Skip to main content

The rules and regulations that govern private foundations can be complicated and time consuming to have to parse through—and no one understands this more than Foundation Source’s Chief Legal Officer Jeffrey Haskell. As a trusted advisor to high-net-worth clients who are charitably inclined, you may be fielding questions that sometimes fall outside your area of expertise.

“The flexibility, creativity and nearly endless giving capabilities offered by a foundation do come with a dose of administrative complexities,” said Jeff. “It can be challenging for foundations to keep pace with government regulations, which are always changing, as well as IRS filings and the required paperwork.”

To save your time (and sanity), we’ve rounded up the top three rules that can help your philanthropic clients steer clear of compliance trouble.

#1 Foundations’ annual minimum distribution requirement (MDR) must be calculated carefully.
Generally, a private foundation is required to distribute 5 percent of the average value of its investment assets for the previous year. The IRS prescribes a specific method for averaging a foundation’s securities and the balances in its savings and checking accounts on a monthly basis. The 12-month average allows for market fluctuations over the year. Special rules apply to the valuation of real estate and all other assets. These calculations can be complex. When performed incorrectly, as is often the case, they can result in under or over payment. The former can result in penalties and the latter can take assets from future grants or commitments. For these reasons, special care must be taken when determining the 5 percent requirement.

Grants to qualifying organizations and all reasonable administrative expenses necessary for conducting a foundation’s charitable activities – other than investment management or custodial fees or bank charges – count as qualifying distributions toward satisfying the annual 5 percent payout requirement. Reasonable administrative expenses may include office supplies, telephone charges, consulting fees, certain legal and accounting fees, training and professional development, employee compensation, publication of the foundation’s annual report, and modest travel expenses associated with foundation business.

#2 Unrelated business taxable income (UBTI) will be taxed at the for-profit rates.   
Unrelated business taxable income (UBTI) is commonly associated with revenue that a charity generates through an activity that has no direct connection with its charitable mission. An example of this is income generated by an asset, such as a piece of real estate or a for-profit business, owned by the foundation. To the extent that a foundation has UBTI, it must be taxed as if it were a for-profit organization. The UBTI rules were enacted to ensure that nonprofit, charitable organizations do not compete with for-profit companies, gaining an unfair competitive advantage. Foundation staff often don’t realize that if a foundation borrows money (for example, on margin) to purchase an investment asset (not related to performing its charitable activities), some or all of the income flowing from that asset will usually be deemed UBTI.

In addition to paying taxes at a for-profit tax rate, a private foundation with significant UBTI must also file an additional tax return, Form 990-T, along with its 990-PF. Many professional advisors counsel their foundation clients to avoid engaging in activities that would generate UBTI, unless the potential for profit is considerable.

#3 The tax status of charities must continually be validated.  
Just because a charity attained tax-exempt status from the IRS at one time does not mean that it maintains that status. For example, if the charity does not continue to maintain its broad public support, it may be reclassified by the IRS as a private foundation.

The IRS lists all tax-exempt organizations in IRS Publication 78. (However, some organizations that are considered public charities, such as schools, houses of worship, and instrumentalities of the government, such as parks and municipalities, aren’t listed in this publication.) Foundations may make grants to public charities listed in this publication without exercising “expenditure responsibility,” a multi-step process to ensure that grant funds will be used for a charitable purpose only.

But what if the charity’s status had been revoked in an Internal Revenue Bulletin issued since the date of the last publication? If a private foundation makes a grant to an organization that is not a public charity in good standing with the IRS, and does not exercise expenditure responsibility, the foundation may be subject to a penalty, and the grant will not count toward satisfying its annual distribution requirement.

Want to See the Other Top 7 Compliance Rules for Private Foundations?
Check out the complete article as featured on the Family Wealth Report.

Learn More About How We Support Advisors
Schedule a call or reach us at 800-839-0054 to learn how we can best support your clients who are passionate about giving. Together, let’s #begiving.

Back to Blog