Grants for All Seasons: Details Every 501(c)(3) Should Remember
With the close of the fiscal year, every private foundation and publicly supported charity should focus closely on the numbers. Grant-making private foundations must work hard to ensure that they have made sufficient grants (the “5%”) to avoid penalty taxes, and public charities must work hard to raise the money needed to carry out their missions. The temptation at times for both grant-makers and grant-seekers is to focus on a few large grants. Unfortunately, doing so can have negative, and possibly serious, consequences for both.
The Framework
Section 501(c)(3) of the Internal Revenue Code covers two basic types of nonprofits, all of which have charitable, religious, literary, scientific, educational or other purposes that make them eligible to receive contributions that donors can deduct as charitable contributions on their annual income tax returns. Within 501(c)(3), each exempt organization is defined as either:
- a “private foundation” (if it is funded by a single individual or family or a small group of donors), or
- a “public charity” (generally, if its funding is from a large group of donors, many of whom make contributions of only one or two percent of the organization’s receipts).
The two different types are subject to very different rules. A private foundation is prohibited from engaging in most financial transactions with its officers, directors, trustees and substantial donors, and is subject to certain very strict grant-making and distribution requirements. A public charity is subject to far fewer technical restrictions as long as it operates in furtherance of its exempt purposes and does not significantly benefit private interests. Yet both private foundations and public charities can be negatively impacted if they make or accept grants without being sensitive to a mathematical calculation referred to as the public support test.
The 1/3 Public Support Test
For a public charity to retain its favored tax-exempt status, it must demonstrate to the IRS that it serves the public on an ongoing basis. Certain organizations, such as churches, schools and hospitals, are deemed inherently public, but other exempt organizations demonstrate their status by maintaining a broad donor base, or by maintaining a close tie to an organization that itself has “public” status. Organizations that take in fees for performing their services use one calculation, and those that primarily receive donations use another, but both must demonstrate to the IRS that they are receiving at least one-third of their support from what these tests define as “public” sources on a rolling five-year basis. After a limited grace period, an organization that fails to pass the test will become a private foundation, regardless of what its IRS determ ination letter indicates.
The problem is that only relatively small gifts count as “public.” In calculating the support for an organization funded by gifts, a contribution from a member of the general public - or from a single private foundation - is counted toward the one-third minimum only to the extent that the contribution does not exceed two percent (2%) of the organization’s total support for the period. For example, if the total support of a nonprofit is $500,000 during the five-year test period, and $50,000 of that amount represents the aggregate contributions from Jane Doe, only $10,000 of Jane Doe’s $50,000 contribution is “public support” because of the 2% total support limitation on contributions from a single member of the general public. Grants from one public charity to another are generally not subject to the 2% limitation, unless the first charity received the money from a donor who earmarked it for the second charity. For service-providing public charities, the limit is one percent (1%) and donations by officers, trustees and directors are never considered “public” support.
New organizations are not required to meet this 1/3 requirement for the first five years of their existence since the IRS recognizes that it will be close to impossible for a new nonprofit to develop a broad base of financial support in less than a few years. Unfortunately, this sometimes allows the leaders of these new charities to lose sight of the test given the always pressing need to bring in money to support operations.
Why is this important to a private foundation?
A grant-making private foundation must spend approximately 5% of its assets each year on grants, and the easiest grants to make are those to public charities. This is because no further work is required of the foundation if the grant recipient is publicly supported. The private foundation may simply write a check and then report the amount and the grantee on its Form 990-PF for that year.
If instead a private foundation makes a grant to another private foundation (or to a foreign charity or, in the case of a “program-related investment,” a for-profit enterprise), the grant will be considered a “taxable expenditure” unless the grant is made subject to a set of procedures known as “expenditure responsibility.” A grant made to an organization that has lost its public charity status by flunking the 1/3 test, or to an organization that will flunk the test because of the size of the grant (and therefore become a private foundation), will in many circumstances be a taxable expenditure that must be reported on the foundation’s Form 990-PF for that year, causing the foundation to incur a penalty tax equal to 20% of the grant amount.
What does expenditure responsibility require?
The expenditure responsibility rules require a private foundation to “exert all reasonable efforts” and to “establish adequate procedures,” which should include the following:
- The foundation should conduct a pre-grant inquiry with respect to the grantee, including a reasonable investigation to ensure that the proposed grant has a charitable purpose and that the grantee is able to perform the proposed activity;
- Each grant must be made subject to a written agreement between the grantor and grantee that addresses certain requirements in the regulations (such as the charitable purpose of the grant, repayment of any funds not used for that purpose, access to relevant records, annual reports and prohibition on use of funds for political or non-charitable purposes);
- The grantee should maintain grant funds in a separate account so that charitable monies are separate from non-charitable monies;
- The foundation must obtain annual reports and a final written report from the grantee organization concerning how the grant was spent; and
- The grantor must provide information concerning such grants on its annual Form 990-PF.
Note that amounts distributed by a foundation to other non-operating foundations or controlled operating foundations, although subject to the expenditure responsibility requirements, will not be credited toward the foundation’s minimum distribution requirement, unless the grantee foundation commits to distributing the grant amount by the end of the succeeding year and the grantor foundation can document that such subsequent distribution was made.
What should be done?
For the above reasons, it is important for a private foundation to look at more than 501(c)(3) status to determine eligible grantees. Private foundations may generally rely on a new public charity’s determination letter from the IRS with respect to its public charity status. However, a foundation may not rely on a determination letter if it is responsible (by virtue of the grant it is making) for causing the grantee to flunk the 1/3 public support test. In such cases, the foundation should consider either exercising expenditure responsibility or reducing the size of its grant. In any case, a private foundation should verify the status of each grantee prior to each grant (or installment). The IRS has launched an online search tool, Exempt Organizations Select Check, available at http://www.irs.gov/Charities-&-Non-Profits/Exempt-Organizations-Select-Check, for this purpose.
Public charities wishing to preserve their status generally have no alternative but to closely monitor their sources of support. Regular consultation with the charity’s accountant or chief financial officer can help the charity tailor its fundraising to help it meet the test, even though this may require it to refuse a large grant from time to time.
In this context, small truly is beautiful.
