CHAPTER 16
Excess Business Holdings and Jeopardizing Investments: IRC §§4943 and 4944

16.1 Excess Business Holdings

A private foundation’s level of ownership in an operating business, other than one conducted as a charitable activity or holding only passive investments, is limited by Internal Revenue Code (IRC) §4943, entitled “Excess Business Holdings.” A foundation is entitled to receive a gift that causes it to have impermissible ownership in a business, but cannot retain it. Specific time periods are prescribed for disposition of such holdings received by a foundation through donation or inheritance. The basic rule is that the combined ownership by the private foundation (PF) and those that fund and manage it (its insiders, who are formally referred to as disqualified persons) in a business enterprise of any legal form—corporation, partnership, joint venture, or other unincorporated company—must not exceed 20 percent. If it can be proved that the foundation and its insiders lack control of the business, the allowable percentage rises to 35 percent. A foundation may own up to 2 percent of a business without regard to the ownership of its insiders. Note that permitted holdings for the 20 percent limits are expressed in the numbers of shares of voting stock without reference to the value of the shares. However, the 2 percent de minimis amount is either 2 percent of voting shares or 2 percent of the value of all outstanding shares of all classes of stock. Neither the code nor the regulations contains specific rules for valuation.

The Pension Protection Act of 2006 made donor-advised funds1 and non-functionally integrated supporting organizations2 subject to the excess business holdings rules. The time period over which such organizations must dispose of excess holdings begins on January 1, 2007, the effective date for this change. The new code says the specified organizations “shall be treated as private foundations for this purpose.”

For donor-advised funds, the disqualified persons whose stock holdings must be taken into account include not only the substantial contributor and his or her family and 35 percent controlled entity, but also persons with advisory privileges regarding fund distributions and investments.3

Two types of supporting organizations (SOs) are now treated as foundations for this purpose:

  1. Type III non-functionally integrated SOs.4
  2. Type I or Type II SOs that are supervised or controlled in connection with one or more §§509(a)(1) or (2) organizations, if the Type I or II SO accepts any gift or contribution from a person who controls the supported §§509(a)(1) or (2) public charity.

For this purpose, the disqualified persons whose stock holdings must be taken into account also include major donors, their family members, and 35 percent owned businesses, plus any person (and his or her family members) who was, at any time during the five-year period ending on the date on which excess holdings were the highest, in a position to exercise substantial influence over the affairs of the organization.

(a) Definition of Business Enterprise

The tax code provides only a negative definition of a business enterprise, by saying what it is not.5 The two enterprises it says can be owned without limitation include a functionally related business and a business 95 percent of the income of which is from passive sources. The regulations define business enterprise broadly, as follows:

A business enterprise includes the active conduct of a trade or business, including any activity which is regularly carried on for the production of income from the sale of goods or the performance of services and which constitutes an unrelated trade or business under IRC §513.6

A private foundation is not treated as owner of excess shares during its permitted five-or-more-year period for disposing of the stock or other business interest that caused it to potentially have excess business holdings.7

The ownership limits apply regardless of whether the business produces a profit. A bond or other form of indebtedness is treated as a business holding if it is essentially a disguised equity holding. A leasehold interest in real estate, the rent from which is based, in whole or part, on profits, is customarily not considered to be a business interest, unless the leasehold constitutes an interest in the lessor’s business.

In a complex nontax case involving a violation of the Pension Benefit Guaranty Corporation standards, a private equity fund was found to be conducting a business owned by an employer pension plan that acquired controlling interests in struggling companies. The IRS used an “Investment Plus” theory to analyze the services provided to the companies in which the fund invested and decided that those services created an active business interest.8 The decision also stated that the donation of shares of the fund by a private foundation would not result in a jeopardizing investment.9

Functionally Related Business. A business conducted to accomplish program-related purposes is not treated as a business enterprise.10 Such businesses are those that are excused from the unrelated business income tax as being basically not businesslike, such as the following:11

  • A business the conduct of which is substantially related (aside from the mere provision of funds for the exempt purpose) to the exercise or performance by the private foundation of its charitable, educational, or other purpose or function constituting the basis for its exemption. A music publishing company concentrating on classical or serious music was considered related to the purposes of a PF promoting music education and the choice of music as a career.12
  • A business in which substantially all of the work is performed for the foundation without compensation.
  • A business carried on by the foundation primarily for the convenience of its members, students, patients, officers, visitors, or employees, such as a cafeteria operated by a hospital or museum.
  • A business that consists of selling merchandise, substantially all of which has been received by the foundation as gifts or contributions.
  • An activity carried on within a larger combination of similar activities related to the exempt purposes of the foundation.

Passive Holding Company. A company that obtains at least 95 percent of its gross income from the passive sources listed in IRC §§512(b)(1), (2), (3), and (5) is not considered a business. The word passive was provided in this code section in 1969, well before the Tax Reform Act of 1986 gave it another dimension. For purposes of excess holdings, passive income is classified as investment income, and includes the following:13

  • Dividends, interest, and annuities.
  • Royalties, including overriding royalties, whether measured by production or by gross or taxable income from the property. Working interests in mineral properties are active businesses.14
  • Rental income from real property and from personal property leased alongside real property, if the rent is incidental (less than 50 percent of the total rent).
  • Gains or losses from sales, exchanges, or other dispositions of property other than stock in trade held for regular sale to customers.
  • Income from the sale of goods if the seller does not manufacture, produce, physically receive or deliver, negotiate sales of, or keep inventories in the goods.

Income classified as passive for this purpose does not lose its character merely because the property is indebted so as to make the foundation’s income from the holding subject to the unrelated business income tax.15

Newman’s Own: A significant exception to these rules now allows a private foundation to own 100 percent of an active business under very specific qualifications.16 The requirements fit the attributes of Newman’s Own business, a for-profit corporation that for years has given all of its profits to charity, as follows:

  • Private foundation must own 100 percent of the voting stock of the business enterprise at all times during the taxable year. All private foundation ownership was acquired by means other than purchase.
  • 100 percent of operating income for each taxable year must be distributed within 120 days from the close of the business enterprise’s taxable year. Operating income essentially means net profits less a reasonable reserve, working capital, and other business needs of the business enterprise to be defined by the U.S. Treasury Department.
  • Powers and responsibilities to control the business may not be possessed by any disqualified persons of the private foundation. Majority of the private foundation’s board of directors must be persons other than disqualified persons. At least a majority of members of the private foundation are not persons who are directors or officers of the business or family members of a substantial contributor to the private foundation.

(b) Corporate Holdings

Permitted holdings of business enterprises by a private foundation vary according to the form of ownership, type of entity, and other characteristics. A foundation may hold 20 percent of the voting stock of an incorporated business enterprise, reduced by the percentage of voting stock owned by all disqualified persons (DPs).17 In other words, the foundation and its contributors and managers and their families cannot generally together control more than 20 percent of a corporation. Note also that permitted holdings for the 20 percent limits are expressed in the number of shares of voting stock without reference to the value of the shares. However, the 2 percent de minimis amount is either 2 percent of the voting shares or 2 percent of the value of all outstanding shares of all classes of stock. Neither the code nor the regulations contain specific rules for valuation.

Nonvoting Stock. If all of the insiders together own no more than 20 percent of the corporation’s voting stock, the foundation can own any amount of nonvoting stock.18 Stock carrying contingent voting rights is treated as nonvoting until the event triggering the right to vote occurs. An example is preferred stock that can be voted only if dividends are not paid; such shares are considered nonvoting until the voting power is exercisable. This exception applies only to an incorporated entity, not to a partnership or other form.19 Entering into a binding agreement (scripted on the shares and transferable to any purchaser of the shares) not to vote the PF’s stock does not reduce excess business holdings.20

Thirty-Five Percent. Up to 35 percent ownership in a corporate business can be held aggregately by the foundation and its insiders, when the foundation establishes to the satisfaction of the Internal Revenue Service (IRS) that the enterprise is controlled by a third person (unrelated parties). Control, for this purpose, means possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of the enterprise, whether through ownership of voting stock, the use of voting trusts, contractual arrangements, or otherwise. It is the reality of control that is decisive, not its form or the means by which it is exercisable.21 The IRS has required actual proof of outside party control.22

Two Percent. The PF can own up to 2 percent of voting stock and up to 2 percent in value of all outstanding shares of all classes of stock, called a de minimis amount, regardless of the insider’s holdings.23 Any commonly controlled PF’s holdings are combined with the PF’s for this purpose.

(c) Partnerships, Trusts, and Proprietorships

The permitted holdings in partnerships and other forms of ownership are determined using the same concepts as those applicable to corporations, although the applicable statutes and regulations use different terms to identify the ownership. For a general or limited partnership or a joint venture, the terms profit interest and capital interest are substituted for voting stock and nonvoting stock.24 The interest of the foundation and its insiders in a partnership is determined using the distributive share concepts of IRC §704(b). Absent a formal partnership agreement, the foundation’s ownership is measured by the portion of assets that the foundation is entitled to receive upon withdrawal or dissolution, whichever is greater.

A private foundation’s interest in a partnership makes it an owner of a proportionate part of the properties owned by the partnership for purposes of measuring excess business holdings. The 20/35 percent limitations apply as if the foundation owned the property directly. Therefore, a foundation owning 45 percent of a partnership is deemed to own 45 percent of properties owned by the partnership. Say, for example, the partnership owned 50 percent of the outstanding shares of a corporation. The PF is considered to own 45 percent of 50 percent, or 22.5 percent of such corporation. Unless the foundation can prove that the corporation is controlled by third parties, as discussed previously, excess business holdings are present and the partnership’s share of the corporation must be reduced. If, instead, the foundation holds a limited partnership interest, 35 percent may be permitted.25 A right on the part of the limited partner PF to veto the general partner’s actions may constitute sufficient control to cause the lower 20 percent limit to apply.26 This requirement creates an unexpected burden for some PFs that hold partnership investments also held by disqualified persons.

The IRS considered two issues regarding the owning and renting of an apartment complex by a private foundation. Less than 1 percent of the gross revenue derived from covered parking spaces and coin-operated laundry machines was unrelated business income. This ratio was at issue in deciding whether the private foundation owner possessed excess business holdings. Because the real property rental was more than 95 percent of the gross revenue, the complex was not treated as a business enterprise under IRC §4943, but instead was considered a proprietorship with passive income.27

For trusts, the term beneficial interest is used to measure ownership, and the permitted holdings are limited to 20 percent.

A foundation may not hold an interest in a proprietorship.28 An interest in a proprietorship given or bequeathed to a foundation (but not purchased) must be disposed of within five years unless the activity is of a nature that can be directed to a charitable purpose, thereby becoming a functionally related business. An interest of less than 100 percent of a proprietorship is treated as an interest in a partnership.

A foundation that invests in hedge funds, private equity, real estate, and similar investment vehicles must determine whether each fund is a business enterprise rather than a passive investment vehicle not subject to the excess business holdings limitations. Several private letter rulings have found that the answer depends on the level of active management of the investments by the partnership. In one instance the partnership purchased partnership interests in private businesses, had no involvement in the management of the companies in which it had invested, and did not participate directly in any sale of goods or performance of services by them.29 Another ruling focused on the nature of the partnership’s investment in lower-tier partnerships. At issue was the character of distributions to the foundation that stemmed from business activity of an investment held by the partnership in which it invests. The ruling said distributions to a limited partner can be viewed as passive source income similar to stock dividends, which are clearly passive in character.30

(d) Constructive Ownership

The stock or other interest owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is considered as being owned proportionately by or for its shareholders, partners, or beneficiaries.31 Corporations engaged in active business are exempt from this attribution rule.32 Stock held in a split-interest trust for which the foundation has only an income interest or is a remainder beneficiary is not considered constructively owned by the foundation unless the foundation can exercise primary investment discretion with respect to such interest.33

Powers of Appointment. Any interest in a business enterprise over which the foundation or a disqualified person has a power of appointment exercisable in favor of the PF or the DP is also treated as owned by the PF or person holding the power of appointment.

Material Restrictions. If the PF disposes of any interest in a business with the retention of any material restrictions or conditions that prevent free use of or prevent disposition of the transferred shares, the PF is treated as owning the interest until the restrictions or conditions are eliminated.34

(e) Disposition Periods

Five-Year Period. A private foundation is given five years to dispose of excess business holdings acquired by gift or bequest. During the disposition period, the foundation is not treated as owning the shares. Generally, if there is a change in the holdings in a business enterprise (other than by purchase by the private foundation or by a disqualified person) that causes the PF to have excess holdings, the interest of the PF shall be treated as held by a disqualified person during the five-year period beginning on the date of such change in holdings.35 A private foundation was able to correct an excess business holding of stock by granting stock to public charities to bring its ownership of the shares to less than the 2 percent de minimis amount; the IRS ruled that the additional criteria accompanying a grant to one of these charities would not entail any material restrictions.36

For shares received under a will or from a trust, the five-year period begins at the time of actual distribution from the fiduciary.37 If the foundation already holds excess shares of the business at the time it is given additional shares, special rules apply.38

Extension of Time. A foundation that is attempting to sell its excess business holdings within the permissible time period (ending on or after November 1, 1983) but is unable to do so can request an additional five-year extension of the time. To obtain permission, the foundation must demonstrate the following:39

  • The gift is an unusually large gift or bequest of diverse business holdings or holdings with complex corporate structures.40
  • It has made diligent efforts to dispose of the holdings within the initial five-year period.
  • Disposition of the holdings was not possible during the first five years because of the size and complexity or diversity of the holdings, except at a price substantially below fair market value (FMV). Congressional hearing testimony considered 5 percent below FMV to be substantial.
  • Before the close of the first five years, the foundation submits a disposition plan to the IRS and seeks approval of its state attorney general (or similar responsible authority).

Private letter rulings show a favorable pattern of granting extensions for PFs that have “made diligent effort” to dispose of their excess holdings.41 A plan developed by an independent financial consultant to assist the foundation to sell its holdings, in conjunction with the substantial contributor’s family members who also owned the same holdings, was approved by the IRS.42 Facts of a private ruling indicated that the PF and DPs, as a result of the initial gift into the PF, owned more than 40 percent of the company shares. Over the initial five years, the PF sold shares to fund charitable programs, but the PF and DPs still held excessive shares. Shortly after the end of the initial five years, renewed attempts to sell shares began, eventually resulting in a merger, but excess business holdings still existed. Amazingly, the ruling says that at the end of the five years, the PF “discovered it had excess holdings.” In what could be considered a lenient decision, the IRS allowed the PF to dispose of the excess by donating shares to a public charity.43

Ninety-Day Period. When a purchase by a DP creates excess business holdings, the PF has 90 days from the date it knows, or has reason to know, of the event that caused it to have such excess holdings.44 The excise tax is not applied if the holdings are properly reduced within the 90-day period. The period can be extended to include any period during which a foundation is prevented by federal or state securities law from disposing of the excess holdings.

No Period. An interest purchased by the PF itself that causes the combined ownership to exceed the limits must be disposed of immediately, and the foundation is subject to tax. If the foundation had no knowledge, nor any reason to know, that its holdings had become excessive, the 90-day period applies and the tax is excused.

Twenty, Fifteen, and Ten Years. Interests held on May 26, 1969 (when these rules were added to the code) were called present interests. Any excess ownership held at that time was disposable over 10, 15, or 20 years, depending on the amount of combined ownership. An interest received from a trust irrevocable on May 26, 1969, or from a will in effect and never revised since that date, is still subject to these longer time periods.45 The selling-off of excess business holdings by many PFs during the 1970s and 1980s was a major undertaking. The regulations contain 30 pages of instructions, exceptions, downward ratchet rules, and complicated procedures that must be carefully studied by any PF subject to such disposition period.

(f) Business Readjustments

Any increases in a foundation’s holdings due to a readjustment are treated as if they were not acquired by purchase. This means that the PF has either 90 days or five years to dispose of them, as a general rule.46 A readjustment may be a merger or consolidation, a recapitalization, an acquisition of stock or assets, a transfer of assets, a change in identity, a change in form or place of organization, a redemption, or a liquidating distribution.47 If the readjustment results in the PF owning a larger percentage than owned prior to the change, a taxable event may occur, and the rules must be carefully studied to decide how to handle the situation.

(g) Tax on Excess Holdings

If the excess holdings are not disposed of within the time periods previously described, an initial tax is due. The tax is imposed only on the private foundation and is equal to 10 percent of the highest value of the excessive amount of the shares during each year. The tax is payable for each tax year during what is called the taxable period. Form 4720 is filed to calculate and report the tax due. The valuation is determined under the estate tax rules.48

Taxable Period. The taxable period begins with the first day that excess business holdings exist, and ends on the earlier of the following dates:

  • The date on which the IRS mails a deficiency notice under §6212.
  • The date on which the excess is eliminated.
  • The date on which the tax is assessed. If the deficiency is self-admitted by voluntarily filing Form 4720, the period ends when the return is filed. Excess holdings found by the IRS upon examination result in the IRS issuing the assessment.

Additional Tax. If excess holdings exist at the end of the taxable period, an additional 200 percent tax is imposed on the value of the excess still held.49 In an egregious case, a third-tier, or termination, tax can be assessed.50

Tax Abatement. The IRC §4962 tax abatement rules discussed in §16.4(c) may also apply, if the excess holdings were due to reasonable cause and not to willful neglect. Before the penalty can be abated, the excess holding condition must be corrected by disposing of the excess.

16.2 Jeopardizing Investments

The managers of a private foundation have a fiduciary responsibility under most state laws to safeguard the assets on behalf of the foundation’s charitable constituency. In a similar spirit, the tax code says that a private foundation should not “invest any amount in such a manner as to jeopardize the carrying out of any of its exempt purposes.”51

The 2008–2009 declines in investment values resulted in significant loss of value in the investment portfolios of nonprofit organizations during that time. In view of the losses, the prudent investment standards were reevaluated by many. The discussions, particularly following the total loss experienced by investors who entrusted their funds to Bernard Madoff,52 focus on revised policies needed to protect an entity’s assets against such losses. No guidance or suggestion of revision to the jeopardizing-investment rules as a result of such thefts occurred.53 To deter a foundation from making investments that might imperil its assets, an excise tax of 10 percent per year the investment held is imposed on the foundation itself and on any of its managers who approve of the making of a jeopardizing investment. Managers are expected to exercise a high degree of fiduciary responsibility in investing foundation funds. The purpose is to shield private foundation assets from risk, to maximize both capital and income available for charity.

A distinction made by the IRS between a jeopardizing and a program-related investment complicates consideration of those investments. The IRS announced that PF managers may consider the relationship between a particular investment and the foundation’s charitable purpose when exercising ordinary business care and prudence in deciding whether to make the investment.54 The regulations provide that an investment made by a private foundation is not considered a jeopardizing investment if, in making the investment, the foundation managers exercise ordinary business care and prudence (under the circumstances prevailing at the time of the investment) in providing for the long-term and short-term financial needs of the foundation to carry out its charitable purposes. Although the regulations list some factors that managers generally consider when making investment decisions, the regulations do not provide an exhaustive list of facts and circumstances that may properly be considered.55

When exercising ordinary business care and prudence to decide whether to make an investment, foundation managers should consider all relevant facts and circumstances, including the relationship between a particular investment and the foundation’s charitable purposes. Foundations are not required to select only investments that offer the highest rate of return, the lowest risks, or the greatest liquidity if PF managers exercise the requisite ordinary business care and prudence in making investment decisions that support, and do not jeopardize, the furtherance of the private foundation’s charitable purposes.

For example, a private foundation will not be subject to a jeopardizing investment tax if foundation managers who have exercised ordinary business care and prudence make an investment that furthers the foundation’s charitable purposes at an expected rate of return that is less than what the foundation might obtain from an investment that is unrelated to its charitable purposes.

The IRS noted that the foregoing standard is consistent with state-law investment standards, which generally provide for consideration of the charitable purposes of an organization or certain factors, including an asset’s special relationship or special value, if any, to the organization’s investment assets. The Uniform Prudent Management of Institutional Funds Act supports this observation.56

Investments made to advance a charitable purpose, such as student loans or low-income housing, are classified as program-related investments and are not subject to the same standards of risk/reward applicable to normal investments. The following investments are not considered to be jeopardizing:

  • Program-related investments the primary purpose of which is to accomplish one or more charitable purposes rather than to produce income.57
  • Property received as gifts or by gratuitous transfers, unless the foundation F pays some consideration in connection with the gift, such as a bargain sale.58
  • Stock received in a corporate reorganization within the meaning of IRC §368.

(a) Identifying Jeopardy

A manager fails to exercise the appropriate level of responsibility if he or she fails to exercise

[o]rdinary business care and prudence, under the facts and circumstances prevailing at the time the investment is made, in providing for the long- and short-term needs of the foundation to carry out its exempt purposes.59

Determination of the existence of jeopardy is made on an investment-by-investment basis, in each case taking into account the foundation’s portfolio as a whole. The identification of jeopardy is based on facts available to the foundation managers at the time the investment is made, not subsequently based on hindsight. Once it is ascertained that an investment is prudent and not jeopardizing, the investment is not considered to be jeopardizing, even if the foundation ultimately loses money. A change in the form or terms of an investment is a new investment as of the date of the change and requires a new determination be made.60

Certain types of investments are said by the regulations to possess a higher degree of risk and must be closely scrutinized. After conceding that no category of investment will be treated as per se jeopardizing, the following types were listed as investments that require close scrutiny:

  • Trading in securities purchased on margin
  • Trading in commodity futures
  • Working interests in oil and gas
  • Puts, calls, and straddles
  • Purchases of warrants
  • Selling short

On April 30, 1998, the IRS expanded the list of investments that require scrutiny to include what it calls recent investment strategies (that by reference are not necessarily prohibited), such as the following:61

  • Investment in junk bonds
  • Risk arbitrage
  • Hedge funds
  • Derivatives
  • Distressed real estate
  • International equities in third-world countries

The IRS expansion of the list reflects the reality of financial markets in the 1990s, which were not anticipated when the regulations were written in 1972. The American Law Institute (ALI) revised its Restatement of the Law, Trusts: Prudent Investor Rule, a compendium of the basic rules governing the investment of trust assets in 1992.62 The ALI guide reflects modern investment concepts and practices now recognized by the IRS. The prudent investor rule acknowledges that return on investment is related to risk, that risk includes the risk of deterioration of real return owing to inflation, and that the risk/return relationship must be evaluated in managing trust assets. Based on this rule, maintaining all of a foundation’s assets in certificates of deposit or other fixed money obligations—a policy thought by many to be secure—could theoretically be treated as a jeopardizing situation.63 Any decline in the equity markets accompanied by a decline in interest rates evidences the need for caution in making decisions about future market performance.

The prudent investor rules have been codified and have been adopted by many states. The Uniform Prudent Investor Act (UPIA) was finalized in 1995 and is applicable to trusts. The Uniform Management of Institutional Funds Act (UMIFA) was finalized in 1972 and updated in 2006 as the Uniform Prudent Management of Institutional Funds Act (UPMIFA). These standards apply to incorporated and unincorporated charitable organizations and certain government organizations. Most states have adopted this standard.

Under both acts, trustees and directors are permitted to delegate their responsibility to third-party managers. UPMIFA directs trustees to review the entire portfolio, but does not require diversification. UPMIFA endorses the total return concept and encourages diversification into a range of assets to achieve a balance of risks.

(b) Examples of Prudent and Jeopardizing Investments

There is precious little guidance on the subject from a tax code standpoint. The regulations, unchanged since issuance in 1972, contain three examples that describe stocks and contrast factors that indicate jeopardy with those that do not:

  • Corporation X has been in business a considerable time, its record of earnings is good, and there is no reason to anticipate a diminution of its earnings. (Not jeopardizing.)
  • Corporation Y has a promising product, has had earnings in some years and substantial losses in others, has never paid a dividend, and is widely reported in investment advisory services to be seriously undercapitalized. (Is jeopardizing, unless Y’s shares are purchased in a new offering of an amount intended to satisfy Y’s capital needs.)
  • Corporation Z has been in business a short period of time and manufactures a product that is new, is not sold by others, and must compete with a well-established alternative product that serves the same purpose. (Is jeopardizing, unless the management has a demonstrated capacity for getting new businesses started successfully and Z has received substantial orders for its new products.)

Unimproved Real Estate. Another example finds E Foundation’s purchase of unimproved real estate not to be jeopardizing where E was following the advice of a professional manager. E sought recommendations on how best to diversify its investments to provide for its long-term financial needs and protect against inflation. E’s short-term financial needs could be satisfied with its other assets.

Whole Life Insurance Policy. The only published ruling on jeopardizing investments concerns a whole life insurance policy. A PF received a gift of an indebted policy covering an insured person with a 10-year life expectancy. Based on the scheduled death benefit, the PF could expect to pay more in premiums and loan interest than it would receive. Each payment on the policy was found to be a jeopardizing investment.64

Bank Stock. In the only case, placement of the entire foundation corpus in a Bahamian bank without inquiring about the integrity of the bank was found to be jeopardizing, because the bank at the time had actually lost its license to do business.65

Gold Stocks. In private rulings, the IRS has approved investments of the type that it says require close scrutiny. In one ruling, gold stocks purchased as a hedge against inflation were not jeopardizing despite a net loss of $7,000 on a $14,500 investment. The PF bought the shares over three years, made money on one block, and lost on two others. The ruling noted that the PF had realized $31,000 in gains and $23,000 in dividends during the same period on its whole portfolio. Importantly, the portfolio performance was found to enable the PF to carry out its purposes.66

Commodities. A “managed commodity trading program” was found to give diversity to a PF’s marketable security portfolio and not to be a jeopardizing investment. Because commodity futures have little or no correlation to the stock market, the added diversity may provide less risk for the PF’s overall investment. The foundation invested 10 percent of its portfolio.67

Nontraditional Investments. Distressed real estate, a U.S. hedge fund, commodities, oil and gas funds, and limited partnerships were also deemed not to be jeopardizing investments by the IRS. Based on professional advice that its stock and bond portfolio be diversified, a foundation asked if it could increase its investment in those “nontraditional investments” by a “certain percentage.”68 The foundation also was advised that it could invest about 10 percent of its portfolio in a market-neutral fund. Though no ruling has discussed the subject, selling covered options against stocks in an investment portfolio is considered under the prudent investor rules to enhance yield without risk.

Many private foundations place some of their investment assets in so-called alternative investments, such as hedge funds and offshore partnerships. These investments involve tax and legal considerations not present in a portfolio of marketable securities. Exhibit 19.10, “Checklist for Alternative Investments of Tax-Exempt Organizations, Including Private Foundations,” prompts foundation representatives to ask those questions in evaluating such alternatives.

A working interest in oil and gas received as a donation was not itself a jeopardizing investment because the foundation received it without consideration; in other words, it did not make an investment.69 The foundation was, however, subject to respond to calls for capital and expenses in connection with its interest. The IRS did not consider the question of whether monies paid by the foundation for an expense call or purchase of a working interest would be a jeopardizing investment. Such an oil investment, however, might be treated as impermissible under the excess business holdings rules.

Limited Partnership. An interest in a limited partnership trading in the futures and forward markets was also found not to be a jeopardizing investment, despite the fact that a “significant amount” of the foundation’s total assets were invested (amount not disclosed).70 An IRS agent had proposed that the investment was jeopardizing because the foundation could have otherwise received a better return with less risk. The IRS privately ruled, however, that the foundation managers had exercised ordinary business care and prudence in entering into the partnership based on the following facts:

  • Foundation managers were actively involved in establishing the partnership and choosing four different advisors to make allocations to diversify the investments.
  • The foundation could withdraw funds at any time.
  • Two legal opinions concluding that the investment was not a jeopardizing one were obtained prior to entering into the partnership agreement.
  • There was no relationship between the investment advisors and the foundation managers that would be furthered by the investment.

For-Profit Venture Fund. A foundation’s investment in a for-profit venture capital fund limited to achieving environmental and economic development goals, subject to environmental guidelines and oversight, accomplishes an exempt purpose. The foundation supports biodiversity and sustainability and believes there is a link between economic development and reduction of poverty and conservation of the biological resources on which nearly all economics are based. Therefore, the foundation’s fund investment qualified as a program-related one. The investment was not thereby jeopardizing, and the expenditure was not a taxable one.71

(c) Donated Assets

An investment asset donated to a foundation is not considered a jeopardizing one as it regards the foundation.72 Similarly, an investment asset acquired by the foundation solely as a result of a corporate organization is not treated as jeopardizing unless the foundation furnishes some consideration in connection with the exchange.73 The reason for this rule is that the foundation is not treated as having made the investment. When receiving a gratuitous transfer, the foundation is not committing its existing assets that are protected by the charitable covenant imposed by the tax statute and its organizational documents. An IRS answer to a request by the estate of a foundation’s founder to approve a proposed asset transfer is instructive.74 The IRS found that the foundation stood to gain and had nothing to lose by accepting the assets. It noted that the foundation would not incur any obligation to use its other resources in the future in connection with maintenance of the bequeathed assets. In this context, it is important to remember that donated property can, however, be subject to the excess business holdings rules.

16.3 Program-Related Investments

A program-related investment (PRI) is not subject to the same standards of risk/reward applicable to normal investments because it serves a charitable, rather than an income-producing, purpose. Program-motivated investments are not treated as jeopardizing investments even if they bear no interest, pay no dividends, and possess a high degree of risk of loss. They are best described by the criteria used in the code and regulations to define them:75

  • The primary purpose of the investment is to accomplish an exempt charitable purpose described in §170(c)(2)(B).76
  • No significant purpose of the investment is the production of income or the appreciation of property.
  • No purpose of the investment is the furthering of substantial legislative or political activities.

Funds expended to make a program investment are treated as qualifying distributions for purposes of the foundation meeting its annual payout requirements and treated as an exempt function asset not counted in calculating the payout.77 Return of the principal amount of a loan or other form of investment will be added back to the distributable amount when it is collected.78 Because such funds are normally held by a non-tax-exempt person or entity, it is important to note that the disbursement is not a taxable expenditure. The foundation, however, must report and monitor a program investment throughout its life, following the expenditure responsibility rules, for the entire period the investment is held.79

Program-related investments are those that “would not have been made” but for the relationship between the investment and the accomplishment of the foundation’s exempt purposes. In evaluating the foundation’s motivation, it is “relevant whether investors solely engaged in investment for profit would be likely to make the investment on the same terms as the foundation.” The fact that such an investment produces significant income or capital appreciation is not, in the absence of other factors, evidence that a charitable purpose does not exist.80 To evaluate qualification of the borrowers or investment beneficiaries, the charitable class rules should be applied.81 The following regulation examples illustrate the concept:82

  • Small business enterprise X located in a deteriorated urban area is owned by members of an economically disadvantaged minority group. Conventional sources of funds are unwilling or unable to provide funds to the enterprise. A PF makes a below-market-interest-rate loan to encourage economic development.
  • The same PF allows an extension of X’s loan to permit X to achieve greater financial stability before it is required to repay the loan. Because the change is not motivated by attempts to enhance yield but by an effort to encourage success of an exempt project, the altered loan is also considered to be program related.
  • Assume instead that a commercial bank will loan X money if it increases the amount of its equity capital. PF’s purchase of X’s common stock, to accomplish the same purposes as the loan described in the first two bullet points, is a program-related investment.
  • Assume instead that substantial citizens own X, but continued operation of X is important for the economic well-being of the low-income persons in the area. To save X, PF loans X money at below-market rates to pay for specific projects benefiting the community. The loan is program related.83
  • The PF wants to encourage the building of a plant to provide jobs in a low-income neighborhood. The PF loans the building funds at below-market rates to SS, a successful commercial company that is unwilling to build the plant without such inducement. Again, the loan is program related.
  • A loan at a rate less than that charged by financial institutions to a nonprofit community development corporation that markets agricultural products to aid low-income farmers in a depressed rural area fosters a charitable purpose.
  • A PF loans X, a socially and economically disadvantaged individual, funds to attend college interest-free. The plan for such a loan program, however, requires preapproval by the IRS to avoid a taxable expenditure.84

Final regulations issued in April 201685 added nine new examples to the existing regulations, which illustrate that a wider range of investments qualify as PRIs. Generally, the charitable activities illustrated in the new examples are based on published guidance and on financial structures described in private letter rulings.

The additional examples demonstrate that a PRI may accomplish a variety of charitable purposes, such as advancing science, combating environmental deterioration, and promoting the arts. New PRI examples demonstrated that an investment to fund activities in one or more foreign countries, including investments that alleviate the impact of a natural disaster or that fund educational programs for poor individuals, may further the accomplishment of charitable purposes. One example illustrates that the existence of a high potential rate of return on an investment does not, by itself, prevent the investment from qualifying as a PRI. Another example illustrates that a private foundation’s acceptance of an equity position in conjunction with making a loan does not necessarily prevent the investment from qualifying as a PRI, and two examples illustrate that a private foundation’s provision of credit enhancement can qualify as a PRI.

The last example demonstrates that a guarantee arrangement may qualify as a PRI under §4944, but also concludes it was not a qualifying distribution under §4942. Finally, the proposed regulations include examples illustrating that loans and capital may be provided to individuals or entities that are not within a charitable class themselves, if the recipients are the instruments through which the private foundation accomplishes its exempt activities.

In rulings, the IRS has considered program-related investments to include the following:

  • A loan program established to make low-interest-rate loans to blind persons unable to obtain funds through commercial sources.86
  • Land purchases made for land conservation, wildlife preservation, and the protection of open and scenic spaces.87
  • Investment in a for-profit company established to encourage creation of jobs in a region targeted for this purpose by a state government.88
  • Loans and investments to promote economic development in a foreign country that has energy and food shortages, natural disasters, and a low standard of living.89
  • A program to support media companies spreading the institution-building process toward open societies and democratic systems in Central and Eastern Europe, Russia, Latin America, Southeast Asia, and Africa.90
  • A foundation’s investment in a for-profit malpractice reinsurance firm, which was found to promote health by encouraging physicians to continue to practice or to relocate to an underserved community.91
  • Taking over the operation of a for-profit farm bequeathed to a foundation, when the farm became a demonstration project.92

Other situations have also been determined to involve PRIs:

  • To stimulate participation of private industry to discover interventions for the developing world, a private foundation will grant funding to commercial companies. Proposals must evidence that the research will achieve a charitable objective,93 a strategy for making the results readily available at affordable prices to those without access, an evaluation of ownership and resulting intellectual property rights, and must outline a global access plan. Grant recipients must have a reasonable strategy and ability to manage innovation to facilitate availability and affordability in the developing world.
  • Results of early-stage research found impractical or unreasonable are published and made available to the public; the expense of doing so is a qualifying distribution.94 The ruling notes that expenditure responsibility must occur.95 There is no mention of terms for returning the “investment”; the ruling refers to the payments as “transactions,” and also refers to “making of grants, contracts, or program-related investments.”
  • Purchase of bonds from a public charity issued to fund mortgage loans to low-income borrowers to enable them to purchase single-family detached homes serves a charitable purpose and is therefore a program-related investment.96
  • Grant to support scientific research on diabetes awarded with the stipulation that the PF has a royalty interest in the event the grantee receives payments in return for the use of any invention. The study sought to find whether a particular cellular process could be standardized and formatted to achieve similar testing results in multiple patients. The testing was not for commercial drug product qualification. The grantee would publish results of the research to the scientific community. The potential private benefit to the researchers was deemed incidental in relation to the public benefit potential for the research.97

A change in the terms of a program-related investment will not create jeopardy, if the change continues to advance the exempt purposes for which the investment was originally made. A change made in order to produce income or appreciation could be considered jeopardizing.98 When the change of circumstances removes the charitable nature of the investment, the investment must be recouped or sold, the terms altered, or other steps taken to restore its program nature.99 The foundation is expected to remove the jeopardy within 30 days of the time the managers have actual knowledge of the change in circumstances. An investment is removed from jeopardy when the foundation sells or otherwise disposes of the investment; the proceeds constitute property that is not itself jeopardizing.

PRIs, MRIs, and SCIs: These three investing philosophies—program-related investments, mission-related investments (MRIs), and socially conscious investments (SCIs)—reflect shades of difference rather than clear distinctions. As prior examples indicate, the primary purpose of a program-related investment is to address a social ill that requires capital to succeed, with return on investment not the primary concern. The last of the three, SCIs, consists of socially conscious investments that originally serve the negative purpose of eliminating investments in companies producing social harm, such as coal mines. SCIs are said to consider environmental, social, and governance criteria in generating long-term financial returns and societal impact.100 SCIs are chosen using screening techniques to identify companies focused on new energy resources, recycling, minimization of chemical wastes, and other goals identified as fostering a healthy and sustainable world while earning a return on the investment.

Mission-related investments combine social concerns with a mission: for example, seeking to eliminate substandard housing for the poor. The preservation of the capital invested is considered plus some profit. An MRI is not treated as a charitable expenditure eligible to satisfy the private foundation mandatory distribution requirements.101 An issue of some concern for private foundation managers considering using MRIs was addressed by the IRS.102 The notice provides that MRIs will not be treated as jeopardizing investments simply because they offer an expected return that is less than what could be earned on other investments. Fiduciary responsibility standards and business care concepts should be followed in evaluating the financial character of any investment.

Lastly, a program-related investment is a purchase motivated by achievement of a charitable purpose without regard to financial return. PRIs are specifically excluded from classification as a jeopardizing investment.

The instructions to both the Form 990 and 990-PF instruct the filer to report the book value of “all investments made, during the year, primarily to accomplish the organization’s exempt purposes rather than to produce income.”

Recoverable Grants: Loan programs referred to as recoverable grants are treated by some foundations as program-related investments and by others as grants. Such grants are most commonly made in support of affordable housing, neighborhood centers in low-income areas, and community development initiatives. The Council on Foundations has suggested, “Recoverable grants are grants that function as interest-free loans. They are made by foundations from their grantmaking budget and are entered on the books as ‘recoverable grants’ … if repayment is not received, they are converted to grant status.”103

Treating such a grant as a current-year expense for accounting purposes seems to require a decision that the funds will not be recovered. Whether classified as an expense or a program-related asset, the amount paid is treated as a qualifying distribution.104 The author found no IRS rulings on the subject and would welcome comment. It is important to remember that such grants paid to an entity that is not a public charity require expenditure responsibility agreements. Application forms and information about recoverable grants can be found on the websites of the Ford Foundation, JPMorgan Chase, Boston LISC (Local Initiatives Support Corp.), Minnesota Housing Partnership, and other agencies and foundations that provide such funding. The Grantsmanship Center has some information on recoverable grants in its “Answers to Some Frequently Asked Questions About PRIs” and “What Do PRIs Fund?” Because program-related investments perform a similar function, one might study the FAQ entitled, “What is a program-related investment (PRI)?” A Web search for “recoverable grants/forgivable loans” reaches a useful chart of available programs with charts and comparisons.

L3Cs: A program-related investment made with a low-profit limited liability company (L3C), also requires an expenditure responsibility agreement because these companies are not qualified for recognition as §501(c)(3) organizations nor as public charities under §509(a). An L3C is a hybrid nonprofit/for-profit organization designed to facilitate investments by private foundations in social programs that advance a charitable mission. Unlike a §501(c)(3), an L3C may distribute its after-tax profits to its investors or owners. Vermont was the first state to recognize this form of organization in April 2008; followed by Michigan in January 2009 and Wyoming in February 2009; and Illinois, Utah, Louisiana, the Crow Indian Nation, and the Oglala Sioux Tribe in 2010; followed in later years by North Dakota, Kansas, and Maine.105

Loan Guarantees. A private foundation’s pledge of marketable securities as collateral to secure a nonprofit hospital’s tax-exempt bond obligation may be treated as a PRI and, consequently, a qualifying distribution. The shares in this instance were “deposited” with a custodian, thereby making the guarantee “fully funded.”106 Similarly, a private foundation’s bank deposits restricted as to withdrawal to allow a bank to create a loan pool with interest rate subsidies were treated as a PRI.107 In both of these situations, the PF continues to receive dividends or interest on its asset during the time it serves as collateral so long as it isn’t called upon due to a default.

16.4 Penalty Taxes

An initial tax of 10 percent on the amount invested for each year in the taxable period is imposed on both the private foundation and certain of its managers for any investment that jeopardizes the carrying-out of the private foundation’s charitable purposes. The taxable period begins on the date the amount is so invested and ends on the earliest of the following:108

  • Date of mailing of a notice of deficiency with respect to the tax.
  • Date on which the tax is assessed.
  • Date on which the amount so invested is removed from jeopardy.

An investment is removed from jeopardy when it is sold or otherwise disposed of and the proceeds are not reinvested in a jeopardizing fashion. Correction may be difficult or impossible if the asset is not marketable. Evidence that the foundation is making every effort to maximize available funds from the investment may help to avoid the additional tax.

(a) When the Manager Knows

Foundation managers who participate in making a decision to purchase an investment while knowing that it is a jeopardizing one are taxed unless their participation is not willful and is due to reasonable cause. A manager is treated as knowing only if three factors are present:109

  1. She or he has actual knowledge of sufficient facts so that, based solely on such facts, such investment would be a jeopardizing one.
  2. She or he is aware that such an investment under such circumstances may violate IRC §4944.
  3. She or he negligently fails to make reasonable attempts to ascertain whether the investment is a jeopardizing investment, or she or he is, in fact, aware that it is such an investment.

Knowledge. Knowing does not mean “having reason to know” that an investment was jeopardizing. The question is whether there is evidence tending to show that the manager had reason to know. The facts and circumstances are examined to find out why the manager did not know. To be excused, the manager must be essentially ignorant of the law or pertinent facts that indicate a bad deal. Assume that a foundation’s board has 10 members, with a three-member finance committee. The written investment policy of the foundation provides that the board approves investment actions proposed by the finance committee, based on the advice of independent counselors. Non-finance-committee board members should not be expected to be aware of details discussed in finance committee meetings.

Willfulness. A manager’s participation must be willful to subject him or her to tax. A motive to avoid the restrictions of the law or incurrence of a tax is not necessary to make this type of participation willful. Voluntary, conscious, and intentional ignorance of the facts pointing to jeopardy is willful participation (ignoring reports of pending difficulties, for example). However, a manager’s participation is not willful if the manager does not know that the investment is jeopardizing.

Reasonableness. The manager must have a good reason for not knowing. To show reasonable cause for not knowing, the manager must prove that good business judgment was exercised with ordinary business care and prudence.110

Participation. Any manifestation of approval of the investment in question indicates participation in the decision to make the investment. Clearly, a vote as a board member to approve a purchase is participation. Board members who do not attend meetings, but sanction investment decisions, may be derelict in their fiduciary responsibility. However, their inability to participate in the decision and resulting lack of knowledge may shield them from the tax. If they receive a board information packet revealing the questionable investment, they have knowledge, but the tax applies only if they participate in the approval.

(b) Advice of Counsel

A manager who relies on legal counsel (including house counsel) will not be treated as knowingly and willfully participating in a jeopardizing investment and may be excused from the tax. The private foundation penalty regime specifically requires that the counsel on which directors or trustees rely for advice and that shields them from penalties come from a lawyer. The intermediate sanction regulations, thanks to the American Institute of Certified Public Accountants (AICPA) Tax-Exempt Organizations Resource Committee, allow reliance on the written opinion of not only legal counsel, but also certified public accountants or accounting firms’ expertise regarding the relevant tax law matters, and an independent valuation expert.111 The opinion of counsel for this purpose must be written, reasoned, and based on the fully disclosed facts of the situation. The fact that a manager failed to seek advice is one of the factors pointing to willful participation.112 The types of reliance permitted may be different for different types of investments:

  • For program-related investments, a manager may rely on a reasoned written opinion that an investment would not jeopardize the carrying-out of any of the foundation’s exempt purposes. The opinion must state that, as a matter of tax law, the investment is a program-related one not classified as a jeopardizing investment under the Internal Revenue Code.
  • For financial investments from which the PF derives its operating income, it is appropriate to rely on qualified investment counselors. Again, all facts must be disclosed to the advisor. Advisors must render advice “in a manner consistent with generally accepted practices” of persons in their business. The written advice must recommend investments that provide for the foundation’s long- and short-term financial needs.

Managers found to be guilty are jointly and severally liable for the tax.113 On a positive note, the maximum tax in the case of the first-tier tax for managers (10 percent rate) is $10,000, and for the second-tier (25 percent rate) the maximum is $20,000 for all.

Removal from Jeopardy. If the jeopardy is not removed within the taxable period, the foundation must pay an additional 25 percent tax. Managers who refuse to agree to part or all of the removal of the investment from jeopardy must pay an additional tax of 25 percent. Removal of jeopardy is accomplished when the investment is sold or otherwise disposed of and the proceeds are reinvested in a fashion that is not jeopardizing.114

(c) Abatement of Penalty

The private foundation excise tax sanctions contain no exception, or excuse, for imposition of the penalty on the private foundation itself for failure to comply with the specific provisions of these code sections. The regulations under these sections do contain relief for those foundation managers who do not condone, or participate in the decision to conduct, a prohibited action. Until 1984, the penalties were strictly applied. Congress, in 1984, added IRC §§4961, 4962, and 4963 to permit abatement of the penalties imposed by §§4942, 4943, 4944, and 4945 on both the foundation and its managers if it is established to the satisfaction of the secretary (by the IRS under responsibility delegated by the Treasury Department) that both of the following conditions exist:

  • The taxable event was due to reasonable cause, not to willful neglect.
  • The event was corrected within the correction period for such event.

To claim abatement of the penalty, the foundation files Form 4720, including explanations of the facts as illustrated in Exhibit 15.2. To allow abatement, the actions of the responsible foundation officials must be considered. Although IRC §4962 is entitled “Definitions,” neither it nor the regulations define the terms “reasonable cause” or “willful neglect.” There have been no court decisions concerning abatement of these penalties. Reliance, in good faith, on incorrect legal advice may be deemed a reasonable cause.115 In a ruling concerning a taxable expenditure penalty for failure to seek advance approval of a scholarship plan, there was no mention of abatement.116 The congressional committee reports say, “A violation which is due to ignorance of the law is not to qualify for such abatement.”117 However, the regulations pertaining to the penalties imposed on self-dealers and on managers approving of self-dealing, jeopardizing investments, and taxable expenditures do contain definitions that one hopes can be applied to justify abatement of the penalties. The definitions of reasonable cause and willful neglect are the same as those mentioned previously. The PF officials must show that they used good business judgment exercised with ordinary business care and prudence. They must show that they made a good-faith effort to follow the rules by seeking the advice of qualified professionals. All of the facts and circumstances of the foundation’s activities must be fully disclosed to such advisors.

For the foundation’s penalty to be abated, its managers must also prove that the failure was due to reasonable causes and not to willful neglect. These terms are not defined in the code or regulations under §§4962 or 4963. No clarifying rulings have been issued to date, nor is the term defined for this purpose in the IRS EO CPE Texts.118 A bankruptcy judge found that a trustee had not demonstrated conscious, intentional, or reckless indifference in failing to file a return or obtain an extension, so reasonable cause for abating penalties existed.119

Under the general rules pertaining to tax penalties,120 the determination of whether a taxpayer’s actions were due to reasonable cause in good faith is made on a case-by-case basis. According to this regulation, “Generally, the most important factor is the extent of the taxpayer’s effort to access the taxpayer’s proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer.” These regulations say that reliance on the advice of a professional tax advisor does not necessarily demonstrate reasonable cause and good faith. However, such reliance constitutes reasonable cause and good faith if, under all the circumstances:

  • The taxpayer did not know, or have reason to know, that the advisor lacked knowledge in the relevant aspects of federal tax law.
  • The advice was based on pertinent facts and circumstances of the transaction(s) and the relevant tax, including the taxpayer’s purpose for entering into the transaction and for structuring a transaction in a particular manner.
  • The advice is based on factual or legal assumptions and does not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person.

In a ruling that found many deficiencies, including failure to enter into a written agreement with the grant recipient setting out the terms of the use of funds, lack of final IRS determination (1023 was still pending), and failure to obtain a statement that the transaction was not subject to Chapter 42 excise tax, the IRS found that the foundation didn’t establish reasonable cause to justify abatement.121

Incorrect calculations in the written advice of counsel that addressed the facts and the applicable law, even though the advice opinion ultimately reached an incorrect conclusion, was the basis for abatement of the penalty for excess business holdings. The IRS noted that “[i]t should not be incumbent upon the foundation to validate the analysis of the professional tax preparer who has full information when it has received specific advice relating to the conclusions used in the preparation of its taxes.” Overall, taking into consideration the facts of this case, the Technical Advice Memorandum found that the foundation should be considered to have reasonable cause to continue with its status quo level of business holdings until it had been advised otherwise. The IRS further observed that the foundation’s excess business holdings were not due to willful neglect and that they had been corrected. Therefore, abating the first-tier taxes was appropriate in that case.122

The second-tier taxes may also be abated under circumstances described in IRC §4961.

(d) Double Jeopardy

The private foundation excise taxes are not applied exclusively. As a result, an investment can conceivably cause three taxes to be imposed simultaneously.123 If the foundation buys a disqualified person’s 40 percent share of an insolvent computer software development company, the following occurs: (1) self-dealing124 (because the purchase takes place between the PF and a DP); (2) excess business holdings (because the combined ownership exceeds 20 percent); and (3) a jeopardizing investment (assuming the foundation is not focused on scientific or scholarly development of software and the company is not a functionally related business). The unrelated business income tax might also apply to the income from such a business investment if the company is a Subchapter S corporation.

Notes

  1. 1 IRC §4943(e).
  2. 2 IRC§4943(f).
  3. 3 IRC §4966(d)(2)(A)(iii).
  4. 4 See discussion of suggested definition of this term in §11.6(c). The revised code directed that the definition be provided in future regulations that as of July 1, 2011, had not been finalized.
  5. 5 IRC §4943(d)(3).
  6. 6 Reg. §53.4943-10(a); see §21.10(c); revenue may, however, be treated as unrelated business income.
  7. 7 IRC §4943(c)(6).
  8. 8 Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund, 124 AFTR2d 2019-6742 (2d Cir. 2019), reversing an earlier district court decision.
  9. 9 See §16.2.
  10. 10 Publication 4221-PF, Compliance Guide for 501(c)(3) Private Foundations, replacing IRS Publication 578, Tax Information for Private Foundations and Foundation Managers, Chapter X, p. 32 (now out of print).
  11. 11 Defined by reference to Reg. §53.4942-2(c)(3)(iii) regarding businesses that are not unrelated pursuant to IRC §§513(a)(1), (2), and (3).
  12. 12 Priv. Ltr. Ruls. 8927031 and 200822041. Language in the 1989 ruling was updated in Priv. Ltr. Rul. 8930047 because the IRS said it could be misconstrued.
  13. 13 Reg. §53.4943-10(c)(2).
  14. 14 Priv. Ltr. Rul. 8407095.
  15. 15 Reg. §53.4943-10(c)(2).
  16. 16 IRC §4943(g)(2)(3)(4), added by Bipartisan Budget Act of 2018, entitled “Exception for Certain Holdings Limited to Independently-Operated Philanthropic Business.”
  17. 17 IRC §4943(c)(2); Reg. §53.4943-3(b)(1); Priv. Ltr. Rul. 201303012.
  18. 18 IRC §4943(c)(2).
  19. 19 Reg. §53.4943-3(c)(4)(i).
  20. 20 Priv. Ltr. Ruls. 9325046 and 9124061.
  21. 21 Reg. §53.4943-3(b)(3).
  22. 22 Rev. Rul. 81-811, 1981-1 C.B. 509.
  23. 23 IRC §4943(c)(2)(C); Reg. §53.4943-3(b)(4).
  24. 24 IRC §4943(c)(3); Reg. §53.4943-3(c)(2).
  25. 25 Reg. §53.4943-3(b)(3)(ii).
  26. 26 Priv. Ltr. Rul. 9250039.
  27. 27 Priv. Ltr. Rul. 201422027; also see §16.1(c).
  28. 28 IRC §4943(c)(3)(B); Reg. §53.4943-3(c)(3).
  29. 29 Priv. Ltr. Rul. 199939046.
  30. 30 Priv. Ltr. Rul. 200611034.
  31. 31 Reg. §53.4943-8.
  32. 32 Reg. §53.4943-8(c).
  33. 33 IRC §4943(d)(1); Reg. §53.4943-8(b)(2).
  34. 34 Reg. §53.4943-2(a)(1)(iv).
  35. 35 IRC §4943(c)(5).
  36. 36 Priv. Ltr. Rul. 201414031.
  37. 37 Reg. §53.4943-6(b)(1).
  38. 38 Reg. §53.4943-6(a)(i)(iii).
  39. 39 IRC §4943(c)(7).
  40. 40 Priv. Ltr. Rul. 201105053 allowed an additional five-year extension because offers for purchase were substantially below market value.
  41. 41 Priv. Ltr. Ruls. 8514098, 8508114, 8737085, and 9029067. In the 1990 ruling, the IRS found that the PF had not been diligent and denied an extension.
  42. 42 Priv. Ltr. Rul. 9115061.
  43. 43 Priv. Ltr. Rul. 201414031.
  44. 44 Reg. §53.4943-2(a)(1)(ii).
  45. 45 IRC §4943(c)(4); Reg. §§53.4943-4 and 53.4943-5.
  46. 46 Reg. §53.4943-6(d).
  47. 47 Reg. §53.4943-7(d)(1).
  48. 48 IRC §4943(a); Reg. §53.4943-2(a).
  49. 49 IRC §4943(b); Reg. §53.4943-2.
  50. 50 See §12.4.
  51. 51 IRC §4944(a)(1).
  52. 52 Marcus S. Owens and Nancy Ortmeyer Kuhn, “Private Foundations and the Protection of Assets,” EXEMPT ORGANIZATION TAX REV. (June 2009).
  53. 53 See §13.3 on Ponzi scheme losses.
  54. 54 Notice 2015-62, 2015-39 IRB 411.
  55. 55 Reg. §53.4944-1(a)(2)(ii).
  56. 56 Uniform Prudent Management of Institutional Funds Act §§3(a), 3(e)(1)(H), accompanying comments 7A, pt. 3 U.L.A. 21-22 (pocket part 2015).
  57. 57 Discussed in §16.3.
  58. 58 Reg. §53.4944-1(a)(2)(ii).
  59. 59 Reg. §53.4944-1(a)(2)(i).
  60. 60 Reg. §53.4944-1(a)(2).
  61. 61 A “Life Cycle of a Private Foundation” chart and Internal Revenue Manual (IRM) 7.26 found at www.irs.gov/charities-and-nonprofits contain links to additional information about this subject and others pertaining to PFs.
  62. 62 American Law Institute Publishers, St. Paul, Minnesota.
  63. 63 See Chapter 5, “Asset Management,” in Jody Blazek, Nonprofit Financial Planning Made Easy (Hoboken, NJ: John Wiley & Sons, 2008), for more information.
  64. 64 Rev. Rul. 80-133, 1980-1 C.B. 258.
  65. 65 Thorne v. Commissioner, 99 T.C. 67(1992).
  66. 66 Priv. Ltr. Rul. 8718006.
  67. 67 Priv. Ltr. Rul. 9237035.
  68. 68 Priv. Ltr. Rul. 9451067.
  69. 69 Priv. Ltr. Rul. 200621032.
  70. 70 Priv Ltr. Rul. 200218038.
  71. 71 Priv. Ltr. Rul. 200136026.
  72. 72 Reg. §53.4944-1(a)(2)(iii); Priv. Ltr. Ruls. 201329028 and 21333020.
  73. 73 Reg. §53.4944-6; also see IRS EO CPE Text 1988, “Investments that Jeopardize Charitable Purposes.”
  74. 74 Priv. Ltr. Rul. 9614002.
  75. 75 IRC §4944(c); Reg. §53.4944-3(a)(1).
  76. 76 See Benjamin N. Feit, “What IRS Private Letter Rulings Reveal About Program Related Investments,” TAXATION OF EXEMPTS (July/August 2011), which explores “the capacious nature of Section 170(c)(2)(B) and the regulations” for this purpose.
  77. 77 See §15.1(c).
  78. 78 See §15.4.
  79. 79 See §17.6.
  80. 80 Reg. §53.4944-3(a)(2)(iii).
  81. 81 See §2.2(a).
  82. 82 Reg. §53.4944-1(b).
  83. 83 If X is owned more than 35 percent by a disqualified person, the loan would be a self-dealing transaction; also see Priv. Ltr. Ruls. 200222034 and 200331006.
  84. 84 See §17.5.
  85. 85 Proposed in 2012.
  86. 86 Rev. Rul. 78-90, 1978-1 C.B. 380.
  87. 87 Priv. Ltr. Rul. 8832074; see also Priv. Ltr. Rul. 9109068, in which a tract of undeveloped land located along a city harbor was found to be a program-related investment because it was part of a plan to encourage civic beautification.
  88. 88 Priv. Ltr. Rul. 199943044.
  89. 89 Priv. Ltr. Rul. 199943058.
  90. 90 Priv. Ltr. Rul. 200034037.
  91. 91 Priv. Ltr. Rul. 200347017.
  92. 92 Priv. Ltr. Rul. 200343028.
  93. 93 See §5.3 for specific requirements for charitable scientific research.
  94. 94 Priv. Ltr. Rul. 200603031.
  95. 95 See §17.6.
  96. 96 Priv. Ltr. Rul. 8821087; similarly, in Priv. Ltr. Rul. 8910027, the bonds purchased by the foundation to fund a microloan program for the poor were treated as program-related investments.
  97. 97 Priv. Ltr. Rul. 201145027.
  98. 98 Reg. §53.4944-3(a)(3).
  99. 99 Reg. §53.4944-5(b).
  100. 100 The Forum for Sustainable and Responsible Investments, available at www.ussif.org/sribasics.
  101. 101 See §15.6.
  102. 102 IRS Notice 2015-62.
  103. 103 David F. Freeman and the Council on Foundations, Handbook on Private Foundations (New York: Foundation Center, 1991).
  104. 104 See §15.4(f).
  105. 105 See §1.7(d) for IRS lack of guidance on L3Cs as of July 2011.
  106. 106 Priv. Ltr. Rul. 201442061.
  107. 107 Priv. Ltr. Rul. 200043050.
  108. 108 IRC §4944(e).
  109. 109 Reg. §53.4944-1(b)(2).
  110. 110 Reg. §53.4944-1(b)(2)(iii).
  111. 111 See §20.10.
  112. 112 Reg. §53.4944-1(b)(2)(v).
  113. 113 IRC §4944(d).
  114. 114 Reg. §53.4944-5(b).
  115. 115 Tech. Adv. Memo. 200347023; but also Tech. Adv. Memo 201129050 and Belaieff v. Commissioner, 15 T.C.M. 1426 (1956), deciding that failure by accountants or attorneys to provide advice and failure by the taxpayer to seek advice does not constitute reasonable cause.
  116. 116 Priv. Ltr. Rul. 9825004.
  117. 117 Pub. L. No. 98-369, Deficit Reduction Act of 1984. See Priv. Ltr. Rul. 201351027, in which penalty abatement was not permitted for reasonable causes.
  118. 118 IRS EO CPE Text 1985, p. 16.
  119. 119 U.S. Bankruptcy Court of Central District of California re Molnick’s Inc., 95-1 USTC 95751 (9th Cir. 1995).
  120. 120 Reg. §6664-4(b).
  121. 121 Priv. Ltr. Rul. 201351027; also see Priv. Ltr. Rul. 201547007.
  122. 122 Priv. Ltr. Rul. 201448032.
  123. 123 Reg. §53.4944-1(a)(2)(iv).
  124. 124 See §14.2.
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