A. The "fantastically intricate and detailed" rules—as one judge labeled them—can spin your head. See IRC §509(a)(3), Reg. §1.509(a)-4 and the excerpt from IRS Pub. 557(5-03) in Appendix "A." See Appendix "B" for IRS’s Supporting Organization check list.

B. In the trade, the three types of supporting organizations are called Type I, Type II and Type III. Clients who are considering a supporting organization (as an alternative to a private foundation or a donor-advised fund) will generally consider a Type III.

C. Basically, IRC §509(a)(3) treats a supporting organization as a public charity (and excludes it from the definition of a private foundation) if it meets these three requirements:

1. Is organized and at all times thereafter operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more specified organizations (which can be either domestic or foreign) described in IRC §509(a)(1) or §509(a)—so-called publicly supported organizations;

2. Is operated, supervised, or controlled by or in connection with one or more of the organizations described in IRC §509(a)(1) or §509(a)(2); and

3. Is not controlled directly or indirectly by disqualified persons other than foundation managers and other than one or more organizations described in IRC §509(a)(1) or §509(a)(2).

D. Simply put, a supporting organization doesn’t conduct a particular activity or receive financial support from the general public. Rather it has established a certain relationship in support of IRC §509(a)(1) or §509(a)(2) organizations. Thus an organization may qualify as other than a private foundation even though it may be funded by a single donor, family, or corporation. This kind of funding ordinarily would indicate private foundation status, but an IRC §509(a)(3) organization has limited purposes and activities and gives up a significant degree of independence.

E. Type I—operated, supervised, or controlled by a publicly supported charity. The majority of the governing body is designated by the supported public charities (a parent-subsidiary relationship).

F. Type II—supervised or controlled in connection with a publicly supported organization. (Common control is called a brother-sister relationship).

G. Type III—operated in connection with one or more publicly supported organizations. Let’s call this a kissing-cousin relationship, but as we shall see (below), IRS and the Tax Court recently gave two supporting organizations the kiss of death, holding them to be private foundations for failing the attentiveness test (part of the integral part test).

H. A donor can have the greatest degree of control with a Type III. But the supporting organization must satisfy an "organizational" test, a "responsive" test and an "integral part" test.

1. Organizational test. See Appendix "A."

2. Responsiveness test. The supporting organization is responsive to the needs or demands of the publicly supported charity by satisfying one of the following:

a. The publicly supported charity must elect, appoint, or maintain a close and continuous working relationship with the officers, directors, or trustees of the supporting organization. Thus, the officers, directors, or trustees of the publicly supported charity have a significant voice in the investment policies of the supporting organization, the timing of grants and the manner of making them, the selection of recipients, and generally the use of the income or assets of the supporting organization, or

b. The supporting organization is a charitable trust under state law, each specified publicly supported organization is a named beneficiary under the trust’s governing instrument, and the beneficiary organization has the power to enforce the trust and compel an accounting under state law.

3. Integral-part test. The supporting organization will meet this test if it maintains a significant involvement in the operations of one or more publicly supported charities and those organizations are in turn dependent upon the supporting organization for the type of support that it provides. To meet this test, either of the following must be satisfied:

a. The activities engaged in, for, or on behalf of, the publicly supported charities are activities to perform the functions of or to carry out the purposes of the organizations, and but for the involvement of the supporting organization, would normally be engaged in by the publicly supported charities themselves, or

b. The supporting organization makes payments of substantially all (at least 85%) of its income to, or for the use of, publicly supported charities, and the amount of support received by one or more of those publicly supported charities is enough to insure the attentiveness of those organizations to the operations of the supporting organization. Except as explained in the next paragraph, the amount of support received by a publicly supported charity must represent a large enough part of the charity’s total support to insure such attentiveness. In applying this, if the supporting organization makes payments to, or for the use of, a particular department or school of a university, hospital, or church, the total support of the department or school must be substituted for the total support of the beneficiary organization.

c. Even when the amount of support received by a publicly supported beneficiary charity does not represent a large enough part of the beneficiary organization’s total support, the amount of support received from a supporting organization may be large enough to meet the requirements of the integral-part test if it can be demonstrated that, in order to avoid the interruption of a particular function or activity, the beneficiary organization will be sufficiently attentive to the operations of the supporting organization. This may occur when either the supporting organization or the beneficiary organization earmarks the support received from the supporting organization for a particular program or activity, even if the program or activity is not the beneficiary organization’s primary program or activity, as long as the program or activity is a substantial one.

d. Normally, the attentiveness of a beneficiary organization is motivated by the amounts received from the supporting organization. Thus the more substantial the amount involved, in terms of a percentage of the publicly supported organization’s total support, the greater the likelihood that the required degree of attentiveness will be present. However, in determining whether the amount received from the supporting organization is large enough to insure the attentiveness of the beneficiary organization to the operations of the supporting organization (including attentiveness to the nature and yield of the supporting organization’s investments), evidence of actual attentiveness by the beneficiary organization is of almost equal importance.

I. Tax Court cases.

1. The Lapham Foundation Inc. was denied Type III Supporting Organization status (and thus held to be a private foundation). Lapham was formed to exclusively benefit a community foundation and was to pay at least 85% of its income to a donor-advised fund at the community foundation. In denying supporting organization status, the court found that Lapham failed the attentiveness test (under the integral part test) because Lapham’s anticipated annual contributions of approximately $7,600 when measured against the community foundation’s annual contributions of over $7 million. Lapham, TC Memo 2002-293. This case has been appealed to the U.S. Court of Appeals for the Sixth Circuit.

2. The Cuddeback Fund—created by a testamentary trust—was denied Type III Supporting Organization status (and thus held to be a private foundation). Cuddeback was formed to benefit two churches (each to receive 10% of Cuddeback’s income) and a nursing home (to receive 80% of the income). The court held that Cuddeback didn’t show that the nursing home would be sufficiently attentive to Cuddeback’s operations to avoid interruption of two of the nursing home’s programs. Cuddeback, 84. T.C. Memo 2002-300.

J. See The Right Fit: Matching Client Goals with Charitable Entities by Nancy P. Marx (Trusts & Estates, Oct. ‘03). The author weighs the advantages and disadvantages of the various charitable donees and concludes regarding Type III organizations: "Until recently, a Type III supporting organization was considered by some to be a desirable alternative to a private foundation, despite its limitations and rather complicated ongoing qualification requirements. Yet the Service’s recent challenge to the use of a donor’s professional advisors as independent trustees and to the funding of such organizations with interests in family-controlled business entities make the Type III supporting organization more a choice of last resort than a true alternative to a private foundation."

A. Definition.

1. A private foundation is any organization described in IRC §501(c)(3) except for an organization referred to in IRC §509(a)(1), (2), (3), or(4). In effect, IRC §501 (c)(3) organizations are divided into two classes, private foundations and public charities. Organizations that aren’t private foundations are generally those that have broad public support or actively function in a supporting relationship to those organizations. Most private foundations are nonoperating foundations. But other categories are private operating foundations, exempt operating foundations and passthrough (conduit) foundations (all described below).

2. An organization is not a private foundation if it is:

a. A church or a convention or association of churches;

b. A school;

c. An organization operated for the benefit of certain state and municipal colleges and universities;

d. A hospital;

e. A medical research organization (operated in conjunction with a hospital);

f. A governmental unit;

g. A publicly supported organization (meeting either a 33 1/3 of support test of a facts and circumstances/10% test);

h. An organization that normally receives no more than one-third of its support from gross investment income and income after tax from unrelated business taxable income, and receives more than one-third of its support from contributions, membership fees, and gross receipts from activities relating to its exempt function—subject to certain exceptions;

i. An organization operated, supervised, or controlled by or in connection with one or more of the organizations described in items a. through h. (above), but not controlled (directly or indirectly) by disqualified persons other than foundation managers;

j. An organization operated solely for the benefit of one or more organizations that are exempt as civic leagues or social welfare organizations, local associations of employees, labor, agricultural, or horticultural organizations, and business leagues, chambers of commerce, real estate boards, boards of trade, or professional football leagues (However, the exempt organization benefited must meet the support tests described in item h., and the organization operated to benefit such organization must meet the control tests of item i. and must not be controlled by disqualified persons other than foundation managers.); or

k. An organization organized and operated to test for public safety.

3. Rebuttable presumption. Even if an organization falls within one of the categories excluded from the definition of private foundation, it will be presumed to be a private foundation, with some exceptions, unless it gives timely notice to the Internal Revenue Service that it is not a private foundation. The presumption of private foundation status is rebuttable. The only exceptions to this requirement are those organizations that are exempt from filing Form 1023, Application for Recognition of Exemption. Nonexempt charitable trusts described in IRC §4947(a)(1) also are excepted. If an organization is required to file the notice, it must do so within 15 months from the end of the month in which it was organized.

B. Tax on net investment income.

1. An excise tax of 2% is imposed on the net investment income of most private foundations, including private operating foundations. Some exceptions apply. An exempt operating foundation (below) is not subject to the tax. IRC §4940. Further, the tax is reduced to 1% in certain cases (below).

2. Reduction in tax. The tax rate on net investment income is reduced from 2% to 1% for any private foundation that meets these distribution requirements: the foundation makes qualifying distributions during the tax year at least equal to the sum of (a) the assets of the foundation for the tax year multiplied by its average percentage payout for the base period, plus (b) 1% of the foundation's net investment income for the tax year, and; the foundation was not liable for Chapter 42 excise taxes for any year of the base period. Qualifying distributions for this purpose are the same as those for purposes of the tax on failure to distribute income (below).

3. The tax is reported on Form 990-PF, Return of Private Foundation. Payment of the tax is subject to estimated tax requirements. See the Instructions for Form 990-PF for the details.

C. Prohibited transactions. The Code imposes two-tier excise taxes on private foundations, foundation managers, or other disqualified persons that engage in certain prohibited acts: failure to distribute income; taxable expenditures; failure to distribute income; self-dealing; jeopardizing investments; and excess business holdings. The prohibited transactions are discussed in great detail starting at X. (below).

D. Excise taxes.

1. First-tier tax (initial tax). Automatically imposed if the foundation engages in a prohibited act. The initial tax may be abated if it is established that the act was due to reasonable cause and not to willful neglect, and that the act was corrected within the correction period.

2. If the prohibited act isn’t corrected by the end of the taxable period, the second-tier tax (additional tax) is imposed. Generally, that period ends on the earlier of: the date a notice of deficiency for the initial tax is mailed, or the date the initial tax is assessed. If the prohibited act is corrected during the correction period, the additional tax will not be assessed. If the tax has been assessed, it will be abated. If the tax has been collected, it will be credited or refunded as an overpayment.

3. The correction period. Begins on the date the prohibited act occurs and ends 90 days after a notice of deficiency for the additional tax is mailed, extended by any period the Internal Revenue Service determines is reasonable and necessary to correct the prohibited act. If a petition is filed with the United States Tax Court to redetermine the tax, the correction period ends when the court's decision is final. If the court determines that the additional tax was properly imposed, it may determine whether the act that gave rise to the tax was timely corrected. A private foundation may also contest the imposition of the additional tax in the United States District Court or in the United States Court of Claims as long as the full amount of the initial tax is paid. The additional tax does not have to be paid.

VI. PRIVATE OPERATING FOUNDATIONS

A. These foundations generally are still subject to the tax on net investment income, and to the other requirements and restrictions that apply to private foundations. However, operating foundations aren’t subject to the excise tax on failure to distribute income. Also, contributions to private operating foundations are income-tax deductible by donors to the same extent as gifts to public charities.

B. A private operating foundation is one that spends at least 85% of its adjusted net income or its minimum investment return, whichever is less, directly for the active conduct of its exempt activities (the income test), and that, in addition, meets the assets test, the endowment test, or the support test.

1. Income test. To qualify as an operating foundation, the organization must make qualifying distributions directly for the active conduct of its exempt activities equal to substantially all (at least 85%) of the lesser of its: adjusted net income, or minimum investment return.

2. Directly for the active conduct of exempt activities means qualifying distributions a foundation makes that are used to conduct exempt activities by the foundation itself, rather than by or through one or more grantee organizations that receive the qualifying distributions directly or indirectly from the foundation.

3. Grants made to other organizations to assist them in conducting their activities are considered an indirect, rather than direct, means of carrying out an exempt purpose of the private foundation, even though the activities of the grantee organization may further the exempt activities of the grantor foundation.

4. Amounts paid to buy or maintain assets used directly in the conduct of the foundation's exempt activities, such as the operating assets of a museum, public park, or historic site, are direct expenditures for the active conduct of the foundation's exempt activities. Also, administrative expenses (such as staff salaries and traveling expenses) and other operating costs necessary to conduct the foundation's exempt activities (regardless of whether they are directly for the active conduct of exempt activities) are treated as qualifying distributions expended directly for the active conduct of exempt activities if the expenses and costs are reasonable. However, administrative expenses and operating costs that are not for exempt activities, such as expenses in connection with the production of investment income, are not treated as qualifying distributions. Expenses for both exempt and non-exempt activities are allocated to each activity on a reasonable and consistently applied basis.

5. Payments to individuals. If a foundation makes grants, scholarships, or other payments to individual beneficiaries (including program-related investments to support active programs to carry out the foundation's exempt purpose), the payments will be treated as qualifying distributions made directly for the active conduct of exempt activities only if the foundation maintains some significant involvement in the active programs in support of which it makes the payments. However, if a foundation does no more than select, screen, and investigate applicants for grants or scholarships, under which the recipients perform their work or studies alone or exclusively under the direction of some other organization, the grants or scholarships will not be treated as qualifying distributions made directly for the active conduct of the foundation's exempt activities.

6. Assets test. A private foundation will meet the assets test if 65% or more of its assets:

a. are devoted directly to the active conduct of its exempt activity, or to a functionally related business, or a combination of the two;

b. consist of stock of a corporation that is controlled by the foundation (by ownership of at least 80% of the total voting power of all classes of stock entitled to vote and at least 80% of the total shares of all other classes of stock) and at least 85% of the assets of which are so devoted; or

c. are any combination of a. and b..

7. Endowment test. A foundation will meet the endowment test if it normally makes qualifying distributions directly for the active conduct of its exempt activities of at least two-thirds of its minimum investment return. The term "directly for the active conduct of its exempt activities" means the same as it does for the income test discussed earlier.

The minimum investment return for any private foundation is deemed to be 5% of the excess of the combined fair market value of all assets of the foundation (other than those used or held for use directly in the active conduct of its exempt purpose) over the amount of indebtedness incurred to buy those assets.

In determining whether the amount of qualifying distributions is at least two-thirds of the organization’s minimum investment return, the organization is not required to trace the source of the expenditures to determine whether they were received from investment income or from contributions.

8. Support test. A private foundation will meet the support test if:

a. At least 85% of its support (other than gross investment income) is normally received from the general public and five or more unrelated exempt organizations.

b. Not more than 25% of its support (other than gross investment income) is normally received from any one exempt organization, and

c. Not more than 50% of its support is normally received from gross investment income.

Here the term support means gifts, grants, contributions, membership fees, the value of services of facilities furnished by a governmental unit without charge, net income from unrelated business activities, and gross receipts from admissions, sales of merchandise, performance of services, or providing facilities in any activity that is not an unrelated trade or business.

The support received from any one exempt organization may be counted toward satisfying the 85% support test only if the foundation receives support from at least five exempt organizations.

Support from the general public includes support received from an individual, trust, corporation, or governmental unit to the extent that the total amount received from any one individual, trust, or corporation does not excess 1% of the foundation’s total support (other than gross investment income) for the period. In applying the 1% limit, all support received from any donor and any person related to the donor is treated as received from one person. Support received from a governmental unit is not subject to the 1% limit.

VII. EXEMPT OPERATING FOUNDATIONS

A. Certain private operating foundations, known as exempt operating foundations, are not subject to the tax on net investment income.

B. To qualify as an exempt operating foundation for a tax year, a private foundation must meet all the following requirements: it must be a private foundation; it has been publicly supported for at least 10 tax years or was a private operating foundation on January 1, 1983, or for its last tax year ending before January 1, 1983; its governing body, at all times during the tax year, consists of individuals less than 25% of whom are disqualified individuals, and is broadly representative of the general public; and it has no officer who is a disqualified individual at any time during the tax year.

C. Letter ruling required. A foundation seeking recognition of "exempt operating foundation" status must obtain a letter ruling from the Internal Revenue Service determining that it has met the specific requirements for this special status.

A. Contributions to a private nonoperating foundation may qualify for the benefit of the 50%/30% contribution deduction limits (instead of the 30%/20% limits), and donors may deduct the fair market value of many appreciated property gifts (instead of the cost basis), if the foundation: distributes an amount equal in value to 100% of all contributions received in the tax year by the 15^th day of the 3rd month after the close of its tax year; has no remaining undistributed income for the year; and distributes only qualifying distributions that are treated as distributions out of corpus.

B. Distributions aren’t qualifying distributions if made to an organization controlled directly or indirectly by the foundation or by one or more disqualified persons, or a private foundation that is not an operating foundation.

C. To qualify for the 50%/30% contribution limits and fair market value deductibility, the organization must distribute all contributions received in any year, whether of cash or property. Distributions will be treated as made first out of contributions of property and second out of cash contributions received by the foundation during the year to qualify for the deduction of the full value of appreciated property.

D. A private foundation is not required to trace specific contributions of property, or amounts into which those contributions are converted, to specific distributions. A private foundation may choose to treat part or all of one or more distributions, made by the 15th day of the 3rd month after the close of the year, as made out of corpus.

E. The fair market value of contributed property, determined on the date of the contribution, generally must be used to determine whether an amount equal to 100% of the contributions received has been distributed. If the property is sold, the foundation may reduce the property's fair market value by any reasonable selling expenses incurred. The foundation must distribute the balance of the fair market value of the property that was sold to meet the 100% distribution requirement. However, if within 30 days after receiving the contributed property, the foundation sells the property or distributes the property to a public charity, the foundation may choose to treat either: the gross amount received on the sale, minus reasonable selling expenses incurred, or the fair market value of the contributed property at the date of its distribution to the public charity as the fair market value for purposes of the 100% distribution requirement.

F. A donor claiming a deduction for a charitable contribution to a passthrough foundation must get adequate records or other sufficient evidence from the foundation showing that the foundation made the required qualifying distributions in the time prescribed. Records or other evidence must be attached to the taxpayer's return for the tax year the charitable contribution deduction is claimed.

G. Being a passthrough foundation is not forever. The decision can be made from year to year.

A. Instead of a company making gifts directly to charitable organizations or to donor-advised funds, some businesses create company foundations.

1. These foundations are generally private foundations because they typically receive all or practically all of their funds from one source—the company. A company foundation can be funded with a large infusion of funds; typically, however, they are funded on a year-to-year basis or from time to time.

2. All the private foundation rules apply to company foundations.

3. Benefits.

a. Enables a business to maintain a level giving program that isn’t dependent on annual profits as with gifts made directly by the company.

b. Can make grants to noncharities provided it exercises "expenditure responsibility."

c. Can be used to keep control of the company’s stock and the timing of its sale within the "excess business holdings" limits.

d. Typically incorporates the company’s name and can be controlled by a board that the company appoints.

B. A company foundation on a year-to-year basis can be a passthrough (conduit) foundation so the fair market value (instead of cost basis) deductibility rules apply. In all cases, the deductibility ceiling for gifts by a corporation to its foundation is 10% of the corporation’s taxable income—with a five-year carryover for any "excess." The Charitable Giving Act (H.R. 7) passed in the House in September ‘03 would—among other tax incentives—gradually increase the 10% ceiling to 20% by 2012.

C. A company can make grants and award scholarships to employees by meeting the requirements that all private foundations must meet under IRC §4945. See XIV. (below). Also see Rev. Proc. 76-47, 1976-2 CB 670 and "Disaster Relief and Emergency Hardship Programs," Exempt Organizations–Continuing Professional Education Technical Instruction Program for FY 1999.

D. If a direct payment by a company to a charity satisfies a business purpose test, it is deductible as an ordinary and necessary business expense and isn’t subject to the 10% of taxable income (with five-year carryover) limitation. See XXV. (below).

E. Any objections to a company foundation? If it is a corporation’s mission to make money for the stockholders, how can it justify giving away their money? State law often grants corporations the power to make charitable gifts. And being a good corporate citizen is good business and generally trumps all other arguments. A practical guideline for company foundations: Don’t offend shareholders, employees, customers, politicians, creditors and suppliers by making grants to controversial charities.

X. TAXES ON SELF-DEALING—IRC §4941; REG. §53.4941

A. An excise tax is imposed on certain transactions (acts of self-dealing) between a private foundation and disqualified persons.

B. Initial tax. An excise tax of 5% of the amount involved (described later) in the act of self-dealing is imposed on the disqualified person, other than a foundation manager acting only as a manager, for each year or part of a year in the taxable period (discussed later). Note: H.R. 7 passed by the House in September ‘03 would increase the initial tax to 25%.

C. An excise tax of 2½% of the amount involved is imposed on a foundation manager who knowingly participates in an act of self-dealing, unless participation is not willful and is due to reasonable cause, for each year or part of a year in the taxable period.

D. Additional tax. An excise tax of 200% of the amount involved is imposed on the disqualified person, other than a foundation manager acting only as a manager, who participated in the act of self-dealing, if the act of self-dealing isn’t corrected within the taxable period. The additional tax will not be assessed, or if assessed will be abated, if the act of self-dealing is corrected during the correction period (described later). If the additional tax is imposed on the disqualified person, an excise tax of 50% of the amount involved is imposed on any foundation manager who refuses to agree to part or all of the correction of the self-dealing act.

E. Limits on liability for management. The maximum initial tax imposed on the foundation manager is $10,000 and the maximum additional tax is $10,000 for any one act.

F. There is no maximum on the liability of the self-dealer, including one who is a foundation manager. If more than one person is liable for the initial and additional taxes imposed for any act of self-dealing, all parties will be jointly and severally liable for those taxes.

G. Acts of self-dealing. (This is an overview; see below for the details and the exceptions.) The following transactions are generally considered acts of self-dealing between a private foundation and a disqualified person:

1. Sale, exchange, or leasing of property;

2. Lending money or other extensions of credit;

3. Providing goods, services, or facilities;

4. Paying compensation or reimbursing expenses to a disqualified person;

5. Transferring foundation income or assets to, or for the use or benefit of, a disqualified person; and

6. Certain agreements to make payments of money or property to government officials. A government official may be a disqualified person for the tax on self-dealing. However, the tax will be imposed only if the government official knows that the act is an act of self-dealing.

H. Participation. A disqualified person who engages or takes part in a transaction alone or with others, or directs any person to do so will be treated as participating in an act of self-dealing. Participation by a foundation manager includes silence or inaction on the manager's part where there is a duty to speak or act, as well as any affirmative action by the manager. However, a foundation manager will not have participated in an act of self-dealing when the manager has opposed the act in a manner consistent with carrying out the manager's responsibilities to the private foundation.

I. Willful. Participation by a foundation manager is willful if it is voluntary, conscious, and intentional. No motive to avoid the restrictions of the law or the incurrence of any tax is necessary to make the participation willful. However, participation by the foundation manager is not willful if the manager does not know (discussed later) that participation in the transaction is an act of self-dealing.

J. Reasonable cause. Participation is due to reasonable cause if the foundation manager has exercised responsibility on behalf of the foundation with ordinary business care and prudence.

K. Advice of counsel. A person who, after full disclosure of the factual situation to legal counsel (including house counsel), relies on the advice of counsel expressed in a reasoned written legal opinion that a transaction is not an act of self-dealing under the law, although the transaction is later held to be an act of self-dealing, will ordinarily not be liable for the initial tax imposed for self-dealing. A written legal opinion is considered reasoned even if it reaches a conclusion that is later determined to be incorrect as long as it addresses itself to the facts and applicable law. However, a written legal opinion will not be considered reasoned if it does nothing more than recite the facts and express a conclusion. The absence of advice of counsel will not, by itself, imply that a person participated in the act knowingly, willfully, or without reasonable cause.

L. Knowing. A person will be considered to have participated in a transaction knowing that it is an act of self-dealing only if:

1. The person has actual knowledge of enough facts so that, based only upon those facts, the transaction would be an act of self-dealing;

2. The person is aware that such an act may violate the provisions of federal tax law governing self-dealing; and

3. The person negligently fails to make reasonable attempts to learn whether the transaction is an act of self-dealing, or the person is aware that the transaction is an act of self-dealing.

The term "knowing" does not mean having reason to know. However, evidence tending to show that a person had reason to know of a particular fact or rule is relevant in determining whether that person has actual knowledge of the fact or rule. The burden of proof that a foundation manager has knowingly participated in an act of self-dealing is on the IRS.

M. Taxable period. The tax on self-dealing is imposed for each year or part of a year within the taxable period. The taxable period begins on the date the act of self-dealing occurs and ends on the earliest of:

1. The date a notice of deficiency for the initial tax is mailed;

2. The date the initial tax is assessed; or

3. The date correction of the act of self-dealing is completed.

N. Correction period. The correction period starts on the day the act of self-dealing occurs and ends 90 days after a notice of deficiency for the additional tax is mailed. The correction period may be extended by:

1. Any period in which the deficiency cannot be assessed because of a petition to the Tax Court; or

2. Any period the IRS determines is reasonable and necessary.

O. Self-dealing—the details (that’s where the devil resides). It includes the following transactions whether direct or indirect. (See indirect self-dealing, exceptions to self-dealing, and transitional rules below.)

1. Sales or exchanges of property.

a. Any sale or exchange of property between a private foundation and a disqualified person is an act of self-dealing. For example, the sale of incidental supplies by a disqualified person to a private foundation is an act of self-dealing regardless of the amount paid to the disqualified person. Similarly, the sale of stock or other securities by a disqualified person to a private foundation in a bargain sale is an act of self-dealing regardless of the amount paid. But see exceptions below.

b. The transfer of real or personal property by a disqualified person to a private foundation is treated as a sale or exchange if the foundation assumes a mortgage or similar lien, which was placed on the property before the transfer, or takes the property subject to a mortgage or similar lien that a disqualified person placed on the property in the 10-year period ending on the date of transfer. A similar lien includes, but is not limited to, deeds of trust and vendors' liens, but does not include any other lien if it is insignificant in relation to the fair market value of the property transferred.

Example: A private foundation received a donation of a life insurance policy from a disqualified person. The policy, which had a face value of $100,000, was subject to an outstanding loan of $46,000 that was made to DP by the insurer within the 10-year period ending on the date of the donation. The cash surrender value of the policy was $50,000 on the date of transfer. Under the terms of the policy, failure to repay the principal or interest on the policy loan reduces the proceeds that are payable to the beneficiary upon voluntary surrender of the policy or upon the death of the insured. The donation is an act of self-dealing.

2. Leases. The leasing of property between a disqualified person and a private foundation is an act of self-dealing. But see exceptions below.

3. Loans. Lending money or other extension of credit between a private foundation and a disqualified person is an act of self-dealing. However, this doesn’t include loaning money by a disqualified person to a private foundation without interest or other charge if the proceeds of the loan are used exclusively for purposes specified in IRC §501(c)(3). A loan by a disqualified person to a private foundation at below-market interest rates is treated as an act of self-dealing to the same extent as a loan at market interest rates. But making a promise, pledge, or similar arrangement regarding money or property to a private foundation by a disqualified person, whether by an oral or written agreement, a promissory note, or other instrument of indebtedness, is not an extension of credit before the date of maturity to the extent that it is motivated by charitable intent and is unsupported by consideration.

4. Providing goods, services, or facilities. Generally, these activities between a private foundation and a disqualified person is an act of self-dealing. This applies to providing goods, services, or facilities, such as office space, cars, auditoriums, secretarial help, meals, libraries, publications, laboratories, or parking lots. However, it is not self-dealing if a disqualified person provides them to a foundation without charge and the goods, services, or facilities are used exclusively for purposes specified in IRC §501(c)(3) of the Code. Also, providing goods, services, or facilities to a foundation manager, to an employee, or to an unpaid worker, is not an act of self-dealing if the value of the items provided is reasonable and necessary to the performance of the tasks involved in carrying out the exempt purpose of the foundation and is not excessive. For example, it is not an act of self-dealing if a private foundation provides meals and lodging which are reasonable and necessary (but not excessive) to a foundation manager. This is true whether or not the value of the meals and lodging is excludable from the manager's gross income.

5. Paying compensation or reimbursing expenses by a private foundation to a disqualified person is an act of self-dealing. But see exceptions below.

6. Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation is an act of self-dealing. For example, an act of self-dealing includes payment by a private foundation of any excise tax imposed on a disqualified person for any prohibited transactions.

7. A grant or other payment made by a foundation to satisfy the legal obligation of a disqualified person is an act of self-dealing.

8. Incidental benefits. The fact that a disqualified person receives an incidental or slight benefit from the use by a foundation of its income or assets will not, by itself, make the use an act of self-dealing. Public recognition that a substantial contributor may receive, arising from charitable activities of a private foundation, does not in itself result in an act of self-dealing since generally the benefit is incidental and tenuous.

9. Payment to a government official. The agreement by a private foundation to make any payment of money or other property to a government official will ordinarily be an act of self-dealing. But, see exceptions below.

P. Indirect self-dealing.

1. Certain business transactions between a disqualified person and an organization controlled by a private foundation is not indirect self-dealing if:

a. The transaction arose from a business relationship established before the transaction could be considered an act of self-dealing,

b. The transaction was at least as favorable to the organization controlled by the foundation as an arm's length transaction with an unrelated person, and

c. Either the organization controlled by the foundation would have suffered severe economic hardship by engaging in a transaction with someone other than a disqualified person, or because of the unique nature of the product or services provided by the organization controlled by the foundation, the disqualified person could not have engaged in a transaction with anyone else, or could have done so only by incurring severe economic hardship.

2. Transactions during the administration of an estate or revocable trust. A transaction involving a private foundation's interest or expectancy in property held by an estate (or revocable trust, including a trust that has become irrevocable on a grantor's death), regardless of when title to the property vests under local law, is not indirect self-dealing if:

a. The administrator, executor, or trustee has the power to sell the property or to reallocate the property to another beneficiary, or is required to sell the property under the terms of any option to which the property was subject when acquired by the estate or trust;

b. The transaction is approved by the probate court having jurisdiction over the estate (or by another court having jurisdiction over the estate, trust, or private foundation);

c. The transaction occurs before the estate is considered terminated for federal income tax purposes (or for a trust, before it is considered a trust that is not tax exempt);

d. The estate (or trust) receives an amount at least equal to the fair market value of the foundation's interest or expectancy in the property, considering any option to which the property was subject when it was acquired; and

e. The transaction results either in the foundation's receiving an interest or expectancy at least as liquid as the one it gave up, or in the foundation's receiving an asset related to the active carrying out of its exempt purpose, or the transaction is required under the terms of any option binding on the estate or trust.

3. Transactions with certain organizations. A transaction between a foundation and a corporation, partnership, estate, or trust not controlled by the foundation in which disqualified persons hold no more than 35% of the total voting power or profits or beneficial interest, is not an indirect act of self-dealing solely on the basis of ownership.

4. Certain transactions involving limited amounts. The term "indirect self-dealing" does not include any transaction between a disqualified person and an organization controlled by a private foundation or between two disqualified persons when the foundation's assets may be affected by the transaction if:

a. The transaction arises in the normal and customary course of a retail business engaged in with the general public;

b. In a transaction between a disqualified person and an organization controlled by a private foundation, the transaction is at least as favorable to the organization controlled by the foundation as an arm's length transaction with an unrelated person; and

c. The total amounts involved in all these transactions with anyone disqualified person in anyone tax year is no more than $5,000.

Q. Exceptions to self-dealing. The following transactions between a private foundation and a disqualified person are not considered self-dealing.

1. Payment of compensation or reimbursement of expenses by a private foundation to a disqualified person (except for a government official) for personal services that are reasonable and necessary to carry out the exempt purpose of the private foundation is not considered an act of self-dealing if the compensation or reimbursement is not excessive.

2. Providing goods, services, or facilities by a private foundation to a disqualified person is not self-dealing if the goods, services, or facilities are made available to the general public on at least as favorable a basis as they are made available to the disqualified person and the goods, services, or facilities are functionally related to the exercise or performance by a private foundation of its exempt purpose. The term "general public" includes those persons who reasonably would be expected to use the foundation's goods, services, or facilities. This does not apply, however, unless a substantial number of persons other than disqualified persons actually use the goods, services, or facilities.

3. The leasing of property by a disqualified person to a private foundation is not an act of self-dealing if the lease is without charge. The lease will be considered without charge even though the foundation agrees to pay for janitorial expenses, utilities, or other maintenance costs it incurs as long as payment is not made directly or indirectly to a disqualified person.

XI. TAXES ON FAILURE TO DISTRIBUTE INCOME—IRC §4942; REG §53.4942

A. An excise tax is imposed on private foundation’s undistributed income. An additional excise tax is imposed on any income remaining undistributed at the end of the taxable period.

B. The foundation’s income must be distributed as qualifying distributions (defined later). Private foundations must make qualifying distributions to the extent of their minimum investment return for the year. However, a foundation may set aside funds for periods up to 60 months for certain major projects. Excess qualifying distributions may be carried forward for a period of 5 tax years immediately following the tax year in which the excess was created.

C. Initial tax. An excise tax of 15% is imposed on the undistributed income of a private foundation that has not been distributed before the first day of the 2^nd (or any succeeding) tax year following the year earned, if the first day falls within the taxable period. A short tax year is considered a tax year. The initial tax may be abated if the foundation can show that the failure was due to reasonable cause and not to willful neglect, and that the failure to distribute was corrected within the correction period (described later).

D. Additional tax. If the initial tax is imposed and the undistributed income has not been distributed by the end of the taxable period, an additional tax of 100% of the amount remaining undistributed will be imposed. The tax will not be assessed, or if assessed will be abated, if the undistributed income is reduced to zero during the correction period.

Payment of the excise tax is required in addition to, rather than instead of, making required distributions of undistributed income.

E. Exceptions. The tax does not apply to the undistributed income of a private operating foundation or of an exempt operating foundation (discussed earlier).

F. Incorrect valuation of assets. The tax also does not apply to the undistributed income of a private foundation that failed to distribute only because of an incorrect valuation of assets, if:

1. The incorrect valuation was not willful and was due to reasonable cause;

2. The undistributed income is distributed as qualifying distributions during the allowable distribution period;

3. The foundation notifies the Service that the income has been distributed to correct its earlier failure to distribute; and

4. The distribution is treated as a correction of deficient distributions for earlier tax years that would otherwise be subject to this tax.

The foundation must be able to show it has made all reasonable efforts in good faith to value its assets according to applicable rules.

G. The correction period begins with the first day of the tax year in which there was a failure to distribute income and ends 90 days after a notice of deficiency for the additional tax is mailed.

The correction period is extended by any period during which a deficiency cannot be assessed. In addition, this period may be extended by any period that the IRS determines is reasonable and necessary to make distributions of undistributed income as required to comply with IRC §4942.

H. The distributable amount is equal to the minimum investment return of a private foundation reduced by the sum of any income taxes and the tax on investment income, and increased by:

1. Amounts received or accrued as repayments of amounts taken into account as qualifying distributions for any tax year;

2. Amounts received or accrued from the sale or other disposition of property to the extent that the acquisition of the property was considered a qualifying disposition for any tax year; and

3. Any amount set aside for a specific project (described below) to the extent the amount set aside was not necessary for the purpose for which it was set aside.

I. Minimum investment return. The minimum investment return for any private foundation is 5% of the excess of the combined fair market value of all assets of the foundation, other than those used or held for use for exempt purposes, over the amount of indebtedness incurred to buy these assets.

J. A qualifying distribution is:

1. Any amount (including program-related investments and reasonable and necessary grant administrative expenses, subject to the limit discussed later) paid to accomplish religious, charitable, scientific, literary, or other public purposes. Qualifying distributions do not include contributions to organizations controlled by the contributing foundation or by one or more disqualified persons with respect to the foundation or to private nonoperating foundations (with exceptions for certain contributions to exempt organization, discussed later).

2. Any amount paid to buy an asset used (or held for use) directly to carry out a charitable or other public purpose. Depreciation on these assets, however, is not considered a qualifying distribution.

3. Any qualifying amount set aside (discussed later).

In general, a distribution to a public charity described in IRC §509(a)(1), (2), or (3) to accomplish a religious, charitable, scientific, literary, educational, or other permitted public purpose is a qualifying distribution.

K. Payment of any Chapter 42 excise tax imposed on the foundation is not considered a qualifying distribution.

L. Set-asides. An amount set aside for a specific project may be treated as a qualifying distribution in the year set aside (but not in the year actually paid) if at the time of the set-aside the foundation establishes to the satisfaction of the Service that:

1. The amount will actually be paid for the specific project within 60 months from the date of the first set-aside, and

2. The set-aside satisfies the suitability test, that is, that the project is one that can be better accomplished by a set-aside than by immediate payment, or the foundation satisfies the cash distribution test (discussed later).

M. Suitability test. To satisfy the suitability test, the foundation must show that the specific project for which the amount is set aside is one that can be better accomplished by the set-aside than by the immediate payment of funds. Such a specific project includes, but is not limited to, situations where relatively long-term grants or expenditures must be made to assure the continuity of particular charitable projects or program-related investments, or where grants are made as part of a matching-grant program. An example of a specific project is a plan to build an art museum even though the exact location and architectural plans have not been finalized. For good cause shown, the period for paying the amount set aside may be extended by the Service.

To qualify under the suitability test, a set-aside must be approved by the IRS, as explained later.

N. Cash distribution test. The foundation satisfies the cash distribution test if:

1. The specific project for which the amount is set aside will not be completed before the end of the tax year in which the set-aside is made;

2. The foundation actually distributes for exempt purposes, in cash or its equivalent, the start-up period minimum amount during the foundation’s start-up period; and

3. The foundation actually distributes the full-payment period minimum amount in each tax year of the foundation’s full-payment period.

O. Start-up period minimum amount. Generally, the start-up period consists of the four tax years following the tax year in which the foundation was created (or otherwise became a private foundation). For this purpose, a foundation is considered created in the tax year in which its distributable amount first exceeds $500. The start-up period minimum amount, the amount that a private foundation must actually distribute during it start-up period, is not less than the sum of:

1. 20% of its distributable amount (as defined earlier) for the first tax year of the start-up period;

2. 40% of its distributable amount for the second year of the start-up period;

3. 60% of its distributable amount for the third year of the start-up period; and

4. 80% of its distributable amount for the fourth year of the start-up period.

The sum of these amounts must be distributed before the end of the start-up period. There is no requirement that any part be distributed in any particular tax year of the start-up period.

In general, only a distribution actually made during the start-up period is taken into account in determining whether the foundation has distributed the start-up period minimum amount. However, a distribution actually made during the tax year in which the foundation was created (the year immediately preceding the foundation’s start-up period) may be treated as made during the start-up period. Also, a distribution actually made within 5½ months after the end of the start-up period will be treated as made during the start-up period if: (a) the foundation was unable to determine its distributable amount for the fourth tax year of the start-up period until after the end of the period, and (b) the foundation actually made distributions before the end of the start-up period based on a reasonable estimate of its distributable amount for that fourth tax year.

XII. TAXES ON EXCESS BUSINESS HOLDINGS—IRC §4943; REG. §53.4943

A. Generally, the combined holdings of a private foundation and all of its disqualified persons are limited to 20% of the voting stock in a business enterprise that is a corporation, a partnership, joint venture, or other unincorporated enterprise. For a partnership or joint venture, profits’ interest is substituted for voting stock, and for any other unincorporated enterprise, beneficial interest is substituted for voting stock. A private foundation that has excess business holdings in a business enterprise may become liable for an excise tax based on the amount of the excess holdings.

B. Initial tax. An excise tax of 5% of the value of the excess holdings is imposed on the foundation. The tax is imposed on the last day of each tax year that ends during the taxable period (described later). The amount of the excess holdings is determined as of the day during the tax year when the foundation's excess holdings in the business were the greatest.

C. The initial tax may be abated if the foundation can show that the excess holdings were due to reasonable cause and not to willful neglect, and that the excess holdings were disposed of within the correction period (described below).

D. Additional tax. After the initial tax has been imposed, an excise tax of 200% of the excess holdings is imposed on the foundation if it has not disposed of the remaining excess business holdings by the end of the taxable period. The additional tax will not be assessed, or if assessed will be abated, if the excess business holdings are reduced to zero during the correction period (described below).

E. Business enterprise. The term business enterprise, in general, includes the active conduct of a trade or business including any activity that is regularly carried on for the production of income from the sale of goods or the performance of services and that constitutes an unrelated trade or business under IRC §513. The term doesn’t include a functionally related business, a trade or business that obtains at least 95% of its gross income from passive sources, or program-related investments.

F. A functionally related business is:

1. A trade or 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;

2. A trade or business in which substantially all the work is performed for the foundation without compensation;

3. A business carried on by the foundation primarily for the convenience of its members, students, patients, officers, or employees (such as a cafeteria operated by a museum for the convenience of its members, employees, and visitors);

4. A business that consists of the selling of merchandise, substantially all of which has been received by the foundation as gifts or contributions; or

5. An activity carried on within a larger combination of similar activities or within a larger complex of other endeavors that is related to the exempt purposes of the foundation (other than the need to simply provide funds for these purposes).

G. Gross income from passive sources includes:

1. Dividends, interest, and annuities;

2. Royalties (including overriding royalties), whether measured by production or by gross or taxable income from the property;

3. Rents from real property, and from personal property leased with real property if the rents from the personal property are an incidental amount of the total rents under the lease (determined at the time the personal property is placed in service). Rents are not considered gross income from passive sources if more than 50% of the total rent under the lease is for personal property, or if the determination of the amount of rent depends in whole or in part on the income or profits received from the leased property (unless the amount is based on fixed percentages of gross receipts or sales);

4. Gains from sales, exchanges, or other dispositions of property other than—

a. Stock in trade or property held primarily for sale to customers in the ordinary course of business; or

b. Gains on the lapse or termination of options written by the organization in connection with its investment activities to buy or sell securities. Gains from cutting timber, that upon election may be considered a sale or exchange, are not considered gross income from passive sources; and

5. 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.

H. Excess business holdings. The excess business holdings of a foundation are the amount of stock or other interest in a business enterprise that exceeds the permitted holdings. A private foundation is generally permitted to hold up to 20% of the voting stock of a corporation, reduced by the percentage of voting stock actually or constructively owned by disqualified persons.

I. Exceptions to this rule.

1. If one or more third persons, who are not disqualified persons, have effective control of a corporation, the private foundation and all disqualified persons together may own up to 35% of the corporation's voting stock. Effective control means the power, whether direct or indirect, and whether or not actually exercised, to direct or cause the direction of the management and policies of a business enterprise. It is the actual control which is decisive, and not its form or the means by which it is exercisable.

2. A private foundation is not treated as having excess business holdings in any corporation in which it (together with certain other related private foundations) owns not more than 2% of the voting stock and not more than 2% of the value of all outstanding shares of all classes of stock.

J. Nonvoting stock (or capital interest for holdings in a partnership or joint venture) is a permitted holding of a foundation if all disqualified persons together hold no more than 20% (or 35% as described earlier) of the voting stock of the corporation. All equity interests which are not voting stock shall be classified as nonvoting stock.

K. Interest in sole proprietorships. A private foundation is not permitted any holdings in sole proprietorships that are business enterprises unless they were held before May 26, 1969, or acquired by gift or bequest thereafter.

L. Attribution of business holdings. For determining the holdings in a business enterprise of either a private foundation or a disqualified person, any stock or other interest owned directly or indirectly by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries. This rule does not apply to certain income interests or remainder interests of a private foundation in a split-interest trust.

M. Dispositions of certain excess holdings within 90 days. A private foundation that acquires excess business holdings, other than as a result of a purchase by the foundation, will not be subject to the taxes on excess business holdings if it disposes of the excess business holdings within 90 days from the date on which it knows, or has reason to know, of the event that caused it to have the excess holdings. This 90-day period will be extended to include the period during which a foundation is prevented by federal or state securities laws from disposing of the excess business holdings. The 90-day disposition period applies, for example, when a disqualified person acquires additional holdings. The amount of holdings the foundation must dispose of is not affected by disposals by disqualified persons during the 90-day period.

N. The taxable period begins on the first day that the foundation has excess business holdings and ends on the earlier of either:

1. The date a notice of deficiency for the initial tax is mailed, or

2. The date the initial tax is assessed.

O. The correction period begins on the first day that the foundation has excess business holdings and ends 90 days after a notice of deficiency for the additional tax is mailed. This period is extended by any period during which a deficiency cannot be assessed or because of pending Tax Court proceedings. In addition, the correction period may be extended by any other period the Service determines is reasonable and necessary.

P. Gifts or bequests of business holdings. If there is a change in a foundation's business holdings (other than by purchase by the foundation or by disqualified persons) such as through gift or bequest, and the additional holdings result in the foundation having excess business holdings, the foundation in effect has 5 years to reduce these holdings or those of its disqualified persons to permissible levels. The excess business holdings (or the increase in excess business holdings) resulting from the gift or bequest are treated as being held by a disqualified person, rather than by the foundation itself, during the 5-year period beginning on the date the foundation obtains the holdings.

Q. Additional time to dispose of large gifts or bequests. The IRS may grant the foundation an additional 5-year extension (beyond the initial 5 years) to reduce excess business holdings to permissible levels if these holdings result from an unusually large gift or bequest of diverse business holdings or holdings with complex corporate structures. To receive this extension:

1. The foundation must establish that it made diligent efforts to dispose of the holdings within the initial 5-year period, and could not do so (except at a price substantially below fair market value) because of the size and complexity or diversity of the holdings;

2. The foundation must submit to the IRS, before the end of the initial 5-year period, a plan for disposing of all the excess business holdings involved in the extension; and

3. The IRS must determine that the foundation's plan for disposal can reasonably be expected to be carried out before the end of the additional 5-year period.

R. The foundation must also submit the plan described above to the state attorney general (or other appropriate official) having administrative or supervisory authority or responsibility for the foundation's disposition of the excess business holdings involved. The foundation must then send to the IRS any response it receives from the attorney general (or other official) regarding its plan.

XIII. TAXES ON INVESTMENTS WHICH JEOPARDIZE CHARITABLE PURPOSE—IRC §4944; REG. §53.4944

A. If a private foundation makes any investments that would financially jeopardize the carrying out of its exempt purposes, both the foundation and the individual foundation managers may become liable for taxes on those investments.

B. Initial tax. An excise tax of 5% of the amount involved (the jeopardizing investment) is imposed on the foundation for each tax year, or part of a year, in the taxable period (described later). The foundation will not be liable for the tax if it can show that the jeopardizing investment was due to reasonable cause and not willful neglect, and that the jeopardizing investment was corrected within the correction period (described later). An excise tax of 5% of the amount involved is also imposed on any foundation manager who knowingly, willfully, and without reasonable cause participated in making the jeopardizing investment. This tax applies to investments of either income or principal.

C. Additional tax. If a private foundation is liable for the initial tax and has not removed the investment from jeopardy within the taxable period, an additional excise tax of 25% of the amount involved will be imposed on the foundation. The additional tax will not be assessed, or if assessed will be abated, if the investment is removed from jeopardy within the correction period.

1. In each case where this additional tax is imposed on the foundation, an additional excise tax of 5% of the amount involved is imposed on any foundation manager who refuses to agree to all or part of the removal from jeopardy within the correction period.

2. If more than one individual manager is liable for the excise tax on jeopardizing investments, all parties will be jointly and severally liable.

D. Limits on liability for management. For any one jeopardizing investment, the maximum initial tax that may be imposed is $5,000, and the maximum additional tax is $10,000.

E. Willful. A manager's participation in making an investment is willful if it is voluntary, conscious, and intentional. However, it is not willful if the manager does not knowingly participate in a jeopardizing investment.

F. Due to reasonable cause. A foundation manager's actions are due to reasonable cause if he or she has exercised responsibility on behalf of the foundation with ordinary business care and prudence.

1. A manager's action will be considered due to reasonable cause if the manager relies on advice of counsel expressed in a reasoned written legal opinion.

2. A foundation manager may also rely on the advice of a qualified investment counselor, given in writing in accordance with generally accepted practices, that a particular investment will provide for the long and short-term financial needs of the foundation.

G. Participation. The participation of any foundation manager in the making of an investment shall consist of any manifestation of approval of the investment.

H. Knowing. Foundation managers will be considered to have participated in making an investment knowing that it is jeopardizing the carrying out of any of the foundation's exempt purposes only if:

1. They have actual knowledge of enough facts so that, based only on those facts, the investment would be a jeopardizing investment;

2. They are aware that an investment under these circumstances may violate the provisions of federal tax law governing jeopardizing investments; and

3. They negligently fail to make reasonable attempts to learn whether the investment is a jeopardizing investment, or in fact are aware that it is such an investment.

The term "knowing" does not mean "having reason to know." However, evidence tending to show that a foundation manager has reason to know of a particular fact or particular rule is relevant in determining whether actual knowledge of such fact or rule is present.

I. Jeopardizing investments generally are those that show a lack of reasonable business care and prudence in providing for the long and short-term financial needs of the foundation for it to carry out its exempt function. No single factor determines a jeopardizing investment. No category of investments is treated as an intrinsic violation, but careful scrutiny is applied to:

1. Trading in securities on margin;

2. Trading in commodity futures;

3. Investing in working interests in oil and gas wells;

4. Buying puts, calls, and straddles;

5. Buying warrants; and

6. Selling short.

In deciding whether the investment of an amount jeopardizes the carrying out of the exempt purposes, the determination must be made on an investment-by-investment basis taking into account the foundation's portfolio as a whole. It is permissible for the foundation managers to take into account expected returns, risks of rising and falling prices, and the need for diversification within the investment portfolio. But to avoid the tax on jeopardizing investments, a careful analysis of potential investments must be made and good business judgment must be exercised. Whether an investment jeopardizes the foundation's exempt purposes is determined at the time of making the investment. If the investment is proper when made, it will not be considered a jeopardizing investment even if it later results in a loss.

J. Program-related investments are not subject to the tax on jeopardizing investments.

A. A private foundation that makes any taxable expenditures, defined later, becomes liable for taxes on those expenditures. The taxes are imposed on both the foundation and on any foundation manager who knowingly and willfully agrees to the expenditures. Both an initial tax and an additional tax may be imposed.

B. Initial tax. The initial tax on the foundation is 10% of the amount expended. The foundation will not be liable for the tax if it can show that the expenditure was due to reasonable cause and not to willful neglect, and that the expenditure was corrected within the correction period (described later). If a foundation manager knowingly, willfully, and without reasonable cause agrees to the taxable expenditure, the initial tax is 2½% of the amount expended, up to a maximum tax of $5,000 for any one expenditure. A foundation manager who acts on advice of counsel, given in a reasoned legal opinion in writing, is not liable for the tax.

C. Advice of counsel. If a foundation manager has made full disclosure of the factual situation to legal counsel (including house counsel) and relies on the advice of counsel expressed in a reasoned written legal opinion that an expenditure is not a taxable expenditure and the expenditure is later held to be taxable, the foundation manager's agreement to the expenditure will ordinarily not be considered knowing or willful and will ordinarily be considered due to reasonable cause.

D. A written legal opinion will be considered reasoned even if it reaches a conclusion that is later determined to be incorrect as long as the opinion addresses itself to the facts and applicable law. However, a written legal opinion will not be considered reasoned if it does nothing more than recite the facts and express a conclusion.

E. The absence of advice of counsel on an expenditure will not, by itself, give rise to any inference that a foundation manager agreed to making the expenditure knowingly, willfully, or , without reasonable cause.

F. A taxable expenditure is an amount paid or incurred to:

1. Carry on propaganda or otherwise attempt to influence legislation;

2. Influence the outcome of any specific public election or carry on any voter registration drive, unless certain requirements (explained later) are satisfied;

3. Make a grant to an individual for travel, study or other similar purposes, unless certain requirements (explained later) are satisfied;

4. Make a grant to an organization (other than an organization described in IRC §509(a)(1), (2), or (3) or an exempt operating foundation) unless the foundation exercises expenditure responsibility with respect to the grant; or

5. Carry out any, purpose other than a religious, charitable, scientific, literary, or educational purpose, the fostering of national or international amateur sports competition (with exceptions) or the prevention of cruelty to children or animals.

G. Grants to individuals for travel, study, or other similar purposes (including loans made for charitable purposes, and program-related investments) are taxable expenditures, unless the following conditions are met:

1. The grant must be awarded on an objective and nondiscriminatory basis under a procedure approved in advance by the Service, and

2. It must be shown to the satisfaction of the Service that one of the following requirements is met—

a. The grant is a scholarship or fellowship and is to be used for study at an educational institution that normally maintains a regular faculty and curriculum and normally has a regularly organized body of students in attendance at the place where the educational activities are carried on. For these purposes, there is no requirement that the grant recipients be limited to degree candidates, nor must the grant be limited to tuition, fees, and course-required books, supplies, and equipment. A recipient may use grant funds for room, board, travel, research, clerical help, or equipment, that are incidental to the purposes of the scholarship or fellowship grant.

b. The grant qualifies as a prize or award under IRC §74(b) if the recipient is selected from the general public. For this purpose, the recipient may keep the prize or award, and need not authorize the foundation to transfer the prize or award to a governmental unit or to another charity.

c. The grant's purpose is to achieve a specific objective, produce a report or similar product, or improve or enhance a literary, artistic, musical, scientific, teaching, or similar capacity, skill, or talent of the grantee.

H. The grant-making procedure, to be approved in advance by the Internal Revenue Service, must provide the following:

1. The group from which the grantees are selected must be reasonably related to the purposes of the grant, and the group must be large enough to constitute a charitable class (unless, taking into account the purposes of the grant, only a few individuals are qualified to be grantees—as in the case of scientific research).

2. The criteria used in selecting grant recipients from the potential grantees should be related to the purpose of the grant. For example, proper criteria for selecting scholarship recipients might include (but are not limited to) the following: past academic performance, performance on tests designed to measure ability and aptitude for college work, recommendations from instructors, financial need, and the conclusions the selection committee might draw from personal interviews.

3. The person or persons who select recipients of grants should not be in a position to receive a private benefit, directly or indirectly, if certain potential grantees are selected over others.

4. Periodic progress reports must be made to the foundation, at least once a year, to deter mine whether the grantees have performed the activities the grants are intended to finance.

5. When these reports are not made or there are other indications that the grants are not being used as intended, the foundation must investigate and take corrective action.

6. The foundation must keep all records relating to all grants to individuals, including—

a. Information obtained to evaluate grantees;

b. Identification of grantees, including any relationship of the grantee to the foundation sufficient to make the grantee a disqualified person;

c. Amount and purpose of each grant; and

d. Follow-up information, including required annual reports and investigation of jeopardized grants.

I. No single procedure or set of procedures is required. Procedures may vary depending upon such factors as the size of the foundation, the amount and purpose of the grants, and whether one or more recipients are involved.

J. Requests for approval of grant-making procedures must be sent to the District Director of the IRS office servicing the foundation’s area. If, by the 45th day after a request for approval of grant procedures has been properly submitted, the foundation has not been notified that the procedures are unacceptable, they may be considered approved from the date of submission until receipt of actual notice from the Service that they do not meet the requirements.

K. Payments of remaining installments of fixed-sum grants awarded during the period the foundation's procedures were considered approved, after the foundation is notified that the procedures are unacceptable, are not taxable expenditures.

L. A renewal of a qualified grant will not be treated as a grant to an individual if:

1. The grantor has no information indicating that the original grant is being used for any purpose other than that for which it was made,

2. The reports due under the terms of the grant have been provided, and

3. Any additional criteria and procedures for renewal are objective and nondiscriminatory.

M. Company scholarship programs are usually administered by company-created private foundations and those foundations may give preference in awarding scholarships to employees, the children or relatives of employees, or the children of deceased or retired employees of the company or related companies. Scholarship grants awarded by those private foundations are taxable expenditures unless the grant programs meet the requirements for individual grants (discussed earlier) and receive advance approval from the Service.

N. Company scholarship programs will not qualify if grants are essentially providing extra pay, an employment incentive, or an employee fringe benefit. Similarly, if scholarship programs are compensatory in nature, an organization administering such a program will not qualify for tax exemption because it is operated for private benefit A private foundation administering such a program could also be involved in direct or indirect self-dealing.

O. Company-related scholarship programs can meet the scholarship requirements by ensuring that the scholarships awarded are for the main purpose of furthering the recipients' education rather than compensating company employees. Certain conditions and tests must establish three facts:

1. The preferential treatment derived from employment must not have any significance beyond that of an initial qualifier;

2. The selection of scholarship grantees must be controlled and limited by substantial nonemployment related factors, including a selection committee of individuals who are independent and separate from the private foundation, its organizer, and the employer concerned; and

3. There must exist only a limited probability that qualified employees or their children will receive scholarship grants.

P. Ruling requests for advance approval of procedures should be sent to the foundation’s key District Director, and should include the statements described earlier under Grants to Individuals, in addition to information responsive to the seven conditions and the percentage test described below.

Q. Educational loans made by a private foundation under an employer-related loan program are not taxable expenditures if the loan program: meets the applicable requirements for grants to individuals (discussed earlier); and satisfies the seven conditions and the percentage tests described below.

R. The seven conditions for approval include:

1. Inducement. The programs must not be used by the employer, the private foundation, or its organizer, to recruit employees or to induce employees to continue their employment or otherwise follow a course of action sought by the employer.

2. Selection committee. Selection of loan recipients must be made by a committee of individuals who are totally independent (except for participation on this committee) and separate from the private foundation, its organizer, and the employer concerned. An individual who is a former employee of either the foundation or the employer concerned will not be considered totally independent. These committees preferably should consist of individuals knowledgeable in the field of education so that they have the background and knowledge to properly evaluate the potential of the applicants.

Forwarding the selections by the independent selection committee to the employer or private foundation only for the purpose of verifying the eligibility requirements and selection criteria followed by the committee in considering the candidates and in making its selection will not disqualify the program. Any public announcement of the awards, however, must be made by the selection committee or by the foundation. The awards may be announced in the employer's newsletter if the foundation or the selection committee is clearly identified as the grantor of the awards.

Loans must be awarded only in the order recommended by the selection committee. The number of loans to be awarded may be reduced but may not be increased from the number recommended by the selection committee. Only the committee may vary the amounts of the loans awarded.

3. Eligibility requirements. The program must impose identifiable minimum requirements for loan eligibility. These requirements must be related to the purpose of the program and must limit the independent selection committee's consideration to those employees, or children of employees, who meet the minimum standards for admission to an educational organization for which the loans are available. No persons will be considered eligible if they would not reasonably be expected to attend such an organization, however, even if they meet the minimum standards. If an employee must have been employed for some minimum period by the employer to which the program relates to be eligible to receive a loan, or to make that employee's children eligible to receive a loan, the minimum period of employment may not be more than 3 years. Moreover, eligibility must not be related to any other employment-related factors, such as the employee's position, services, or duties.

4. Objective basis of selection. Selection of loan recipients must be based only upon substantial objective standards that are completely unrelated to the employment of the recipients or their parents and to the employer's line of business. Such standards as past academic performance, performance on tests designed to measure ability and aptitude for higher education, recommendations from instructors or other individuals not related to the potential awardees, financial need, and conclusions drawn from personal interviews as to motivation and character, may be used.

5. Employment. Once a loan has been awarded, it may not be terminated because the recipient or the recipient's parent no longer works for the employer regardless of the reason for the termination of employment. If a loan is awarded for one academic year and the recipient must reapply for an additional loan or loans to continue studies for a later year, the recipient may not be considered ineligible for a subsequent loan simply because that individual or the individual's parent is no longer employed by the employer. If a loan is awarded for a period of more than one academic year, subject to renewal, the standards for renewal must be based only on nonemployment related factors such as need and maintenance of scholastic standards. At the time the loan is awarded or renewed, there must be no requirement, condition, or suggestion, express or implied, that the recipient or parent is expected to perform future employment services for the foundation or the employer, or be available for future employment, even though the future employment is at the discretion of the foundation or the employer.

6. Course of study. The courses of study for which loans are available must not be limited to those that would be of particular benefit to the employer or to the foundation. If the courses of study for which loans are available include one or more that would be of particular benefit, a loan may not be conditioned on the recipient choosing such a course of study. The recipient must have free choice to use the loan in the pursuit of a course of study for which the loan is otherwise available that is not of particular benefit to the employer or to the foundation.

7. Other objectives. The terms of the loan and the courses of study for which loans are available must be consistent with a disinterested purpose of enabling the recipients to obtain an education in their individual capacities only for their personal benefit. The terms of the loan and courses of study must not include any commitments, understandings, or obligations, conditional or unconditional, suggesting that the studies are undertaken by the recipients for the benefit of the employer or the foundation or have as their objective the accomplishment of any purpose of the employer or the foundation, even though consistent with its exempt status, other than to enable the recipients to obtain an education in their individual capacities.

S. Percentage test. For a program that awards loans to children of employees of a particular employer, the program meets the percentage test if the number of loans awarded under that program in any year to those children are not more than:

1. 25% of the number of employees' children who—

a. Were eligible;

b. Were applicants for such loans; and

c. Were considered by the selection committee in selecting the recipients of loans in that year; or

2. 10% of the number of employees' children who can be shown to be eligible for loans (whether or not they submitted an application) in that year. For purposes of this 10% test, children can be shown to be eligible only if they meet the minimum eligibility requirements of the loan program and the minimum standards for admission to an educational institution for which grants or loans are available. A private foundation may include as eligible only those children who submit a written statement (or on behalf of whom a statement is submitted by an authorized representative), or for whom sufficient information is maintained to demonstrate that:

a. the child meets the foundation's eligibility requirements; and

b. the child has enrolled in or has completed a course of study to prepare for admission to an educational institution at the level for which loans are available and has applied, or intends to apply, to such an institution for enrollment in the immediately succeeding academic year with the expectation, if accepted by the institution, of attending the institution; or

c. in lieu of b. above, the child is currently enrolled in an educational institution for which loans are available and is not in the final year for which awards may be made.

T. For a program that awards loans to employees of a particular employer, the program meets the percentage test if the number of loans awarded under that program in any year to the employees are not more than 10% of the number of employees who:

1. Were eligible;

2. Were applicants for such loans; and

3. Were considered by the selection committee in selecting the recipients of loans in that year.

In meeting these percentage tests, an employee or child of an employee will be considered eligible only if the individual meets all of the eligibility requirements imposed by the program. Renewals of loans awarded in earlier years will not be considered in determining the number of loans awarded in a current year. Loans awarded to children of employees and those awarded to employees will be considered as having been awarded under separate programs whether or not they are awarded under separately administered programs.

If a private foundation's employer-related program includes educational loans and scholarship or fellowship grants to the same group of eligible employees' children, the percentage tests apply to the total number of individuals receiving combined grants of scholarship, fellowship, and educational loans.

If the loan program satisfies the seven conditions, but does not meet the percentage test, all the relevant facts and circumstances will be considered in determining the primary purpose of the program.

U. Reliance by grantors on public charity status of grantees. As discussed earlier, a private foundation need not exercise expenditure responsibility with respect to a grant if the grant is made to a public charity described in IRC §509(a)(1), (2), or (3). If an organization to which a private foundation wishes to make a grant has received a final ruling or determination letter classifying it as an organization described in IRC §509(a)(1), (2), or (3), the treatment of grants and contributions and the status of grantors and contributors to the organization will generally not be affected by reason of a later revocation by the Service of the organization's classification until the date on which notice of change of status is made to the public (such as by publication in the Internal Revenue Bulletin) or another applicable date, if any, specified in the public notice. In appropriate cases, however, the treatment of grants and contributions and the status of grantors and contributors to an organization described in IRC §509(a)(1), (2), or (3) may be affected pending verification of the continued classification of the organization. Notice to this effect is made in a public announcement by the Service. In those cases, the effect of grants and contributions made after the date of the announcement will depend on the statutory qualification of the organization as an organization described in IRC §509(a)(1), (2), or (3).

V. The preceding paragraph doesn’t apply if the grantor or contributor:

1. Had knowledge of the revocation of the ruling or determination letter classifying the organization as an organization described in IRC §509(a)(1), (2), or (3), or

2. Was in part responsible for, or was aware of, the act, the failure to act, or the substantial and material change on the part of the organization that gave rise to the revocation.

W. A grantor or contributor will not be considered responsible for the substantial and material change if:

1. The total support received from such grantor or contributor for a taxable year is 25% or less of the total support received by the donee organization from all sources (excluding support provided by the grantor or contributor or related parties) for the four immediately preceding taxable years, or

2. The grant or contribution qualifies as an unusual grant.

X. Expenditure responsibility means that the foundation exerts all reasonable efforts and establishes adequate procedures:

1. To see that the grant is spent only for the purpose for which it is made;

2. To obtain full and complete reports from the grantee organization on how the funds are spent; and

3. To make full and detailed reports on the expenditures to the IRS.

Y. Pre-grant inquiry. If expenditure responsibility must be exercised, the foundation should conduct a limited inquiry concerning the potential grantee before the grant is made. The inquiry should deal with matters such as the identity, past history and experience management, activities, and practices of the grantee organization, and should be complete enough to give reasonable assurance that the grantee will use the grant for the purposes for which it is made.

Z. Reports from grantees. The granting private foundation must require reports on the use of the funds, compliance with the terms of the grant, and the progress made by the grantee toward achieving the purposes for which the grant was made. The grantee must make an annual accounting of the funds at the end of its accounting period and must make a final report on all expenditures made from the funds in addition to the progress made toward the goals of the grant.

AA. Reliance on information supplied by grantee. A private foundation, exercising expenditure responsibility with respect to its grants, may rely on adequate records or other sufficient evidence supplied by the grantee organization showing the information that the grantor must submit to the IRS.

BB. Recordkeeping requirements. In addition to the information required when filing a return, the granting foundation must make available to the IRS at its main office each of the following items:

1. A copy of the agreement covering each expenditure responsibility grant made during the year;

2. A copy of each report received during the tax year for each grantee on any expenditure responsibility grant; and

3. A copy of each report made by the grantor's personnel or independent auditors of any audits or other investigations made during the tax year on any expenditure responsibility grant.

CC. Violations of expenditure responsibility requirements. Any diversion of grant funds (including income from an endowment grant) for a use not specified in the grant may result in that part of the grant being treated as a taxable expenditure. If the use of the funds is consistent with the purpose of the grant, the fact that a grantee does not use any funds as indicated in the original budget projection is not a diversion of funds.

DD. If a grantor foundation determines that any part of the grant has been used for improper purposes and the grantee has not previously diverted grant funds, the foundation will not be treated as having made a taxable expenditure if it:

1. Takes all reasonable and appropriate steps either to recover the grant funds or to ensure the restoration of the diverted funds and the dedication of the other grant funds held by the grantee to the purposes of the grant, and

2. Withholds any further payments to the .grantee, after being made aware that a diversion of funds may have taken place, until it has received the grantee's assurance that future diversions will not occur and required the grantee to take extraordinary precautions to prevent further diversions from occurring.

EE. If a foundation is considered to have made a taxable expenditure, the amount of the taxable expenditure can be the amount of the diversion plus any further payments, or just the amount of further payments depending on the measure of compliance by the foundation.

FF. Grantee's failure to make reports. A failure to make the required reports by the grantee will result in the grant being treated as a taxable expenditure by the grantor unless the grantor:

1. Awarded the grant according to the expenditure responsibility requirements discussed earlier;

2. Complied with all the reporting requirements;

3. Made a reasonable effort to get the required reports; and

4. Withholds all future payments on this grant and on any other grant to the same grantee until the report is provided.

GG. Violations by the grantor. In addition to the circumstances discussed earlier concerning taxable expenditures, a granting foundation will be treated as making a taxable expenditure if it:

1. Fails to make a pre-grant inquiry;

2. Fails to obtain the required written commitments described earlier; or

3. Fails to make reports to the IRS as discussed earlier.

HH. The reports to the Internal Revenue Service by the foundation on each expenditure responsibility grant must be made each year that any part of the grant remains unexpended by the grantee at any time during the year. The required reports must be submitted with the organization's annual return (Form 990-PF or Form 5227). They must include the following information on each grant:

1. The name and address of the grantee;

2. The date and amount of the grant;

3. The purpose of the grant;

4. The amounts spent by the grantee (based on the most recent report received from the grantee);

5. Whether, to the knowledge of the grantor foundation, the grantee has diverted any funds from the purpose of the grant;

6. The dates of any reports received from the grantee; and

7. The date and results of any verification of the grantee's reports undertaken by or at the direction of the grantor foundation.

II. Expenditures ordinarily not treated as taxable expenditures include:

1. Expenditures to acquire investments that generate income to be used to further the purposes of the organization;

2. Reasonable expenses related to acquiring these investments;

3. Payment of taxes;

4. Expenses that qualify as allowable deductions in figuring the tax on unrelated business income;

5. Any payment that is a qualifying distribution;

6. Any deduction allowed in arriving at taxable net investment income;

7. Reasonable expenditures to evaluate, acquire, modify, and dispose of program-related investments; and

8. Business expenses of the recipient of a program-related investment.

JJ. However, payment of unreasonable administrative expenses, including wages, consultant fees, and other fees for services performed, ordinarily will be taxable expenditures unless made by the foundation in the good faith belief that the amounts were reasonable and were consistent with ordinary business care and prudence.

KK. Unless stringent rules are met, grants by private foundations to foreign charities will be taxable expenditures.

LL. Preventing charitable funds from financing terrorism. Treasury guidelines provide "voluntary best practices for U.S.-based charities" to reduce the possibility that charitable funds will finance terrorist activities. Treasury in an 11/7/02 news release detailed the best procedures for governance, disclosure of governance and financing, financial practices and accountability.

Treasury suggested that the following steps be taken before charitable funds are distributed to foreign organizations:

Collect basic information about a foreign recipient organization (FRO):

• The FRO’s name in English, in the language of origin, and any acronym or other names used to identify the FRO.

• The jurisdictions in which the FRO maintains a physical presence.

• The jurisdiction of the FRO’s incorporation or formation.

• The address and phone number of any place of the FRO’s business.

• The FRO’s principal purpose, including a detailed report of its projects and goals.

• The names and addresses of organizations to which the FRO currently provides or proposes to provide funding, services, or material support.

• The names and addresses of any of the FRO’s subcontracting organizations.

• Copies of any of the FRO’s public filings or releases, including most recent official registry documents, annual reports, and annual filing with the pertinent government.

• The FRO’s existing sources of income, such as official grants, private endowments, and commercial activities.

The U.S. charity’s basic vetting should:

• Demonstrate that it conducted a reasonable search of public information, including information available via the internet, to determine if the FRO is or has been implicated in any questionable activity.

• Demonstrate that it verified that the FRO doesn’t appear on any list of the U.S. Government, the United Nations, or the European Union identifying it as having links to terrorism or money laundering. The U.S. charity should consult the Department of the Treasury's Office of Foreign Assets Control Specially Designated Nationals List, which will identify entities designated by the U.S. Government as Foreign Terrorist Organizations or as supporters of terrorism. The U.S. charity also should consult the U.S. Government's Terrorist Exclusion List maintained by the Department of Justice, the list promulgated by the United Nations under U.N. Security Council Resolutions 1267 and 1390, the list promulgated by the European Union under EU Regulation 2580, and any other official list available to the U.S. charity.

• Obtain the full name in English, in the language of origin, and any acronym or other names used, as well as nationality, citizenship, current country of residence, place and date of birth for key staff at the FRO’s principal place of business, such as board members, and for senior employees at the FRO’s other locations. The U.S. charity should run the names through public databases and compare them to the lists noted above.

• Require FROs to certify that they don’t employ or deal with any entities or individuals on the lists referenced above, or with any entities or individuals known to the FRO to support terrorism.

U.S. Charity’s review of the financial operations of the FRO should:

• Determine the identity of the financial institutions with which the FRO maintains accounts. It should also seek bank references and determine if the financial institution is: (i) a shell bank; (ii) operating under an offshore license; (iii) licensed in a jurisdiction that has been determined to be non-cooperative in the international fight against money laundering; (iv) licensed in a jurisdiction that has been designated by the Secretary of the Treasury to be a primary money laundering concern; and (v) licensed in a jurisdiction that lacks adequate anti-money laundering controls and regulatory oversight.

• Require periodic reports from the FRO on its operational activities and use of the disbursed funds.

• Require the FRO to undertake reasonable steps to ensure that funds provided by the charity are not ultimately distributed to terrorist organizations. Periodically, the FRO should apprise the U.S. charity of the steps it has taken to meet this goal.

• Perform routine, on-sight audits of FROs whenever possible, consistent with the size of the disbursement and the cost of the audit.

TREASURY WARNING. Compliance with these guidelines shall not be construed to preclude any criminal or civil sanctions by the Department of the Treasury of the Department of Justice against persons who provide material, financial, or technological support or resources to, or engage in prohibited transactions with, persons designated pursuant to the Antiterrorism and Effective Death Penalty Act of 1986, as amended, or the International Emergency Powers Act, as amended.

XV. DISQUALIFIED PERSONS—IRC §4946; REG §53.4946

A. The following are disqualified persons with respect to a private foundation:

1. All substantial contributors to the foundation (defined later),

2. All foundation managers of the foundation (defined later),

3. An owner of more than 20% of—

a. The total combined voting power of a corporation;

b. The profits’ interest of a partnership; or

c. The beneficial interest of a trust or unincorporated enterprise, which is (during the ownership) a substantial contributor to the foundation.

4. A member of the family (defined later) of any of the individuals described in 1., 2., or 3.;

5. A corporation of which more than 35% of the total combined voting power is owned by persons described in 1., 2., 3., or 4.;

6. A partnership of which more than 35% of the profits interest is owned by persons described in 1., 2., 3., or 4.;

7. A trust, estate, or unincorporated enterprise of which more than 35% of the beneficial interest is owned by persons described in 1., 2., 3. or 4.;

8. For purposes of the tax on excess business holdings only. another private foundation which either

a. is effectively controlled, directly or indirectly, by the same person or persons who control the private foundation in question, or

b. receives substantially all of its contributions, directly or indirectly, from the same persons described in 1., 2. or 3. or members of their families, who made, directly or indirectly, substantially all the contributions to the private foundation in question, and

c. For purposes of the tax on self-dealing only a government official (defined later).

B. Attribution of ownership. Indirect ownership of stock in a corporation, profits interest in a partnership, or beneficial interest in a trust, estate, or unincorporated enterprise is taken into account for determining whether:

1. The stockholdings, or profits or beneficial interest, amount to more than 20% of the total combined voting power of the corporation or more than 20% of the profits or beneficial interests, or

2. More than 35% of the total combined voting power of the corporation or more than 35% of the profits or beneficial interests are owned by persons described in categories 1., 2., 3., or 4.

C. The following rules apply for determining the ownership of stock or profits or beneficial interests:

1. Stock (or profits or beneficial interests) owned directly or indirectly by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries,

2. An individual is considered to own the stock (or profits or beneficial interests) owned, directly or indirectly, by or for his or her family members. An exception to this rule is that, for the more than 35% ownership described in categories A5., 6., and 7., stock (or profits or beneficial interests) is not treated as constructively owned by an individual solely because that individual is a member of the family of another disqualified person. For purposes of these 35% ownership rules, an individual will be treated as a constructive owner only if that individual himself or herself is a substantial contributor, a foundation manager, or a 20% owner of the combined voting power, profits interest, or beneficial interest, of a substantial contributor.

3. Any stockholding, profits Interest, or beneficial interest, that has been counted once (whether because of actual or constructive ownership) in applying categories A5., 6., and 7. may not be counted a second time.

D. Combined voting power includes voting power represented by actual or constructive holdings of voting stock, but does not include voting rights held only as a director or trustee.

E. Voting power includes outstanding voting power and does not include voting power obtainable, but not obtained, such as voting power obtainable by converting securities or nonvoting stock into voting stock, by exercising warrants or options to obtain voting stock, and voting power available to preferred shareholders if dividends on preferred stock are in arrears.

F. The profits’ interest of a partner is the partner's distributive share of partnership income.

G. The beneficial interest in an unincorporated enterprise, other than a trust or estate, includes any right to receive a share of distributions from the profits of the enterprise, or if there is no profit-sharing agreement, the right to receive a share of the assets on liquidation of the enterprise, except as a creditor or employee. When no agreement fixing the rights of the participants in the enterprise exists, the fraction of the respective interests of each participant in the enterprise will be determined by dividing the total investment or contributions to capital made or obligated to be made by the participant by the amount of all investments and capital contributions made by all participants.

H. The beneficial interest in a trust will be determined in proportion to the person's actuarial interest in the trust.

I. A substantial contributor includes any person who contributed or bequeathed a total amount of more than $5,000 to the private foundation if the amount is more than 2% of the total contributions and bequests received by the foundation from its creation up through the close of the tax year of the foundation in which the contribution or bequest is received from that person. For a trust, a substantial contributor includes the creator of the trust. However, in no case does the term include a governmental unit.

J. In determining whether the total contributions and bequests from a person are more than 2% of the total contributions and bequests received by a private foundation, both the total of the amounts received by the foundation, and the total of the amounts contributed and bequeathed by the person, are determined as of the last day of each tax year. Although the determination is made on the last day of the foundation's tax year, a donor is a substantial contributor as of the first day the foundation receives a gift large enough to make the donor a substantial contributor. Each contribution or bequest is valued at its fair market value on the date it is received by the foundation. Gifts by an individual include all contributions and bequests made by that individual and his or her spouse.

K. A determination is to be made as to whether a person is a substantial contributor as of the end of each of the foundation's tax years, based on the respective totals of all contributions received and the total amount received from a particular person by that date. Status as a substantial contributor will date from the time the donor first met the $5,000—2% test. Once a person is a substantial contributor to a private foundation, generally that person remains a substantial contributor even though the individual might not be so classified if a determination were first made at some later date. For instance, even though the total contributions and bequests of a person become less than 2% of the total received by a private foundation, generally the person remains a substantial contributor to the foundation.

L. However, a person ceases to be a substantial contributor as of the end of a private foundation's tax year if:

1. That person (and all related persons) have not made any contributions to the foundation during the 10-year period ending with that tax year, and

2. That person (or any related person) was not a foundation manager of the foundation at any time during that 10-year period, and

3. The total contributions made by that person (and related persons) are determined by the IRS to be insignificant compared to the total contributions to the foundation by one other person. For the purpose of this comparison, appreciation on contributions while held by the foundation is taken into account.

M. A person is related to a substantial contributor, for this rule, if that person's relationship to the contributor would make that other person a disqualified person with respect to the contributor. If the contributor is a corporation, the term "related person" also includes any officer or director of the corporation.

N. Entities excluded from the definition of substantial contributor (discussed earlier) are also excluded from the definition of disqualified person.

O. Foundation manager means:

1. An officer, director, or trustee of a foundation (or an individual having powers or responsibilities similar to those of officers, directors, or trustees of the foundation), or

2. For any act or failure to act, any employee of the foundation having final authority or responsibility (either officially or effectively) for the act or failure to act.

P. A person who is specifically designated as an officer under the incorporation certificate, bylaws, or other documents of the foundation, or who regularly exercises general authority to make administrative and policy decisions for a foundation is considered an officer of the foundation.

Q. For any act or failure to act, any foundation employee who has authority merely to recommend particular administrative or policy decisions, but not to implement them without approval of a superior, is not an officer. Independent contractors, such as accountants, lawyers, and investment managers or advisors, acting in their capacity as such, are not considered officers of the foundation.

R. A member of the family includes: a spouse, ancestors, children, grandchildren, great grandchildren, and spouses of children, grandchildren, and great grandchildren. A brother or sister of an individual is not a member of the family for this purpose. A legally adopted child of an individual is treated as a child by blood.

S. Government official. For the excise tax on self-dealing, a government official is a disqualified person.

XVI. PRIVATE FOUNDATIONS—10 PITFALLS

A. Pledges. A foundation’s satisfying a pledge (a legal obligation) made by a disqualified person is a prohibited act of self-dealing. Reg. §53.4941(d)-2(f)(1).

1. Avoid problem by having the pledge made by the foundation itself.

2. William Firestone, Esq., alerts us that an individual’s pledge cannot be satisfied by a donor-advised fund that is maintained by a public charity "but not because of IRC §4941 which applies only to private foundations. The Internal Revenue Service has an unwritten policy of requiring as a condition of granting recognition of tax-exempt status to a newly formed donor-advised fund, that the fund agrees not to make grants in satisfaction of outstanding pledges." Charitable Gift Planning News, July/August 2003.

B. The $250-and-over substantiation requirement applies to gifts to private foundations; for example, a donor to his own private foundation has to give a "contemporary written acknowledgment" to himself on behalf of his foundation. In Stussy, TC Memo 2003-232, the court didn’t have to decide whether the expenses claimed to have been incurred on behalf of the foundation were appropriate. Lack of a receipt made it an open-and-shut case. See XXXV. (below) for a discussion of the $250-and-over substantiation rules.

C. Tickets to fund-raising events—watch out for the rubber chicken. If a private foundation purchases a ticket to a fund-raising event and a disqualified person attends, that’s a prohibited act of self-dealing. Letter Ruling 8449008. Suppose the purchase price is split between the disqualified person who pays for the chicken dinner (the quid pro crow) and the private foundation that pays for the charitable gift element of the ticket? That’s still prohibited self-dealing. Letter Ruling 9021066.

D. Disqualified person’s purchase at auction. CCH’s Tax Exempt Advisor (8/18/03) (in a hypothetical) alerts us that a disqualified person’s highest and winning bid at an auction of the foundation’s paintings is a prohibited act of self-dealing under IRC §4941(d)(1)(A).

E. Terminating charitable remainder trusts and dividing the proceeds between the life beneficiary and the charitable remainder organization (a private foundation) based on their respective interests at the time of termination: IRS has ruled that the termination is a sale and not to a third party. Thus the holder of the life interest has a zero basis and a capital gain equal to the value of his life interest. IRS has also ruled that early termination and division of the trust isn’t self-dealing under IRC §4941(a)(1) by the trustee, by the donor with respect to the trust, or by the donor with respect to the foundation. Letter Rulings 200310024, 200314021, and 200252092.

The editors of Charitable Gift Planning News (April 2003) caution: "The payment of the present value of the income interest as a lump sum isn’t self-dealing between the beneficiary and the CRT because the payment of the unitrust interest is specifically excluded from self-dealing under Reg. section 53.4947-1(c)(2)(i); however, that exception doesn’t necessarily cover the sale of that interest by the beneficiary to the private foundation."

F. "Qualified appreciated stock" to private foundation. Gifts of long-term appreciated assets to private foundations are generally deductible at cost basis only. However, if the gift is "qualified appreciated stock" it is deductible at full fair market value. You’ve got to meet that definition right on the nose—otherwise cost-basis deduction it is. Here now the tales of two donors—Hapless and Happy.

1. Acme Corp. has two classes of voting common stock—Class A and Class B. Class A stock is listed on the Nasdaq National Market, an established securities market. That stock is "qualified appreciated stock." The Class B stock is not listed on any established securities market so it is not "qualified." However, Acme Corp. shareholders can convert Class B shares into Class A shares at any time on a share-for-share basis. And Class B shares—when transferred to anyone other than a specified class of transferees—convert automatically on a share-for-share basis to Class A shares. Hapless could have—but did not—swap her Class B shares for Class A shares and then contribute the Class A stock. She contributed the Class B shares to a private foundation.

IRS ruled. Hapless’s deduction is limited to the cost basis because the contributed Class B shares weren’t qualified appreciated stock under the literal language of the Code. Market quotations are readily available on an established securities market for Class B stock. The legislative history of IRC §170(e)(5) does not directly discuss whether "qualified appreciated stock" includes stock that is convertible to stock for which market quotations are readily available on an established securities market. But the legislative history (H.R. Rep. No. 432 98th Cong. 2d sess., pt. 2 at 1464 (1984) does state: "It is not sufficient merely that market quotations of the stock are readily available (e.g., from established brokerage firms); rather, the market quotations must be readily available on an established securities market."

IRS goes on to say that the just-quoted legislative history language indicates that "there is clear evidence that Congress in enacting section 170(e)(5) did not intend the qualified appreciated stock exception to be applied wherever the value of the contributed property could be determined. For example, the legislative history states that, even where the price of contributed stock is ‘readily available’—from a broker for example—the exception does not apply if the stock is not regularly traded on an established securities market. Similarly, even if it is regularly traded, the exception does not apply to contributions of property other than corporate stock."

Hard cheese! "Since price quotations for Class B stock were not available on an established securities market at the time of the contribution, the contributed Class B shares do not constitute qualified appreciated stock for purposes of [full fair market value deductibility]," rules IRS. Letter Ruling 199915053.

2. Happy contributed mutual fund shares (stock in an open-end investment company) to a private foundation.

IRS ruled. The gift is of "qualified appreciated stock," entitling Happy to full fair market value deductibility. To qualify, market quotations of the stock must be readily available on an established securities market as of the date of the contribution. In this case, the mutual funds are treated as corporations that must redeem the shares at net asset value upon an investor’s demand. The net asset value quotations of the shares are published on a daily basis in a newspaper of general circulation throughout the United States.

IRS pointed out that none of the shares were subject to any resale restrictions, including SEC rule 144 restrictions, private contractual restrictions or any other restriction that may have limited taxpayer’s or the private foundation’s disposal of the shares. Letter Ruling 199925029.

G. IRA gift to private foundation—2% excise tax?

1. An IRA or other pension plan properly given to charity at death avoids estate and generation-skipping taxes, and neither the donor’s estate nor the charity pays income-in-respect-of-a-decedent tax. Further, the 2% excise tax on a private foundation’s net investment income doesn’t apply to pension plan gifts, according to Letter Ruling 9838028. IRS’s rationale. The 2% excise tax on net investment income under IRC §4940(a) is limited to the specific types of income listed in that section. Amounts from retirement accounts are deferred compensation income and neither IRC §4940(c) nor Reg. §1.512(b)-1(a) on unrelated business income tax includes deferred compensation in a foundation’s gross investment income. And in Letter Ruling 9341008, the donor named her private foundation as the beneficiary of her IRA on her death. IRS ruled that the foundation wouldn’t be subject to the excise tax when the donor’s assets pass to it. That tax applies when a foundation has already received an asset and is earning income from, or sells, the asset. There’s no tax if the foundation merely receives an asset as it did in this situation.

But in Letter Ruling 9633006, the donor named his private foundation as the beneficiary of his Keogh plan on his death and IRS ruled that the portion of the Keogh plan proceeds exceeding the donor’s original contribution would be considered investment income to him—and therefore to the foundation—and is subject to the 2% excise tax on net investment income.

As every school child knows, letter rulings aren’t precedents.

H. A five-year carryover isn’t available when a lead trust is for the benefit of a private foundation. Letter Ruling 8824039.

1. IRS gave the nod to a 10-year charitable lead unitrust that would benefit a private foundation. It said that gifts for the use of public charities are deductible up to 30% of the donor’s AGI under IRC §170(b)(1)(B), noting that "[i]f the aggregate of such contributions exceeds the limitation of the preceding sentence, such excess shall be treated (in a manner consistent with the rules of subsection (d)(1)), as a charitable contribution (to which subparagraph A does not apply) in each of the 5 succeeding taxable years in order of time."

2. Then IRS dropped the bomb:

"Section 170(d)(1) provides that the carryover of unused charitable contributions is only available to contributions to charities described in section 170(b)(1)(A) [i.e., public charities; emphasis added].

"Since a gift to a charitable lead unitrust is deemed to be a gift ‘for the use of’ charity and not a gift ‘to’ charity, the income tax deduction is limited to 30% of adjusted gross income, See section 1.170A-8(a)(2) of the regulations. The unused deductions for gifts ‘for the use of’ charity cannot be carried forward and used to offset income in future years."

3. The problem: When Congress allowed a five-year carryover for gifts to private foundations, (TRA ‘84) it did so by amending IRC §170(b)(1)(B) and adding a new IRC §170(b)(1)(D). Both of those subparagraphs allow a five-year carryover; both say the carryover must be treated "in a manner consistent with the rules of subsection (d)(1)."

Subsection (d)(1) tells how to apply the carryover to gifts described in subsection (b)(1)(A). But subsection (b)(1)(A), by its terms, covers gifts to public charities, not to or for the use of public charities. Got that?

4. My opinion: When Congress said the carryover for gifts to private foundations should be treated "in a manner consistent with the rules of subsection (d)(1)," it clearly was referring to the method described in (d)(1), not the cross-references.

Taken to its very literal extreme, IRS’s reasoning would disallow the carryover for any gift to private foundations because 170(b)(1)(A) encompasses only gifts to public charities. Come to think of it, there wouldn’t even be a carryover when the gift is "for the use of" a public charity, because (b)(1)(A) only covers gifts to public charities. Obviously, that isn’t what congress had in mind.

5. The ruling didn’t say what kind of property would be placed in the trust. However, the taxpayer asked IRS to rule that she wouldn’t recognize any gain or loss on transferring property to the trust, leading one to suspect that capital gain property would be used. In that case, wouldn’t the 20% ceiling of IRC §170(b)(1)(D) apply? Or did IRS’s over-literal reading of the statute give the grantor a windfall in that respect? Note the caption for subparagraph (D):

"SPECIAL LIMITATION WITH RESPECT TO CONTRIBUTIONS OF CAPITAL GAIN PROPERTY TO ORGANIZATIONS NOT DESCRIBED IN SUBPARAGRAPH (A)" (emphasis added).

I. Charitable lead trust benefiting private foundations.

1. Be careful not to cause the assets of a lead trust to be includable in a donor’s estate when her private foundation is the beneficiary of the lead trust.

2. Letter Ruling 200138018 gives a road map for avoiding the problem. The donor’s irrevocable charitable lead annuity trust will pay an annuity amount for 10 years to the foundation with remainder to children and grandchildren. The trust prohibits her from serving as a trustee and she retained no right to amend the trust.

The donor will be the foundation’s director for life or until she resigns or is removed. While the foundation is the CLAT beneficiary, the donor is prohibited from voting on or participating in any matters relating to the CLAT’s funds. And, the funds that the foundation receives from the CLAT will be segregated into a separate account to be administered and distributed by a separate fund committee. The donor will not have any power over the account or the committee.

a. IRS ruled. The trust is a qualified charitable lead annuity trust. The donor made a completed gift—relinquished all control over the stock—when she funded the trust. She is entitled to an IRC §2522 gift tax charitable deduction for the present value of the foundation’s 10-year interest. And key, the trust assets won’t be includible in the donor’s gross estate.

b. Comment. Even if a donor isn’t a control freak, her do-gooder CLAT can be taxable to her estate if her foundation is the CLAT beneficiary and she retains a scintilla of control. Here the donor gave up all control.

J. Reformation to conform to donors’ intent that private foundation is allowable remainder organization of a charitable remainder unitrust.

1. The donors, wife and husband, funded their net-income-with-makeup unitrust with non-publicly traded stock, naming a bank as trustee. After their lives, the remainder "shall be distributed to one or more charitable remaindermen, each of which must be a type of charity described in each of sections 170(c), 170(b)(1)(A), 2055(a) and 2522(a). [emphasis supplied] The charitable remaindermen are designated in a schedule, attached to the governing instrument of Trust and incorporated by reference into Trust, to receive the remaining trust estate in the percentages specified in the schedule."

The trustee asked the court to reform the trust because a scrivener’s error makes it impossible for the donors to designate a private foundation as the charitable remainderman as they originally intended. That’s because a private foundation is described in IRC §170(c) but not in IRC §171(b)(1)(A). (The later code section describes publicly supported charities.)

To prove their original intent, the donors showed the schedule executed on signing the trust, designating a foundation as the 100% charitable remainderman. And they had an affidavit from their former representative who drafted the trust stating that the donors intended the foundation to be the charitable remainderman.

2. IRS ruled. The proposed reformation will not disqualify the trust. Because of a scrivener’s error in the original trust agreement and evidence presented by the donors, the proposed reformation is clearly in accord with their original intent. The reformation doesn’t violate the requirement that the charitable remainder interest be irrevocable.

3. IRS imposed some conditions (donors anticipated and said they’d meet them in their ruling request). The reformation affects the donors’ income tax deduction because closely held stock was used to fund the trust (rather than "qualified appreciated stock"). A gift of remainder interest to a private foundation is based upon the remainder value of the adjusted basis, rather than of the stock’s fair market value. Further, the deductibility ceiling for stock gifts to private foundations is 20% of AGI, rather than 30% of AGI for gifts to public charities. So IRS conditioned its ruling on the donors filing an amended return for the two years the trust existed before the reformation, reporting reduced charitable deductions and paying the increased tax plus interest. Letter Ruling 200002029.

4. This ruling highlights a tax trap. Using a form without examining every word and Code section can be dangerous to your client’s wealth. Here the donors wanted the remainder to go to a private foundation and were willing to have their deduction reduced and the ceilings lowered. In many cases, however, the intended gift is to a public charity. A donor can run into a situation where he or she is treated as if the remainder is to a private foundation even though a public charity is named and intended. Reason: a governing instrument provision must state what happens if the named charity is not tax exempt when any income or principal is to go to it. You’ll have a qualified trust if it states that it must go to an organization described in IRC §§170(c), 2055(a) and 2522(a). But if it omits also reciting the all-important IRC §170(b)(1)(A), the remainder can be treated as a gift to a private foundation even though a public charity is named in the trust.

5. In Rev. Rul. 79-368, 1979-2 CB 109, a donor kept the power to substitute any other charity as remainder organization, as long as it was described in IRC §170(c). That subsection encompasses both public charities and private foundations, so the donor could have named a private foundation. Because the donor’s choice wasn’t restricted to organizations described in IRC §170(b)(1)(A)—public charities—IRS ruled that his charitable deduction was subject to the lower AGI deductibility limits. A deduction for a trust funded with appreciated property—unless with "qualified appreciated stock"—will have to be reduced by all appreciation allocable to the remainder interest, and in all cases be subject to a 20%-of-adjusted-gross-income ceiling.

6. Worth knowing about. In an earlier revenue ruling, a donor’s unitrust named as remainder organization a charity described in IRC §§170(c) and 2522(a), and it only required that any alternate remainder organization be described in §170(c). But IRS let it slide, reasoning that the chance of the named remainder organization not qualifying under §§170(c) and 2522(a) when the trust ended was so remote as to be negligible. Rev. Rul. 76-307, 1976-2 CB 56; similarly, Letter Rulings 7835030, 7925089 and 9327006.

XVII. TERMINATION OF PRIVATE FOUNDATION STATUS—EXIT STRATEGIES

A. Once an organization is determined to be a private foundation, its status may be terminated only under the provisions of IRC §507. Under that section, an organization's status as a private foundation may be terminated voluntarily or involuntarily.

B. If the organization's status is terminated either voluntarily or involuntarily under IRC §507(a), the organization becomes liable for tax under IRC §507(c). That tax is the lesser of (1) all the income, gift and estate tax benefits (with interest) received by the foundation and any of its substantial contributors since the inception of the income tax law in 1913, or (2) the value of the foundation’s net assets as defined in IRC §507(a) and Reg. §1.507-4(a).

C. Termination taxes can be avoided by: transferring all of the foundation’s assets to one or more public charities (including donor-advised funds) that have been in existence for at least five years; or the foundation itself becoming a public charity or a supporting organization. The foundation can also transfer all its assets to another private foundation. Another approach is to make grants of all the foundation’s assets (spend down) before termination.

D. See Rev. Rul. 2003-13, 2003-4 IRB 1 for guidance on the tax ramifications and reporting requirements when a private foundation distributes all its assets to one or more public charities. This ruling obviates requesting a private letter ruling in many cases.

E. See Rev. Rul. 2002-28, 2002-20 IRB 94 for guidance on the ramifications of a private foundation’s distributing all its assets to another private foundation.

F. Private foundation’s assets to community foundation’s advised fund

1. Private Foundation wanted to transfer all its assets to Community Foundation. An agreement between the organizations will name a donor-advised fund for a deceased child of Private Foundation’s creators. That fund will provide scholarships for needy students. As a donor-advised fund of Community Foundation, Private Foundation will make non-binding recommendations on distribution amounts and scholarships recipients. Community Foundation will not be bound by the recommendations and will follow them only after it independently determines that they are consistent with its exempt purposes.

2. IRS ruled: Private Foundation's transfer of its assets to Community Foundation will be for IRC §501(c)(3) exempt purposes and won’t adversely affect its or the Community Foundation’s tax exemption. The transfer by Private Foundation of all its assets to Community Foundation, a public charity, terminates its private foundation status under IRC §509(a). However, the transfer won’t result in an IRC §507(c) private foundation termination tax. Nor will the transfer be an act of self-dealing under IRC §4941 because Private Foundation's transfer is for exempt purposes to a tax-exempt organization. And the transfer will be a qualifying distribution under IRC §4942(g)(1) and not subject to tax. Further, the transfer will not be a disposition of property subject to tax under IRC §4940, nor will it be a jeopardizing investment, nor result in tax under IRC §4944, nor be a taxable expenditure under IRC §4945. Letter Ruling 200009048.

3. Comment: Can’t ask for more than that from IRS.

G. Divorce American Style—breakup of marriage and private foundation

1. Wife and husband—directors and officers of their private foundation—were divorcing. They wanted to split the foundation into two new foundations, each of which would be controlled by one of the spouses.

2. IRS ruled—no tax penalties. Transferring the foundation’s assets to new foundations won’t be self-dealing under IRC §4941 or a taxable expenditure under IRC §4945(d)(4). The new foundations won’t be treated as newly created organizations and the transaction won’t terminate the old foundation’s exemption under IRC §507. Further, the old foundation’s voluntary termination after the assets are transferred to the new foundations will be a taxable termination under IRC §507(a)(1), but no tax will be due under IRC §507(c) because the foundation won’t have any assets then. Transfers to the new foundations won’t be investments jeopardizing the old foundation’s charitable purposes under IRC §4944. Letter Ruling 9826041.

XVIII. HELPFUL IRS PUBLICATIONS AND FORMS

A. IRS, in November 2003, published two new brochures to help prospective charities apply for tax exemption and then comply with the law (record keeping, return filing and disclosure rules).

B. The publications are: IRS Publication 4220, Applying for 501(c)(3) Tax-Exempt Status; and Publication 4221, Compliance Guide for 501(c)(3) Tax-Exempt Organizations.

C. The publications give an English language overview and provide references to other more detailed IRS publications and forms—plus special telephone numbers to call if you need specific help on more complex issues.

D. Publications 4220 and 4221 are available on the IRS Web site, www.irs.gov and can be ordered by calling toll-free 1-800-829-3676.

E. Related links on IRS.gov:

• IR-2003-131 http://www.irs.gov/newsroom/article/0,,id=117986,00.html 

• Publication 4220, Applying for 501(c)(3) Tax-Exempt Status http://www.irs.gov/pub/irs-pdf/p4220.pdf

• Publication 4221, Compliance Guide for 501(c)(3) Tax-Exempt Organizations http://www.irs.gov/pub/irs-pdf/p4221.pdf

F. The whole kit and caboodle from IRS: Tax-Exempt Organizations Tax Kit—a packet of forms and publications often used by tax-exempt organizations. Most forms are available in a fillable version shortly after they are available in Acrobat Reader format.

1. Forms. Adobe Acrobat Reader software is required to view, print, and search the items listed below.

• Form 1028, Application for Recognition of Exemption under Section 521 of the Internal Revenue Code, fillable, with instructions.

• Form 1120-POL, U.S. Income Tax Return for Certain Political Organizations, fillable, with no instructions.

• Form 1128, Application to Adopt, Change, or Retain a Tax Year, fillable, with instructions.

• Form 2848, Power of Attorney and Declaration of Representative, fillable, with instructions.

• Form 3115, Application for Change in Accounting Method, fillable, with instructions.

• Form 4720, Return of Certain Excise Taxes on Charities and Other Persons under Chapter 41 and 42 of the Internal Revenue Code, fillable, with instructions.

• Form 5227, Split Interest Trust Information Return, fillable, with instructions.

• Form 5578, Annual Certification of Racial Nondiscrimination for a Private School Exempt from Federal Income Tax, fillable, with no instructions.

• Form 5768, Election/Revocation of Election by an Eligible Section 501(c)(3) Organization to Make Expenditures to Influence Legislation, fillable, with no instructions.

• Form 6069, Return of Excise Tax on Excess Contributions to Black Lung Benefit Trust under Section 4953 and Computation of Section 192 Deduction, fillable, with no instructions.

• Form 7004, Application for Automatic Extension of Time to File Corporation Income Tax Return, fillable, with no instructions.

• Form 8274. Certification by Churches and Qualified Church-Controlled Organizations Electing Exemption from Employer Social Security and Medicare Taxes, fillable, with no instructions.

• Form 8282, Donee Information Return, fillable, with no instructions.

• Form 8283, Noncash Charitable Contributions, fillable, with instructions.

• Form 8300, Report of Cash Payments Over $10,000 received in a Trade or Business, fillable, with no instructions.

• Form 8718, User Fee for Exempt Organization Determination Letter Request, fillable, with no instructions.

• Form 8734, Support Schedule for Advance Ruling Period, fillable, with no instructions.

• Form 8821, Tax Information Authorization, fillable, with no instructions.

• Form 8868, Application for Extension of Time to File an Exempt Organization Return, fillable, with no instructions.

• Form 8870, Information Return for Transfers Associated with Certain Personal Benefit Contracts, fillable, with no instructions.

• Form 8872, Political Organization Report of Contributions and Expenditures, fillable, with instructions.

• Form 8886, Reportable Transaction Disclosure Statement, fillable, with instructions.

• Form 990, Return of Organization Exempt from Income Tax, fillable, with instructions.

• Form 990-BL, Information and Initial Excise Tax Return for Black Lung Benefit Trusts and Certain Related Persons, fillable, with instructions.

• Form 990-C, Farmer’s Cooperative Association Income Tax Return, fillable, with instructions.

• Form 990-EZ, Short Form Return of Organization Exempt from Income Tax, fillable, with instructions.

• Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Nonexempt Charitable Trust Treated as a Private Foundation, fillable, with instructions.

• Form 990-T, Unrelated Business Income Tax Return, fillable, with instructions.

• Form 990-W, Estimated Tax on Unrelated Business Taxable Income for Tax-Exempt Organizations, fillable, with no instructions.

• Form SS-4, Application for Employer Identification Number, fillable, with instructions.

• Form 1023, Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code (package) (includes Form 872-C), fillable, with no instructions.

• Form 1024, Application for Recognition of Exemption under Section 501(a), fillable, with no instructions.

• Schedule A, Forms 990 and 990-EZ, Organization Exempt under Section 501(c)(3) Supplementary Information, fillable, with instructions.

• Schedule B, Forms 990, 990-PF, and 990-EZ, Schedule of Contributors, fillable, with no instructions.

• Form 872-C, Consent Fixing Period of Limitations Upon Assessment of Tax under Section 4940 of the Internal Revenue Code, fillable, with no instructions.

2. Publications.

• Publication 15, Circular E, Employer’s Tax Guide, English.

• Publication 15-A, Employer’s Supplemental Tax Guide (Fringe Benefits), English.

• Publication 557, Tax-Exempt Status for Your Organization, English.

• Publication 578, Tax Information for Private Foundations and Foundation Managers, English..

• Publication 598, Tax on Unrelated Business Income of Exempt Organizations, English.

• Publication 892, Exempt Organization Appeal Procedures for Unagreed Issues, English.

• Publication 1771, Charitable Organizations, Substantiation and Disclosure Requirements, English.

• Publication 1828, Tax Guide for Churches and Religious Organizations, English.

• Publication 3079, Gaming Publication for Tax-Exempt Organizations, English.

• Publication 3386, Tax Guide for Veterans Organizations, English.

• Publication 3833, Disaster Relief, Providing Assistance through Charitable Organizations, English.

3. Additional forms, publications, and ordering instructions may be found at: www.irs.gov/formspubs/index.html 

XIX. INCOME TAX CHARITABLE DEDUCTION REDUCES COST OF GIFT: ELEMENTARY (ELEEMOSYNARY) DEAR WATSON

A. Tax savings for itemizers equal amount of deductible gift multiplied by effective income tax bracket. Example: $1,000 gift × 35% bracket equals $350 tax savings.

B. Out-of-pocket cost of gift equals amount contributed minus tax savings. Example: $1,000 gift minus $350 tax savings equals $650 out-of-pocket cost of gift.

C. Computing the combined tax effect of federal and state income taxes requires more than merely adding the two rates together. Since state income taxes are generally deductible from a taxpayer's federal income tax liability, the combined rate for state and federal taxes is lower than the sum of the two rates. Here's a formula to determine the blended rate:

Blended rate = federal rate + ((1 - federal rate) X state rate)

Example: David is in the 35% federal income tax bracket and the 4% state income tax bracket. His blended rate is .35 + ((1 - .35) X .04) or .376. That's 37.6% rather than 39% (35% federal plus 4% state).

XX. CHARITABLE DEDUCTION ENABLES DONOR TO MAKE BIGGER GIFT THAN ORIGINALLY PLANNED BY A GIFT OF TAX ADVANTAGE

A. The charitable deduction is often thought of exclusively in terms of reducing a gift's cost—because of the tax savings generated.

B. But the charitable deduction enables a generous donor to give more than he or she initially thought possible—by a gift of the tax advantage.

C. Example: Donor in 35% bracket who wishes to give a charity $1,000 of his net worth can actually make $1,538 available at out-of-pocket cost of only $1,000. The $1,538 charitable deduction in 35% bracket reduces by $538 the tax he would pay if he made no gift. Thus his net worth is reduced by only $1,000 ($1,538 gift minus $538 tax savings).

D. Formula to determine how much a donor can contribute and reduce net worth by $1,000:

X (amount of gift that reduces net worth by $1,000)		= $1,000 100% minus top tax bracket
Example: Ann is in the 35% bracket. She can contribute $1,538 and reduce her net worth by only $1,000.
X =	$1,000	= $1,538
	100% minus 35%

XXI. "3% REDUCTION RULE"

Taxpayers must reduce their itemized deductions (except medical expenses, casualty and theft losses, and investment interest) by an amount that equals 3% of adjusted gross income over $142,700 (over $71,350 if married filing separately) in 2004 (these figures are indexed for inflation). However, the rule won't take away more than 80% of the itemized deductions that are subject to the "3% reduction rule." The charitable deduction generally isn't affected by this rule, because most itemizers pay home mortgage interest and state and local taxes. So, in effect, those non-discretionary payments bear the burden of any reduction. But taxpayers with very high adjusted gross incomes and those with no or low mortgage interest and no or low state and local taxes can be walloped.

Note: Allowing a tax-free IRA/charitable rollover would enable a donor to make a charitable gift without getting entangled in the 3% reduction rule. See XXXXIII. A. (below)

XXII. AMOUNT OF CONTRIBUTION AND APPLICABLE INCOME TAX CEILING ON DEDUCTION DEPENDS ON TYPE OF GIFT, HOLDING PERIOD, TYPE OF DONEE AND SOMETIMES ELECTION MADE BY DONOR

A. Gifts to public charities (churches, schools, hospitals, etc.), publicly supported charities (including community foundations, donor- advised funds, supporting organizations, private operating foundations and passthrough foundations).

1. Cash gifts: 50% of adjusted gross income (with five-year carryover for any "excess"). IRC §170(b)(1)(A), (d)(1)(A), and Reg. §1.170A-8(b).

2. Appreciated securities and real estate held long-term (more than one year):

a. Amount of deduction. Full present fair market value with no capital gains tax on appreciation. IRC §170(e)(1).

b. Ceiling on deductibility.

(1) 30% of adjusted gross income. IRC §170(b)(1)(C)(i); Reg. §1.170A-8(d)(1); or

(2) 50% of adjusted gross income if donor makes this election regarding all long-term property contributions during the year: Reduce the amount deemed contributed by 100% of gain that would have been long-term capital gain if the contributed property had been sold by donor at its fair market value. IRC §170(b)(1)(C)(iii); Reg. §1.170A-8(d)(2).

(3) "Price" paid for increase of ceiling to 50%.

(a) Reduction of amount of all long-term property gifts for the year.

(b) Amount of carried-over contribution reduced for long-term property given in prior years (if election not made in prior years).

(c) Once made, 50% election is irrevocable and can't be retracted after the tax return's due date (or extended due date)—even if improperly made. Woodbury, 55 TCM 1131 (1988), aff'd 90-1 USTC ¶50,199 (CA-10, 1990); Grynberg, 83 TC 255 (1984); Rev. Rul. 77-217, 1977-1 CB 68.

(4) Should ceiling be increased from 30% to 50% of adjusted gross income?

(a) Generally, no—when donor can deduct "excess" as 30% gift in carryover years.

(b) Generally, yes—if gift (or other gifts) so large that donor won't be able to deduct as 30% gift making full use of carryover.

(c) Generally, yes—when appreciation is small.

(d) Sometimes—if donor is in higher tax bracket this year than will be in carryover years.

(e) Executor or administrator should make 50% election on decedent's final income tax return for decedent's last taxable year because any carryover is lost.

(5) How to make 50% election. Reg. §1.170A- 8(d)(2)(iii).

(a) Attach statement to income tax return for the election year indicating that the election under IRC §170(b)(1)(C)(iii) and Reg. §1.170A -8(d)(2) is being made.

(b) If there's a carryover from prior taxable year or years, statement should show a recomputation of carryover reducing by 100% of appreciation, setting forth sufficient information for the previous taxable year or any intervening year to show the basis of the recomputation.

(c) Statement should indicate the District Director or the Director of Internal Revenue Service Center with whom the return for the prior taxable year or years was filed, the name (or names) in which the returns were filed and whether the returns were joint or separate.

3. Appreciated tangible personal property held long-term (more than one year) (e.g., works of art, antiques, books). IRC §170(e)(1)(B)(i); Reg. §1.170A-4.

a. Use of property related to donee's exempt function.

(1) Amount of deduction. Full present fair market value with no capital gains tax on the appreciation.

(2) Ceiling on deductibility.

(a) 30% of adjusted gross income.

(b) 50% of adjusted gross income if the election detailed above is made. That is, deduction is fair market value minus 100% of the appreciation.

(3) See discussion, above, for whether to make the election.

b. Use of property unrelated to donee's function.

(1) Amount of deduction. Fair market value reduced by 100% of the appreciation. Ceiling on deductibility. 50% of adjusted gross income.

(2) "Unrelated use" means a use that is unrelated to the purpose or function constituting the basis of the charitable organization's exemption under IRC §501 (or, in the case of a contribution to a governmental unit, the use of the property by the governmental unit for other than exclusively public purposes).

(a) Example. If a painting contributed to an educational institution is used for educational purposes by being placed in its library for display and study by art students, the use is not an unrelated use. But if the painting is sold and the proceeds used for educational purposes, the use of the property is unrelated.

(b) Example: If furnishings contributed to a charitable organization are used by it in its offices and buildings in the course of carrying out its functions, the use of the property is not unrelated. (The question to ask: Is the furniture appreciated?)

(c) Example: If a set or collection of items of tangible personal property is contributed to a charitable organization or a governmental unit, the use is not unrelated if the donee sells (or otherwise disposes of) only an insubstantial portion of the set or collection.

(3) Proof of use. Reg. §1.170A-4(b)(3). Donor who contributes tangible personal property to a charitable organization or governmental unit may treat the property as not being put to an unrelated use by the donee if—

(a) Donor establishes that the property is not in fact put to an unrelated use by the donee, or

(b) At the time of the contribution, it was reasonable to anticipate that the property wouldn't be put to an unrelated use by the donee. For gift to a museum, if the object donated is of a general type normally retained by museums for museum purposes, it will be reasonable for the donor to anticipate, unless he has actual knowledge to the contrary, that the object won't be put to an unrelated use, even if the object is later sold or exchanged by the donee.

(c) Can the issue of "unrelated use" be avoided by forming a corporation, transferring the tangible personal property to a corporation and then contributing the stock to charity. Donors who try this should be mindful of the "IRS-wasn’t-born yesterday" rule and have a valid business purpose for forming corporation. IRS is likely to attack. See Ford, TC Memo 1983-556. The court held the gift was not the stock, but of the underlying asset subject to ordinary-income recapture rules and the deduction was reduced to zero.

4. Securities, real estate and tangible personal property held short-term.

a. Amount of deduction. Fair market value minus amount of gain that wouldn't have been long-term gain on a sale at fair market value. IRC §170(e)(1)(A).

b. Simply stated: Contribution is the cost basis.

c. Ceiling on deductibility: 50% of adjusted gross income. IRC §170(b)(1)(A).

5. Ordinary income property. Reg. §1.170A-4(b)(1).

a. Definition. Gain on sale taxed as ordinary income rather than capital gain.

b. Examples of ordinary income property.

(1) Capital asset held for one year or less (short-term property above).

(2) Business inventory.

(3) Crops grown by farmer.

(4) Artwork created by donor.

(5) Manuscript prepared by donor.

(6) Letters and memoranda prepared by or for donor.

(7) Real estate when donor is a "dealer."

(8) Artworks when donor is a "dealer." Even if not a dealer, deduction limited to cost-basis for unrelated use gift.

c. Amount of deduction.

(1) Fair market value minus amount that wouldn't have been long-term capital gain on a sale at fair market value. IRC §170(e)(1)(A).

(2) Simply stated: Contribution is cost basis.

d. Ceiling on deductibility. 50% of adjusted gross income. IRC §170(b)(1)(A).

6. Standard deduction claimed in a year after "excess" charitable contribution. Reg. §1.170A-10(a).

a. First, compute amount of carryover donor would have been allowed to deduct if she hadn't taken standard deduction. That amount is treated as being "paid" in standard deduction year.

b. However, because she took standard deduction, donor has no deductible contribution for the year. And amount of carryover treated as being "paid" in standard deduction year is lost forever.

7. Five-year carryover. Reg. §1.170A-10.

a. Available for "excess" 20%, 30% and 50% gifts.

b. Gifts made in current year deducted first.

c. If donor makes "50%" election, carryovers reduced as if election had been made in prior years. IRC §§170(d)(1)(A) and (b)(1)(C)(iii).

d. If initial contribution not properly deductible and would be disallowed had statute of limitations not expired, any carryovers resulting from the gift (for years for which the statute of limitations has not expired) aren't allowable. Rev. Rul. 77-225, 1977-2 CB 73.

8. Charitable gift of appreciated property followed by repurchase by donor to step up basis—

a. Donor contributed stock of M Corporation to charitable organization. Fair market value of stock was $4 per share; cost basis was $2 per share.

(1) Gentleperson's agreement for resale to donor one month later at $4 a share.

(2) Donor hoped to obtain charitable deduction for fair market value and get "stepped-up" basis for stock.

(3) IRS looks to substance, not form. Donor had no intention of relinquishing stock ownership, so transfer and re-purchase of stock were disregarded. Donor's cost basis remains at $2 a share. Instead, charitable contribution was amount paid to reacquire stock. Rev. Rul. 67-178, 1967-1 CB 64.

(4) Under present law, above ruling inapplicable to gift of traded stock with purchase by donor of stock in same or similar corporation on open market.

(5) U.S. Treasury Tax Reform Proposals (February 5, 1969) would have required donor to retain original cost basis if "substantially similar property" pur-chased within 90 days before or after gift. This proposal has not been enacted.

B. Private foundations (other than private operating foundations and pass-through foundations).

1. General rule: Appreciated securities, real estate and tangible personal property (even if for a "related use") held long-term. Deduction is fair market value minus 100% of appreciation. IRC §170(e)(1)(B)(ii).

2. Special rule—long-term appreciated qualifying publicly traded stock. A deduction for full fair market value is allowable for certain contributions of stock in a corporation for which (as of the contribution date) market quotations are readily available on an established securities market.

a. Full fair market valuation is only allowed for an aggregate 10% (per donor) of any one corporation's outstanding stock donated to private foundations. For purposes of this rule, both donors and donees are aggregated: a donor's spouse, siblings, ancestors and lineal descendants are all treated as one donor; similarly, all private foundations are treated as one foundation.

b. What is publicly traded stock? Listed securities, of course. IRS's definition also includes mutual fund shares if quotations are published daily in readily available newspapers. Reg. §1.170A-13(c)(7)(xi)(A)(3). It also includes securities traded on a national or regional over-the-counter market. Reg. §1.170A-13(c)(7)(xi)(A)(2). Letter Ruling 9623018. Gifts of stock subject to SEC rule 144 restrictions, including volume and resale limitations, may not qualify for FMV deductibility. Letter Ruling 9746050 See also Letter Ruling 9812030. Caution: See XVI. F. (above) for situation where stock appeared to qualify but didn’t.

3. Special rule—passthrough foundations. Deduction allowed for full present fair market value where private foundation, within 2½ months following the year of receipt, gives an amount equal to all gifts during the year to churches, schools, hospitals, publicly supported charities or private operating foundations. Note: Unless tangible personal property is for a "related" use, deduction is limited to cost basis. IRC §§170(b)(1)(d) and (e)(1)(B)(ii); Reg. §1.170A-9(g)(2)(iv).

4. Ordinary income and short-term property gifts. Deduction is for cost basis. IRC §170(e)(1)(A).

5. Ceiling on deductibility.

a. Gifts of cash and ordinary income property: 30% of adjusted gross income.

b. Gifts of all capital gain property (including stock deductible at fair market value under qualifying publicly traded stock rule): 20% of adjusted gross income. IRC §170(b)(1)(D).

c. Passthrough foundations. If foundation meets distribution requirements, ceiling is 30% or 50% of adjusted gross income (as for direct gifts to public charities). IRC §170(b)(1)(A)(vii).

6. Carryover. Five-year carryover for "excess" gifts. IRC §170(b)(1)(B).

C. Interplay among ceilings. Doping out the deductibility ceilings for various types of charitable gifts can be complicated enough. But the interplay among ceilings when a donor contributes different types of property in the same year gets even stickier. Stickier still: interplay among carried-over deductions. See Reg. §1.170A-10 or hope that your tax-preparation software has figured this out.

D. Gift of appreciated securities instead of cash, with cash used to buy same securities on open market.

1. Achieve stepped-up basis without dying.

2. If new securities go down in value, a sale produces a capital loss, instead of capital gain donor would have had when selling the original securities.

3. Example: Linda plans on making a $10,000 cash gift to her college. As it happens, she has some listed securities she bought a number of years ago for $4,000 that are now worth $10,000. Instead of making a $10,000 cash gift, Linda should contribute her listed securities. She will receive a $10,000 income tax charitable deduction (just as if she gave $10,000 cash) and completely avoid capital gain on the $6,000 appreciation. With the $10,000 cash (which she initially intended to contribute) she buys stock in the same corporation on the open market. Now she owns same stock (only the certificate number differs) with a basis of $10,000—instead of $4,000. If two years from now the securities are worth $13,000, her capital gain on a sale will be only $3,000 ($13,000 sales price minus $10,000 new basis). If she kept her original securities (donating $10,000 cash instead), her gain on the sale would be $9,000 ($13,000 sales price minus $4,000 original basis).

If the securities go down in value, Deus vetet, Linda is still better off having given her presently owned securities and using the $10,000 cash to buy new securities. Suppose the value of the new securities declines to $9,000. Had Linda contributed $10,000 cash and kept her original securities, she would have a $5,000 capital gain on a sale ($9,000 sales price minus $4,000 basis). However, if she contributes her present securities and uses the $10,000 cash to buy identical securities, she has a $10,000 basis. If the value goes down to $9,000 and she sells, Linda will have a $1,000 capital loss (better than a $5,000 capital gain). Of course, it is hoped the new securities appreciate. But either way, Linda is better off by contributing her presently owned securities and using the $10,000 cash to replace them.

E. Gifts earmarked for a particular individual.

1. An otherwise deductible payment to a qualified charity isn’t deductible if the gift is earmarked for a particular individual—no matter how worthy he or she may be. Whether a transfer to a charity is earmarked is a fact question. It’s helpful to see how IRS and the courts have dealt with this issue.

2. Musical composer: For many years, Charity has supported musical composition and performance. It hosts composer events, places composers in residencies with professional arts institutions, funds recordings of new American music and makes agreements with professional arts institutions to commission works to be performed by those institutions.

In January, Donors (husband and wife) told Charity that they were interested in supporting the composition of a work by Rosa Composer.

In July, they contributed funds to Charity. At that time, Charity didn’t make any commitment to use the funds to commission a work by Ms. Composer, and didn’t represent that the funds would be so used. Rather, Charity told Donors that the funds would be used at the discretion of its officers, and Donors represented to IRS that they understood that. Charity’s acknowledgment letter thanking Donors for their contribution, stated that there could be no assurance that their contribution would be used to support Ms. Composer’s work.

In November, Charity, Ms. Composer and Orchestra entered into agreement that provided that Charity would pay her a commissioning fee and copying costs, and would reimburse her expenses for appearing at her work’s premier. Donors’ contribution was sufficient to pay for all of that. Ms. Composer agreed to complete a work of specified form and duration and Orchestra agreed to make reasonable efforts to perform it and was granted the exclusive right to perform the premier and for a limited time thereafter.

IRS ruled: Donors’ contribution wasn’t impermissibly earmarked for Ms. Composer and thus is deductible. Letter Ruling 200250029.

3. Professor’s research project. Aa donor contributed to a university, requiring that the gift be used for a particular professor’s research project. The university had no discretion over the gift’s use. IRS ruled that the university was a conduit only, that the real donee was the professor and thus as a payment to an individual it wasn’t deductible. Rev. Rul. 61-66, 1961-1 C.B. 19.

4. My son, the missionary. A donor gave cash to a missionary fund that reimbursed missionaries for approved expenses not covered by amounts received from the missionaries’ parents, others and personal savings. The donor’s son was a missionary and eligible to receive reimbursements. The donor directly provided his son’s support. Donor had previously contributed to the missionary expense fund.

IRS ruled: If contributions to the missionary fund are earmarked by the donor, they are treated, in effect, as gifts to the designated individual and aren’t deductible. However, contrary to what you might imagine, IRS allowed a charitable deduction by ruling that the donor intended the gift was for the organization and not a gift to an individual. Rev. Rul. 62-113, 1962–2 C.B. 10.

Comment. The ruling could be viewed as establishing a bright-line test. (1) Does the charity have full control of the donated funds and discretion as to their use, and (2) does the donor intend to benefit the charity and not the individual? If so, a charitable deduction is allowable. The ruling went on to say that unless the donor’s contributions to the fund were distinctly marked by him so that they could be used only for his son or were received by the fund under an understanding that they would be so used, they are deductible. It is, of course, easy to cite the rule. However, you still have a fact question in each case.

5. Corporate scholarship programs. A corporation, under its scholarship program, contributed to universities from which it drew a substantial number of its employees. The universities selected scholarship recipients in their own discretion and there weren’t employment commitments between the corporation and scholarship recipients.

IRS said that for a contribution to be deemed made to, or for the use of, a charity—rather than to a particular individual who ultimately benefits from the contribution—the charity must have full control of the use of the donated funds, and that the donor’s intent in making the payment must have been to benefit the charity and not the individual recipient. IRS allowed the deduction. Rev. Rul. 68-484, 1968-2 C.B. 105.

6. Tuition paid by "sponsors." Students at a religious educational institution had their tuition paid by "sponsors." The sponsor was often the student’s parent.

The sponsors signed a commitment form that set the contribution amount, the payment schedule, and indicated the names of the sponsor and the student. There was also a space on the payment envelopes for the student’s name. Although the form stated that contributions were nonrefundable and that the use of money was "solely at the discretion" of the organization, IRS—under the "wasn’t- born-yesterday rule"—denied a charitable deduction, stating that deductibility requires both full control by the charity and the intent by the donor to benefit the charity and not a particular recipient. The commitment form and the envelopes, IRS found, indicated that the payments were designated for the benefit of particular students. Rev. Rul. 79-81, 1979-1 C.B. 107.

7. Tuition payments. The taxpayer’s charitable deduction for payments to a college was disallowed. In a letter accompanying the payment he stated, "I am aware that a donation to a Scholarship Fund is only deductible if it is unspecified, however, if in your opinion and that of the authorities, it could be applied to the advantage of Mr. Robert F. Roble, I think it would be constructive." In denying the deduction, the appellate court stated, "[i]t is clear from the record that the petitioner intended to aid Roble in securing an education and the payments to the college were earmarked for that purpose." Tripp v. Commissioner, 337 F.2d 432 (7^th Cir. 1964).

8. Charity’s control over donated funds. A Tax Court case gives some guidance on whether a charity has control of donated funds. Despite the listing of the names of specific missionaries on the checks donated to a missionary fund and the apparent sending of funds by the mission to the particular missionaries, the court found that the donor’s intention was to donate the funds to the mission’s common fund to be used as the mission determined. The court reached this result based in part on its finding that the mission had exclusive control of both the administration and distribution of the contributed funds, and that the donor intended that the contributions go into a common pool to be distributed among all missionaries. Peace v. Commissioner, 43 T.C. 1 (1964), acq. 1965-2 C.B. 6.

9. Back to the gift-that-benefitted-the-composer ruling—IRS’s rationale for ruling favorably. Donors made a payment to a recognized charity, and expressed an interest in supporting the work of a particular composer. This expression of interest raises the issue of whether the contribution was impermissibly earmarked for this composer. However, no commitment or understanding existed between donors and the charity that the contribution would benefit the composer. Donors understood, IRS determined, that any funds contributed to the charity would be distributed in the charity’s discretion.

IRS found the composer case similar to Rev. Rul. 62-113, and Peace (above). Although the donors expressed an interest in the selection of a particular individual to compose a work for the charity, the common understanding was that the contribution would become part of the general funds of the charity, and would be distributed as determined by its officers.

10. What can we learn from these letter rulings and cases? As any trial lawyer worth his or her salt will tell you, it’s important to "build a record." In the composer ruling, IRS was told that the donors expressed an interest to the charity in supporting the composition of a work by a particular composer. But that at the time of the gift, the charity made no commitment to use the funds to commission her work and there was no representation that the funds would be so used. The charity represented to the donors that the funds would be used at its discretion and the donors represented to IRS that they understood that. IRS took the donors and the charity at their word. If the IRS, or a court, determine that the words were spoken, but the parties were winking, the income tax charitable deduction will be disallowed.

11. Loss of income tax deduction—law of extended consequences. If a gift is held to be earmarked for an individual, not only will the donor lose the income tax charitable deduction, but he or she could also be subject to federal (and possible state) gift taxes on transfers to individuals. This could be softened by the $11,000-per-donee annual exclusion and in some cases the gift tax exclusion for tuition paid directly to an educational institution. Then there is the $1 million lifetime gift tax exemption, but you don’t want to dip into that willy-nilly.

12. Caution: Under the qualified appraisal requirements at XXXVI (below) the donor must disclose the terms of any agreement or understanding entered into (or expected to be entered into) by or on behalf of the donor or donee that relates to the use, sale, or other disposition of the property contributed, including, for example, the terms of any agreement or understanding that earmarks donated property for a particular use. Reg. §1.170A-13(c)(3).

XXIII. GIFT AND ESTATE TAX CHARITABLE DEDUCTIONS

A. Unlimited gift and estate tax charitable deductions for qualified charitable gifts.

B. No differentiation among gifts to the various charitable-donees as is the case for the income tax charitable deduction.

C. Caution: Split-interest charitable gifts often involve individuals other than—or in addition to—the donor. Then the annual exclusion, the $1 million gift tax exemption, the increasing estate tax exemption, the marital deduction (for citizen and alien spouses) come into play.

A. No charitable deduction allowed in computing taxable income of a partnership.

B. However, a partner's distributive share of charitable contributions actually paid by partnership during its taxable year is allowed as a deduction in the partner's separate return for his or her taxable year or within which the taxable year of the partnership ends.

C. Partner's deduction on the partner's individual income tax return—allowed to the extent his or her share of the partnership's contributions and own contributions don't exceed the applicable adjusted gross income ceilings.

XXV. CORPORATION GIFTS. IRC §§170(b)(2), (d)(2)(A) AND (a)(2); Reg. §1.170A-11

A. Ceiling is 10% of contribution base. Contribution base means taxable income computed without regard to—

1. Charitable deductions;

2. Any net operating loss carry back to the taxable year under IRC §172;

3. Any capital loss carryback to the taxable year under IRC §1212(a)(1).

B. Five-year carryover for "excess" gifts—up to 10% of contribution base in each carryover year. Note: H.R. 7 would increase this gradually to 20% by 2012.

C. General rule—contribution deductible only in year made.

1. Special rule allows corporation to deduct on last year's tax return gift made this year when these tests met:

a. Board of Directors authorized gift last year;

b. Gift is paid within 2½ months of beginning of this year; and

c. Corporation uses accrual method of tax reporting.

2. If corporation reports on fiscal year basis (instead of calendar year) to qualify authorized gift as deduction on last fiscal year's return although paid this final year:

a. Board of Directors must have authorized gift last fiscal year; and

b. Gift must be made within 2½ months of beginning of this fiscal year; and

c. Corporation must use accrual method of tax reporting.

3. Flexibility in year of deduction achieved by passing resolution at end of each year.

a. If increase or decrease in tax rates, in some instances can elect which year gift deductible.

b. Must pass resolution in prior year to have flexibility.

c. Even though resolution passed, gift can be deducted on current tax return if election not filed.

d. Resolution needn't name charitable donee, simply must authorize contribution. Letter Ruling 7802001.

4. To assure deduction on prior year's return for gift made in current year, comply with these additional requirements.

a. Report election on prior year's return by reporting contribution on return.

b. Attach to filed return a written declaration that resolution authorizing contribution was adopted by Board of Directors during prior year.

c. Declaration must be verified by authorized officer under penalties of perjury.

d. Attach to filed return copy of resolution of Board of Directors authorizing contribution.

5. IRS insists on strict compliance with regulations. See Columbia Iron and Metal, Inc., 61 TC 5 (1973).

6. Can void election by filing amended return by due date for filing.

D. Gifts designated by corporation's shareholders. IRS will allow a corporation to deduct gifts to charities named by the corporation's shareholders. Further, the gifts will not be treated as dividends to shareholders as long as no property or economic benefit is received by the shareholders or their families. Letter Rulings 8152094 and 8211127. See also Knott, 67 TC 681 (1977).

E. Special rules for some charitable contributions of inventory by corporations.

1. A corporation is allowed a charitable deduction for the lower of: (1) its basis in the inventory property plus half of the unrealized appreciation, and (2) twice the property's basis. IRC §170(e)(3)(B). Rev. Rul. 85-8, 1985-1 CB 59.

2. Limitation: No deduction is allowable for any part of the unrealized appreciation that would have been ordinary income (if the property had been sold) because of the application of the recapture provisions relating to depreciation, certain mining exploration expenditures, etc. IRC §170(e)(3)(C).

3. Additional requirement: Property that doesn't satisfy the relevant requirements of the Federal Food, Drug and Cosmetic Act is not eligible for increased deductions under these provisions. IRC §170(e)(3)(A)(iv).

4. Deductible up to 10% of taxable income—with a five-year carryover for any "excess."

5. Subchapter S corporations and individuals not entitled to this deduction, but limited to deduction for cost basis only. IRC §170(e)(3)(A).

6. Property that qualifies for the special deduction:

a. Ordinary-income property, such as inventory, donated to a public charity or private foundation, but only if the following conditions are satisfied:

(1) The donee must use the property in a use related to its exempt purpose and solely for the care of the ill, needy or infants (minors under local law);

(2) The donee must not transfer the property in exchange for money, other property or services;

(3) The donor must receive a statement from the donee representing that its use and disposition of the property will comply with requirements i and ii above.

b. Inventory property donated to an institution of higher education or qualified scientific research organization and then used by donee for research purposes. To qualify, a corporate contribution of ordinary-income property must satisfy these requirements:

(1) The property contributed must have been constructed by the taxpayer. The property is deemed constructed by the taxpayer only if the cost of parts (other than parts manufactured by the taxpayer or a related person) used in construction do not exceed 50% of the taxpayer's basis in the property;

(2) The contribution must be made within two years of substantial completion or construction of the property;

(3) The original use of the property is by the donee;

(4) The property is scientific equipment or apparatus and substantially all of its use is for research, experimentation or research training in the U.S. in the physical or biological sciences. Donated inventory property will qualify under this requirement if at least 80% of its use by the donee is for research purposes or a combination of research and research training. The physical sciences include physics, chemistry, astronomy, mathematics and engineering; the bio-logical sciences include biology and medicine;

(5) The property is not transferred by the donee in exchange for money, other property or services; and

(6) The taxpayer receives the donee's written statement representing that the use and disposition of the property contributed will meet the last two requirements. IRC §170(e)(4)(B), (C).

A. Transfers of property to a charitable organization that bear a direct relationship to the taxpayer's trade or business—and that are made with a reasonable expectation of financial return commensurate with the amount of the transfer—may be deductible as trade or business expenses rather than as charitable contributions. See IRC §162 and its regulations.

B. If a gift is deductible as a business expense, no ceiling on deduction except that it be "ordinary and necessary."

C. Fact that gift exceeds the percentage of adjusted gross income ceiling does not make the gift deductible as business expense.

D. See Rev. Rul. 72-314, 1972-1 CB 44; Marquis, 49 TC 695; Jefferson Mills, 259 F. Supp. 305, aff'd 367 F.2d 392; May, TC Memo 1996-135; Irwin, TC Memo 1996-498. See also Reg. §1.170A-8(a) and Letter Rulings 8145020, 9045015, 9309006 and 9335022. In Letter Ruling 7730005 a corporation asked IRS to rule that transfers to a charity would be deemed to be in the ordinary course of business. IRS refused to rule on the question in advance: Whether a transfer is made in the ordinary course of business, said IRS, is a question of fact to be determined by the District Director of Internal Revenue having audit jurisdiction over the donor. In other words, make the transfer and then let’s talk about it.

A. No charitable deduction for value of services performed free for charity. Reg. §1.170A-1(g).

B. Blood (Rev. Rul. 53-162, 1953-2 CB 127), newspaper advertisements (Rev. Rul. 57-462, 1957-2 CB 157) and free broadcast time (Rev. Rul. 67-236, 1967-2 CB 103) are services, rules IRS.

A. Deductible when incurred in rendering services for charity. Rev. Rul. 55-4, 1955-1 CB 291. Ceiling is 50% of adjusted gross income, with a five-year carryover. Rockefeller, 76 TC 178, aff'd 676 F.2d 35 (2d Cir. 1982); Rev. Rul. 84-61, 1984-1 CB 39. Apparently, 20% ceiling for expenses when benefitting a private foundation.

B. Volunteers' unreimbursed automobile expenses. Donors who use their automobiles in rendering gratuitous services to charitable organizations may deduct their gas, oil, tolls and parking costs (but not insurance and depreciation); or they may deduct a standard cents-per-mile rate in computing the cost of operating the automobile while volunteering. Optional rate of 14¢ per mile. IRC §170(j). Those who take the optional 14¢ per mile deduction may still deduct costs of parking and tolls.

C. Unreimbursed babysitting expenses incurred to render volunteer services not deductible. Rev. Rul. 73-597, 1973-2 CB 69.

D. Volunteers whose duties keep them away from home overnight may deduct costs of food and lodging. Query. Does the limit on the business meal deduction apply to a volunteer's meals? Reg. §1.170(A)-(1)(g) says that the deduction is limited to "reasonable expenditures for meals and lodging ...." No percentage limitation is imposed by the regulations. But no inference should be drawn because the regulation was promulgated before the percentage limit on business meal deductions was enacted.

E. Several years ago, IRS Publication 526, "Charitable Contributions," said that only 80% of otherwise-allowable meal expenses could be deducted as with the then-applicable limit on business meals. But more recent versions (including the current one) of Publication 526 don't make that point.

F. Also, no amount is deductible if the travel has a significant element of personal pleasure, recreation or vacation. IRC §170(j). Here's how Congress explained that rule, enacted in the 1986 Tax Reform Act:

"In determining whether travel away from home involves a significant element of personal pleasure, recreation, or vacation, the fact that a taxpayer enjoys providing services to the charitable organization will not lead to denial of the deduction. For example, a troop leader for a tax-exempt youth group who takes children belonging to the group on a camping trip may qualify for a charitable deduction with respect to his or her own travel expenses if he or she is on duty in a genuine and substantial sense throughout the trip, even if he or she enjoys the trip or enjoys supervising children.

"By contrast, a taxpayer who only has nominal duties relating to the performance of services for the charity, who for significant portions of the trip is not required to render services, or who performs activities similar to activities that many individuals perform while on vacations paid out of after-tax dollars, is not allowed any charitable deduction for travel costs. . . . [T]he disallowance rule does not apply where an officer of a local branch of a national charitable organization travels to another city for the organization's annual meeting and spends the day attending meetings, even if the individual's evening is free for sightseeing or entertainment activities."

G. Substantiating deduction for volunteer's unreimbursed expenses. Long-standing regulations provide that an unreimbursed expenditure made while performing services for a charity may be a deductible contribution. Reg. §1.170A-1(g). An individual's unreimbursed expenditure—such as a plane ticket—may be $250 or more, requiring substantiation. A volunteer who has unreimbursed expenditures of $250 or more while providing services to a charity is treated as having obtained a receipt from the charity (i.e., may deduct those expenses) if the volunteer has adequate records (those generally required to substantiate deductions) and obtains an abbreviated receipt from the charity. The receipt must contain: (1) a description of the volunteer's services; (2) a statement whether the charity provided any goods or services in exchange for the unreimbursed expenses; and (3) a description and good faith estimate of the value of any goods or services provided. If the goods or services provided consist solely of intangible religious benefits, the receipt must so state. Reg. §1.170A-13(f)(10). Reminder. If no goods or services were provided, the receipt must so state.

XXIX. AVOIDING CAPITAL GAINS ON GIFT OF APPRECIATED SECURITIES

A. Donor’s broker should not sell appreciated securities that donor wishes to contribute and then deliver proceeds to charity. If he does, the donor will be taxable on the gain. Ankeny, 53 TCM 287 (1987).

B. When a donor has given an option to purchase the gifted property (or worse, has signed a sales contract) he’ll end up paying capital gains tax on the appreciation (and out of his pocket) not out of the proceeds of the sale. This unfortunate situation can also result when there is a merger, initial public offering or liquidation in the wind. For IRS rulings and court cases on the foregoing and on rights of first refusal, redemptions, gifts of warrants, tender offers, assignment -of-income doctrine, the substance-over-form doctrine, the IRS-was-not-born-yesterday rule and the realities-and-substance (forgone conclusion) rules see: Letter Ruling 200321010, Rauenhorst, 119 TC, No. 9 (10/7/02); Field Service Advice 200149007, Ferguson, No. 98-70095 (CA-9, 4/7/99), Blake, 697 F.2d 473 (CA-2, 1988); Palmer, 62 TC 684 (1974); and Rev. Rul. 78-197, 1978-1 CB 83.

C. In Rauenhorst (cited above), the Tax Court held that IRS couldn’t disavow Rev. Rul. 79-197 (IRS’s acquiescence in Palmer). Rev. Rul. 78-179—the ruling in play in Rauenhorst—simply put, says that a donor of appreciated property is not taxed on the gain on a subsequent sale by the charity if the charity wasn’t legally obligated to sell the property. IRS’s pronouncement in Rev. Rul. 78-197 merely confirms the law.

In all cases, however, the factual issue remains: Was the charity under an obligation (express or implied) to sell the contributed property? Had the gain "ripened" before the gift?

D. IRS’s Chief Counsel (apparently in response to Rauenhorst) issued a reminder to its attorneys: "It has been a longstanding policy . . . that we are bound by our published positions, whether in regulations, revenue rulings, or revenue procedures, and that we will not argue to the contrary. Accordingly, we do NOT take positions in litigation, TAMs, PLRs, CCAs, advisory opinions, etc., inconsistent with a position that the Service has taken in published guidance or in proposed regulations. This policy applies even when attorneys disagree with the published guidance or even if there are plans to revoke, change or clarify the position taken in the published guidance. The policy applies regardless of the age of the guidance and regardless of whether courts have chosen to follow the published position. So long as the published guidance remains on the books, the Office of Chief Counsel will follow it. Counsel can, however, take positions inconsistent with prior informal advice, such as TAMs, CCAs, etc., but should never take a position inconsistent with published guidance or proposed regulations. CC-2002-043.

XXX. GIFT OF PROPERTY HAVING FAIR MARKET VALUE LOWER THAN COST BASIS

A. Sell and contribute the proceeds.

B. Do this to take advantage of the capital loss deduction (but not available for personal use assets—e.g., personal residence, automobile).

A. Definition. Sale by donor of appreciated property to public charity for less than present fair market value.

B. The rules.

1. When sale to public charity for less than fair market value, donor must allocate cost basis between the gift element and sale element based on the fair market value of each part.

2. Charitable deduction for bargain sale to public charity allowed for difference between sales price and fair market value for certain types of property—long term appreciated securities, real estate and related-use tangible personal property.

3. Donor incurs gain on the difference between the sales price and the cost basis allocated to the sale element. No tax on the gain allocated to the gift element.

4. Donor is entitled to a charitable deduction if he or she bargain sells a remainder interest in his or her home and receives cash or an annuity in return. Donor can also sell stock in closely held corporation to charity for a price below fair market value and get a charitable deduction even if the shares are later redeemed by the corporation. See Rev. Rul. 78-197, 1978-1 CB 83.

5. Caveat. Gift of mortgaged property is a bargain sale. Reg. §1.1011-2(a)(3); Guest, 77 TC 9 (1981).

C. Donor should clearly express intention to make charitable gift of difference between sale price and fair market value. See Connell, 51 TCM 1567 (1986) and Maier Brewing Company, 54 TCM 46 (1987) ("The taxpayer who negotiates for the best terms he can obtain in a commercial transaction cannot subsequently claim a deduction based upon any excess value of the `contributed' property over the consideration received therefore.")

1. Should not be oral.

2. Proven by written instrument and correspondence.

D. Caveat. Bargain sale to a private foundation is a prohibited act of self-dealing.

A. Deductible when fulfilled—not when made. IRC §170(a)(1).

B. Satisfying with appreciated property. Follow same rules to determine amount of deduction and applicable ceiling as when initially making a gift of appreciated property.

C. No capital gain incurred—not like paying a debt with appreciated property. Rev. Rul. 55-410, 1955-1 CB 233.

D. Important that pledges be enforceable.

1. If donor dies before pledge fulfilled, deductible on federal estate tax return only if:

a. Amount of unfulfilled pledge is paid to charity;

b. Donor's promise is enforceable against his estate; and

c. Contribution would have been allowed as an estate tax deduction if gift made by donor's will. Reg. §20.2053-5. See Estate of Levin, T.C. Memo 1995-81.

2. Pledges held binding on one or more grounds:

a. Donor's pledge is offer to contract. Binding when work towards pledge that was promised is begun or completed, or charity incurs liability in reliance on pledge.

b. Consideration for donor's pledge is that it is supported by pledges of others.

c. Other pledges induced based on donor's pledge.

d. Charity's acceptance of pledge imparts promise to apply the funds according to donor's wishes, and the donor's pledge is supported by that promise.

e. Some courts emphasize public policy as the basis upon which they find consideration to uphold donor's liability.

E. A private foundation’s payments of a donor’s pledge is a prohibited act of self-dealing. See XVI. A. (above).

F. Payment of another's pledge to charity is not a charitable gift and is not eligible for the gift tax charitable deduction by the payor. The payment of the pledge is deemed to be a gift to the person who made the pledge. Rev. Rul. 81-110, 1981-1 CB 479.

G. Qualifying for special estate tax benefits. If a donor of a sizable testamentary charitable bequest is close to death and it is questionable whether the estate will qualify for IRC §6166 deferral, this technique may help: Donor cancels the testamentary charitable bequest (by codicil or new will) and makes a binding (under state law) charitable pledge instead. The pledge is then deductible under IRC §2053 (as a debt) and thus will reduce the adjusted gross estate for purposes of meeting the IRC 6166 requirements. (A gift to the charity within three years of death is disregarded for purposes of determining the 35% of adjusted gross estate test.)

XXXIII. GIFT OF UNDIVIDED PORTION OF DONOR'S ENTIRE INTEREST IN PROPERTY. IRC §§170(f)(3)(B), 2522(c)(2), 2055(e)(2); Reg. §1.170A-7(a)

A. Income, gift and estate tax deductions allowed.

B. Example: Undivided one-fifth interest in Greenacre.

C. Applies to both real property and tangible personal property. Although no income, gift or estate tax charitable deductions are allowable for remainder interests in tangible personal property, those deductions are allowable for gifts of undivided interests—e.g., an undivided one-sixth interest in painting given to museum, with the museum having possession two months each year.

A. The deductibility rules (discussed above) for outright gifts to the various donee-charities generally apply to the split-interest charitable gifts (described below). For example, the 20%, 30% and 50% income tax deductibility ceilings for outright gifts also apply to split-interest remainder gifts and charitable gift annuities. If the deduction for an outright gift of long-term appreciated securities and real estate is based on the fair market value for an outright gift, then that rule applies to charitable remainder gifts. Conversely, when the deduction for a gift of appreciated property for an outright gift is based on the cost basis (e.g., short-term securities to a public charity or long-term real estate to a private foundation), then the value of a remainder interest will be based on the remainder interest in the cost-basis and not the remainder interest in the property’s fair market value.

B. Caveat: The following descriptions of the various split-interest charitable gifts briefly outline each split-interest gift. However, a full description of each plan, the ramifications of which one to use in a particular situation, how the income beneficiary is taxed, the income tax, capital gains, gift tax, estate, tax, marital deduction rules (citizens and alien spouses) are beyond the scope of this outline.

C. Charitable remainder unitrusts (CRUTS) and annuity trusts (CRATS).

1. STAN-CRUT—STANDARD (FIXED PERCENTAGE) CHARITABLE REMAINDER UNITRUST: Pays the income beneficiary ("recipient" in the regulations) an amount determined by multiplying a fixed percentage of the net fair market value (FMV) of the trust assets, valued each year. On death of beneficiary or survivor beneficiary (or at end of trust term if trust measured by term of years—not to exceed 20 years) charity gets the remainder. The fixed percentage can’t be less than 5% nor more than 50% and the remainder interest must be at least 10% of the initial net fair market value of all property placed in the trust. Sometimes the regulations refer to this trust as a "fixed percentage trust."

2. NIM-CRUT—NET INCOME WITH MAKEUP CHARITABLE REMAINDER UNITRUST: Pays only the trust’s income if the actual income is less than the stated percentage multiplied by the trust’s FMV. Deficiencies in distributions (i.e., where the unitrust income is less than the stated percentage) are made up in later years if the trust income exceeds the stated percentage.

3. NI-CRUT—NET INCOME CHARITABLE REMAINDER UNITRUST: Pays the fixed percentage multiplied by the trust's FMV or the actual income, whichever is lower. Deficiencies are not made up.

4. FLIP-CRUT: A trust set up as a NIM-CRUT or NI-CRUT. On a qualifying triggering event specified in the trust instrument (e.g., the sale of the unmarketable asset used to fund the trust) it switches to a STAN-CRUT. The regulations sometimes refer to this trust as a "combination of methods unitrust." That's a trust that on a triggering event converts from the "initial method" (NIM-CRUT or NI-CRUT) to a fixed percentage unitrust (STAN-CRUT).

5. FLEX-CRUT: That's my name for a FLIP-CRUT drafted so as to give great flexibility in determining when—if ever—a NIM-CRUT or NI-CRUT will flip to a STAN-CRUT. More about this soon.

6. CAPITAL GAIN NIM-CRUT: Post-transfer-to-the-trust capital gains (governing state law permitting) can be treated as income for purposes of paying income to the income beneficiary. This provides another way of making up NIM-CRUT deficits in payments from earlier years. More about this below.

7. FULL-MONTY CRUT: That's my coinage for a FLIP-CRUT that goes all the way—has FLEX-CRUT and CAPITAL GAIN CRUT provisions. More about this later.

8. FLEX-CRUT—practice pointer: If you want a CRUT to flip on the sale of a parcel of real estate, on a specified date or other permissible event, say so in the FLIP-CRUT. BUT if you want maximum flexibility, specify that the trust is to flip on the sale of an unimportant unmarketable asset that is one of the assets used to fund the trust. That way you have great flexibility in determining when—if ever—a NIM-CRUT or NI-CRUT will flip to a STAN-CRUT.

a. Time of flip—don't shoot yourself in the foot: a FLIP-CRUT converts from a NIM-CRUT or NI-CRUT to a STAN-CRUT at the beginning of the taxable year that follows the taxable year of the triggering event. Reg. §1.664-3(c)(2). For example, Donor's NIM-CRUT provides that it is to convert to a STAN-CRUT on his marriage, and he marries on December 1, 2004. His trust becomes a STAN-CRUT on January 1, 2005.

b. Forfeiture of NIM-CRUT'S make-up amounts (deficits)—side effect and warning. Once a NIM-CRUT converts to a STAN-CRUT (in the taxable year following the triggering event) all deficits in earlier payments are forfeited. Reg. §1.664-3(c)(3).

9. FLIP-CRUT practice pointer: Strongly consider including in FLIP-CRUTS a "post-transfer-to-the-trust-capital-gains-as-income pro-vision." That could eliminate or reduce a forfeiture of unitrust amounts. FLIP-CRUTs become STAN-CRUTs the tax year following the triggering event. All shortfalls (deficits) in all prior years while the trust was a NIM-CRUT are lost. But the deficit might be eliminated or reduced with a capital-gain-as-income provision. How so?

Example: On January 1 of year 1 Donor funds her 5% FLIP-CRUT with an unmarketable asset that has a FMV of $100,000 and a cost basis of $60,000. The trust takes over the donor's cost basis (holding period too). But the pre-transfer-to-the-trust appreciation is irrelevant for purposes of this example. The trust's governing instrument provides that any post-transfer-to-the-trust capital gain on a sale may be treated as income. The trust starts out as a NIM-CRUT and is to become a STAN-CRUT the year after the unmarketable asset is sold. The trust is to be valued on the last day of each year. The trust has no income in years 1, 2 or 3.

December 31 value

Unitrust amount

Year 1	$110,000	$ 5,500
Year 2	120,000	6,000
Year 3	130,000	6,500
Shortfall		$18,000

On December 31 of year 3 the trust sells the unmarketable asset for $130,000. The trust becomes a STAN-CRUT in year 4 (the year following the triggering event). So say the regulations. Reg. §1.664-3(c)(2). Any deficits in years 1, 2 or 3 are forfeited. But wait. The governing instrument directs the trustee to treat post-transfer-to-the-trust capital gain as income. The fair market value of the trust was $100,000 on funding and the trust appreciated to $130,000. The trust can pay the $18,000 shortfall from the capital gain (treated as income for purposes of making payments to the beneficiary) and there is no forfeiture. Without the capital-gain-as-income governing instrument provision, the $18,000 would have been forfeited by the beneficiary as the price of flipping from a NIM-CRUT to a STAN-CRUT. Naturally, each case should be decided on its own circumstances—and, of course, state law.

10. CRAT—CHARITABLE REMAINDER ANNUITY TRUST: Pays the income beneficiary ("recipient" in the regulations) a fixed dollar amount (at least annually) specified in the trust instrument. On the death of the beneficiary or survivor beneficiary (or at end of trust term if trust measured by a term of years—not to exceed 20 years) charity gets the remainder. The fixed dollar amount must be at least 5% but not more than 50% of the initial net fair market value of the transferred assets and the remainder interest must be at least 10% of the initial net fair market value of all property placed in the trust. Caveat: CRAT must meet "5% probability test" of Rev. Rul. 77-374, 1977-2 CB 329. But see Moor, 43 TCM 1530 (1982).

11. Four problem issues—watch your step.

a. Multiple grantor CRTS: IRS privately ruled that a CRUT with more than one donor is not a qualified trust. Letter Ruling 9547004. Responding to requests that the ruling be withdrawn and that IRS affirmatively announce that multiple grantor CRTs are OK, the author of that ruling said IRS holds to its position—except the letter ruling wouldn't apply when spouses are the grantors. And in Letter Ruling 200203034, too many grantors also spoiled the trust. Jack Hill was the sole shareholder of Hill Corp., an S corporation. Hill Corp. intended to create a charitable remainder unitrust, funding it with appreciated stock. The trust would pay Hill Corp. for a 19-year term, then Jack and his wife, Jill (and the survivor of them) for life, with remainder to charity. If Hill Corp. is dissolved before the end of the 19-year term, Jack and Jill would receive the unitrust payments for the balance of the term. IRS noted that a part of Hill Corp.’s stock contribution would be for Jack’s and Jill’s benefit; therefore, a portion of the donated stock will constitute a constructive distribution (equal to the present value of Jack’s and Jill’s life interests) to Jack as the sole shareholder. Jack will then be deemed to have contributed his share of the stock to the trust; thus, both Jack and Hill Corp. will be the trust’s grantors. Reg. §1.671-2(e)(4). Bottom line: The proposed trust, ruled IRS, doesn’t qualify as a charitable remainder unitrust because the arrangement isn’t a trust for federal income tax purposes. IRC §664(d)(2); Reg. §301.7701-4(a), (c).

b. Funding CRTS with undivided property interests: Spouses wanted to fund CRUTs with an undivided interest in a shopping center keeping an undivided interest for themselves in Letter Ruling 9114025. But IRS—I understand—warned the spouses that common ownership of the center with the trusts would be deemed self-dealing. So the couple transferred their interests to a limited partnership and funded the CRUTs with part of the partnership interest. The partnership arrangement apparently "cleansed" the relationship to IRS's satisfaction and IRS ruled that the CRUTs qualified.

c. Funding CRTS with mortgaged property: IRS disqualified a CRUT because it was funded with mortgaged property and the donor remained personally liable on the mortgage. IRS reasoned that a CRT must function exclusively as one from its creation. But a trust isn't deemed "created," said IRS, as long as the donor is treated as an owner of the trust under the grantor trust rules. Letter Ruling 9015049. Another donor funded a CRUT with mortgaged property but wasn't personally liable on the mortgage. IRS ignored the issue of whether the nonrecourse mortgaged property disqualified the trust and didn't rule whether the trust qualified. From 1970 until 1990 many donors funded CRTs with mortgaged property without a peep from IRS.

d. CRAT "5% probability test:" A CRAT doesn't qualify for a charitable deduction (and by implication isn't a qualified trust) unless the possibility that the charitable transfer will not become effective is so remote as to be negligible. If there's more than a 5% probability that the noncharitable income beneficiary will survive the exhaustion of the trust assets, that probability isn't negligible. Rev. Rul. 77-374, 1977-2 CB 329. The Tax Court upheld the "5% probability test" in Moor, 43 TCM 1530 (1982). However, the court also held that the test is satisfied as long as the trust's annual earnings can be reasonably anticipated to exceed the required annual payout to the beneficiary. Suppose a donor creates an inter vivos two-life CRAT that pays the donor for life, then his sister for life and it passes the 5% probability test. So the donor is entitled to an income tax charitable deduction. But because of a new interest assumption every month for computing the value of the charitable deduction, it's not certain that the trust will pass the 5% probability test on the donor's death. That puts a shadow over the estate tax charitable deduction. An IRS official—many years ago—said that as long as a trust passes the 5% probability test upon funding, it needn't pass it again when the donor dies. Of course, that statement isn't the law. According to the legislative history of the 10% minimum remainder interest requirement, if you pass that test at the outset, you pass it for all time.

Caution: It’s possible to pass the 10% minimum remainder interest requirement by a mile, but nevertheless flunk the 5% probability test.

12. Q-TIP/CRUT COMBO: We know that there’s no estate tax marital deduction for a CRUT (or CRAT) created by Husband that pays Wife for life, then another beneficiary and then remainder to Charity. Instead, Husband’s will creates a Q-TIP marital deduction trust for Wife to be followed by a CRUT for the other beneficiary, with remainder to Charity. Under the Q-TIP rules, Husband’s estate gets a 100% marital deduction. (There’s no charitable deduction, but, hey, a 100% marital deduction avoids the estate tax). And the marital deduction is available even though the Q-TIP trust benefits another individual after the surviving spouse’s death.

But wait a minute. The fair market value of the Q-TIP trust will be includable in the surviving Wife’s gross estate. Yes, but. The surviving Wife’s estate will get an estate tax charitable deduction for the value of the charitable remainder interest based on the other beneficiary’s age at her death, the unitrust payout, and the applicable federal rate for the month of Wife’s death, or either of the two prior months (at the estate’s election).

Yet another reason to create a testamentary Q-TIP/CRUT COMBO. With a Q-TIP trust for the surviving spouse, the trustee can make payments to her (or him) out of principal for health, maintenance, support or for other reasons. Authorizing those payments from charitable remainder unitrusts (and annuity trusts) would disqualify those trusts. So even if there is to be no income beneficiary other than the surviving spouse (and thus no marital deduction concerns), a Q-TIP for the surviving spouse’s life, with remainder to charity makes sense if principal may be needed by the surviving spouse.

13. POOLED INCOME FUNDS: Donor transfers money or securities to school, church, hospital or other public charity (only charities described in IRC §170(b)(1)(A)(i), (ii), (iii), (iv), (v) or (vi) can have pooled income funds). Charity adds donor's gift to its separately maintained pooled income fund, where it is invested together with gifts of other donors who make similar gifts. Each donor gets her pro rata share of pooled income fund earnings each year for life. Income the beneficiary receives is taxed as ordinary income. On income beneficiary's death, charitable organization removes assets from fund equal to her share of the fund and uses it for charitable purposes. Donor's pooled income fund gift can also provide life income for a survivor—e.g., a spouse. IRC §642(c)(3), (4), (5); Reg. §§1.642(c)-5 and (c)-6.

a. Community foundation pooled income funds.

1. Background—community foundations. Not to be confused with private foundations, community foundations are broad-based public charities that help foster a number of charitable causes and organizations in a given geographic area. Like a national charity and its local chapters, a community foundation can help achieve economies of scale for neighborhood charities—for instance, by managing and investing their endowments.

2. Background—component funds. Multiple funds maintained by a community foundation for other charities may be treated as a single component fund if they prepare common reports and share a common name, governing instrument and governing board that can—in certain circumstances—modify restrictions on fund distributions. Reg. §1.170A-9(e)(11).

3. Background—pooled income fund maintenance requirement. A pooled income fund must be maintained by the organization receiving the remainder interest. IRC §642 (c)(5)(E); Reg. §1.642(c)-5(b)(5).

b. 1992 Revenue Ruling: A community foundation's pooled income fund satisfies the maintenance requirement if the donor permits the foundation to choose the charity that will benefit from the remain-der interest. When the foundation has discretion over the use of the remainder interest, the donor makes a gift of that interest to the foundation, reasoned IRS. Since the foundation maintains the fund, it satisfies the maintenance requirement and qualifies, ruled IRS. But IRS went on to rule—unfavorably—that when the donor may designate the charity for whose benefit the foundation will use the remainder interest, the fund fails the maintenance requirement. It's as if the donor isn't donating a remainder interest to the foundation, but rather to some other designated organization, reasoned IRS. Because that other organization isn't maintaining the pooled income fund, the maintenance requirement is failed and the fund doesn't qualify. Rev. Rul. 92-108, 1992-2 CB 121.

IRS revoked the 1992 ruling "pending further study" after a number of charities expressed unhappiness. That did not necessarily mean a change in IRS's position.

c. The latest revenue ruling. Two community foundations are involved; I'll call them CF1 and CF2. Each is qualified to create and maintain a pooled income fund, and each pooled fund generally satisfies the requirements of IRC §642(c)(5).

Situation 1. CF1's pooled fund allows the foundation to determine how, and by whom, the remainder interest will be used for charitable purposes. CF1 may use some or all of the remainder interest to benefit other charitable organizations.

IRS rules—situation 1. CF1 has discretion over how to use the remainder interest to further charitable purposes. Thus, the donor is treated as contributing the remainder interest to CF1. Since CF1 maintains the pooled income fund, it satisfies the maintenance requirement and qualifies, rules IRS. Rev. Rul. 96-38, 1996-2 CB 44.

Situation 2. CF2's pooled fund allows the donor to request or require that after the donor's designated income beneficiaries die, CF2 transfer the remainder interest proceeds to one of its component funds designated to benefit a specific charity. However, CF2's governing body can modify any restrictions on component fund distributions if—in the governing body's sole judgment—the restriction becomes unnecessary, incapable of fulfillment or inconsistent with the charitable needs of the community or area served. Reg. §1.170A-9(e)(11)(v)(B)(i).

IRS rules—situation 2. CF2's component funds are treated as a single entity. Reg. §1.170A-9(e)(11)(ii). Thus, even though the donor can request or require that CF2 transfer the remainder interest proceeds into one of those funds, the donor is treated as contributing the remainder interest to CF2. Since CF2 maintains the pooled income fund, it satisfies the maintenance requirement and qualifies, rules IRS.

Comment. What about this situation? Donor contributes to CF3's pooled income fund. He gets income for life. Then the remainder interest is to be paid directly to a qualified charity that Donor designates at the time he makes his pooled income fund gift. The charity so designated could have maintained its own pooled income fund.

IRS did not—in the latest ruling—specifically rule on this situation, but from its "law and analysis" (in the text of the ruling) it states:

For an organization to satisfy the maintenance requirement of §642(c)(5)(E), it may not be serving merely as a conduit for a gift to another beneficiary, but instead must be receiving a contribution itself that it will use to achieve its charitable purposes.

Thus it isn't a great leap to conclude that IRS would rule that CF3's pooled income fund would not qualify. That's the situation on which IRS ruled on negatively in 1992. It soon withdrew the ruling "pending further study."

In this latest revenue ruling, IRS—in its law and analysis—quotes from the Ways and Means Committee report on pooled income funds:

The maintenance requirement is designed to ensure that the fund's assets will not be manipulated for the benefit of noncharitable interests and that the amount received by the charitable organization will reflect the amount of any charitable contribution deduction the donor may have taken for contributing the remainder interest. H.R. Rep. No. 43 (Part I), 91st Cong., 1st Sess. 58 (1969), 1969-3 C.B. 200, 237; and S. Rep. No. 552, 91st Cong., 1st Sess. 87 (1969), 1969-3 C.B. 423, 479.

Query. How does the maintenance requirement "ensure that the fund's assets will not be manipulated for the benefit of noncharitable interests"? Suppose Harold makes a gift to Plato University's pooled income fund providing income for himself with remainder to Plato University. He also makes a gift to CF3's pooled income fund providing life income for himself with remainder to Plato University. What's the difference? Plato University—qualified to have its own pooled income fund—gets the remainder interest in both cases.

Treasury regulations provide:

A national organization which carries out its purposes through local organizations, chapters, or auxiliary bodies with which it has an identity of aims and purposes may maintain a pooled income fund... in which one or more local organizations, chapters, or auxiliary bodies which are public charities have been named as recipients of the remainder interests. For example, a national church body may maintain a pooled income fund where donors have transferred property to such fund and contributed an irrevocable remainder interest therein to or for the use of various local churches or educational institutions of such body. The fact that such local organizations or chapters have been separately incorporated from the national organization is immaterial. Reg. §1.642(c)-5(b)(5).

Why can't a community organization—a community foundation—that carries out its purposes through local charities maintain a pooled income fund in which one or more local charities have been named as recipients of remainder interests? It's not economically feasible for many local charities to have their own pooled income funds. Allowing a community foundation to maintain a "master" pooled income fund makes sense and is consistent with congressional intent—seems to me.

14. GIFT OF REMAINDER IN PERSONAL RESIDENCE OR FARM: Donor can obtain income and estate tax benefits by making a charitable gift of a personal residence or farm (Section E.I.E.I.O.) even though he or she retains the right to life enjoyment. A life estate may be retained for one or more lives. Or an estate may be retained for a term of years. The remainder interest must be in a personal residence or farm. Does not include furnishings or other tangible personal property. However, property that qualifies as a fixture under local law can be included in value. See Letter Ruling 8529014 (heating and air conditioning system).

15. CHARITABLE GIFT ANNUITIES: A donor irrevocably transfers money or property to a public charity in return for its promise to pay the donor, another or both, fixed and guaranteed payments for life. In essence, the transfer is part charitable gift and part purchase of an annuity. The amount of the annual payment—which can also be paid in monthly, quarterly or semi-annual installments—is fixed at the outset and never varies. As with a commercial annuity: (1) the older the annuitant at the annuity starting date, the larger the annual payments; (2) when there are two annuitants, the annual payments are smaller than if there is one annuitant; and (3) a portion of each annuity payment is excludable from gross income for the period of the annuitant's life expectancy. The excludable (tax-free) amount is established at the annuity starting date.

16. THE DEFERRED PAYMENT GIFT ANNUITY: A donor transfers money or property to a public charity in exchange for its promise to pay an annuity to the donor, another or both, to begin more than one year from the date of the transfer. The donor is able to make a gift now and get an income tax charitable deduction when he or she is in a high tax bracket, deferring payment until those years when the donor may need the income more (e.g., after retirement) and may be in a lower income tax bracket.

17. CHARITABLE LEAD TRUSTS: Unitrust or annuity trust payments are made to charity for a life or a predetermined number of years, with either a reversion in the grantor or a remainder in family members or other non-charity remainderpersons. The lead trust is the converse of charitable remainder trust, in which grantor and/or other non-charity beneficiaries receive trust payments for life or term of years (not to exceed 20 years), with a remainder interest in charitable institution. Non-grantor lead trusts can often enable a donor to benefit charity and pass assets on to family members down the road at reduced or no gift, estate and generation-skipping transfer taxes.

XXXV. SUBSTANTIATING INCOME TAX CHARITABLE DEDUCTIONS

A. Overview. Donors need a receipt in hand from a charity to claim a charitable deduction of $250 or more. A canceled check without a receipt is insufficient. But a donor who makes a $100 gift, for example, will not need a receipt as a condition of claiming the charitable deduction; however, that donor will need to substantiate the gift if IRS questions it. The fact that a donor gets a receipt from the charity doesn’t necessarily mean that IRS will agree to the deduction, because receipt or not, IRS may challenge the deduction for other reasons (e.g., the charity isn’t qualified, the donor inflated the gift’s value, or the donor received a benefit.)

B. The substantiation requirements are in addition to other rules. For example, a gift of real estate or artworks (for which an income tax charitable deduction of over $5,000 is claimed) requires a qualified appraisal and an appraisal summary. But IRS will deny the charitable deduction if a donor gets the appraisal too early or too late, or neglects to attach the appraisal summary to the tax return. Further, timely obtained and filed appraisals and appraisal summaries are useless if the appraiser is not "qualified." See XXXVI. (below).

Query. When is the amount "contributed" less than $250? Suppose a donor pays $300 and receives an item with a fair market value of $55 in return. The Code and regulations are clear that the donor’s deduction is $245 ($300 less $55). But is $245 also the amount contributed? Yes, according to an IRS’s spokesperson’s unofficial comments. That means the $250-or-over substantiation rules don’t apply. In any event, all donors should be given receipts containing the amount paid, a description of the item given to the donor, and a good faith estimate of its value. Then no one has to stay up nights worrying about this.

C. Charitable contributions of $250 or more must be substantiated to be deductible. IRC §170(f)(8) provides that no deduction is allowable for a gift of $250 or more unless the donor substantiates the deduction by a contemporaneous written acknowledgment of the gift by the charity. This rule applies to both individuals and corporations (but apparently not to trusts, whose charitable deduction is governed by IRC §642(c), not IRC §170). And the rule would not apply to a business that can properly deduct the gift as a business expense rather than as a charitable contribution.

D. Contemporaneous acknowledgment. For an acknowledgment to be contemporaneous, the donor must obtain a receipt from the charity "on or before the earlier of: (i) the date on which the taxpayer files a return for the taxable year in which the contribution was made; or (ii) the due date (including extensions) for filing such return."

E. Charitable remainder trust and lead trust gifts—background. Grantors of charitable remainder annuity trusts, charitable remainder unitrusts, and charitable lead trusts don’t always name the charity to receive the remainder or lead interest when their trusts are created. In some cases, the grantor retains the right to revoke the designation and name other charities; thus, there may be no specific charity to acknowledge the gift of the remainder or lead interest. The $250 substantiation rules don’t apply to charitable remainder annuity trusts, charitable remainder unitrusts, and charitable lead trusts. Reg. §1.170A-13(f)(13).

F. Pooled income fund gifts—background. Pooled income funds are created and maintained by the charity, so having information for gift acknowledgment isn’t a problem. The substantiation rules apply to pooled income funds. To deduct a gift of a remainder interest of $250 or more, a donor must have an acknowledgment from the charity. The acknowledgment must state that the cash or property was transferred to the charity’s pooled fund, and whether or not any goods or services (in addition to the fund’s income interest) were provided to the donor. The acknowledgment doesn’t have to include a good faith estimate of the income interest’s value. Reg. §§ 1.170A-13(f)(2), (13).

G. Gift annuities—regulations. When the gift portion of a gift annuity or a deferred payment gift annuity is $250 or more, a donor must have an acknowledgment from the charity stating whether or not any goods or services (in addition to the annuity) were provided to the donor. The acknowledgment doesn’t have to include a good faith estimate of the annuity’s value. Reg. §§1.170A-13(f)(2), (16).

H. Charitable remainders in personal residences and farms. The regulations are silent on the substantiation rules for remainder interests in personal residences and farms. Verbum sapienti: Unless IRS says otherwise, the $250 substantiation rules should be deemed to apply to those gifts.

I. Partnership and S corporation gifts—regulations. Partnerships and S corporations that give $250 or more to charity are treated the same as individual taxpayers for purposes of the $250 substantiation rules. Thus, a partnership or S corporation must get an acknowledgment from the charity before filing its return, even if a partner’s or shareholder’s distributive share of the contribution is less than $250, and must retain the receipt in its records. Partners and S corporation shareholders don’t have to obtain any additional substantiation for their allocable shares of the contributions. Reg. §1.170A-13(f)(14).

J. C corporation gifts. IRS didn’t adopt suggestions that C corporations be exempt from the substantiation requirements, or that they qualify for a "de minimis" exception. According to IRS, exempting C corporations from the substantiation requirement could encourage abuses, thereby conflicting with the purpose of IRC §170(f)(8).

K. Amended returns. Donors must have their receipts in hand before filing their income tax returns. If the donor files the return after the due date (or after an extended due date), the receipt must nevertheless have been in the donor’s hand by the due date (plus any extensions). IRC §170(f)(8)(C). What about claiming a "$250 or over" gift on an amended return? IRS first raised the issue in a training manual for its agents, stating that allowing a deduction on an amended return "would be contrary to the statute." Comment. IRS is saying "Congress makes us do it." That’s not necessarily so. A most unusual Code provision empowers Treasury to issue "regulations . . . provid[ing] that some or all of the [substantiation and quid pro quo] requirements . . . do not apply in appropriate cases." IRC §170(f)(8)(E). So IRS does have authority to provide that charitable deductions on late amended returns are allowable as long as donors have the receipts before filing their returns.

L. Preamble to the regulations on "amended return" issue. While the regulations don’t refer to the "amended return" issue, IRS’s preamble to the regulations puts the kibosh on the deduction under these facts: A taxpayer obtained a written acknowledgment for his contribution after timely filing his original return. He then filed an amended return (with the receipt in his hand) claiming the deduction. No deduction is allowable, says IRS, in the preamble:

Section 170(f)(8)(C) provides that a written acknowledgment is contemporaneous if obtained on or before the earlier of: (1) the date that the taxpayer files the return for the year in which the contribution was made; or (2) the due date (including extensions) for filing the return for that taxable year. A written acknowledgment obtained after a taxpayer files the original return for the year of the contribution is not contemporaneous within the meaning of the statute.

M. Last ditch stand—something to hang your hat on. If you have to do battle with IRS on this issue, see Bond, 100 TC 32 (1993), where the Tax Court held that the qualified appraisal requirements are merely procedural, so they may be fulfilled by substantial rather than strict compliance.

N. The receipt must meet five requirements:

1. It must state the amount of cash contributed.

2. It must describe—but not value—any property contributed.

3. If the donor received no goods or services in return for the donation, the acknowledgment must so state.

4. If the donor received goods or services in return for the donation—other than an intangible religious benefit", or token items of "insubstantial value"—the acknowledgment must describe them and provide a "good faith estimate" of their value.

5. If the only benefit the donor has received is an "intangible religious benefit," the acknowledgment must so state.

O. Donor makes payment to charity this year and gets goods or services in a future year—IRS’s explanation in the preamble to the regulations. If a donor makes a gift to charity in exchange for goods or services (e.g., cash, property, benefits, privileges, and services), the donor’s charitable deduction for the year of the gift is limited to the amount by which the payment exceeds the value of those goods or services. So far, so good. That limitation applies when the goods or services are provided to the donor in the year of the gift. Still so far, so good. IRS goes on to say that the contribution is the excess of the payment over the goods or services, even if they’re not available to the donor until a later year. Reg. §1.170A-13(f)(5), (6).

P. A "good faith estimate" (for purposes of complying with the $250-and-over rules) is the charity’s estimate of the FMV of goods or services, regardless of how the charity makes the estimate. Reg. §1.170A-13(f)(7).

Q. Comment. The quid pro quo contribution rules provide (among other things) that a charity must use a "reasonable methodology" in good faith in making its estimate. Thus, a charity that uses the same document to satisfy both the $250 substantiation rules and the quid pro quo contribution rules should follow the apparently more stringent quid pro quo contribution rules.

R. In determining whether a payment made for goods or services is deductible, the donor may rely on the charity’s estimate of value in either: (1) a charity’s contemporaneous written acknowledgment of a gift of $250 or more; or (2) a charity’s written disclosure of a quid pro quo gift over $75. But a donor who knows, or has reason to know, that the charity’s estimate of fair market value is unreasonable may not use the charity’s valuation. Reg. §1.170A-1(h)(4)(i).

The IRS lists organizations that are qualified to receive tax-deductible contributions in IRS Publication 78, Cumulative List of Organizations Described in Section 170(c) of the Internal Revenue Code of 1986. This publication is sold to the public through the Superintendent of Documents, U.S. Government Printing Office, Washington, DC. Publication 78 can also be downloaded from the IRS Website at Note that not every organization that is eligible to receive tax-deductible contributions is listed in Publication 78. For example, churches that have not applied for recognition of tax-exempt status are not included in the publication. Only the parent organization in a group ruling is included by name in Publication 78.

If you have questions about listing an organization, correcting an erroneous entry, or deleting a listing in Publication 78, contact Customer Account Services for IRS, Exempt Organizations at (877) 829-5500.

See also: www.guidestar.org the website for Philanthropic Research, Inc., a 501(c)(3) nonprofit organization. The site offers—for a fee—megatons of information for nonprofits, donors, grantmakers and their advisers..

All IRC §501(c)(3) organizations must abide by these rules:

• Net earnings may not inure to any private shareholder or individual;

• Must not provide a substantial benefit to private interests;

• Must not devote a substantial part of their activities to attempting to influence legislation (private foundations may not lobby at all);

• Must not participate in, or intervene in, any political campaign on behalf of (or in opposition to) any candidate for public office; and

• No part of an organization’s purposes or activities may be illegal or violate fundamental public policy.

All IRC §501(c)(3) organizations are prohibited from engaging in activities that result in inurement of the organization’s income or assets to insiders (i.e., persons having a personal and private interest in the activities of the organization). Insiders could include board members, officers, and in certain circumstances, employees. Examples of prohibited inurement include the payment of dividends, the payment of unreasonable compensation to insiders, and transferring property to insiders for less than fair market value. The prohibition against inurement to insiders is absolute; therefore, any amount of inurement is, potentially, grounds for loss of tax-exempt status. In addition, the insider involved may be subject to excise taxes. See the discussion of self-dealing rules for private foundations. See the discussion of excess benefit transactions.

An IRC §501(c)(3) organization’s activities must be directed exclusively toward charitable, educational, religious, or other exempt purposes. An organization’s activities may not serve the private interests of any individual or organization. Rather, beneficiaries of an organization’s activities must be recognized objects of charity (such as the poor or the distressed) for the community at large. Private benefit is different from the inurement to insiders. Private benefit may occur even if the persons benefitted are not insiders. Also, private benefit must be substantial for exempt status to be jeopardized.

A. Background: An otherwise qualified organization is entitled to IRC §501(c)(3) status only if "no part of [its] net earnings . . . inures to the benefit of any private shareholder or individual." Until the enactment in 1996 (retroactive to September 14, 1995) of IRC §4958's intermediate sanctions, the Code offered the IRS no statutory means to control financial abuses of tax-exempt organizations short of revoking their exempt status.

Given the unfortunate collateral effects of tax-exempt status revocation (e.g., loss of the community benefits provided by the organization, the loss of the availability of tax-exempt pensions under IRC §403(b)), the IRS was reluctant to apply that draconian measure, except in the most egregious cases.

Why the term intermediate sanctions? Before enactment of IRC §4958, the IRS could either revoke an organization's tax exemption or do nothing. Presumably, the new sanctions fall in between. But doing nothing is hardly a sanction. So intermediate sanctions are, in effect, between a rock and a soft place. But what’s in a name? That which the law calls an intermediate sanction, by any other name would still do the job—inhibit improper transactions and punish transgressors.

B. Actually, over the years there has been a Mr. In-Between, occupying the territory between loss of exemption and no consequence at all. Specifically, the IRS had been imposing the equivalent of intermediate sanctions through the use of a closing agreement to conclude an audit. That agreement required the exempt organization (and not the individual who improperly benefitted from the transaction) to pay an identified dollar amount and agree to terminate the challenged activities. In exchange, the IRS agrees to refrain from revoking the organization’s exempt status.

C. The enactment of intermediate sanctions doesn’t mean that, in egregious cases, the IRS will not revoke an organization’s tax exemption as well as impose intermediate sanctions on the individuals involved.

D. IRC §4958 and Reg. §53.4958 impose dollar penalties on organization managers (generally officers, directors, trustees and persons having similar responsibilities) who authorize the payment of excess benefits such as unreasonable compensation to disqualified persons (i.e., "insiders" —individuals in a position to exercise substantial control over the affairs of IRC §501(c)(3) public charities and IRC §501(c)(4) social welfare organizations). Excess benefits also include the sale by an IRC §501(c)(3) or §501(c)(4) charity of property to a disqualified person at below fair market value (or the purchase of property from a disqualified person at above fair market value). The dollar penalty that can be imposed on managers—who are jointly and severally liable—is 10% of the excess benefit per transaction with a ceiling of $10,000. Penalties that can be levied against disqualified persons are a first-tier tax of 25% of the excess benefit. That benefit must, of course, be returned And, if the benefit’s return is not timely, an additional 200% penalty is levied.

E. Intermediate sanctions can be avoided by following prudent business practices, exercising due diligence, following well-defined conflict-of-interest policies and documenting the procedures.

F. Strict IRS enforcement is a given. This is a revenue-raising as well as compliance measure. Not engaging in excess benefit transactions is laudable, but not enough. You must document that due diligence has been exercised to avoid those transactions. See Avoiding Intermediate Sanctions by Conrad Teitell and Richard Siegal (Warren, Gorham & Lamont, 1998).

Note: The self-dealing rules, rather then the intermediate sanctions, apply to private foundations.

XXXXIII. EXEMPT ORGANIZATIONS—LEGISLATION AND ISSUES ON THE HORIZON

XXXXIV. PRIVATE FOUNDATIONS—PROPOSED LEGISLATION

A. H.R. 7 passed by the House in September ‘03 by 408 to 13 would:

• Self-dealing. Increase the initial excise tax from 5% to 25%.

• Replace the 2% excise tax on private foundation net-investment income to 1%.

• 5% minimum distribution. Would disallow some private foundation administrative costs as counting toward the 5% minimum-distribution requirement. Among the excludable costs would be compensation paid to "disqualified persons" in excess of $100,000 per person and first-class airfare. [An early draft of H.R. 7 would have removed practically all administration expenses from counting toward the 5% minimum-distribution requirement.]

B. Arguments for and against disallowing administration expenses to count toward the 5% distribution requirement.

1. National Council for Responsive Philanthropy—FOR:

This is a modest and reasonable reform that would help charities with desperately needed new grantmaking while simultaneously safe- guarding foundation perpetuity. Rather than stopping foundations from spending funds on administrative and operating costs, the proposed provision of the Charitable Giving Act simply guarantees that at least 5 percent of foundations’ endowments will be devoted to strengthening the budgets of America’s nonprofits on the front lines of social progress.

This modest change is sustainable for foundations. It doesn’t require them to reduce their administrative expenditures one iota, but it does get new money into nonprofits now, to address today’s problems, when nonprofits face the triple whammy of charitable giving declines, federal and state public investment cutbacks, and increasing demands from constituents in the most difficult economy in two decades.

2. Council on Foundations—AGAINST:

After you write a check to a charity, don’t you want to know that it made a difference? So do foundations. That’s why foundations —which spend private money for the public good—have staff, conduct research, assist grantees and evaluate the grants they make.

But a provision in a bill now before Congress would bar private foundations from counting these activities as charitable work on their tax returns. Congress and the public count on foundations to provide long-term, well-informed, accountable and transparent support to charities, but this provision sends a message that foundations are good only for writing checks.

Foundations trade in two currencies: money and knowledge. In addition to writing the grant that makes an immunization clinic possible, foundations also spend money to tell the community about this resource, to ensure the immunization is effective and to follow up with patients to make sure they have access to care.

Foundations have been tremendously effective because they do their homework, enabling them to select, develop and fund the right initiatives. This diligence has paid big benefits to society. Foundation funding has made some great things possible: the polio vaccine, Head Start, Sesame Street and the 911 emergency number, to name a few.

The most effective qualities of philanthropy are the innovation, flexibility, experimentation and foresight that have served the public good since the inception of our nation. Congress should encourage, not punish, this work.

XXXXV. ADVANTAGES AND DISADVANTAGES OF PUBLIC CHARITIES, PRIVATE FOUNDATIONS AND EVERYTHING IN BETWEEN: ACCOMPLISHING CHARITABLE OBJECTIVES; TAX BENEFITS; CONTROL; FAMILY INVOLVEMENT; SIMPLICITY; COMPLEXITY; AND PERSONAL LIABILITY

A. Publicly supported charities—churches, schools, hospitals, etc. and those donees meeting "mechanical" public support tests.

1. Advantages to donor:

• Maximum income tax benefits.

• No administration, investment or reporting responsibilities.

• Private foundation excise taxes and penalties (e.g., self-dealing, taxable expenditures) are inapplicable but subject to intermediate sanctions for excess benefit transactions.

• For large gifts, can get name recognition—e.g., name on a building or endowed chair.

• Limited control by designating use of the gift before made—e.g., to be added to endowment and income to be used for specified research.

• Charity can lobby within limits.

2. Disadvantages to donor:

• Once the gift is made, no control over use (other than as originally designated).

• No control over investments.

• Down the road, charity might take name off building or not use gift as originally designated. Donor or heirs may have to go to court to enforce and may not have "standing" (state law controls).

B. Donor-advised funds.

1. Advantages to donor:

• Maximum income tax benefits.

• Piece of cake to create.

• Can often accomplish philanthropic objectives without the hassle of a private foundation.

• Advice from the community foundation to the donor can help a donor meet important needs of which the donor acting alone may be unaware.

• Name recognition available.

• Family members can be involved in giving advice.

• Private foundation excise taxes and penalties (e.g., self-dealing, taxable expenditures) are inapplicable, but subject to intermediate sanctions for excess benefit transactions.

2. Disadvantages to donor:

• Can’t control grants, but only recommend.

• Donor-advised fund subject to administration fees, but regardless of the charitable donee there’s no free philanthropy.

• Depending upon the fund, there may be geographic restrictions on where grants can be recommended.

C. Supporting organizations—Type III.

1. Advantages to donor:

XXXXVI. CONCLUSION—THE AMERICAN PHILANTHROPIC TRADITION

A widespread foreign misconception is that Americans contribute because gifts are tax-deductible; in fact, the reverse is true. Gifts are deductible because Americans contribute and because our government, which regards the charitable world as its partner, wants to encourage private charitable giving.

U.S. federal income taxes only became legal with the Constitution’s Sixteenth Amendment in 1913; they only became substantial with the Federal Tax Act of 1935, since until 1932 custom duties were the chief source of federal revenue.

Every one of our nation’s major universities, art museums and hospitals was created before taxes were a factor in giving.

Foreigners admire these American institutions but tend to forget that the best of them are funded and managed by private individuals (or Tocqueville’s "associations") to an extent unheard of elsewhere. Last year, for example, to celebrate a major anniversary of our graduation, an astounding 75% of my living college classmates contributed to our alumni fund.

What are the lessons to be learned from the American philanthropic experience that can be applicable to other nations?

First is to echo the French statesman Clemenceau who, when he observed that "war is too important to be left to the generals," could just as easily have noted that social welfare and the public good are too important to be left to government.

All religions, all nations, all societies wish to feed their hungry, clothe their naked, house their homeless. All wish to help their sick, see their elderly age with dignity, and so forth; and Americans have no unique patent on compassion.

But just as Americans believe that free market economies better harness the energies and creative juices of the public than do planned or government controlled economies, so do they believe that a vibrant "independent sector" in philanthropy can accomplish things that government cannot. England’s Edmund Burke sang the praises of "the little platoons," and American society agrees.

The last word appropriately belongs to Andrew Carnegie, that great and good man who for a century has been the quintessential role model for us all.

Why, he asked, should we not spend the same thought, energy and imagination in disposing of our wealth as we expended in acquiring it?

He was right! We should.

Excerpted from an address by Daniel Rose, Chairman,

Harlem Educational Activities Fund, Inc. to the

International Fellows Program, Center for the

Study of Philanthropy, The Graduate Center, CUNY, April 2, 2003   Taxwise Giving & Philanthropy Tax Institute PO Box 299, Old Greenwich, CT 06870-0299 e-mail: Conrad@taxwisegiving.com © Conrad Teitell 2005

Excerpted from IRS Pub 557(5-03)

TAX-EXEMPT STATUS FOR YOUR ORGANIZATION