PRIVATE FOUNDATIONS HOW PRIVATE OPERATING FOUNDATIONS USE PROGRAM- RELATED INVESTMENTS AS QUALIFYING DISTRIBUTIONS BRIGIT KAVANAGH, ESQ. AND JANE M. SEARING, CPA An exception to the jeopardizing investment rules Background and definitions under Section 4944(c) allows a private foundation Non-POF private foundations. By default, all domes - to make an investment that might otherwise jeop - tic or foreign organizations described in Section ardize the private foundation’s ability to achieve its 501(c)(3) are private foundations, and it is only by exempt purposes. Such program-related invest - satisfying one of several tests that the organization ments (PRIs), are allowed only if (1) the primary avoids private foundation status. 6 Non-operating purpose of the investment is to accomplish one or private foundations (non-POF) are subject to the more charitable purposes, (2) neither the produc - strict set of laws found in Chapter 42 of the Code. tion of income nor the appreciation of property is a These include the excise taxes on net investment significant purpose of the investment, and (3) nei - income, self-dealing, the failure to distribute in - ther influencing legislation nor participating or in - come, excess business holdings, jeopardizing in - tervening in a political campaign on behalf of or in vestments, and taxable expenditures. 7 In addition, opposition to any candidate for public office is a the income tax charitable contribution deduction purpose of the investment. PRIs are treated as limit for gifts to a non-POF foundation is less favor - grants, 1 and allowed as qualifying distributions of able than for gifts to public charities. 8 the investor private foundation 2 when the distribu - tion is made. 3 Non-POF qualifying distributions. Non-POF foun - Private operating foundations (POFs) must make dations must distribute a certain amount of their a certain amount of qualifying distributions directly assets each year on expenditures that constitute for the active conduct of activities constituting the qualifying distributions. Qualifying distributions POF’s charitable, educational, or other similar ex - are defined generally as amounts paid to accom - empt purposes. 4 Generally, the POF must use such plish charitable purposes, capital purchases to car - qualifying distributions itself rather than by or ry out the organization’s exempt purpose, and through one or more grantee organizations. 5 reasonable and necessary administrative expenses Because PRIs are used by the recipient organiza - to accomplish the private foundation’s charitable tion, akin to a grantee organization, a question arises purposes. 9 Non-POF qualifying distributions are regarding when, if ever, a POF’s PRI will be treated calculated on the cash method of accounting. as a qualifying distribution made directly for the ac - The amount the non-POF foundation must spend is tive conduct of activities, and countable toward the its “distributable amount,” which is roughly equal to 5% POF’s satisfaction of the private operating founda - of the foundation’s average non-charitable use asset bal - tion tests. ance of the prior year. 10 While non-POF foundations can engage in direct charitable activities, and many do, non-POF foundations generally spend the distributable BRIGIT KAVANAGH is a founding partner in the California law firm of Kavanagh Rhomberg LLP and an adjunct professor in the Golden amount on making grants to support the programs of Gate University School of Law LL.M. program. JANE M. SEARING is other organizations. All qualifying distributions are a tax shareholder at Clark Nuber PS in Bellevue, WA, where she leads the tax-exempt organization group. counted, whether the activities supported by the non- JULY/AUGUST 2017 taxation of exempts 39 from a non-POF foundation. As described below, EXHIBIT 1 the required distribution amount is calculated using Data for Hypo 1 POF (Example 1) the “income test” and one of three alternative tests. The penalty for failure to meet the distribution require- Non-charitable use assets $ 1,000,000 ments of a POF is reversion to non-POF status and Adjusted Net Income (Page 1, Part I, Line 27c) $ 30,000 the potential to fail the 5% minimum distribution Minimum Investment Return requirement under Section 4942(d). Like a non-POF (Page 8, Part X, Line 6) $ 50,000 foundation, POF qualifying distributions are calcu- Qualifying Distributions lated on the cash method of accounting. In addition, (Page 8, Part XII, Line 4) $ 40,000 the income tax charitable contribution deduction for gifts to a POF is the enhanced deduction limit POF’s grants are conducted by the non-POF founda- available for gifts to public charities.13 tion or by one or more grantees of the non-POF foun- dation. Failure to spend the entire distributable amount Qualifying as an operating foundation. As described results in an excise tax on the undistributed portion. above, to qualify as an operating foundation, a POF Non-POF foundations must spend the distrib- must meet one mandatory test, the “income test,” and utable amount by the close of the following tax year.11 one of three alternative tests—the “assets test,” the That is, the distributable amount for a given year is “endowment test,” or the “public support test.” based on the asset balance of the prior year. The income test requires a POF to spend substan- tially all (defined as 85%14) of the lesser of the POF’s Where to find this on Form 990-PF. POFs and Non- adjusted net income (ANI) or its minimum invest- POF foundations both use Form 990-PF (Return ment return (MIR) on direct charitable activity.15 of Private Foundation) to report that they are meet- Stated differently, first look at the POF’s ANI and its ing the distribution requirements under Section MIR. Then take the lesser of the two and multiply that 4942. There is some overlap in the way the two number by 85%. The POF must spend at least that types of foundations approach the form, but there much in qualifying distributions for direct charitable are also differences. The following sections on the activities to satisfy the income test.16 If the POF’s qual- Form 990-PF relate to calculating non-POF quali- ifing distributions are greater than its MIR, or if MIR fying distributions: is less than ANI, the rule is slightly different and often • Page 8, Part X (“Minimum Investment Return”). overlooked, as the difference is not highlighted in • Page 8, Part XI (“Distributable Amount”). Form 990-PF.17 All POFs must satisfy the income test. • Page 8, Part XII (“Qualifying Distributions”). Next, the POF must satisfy one of the three alter- • Page 9, Part XIII (“Undistributed Income”). native tests: 1. The assets test is satisfied if substantially more than Private operating foundations. In many ways, a POF half (defined as 65% or more18) of the POF’s assets works just like a non-POF foundation. A POF is are devoted directly to the foundation’s direct char- equally subject to the operating restrictions found itable activities, to functionally related businesses,19 in Chapter 42, with one significant exception: Section or to both.20 In other words, the POF will satisfy the 4942 qualifying distributions. A POF is not subject assets test if more than 65% of its assets are chari- to the excise tax for failure to distribute income under table use assets or functionally related businesses. Section 4942.12 Instead, a POF’s qualifying distribu- 2. The endowment test is satisfied if the POF normally tions must constitute direct charitable activity qual- makes qualifying distributions for direct charitable ifying distributions (discussed below) and the amount activity in an amount not less than two-thirds of the a POF must spend each year is calculated differently foundation’s MIR,21 or roughly 3.3% of the POF’s 1 12 Reg. 53.4945-4(a)(2). Section 4942(a)(1). 2 13 Reg. 53.4942(a)-3(a)(2). Section 170. 3 14 Reg. 53.4942(a)-3(a)(1). Reg. 53.4942(b)-1(c). 4 15 Reg. 53.4942(b)-1(a). Section 4942(j)(3)(A). 5 16 Reg. 53.4942(b)-1(b)(1). Id. 6 17 Section 509(a). Section 4942(j)(3)flush language and Reg. 53.4942(b)-1(a)(1)(ii). If 7 Sections 4940-4945, respectively. the POF’s qualifying distributions are greater than its MIR but less 8 Section 170(b), Section 170(e). than ANI, then at least 85% of the POF’s qualifying distributions 9 must constitute direct charitable activity. However, if the POF’s MIR Section 4942(g)(1)(A) and (B). 10 is less than its ANI and the POF’s qualifying distributions are equal Section 4942(d). to or greater than ANI, then only the portion of qualifying distribu- 11 Section 4942(a). tions equal to 85% of ANI must constitute direct charitable activity. 40 taxation of exempts JULY/AUGUST 2017 PRIVATE FOUNDATIONS EXHIBIT 2 Form 990-PF Extract for Hypo 1 POF (Example 1) average asset balance for the year. The endowment planning challenges as it is impossible to know the test is the test POFs tend to meet most frequently. ANI and the MIR for a year prior to the end of that 3. The support test is satisfied if the POF is receiving year. There is some relief, however, in that a POF may a specified level of public support from the general meet the tests either on a three-out-of-four-years public and other exempt organizations. 22 It is very basis, or on a four-year aggregation basis. 24 A new or - unusual for a POF to meet this test. It is comprised ganization generally must satisfy the tests in its first of three sub-tests, all of which must be met.