With continued challenges, private foundations should proactively focus on their year-end tax strategies to prepare for 2023.
Throughout 2022, the industry continued to focus on the COVID-19 pandemic and political climate, bringing challenges and opportunities for foundations and their grantees.
Learn how to focus on key tax laws and opportunities which could affect your private foundation, as the following sections illustrate:
The Taxpayer First Act, enacted July 1, 2019, requires tax-exempt organizations to electronically file information returns and related forms. The law affects tax-exempt organizations in tax years beginning after July 1, 2019.
Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Trust Treated as Private Foundation, for tax years ending July 31, 2020, and later must be filed electronically.
Form 990-T, Exempt Organization Business Income Tax Return, for tax years ending December 2020 and later with a due date on or after April 15, 2021, must be filed electronically and not on paper. A limited exception applies for 2020 Form 990-T returns submitted on paper that bear a postmark date on or before March 15, 2021.
Notice 2021-01 provides that as a result of this electronic filing mandate, each taxpayer filing Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code (IRC), must file their own return.
Taxpayers such as disqualified persons and foundation managers can no longer rely on Treasury Regulation Section 53.6011-1(c) to report and pay an excise tax reported on Form 4720 on the private foundation’s return.
For tax years ending December 2020 and later with a due date on or after July 15, 2021, a private foundation filing Form 4720 must file the return electronically.
A limited exception applies for 2020 Form 4720 returns submitted on paper that bear a postmark date on or before June 15, 2021.
IRS Priorities and Accomplishments
Priorities for FY2022 have been to collaborate across the IRS on existing and emerging issues, such as:
- Conservation easements
- Abusive charitable remainder trusts and employee stock ownership plans (ESOPs)
- COVID-19-related employer credits
- Potentially abusive promoter schemes
- Final regulations on section 509(a)(3) supporting organizations
- Guidance on the tax treatment of transactions involving digital assets
There has been an increased focus on exams of high-income taxpayers with tax-exempt entity issues, including foundations’ tax filings being pulled into examinations of estates and high-income individual tax return filings due to large charitable contribution deductions.
The IRS Tax-Exempt/Government Entities (TE/GE) division published their FY2021 accomplishments letter earlier this year. Below are some items to note from their accomplishments letter:
Completed 3,249 Exempt Organizations Examinations
- 82% of the examinations resulted in a tax change
- 34% of the examinations were from a related examination
- 94 revocations were proposed, generally not operating for exempt purpose or private inurement or political activities present
Exam Issues Identified
- Unrelated business income
- Excise taxes
- Employment tax issues, including employee misclassification and taxable fringe benefits
The Inflation Reduction Act allocated approximately $80 billion to the IRS over the next ten years. The IRS indicated their FY2023 program and priorities as listed below.
Enhance Taxpayer Services
This IRS noted promoting the use of taxpayer digital communications to taxpayers and representatives, increasing access to tax services throughout Indian Country, and more.
Strengthen Compliance Activities
This includes employing the issue scoring model to develop issues submitted in the Issue Portal for potential compliance strategies. It also covers collaboration across the IRS on existing and emerging issues, including examinations of wealthy individuals and expansion of use of data, machine learning, and artificial intelligence algorithms to select returns for exam.
Develop the Workforce
Workforce development includes revising the Frontline Leadership Readiness Program (FLRP) training to include hands-on training early in the curriculum to set candidates up for success.
This encompasses the deployment of electronic filing of additional returns filed by TE/GE taxpayers, including Forms 5227, 5330, and 8038-CP, as well as the launch of the new consolidated TE/GE Examination Internal Revenue Manual (IRM).
Initiative to Accelerate Charitable Giving
The Accelerating Charitable Efforts Act (ACE Act) bipartisan legislation was introduced on June 9, 2021. The legislation was introduced in the Senate in February 2022. The bill’s provisions spurred some debate in the sector, but the proposals haven’t been enacted as of the date of this article.
The initiative’s proposed reforms seek to change certain rules around the private foundation 5% minimum distribution requirement so that salaries or travel expenses paid to foundation managers won’t count as charitable distributions.
The proposal includes a provision so that most distributions by private foundations to donor-advised funds wouldn’t count against the 5% minimum distribution requirement—ending the ability of private foundations to meet the 5% distribution requirement by making a distribution to a donor-advised fund.
The proposed reforms would also eliminate the 1.39% annual net investment income excise tax for any year in which a private foundation pays out 7% or more of the fair market value of its assets or agrees to limit its life span to 25 years or less.
COVID-19 Relief and Assistance
Disruption from COVID-19 continues to strain individuals and organizations, including private foundations; however, as outlined below, legislation could provide private foundations or their grantees relief and assistance concerning tax credits and more. Some of the below opportunities may require filing amended returns and have dates for which to file by due to the statute of limitations.
Employee Retention Tax Credit for Employers
Under the Employee Retention Credit (ERC), in 2020, employers could obtain a credit of 50% for qualified compensation paid to employees, up to $10,000 for all quarters. The credit is refundable and applicable against other payroll taxes.
The Consolidated Appropriations Act of 2021 and the American Rescue Plan Act (ARPA) of 2021 extended the ERC credit through June 30, 2021, and further to December 31, 2021. However, it was then terminated early on September 30, 2021. This article provides details on the eligibility requirements during qualified quarters and how employers could qualify.
Paid Sick Leave Credit
This credit is for eligible employers that must pay compensation to employees who can’t work because they’re in self-quarantine, caring for someone in quarantine, or caring for a child because of school or other care facility closures.
The credit is limited to a daily amount dependent on the reason for the leave. Learn more in our webcast.
Paid Family and Medical Leave Credit
In addition to the paid sick leave credit, eligible employers can receive a credit for compensation paid to employees who can’t work due to caring for a child because of school or other care facility closures.
Limitations also apply to compensation eligible for the credit. Get additional details in our article.
Disaster Relief Payments to Employees
On March 13, 2020, former President Donald Trump declared a national emergency in response to COVID-19. Under IRC Section 139, private foundations may provide assistance to employees and their families following the declaration of national emergency without the risk of incurring certain tax liability.
A foundation can make financial assistance payments as long as certain safeguards are in place. Learn about relief payments and next steps for employers in our article.
Disaster Relief Assistance
Due to the COVID-19 pandemic, many private foundations are exploring ways to provide disaster-relief assistance to those in need—including individuals, for-profit businesses, governments, and foreign organizations. These payments could likely be eligible for treatment as a qualifying distribution.
However, due to restrictions around private foundations, consider several factors regarding these funds, including:
- Assistance must be provided and used for a charitable purpose.
- Assistance must be given to a charitable class. A charitable class must be large or indefinite, and there must be a public benefit to assisting the charitable class.
- If the disaster relief assistance doesn’t fall within the private foundation’s exempt purpose, the organization will need to notify the IRS of the change.
- Assistance may require expenditure responsibility reporting or an equivalency determination, so it isn’t considered a taxable expenditure.
- Assistance may require pre-approval from the IRS.
- It’s important to document assistance programs, qualifications, and assessments of recipients.
Private foundations that wish to launch a disaster-relief assistance program should consult with their tax advisor.
Flat Tax Rate
Private foundations can continue to plan for a flat tax rate on net investment income for now.
Effective for tax years beginning after December 20, 2019, the following changes apply:
- IRC Section 4940(a) amended to provide a single tax rate of 1.39% on net investment income
- IRC Section 4940(e) repealed
For tax years beginning after December 20, 2019, all private foundations subject to IRC Section 4940 excise tax on net investment income calculate the tax using the 1.39% rate.
Learn more about the flat tax rate and other important tax changes for foundations in our article.
Minimum Distribution Requirement
IRC Section 4942 imposes a minimum distribution requirement on nonoperating private foundations. Foundations that fail to meet this requirement must pay an excise tax.
The following expenses are qualifying distributions if they’re incurred while implementing a foundation’s charitable purpose:
- Directly incurred expenses
- Reasonable and necessary administrative expenses
- Contributions, gifts, and grants paid to individuals and other organizations
- Acquisition costs of assets used in a foundation’s charitable activities in the year the assets are acquired or converted to a tax-exempt use
- Increases in program-related investments
Qualifying distributions are determined on the cash receipts and disbursements method of accounting, regardless of the accounting method used to maintain a foundation’s books and records.
These distributions must be made by the end of a foundation’s succeeding tax year. For example, if the undistributed requirement for 2021 was $500,000, qualifying distributions of $500,000 must be made by the end of the 2022 tax year.
Foundations should determine whether they met the minimum distribution requirement for prior years by the end of the 2022 tax year. If not, they should make final qualifying distributions before the last day of the tax year to avoid the excise tax.
Foundations may also want to consider incorporating the current- and future-year minimum distribution requirements into their planning strategies.
A foundation’s strategic plan can be invaluable, particularly when determining how to increase the use of any carryforwards.
A private foundation that distributed more than its minimum required distribution in a previous year could have an excess-distribution carryforward, which it must use within five years.
Capital Gains and Losses
To determine gross investment income, a foundation must add net capital gains to the net investment income used to calculate excise tax.
Capital losses from the sale, or other disposition, of investment property can reduce capital gains recognized during a tax year. However, these losses can’t go below zero for a private foundation, regardless of whether it’s set up as a corporation or trust.
This means if capital losses exceed capital gains in a tax year, the excess might not offset gross-investment income in that year. The excess can’t be carried back or forward to offset gains in prior or future tax years either.
A foundation can review its portfolio to determine if it’s beneficial to trigger capital gains before the end of the year. This can help a foundation offset excess capital losses and avoid losing their benefit.
Depending on the circumstances, a foundation could repurchase the sold assets or buy replacement investment assets. This would result in a stepped-up tax basis that would reduce the future gain when the investment asset is eventually sold. Alternatively, a foundation may want to trigger losses to offset capital gains.
Privately Held Stock and Highly Appreciated Property
With some exceptions, the rules limit how much donors may identify for charitable deductions of certain privately held stock and highly appreciated property.
Donating property encumbered with debt may require a donor to pay a self-dealing tax, and a foundation is forbidden from entering into a sale or exchange with a disqualified person—even if the sale price is less than the fair-market value.
A private foundation may face a liquidity dilemma if it holds a large amount of privately held stock or other non-income producing assets. If the organization holds these assets for investment, they’re included in the minimum required distribution calculation and may not produce sufficient income to satisfy the foundation’s annual payout requirements.
This issue should be considered prior to accepting gifts, and illiquid holdings should be reviewed annually for liquidity concerns.
Appreciated Asset Grants
A private foundation could consider granting an appreciated asset, such as a publicly traded security, to a public charity instead of selling the asset and granting cash.
By doing this, the foundation avoids the excise tax on the security’s inherent capital gain, while still making a grant equal to the asset’s fair-market value. This can be especially valuable because the donor’s basis in the appreciated asset is carried over to the foundation and could result in a substantially large gain.
Gift Acceptance Policy
A foundation should periodically review its gift acceptance policy to verify it covers illiquid gifts and unusual donations.
This preparation can help address donors who propose these types of gifts, especially at year-end.
The IRS stated that virtual currency is property for tax purposes. However, since there is no valid charitable deduction without a contemporaneous written acknowledgement, the major issue is likely to be valuation.
IRC Section 170(f)(11)(E)(ii)(I) criteria for a valid deduction requires that the individual have verifiable education and experience in valuing the type of property for which the appraisal is performed.
A foundation with alternative investments generally receives a Schedule K-1 each year. This form provides necessary information for tax compliance and planning needs.
Alternative investments can do any of the following:
- Generate unrelated business income that organizations need to report on Form 990-T
- Generate state-tax liabilities or filing requirements
- Trigger one or more foreign disclosure filings, such as Forms 5471, 926, 8938, 8865, or 8621
A foundation should seek assistance when determining its potential income-tax liabilities, filing requirements, and estimated income-tax payments that it needs to make before year-end.
Unrelated Business Taxable Income
Under prior tax law, a foundation paid tax on the net of all taxable unrelated business income (UBI) activities at either the corporate or trust income tax rates, depending on the structure of the foundation.
However, final tax reform legislation enacted in 2017 requires each unrelated trade or business activity be reported separately, rather than netted with tax paid on the profitable activities.
This means a foundation needs to track UBI activities separately and track net operating losses (NOLs) by activity rather than in total.
IRS published final regulations effective December 2, 2020. The regulations build on the prior guidance released in IRS Notice 2018-67 but also simplify and clarify some areas. The final regulations allow private foundations to categorize UBI activities based on the first two digits of the NAICS code only, which designate the sector of a trade or business.
Qualified Partnership Interests
The IRS’s final regulations permit, but don’t require, a foundation to aggregate its unrelated business taxable income (UBTI) from all qualified partnership interests (QPIs)—including those that lower-tier partnerships conduct—if the foundation meets the de minimis or significant participation tests or it held the partnership interest as of August 21, 2018.
De Minimis Test
A foundation meets this test if it directly holds no more than 2% of the profits and no more than 2% capital interest in a partnership. The proposed regulations simplified this test.
Significant Participation Test
A foundation meets this test if its controlled entities, or related supporting organizations, directly hold no more than 20% of the capital interest and don’t have control or influence over the partnership.
Income from debt-financed property is also considered an investment activity and can be aggregated with qualifying partnership and S corp investments.
S Corp interests that don’t meet the de minimis or significant participation tests are treated as separate activities. A foundation can’t group this income with income from other activities, even if the activities are the same.
Corporate Tax Structure
Tax reform in 2017 created a simplified corporate tax-rate structure, lowering it to a flat 21% tax rate for all corporations and lowering the tax-rate brackets for trusts. Foundations that generate UBTI may stand to benefit from this change.
Net Operating Losses
Consider leveraging net operating losses (NOLs) to reduce your tax burden.
The 2017 tax reform law affected NOLs in several ways:
- The carryforward period is indefinite rather than limited to 20 years.
- The opportunity to carryback losses has been removed for those losses generated in years starting after December 31, 2017.
- New losses generated are limited to offsetting taxable income in a given year to 80% of taxable income rather than 100%. These losses can apply only to offset taxable income from the trade or business that generated the NOL.
- Losses generated before January 1, 2018, can offset 100% of taxable income from any source, including qualified transportation and parking benefits, until exhausted.
Learn more about tax reform’s impacts on NOLs.
The US Department of the Treasury and the IRS issued final regulations for global intangible low-taxed income (GILTI), which taxes US shareholders and controlled foreign corporations (CFCs) on their share of intangible income if that income was subject to a low local tax rate.
For reporting purposes, GILTI is considered a deemed dividend and therefore generally excluded from UBTI. However, even if the inclusion isn’t UBTI and doesn’t create an income tax liability, additional international filings may be required—such as Form 5471—for taxable years after December 31, 2017.
For private foundations, the deemed dividend created by the GILTI inclusion is subject to net-investment income tax.
Bipartisan Budget Act
The Bipartisan Budget Act of 2018 became law on February 9, 2018. The act includes an exception, known as the Newman’s Own exception, to the excess business holdings rule that the tax on excess business holdings of a private foundation doesn’t apply to independently operated, philanthropic business holdings after December 31, 2017.
Generally, this exclusion must meet three criteria to qualify:
- The foundation owns 100% of the voting stock at all times throughout the year, and the foundation acquired it by means other than purchasing
- All profits go to charity
- The foundation is an independent operation in terms of board, employee, or trustee positions
Learn more about this exception and potential benefits in our webcast.
Different operating statuses affect donor deductibility and how a private foundation meets annual payout or spending requirements.
Private Operating Foundation Status
Similar to public charities, private operating foundations provide better tax treatment for donors than private foundations and aren’t subject to the minimum required distribution.
If a foundation directly conducts charitable activities, it should evaluate whether it qualifies as a private operating foundation.
Operating status require two annual tests, an income test as well as one of the following alternative tests:
A foundation must meet both tests in three of the four most recent tax years or in the aggregate over those four years. Private foundations seeking to qualify as a private operating foundation should project if they’ll pass the tests and determine if they need to take any steps before or after year-end.
Learn how to qualify for and retain your status as a private operating foundation in here.
Conversion to a Public Charity
Public charities provide a more favorable charitable contribution deduction threshold. Unlike private foundations, they aren’t prohibited from engaging in certain activities with disqualified persons.
A foundation should consider converting to a public charity if it finds itself:
- Consistently receiving contributions from multiple donors—not only the founding individual or corporation
- Holding fundraising events
- Meeting the support test as an operating foundation
Conduit Foundation Status
A private foundation qualifies as a conduit foundation for the purpose of donor-deduction limits if it makes qualifying distributions no later than two and a half months of tax year-end equal to 100% of the contributions received in that same year.
Once a private foundation qualifies as a conduit foundation, its donors can adhere to the adjusted gross income limitation of 60% imposed on cash contributions to public charities—effective for tax years beginning in 2022—rather than the 30% limit for private foundation contributions.
The requirements for treatment as a conduit foundation must be met on an annual basis, and the foundation must have no undistributed income remaining for the tax year in which the status applies.
We’re Here to Help
As regulations change and markets continue to fluctuate, it’s important for your private foundation to plan for the future.
Our professionals provide a range of services to help private foundations address tax compliance, mitigate consulting issues, and benefit from regulation developments. For example, important resources like a planning analysis can help your private foundation forecast up to 20 years into the future to plan for your minimum distribution requirements.
Planning Analysis Benefits
A planning analysis can help your foundation:
- Gain insight into necessary actions your foundation can take—based on its specific goals—to meet payout requirements and comply with applicable regulations
- Run minimum distribution requirement estimates based on a variety of selection criteria, such as investment-return rates or large contributions to the foundation
- Estimate excess distribution carryover, especially amid volatile markets
This analysis can provide a full view of your foundation’s minimum distribution requirements environment, helping you better manage your distributions as your investment and donor mix evolves. It can also help you navigate the challenges of investing your foundation’s assets.
To learn more about how this information may apply to your foundation or for help creating a strategy, contact your Moss Adams professional.