Foundations have legal and tax implications, both at formation and throughout their existence. Chapter 42 of the Internal Revenue Code lays out various restrictions on the activities of private foundations. These laws can be stringent, and there are stiff penalties for overstepping the bounds. Here are some of the key issues your foundation needs to understand to avoid some of the legal and tax minefields.

Rule Against Self-Dealing

With few exceptions, Section 4941 of the tax code prohibits most transactions between the foundation and a "disqualified person." A disqualified person is anyone in a broad group of people that includes Officers, Directors, Trustees, substantial contributors, and entities in which the foundation has a greater than 20% interest. It also covers the spouses, ancestors, descendants and entities owned (using the 35% threshold) by any of the individuals listed above. Siblings are not included.

The list of prohibited transactions is very broad too. Sales, leases, loans, exchanges and certain forms of compensation are strictly prohibited. Similarly prohibited are the transfer of any income or assets from the foundation to a disqualified person or for the disqualified person's use or benefit; or agreeing to pay a government official with foundation assets.

The prohibition against self-dealing, added to the tax code in 1969, was a direct response to the widespread misuse of private foundations for personal, rather than wholly charitable, purposes. Congress felt that the arm's length approach was insufficient, so the prohibitions on transactions between disqualified persons and family foundations are nearly absolute. In other words, transactions of this nature are prohibited, even if they are fair and reasonable, and even if they benefit the foundation.

A few examples might help to illustrate the rule against self-dealing. For example, if you pledge $10,000 to your college alma mater, your private foundation is prohibited from writing the check to the college on your behalf. In a similar vein, if you purchase a ticket to a nonprofit fundraiser where a portion of the ticket price is allocated to the benefits you receive (e.g., a dinner) and the rest to a charitable gift, it is the IRS' position that the foundation cannot pay any of the ticket price, even the charitable gift portion, without violating the self-dealing rules.

As another example, let's say your foundation shares space with your family office. The family can let the foundation occupy the space for free, but it can't accept rent from the foundation, even if such rent is at or below fair market value. If another party, who is not a disqualified person, owns the property to be leased, the private foundation should pay that landlord directly rather than indirectly as part of the family's lease payment. It's also best for the foundation to pay for a separate phone line if the family office is not donating that service as well, because even reimbursing the family for the phone bill is considered a violation of the self-dealing rules.

There is an important exception to the self-dealing rules which involves employing disqualified persons or retaining their professional services (e.g., legal, accounting, banking or investment advice). Either action is allowed if the personal services are "necessary" to carrying out the foundation's exempt purposes and how much the foundation pays for them is "reasonable" and not "excessive". As this is a somewhat subjective test, a general rule of thumb is that you should not pay a disqualified person more than what you would pay an independent third party to do the same job.

Violations of these rules can result in serious tax consequences. The penalties for self-dealing transactions are often steep and may be imposed upon the disqualified person and any foundation manager who willfully participated in the self-dealing. Initially, the penalties imposed upon the disqualified person and the participating foundation manager are 10% and 5%, respectively, of the amount involved in the transaction. The dollar limitation on the amount of the initial and additional tax on the foundation manager is $20,000 per act. If the self-dealing is not corrected within a specified time, additional penalties of 200% and 50%, respectively, may result.

5% Distribution Requirements

Section 4942 of the tax code requires a foundation to distribute annually a minimum amount of its funds, equal to approximately 5% of the fair market value of the foundation's non charitable use of assets (the "distributable amount"). In general, distributions which meet this goal ("qualifying distributions") are foundation administrative expenses and grants to independent public charities. Administrative expenses could include the price of acquiring property to serve as the foundation headquarters, and such "reasonable and necessary" administrative expenses as rent, salaries, and/or overhead, provided such expenses were incurred with respect to furthering the foundation's exempt purposes. In contrast, investment management and brokerage fees would not count towards the foundation's annual distribution requirement. The foundation has up to 12 months from the end of its tax year to make the required distributions.

To calculate the 5% payout for a given year, you must first tally up the non-charitable use assets — essentially stocks, bonds, CDs and other investments that make up the foundation's endowment (you use their average fair market value during the 12 month periods in question). Charitable assets, which are not considered part of the endowment, tend to be those types of assets used in furthering the foundation's exempt purpose. Examples of charitable use assets might include low interest loans to low income individuals or, the building where the foundation's charitable projects are worked on. If the foundation fails to distribute its entire distributable amount in a timely fashion, it is generally subject to a series of excise taxes ranging from 30% to 100% of the shortfall.

Grantmaking Responsibilities (Taxable Expenditures)

Perhaps the second most common problem for private foundations is ensuring grants are made only to organizations that are eligible to receive them, and not making grants to individuals without following the necessary procedures. If that happens, the grant is considered a taxable expenditure under Section 4945 of the Internal Revenue Code. That means it will not count towards the foundation's minimum distribution requirements, the foundation will be subject to an initial excise tax of 20% of the amount involved, and the money will have to be repaid. Additionally, any foundation manager who knowingly approves a taxable expenditure must personally pay a 5% excise tax (not to exceed $10,000) on the amount involved.

Grants to domestic Internal Revenue Code Section 501(c)(3) public charities are clearly permitted unless the foundation earmarks the grant funds for a taxable expenditure (for instance, requiring the money be given to a particular individual, or used for lobbying or political purposes). Unless an organization is a well-known public charity, donors are often concerned about the status of a contribution to such organization. To remove this uncertainty, IRS Publication #78, which lists all organizations that are qualified to receive gifts, could be used to select appropriate grant recipients.

For other grants to organizations that do not qualify as a public charity or a private operating foundation or grants to individuals, the foundation must exercise "expenditure responsibility" with respect to the grant. Expenditure responsibility is a legal requirement wherein the grantor makes certain the grant is used solely for charitable purposes. In general, expenditure responsibility requires entering into a grant agreement with the recipient, monitoring how the grant money is spent, and attaching this documentation to the foundation's tax return. Additional restrictions apply to educational scholarships granted to individuals, including having your grant procedures pre-approved by the IRS. Finally, before making grants to foreign charities, you must make sure they're the equivalent of domestic ones — either by obtaining a legal opinion letter from an attorney or an affidavit from the grant recipient.

The IRS prefers that the entire board of the foundation make all grantmaking decisions. But to avoid family squabbles, some private foundations give individual board members the power to make "discretionary grants" up to a certain amount per year, without such approval. While this practice is perfectly legal, it's wise for the board to set parameters for discretionary grants — both by limiting the dollar amounts, and by offering guidelines for what fits within the foundation's charitable purpose(s). The people making such grants, in turn, must operate within the framework that the board has approved.

Rule Against Excess Business Holdings

Section 4943 of the Internal Revenue Code prohibits a private foundation and disqualified persons together from owning more than 20% of the voting stock of the entity (in calculating the 20%, constructive ownership rules apply). For purposes of this rule, disqualified persons include a substantial contributor to the foundation, the foundation manager, and relatives of either. Permitted holdings by a foundation and a disqualified person are increased to 35% if it can be established that effective control of the corporation is possessed by persons who are not disqualified persons. However, a private foundation must hold, directly or indirectly, more than 2% of the voting stock or other value of a business enterprise before either of these limitations becomes applicable.

The rule on excess business holdings is of particular relevance to families that fund their private foundations with closely-held stock. If a private foundation obtains holdings in a business enterprise other than by purchase by the foundation or by disqualified persons with respect to it, and the additional holdings cause the foundation to exceed the limits described above, the foundation has five years to reduce these holdings to permissible levels.

Furthermore, there are traps for the unwary. For example, if the holdings are reduced by means of a corporate redemption of the stock, depending on how such redemption is made, such transaction could violate the rules against self-dealing.

And if the foundation has committed to sell property before an individual donates it, because such donation will cause the foundation's holdings to exceed permissible levels, there's a risk that the IRS will treat the sale as if it occurred before the donation. As a result of this "assignment of income," the donor could be liable for capital-gains tax on the donated appreciated property.

A foundation that exceeds the specified limits must usually dispose of the excess business holdings within a given time or potentially face a series of excise taxes ranging from 10% to 200% of the fair market value of the excess stock.

Jeopardy Investments

A private foundation can not invest its assets in such a manner that the carrying out of its exempt purposes is jeopardized. An investment is considered "jeopardized" if the foundation's officers or directors failed to exercise ordinary care and prudence when the investment was made, given the facts and circumstances existing at the time.

The IRS has only issued guidelines, no absolute statements, about what these "jeopardy investments" might be. Regulations on the subject, issued in 1972, mention as potential jeopardy investments, but not per se jeopardy investments, certain common investing techniques such as puts, calls, oil and gas interests, and others. To protect against jeopardy investments, before investing always consider how volatile a particular investment is, and how much of the entity's total funds it will represent.

A foundation is least likely to run afoul of the rule if it has a well-diversified portfolio of stocks, bonds, and cash equivalents. It's also a good idea to diversify within each class of investment, so the performance of one holding won't dramatically affect the value of the entire portfolio. With stocks, for example, the foundation can invest in different industries or sectors. When buying bonds, it can ladder the portfolio, to include issues of different yields and maturities. As a hedge against fluctuating interest rates, it's possible to take the same approach with CDs.

Learn more about Jeopardy Investments

Fiduciary Responsibility

The Directors, Officers and Trustees of a foundation are considered fiduciaries. Under state law, that means they have a duty to act prudently, in good faith, and to protect the foundation. These duties apply to all aspects of managing the foundation, from avoiding self-dealing to directing the investments.

Fiduciaries who don't live up to these responsibilities can be personally liable for any damage they have caused the foundation. If their actions were criminal, they can be prosecuted under state law. Plus, as managers of the foundation, they can also be jointly liable under federal law for certain excise taxes if the entity has engaged in prohibited transactions. For instance, the penalty on them as managers for making jeopardizing investments initially is 10% of the transaction amount up to $10,000 per transaction. The additional tax on foundation managers that do not remove the investment from jeopardy may not exceed $20,000. An additional tax of 25% of the investment is imposed on the foundation if the investment is not removed from jeopardy in a timely manner.

Tax on Investment Income and Unrelated Business Income

Private foundations must pay an annual tax, known as an excise tax, on their net investment income. The tax applies to interest, dividends, rents, and payments with respect to securities loans, royalties, and capital gains from the sale or disposition of property used for the production of such income. In calculating net investment income, a foundation can deduct all of the "ordinary and necessary" expenses of producing or collecting that income. Such expenses include investment management and brokerage fees.

Ordinarily, the tax is 2% of net investment income, although in certain years foundations can make extra qualifying distributions to reduce the tax to 1%. Figuring how much extra you must distribute in order to do this is a two-step process. First, compute the average percentage payout for the past five years and multiply that by the foundation's current endowment. For example, if the foundation's average payout over the past five years is 6.25% and its current assets are $1,000,000, this number would be $62,500. Then you add 1% of the latest year's net investment income. For example, if last year's net investment income was $50,000, you would add $500 to the $62,500, meaning that the foundation must pay out at least $63,000 during the current tax year to cut its current excise tax to 1%.

Another tax to be aware of is the tax on unrelated business taxable income ("UBTI"), which applies when a foundation is engaged in a business outside its charitable purpose. The tax also applies to the organization's debt-financed income — something to keep in mind if the foundation borrows money. Even investing in a partnership that holds passive investments could trigger unrelated business income tax if the partnership has any debt. The tax on UBTI is due in quarterly estimated payments once estimated UBTI exceeds $1,000. Similarly, the tax on net investment income is due in quarterly estimated payments once the estimated tax exceeds $500.

Penalties

Foundations that blatantly violate the law or otherwise conduct activities inconsistent with their exempt purpose can lose their tax-exempt status. More often, the only sanction will be an excise tax, although such tax can be substantial. (This tax is in addition to the yearly excise tax that foundations have to pay on their net investment income.) Depending on which law is violated, the initial ("first-tier") excise tax is typically between 10% and 20% of a prohibited transaction. It may fall on the foundation, the disqualified person, or both. With self-dealing, for instance, the excise tax is 10% of the amount involved, and it usually applies just to the self-dealers and foundation managers, not to the foundation.

In addition to paying the tax, the parties must undo the transaction or restore the foundation to the position it was in before the transaction occurred. If they don't within a reasonable period — how long depends on the IRS — a "second-tier" excise tax, which ranges from 25% to 200%, kicks in.

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