Private foundations are subject to strict rules regarding their spending, and the regulations on taxable expenditures cover a range of activities. If a private foundation violates these regulations, it could face costly penalties.
To avoid risking a violation, boards and staff members of private foundations should become familiar with these rules and adopt good governance policies.
Below, learn what activities could result in a taxable expenditure, penalty amounts, how to correct a taxable expenditure, and detailed breakdowns of the guidelines for each activity.
What’s a Taxable Expenditure?
As detailed in Internal Revenue Code (IRC) Section 4945(d), a taxable expenditure is an amount paid or incurred to:
- Attempt to influence legislation, known as lobbying
- Influence the outcome of any public election or carry on any voter registration drive, unless certain requirements are met
- Make a grant to an individual for travel, study, or other similar purposes, unless certain requirements are met
- Make a grant to an organization, other than most public charities or exempt operating foundations, unless the private foundation exercises expenditure responsibility for the grant
- Carry out any purpose other than the private foundation’s exempt purpose
The restrictions were enacted as part of the Tax Reform Act of 1969. The US Congress had concerns over private foundations becoming more politically active and wanted to limit the way private foundations were spending tax-exempt funds.
If a private foundation makes a taxable expenditure, it faces an excise tax of 20% of the taxable expenditure amount. Additionally, any foundation manager who agreed to make the expenditure faces an excise tax of 5% of the expenditure, up to a maximum of $10,000 for a single expenditure, unless the action had reasonable cause and wasn’t willful.
A foundation manager knowingly agreed to a taxable expenditure if they:
- Had actual knowledge of sufficient facts so that, based on those facts, the expenditure would be a taxable expenditure
- Were aware such an expenditure may violate the rules governing taxable expenditures
- Failed to make reasonable attempts to determine if the activity is a taxable expenditure in a negligent manner, or is already aware it’s a taxable expenditure
Additional taxes could be imposed if the taxable expenditure isn’t corrected within the taxable period—up to 100% of the taxable expenditure amount to the foundation and 50% of the amount, with a maximum of $20,000 for a single expenditure, to the foundation manager.
The taxable period is the duration from the date when the expenditure occurred to either the date a notice of deficiency for the initial tax is mailed or the date the tax is assessed, whichever falls earlier.
Correcting a taxable expenditure is done by recovering part or all of the expenditure to the extent recovery is possible. If full recovery isn’t possible, the foundation should take other corrective actions as determined by the circumstances in the situation.
Types of Taxable Expenditure Activities
A private foundation will incur a taxable expenditure if it attempts to influence legislation, commonly referred to as lobbying.
Lobbying can include:
- Direct lobbying, such as communication with legislators, government officials, or employees who may draw up legislation
- Grass roots lobbying, such as an attempt to affect public opinion on legislation
Legislation is defined, according to Treasury Regulation 56.4911-2(d)(1), as “action by the Congress, any state legislature, any local council, or similar legislative body, or by the public in a referendum, ballot initiative, constitutional amendment, or similar procedure.”
The regulations allow several exceptions for what’s considered to be lobbying, including:
- Nonpartisan analysis, study, or research
- Technical advice or assistance to a government body in response to a written request for that information
- Appearances before or communications with a legislative body regarding any decision that may affect the existence of the private foundation, its powers and duties, its tax-exempt status, or the deductibility of contributions
- Examinations and discussions of broad social and economic issues
Can a Private Foundation Make Grants to Charities that Lobby?
A private foundation can make a general support grant to a public charity that engages in lobbying, as long as the grant isn’t earmarked for lobbying.
For specific projects, such as funding a charity’s literacy program, a private foundation can also make a grant to a public charity as long as:
- The grant isn’t earmarked for lobbying
- The sum of all grants made by the private foundation for the year don’t exceed the budgeted amount for the project’s nonlobbying activities
Private foundations should include language in their grant-making literature and grant agreements that grants aren’t to be spent on lobbying or political activities.
A private foundation is deemed to influence a public election if it participates or intervenes in any political campaign for or against a candidate for public office, which results in a taxable expenditure. The regulations state that these activities include, but aren’t limited to:
- Publishing or distributing written statements or making oral statements for or against a candidate
- Paying campaign workers’ salaries or expenses
- Conducting or paying for a voter-registration drive limited to the geographic area covered by the campaign
Can a Private Foundation Engage in Nonpartisan Activities?
A private foundation can engage in nonpartisan activities, such as nonpartisan public education and training sessions about participation in the political process, under the following conditions:
- Political activities are nonpartisan, not confined to one election period, and carried on in five or more states
- The foundation spends at least 85% of its income directly for the active conduct of its exempt purpose
- The foundation receives at least 85% of its support, other than gross investment income, from exempt organizations, the general public, and governmental units
- The foundation receives no more than 25% of this support from any one exempt organization and no more than 50% of total support from gross investment income; support is determined by looking at the current year and preceding four years
Can a Private Foundation Participate in Voter Registration Drives?
Yes, as long as the criteria for nonpartisan activities are met. In addition, any contributions a foundation receives for voter registration drives can’t be subject to conditions limiting the drives to specific states, political subdivisions, or to one election period.
Grants to Individuals
In general, a grant to an individual for travel, study, or other similar purposes by such individual is considered a taxable expenditure.
The exception would be if the individual grant is awarded on an objective and nondiscriminatory basis pursuant to a procedure approved in advance and one or more of the following:
- The grant constitutes a scholarship or fellowship grant excluded from gross income under IRC Section 117(a) for study at an educational institution described in IRC Section 170(b)(1)(A)(ii)
- The grant constitutes a prize or award subject to the provisions of IRC Section 74(b) if the recipient of such prize or award is selected from the general public
- The purpose of the grant is to achieve a specific objective, produce a report or other similar product, or improve or enhance a literary, artistic, musical, scientific, teaching, or other similar capacity, skill, or talent of the grantee
How Does a Private Foundation Receive Advance Approval from the IRS?
As noted above, if a private foundation is beginning an individual grant program that provides scholarships, fellowships, educational loans, or other educational grants that weren’t described in its exemption application, it must request advance approval of its grant-making procedures from the IRS.
Advance approval is a one-time approval of the private foundation’s system of standards and procedures for awarding grants. Approval will apply to succeeding grant programs if the standards and procedures under which they are conducted don’t differ materially from those described in the organization’s initial request for advance approval.
To request advance approval, the private foundation should send a letter providing the information requested on Form 1023.
A private foundation could be subject to taxable expenditure taxes for donating to an organization that subsequently awards grants to individuals for travel or study. The regulations provide a safe harbor that allows a private foundation to make a grant of this nature if:
- The private foundation doesn’t earmark the grant for any specific person.
- There isn’t an oral or written agreement allowing the private foundation to cause the selection of a specific person.
In a grant given to a public charity, the private foundation could participate in the selection of an individual grantee to a limited extent, as long as:
- The public charity remains in control of the selection process.
- The grant is made for a project under the public charity’s supervision.
A private foundation can make a grant to a government agency and earmark its use to an individual if the agency gets advance approval from the IRS that its grant-making program does the following:
- Furthers a charitable purpose
- Requires the individual to submit reports to the agency
- Requires the agency to investigate any grants in jeopardy
Disaster Relief Payments
Beyond grants for scholarships and travel, private foundations can provide direct assistance to individuals in need of assistance—including those hit by a natural disaster or the COVID-19 pandemic—without triggering a taxable expenditure. This typically, but not always, comes in the form of support for individuals who need emergency assistance and disaster relief.
Examples include grants to individuals in need of food or shelter because of a natural disaster, grants to individuals who need short-term emergency assistance, or grants to individuals experiencing hardship caused by job loss, family illness, violent crime, or physical abuse.
Grants to Other Organizations
A taxable expenditure includes any amount paid or incurred by a private foundation as a grant to an organization, unless the grant is made to certain types of public charity organizations or the foundation exercises expenditure responsibility.
A private foundation need not exercise expenditure responsibility for grants made to the organizations that are described in Section 501(c)(3) and or the categories below:
- IRC Section 509(a)(1):
- Churches described in Section 170(b)(1)(A)(i)
- Educational institutions described in Section 170(b)(1)(A)(ii)
- Hospitals described in Section 170(b)(1)(A)(iii)
- Organizations supporting state colleges and universities described in Section 170(b)(1)(A)(iv)
- Governmental units described in Section 170(c)(1)
- Organizations publicly supported by the general public and governmental units described in Section 170(b)(1)(A)(vi)
- State schools described in Section 511(a)(2)(B)
- Foreign government agencies
- International organizations listed in Executive Order under 22 U.S.C. 288
- Section 509(a)(2) organizations receiving more than one-third of their support from any combination of gifts, grants, contributions, membership fees, and gross receipts from permitted sources
- Section 509(a)(3) supporting organizations unless the supporting organization is a Type III non-functionally integrated organization
- Section 4940(d)(2) organizations which describe certain private exempt operating foundations
IRC Section 4945(h) states the private foundation, “is responsible to exert all reasonable efforts to establish procedures: (1) to see that the grant is spent solely for the purpose for which it is made, (2) to obtain full and complete reports from the grantee on how the funds are spent, and (3) to make full and detailed reports available to the IRS.”
Treasury Regulations Section 53.4945-5(b) provides additional guidance on the steps, including the following:
- The private foundation must conduct a pre-grant inquiry.
- The private foundation must receive a written agreement containing certain terms of the grant.
- The private foundation must obtain certain reports from the grantees.
- The private foundation must properly report the expenditure responsibility grants to the IRS.
- The private foundation must take-action in recovering the grant if the grantee fails to comply with any of the aforementioned items.
Additional guidelines related to expenditure responsibility can be found in our article, 3 Steps of Grantmaking Due Diligence for Private Foundations.
Expenditures for Noncharitable Purposes
According to Treasury Regulation 53.4945-6(b)(2), unreasonable administrative expenses—such as compensation, consultant fees, or payment for other services—will result in a taxable expenditures unless the private foundation can demonstrate the expenses were “paid or incurred in the good faith belief they were reasonable,” and payment of these expenses was done with “ordinary business care and prudence.” Facts and circumstances of each case will determine if an expense is unreasonable.
Expenses that Aren’t Treated as Taxable Expenditures
The regulations list several types of expenses that aren’t treated as taxable expenditures, including:
- Expenses for investments to earn income that is used to further the foundation’s charitable purpose
- Any expenses that qualify as deductions in the computation of unrelated business income
- Any payment that constitutes a qualifying distribution or an allowable deduction under IRC Section 4940
- Reasonable expenses to evaluate, acquire, modify, or dispose of program-related investments
- Business expenses by the recipient of a program-related investment
We’re Here to Help
If you have any questions about taxable expenditures and how to avoid penalties, please contact your Moss Adams professional.