November 22, 2021
While the Internal Revenue Code Section 501(c) lists 29 different types of nonprofit organizations, most tax-exempt organizations are those described in Section 501(c)(3) and have a charitable, religious, educational, or scientific purpose. Every 501(c)(3) tax-exempt organization must be further classified as either a public charity or a private foundation. Some types of charities, such as schools, churches, hospitals, and medical research organizations, are statutorily classified as public charities.
If a 501(c)(3) organization is not automatically classified as a public charity, it is a private foundation unless it demonstrates otherwise to the IRS. The proof is most often done as part of the Form 1023 application, the process used to obtain tax-exempt status.
If the IRS accepts the organization’s public charity position, the organization is deemed to be a public charity for the first five years of its existence. 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.
What are the consequences of becoming a private foundation, or PF?
From a compliance perspective, a private foundation must file a more complex return, Form 990-PF rather than the Form 990 series filed by public charities. This form requires a significant number 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, private foundations are subject to much more restrictive operational provisions than public charities, including several provisions to help ensure that the private foundation 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 private foundations. Below is a brief description of each including the initial taxes that may be imposed. “Second-tier” taxes, which are substantial and can be imposed for failure to correct a violation, are not included.
- Section 4940imposes a 1.39 percent excise tax on the net investment income of a private foundation. 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 private foundation and a “disqualified person” (DP). Disqualified persons 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 is 10 percent, with 5 percent imposed on a foundation manager who knowingly participates in such acts. Self-dealing includes many transaction types between a private foundation and a disqualified person, the most common of which are the sale or leasing of property, lending, or borrowing of money, and payment for services. (There is an exception for reasonable compensation for certain services.)
- Section 4942 imposes a 30-percent tax on a private for failure to make minimum distributions each year. While the calculation is complex, the rules essentially require 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 private foundations generally do not count as qualifying distributions.
- Section 4943 imposes a 10 percent tax on a private foundation 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 disqualified persons. However, if a non-DP third party effectively controls management and policies of the enterprise, the private foundation 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 private foundation’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 private foundation (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-501(c)(3) organizations in which the private foundation does not exercise “expenditure responsibility”. This is often a cumbersome evaluation and record-keeping process.
These private foundation code section descriptions are brief overviews. The Internal Revenue Code and related regulations are complex and should be referred to for more detailed information.
For more information about the public support test for private foundations, contact a CPA who specializes in tax-exempt organizations.
Richard J. Locastro, CPA, JD
Partner and Director, Nonprofit Tax