February 9, 2015
Internal Revenue Code (Code) Section 501(c) lists 29 different types of nonprofit organizations.
However, the vast majority of exempt organizations are those described in Code Section 501(c)(3) and have a charitable, religious, educational or scientific purpose.
Every 501(c)(3) exempt organization must be further classified as either a public charity or a private foundation (PF). Some types of charities, such as schools, churches, hospitals and medical research organizations, are statutorily classified as public charities.
However, if a 501(c)(3) organization is not automatically classified as a public charity, it is a PF unless/until it demonstrates otherwise to the IRS. This proof is most often done as part of the Form 1023 application, the process used to get tax-exempt status.
If the IRS accepts the organization’s public charity position as set forth in the application, the organization is deemed to be a public charity for the first five years of its existence. However, during this time, the organization does not disclose its public support percentage on Schedule A. In the sixth and subsequent years, the organization must disclose its public support percentage on Schedule A to demonstrate that it continues to pass the public support test.
In future articles, we will outline how an organization demonstrates to the IRS that it meets the definition of a public charity. However, this article will focus on the consequences of being a PF. Those consequences, described below, include the filing of a more complex return and several operational limitations.
From a compliance perspective, a PF must file Form 990-PF (rather than the Form 990 series filed by public charities). This form requires a significant amount of calculations.
Further, unlike a Form 990 filing, the Schedule B attached to a 990-PF, which lists contributors of more than $5,000, cannot redact the names and addresses of contributors on the publicly available version of the form. As a result, the names of donors to a private foundation are available to the public.
More importantly, PFs are subject to much more restrictive operational provisions than public charities, including a number of provisions to help ensure that the PF is operated in a manner consistent with its mission and it functions as a charitable organization. These restrictions arose out of a concern for abuse that could arise with private foundations, which are often controlled by a small group of related individuals.
Code Sections 4940-4945 outline the additional restrictions imposed on PFs. Below is a brief description of each. We have listed the initial taxes that may be imposed. We have not included the “second-tier” taxes, which are substantial, and can be imposed for failure to correct a violation.
- Section 4940 imposes a 2 percent excise tax on the net investment income of a PF. This tax can be lowered to 1 percent if certain charitable payout requirements are met. Net investment income includes interest, dividends, rents, royalties and securities loan payments.
- Section 4941 imposes a tax of the amount involved in any act of “self-dealing,” which is a prohibited transaction between a PF and a “disqualified person” (DP). DPs include substantial contributors, foundation managers, and certain related organizations and individuals. Foundation managers include officers, directors and trustees. The tax is imposed on the DP (10 percent) and on a foundation manager (5 percent) who knowingly participates in such acts. Self-dealing includes many transaction types between a PF and a DP, but the most common are the sale or leasing of property, lending or borrowing of money, and payment for services (although there is an exception for reasonable compensation for certain services).
- Section 4942 imposes a 30 percent tax on a PF for failure to make minimum distributions each year. While the calculation is complex, the rules essentially requires a PF to make qualified annual distributions of not less than 5 percent of the fair market value of the foundation’s noncharitable assets. Qualified distributions are those made to further a charitable purpose, and include grants to public charities and administrative expenses incurred by the private foundation necessary to carry out its exempt purpose. However, distributions to controlled entities or to other PFs generally do not count as qualifying distributions.
- Section 4943 imposes a 10 percent tax on a PF owning more than 20 percent of the voting stock of an incorporated business enterprise. The allowable ownership limit is further reduced by the percentage of voting stock owned by all DPs. However, if a non-DP third party effectively controls management and policies of the enterprise, the PF and DPs may collectively own up to 35 percent.
- Section 4944 imposes a 10 percent tax of the amount invested in a manner that may jeopardize the PF’s ability to carry out its exempt purposes. This tax is levied on the PF and a foundation manager who knowingly participates in making the investment.
- Section 4945 imposes taxes on “taxable expenditures.” The tax is imposed on the PF (20 percent rate) and may be imposed on PF managers (5 percent rate) who knowingly participated in the prohibited expenditure. The most frequent types of taxable expenditures are expenses incurred for political intervention, lobbying or certain grants. These grants include those made to non-(c)(3) organizations in which the PF does not exercise “expenditure responsibility,” an often cumbersome evaluation and record-keeping process.
These PF-specific code section descriptions are brief overviews. The code and related regulations are complex and should be referred to for more detailed information.
This article was originally posted on February 9, 2015 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at firstname.lastname@example.org.