Private Foundation Law Made Easy

Bruce R. Hopkins

• Publisher: Wiley
• Year: 2008
• ISBN:
  9780470454329
• Edition: 1
• Topic: Business
• Subtopic: Nonprofit Organizations & Charities
• Index: Business

Now your foundation can be fully informed about the basic legal requirements affecting private foundations and avoid the perils lurking in nonprofit tax law traps. Private Foundation Law Made Easy clearly shows you how, with information on reaping the charitable and tax advantages of your private foundation. Filled with straightforward guidance, author Bruce Hopkins?a leading authority on the laws regulating private foundations?demystifies this topic for you and your board members with practical legal information in easy-to-understand English.

1

PRIVATE FOUNDATIONS AND PUBLIC CHARITIES

The purpose of this chapter is to explain the distinctions between private foundations and public charities. There are, however, different types of private foundations and likewise different types of public charities. Specifically, this chapter will:

• Provide a generic and a technical definition of the term private foundation .

• Explain the terms private operating foundations, exempt operating foundations, conduit private foundations, and nonexempt charitable trusts.

• Explain the concept of a public charity.

• Define the public charities that are the institutions.

• Define the public charities that are the donative publicly supported charities .

• Define the public charities that are the service provider publicly supported charities.

• Provide a comparative analysis of publicly supported charities.

• Define the public charities that are supporting organizations.

• Define the public charities that test for public safety.

• Summarize the rules as to the excise tax on net investment income.

• Explain the significance of the private foundation-public charity dichotomy.

• Review some of the most recent IRS statistics on these subjects.

PRIVATE FOUNDATION DEFINED

A private foundation is a form of tax-exempt charitable organization. In this context, the term charitable includes program undertakings that are classified as educational, scientific, and religious. Generically, however, a private foundation typically has four other characteristics:

1. A private foundation is usually funded from a single source, often an individual, a family, or a corporation.

2. This funding is usually a one-time occasion, by means of a sizeable charitable contribution. While a private foundation may receive an ongoing flow of gifts, that is a rarity.

3. The year-by-year revenue derived by a private foundation is almost always in the form of investment income earned on their assets (also known as principal or corpus).

4. The typical private foundation makes grants for charitable purposes to other persons (individuals and/or organizations), rather than conduct its own programs.

The private aspect of the concept of a private foundation, then, principally reflects the nature of its financial support, particularly its initial funding. The private nature of a foundation, however, is often reflected in its governing board structure (see Chapter 12).

Because private foundations are generally exempt from federal income tax, the term private foundation appears in the Internal Revenue Code. This technical tax law definition, however, does not match the generic definition. Congress could have crafted a definition of private foundation in accord with the four unique attributes of foundations but it elected another approach. The reason for this distinction is rooted in the history of private foundation law, which came into being in 1969.

When most of the law as to private foundations was created in that year, Congress was in a horrific anti-foundation mood. The antipathy toward foundations at that time was substantial, largely because members of Congress were being regaled with tales of foundation abuse (mostly apocryphal) and many were in a populist mind-set, with foundations seen as playthings (and pocketbooks) of the wealthy. Consequently, when fashioning a definition of the term private foundation, Congress was careful to write it in such a way as to minimize the likelihood that crafty tax lawyers would find ways around the foundation laws.

Thus, the technical definition of private foundation has two key characteristics:

1. Despite the fact that the Internal Revenue Code purports to define the term, it does not. Instead, the Code defines what a private foundation isn’t. (A private foundation is a tax-exempt charitable organization that is not a public charity.)

2. A unique feature in the law causes every tax-exempt charity in the United States to be presumed to be a private foundation. Among other outcomes, this forces nearly all charities that are not private foundations to convince the Internal Revenue Service of that fact and be officially classified as public entities. Put another way, a charitable organization that cannot, or subsequently fails to, qualify as a public charity is, by operation of law, a private foundation.

PRIVATE OPERATING FOUNDATIONS

As noted, one of the characteristics of a conventional private foundation is that it is a grant-maker. That is, the typical foundation serves as a funder of the charitable programs of other organizations. There are some private foundations, however, that, instead of grant-making, use their funds principally to administer their own charitable programs. This type of private foundation is known as a private operating foundation, with the word operating intended to convey this feature of internal program operations (rather than external funding). (These foundations are exempt from the standard income distribution requirement [see Chapter 4].) Some museums, libraries, housing and health care facilities, and scientific research entities, for example, are structured as private operating foundations. To qualify as an operating foundation, a private foundation must meet an income test and one of three other tests: an assets test, an endowment test, or a support test.

A private foundation satisfies the income test if it expends at least 85% of the lesser of its (1) minimum investment return (which, as explained in Chapter 4, is an amount equal to 5% of the foundation’s investment assets) or (2) adjusted net income for the direct, active conduct of charitable activities. Adjusted net income is the amount of income from charitable functions, investment activities, set-asides, unrelated business, and short-term capital gains that exceeded the cost incurred in earning the income.

To meet the assets test, a private foundation must directly use at least 65% of its assets for the active conduct of charitable activities. Satisfaction of the endowment test requires that the foundation regularly make distributions for the active conduct of charitable activities in an amount not less than two-thirds of its minimum investment return. To meet the support test, a private foundation must regularly receive substantially all of its support (other than from gross investment income) from the public or from five or more qualifying exempt organizations; receive no more than 25% of its support (other than from gross investment income) from any one qualifying exempt organization; and receive no more than 50% of its support in the form of gross investment income.

EXEMPT OPERATING FOUNDATIONS

Certain private operating foundations are exempt from the excise tax on net investment income paid by most private foundations (discussed later in this chapter). This type of operating foundation must maintain public support for a minimum of 10 years; maintain a governing body at all times that is broadly representative of the public, where no more than 25% of that board consists of disqualified individuals; and not have at any time during the year an officer who is a disqualified individual. These foundations are also exempt from the expenditure responsibility requirements (see Chapter 5).

CONDUIT FOUNDATIONS

A conduit private foundation is not a separate category of private foundation; it is a standard private foundation that, under certain circumstances, is regarded as a public charity for charitable contribution deduction purposes. A foundation functions as a conduit when it makes qualifying distributions (see Chapter 4) that are treated as distributions from its corpus in an amount equal to 100% of all contributions received in the year involved, whether as money or property. These distributions, to qualify, must be made not later than the 15th day of the third month after the close of the foundation’s tax year in which the contributions were received. The foundation must not have any remaining undistributed income for the year.

These distributions are treated as made first out of contributions of property and then out of contributions of money received by the private foundation in the year involved. The distributions cannot be made to an organization controlled, directly or indirectly, by the distributing foundation or by one or more disqualified persons (see Chapter 2) with respect to the foundation or to a private foundation that is not a private operating foundation.

NONEXEMPT CHARITABLE TRUSTS

Nonexempt charitable trusts are trusts that are not tax exempt but are treated as private foundations for federal tax law purposes. These trusts are funded and operated in nearly identical fashion as exempt private foundations. This type of trust has exclusively charitable interests; donors to them are allowed to claim a tax deduction for charitable contributions. Unlike private foundations, nonexempt charitable trusts are required to pay an annual tax on income that is not distributed for charitable purposes.

CONCEPT OF PUBLIC CHARITY

The dichotomy thus established in the Internal Revenue Code forces every U.S. charity to be classified as a public charity or a private foundation. This is by no means an equal division, in that, while there are millions of public charities, there are about 80,000 private foundations. (This disparity as to numbers, however, is not reflected in any balancing of the volume of federal tax law concerning charitable organizations; there are many pages of rules in the Internal Revenue Code that are applicable only to private foundations.)

As noted, a private foundation is a tax-exempt charitable organization that is not a public charity. The Code “definition” of private foundation focuses on the meaning of the term public charity. There are many categories of public charities. From a big-picture standpoint, however, there are four types of public charities: the institutions, publicly supported charities, supporting organizations, and (of minor import) public safety testing organizations.

As will be seen, public charities tend to be organizations with inherently public activity, entities that are financially supported by the public, or entities that have a close operating relationship with one or more other public charities. The term public can, however, be misleading; it is not used in the sense of a governmental entity (department, agency, etc.). The confusion is emblematic in the notion that a private school is a public charity. (Governmental entities are public charities.)

Most private foundations confine their grant-making to public charities. Therefore, it is essential (to avoid tax penalties [see Chapter 4]) that foundations having that approach understand the various ways in which a tax-exempt charitable organization can also be a public charity.

INSTITUTIONS

A category of public charity is loosely defined as institutions. These are entities that have inherently public activity. Embraced by the ambit of the institutions are churches, certain other religious organizations, schools, colleges, universities, hospitals, medical research organizations, and governmental units.

Churches

A church (including a synagogue and a mosque) is a public charity. The federal tax law is imprecise in defining this term, largely due to constitutional law (First Amendment) constraints. Although the term is not defined in the Internal Revenue Code, the IRS formulated criteria that it uses to ascertain whether a religious organization constitutes a church. Originally, these criteria (unveiled in 1977) were in a list of 14 elements, not all of which needed to be satisfied. These elements include:

• A distinct legal existence

• A recognized creed and form of worship

• An ecclesiastical government

• A formal code of doctrine and discipline

• A distinct religious history

• A literature of its own

• Established places of worship

• Regular congregations

• Regular religious services

• Schools for the religious instruction of youth and preparation of its ministers

Over the ensuing years, however, the IRS has added criteria and become more rigid (and inconsistent) in its interpretation of the term church. It is currently the position of this agency that, to be a church, an organization must—in addition to being religious—have a defined congregation of worshippers, an established place of worship, and regular religious services. Some of the criteria in the original 14-element list have been downgraded in importance, as being common to tax-exempt organizations in general.

Associations and Conventions of Churches

Some religious entities are public charities because all of their members are churches. An association of churches is a church-membership entity where the membership is confined to churches in a state. A convention of churches is a church-membership entity where the membership embraces a multistate region of the United States or perhaps the entire nation.

Educational Institutions

An educational institution is a public charity. The concept of what is educational is much broader than educational institution, so it is insufficient for these purposes that an organization is merely educational in nature. To be an educational institution, an organization must normally maintain a regular faculty and curriculum, and normally have a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. This type of institution is generically a school; consequently, it must have as its primary function the presentation of formal instruction.

Educational institutions that qualify for public charity status include primary, secondary, preparatory, and high schools and colleges and universities. (Public schools are public charities by virtue of being units of government.) An organization cannot achieve public charity status as an operating educational institution where it is engaged in educational (institution-type) and educational (non-institution-type) activities, unless the latter activities are merely incidental to the former. For example, an organization cannot qualify as this type of public charity if its primary function is the operation of a museum, rather than the presentation of formal instruction.

A university generally is an institution of higher learning with teaching and research facilities, comprising an undergraduate school that awards bachelor’s degrees and a graduate school and professional schools that award master’s or doctor’s degrees. A college is generally referred to as a school of higher learning that grants bachelor’s degrees in liberal arts or sciences; the term is also frequently used to describe undergraduate divisions or schools of a university that offer courses and grant degrees in a particular field. The term school is defined as a division of a university offering courses of instruction in a particular profession; the term is also applicable to institutions of learning at the primary and secondary levels of education.

An organization may be regarded as presenting formal instruction even though it lacks a formal course program or formal classroom instruction. For example, an organization that conducted a survival course was classified as a public charity, even though its course periods w...