Putting too many eggs in one basket—or overinvesting one company—isn’t only risky; for private foundations, it’s also punishable.

Under the excess business holdings rules, percentage thresholds determine how much ownership a foundation and certain associated persons may hold in a business enterprise and for how long. Exceed those thresholds and your foundation may find itself paying a hefty excise tax. Thoughtful procedures for monitoring enterprise investments will help your foundation stay out of hot water—but to do that, you’ll need some background: why the rules exist, which holdings qualify, who can hold them, and how long you have to correct any excess business holdings situation. We’ll cover each of these in turn.

The excess business holdings rules were enacted by Congress more than 40 years ago to limit individuals’ ability to retain control of a business enterprise by setting up a private foundation and transferring substantial ownership to the private foundation. The result of those rules is that private foundations are limited in the percentage of ownership they may have in a business enterprise. The rules lay out a fixed period of time for disposing of excess business holdings and control who may receive them. (In short, they cannot be sold to a disqualified person, which we’ll cover in greater detail later.) Certain support organizations and donor-advised funds are now also required to comply with the same rules.

What Are Excess Business Holdings?

An excess business holding exists when a foundation and its disqualified persons’ combined holdings in a business enterprise exceed set percentage thresholds. For these purposes, business enterprises include corporations, partnerships, trusts, and their holdings. Limitations on excess business holdings are calculated using the following ownership definitions:

• For incorporated businesses, both voting and nonvoting ownership stock are included.
• For partnerships “voting stock and nonvoting stock” is substituted with “profits and capital interests.”
• For trusts, the rules are applied by substituting beneficial interest for voting stock.

It’s important that private foundations set up procedures to monitor business enterprise investment ownership, especially when these investments also are held by disqualified persons.

What Business Enterprises Are Excluded?

An investment in a trade or business that derives at least 95 percent of its gross income from passive sources isn’t considered a business enterprise for purposes of the excess business holdings rules. For example, a private foundation could invest in various partnerships that generate passive income—interest, dividends, royalties, capital gains, or rents from real property. Second, an enterprise that performs an activity related to the exempt purpose of the organization—that is, a functionally related business—wouldn’t be considered a business enterprise for purposes of these rules.

What Is a Disqualified Person?

In general, private foundations must consider the following to be disqualified persons:

• A substantial contributor. This is any person who has contributed more than $5,000 to the foundation if that amount is more than 2 percent of total contributions. The test is applied to cumulative contributions since the foundation’s existence, not only the current year.
• A foundation manager. This includes officers, directors, and trustees of the foundation and anyone that has similar powers.
• An owner of more than 20 percent of:
  • The total combined voting power in a corporation (directly or indirectly)
  • The profit interest in a partnership
  • The beneficial interest in a trust or unincorporated enterprise that is a substantial contributor
• A family member of any person listed in the above. This includes a person’s spouse, ancestors, children (including legally adopted children), grandchildren, great-grandchildren, and the spouses of these descendants. Note that a person’s brothers and sisters aren’t included.
• A corporation, partnership, trust, or estate in which any person listed above owns more than a 35 percent interest.
• A controlled or related private foundation that’s effectively controlled by the same person or persons or that also received substantially all of its contributions from the persons listed in the first three points above.
• Certain governmental officials.

What Business Enterprise Holdings Are Permitted?

In general, permitted holdings include the items listed below:

• The 2 percent de minimis amount. A private foundation isn’t treated as having an excess business holding in any corporation, partnership, or trust in which it, together with related foundations, owns 2 percent or less of the voting stock and 2 percent or less of the value of all shares outstanding.
• The 20 percent permitted holding level. A private foundation can hold up to 20 percent of the voting stock of a corporation, partnership, or trust; however, the 20 percent must be reduced by each percentage of voting stock owned by disqualified persons.
• The aggregate 35 percent threshold. If one or more persons who are outsiders (not disqualified persons) effectively control a corporation, partnership, or trust, the foundation is permitted to hold 35 percent of its voting stock. This amount is reduced by the percentage owned by disqualified persons.

What Should You Do with Excess Business Holdings?

Generally, a private foundation has 90 days from the time it knows or has reason to know there was an excess business holdings problem. However, if the problem is created as the result of a gift or bequest, the foundation has five years to reduce the business holdings—or those of its disqualified persons—to the permissible levels. Furthermore, the IRS has authority to allow an additional five-year period to dispose of excess business holdings that were created by unusually large gifts or bequests as long as certain conditions are met and a plan of disposition is submitted to the state attorney general and IRS.

How Much Will Excess Business Holdings Cost You?

If you’re wondering what it all amounts to for your private foundation, the answer is a penalty for those who fail to comply. If a foundation has excess business holdings, an initial excise tax of 10 percent is imposed on the excess business holdings. A private foundation is subject to a second 200 percent tax if the excess business holdings aren’t disposed of during the taxable period. This taxable period begins on the first day there are excess business holdings and ends on either the date a notice of deficiency with respect to the initial excise tax is mailed or the date the initial excise tax is assessed, whichever is earlier.

We're Here to Help

The excess business holdings rules are complicated and easy to miss, especially if the portfolios of the foundation and its disqualified persons contain the same investments. Foundations should develop procedures to identify all their disqualified persons and any potential excess business holdings, which requires disqualified persons to inform the foundation of any potential excess business holdings issues.

One approach could be providing a list of your foundation’s investments and its level of ownership to disqualified persons, requesting acknowledgement of the percentage owned in the same investments held by each disqualified person. Second, consider vetting any investment for ownership issues before it is purchased. Last, note that private foundations may reduce their holdings in business enterprises by granting the excess business holdings to public charities and certain supporting organizations, an action that would also count toward the foundation’s minimum distribution requirement.

For more information about the excess business holdings rules—or for insight on how your organization can set up a program for monitoring its investments or disposing of them—contact your Moss Adams professional.