The Business-Charity Connection

As our readers know, this blog is dedicated to addressing the tax-related business and succession planning issues that are most often encountered by the owners of a closely held business. Occasionally, however, we have crossed over into the space occupied by tax-exempt charitable organizations inasmuch as such an exempt organization (“EO”) may be the object of a business owner’s philanthropy, either during the owner’s life or at their demise.

Foundations

For example, we have considered grant-making private foundations (“PF”) that have been funded by the business owner and, thus, are not reliant upon the general public for their financial survival. In particular, we have reviewed a number of the penalty (“excise”) taxes applicable to PFs. These are rooted in the government’s tacit recognition that the activities of such a PF cannot be influenced by the withholding of public support from the foundation. Rather, the threatened imposition of these taxes is intended to encourage certain “good” behavior and to discourage certain “bad” behavior by a PF.[i]

Although PFs are important players in the charitable world, a business owner is far more likely to support charitable activities by making direct financial contributions to publicly-supported charities that operate within their community, rather than to create a PF through which to engage in such charitable giving.[ii]

Board Service

Where the business owner has a personal connection to an EO’s charitable mission, the owner may seek to become a member of the organization’s board of directors. In other cases, the EO itself may solicit the owner’s involvement, in part to help secure their financial support, not to mention the access they can provide to other potential donors from the business world.

Another reason that business owners may be attractive candidates for an EO’s board of directors is that they are experienced in . . . running a business.[iii] This skillset may be especially important in light of recent changes to the Code that reflect Congress’s heightened skepticism toward EOs, and that are aimed at limiting the amount of executive compensation payable by EOs.

Increased Public Scrutiny

Congress’s reaction to EO executive compensation is, in part, attributable to the public’s own changing perspective. As the charitably-inclined segment of the “public” has become more sophisticated, and better informed, it has demanded more accountability as to how its charitable contributions are being utilized, including what percentage of the contributions made to a charity is being used for executive compensation.[iv]

These “economic” concerns are magnified when viewed in light of the reality that the vast majority of charitable organizations are governed by self-perpetuating boards of directors,[v] which in turn hire the executive employees who operate these organizations on a day-to-day basis.

In response to these concerns, Congress has slowly been adding provisions to the Code that are intended (as in the case of the excise taxes applicable to PFs) to dissuade public charities and their boards from engaging in certain behavior.

Until the passage of the Tax Cuts and Jobs Act of 2017,[vi] the most notable of these provisions was that dealing with “excess benefit transactions.”[vii]

Blurring the Lines

As a result of these economic pressures, not to mention the attendant governmental scrutiny, most public charities have sought to fulfill their charitable missions on a more efficient basis. In other words, they have tried to become more “business-like” in performing their charitable functions. In furtherance of this goal, many EOs have tried to attract and retain the services of talented and experienced executives, while also inviting successful business owners onto their boards.

Notwithstanding these efforts, many EOs continue to be in the Congressional crosshairs. In particular, some larger EOs have been accused, in some circles, of taking advantage of their tax-preferred status to generate what critics have characterized as large profits, a not-insignificant portion of which find their way, or so these critics assert, into the hands of the organizations’ key executives in the form of generous compensation packages.

The Act represents the latest Congressional effort to rein in what its proponents perceived as abuses in the compensation of EOs’ top executives.

In order to stem these “abuses,” the Act draws liberally from the tax rules applicable to executive compensation paid or incurred by business organizations. Before delving into these provisions, it would be helpful to briefly review the “for-profit” rules from which they were derived.

For-Profit Compensation Limits

In determining its taxable income from the conduct of a trade or business, an employer may claim a deduction for reasonable compensation paid or incurred for services actually rendered to the trade or business.[viii] Whether compensation is reasonable depends upon all of the facts and circumstances. In general, compensation is reasonable if the amount thereof is equal to what would ordinarily be paid for “like services by like enterprises under like circumstances.”[ix]

However, Congress has determined – without stating that it is per se unreasonable – that compensation in excess of specified levels may not be deductible in certain situations.

Public Corporations

Prior to the Act, and in order to protect shareholders from grasping executives, a publicly-held corporation generally could not deduct more than $1 million of compensation in a taxable year for each “covered employee,”[x] unless the corporation could establish that the compensation was performance-based.[xi]

Golden Parachutes

In addition, a corporation generally cannot deduct that portion of the aggregate present value of a “parachute payment” – generally a payment of compensation that is contingent on a change in corporate ownership or control[xii] – which equals or exceeds three times the “base amount” of certain shareholders, officers and highly compensated individuals.[xiii] The nondeductible excess is an “excess parachute payment.”[xiv]

The purpose of the provision is to prevent executives of widely-held corporations from furthering their own interests, presumably at the expense of the shareholders, in the sale of the business.[xv]

Quite reasonably, certain payments are excluded from “parachute payment status” – in particular, the amount established as reasonable compensation for services to be rendered after the change in ownership or control is excluded.[xvi]

In addition, the amount treated as an excess parachute payment is reduced by the amount established as reasonable compensation for services actually rendered prior to the change in ownership or control.[xvii]

Finally, the individual who receives an excess parachute payment is subject to an excise tax of 20% of the amount of such payment.[xviii]

EO Compensation Limits

Prior to the Act, the foregoing deduction limits generally did not affect an EO.

That being said, there were other provisions in the Code that addressed the payment of unreasonable compensation by an EO to certain individuals.

Self-Dealing

PFs are prohibited from engaging in an act of “self-dealing,” which includes the payment of compensation by a PF to a disqualified person.[xix]

However, the payment of compensation to a disqualified person by a PF for the performance of personal services which are reasonable and necessary to carry out the PF’s exempt purpose will not constitute self-dealing if the compensation is not excessive.[xx]

In other words, the EO-PF may pay reasonable compensation to a disqualified person.[xxi]

Where it has paid excess compensation, the EO is expected to recover the excess from the disqualified person.[xxii]

Excess Benefit Transaction

A public charity is prohibited from engaging in an “excess benefit transaction,” meaning any transaction in which an economic benefit[xxiii] is provided by the organization to a disqualified person if the value of the economic benefit provided exceeds the value of the consideration, including the performance of services, received for providing such benefit.[xxiv]

To determine whether an excess benefit transaction has occurred, all consideration and benefits exchanged between the disqualified person and the EO, and all entities that the EO controls, are taken into account.[xxv]

In other words, the EO-public charity may pay reasonable compensation to a disqualified person without triggering the excess benefit rules.

As in the case of a PF, the public charity is expected to recover the amount of any excess payment made to the disqualified person.[xxvi]

Private Inurement

An organization is not operated exclusively for one or more exempt purposes if its net earnings inure, in whole or in part, to the benefit of private individuals.[xxvii]

Whether an impermissible benefit has been conferred on an individual is essentially a question of fact. A common factual thread running through the cases where inurement has been found is that the individual stands in a relationship with the organization which offers them the opportunity to make use of the organization’s income or assets for personal gain. This has led to the conclusion that a finding of inurement is usually limited to a transaction involving “insiders.”

Whereas the excise taxes on acts of self-dealing and on excess benefit transactions are intended to address situations that do not rise to the level at which the EO’s tax-favored status should be revoked, a finding that the organization’s net earnings have inured to the benefit of its “insiders” connotes a degree of impermissible benefit that justifies the revocation of its tax-exemption.

The Act

Congress must have believed that the foregoing limitations were not adequate to police or control the compensation practices of EOs. The committee reports to the Act, however, do not articulate the reason for the enactment of the provisions we are about to consider.

The only rationale that I can think of is that Congress was attempting to maintain some sort of “parity” between for-profits and EOs with respect to executive compensation.[xxviii]

Thus, the new provision draws heavily from the limitations applicable to business organizations, described above, and its purpose likewise may be deduced from the purposes of such limitations: to prevent certain individuals in the EO from paying themselves “excessive” salaries and other benefits, and thereby ensuring that those amounts are instead used in furtherance of the EO’s exempt purpose and for the benefit of its constituents.[xxix]

The Tax

Under the Act, effective for taxable years beginning after December 31, 2017, an employer (not the individual recipient of the payment) is liable for an excise tax equal to 21 percent[xxx] of the sum of:

(1) any “remuneration” in excess of $1 million paid to a covered employee by an EO for a taxable year, and

(2) any excess parachute payment paid by the EO to a covered employee.[xxxi]

Accordingly, the excise tax may apply as a result of an excess parachute payment, even if the covered employee’s remuneration[xxxii] does not exceed $1 million; in other words, there are two events that may trigger the imposition of the tax.

Where both provisions may apply, the remuneration that is treated as an excess parachute payment is not accounted for in determining if the $1 million limit is exceeded.

Covered Employee

For purposes of the provision, a covered employee is an employee (including any former employee) of an applicable tax-exempt organization if the employee

  • is one of the five highest compensated employees of the organization for the taxable year (the current year; there is no minimum dollar threshold for an employee to be a covered employee), or
  • was a covered employee of the organization (or of a predecessor organization) for any preceding taxable year beginning after December 31, 2016.[xxxiii] Thus, if the individual was a covered employee in a prior year (beginning with 2017), they continue to be treated as such for purposes of determining whether any payments made to them in subsequent years violate one of the two limitations described above.[xxxiv]

Related Persons

Remuneration of a covered employee also includes any remuneration paid with respect to employment of the covered employee by any person related to the EO.

A person is treated as related to an EO if the person:

(1) controls, or is controlled by, the organization,

(2) is controlled by one or more persons that control the organization,

(3) is a supported organization with respect to the organization, or

(4) is a supporting organization with respect to the organization.

Parachute Payments

Under the provision, an excess parachute payment is the amount by which any parachute payment exceeds the portion of the base amount allocated to the payment.

A parachute payment is a payment in the nature of compensation to a covered employee if:

  • the payment is contingent on the employee’s separation from employment and
  • the aggregate present value of all such payments equals or exceeds three times the base amount.[xxxv]

It should be noted that this definition differs from that applicable in the case of a business organization, where the disallowance of the employer’s deduction, and the imposition of the excise tax on the employee-recipient, are not contingent on the employee’s separation from employment.

It should also be noted that the Act did not provide an exception for a payment that represents reasonable compensation. Thus, even where the payment is reasonable in light of the services provided by the employee, and thus would not be trigger an excise tax for self-dealing or an excess benefit, the excise tax will nevertheless be applied.[xxxvi]

Liability

The employer of a covered employee – not the employee – is liable for the excise tax.

This is to be contrasted with the case of an employer that is a business organization. The employer is denied a deduction for the excess parachute payment, but an excise tax is also imposed upon the employee to whom the payment was made.

In addition, if the remuneration of a covered employee from more than one employer is taken into account in determining the excise tax, each employer is liable for the tax in an amount that bears the same ratio to the total tax as the remuneration paid by that employer bears to the remuneration paid by all employers to the covered employee.[xxxvii]

Parting Thoughts

The rules described above are complicated, and the IRS has yet to propose interpretive regulations, though it recently published interim guidance[xxxviii] to assist EOs with navigating the new rule, and on which they may rely, until regulations can be issued.

Of course, an EO will not be impacted by these provisions if it does not pay an employee enough remuneration to trigger the tax; there can be no excess remuneration if an EO (together with any related organization) pays remuneration of less than $1 million to each of its employees for a taxable year, and there can be no excess parachute payment if the EO does not have any “highly compensated” employees for the taxable year.[xxxix]

Does this mean that an EO should not pay any of its executives an amount that would trigger the imposition of the above tax? Should it walk away from candidates whom the EO can only hire by paying a larger amount? Or should it seek out the best people, pay them an amount that would trigger the tax but that the EO determines would be reasonable,[xl] and accept the resulting tax liability as a cost of doing business?[xli]

These are the kind of decisions that I have seen business owners make every day, and these are usually preceded by another set of inquiries: Will the return on our investment (in this case, in intellectual capital) justify the cost? Are we overpaying, or is the amount reasonable under the circumstances? Is there another way by which we can secure the same benefit – perhaps through a different mix of incentives, payable in varying amounts and at different times so as to skirt the literal terms of the Act, while also securing the services of a great executive?

The ability to bring this type of business analysis to an EO’s board discussion on executive compensation may be at least as valuable, in the current environment, as one’s willingness to open one’s wallet to the EO.

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[i] See Subchapter A of Chapter 42 of the Code. Examples include the excise tax on a foundation that fails to pay out annually, to qualifying charities, an amount equal to at least five percent of the fair market value of its non-charitable assets, and the excise tax on certain “insiders” (with respect to the foundation) who engage in acts of self-dealing with the foundation (e.g., excessive compensation).

[ii] There are many reasons a business owner chooses to form a foundation; ego, tax planning, continued control, and family involvement are among these. There are also many reasons not to form one; the resulting administrative burden and the cost of tax compliance should not be underestimated.

[iii] Take a look at the board of any local charity. It is likely populated, in no small part, by the owners of businesses that operate within, or employ individuals from, the locality in which the EO is headquartered or that it services.

[iv] Instead of, say, furthering the charitable mission. It should be noted that these expenditures are not necessarily mutually exclusive.

[v] That’s right. The members of these boards elect themselves and their successors. It is rare for a larger charity to have “members” in a legal, “corporate law” sense– i.e., the counterparts to shareholders in a business organization – with voting rights, including the right to elect or remove directors. Rather, these charities depend upon honest, well-intentioned individuals to ensure that their charitable mission is carried out. Many of these individuals – the directors of the organization – are drawn from the business community. Of course, the Attorney General of the State in which a charity is organized also plays an important role in ensuring that the charity and those who operate it stay the course.

[vi] P.L. 115-97 (the “Act”).

[vii] IRC Sec. 4958; P.L. 104-168; enacted in 1996, it is generally applicable to public charities. More on this rule later.

[viii] IRC Sec. 162(a)(1).

[ix] Reg. Sec. 1.162-7.

[x] Specifically, its CEO, CFO, and the three other most highly compensated officers.

[xi] IRC Sec. 162(m); enacted in 1993 as part of the Omnibus Budget Reconciliation Act, P.L. 103-66. The Act eliminated the exception for performance-based pay.

[xii] IRC Sec. 280G(b)(2) and (c).

[xiii] An individual’s base amount is the average annualized compensation includible in the individual’s gross income for the five taxable years ending before the date on which the change in ownership or control occurs. IRC Sec. 280G(b)(3).

[xiv] IRC Sec. 280G(a) and (b)(1); enacted in 1984; P.L. 98-369.

[xv] The provision does not apply to “small business corporations” or to non-traded corporations that satisfy certain shareholder approval requirements. IRC Sec. 280G(b)(5).

[xvi] IRC Sec. 280G(b)(4)(A).

[xvii] IRC Sec. 280G(b)(4)(B).

[xviii] IRC Sec. 4999. Presumably because they would have been in a position to contractually obligate the corporation to make the payment.

[xix] IRC Sec. 4941. “Disqualified person” is defined in IRC Sec. 4946. https://www.law.cornell.edu/uscode/text/26/4946.

[xx] IRC Sec. 4941(d)(2)(E).

[xxi] The key, of course, is for the board to be able to demonstrate the basis for its determination of reasonableness.

[xxii] A “correction” under IRC Sec. 4941(e). The “obligation” to recover the excess portion is implicit in the calculation of the penalty.

[xxiii] For purposes of this rule, an economic benefit provided by an EO will not be treated as consideration for the performance of services rendered to the EO unless the EO clearly indicated its intent to treat such benefit as compensation.

[xxiv] IRC Sec. 4958(c)(1)(A).

[xxv] Reg. Sec. 53.4958-4. Congress foresaw that some individuals may try to circumvent the proscription by drawing down salaries from non-exempt organizations related to the EO.

[xxvi] IRC Sec. 4958(f)(6).

[xxvii] Reg. Sec. 1.501(a)-1.

[xxviii] Query whether EOs have been enticing executives away from business organizations in droves – I don’t think so.

[xxix] Interestingly, the Act made no distinction between public charities and PFs. In contrast, the comparable limitations for business organizations do not apply to “small business corporations” or certain non-publicly traded corporations.

[xxx] I.e., the newly established flat rate for C corporations – in order to mirror the amount of tax that such a corporation would have to pay in respect of the disallowed portion of the compensation paid to the individual service provider.

[xxxi] IRC Sec. 4960. https://www.law.cornell.edu/uscode/text/26/4960.

[xxxii] Remuneration includes amounts required to be included in the employee’s gross income under IRC Sec. 457(f).

Such amounts are treated as paid (and includible in gross income) when there is no substantial risk of forfeiture of the rights to such remuneration within the meaning of section 457(f). Sec. 4960(c)(3). For this purpose, a person’s rights to compensation are subject to a substantial risk of forfeiture if the rights are conditioned on the future performance of substantial services by any individual, or upon the achievement of certain organizational goals.

Up until now, the only cap on 457(f) arrangements was that the payment be reasonable for the services actually rendered.

In determining reasonableness, one looks to the totality of the recipient’s services to the EO, not only for the year paid; in other words, the payment may be “prorated” over many years for this purpose. Accordingly, the tax imposed by this provision can apply to the value of remuneration that is vested even if it is not yet received. Indeed, the excise tax can apply to amounts that are paid currently though they were earned in earlier years.

[xxxiii] Sec. 4960(c)(2).

[xxxiv] The list of covered employees may grow to include individuals who are no longer included in the five highest paid.

[xxxv] The base amount is the average annualized compensation includible in the covered employee’s gross income for the five taxable years ending before the date of the employee’s separation from employment.

[xxxvi] That being said, the Act does exempt compensation paid to employees who are not “highly compensated” employees from the definition of parachute payment.

Significantly for EO-hospitals, compensation attributable to medical services of certain qualified medical or veterinary professionals is exempted from the definitions of remuneration and parachute payment; remuneration paid to such a professional in any other capacity is taken into account.

Unfortunately, neither the Act nor the committee reports provide any guidance regarding the allocation of a medical professional’s remuneration between their medical services and, say, their administrative functions within the EO-employer.

[xxxvii] It should be noted that the Act authorizes the IRS to issue regulations to prevent the avoidance of the excise tax through the performance of services other than as an employee.

[xxxviii] Notice 2019-09, which consists of ninety pages of Q&A.

[xxxix] Within the meaning of IRC Sec. 414(q).

[xl] It should always be reasonable under the facts and circumstances.

[xli] Assuming the amount is reasonable within the meaning of the self-dealing and excess benefit rules, will there be any argument under state law that the imposition of the tax reflects a per se breach of the board’s fiduciary duty?

If the amount is not reasonable, such that the excise taxes on self-dealing and excess benefits become payable, what is purpose of the new tax?

Home for the Holidays?

Our last post considered the division of a business between family members as a means of preempting the adverse consequences that will often follow disagreements within the family as to the management or direction of the business. https://www.taxlawforchb.com/2018/12/business-purpose-and-dividing-the-family-corporation-think-before-you-let-it-rip/.

This week, as family members return to work – after having come together to celebrate the holidays and renew their commitment to one another – we turn to a recent IRS ruling that considered a situation that presents the proverbial “trap for the unwary,” and that arises more often than one might think in the context of a business that is plagued by family discord. https://www.irs.gov/pub/irs-wd/201850012.pdf.

Another Family Mess

Corp was formed by Dad, who elected to treat it as an S corporation for federal tax purposes.[i] Immediately prior to the events described in the ruling, Dad owned more than 50% of Corp’s non-voting shares, but less than 50% of Corp’s voting shares. Mom and Daughter owned the balance of Corp’s issued and outstanding shares.

Following Mom’s death, Daughter – who was also the CEO of the business – received a testamentary transfer of all of Mom’s voting shares, resulting in Daughter’s owning a majority of Corp’s voting shares.

For reasons not set forth in the ruling, Daughter subsequently terminated Dad’s employment with Corp. In response, Dad filed a lawsuit against Corp and Daughter (the “Litigation”) in which he alleged shareholder oppression and breach of fiduciary duties. Dad asked the court to enter an order requiring Daughter and/or Corp to buy Dad’s shares in Corp (“Dad’s Shares”), or an order requiring Dad to purchase Daughter’s shares.[ii]

Within three months after Dad initiated the Litigation, Corp and Daughter filed a notice under the Litigation (the “Election”) for Corp to purchase Dad’s Shares (the “Proposed Transaction”). Dad filed a motion to nullify the Election.[iii] The court denied Dad’s nullification motion, and ruled that the Election was valid.

Proposed Buyout

Dad died before the Litigation could be resolved and his shares in Corp purchased. His revocable trust (the “Trust”) – which became irrevocable upon his death – provided that Dad’s Shares would pass to Foundation, a tax-exempt charitable organization that was created and funded by Mom and Dad, and that was treated as a private foundation under the Code. [iv]

Pursuant to the terms of the Trust, the trustee had the power and authority to sell any stock held by or passing to the Trust, including Dad’s Shares.[v] However, because of the Litigation, Foundation did not receive Dad’s Shares from the Trust; nor could the Trust sell Dad’s Shares to anyone other than Corp during the Litigation.[vi]

The court in the Litigation was required by state law to determine the “fair value” of Dad’s Shares as of the date the Litigation was initiated, or such other date the court deemed appropriate. The Foundation represented to the IRS that the Litigation court could determine the fair value of Dad’s Shares to be less than their fair market value after marketability and control discounts were applied.[vii]

The administration of the Trust was overseen by a probate court, not the court in which the Litigation was ongoing. The probate court had the responsibility to ensure that Foundation received the full value of Dad’s Shares, and was required to approve the valuation of Dad’s Shares and the Proposed Transaction. According to the Foundation, if the probate court approved the Proposed Transaction, the Litigation court would honor the probate court’s decision.

Self-Dealing

The foregoing may seem innocuous to most persons – just a buyout of a decedent’s shares in a corporation. Fortunately, Foundation recognized that Corp’s redemption of Dad’s Shares could be treated as an act of “self-dealing” under the Code, which could in turn result in the imposition of certain penalties (i.e., excise taxes) on the “self-dealer” and on the “foundation managers.”

The Code imposes a tax on acts of self-dealing between a “disqualified person”[viii] and a private foundation.[ix] The tax with respect to any act of self-dealing is equal to 10% of the greater of the amount of money and the fair market value of the other property given or the amount of money and the fair market value of the other property received in the transaction.[x] In general, the tax imposed is paid by any disqualified person who participated in the act of self-dealing.

The term “self-dealing” includes any direct or indirect sale or exchange of property between a private foundation and a disqualified person. For purposes of this rule, it is immaterial whether the transaction results in a benefit or a detriment to the private foundation; the act itself is prohibited.

An “indirect sale” may include the sale by a decedent’s estate (or revocable trust),[xi] to a disqualified person, of property that would otherwise have passed from the estate to the private foundation pursuant to the terms of the decedent’s will; in other words, property in which the foundation had an expectancy.

However, the term “indirect self-dealing” does not include a transaction with respect to a private foundation’s interest or expectancy in property held by a revocable trust, including a trust which became irrevocable on a grantor’s death, and regardless of when title to the property vested under local law, provided the following conditions are satisfied:

(i) The trustee of the revocable trust has the power to sell the property;

(ii) The transaction is approved by a court having jurisdiction over the trust or over the private foundation;

(iii) The transaction occurs, in the case of a revocable trust, before the trust is considered a “non-exempt charitable trust”;[xii]

(iv) The trust receives an amount which equals or exceeds the fair market value of the foundation’s interest or expectancy in the property at the time of the transaction; and

(v) The transaction results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up.[xiii]

The IRS Ruling

Foundation conceded that Dad was a disqualified person (a “substantial contributor”) as to Foundation while he was alive, having funded Foundation with Mom.[xiv] Daughter was a disqualified person as to Foundation because her father (a “member of her family”) was a substantial contributor to Foundation. Corp was also a disqualified person as to Foundation because Daughter owned more than 35% of Corp’s voting shares.[xv]

Because Corp was a disqualified person as to Foundation, and because of Foundation’s expectancy interest in receiving Dad’s Shares from the Trust, the proposed sale of Dad’s Shares by the Trust to Corp pursuant to the Litigation court’s order (the Proposed Transaction) could be an act of indirect self-dealing.

Foundation requested a ruling from the IRS that Corp’s purchase (i.e., redemption) of Dad’s Shares – which were held by the Trust – would satisfy the indirect self-dealing exception, described above, and would not be treated as an act of self-dealing for which a penalty could be imposed.

The IRS reviewed each of the requirements for the application of the exception.

First, a trustee must have the power to sell the trust’s property. Pursuant to the trust agreement that created Trust, Trust’s trustee had the power to sell any Trust assets, including Dad’s Shares. Thus, the Proposed Transaction met the first requirement.

Second, a court with jurisdiction over the trust must approve the transaction. Foundation sought, and was waiting to obtain, the approval of the Proposed Transaction from the probate court that had jurisdiction over, and was overseeing administration of, the Trust. Thus, the Proposed Transaction would meet the second requirement upon the Trust’s receipt of the probate court’s approval of the proposed sale.

Third, the Proposed Transaction must occur before the Trust became a non-exempt charitable trust. Foundation represented that because of the active and on-going status of the Litigation, the Trust’s trustees were, and would continue to be, unable to complete the ordinary duties of administration necessary for the settlement of Trust prior to the date of the sale of Dad’s Shares. Thus, the Trust would not be considered a non-exempt charitable trust prior to the date of the sale of Dad’s Shares; until then, the trustee would still be performing the ordinary duties of administration necessary for the settlement of the Trust.

In addition, before the sale of Dad’s Shares, the Trust will have made those other distributions required to be made from the Trust to any beneficiary other than Foundation, which would then be the sole remaining beneficiary.

Thus, if the Trust were not considered terminated for Federal income tax purposes prior to the Proposed Transaction, the Proposed Transaction would meet the third requirement.

Fourth, the Trust must receive an amount that equals or exceeds the fair market value of the foundation’s interest or expectancy in such property at the time of the transaction. The Litigation court was tasked with valuing Dad’s Shares. Foundation would endeavor to ensure that the Litigation court ordered the sale of Dad’s Shares to Corp at a price that was not less than the fair market value at the time of the Proposed Transaction. Thus, the Proposed Transaction would meet the fourth requirement if Dad’s Shares were sold to Corp at no less than their fair market value at the time of the transaction.

Fifth, the sale of Foundation’s interest or expectancy must result in its receiving an interest as liquid as the one that was given up. Pursuant to the trust agreement, Foundation had the expectancy of receiving Dad’s Shares, which were illiquid. Upon the completion of the Proposed Transaction, Foundation would receive the money that Corp paid Trust for Dad’s Shares. Thus, the Proposed Transaction would meet the fifth requirement if Foundation received the money proceeds from the Proposed Transaction.

Based on the foregoing, the IRS ruled that Corp’s purchase of Dad’s Shares held by the Trust would satisfy the “probate exception” from indirect self-dealing provided the following contingencies occurred:

  1. The probate court approved the Proposed Transaction;
  2. The Trust did not become a non-exempt charitable trust prior to the date of the sale of Dad’s Shares by the Trust; and
  3. The Trust received from the sale of Dad’s Shares to Corp an amount of cash or its equivalent that equaled or exceeded the fair market value of Corp’s Shares at the time of the transaction.

Trap for the Unwary?

Some of you may be thinking that the issue presented in the ruling discussed above, although somewhat interesting, is unlikely to arise with any regularity and, so, does not represent much of a trap for the unwary.[xvi]

I respectfully disagree. The fact pattern of the ruling is only one of many scenarios of indirect self-dealing that are encountered by advisers whose practice includes charitable planning for the owners of a closely held business.

There are two major factors that contribute to this reality: (i) the owner’s business will likely represent the principal asset of their estate, and (ii) the owner may have established a private foundation that they plan to fund at their demise (and thereby generate an estate tax deduction), either directly or through a split-interest trust.[xvii]

It is likely that the owner’s spouse, or some of their children, or perhaps a trust for their benefit, will be receiving an interest in the family business (an illiquid asset). It is also possible that the foundation will be funded with an interest in the business.

In these circumstances, the foundation may have to divest its interest in the family business in order to avoid the imposition of another private foundation excise tax (the one on “excess business holdings”).[xviii] Because of the limited market for such an interest, the foundation (or the owner’s estate or revocable trust) will probably have to sell its interest to the business itself (a redemption, as in the ruling above) or to another owner – each of which may be a disqualified person, thereby raising the issue of self-dealing. https://www.taxlawforchb.com/2018/10/private-foundations-and-business-ownership-a-new-day/.

In other circumstances, the divergent interests of the foundation to be funded, on the one hand, and of the individual beneficiaries of the owner’s estate or trust, on the other, may require that the foundation’s interest in the business be eliminated. For example, the foundation will need liquidity in order to engage in any charitable grant-making, while the other owners may prefer that the business reinvest its profits so as to expand the business; the foundation may prefer not to receive shares of stock in an S corporation, the ownership of which would result in the imposition of unrelated business income tax;[xix] or the foundation may be managed by individuals other than those operating the business, thereby setting the stage for a shareholder dispute as in the above ruling.

Bottom line:  It behooves the owners of the closely held business to consider these issues well before they arise. In many cases, it will be difficult to avoid them entirely, but the relevant parties should plan a course of action that is to be implemented after the demise of an owner.[xx] In this way, they may be able to avoid the personal, financial, and business disputes that may otherwise arise.

———————————————————————————-

[i] IRC Sec. 1361; IRC Sec. 1362.

[ii] The ruling does not disclose the jurisdiction under the laws of which Corp was formed.

In New York, the holders of shares representing 20% or more of the votes of all outstanding shares of a corporation may present a petition of dissolution on the ground that the directors or those in control of the corporation are guilty of oppressive acts toward the complaining shareholders. In determining whether to proceed with involuntary dissolution, the court must take into account whether liquidation of the corporation is the only feasible means by which the petitioners may reasonably expect to obtain a “fair return” on their investment. BCL 1104-a. This typically involves the valuation and buyout of the petitioners’ shares. However, the other shareholder(s) or the corporation may also elect to purchase the shares owned by the petitioners at fair value. BCL 1118. “Fair value” is not necessarily the same as “fair market value.” See Friedman v. Beway Realty Corp. 87 N.Y.2d 161 (1995).

[iii] Go figure. If the goal was to be bought out, congratulations. Why fight it? Or was Dad concerned that Daughter would render Corp unable to buy him out and, so, he wanted to pursue his own remedies?

[iv] Exempt from federal income tax under Sec. 501(a) of the Code, as an organization described in Sec. 501(c)(3) of the Code (educational, religious, scientific, and charitable purposes); a “private foundation” in that it did not receive financial support from the “general public.”

[v] Although a decedent should fund their revocable trust to the fullest extent possible prior to their demise, it is often the case that they forget to transfer – or that they intentionally retain direct ownership of – an asset, which thereby becomes part of their probate estate. In that case, the decedent’s last will and testament typically provides that the probate estate shall “pour over” into the now irrevocable trust – which acts as a “will substitute” – to be disposed of in accordance with the terms of the trust.

[vi] It should be noted that, effective for tax years beginning after December 31, 1997, certain tax-exempt organizations became eligible to own shares of stock in an S corporation; however, a qualifying organization’s share of S corporation income is treated as unrelated business income. IRC Sec. 1361(c)(6) and Sec. 512(e).

[vii] In general, “fair market value” as of the date of a decedent’s death is the value at which the property included in the decedent’s gross estate must be reported on their estate tax return. Reg. Sec. 20.2031-1(b).

[viii] The term “disqualified person” means, in part, with respect to a private foundation, a person who is:

(A) a “substantial contributor” to the foundation,

(B) a “foundation manager”,

(C) an owner of more than 20% of:

(i) the total combined voting power of a corporation,

(ii) the profits interest of a partnership, or

(iii) the beneficial interest of a trust or unincorporated enterprise, which is a substantial contributor to the foundation,

(D) a “member of the family” of any individual described in subparagraph (A), (B) or (C), or

(E) a corporation of which persons described in subparagraph (A), (B), (C), or (D) own more than 35% of the total combined voting power.

The term “members of the family” with respect to any person who is a disqualified person includes the individual’s spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren. IRC Sec. 4946.

[ix] The Code authorizes the imposition of certain excise taxes on a private foundation, on those who are disqualified persons with respect to such foundation, and on the foundation’s managers. These taxes are intended to modify the behavior of these parties – who are not otherwise dependent upon the public for financial support – by encouraging certain activities (e.g., expenditures for charitable purposes) and discouraging others (such as self-dealing).

[x] https://www.law.cornell.edu/uscode/text/26/4941

[xi] See EN iv, above.

[xii] See IRC Sec. 4947, which treats such a trust as a private foundation that is subject to all of the private foundation requirements.

A revocable trust that becomes irrevocable upon the death of the decedent-grantor, from which the trustee is required to distribute all of the net assets in trust for or free of trust to charitable beneficiaries, is not considered a charitable trust under section 4947(a)(1) for a reasonable period of settlement after becoming irrevocable. After that period, the trust is considered a charitable trust under section 4947(a)(1). The term “reasonable period of settlement” means that period reasonably required (or if shorter, actually required) by the trustee to perform the ordinary duties of administration necessary for the settlement of the trust. These duties include, for example, the collection of assets, the payment of debts, taxes, and distributions, and the determination of the rights of the subsequent beneficiaries.

[xiii] Reg. Sec. 53.4941(d)-1(b)(3); the so-called “probate exception.” https://www.law.cornell.edu/cfr/text/26/53.4941%28d%29-1 This exception had its genesis in the IRS’s recognition that a private foundation generally needs liquidity in order to carry out its charitable grant-making mission. With the appropriate safeguards (supervision by a probate court) to ensure that the foundation receives fair market value and attains the requisite liquidity, the act of self-dealing presented by the foundation’s sale of an interest in a closely held business may be forgiven.

[xiv] Interestingly, a substantial contributor’s status as such does not terminate upon their death; thus, a member of their family also remains a disqualified person.

[xv] See EN vii.

[xvi] A group of individuals to which the reader no longer belongs.

[xvii] For example, a charitable lead trust or a charitable remainder trust. IRC Sec. 2055(e). https://www.law.cornell.edu/uscode/text/26/2055.

[xviii] IRC Sec. 4943. https://www.law.cornell.edu/uscode/text/26/4943.

[xix] Taxable at 21% – as opposed to a 1% or 2% tax on investment income under IRC Sec. 4940 – and perhaps without a distribution from the corporation with which to pay the tax.

[xx] For example, corporate-owned life insurance to fund the buyout of the foundation’s interest, or the granting of options to family members to acquire the foundation’s interest.

Relationships are Hard

The well-being of a closely held business is based, in no small part, upon a number of relationships, including, for example, its dealings with customers, suppliers, service providers, employees, competitors, and government (including taxing authorities). The cultivation, management, and preservation of these relationships presents the business with many challenges. However, if I had to identify the two most-difficult-to-manage of such relationships, at least based upon the adverse tax consequences that are visited upon the business and its owners as a result of such relationships, I would point to the business’s dealings with its owners and with related companies.

This should come as no surprise. When unrelated parties are transacting with one another – as the business will do with, say, a vendor – each is seeking to maximize its potential for economic gain and to minimize its exposure to economic loss. Like any system of checks and balances, there are forces at work that encourage a reasonable resolution of the transaction; the so-called “win-win” result in which neither side wins or loses every point.

Unfortunately, these “natural” forces do not apply in the case of a closely held business because its owners generally do not view the business as something separate from themselves.

In just the last two weeks, I have encountered questions regarding a sale between commonly-owned companies, a rental between related companies, the sharing of employees between a parent and a subsidiary, a disproportionate dividend distribution by a corporation to similarly-situated shareholders, and a corporation’s guarantee of a shareholder’s personal obligation. The characteristic shared by these transactions – aside from the parties’ being “related” to one another – was the absence of any meaningful negotiation between the parties.[1]

Which brings me to one of the most frequently recurring issues raised by the IRS in its examination of closely held businesses: the true nature of an investor’s transfer of funds to the business. A recent Tax Court opinion provides a good overview of the factors to which a taxpayer-investor must be attuned.

“If You’ve Got the Money, . . . ”[2]

Taxpayer decided to transfer money to his long-time friend, Partner, provided Partner gave him an “interest” in Business. Shortly after Taxpayer transferred the funds, he and Partner together incorporated Business. Taxpayer never prepared formal loan documents for the payment, but instead recorded it in his personal books and gave a copy of that record to Partner. The two of them owned the corporation as equal shareholders, with Partner overseeing the management of Business.

As Business grew and required more capital, Taxpayer provided the money. Taxpayer kept a personal record of the amounts transferred to Business, and at the end of each year he turned it over to the corporation for inclusion in the corporate records, though Taxpayer never saw those records.

This pattern continued for several years, during which Business never ran at a profit. Eventually, Taxpayer found it necessary to seek outside financing for Business. In addition, a third owner – who became a 10% shareholder through dilution of Partner’s interest – was admitted to Business to help bear the financial burden.

Taxpayer himself continued to advance funds, though, and – amid growing concern about Business’s future – he asked for and received an additional 10% share in the corporation. After revenues continued to fall short of expectations, and after having invested over $11 million over the course of 15 years, Taxpayer finally gave up.

In 2010, Taxpayer’s attorneys prepared three promissory notes from Business. Each note was dated January 1, 2010, and was signed by Partner on behalf of Business.

In November 2010, Taxpayer sold one of his promissory notes to Partner for $1. Then, in December 2010, Business retired both Partner’s and Taxpayer’s “debt”. In exchange, Taxpayer received an additional 12.5% interest in Business (bringing his total to 82.5%).

With all this “paperwork” in place, Taxpayer’s attorneys advised him that he was entitled to claim capital losses in 2010 and 2011.

The IRS audited Taxpayer’s returns for those years and asserted tax deficiencies against Taxpayer. Taxpayer petitioned the Tax Court, where the only issue was whether Taxpayer’s advances to Business were loans or capital contributions.

Debt or Equity

Taxpayer argued that his advances to Business were bona fide debts, and the IRS argued that the advances looked more like equity.

A bona fide debt, the Court began, is one that “arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Whether a purported loan is a bona fide debt, it continued, is determined by the facts and circumstances of each case.

The Court identified several factors to consider in its debt-equity analysis; it cautioned that no single factor was determinative.

Names

Formal loan documentation, such as a promissory note, tends to show that an advance is a bona fide debt.

Taxpayer did not get formal loan documentation when he made each advance. Instead, his first advance got him a 50% interest in Business, and his later advances got him a 10% increase in his ownership.

Taxpayer pointed to the January 2010 promissory notes as evidence of indebtedness, but the Court found those promissory notes were of little help in determining Taxpayer’s intent when he made the advances.

The Court also stated that the “long-after-the-fact” papering was inconsistent with how Business treated unrelated lenders.

Maturity Date

“The presence of a fixed maturity date indicates a fixed obligation to repay, a characteristic of a debt obligation.”

Taxpayer’s alleged loans to Business had no fixed maturity date, and he explained that he expected to be paid only when Business was sold or became profitable.

Source of the Payments

The Court stated that if the source of repayments depended on earnings, an advance was more likely to be equity.

According to the Court, that’s exactly what happened here: Taxpayer admitted that he didn’t expect to receive payment until the business was profitable and he’d “be paid [his] share of the profits.”

Right to Enforce

An enforceable and definite obligation to repay an advance indicates the existence of a bona fide debt.

Taxpayer argued that Business had an enforceable and definite obligation to repay his advances both before and after the execution of the 2010 promissory notes. He argued that, before the notes, Business’s financial statements recorded his advances as loans, but the Court noted that Taxpayer pointed to no authority that this would give him a right to enforce their repayment.

In any case, Taxpayer failed to take customary steps to ensure repayment – he never asked for repayment. Moreover, the Court found that he never intended to enforce the notes.

Participation in Management

The Court stated that when a taxpayer receives a right to participate in management, or an increase in his ownership stake, in exchange for an advance, it suggests that the advance was an equity investment and not a bona fide debt.

Because Taxpayer’s initial transfer to Business came with a 50% share in the company, that advance indicated an equity investment. After that, however, Taxpayer’s participation in management was unclear. He testified that his only role was to lend money, but later said that he reviewed tax documents and cash flow statements. It does not, however, seem he was involved in the day-to-day operations of Business, and any involvement he did have was minimal.

Taxpayer did not receive additional stock for later contributions until after he had already advanced millions of dollars, and this was only a 10% increase in a failing company. He testified that he wanted the additional 10% so that he would have more control over Business’s direction, given its condition and the substantial funds he had already advanced; and he emphasized that he needed it if he was going to give Business any more money.

The Court observed that an increased interest or participation needed to prevent a company’s collapse did not, by itself, mean an advance was an equity investment. But Taxpayer also received an extra 12.5% interest in Business in 2010 when it retired his debt.

Status Equal or Inferior to Other Creditors

Taking a subordinate position to other creditors indicates an equity investment.

Taxpayer admitted that his purported loans were subordinate to those of Business’s secured creditors. He argued, however, that they were not subordinate to those of Business’s unsecured creditors, though the Court noted that there was nothing in the record to support this position. And Taxpayer in fact testified that his “debt” was subordinate to several other of Business’s financial arrangements.

The Parties’ Intent

“[T]he inquiry of a court in resolving the debt-equity issue is primarily directed at ascertaining the intent of the parties.” The Court treated this factor as “the place to look for contemporaneous evidence of subjective intent.”

That evidence showed that Taxpayer never received or demanded payments of either interest or principal from Business, and that he expected to be paid back only out of profits.

That evidence also showed no contemporaneous documentation from Business that stated the advances were loans, a lack which was telling because Business did borrow money from more conventional lenders, and it papered those transactions as conventional loans.

Taxpayer admitted that during the time he was making advances to Business, he did not know for sure that they were being recorded as loans in its books.

While Business’s financial statements showed that they included Taxpayer’s advances in their total debt, the Court gave this little weight because no one from Business, other than Taxpayer, testified on its behalf.

“Thin” or Adequate Capitalization

The Court stated that thin or inadequate capitalization was strong evidence of a capital contribution where: “(1) The debt to equity ratio was initially high, (2) the parties realized that it would likely go higher, and (3) substantial portions of these funds were used for the purchase of capital assets and for meeting expenses needed to commence operations.”

However, neither Taxpayer nor the IRS argued that evidence in the record directly supported or negated this factor.

Identity of Interest

Advances in proportion to the stockholder’s capital interest indicate a finding that the advance was an equity investment.

Business’s financial records indicated that its liabilities exceeded its assets. And when Business lacked money to cover its operating expenses, Taxpayer just handed over the funds. These circumstances, the Court stated, create an identity of interest between the purported creditor and the controlling shareholder.

Payment of Interest Out of “Dividend” Money

The presence of a fixed rate of interest, and the actual payment of interest, indicate a bona fide debt.

There was no evidence, aside from Taxpayer’s testimony, that his advances were supposed to accrue interest. In addition, Business never paid any interest, and Taxpayer never asked for it. “The failure to insist on interest payments indicates that the payors are not expecting substantial interest income, but are more interested in the future earnings of the corporation or the increased market value of their interest.”

The Ability to Obtain Loans From Outside Lenders

If a corporation is able to borrow funds from an outside source at the time of the advance, the transaction looks more like a bona fide debt.

The Court claimed that the IRS had mistakenly distorted this factor to say that, although Business was able to obtain financing from other lenders, those transactions were at arm’s length and Taxpayer’s were not, and so should count against him.

The Court’s Decision

Based upon the foregoing factors, the Court concluded that the absence of the normal incidents of a loan, especially a maturity date and a stated interest rate, were the most telling. Without those aspects of a loan, the Court stated, the advances looked much more like capital contributions. Moreover, the “papering” that Taxpayer’s advisers prepared in 2010 to make the advances look more like loans just made it more likely than not that, at the time of the advances, Taxpayer and Partner intended those advances to be capital contributions.

Which brings us back to where we started: unrelated parties would have behaved differently in structuring the terms of a transaction than Taxpayer and Business did with respect to the transfers made to Business. (Indeed, the unrelated party would not have continued funding Business as Taxpayer did.) The unrelated party would have “papered” the transfers as loans on a contemporaneous basis, and would have required a maturity date, scheduled interest payments, covenants regarding expenditures and dividends, periodic financial reports, etc.

Unfortunately, as stated earlier, too many owners treat their business as their alter ego. Consequently, they sometimes treat their business, or cause their business to treat them, in a way that an unrelated party wouldn’t. While this may generate some inquiries by taxing authorities, it may also strain relationships with, and even antagonize, minority owners (including disgruntled family members), which can lead to a world of hurt, both financially and emotionally.[3] Ultimately, the owner must realize that it is in their own, long-term self-interest to act at arm’s-length with their business.


(*) A tax twist on the “golden rule.” Apologies to Matthew, 7:12 (the sermon on the mount).

[2] Of course, the relationship between the parties accounted for the absence of arm’s-length dealing. This sounds like the criticism leveled by the IRS at many gift and estate tax planning transactions (including certain sales to trusts and FLP transactions, for example) – no coincidence there.

[3] Apologies to Lefty Frizzell – I prefer Willie Nelson’s rendition.

[4] There’s a reason minority owners may claim “self-dealing” by a controlling owner.

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.

Private Foundations

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.

Parting Advice

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.