If a private foundation holds too much of an investment, the organization could face major complications.
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 avoid conflict—but to do that, you’ll need background on why the rules exist, which holdings qualify, who can hold them, and how long you have to correct any excessive holdings situation.
Excess Business Holdings History
Congress enacted excess business holdings rules 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.
Those rules limit private foundations in the percentage of ownership they may have in a business enterprise. The rules lay out a fixed period for disposing of excess holdings.
Keep in mind these excess holdings can’t be sold to a disqualified person, defined later.
Certain support organizations and donor-advised funds must now comply with the same rules.
What Are Excess 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 and trusts, and the holdings.
Limitations on excess holdings are calculated using the following ownership definitions:
- Voting ownership stock is included for incorporated businesses. Nonvoting stock held by the private foundation is permitted holdings if disqualified persons together don’t own more than 20% of voting stock.
- For partnerships , profits interest substitutes voting stock and nonvoting stock and nonvoting stock substitutes capital interest
- For trusts, the rules substitute beneficial interest for voting stock.
- Proprietorships aren’t permitted holdings.
It’s important that private foundations set up procedures to monitor business enterprise investment ownership, especially when disqualified persons hold these investments.
What Is a Disqualified Person for a Private Foundation?
In general, a disqualified person is any of the following for a private foundation:
- Substantial contributor. Has contributed more than $5,000 to the foundation if that amount is more than 2% of total contributions. The test applies to cumulative contributions since the foundation’s existence, not only the current year.
- Foundation manager. Includes officers, directors, and trustees of the foundation and anyone with similar powers.
- Owner of more than 20% of the total combined voting power in a corporation, directly or indirectly; the profits interest in a partnership; or the beneficial interest in a trust or unincorporated enterprise, which is a substantial contributor.
- 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 spouses of these descendants. Note that a person’s brothers, sisters, aunts, and uncles aren’t included.
- Corporation, partnership, trust, or estate in which any person listed above owns more than a 35% interest.
- Controlled or related private foundation that’s effectively controlled by the same person or that received substantially all of its contributions from the persons listed in the first three points above.
- Certain governmental officials.
Which Business Enterprises Do Excess Holdings Rules Exclude?
The following business enterprises are excluded:
- A trade or business with substantial passive income. An investment in a trade or business that derives at least 95% 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—such as interest, dividends, royalties, capital gains, or rents from real property.
- Functionally related business. An activity related to the exempt purpose of the private foundation organization wouldn’t be considered a business enterprise for purposes of the excess business holding rules.
Newman’s Own Exception
The rules also exclude companies devoting 100% of profits for charitable purpose owned 100% by the private foundation. This is informally known as the Newman’s Own Exception.
For tax years beginning after December 31,2017, a new exception from the excess business holding rules applies to private foundations if the following requirements are met:
- The private foundation owns 100% of the voting stock during the entire tax year.
- The ownership interest of the company isn’t acquired by purchase.
- Net operating income is distributed to the private foundation within 120 days following the close of the tax year. The net operating income is calculated as gross income less related expense, less taxes imposed, and less a reasonable reserve for working capital or other business needs.
- The private foundation board must be independent to the company—there can’t be a majority overlap of the board of the private foundation and the company.
- No substantial contributor to the private foundation or their family members can be a director, officer, trustee, manager, employee, or contractor to company.
- There can be no loan outstanding from the business to a substantial contributor to the private foundation or their family members.
Keep in mind this is an exception from the excess business holdings rules but not the self-dealing rules.
Which Business Enterprises Are Permitted Holdings?
In general, permitted holdings include the following. Please note, we reference incorporated businesses, but a partnership or trust may be substituted in place of a corporation:
- The 2% de minimis. A private foundation isn’t treated as having an excess business holding in any corporation in which it, together with related foundations, owns 2% or less of the voting stock and 2% or less of the value of all shares outstanding.
- The 20% permitted holding level. A private foundation can hold up to 20% of the voting stock of an incorporated business enterprise; however, the 20% must be reduced by each percentage of voting stock owned by disqualified persons. If disqualified persons together own less than 20% of voting stock the private foundation may hold nonvoting stock.
- The aggregate 35% threshold. If one or more persons who are outsiders, not disqualified persons, effectively control an incorporated business enterprise, the foundation may hold 35% of the voting stock of the corporation. This amount is reduced by the percentage owned by disqualified persons.
What Should a Private Foundation Do with Excess Holdings?
Generally, a private foundation has 90 days to dispose of an excess business holding, acquired other than by purchase, from the time it knows or has reason to know there was an excess business holding problem.
However, if the excess business holding 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 created by unusually large gifts or bequests as long as the foundation meets certain conditions and submits a plan of disposition to the state attorney general and IRS.
How Much Will Excess Holdings Cost Private Foundations?
Penalties will apply for those who fail to comply. If a foundation has excess business holdings, an initial excise tax of 10% is imposed on the foundation on the value of the excess holding.
A private foundation is subject to an additional 200% 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.
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 holding issues.
One approach could be providing a list of the foundation’s investments and its level of ownership to its disqualified persons, requesting acknowledgement of the percentage owned in the same investments held by each disqualified person. Consider vetting any investment for ownership issues before it’s purchased.
Last, private foundations may also reduce their holdings in business enterprises by granting the excess holding to public charities and certain supporting organizations, which would also count towards meeting the foundation’s minimum distribution requirement.
We’re Here to Help
For more information about the excess business holdings rules—or for insight on how your organization can set up a program for monitoring or disposing its investments—contact your Moss Adams professional.