Insights: Article

Private Foundations: Penalty Taxes

By   Brenda Blunt, Deb Nelson

June 17, 2016

The webinar which can be viewed hereThis link takes you to an external website., is an overview of penalty excise taxes applicable specifically to prohibited transactions and penalty taxes for private foundations. The penalty taxes arise in five key areas and this webinar discusses each of them:

  • Self-Dealings
  • Mandatory Distributions
  • Excess Business Holdings
  • Jeopardy Investments
  • Taxable Expenditures

Self – Dealings
Self- dealing is defined as direct & indirect financial transactions between a private foundation and its disqualified persons. The following actions may be considered self-dealings: any sale, exchange or leasing of property, lending of money or other extension of credit, the furnishing of goods, services or facilities, payment of compensation to a disqualified person, the transfer to or use of the income or assets of a private foundation by a disqualified person and the agreement by a private foundation to pay money or other property to a government official. A self-dealing transaction will result in an initial tax of 10% to be paid by the disqualified person who received the payment and the disqualified person is required to restore the organization as if the payment had never occurred, known as a “correction” of the transaction.   If not corrected, the tax on the disqualified person jumps to 200% and the foundation runs the risk of termination. Finally there are penalty taxes assessed against foundation managers who knowingly approved the transaction.

A disqualified persons is anyone who has control of, or has significantly contributed to, the private foundation. This includes, all substantial contributors, all foundation managers, owners of more than 20% of the stock of a corporation, partnership or trust that is considered to be a substantial contributor, a family member of a substantial contributor, foundation manager or one of the previously discussed 20% owners and a corporation, partnership or trust in which more than 35% is owned by any of the above.

Mandatory Distributions
Mandatory distribution rules, applicable only to non-operating foundations, ensures that foundations aren’t just sitting on their funds but are using them for charitable causes. Non-operating private foundations are required to distribute for charitable purposes roughly 5% of the average fair market value of the private foundation’s non-charitable-use assets for the year. The deadline for payout of minimum distributions is the close of the following year and failure to payout the required amount results in a 30% excise tax and tax applies again each year until the foundation pays out the shortfall.

Excess Business Holdings
Excess business holding is generally defined as the ownership of more than the minimal portion of an active trade or business activities of which do not directly advance the organization’s tax-exempt purpose. Private foundations and all disqualified persons are normally permitted to hold up to 20% combined ownership of a business enterprise. If the private foundation owns 2% or less of the enterprise, the excess business holdings rules do not apply. Generally, tripping up on this rule will result in a penalty of 10% of the greatest value of excess holdings during the year and if not corrected a 2nd tier tax of 200% of the excess holdings.

Jeopardy Investments|Jeopardy investments, which are defined as the act of investing in an investment that is so risky that doing so has the potential of putting the private foundations continued existence at risk. This excise tax penalty encourages managers to exercise good judgement when investing in assets. There are certain investment methods that are highly scrutinized, including; trading in securities on margin, trading in commodity futures, investments in oil & gas syndication, purchase of puts, calls and straddles, purchase of warrants and selling short. If there is a jeopardy investment an initial excise tax of 10% of the amount will be incurred and the private foundation manager may be responsible for an additional 10% excise tax.

Taxable Expenditures
Lastly, taxable expenditures are covered in the webinar. Private foundations must devote their income and assets for charitable purposes and maintain the appropriate records. With that principle in mind, certain transactions have been identified by Congress as generally inappropriate uses of private foundation resources including the following: carrying out propaganda or attempting to influence legislation, influencing the outcome of any specific public election or to directly or indirectly carry on any voter registration drive, giving a grant to an individual for travel or study and giving a grant to any organization without exercising sufficient control to ensure it is used for a charitable organization purpose.

To be safe, most private foundations limit their giving to public charities described in section 509(a)(1), (2) and 509(1)(3) other than 509(a)(3) organizations described in clause (i) or (ii) of section 4942(g)(4)(A), (in other words type I or type II, but not type III supporting organizations), only. However, private foundations can give to a variety of organizations, business entities and individuals if they adhere to a list of established rules. Failure to adhere to these rules will result in a tax of 20% the amount expended and the manager may be taxed an additional 5% expended up to $10,000.  Failure to correct the taxable expenditure, which often means getting the money back, will result in an additional tax of 100% of the expenditure to be paid by the private foundation and 50% of the expenditure to be paid by managers who refused to agree to part of all of the correction.

Now that you are aware of these penalty taxes, it is important to educate board members and other disqualified persons about their existence and institute internal controls to ensure transactions don’t violate the rules. Don’t be afraid to ask questions if something doesn’t seem right and watch the full webinar hereThis link takes you to an external website. to learn more.

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