from the Internal Revenue Service. This registration is not as involved as the IRS application and no acceptance of the registration is required.
- Excise Taxes
As mentioned above, private foundations are not truly exempt from tax. The Internal Revenue Code imposes a tax of 2% on a private foundation's 'net investment income'. This includes dividends, non-exempt interest, rents, royalties and capital gain. Expenses to produce investment income are deductible.
It is possible under certain circumstances to reduce the tax rate on net investment income from 2% to 1% provided the private foundation distributes the other 1% as 'qualifying distributions' (defined below) and meets certain other tests over a 5-year period.
- What a Private Foundation Must Do
A private foundation is required to distribute annually as 'qualifying distributions' an amount equal to 5% of the aggregate annual fair market value of its assets (deemed the minimum investment return by the Internal Revenue Service), less the sum of its net investment income tax and tax on unrelated business income (unrelated business income is income received from a tax exempt entity that is not related to its tax exempt purpose).
Distributions for any given tax year must be made before the end of the succeeding tax year. That is, the qualifying distributions based on the fair market value of assets for the year 1999 must be made in the year 2000. There are rules and regulations as to how and when assets are valued. Most importantly, there are severe taxes and penalties if the required qualified distributions are not made in a timely fashion.
The Internal Revenue Code provides that qualifying distributions must be made to an exempt organization which is not another private foundation. This means that qualifying distributions should be made to independent public charities or to private operating foundations. If contributions are made to private foundations, they will not count toward the 5% figure. Therefore, we suggest, at least initially, all qualifying distributions should be made to independent public charities. You will probably know whether a charity is public or not without a thorough investigation, e.g., universities, hospitals, major charitable organizations such as The American Red Cross or The Sierra Club. However, if there is any possible question, you must ask the charity to give you a determination letter from the Internal Revenue Service stating that it is a public charity. You may also want to request an opinion of counsel to the effect that the grant from your foundation will not alter the grantee status as a public charity (this can happen when a small public charity receives a major gift from a large foundation such as The Ford Foundation). Grants may not be made to public charities controlled directly or indirectly by the foundation or any of its substantial contributors.
It is possible to make a grant to another private foundation or even a non-tax exempt entity although such grant, as stated above, will not count as a 'qualifying distribution'. In order to do so, you must exercise what is called 'expenditure responsibility'. Under Internal Revenue Service regulations this means you must conduct a pre-grant inquiry and the grant must be made pursuant to a written agreement and must be reported to the Internal Revenue Service on a special form.
- What a Private Foundation Must Not Do
- Self-Dealing â€” It is prohibited for a private foundation to have any economic transactions with a 'disqualified person' even if they benefit the foundation. These transactions include the sale or lease or exchange of property, loans, furnishing of goods, services and facilities and payment of compensation (except reasonable compensation to officers for services rendered directly to the foundation). Disqualified persons include a substantial contributor and any family member or the manager of any foundation.
- Excess Business Holdingsâ€”The foundation cannot hold business interests if the foundation and all of its disqualified persons hold in the aggregate 20% of the business subject to certain minor exceptions.
- Investments which Jeopardize Charitable Purposesâ€”a foundation is prohibited from investing 'in such a manner as to jeopardize the carrying out of any of its exempt purposes'. Further on in this Primer will be a discussion of investment standards of a New York non-for-profit corporation. The Internal Revenue Code and regulations state that the following investments are suspect: margin trading, trading in commodity futures, puts calls and straddles, purchase of warrants, selling short, lack of portfolio diversification and investments in oil and gas wells. The Code does permit retaining an investment received by gift.
- Fail to Make Required Qualifying Distributions. See Section 5 for a discussion of what a private foundation must do.
- Certain 'Taxable Expenditures'â€”Under the Internal Revenue Code, foundations are prohibited from making certain expenditures which are labeled 'taxable expenditures.' These include expenditures for propaganda, to influence legislation, to influence the outcome of an election and also grants to individuals for travel and study unless pre-approved by the Internal Revenue Service. Taxable expenditures also include grants for any non-exempt purposes and grants to any other private foundations unless 'expenditure responsibility' has been exercised.
- Penalties and Taxes
There are severe penalties and taxes if the foundation engages in any of the prohibited activities listed above. These penalties and taxes can be assessed against the foundation and the directors. In some instances, a single transaction can give rise to a violation of several rules causing the imposition of multiple taxes and penalties. For example, if a foundation loans money to a family business, it is an act of self-dealing and may be an act jeopardizing the charitable purposes and also a 'taxable expenditure.' The penalties and taxes are assessed until the matter is corrected.
- What a Private Foundation May Do
- Expenditures for Business Purposes. Reasonable expenditures for heat, light, rent, etc., are permitted.
- Reimbursement for Travel Expenses. A director who visits the site of a charity to determine if it is a candidate for a grant may be reimbursed for his or her reasonable travel expenses.
- Reasonable Salaries. It is permissible to pay to a director who is also an officer a reasonable salary for the time spent managing the affairs of the foundation but we do not think you should pay any salaries.
- Miscellaneous Other Business Expenses. Expenditures for investment advice and professional fees are permitted.
- Unrelated Business Income
Under certain circumstances, it is possible for a foundation to engage in a trade or business provided all the profits are used for foundation purposes (for example, Paul Newman's Salad Dressing), but such profits are subject to an income tax known as the Unrelated Business Income Tax (UBT) and it is our recommendation that you should not even consider engaging in any unrelated business.
The Section of the Code dealing with unrelated business income are quite complicated. For example, sales of a donated merchandise and, in certain instances, the receipt of rent may not be regarded as unrelated business income subject to a tax. Seek advice before doing anything other than a grant to another exempt organization.
- Investment Standards
The New York Not for Profit Law imposes certain investment standards on the directors. Although the language is somewhat different from the New York Prudent Investment Act, the standards are basically the same. The directors should take into consideration the long and short-term needs of the foundation, its purposes, its financial requirements and the anticipated return on its investments and general economic conditions. The investments should be diversified and made in good faith and in the exercise of good judgment. The future performance of any investment has no effect on whether it was appropriate when made. While the Internal Revenue Service does not impose investment standards, it does regard certain activities as suspect (see Article 6(C)).
It is appropriate but not essential to retain investment counsel to advise the directors as to the nature, type and diversification of investments appropriate for a not for profit organization. Directors have no liability if they act in good faith and in a prudent manner or rely on an expert.
- Grant Procedure
It is important for foundations to establish a proper grant-making procedure. There should be regular meetings to consider and evaluate grants to specific organizations. The directors are expected to know and document the status of a grantee prior to making the grant. Post-grant due diligence is not enough. Below are some of the matters the directors should consider.
- The grant must be for a religious, charitable, scientific or educational purpose or to foster certain amateur sports or for the prevention of cruelty to children or animals.
- The grant should be to a public charity and the grantee should furnish a copy of its determination letter from the Internal Revenue Service. The Internal Revenue publication lists all organizations eligible to receive tax deductible contributions. An electronic version of Publication 78 may be found online by visiting the IRS website at www.irs.ustreas.gov and following the lines 'charities & non-profits,' 'charitable organizations' and 'more topics.'
- It is possible that a public charity's status can be affected by a private foundation grant and if there is any doubt, the foundation can ask for a letter from the counsel of the public charity that it will not lose its publicly supported status because of the grant.
- If the grant is to another private foundation, then the foundation must exercise 'expenditure responsibility' before making the grant.
- You should keep good records and retain all receipts.
- Tax Returns, Reports and Required Filings
There are a number of filings which must be made annually to both the Internal Revenue Service and the Office of the Attorney General of the State of New York. The Annual Information Return (Form 990) to the Internal Revenue Service must be filed on the 15th day of May of each calendar year. A copy of annual return must be filed with the New York State Attorney General's office. If there is unrelated business income, a return must be filed with respect thereto.
The accountants for the corporation will generally take care of the filing of all tax returns and annual reports.
There are New York State and Internal Revenue Code rules governing the termination of a not-for-profit corporation and/or a private foundation. Since these foundations are just beginning, we do not feel it is necessary to discuss termination except you should know none of the funds or assets can come back to any individual.
This Primer is not intended to cover all the laws and regulations applicable to not-for-profit corporations or private foundations. Even so, some of these items discussed may seem complicated. However, if you follow these simple steps, there should be no difficulty in operating your private foundation.
- Invest your assets carefully
- Make your required distributions each year to public charities.
- Follow your grant procedures.
- Keep good records of your grants and expenditures and keep receipts.
- Make sure that all reports, returns and filings are timely filed.
- Do not engage in any of the prohibited activities.
- Get advice from the lawyer or accountant if there are any questions.