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January 24, 2023
2023-0148

IRS allows private foundation to set aside funds for pending construction project without incurring excise tax on undistributed income

  • In a private letter ruling, the IRS grants a private foundation permission to set aside funds for use on a pending construction project, recognizing that paying a contractor or other professional in advance would be imprudent.
  • The set-aside will not cause the foundation to incur IRC Section 4942 excise tax on undistributed income.
  • Organizations should consider the opportunity to request treating any undistributed income as a set-aside.

In a private letter ruling (PLR 202302014), the IRS has approved a private foundation's request to establish a "set-aside" under IRC Section 4942(g)(2) so that funds the foundation retains to spend on a future construction renovation project will not be subject to the 30% excise tax on undistributed income under IRC Section 4942.

Facts

The mission of the private foundation (Foundation) is to provide space for writers and visual artists to work without interruption. This space includes residencies where artists may live and work for certain periods. Before the COVID-19 pandemic, the Foundation had launched plans to convert certain property to residential use, hiring an architect and general contractor. The local government for the area in which the project is located informed the Foundation that variances would be required, which slowed progress. The COVID-19 pandemic caused further delays, though the foundation "worked diligently to comply with the requirements of the … town planner and to obtain the various permits required," the PLR states.

The Foundation had applied for a building permit and planned to begin construction once the permit is granted. Further, the Foundation indicated that it already paid a certain amount of money to architects, surveyors, landscapers, attorneys, appraisers and the general contractor. Finally, the Foundation indicated that it intended to pay out certain charitable set-asides for project-related costs within 60 months after making the first set-aside.

Applicable law

IRC Section 4942 imposes a 30% excise tax on the undistributed income of most domestic private foundations. However, a private foundation can avoid the excise tax on undistributed income if an amount set aside for a specific project is treated as a qualifying distribution under IRC Section 4942(g)(2)(A). A private foundation may meet the qualifying distribution requirement by establishing that the set-aside amount will be paid within 60 months of the time of the set-aside and the project can be better accomplished by setting the funds aside than by paying them out immediately.

Ruling

Noting that "it would be imprudent … to prepay funds to contractors and professionals for work that has not commenced" and that using set-asides would allow the foundation "to maximize control over the project, with the goal of achieving a better result," the IRS ruled that the set-aside was permissible and would not result in adverse tax consequences.

The ruling directs the foundation to:

  • Document the approved set-asides in the foundation's records as pledges or obligations
  • Pay the set-aside amounts within 60 months after the date of the first set-aside, as IRC Section 4942(g)(2) requires
  • Take into account both:
    • The set-aside amounts when determining the foundation's minimum investment return under IRC Section 4942(e)(1)
    • Income attributable to the set-asides when computing the foundation's adjusted net income under IRC Section 4942(f)

Implications

This private letter ruling serves as a reminder for private foundations to consider whether certain funds may qualify for set-aside treatment. Although set-aside rulings are somewhat rare, organizations should review the specific facts in available PLRs (such as PLR 202302014) and evaluate whether they may benefit from and qualify for set-aside treatment.

Please contact your Ernst & Young tax professional with any questions.

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Contact Information
For additional information concerning this Alert, please contact:
 
Exempt Organization Tax Services
   • Steve Clarke (stephen.clarke@ey.com)
   • Melanie McPeak (melanie.mcpeak@ey.com)
   • Morgan Moran (morgan.moran@ey.com)
   • Cal Hoke (cal.hoke@ey.com)

Published by NTD’s Tax Technical Knowledge Services group; Carolyn Wright, legal editor

 

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