3 Steps of Grantmaking Due Diligence for Private Foundations

While some private foundations deliberately provide grants to entities other than qualifying public charities, many foundations are often surprised to learn their grantmaking incurred taxable expenditures. This scenario often happens when foundations grant funds to entities that aren’t qualifying public charities, such as:

  • Private foundations
  • Section 509(a)(3) nonfunctionally integrated supporting organizations
  • Foreign nongovernmental organizations (NGO)
  • Public charities that lost tax-exempt status before the grants were made

Either way, private foundations can avoid surprises by approaching expenditure responsibility as part of grantmaking due diligence. Performing proper due diligence can help a private foundation identify and address grantmaking to nonqualified charities before funds go out the door.

In this article, learn grantmaking due-diligence best practices that can help your private foundation tackle expenditure responsibility requirements, update grant procedures, and prepare for the future. 

Step 1: Complete Pre-grant Inquiry

To comply with expenditure responsibility, a private foundation needs to take certain steps before a grant is approved and made.

The first step is to conduct a limited inquiry—also known as a pre-grant inquiry—concerning the potential grantee. This inquiry must be complete enough to assure a person that the grantee will use the grant for the proper purposes.

Pre-grant Inquiry Content

The inquiry should look at the following topics:

  • Identity, prior history, and experience of the grantee organization and its managers
  • Any knowledge the private foundation has, based on prior experience or otherwise, or other information that is readily available about the management, activities, and practices of the grantee organization

Pre-grant Inquiry Scope

The scope of the inquiry can vary from case to case, depending on the following:

  • Size and purpose of the grant
  • Period over which it’s to be paid
  • Prior experience the grantor has regarding the grantee’s capacity to use the grant for the proper purposes

Written Commitments with Grant Recipients

A foundation will need to enter into a written commitment with the grant recipient prior to paying the grant. There are a few requirements for these written commitments, and they differ slightly based on whether the expenditure is a grant- or program-related investment.

Grant Commitments

To meet the expenditure responsibility requirements regarding the making of a grant commitment, a private foundation must require that each investment is signed by an appropriate officer, director, or trustee of the grantee organization.

The grantee must also make the following commitments:

  • Provide repayment. Reimburse any portion of the grant that isn’t used for the purposes of the grant.
  • Complete annual reports. Submit full and complete annual reports on the way the funds are spent and the progress made in accomplishing the purposes of the grant.
  • Keep updated records. Maintain records of receipts and expenditures and make books and records available to the grantor at reasonable times.
  • Maintain political neutrality. Refrain from using any granted funds for propaganda purposes or to attempt to influence legislation; to influence the outcome of a specific public election or to carry on, directly or indirectly, a voter-registration drive; or to make a grant that doesn’t comply with the requirements of Internal Revenue Code (IRC) Section 4945(d)(3).
Program-Related Investments

To meet the expenditure responsibility requirements for a program-related investment, a private foundation must require that each investment is signed by an appropriate officer, director, or trustee of the recipient organization.

The written commitment must also specify the purpose of the investment and include an agreement by the organization to do the following:

  • Use funds appropriately. Apply all funds received from the private foundation only for the purposes of the investment and repay any portion not used for such purposes, provided that, with respect to equity investments, the repayment will be made only as permitted by applicable law concerning distributions to holders of equity interests.
  • Submit financial reports and statements. At least once a year during the existence of the program-related investment, submit full and complete financial reports of the type ordinarily required by commercial investors under similar circumstances and a statement that it’s complied with the terms of the investment.
  • Keep adequate records. Maintain books and records adequate enough to provide information ordinarily required by commercial investors under similar circumstances, and make these books and records available to the private foundation at reasonable times.
  • Avoid political involvement. Don’t use any of the funds for propaganda purposes or to attempt to influence legislation; to influence the outcome of a specific public election or to carry on, directly or indirectly, a voter-registration drive; or to make a grant that doesn’t comply with the requirements of IRC Section 4945(d)(3) or (4).

Private foundations should document contemporaneously that each of the above items has been completed and retain documentation along with its grant files.

Step 2: Obtain a Complete Report

Next, the private foundation must obtain grant reports that detail how the grantee has spent their funds. The type of reporting depends on the grant being made.

Operational Grants

Two types of reports are required for operational grants: annual and final.

Annual Report

For the duration of a grant, a private foundation should obtain an annual report on how the grant is being spent. Generally, a grantee must make these reports at the end of annual accounting periods, within which the grant or any portion thereof is received. Reports are provided until all amounts are expended.

These reports should include information about the following topics:

  • Use of grant funds
  • Compliance with the terms of the grant
  • Progress made by the grantee toward achieving the purposes of the grant
Final Report

It’s important for the grant recipient to provide a final report upon spending all grant funds—especially if a grant spans more than one year. The grantee should submit this final report within a reasonable period of time after the close of the annual accounting period when the use of funds is completed. The report should include the following:

  • Detailed account of all expenditures made from the grant funds, including salaries, travel, and supplies
  • Indication of the progress made toward the goals of the grant

Capital-Endowment Grants

If a private foundation makes a grant described in IRC Section 4945(d)(4) to another private foundation that is exempt from taxation under IRC Section 501(a) for endowment, the purchase of capital equipment, or other capital purposes, the grantor foundation should require reports from the grantee on the use of the principal and the income, if any, from the grant funds.  

The grantee should then submit these reports for the following years:

  • The taxable year in which the grant was made
  • The two immediately succeeding taxable years

However, the grantor may allow these reports to be discontinued if it’s reasonably apparent that, before the end of the second succeeding taxable year, neither the principal, income from the grant funds, or equipment purchased with grant funds has been used for any purpose that would result in a tax liability under IRC Section 4945(d).

Step 3: File a Report with the IRS

The final step of expenditure responsibility involves reporting to the IRS via the Form 990-PF.

A granting foundation must provide the required information on the Form 990-PF for each grant made during the taxable year that’s subject to expenditure responsibility requirements. For each of these grants, a foundation must also list any outstanding amount or reports applicable to the taxable year.

For capital-endowment reporting, the grantor must provide the required information only for taxable years when they required a report from the grantee.

Information to Include on the Form 990-PF

The report on the Form 990-PF should contain the following information:

  • Grantee name and address
  • Date and amount of the grant
  • Grant purpose
  • Amounts expended by the grantee, based on the most recent report received from the grantee
  • Whether the grantee has diverted any portion of the funds—or their income, in the case of an endowment grant—from the purpose of the grant, to the knowledge of the grantor
  • Dates of any reports received from the grantee
  • Date and results of any verification of the grantee's reports

Reports received by a private foundation after the close of its accounting year but before the due date of its information return for that year don’t need to be reported on this return. They may instead be reported on the grantor's information return for the year in which the reports are received from the grantee.

Information to Maintain for the IRS

While reporting on the 990-PF is limited to the above items, a granting foundation may benefit from maintaining the following records in case the IRS has further questions:  

  • The agreement covering every expenditure-responsibility grant made during the taxable year
  • Reports received during the taxable year from grantees on expenditure-responsibility grants
  • Reports made by the grantor's personnel or independent auditors of any audits or investigations conducted during the taxable year with respect to any expenditure-responsibility grant

Potential Consequences of Incorrect Filing

If a taxable expenditure is identified after the fact, it’s often too late to correct and undo the expenditure and the following consequences could apply.

Form 4720 Reporting

The transaction will need to be reported on the Form 4720 with tax paid, which is 20% of the amount expended. If the expenditure isn’t corrected within the taxable period, an additional tax of 100% of the amount expended is imposed on the foundation.

Additional Tax Responsibilities for Foundation Executives

A foundation board member or executive could also be responsible for a tax on the transaction. If a foundation manager knowingly, willfully, and without reasonable cause agrees to the taxable expenditure, the initial tax on the management is 5% of the amount expended, up to a maximum tax of $10,000 for any expenditure.

The foundation manager isn’t liable for the tax, however, if it can show the expenditure was due to reasonable cause and not to willful neglect. The expenditure must also be corrected within the correction period

We’re Here to Help

While many organizations hope to avoid taxable expenditures and the related expenditure responsibility, the above road map can be used by foundations to help establish their overall due-diligence best practices for grantmaking.

If you have any questions about expenditure responsibility, please contact your Moss Adams professional.