August 17, 2022
IRS rulings offer private nonoperating foundations informal guidance on making distributions to, and receiving distributions from, nonpublic charities
Two recently published IRS Private Letter Rulings (PLRs) provide helpful, informal guidance for private nonoperating foundations, particularly ones that receive and/or make grants from/to other private foundations. PLR 202231007 (PLR I) underscores the need for private nonoperating foundations to engage in careful tax planning to avoid negative tax consequences when making distributions to nonpublic charities, including related private foundations. And, PLR 202231010 (PLR II) reminds nonoperating foundations that making proper, timely elections could avert negative tax consequences — for instance, mitigating a shortfall in a foundation's distributions and avoiding excise tax liability under IRC Section 4942 for failure to make sufficient qualifying distributions.
PLR I: Transfers to two private foundations won't generate negative tax consequences
In PLR 202231007, the IRS ruled that proposed transfers from a private nonoperating foundation (Family Foundation) to two related private nonoperating foundations would not result in negative tax consequences for the three foundations or require Family Foundation to exercise expenditure responsibility over the grants for longer than three years.
Family Foundation is an IRC Section 501(c)(3) entity classified as a private nonoperating foundation under IRC Section 509(a). Family Foundation's only trustee (Trustee) is a family trust company that provides fiduciary, financial and personal services to one family and its related charitable entities. The family members make up the majority of Trustee's board of directors and are donors to Family Foundation. The family members own the controlling shares of Company, a business corporation.
"Company Foundation," an IRC Section 501(c)(3) corporation classified as a private nonoperating foundation under IRC Section 509(a), makes grants and supports educational programs in locations where Company has a business presence. In addition, Company Foundation makes grants to support college programs that train students in Company's industry. Company Foundation is controlled by Company, which is controlled by the family members.
A third private nonoperating foundation, "New Foundation," is a grant-making charitable trust recognized as an IRC Section 501(c)(3) tax-exempt organization. The terms of the trust agreement that created New Foundation are essentially identical to the terms of the agreement that created Family Foundation. Trustee is the sole trustee of both Family Foundation and New Foundation. The taxpayer represents that all three foundations are effectively controlled by the same persons within the meaning of Treas. Reg. Section 1.507-3(a)(2)(ii).
Family Foundation established New Foundation in anticipation of receiving a large bequest (Bequest), distributed over the course of Year 2. In Year 3, Family Foundation anticipates making a series of transfers (Proposed Transfers) of at least 80% of Family Foundation's assets to Company Foundation and New Foundation. The transfers are intended to "better facilitate separate and distinct programmatic grantmaking between the two transferee foundations, increase transparency of the foundations' respective charitable activities, and allow a separate annual financial statement audit for New Foundation that covers the Bequest."
To better serve the decedent's charitable intent, Family Foundation's transfers to New Foundation will be made as capital endowment grants. This will "allow the Bequest to be administered and invested within New Foundation, with its activities separated from the smaller-in-scale grant-making activities of Family Foundation," permitting greater flexibility in charitable programing and eliminating additional costs that Family Foundation would otherwise incur in managing the Bequest.
Family Foundation also plans to make capital endowment grants to Company Foundation and restrict Company Foundation's endowment spending to only the annual income from the endowment in furtherance of Company Foundation's charitable purposes.
Family Foundation will exercise expenditure responsibility over the capital endowment grants to New Foundation and Company Foundation for three years — the year in which the grants are made plus the next two years. Grant agreements will be entered specifying how the Proposed Transfers may be used and require annual reporting on the use of the funds and any income generated. Following each Proposed Transfer, Family Foundation intends to review the reports from the two transferee foundations and their overall operations to confirm that the funds have been used properly.
Family Foundation does not intend to distribute all its assets or to dissolve. It further represents that it has not engaged, and will not engage, in acts that would give rise to tax under IRC Chapter 42.
Noting that transferee foundations "are not treated as newly created foundations as a result of [an IRC Section] 507(b)(2) transfer of assets" and that Family Foundation would be making IRC Section 507(b)(2) transfers to Company Foundation and New Foundation, the IRS concluded that the transferee foundations would not be considered newly created.
As Family Foundation did not intend to distribute all of its assets or to inform the IRS that it was dissolving, the IRS concluded that the proposed transfers would not cause Family Foundation's termination as a private foundation under IRC Section 507(a) or generate liability for termination tax under IRC Section 507(c). Similarly, because Family Foundation would not be transferring all of its net assets in making the Proposed Transfers, the IRS concluded that the two transferee foundations would not be treated as if they were Family Foundation with respect to the Proposed Transfers. Further, the IRS ruled that, based on Family Foundation's representation that all three of the foundations were effectively controlled by the same persons, the two transferee foundations each will succeed to a portion of Family Foundation's aggregate tax benefit in proportion to the Family Foundation assets they receive, under Treas. Reg. Section 1.507-3(a)(1) and (2)(ii) and (iii).
Noting that both Company Foundation and New Foundation are IRC Section 501(c)(3) organizations, the IRS concluded that the Proposed Transfers would not constitute transfers to disqualified persons that would violate the self-dealing prohibition of IRC Section 4941.
Noting that Family Foundation plans to make capital endowment grants to both transferee foundations and does not plan to request records from the transferees showing that they have made distributions from corpus in connection with the transfers, the IRS concluded that the Proposed Transfers would not constitute qualifying distributions under IRC Section 4942(g)(3).
The IRS further concluded that the Proposed Transfers would not be jeopardizing investments under IRC Section 4944 because they would be given as grants for capital endowments to further charitable purposes and thus would not constitute investments. Similarly, because the Proposed Transfers are grants rather than income-producing investments, they will not generate any net investment income that would be subject to the IRC Section 4940 excise tax.
The IRS also determined that the Proposed Transfers would not be considered taxable expenditures under IRC Section 4945 "as long as Family Foundation exercises expenditure responsibility over the transfers in accordance with [IRC Section] 4945(h) and [Treas. Reg. Section] 53.4945-5(c)(2)." Family Foundation represented that it would exercise expenditure responsibility during the year of the transfer and at least the following two tax years; therefore, the Proposed Transfers would not be considered taxable expenditures, the IRS ruled. In so ruling, the IRS confirmed that Family Foundation would not need to exercise expenditure responsibility over those grants in perpetuity because Family Foundation's grants to New Foundation and Company Foundation were capital endowment grants. (Normally, a private foundation must exercise expenditure responsibility until the grant funds are expended in full or the grant is otherwise terminated.)
Finally, the IRS considered whether, following the Proposed Transfers, any part of Family Foundation's excess qualifying distribution carryover would transfer to New Foundation or Company Foundation. Because neither of the transferee foundations would be treated as Family Foundation, the IRS concluded that no part of Family Foundation's excess qualifying distribution carryover will transfer to either transferee foundation.
PLR II: Extension granted to elect to treat grants received as distributions out of corpus
In PLR 202231010, the IRS granted an extension of time to a private nonoperating foundation (Foundation) for making an election under Treas. Reg. Section 53.4942(a)-3(c)(2)(iv) to treat amounts it received from another private nonoperating foundation as distributions out of corpus.
Both Foundation and the grantor (X) are private nonoperating foundations under IRC Sections 509(a) and 4942(j)(3). X routinely makes grants to Foundation under agreements that require Foundation to distribute the contributions within 12 months of the end of the year in which X's contributions are made. In Years 1 and 2, the grant agreements required Foundation to elect under Treas. Reg. Section 53.4942(a)-3(c)(2)(iv) to treat the grant amounts received from X as distributions out of corpus.
Foundation relied on its first tax service provider to make these elections but discovered when it changed tax advisors that the first advisor had failed to make the elections. These facts were confirmed in an affidavit stating the first advisor was to complete the returns and elections but inadvertently neglected to do so. Foundation promptly sought professional advice on how to correct the oversight.
The IRS granted relief under Treas. Reg. Section 301.9100-3, determining that Foundation "acted reasonably and in good faith" because it relied in good faith on a qualified tax professional in seeking advice relating to the election, expecting that the first advisor would make the elections consistent with the grant agreements, and because it requested relief before the IRS discovered that the election had not been made.
Together, PLRs I and II remind taxpayers of the complex regulations and penalties that private nonoperating foundations may face when making distributions to nonpublic charities and making (or failing to timely make) required yearly elections.
PLR 202231007 is an example of how a private nonoperating foundation may utilize careful estate and tax planning to avoid negative tax consequences when making distributions to nonpublic charities, including related private foundations. For instance, if a private foundation is able to treat a distribution to another private foundation as a capital endowment grant, it will need to exercise expenditure responsibility over the grant for only three years, rather than until the grant funds are expended in full. Also, careful planning is needed to properly transfer a private foundation's aggregate tax benefits, including tax basis of noncash assets, to another private foundation, and/or to avoid transferring other tax benefits (e.g., excess qualifying distribution carryover) to the transferee foundation.
If the IRS had not granted the relief requested in PLR 202231010, the Foundation would not have been able to treat the grants received from another private foundation as distributions out of corpus. If the Foundation had timely made the election on its Form 990-PF, it would not have needed to seek an extension of that election deadline from the IRS. Electing and treating a distribution as made out of corpus permits a private nonoperating foundation to count the distribution toward its annual mandatory distribution requirement. A proper election and related planning could help mitigate a shortfall in the foundation's distributions and provide relief from excise tax imposed under IRC Section 4942 for failure to make sufficient qualifying distributions.