Private Foundations and Public Charities

It is important that you determine if your organization is a private foundation. Most organizations exempt from income tax (as organizations described in section 501(c)(3)) are presumed to be private foundations unless they notify the Internal Revenue Service within a specified period of time that they are not. This notice requirement applies to most section 501(c)(3) organizations regardless of when they were formed.

Private Foundations

Every organization that qualifies for tax exemption as an organization described in section 501(c)(3) is a private foundation unless it falls into one of the categories specifically excluded from the definition of that term (referred to in section 509(a)(1), 509(a)(2), 509(a)(3), or 509(a)(4)). In effect, the definition divides these organizations into two classes, namely private foundations and public charities. Public charities are discussed later.

Organizations that fall into the excluded categories are generally those that either have broad public support or actively function in a supporting relationship to those organizations. Organizations that test for public safety also are excluded.

Notice to IRS.   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 IRS that it is not a private foundation. This notice requirement applies to an organization regardless of when it was organized. The only exceptions to this requirement are those organizations that are excepted from the requirement of filing Form 1023 as discussed, earlier, under Organizations Not Required To File Form 1023.

When to file notice.    If an organization has to file the notice, it must do so within 15 months from the end of the month in which it was organized.

If your organization is newly applying for recognition of exemption as an organization described in this chapter (a section 501(c)(3) organization) and you wish to establish that your organization is a public charity rather than a private foundation, you must complete the applicable lines of Part III of your exemption application (Form 1023). An extension of time for filing this application may be granted by the IRS if your request is timely and you demonstrate that additional time is needed. See Application for Recognition of Exemption, earlier in this chapter, for more information.

In determining the date on which a corporation is organized for purposes of applying for recognition of section 501(c)(3) status, the IRS looks to the date the corporation came into existence under the law of the state in which it is incorporated. For example, where state law provides that existence of a corporation begins on the date its articles are filed by a certain state official in the appropriate state office, the corporation is considered organized on that date. Later nonsubstantive amendments to the enabling instrument will not change the date of organization, for purposes of the notice requirement.

Notice filed late.   An organization that states it is a private foundation when it files its application for recognition of exemption after the 15-month period will be treated as a section 501(c)(3) organization and as a private foundation only from the date it files its application.

An organization that states it is a publicly supported charity when it files its application for recognition of exemption after the 15-month period cannot be treated as a section 501(c)(3) organization before the date it files the application. Financial support received before that date may not be used for purposes of determining whether the organization is publicly supported. However, an organization that can reasonably be expected to meet the support requirements (discussed later under Public Charities) can obtain an advance ruling from the IRS that it is a publicly supported organization.

Excise taxes on private foundations.    There is an excise tax on the net investment income of most domestic private foundations. This tax must be reported on Form 990-PF and must be paid annually at the time for filing that return or in quarterly estimated tax payments if the total tax for the year is $500 or more. In addition, there are several other rules that apply. These include:

1. Restrictions on self-dealing between private foundations and their substantial contributors and other disqualified persons,
2. Requirements that the foundation annually distribute income for charitable purposes,
3. Limits on their holdings in private businesses,
4. Provisions that investments must not jeopardize the carrying out of exempt purposes, and
5. Provisions to assure that expenditures further exempt purposes.

Violations of these provisions give rise to taxes and penalties against the private foundation and, in some cases, its managers, its substantial contributors, and certain related persons.

Governing instrument.   A private foundation cannot be tax exempt nor will contributions to it be deductible as charitable contributions unless its governing instrument contains special provisions in addition to those that apply to all organizations described in section 501(c)(3).

Sample governing instruments.   The following samples of governing instrument provisions illustrate the special charter requirements that apply to private foundations. Draft A is a sample of provisions in articles of incorporation, Draft B, a trust indenture.

Draft A

General  

1. The corporation will distribute its income for each tax year at a time and in a manner as not to become subject to the tax on undistributed income imposed by section 4942 of the Internal Revenue Code, or the corresponding section of any future federal tax code.
2. The corporation will not engage in any act of self-dealing as defined in section 4941(d) of the Internal Revenue Code, or the corresponding section of any future federal tax code.
3. The corporation will not retain any excess business holdings as defined in section 4943(c) of the Internal Revenue Code, or the corresponding section of any future federal tax code.
4. The corporation will not make any investments in a manner as to subject it to tax under section 4944 of the Internal Revenue Code, or the corresponding section of any future federal tax code.
5. The corporation will not make any taxable expenditures as defined in section 4945(d) of the Internal Revenue Code, or the corresponding section of any future federal tax code.

Draft B

Any other provisions of this instrument notwithstanding, the trustees shall distribute its income for each tax year at a time and in a manner as not to become subject to the tax on undistributed income imposed by section 4942 of the Internal Revenue Code, or the corresponding section of any future federal tax code.

Any other provisions of this instrument notwithstanding, the trustees will not engage in any act of self-dealing as defined in section 4941(d) of the Internal Revenue Code, or the corresponding section of any future federal tax code; nor retain any excess business holdings as defined in section 4943(c) of the Internal Revenue Code, or the corresponding section of any future federal tax code; nor make any investments in a manner as to incur tax liability under section 4944 of the Internal Revenue Code, or the corresponding section of any future federal tax code; nor make any taxable expenditures as defined in section 4945 (d) of the Internal Revenue Code, or the corresponding section of any future federal tax code.

Effect of state law.   A private foundation's governing instrument will be considered to meet these charter requirements if valid provisions of state law have been enacted that:

1. Require it to act or refrain from acting so as not to subject the foundation to the taxes imposed on prohibited transactions, or
2. Treat the required provisions as contained in the foundation's governing instrument.

The IRS has published a list of states with this type of law. The list is in Revenue Ruling 75-38, 1975-1 CB 161(or later update).

Public Charities

A private foundation is any organization described in section 501(c)(3), unless it falls into one of the categories specifically excluded from the definition of that term in section 509(a), which lists four basic categories of exclusions. These categories are discussed under the Section 509(a) headings that follow this introduction.

If your organization falls into one of these categories, it is not a private foundation and you should state this in Part III of your application for recognition of exemption (Form 1023).

If your organization does not fall into one of these categories, it is a private foundation and is subject to the applicable rules and restrictions until it terminates its private foundation status. Some private foundations also qualify as private operating foundations; these are discussed near the end of this chapter.

Generally speaking, a large class of organizations excluded under section 509(a)(1) and all organizations excluded under section 509(a)(2) depend upon a support test. This test is used to assure a minimum percentage of broad-based public support in the organization's total support pattern. Thus, in the following discussions, when the one-third support test (see Qualifying As Publicly Supported, later) is referred to, it means the following fraction normally must equal at least one-third:

	Qualifying support
	Total support

numerator of the fraction) or excluding items of support from total support (the denominator of the fraction) may decide whether an organization is excluded from the definition of a private foundation, and thus from the liability for certain excise taxes. So it is very important to classify items of support correctly.

Excise tax on excess benefit transactions.    A person who benefits from an excess benefit transaction such as compensation, fringe benefits, or contract payments from a section 501(c)(3) or 501(c)(4) organization may have to pay an excise tax under section 4958. A manager of the organization may also have to pay an excise tax under section 4958. These taxes are reported on Form 4720, Return of Certain Excise Taxes on Charities and Other Persons Under Chapters 41 and 42 of the Internal Revenue Code.

The excise taxes are imposed if an applicable tax-exempt organization provides an excess benefit to a disqualified person and that benefit exceeds the value of the benefit an organization received in the exchange.

There are three taxes under section 4958. Disqualified persons are liable for the first two taxes and certain organization managers are liable for the third tax.

Taxes imposed on excess benefit transactions apply to transactions occurring on or after September 14, 1995. However, these taxes do not apply to a transaction pursuant to a written contract that was binding on September 13, 1995, and at all times thereafter before the transaction occurred.

Tax on disqualified persons.   An excise tax equal to 25% of the excess benefit is imposed on each excess benefit transaction between an applicable tax-exempt organization and a disqualified person. The disqualified person who benefitted from the transaction is liable for the tax. If the 25% tax is imposed and the excess benefit transaction is not corrected within the taxable period, an additional excise tax equal to 200% of the excess benefit is imposed.

If a disqualified person makes a payment of less than the full correction amount, the 200% tax is imposed only on the unpaid portion of the correction amount. if more than one disqualified person received an excess benefit from an excess benefit transaction, all such disqualified persons are jointly and severally liable for the taxes.

To avoid the 200% tax, a disqualified person must correct the excess benefit transaction during the taxable period. The taxable period begins on the date the transaction occurs and ends on the earlier of the date the statutory notice of deficiency is issued or the section 4958 taxes are assessed. The 200% tax is abated (refunded if collected) if the excess benefit transaction is corrected within a 90-day correction period beginning on the date a statutory notice of deficiency is issued.

Tax on organization managers.   An excise tax equal to 10% of the excess benefit is imposed on an organization manager who knowingly participated in an excess benefit transaction, unless such participation was not willful and was due to reasonable cause. This tax may not exceed $10,000 with respect to any single excess benefit transaction. There is also joint and several liability for this tax. A person may be liable for both the tax paid by the disqualified person and the organization manager tax.

An organization manager is any officer, director, or trustee of an applicable tax-exempt organization, or any individual having powers or responsibilities similar to officers, directors, or trustees of the organization, regardless of title. An organization manager is not considered to have participated in an excess benefit transaction where the manager has opposed the transaction in a manner consistent with the fulfillment of the manager's responsibilities to the organization. For example, a director who votes against giving an excess benefit would ordinarily not be subject to the 10% tax.

A person participates in a transaction knowingly if the person has actual knowledge of sufficient facts so that, based solely upon such facts, the transaction would be an excess benefit transaction. Knowing does not mean having reason to know. The organization manager ordinarily will not be considered knowing if, after full disclosure of the factual situation to an appropriate professional, the organization manager relied on the professional's reasoned written opinion on matters within the professional's expertise or if the manager relied on the fact that the requirements for the rebuttable presumption of reasonableness have been satisfied. Participation by an organization manager is willful if it is voluntary, conscious, and intentional. An organization manager's participation is due to reasonable cause if the manager has exercised responsibility on behalf of the organization with ordinary business care and prudence.

Excess benefit transaction.   An excess benefit transaction is a transaction in which an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of any disqualified person, and the value of the economic benefit provided by the organization exceeds the value of the consideration (including the performance of services) received for providing such benefit.

To determine whether an excess benefit transaction has occurred, all consideration and benefits exchanged between a disqualified person and the applicable tax-exempt organization, and all entities it controls, are taken into account. For purposes of determining the value of economic benefits, the value of property, including the right to use property, is the fair market value. Fair market value is the price at which property, or the right to use property, would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy, sell or transfer property or the right to use property, and both having reasonable knowledge of relevant facts.

Correcting the excess benefit.   An excess benefit transaction is corrected by undoing the excess benefit to the extent possible, and by taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.

A disqualified person corrects an excess benefit by making a payment in cash or cash equivalents, excluding payment by a promissory note, equal to the correction amount to the applicable tax-exempt organization. The correction amount equals the excess benefit plus the interest on the excess benefit. The interest rate may be no lower than the applicable federal rate.

A disqualified person may, with the agreement of the applicable tax-exempt organization, make a payment by returning the specific property previously transferred in the excess transaction. In this case, the disqualified person is treated as making a payment equal to the lesser of:

• The fair market value of the property on the date the property is returned to the organization, or
• The fair market value of the property on the date the excess benefit transaction occurred.

If the payment resulting from the return of property is less than the correction amount, the disqualified person must make an additional cash payment to the organization equal to the difference.

If the payment resulting from the return of the property exceeds the correction amount described above, the organization may make a cash payment to the disqualified person equal to the difference.

Applicable tax-exempt organization.   An applicable tax-exempt organization is a section 501(c)(3) or 501(c)(4) organization that is tax-exempt under section 501(a), or was such an organization at any time during a five-year period ending on the day of the excess benefit transaction.

An applicable tax-exempt organization does not include:

• A private foundation as defined in section 509(a),
• A governmental entity that is exempt from (or not subject to) taxation without regard to section 501(a), or
• A foreign organization, recognized by the IRS or by treaty, that receives substantially all of its support (other than gross investment income) from sources outside the United States.

An organization is not treated as a section 501(c)(3) or 501(c)(4) organization for any period covered by a final determination that the organization was not tax-exempt under section 501(a), but only if the determination was not based on private inurement or one or more excess benefit transactions.

Disqualified person.   A disqualified person is any person, with respect to any transaction, in a position to exercise substantial influence over the affairs of the applicable tax-exempt organization at any time during a five-year period ending on the date of the transaction. Persons who hold certain powers, responsibilities, or interests are among those who are in a position to exercise substantial influence over the affairs of the organization. This includes, for example, voting members of the governing body, and persons holding the power of:

• Presidents, chief executives, or chief operating officers.
• Treasurers and chief financial officers.

A disqualified person also includes certain family members of a disqualified person, and 35% controlled entities of a disqualified person.

Family members.   Family members of a disqualified person include a disqualified person's spouse, brothers or sisters (whether by whole or half-blood), spouses of brothers or sisters (whether by whole or half-blood), ancestors, children (including a legally adopted child), grandchildren, great grandchildren, and spouses of children, grandchildren, and great grandchildren (whether by whole or half-blood).

35% controlled entity.   The term 35% controlled entity means:

1. A corporation in which a disqualified person owns more than 35% of the total combined voting power,
2. A partnership in which such persons own more than 35% of the profits interest, or
3. A trust or estate in which such persons own more than 35% of the beneficial interest.

In determining the holdings of a business enterprise, any stock or other interest owned directly or indirectly shall apply.

Persons not considered to have substantial influence.   Persons who are not considered to be in a position to exercise substantial influence over the affairs of an organization include:

• An employee who receives benefits that total less than the highly compensated amount in section 414(q)(1)(B)(i) and who does not hold the executive or voting powers mentioned earlier in the discussion on Disqualified person, is not a family member of a disqualified person, and is not a substantial contributor,
• Tax-exempt organizations described in section 501(c)(3), and
• Section 501(c)(4) organizations with respect to transactions engaged in with other section 501(c)(4) organizations.

Facts and circumstances.   The determination of whether a person has substantial influence over the affairs of an organization is based on all the facts and circumstances. Facts and circumstances that show a person has substantial influence over the affairs of an organization include, but are not limited to, the following.

• The person founded the organization.
• The person is a substantial contributor to the organization under the section 507(d)(2)(A) definition, only taking into account contributions to the organization for the past 5 years.
• The person's compensation is primarily based on revenues derived from activities of the organization that the person controls.
• The person has or shares authority to control or determine a substantial portion of the organization's capital expenditures, operating budget, or compensation for employees.
• The person manages a discrete segment or activity of the organization that represents a substantial portion of the activities, assets, income, or expenses of the organization, as compared to the organization as a whole.
• The person owns a controlling interest (measured by either vote or value) in a corporation, partnership, or trust that is a disqualified person.
• The person is a non-stock organization controlled directly or indirectly by one or more disqualified persons.

Facts and circumstances tending to show that a person does not have substantial influence over the affairs of an organization include, but are not limited to, the following.

• The person has taken a vow of poverty.
• The person is an independent contractor whose sole relationship to the organization is providing professional advice (without having decision-making authority) with respect to transactions from which the independent contractor will not economically benefit.
• Any preferential treatment the person receives based on the size of the person's donation is also offered to others making comparable widely solicited donations.
• The direct supervisor of the person is not a disqualified person.
• The person does not participate in any management decisions affecting the organization as a whole or a discrete segment of the organization that represents a substantial portion of the activities, assets, income, or expenses of the organization, as compared to the organization as a whole.

In the case of multiple affiliated organizations, the determination of whether a person does or does not have substantial influence is made separately for each applicable tax-exempt organization. A person may be a disqualified person with respect to transactions with more than one organization.

Date excess benefit transaction occurs.   An excess benefit transaction occurs on the date the disqualified person receives the economic benefit from the organization for federal income tax purposes. However, when a single contractual arrangement provides for a series of compensation payments or other payments to a disqualified person during the disqualified person's tax year (or part of a tax year), any excess benefit transaction with respect to these payments occurs on the last day of the tax year (or if the payments continue for part of the year, the date of the last payment in the series).

In the case of benefits provided to a qualified pension, profit-sharing, or stock bonus plan, the transaction occurs on the date the benefit is vested. In the case of the transfer of property subject to a substantial risk of forfeiture, or in the case of rights to future compensation or property, the transaction occurs on the date of the property, or the rights to future compensation or property, is not subject to a substantial risk of forfeiture. Where the disqualified person elects to include an amount in gross income in the tax year of transfer under section 83(b), the excess benefit transaction occurs on the date the disqualified person receives the economic benefit for federal income tax purposes.

Reasonable compensation.   Reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circumstances. The section 162 standard will apply in determining the reasonableness of compensation. The fact that a bonus or revenue-sharing arrangement is subject to a cap is a relevant factor in determining reasonableness of compensation.

To determine the reasonableness of compensation, all items of compensation provided by an applicable tax-exempt organization in exchange for performance of services are taken into account in determining the value of compensation (except for economic benefits that are disregarded under the discussion, Disregarded benefits, later). Items of compensation include:

• All forms of cash and noncash compensation, including salary, fees, bonuses, severance payments, and deferred compensation that is earned and vested, whether or not funded and whether or not paid under a deferred compensation plan that is a qualified plan under section 401(a),
• The payment of liability insurance premiums for, or the payment or reimbursement by the organization of taxes or certain expenses under section 4958, unless excludable from income as a de minimis fringe benefit under section 132(a)(4),
• All other compensatory benefits, whether or not included in gross income for income tax purposes,
• Taxable and nontaxable fringe benefits, except fringe benefits described in section 132, and
• Foregone interest on loans.

An economic benefit is not treated as consideration for the performance of services unless the organization providing the benefit clearly indicates its intent to treat the benefit as compensation when the benefit is paid.

An applicable tax-exempt organization (or entity that it controls) is treated as clearly indicating its intent to provide an economic benefit as compensation for services only if the organization provides written substantiation that is contemporaneous with the transfer of the economic benefits under consideration. Ways to provide contemporaneous written substantiation of its intent to provide an economic benefit as compensation include:

• The organization produces a signed written employment contract,
• The organization reports the benefit as compensation on an original Form W-2, Form 1099 or Form 990, or on an amended form filed before starting an IRS examination, or
• The disqualified person reports the benefit as income on the person's original Form 1040 or on an amended form filed before starting an IRS examination.
  Exception. If the economic benefit is excluded from the disqualified person's gross income for income tax purposes, the applicable tax-exempt organization is not required to indicate its intent to provide an economic benefit as compensation for services.

Rebuttable presumption that a transaction is not an excess benefit transaction.   Payments under a compensation arrangement are presumed to be reasonable and the transfer of property (or right to use property) is presumed to be at fair market value, if the following three conditions are met.

• The transaction is approved by an authorized body of the organization (or an entity it controls) which is composed of individuals who do not have a conflict of interest concerning the transaction.
• Before making its determination, the authorized body obtained and relied upon appropriate data as to comparability. (There is a special safe harbor for small organizations. If the organization has gross receipts of less than $1 million, appropriate comparability data includes data on compensation paid by three comparable organizations in the same or similar communities for similar services.)
• The authorized body adequately documents the basis for its determination concurrently with making that determination. The documentation should include:

1. The terms of the approved transaction and the date approved,
2. The members of the authorized body who were present during debate on the transaction that was approved and those who voted on it,
3. The comparability data obtained and relied upon by the authorized body and how the data was obtained,
4. Any actions by a member of the authorized body having conflict of interest, and
5. Documentation of the basis of the determination before the later of the next meeting of the authorized body or 60 days after the final actions of the authorized body are taken, and approval of records as reasonable, accurate and complete within a reasonable time thereafter.

Disregarded benefits.   The following economic beneifts are disregarded for section 4958 purposes.

• Nontaxable fringe benefits that are excluded from income under section 132.
• Benefits provided to a volunteer for the organization if the benefit is provided to the general public in exchange for a membership fee or contribution of $75 or less.
• Benefits provided to a member of an organization due to the payment of a membership fee or to a donor as a result of a deductible contribution, if a significant number of disqualified persons make similar payments or contributions and are offered a similar economic benefit.
• Benefits provided to a person solely as a member of a charitable class that the applicable tax-exempt organization intends to benefit as part of the accomplishment of its exempt purpose.
• A transfer of an economic benefit to or for the use of a governmental unit, as defined in section 170(c)(1), if exclusively for public purposes.

Special exception for initial contracts.   Section 4958 does not apply to any fixed payment made to a person under an initial contract.

A fixed payment is an amount of cash or other property specified in the contract, or determined by a fixed formula that is specified in the contract, which is to be part of or transferred in exchange for the provision of specified services or property.

A fixed formula may, generally, incorporate an amount that depends upon future specified events or contingencies, as long as no one has discretion when calculating the amount of a payment or deciding whether to make a payment (such as a bonus).

An initial contract is a binding written contract between an applicable tax-exempt organization and a person who was not a disqualified person immediately before entering into the contract.

A binding written contract providing it may be terminated or cancelled by the applicable tax-exempt organization without the other party's consent (except as a result of substantial nonperformance) and without substantial penalty, is treated as a new contract, as of the earliest date any termination or cancellation would be effective. Also, if the parties make a material change to a contract, which includes an extension or renewal of the contract (except for an extension or renewal resulting from the exercise of an option by the disqualified person), or a more than incidental change to the amount payable under the contract, it is treated as a new contract as of the effective date of the material change.

More information.   For more information, see the instructions to Forms 990 and 4720.

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