The Charitably-Inclined Business
Many successful business owners attribute some part of their financial success to their community. The term “community” may have a different meaning from one business owner to another. In some cases, it may refer to the community in which the owner grew up, was educated, learned the values of hard work and sacrifice, and came to appreciate the importance of team effort. In other cases, it may refer to the community in which the business operates, from which it draws its workforce, to which it sells its services or products, and that supports the business in both good times and bad.
For some of these business owners, it is not enough to simply acknowledge this “debt” their community; rather, they feel an obligation to share some of their financial success with the community. Some owners or businesses will make contributions to local charities, religious organizations, schools, hospitals and civic groups. Others will provide scholarships or grants to local residents who otherwise could not afford to cover educational, medical, or other expenses. Still others will solicit the voluntary assistance of their workforce to support a local charitable organization in a fundraising or other public event.
These endeavors are commendable, but they are of an ad hoc nature, which means they are also of limited duration. This is because such activities are not necessarily institutionalized and they are dependent, in no small part, upon the business owner, who acts as the catalyst or motivating force for the charitable activities of the business.
Recognizing these limitations, some business owners will establish a private foundation – typically, a not-for-profit corporation (separate from the business), that may be named for the owner, the owner’s family, or the business – which they will fund, either personally or through the business, with an initial contribution of cash or property. In later years, the owner may contribute additional amounts to the foundation, often culminating with a significant bequest to the foundation upon the death of the owner. With this funding, the foundation – which will not be financially dependent upon contributions from the general public (thus a “private” foundation, as distinguished from a “public” charity) – will have the wherewithal to conduct its charitable activities.
The foundation may be formed for a single charitable purpose or for a variety of charitable purposes. In most cases, the foundation’s only activity will be to make grants of money to other not-for-profit organizations that are directly and actively engaged in charitable activities (i.e., not grant-making), provided these grants and activities are in furtherance of the foundation’s stated purposes. In some cases, the foundation may, itself, be directly and actively engaged in conducting a charitable activity.
Whatever the nature of the foundation’s activities, the Code prescribes a number of rules with which the business owner must become familiar, and with which the foundation must comply if it hopes to secure and maintain an exemption from federal income tax. The following is a brief description of these rules.
Federal Tax-Exempt Status
Many business owners embark upon the establishment of a private foundation without first educating themselves as to the operation and tax treatment of a not-for-profit organization. Too often, they create the not-for-profit, transfer funds and other property to it, and begin conducting charitable activities. Years later, they learn that, under the Code, a not-for-profit is not per se exempt from federal income tax; indeed, they learn that the organization is fully taxable unless and until it applies to the IRS for recognition of its status as a tax-exempt organization; even then, they learn that the organization may lose its tax-favored status if it fails to file annual tax returns with the IRS.
In addition, because foundations are not dependent upon the public support for their financial survival – and, so, are not to “answerable” to the public – the Code provides a number of restrictions upon the use of foundation funds. These restrictions seek to discourage, and hopefully prevent, certain activities by a foundation that the IRS deems to be contrary to, or inconsistent with, the charitable nature, and tax-exempt status, of a foundation. The IRS enforces these restrictions through the imposition of special excise (i.e., penalty) taxes upon the foundation, the foundation’s managers (e.g., its board of directors), and so-called disqualified persons (“DP”; i.e., persons who are considered to be “insiders” with respect to the foundation).
Federal Tax Compliance Checklist
Securing recognition by the IRS of its tax-exempt status is only the beginning of a private foundation’s life as an organization for which tax considerations, and compliance with various tax rules, will play a significant role.
“It pays to know,” as the saying goes. In that spirit, the following “compliance checklist” should be reviewed by any business owner who has already formed, or who is contemplating the establishment of, a typical grant-making private foundation.
Is the Foundation being operated in furtherance of its charitable purposes? The Foundation must be operated in accordance with the exempt purposes set forth in its certificate of incorporation and described in its tax-exemption application (Form 1023) filed with the IRS. It must be operated to further a public interest, and no part of its net earnings may inure to the benefit of any private individual. If the Foundation’s activities result in any prohibited private benefit or inurement, its tax-exempt status could be revoked by the IRS.
- Does the Foundation have a grant-making policy? How does it select the organizations to which it make grants? What criteria are used? Does it accept applications for grants? How is the selection process recorded? How does the Foundation assure itself of a donee’s tax-exemption, its public charity status, and the grant’s furtherance of the Foundation’s charitable purpose, prior to making a distribution?
- Is the Foundation authorized to make grants to organizations in addition to those that are recognized as tax-exempt charities by the IRS? How do such grants further charitable purposes?
- Is the Foundation authorized to make grants to foreign charities? If so, how will it establish that the foreign charity would have qualified as a tax-exempt organization if it had been formed in the U.S.? Does it make pre-grant inquiries, including the donee’s financial status and its ability to accomplish the purpose for which the grant is being made? How does the Foundation verify that the grant funds are being used for the intended purpose?
- Is the Foundation authorized to make grants to other private foundations? Is it prepared to exercise “expenditure responsibility” with respect to such grants? What types of reports does it require from the donee as to the use of the grant monies?
- Is the Foundation authorized to make grants to individuals and, if so, for what purposes? How will it select individuals for grants? What criteria will it use? If the purposes are for travel or education, will it require periodic reports from the grantee? Does it maintain case histories?
- Has the Foundation engaged in any political campaign activity? If the Foundation engages in any political activity, its tax-exempt status could be revoked by the IRS.
- Has the Foundation sought to influence legislation? Has it engaged in any “lobbying” activity and, if so, to what degree? Does it limit itself to “educating” the public, to presenting both sides of an issue?
- Has the Foundation distributed the prescribed minimum annual amount, equal to five percent of the fair market value of its non-charitable assets, to accomplish charitable purposes? In general, “qualifying distributions” include administrative expenses and grants to independent public charities.
- Does the Foundation have, and has it complied with, a conflict of interest policy?
- Does any DP have any business dealings with the Foundation? For example, has the Foundation sold property to, or purchased property from, a DP? Generally speaking, it shouldn’t have such business dealings.
- Does the Foundation lease property from a DP? It may only do so on a rent-free basis.
- Has the Foundation leased its property to a DP? It is prohibited from doing so.
- Has the Foundation borrowed money from a DP? It may only do so on an interest-free basis.
- Has the Foundation loaned money to a DP? It is prohibited from doing so.
- Has the Foundation paid compensation to, or has it reimbursed the expenses incurred by, a DP? The Foundation may only pay compensation that is reasonable for the services rendered. How will it determine the reasonableness of the compensation? Has it looked for comparables? How does it memorialize its compensation decisions?
- Has the Foundation paid the personal expenses, or satisfied the personal obligations, of any DP?
- Has the Foundation invested in business entities, including any in which a DP owns an interest? A private foundation is not permitted any holdings in a sole proprietorship that is a “business enterprise.” In general, a private foundation is permitted to hold up to twenty percent of the voting stock of a corporation, reduced by the percentage of voting stock actually or constructively owned by DP. (There are some exceptions.)
- Has the Foundation invested any of its assets in such a manner that the carrying out of its exempt purposes is jeopardized? An “ordinary business care and prudence” standard applies in determining whether the Foundation has made investments that may jeopardize its exempt purpose.
- Has the Foundation reported the existence of any of the proscribed situations set forth above? Has it, along with its DP, “corrected” any of these?
- Has the Foundation paid the annual excise tax on its investment income?
- Has the Foundation engaged in any business that is unrelated to its exempt purpose? Has it reported this activity and the income therefrom to the IRS on Form 990-T?
- Has the Foundation made its annual federal tax return (on IRS Form 990‑PF), its tax-exemption application (IRS Form 1023), and its IRS determination letter available for public inspection?
- Has the Foundation issued a receipt to its donors in respect of any contribution to the Foundation of two hundred fifty dollars ($250) or more? Contemporaneous written acknowledgment of the contribution is required in order for the donor to claim a deduction.
The above checklist may intimidate many business owners and their families. The operation of a private foundation, however, is no small matter. Because of its tax status, it is effectively a quasi-public organization. A business owner who is used to “doing things his own way” may find these rules too restrictive or onerous.
As was stated earlier, the foregoing is intended as a resource for those already operating a foundation, and for those thinking about starting one. However, it is no substitute for retaining the services of knowledgeable and experienced tax and not-for-profit corporate advisers. Although a sophisticated business owner may be familiar with, or may intuit, some of the rules described above, there are many more that will be foreign to one who is not immersed in the world of tax-exempt not-for-profits. These rules are the price exacted for the favorable tax treatment bestowed upon private foundations and their contributors.
As always, the well-intentioned, charitably-inclined business owner will be well-served, and will successfully accomplish his charitable goals (and avoid unpleasant surprises), if he educates himself and consults with a qualified professional.