Private Foundations: The Legal Issues

Private foundations are 501(c)(3) organizations that do not qualify as public charities and are subject to certain restrictions and requirements including:

restrictions on self-dealing between private foundations and their substantial contributors and other disqualified persons;
requirements that the foundation annually distribute income for charitable purposes;
limits on their holdings in private businesses;
provisions that investments must not jeopardize the carrying out of exempt purposes; and
provisions to assure that expenditures further exempt purposes.

Violations of these provisions give rise to taxes and penalties against the private foundation and, in some cases, its managers, its substantial contributors, and certain related persons. This makes it all the more important for leaders of private foundations to understand the applicable rules.

Note that this article focuses on private foundations and refers to them generally as "foundations." Community foundations generally qualify as public charities, which are subject to some different sets of rules.

Minimum Distribution Requirement

A foundation must annually distribute a minimum amount for grants and its direct charitable activities (including reasonable and necessary administrative expenses and program related investments). The minimum distributable amount is generally expressed as 5% of the foundation’s net investment assets (i.e., those assets not used, or held for use, directly in carrying out the foundation’s exempt purpose). A foundation has 12 months after the tax year in question to satisfy the minimum distribution requirement. The purpose behind this mandatory payout is to ensure foundations are actively funding charitable programs and not simply hoarding charitable funds.

Grantmaking

Most private foundations engage in grantmaking, making it important for their leaders to be aware of the rules and best practices associated with making grants with due care in a strategic manner. To be compliant, grants must be made in furtherance of the foundation's specific exempt purpose, and leaders should review the governing documents (e.g., articles of incorporation and bylaws) to ensure that this is the case. Further, grants must be made in a manner that does not produce a prohibited private benefit. This requirement is often difficult to assess when grants are being made to individuals or to for-profit social enterprises. A private benefit may be permissible if it is incidental, quantitatively and qualitatively, to furthering the foundation's exempt purpose.

Grants to for-profits as well as to other private foundations will require expenditure responsibility ("ER"). ER refers to the adequate procedures observed by a foundation to see that the grant is spent only for the purpose for which it is made, to obtain full and complete reports from the grantee on how the funds are spent, and to make full and detailed reports on the expenditures to the IRS.

Grants may not be earmarked for lobbying because private foundations, unlike public charities, are generally not permitted to lobby, except in certain "self-defense" matters. However, this does not mean that grants must contain a restriction that prohibits their use in lobbying. Foundations may provide general support grants to organizations that lobby and even for a specific project that has a lobbying component, so long as the grant amount does not exceed the budgeted non-lobbying expenses for such project.

Grants to foreign organizations raise additional requirements and concerns. Such grants will be considered taxable expenditures (subject to a penalty tax) unless the foundation either exercises expenditure responsibility or makes an equivalency determination, each of which follows a set of formal procedures. In addition, a foundation should take reasonable steps to ensure that its grants are not used to (i) conduct or support terrorist activity, (ii) support individuals or entities identified as terrorists, (iii) support persons or organizations listed on the Specially Designated Nationals and Blocked Persons list (the "SDN List") maintained by the Office of Foreign Assets Control of the United States Department of Treasury (“OFAC”) and otherwise is not subject to economic or trade sanctions as administered by OFAC, (iv) conduct or support money laundering, or (v) make corrupt payments to government officials.

Typically, a foundation's board approves a slate of grants vetted by its officers or staff. However, an executive and/or program officers may also be delegated with the authority to make a limited amount of discretionary grants. Such delegated authority and the appropriate limitations should be set by the board and codified in policy with reasonable care.

A grantmaking policy should provide details about the selection process, information required from a prospective grantee in a proposal or application or otherwise to be reviewed by the foundation in advance of approval, obligations and requirements for grantees, and follow-up requirements for the foundation in overseeing the grant. A grant agreement should specify the grant purposes, require the grantee to use the grant consistent with the grant purposes, subject the grantee to returning misused funds, and complete and submit written grant reports that account for how the grant was used and what impact the grant had in advancing the grant purposes. The form of grant agreement may vary depending on the nature of the grant and the grantee (e.g., public charity, for-profit organization, international NGO).

Self-Dealing

A private foundation is generally restricted from engaging in financial transactions with disqualified persons (including directors, officers, substantial contributors, family members, or 35% controlled entities). The Internal Revenue Code ("IRC") identifies six specific transactions that, if engaged in by the foundation and a disqualified person, constitutes an act of self-dealing:

sale or exchange, or leasing, of property between a private foundation and a disqualified person;
lending of money or other extension of credit between a private foundation and a disqualified person;
furnishing of goods, services, or facilities between a private foundation and a disqualified person;
payment of compensation (or payment or reimbursement of expenses) by a private foundation to a disqualified person;
transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation; and
agreement by a private foundation to make any payment of money or other property to a government official, other than an agreement to employ such individual for any period after the termination of his government service if such individual is terminating his government service within a 90-day period.

Program-Related Investments

Program-related investments ("PRIs") are those in which:

The primary purpose is to accomplish one or more of the foundation's exempt purposes,
Production of income or appreciation of property is not a significant purpose, and
Influencing legislation or taking part in political campaigns on behalf of candidates is not a purpose.

The IRS has provided a list of possible forms of a PRI:

Low-interest or interest-free loans to needy students,
High-risk investments in nonprofit low-income housing projects,
Low-interest loans to small businesses owned by members of economically disadvantaged groups, where commercial funds at reasonable interest rates are not readily available,
Investments in businesses in deteriorated urban areas under a plan to improve the economy of the area by providing employment or training for unemployed residents, and
Investments in nonprofit organizations combating community deterioration.

PRIs are exempt from excise taxes that apply to jeopardizing investments and, as noted above, are qualifying distributions for purposes of meeting the minimum distribution requirement. They are also excluded from the foundation’s investment base in calculating the minimum distribution required.

PRIs are a powerful, but underutilized tool, for foundations to effectively recycle the power of their capital. For example, in lieu of making a grant, a foundation can make an interest-free loan to a charity to allow it to launch a nonprofit social venture and later have it paid back so the foundation can reuse the funds to make another PRI. By providing charities with access to capital that might otherwise be unavailable to them, particularly when under favorable terms not available in traditional commercial financing, a foundation can empower charities to be more effective and efficient at advancing their missions. This is not to suggest that PRIs should replace grants. Each has its best set of uses.

Mission Related Investments

While a mission-related investment ("MRI") is not currently defined by federal tax law, it is generally considered to be an investment for both a financial return and a social impact return (more specifically, one that advances the particular mission of the investor). In some cases, there may be no need to balance those potentially competing concerns. But in many cases, the investor will need to balance at least short-term financial return with the social impact return. Some simple examples of MRIs include a purchase of equity in a company creating jobs in economically disadvantaged communities, a loan to an organization distributing essential resources in developing countries, and an investment in an alternative energy company.

In 2015, the IRS released Notice 2015-62, Investments Made for Charitable Purposes, which provided some assurance that a MRI would not be considered a jeopardizing investment merely because the foundation managers weighed more than just financial considerations:

Foundation managers are not required to select only investments that offer the highest rates of return, the lowest risks, or the greatest liquidity so long as the foundation managers exercise the requisite ordinary business care and prudence under the facts and circumstances prevailing at the time of the investment in making investment decisions that support, and do not jeopardize, the furtherance of the private foundation’s charitable purposes.

Endowments

Under California laws, an endowment fund is "an institutional fund or part thereof that, under the terms of a gift instrument, is not wholly expendable by the institution on a current basis." It may include a fund which a donor has made permanently restricted from expenditure except for income generated by the fund, but such strict restriction is not required by the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which has been adopted in all states except for Pennsylvania.

Under UPMIFA, a foundation must consider all of the following in its investment decisions:

1. General economic conditions,
2. Effects of inflation and deflation,
3. Tax consequences,
4. The role of each investment in the overall portfolio,
5. Expected total return from income and appreciation,
6. The charity’s other resources, and
7. The needs of the charity and the fund to make distributions and preserve capital.

In addition, under federal law, a foundation must ensure that it does not violate the jeopardizing investments rule. Jeopardizing investments generally are 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.

Under UPMIFA, a foundation must consider all of the following in its spending decisions:

1. The duration and preservation of the endowment fund,
2. The purposes of the charity and the fund,
3. General economic conditions,
4. Effects of inflation and deflation,
5. Expected total return from income and appreciation,
6. The charity’s other resources, and
7. The charity’s investment policy.