Report Of Task Force on Revision and Simplification of Rules

Exempt Organizations Committee
Section of Taxation
American Bar Association

This draft report represents the views of the individuals who prepared it and has not been approved by the House of Delegates, Board of Governors, or the Tax Section of the American Bar Association. Accordingly, it should not be construed as representing the policy of the ABA or the Tax Section. The principal authors, Dick Gallagher and Bob Ferguson, welcome comments and can be reached at rgallagher@foleylaw.com and fergub@IX.netcom.com, respectively.

The Task Force

This report, prepared by a task force of the Exempt Organizations Committee of the Section of Taxation of the American Bar Association, summarizes some of the more important differences between the tax treatment of “private foundations” and “public charities.” In appropriate cases, the report makes recommendations for modifications of the Code and Regulations where the effect would be to simplify and improve the existing regime.

This report represents the consensus view of the members of the task force: Richard S. Gallagher, Chair, Betsy Buchalter Adler, Victoria B. Bjorklund, Paul H. Feinberg, Robert H. M. Ferguson and Douglas N. Varley.¹ It also reflects informal discussions among other members of the Exempt Organizations Committee following summary presentations of the task force’s proposed recommendations at the fall 2000 and midwinter 2001 meetings of the Committee in Los Angeles and Scottsdale. Several members of the task force would have preferred to deal with issues that are not touched on in the final version of this report, but the majority of the group thought it preferable to limit the subject matter to those provisions that were most badly in need of revision and were most likely to receive positive consideration by tax administrators and legislators.

Organization of This Report

This report briefly describes the origins of the “private foundation” provisions included in the Tax Reform Act of 1969, the principal modifications to those provisions, the extension of certain of the provisions (most notably a form of prohibition against “self–dealing”) to organizations that are not private foundations, and the current definition of how an organization becomes classified as a “private foundation” (or, more properly, how an organization becomes classified as one that is not a private foundation since a § 501(c)(3) organization is deemed to be subject to the private foundation rules unless it satisfies certain criteria included in the statute).

The current private foundation tax rules motivate compliance by imposing a series of excise taxes on violations of the rules. The definition of “disqualified persons,” including “substantial contributors,” is key to an understanding of some of the most important private foundation rules because the rules prohibit many transactions between a private foundation and “disqualified persons” and also compute the amount of permitted ownership in a business enterprise by reference to the percentage ownership in that business enterprise by “disqualified persons.” In addition, whether an organization is defined as a private foundation in the first place depends in some cases on the level of support from or relationships with such “disqualified persons.” Accordingly, this report first discusses current definitions of “disqualified persons,” including “substantial contributors,” and then recommends changes to those definitions.

The report then deals with the statutory exclusions from the definition of “private foundation” and makes recommendations with respect thereto, especially with respect to the exclusion contained in § 509(a)(2). Section 507 contains provisions for a “termination tax” unless a private foundation goes out of business in a particular way. The report comments on the uselessness of this provision and the administrative advantages of repealing it and ending the countless and needless private letter ruling requests that have resulted from its continuation.

Finally, the report discusses each of the substantive provisions of Chapter 42 contained in §§ 4940 through 4945 (the excise tax on investment income, the self–dealing rules, the minimum distributions requirements, the limitations on investment holdings in a particular business enterprises, the rules against making imprudent investments [including a discussion of permitted “program–related investments”], and the limitations on expenditures by private foundations for grants to individuals or other organizations [including foreign grants] as well as lobbying). The report does not deal with issues of deductibility of contributions, as that subject was deemed to be outside the scope of the assignment given to the task force.

Historic Background

The Tax Reform Act of 1969² created Chapter 42 of the Internal Revenue Code, dealing extensively with “private foundations.” These provisions, which were enacted in response to perceived abuses, created a series of penalty excise taxes to limit, and in some cases prohibit, certain actions by private foundations, as well as transactions between these foundations and their “disqualified persons.” These provisions have remained largely unchanged for more than 30 years.

Definition of “Private Foundation”

Although the term “private foundation” has been a generally understood phrase for over half a century, it did not become a defined term in the Code until the enactment of § 509(a) in 1969. As so defined, the term includes any charitable organization described in § 501(c)(3) other than an organization described in:

The above–described organizations are referred to a “public charities” (although this term does not appear in § 509).

The task force concluded that there are three areas that have proven especially troublesome over the years and where changes in the statute defining public charities should be made.

The first area involves the “support” requirement under § 509(a)(2). That part of the definition provides that in order to qualify as a § 509(a)(2) public charity, an organization must —

The receipt requirements quoted above are considerably, and in our view needlessly, more restrictive than the analogous provisions defining “publicly supported charities” (also referred to as “public charities”) in § 170(b)(1)(A)(vi). Because this latter section requires only that “a substantial part” of the organization’s support be derived from public sources, the regulations are free to provide for a “facts and circumstances test,” under which public support is permitted to fall to as low a level as 10% as long as the organization’s governing board and method of operation are sufficiently publicly oriented to ensure responsiveness to public rather than private interests. In addition, under § 170(b)(1)(A)(vi), government support is counted as “public” without limitation, whereas under § 509(a)(2) receipts from governmental bureaus or agencies from the performance of services and certain other activities are excluded as “public” support to the extent that they exceed the greater of $5,000 or 1% of the organization’s total support in any given year. Based on years of experience with organizations meeting the general ambit of § 509(a)(2), the task force is convinced that there is no basis for treating these kinds of government receipts as “suspect” or for limiting the extent to which they qualify as receipts from truly “public” sources. Finally, unlike § 509(a)(2), which disqualifies all support received from disqualified persons, § 170(b)(1)(A)(vi) permits contributions from disqualified persons to be included in the numerator of the organization’s public support fraction to the extent that contributions from any such person (and his or her spouse) do not exceed 2% of the organization’s total support during the applicable measuring period. Once again, it is our view that there is no justifiable basis for treating § 509(a)(2) organizations differently, and that the inclusion of support received from disqualified persons, limited to the same extent as under § 170(b)(1)(A)(vi), would be both appropriate and desirable.

2. Investment Limitation

A second problem area is the limitation currently imposed under § 509(a)(2)(B), which disqualifies any organization that normally receives more than one–third of its support from investment income and net (after–tax) income from an unrelated trade or business. Although it is true that most organizations that currently qualify as “publicly supported” under § 509(a)(2) will receive the majority of their income from the performance of their exempt functions, there seems no reason to deny that status to an organization simply because it is fortunate enough to have a large endowment. Under the current statutory framework, an organization in that situation, subject to Treas. Reg. § 1.509(a)–5(b), still can qualify for publicly supported status by transferring its endowment to a separate organization that qualifies as a “supporting organization” under § 509(a)(3). Forcing an organization to pursue such an escape route serves no worthwhile purpose; as long as the “supported” organization meets the numerical tests of § 509(a)(2)(A), it ought not to matter that as much as two thirds of its support is in the form of “contributions” derived from the endowment of the supporting organization. If this simplifying change is adopted, we believe that it would not be inappropriate to retain the limitation that currently exists with respect to net income from an unrelated trade or business.

3. Healthcare Holding Companies

A third problem area related to the definition of what is and is not a private foundation arises in part as the result of the recent reconfigurations that have taken place in the field of nonprofit healthcare. As a result of these transactions, families of affiliated healthcare organizations frequently end up under the control of a single parent organization (or “holding company”) which, while clearly serving a public function, may meet none of the technical definitions necessary to escape the definition of “private foundation” under § 509(a). In addition to curtailing the effectiveness of these holding companies as fund–raising vehicles, this statutory anomaly also creates an undesirable disparity between healthcare systems dominated by religious organizations, which are frequently exempt from private foundation status because of their church affiliation, and those systems that are not.

Definition of “Disqualified Person”

There are three major inconsistencies between the manner in which the term “disqualified person” is defined for purposes of the private foundation provisions under Chapter 42 of the Code and for purposes of excess benefit transactions by public charities under § 4958. The statutory formulation under § 4946 deals with specifics, including in the definition “substantial contributor” (itself a defined term), foundation manager, family members of either of both these persons, 35%–controlled entities, affiliated private foundations (solely for purposes of § 4943), and government officials (solely for purposes of the compensation provisions of § 4941). Section 4958, on the other hand, approaches the definition with the vaguer standard of “any person who was, at any time during the five–year period ending on the date of [the offending] transaction, in a position to exercise substantial influence over the affairs of the organization,” and then adds family members and 35%–owned entities of such persons.

For the reasons given below, we recommend that (with the exception of the treatment of siblings of disqualified persons) these inconsistencies be resolved.

1. Substantial Contributor: The § 4946 definition of “substantial contributor” includes any person who, as of the end of any year after 1969, had contributed the greater of $5,000 or 2% of the total support that a foundation has received through the end of such year. Once a person is caught by that definition, even if it occurs at the end of only a single year, he or she is a substantial contributor for all time. Based on more than three decades of experience in representing private foundations, we are convinced that these numerical limitations are far too strict. We therefore recommend that the definition be relaxed so that anyone who has given less than $50,000 or 5% of a foundation’s total support (if that figure is greater than the applicable dollar amount) not be included. The idea that anyone giving a lesser amount would be in a position to (or want to) take advantage of the donee is, in our view, too unlikely to warrant statutory protection. We also believe that the permanence of the definitional stigma is unreasonable and recommend that § 4946 be amended to incorporate the five–year principle currently found in § 4958, i.e., once the contributions that create the “substantial contributor” status are more than five years old, the donor ceases to be a “disqualified person” by reason of such gifts.³

2. Family Members: The stigma of the disqualified person definition also attaches to the “family members” of such person, a term that includes spouses (whether or not widowed or divorced and, if widowed or divorced, whether or not remarried) and four generations of descendants and their spouses. However, unlike § 4958 and for reasons that are unexplained in the applicable legislative history, siblings are not included. We believe that the inclusion of divorced spouses (whether or not remarried) and widows and widowers who are not ancestors (i.e., where there are no descendants who are disqualified persons because of their relationship with the deceased substantial contributor) in the category of disqualified person is unreasonable and should be changed. However, we view siblings somewhat differently. If we were starting from a clean slate, we should recommend that § 4946 be expanded to include siblings as § 4958 now does. The slate is not clean however. Private foundations, especially those with interests in complex investment partnerships, have made painstaking compilations of their disqualified persons, including all of the family members of substantial contributors many of whose gifts were made close to a century ago. To revise those lists at this point to include all of the nieces, nephews and other relations that would be required by the inclusion of “siblings” in the definition would be patently unreasonable. We therefore recommend that § 4946 not be amended to include siblings.

3. Government Official: Section 4941(a)(1) provides that, for purposes of § 4941 only, the definition of disqualified persons includes certain government officials as defined in § 4946(c). In contrast, § 4958 defines disqualified persons to include only those persons who have substantial influence over the organization and, consequently, does not specifically include transactions between a public charity and a government official as such within the set of transactions that are potentially subject to penalty tax. The legislative history of § 4941 suggests that Congress was responding to a few isolated instances of private foundations providing funds to senior officials within the federal government when it decided to treat government officials as disqualified persons.

The inclusion of government officials within the definition of disqualified persons creates a trap for the unwary because foundation managers generally understand the self–dealing rules to be about policing insider dealings, not transactions with unrelated third parties. As such, this aspect of the rule creates confusion and risks generating inadvertent violations of the statute, as for example, when a foundation pays a government official an honorarium on the same basis as other participants in a conference or symposium. Further, under the current regulations, the definition of “government official” is frequently confusing and, in many cases, requires an uncertain facts and circumstances analysis of whether the official in question performs a “policy making function.” Consequently, compliance with this aspect of the self–dealing rule requires considerable administrative effort for those foundations that invite experts from government to participate in their charitable programs.

The task force believes that the rule prohibiting transactions between foundations and government officials has out–lived its usefulness and should be repealed. The comprehensive ethics rules the House and Senate impose on their members prohibit many of the same transactions picked up by § 4941 and require public disclosure of many others. Consequently, a majority of the task force believes it more appropriate and more efficient to rely on these rules — and similar rules that apply to administrative officials and to state officials — to regulate transactions between foundations and government officials. If the provision is retained, then the task force recommends that the regulations interpreting § 4946 be modified to provide a simple, bright–line definition of the term “government official” that foundation managers can apply easily.

Section 507: Termination Tax

The § 507 “termination tax” applies when a foundation “terminates private foundation status.” This provision was, in 1969, the cousin of a proposed requirement that foundations lose their exempt status if they existed for more than 40 years. The “termination tax” provisions were intended to prevent a foundation that had been in existence for 39 years from distributing its assets to another foundation that had just been created.

The 40–year termination requirement was not enacted, but the termination tax provisions which dovetail with that requirement were retained. As a result, the § 507 termination tax has taken on a life of its own that serves no purpose whatever.

The task force recommends the § 507 termination tax be repealed in its entirety, but that the carryover attribution rules for successor foundations be retained for purposes of other Chapter 42 requirements.

Section 4940: Investment Tax on Investment Income

Section 4940 imposes a 2% tax on the net investment income of private foundations. Net investment income for these purposes includes interest, dividends, rents, payments with respect to security loans, royalties and capital gains, less associated expenses. The tax rate can be reduced from 1 to 2% if the charitable expenditures of the foundation equal or exceed the average of such expenditures, expressed as a percentage of investment assets, during the preceding five years plus an amount equal to one–half the otherwise applicable tax on investment income. The philosophical intent of this provision, which is relatively complicated, is to permit a reduction in the tax if charitable expenditures are at least equal to the average of the preceding five years and the 1% tax “savings” is passed along to charitable beneficiaries.

As originally conceived, the revenues generated by the § 4940 tax were to provide the funding necessary for the Office of Employee Plans and Exempt Organizations (now the Tax Exempt and Government Entities Division) of the Internal Revenue Service to supervise the operations and examine the returns of all organizations exempt from taxation under § 501(a).⁴ Notwithstanding the relatively clear directions to this effect in former § 7802(b) and the legislative history of the 1969 Act,⁵ the required cooperation of the budget writing committees of Congress was never obtained and the funds generated by this tax have never been allocated for the intended purpose but have simply gone into the coffers of the U.S. Treasury to be used for general purposes.

The investment income tax should be repealed. It is the consensus of the task force that the tax on investment income should be repealed. During the more than three decades that it has been in effect, the only practical consequence of this tax has been to make private foundations the sole category of “tax–exempt” charitable organizations whose investment income is subject to tax (absent applicability of the debt–financed income provisions under the unrelated business income tax). The initial premise of the tax — to make the endowments of private foundations the source of funding for the Internal Revenue Service’s oversight of the exempt organization community — was questionable at best, but now that it has been established beyond any reasonable doubt that the revenues generated by this tax will never be made available for that purpose, there is no basis for extending it. The charitable accomplishments of private foundations are no “less worthy” than those of public charities. There is no good reason for taxing their endowments differently from those of hospitals, universities and community foundation trusts.

If the tax on investment income is not repealed, then it is the view of the members of the task force that the following simplifications should be made to the tax:

Alternative A: Consider replacing the tax on investment income with a true excise tax imposed annually on the value of a private foundation’s investment assets. Calling the current tax an “excise tax on net investment income” is a disingenuous and ineffective attempt to obscure the fact that the tax imposed by § 4940 is in fact an income tax. The task force believes that this inaccuracy could be corrected and that the tax could be greatly simplified by restructuring it as an annual excise tax of, say, 0.05% on the value of a foundation’s net investment assets.⁶ An audit–fee tax in this form was in fact reported out by the Senate Finance Committee in 1969,⁷ but it was converted back to an income tax by the Conference Committee.

Alternative B: If the tax is retained as an income tax, the following simplifications and revisions should be made:

1. Reduce the tax rate to 1%. The computations and planning necessary to qualify for the 1% tax reduction are overly complicated. Moreover, for those foundations that actually take the trouble to qualify, the tax reduction frequently serves as a deterrent, deferring charitable expenditures to future years where the foundation, left to its own devices, would accelerate distributions to the current year.⁸ The current U.S. Treasury proposal to reduce the tax to a flat 1.25% rate takes cognizance of the fact that for many smaller private foundations, the computational game simply is too complex and costly, but the proposal fails to take into account that for many larger foundations with the staff and expertise necessary to qualify for the reduction, the proposal would result in a 25% increase in the tax actually paid.⁹ Tax simplification ought not to result in an arbitrary increase in rates. If a reduction to a flat rate is enacted, then the rate should be no greater than 1%.

2. Exempt smaller foundations by establishing a minimum income floor that is not subject to tax. For many small private foundations, the net investment income tax is more of a nuisance than a financial hardship. For this reason, the tax force recommends that a simplifying provision be added exempting the first $250,000 of a private foundation’s net investment income from the tax.¹⁰ An additional provision making no more than one exemption applicable to any group of related foundations may be necessary to prevent abuse.

3. Provide that for purposes of computing gain or loss, the basis of contributed assets be fair market value at the time of contribution. As currently administered, the tax basis of contributed assets disposed of by a private foundation is governed by § 1015 of the Internal Revenue Code, which provides that for purposes of computing gain, a foundation is to use the donor’s basis, and for purposes of computing loss, the basis is the lower of the donor’s basis or fair market value at the time of gift. Although there is ample justification for these rules in the case of donees who are subject to individual or corporate income taxes, the provision seems needlessly harsh and adds undesirable complexity when incorporated into a 2% excise tax on organizations that are otherwise exempt from income tax. Accounting principles generally applicable to tax–exempt organizations require that contributed property be entered on the donee’s books at value at the time of contribution. There is no good reason for requiring a different treatment for tax purposes.

4. Permit the use of capital loss carryforwards. For reasons that have never been adequately explained, private foundations are not permitted to carry forward and apply unused capital losses against future years’ capital gains. There is no justifiable reason for treating private foundations differently from other taxpayers in this regard.

Suggested Revisions Applicable to Both Alternatives A and B: If either Alternative A or Alternative B, above, is adopted, the task force believes the following additional revisions to be desirable:

1. Raise the floor for requiring payment of estimated taxes from $500 to $5,000. Once again, the current floor is too low, introducing an element of undesirable complexity and needlessly adding to the time and administrative expense of operating a private foundation.

2. Repeal the exception for exempt operating foundations. If the investment income tax imposed by § 4940 is not repealed, then it should apply to all private foundations equally. The exception currently provided in § 4940(d) for “exempt operating foundations” has no logical rationale and appears to be nothing more than a “special interest” loophole. It should be repealed.

Section 4941: Self–Dealing

Section 4941 imposes excise taxes on “disqualified persons” who engage in “self–dealing” transactions with private foundations.¹¹ Included among the transactions that give rise to these penalty taxes are sales, exchanges, leases, loans and the furnishing of goods, services and facilities between a private foundation and a disqualified person, and the payment of compensation or the reimbursement of expenses by a private foundation to a disqualified person. Exceptions are provided where a disqualified person makes a loan or furnishes goods, services or facilities to a foundation free of charge and where the private foundation pays reasonable compensation to, or reimburses the expenses of, a disqualified person (except for a special category of disqualified person known as “government officials”) in connection with the performance of personal services that are reasonable and necessary to the exempt activities of the foundation.

If a transaction results in an act of self–dealing, there are two sanctions imposed on the disqualified person who participates in the transaction: The first is an excise tax imposed at the rate of 5% of the “amount involved” for each year beginning with the year in which the transaction took place and continuing until the act is corrected. The second sanction, frequently more severe than the first, is that the disqualified person must undo (i.e., “correct”) the transaction in a manner that places the foundation in a position no worse than it would have been if the disqualified person were dealing under the highest fiduciary standards.

Because of the distrust with which private foundations and their disqualified persons were viewed at the time of the passage of the 1969 Act, Congress chose a statutory regime of “bright line prohibitions” which imposed sanctions on any of a number of acts, without regard to whether any particular transaction was harmful (or for that matter beneficial) to the private foundation. By contrast, the more recent “intermediate sanctions” provisions that regulate transactions between public charities and their disqualified persons¹² permit all such transactions to occur, as long as they meet an arm’s length standard of fairness. In addition, § 4941 singles out “government officials” as a separate category of disqualified persons, while § 4958 makes no such distinction. This is another difference that may be explained solely by the legislative atmosphere at the time the two provisions were enacted.

As a general proposition, the task force believes that it would be preferable that a single standard apply to the limitations imposed on both private foundations under § 4941 and public charities under § 4958. Both sets of limitations were directed at the same situation — protecting the charitable organization from those who are in a position to take unfair advantage of it. Once it is determined that the power to exert substantial influence exists, it’s difficult to understand why one group of charities should be governed by an “arm’s length” standard of fairness and the other subject to a set of bright line prohibitions. There are those who would argue that bright line prohibitions are easier to administer than a fair market value standard. However, others are convinced that ease of application is insufficient justification for a statutory system that is frequently arbitrary and so contrary to what most understand to be ethically required that it becomes a trap for the unwary. Indeed, in many situations, including the furnishing of goods and services and the sharing of goods and services furnished by unrelated third parties, the effect of the bright line prohibitions is to prevent private foundations from adopting courses of action that are advantageous to them and to the fulfillment of their charitable programs. Nevertheless, it must be acknowledged that in a small number of situations, such as a sale or lease of property for which there is no public market, an arm’s length standard may be insufficient to protect the charity from an unscrupulous steward. In these situations nothing less than an outright prohibition may be necessary.

With these considerations in mind, the task force recommends that § 4941 be amended to ameliorate its current harshness as follows:

1. Alternative A: adopt an arm’s–length fairness standard for those transactions that could clearly be shown to be beneficial to the private foundation (e.g., rental of office space at or below market rates from a disqualified person), while retaining a bright–line prohibition for those transactions that cannot be shown clearly to benefit the private foundation (e.g., a forced sale or lease of real or personal property for which there is no public market, or the extension of credit by the private foundation to disqualified persons); or Alternative B: give the Internal Revenue Service the authority, either in advance in a ruling or retrospectively on audit and/or upon request by a private foundation, to authorize a waiver for a particular transaction that can be shown to be or to have been favorable to the private foundation. The law should require the Internal Revenue Service to exercise this authority when it is demonstrated that no harm has occurred or will occur.

2. Add to § 4941 an abatement procedure, the need for which would be reduced or eliminated by the enactment of Alternative B above.

3. Add to § 4941 the ability to calculate the self–dealing penalty, not by reference to the “amount involved” but, in cases of inadvertent or harmless self–dealing by reference to the excess, if any, above the fair market value. Thus, for example, in Rockefeller v. U.S., 572 F. Supp. 9 (8th Cir. 1983), the penalty would have been calculated not on the full value of the stock but on the difference between the fair market value between the taxpayer’s expert appraiser and the fair market value as finally determined by the Tax Court.

In addition, it is the consensus of the task force that the exceptions to self–dealing should be expanded to permit administrative expense and office sharing in a manner more flexible than that permitted under current law.¹³

Section 4942: Expenditure Requirements; Definition of “Operating Foundation”

The task force has intentionally refrained from making any recommendation regarding the annual minimum distribution requirement, currently 5% of average asset value. The task force notes that the requirement adopted in 1969 was the greater of adjusted net income or a minimum investment return (percentage of annual average asset value), but that this requirement was subsequently changed to the current requirement that the annual distribution/expenditure must be at least 5% of average asset value (less the amount of the excise tax on investment income for the year). There are those who argue that the current percentage requirement is too low and those that argue that it is too high. The task force takes no position on that subject.

The task force recommends that the Service formally adopt the principles enunciated by the Ninth Circuit Court of Appeals in Ann Jackson Family Foundation, 97 T.C. 534 (1991), aff’d, 15 F3rd 917 (9th Cir. 1994), wherein the court invalidated the provision in Treas. Reg. § 53.4942(a)–2(b) that requires that a distribution received by a private foundation from a charitable lead trust be applied to increase the foundation’s distributable amount. The court held, instead, that the only consequence of such a distribution was that the amount received be included in the foundation’s asset base when and as received. It has been widely understood for a number of years that the Service concedes that the Ninth Circuit’s holding is correct and that the principle of the holding would also prevent the amount of any distribution from a charitable lead trust from being included in the recipient private foundation’s investment income under § 4940. The task force recommends that the Service formally acknowledge this position by deleting the invalid provision in Treas. Reg. § 53.4942(a)–2(b) and amending the applicable instructions to Form 990–PF.

Section 4943: Excess Business Holdings

Section 4943 essentially prohibits a private foundation from owning more than 20% of the voting or similar interests in a business enterprise reduced by the amount held by those who are “disqualified persons” with respect to the foundation. As initially enacted in 1969, this prohibition was intended to prevent persons who owned controlling interests in commercial enterprises from obtaining an immediate charitable contribution deduction by transferring those interests to a private foundation while still retaining control of the business enterprise by reason of their positions of influence in the private foundation. This provision represents an important distinguishing element between the treatment of private foundations and public charities, as the latter are not constrained by any similar rule and in fact can own up to 100% of a business enterprise.

Although some members of the task force believe that there is no good rationale for distinguishing between private foundations and public charities with respect to the level of ownership interest that may be held in commercial enterprises, they also recognize that there may be some residual validity to the position taken by the legislature in 1969. For that reason, the task force would propose no major overhaul to this provision. There are, however, two aspects of the restrictions currently imposed by § 4943 that we believe require change:

First, the 2% de minimis rule of § 4943(c)(2)(C) is unreasonably low. That rule, which was part of the 1969 Act, provides a limited safe harbor which excepts from treatment as excess business holdings any interest of less than 2% of the voting stock of a business enterprise owned by a private foundation. While the safe harbor provided by this section makes good sense, the 2% level is unrealistically low, especially when the provision that requires the inclusion of holdings of “related private foundations” is taken into account. The task force is of the view that the appropriate de minimis level ought to be no lower than 5%.

The second change that we believe is required is in the definition of “business enterprise” and the way that that definition operates in the context of partnership investments made by private foundations. As currently written, § 4943(d)(3)(B) excepts from the definition of business enterprise, “a trade or business at least 95% of the gross income of which is derived from passive sources” (essentially dividends, interest, rents, royalties and capital gains from the sale of property held to produce such income). As construed by the regulations, this means that a private foundation’s interest in an investment partnership or limited liability company is not treated as a business enterprise; instead, these investment vehicles are treated as “look through” entities, and the private foundation is treated as owning its proportionate share of any interest in business enterprises held by such vehicle.¹⁴ Although it is likely that these statutory and regulatory provisions were intended to provide some measure of relief to the private foundation community at the time of their adoption some 30 years ago, their practical effect has been to make the administration of private foundation investments considerably more complicated than is necessary. Thus, a private foundation that takes a limited partnership interest in an investment partnership that owns stock in 100 portfolio companies is not permitted to test its excess business holdings merely by adding its limited partnership interest to those held by its disqualified persons and determining whether the combined interests total less than 20%. Instead, it must look at its indirectly attributed interest in each of the 100 portfolio companies owned by the partnership and must then take into account the amount of voting stock held in each and every such company by all of its disqualified persons. In effect, the foundation must make 100 separate computations before it can be sure that its partnership interest has not resulted in its having excess business holdings. The practical effect of this requirement is that a private foundation must assemble and give to the general partner of each such investment partnership a complete list of all of its disqualified persons, including, in many cases, four generations of family members of its founder. An extended negotiation then takes place pursuant to which the investing private foundation will attempt to require the general partner to inform it of the amount of stock of each portfolio company owned by each of its disqualified persons. Predictably, the general partner will resist agreeing to this requirement. The terms of the partnership agreement (or, more frequently, a “side letter agreement” between the private foundation and the general partner) can become horrendously complex, with the general partner frequently being saddled with a multitude of needless administrative requirements, many of which still do not provide complete protection to the private foundation when it seeks to obtain absolute assurance that a technical violation of this section has not occurred. The task force believes that no matter how well intended, the “business enterprise” definition would be vastly improved, and the time and expense devoted by private foundations making investments in these partnerships vastly reduced, if the definition of “business enterprise” were amended to dispense with this problem. The easiest way to achieve this result without creating an opportunity to avoid the basic intent of the statute would be to provide that a “look through” entity such as a partnership or a limited liability company would be treated as a “business enterprise” (and thus forgo the requirement that each underlying portfolio company held by the partnership be tested for excess business holdings), unless one or more disqualified persons is acting as general partner of, or holds a similar management position in, the investment vehicle. If this recommendation is adopted, a private foundation investor would be able to assure itself that it is not in violation of § 4943 as long as its limited partnership interest together with the partnership interests held by its disqualified persons do not exceed 20% of the total partnership interests. In this way, the private foundation and the general partner of the partnership would not have to go through the complex exercise that they now do in order to determine the individual stockholdings of each and every portfolio company held by the limited partnership.

Section 4944: Jeopardizing Investments; Program–Related Investments

Section 4944 generally prohibits a foundation from making an investment which “jeopardizes the carrying out of any of its exempt purposes.” The regulations interpret these provisions as being effectively a diversification and “prudent investor” standard.

The task force recommends that § 4944 be repealed with respect to its prohibition on jeopardizing investments and that such issues be left to the jurisdiction of state attorneys general, as they are in the case of public charities. The provisions dealing with program–related investments, modified as discussed below, should be moved to another section of the Code, perhaps § 4943 or § 4945.

If § 4944 remains in effect, the task force recommends that the Internal Revenue Service update the regulations under § 4944, particularly Treas. Reg. § 53.4944–1(a)(2), to eliminate any reference to “close scrutiny” of particular investments and instead to recognize the current balanced–portfolio practices of foundations and exempt organizations, including so–called alternative investments.

The regulations adopted in the early 1970s are, in the view of the task force, seriously out of date with current investment standards and vehicles. Foundations and other exempt organizations are today using sophisticated investment strategies to attempt to manage portfolios in accordance with modern portfolio theory, volatility considerations, and other matters. The simplistic view of the regulations that certain transactions such as puts, calls and straddles will be subject to “special scrutiny” may have been appropriate when adopted but, if literally enforced, now put foundations at a serious disadvantage in their efforts to act responsibly to increase the worth of their investment assets.

The Internal Revenue Service in private letter rulings has recognized more modern investing considerations, including so–called “alternative” (generally less liquid venture capital) investments.¹⁵ This approach is consistent with the evolution of trust law generally (see, Restatement of Trusts 3d, § 227 (1990)), and the regulations should be resolved to take this fact into account.

Section 4944(c) of the Code and Treas. Reg. § 53.4944–3 except “program– related investments” (“PRIs”) from the application of the jeopardy investment rules. Other Chapter 42 regulations exempt gains from the sale or exchange of PRIs from the excise tax on investment income under § 4940,¹⁶ from the calculation of minimum investment return for purposes of the mandatory distribution requirement,¹⁷ and from the definition of “business enterprise” under § 4943.¹⁸ If § 4944 is repealed, the definition of PRIs will need to be moved to another section of the Internal Revenue Code, possibly § 4943. In any event, the task force recommends that the definition of PRIs be maintained and that PRIs continue to be exempted from all the foregoing rules.

The task force also recommends that the regulations defining PRIs be amended to provide further examples of PRIs, including PRIs in non–U.S. entities, to reflect changes in PRI activities since the regulations were adopted in the 1970s, including those approved by the Internal Revenue Service by private letter ruling. Thus, it would be helpful if the Service were to give further guidance in this area, consistent with private letter rulings that have been issued, and make it clearer — without foundations having in each instance to request private letter rulings and would–be recipients suffering long delays in the receipt of funding — that:

A. The charitable and other exempt purposes set forth in § 170(c)(2)(B), for which private foundations are allowed to make PRIs, may be accomplished through loans to or investments in for–profit domestic or foreign organizations, to support programmatic activities such as:

B. PRIs may be properly effected through the mechanisms of loans to or investments in for–profit foreign or domestic financial intermediaries, including but not necessarily limited to banks, credit unions, investment banking organizations and investment companies, irrespective of whether organized as corporations, limited liability companies, limited partnerships or other locally permissible legal forms; and

C. The presence of a seemingly high projected rate of return should not by itself prevent an investment from qualifying as a PRI. Additional factors, such as anticipated rates of return and levels of risk associated with other similar potential investments by the hypothetical investor solely engaged in the investment for profit, are clearly relevant in making such determination. Thus, for example, returns on foreign PRIs should be compared to returns on foreign investments.

In recent years, the Service has issued private letter rulings approving PRIs in a number of for–profit foreign entities.¹⁹ While those and other rulings are indicative of the Service’s (a) favorable view of charitable activities, domestic and foreign, not specifically addressed in the § 4944 regulations, and (b) understanding that there is more to analyzing an investment than just the projected rate of return, they are of no direct precedential value to other private foundations wishing to replicate them or make other innovative PRIs. Therefore, incorporating these PRI fact patterns into expanded regulations or other precedential form is desirable.

Section 4945: Taxable Expenditures Section 4945 imposes penalty taxes on a private foundation that makes a “taxable expenditure.”

Taxable expenditures include grants to individuals for travel, study or other similar purposes, unless made pursuant to a selection procedure approved in advance by the Internal Revenue Service; grants to organizations that are not § 501(c)(3) public charities, unless certain procedural “expenditure responsibility” requirements are met; and grants or expenditures for political, legislative, or noncharitable purposes.

The task force recommends changes with respect to the procedural requirements for grants to individuals and grants to organizations other than § 501(c)(3) public charities, and with respect to the substantive prohibition on lobbying to the extent that it differs from that imposed on public charities.

Grants to individuals for travel, study or other similar purposes can be made by private foundations so long as advance Internal Revenue Service approval is received of an objective and nondiscriminatory selection procedure. While the regulations provide some flexibility (e.g., permitting such a grant program to proceed if an adverse Internal Revenue Service determination has not been received within 45 days of filing a request for approval), the requirement has, in practice, resulted in a rubber stamp approval process, the only practical consequences of which are to create additional paperwork and needlessly tie up Internal Revenue Service personnel whose services would be better utilized in other pursuits. More importantly, the pre–approval process does nothing meaningful to achieve the desired objective of assuring that grants to individuals are made in an objective and nondiscriminatory manner.

The primary motivation for the rules requiring advance Internal Revenue Service approval of individual grant procedures was to prevent grants being made on an ad hoc basis for purposes that were not clearly defined. As noted above, we question whether the advance approval of a procedure by the Internal Revenue Service is the most effective or efficient way of preventing the misuse of funds by foundations. Objectivity could be as easily achieved by the articulation of general principles in the regulations and by requiring each grant–making foundation to adopt written procedures incorporating such principles. Further, the regulations regarding “earmarking” give considerable flexibility to foundations in terms of funding the work of individuals.²⁰ In view of this, there seems no reason not to at least permit programs of direct grants to individuals for activities conducted in affiliation with educational organizations to be made without the necessity of Internal Revenue Service advance approval of a procedure for awarding such grants.

The task force recommends that the advance approval requirement be eliminated because it does nothing to further the statutory objective. In its place, we recommend that each private foundation that makes grants to individuals be required to adopt a selection procedure before making any such grant and that it be required to file such procedure with its Form 990–PF for the first year in which any such grant is made. In subsequent years, each foundation should be required to confirm, on its Form 990–PF, that such procedure is still in place and that the foundation has complied with it.

A private foundation still would have the option of requesting advance Internal Revenue Service approval of its procedures, particularly if those procedures varied significantly from the general principles expressed in the regulations. However, we would envision that any such request would be the exception rather than the rule.

We also recommend that if the preapproval requirement is not eliminated, a private foundation should be able to have any penalty taxes for violation of the rules relating to such procedures abated if it can demonstrate on an after–the–fact basis that it attempted in good faith to implement an objective and nondiscriminatory selection process for grants to individuals for travel, study or other similar programs.

The task force also questions why the requirement of an objective selection process implemented as recommended above should be limited to grants for “travel, study or other similar purposes.” Indeed, we believe that all grants to individuals should be specifically required to be awarded pursuant to an objective and nondiscriminatory process for a purpose consistent with the exempt purposes of a foundation.

Section 4945 imposes penalty taxes if a grant is made to an organization that is not a public charity, unless expenditure responsibility is exercised as provided in § 4945(h). The requirements of § 4945(h) are essentially paperwork requirements that, in the view of the task force, do not effectively prevent the misuse of grant funds. Most foundations respond appropriately when notified of inappropriate uses of their funds, whether or not detailed agreements are in place and, in fact, have a fiduciary duty under state law to do so.

The task force recommends that the expenditure responsibility rules be eliminated except for grants to non–§ 501(c)(3) organizations, or at least changed to require only a grant agreement with appropriate limitations.

The task force recommends, alternatively, that foundations be able to have penalty taxes abated for technical violations, such as failure to meet specific reporting requirements, if it can be demonstrated that there was no inappropriate expenditure of grant funds or funds provided through a PRI. ²¹

With respect to grant requirements for distributions to organizations other than § 501(c)(3) public charities, the task force notes that most of the compliance difficulties are in the foreign grant area. In today’s climate of “globalization,” there has been a significant increase in grants to charitable organizations outside the United States.

The task force recommends that private foundations be permitted to make grants to non–U.S. charitable organizations under the same rules as are applicable to public charities, which can make grants to foreign organizations so long as they are in furtherance of the U.S. charity’s § 501(c)(3) purposes and the U.S. charity has control and discretion as to the use of the grant funds. See Rev. Rul. 66–79. The focus for private foundations, just as in the case of public charities, should be on the purpose of the grant rather than the nature or location of the grantee.

The task force recommends, however, that expenditure responsibility continue to be required for grants to organizations that are not charitable organizations under United States or foreign law. Thus, the expenditure responsibility requirements for foreign charitable organizations would be eliminated where the foundation in good faith determines that the foreign organization is a charitable organization under local law and will expend the grant funds for charitable purposes in accordance with the limitations on private foundations (i.e., no expenditures for lobbying, political campaigns, voter registration, or grants to individuals made other than on an objective and non–discriminatory basis). Alternatively, expenditure responsibility requirements could be limited to requiring a grant agreement containing appropriate limitations on the use of grant funds, but no reporting requirement. It should be noted that a private foundation would still have to require reports confirming the amount of a grantee’s annual expenditures if the foundation wanted to treat grants to nonpublic charities as qualifying distributions under § 4942.

If the current standards for expenditure responsibility are retained, the task force recommends that the duration of expenditure responsibility reporting be considerably shortened from that which currently exists in the regulations. Under the current regulations, expenditure responsibility reporting must continue until the grant is entirely expended, except reports must be submitted for three years for grants for capital purposes (e.g., endowment or capital equipment).

Unfortunately this simple statement of rules is not necessarily interpreted consistently or in a common sense manner by all officials of the Internal Revenue Service. It is the understanding of some members of the task force that the three–year rule for discontinuing expenditure responsibility for grants for capital purposes is regarded by some rule–making personnel at the Internal Revenue Service as applying only to grants to organizations holding Internal Revenue Service determination letters that they are not private foundations, notwithstanding the fact that no such specific requirement is in the regulations. Since few foreign organizations hold such letters, the three–year limitation would not apply. As a result, the grantor foundation must determine when the grant is “fully expended.” Some Internal Revenue Service officials believe that a capital endowment grant is never “fully expended” so long as the principal is held by the foreign grantee. Thus, expenditure responsibility requirements would be perpetual. Further, these Internal Revenue Service officials may regard grants for capital equipment as not “fully expended” so long as the equipment is in use, whether or not it is fully depreciated under normal Internal Revenue Service rules. If the three–year rule does not apply in these situations, a private foundation that does not thereafter maintain expenditure responsibility (including receipt of a report from the foreign grantee) would be in violation of the rules starting in the fourth year.

It is the view of the task force that endowment and capital equipment grants should be deemed “fully expended” in at least the case or foreign grants at the earlier of (a) three years from the date of the grant (assuming the grantor foundation has no information that the grant has not been or is not being used for the intended purposes) or (b) when the grant becomes part of the principal of the endowment fund (in the case of an endowment grant) or, in the case of a grant for capital equipment or building purposes, when the equipment is purchased or the building is under construction and the grantor’s money has been spent for that purpose.

Section 4945: Lobbying Prohibition

The task force finds no intellectual rationale why a private foundation should be any more or less subject to prohibitions on legislation activities than public charities. The task force recommends that the § 4945 requirements with respect to lobbying activities be deleted from the expenditure responsibility rules, and that private foundations be subject to the same “substantiality” requirement (or alternative fixed dollar amount election) as public charities.

Sections 508, 4942 and 4945: Renunciation of 501(c)(3) Determination Letters by Certain Organizations

The task force recommends that the Internal Revenue Service be directed to permit foreign organizations and § 115 governmental instrumentalities that have received § 501(c)(3) determination letters from the Internal Revenue Service to renounce their status under those letters.

Most foreign charitable organizations have no need for Internal Revenue Service determination letters, as they have no income from United States sources that would be subject to tax, and contributions to such organizations are not deductible under § 170. There are, however, a small number of such organizations that do have determination letters, and the same is true of a few governmental organizations that are not subject to tax under § 115. In almost every case, these letters were obtained shortly after the passage of the 1969 Act as an accommodation to domestic private foundation grantors that were unsure of the consequences of transferring funds to organizations that had not received formal recognition of their § 501(c)(3) status from the Internal Revenue Service. Regulations promulgated subsequent to that time, which permit these grant–making organizations to make a “reasonable judgment” that a foreign organization is one described in § 501(c)(3)²² and a “good faith determination” that it is other than a private foundation²³ make these determination letters unnecessary. Most of the foreign organizations in question would prefer voluntarily to abandon their § 501(c)(3) status, thus avoiding the needless time and expense required to file annual returns with the Internal Revenue Service. The Service, however, takes the position that once an organization obtains § 501(c)(3) status, it is powerless to renounce it, notwithstanding that the determination letter was unnecessary at the time it was requested and no matter how inconsequential the organization’s contacts with the United States. The task force believes that this policy is mistaken and recommends that the Internal Revenue Service be instructed to permit these organizations voluntarily to renounce their § 501(c)(3) status if they wish to do so.

Respectfully submitted

NOTES:

1. The task force acknowledges with appreciation the very significant assistance of Kim V. Heyman.

2. Pub. L. No. 91-172, 83 Stat. 487 (1969).

3. In fairness, the five-year “look-back” rule currently found in § 4958(f)(1)(A) should probably also apply to disqualified persons of a private foundation who are such by reason of their status as foundation managers.

4. These organizations include all organizations described in §§ 501(c) and (d) and all qualified employee plans described in § 401(a). HR Rep. No. 413, 91st Cong., 1st Sess. Pt. I at 19 (1969), reprinted in 1969-3 CB 213; S. Rep. No. 552, 91st Cong., 1st Sess. 27 (1969), reprinted in 1969-3 CB 423 at 441-442.

5. HR Rep. No. 413, 91st Cong., 1st Sess. Pt. I at 19 (1969), reprinted in 1969-3 CB 213; S. Rep. No. 552, 91st Cong., 1st Sess. 27 (1969), reprinted in 1969-3 CB 423 at 441-442.

6. The same figure as is now used to determine minimum investment return under § 4942(e) could be used for this purpose.

7. As originally proposed, the tax would have been imposed at the rate of 0.2% of investment assets, a rate which was reduced to 0.1% by floor amendment (115 Cong. Rec. 37,590-37,593 (1969)). The proposals have been described as producing revenue equivalents somewhat greater than income taxes imposed on investment income at the rates of 4% and 2%, respectively. Ruth & Ralph Friedman Foundation v. Commissioner, 71 TC 40, 46 at n. 16 (1978). The 0.05% rate proposed herein is intended as the rough equivalent of an investment income tax imposed at the rate of 1%.

8. To the extent that a private foundation’s qualifying distributions exceed the level necessary to qualify for the 1% tax reduction, the excess serves (1) to deplete the distributions available to permit qualification in future years and (2) to increase the year’s average distribution percentage and thus the amount of distributions required to qualify for the reduction in the five succeeding years. For this reason, many private foundations seeking to qualify for the reduction restrict their expenditures so that no more than the minimum amount necessary to qualify for the reduction is distributed in any given year.

9. For private foundations with an average annual realized rate of return of 6%, the increase comes to 0.015% of investment assets. The percentage may seem small, but for a private foundation with a billion dollars of assets, the tax cost – and the amount ultimately taken from charitable beneficiaries – is $150,000 per year.

10. An equivalent provision, exempting the first $5,000,000 of a private foundation’s investment assets, would also be appropriate if the excise tax provision described in Alternative A, above, is adopted.

11. Taxes are also imposed, on a limited basis, on “foundation managers” who “knowingly” permit such transactions to take place.

12. These provisions which are found in § 4958 apply to public charities and organizations described in § 501(c)(4).

13. See, e.g., Priv. Ltr. Ruls. 9702036-039, 9703031 and 9312022.

14. Treas. Reg. § 53.4943-10(c).

15. See, e.g., Priv. Ltr. Rul. 9451067.

16. Treas. Reg. § 53.4940-1(f)(1).

17. Treas. Reg. § 53.4942(a)-2(c)(3)(ii)(d).

18. Treas. Reg. § 53.4943-10(b).

19. See, e.g., Priv. Ltr. Ruls. 9551005 (September 15, 1995); 200034037 (May 31, 2000); 9826048 (March 31, 1998); 199943058 (August 6, 1999); 8225073 (March 24, 1982) and 8301110 (October 8, 1982).

20. See, e.g., Treas. Reg. §§ 53.4945-4(a)(4)(ii) and (iv) dealing with grants made to support research activities at universities.

21. See Mott Foundation v. United States, 938 F.2d 58 (6th Cir. 1991).

22. Treas. Reg. § 53.4945-6(c)(2)(ii).

23. Treas. Reg. §§ 53.4942(a)-3(a)(5) and 53.4945-5(a)(5).