Private Foundation Excise Taxes By Greg Rogers, CPA, MBA Private foundations are 501(c)(3) tax-exempt organizations that are generally supported by a limited donor base that typically consists of individuals, families, and/or corporate entities. Because their funding is not predominantly provided by public sources (i.e. public charities and governmental entities), private foundations are not afforded the same tax benefits available to public charities, which include unlimited tax deductibility and tax-exempt status on most revenue sources (excepting unrelated business taxable income). Private foundations are typically established by individuals, families, or other private parties to fund a charitable cause of specific interest with primarily private funding. Because private foundations do not receive the same level of philanthropic support as public charities, they normally rely on income earned from invested assets to support operations.

Private foundations are widely viewed as an impactful vehicle for charitable giving that are frequently more targeted with respect to grantmaking and charitable impact efforts when compared to public charities. Although donations made to private foundations are limited with respect to their tax deductibility, private foundation supporters still receive tax advantages while funding worthy philanthropic causes. In spite of the philanthropic benefits associated with private foundations, the Internal Revenue Service (IRS) imposes a strict and potentially costly set of excise taxes on private foundations who engage in prohibited activities. These excise taxes are imposed on private foundations who: report net investment income under Internal Revenue Code (IRC) Section 4940; engage in selfdealing (IRC Section 4941); fail to distribute income as required under IRC Section 4942; have excess business holdings (IRC Section 4943); hold funds in jeopardizing investments (IRC Section 4944); and fail to exercise expenditure responsibility (IRC Section 4945).

IRC 4940 - Excise Tax on Net Investment Income Under IRC 4940, private foundations are subject to an excise tax on net investment income. What is net investment income? Net investment income is calculated as gross investment income (which includes interest, dividends, realized gains/(losses), and any other investment income) less any expenses incurred in generating said income. Net investment income is taxed at a rate of either 1% or 2% depending on the level of adjusted qualifying distributions made by the foundation during the year. If the foundation makes charitable distributions in excess of an annual threshold (calculated based on the foundation’s historical distribution ratio on noncharitable-use assets), the foundation pays tax at a reduced excise tax rate of 1% on net investment income for the year. If the foundation’s charitable distributions fall short of that threshold, then it pays tax on net investment income at a rate of 2%. This has been the historical tax structure and will remain so until the end of the 2019 tax year. However, the Taxpayer Certainty and Disaster Tax Relief Act of 2019 signed into law on December 20, 2020 overhauls the current excise tax structure for private foundations by establishing a fixed 1.39% excise tax rate for private foundations to

replace the existing two-tiered tax structure effective for private foundations with tax years beginning January 1, 2020 or after.

IRC 4941 - Excise Tax on Self-Dealing IRC Section 4941 assesses an excise tax on private foundations who engage in self-dealing with disqualified persons. Disqualified persons include substantial contributors to the foundation, foundation managers, family members, and other parties who hold a significant ownership interest in the private foundation. According to the IRS, self-dealing between a private foundation and a disqualified person includes sale/exchange/leasing of property, lending money, providing goods or services, paying compensation or reimbursing expenses, or transferring income or assets. The self-dealing excise tax includes an initial tax at a rate of 10% of the value of the associated transactions as well as an additional tax of 200% of the amount involved if not corrected within the applicable tax period.

IRC 4942 - Excise Tax on Failure to Distribute Income Pursuant to IRC Section 4942, private foundations with undistributed income at the end of a tax year are subject to an excise tax for failure to distribute income. To avoid this excise tax, private foundations must ensure that their qualifying charitable distributions exceed the required distributable amount each year. The distributable amount represents the minimum investment return (calculated at 5% of the value of noncharitable-use assets less current year excise tax expense plus any recoveries of amounts treated as qualifying distributions in prior years). The excise tax rate for failing to distribute income is 30% of the undistributed amount along with an additional tax of 100% on any undistributed amounts if the deficiency is not corrected within 90 days of notification from the IRS of the deficiency.

IRC 4943 - Excise Tax on Excess Business Holdings IRC Section 4943 imposes an excise tax on private foundations who, along with its disqualified persons, hold greater than 20% of the voting stock of business enterprises. The excess business holdings excise tax includes an initial tax of 10% of the value of excess holdings along with an additional tax of 200% of the excess business holdings if the private foundation does not dispose of the holdings by the end of the taxable period. The initial tax can be abated if the private foundation can demonstrate that the excess business holdings were due to reasonable cause and not as a result of intentional neglect.

IRC 4944 - Excise Tax on Investments Which Jeopardize Charitable Purpose Under IRC Section 4944(a), private foundations are assessed an excise tax for holding investments that jeopardize its ability to carry out its exempt purposes. The excise tax for holding jeopardizing investments is equal to 10% of the value of the jeopardizing investments involved. An additional tax of 25% of the amount invested if the jeopardizing investment is not divested within the taxable period. There is an exception in the Code for program-related investments made with the principal objective of accomplishing charitable purposes pursuant to IRC Section 170(c)(2)(B). A jeopardizing investment, as defined in IRC Section 4944(c), is an investment that jeopardizes the carrying out of the exempt purposes of a private foundation if it is determined that the private foundation managers, in making the investment, have failed to exercise ordinary business care and prudence in providing for the short and long term financial needs of the private foundation.

IRC 4945 - Excise Tax on Expenditure Responsibility Private foundations who do not exercise expenditure responsibility on grants made to non-public charities (defined as “taxable expenditures”) are subject to excise tax at an initial rate of 20% of the grant award amount under IRC Section 4945. Foundation managers are subject to an initial excise tax at a rate of 5% if the grant to the non-public charity was made knowingly. An additional set of excise taxes are imposed on private foundations and their managers who do not correct or agree to correct the taxable expenditure within the taxable period. The private foundation must correct the taxable expenditure before the end of the taxable period or be subject to an additional tax at a rate of 100% of the taxable expenditure. Foundation managers who refuse to correct the taxable expenditure are subject to an additional tax of 50% of the taxable expenditure. Exercising expenditure responsibility to avoid the excise tax can be accomplished by performing the following procedures:

1. Ensuring that the grant is spent solely for intended purpose – this can be done by conducting a limited pre-grant inquiry, obtaining a written commitment signed by an appropriate officer of the grantee organization that includes the grant recipient’s agreement to repay funds not used for the intended purpose of the grant, submitting full and complete annual reports showing how the grant funds were spent and the progress made in achieving grant objectives, maintaining books and records of receipts and expenditures for grant funds, and ensuring funds are not spent to influence legislation or the outcome of a public election or to carry on a voter registration drive or any other purpose other than the intended purpose of the grant. 2. Obtaining full and complete reports from the grantee on how funds were spent – this can be accomplished by the private foundation by requiring reports from the grantee that provide evidence on how the grant funds were spent, how the grant terms were complied with, and the level of progress made by the grantee towards achieving grant objectives. 3. Making full and detailed reports with respect to expenditures available to the IRS – the IRS requires that all grants made to non-public charities to be reported to the IRS in an Expenditure Responsibility Statement that is attached to IRS Form 990-PF. The Expenditure Responsibility Statement must reflect the following information: a. Name and address of grantee b. Date and amount of grant c. Grant purpose d. Amount expended by the grantee e. Whether or not the grantee diverted any portion of the funds from the intended grant purpose f. Dates of any reports received from the grantee g. Dates and verification results of any efforts undertaken by the grantee to corroborate information reported by grantee

Greg Rogers is a senior audit manager with Kevin P. Martin & Associates. He has over 15 years of experience in public accounting with a proven track record of effectively addressing the financial reporting and tax compliance needs of a diverse array of small to medium-sized entities. Greg has in-depth knowledge of nonprofit organizations, spending the majority of his career specializing in the nonprofit industry.