One of the top reasons individuals decide to establish a Private Foundation over contributing to a donor-advised fund relates to control. Private Foundations allow you (and your family members) to maintain direct control over the foundation’s investments and charitable activities.
Five Prohibited Transactions to Avoid
1. Avoid Acts of Self-Dealing
Has your organization purchased a charity event ticket for a spouse? Or does it rent office space from a related party? The IRS definition of self-dealing includes virtually any direct or indirect financial transaction with a “disqualified person”. The term disqualified person is far-reaching and includes substantial contributors to your organization and their family members, members of the foundation’s governing board and their family members, certain government officials, and businesses in which disqualified persons or their family members hold a substantial interest.
Other common examples of self-dealing transactions include:
- satisfying a personal pledge of a disqualified person;
- paying travel expenses of a spouse or family member;
- buying or selling property to or from a disqualified person, even on fair and reasonable terms; or
- paying excessive compensation to disqualified persons.
2. Meet Distribution Requirements
The IRS requires your organization to generally distribute 5% of its assets each year. Direct grants to 501(c) (3) organizations count towards the distribution requirement. You can also include administrative expenses that are reasonable and necessary to accomplish the foundation’s charitable purpose, such as office supplies and accounting fees.
Your organization should use caution and discuss with us before making grants to organizations other than traditional 501(c) (3) organizations. Grants to non-501(c) (3) organizations require your organization to make pre-grant inquiries, have written grant agreements and obtain complete reports on the backend from the grantee detailing how the funds were spent. Failure to follow the rules could classify these grants as a “taxable expenditure” – mentioned later on.
3. Limit Private Business Holdings
Your foundation and all of its disqualified persons cannot own more than 20% of the total voting stock of the same corporation. If an unrelated party has effective control of the corporation, your organization and all of its disqualified persons together may own up to 35% of the total voting stock of the same corporation. The 20% limitation also applies to holdings in business enterprises that are partnerships, joint ventures, or other unincorporated entities. There are no permitted holdings for proprietorships.
4. Invest Assets Wisely
You should exercise ordinary business care and prudence when investing assets for the long and short term financial needs of the foundation. Examples would be taking into account the expected return, the risks of rising and falling price levels and the need for diversification within the investment portfolio. The determination of whether or not an investment is jeopardizing is made on an investment by investment basis, in each case taking into account the portfolio as a whole. Although there is no per se jeopardy investment, some examples of investments that warrant close scrutiny are trading in securities on margin, trading in commodity futures, investments in working interests in oil and gas wells, the purchase of puts, calls, and straddles, the purchase of warrants, and selling short. Your organization does not have to make these decisions alone and should consult with LBMC Investment Advisors whenever it has investment questions.
5. Avoid Prohibited Payments
The final provision is a catch-all for several types of expenditures that are explicitly prohibited. These “taxable expenditures” include:
- Carrying on propaganda, or otherwise attempting, to influence legislation;
- Influencing the outcome of any specific public election or carrying on any voter registration drive, directly or indirectly
- Providing grants to individuals for travel, study, or other similar purposes
- Providing grants to organizations, other than public charities, unless the granting foundation exercises expenditure responsibility (previously discussed in Failure to Distribute Income).
Excise Taxes/Penalties - Private Foundation Funds
The following table lists the excises taxes the IRS uses to enforce compliance.
Prohibited Act | 1st Tier Penalty | 2nd Tier Penalty |
Acts of Self-Dealing | 10% of the amount involved for self-dealers and 5% of the amount involved for foundation managers | If either party refuses to agree to all or part of the correction (i.e. reverse the transaction), a second-tier tax of 200% of the amount involved for the self-dealer and 50% of the amount involved for the foundation manager is imposed |
Failure to Distribute Income | 30% of the income remaining undistributed at the beginning of the second (or succeeding) taxable year | 100% of the remaining undistributed income at the close of the taxable period |
Excess Business Holdings | imposed on the excess business holdings of any private foundation in a business enterprise equal to 10% of the value of the holdings | If the foundation still has excess business holdings at the close of the taxable period, additional taxes are imposed equal to 200% of the value of the excess holdings |
Investments Which Jeopardize Charitable Purpose | 10% of the amount invested each year in the taxable period, unless the participation is not willful and is due to reasonable cause | If the investment is not removed from jeopardy within the taxable period, additional taxes are imposed on the foundation at 25% of the amount invested. If the manager refuses to agree to part or all of the removal from jeopardy, additional taxes are imposed for 5% of the amount invested |
Taxable Expenditures | Initial taxes imposed on the foundation are 20% of the expenditure. First-tier taxes imposed on managers are 5% of the expenditure amount, unless the agreement to make such expenditure is not willful and is due to reasonable cause | If expenditures are not corrected, second-tier taxes are imposed at 100% for the foundation and 50% for the managers |
Foundations can be wonderful tools for planned charitable giving. They can be used not only to fulfill your charitable giving desires but to instill in other family members similar charitable goals, intentions and business management philosophy. However, you should fully understand the various rules and compliance requirements before choosing a Private Foundation over a Donor Advised Fund or other means of giving.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.