Many not-for-profit organizations are dependent, in no small part, upon the generosity of successful businesses and their owners. The latter are motivated by a number of factors; for some, this generosity is an expression of their gratitude to the community that enables them to thrive; for others, it is a desire to share their good fortune with those in need; a not insignificant number are driven by a desire for public recognition.[i]

Whatever the motivation of these business owners, the tax laws have long played an important role in encouraging certain types of behavior relating to the contribution of property to a charity, and in discouraging certain activities that have the potential to harm a charitable organization, or to distract the organization from its charitable mission.[ii]

These tax-related, “charitable behavior modification” rules are intended to be most keenly felt by so-called “private foundations” and by those who control them.

Historical Behavior Modification

A private foundation (“foundation”) is a kind of charitable organization that is not dependent upon the “general public” for financial support;[iii] rather, it is generally controlled by the individual who created the foundation and funds its operations.[iv]

In general, the foundation limits its charitable activities to making grants to those “public charities” selected by this founder or their family, in the amounts and at the times determined by these individuals.[v]

Thus, it may be presumed that the foundation’s behavior cannot be readily influenced by the public in most instances.[vi] It is for that reason that the Code limits the tax benefits allowable to a foundation and its supporters, and also seeks to regulate certain activities in which they may engage.

Reduced Income Tax Deduction

For example, the owner of a closely held business may donate shares of stock in the business (i.e., capital gain property) to their foundation, but the amount that they may deduct for purposes of determining their income tax liability is limited to their adjusted basis in the donated stock – not its fair market value at the time of the donation – and their deduction is capped at a lower percentage of their adjusted gross income [vii] than would a similar contribution to a public charity.[viii]

The reduced tax benefit for the donor reflects the illiquid nature of an interest in a closely held business – the foundation cannot simply sell it on a public market. The Code also seeks to prevent the donor-business owner from receiving a more favorable tax benefit without giving up de facto control over the donated business interest.

Excess Business Holdings

Similarly, a foundation is generally not permitted to hold more than twenty percent of the voting stock of a corporation,[ix] reduced by the percentage of the voting stock owned by all disqualified persons[x] with respect to the foundation.[xi] If a foundation violates this rule, it may be subject to an excise tax equal to ten percent of the fair market value of its holdings in the business in excess of the permitted amount.[xii]

This prevents a business owner from contributing stock in their corporation to a foundation, either during their life or at their death, and thereby avoiding or reducing federal estate and gift taxes while at the same time enabling their family to retain indirect control of the donated stock through the foundation.

Depending upon the size of the gift or bequest, the foundation may have between five and ten years to dispose of the stock.

Minimum Distribution

Finally, a foundation is required to distribute annually an amount equal to at least five percent of the fair market value of its assets.[xiii] This rule is aimed, in part, at preventing a business owner from contributing to a foundation, and a foundation from investing in, an interest in a close business that is illiquid and that may not produce current income. A foundation that violates this rule faces a penalty tax equal to thirty percent of the distribution shortfall.

BBA of 2018

The foregoing rules have governed the relationship between foundations and closely held businesses for almost fifty years. Then, on February 9, 2018, the Bipartisan Budget Act of 2018 (the “Act”) was signed into law, effective for taxable years beginning after December 31, 2017.[xiv]

According to the accompanying committee report,[xv] in recent years, a new type of philanthropy has combined “private sector entrepreneurship” with charitable giving; for example, through the donation of a private company’s entire after-tax profits to charity.[xvi]  The report goes on to state that it is appropriate “to encourage this form of philanthropy by eliminating certain legal impediments to its use, while also ensuring that private individuals cannot improperly benefit from charitable dollars.”

Therefore, the Act amended the Code[xvii] to permit a business owner to gift or bequeath an entire business to a foundation, provided that the after-tax profits of the business will be paid to the foundation and certain other requirements are satisfied, while also ensuring that the donor’s heirs cannot improperly benefit from the arrangement.

The new provision creates an exception to the excess business holdings rules for certain “philanthropic business holdings.” Specifically, the tax on excess business holdings will not apply with respect to the holdings of a foundation in any business enterprise that, for the taxable year, satisfies:

  • the “exclusive ownership” requirements;
  • the “all profits to charity” requirement; and
  • the “independent operation” requirements.

Exclusive Ownership

The exclusive ownership requirements are satisfied for a taxable year if:

  • all voting ownership interests[xviii] in the business enterprise[xix] are held by the foundation at all times during the taxable year; and
  • all the foundation’s ownership interests in the business enterprise were acquired by the foundation as gifts during the life of the donor, or as testamentary transfers at the donor’s demise, under the terms of the donor’s will or trust, as the case may be.[xx]

All Profits to Charity

The “all profits to charity” requirement is satisfied if the business enterprise, not later than 120 days after the close of the taxable year, distributes an amount equal to its net operating income for such taxable year to the foundation.

For this purpose, the net operating income of any business enterprise for any taxable year is an amount equal to the gross income of the business enterprise for the taxable year,[xxi] reduced by the sum of: (1) the deductions allowed for the taxable year that are directly connected with the production of the income; (2) the federal income tax imposed on the business enterprise for the taxable year;[xxii] and (3) an amount for a reasonable reserve[xxiii] for working capital and other business needs of the business enterprise.

Independent Operation

The independent operation requirements are met if, at all times during the taxable year, the following three requirements are satisfied:

  • First, no substantial contributor to the private foundation, or a family member of such a contributor, is a director, officer, trustee, manager, employee, or contractor of the business enterprise (or an individual having powers or responsibilities similar to any of the foregoing[xxiv]).
  • Second, at least a majority of the board of directors of the foundation are individuals who are not (1) directors or officers of the business enterprise, nor (2) members of the family of a substantial contributor to the foundation.
  • Third, there is no loan outstanding from the business enterprise to a substantial contributor to the foundation or a family member of such contributor.

What Does It Mean?

In light of the foregoing, a foundation may now be able to own all of the issued and outstanding stock[xxv] of a corporation that operates an active business.

The Act

Of course, in order to do so, the foundation and the business must satisfy the requirements described above, some of which need to be clarified by the government; even then, there are still many issues to consider.

Of the three requirements described, the most challenging may be the “independent operation” requirement. It is clearly aimed at ensuring that the foundation’s charitable mission is not compromised because its managers are also overseeing, and are distracted by, the operation of a business.

However, we are talking about a closely held business. How likely is it that the owner or their family will give up control of the foundation or of the business (at least while the owner is alive)? In most cases, it is likely that the owner will wait until their death, or the death of their surviving spouse, before giving up their entire ownership of the business.[xxvi]

Might an owner split up their business into separate businesses – for example, geographically or according to line of business – in anticipation of contributing one of them to a foundation? Should the government be allowed to aggregate these businesses in certain situations so as to avoid abuse of the new rule?

Other Foundation Rules

Assuming the requirements established by the Act are met, the foundation must still consider the various “behavior modification” rules.

The Act did not change the limited income tax deduction available to the business owner who contributes an interest in a closely held business to a foundation. It remains limited to the owner’s adjusted basis in the interest.

Where the business contributed is an S corporation, the corporation’s election to be treated as a small business corporation will not be affected, but the foundation will be subject to the unrelated business income tax on its allocable share (100%) of the S corporation’s taxable income.[xxvii]

If all of the interests in an LLC, treated as a partnership, are transferred to a foundation, the LLC will become a disregarded entity, and the foundation will be treated as engaging directly in the LLC’s business.[xxviii] Obviously, this will raise unrelated business income tax issues, but it may also jeopardize the foundation’s tax-exempt status if the business is substantial relative to the foundation’s charitable activities.

Speaking of taxes – parum pum – although any dividends distributed to the foundation by a wholly-owned business corporation will not be subject to income tax,[xxix] the excise tax on the foundation’s net investment income will continue to apply.[xxx]

In addition, the foundation will continue to be subject to the five-percent-minimum annual distribution requirement. Query how difficult (and expensive) it will be to determine the fair market value of the closely held business every year for this purpose.

And what if the business does not make a distribution to the foundation in a particular year; for example, where it sets aside “reasonable reserves” for a bona fide business purpose? How will the foundation generate the necessary liquidity? Will it be forced to borrow money?

If there is a prolonged period during which insufficient dividends are paid, will the foundation’s continuing ownership of the business represent a “jeopardy investment” – one that jeopardizes the carrying out of its exempt purposes – with respect to which the ten percent penalty tax should be imposed?[xxxi] Might the foundation be forced to sell the business at that point?[xxxii]

Along that same line of reasoning, what if the business requires a capital contribution? If the foundation is somehow able to make the necessary infusion of cash, will it have engaged in a non-charitable activity of a type with respect to which the twenty percent, so-called “taxable expenditure,” penalty should be imposed?[xxxiii]

That’s All Folks

Lots of questions. It’s early yet – we’ll see how it plays out. Frankly, I don’t get it.[xxxiv]


[i] By now, you are aware of one of the themes of this blog: A business should only undertake an activity because it makes business sense, not because of the tax result. The same applies to charitable giving: One should not make a charitable transfer because of an expected economic benefit, but because one believes in the charitable organization or activity.

[ii] See the General Explanation of the Tax Reform Act of 1969, prepared by the Staff of the Joint Committee on Internal Revenue Taxation, December 3, 1970 (Joint Committee Explanation), for a good review.

[iii] Compare the public charity, the revenues of which come, by and large, from the general public (as contributions or as fees for services), including other charities and government. IRC Sec. 509(a).

[iv] Whether directly or through their business.

[v] Rather than providing any charitable service, itself.

[vi] The public cannot tighten the proverbial “purse strings.”

[vii] 30% vs 20%. IRC Sec. 170(e)(1) and Sec. 170(b)(1).

[viii] Query whether an independent public charity would accept equity in a close corporation that could not be converted into cash or a cash equivalent.

Note that the Small Business Job Protection Act of 1996 amended the Code to allow charities to own shares of stock in an S corporation.

[ix] Profits interest in the case of a partnership.

[x] Among others, this includes substantial contributors to the foundation, foundation managers, family members of such individuals, and certain business entities controlled by such individuals. IRC Sec. 4946.

[xi] If the foundation and its disqualified persons together do not own more than 35% of the voting stock of an incorporated business enterprise, then the foundation may own up to 35% of the voting stock, reduced by the amount owned by its disqualified persons, provided no disqualified person has effective control of the corporation.

[xii] IRC Sec. 4943.

[xiii] Other than those assets which are used directly in carrying out the foundation’s exempt purpose. IRC Sec. 4942.

[xiv] P.L. 115-123.

[xv] S. Rept. 114-20

[xvi] Newman’s Own, anybody?

[xvii] IRC Sec. 4943(g).

[xviii] What about non-voting interests? What about the “all profits” requirement? The provision should have stated that all of the equity must be owned by the foundation.

[xix] A “business enterprise” does not include a business that is functionally related to the foundation’s exempt activities, or a trade or business at least 95% of the gross income of which is derived from “passive sources.”

Might some donors with foresight be tempted to split up their business so as to satisfy the exclusive ownership interest as to those segments of the business intended for the foundation?

[xx] It appears that the donor cannot transfer some of the equity as a lifetime gift and the balance at their death. Presumably, the business may redeem a portion of the donor’s equity from their estate (thereby providing the estate with liquidity to pay taxes or make other testamentary transfers), and passing the remaining equity to a foundation.

[xxi] Including any investment income.

[xxii] Of course, the business remains subject to federal income tax. Moreover, if the foundation were to liquidate the business, such liquidation would be a taxable event under regulations issued under IRC Sec. 337.

[xxiii] Query what constitutes a “reasonable” reserve.

[xxiv] Query whether, in the case of a N.Y. membership corporation, this would cover a member of the foundation.

[xxv] Voting and non-voting.

[xxvi] For example, the owner may establish a QTIP trust for the benefit of the spouse, with the remainder passing to the foundation at the death of the spouse.

[xxvii] IRC Sec. 512(e). The gain from the sale of the S corporation stock will also be taxable.

[xxviii] IRC Sec. 512(c).

[xxix] IRC Sec. 512(b).

[xxx] IRC Sec. 4940.

[xxxi] IRC Sec, 4944.

[xxxii] If the foundation accepts a discounted price – a “fire sale” – will the state’s attorney general be knocking on the foundation’s door shortly thereafter?

[xxxiii] IRC Sec. 4945.

[xxxiv] Well, I guess I do. The Act was intended to benefit one taxpayer: Newman’s Own. Hell of a way to legislate. Just as bad as enacting provisions that are scheduled to expire only a few years later. I’ll get off my soapbox now.