ABC Foundation (the “Foundation”) is a private foundation in a major city in the United States. The Foundation has been renting office space in the city’s commercial district, for which it has entered into a lease with an unrelated third party at a market rate. The Foundation is expanding, and its staff requires additional space, actively seeking office space in the local area. One of the Foundation’s directors informs the Executive Director that his son owns a building in the heart of the commercial district and is willing to rent office space to the Foundation at a significantly discounted rate. Aside from the steeply discounted rent, the Foundation would reimburse the director’s son for its share of janitorial services. The Foundation’s Executive Director signs a lease for office space with the director’s son and has paid the necessary deposits.  

On its face, this hypothetical appears harmless. The Foundation stands to gain a significant financial benefit. Although it seems advantageous, this hypothetical contains a number of prohibited transactions under the United States Internal Revenue Code (the “Code”) known as acts of self-dealing. Before I explore why, let’s review the basics.

Self-dealing involves any direct or indirect transaction between a private foundation and a disqualified person that personally benefits the disqualified individual. The rules governing such transactions are meant to prevent insiders from improperly benefiting from the foundation’s assets.

More specifically, section 4941 of the Code imposes an excise tax on any “disqualified person” who engages in self-dealing with a private foundation and any foundation manager involved in such self-dealing. An initial tax of 10% of the transaction amount is applied to the disqualified person, while the foundation manager faces an initial tax of 5% of the same amount. If the self-dealing is not corrected, it results in a second-tier tax of 200% on the disqualified person and 50% on the foundation manager.

What is Self-Dealing?

Under section 4941 of the Code, the following transactions constitute acts of self-dealing. 

1. Sale, Exchange, or Leasing of Property

Any sale, exchange, or leasing of property between a private foundation and a disqualified person is considered self-dealing. 

2. Lending of Money or Other Extension of Credit

The lending of money or other extension of credit between a private foundation and a disqualified person constitutes self-dealing. However, loans without interest or other charges from a disqualified person to a foundation are exceptions if the proceeds are used exclusively for charitable purposes.

3. Furnishing of Goods, Services, or Facilities

The furnishing of goods, services, or facilities between a private foundation and a disqualified person is self-dealing unless they are provided by the disqualified person to the foundation without charge and used exclusively for charitable purposes.

4. Payment of Compensation

Payment of compensation or reimbursement of expenses by a private foundation to a disqualified person is self-dealing unless it is for “personal services” that are reasonable, necessary, and not excessive.

5. Transfer or Use of Income or Assets

 Any transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation is self-dealing. This includes transactions that affect the price of securities to benefit a disqualified person.

6. Payments to Government Officials

Agreements by a private foundation to make payments to government officials are self-dealing, with certain limited exceptions for specific types of payments such as scholarships or awards.

It’s important to understand that the self-dealing rules apply regardless of whether the transaction benefits the private foundation. There is also no minimum threshold—even minor transactions can trigger a violation.

Common Inadvertent Acts of Self-Dealing

Private foundations can inadvertently engage in self-dealing when attempting to operate efficiently or fulfill their charitable mission—often without realizing they’re crossing legal boundaries. Here are five common self-dealing transactions that foundations most commonly run afoul of.

1. Paying personal expenses of a disqualified person
2. Leasing office space from a disqualified person 
3. Loans between a foundation and a disqualified person
4. Excessive or improper compensation to a disqualified person
5. Improper use of foundation assets by a disqualified person

Who is a Disqualified Person?

Generally, a disqualified person regarding a private foundation is anyone or any entity that has significant influence over the foundation’s activities or finances, or who might improperly benefit from the foundation’s assets.

More specifically, section 4946(a) of the Code defines “disqualified persons” (for purposes of the self-dealing rules) as any of the following. 

1. “Substantial contributors” to the foundation. 

2. Owners of more than 20% of the (i) total combined voting power of a corporation, which includes voting power represented by holdings of voting stock, actual or constructive, but does not include voting rights held only as a director or trustee; (ii) profits interest of a partnership; or (iii) beneficial interests of a trust or unincorporated enterprise; if the corporation, partnership, trust or enterprise is a “substantial contributor” to the foundation.

3. Certain foundation managers

4. Family members of any individual described in paragraphs 1, 2, or 3 above. 

5. Corporations, partnerships, trusts, or estates in which persons described in paragraphs 1, 2, 3 or 4 above own more than 35% of the total combined voting power, profits interests, or beneficial interests, respectively.

6. Government officials

Under the Code, a foundation manager is an officer, director, or trustee of a private foundation (or an individual having powers or responsibilities similar to those of officers, directors, or trustees of the foundation). Generally, independent contractors, such as lawyers, accountants, and investment managers and advisors, acting in their respective capacities as such, are not considered officers of the foundation they advise. 

The Code defines “family members” as spouses, ancestors, lineal descendants, and spouses of lineal descendants of substantial contributors, foundation managers, and 20 percent owners. Legally adopted children of an individual are the lineal descendants of the individual under this definition. The notable exception here is siblings. Siblings of anyone in the first three categories are not considered disqualified persons.

Key Exceptions to the Self-Dealing Prohibition

Although the self-dealing rule is broad, there are several important exceptions to it.  These include the following.  

1. A disqualified person can loan funds to a private foundation provided the loan is without interest or charge and the proceeds are used exclusively for charitable purposes. 
2. The furnishing of goods, services, or facilities by a disqualified person to a private foundation is not an act of self-dealing if the furnishing is without charge and if the goods, services, or furnished facilities are used exclusively for charitable purposes. 
3. In addition, the furnishing of goods, services, or facilities by a private foundation to a disqualified person is not an act of self-dealing if such furnishing is made on a basis no more favorable than that on which such goods, services, or facilities are made available to the general public. 
4. A foundation’s sharing of office space, equipment and supplies, support staff, and group insurance with a disqualified person is not an act of self-dealing when the foundation contracts with and pays for such services, etc., directly to lessors and vendors who are not disqualified persons. 
5. Generally, naming opportunities and favorable publicity that benefit a disqualified person due to the private foundation’s payment or grant are considered incidental and tenuous benefits that do not give rise to an act of self-dealing.
6. The payment of compensation (and the payment or reimbursement of expenses) by a private foundation to a disqualified person for personal services that are reasonable and necessary to carry out the exempt purpose of the private foundation is not an act of self-dealing if the compensation (or payment or reimbursement) is not excessive. For example, legal services and investment counseling are considered personal services; however, it is prudent to consult with legal counsel to determine what types of services can be considered personal services.

Correction

The Code allows a private foundation to “correct” an act of self-dealing by undoing the transaction to the extent possible, but in any case, placing the private foundation in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards. Returning to our hypothetical situation, we can now re-evaluate which options would and wouldn’t be considered self-dealing.

The director’s son, who owns the office building, is a disqualified person in relation to the Foundation. Therefore, he cannot rent space to the Foundation for a fee, no matter how favorable the deal might be for the Foundation. Furthermore, the Foundation cannot reimburse the director’s son for the janitorial expenses; this would be considered self-dealing even though it is only paying its share of the expense. Had the Foundation paid its share of the janitorial services directly to the vendor, that may have been allowed. Several individuals and entities, including the executive director of the Foundation, and the son of the director, who owns the building, could face excise taxes.

In Closing

Sometimes doing a good deed isn’t that simple. Given the complex and extensive tax rules that govern self-dealing transactions, foundations and their disqualified persons should proceed cautiously and seek proper tax guidance before engaging in transactions with disqualified persons.

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Basic Legal Principles

The New York Prudent Management of Institutional Funds Act (“NYPMIFA”), the New York version of UPMIFA, took effect on September 17, 2010.  That law made important changes to rules governing the spending of institutional funds and replaced key provisions of the prior statute known as the Uniform Management of Institutional Funds Act (“UMIFA”).  The new law was passed after the 2008-2009 financial crisis, a very difficult period for charities administering institutional funds, and gave nonprofit boards broader authority to spend donor-restricted institutional funds while establishing provisions to ensure that boards exercise their authority responsibly.  

Significantly, NYPMIFA made a few changes to the rules governing the modification or release of donor-imposed restrictions on institutional funds.  These changes are summarized in the guidance provided on the website of the Office of the New York Attorney General (the “Attorney General”), entitled A Practical Guide to The New York Prudent Management of Institutional Funds Act. In this article we focus on a new procedure created by NYPMIFA for lifting or modifying a donor-imposed restriction on the management, investment, or purpose of an institutional fund without donor or court approval when the institutional fund is less than $100,000 in value and has been in existence for more than 20 years. 

Below I outline the steps for releasing or modifying donor-restricted institutional funds that are under $100,000 and older than 20 years, as outlined in section 555(d) of the Not-for-Profit Corporation Law (N-PCL). In brief, if the institution determines that the restriction is unlawful, impracticable, impossible to achieve, or wasteful, the institution may release or modify the restriction, in whole or part, without court approval, after giving written notice to the Attorney General, unless the Attorney General objects to the release or modification within 90 days. It is the view of the Attorney General that such notice must also be given to the donor if available. The organization may proceed to release or modify the restriction if the Attorney General does not notify the institution within 90 days, or if the Attorney General provides its consent. 

Step 1. Identify Eligible “Small and Old Funds”

The institution should identify any donor-restricted institutional funds that are currently less than $100,000 in value and more than 20 years have elapsed since the fund was established. The institution should locate the original gift instrument and any other supporting document that indicates the fund’s age and value. 

Step 2. Determine Whether to Seek Modification/Release

Once the eligible small and old funds are identified, the institution should determine whether the restrictions on any or all of those funds are unlawful, impracticable, impossible to achieve, or wasteful, such as to warrant release or modification of the restrictions in whole or in part. This determination should be made in a careful and prudent manner by the institution’s board in the exercise of its reasonable business judgment, and documented in appropriate detail in the minutes of the board meeting where the decision was made. 

Step 3. Notify Donors 

Once the institution has determined which of the applicable small and old funds warrant release or modification, the institution must contact the original donor, if available, and try to obtain consent to the modification. A donor who is an individual is “available” if the donor is living and can be identified and located with reasonable efforts. There is no requirement to contact an executor or heir of the donor of the fund. If a donor’s current address is unknown, the institution should make reasonable efforts to locate the donor, including Internet searches and contacting known associates of the donor, such as an attorney who represented the donor when the gift was made. The institution should keep a record of its statutory notice to donors and should document the institution’s efforts to locate donors, even if those efforts are unsuccessful. If donor consent is received, the institution can proceed with its intentions without any further action. 

Step 4. Notify the New York Attorney General 

If the original donor cannot be reached or does not consent to the proposed modification, the institution must notify the New York Attorney General of the institution’s intent to modify or release the donor restrictions from the institutional funds. 

The notice to the Attorney General must contain the following. 

1. An explanation of the institution’s determination that the restriction is unlawful, impracticable, impossible to achieve, or wasteful.
2. An explanation of the proposed release or modification.
3. A copy of a record of the institution approving the release or modification.
4. A statement of the proposed use of the institutional fund after such release or modification.

The notice to the Attorney General must be submitted with the following supporting documents.

1. A copy of the gift instrument and other documentary evidence sufficient to show that the fund’s total value is less than $100,000 and that more than 20 years have elapsed since the fund was established.
2. If the donor is available, and particularly if the donor has withheld consent, a copy of any correspondence between the institution and the donor regarding the proposed release or modification.

The notice must also be given to the original donor, if available. The Attorney General has 90 days to review the notification and object to the release or modification. If the Attorney General does not respond within 90 days, or if the Attorney General responds favorably, then the modification or release is deemed approved. 

Given the many specific requirements that must be met to obtain approval for the release or modification of small and old funds, institutions should consider consulting with legal counsel to ensure compliance with the required process. 

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This article answers five key questions about private operating foundation status that can help philanthropists determine if it is the right tax-exempt vehicle for their charitable objectives, including:

• What are the key characteristics of a private operating foundation?
• How does private operating foundation status differ from public charity status and private non-operating foundation status?
• What are the financial tests that must be met in order to maintain private operating foundation status?
• What expenditures are considered “directly for the active conduct of” an operating foundation’s tax-exempt activities?
• What if the organization meets the private operating foundation tests initially, but fails to meet it in a given future year?

(1)  What are the key characteristics of a private operating foundation?

A private operating foundation is a 501(c)(3) tax-exempt private foundation that devotes most of its resources (i.e., earnings and/or assets) toward the active conduct of its tax-exempt activities.  More specifically, a private operating foundation is any private foundation that spends at least 85 percent of its adjusted net income or its minimum investment return (whichever is less) directly for the active conduct of its exempt activities – this is known as the income test.  In addition to meeting the income test, the foundation must also meet one of the following tests: (1) the assets test; (2) the endowment test; or (3) the support test. Questions 3 and 4 of this blog post explain these requirements in greater detail.

A private operating foundation is a type of private foundation because it is funded by one or a few sources, however, since it operates more like a public charity (e.g., by conducting programs rather than focusing primarily on grantmaking), the Internal Revenue Code treats the organization partly like a private nonoperating foundation and partly like a public charity.

When seeking 501(c)(3) tax-exempt status, the default classification is that of a private non-operating foundation. Non-operating foundations must distribute a certain amount of their assets annually to support charitable purposes, but those distributions can be solely in the form of grants to other charitable organizations. Organizations seeking private operating foundation status must affirmatively explain or demonstrate to the IRS at the time of applying for tax-exempt status that they meet or will meet the requirements of private operating foundation status, and must annually provide financial disclosures to the IRS demonstrating that they continue to meet those requirements.[2]

(2)  How does private operating foundation status differ from public charity status and private non-operating foundation status?

Private operating foundations are subject to a number of the same regulations as public charities on a few key matters, which are generally more favorable than the rules applicable to non-operating foundations:

• Greater tax-deductibility of donations than non-operating foundations: Private operating foundations are subject to the more generous donation deductibility limits applicable to public charities (whereas donations to non-operating foundations have lower deductibility limits). Because wealthier donors are sensitive to the deductibility cap, the more generous tax-deductibility limits available to private operating foundations is typically the primary motivation for founder-philanthropists to seek private operating foundation status over non-operating foundation status.
  • Like public charities, cash contributions to operating foundations are deductible up to 60%[3] of a taxpayer’s adjusted gross income (“AGI”) (compared with 30% for non-operating foundations).
  • Like public charities, donations of long-term capital gain property (e.g., artwork; real property) to operating foundations are deductible up to 30% of the taxpayer’s AGI (compared with 20% for non-operating foundations).[4] In addition, the deduction for long-term capital gain property for an operating foundation is typically based on the fair market value of the property on the date of the contribution, whereas for non-operating foundations, the deduction for long-term capital gain property (other than qualified appreciated stock) is deductible only to the extent of the donor’s tax basis in the property.
• Differing requirements with respect to annual distributions: Private nonoperating foundations are required to make “qualifying distributions” (most typically in the form of charitable grants) each year equal to at least five percent (5%) of the fair market value of the foundation’s assets.[5] Non-operating foundations are subject to a tax on their failure to distribute income as “qualifying distributions.” Private operating foundations are subject to a different “qualifying distribution” requirement — they are required to devote most of their resources to the active conduct of tax-exempt activities (instead of through grantmaking), as further discussed in Question 3, below.
• Private operating foundations can obtain grants from private non-operating foundations more easily than non-operating foundations: The federal tax laws make it easier for an operating foundation to receive grants from a non-operating foundation compared to a non-operating foundation grantee.[6]  As such, this more favorable treatment of grants to operating foundations than non-operating foundations is a distinct advantage of operating foundation status over non-operating foundation status.  This benefit might not be that important to all operating foundations because many (and perhaps most) operating foundations are fully funded by their founder(s), and as such, may not be seeking external funding.

Now that we’ve reviewed some of the key “advantages” of private operating foundation status, we should also recognize that operating foundations are still subject to many of the stricter tax regulations applicable to all private foundations, which are not applicable to public charities.  The penalties for violating these rules are in the form of tax penalties.  In some cases, those penalties are significant enough that the restricted activities are effectively viewed as prohibited.  Private foundations (including both operating and non-operating foundations) are subject to the following taxes:

• Taxes on Self-dealing: The taxes on self-dealing are designed to prevent “disqualified persons” (e.g., directors, officers, and managers of the foundation, and their related businesses and family members) from benefiting personally from any transactions that the foundation engages in.[7]
• Taxes on Excess Business Holdings: A significant tax is assessed against any private foundation where the combined holdings of the private foundation and all of its disqualified persons exceeds 20 percent of the voting stock in a business enterprise that is a corporation.[8]
• Taxes on Jeopardizing Investments: Certain excise taxes are imposed on foundations that engage in risky investments, with the goal of discouraging such investments, which may detract from a foundation’s ability to further its charitable purposes.
• Tax on Net Investment Income: Operating foundations are subject to the tax on net investment income and to the other requirements and restrictions that gener­ally apply to all private foundations. [9]
• Taxes on Failure to Distribute Income (generally, grants): As discussed earlier, non-operating foundations that fail to distribute the required annual minimum qualifying distributions are subject to a tax. However, the types of distributions that constitute “qualifying distributions” differ for operating vs non-operating foundations.

(3)  What are the financial tests that must be met in order to maintain private operating foundation status?

To obtain and maintain private operating foundation status, operating foundations must meet a combination of financial tests on an ongoing basis, explained further below.

(Mandatory) Income Test

The one universal requirement applicable to every private operating foundation is that it must spend at least 85% of its adjusted net income or minimum investment return, whichever is less, directly for the active conduct of its exempt activities. This is known as the “income test.”

In addition, all operating foundations must also annually meet one of the following three financial tests: (1) the assets test, (2) the endowment test, or (3) the support test.  These three tests reflect different approaches by which a foundation can devote most of its resources towards the active conduct of its tax-exempt activities.

(a)  Assets Test: A foundation will meet the assets test if at least 65% of its assets:

1. Are devoted directly to the active conduct of its exempt activity, a functionally related business, or a combination of the two,
2. Consist of stock of a corporation that is controlled by the foundation (by ownership of at least 80% of the total voting power of all classes of stock entitled to vote and at least 80% of the total shares of all other classes of stock) and at least 85% of the assets of which are so devoted, or
3. Are any combination of (1) and (2).

Example: Assets such as real property, physical facilities or objects (such as museum artwork that is publicly displayed, classroom fixtures, and research equip­ment) and intangible assets (such as patents, copyrights, and trademarks) are directly de­voted to the extent they are used by the founda­tion in directly carrying on its exempt activities or program. Museums and research organizations are likely to meet the Assets Test.

(b)  Endowment Test: A foundation will meet the endowment test if it normally distributes at least two-thirds of its annual minimum investment re­turn for the active conduct of its exempt activities

Example: An organization whose founder funds the foundation with a significant endowment in the form of cash as well as stocks or other investments held primarily for the production of income, is likely to meet the Endowment Test.

(c)  Support Test: A private foundation will meet the support test if: (1) at least 85 percent of its support (other than gross investment income) is normally received from the general public and 5 or more unrelated exempt organizations; (2) not more than 25 percent of its support (other than gross investment income) is normally received from any one exempt organiza­tion; and (3) not more than 50 percent of its support is normally received from gross investment income.

Example: This test is used by operating foundations that are funded by fairly diverse sources of support (including at least five unrelated exempt organizations) rather than just by their founder-donor, but whose funding sources may not be diverse enough to consistently meet the public support tests required for public charity status. This is the least used financial test for meeting private operating foundation.

To qualify as an operating foundation in a given tax year, a foundation must meet the income test and either the assets, endowment, or sup­port test for any three years during a four-year period (“three-out-of-four-year method”), or based on a combination of all pertinent amounts of income or assets held, received, or distributed during the four-year period (“four-year combination method”). The four-year period consists of the tax year in question and the three years immediately preceding that year.

(4)  What expenditures are considered “directly for the active conduct of” an operating foundation’s tax-exempt activities?

Let’s look more closely at the principle that private operating foundations must devote most of its resources “directly for the active conduct of the activities” constituting the foundation’s tax-exempt purposes.  The following are examples of expenditures that would be considered “directly for the active conduct of the” foundation’s tax-exempt activities:

• Amounts paid to buy or maintain assets used directly in the conduct of the foundation’s exempt activities, e.g., the operating assets of a museum, public park, or historic site.
• Pro rata allocations of staff compensation, travel, overhead costs (office space, supplies) based on a reasonable allocation of use towards direct program activities.
• An amount set aside by a foundation for a specific project, e.g., to buy and restore or build buildings/facilities to be used by the foundation directly for the active conduct of the foundation’s exempt activities, if the set-aside meets certain requirements.

Under certain circumstances, payments or grants to individuals (including scholarships) made in conjunction with ongoing supervision by the foundation and certain grantee reporting requirements may qualify as “active conduct” expenditures.  If a foundation awards grants or scholarships, or makes other payments to individuals (including program-related investments[10], such as to support active programs to carry out its exempt purpose, the payments will be treated as qualifying distributions made directly for the active conduct of exempt activities only if the foundation maintains some significant involvement in the programs. Whether the foundation is considered to maintain significant involvement sufficient for these grants to individuals to be treated as “active conduct” expenditures depends on the facts and circumstances in each case.

Examples of “significant involvement” in a program involving grants to individuals include: (1) a grant program in which the recipients, in addition to independent study, attend classes, seminars, or conferences sponsored or conducted by the foundation, or (2) a grant to engage in social work or scientific research projects which are under the general direction and supervision of the foundation.

If, however, a foundation’s role in the grant process is limited to selecting, screening, and seeking out applicants for grants or scholarships, pursuant to which the recipients perform their work or studies alone or exclusively under the direction of some other organization, such grants or scholarships will not be treated as expenditures made directly for the active conduct of the foundation’s exempt activities.

(5)  What if the organization meets the private operating foundation tests initially, but fails to meet it in a given future year?

For any year in which a foundation that has been approved as qualifying for private operating foundation fails to meet the income test and one of the other three tests in a given tax year, the foundation must report as a non-operating foundation on its Form 990-PF.

The deductibility of contributions to an operating foundation will not be affected until notice of a change in the status of the foundation is made to the public (such as by publication in the Internal Revenue Bulletin), unless, at the time of the contribution, the donor was aware that the IRS would remove the foundation’s operating foundation status, or the donor was responsible for, or was aware of, the act or failure to act which caused the foundation to be unable to qualify as an operating foundation.

[1] Philanthropists who do not have the time, interest, or intention to conduct direct programmatic activities on a continuous basis may find it more appropriate to establish a non-operating foundation or even a donor-advised fund. Note that private non-operating foundations can also conduct direct charitable activities, but are not required to do so.

[2] Public charities must also demonstrate to the IRS that they are not a private foundation, but that is not the subject of this article.

[3] The limitation was previously 50% of AGI, but the limit was temporarily raised to 60% as part of the Tax Cuts and Jobs Act of 2017 through January 1, 2026, but was increased to 100% of AGI for 2020 and 2021 under the CARES Act.

[4] 26 U.S.C. § 170(b)(1)(B). The deduction for long-term capital gain property is typically based on the fair market value of the property on the date of the contribution.

[5] 26 U.S.C. § 4942.

[6] A grant by a non-operating foundation to an operating foundation counts towards the non-operating foundation’s annual minimum qualifying distribution requirement, whereas a similar grant to a non-operating foundation generally would not.  26 U.S.C. § 4942. Note, however, that a non-operating foundation must still exercise expenditure responsibility with respect to grants to most operating foundations, whereas it would not have to do so for grants to public charities.

[7] See IRC §4941. The following transactions are generally considered acts of self-dealing between a private foundation and a disqualified person: (1) sale, exchange, or leasing of property; (2) leases; (3) lending money or other extensions of credit; (4) providing goods, services, or facilities; (5) paying compensation or reimbursing expenses to a disqualified person; (6) transferring foundation income or assets to, or for the use or benefit of, a disqualified person; and (7) certain agreements to make payments of money or property to government officials.

[8] The rules governing excess business holdings were designed to prevent individuals from retaining control of businesses by transferring a significant amount of ownership in the businesses to their private foundation.

[9] Effective January 1, 2020 following enactment of new legislation, the net investment income tax applicable to private foundations is a flat, one-tier rate of 1.39%. This is not an excise tax aimed at restricting any type of transaction, like some of the other taxes, but is simply applicable to all private foundations.

[10] An example of a program-related investment that can constitute the “active conduct of” an operating foundation’s exempt purposes is a low-interest loan program designed to stimulate the local economy and create jobs in an economically depressed area, where the foundation has significant involvement in the form of staff who design, implement, and supervise the program, and the provision of technical assistance and training to borrowers. In that case, the loan funds as well as the expenses of conducting such program would be considered qualifying distributions for the active conduct of the operation foundation’s exempt purposes. See, e.g., PLR 9826048.

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In response to the dilemma faced by many charities during the 2008 recession, which had limited operating income, but large sums in endowments, 47 states adopted some form of the Uniform Prudent Management of Institutional Funds Act (UPMIFA) which, amongst other things, allows charities to draw on the principal of endowment funds under certain circumstances.

Under New York’s version of the uniform law, the New York Prudent Management of Institutional Funds Act (NYPMIFA), institutions can, under certain circumstances, spend endowment funds below their original gift amount (“historic dollar value”) without court approval or Attorney General review, if the institution’s board of directors concludes that such spending is prudent. More specifically, NYPMIFA requires that boards, when deciding whether to appropriate from an endowment fund, must act “in good faith, with the care that an ordinarily prudent person in a like position would exercise under similar circumstances,” and must consider, if relevant, the following factors:

1. the duration and preservation of the endowment fund;
2. the purposes of the institution and the endowment fund;
3. general economic conditions;
4. the possible effect of inflation or deflation;
5. the expected total return from income and the appreciation of investments;
6. other resources of the institution;
7. where appropriate and circumstances would otherwise warrant, alternatives to expenditure of the endowment fund, giving due consideration to the effect that such alternatives may have on the institution; and
8. the investment policy of the institution.

There are situations where an institution cannot spend below historic value without court approval, including when donors specifically explicitly prohibit this type of spending in the gift instrument.

Lastly, an institution may lift or modify a donor-imposed restriction on the management, investment, or purpose of an institutional fund if the fund is less than $100,000 in value and has been in existence for more than 20 years. If an institution determines that such a restriction is unlawful, impracticable, impossible to achieve, or wasteful, the institution may release or modify the restriction, in whole or part, without court approval, after giving written notice to the Attorney General, who then has 90 days to object. If the Attorney General does not notify the institution within 90 days, the institution may proceed with the release or modification.

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1. Can my 501(c)(3) charitable organization conduct an emergency hardship assistance program, even if such assistance was not part of the stated purposes of my organization when it applied for tax-exempt status with the IRS?

With respect to federal tax law considerations, 501(c)(3) organizations do not have to obtain pre-approval from the IRS to provide emergency hardship or disaster relief assistance, including fundraising to make grants for such purpose.  However, if a public charity carries on emergency hardship and disaster relief assistance as one of its three largest programs, it will need to describe those services in the organization’s annual Form 990 filed with the IRS. The organization may also need to report grants and other assistance given to organizations or individuals within and outside the U.S., and noncash contributions received, such as donations of food or other supplies to distribute to families in need.

With respect to state law considerations, organizations should review their statement of legal purposes, as documented in their certificate of incorporation filed with the state in which they are incorporated.  Some organizations draft their statement of purpose very broadly to include any charitable purposes and activities that are permissible under section 501(c)(3) of the Internal Revenue Code (which would include operation of a disaster or emergency hardship assistance program).  However, some organizations draft their statement of purposes narrowly.  If the organization’s legal purposes are drafted narrowly, and would not include the operation of a disaster or emergency hardship assistance program, the organization may need to amend the purposes in its certificate of incorporation to conduct the program.  In addition, organizations should use donations that were previously received for a different charitable purpose for those specified purposes only, and only apply new donations solicited for purposes that include disaster or emergency hardship assistance for that purpose.

2. Can my organization solicit donations to support specific individuals or families in need?

An emergency hardship or disaster relief assistance program cannot be designed to serve any particular individuals, but rather, must be designed to assist a “charitable class.” An assistance program serves a “charitable class” if the group of eligible beneficiaries is either: (1) large enough that the potential beneficiaries cannot be individually identified, or (2) sufficiently indefinite such that the entire community benefits from the charitable assistance.

If the group of eligible beneficiaries is limited to a smaller group, an assistance program will still be considered to benefit a charitable class if the group of beneficiaries is indefinite. For the group of beneficiaries to be indefinite, the program should be open-ended such that the total number of potential members making up the charitable class cannot be counted or identified. For example, if a financial assistance program is designed to benefit families of alumni from a particular college in connection with a current disaster or emergency as well as future disasters and emergencies, the program would be viewed as serving an indefinite charitable class.

3. What kind of documentation must my organization maintain as part of an emergency assistance program?

In general, organizations must maintain adequate records to show that the organization’s assistance, whether in the form of tangible goods, services, or cash assistance, furthered charitable purposes, and that the recipients are needy or distressed.

Organizations providing emergency short-term assistance (e.g., hot food, clothing) to individuals in need of immediate assistance with basic necessities are not required to undertake a needs assessment. The organization should document the criteria for disbursing assistance (e.g., sudden loss of home and/or belongings), date/place of distribution, estimated number of individuals assisted, the charitable purpose intended to be accomplished, and the cost of the aid.

For longer-term assistance, organizations must maintain more detailed records to demonstrate that the organization has conducted an appropriate needs assessment which confirms that the individuals or families are financially in need. Being in financial need does not require individuals to be totally destitute; it is sufficient if they simply lack the resources to obtain basic necessities. An organization’s decision to provide financial assistance should be based on a reasonable determination that the individual’s financial resources, such as available cash, expenses, other financial obligations, assets that can be disposed of without causing further personal hardship, and anticipated cash flow (income, insurance proceeds, etc.), will be insufficient to provide for timely coverage of his/her existing obligations and basic needs.  Longer term financial assistance may include assistance with rent, mortgage payments or car loans to prevent loss of a primary home, utilities payments, and childcare and tuition costs for children.

Documentation relating to long-term assistance should generally include:

• a complete description of the assistance provided,
• costs associated with providing the assistance,
• the purpose for which the aid was given,
• the charity’s objective criteria for disbursing assistance under each program,
• how the recipients were selected,
• the name, address, and amount distributed to each recipient,
• any relationship between a recipient and officers, directors, or key employees of, orsubstantial contributors to, the charitable organization, and,
• the composition of the selection committee approving the assistance.

4. How do we determine the appropriate amount of assistance to provide to families as part of our financial assistance program?

An organization’s decision about how much to distribute to individuals and families in need must be based on an objective evaluation of the individual’s needs at the time the grant is made.  The amount needed to relieve financial hardship and distress should be based on all the facts and circumstances of the individual’s situation and the charity’s resources.  Making an individual whole on account of a disaster or emergency hardship does not, necessarily, further charitable purposes. IRS guidance cautions that an outright transfer of funds based solely on an individual’s involvement in a disaster or without regard to meeting the individual’s particular distress or financial needs would result in private benefit, which is impermissible. Similarly, grants to replace lost income rather than to meet basic living needs would generally be viewed as serving personal and private interests, which is also impermissible.  Adequate documentation should be maintained to justify that the individual grants are appropriate in amount and further charitable purposes.

5. Will recipients of financial hardship funds need to pay taxes on the amounts received from a 501(c)(3) tax-exempt organization?

Financial assistance that a 501(c)(3) tax-exempt organization gives to individuals or families in need for emergency hardship situations are excludible from the recipient’s gross income as a gift under Section 102 of the Internal Revenue Code.

6. Can a public charity, private foundation, or donor-advised fund established by a company provide disaster or emergency hardship assistance to the company’s employees and their families as a result of COVID-19?

Companies can provide disaster or emergency hardship assistance to employees and their families in connection with the COVID-19 outbreak through these charitable vehicles, but as further discussed below, need to structure their programs in ways that do not provide impermissible private benefit to the employer.

Employer-sponsored public charities, which typically receive broad financial report from the general public and are subject to greater transparency requirements, may provide disaster or emergency hardship assistance to their employees and their family members, as long as a related employee does not exercise excessive control over the organization.  Typically, a significant portion of the board of such employer-sponsored public charities are individuals who are not in a position to exercise substantial influence over the affairs of the employer.

Employer-sponsored donor-advised-funds (DAFs) and private foundations are only allowed to provide assistance to employees and their family members if they’ve been affected by a “qualified disaster.” COVID-19 was officially declared a “qualified disaster” on March 13, 2020, so employer-sponsored DAFs and private foundations can provide payments to employees and their family members as long as there are safeguards in place to make sure the payments are for charitable purposes.

Employer-sponsored assistance programs should follow the program requirements discussed above (e.g., support of a charitable class, selection of recipients based on an objective determination of need, and adequate documentation of recipients’ need for assistance). In addition, the selection of beneficiaries must be made using either an independent selection committee or adequate substitute procedures to ensure that any benefit to the employer is incidental and tenuous. The selection committee is considered “independent” if a majority of the members of the committee are not in a position to exercise substantial influence over the affairs of the employer.  Pursuant to statutory restrictions applicable to donor-advised funds, no payment may be made from the DAF to or for the benefit of any director, officer, or trustee of the sponsoring public charity, or members of the fund’s selection committee.

Additional information about providing disaster relief assistance through charitable organizations, including employer-sponsored assistance programs, is available in IRS Publication 3833.

The information provided does not constitute legal advice, and is not intended to substitute for legal counsel.

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Three Key Benefits of Establishing a Corporate Foundation

Provides Consistent Funding for Charitable Programs
A corporate foundation can be a vehicle to build up a charitable reserve in years of higher profits, allowing for a steady flow of charitable grants to organizations in leaner years.[1]  Companies can donate appreciated assets or make a large infusion of cash to establish an endowment. Corporate foundations can be used to fund grants to public charities, pay employee matching grants, or administer scholarship programs for employees’ family members.

When grants are made directly out of a corporate giving department, the funds may be required to be expended during the period for which they are budgeted.  This reduces the control the corporation has over the strategic timing of grants, including support of larger charitable projects.  It should be noted, however, that many companies simply fund their foundation with the same amount as they grant out each year. When considering the compliance obligations that come with the operation of a tax-exempt entity (see below), a company with this type of funding and grant-making strategy may not find that a corporate foundation provides sufficient value vis-à-vis the regulatory burdens.

Accomplishes Strategic Programmatic Objectives
Companies are increasing their focus on issues that align with the companies’ brand(s) and the philanthropic concerns of their customer base.  Financial institutions, for example, may emphasize financial literacy and inclusion issues, while athletic and outdoor gear companies may align their charitable giving towards healthy living and environmental protection initiatives.  In many instances, companies want to not only make strategic grants, but also to operate their own programs that further their charitable objectives. Having a dedicated charitable entity through which the program will operate can help the business maintain its charitable mission focus.

Companies that decide to establish corporate foundations must ensure that they do not use charitable assets to improperly benefit the business.  Companies should review any such initiatives with legal counsel to safeguard against violations of the IRS’s rules prohibiting self-dealing.[2]

Allows One Charitable Entity to Receive Steady Contributions Triggered by All or a Portion of Sales of the Company’s Goods or Services
A number of companies have formed corporate foundations that receive donations triggered by customer sales. Through this structure, the charitable cause becomes part of the brand identity. The IRS, recognizing that payments to charities can, in fact, benefit a business’s bottom line, issued a General Information Letter in 2016, stating that a new group of socially conscious companies formed as “benefit corporations” may treat payments to charitable organizations as a business expense rather than as a charitable donation so long as the payments “bear a direct relationship to the taxpayer’s business and are made with a reasonable expectation of a commensurate financial return.” The General Information Letter therefore clarifies that benefit corporations can take unlimited business expense deductions on their charitable contributions as opposed to limiting such deductions to the standard 10% cap for corporate donations to charitable organizations.

While IRS regulations do provide other advantages that come with the operation of a corporate foundation, such as facilitating employee matching grants and scholarship programs, today, a number of independent public charities exist that manage such programs for companies, obviating the need to form a separate foundation for this purpose.  As such, these charitable programs no longer seem to be key drivers for companies to form corporate foundations.

Three Reasons Companies May Not Want to Establish a Corporate Foundation

Meeting the Compliance Obligations of Corporate Foundations Can Be Costly and Time-Consuming
A corporate foundation is a separate legal entity, whose board members owe a fiduciary duty to act in the best interest of the foundation.  In addition, a separate annual financial report must be filed with the IRS.  Corporate foundations that fundraise, either by being the beneficiary of charitable sales promotions conducted by their founding company, or by soliciting customer donations, may need to register to solicit charitable contributions in up to 38 states, each requiring annual renewal.  The state registration process also requires the foundation to prepare and file audited financial statements, adding to the compliance burden.

Companies should evaluate whether the anticipated annual donations and the sought-after social impact outcomes are significant enough to warrant taking on the cost of compliance.  In many cases, the same results could be achieved through a direct relationship with one or more existing charities, wherein the partner charities are responsible for their own compliance.

The Self-Dealing Rules Can Be Challenging
The IRS prohibits private foundations from engaging in certain financial transactions with certain “disqualified persons,” a category which includes the founding company.  For example, the company’s provision of goods or services to the foundation at a significant discount would be a violation of the self-dealing rules (although donating such goods or services is permitted).  Companies must carefully navigate any financial transactions, including shared expenses, to ensure that the corporate foundation’s charitable assets are not used in a manner that violates the self-dealing rules.

Certain Grants Require Burdensome Oversight Obligations
International grants and grants to non-charitable entities to support charitable activities may be undertaken by corporate foundations, but the federal tax code requires the foundation to follow special grant oversight procedures.  Foreign grants also require additional oversight.  Today, a number of charities serve as charitable giving vehicles through which donors (including corporations) can make such grants, and will undertake the required grant oversight, while the corporation can receive the full tax-deductible benefits. The fees charged by these third party charities to provide grant administration and oversight services may be less than the costs of operating an affiliated foundation, and come with the benefit of staff trained in the IRS’s requirements and best practices for grantmaking.

Companies Can Achieve Their Social Impact Objectives Using Strategies That Work Alongside, or in Place Of, a Corporate Foundation

Direct Corporate Giving
Companies can make direct tax-deductible donations to 501(c)(3) tax-exempt charities, either in the form of restricted gifts (documented through a grant agreement) to support a specific charitable purpose or program, or unrestricted grants. Companies are also uniquely positioned to donate significant volumes of in-kind goods to organizations that will distribute them to individuals, families, or organizations in furtherance of charitable purposes.  Sponsorship agreements allow the company to connect its brand to the brand of a charitable partner and its programs. Many longstanding businesses strategically utilize direct corporate giving alongside the work of their corporate foundation. Walmart recently rebranded the collective corporate giving efforts of the company and its foundation under the new philanthropic name, Walmart.org.

Cause Marketing
Cause marketing campaigns, whereby the company advertises that the sale of its goods or services will result in a donation to a charitable organization or cause, or otherwise engages its customers to take actions to support a cause, can be conducted to benefit an unrelated charity or a company’s own corporate foundation.  Partnering with a reputable independent charity allows the company to benefit from a charity’s strong reputation and proven record of making a real impact on a charitable issue. During the last decade Subaru of America achieved success by donating $140 million to four national charities and hundreds of local nonprofits as part of its annual Share the Love cause marketing campaign.

While less common, a few companies have made their own corporate foundations the beneficiary of cause marketing campaigns, and either fund the foundation’s own charitable program or support other charities addressing specific causes through strategic grants. Since 2000, the Ralph Lauren Corporation has sold a line of pink products to benefit the Pink Pony Fund, a program of the Polo Ralph Lauren Foundation focused on fighting cancer.

Collaborations and Joint Ventures with Established Nonprofits
Companies can collaborate with existing nonprofits to generate social good without forming their own nonprofit entity. This collaborative strategy is increasingly evident in companies’ corporate social responsibility (CSR) reports, which often highlight partnerships with nonprofits as a core strategy for fulfilling their CSR objectives.  Given that nonprofits often have expertise and on-the-ground implementation capabilities on social and environmental issues, this strategy makes sense. In 2015, American Diabetes Association launched a joint marketing and communications initiative with the Hispanic television network Telemundo, aimed at improving overall health and wellness for Latinos in the United States. These types of collaborations are particularly successful because they leverage each partner’s core strengths in order to achieve their shared charitable and social impact objectives.  Companies have also made strategic grants to fund research that will hopefully lead to more sustainable and responsible business practices.

Determining whether a corporate foundation will provide good value for a company ultimately depends on the company’s overall objectives, and should take into account the benefits and challenges of, and alternatives to, operating a corporate foundation.  For this reason, performing a strategic assessment on whether to form a corporate foundation is a worthy upfront investment.

[1] Corporate foundations classified as private foundations under the Internal Revenue Code must distribute a minimum amount annually, equal to approximately 5% of their net investment assets each year, which must be used for charitable purposes, typically in the form of charitable grants.

[2] The IRS has carved out benefits to the company that are “incidental and tenuous” from the self-dealing prohibition, such as through positive goodwill and recognition received by the company arising from the shared name, but how that rule applies in various contexts should be carefully reviewed with legal counsel.

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Newman’s Own Foundation needed the new law to avoid a requirement that it divest itself of at least 80% of No Limit under the “excess business holdings rule” of Internal Revenue Code Section 4943. The excess business holdings rule generally prohibits a private foundation from owning more than 20% of a for-profit company. It imposes extreme penalties on a foundation that are equal to twice the value of the holdings above the 20% limitation. In most cases, this will completely destroy the value of the “excess” holdings to the foundation. The new law creates an exception to the excess business holdings rule for foundations that own 100% of a business and devote all profits to charity.

Foundations that acquire more than 20% of a company normally have a five-year deadline to sell their excess holdings before the penalties apply. Newman’s Own originally faced that deadline in 2013 but was able to get a five-year extension that would have expired this year. The passage of the new law relieves Newman’s Own from the requirement that it divest itself of No Limit, meaning it can continue operating as it always has without interruption.

New law, new rules
The new law, Section 4943(g) of the Internal Revenue Code, permits a private foundation to own 100% of a company under the following conditions:

1. The foundation must own 100% of the shares. There cannot be any other shareholders, and the shares must have been donated to the foundation or acquired in some manner other than by purchase.
2. All profits must go to charity. The company has to distribute 100% of its net operating income to the foundation within 120 days of the end of each fiscal quarter. Net operating income is defined as gross income minus taxes, deductions directly attributable to the production of income, and an amount for a reasonable reserve.
3. The for-profit company is operated independently of the foundation. First, no substantial donor to the foundation can be a director, officer, or employee of the company. A substantial donor is someone who donates more than 2% of the foundation’s total contributions in a given year, and it includes these who donated shares or anything else of value to the foundation, if their donations exceed 2% of contributions to the foundation for the year. Second, a majority of the company’s directors have to be persons who are not also on the foundation’s board. Finally, the company may not make loans to substantial donors of the foundation.
4. Donor-advised funds and some supporting organizations cannot take advantage of the new law. Donor-advised funds and non-functionally integrated Type III supporting organizations are specifically excluded from the new law, thus are still subject to the 20% rule.

The new law, which took effect December 31, 2017, opens a world of possibilities for founders of companies that want to devote all profits from their businesses to charity, allowing them to place their companies under the ownership of a private foundation and permanently devote all profits to charity.

One way to adopt this model is to have the founder or the shareholders donate their shares to a foundation. They get a tax deduction for the value of their shares, but no buy-out. Since this is a gift, not a purchase, donating the shares satisfies the requirements of the new rule. The donations can happen anytime or even over time, but the new rule does not apply until 100% of the shares have been transferred to the foundation.

Under the new law, a total separation of the two entities is not required. The for-profit company will continue to be governed by its own board and managed by its own managers, with appropriate separation from the foundation. The new law permits the foundation, as the sole shareholder, to appoint the board, and the foundation may also hold other rights, depending on the jurisdiction where it was formed. For example, in many states, a sole shareholder has the right to inspect the books and records of the company and to sue the directors for breach of fiduciary duty (including the duty to pursue a social mission, if the company is a benefit corporation.) The shareholder may also reserve to itself the right to approve mergers, sales of assets, dissolutions, and to veto other fundamental decisions.

Profits of the business will be up-streamed to the foundation in the form of after-tax corporate dividends or, in the case of a pass-through LLC, as partnership distributions, in which case the tax on unrelated business income may apply.

We are sure to see a growing number of private foundations take ownership of profitable businesses as a result of this new law. It also offers another option for founders of mission-oriented companies who want a philanthropic exit that locks mission into the company on a permanent basis.

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Questions

In order to obtain tax-exempt status, charities cannot spend a substantial part of their activities attempting to influence legislation (aka lobbying). This means charities are allowed to lobby, but only an insubstantial amount. But what is or is not lobbying? Can an exempt organization escape the lobbying limitation if it opposes an Executive Order? What if the charity urges its supporters to call their senators to oppose a cabinet nominee? Can a charity support the organization of a march that supports its charitable mission?

The Rule

A charity can engage in advocacy around its core causes, but has to be cautious when its advocacy places the charity in the position of supporting or opposing legislation or nominees. The IRS prohibits organizations exempt under section 501(c)(3) from being organized or operated as “action” organizations. Generally this prohibition requires exempt organizations to spend an insubstantial amount of time and resources to lobbying. Unfortunately, there is no clear definition of “substantial” or “insubstantial” in the eyes of the IRS. So while a charity may lobby, the line between the safe amount of advocacy and too much lobbying can sometimes be hard to draw. The rules are stricter for private foundations – any time or resources spent on lobbying or political activity by a private foundation is considered a taxable expenditure.

Some types of lobbying are easy to identify. If a charity contacts their senator or representative to urge a vote in favor or against a particular bill, the charity is engaged in direct lobbying. If the charity encourages its supporters to take action in favor or against a particular piece of legislation, the charity is engaged in grass roots lobbying. Direct and grass roots lobbying are subject to the IRS’s rules on lobbying.

Cabinet and Judicial Nominations

At first glance, a cabinet or judicial nomination might not seem like “legislation.” Charities might think they are allowed to contact their legislators about nominees, or urge supporters to do so, without considering those activities as lobbying. But under long-standing guidance, the IRS considers a legislature’s advice and consent on the nomination process for cabinet appointees and federal judges to fall within the definition of “legislation.” Therefore, if a charity attempts to sway a legislator in favor or against a cabinet or judicial appointee (either directly or via public opinion), the charity is engaged in lobbying. In the case of a private foundation, such lobbying will trigger a tax liability.

Executive Orders

An Executive Order, on the other hand, is outside the legislative process. A charity can attempt to rally support for or opposition against an Executive Order without triggering the restriction on lobbying so long as it does not urge lawmakers to pass new legislation in response to the order. This applies equally to public charities and private foundations.

Marches & Rallies

In recent weeks numerous high-profile marches and rallies were organized around the country in support of or opposition to a number of causes. Some were in response to particular actions by the Executive Branch, while others were organized to support women’s rights, immigrants’ rights, or refugees’ rights. Where a march furthers a charity’s exempt purpose it is not lobbying. Consider a pro-environment march organized by a charity whose mission involves protecting the environment – the expenditures by the charity will further the charity’s mission, and are entirely appropriate. So long as a march or rally is not in support of or opposition to legislation, or a particular candidate for political office, the charity’s activities will not be subject to the lobbying or political action restrictions imposed by the IRS. As noted above, a march or rally in response to an Executive Order would not be considered lobbying, since an Executive Order is not legislation.

We Lobbied or We Want to Lobby– Now What?

If a 501(c)(3) already lobbied, or it wishes to lobby in the future, there are a few steps the organization should take. The first is to set up accounting and bookkeeping procedures that ensure all expenditures on lobbying activity are clearly accounted for. A public charity may choose to make a 501(h) election which will provide a fixed limit on what the charity can spend on lobbying. While the 501(h) election imposes a limit, it also acts as a safe harbor – the charity knows exactly how much it can spend on lobbying activity. Under 501(h), a charity may use up to 20% of the first $500,000 of its exempt-purpose expenditures to lobby – the limit increases depending on the size of the charity’s expenditures on charitable activities.

Charities should note that the 501(h) election only applies to the money spent on lobbying activities. If the charity has very cost effective methods of lobbying (such as rallying support on social media), it will be able to engage in a significant amount of lobbying activity.

A public charity also has the option to forego the 501(h) election. The charity would then be subject to the “insubstantial part test.” The test examines whether the charity’s lobbying activities are “substantial” or “insubstantial”, the vague standard set by the IRS.

Get Help

In today’s political climate, many charities find themselves confronting challenging questions regarding lobbying and political activity. While some of these questions have straightforward answers, others require careful consideration. A charity’s decisions around lobbying and political activity have potentially significant consequences, ranging from possible taxes to loss of exemption.  If you have any questions regarding lobbying or political activity, consultation with a legal professional may be a good idea.

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