Private Foundations: The Legal Issues

Neo Legal TeamJanuary 1, 202418 min read

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.

Grants to for-profits as well as to other private foundations will require expenditure responsibility ("ER").

Grants may not be earmarked for lobbying and may not be made to support or oppose candidates for public office. Grants for general operating support of a public charity, however, are permissible even if the grantee engages in lobbying. A grant earmarked for a grantee's lobbying activities, however, may be treated as a taxable expenditure.

Self-Dealing

The self-dealing rules prohibit direct or indirect transactions between a private foundation and a disqualified person (which includes board members, substantial contributors, family members of disqualified persons, and certain related entities). Prohibited transactions include sales, leases, lending money, providing goods and services, and paying compensation (except for reasonable compensation for personal services necessary to carry out the exempt purpose).

Expenditure Responsibility

Expenditure responsibility is a set of due diligence and oversight procedures that must be followed when a foundation makes a grant to an organization that is not a public charity. These include: (1) conducting a pre-grant inquiry, (2) entering into a written agreement with specific provisions, (3) ensuring the funds are segregated, (4) obtaining periodic reports from the grantee, and (5) reporting the grant to the IRS.

Program-Related Investments (PRIs)

Program-related investments are investments made by foundations to support charitable activities that involve the potential return of capital within an established time frame. PRIs can take the form of loans, loan guarantees, or equity investments. To qualify as a PRI, the primary purpose must be to accomplish a charitable purpose, and the production of income or appreciation of property must not be a significant purpose. PRIs do count toward the 5% distribution requirement.

Excise Tax on Investment Income

Private foundations are subject to a 1.39% excise tax on their net investment income (including interest, dividends, rents, and capital gains). This tax is reported annually on Form 990-PF.

Termination of Private Foundation Status

Terminating a private foundation is not as simple as dissolving a corporation. To terminate its status, the foundation generally must pay a termination tax equal to the value of its net assets unless it distributes all of its assets to a qualified public charity or undergoes a transfer or conversion that meets IRS requirements.