The IRS has released final regulations that will impact how U.S. private foundations determine that a foreign charitable organization – i.e., one not organized under U.S. law or recognized as a public charity by the IRS – is the “equivalent” of a U.S. public charity for certain purposes.  This determination is useful in the context of a private foundation’s compliance with the qualifying distribution rules under Section 4942 of the Internal Revenue Code (the “Code”) as well as with the taxable expenditure rules under Section 4945 of the Code.

Under Section 4942 of the Code and the applicable Treasury Regulations, a qualifying distribution generally consists of any amount paid by a private foundation to accomplish one or more charitable purposes.  Special rules govern when and under what circumstances a grant to another private foundation may be treated as a qualifying distribution.  In the case of foreign organizations, the Treasury Regulations helpfully permit a foundation to make a “good faith determination” that a foreign grantee is the equivalent of a public charity (as described in Code section 509(a)(1), (a)(2) or (a)(3)), thereby obviating the need to apply and work through the special Code Section 4942 private foundation rules for grants to a foreign charitable organization that has not otherwise been recognized by the IRS as a public charity.

Similarly, under Section 4945, which requires a private foundation to exercise expenditure responsibility with respect to grants to entities other than public charities (and certain “public” entities), a private foundation may treat a grant to a foreign organization that has not been recognized by the IRS as a public charity as the equivalent thereof if the foundation makes a “good faith determination” that the foreign grantee is a public charity.  This good faith determination requirement is referred to as the “general rule” in the preamble to the final regulations.

Regulations in effect prior to 2012 provided that a foundation could ordinarily rely on a grantee’s affidavit or an opinion of counsel in making this “good faith determination” (referred to in the preamble of the final regulations as the “special rule”).

Proposed regulations issued in 2012 modified the special rule, providing that a foundation could ordinarily rely on a grantee’s affidavit or written advice from a qualified tax practitioner (defined as an attorney, a CPA or an enrolled agent who is subject to the Circular 230 requirements) rather than restricting reliance to opinions of counsel.  This change was intended to reduce the expense of obtaining an equivalency determination by expanding the class of tax practitioners that could provide this advice.

The New Regulations

Qualified Tax Practitioner Expansion Stays; Use of Affidavits Narrows

The final regulations – which were released at the end of September – significantly modify the special rule by narrowing a foundation’s ability to rely (solely) on a grantee’s affidavit.  Now, a foundation can only ordinarily rely on current written advice from a qualified tax practitioner (using the expansive definition in the 2012 proposed regulations) in making a good faith determination.  The grantee affidavit option has been eliminated as a stand-alone basis for making this determination.

Nevertheless, a grantee affidavit still might have some utility in this process.  The preamble to the final regulations notes that:

The final regulations do not, however, foreclose the use of grantee affidavits as a source of information in otherwise making a good faith determination.  Nor does elimination of the affidavit for purposes of the special rule mean that the foundation must obtain written advice from a qualified tax practitioner in order to make a good faith determination.  (Emphasis added.)  For example, a foundation manager with understanding of U.S. charity tax law may under the general rule make a good faith determination that a foreign grantee is a qualifying public charity based on the information in an affidavit supplied by the grantee.  Furthermore, foundation managers or their in-house counsel may themselves be qualified tax practitioners, whose written advice may be reasonably relied upon […].

From a practical perspective, then, the final regulations give foundations two options:

  • First, a foundation can satisfy the special rule by obtaining current written advice from a qualified tax practitioner. If the foundation has an employee on staff who satisfies the qualified tax practitioner requirements, then the special rule can be satisfied in-house; if not, the foundation would need to obtain written advice from outside counsel, an accountant, or a third-party repository.
  • Second, a foundation can choose, instead, to rely on the less precise general rule and have a foundation manager with an understanding of U.S. charity tax law (but who may or may not be a “qualified tax practitioner”) make a good faith determination. Obtaining a grantee affidavit may be a useful due diligence tool in connection with this process, which should also include appropriate internal documentation indicating how and by whom the determination was made and the steps followed. This option likely will be used mostly by foundations without a qualified tax practitioner on staff.

The first option provides certainty for foundations, but involves additional cost for those foundations without an in-house qualified tax practitioner.  At first glance, the second option provides flexibility for foundations without a legal budget or a qualified tax practitioner on the payroll.  However, in order to comfortably rely on their good faith determinations (particularly given the high stakes involved), many foundations in this position might need to work with outside counsel to ensure that the foundation manager making these determinations has a sufficient understanding of U.S. charity tax law, which could ultimately be more costly than obtaining written advice from a third-party repository.

For foreign grants involving any complexity or challenging grantee classification issues, foundations (both with and without qualified tax practitioners on staff) might need to work with outside counsel, as these types of grants are often outside the scope of equivalency determinations performed by third-party repositories and possibly beyond the scope of in-house qualified tax practitioners.

Current Written Advice – Clarification

The final regulations also clarify that a foundation may only rely on a qualified tax practitioner’s written advice that is “current”, meaning that the relevant law on which the advice is based has not changed since the date of the advice and the factual information on which the advice was based is from the organization’s current or prior year.  (In addition, written advice that a grantee has satisfied one of the public support tests under the Code, based on a five-year test period, will be treated as current for the two years immediately following the end of that test period.)  According to the preamble to the final regulations, the purpose of this timeliness rule is to permit the IRS to determine that the grantee would be likely to qualify as a public charity at the time the advice is written.  This clarification might require charities to update their equivalency determinations more frequently than they did in the past.

Rev. Proc. 92-94 – Update in the Works

The IRS also indicated that it intends to publish an update to Rev. Proc. 92-94, which provides further guidance on making good faith determinations, to reflect the final regulation changes as well as changes to the public support tests that went into effect in 2011.  Additionally, the preamble noted that, until further guidance is issued, sponsoring organizations of donor advised funds may use the final regulations as guidance in making equivalency determinations.  In a perfect world, the update would also address the parameters of the general rule and how foundations can go about making a good faith determination without a qualified tax practitioner – but there’s no indication that the update will go that far.

Transition Period

While the final regulations went into effect on September 25, 2015, there is a 90-day transition period during which a foundation may continue to make good faith determinations based on the proposed regulations issued in 2012.  In addition, a foundation that has made a written grant commitment to a grantee on or before September 25, 2015 pursuant to a good faith determination based on the prior regulations has up to five years to fulfill that commitment.