Private foundations sometimes make grants to charitable organizations that have applied for, but not yet received, recognition as tax-exempt, charitable (i.e., Section 501(c)(3)) organizations by the Internal Revenue Service (“IRS”). With long wait times for determinations of exemption, this practice is increasingly common. A recent IRS private letter ruling serves as a strong reminder that the failure to exercise expenditure responsibility with respect to any grant made during that time period may result in penalty taxes on the grantor foundation.
In IRS Private Letter Ruling 201351027 (the “PLR”), a private operating foundation made a grant to an organization in which the foundation held a 60 percent membership interest and which shared a president with the foundation. At the time of the grant, the foundation was aware that the grantee had applied for Section 501(c)(3) tax exemption but had not yet received its determination letter from the IRS. If it had received a determination letter pursuant to the application, the exemption would have been effective as of the grantee’s date of incorporation. After the grant was made, however, the grantee, with the foundation’s knowledge, withdrew its application for tax exemption. Accordingly, the grantee was not a tax-exempt organization at the time the grant was made.
A grant by a private foundation to an organization that is not an appropriate type of public charity is a “taxable expenditure” under Section 4945 of the Internal Revenue Code, subject to a 20 percent penalty excise tax and a requirement of correction, unless the foundation exercises “expenditure responsibility” with respect to the grant. Expenditure responsibility requires that the foundation establish procedures to ensure that the grant is spent solely for the charitable purposes for which it was made, obtain reports from the grantee on the use of the grant funds, and make reports to the IRS on the grant expenditures.
The expenditure responsibility rules specifically require, among other things, that the foundation and grantee enter into a written agreement governing the terms of the grant, and that this agreement obligate the grantee to return any portion of the grant funds not used for the purposes of the grant. In the circumstances considered in the PLR, due to an “oversight” by the foundation, the foundation and grantee did not enter into the required written agreement. The foundation also did not request that the grant funds be returned when the grantee withdrew its application. Despite these lapses, the foundation reported the grant as an expenditure responsibility grant on its Form 990-PF for the year of the grant. The grant funds eventually were returned to the foundation, which amended its Form 990-PF to report the grant as a taxable expenditure and paid the first-tier excise tax under Code Section 4945. When it reported the taxable expenditure, the foundation requested an abatement of that excise tax for reasonable cause.
The IRS ruled that the foundation failed to show that the taxable expenditure was due to reasonable cause and not to willful neglect (the standard for abatement) because the foundation failed to enter into a written agreement with the grantee as required by the expenditure responsibility rules, was “fully aware” that the grantee was not exempt at the time of the grant, and did not seek professional advice before making the grant. The IRS noted that there must be “strict compliance” with the expenditure responsibility requirements, and that the foundation could not rely on the grantee’s pending application, particularly given the “close ties” between the foundation and grantee.
Quarles & Brady Comment
The PLR highlights the risk that a private foundation takes in making a grant to a grantee before it has received an IRS determination of its tax exemption without exercising expenditure responsibility. While in the situation considered in the PLR the foundation and grantee were related, under the law that fact was not essential to the IRS’s conclusion. Given the extended processing times for exemption applications, there is no guarantee that a grantee’s determination letter will be issued prior to the time the foundation must file its annual tax return reporting the grant (when expenditure responsibility grants must be reported), and there never is a guarantee that the grantee will be granted the determination, including specific public charity classification, that it has sought. The increased processing time recently also heightens the risk to the foundation due to the numerous unforeseen events that could occur during that time with respect to the grant, the grantee, or the foundation.
Private foundations wanting to make grants to grantees that have not yet received their determination letters, and who do not want to exercise expenditure responsibility, may consider suggesting to the grantee a properly structured fiscal sponsorship (not a fiscal agent relationship), which may avoid the expenditure responsibility requirements so long as the grant is made to the public charity fiscal sponsor and is not earmarked for any nonqualified recipient.
While foundations that are public charities rather than private foundations do not have an obligation to exercise expenditure responsibility, they do have an obligation to operate exclusively for charitable purposes. Accordingly, they also should exercise caution in making grants to organizations that have not yet been recognized as charitable by the Internal Revenue Service and be sure to confirm that the activities to be funded will in fact qualify as charitable.