purposes, the grant is not a taxable expenditure
by the private foundation if the governmental
agency satisfies the Service in advance that its
grant-making program:

1) Is in furtherance of exempt purposes under
section 501(c)(3),

2) Requires the individual grantee to submit
annual progress reports, and

3) Requires the organization to investigate jeop-
ardized grants.

Earmarked grants to individuals. A grant by a
private foundation to an individual is a taxable
expenditure if:

1) The grant is earmarked to be used for a
purpose described earlier under Taxable
Expenditures,

2) The grantor foundation causes the grantee,
through an oral or written agreement, to
engage in a prohibited activity and the grant is
in fact a taxable expenditure, and

3) The grant is made for a purpose other than a
purpose of an organization organized and
operated exclusively for religious, charitable,
scientific, literary, or educational purposes,
the fostering of national or international ama-
teur sports competition (but only if no part of
its activities involve providing athletic facilities
‘or equipment), or the prevention of cruelty to
children or animals.

A grant by a private foundation is earmarked if
it is given under an agreement (oral or written) that
the grant will be used for specific purposes.

Grants to organizations (including loans and
program-related investments) are taxable expendi-
tures, unless the recipients are public charities
described in section 509(a)(1), (2), or (3), or
unless the private foundation exercises
expenditure responsibility with respec
grant. However, expenditure responsi
required if the grantee organization meets the
exception requirements described earlier under
Influencing elections and carrying on voter
registration drives.

Reliance by grantors on public charity status
of grantees. As discussed in the preceding para-
graph, a private foundation need not exercise
expenditure responsibility with respect to a grant if
the grant is made to a public charity described in
section 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
section 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
section 509(a)(1), (2), or (3) may be affected
pending verification of the continued classification
of the organization. Notice to this effect will be
made in a public announcement by the Service. In
these cases the effect of grants and contributions
made after the date of the announcement will
depend on the statutory qualification of the organi-
zation as an organization described in section
509(a)(1), (2), or (3).

Note. The preceding paragraph shall not apply
if the grantor or contributor:

1) Had knowledge of the revocation of the ruling
or determination letter classifying the organi-
zation as an organization described in section
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

20

and material change on the part of the organi-
zation that gave rise to the revocation.

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 unu-
‘sual grant.

Expenditure responsibility means that the
foundation exerts all reasonable efforts and estab-
lishes 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.

Pre-grant inquiry. \f 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.

Terms of grants. To meet the expenditure
responsibility requirements, each grant must be
made subject to a written commitment signed by
an appropriate officer, director, or trustee of the
grantee organization. This commitment must
include the following agreements by the grantee:

1) To repay any amount not used for the
purposes of the grant,

2) To submit full and complete annual reports to
the grantor foundation on the manner in which
the funds are spent and the progress made in
accomplishing the purposes of the grant,

3) To keep records of receipts and expenditures
and to make its books and records available
to the grantor at reasonable times, and

4) Not to use any of the funds to influence legis-
lation, to influence the outcome of elections,
to carry on voter registration drives, to make
grants to individuals or other organizations, or
to undertake any nonexempt activity, when
such use of the funds would be a taxable
expenditure if made directly by the foundation.

Terms of program-related investment. To
meet the expenditure responsibility requirements
in making a program-related investment, a private
foundation must require that each investment be
made subject to a written commitment signed by
an appropriate officer, director, or trustee of the
recipient organization’

The commitment should specify the purpose of
the investment and should contain an agreement
by the organization:

1) To use all amounts received from the private
foundation only for the purposes of the
investment and to repay any amount not used
for those purposes, provided that, for equity
investments, the repayment is within the limi-
tations concerning distributions to holders of
equity interests,

2) To submit, at least once a year, a full and
complete financial report of the type ordinarily
required by commercial investors under simi-
lar circumstances and a statement that it has
complied with the terms of the investment,

3) To keep adequate books and records and to
make them available to the private foundation
at reasonable times, and

4) Not to use any of the funds to carry on propa-
ganda, influence legislation, influence the
outcome of any public elections, carry on
voter registration drives, or, when the recipient
is a private foundation, to make grants that do
not comply with the requirements regarding
individual grants or expenditure responsibility.

Certain grants to foreign organizations.
Grants made to foreign organizations, other than
an organization described in section 509(a)(1), (2),
or (3), are subject to the same restrictions on the
use of the grant as those imposed on domestic
private foundations. These restrictions may be
phrased in appropriate terms under foreign law or
custom and ordinarily will be considered sufficient
if an affidavit or opinion of counsel (of the grantor
or grantee) is obtained stating that, under foreign
law or custom, the agreement imposes the same
restrictions on the use of the grant as those
imposed on a domestic private foundation.

Special rules for grants by foreign private
foundations. The failure of a foreign private
foundation to comply with the restrictions imposed
‘on grants will not constitute an act or failure to act
that is a prohibited transaction under section
4948(c) of the Code.

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 achiev-
ing 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.

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.

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.

Violations of expenditure responsi
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.

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


For purposes of determining gain on property
acquired by gift after December 31, 1969, the
basis of the property is its basis in the hands of
the donor at the time of the gift.

Normal basis rules are used in determining a
loss on disposition, For purposes of determining a
loss, the basis of property acquired by gift is the
lesser of the donor’s basis at the time of the gift or
the fair market value at the time of the gift.

Example 1. A private foundation held depre-
ciable real property on December 31, 1969, that
had a basis of $127,500 and a depreciable basis
of $102,000. The fair market value of the property
on that date was $100,000. For tax years 1970
through 1984 the foundation was allowed $61,200
depreciation, figured under the straight tine
method using a 25—year useful life (4%) on the
$102,000 basis. The property was sold on January
2, 1985, for $175,000. Since the fair market value
on December 31, 1969 ($100,000) minus
adjustments ($61,200 depreciation), or $38,800, is
less than the actual adjusted basis on the date of
sale ($66,300 ($127,500 — $61,200)), a gain of
$108,700 is recognized ($175,000 sales price
minus the greater of $66,300 or $38,800).

Example 2. A private foundation held depre-
ciable real property on December 31, 1969, val-
ued at $110,000, with a basis of $102,000 and a
depreciable basis of $82,000. It was allowed
$26,240 depreciation for years 1970 through
1977, figured under the straight line method using
a 25—year useful life on the $82,000 depreciable
basis. The property was sold on January 2, 1978,
for $80,000. The fair market value minus
adjustments after 1969 ($110,000 — $26,240 =
$83,760) is greater than the basis of the property
on the date of disposition ($102,000 — $26,240 =
$75,760). The greater figure would be used to fig-
ure a gain. Because basis for determining a gain is
greater than the selling price, there is no gain. The
basis for determining a loss is the actual basis on
the date of disposition ($75,760). Because this fig-
ure is less than the selling price, there is no loss.
In this situation there is no recognized gain or loss
for section 4940 purposes.

Example 3. On January 1, 1987, a private
foundation received a gift of rental property with a
fair market value of $100,000. At the time of the
gift, the adjusted basis of the donor was $20,000.
On January 2, 1987, the private foundation sold
the property for $99,000. The gain to be recog-
nized from the sale of donated property is $79,000
{820,000 sales price minus $20,000 donor's

yasis).

Example 4. On February 1, 1987, a private
foundation received a gift of rental property with a
fair market value of $100,000. At the time of the
gift, the adjusted basis of the donor was $105,000.
On February 2, 1987, the private foundation sold
the property for $99,000. The loss to be recog-
nized from the sale of donated property is $1,000
($100,000 fair market value minus $99,000 sales
price).

Securities listed on recognized stock
exchange. The fair market value for figuring
basis for determining gain on the sale or exchange
of stocks and bonds traded on a stock exchange,
in an over-the-counter market, or otherwise, is the
mean between the highest and lowest quoted sell-
ing prices on the valuation date.

Example. A private foundation bought 100
shares of common stock of the M Corporation on
February 27, 1968, for $4,000. The foundation
‘sold the stock on December 27, 1987, for
$10,000. At all times the stock was registered and
listed on a recognized securities exchange. On
December 31, 1969, sales of M Corporation
common stock on the exchange ranged from a
high of $45 a share to a low of $40 a share,
whereas the closing price was $44 a share. There
were no adjustments to basis for the period the
‘stock was held. The foundation’s capital gain net
income is figured as follows:

14

Amount received from sale

$10,000
Minus the greater of (1) or (2):
1) Fair market value as of 12/31/69
$45 + $40 x 100 shares = $4,250
2
2) Adjusted basis $4,000 __ 4,250

Capital gain net income

Deductions. In determining net investment
income, a private foundation may deduct from
gross investment income all the ordinary and nec-
essary expenses paid or incurred for the produc-
tion or collection of gross investment income or
for the management, conservation, or mainte-
nance of property held for the production of
income, subject to the modifications given later.
Expenses include the part of the foundation’s
operating expenses that is paid or incurred for the
production or collection of gross investment
income. A private foundation’s operating
expenses include compensation of officers, other
salaries and wages of employees, outside profes-
sional fees, interest, rent, and taxes on property
used in the foundation’s operations. However, the
tax on net investment income may not be
deducted.

If any expenses, including salaries and
compensation, are incurred for both investment
purposes and exempt purposes, they must be
allocated between the investment activities and
the exempt activities. Expenses paid or incurred
for exempt functions are not deductible in figuring
net investment income. Also, any expenses that
are taken into account in figuring the tax on
unrelated business income may not be deducted
in figuring net investment income.

No deduction is allowed for any expense that
was not incurred for the purposes stated earlier.
Thus, no deduction is allowed for charitable contri-
butions, net operating losses, or any of the special
deductions for corporations.

Deduction modifications. The following modifi-
cations must be made to otherwise allowable
deductions in arriving at net investment income:

1) Depreciation is allowed only on the basis of
the straight line method,

2) Depletion is allowed only on the basis of the
cost depletion method,

3) The basis used in figuring depreciation or
depletion is the basis determined under nor-
mal basis rules, without regard to the fair mar-
ket value on December 31, 1969 (see Basis,
earlier), and

4) The deduction for expenses paid or incurred
in any tax year for the production of gross
investment income earned as an incident to a
charitable function cannot be greater than the
income earned from the function that is
includible as gross investment income for the
year. For example, when rental income is inci-
dentally realized in 1988 from historic
buildings held open to the public, deductions
paid or incurred in 1988 for the production of
that income will be limited to the amount of
rental income includible as gross investment
income for 1988.

Chapter V

Disqualified Persons

For the rules discussed in this publication, the
following persons are considered 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 unin-
corporated 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), (8), 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 (Chapter X), another private
foundation which either
a) is effectively controlled, directly or indi-
rectly, by the same person or persons who
control the private foundation in question,
or

b) receives substantially all of its contribu-
tions, 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 (Chapter VIII), a government official
(as defined later).

Attribution of ownership. indirect ownership
of stock in a corporation, profits interest in a part-
nership, 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 corpora-
tion or more than 20% of the profits or benefi-
cial 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

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 sharehold-
ers, 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 (5), (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 man-
ager, or a 20% owner of the combined voting
power, profits interest, or beneficial interest,
of a substantial contributor.

3) An individual's family includes only those
persons described in A member of the family,
later, and

4) Any stockholdings, profits interest, or benefi-
cial interest, that have been counted once
(whether because of actual or constructive


1) 0.65% of the sum of the foundation’s net
assets for the tax year and the immediately
preceding 2 tax years, over

2) The total amount of grant administrative
expenses paid during the 2 preceding tax
years that were included as qualifying distribu-
tions. However, the amount of grant adminis-
trative expenses taken into account for any
preceding tax year that began before 1985 is
limited to 0.65% of the foundation’s net
assets for that year.

For this purpose, “grant administrative
expenses” are any administrative expenses allo-
cable to the making of contributions, gifts, or
grants that are qualifying distributions. “Net
assets” are the combined fair market values of all
the foundation's assets other than those used or
held for use in carrying out exempt purposes,
minus the amount of indebtedness incurred to buy
these assets.

Borrowed funds. If a private foundation borrows
money during a tax year to make a charitable
expenditure, then a qualifying distribution is con-
sidered made only at the time the borrowed funds.
are actually distributed for a charitable purpose.

Control. An organization is controlled by a foun-
dation or by one or more disqualified persons if
any of these persons may, by combining their
votes or positions of authority, require the organi-
zation to make an expenditure or prevent the
organization from making an expenditure, regard-
less of the method by which control is exercised
or exercisable. Control of a donee organization is
determined without regard to any conditions
imposed on the donee as part of the distribution or
any other restrictions as to how the distribution
may be used unless the conditions and restric-
tions are imposed on a distribution of net assets to
terminate private foundation status (as discussed
in Chapter III).

In general, it is the donee, not the distribution,
that must be controlled by the distributing private
foundation to disqualify an otherwise qualifying
distribution. If a foundation provides support to an
organization and imposes budgetary procedures
‘on that organization, this will not, of itself,
constitute control of the donee. Budgetary proce-
dures include expenditure responsibility to require
reports from the donee organization on:

1) The use of the funds,
2) Compliance with the terms of the grant, and

3) The progress made by the donee toward
achieving the purposes for which the grant
was made.

The controlled organization does not have to be
a private foundation. It may be any kind of exempt
or nonexempt organization including a school,
hospital, operating foundation, or social welfare
organization.

Changes in asset use. If an asset not used or
held for use for public or charitable, educational,
etc. purposes is later converted to exempt use,
the foundation may treat the conversion as a qual-
ifying distribution. The amount of the qualifying
distribution is the fair market value of the con-
verted assets on the conversion date. For deter-
mining fair market value of the assets, see
Valuation of Assets, discussed earlier.

The date a foundation adopts and immediately
begins to implement a plan to convert property
from nonexempt to exempt uses is the conversion
date even if the actual conversion occurs later.

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

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:

24

1) The amount will actually be paid for the spe-
cific 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 satis-
fies the cash distribution test (discussed
later).

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 particu-
lar charitable projects or program-related
investments, or where grants are made as part of
a matching-grant program. An example of a spe-
cific 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.

Cash distribution test. The foundation satis-
fies 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 foun-
dation’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.

Start-up period minimum amount. Generally,
the start-up period consists of the 4 tax years
following the tax year in which the foundation was
created (or otherwise became a private founda-
tion). 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 foun-
dation must actually distribute during its 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 par-
ticular 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 distrib-
uted the start-up period minimum amount. How-
ever,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
5‘ 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 distrib-
utable 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 reasona-
ble estimate of its distributable amount for that
fourth tax year.

Full payment period minimum amount. The
foundation’s full-payment period includes each tax
year that begins after the end of the start-up
period. The full payment period minimum amount,
the amount that the foundation must actually
distribute in cash or its equivalent in each tax year
of the full-payment period, and must be not less
than 100% of its distributable amount, described
earlier, for that year, without regard to the
Carryover of excess qualifying distributions,
discussed later.

However, if the foundation distributes in a tax
year an amount in excess of the full-payment
period minimum amount for that year, the excess
reduces the full-payment period minimum amount
for the 5 tax years immediately following the tax
year in which the excess distribution is made. The
excess is applied to reduce the full-payment
period minimum amount in each successive tax
year of the 5-year period, in order, until completely
used up.

Failure to distribute minimum amounts. If
the foundation fails to actually distribute the start-
up period minimum amount during the start-up
period or, generally, if it fails to distribute the full-
payment period minimum amount during a tax
year of the full-payment period, then any set-aside
made by the foundation during the appropriate
period will not be treated as a qualifying distribu-
tion unless it was approved by the IRS under the
suitability test. Also, any set-aside made after
the year of such a failure to distribute a minimum
amount will be treated as a qualifying distribution
only if the Service approves it under the suitability
test.

However, if the foundation's failure to distribute
the full-payment period minimum amount during a
tax year of the full-payment period is not willful
and is due to reasonable cause, the foundation
may correct the failure. To do so, it must distribute
within the correction period (discussed earlier)
cash or its equivalent in an amount not less than
the difference between the full-payment period
minimum amount for the tax year and the amount
actually distributed during that year. The additional
distribution is treated as though it had been made
in the year in which it originally should have been
made, for purposes of meeting the cash distribu-
tion test. If a foundation fails to distribute the full-
payment period minimum amount during the
appropriate tax year because the amount can be
determined only after the end of that tax year, no
“willful failure to distribute” will occur if the foun-
dation makes an additional distribution within 5'/.
months after the end of the tax year.

Contingent set-aside. If a private foundation is
involved in litigation and may not distribute assets
or income because of a court order, it may seek
and obtain a set-aside for the purpose of making a
qualifying distribution. The amount that may be set
aside is equal to the part of the foundation’s dis-
tributable amount that is attributable to the assets
‘or income held under the court order that would
otherwise have been distributed.

If the litigation lasts more than one tax year, the
foundation may seek additional contingent set-
asides. The amounts must actually be distributed
by the last day of the tax year following the tax
year in which the proceedings end. Amounts the
foundation does not distribute by the end of that
year will be considered gross income to the foun-
dation for the following tax year.

Approval of a set-aside must be obtained from
the IRS for the set-aside to qualify under the suit-
ability test. No advance approval is required for
qualification under the cash distribution test. A
foundation must apply for Service approval by the
end of the tax year in which the amount is to be
set aside. If the foundation fails to seek approval
before that date, an otherwise proper set-aside
will not be treated as a qualifying distribution.

To obtain approval for a set-aside under the
suitability test, a foundation must write to the Inter-
nal Revenue Service, 1111 Constitution Avenue,


does not normally receive more than a third of
its support from gross investment income (see
Chapter IV) plus any excess of unrelated busi-
ness taxable income over the tax on unrelated
business income.

A “substantial part” of the foundation's support,
for purposes of (1) above, generally is a third of its
total support, figured on a combined basis for the
4 tax years immediately preceding the tax year in
question. However, if the foundation does not
meet this one-third support test, it may still qualify
as deriving a substantial part of its support from
governmental units and from the general public if
it

14) Normally receives at least 10% of its support
from these sources,

2) Satisties the “attraction of public support”
requirement by being organized and operated
to attract new and additional public or govern-
mental support on a continuous basis, and

3) Satisfies some or all of 5 public support
factors.

Substantial pubiic support is discussed in detail
in Publication 557, Tax-Exempt Status for Your
Organization.

Disqualified individual, tor purposes of the
requirements regarding composition of the gov-
erning body and officers of the foundation, means
any of the following:

1) A substantial contributor, as defined in Chap-
terV,
2) 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 unin-
corporated enterprise, which is a
substantial contributor to the foundation, or

3) A member of the family (defined in Chapter V)
of any individual described in (1) or (2).

Indirect ownership of stock in a corporation,
profits interest in a partnership, or beneficial
interest in a trust or unincorporated enterprise is
taken into account for determining a disqualified
individual under (2) above, according to the rules
explained under Attribution of ownership in Chap-
ter V.

Ruling letter required. A foundation wanting
recognition of “exempt operating foundation” sta-
tus must obtain a ruling letter from the Internal
Revenue Service determining that it has met the
specific requirements of this special status. To
claim exemption from the tax on net investment
income, the foundation should attach a copy of
this ruling letter to its annual returns, Forms
990-PF, for tax years beginning after 1984 for
which the claim for exemption is made.

To obtain the ruling letter, the foundation should
‘submit its request to Internal Revenue Service,
Assistant Commissioner (Employee Plans and
Exempt Organizations), 1111 Constitution Avenue,
Washington, DC 20224, Supporting documents
and materials with the ruling request must
demonstrate that requirements (1) through (4)
listed at the beginning of this discussion are met.
Specifically, for purposes of requirements (3) and
(4), the foundation must list all its officers and
members of its governing body for the current
year and identify any that are disqualified
individuals.

Special Rules for Certain
Foundations and Trusts
Private Nonoperating Foundation

Distributing All Contributions
Received
Contributions to a private nonoperating foundation

may qualify for the benefit of the 50% contribution
deduction limit, and donors may deduct the full

value of appreciated property, if the private nonop-
erating foundation:

1) Distributes an amount equal in value to 100%
of all contributions received in the tax year by
the 15th day of the 3rd month after the close
of its tax year,

2) Has no remaining undistributed income for the
year, and

3) Distributes only qualifying distributions that
are treated as distributions out of corpus.

Qualifying distributions cannot be made to:

1) An organization controlled directly or indirectly
by the foundation or by one or more disquali-
fied persons, or

2) A private foundation that is not an operating
foundation.

To qualify for the 50% contribution deduction,
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. A private founda-
tion is not required to trace specific contributions
of property, or amounts into which those contribu-
tions 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. The choice is discussed in
Chapter Vil under Treatment of qualifying
distributions.

The fair market value of contributed property,
determined on the date of the contribution, gener-
ally 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 bal-
ance of the fair market value of the property that
was sold to meet the 100% distribution require-
ment. 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—

1) The gross amount received on the sale, minus
reasonable selling expenses incurred, or

2) The fair market value of the contributed prop-
erty at the date of its distribution to the public
charity as the fair market value for purposes
of the 100% distribution requirement.

A taxpayer claiming a deduction for a charitable
contribution to a private nonoperating foundation
must get adequate records or other sufficient evi-
dence from the foundation showing that the foun-
dation 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.

Private Foundation Maintaining
a Common Fund

Designation by substantial contributors.
Donors to a private foundation that pools all con-
tributions received in a common fund are also eli-
gible for the 50% contribution deduction limit, and
may deduct the full value of appreciated property
(see above discussion under Private Nonoperating
Foundation Distributing All Contributions
Received), if the foundation meets certain require-
ments. The foundation must be described as a
supporting organization of a public charity (as
defined in section 509(a)(3) of the Internal Reve-
nue Code) except for the fact that any donor (or
donor’s spouse) who is a substantial contributor
has the right to designate annually the public char-
ities that are to receive the income from the

donor’s contribution to the fund and to direct (by
deed or by will) the payment to public charities of
the corpus in the common fund from the donor's
contribution.

Distribution requirements. To qualify, the
private foundation must be required by its gov-
erning instrument to distribute, and it must actually
distribute (including administrative expenses):

1) Alll of the adjusted net income of the common
fund to one or more public charities by the
15th day of the 3rd month after the close of
the tax year in which the income is realized by
the fund, and

2) All the corpus from any donor's contribution to
the fund to one or more public charities not
later than one year after the donor's death or
after the death of the donor's surviving
spouse if the surviving spouse has the right to
designate the recipients of the corpus.

Failure to designate. A private foundation will
not fail to qualify if a substantial contributor or
spouse fails to exercise the right to designate the
recipients of income or corpus of the fund, as long
as the income and corpus from the contribution
are distributed as required.

Nonexempt Trusts

Section 4947 generally subjects trusts that are not
exempt from tax to the same requirements and
restrictions that apply to private foundations if the
trusts have any unexpired interests devoted to
charitable purposes. The aim of section 4947 is to
prevent a trust of this nature from being used to
avoid the requirements and restrictions that apply
to private foundations.

In this connection, a charitable purpose includes
a religious, educational, charitable, scientific, or lit-
erary purpose, a purpose to foster national or
international sports competition (but only if there is
no provision of athletic facilities or equipment), a
purpose to prevent cruelty to children or animals,
or a gift to or for the use of a state, a possession
of the United States, or any political subdivision of
the same, the United States, or the District of
Columbia, when the gift is to be used exclusively
for public purposes.

Charitable trusts. A charitable trust described in
section 4947(a)(1) is a trust that is not tax exempt,
all of the unexpired interests of which are devoted
to one or more charitable purposes, and for which
a charitable contribution deduction was allowed
under a specific section of the Internal Revenue
Code. A charitable trust is treated as a private
foundation unless it meets the requirements for
‘one of the exclusions that classifies it as a public
charity. Thus, it is subject to the private foundation
excise tax provisions described in this publication
and the other provisions that apply to exempt
private foundations, including termination require-
ments and governing instrument requirements.
However, a charitable trust is not treated as a
charitable organization for purposes of exemption
from tax. Accordingly, the trust is subject to the
excise tax on its investment income under the
tules that apply to taxable foundations rather than
those that apply to tax-exempt foundations.

For purposes of the organizational test, when a
charitable trust seeks exemption from tax as a
charitable organization, the trust is considered
organized on the day it first becomes subject to
section 4947(a)(1). Generally, for purposes of the
special and transitional rules for excise taxes
discussed in this publication, a charitable trust will
be considered organized on the first day it has
amounts in trust for which a deduction was
allowed under the Internal Revenue Code. Under
this rule, a trust may be treated as a private foun-
dation in existence on a date governing one of the
applicable special and transitional rules even
though the trust did not otherwise become subject
to the provisions that apply to private foundations
until a later date.


Index
Abatement of section 507(c) taxes .....11
Appeal procedures .....8, 33
Assets:
For exempt purposes .....22
Use of (self-dealing) .....27
Valuation of .....23
Assets test, private foundations .....3
Capital gains and losses .....13
Charitable trusts .....5
Claims for refund or credit .....34

Classification as other than a private
foundation .....9

Governing instruments ....:
Common trust funds 3
Company scholarship programs .....18
Compensation (self-dealing) .....27
Conference and protest procedures .....34
Correction of a taxable expenditure
Credit, claims for .....34
Declaratory judgments
Deduction Modifications
Disqualified persons:

Foundation managers

Government officials

Substantial contributors .....15
Distributable amount
Elections, influencing
Endowment test .....4
Estates .....6, 7
Exceptions (self-dealing) ....
Excess business holdings tax ......
Exempt operating foundations .....4
Filing of notice .....7
Filing requirements:
Foreign foundations .....
Form 990-PF .....9
Form 4720...
Form 5227 .....9
Governing instruments .....9
Government officials (self-dealing) .....28

15

To organizations .....17, 20, 21
Gross investment income .....
Income modifications .....2
Income test .....2
Indirect self-dealing .....28
Investments:

Jeopardizing ....

Program-related

Tax on jeopardizing .....30
Investment return, minimum .....
Involuntary termination
Leases (self-dealing)
Legislation, influencing
Loans (self-dealing) ...
Minimum investment return
Net investment income ....
Nonexempt trusts .....5
Notice requirements ..
Penalties .....10
Percentage test, grants to individuals ....19
Political:

Influencing elections

Influencing legislation
Private nonoperating foundation
Private operating foundations
Program-related investments.
Public inspection .....10
Qualifying distributions .....23
Refund, claims for .
Revocable trusts
Ruling requests, grants to indivi
Sales or exchanges of property
Scholarship programs, company
Section 507:

Section 507(a)(1)

Section 507(b)(1)

Section 507(b)(2)

Section 507(c)

31

7

18

Self-dealing tax
Set-asides .....24, 25

Split-interest trusts .....
Status:

Support test
Tax:

Voluntary terminations:

Compensation .....27

Exceptions .....28
Indirect self-dealing .....27
Leases

Loans ..
Payment to a government official
Providing goods, services, or fa
Sales or exchanges of property .....
Use of income or assets .....27

6

Cash distribution test .....24
Suitability test .....24

Determination of .....1
Termination of private foundation .....10, 11
4

On excess business holdings.....
On failure to distribute income
On jeopardizing investments
On net investment income
On self-dealing .....26

On taxable expenditures .....15

Taxable expenditures .....16
Termination

Involuntary .....11

Of private foundation status
Operation as a public charity
Under Section 507(a) i}
Voluntary .....10.

Transfer of assets to a public charity .....11
Transferee foundations .....12
Valuation of assets:

Common trust funds

Section 507(b)(1)
Transfer of assets .....11

35


2) Withholds any further payments to the
grantee, after being made aware that a diver-
sion 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.

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.

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.

Violations by the grantor. In addition to the
circumstances discussed earlier concerning taxa-
ble 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.

The reports to the Internal Revenue Service
by the foundation on each expenditure responsi-
bility 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.

Exceptions to taxable expenditures. Examples
of expenditures ordinarily not treated as taxable
expenditures include:

1) Expenditures to acquire investments that gen-
erate 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 pro-
gram-related investment.

However, payment of unreasonable administra-
tive 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.

Grants to noncharitable organizations. A
private foundation cannot make a grant for a
purpose not described in section 170(c)(2)(B).
Permitted purposes are religious, charitable, scien-
tific, literary or educational purposes, fostering
national or international amateur sports
competition (but only if no part of the activities
involve providing athletic facilities or equipment),
and preventing cruelty to children or animals.
Section 501(c)(3) describes organizations that are
organized and operated exclusively for these
purposes. Grants for nonpermitted purposes are
taxable expenditures.

Accordingly, a private foundation may not make
a grant to an organization that is not described in
section 501(c)(3) unless, making the grant itself is
a direct charitable act or a program-related
investment, or the grantor is reasonably assured
that the grant will be used exclusively for the
purposes of an organization described here.

If a private foundation makes a grant that is not
a transfer of assets resulting from any liquidation,
merger, redemption, recapitalization, organization,
reorganization, or other adjustment to any organi-
zation (other than an organization described in
section 501(c)(3) that is not exclusively organized
and operated for testing for public safety), the
grantor is reasonably assured that the grant will be
used exclusively for section 170(c)(2)(B) purposes.
(described earlier) only if the grantee organization
agrees to keep these funds ina separate fund
dedicated to section 170(c)(2)(B) purposes. In
addition, the grantor must comply with the
expenditure responsibility requirements discussed
earlier.

If a private foundation makes a transfer of
assets under any liquidation, merger, etc., to any
person, the transferred assets will not be consid-
ered to be used exclusively for section
170(c)(2)(B) purposes unless the assets are trans-
ferred to a fund or organization described in
section 501(c)(3) (other than an organization
organized and operated for testing for public
safety).

Chapter VII

Taxes on Failure to
Distribute Income

Generally, section 4942 of the Internal Revenue
Code imposes an excise tax on any undistributed
income of a private foundation. An additional
excise tax will be imposed on any income remain-
ing undistributed at the end of the taxable period.

The income of the foundation must be distrib-
uted as qualifying distributions, defined later.
Private foundations must make qualifying distribu-
tions 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 distri-
butions may be carried forward for a period of 5
tax years immediately following the tax year in
which the excess was created. Special transitional
rules apply to foundations created before May 27,
1969.

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 2nd (or any succeeding) tax year following
the year earned, if the first day falls within the tax-
able 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 fail-
ure to distribute was corrected within the
correction period (described later).

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 undistrib-
uted 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 distribu-
tions of undistributed income.

Exceptions. The tax does not apply to the undis-
tributed income of a private operating foundation
or of an exempt operating foundation,

Certain long-established private foundations
that have provided long-term care facilities contin-
uously since May 26, 1969, are treated as private
operating foundations and, therefore, are not
subject to the excise tax on failure to distribute
income.

To qualify for this treatment, the foundation
must, on May 26, 1969, and continuously thereat-
ter to the end of the tax year, operate and keep up
facilities for the long-term care, comfort, mainte-
nance or education of the permanently and totally
disabled, elderly, needy widows, or children as its
principal functional purpose. In addition, the foun-
dation must meet the requirements of the
endowment test (defined in Chapter |) that
applies to private operating foundations.

An organization will meet the principal function
purpose requirement if it is organized for the prin-
cipal purpose of operating and maintaining these
residential facilities and at least 50% of the quali-
fying distributions normally made by the organiza-
tion are spent for the operation and upkeep of
these facilities.

These foundations are treated as private oper-
ating foundations only for the purposes of the dis-
tribution requirements of section 4942 of the
Code. All other rules governing nonoperating
private foundations, including rules governing
deductibility of contributions, apply.

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 ear-
lier 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 (see Valu-
ation of assets, later),

if a foundation, after full disclosure of the facts,
obtains a good faith appraisal of an asset's fair
market value by a qualified appraiser (whether or
not that appraiser is a disqualified person with
respect to the foundation), and the foundation
relies on that appraisal, then failure to properly
value an asset will ordinarily be regarded as not
willful and due to reasonable cause. However, if a
foundation does not obtain a good faith appraisal,
the lack of such an appraisal will not, by itself,
imply that the foundation's failure to properly value
an asset was willful and not due to reasonable
cause.

Example. \n 1986 the Martin Foundation,
which was established in 1985, incorrectly valued
its assets in a manner that was not willful and was
due to reasonable cause. As a result of the
incorrect valuation, $20,000, which should have

21


2) The person is aware that such an act may
violate the provisions of federal tax law gov-
erning self-dealing, and

3) The person negligently fails to make reasona-
ble 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 rea-
son 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.

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.

Example 1. On July 2, 1986, Joe Jones, a
manager of private foundation X, acting on behalf
of the foundation, knowing the act to be one of
self-dealing, willfully and without reasonable cause
sold certain real estate to Paul Smith, a disquali-
fied person. On March 1, 1988, the IRS mailed a
notice of deficiency to Smith for the initial and
additional tax imposed by section 4941 on the
sale. The taxable period for both Jones and Smith
is July 2, 1986, through March 1, 1988.

Example 2. The facts are the same as in
Example 1 except that on July 2, 1987, correction
of the act of self-dealing is completed. The taxa-
ble period for both Jones and Smith is July 2,
1986, through July 2, 1987.

The initial tax is figured based on the tax year of
the disqualified person liable for the tax, rather
than the tax year of the private foundation.

An act of self-dealing occurs on the date all
the terms and conditions of the transaction and
the liabilities of the parties are fixed. For example,
if a private foundation gives a disqualified person
a binding option on June 17, 1985, to buy property
owned by the foundation at any time before June
16, 1986, the act of self-dealing has occurred on
June 17, 1985.

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.

What Is Self-Dealing

The term, self-dealing includes the following
transactions whether direct or indirect. However,
see Indirect Self-Dealing, Exceptions to Self-
Dealing, and Transitional Rules, for special rules.

Sales or Exchanges of
Property

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 inci-
dental supplies by a disqualified person to a
private foundation is an act of self-dealing regard-
less 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. However, see Exceptions to
Self-Dealing later in this chapter.

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 prop-
erty 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. On May 17, 1988, the Gray Founda-
tion, a private foundation, received a donation of a
life insurance policy from Joe Brown, 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 Joe 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 May 17, 1988. 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 surren-
der of the policy or upon the death of the insured.
The donation is an act of self-dealing.

Leases

The leasing of property between a disqualified
person and a private foundation is an act of self-
dealing. But see Leases, under Exceptions to Self-
Dealing, later in this chapter.

Loans

Lending money or other extension of credit
between a private foundation and a disqualified
person is an act of self-dealing. However, this
does not 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 section
501(c)(3) of the Code. For these purposes, 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 mar-
ket interest rates.

An act of self-dealing occurs when a third party
buys property and assumes a mortgage, the mort-
gagee of which is a private foundation, and later
the third party transfers the property to a disquali-
fied person who either assumes liability under the
mortgage or takes the property subject to the
mortgage. In this transaction the foundation is
considered to have made a loan to the disqualified
person in the amount of the unpaid indebtedness
on the property at the time of the transfer.

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 promis-
sory 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 chari-
table intent and is unsupported by consideration.

Performing trust functions and certain general
banking services by a bank or trust company,
which is a disqualified person, is not an act of self-
dealing if the services are reasonable and neces-
sary in carrying out the exempt purposes of the
private foundation and the compensation paid to
the bank or trust company is not excessive (con-
sidering the fair interest rate for the use of the
funds by the bank or trust company).

The general banking services that are not self-
dealing are:

1) Checking accounts, as long as the bank does
not charge interest on any overdrafts or a
service fee greater than the actual cost of
processing the amount overdrawn,

2) Savings accounts, as long as the foundation
may withdraw its funds on no more than 30
days notice without subjecting itself to a loss

of interest on its money for the time the
money was on deposit, and

3) Safekeeping activities.

The purchase of certificates of deposit that
provide a reduced rate of interest if not held to
maturity from a banking institution, a disqualified
person with respect to the private foundation,
does not fall within the scope of the general
banking services permitted, and is an act of self-
dealing.

Providing Goods, Services, or
Facilities

Generally, providing goods, services, or facilities
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 dis-
qualified person provides them to a foundation
without charge and the goods, services, or facili-
ties are used exclusively for purposes specified in
section 501(c)(3) of the Code. Also, providing
goods, services, or facilities to a foundation man-
ager, 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 per-
formance 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.

Paying Compensation

Paying compensation or reimbursing expenses by
a private foundation to a disqualified person is an
act of self-dealing. But see Exceptions to Self-
Dealing, discussed later.

Use of Income or Assets

Transfer to, or use by or for the benefit of, a dis-
qualified 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 trans-
actions discussed in this publication.

Similarly, payment of premiums for an insurance
policy providing liability insurance to a foundation
manager for excise taxes on prohibited transac-
tions is an act of self-dealing unless the premiums
are treated as compensation to the manager. In
addition, the purchase or sale of stock or other
securities by a private foundation is an act of self-
dealing if the purchase or sale is made in an
attempt to manipulate the price of the stock or
other securities to the advantage of a disqualified
person.

Indemnification by the foundation of its manag-
ers against reasonable expenses (other than
taxes, penalties, and expenses of correction)
incurred in an IRS or court proceeding involving
the imposition of the excise taxes described in this
publication on the foundation manager will not be
an act of self-dealing if:

1) The manager is successful in the defense, or
the proceeding is ended by settlement, and

2) The manager has not acted willfully and with-
out reasonable cause in the act or failure to
act giving rise to liability for the excise taxes.

Similarly, indemnification of a foundation man-
ager for reasonable expenses incurred for
defense in a judicial or administrative proceeding
relating to the mismanagement of funds of a chari-
table organization is not an act of self-dealing if
the applicable preceding conditions are met.

27


fixtures and equipment, and research facilities
and related equipment which, under the facts
and circumstances, serve a useful purpose in
the conduct of the exempt activities,

4) Any interest in a functionally related business
(see Chapter X), or in a program-related
investment (see Chapter IX),

5) The reasonable cash balances necessary to
cover current administrative expenses and
other normal and current disbursements
directly connected with the foundation’s chari-
table, educational, or other similar exempt
activities, and

6) Any property leased by a foundation in
carrying out its exempt purpose at no cost, or
at a nominal rent, to the lessee or for a pro-
gram-related purpose such as the leasing of
renovated apartments to low-income tenants
at a low rental as part of the lessor-founda-
tion’s program for rehabilitating a blighted
area of a community.

Reasonable cash balance. The reasonable
cash balances that a private foundation needs to
have on hand to cover current administrative
‘expenses and other normal and current distribu-
tions for exempt purposes generally will be con-
sidered to be an amount figured on an annual
basis equal to 1% of the combined fair market
value of all foundation assets used in figuring mini-
mum investment return (reduced by any acquisi-
tion indebtedness for those assets but without
reduction for the reasonable cash balance). A
foundation may exclude 1'/% under this rule even
if it is more than the average cash balance of the
foundation. However, if an additional amount is
necessary to pay expenses and make disburse-
ments, that amount does not have to be included
in figuring minimum investment return. All remain-
ing cash balances will be included in the computa-
tion.

If an amount in excess of the 1'% figure is
claimed for any year, a statement must be
attached to Form 990-PF for that year explaining
the reasons for the larger amount.

Valuation of assets. When figuring the mini-
mum investment return, a foundation may use any
reasonable method to determine the fair market
value on a monthly basis of securities including,
but not limited to, common and preferred stock,
bonds, and mutual fund shares, for which market
quotations are readily available as long as that
method is consistently used. Market quotations
are considered readily available if a security is:

1) Listed on the New York or American stock
exchanges or any city or regional exchange
for which quotations appear on a daily basis,
including foreign securities listed on a recog-
nized foreign, national, or regional exchange,

2) Regularly traded in the national or regional
over-the-counter market for which published
quotations are available, or

3) Locally traded, for which quotations can read-
ily be obtained from established brokerage
firms.

For securities held in trust for, or on behalf of, a
foundation by a bank or other financial institution
that values those securities periodically using a
computer, a foundation may determine the correct
value of the securities by use of this computer
pricing system if the system is acceptable to the
IRS for federal estate tax purposes.

Example 1. The Young Foundation, a private
foundation, owns 1,000 shares of Smith Corpora-
tion stock, which is regularly traded on the New
York Stock Exchange. The Young Foundation may
follow a consistent practice of valuing Smith Cor-
poration stock on the last trading day of each
month based on its closing price for that day.

Example 2. The Young Foundation, a private

foundation, owns 1,000 shares of an unlisted cor-
poration, which is locally traded. Quotations on

unlisted stock can be readily obtained from estab-
lished brokers. The Young Foundation may con-
sistently value its unlisted stock as of the 15th day
of each month by getting a bona fide quote of the
bid and asked prices from an established broker-
age firm and by taking the mean of those prices
on that day. If a quotation is not available on the
regular valuation dates, the Young Foundation
may value its unlisted stock based on a bona fide
quote obtained on the first day after the regular
valuation date that the quotation is avaitable.

Reductions in value for blockage or similar
factors. In determining the value of securities,
the private foundation may establish that as a
result of (1) the size of the block of securities, (2)
the fact that the securities are in a closely held
corporation, or (3) the fact that the sale of the
securities would result in a forced or distress sale,
the price at which the securities could be sold
outside the usual market may be a more accurate
indication of value than market quotations. In such
a case, any reduction in value for all of these rea-
sons together may not be more than 10% of the
fair market value of the securities to which the
discount applies.

Unlisted securities effectively controlled by
foundation and disqualified persons. \f the
foundation owns voting stock of an issuer of
unlisted securities and has, or together with dis-
qualified persons or another private foundation
has, effective control of the issuer, then, to the
extent that the issuer’s assets consist of shares of
listed securities issues, the assets shall be valued
monthly on the basis of market quotations.

Cash. For purposes of the minimum
investment return, a foundation figures its cash
balances on a monthly basis by averaging the
amount of cash on hand on the first and last days
of each month.

Common trust funds. If a private foundation
owns a participating interest in a common trust
fund established and administered under a plan
providing for the periodic valuation of participating
interests during the fund’s tax year and reporting
these valuations to participants, the value of the
foundation's interest in the common trust fund
based on the average of the valuations reported
to the foundation during its tax year will ordinarily
be an acceptable method of valuation for
purposes of the minimum investment return.

Other assets. The fair market value of assets
other than those described earlier is determined
annually except as described later. The valuation
may be made by private foundation employees or
by any other person, whether or not that person is
a disqualified person. Such a valuation, if
accepted by the IRS, is valid only for the tax year
for which it is made. A new valuation is required
for the following tax year. However, the fair market
value of any interest in realty, including any
improvements thereon, may be determined on a
5-year basis by a written, certified, independent
appraisal by a qualified person who is neither a
disqualified person (see Chapter V) nor an
employee of the private foundation.

The appraisal must contain a statement to the
effect that, in the appraiser's opinion, the
appraised assets were valued in accordance with
valuation principles regularly employed in making
appraisals of such property using all reasonable
valuation methods. The foundation must keep a
copy of the independent appraisal for its records.
If a valuation is reasonable, the foundation may
use it for the tax year for which the valuation is
made and for each of the 4 following tax years.

Any valuation of real property by a certified,
independent appraisal may be replaced during the
5-year period by a later 5-year valuation by a
certified, independent appraisal or by an annual
valuation. The most recent valuation will be used
in figuring the foundation’s minimum investment
return.

The valuation must be made no later than the
last day of the first tax year for which the new val-
uation applies.

A valuation, if properly made according to the
rules discussed here, will not be disturbed by the
IRS during the 5-year period for which it applies,
even if the actual fair market value of the property
changes during that period.

Commonly accepted valuation methods must be
used in making the appraisal. A valuation based
‘on acceptable methods of valuing property for
federal estate tax purposes is acceptable. An
appraisal is a determination of fair market value
and should not be construed in a technical sense
to be peculiar to particular property or interests
therein as, for example, mineral interests in real
property.

Valuation date. |f an asset is required to be val-
ued annually, the asset may be valued as of any
day in the private foundation's tax year if the foun-
dation follows a consistent practice of valuing the
asset as of that date in all tax years. A valuation of
real estate determined on a 5-year basis by a
certified, independent appraisal may be made as.
of any day in the first tax year of the private foun-
dation to which the valuation is to be applied.

Assets held for less than a tax year. \f an
asset is held for less than one tax year, the value
of that asset is found by multiplying the fair market
value of the asset by a fraction. The numerator of
the fraction is the number of days in the tax year
that the foundation held the asset, and the
denominator is the total number of days in the tax
year.

Qualifying distributions. A qualifying distribution
is:

4) Any amount (including program-related
investments and reasonable and necessary
grant administrative expenses, subject to the
limit discussed later) paid to accomplish relig-
ious, 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 (see Chapter V) or to private
nonoperating foundations (with exceptions for
certain contributions to exempt organizations,
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 aualiving amount set aside (discussed
later).

In general, a distribution to a public charity
described in'section 509(a)(1), (2), or (3) to
accomplish a religious, charitable, scientific, liter-
ary, educational, or other permitted public purpose
is a qualifying distribution. See Chapter VI, under
the heading Grants to Organizations, for rules on
when a private foundation may rely on the public
charity status of a grantee.

The amount of a qualifying distribution of prop-
erty is the fair market value of the property on the
date it is made. The amount of a qualifying distri-
bution is determined only under the cash receipts
and disbursements method.

A private foundation that bought an asset and
claimed a qualifying distribution under item (2) will
be allowed a second qualifying distribution for the
‘same asset if the asset is later given to a publicly
supported charitable organization that is not con-
trolled by the foundation, and it is donated for a
Purpose described in item (1).

The amount of the second qualifying distribution
will be the difference between the fair market
value of the asset on the date of the contribution
and the amount of the first qualifying distribution.

Limit on administrative expenses. For tax
years beginning after 1984 and before 1991, the
beginning amount of grant administrative
expenses that may be included in any tax year as.
a qualifying distribution is limited to the excess of:

23



List of Tax Publications for Business Taxpayers

General Guides

Your Rights as a Taxpayer

17. Your Federal income Tax
(For individuals)

225 Farmer's Tax Guide

934 ....... Tax Guide for Small Business

509 ....... Tax Calendars for 1991

553 Highlights of 1990 Tax Changes

595. Tax Guide for Commercial Fishermen

910 ....... Guide to Free Tax Services

Employer's Guides

15. Employer's Tax Guide (Circular E)

51 Agricultural Employer's Tax Guide
(Circular A)

80........ Federal Tax Guide for Employers in the

Virgin istands, Guam, American Samoa,
and the Commonwealth of the Northern
Mariana Islands (Circular SS)

Specialized Publications

349 on Federal Highway Use Tax on Heavy
Vehicles

Fuel Tax Credits and Refunds
Travel, Entertainment, and Gift
Expenses

Tax Withholding and Estimated Tax
Excise Taxes for 1991

Withholding of Tax on Nonresident
Aliens and Foreign Corporations

.. Social Security tor Members of the
Clergy and Religious Workers
Residential Rental Property
Self-Employment Tax

Depreciation

Business Expenses

Net Operating Losses

Installment Sales

‘Accounting Periods and Methods

Tax Information on Partnerships

Tax Information on Corporations

. Sales and Other Dispositions of Assets

Basis of Assets

Examination of Returns, Appeal Rights,

and Claims for Refund

Tax-Exempt Status for Your Organization

Retirement Plans for the Self-Employed

Determining the Value of Donated

Property

Tax Information for Private Foundations

and Foundation Managers

. Taxpayers Starting a Business

The Collection Process (Income Tax

Accounts)

Business Use of Your Home

. Tax Information on S Corporations

The Collection Process (Employment Tax

Accounts)

. Information on the United States-Canada
Income Tax Treaty

. Tax on Unrelated Business income of

Exempt Organizations

. Certification for Reduced Tax Rates in
Tax Treaty Countries

. Bankruptcy and Other Debt

Cancellation

Alternative Minimum Tax for Individuals

Tax Information for Direct Sellers

Business Use of a Car

Reporting of Real Estate Transactions to

IRS

Passive Activity and At-Risk Rules

Employment Taxes for Household

Employers

. Business Reporting (Employment Taxes
and Information Returns)

. Reporting Cash Payments of Over

$10,000

Spanish Language Publications

1S
179.

556S.....

579S.....
5868...
5948...
850.0...

Derechos del Contribuyente
Guia Contributiva Federal Para Patronos
Puertorriquefios (Circular PR)

Revision de las Declaraciones de
Impuesto, Derecho de Apelacion y
Reclamaciones de Reembolsos

‘Como Preparar la Declaracion de
Impuesto Federal

Proceso de Cobro (Deudas del Impuesto
Sobre Ingreso)

Proceso de Cobro (Deudas del Impuesto
por Razén del Empieo)

English-Spanish Glossary of Words

and Phrases Used in Publications Issued
by the Internal Revenue Service

How to Get IRS Forms and Publications

You can order tax forms and
publications from the IRS Forms
Distribution Center for your state
at the address below. Or, if you
prefer, you can photocopy tax
forms from reproducible copies
kept at many participating public
libraries. In addition, many of these
libraries have reference sets of IRS
publications which you can read
or copy.

Send to
“Forms Distribution
Center”
for your state

¥

{f you are located in:

¥

Alaska, Arizona,
California, Colorado,

Hawaii, Idaho,

Montana, Nevada, Rancho Cordova,
New Mexico, Ca. 95743-0001
Oregon, Utah,

Washington, Wyoming

Alabama, Arkansas,
Illinois, Indiana, towa,
Kansas, Kentucky,
Louisiana, Michigan,
Minnesota,

Mississippi, Missouri, P.O, Box 9903,
Nebraska, North Bloomington, IL
Dakota, Ohio, 61799

Oklahoma, South
Dakota, Tennessee,
Texas, Wisconsin

Connecticut, Delaware,
District of Columbia,
Florida, Georgia,

Maine, Maryland,
Massachusetts, New
Hampshire, New

Jersey, New York,
North Carolina,
Pennsylvania, Rhode
Island, South Carolina,
Vermont, Virginia, West
Virginia

P.O, Box 25866,
Richmond, VA 23289

Foreign Addresses—Taxpayers

with mailing addresses in foreign
countries should send their re-
quests for forms and publications
to: Forms Distribution Center,
P.O. Box 25866, Richmond, VA
23289; Forms Distribution
Center, Rancho Cordova, Ca.
95743-0001, whichever is closer,

Puerto Rico—Forms Distribution

Center, P.O. Box 25866, Rich-
mond, VA 23289

Virgin Islands—V.1. Bureau of

Internal Revenue, Lockharts
Garden, No. 1A, Charlotte
Amalie, St. Thomas, V1 00802



Influencing elections and carrying on
voter registration drives.

Taxable expenditures include amounts paid or
incurred by a private foundation to influence the
outcome of any specific public election or to carry
on, directly or indirectly, any voter registration
drive. Activities that are considered participation or
intervention in a political campaign include, but are
not limited to:

1) Publishing or distributing written or printed
statements or making oral statements on
behalf of or in opposition to a candidate,

2) Paying salaries or expenses of campaign
workers, and

3) Conducting or paying the expenses of con-
ducting a voter registration drive limited to the
geographic area covered by the campaign.

Exceptions. This rule does not apply to non-
partisan activities carried on under all the following
conditions:

1) The organization making the expenditure is
described in section 501(c)(3) and is exempt
from tax,

2) Its activities are nonpartisan, are not confined
to one specific election period, and are
carried on in at least 5 states,

3) The organization spends at least 85% of its
income directly for the active conduct of the
exempt purposes or functions for which it is
organized and operated,

4) The organization receives at least 85% of its
support (other than gross investment income)
from exempt organizations, the general public,
governmental units, or any combination of
these; it does not receive more than 25% of
its support (other than gross investment
income) from any one exempt organization;
and it does not receive more than 50% of its
‘support from gross investment income, and

5) Contributions to the organization for voter
registration drives are not subject to
conditions that they may be used only in spec-
ified states or other localities of the United
States, or that they may be used in only one
specific election period.

In determining whether the organization meets the
support test in item (4) for a tax year, the support
received during the tax year and the 4 immediately
preceding tax years of the organization is taken
into account.

For organizations with less than 4 years of oper-
ational experience, the support test may be deter-
mined by taking into account all available years
the organization has been in existence.

Advance ruling. An organization will be given an
advance ruling that it qualifies under the
exceptions that apply to nonpartisan activities if it
submits evidence establishing that it can reasona-
bly expect to meet these tests for the year. Grant-
ors or contributors to these organizations may rely
on the advance ruling until a notice of change of
status of the organization is made to the public.
This does not apply, however, if the grantor or
contributor was responsible for, or was aware of,
the fact that the organization did not qualify under
these provisions at the end of the tax year for
which it obtained an advance ruling or determina-
tion letter, or acquired knowledge that the Service
had given notice to the organization advising that
it would be deleted from this classification.

Grants to individuals

Grants to individuals for travel, study, or other sim-
ilar purposes (including loans made for charitable
purposes, and program-related investments as
defined in Chapter IX) are taxable expenditures,
unless the following conditions are met:

1) The grant must be awarded on an objective
and nondiscriminatory basis under a proce-
dure approved in advance by the Service, and

18

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 educa-
tional 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 edu-
cational activities are carried on. For these
purposes, there is no requirement that the
grant recipients be limited to degree candi-
dates, nor must the grant be limited to tui-
tion, 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 schol-
arship or fellowship grant.

b) The grant qualifies as a prize or award
under section 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 foun-
dation to transfer the prize or award to a
governmental unit or to another charity.

©) The grant’s purpose is to achieve a spe-
cific 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.

Advance approval of grant-making procedure.
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 recipi-
ents might include (but are not limited to) the
following: past academic performance, per-
formance on tests designed to measure ability
and aptitude for college work, recommenda-
tions 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 cer-
tain 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 founda-
tion sufficient to make the grantee a dis-
qualified person,

c) Amount and purpose of each grant, and

d) Follow-up information, including required
annual reports and investigation of jeop-
ardized grants.

However, no single procedure or set of proce-
dures 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.

Requests for approval of grant-making proce-
dures should be sent to the District Director of the
IRS office servicing your 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 unac-
ceptable, 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.

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.

Renewals. A renewal of a qualified grant will not
be treated as a grant to an individual subject to
the requirements of this chapter 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.

Any extension of a period over which a grant is
to be paid will not by itself be regarded as a grant
or a renewal of a grant.

Company scholarship programs are usually
administered by company-created private founda-
tions. These 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 these private foundations are taxable expendi-
tures unless the grant programs meet the require-
ments for individual grants (discussed earlier) and
receive advance approval from the Service.

Company scholarship programs will not qualify if
grants are essentially providing extra pay, an
employment incentive, or an employee fringe ben-
efit. Similarly, if scholarship programs are compen-
satory 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.

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

There must exist only a limited probability that,

qualified employees or their children will

receive scholarship grants.

3)

Ruling requests for advance approval of proce-
dures are to be sent to your key District Director,
and should include the statements described ear-
lier under Grants to Individuals, in addition to infor-
mation responsive to the seven conditions and the
percentage test described below.

Educational loans made by a private founda-
tion under an employer-related loan program are
not taxable expenditures if the loan program—


Where to file. Form 990-PF or Form 5227, if
applicable, should be filed with the Internal Reve-
nue Service Center listed in the instructions for
these forms.

Failure to file timely. \f an organization fails to
file Form 990-PF by the due date (taking into
account any extensions granted), it will have to
pay $10 for each day the return is late, not to
exceed the lesser of $5,000 or 5% of the organi-
zation’s gross receipts, unless it can show that the
failure was due to reasonable cause. The IRS may
make written demand that the delinquent return
be filed within a reasonable time after the date of
mailing the demand. If the organization does not
file by the date specified in the demand, the
person or persons responsible for the failure to file
will be subject to a penalty of $10 a day for each
day after the date specified in the notice that the
return is not filed unless it is shown that the failure
to file is due to reasonable cause. The total
amount imposed on all persons responsible for
the failure to file is limited to $5,000. The penalty
is also applicable to a failure to provide informa-
tion required by the return, or a failure to provide
correct information.

Public inspection. All the information reported
‘on Form 990-PF, including attachments, will be
made available by the IRS for public inspection,
except any information the release of which would
adversely affect the national defense, or informa-
tion that the IRS determines relates to any trade
secret, patent, process, style of work, or appara-
tus of the organization.

In these cases, the organization must submit a
statement, marked “Not Subject to Public
Inspection,” identifying which items are to be with-
held and the reasons. The schedule of contribu-
tors will be available for inspection only in the
case of private foundations.

In addition, Form 990-PF must be made avail-
able by the foundation manager for public
inspection at the main office of the foundation. If
the foundation has no main office, or if the main
office is in a personal residence, the manager may
make the return available for public inspection at
an appropriate substitute location or by furnishing
a copy free of charge (including postage and cop-
ying) to persons who request inspection.

The return must be available during regular bus-
iness hours for inspection by any citizen upon
request made within 180 days after the date of the
publication of notice of its availability. The notice
must be published in a newspaper having general
circulation in the county in which the foundation's
main office is located, no later than the day pre-
scribed for the filing of the return. The notice must
state that the annual return is available at the
foundation’s main office for inspection during reg-
ular business hours by any citizen who requests
inspection within 180 days after the date of
publication, and must state the address and tele-
phone number of the foundation's main office and
the name of its principal manager. A copy of this
notice and proof of publication must be filed with
the annual return. Proof of publication may consist
of a copy of the notice as published, along with a
statement signed by a foundation manager saying
that the notice was published and listing the date
of publication and the name of the publication in
which the notice appeared.

Penalty for failure to comply. If the annual
return is not made available for public inspection
on the date and in the manner prescribed, the
person or persons responsible for failing to meet
the publicity requirements will be liable for a pen-
alty of $10 a day for each day that the failure con-
tinues, not to exceed $5,000, unless the failure is
due to reasonable cause. In addition, when the
failure to comply with the publicity requirements is
willful, the person or persons responsible for the
failure will be liable for a penalty of $1,000 for
each return.

Listing of states. A private foundation is
required to attach to its Form 990-PF a list of all
states:

10

1) To which the organization reports in any fash-
ion concerning its organization, assets, or
activities, or

2) With which the organization has registered (or
notified in any manner) that it intends to be, or
is, a charitable organization or a holder of
property devoted to a charitable purpose.

Providing copies to state officers. The founda-
tion managers of a private foundation (except cer-
tain foreign organizations) must provide a copy of
the annual return to the Attorney General of:

1) Each state listed on the Form 990-PF,

2) The state in which the main office of the foun-
dation is located,

8) The state in which the foundation was incor-
porated or created, or

4) Any state that requests it.

The annual return must be sent to the Attorney
General of these states at the same time it is filed
with the Internal Revenue Service. A copy of the
Form 4720, if any, filed by the foundation for the
year must be attached to each copy of the annual
return sent to state officers.

Form 4720, Return of Certain Excise Taxes on
Charities and Other Persons Under Chapters 41
and 42 of the Internal Revenue Code, is intended
primarily for use with Form 990-PF and provides
for figuring and reporting the initial taxes imposed
under sections 4941, 4942, 4943, 4944, and 4945
on private foundations, foundation managers, and
disqualified persons. These sections are
discussed in Chapters VI through X of this
publication.

Paying the tax and filing Form 4720 are required
for each year (or part of a year) in the taxable
period applicable to the act or investment. Gener-
ally, the taxable period begins with the date of the
act or investment and 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.

When to file. Generally, Form 4720 must be filed
by the due date for filing Form 990-PF or 5227.
Foundation managers and disqualified persons,
whose tax years end on the same date as that of
the foundation, who are liable for taxes described
in Chapters VI through X, and who file separate
returns, must file their returns by the due date for
filing Form 990-PF or 5227 by the private founda-
tion with respect to which they are liable for tax.
However, the Form 4720 of a person whose tax
year ends on a date other than that of the founda-
tion’s must be filed by the 15th day of the 5th
month following the close of that person's tax
year. The IRS may, in some cases, require imme-
diate filing of Form 4720 and immediate payment
of tax by private foundations, foundation manag-
ers, and disqualified persons at an earlier date
during the foundation’s tax year.

Where to file. Form 4720 is filed at the same
place as specified for filing Form 990-PF.

Other returns that may be required for trusts
described in section 4947. Forms 1041 and
1041-A are not required to be filed by organiza-
tions that are exempt under section 501(a), but
they may be required to be filed by certain nonex-
empt trusts described in section 4947. Form 1041
is required to be filed by all nonexempt charitable
trusts having gross income of $600 for the year,
unless they owe no tax. Split-interest trusts having
gross income of $600 must file Form 1041 except
for charitable remainder trusts described in
section 664. Charitable remainder trusts must file
Form 1041 as an attachment to Form 5227 if they
have unrelated business taxable income. Form
1041-A must be filed by split-interest trusts
{including trusts described in section 664) that are
not required under their governing instruments to
distribute all of their income annually.

When to file. The returns must be filed by the
15th day of the 4th month following the close of
the trust’s tax year.

Where to file. The returns should be filed with
the appropriate Internal Revenue Service Center
listed in the form instructions.

Extensions. A foundation may file application
Form 2758 to request an extension of time to file
its return(s).

Reasonable cause for failure to file or pay tax.
An organization that is in fact a private foundation
will be considered to have reasonable cause for
failure to meet the private foundation filing and
Payment requirements until 90 days after it is
issued a letter from the Service notifying it of the
determination of private foundation status or a
determination that the organization cannot rea-
sonably be expected to be a public charity. In
order for the organization not to be subject to the
penalties for failure to file or pay tax, the organiza-
tion must have filed Form 1023, claiming not to be
a private foundation, before the due date for filing
Form 990-PF. By the end of the 90-day period,
the organization must file all the necessary returns
for the prior years and pay all taxes due, including
interest. A statement explaining the basis for rea-
sonable cause for failure to file timely should be
attached to the returns. Revenue Procedure 79-8,
1979-1 C.B. 487, should also be cited in the
statement.

Chapter III

Termination of
Private Foundation
Status

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

If the organization's status is terminated either
voluntarily or involuntarily under section 507(a),
the organization becomes liable for tax under
section 507(c). After assessment is made, it is
possible to have the tax abated by the IRS if cer-
tain actions, discussed later, are taken.

An organization may voluntarily terminate its
status under section 507(b)(1) and not be subject
to tax under section 507(c). This is often a major
consideration for organizations considering a vol-
untary termination.

Termination under
Section 507(a)

Voluntary termination. To voluntarily terminate
under section 507(a)(1), the organization must
send a statement to its District Director of its
intent to terminate its status under section
507(a)(1). The statement must provide, in detail,
the computation and amount of tax imposed under
section 507(c). Unless the organization requests
abatement, it must pay the tax at the time the
statement is filed. The organization may request
abatement of all the tax imposed under section
507(c), or it may pay part of the tax and request
abatement of the unpaid part. However, if the
organization's request for abatement is denied,
the organization must pay the tax in full when
notified by the Service that the tax will not be
abated.

Termination of private foundation status under
section 507(a)(1) will not relieve the foundation, or
any disqualified person, of any liability for Chapter
42 excise taxes (the taxes described in Chapters
‘VI through X of this publication).

If an organization that has terminated its private
foundation status under section 507(a) continues
in operation and wishes to be treated as a charita-
ble, educational, religious, scientific, etc., organi-
zation, it must apply for appropriate exemption
recognition. See Status of organization after termi-
nation of private foundation status in Chapter |.


by any other period the Service determines is rea-
sonable and necessary.

Gifts or bequests of business holdings. If
there is a change in a foundation's business
holdings (other than by purchase by the founda-
tion 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 busi-
ness 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 founda-
tion obtains the holdings.

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 per-
missible 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 dil-
igent efforts to dispose of the holdings within
the initial 5-year period, and could not do so
(except at a price substantially below fair mar-
ket 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.

The foundation must also submit the plan men-
tioned in (2) 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 Attor-
ney General (or other official) regarding its plan.

A request for extension of the period for disposi-
tion, as well as the copy of any response received
from state officials, should be addressed to the
Assistant Commissioner (Employee Plans and
Exempt Organizations), 1111 Constitution Ave.,
NW, Washington, DC 20224.

Business holdings on May 26, 1969.
Transitional rules are provided to prevent holdings
of a foundation as of May 26, 1969, that are
greater than the 20% (or 35%) limits permitted
under the general rules of section 4943(c)(2), from
being subject to the initial tax. The foundation is.
given time, in three phases, to dispose of its
excess business holdings.

First, the transitional rules provide that, all foun-
dation holdings on May 26, 1969, are treated as
held by disqualified persons for a certain period of
time (the “first phase”). Second, the percentage
of permitted holdings in a business enterprise is
initially increased to a percentage equal to the
difference between —

1) The percentage of combined holdings of the
foundation and alll disqualified persons on
May 26, 1969 (up to a 50% maximum), and

2) The percentage of holdings of all disqualified
persons.

The percentage in (1) is called the “substituted
level” and it applies to both the voting stock, and,
separately, to the value of all outstanding shares
of all classes of stock.

The main purpose of the substituted level is to
indicate what the permitted holdings will be imme-
diately after the end of the first phase, when the
holdings are no longer treated as held by disquali-
fied persons.

The substituted level is reduced by dispositions
of holdings by the foundation or disqualified
persons (but not below 20% or 35%) after May
26, 1969.

Example. On May 26, 1969, the Watson Foun-
dation and its disqualified persons owned 49% of
the voting stock of the Brown Corporation. The
foundation could continue to hold its stock during
the first phase. However, if the foundation
disposes of 10% of its Brown Corporation stock,
its permitted holdings could then not be greater
than 39% of the stock.

Holdings on May 26, 1969, include business
interests acquired later by the foundation under
the terms of a trust irrevocable on that date, or
under the terms of a will executed before May 27,
1969.

Generally, an active corporation in which a
private foundation has excess stock held since
May 26, 1969, may acquire new subsidiaries or
assets without creating excess business holdings
for the foundation.

The first phase is 20 years if the foundation
and all disqualified persons owned more than
95% of the voting stock of a corporate business
(or more than 95% of comparable interests in an
unincorporated business) on May 26, 1969.

The first phase is 15 years if the foundation
(and its disqualified persons) owned on that date
more than 75% of either the voting stock or the
value of all outstanding shares of all classes of
‘stock of a corporation, or more than 75% of the
profits or capital interests of an unincorporated
business.

The first phase is 10 years in all other cases.

Phase one is suspended during the time a judi-
cial proceeding is pending, for the purpose of
reforming or excusing the foundation from comply-
ing with its governing instrument or any other
instrument in effect on May 26, 1969, to allow dis-
position of excess business holdings.

During the first phase, business interests owned
by the foundation on May 26, 1969, are treated as
held by a disqualified person, rather than by the
foundation. The combined holdings of the founda-
tion and its disqualified persons must be reduced
so that by the end of the first phase they are not
greater than either 50% of the voting stock or
50% of the value of all outstanding shares of a
corporation (or 50% of comparable interests in an
unincorporated enterprise).

Also for holdings acquired under the terms of a
will existing before May 27, 1969, or under the
terms of a trust irrevocable before May 27, 1969,
the first phase begins on the date of actual distri-
bution of the holdings. However, only the 15-year
and 10-year first phase periods apply in these
circumstances.

Present holdings greater than 20% but less
than 50% need not be decreased during the first
phase, but also may not be increased.

The second phase is the 15-year period imme-
diately following the first phase. During the second
phase, the foundation’s ownership of business
interests that it held on May 26, 1969, must be
reduced so that by the end of the phase the
combined holdings of the foundation and its dis-
qualified persons are not greater than 35% of the
Voting stock of a corporation (or 35% of the value
of all outstanding shares of all classes of stock, or
35% of comparable interests in an unincorporated
enterprise).

If, at any time during the second phase, the
holdings of all disqualified persons together are
greater than 2% of the voting stock, the holdings
of the foundation itself may not be more than 25%
of the voting stock or 25% of the value of all
outstanding shares of all classes of stock.

The third phase is the entire period following the
second phase. If a foundation enters the third
phase with not more than 2% of the voting stock
held by alll disqualified parties, and any time after
the beginning of the third phase these holdings
exceed 2%, then the 25% rule applies.

Separation of phases and special rules. A
private foundation may acquire other interests in a
business enterprise, which are also entitled to be
treated as held by disqualified persons for varying
holding periods (certain holdings acquired under
the terms of a trust or will in effect on May 26,
1969, and the initial and additional 5-year periods
to dispose of certain gifts, bequests, etc.). The
phase periods for each different interest acquired
work independently of one another. For example,
the phases for certain holdings acquired under the
terms of a trust or will in effect on May 26, 1969,
start independently from those for certain other
interests of the foundation in the same enterprise.
In any case, however, holdings the private founda-
tion disposes of are charged first against those
holdings it must dispose of in the shortest period
to avoid the initial tax thereon.

In certain situations, holdings during the phase
periods may become so reduced that they would
be permitted holdings subject to the general rules
of section 4943 instead of the transitional rules.
For example, when the combined voting levels
have been reduced to 20%, the provisions
concerning nonvoting stock as permitted holdings
generally apply.

There is a limited exception from the taxes on
self-dealing for private foundations that dispose of
certain excess business holdings to disqualified
persons as long as the sales price at least equals
the fair market value.

The excess business holdings involved are
those interests that are subject to the transitional
rules and that would be subject to the initial tax if
the required reductions in amount were not
accomplished.

Chapter XI
Excise Tax Appeal Procedures

This chapter explains the procedures an organiza-
tion must follow in appealing the imposition of the
excise taxes explained in Chapters VI through X.
Appeals of these taxes are handled by the
Appeals Division in each of the regional offices of
the Internal Revenue Service.

For appeal procedures that apply to cases
involving issues subject to the declaratory
judgment provisions of section 7428 of the Code,
see Publication 557 and Chapter II of this
publication. These issues include qualification
under section 501(c)(3) or as an operating founda-
tion, classification as a private foundation, and eli-
Gibility to receive deductible contributions.

Thirty-Day Letter

Upon conclusion of an examination that results in
a proposed tax deficiency, the taxpayer will be
issued a 30 -day letter including a report of the
‘examination that indicates the proposed tax defi-
ciency and the reasons for it. The letter will also.
advise the taxpayer of the right to appeal the
proposed action if the taxpayer does not agree
with it

The taxpayer may, within 30 days of the date of
the letter, request consideration by the Regional
Director of Appeals for the region that has jurisdic-
tion over the case. The procedures regarding the
regional consideration and claims for refund or
credit are discussed later. In situations where the
expiration of the statute of limitations for
assessment and collection of tax is imminent,
extensions of time to file a 30-day protest will be
granted only if the taxpayer signs a consent to
extend the statute of limitations.

if the taxpayer does not respond in 30 days,
a statutory notice of deficiency will be issued by
the key District Director of the Internal Revenue
Service. The taxpayer has 90 days (150 days if the
notice is mailed to a person outside of the States
of the Union and the District of Columbia) to file a
petition with the United States Tax Court for a
redetermination of the deficiency.

33


have made a good faith effort to determine fair
market value. Ordinarily a good faith effort to
determine fair market value will be considered
made when:

1) The person making the valuation is not a dis-
qualified person with respect to the founda-
tion, is competent to make the valuation, and
is not in a position, whether by stock
ownership or otherwise, to receive an eco-
nomic benefit from the value used, and

2) The valuation is made using a generally
accepted method for valuing comparable
property, stock, or securities in arm’s length
business transactions when valuation is a sig-
nificant factor.

For example, if a corporation that is a disquali-
fied person (as to the foundation) undertakes a
recapitalization referred to earlier under the
exceptions to the self-dealing rule, but the founda-
tion receives stock worth $95,000 in exchange for
stock worth $100,000, the amount involved would
be $5,000 if a good faith effort was made to value
the stock.

Time for determining fair market value. The
fair market value of property or the use thereof, as
the case may be, for purposes of the initial taxes
is the value as of the date the act of self-dealing
occurred and for purposes of the additional taxes
is the highest fair market value during the taxable
period.

Correction

Correction will be accomplished by undoing the
transaction that constituted the act of self-dealing,
to the extent possible, but in no case placing the
foundation in a worse financial position than that
in which it would have been had the disqualified
person acted under the highest fiduciary stan-
dards. For example, when a disqualified person
sells property to a private foundation for cash,
correction may be accomplished by recasting the
transaction in the form of a gift by returning the
cash to the foundation.

The following paragraphs give examples of mini-
mum standards of correction in the case of certain
specific acts of self-dealing. Use similar principles
and apply them to other acts of self-dealing. Any
correction under these standards is not an act of
self-dealing.

Sales by foundation. In a sale of property by a
private foundation to a disqualified person for
cash, undoing the transaction includes, but is not
limited to, rescinding the sale if possible. However,
to avoid placing the foundation in a position worse
than that in which it would be if rescission were
not required, the amount returned to the disquali-
fied person may not be greater than the lesser of
the cash received by the foundation or the fair
market value of the property received by the dis-
qualified person.

Fair market value is determined either at the
time of the act of self-dealing or at the time of
rescission, whichever results in the lesser fair mar-
ket value. In addition, the disqualified person must
pay the foundation any net profits realized from
the property while it was in the disqualified
person’s possession. For example, the disqualified
person must pay the foundation any net profits
realized from the property during the correction
period, but only to the extent the income is greater
than the income received by the foundation during
the correction period from the cash originally paid
to the foundation.

If, before the end of the correction period, the
disqualified person resells the property in an arm's.
length transaction to a bona fide buyer who is not
the foundation or another disqualified person, no
rescission is required. The disqualified person
must pay the foundation the excess (if any) of the
greater of the fair market value of the property on
‘the date of correction or the amount realized in
the arm’s length resale over the amount that
would have been returned to the disqualified
person if rescission had been required. In addition,

30

the disqualified person must pay the foundation
any net profits realized as described in the pre-
ceding paragraph.

Sales to foundation. If a disqualified person
sells property to a private foundation, undoing the
transaction includes, but is not limited to, requiring
rescission of the sale if possible. However, to
avoid placing the foundation in a worse position
than it would be in if rescission were not required,
the amount to be received from the disqualified
person will be the greatest of:

1) The cash paid to the disqualified person,

2) The fair market value of the property at the
time of the original sale, or

3) The fair market value of the property at the
time of rescission.

In addition, the disqualified person is required to
pay the private foundation any net profit realized
after the original sale from the amount received
from the sale, to the extent the net profit during
the correction period is greater than the income
received by the foundation from the property
during the correction period.

If, before the end of the correction period, the
foundation reselis the property in an arm’s length
transaction to a bona fide buyer who is not a dis-
qualified person, no rescission is required. But, the
disqualified person must pay the foundation the
excess (if any) of the amount that would have
been paid to the foundation if the original sale had
been rescinded over the amount realized by the
foundation upon the resale of the property. In
addition, the disqualified person must pay the
foundation any net profits realized from the
amount received from the original sale, described
earlier.

Use of property by a disqualified person. Ifa
disqualified person uses property owned by a
private foundation, undoing the transaction
includes, but is not limited to, terminating the use
of the property. In addition, the disqualified person
must pay the foundation the excess (if any) of:

1) The fair market value of the use of the prop-
erty over the amount paid by the disqualified
person for the use until termination, and

2) The amount that would have been paid by the
disqualified person for the use of the property
on or after the date of termination, for the
period the disqualified person would have
used the property (disregarding further
extensions or renewals of the period) were it
not for termination, over the fair market value
of the use for the period.

In (1), the fair market value of the use of the
property will be the greater of the rate at the time
of self-dealing, or the rate at the time of correction
of the act of self-dealing. In (2), the fair market
value of the use of property will be the rate at the
time of correction.

The rate for use of property other than money
will be the fair rental value per period. For use of
money, the rate will be the fair interest rate.

Use of the property by a private foundation. If
a private foundation uses property that is owned
by a disqualified person, undoing the transaction
includes, but is not limited to, terminating the use
of the property. In addition, the disqualified person
must pay the foundation the excess (if any) of:

1) The amount paid to the disqualified person for
‘the use until termination over the fair market
value of the use of the property, and

2) The fair market value of the use of the prop-
erty, for the period the foundation would have
used the property (disregarding extensions or
renewals of the period) had use not been ter-
minated over the amount that would have
been paid to the disqualified person on or
after the date of termination for use during
that period.

In (1), the fair market value of the use of the
property will be the lesser of the rate (that is, the
fair rental value per period for use of property

other than money or the fair interest rate for the
use of money) at the time of self-dealing, or the
rate at the time of correction of the act of self-
dealing. In (2), the fair rental value of the use of
property will be the rate at the time of correction.

Excessive compensation paid by a private
foundation to a disqualified person for performing
personal services that are reasonable and neces-
sary to carry out the exempt purpose of the foun-
dation may be corrected by repaying to the
foundation any excessive amount. Termination of
the employment or independent contractor
relationship is not required.

Correction of valuation errors. If, but for an
error in the valuation of property, a transaction
would not have been an act of self-dealing had
the foundation received fair market value, a
correction of the transaction means that the foun-
dation is paid an amount equal to the excess of
the fair market value of the property transferred
over the amount that the foundation received for
the property (assuming a good faith effort to deter-
mine fair market value). In addition, the foundation
must receive the amount necessary to
compensate it for the loss of the use of the money
or other property during the period beginning on
the date of the act of self-dealing and ending on
the date the transaction is corrected.

Number of Acts

If a transaction is determined to be an act of self-
dealing, there is generally only one act of self-
dealing. If the transaction involves leasing prop-
erty, lending money or other extension of credit,
other use of money or property, or payment of
compensation, the transaction will be treated as
an act of self-dealing on the day the transaction
occurs plus an act of self-dealing on the first day
of each tax year or part of a year within the taxa-
ble period that begins after the tax year in which
‘the transaction occurs.

If transaction involves joint participation by
two or more disqualified persons, the transaction
will be treated as a separate act of self-dealing for
each individual involved.

However, for purposes of terminating tax-
exempt status and for purposes of determining a
foundation manager's liability for penalties for
repeated, willful or flagrant disregard of self-
dealing prohibitions, the transaction will be treated
as only one act of self-dealing. An individual and
‘one or more members of the individual's family will
be treated as one person regardless of whether a
member of the family is a disqualified person as
defined in Chapter V. The liability imposed on a
disqualified person and one or more members of
the individual's family for joint participation in an
act of self-dealing is joint and several.

Fair market value of a specific asset is deter-
mined under the same rules discussed in Chapter
VIl under Valuation of Assets.

Chapter IX

Taxes on
Jeopardizing
Investments

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 these jeopardizing investments under
section 4944,

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).


interests, then that latter amount will be treated as
a split-interest trust.

Accounting for segregated amounts. A trust,
that has segregated amounts must separately
account for the income, deductions, and other
items attributable to each segregated amount in
the books of account and separately account to
each of the beneficiaries of the trust.

Separate accounting will be made according to
the method regularly employed by the trust, if
the method is reasonable. In all other cases, it will
be made in a manner that, in the opinion of the
Internal Revenue Service, is reasonable.

A method of separate accounting will be consid-
ered regularly employed by a trust when the
method has been consistently followed in earlier
tax years or when a trust that has never before
kept segregated amounts begins a reasonable
method of separate accounting for its segregated
amounts and consistently follows such method in
the future. The trust will keep permanent records
and other data relating to the segregated amounts
as are necessary to enable the IRS to determine
the correctness of the methods used to segregate
these amounts.

Scope of provi:
trusts. The provisions generally apply to trusts in
which some but not all unexpired interests are
charitable. An estate from which the executor or
administrator is required to distribute all of the net
assets in trust or free of trust to both charitable
and noncharitable beneficiaries will not be consid-
ered a split-interest trust during the period of
estate administration or settlement with the
exception of the provisions discussed under
Estates in the next paragraph. A split-interest trust
created by a will is considered a split-interest trust
as of the date of death of the decedent-grantor
except for the exceptions discussed under Certain
revocable and testamentary trusts that wind up
later in this chapter.

Estates. When an estate, from which the
executor or administrator is required to distribute
all of the net assets in trust or free of trust to both
charitable and noncharitable beneficiaries, is con-
sidered terminated for federal income tax
purposes, then the estate will be treated as a split-
interest trust or charitable trust (if applicable)
between the date on which the estate is consid-
ered terminated and the date on which final distri-
bution of the net assets to the last remaining
charitable beneficiary is made. This does not
affect the determination of the tax liability of either
charitable or noncharitable beneficiaries of the
estates.

Example. Henry Post died on January 15,
1983, and bequeathed $10,000 to M, an organiza-
tion described in section 501(c)(3), and the
remainder of his estate to Wilma, his wife. A
deduction for the charitable bequest was allowed
to Henry's estate. Substantially all of Henry's
estate consisted of 100% of the stock of a wholly
‘owned corporation, certain liquid assets such as
marketable stocks and securities and bank
accounts, and Henry's home, automobile, and
other personal property. Henry's will gave his
executor a full range of powers, including the
power to sell the stock. After Henry’s death, his
executor continued to manage the wholly owned
corporation while attempting to sell the stock of
the corporation. During this period, the executor
made no distributions to M. On May 24, 1988, the
Internal Revenue Service determined that the
administration of the estate has been unnecessa-
ily prolonged and the estate is considered termi-
nated as of that date for federal income tax
purposes. Henry’s estate will be treated as a split-
interest trust between May 24, 1988, and the date
‘on which the $10,000 bequest to M is satisfied.
Henry's estate will be subject to the private foun-
dation provisions that apply during that period. For
example, a sale of the house by the estate to any
disqualified person would be an act of self-
dealing.

Revocable trusts that become split-interest
trusts. A revocable trust that becomes irrevoca-
ble upon the death of the decedent-grantor and
whose governing instrument provides that the
trustee is required to hold some or all of its net
assets in trust for both charitable and noncharita-
ble beneficiaries after becoming irrevocable is not
considered a split-interest trust for a reasonable
period of settlement after becoming irrevocable,
except that the tax on self-dealing may apply.

After that period, the trust is considered a split-
interest trust.

For a definition of “reasonable period,” see the
previous discussion of Split-interest trusts that
become charitable trusts.

Certain revocable and testamentary trusts
that wind up. A revocable trust that becomes
irrevocable upon the death of the decedent-gran-
tor, or a trust created by will, from which the
trustee is required to distribute all of the net
assets in trust or free of trust to both charitable
and noncharitable beneficiaries is not considered
a split-interest trust for a reasonable period of
settlement after becoming irrevocable. After that
period, the trust is considered a split-interest trust
or a charitable trust, whichever applies.

Governing instrument requirements, charitable
deduction limitations, denial of deductions, and
other provisions that apply to exempt private foun-
dations also apply to charitable remainder trusts.

Application of the rules relating to termination
of private foundation status. The termination
tules discussed in Chapter III do not apply toa
charitable or split-interest trust by reason of any
payment to a beneficiary that is directed by the
terms of the governing instrument of the trust and
is not discretionary with the trustee or, in the case
of a discretionary payment, because of, or
following, the expiration of the last remaining char-
itable interest in the trust.

Example. H creates a nonexempt charitable
trust under which the income is to be paid for 15
years to R, a section 501(c)(3) organization. After
15 years, the trust is to terminate and distribute all
of its assets to S, another section 501(c)(3) organ-
ization. Distribution of the corpus of the trust to S
will not be subject to the rules governing termina-
tion of private foundation status.

Limit to segregated amounts. If any amounts
held in trust are segregated, the value of the net
assets for purposes of determining the tax
imposed on the termination of private foundation
status under section 507(a), and for determining
the amount of tax to be abated, will be limited to
the segregated amounts for which a charitable
deduction was allowed.

Split-interest trusts are not subject to the restric-
tions concerning excess business holdings (Chap-
ter X) and the restrictions concerning investments
that jeopardize charitable purpose (Chapter IX) if
all of the trust's income interest (and none of the
remainder interest) is devoted solely to one or
more charitable purposes and all amounts for
which a charitable deduction was allowed have a
combined value at the time of the deduction of not
more than 60% of the fair market value of the
entire trust (after the payment of estate taxes and
all other liabilities). In addition, these two restric-
tions will not apply if a charitable contribution
deduction was allowed for amounts payable under
the terms of the trust to every remainder benefici-
ary, but not to any income beneficiary. However, in
the latter case, the trust will become a charitable
trust at the expiration of the income interests.

Income interest includes an interest in property
transferred in trust that is in the form of a guaran-
teed annuity interest or unitrust interest.

Remainder interest includes an interest that
succeeds an income interest.

Income beneficiary includes a recipient of
payments from a pooled income fund, a recipient
of payments from a charitable remainder annuity
trust, or a recipient of payments from a charitable
remainder unitrust.

Remainder beneficiary includes a beneficiary of
a remainder interest.

Foreign Foundations

Foreign organizations that are private foundations
and that have been granted tax-exempt status
under U.S. tax law are required to pay an excise
tax equal to 4% of their gross investment income
received from sources in the United States, any
territory, any political subdivision of a territory, or
the District of Columbia.

An exception to this rule is made when a tax
treaty between the United States and the foreign
country of which the private foundation is a resi-
dent specifically exempts income received by
these organizations from any tax.

Foreign private foundations receiving at least
85% of their support (excluding gross investment
income) from sources outside the United States
are not subject to the taxes on self-dealing, failure
to distribute income, excess business holdings,
investments that jeopardize charitable purposes,
and taxable expenditures. Such foundations also
are not subject to section 507, relating to termina-
tion of private foundation status, and section 508,
regarding special rules for giving notice that they
are applying for recognition of exempt status,
which are all discussed in this publication.

‘An exempt organization that is organized in a
foreign country and receives a substantial portion
of its support from a foreign government is not a
private foundation.

A foreign private foundation can have its
exempt status terminated for repeatedly engaging
in prohibited transactions. A prohibited transaction
is an act or a failure to act by a foreign organiza-
tion that, if engaged in by a domestic organization,
would subject the domestic organization to the
taxes and sanctions imposed on private founda-
tions.

If a foreign private foundation engages in one
‘such act or failure to act, and has been warned by
the IRS that a second act or failure to act would
result in a prohibited transaction, the second act
or failure to act will be considered a prohibited
transaction.

The repeated act or failure to act does not nec-
essarily have to be related to the earlier act or fail-
ure to act that caused the Service to issue a
warning.

Any foreign private foundation whose exemption
has been terminated under the provisions outlined
earlier may reapply for exemption by filing a Form
1023 in the 2nd tax year following the tax year in
which exemption was denied.

For further information concerning foreign
private foundations contact the District Director,
Internal Revenue Service, Baltimore, MD 21201.

Chapter II

Filing, Notice,
and Other
Requirements

This chapter discusses the notice requirements,
annual filing requirements, and other actions that
must be complied with for an organization to be
recognized as exempt under section 501(c)(3).

Filing of Notice

Except for those organizations noted later, any
charitable organization organized after October 9,
1969, will not be treated as tax exempt unless it
applies for recognition of exemption by filing a
current Form 1023, Application for Recognition of
Exemption, with the appropriate office listed in the
Instructions to that form. A user fee must accom-
pany Form 1023 if it is filed before September 30,
1990. For more information on the specific fee
applicable to your organization, obtain Form 8718
from the IRS Forms Distribution Center for your
state.


Scope of provisions regarding charitable
trusts. These provisions apply to nonexempt
trusts in which all unexpired interests are
charitable.

An estate from which the executor or adminis-
trator is required to distribute all of the net assets
in trust to charitable beneficiaries will not be con-
sidered a charitable trust during the period of
estate administration or settlement except for the
conditions discussed in the next paragraph. A
charitable trust created by a will is considered a
charitable trust as of the date of death of the
decedent-grantor. However, a revocable trust that
becomes irrevocable upon the death of the dece-
dent-grantor, or a trust created by will from which
the trustee is required to distribute all of the net
assets for, or free of trust to, charitable benefi-
ciaries, is not considered a charitable trust for a
reasonable period of settlement (defined later)
after becoming irrevocable. After that period, the
trust is considered a charitable trust.

Estates. When an estate from which the execu-
tor or administrator is required to distribute all of
the net assets in trust for charitable beneficiaries,
or free of trust to those beneficiaries, is consid-
ered terminated for federal income tax purposes,
the estate will then be treated as a charitable trust
between that date and the date the final distribu-
tion of all the net assets is made to or for the ben-
efit of the charitable beneficiaries. These
provisions do not affect the determination of the
tax liability of the beneficiaries of the estate.

Example. Malcolm Thorn bequeaths his entire
estate, including 100% of the stock of a wholly-
owned corporation, to M, an organization
described in section 501(c)(3), under a will that
gives his executor authority to hold the stock and
manage the corporation for a period of up to 10
years for the benefit of M before its ultimate dispo-
sition. A deduction for the charitable bequest was
allowed to Malcolm's estate. The executor is
vested with a full range of powers, including the
power of sale. Upon Malcolm's death, his execu-
tor distributes Malcolm’s assets to M except for
the stock of the corporation, which he holds for 5
years before its disposition. Because the executor
held the stock of the corporation beyond a rea-
sonable time for performing all the ordinary duties
of administration, the estate is considered termi-
nated for federal income tax purposes and is
subject to the provisions of section 4947(a)(1)
from the date of this termination to the date of
final disposition of the stock of the corporation.

Certain split-interest trusts that wind up. A
split-interest trust (defined later) in which all of the
unexpired interests are charitable remainder
interests and in which the charitable beneficiaries
have become entitled to distributions of corpus in
trust or free of trust will continue to be treated as a
split-interest trust until the date final distribution of
all the net assets is made. However, if after the
expiration of any intervening interests, the trust is
considered terminated for federal income tax
purposes, the trust will then be treated as a chari-
table trust rather than a split-interest trust
between the date on which the trust is considered
terminated and the date final distribution of all the
net assets is made. These provisions do not affect
the determination of the tax liability of the benefi-
ciaries of the trusts.

Split-interest trusts that become charitable
trusts. A split-interest trust in which all of the
unexpired interests are charitable remainder
interests and in which some or all of the charitable
beneficiaries are not entitled to distributions of
corpus will continue to be treated as a split-
interest trust for a reasonable period of settlement
after the expiration of the noncharitable interest. A
split-interest trust that under its terms is to con-
tinue to hold assets for charitable beneficiaries
after the expiration of the noncharitable interest
rather than distributing them is allowed a reasona-
ble period of time for settlement before being
treated as a charitable trust.

6

Reasonable period of settlement is that period
reasonably required (or if shorter, actually
required) by the trustee to perform the ordinary
duties of administration necessary for the
settlement of the trust. For example, these duties
include the collection of assets, the payment of
debts, taxes, and distributions, and the determina-
tion of the rights of the subsequent beneficiaries.

Example. On January 15, 1983, Cyril Elmwood
created a charitable remainder annuity trust under
which the trustees were required to distribute
$10,000 a year to Betty, Cyril's wife, for life and to
hold the remainder in trust for the use of M, an
organization described in section 501(c)(3). Cyril
was allowed a deduction for the amount of the
charitable interest, and the trust was treated as a
split-interest trust from the date of its creation.
Betty died on February 10, 1988. On April 15,
1988, the trustees completed the ordinary duties
of administration necessary for the settlement of
the trust brought about by Betty’s death. These
duties include, for example, an accounting for and
payment to Betty’s estate of amounts accrued by
Betty while alive during 1988. However, the trust-
ees did not distribute the corpus to M by April 15,
1988. The trust would continue to be treated as a
split-interest trust until April 15, 1988. After April
15, 1988, the trust would be treated as a charita-
ble trust.

Revocable trusts that become charitable
trusts. A revocable trust that becomes irrevoca-
ble upon the death of the decedent-grantor in
which all of the unexpired interests are charitable
and whose governing instrument provides that the
trustee is required to hold some or all of the net
assets in trust (after becoming irrevocable) solely
for charitable beneficiaries, is not considered a
charitable trust for a reasonable period of
settlement after becoming irrevocable, except that
certain rules concerning self-dealing apply. After
that period, the trust is considered a charitable
trust.

Trust devoted to qualified charitable
contribution purposes. A trust in which all of
the unexpired interests are devoted to war veter-
ans’ organizations or certain cemetery companies
as well as the types of organizations listed earlier
under Scope of provisions regarding charitable
trusts will be considered a charitable trust.
Payments made to veterans’ organizations and
certain cemetery companies will be considered
qualifying distributions under these circumstances.

Example. Hugo Briar creates an inter vivos
trust whose governing instrument provides that M,
a war veterans’ organization, and N, an organiza-
tion described in section 501(c)(3), are each to
receive 50% of the income for a period of 10
years. At the end of the 10-year period, the
corpus is to be distributed to O, an organization
also described in section 501(c)(3). Hugo is
allowed an income tax deduction for the value of
all interests placed in trust. The payments to M
are qualifying distributions, Accordingly, the trust
will be considered a charitable trust.

Charitable trusts that support public charities.
Charitable trusts that qualify under section
509(a)(3) (as supporting organizations of public
charities) are not treated as private foundations
and, thus, are not subject to the taxes and restric-
tions that apply to private foundations. In deter-
mining whether it qualifies under section 509(a)(3),
a charitable trust will be treated as if organized on
the day it first becomes subject to section
4947(a)(1). The previous relationship between the
charitable trust and the organizations it benefits or
supports may be considered. The charitable trust
may obtain recognition of its status as a section
509(a)(3) organization by requesting a ruling from
the Internal Revenue Service.

Split-interest trusts. A splitinterest trust is a
trust:

1) That is not exempt from tax,

2) Not all of the unexpired interests of which are
devoted to religious, charitable, scientific, liter-
ary, or educational purposes, or to foster
national or international amateur sports
competition, or for the prevention of cruelty to
children or animals, and

3) That has amounts in trust for which a charita-
ble contribution deduction has been allowed.

Also included under these provisions is a split-
interest trust that is not treated as a charitable
trust during a reasonable period of settlement or
while it is in the process of winding up. See the
earlier discussion under Certain split-interest trusts
that wind up or Split-interest trusts that become
charitable trusts.

Asplit-interest trust is subject to the following
provisions discussed in this publication in the
same manner as is a private foundation:

1) Terminations, Chapter III,

2) Governing instruments, Chapter II,

3) Tax on self-dealing, Chapter VIII,

4) Tax on excess business holdings, Chapter X,

5) Tax on investments that jeopardize charitable
purpose, Chapter IX, and

6) Tax on taxable expenditures, Chapter VI.

These provisions do not apply to amounts trans-
ferred in trust before May 27, 1969.

Also, the provisions do not apply to any
amounts payable under the terms of a split-
interest trust to income beneficiaries, unless a
charitable contribution deduction was allowed with
respect to the income interest of the beneficiary.
For example, Hyram Jones created a split-interest
trust that is required annually to pay Melanie
Jones 5% of the net fair market value of the trust
assets, valued annually, for her life; and to pay the
remainder to Y, a section 501 (c)(3) organization. A
charitable contribution deduction was allowed for
the remainder interest. Each annual amount paya-
ble to Melanie for her life is not subject to the pro-
visions listed earlier. These payments are not acts
of self-dealing or taxable expenditures. However,
with the exception of the income interest so paid,
the trust is subject to the provisions in the same
manner as if the trust were a private foundation.

Exception for certain segregated amounts.
These provisions will not apply to assets held in
trust (including income and capital gains received
from these assets), other than assets for which a
charitable contribution deduction has been
allowed, if these assets are segregated from the
other assets held in trust.

Segregation of amounts. Amounts generally
will be considered segregated if:

1) The assets for which no deduction was
allowed are separately accounted for from
assets for which a deduction was allowed for
any income or remainder interest, and

2) Because there is a separate accounting, the
trust can be treated as two separate trusts,
one devoted exclusively to noncharitable
income and remainder interests and the other
as a charitable trust or a split-interest trust.

Under these circumstances, only the trust that
is devoted exclusively to noncharitable income
and remainder interests will be considered a seg-
regated amount which is not subject to the restric-
tions described above for split-interest trusts.

Exclusively charitable amounts. |f an amount
held in trust that is devoted exclusively to non-
charitable income and remainder interests is seg-
regated from an amount held in trust that is
devoted exclusively to charitable income and
remainder interests, then the latter amount will be
treated as a charitable trust.

Charitable and noncharitable amounts. |f an
amount held in trust that is devoted exclusively to
noncharitable income and remainder interests is
segregated from an amount held in trust that is
devoted to both charitable income or remainder
interests and noncharitable income or remainder



1) Meets the applicable requirements for grants
to individuals, discussed earlier, and

2) Satisfies the seven conditions and the per-
centage tests described below.

The seven conditions for approval include
the following items:

1) Inducement. The programs must not be used
by the employer, the private foundation, or the
organizer thereof, 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 indi-
viduals knowledgeable in the field of educa-
tion so that they have the background and
knowledge to properly evaluate the potential
of the applicants.

Forwarding the selections by the indepen-
dent selection committee to the employer or
private foundation only for the purpose of
verifying the eligibility requirements and selec-
tion criteria followed by the committee in con-
sidering 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 employ-
ees, or children of employees, who meet the
minimum standards for admission to an edu-
cational organization for which the loans are
available. No persons will be considered eligi-
ble 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 eli-
gible 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, recommenda-
tions 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 consid-
ered ineligible for a subsequent loan simply
because that individual or the individual's par-
ent 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 recipi-
ent 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 founda-
tion 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 particu-
lar 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 avail-
able 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, sug-
gesting that the studies are undertaken by the
Tecipients 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 educa-
tion in their individual capacities.

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 pro-
gram 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 stan-
dards for admission to an educational
institution for which grants or loans are availa-
ble. A private foundation may include as eligi-
ble 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 main-
tained 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 suc-
ceeding academic year with the expecta-
tion, if accepted by the institution, of
attending the institution; or

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.

For a program that awards loans to employ-
ees 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:

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.

°)

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 con-
sidered 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 pro-
gram 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.

If your private foundation holds a ruling letter
issued before September 29, 1980, you may con-
tinue to rely on that ruling letter provided the loan
program fully complies with the seven conditions
and the percentage tests continuously from the
date on which the ruling letter was issued. Upon
written request, the Service will issue a current
tuling letter affirming the qualification of the loan
program under these requirements.

Certain designated grants. A grant by a private
foundation to another organization that makes
payments to a qualified individual will not be
treated as a grant by the private foundation to the
individual if the foundation does not earmark the
use of the grant for any named individual and
there is no agreement (oral or written) whereby
the grantor organization has any part in selecting
the individual grantee.

Certain grants to public charities. A grant by a
private foundation to a public charity, other than
an organization organized and operated
exclusively for testing for public safety, that the
grantee organization uses to make payments to
an individual as a qualified grant, will not be
treated as a grant by the private foundation to the
individual grantee if the grant is made for a project
to be undertaken and controlled by the public
charity. The public charity must also control the
selection of the grantee, although the selection
need not be completely independent of the private
foundation,

Grants to governmental agencies. If a private
foundation makes a grant to a governmental
agency, and the grant is earmarked for use by an
individual for travel, study, or other similar

19


application or request for determination of
Private foundation status; and

4) Exhaustion of all administrative appeals avail-
able within the Service, including protest of an
adverse ruling in National Office original juris-
diction exemption application cases.

An organization will not be deemed to have
exhausted its administrative remedies before
the earlier of:

1) The completion of the steps just listed and the
sending by certified or registered mail of a
notice of final determination, or

2) The expiration of the 270—day period in which
the Service has not issued a notice of final
determination and the organization has taken,
in a timely manner, all reasonable steps to
secure a ruling or determination.

The steps described earlier will not be consid-
ered completed until the Internal Revenue Service
has had a reasonable time to act upon the appeal
or protest, as the case may be.

A notice of final determination to which the
declaratory judgment procedures apply is a ruling
or determination letter sent by certified or regis-
tered mail that holds the organization is not
described in section 501(c)(3) or section 170(c)(2)
of the Code, is a private foundation as defined in
section 509(a), is not a private operating founda-
tion as defined in section 4942(j)(3), or is a public
charity described in a part of section 509 or
section 170(b)(1)(A) other than the part under
which the organization requested classification.

The 270-day period will be considered by the
Service to begin on the date a substantially com-
pleted Form 1023 is sent to the appropriate key
District Director. If the application does not
contain all of the required items, it will not be fur-
ther processed and may be returned to the
applicant for completion. The 270- period, in this
event, will not be considered as starting until the
date the application is remailed to the Service with
the requested information, or, if a postmark is not
evident, on the date the Service receives a
substantially completed application.

The following procedural limitations apply to a
suit for declaratory judgment:

1) The petition must be filed by the organization
whose qualification for exemption or classifi-
cation is at issue;

2) A petition for declaratory judgment must be
filed with the appropriate court (as specified
earlier in this discussion) before the 91st day
after the date on which the Internal Revenue
Service has mailed a notice of its determina-
tion by certified or registered mail; and

3) A declaratory judgment will not be issued
unless the organization has exhausted the
administrative remedies (described earlier)
available to it within the IRS.

Classification as Other Than a
Private Foundation

Any organization described in section 501(c)(3),
regardless of when it was organized, will be pre-
sumed to be a private foundation unless it gives
timely notice to the IRS that it is not a private
foundation.

The only exceptions to this requirement apply to
those organizations that are excepted from filing
Form 1023 as stated earlier. Charitable trusts
described in section 4947(a)(1) also are excepted.

If the organization received a ruling or determi-
nation letter from the IRS dated before July 14,
1970, recognizing its tax-exempt status under
section 501(c)(3), and did not file Form 4653, Noti-
fication Concerning Foundation Status, before
March 22, 1973, the organization is presumed to
be a private foundation. This presumption is rebut-
table; and if the organization is, in fact, one as
described in section 509(a)(1), (2), (3), or (4) of

the Internal Revenue Code, it is not a private foun-
dation. However, for the Service to recognize that
‘such an organization is not a private foundation,
the organization must establish that status by
sending a request for a determination to the
District Director.

Any organization seeking tax-exempt status
under section 501 (c)(3) and classification as other
than a private foundation should file its notice by
sending a completed and signed Form 1023 and
provide information that it is not a private founda-
tion.

The notice may not be relied on by the organi-
zation or by grantors or contributors until the IRS
notifies the organization that it is not a private
foundation.

Statement that an organization is an operating
foundation. Any organization that is applying for
recognition of exemption under section 501(c)(3)
may submit information that it is an operating
foundation.

The operating foundation should include the
following:

1) Necessary supporting information to confirm
the determination, and

2) Awritten declaration by the principal officer,
manager, or authorized trustee that there is a
reasonable basis in law and in fact that the
organization is an operating foundation, and
that to the best of the knowledge and belief of
the officer, manager, or trustee, the informa-
tion given is complete and correct.

The notice may not be relied upon by the organ-
ization or by its grantors or contributors until the
IRS notifies the organization that it is not a private
foundation.

Additional information on applying for recogni-
tion of exemption and notification of nonprivate
foundation status may be found in Publication 557,
Tax-Exempt Status for Your Organization.

Governing Instruments

A private foundation cannot be tax exempt nor will
contributions to it be deductible as charitable con-
tributions unless its governing instrument contains
special provisions in addition to those that gener-
ally apply to section 501(c)(3) organizations.
These special provisions, generally, must require
or prohibit, as the case may be, the foundation to
act or refrain from acting so that it will not be liable
for the taxes imposed by sections 4941, 4942,
4943, 4944, and 4945, discussed later in this
publication. Specific reference to these sections
generally must be included in the governing
instrument, unless equivalent language is used
that is considered by the IRS to have the same full
force and effect.

A private foundation's governing instrument will
be considered to have been amended to conform
to this requirement if valid provisions of state law
have been enacted that:

1) Require the foundation to act or refrain from
acting so that it will not be liable for any of the
taxes imposed on the prohibited transactions
discussed later, or

2) Treat the required provisions as though they
were contained in the foundation's governing
instrument.

The IRS periodically updates a published list of
states with these statutes. Contact your key
District Office for this information.

The following samples of governing instrument
provisions meet 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 such time and in such
manner so that it will not become subject to
the tax on undistributed income imposed by
section 4942 of the Internal Revenue Code, or
corresponding provisions of any later federal
tax laws.

2) The corporation will not engage in any act of
self-dealing as defined in section 4941(d) of
the Internal Revenue Code, or corresponding
provisions of any later federal tax laws.

3) The corporation will not retain any excess
business holdings as defined in section
4943(c) of the Internal Revenue Code, or cor-
responding provisions of any later federal tax

laws.

4) The corporation will not make any
investments in a manner that would subject it
to tax under section 4944 of the Internal Rev-
enue Code, or corresponding provisions of
any later federal tax laws.

5) The corporation will not make any taxable
expenditures as defined in section 4945(d) of
the Internal Revenue Code, or corresponding
provisions of any later federal tax laws.

Draft B

Any other provisions of this instrument notwith-
standing, the trustees will distribute its income for
each tax year at such time and in such manner so
that it will not become subject to the tax on undis-
tributed income imposed by section 4942 of the
Internal Revenue Code, or corresponding provi-
sions of any later federal tax laws.

Any other provisions of this instrument notwith-
standing, the trustees will not engage in any act of
self-dealing as defined in section 4941(d) of the
Internal Revenue Code, or corresponding provi-
sions of any later federal tax laws; nor retain any
excess business holdings as defined in section
4943(c) of the Internal Revenue Code, or corre-
sponding provisions of any later federal tax laws;
nor make any investments in a manner that would
incur tax liability under section 4944 of the Internal
Revenue Code, or corresponding provisions of
any later federal tax laws; nor make any taxable
expenditures as defined in section 4945(d) of the
Internal Revenue Code, or corresponding provi-
sions of any later federal tax laws.

Return Requirements

All private foundations (including nonexempt
private foundations, and nonexempt charitable
trusts described in section 4947(a)(1) of the Code
having no taxable income for the tax year that
they are treated as private foundations) are
required to file an annual return on Form 990-PF,
Return of Private Foundation. \f your organization
has an application for recognition of exemption
pending with the IRS, and you acknowledge that
your organization is a private foundation, you
should file this return.

Split-interest trusts described in section
4947(a)(2) of the Code must file Form 5227, Split-
Interest Trust Information Return, instead of filing
Form 990-PF.

When to file. Form 990-PF must be filed by the
15th day of the 5th month following the close of
the organization’s accounting period.

If the foundation is on a calendar year, or if it
has no established accounting period, the return
will be due May 15 each year.

For a complete liquidation, dissolution, or termi-
nation, the return must be filed by the 15th day of
the 5th month following complete liquidation, dis-
solution, or termination.

Form 5227 must be filed by the 15th day of the
4th month following the close of the trust’s tax
year.


N.W., Washington, DC 20224, Attention: E:EO,
and include:

1) A statement describing the nature and
purposes of the specific project and the
amount of the set-aside for which approval is
requested,

2) A statement describing the amounts and
approximate dates of any planned additions to
the set-aside after its initial establishment,

3) A statement of the reasons why the project
can be better accomplished by the set-aside
than by immediate payment,

4) A detailed description of the project, including
estimated costs, sources of any future funds
‘expected to be used for completion of the
project, and the location or locations (general
‘or specific) of any physical facilities to be
acquired or constructed as part of the project,
and

5) A statement by an appropriate foundation
manager that the amounts set aside will
actually be paid for the specific project within
a specified period of time ending not more
than 60 months after the date of the first set-
aside; or a statement showing good cause
why the period for paying the amount set
aside should be extended {including a
showing that the proposed project could not
be divided into two or more projects covering
periods of no more than 60 months each),
and giving the extension of time requested.

Statement required for cash distribution
test. Although Service approval is not required
for set asides qualifying under the cash distribu-
tion test, the foundation must attach to its annual
return for any tax year in which amounts are set
aside, the following:

1) A statement describing the nature and
purposes of the specific project for which
amounts are set aside,

2) A statement that the amounts set aside will
actually be paid for the specific project within
a specified period that ends no more than 60
months after the date of the set-aside,

3) A statement that the project will not be com-
pleted before the end of the tax year in which
the set-aside is made,

4) A statement showing the distributable
amounts for any past tax years in the founda-
tion's start-up and full-payment periods, and

5) A statement showing the total amount of
actual payments in cash or its equivalent for
‘exempt purposes during each tax year in the
foundation’s start-up and full-payment peri-
ods. This statement should include a detailed
description of any corrective or other
payments that are treated, according to the
tules discussed earlier, as distributed during a
tax year prior to the tax year in which actually
made, and should explain the circumstances
that justify the application of those rules.

The foundation must also attach to its annual
return for each of the 5 tax years following the tax
year in which the amount is set aside (and for
each tax year in any extended period for paying
the amount set aside) the statements described in
(4) and (5) above.

Evidence of set-aside. A set-aside approved
by the Service or that meets the cash distribution
test should be shown by entering a dollar amount
‘on the books of the foundation as a pledge or
obligation to be paid at a future date or dates. Any
amount set aside will be taken into account in fig-
uring the foundation's minimum investment return
and any income from the set-aside should be
taken into account in figuring the adjusted net
income of private operating foundations. The
amount set aside need not reflect an
accumulation of income, but may be a
bookkeeping entry that will require funding out of
corpus by the end of the set-aside period.

Certain contributions to exempt organizations.
A “qualifying distribution” includes a contribution
to a private nonoperating foundation or to an
organization formed for certain religious, charita-
ble, scientific, educational, or other exempt
purposes that is controlled (see Control, earlier)
by the contributing foundation or by one or more
disqualified persons or to a private nonoperating
foundation if:

1) Not later than one year after the end of the
tax year in which the donee organization
received the contribution, it makes a distribu-
tion equal to the full amount of the contribu-
tion and the distribution is a qualifying
distribution that is treated as being made out
of corpus (or would be treated as such if the
donee organization were a private nonoperat-
ing foundation), and

2) The private foundation making the contribu-
tion obtains adequate records or enough
other evidence from the donee organization
showing that the donee organization has
made a qualifying distribution, The evidence
must also show the names and addresses of
the recipients of the qualifying distributions,
the amount received by each, and that the
distribution is treated as being made out of
corpus (or would be so treated if the donee
organization were a private nonoperating
foundation).

When a distribution is for an administrative
‘expense that is for public charitable purposes or is
part of another public charitable expenditure that
cannot reasonably be separately accounted for,
the record-keeping requirements of item (2), are
satisfied if the donee organization submits a
statement giving the general purpose for which it
is making the expenditure and stating that the
amount was distributed as a qualifying distribution.

If both requirements are not met, no part of the
contribution will be treated as a qualifying distribu-
tion. To meet the distribution requirements, the
donee organization must, by the close of the first
tax year after the tax year in which the contribution
is received, distribute an amount equal in value to
the contribution, and it must have no remaining
undistributed income for the year in which the con-
tribution was received.

If a donee organization redistributes less than
an amount equal to the total contributions from
donor organizations that are required to be redis-
tributed by the end of the first tax year after the
tax year in which they were received, amounts.
treated as redistributions will be considered as
made pro rata from all contributions received in
the prior tax year that are required to be redis-
tributed by the donee organization regardless of
any earmarking or identification of the source
made by the donee. The amounts considered as
not to have been redistributed will be included pro.
rata in the gross income of each donor foundation
in the foundation’s first tax year beginning after
the close of the donee organization's tax year in
which the amount should have been distributed.

The characterization of qualifying distributions
made during the tax year (that is, whether out of
the prior or current year’s undistributed income, or
corpus) is made as of the close of the tax year in
question, except when the donee organization
chooses to treat all or part of the distribution as
made out of a distribution from corpus made in a
designated prior tax year (see Treatment of quali-
fying distributions, discussed later). Once it is
determined that a qualifying distribution is from
corpus, that distribution will first be charged to dis-
tributions that are required to be redistributed as
described earlier.

All amounts contributed to a specific charitable,
educational, religious, etc. exempt organization in
any one tax year of that organization will be
treated as a single contribution by the contributing
private foundation,

If the requirements for establishing the contribu-
tion as a qualifying distribution to certain exempt

organizations are not completely satisfied, then
only that part of the contribution that was redis-
tributed will be treated as a qualifying distribution.

To satisfy distribution requirements, a donee
organization may choose to treat as a qualifying
distribution from corpus for the current year any
amount distributed in a prior tax year that was
treated as a distribution out of corpus if:

1) That amount has not been used for any other
purpose (such as a carryover of excess quali-
fying distributions, or a prior year
redistribution),

2) The corpus distribution occurred within the
preceding 5 years, and

3) The amount distributed is not later used for
another purpose.

The choice must be made by attaching a
statement to the Form 990-PF filed for the tax
year for which the choice is to apply. The
statement must contain a declaration by the
appropriate foundation manager that the founda-
tion is making a choice under these provisions,
and must specify that the distribution is to be
treated as having been made out of a distribution
from corpus in a designated prior tax year or
years.

Example. \n 1987, the Miller Foundation, a
private foundation, made a contribution out of
1986 income to the James Foundation, a private
nonoperating foundation. The contribution was the
‘only one received by the James Foundation in
1987. In 1988 the James Foundation made a qual-
ifying distribution to an art museum maintained by
an operating foundation in an amount equal to the
contribution received from the Miller Foundation.
The James Foundation aiso distributed all of its
undistributed 1987 and 1988 income for other
charitable, educational, religious, etc. purposes.
The distribution to the art museum is treated as
made out of corpus.

The Miller Foundation’s contribution to the
James Foundation is a qualifying distribution out
of the Miller Foundation’s 1986 income. This is a
qualifying distribution if it obtains adequate
records or enough other evidence from the James
Foundation showing the nature and amount of the
distribution, the recipient's identity, and the fact
that the distribution is treated as made out of
corpus. If the James Foundation’s qualifying distri-
butions during 1988 had been equal only to the
contribution received from the Miller Foundation
and its 1988 undistributed income, the James
Foundation could have chosen to treat the
amount distributed in excess of its 1987 undistrib-
uted income as a qualifying distribution made out
of corpus (see Special choice, later) and thus sat-
isfy the qualifying distribution requirements.

Limit. A contribution by a private foundation to a
recipient organization, which the recipient uses to
make payments to a secondary recipient, is not a
contribution by the private foundation to the sec-
ondary recipient if the foundation does not
earmark the use of the contribution for any named
secondary recipient, and does not keep the power
to control the selection of the secondary recipient
by the organization to which the foundation has
contributed.

Treatment of qualifying distributions. Any
qualifying distribution made during the tax year will
be treated as being made:

1) First, out of undistributed income of the imme-
diately preceding tax year (if the private foun-
dation was subject to the initial excise tax for
the prior tax year) to the extent thereof,

2) Second, out of undistributed income for the
current tax year to the extent thereof, and

3) Then, out of corpus.

Distributions are taken into account in the order of
time in which made.

Special choice. If any qualifying distribution is
not treated as being made out of undistributed
income of the immediately preceding tax year, the

25



Department of the Treasury
Internal Revenue Service
Catalog Number 46586F

Publication 578
(Rev. Jan. 89)

Tax Information
for Private
Foundations
and Foundation
Managers

Contents

Introduction .....1

Chapter |, Determination of Status ..
Private Foundation Status .....2
Private Operating Foundations
Exempt Operating Foundations .....4

Special Rules for Certain Foundations &
Trusts .....5

Chapter II, Filing, Notice, and Other
Requirements .
Return Requirements .....9
Chapter III, Termination of Private
Foundation Status .....10
Termination under Section 507(a) .....10
Voluntary Termination under Section
507(b)(1) .....11
Transferee Foundations Section
507(b)(2) .....12
Chapter IV, Tax on Net Investment
Income .....13
Chapter V, Disqualified Persons .....14

Chapter VI, Taxes on Taxable
Expenditures .....15

Chapter VII, Taxes on Failure to Distribute
Income .....21

Chapter VIII, Taxes on Self-Dealing
What Is Self-Dealing .....27
Indirect Self-Dealing .....28
Exceptions to Self-Dealing

Chapter IX, Taxes on Jeopardizing
Investments .....30

Chapter X, Taxes on Excess Business
2

26

28

Holdings ..
Chapter XI, Excise Tax Appeal
Procedures .....33
Introduction

A private foundation is any domestic or foreign
organization described in section 501(c)(3) of the
Internal Revenue Code except for an organization
referred to in section 509(a)(1), (2), (3), or (4) of
the Code. In effect, the definition divides organiza-
tions described in section 501(c)(3) into two clas-
ses, namely private foundations and public
charities.

Organizations that are not private foundations
are generally those which have broad public
support or actively function in a supporting
relationship to those organizations.

An excise tax is imposed on the net investment
income of most domestic private foundations. This
is discussed in Chapter IV of this publication.

The Code contains five provisions that impose
two-tier excise taxes on private foundations, foun-
dation managers, or other disqualified persons
that engage in certain prohibited acts. These five
provisions are discussed in Chapters VI through X
of this publication. Foundation managers and dis-
qualified persons are defined in Chapter V.

Thé first-tier tax (initial tax) is automatically
imposed if the foundation engages in a prohibited
act. For prohibited Acts occurring after 1984, the
initial tax may be abated (set aside) if it is estab-
lished that the prohibited act was due to reasona-
ble cause and not to willful neglect, and that the
act was corrected within the correction period. If
the prohibited act is not corrected by the end of
the taxable period, the second-tier tax (additional
tax) is imposed. Generally, the taxable period
ends on the earlier of:

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

2) The date the initial tax is sent

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.

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.

In addition, a private foundation may 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.

Other publications that may be of general
interest are Publication 526, Charitable Contribu-
tions, Publication 557, Tax-Exempt Status for
Your Organization, and Publication 598, Tax on
Unrelated Business Income of Exempt
Organizations.

Chapter |

Determination of
Status

Every organization that qualifies for tax exemption
as an organization described in this publication is
a private foundation unless it falls into one of the
categories specifically excluded from the definition
of that term. Organizations that fall into the
excluded categories, discussed later, are generally
those that either have broad public support or
actively function to support those organizations.
Organizations that test for public safety also are
excluded.

An organization is not a private foundation if
it

1) A church or a convention or association of
churches,

2) A school,

3) An organization operated for the benefit of
certain state and municipal colleges and
universities,

4) A hospital,

5) A medical research organization (operated in
conjunction with a hospital),

6) A governmental unit,

7) A publicly supported organization,

8) 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,

9) An organization operated, supervised, or con-
trolled by or in connection with one or more of
the organizations described in items (1)
through (8), but not controlled (directly or indi-
rectly) by disqualified persons other than foun-
dation managers,

10) An organization operated solely for the bene-
fit of one or more organizations that are
exempt as civic leagues or social welfare
organizations, local associations of employ-
ees, labor, agricultural, or horticultural organi-
zations, and business leagues, chambers of
commerce, real estate boards, boards of


Failure to meet 60-month requirements. Gen-
erally, any organization that does not meet section
507(b)(1)(B) termination requirements during the
60-month period will be treated as a private foun-
dation for the entire 60-month period. Any grants
or contributions made to such an organization will
be treated as contributions made to a private
foundation.

However, the organization will be treated as a
section 509(a)(1), (2), or (3) organization for any
tax year or years that the requirements are met.
Any grants or contributions to the organization
during such year or years will be treated as made
to a section 509(a)(1), (2), or (3) organization and
the organization itself will not be subject to Chap-
ter 42 taxes and restrictions for such year or
years.

In determining whether an organization meets
section 509(a)(1), (2), or (3) requirements for any
year in the 60-month period, the organization will
be treated as if it were a new organization with its
first tax year beginning on the date the 60-month
period begins.

Advance rulings for 60-month terminations.
An organization which files the notification
required for a 60—-month termination may receive,
at the discretion of the Service, an advance ruling
that the organization can reasonably be expected
to terminate its private foundation status over the
60-month period.

To receive an advance ruling, the organization
must also agree to an extension of time to assess
the section 4940 tax on net investment income
(discussed in Chapter IV) for the years in the
60-month termination period. If an organization
agrees to the extension and it is accepted, it will
not have to pay the tax on net investment income
during the 60-month period. The signed and dated
agreement Form 872, Consent to Extend the Time
to Assess Tax, should be filed with the request for
the advance ruling. The assessment period for all
years in the termination period must be extended
to 4 years, 4 months and 15 days after the end of
the last year in the 60-month termination period.

The decision to grant a favorable ruling will be
based on the facts and circumstances, taking into
account organizational structure, proposed pro-
grams and activities, intended methods of opera-
tion, and projected sources of support.

Grantors or contributors to an organization
that has obtained a favorable advance ruling may
rely on that ruling until notice of revocation is
published in the Internal Revenue Bulletin. How-
ever, a grantor or contributor may not rely on such
a ruling if the grantor or contributor was responsi-
ble for, or aware of, the action or inaction that
resulted in the organization's failure to meet the
requirements of section 509(a)(1), (2), or (3) or
knew that the Service had notified the organiza-
tion that its advance ruling would be revoked.

A potential grantee organization may request
an advance ruling before receiving a grant or con-
tribution, to the effect that the grant or contribution
will not result in the grantee’s failing to meet
section 509(a)(1), (2), or (3) requirements. The
ruling request may be filed by the grantee organi-
zation with its District Director. If a favorable ruling
is issued, the grantor or contributor may rely upon
it.

However, an advance ruling may not be relied
upon by the organization obtaining that ruling. If
the organization later fails to complete a
successful termination under section 507(b)(1)(B)
and was not a section 509(a)(1), (2), or (3) organi-
zation, it will have to pay interest on the amount of
tax imposed on net investment income under
section 4940 that is unpaid as of the last date for
payment of that tax. However, since the failure to
pay the tax during the 60-month period (or before
revocation of the ruling) is due to reasonable
cause, no penalty will be assessed.

Organizations without advance rulings. An
organization that does not receive an advance
ruling does not have to pay the tax on net

12

investment income during the 60-month termina-
tion period if it signs the consent to extend the
assessment period for the tax. The same rules
regarding interest and penalties apply if the organ-
ization does not complete a successful termina-
tion of its private foundation status under section
507(b)(1)(B).

Transferee Foundations
Section 507(b)(2)

The transfer of assets of a private foundation to
another private foundation in a liquidation, merger,
recapitalization, redemption, or other adjustment,
organization, or reorganization is a section
507(b)(2) transfer. A transfer under this section
will not cause the transferee to be treated as a
newly created organization for purposes of the
private foundation provisions. However, the
transferee may be required to reapply for
exemption if it wishes to be exempt under section
501(c)(3) of the Code.

The term “other adjustment, organization, or
reorganization” includes any partial liquidation, or
any other significant disposition of assets (defined
later), to one or more private foundations, other
than transfers for full and adequate consideration
or distributions out of current income (including
qualifying distributions out of current and earlier
years’ undistributed income).

A transferee organization will succeed to the
combined tax benefit of the transferor organization
to the extent of the combined tax benefit multi
plied by a fraction. The numerator of the fraction is
the fair market value of the assets (minus
encumbrances) transferred, and the denominator
is the fair market value of the total assets of the
transferor (minus encumbrances) immediately
before the transfer. Fair market value is deter-
mined as of the time of the transfer. A transferee
organization not effectively controlled, directly or
indirectly, by the same person or persons who
control the transferor organization will not
succeed to a combined tax benefit greater than
the fair market value of assets transferred at the
time of the transfer.

Example. |n a liquidation, the White Founda-
tion, a private foundation, transfers to the Oak
Foundation, a private foundation, all of its assets,
which have a fair market value of $400,000. Imme-
diately before the transfer the White Foundation’s
combined tax benefit was $200,000, and the Oak
Foundation’s combined tax benefit was $300,000.
After the transfer, the Oak Foundation has a
combined tax benefit of $500,000 ($200,000
$300,000).

Except as otherwise provided in Transfer to an
effectively controlled foundation later, a private
foundation must meet the distribution require-
ments described in Chapter VIl for any year in
which it makes a section 507(b)(2) transfer of all
or part of its net assets to another private founda-
tion. The transfer itself will be counted as a quali-
fying distribution if it meets the requirements given
in Chapter VII. However, when the transferor has
disposed of all its assets, the recordkeeping
requirements will not apply to any period in which
it has no assets:

Whenever a private foundation makes a section
507(b)(2) transfer of all or part of its net assets to
another private foundation, the applicable time
period described in Chapter X will include the
respective holding periods of both the transferor
and the transferee. Except as otherwise provided
in Transfer to an effectively controlled foundation,
the provisions of Chapter VI will not apply to the
transferee or to the transferor for any expenditure
responsibility grants as discussed in Chapter VI
made by the transferor during any period in which
the transferor has no assets. However, the infor-
mation reporting requirements described in Chap-
ter VI remain in effect.

A substantial contributor of the transferor foun-
dation will be considered a substantial contributor
of the transferee organization even if the individual

does not meet the definition of a substantial con-
tributor with respect to the transferee organization.
With respect to the transferor foundation, a
person is a substantial contributor if the person
contributed or bequeathed an aggregate amount
of more than $5,000 to the foundation, provided
that the amount contributed is more than 2% of
the total contributions received by the foundation
before the close of the taxable year in which the
contribution or bequest is received by the founda-
tion. See Chapter V for a discussion of the term
“substantial contributor.”

Also, if a private foundation incurs a liability for
any excise taxes discussed in Chapters VI through
X of this publication either before a transfer or as
a result of a transfer of assets, then the transferee
foundation will be considered to have received the
assets subject to the tax to the extent that the
transferor foundation does not satisfy the liability.

Transfer to an effectively controlled founda-
tion. |f a private foundation transfers all of its net
assets to one or more private foundations that are
effectively controlled, directly or indirectly, by the
same person or persons who effectively controlled
the transferor private foundation, then the
transferee foundation is treated as if it were the
transferor for purposes of all excise taxes
discussed in this publication as well as the termi-
nation provisions discussed in this chapter. When
proportionality is appropriate, the transferee foun-
dation will be treated as if it were the transferor in
the proportion that the fair market value of the
assets transferred (minus encumbrances) bears to
the fair market value of the assets (minus
encumbrances) of the transferor immediately
before the transfer. This does not relieve the
transferor private foundation from filing required
returns, reports, and other information.

Example. The trustees of X charitable trust, a
private foundation, form Y, a charitable corpora-
tion, also a private foundation, to make the
conduct of their activities easier. The trustees of X
are also the directors of Y. Y has the same chari-
table purposes as X. All the assets of X are trans-
ferred to Y, and Y continues to carry on X’s
charitable activities. Under these circumstances, Y
is treated as if it were X. Y will be permitted to
take advantage of any special rules relating to
excise tax requirements to the same extent as
could X if X had continued in existence.

Status of transferee organization under
section 507(b)(2). A transfer of assets under
any liquidation, merger, redemption, recapitaliza-
tion, or other adjustment, organization, or reorgan-
ization to an organization other than a charitable,
educational, religious, scientific, etc. organization
(other than an organization engaged in testing for
public safety) or a nonexempt charitable trust
described in section 4947(a)(1) is a taxable
expenditure (see Chapter VI). For a transfer of
assets not to be a taxable expenditure, it must be
to one of the organizations described earlier.
Unless the transferee is a section 509(a)(1), (2), or
(3) organization, section 507(b)(2) applies.

However, if the assets are transferred to a
transferee organization other than a section
501(c)(3) organization (excluding organizations
engaged in testing for public safety) or section
4947(a)(1) organization, and the assets are then
transferred to a private foundation to correct a tax-
able expenditure, section 507(b)(2) applies as if
the transfer of assets had been made directly to a
private foundation.

A significant disposition of assets to one or
more private foundations includes any disposition
for the tax year when both:

1) The dispositions to one or more private foun-
dations for the tax year, and

2) The total related dispositions made during
earlier tax years in which any disposition to
‘one or more private foundations for the tax
year was part of a series of related disposi-
tions made during those years. These total
25% or more of the fair market value of the
foundation's net assets at the start of the tax


Notice to the public. The Internal Revenue
Service will publish in the Internal Revenue
Bulletin any notice it receives of voluntary termina-
tion under section 507(a)(1) (or any notice it
issues of involuntary termination of exempt status,
discussed later).

No termination can take place under section
507(a)(1) if the private foundation transfers all or
part of its assets to another private foundation or
to one or more private foundations and to one or
more section 509(a)(1), (2), (3), or (4) organiza-
tions, under a liquidation, merger, redemption,
recapitalization, or other adjustment, organization,
or reorganization.

Transferee liability. A termination under section
507(a) does not result from either a transfer of all
its assets or a significant disposition of its assets
(defined later) by a private foundation unless it
chooses to terminate under section 507(a)(1), or
an involuntary termination occurs. If a private
foundation incurs any liability for the Chapter 42
excise taxes before or in connection with the
transfer, transferee liability may be applied against
the transferee organization for payment of those
taxes. Liability for Chapter 42 excise taxes is con-
sidered to be incurred on the date the act or fail-
ure to act occurs that gives rise to the initial tax
liability.

A private foundation that transfers all of its net
assets must file Form 990-PF, Return of Private
Foundation. However, neither a private foundation
nor its managers are required to file this form for
any tax year after the tax year in which the last
transfer occurs if during those later years the foun-
dation has neither legal nor equitable title to any
assets nor engages in any activity.

Section 507(c) tax. The tax imposed under
section 507(c) on the termination of a private
foundation is the lesser of:

1) The combined tax benefit resulting from the
section 501(c)(3) status of the organization, or

2) The value of the net assets of the
organization.

The combined tax benefit resulting from the
section 501(c)(3) status of any private foundation
is the sum of:

1) The combined increases in income, estate,
and gift taxes that would have been imposed
on all substantial contributors if deductions
for all contributions made by those contribu-
tors to the foundation after February 28, 1913,
had been disallowed, and

2) The combined increases in income tax that
would have been imposed on the private
foundation’s income for tax years beginning
after 1912 if —

a) The foundation had not been tax exempt,
and

b) In the case of a trust, its charitable deduc-
tion had been limited to 20% of its taxable
income, and

3) Amounts received from private foundations to
which transferee liability applies, and

4) The interest on the tax increases in (1), (2),
and (3) from the first date the increase would
have been due or payable to the date the
organization ceases to be a private
foundation.

In figuring the combined increases in tax under
(1), all deductions for a particular contribution for
income, estate, or gift tax purposes must be
included. For example, if a substantial contributor
had taken income tax and gift tax deductions for a
charitable contribution to the foundation, the
amount of each deduction must be included. The
combined tax benefit may be more than the fair
market value of the property transferred.

The value of the net assets of the organization
is the greater of:

1) The value on the first day action was taken to
terminate private foundation status, or

2) The value on the date the organization
ceased to be a private foundation.

The valuation date in (1) is the date the organi-
zation gave notice it was terminating private foun-
dation status,

When tax is imposed. These same dates deter-
mine when liability for the section 507(c) tax is
imposed because a transfer of assets by a private
foundation is involved.

Substantial contributors. See Chapter V for the
definition of what is a substantial contributor.

Abatement of section 507(c) taxes. The
unpaid part of section 507(c) tax can be abated by
the IRS if:

1) The private foundation distributes all of its net
assets to one or more charitable organiza-
tions described in section 509(a)(1) that have
been in existence and so described for at
least 60 months, or

2) The Service receives effective assurance
through corrective action taken in state pro-
ceedings that assets dedicated to charitable
purposes will, in fact, be used for charitable
purposes.

Corrective action in state proceedings. The
section 507(c) tax may be abated by the IRS if,
within a year from the date of issuing a notice of
deficiency for that tax, an appropriate state officer
certifies that corrective action has been initiated
under state law under court order or approval.

Corrective action is the vigorous enforcement
of state laws sufficient to assure implementation
of the excise tax provisions of Chapter 42 and to
insure that foundation assets are preserved for
charitable purposes.

Involuntary termination. An organization's sta-
tus may be involuntarily terminated if the IRS
notifies the organization that, because of willful,
flagrant, or repeated acts or failures to act giving
rise to the Chapter 42 excise taxes, the organiza-
tion is liable for section 507(c) tax.

Willful repeated acts are at least two acts or fail-
ures to act which are voluntarily, consciously, and
knowingly committed in violation of the excise tax
provisions of Chapter 42, and which appear to a
reasonable person to be a gross violation of these
provisions. The act or failure to act may result in
termination of the foundation's status even though
the tax is imposed on the foundation's managers
rather than on the foundation itself. Furthermore,
the failure to correct the act or acts (or failure or
failures to act) that gave rise to excise tax liability
under Chapter 42 may cause involuntary termina-
tion of the private foundation. No motive to avoid
legal restrictions or incur tax is necessary to make
‘the act or failure to act willful. However, a founda-
tion’s act or failure to act is not willful if the foun-
dation or its manager, if applicable, does not know
that the act or failure to act is an act of self
dealing, a taxable expenditure, or other act or fail-
ure to act giving rise to liability for excise taxes.

In the case of an involuntary termination,
section 507(c) tax is computed in the same
manner as for voluntary terminations. However, in
determining the value of net assets of the founda-
tion on the first day action was taken to terminate
private foundation status, the valuation date is the
date a willful arid flagrant act, failure to act, or
series of repeated acts or failures to act first
occurred.

Although the section 507(c) tax resulting from
an involuntary termination may be abated (see
Abatement of section 507(c) taxes earlier), this is
not true for any excise tax liability attributable to
the acts or failures to act that caused the involun-
tary termination.

Voluntary Termination
under Section 507(b)(1)
A private foundation may voluntarily terminate its

status under section 507(b)(1) by either
transferring all its net assets to one or more public

charities, or by meeting the requirements of
sections 509(a)(1), (2), or (3) continuously for 60
months beginning with the first day of any tax
year. Private foundation status may not be termi-
nated under either of these methods if there have
been either willful repeated acts (or failures to act)
or a willful and flagrant act (or failure to act) that
gives rise to liability for excise taxes on transac-
tions discussed in Chapters VI through X, known
as “Chapter 42” excise taxes.

Transfer of Assets
to a Public Charity

A private foundation may terminate its status
under section 507(b)(1)(A) by distributing all its net
assets to one or more organizations with a ruling
or determination letter described in section
509(a)(1). However, the organization to which the
distribution is made must have been in existence
and so described for a continuous period of at
least 60 months before the distribution.

A distribution to a public charity formed from the
consolidation of two public charities, for the same
purpose and with the same activity, each of which
would have met the 60-month existence require-
ment, had they not consolidated, is a qualifying
distribution.

A private foundation that terminates its status in
compliance with section 507(b)(1)(A) is not
required to notify the IRS of its intent to terminate.

An organization will have distributed all its net
assets only if it transfers all of its right, title, and
interest in, and to, all of its net assets.

An organization that continues in existence after
terminating its private foundation status under
section 507(b)(1)(A) must file a new application on
Form 1023 in order to be treated as a section
501(c)(3) organization, unless it is a type of organi-
zation that is not required to file Form 1023. A list
of these types of organizations can be found in
Publication 557, Tax-Exempt Status for Your
Organization.

Operation as a Public Charity

An organization may terminate its private founda-
tion status under section 507(b)(1)(B) if it meets
the requirements of section 509(a)(1), (2), or (3)
for a continuous 60-month period beginning with
the first day of any tax year, and notifies its District
Director before the beginning of the 60-month
period that it is terminating its private foundation
status. Also, it must establish immediately after
the end of the 60-month period that it has met the
requirements of section 509(a)(1), (2), or (3).

Notification to the Service by a foundation
that it is terminating under section 507(b)(1)(B)
does not constitute notice of a section 507(a) ter-
mination even if the foundation fails to meet the
requirements of section 507(b)(1)(B). However, a
successful section 507(b)(1)(B) termination will
incur no tax under section 507(c) and, therefore,
will require no abatement of tax.

Notice of termination. The notice of termina-
tion should include:

1) The name and address of the private
foundation,

2) Its intention to terminate its private foundation
status,

3) The Code section under which it seeks classi-
fication (section 509(a)(1), (2), or (3)),

4) If section 509(a)(1) applies, the specific type
of section 170(b)(1)(A) organization for which
it seeks classification,

5) The date its regular tax year begins, and

6) The date the 60-month period begins.

Effect of satisfaction of termination require-
ments. If the organization meets the require-
ments of section 507(b)(1)(B) during the
continuous 60-month period, it will be treated as a
section 509(a)(1), (2), or (3) organization for the
entire 60-month period.

an


period is extended by any period during which a
deficiency cannot be assessed because of
pending Tax Court proceedings, and any other
period the IRS determines is reasonable and
necessary.

Chapter X

Taxes on Excess
Business Holdings

Generally, under section 4943 of the Internal Rev-
enue Code, the combined holdings of a private
foundation and ail of its disqualified persons are
limited to 20% of the voting stock in a business
enterprise (described later) that is a corporation.
The 20% limitation also applies to holdings in bus-
iness enterprises that are partnerships, joint
ventures, or other unincorporated enterprises. 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 (described
later), in a business enterprise may become liable
for an excise tax based on the amount of the
excess holdings.

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 deter-
mined as of the day during the tax year when the
foundation's excess holdings in the business were
the greatest.

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 later).

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 later).

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 produc-
tion of income from the sale of goods or the per-
formance of services and that constitutes an
unrelated trade or business under section 513 of
the Code. The term does not include a
functionally related business, a trade or busi-
ness that obtains at least 95% of its gross income
from passive sources, or program-related
investments as discussed in Chapter IX.

A functionally related business is:

1) A trade or business the conduct of which is
substantially related (aside from the mere pro-
vision of funds for the exempt purpose) to the
‘exercise or performance by the private foun-
dation 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 with-
out compensation,

8) A business carried on by the foundation pri-
marily 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, employ-
ees, and visitors),

4) A business that consists of the selling of mer-
chandise, substantially all of which has been
received by the foundation as gifts or contri-
butions, or

32

5) An activity carried on within a larger combina-
tion 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).

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 dispo-
sitions 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 consid-
ered a sale or exchange, are not consid-
ered 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.

Income that is otherwise considered
passive will not lose its character merely
because it is unrelated debt-financed income
described in section 514.

Excess business holdings. The excess busi-
ness 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
(defined in Chapter V, of this publication). There
are two exceptions to this rule.

First, if one or more third persons, who are not
disqualified persons, have effective control of a
corporation, the private foundation and all disqual-
ified 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 poli-
cies of a business enterprise. It is the actual
control which is decisive, and not its form or the
means by which it is exercisable.

Second, a private foundation is not treated as
having excess business holdings in any corpora-
tion 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.

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 corpo-
ration. All equity interests which are not voting
‘stock shall be classified as nonvoting stock.

Interest in sole proprietorships. A private foun-
dation is not permitted any holdings in sole propri-
etorships that are business enterprises unless
they were held before May 26, 1969, or acquired
by gift or bequest thereafter. See the discussion
‘on these special rules later.

Attribution of business holdings. For determin-
ing 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 ina
split-interest trust, which are discussed in Chapter
).

Example. Tim Jones, a foundation manager of
X Foundation, owns 50% of the stock of Y Corpo-
ration. (Y Corporation is not actively engaged in a
trade or business.) Z Corporation is an
80%-owned subsidiary of Y Corporation. There-
fore, 40% of the Z Corporation stock is consid-
ered held by a disqualified person to X
Foundation. Any holding of more than 2% of the
voting stock or 2% of the value of the Z Corpora-
tion stock will result in all of the Z Corporation
stock held by the foundation being treated as an
excess business holding.

In making its computations, the foundation must
determine its proportionate interest and that of all
disqualified persons in each class of stock, in
relation to the proportion that the voting interest of
each class has to all votes in the corporation. For
example, if the foundation owns 50% of the
outstanding shares of a class of stock that has
60% of the voting rights in a corporation, the foun-
gation’s holdings in the voting stock would be

0%.
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 securi-
ties 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.
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.

Example. The Y private foundation files tax
returns on a calendar year basis. It acquires
‘excess business holdings on July 7, 1987, and
does not dispose of them until after the Service
mails a notice of deficiency for the initial and
additional tax on December 10, 1988. For Y's
excess business holdings, the taxable period
begins on July 7, 1987, and ends on December
10, 1988. Because the 1987 tax year of the foun-
dation ended in the taxable period, the foundation
is liable for a tax of 5% of the largest amount of
excess holdings it had at any time during that
year.

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


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.

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.

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.

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

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

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 jeop-
ardizing investment.

Due to reasonable cause. A foundation man-
ager’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.

Advice of counsel. A manager's action will be
considered due to reasonable cause if the man-
ager relies on advice of counsel expressed in a
reasoned written legal opinion (discussed under
Advice of counsel, in Chapter Vill). In addition, a
foundation manager may 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 founda-
tion.

Participation. The participation of any founda-
tion manager in the making of an investment shall
consist of any manifestation of approval of the
investment,

Knowing. Foundation managers will be consid-
ered 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 provi-
sions 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 rele-
vant in determining whether actual knowledge of
such fact or rule is present.

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 founda-
tion’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
loss.

These rules do not exempt or relieve any
person from compliance with any federal or state
law imposing any obligation, duty, responsibility, or
other standard of conduct on the operation or
administration of an organization or trust. Nor shall
any state law exempt or relieve any person from
any obligation, duty, responsibility, or other stan-
dard of conduct provided in these rules.

The tax on jeopardizing investments does not
apply to investments originally made by a person
who later transferred them as gifts to the founda-
tion. However, if the person receives any consid-
eration from the foundation on the transfer, the
foundation will be treated as having made an
investment in the amount of the consideration.

The tax on jeopardizing investments does not
apply to investments that are acquired by the
foundation as a result of a corporate reorganiza-
tion nor does the tax apply to investments made
before 1970 unless the form or terms of the
investments are later changed, or they are
exchanged for other investments.

Program-related investments are not subject to
the tax on jeopardizing investments. Program-
related investments are those in which:

1) The primary purpose is to accomplish one or
more of the foundation’s exempt purposes,

2) Production of income or appreciation of prop-
erty is not a significant purpose, and

3) Influencing legislation or taking part in political
campaigns on behalf of candidates is not a
Purpose.

In determining whether a significant purpose of
an investment is the production of income or the
appreciation of property, it is relevant whether
investors who engage in investments only for
profit would be likely to make the investment on
the same terms as the private foundation.

If an investment incidentally produces signifi-
cant income or capital appreciation, this is not, in
the absence of other factors, conclusive evidence
that a significant purpose is the production of
income or the appreciation of property.

The investments, to be program related, must
significantly further the foundation's exempt
activities. They must be investments that would
not have been made except for their relationship
to the exempt purposes. The investments include
those made in functionally related activities
(described in Chapter X) that are carried on within
a larger combination of similar activities related to
the exempt purposes.

The following are some typical examples of pro-
gram-related investments:

1) Low-interest or interest-free loans to needy
Students,

2) High-risk investments in nonprofit low-income
housing projects,

3) Low-interest loans to small businesses owned
by members of economically disadvantaged
groups, where commercial funds at reasona-
ble interest rates are not readily available,

4) Investments in businesses in deteriorated
urban areas under a plan to improve the
economy of the area by providing employment
or training for unemployed residents, and

5) Investments in nonprofit organizations
combating community deterioration.

If a foundation changes the form or terms of an
investment, and if the investment no longer quali-
fies as program-related, it then must be deter-
mined whether or not the investment jeopardizes
carrying out its exempt purposes.

Once an investment is determined to be pro-
gram-related, it will continue to qualify as a pro-
gram-related investment if changes in the form or
terms of the investment are made primarily for
exempt purposes and not for any significant
purpose involving the production of income or the
appreciation of property. A change made in the
form or terms of a program-related investment for
the prudent protection of the foundation’s
investment will not ordinarily cause the investment
to cease to qualify as program-related. Under cer-
tain conditions a program-related investment may
cease to be program-related because of a critical
change in circumstances, such as serving an
illegal purpose or serving the private purpose of
the foundation or its managers.

An investment that ceases to be program-
related because of a critical change in
circumstances does not subject the foundation
making the investment to the tax on jeopardizing
investments before the 30th day after the date on
which the foundation (or any of its managers) has
actual knowledge of the critical change in
circumstances.

The taxable period begins with the date of the
investment and ends on the earliest of:

1) The date of removal from jeopardy, or

2) The date a notice of deficiency for the initial
tax is mailed, or

3) The date the initial tax is assessed.

It may include more than one tax year of the
foundation.

Example. The Wilson Foundation has the cal-
endar year as its tax year. It makes a jeopardizing
investment on November 28, 1988, and does not
remove the investment from jeopardy until Janu-
ary 15, 1989. The taxable period is from Nov-
ember 28, 1988, to January 15, 1989. It therefore
is liable for a total initial tax of 10% of the amount
invested (5% for each tax year or part of a year in
the taxable period).

Removal from jeopardy. The foundation
removes an investment from jeopardy when it
sells or otherwise disposes of it, and the proceeds
of the sale or other disposition are not themselves
jeopardizing investments.

A change by a foundation in the form or terms
of a jeopardizing investment results in the removal
of the investment from jeopardy if, after the
change, the investment no longer jeopardizes the
carrying out of the foundation’s exempt purposes.
Making one jeopardizing investment and later
exchanging this investment for another jeopardiz-
ing investment will be treated as only one jeopard-
izing investment. A jeopardizing investment is not
removed from jeopardy by a transfer to another
private foundation related to the transferor foun-
dation unless the investment is a program-related
investment in the hands of the transferee
foundation.

The correction period begins with the date of
the investment and ends 90 days after a notice of
deficiency for the additional tax is mailed. This

31



An organization will not be treated as tax
‘exempt for any period before it files Form 1023
unless it files the form within 15 months from the
end of the month in which it was organized. If the
application is not timely filed, exemption will be
recognized only for the period following receipt of
the application.

Certain organizations are not required to file
Form 1023. These include churches, interchurch
organizations of local units of a church,
conventions or associations of churches, or inte-
grated auxiliaries of a church, such as a men’s or
women’s organization, religious school, mission
society, or youth group. While there are certain
other exceptions to the Form 1023 filing require-
ment that apply to small public charities and to
subordinate organizations of a central organization
that has a group exemption letter, these
exceptions do not apply to private foundations.

If an organization that is required to file Form
1023 does not comply with the filing requirements,
charitable contribution deductions will not be
allowed for any gift or bequest made to the organi-
zation.

Extension of time. An extension of time for filing
Form 1023 may be granted by the key District,
Director if your request is submitted before the
15-month period has passed and you demonstrate
that additional time is needed.

If the 15-month period for filing Form 1023 has
passed, an extension of time to file it may be
granted by the Commissioner of the Internal Reve-
nue Service under section 1.9100 of the Income
Tax Regulations if you can show good cause.
Since the 15-month period, in which time an
organization must file a Form 1023, is fixed by the
regulations, rather than by statute, an extension
may be granted if the request meets certain
conditions.

The following factors will be taken into account
in determining if good cause for granting the
extension has been shown,

1) Due diligence of the taxpayer.

2) Prompt action by the taxpayer.

3) Intent of the taxpayer.

4) Prejudice to the interests of the government.
5) Statutory and regulatory objectives.

Specific questions are to be answered for each
of these factors. These questions can be found in
Revenue Procedure 79-63, 1979-2 C.B. 578,
which is available from the IRS. The information
and other documents submitted must be specifi-
cally responsive and relevant to answering these
questions.

The information submitted by the organization
should include a chronological account of the
events leading to the failure to make the
application, names and current addresses of each
person having knowledge or information about the
events, affidavits or statements from such
persons, and any other information bearing on the
Service's consideration of the request. The
request must be signed under penalties of perjury
by an officer of the organization who has
knowledge of the facts. Supporting affidavits or
statements must also be signed under penalties of
perjury.

The request for an extension must be sent to
the appropriate key District Director.

Appeal Procedures

If an organization applies for tax-exempt status
and receives an adverse determination letter as to
tax exemption, classification as to status under
section 509(a) as an organization that is not a
private foundation, classification as a private oper-
ating foundation, the organization will be advised
of its right to protest the determination by request-
ing Appeals Office consideration. The protest
must be submitted to the key District Director
within 30 days from the date of the adverse deter-
mination letter and must state whether it wishes
an Appeals Office conference.

8

Any determination letter issued on the basis of
technical advice from the National Office may not
be appealed to the Appeals Office for those
issues that were the subject of the technical
advice.

If an application is referred to the National
Office for issuance of a ruling and an adverse
tuling is issued, the organization will be informed
of the basis for the conclusion, of its right to file a
protest within 30 days, and for a conference at the
National Office.

Appeals Office consideration. The protest to
the Appeals Office should be filed with the key
district office and contain the following
information:

1) The organization’s name, address, and
employer identification number;

2) A statement that the organization wants to
protest the determination;

3) The date and symbols on the determination
letter;

4) A statement of facts supporting the organiza-
tion’s position in any contested factual issue;

5) A statement outlining the law or other author-
ity the organization is relying on; and

6) A statement as to whether a conference at
the Appeals Office is desired.

The statement of facts (item 4) must be
declared true under penalties of perjury. This may
be done by adding to the protest the following
signed declaration: “Under penalties of perjury, |
declare that | have examined the statement of
facts presented in this protest and in any accom-
panying schedules and statements and, to the
best of my knowledge and belief, it is true, correct,
and complete.”

If the organization's representative submits the
protest, a substitute declaration must be included,
stating:

1) That the representative prepared the protest
and accompanying documents; and

2) Whether the representative knows personally
that the statements of fact contained in the
protest and accompanying documents are
true and correct.

Be sure the protest contains all of the informa-
tion requested. Incomplete protests will be
returned for completion.

If a conference is requested, it will be held at
the Appeals Office, unless the organization
requests that the meeting be held at a district
office convenient to both parties.

The Appeals Office, after considering the organ-
ization’s protest as well as information presented
in any conference held, will notify the organization
of its decision and issue an appropriate determina-
tion letter. An adverse decision may be appealed
to the courts (discussed later).

Appeals offices must request technical advice
from the National Office on any exempt organiza-
tion issue concerning qualification for exemption
or foundation status for which there is not
published precedent or for which there is reason
to believe that nonuniformity exists. If an organiza-
tion believes that its case involves such an issue,
it should ask the Appeals Office to request techni-
cal advice.

Representation. A principal officer or trustee
may represent an organization at any level of
appeal. Or, the organization may be represented
by an attorney, certified public accountant, or indi-
vidual enrolled to practice before the Internal Rev-
enue Service.

If the organization’s representative attends a
conference without a principal officer or trustee,
the representative must file a proper power of
attorney or a tax information authorization before
receiving or inspecting confidential information.
Form 2848, Power of Attorney and Declaration

of Representative, or Form 2848-D, Tax Infor-
mation Authorization and Declaration of Rep-
resentative, as appropriate (or any other properly
written power of attorney or authorization), may be
used for this purpose. These forms may be
obtained from the IRS.

Appeal to courts. In addition to administrative
remedies, an organization may use certain judicial
remedies. If the statutory prerequisites are met, an
organization may file suit in a United States
District Court or the United States Claims Court for
a refund of taxes paid, or in the United States Tax
Court for a redetermination of any tax deficiencies.
For more information on these types of suits, see
Publication 556, Examination of Returns,
Appeal Rights, and Claims for Refund. An
‘exempt organization may also file suit for a declar-
atory judgment (discussed later) in certain sit
tions. Any of these suits may result in a decision
that an organization was exempt for the period
considered by the court.

{f the final judicial determination is that an
organization is exempt from tax, is not a private
foundation, or is a private operating foundation,
the Service will issue a favorable ruling or determi-
nation letter, under the following procedures, pro-
viding the underlying facts and applicable law are
the same as in the period considered by the court.

An organization that had previously filed an
application for recognition of exemption and has
been determined to be exempt by the court does
not need to submit a new application. The organi-
zation should submit a brief statement that its
acti S are the same as those in the period con-
sidered by the court. The statement must be
signed by a principal officer. If the applicable law
has not changed, the Service will issue a
favorable ruling upon receipt of this statement.

An organization that had not previously filed an
application for recognition of exemption but has
been determined to be exempt by the court will be
issued a ruling or determination letter only when it
makes application in the appropriate manner. The
application should contain a statement that the
organization's activities are the same as those in
the period considered by the court.

Declaratory judgments. If an organization has.
exhausted all administrative remedies, then, in
certain cases, the organization may seek a declar-
atory judgment from the U.S. Tax Court, the U.S.
Claims Court, or the U.S. District Court for the
District of Columbia. This remedy is available for
adverse determinations (or failure by the Service
to make a determination) on the initial or continu-
ing qualification or classification of an organization
as an exempt organization under section
501(c)(3), as an organization to which a deduction
for a contribution is allowed under section
170(c)(2), as other than a private foundation under
section 509, or as a private operating foundation
under section 4942()(3).

The declaratory judgment remedy can be used
only after all administrative remedies have been
exhausted, or, if the Service has not issued a
notice of final determination, 270 days have
elapsed since the organization requested a deter-
mination as to the issue in question and the organ-
ization has taken, in a timely manner, all
reasonable steps to secure such determination.

The administrative remedies that must be
exhausted within the Internal Revenue Service
include these steps:

1) The filing of a substantially completed
application Form 1023 (described earlier in
this chapter) or the filing of a request for a
determination of foundation status;

2) In the case of a late-filed application, request-
ing relief under section 1.9100 of the Income
Tax Regulations regarding applications for
extensions of time for making an election or
application for relief from tax;

3) The timely submission of all additional infor-
mation requested to perfect an exemption



been distributed by the end of 1987, is still undis-
tributed as of January 1, 1988. On September 29,
1988, a notice of tax deficiency is mailed to the
foundation.

On November 5, 1988, (within the allowable dis-
tribution period) the foundation makes a qualifying
distribution of $20,000 which is treated as made
out of the foundation’s undistributed income for
1986. The foundation notifies the Service of its
action. Under these circumstances the foundation
would have been liable for an initial tax of $3,000
(15% of $20,000). However, because the founda-
tion meets the exception for failure to distribute
because of an incorrect valuation of assets, it is
not liable for the taxes.

Taxable period. The taxable period begins on
the first day of the tax year 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.

The allowable distribution period begins on
the first day of the first tax year following the tax
year in which an incorrect valuation of foundation
assets occured. The period ends 90 days after a
notice of deficiency for the initial tax is mailed.
This period is extended by any period in which the
deficiency cannot be assessed, and any other
period which the IRS determines is reasonable
and necessary to permit a distribution of undistrib-
uted income as required under section 4942.
Where a notice of deficiency is not mailed
because there is a waiver of restrictions on
assessment and collection of a deficiency, or
because the deficiency is paid, the filing date of
the waiver or the date of payment, is treated as
the end of the allowable distribution period.

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
section 4942,

Example 1. In 1985 the Jones Foundation, a
private foundation that uses the calendar year as
its tax year, made an error in asset valuation that
was not willful and was due to reasonable cause.
The error caused the Jones Foundation not to
distribute $25,000 that should have been distrib-
uted for 1985. On March 2, 1988, a notice of defi-
ciency for the initial and additional tax was
mailed to the Jones Foundation. For the undistrib-
uted 1985 income, the taxable period runs from
January 1, 1985, through March 2, 1988, and the
allowable distribution period runs from January 1,
1986, through May 31, 1988 (90 days after the
notice of deficiency was mailed). If the Service
determines that it is reasonable and necessary to
extend the distribution period through June 15,
1988, the allowable distribution period runs from
January 1, 1986, through June 15, 1988.

Example 2. Assume the facts given in
Example 1 except that the failure to distribute was
not due to an incorrect valuation of assets. On
April 1, 1988, a notice of deficiency for the initial
and additional tax was mailed to the foundation.
If the Jones Foundation has not filed a petition
with the Tax Court for a redetermination of the
deficiency, the correction period runs from Janu-
ary 1, 1985, through June 30, 1988, unless the
Service determines it is reasonable and necessary
to extend the correction period to permit the
Jones Foundation to distribute the 1985 undistrib-
uted income.

Undistributed income means _the amount by
which the distributable amount for any tax year
exceeds the qualifying distributions made out of
the distributable amount before the end of the
following tax year.

22

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 quallifying distribution for any tax year, and

3) Any amount set aside for a specific project
(see Set-asides, later) to the extent the
amount set aside was not necessary for the
purposes for which it was set aside.

If a private foundation has income from distribu-
tions from a split-interest trust (defined in Chapter
|) attributable to the income portion of amounts
placed in trust after May 26, 1969, this income is
included in the distributable amount.

It a split-interest trust distributes income from
amounts placed in trust both on or before and
after May 26, 1969, these distributions must be
allocated between those amounts placed in trust
during these periods to determine the extent to
which the distributions are included in the founda-
tion's distributable amount.

The income portion of a distribution from a
split-interest trust to a private foundation is the
greater of:

1) The amount of the distribution that is treated
as trust income (under the governing
instrument and local law that applies), or

2) The guaranteed annuity, or fixed percentage
of the fair market value of the trust property
as determined annually, that the private foun-
dation is entitled to receive for a particular tax
year, regardless of when the amount is
actually received.

Limits. A private foundation does not have to
distribute an amount greater than required for any
tax year (without regard to the rules discussed
earlier) if for that year the entire corpus of the
split-interest trust making distributions to the foun-
dation had been taken into account by the founda-
tion as an asset used in figuring minimum
investment return.

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.

The combined fair market value of all
foundation assets includes:

1) The average of the fair market values on a
monthly basis of securities for which market
quotations are readily available,

2) The average of the foundation's monthly cash
balances (minus cash balances excluded as
cash held for charitable and related activities),
and

3) The fair market value of all other assets
(except assets excluded from the computation
of minimum investment return or assets used
for exempt purposes) for the period of time
during the tax year those assets are held by
the foundation. For the determination of the
fair market value of the asset, see Valuation
of assets, later in this chapter.

Certain assets are not included in determin-
ing minimum investment return. These include:

1) Any future interest (such as a vested or con-
tingent remainder, whether legal or equitable)
of a foundation in the principal or income of
any real or personal property (other than a
future interest created by the foundation after
1969) until all intervening interests in, and
rights to the actual possession or enjoyment
of, that property have expired, or until the

future interest has been constructively
received by the foundation even though the
future interest has not been actually reduced
to possession by the foundation. Examples of
a constructively received future interest are a
future interest that has been credited to the
foundation’s account, set apart for the foun-
dation, or otherwise made available so that
the foundation may acquire it at any time, or
could have acquired the interest had the foun-
dation given notice of its intention to acquire,

2) The assets of an estate until those assets
are distributed to the foundation or, due to a
prolonged period of administration, the estate
is considered terminated for federal income
tax purposes,

3) Any present foundation interest in any trust
created and funded by another person,

4) Any pledge of money or property to the
foundation, whether or not the pledge is.
legally enforceable, and

5) Any assets used (or held for use) for
exempt purposes.

Assets used for exempt purposes. An asset is
used (or held for use) for exempt purposes only if
it is actually used by the foundation in carrying on
the charitable, educational, or similar function that
gives rise to its exempt status, or if the foundation
owns the asset and establishes to the satisfaction
of the Service that its immediate use in exempt
functions is not practical and that definite plans
exist to begin the use within a reasonable period
of time.

Assets held for the production of income or for
investment (for example, stocks, bonds, interest-
bearing notes, endowment funds, or generally,
leased real estate) are not considered used or
held for use for exempt purposes even though the
income from those assets is used to carry out an
exempt purpose. Whether an asset is held for the
production of income or for investment rather than
used or held for use directly by the foundation for
exempt purposes is a factual question. For
‘example, an office building used to provide offices
for employees engaged in managing endowment
funds for the foundation is not considered an
asset used for exempt purposes.

However, where property is used both for
exempt and nonexempt purposes, the property
will be considered as being used entirely for
exempt purposes if at least 95% of its total use is
for exempt purposes. But, if less than 95% of its
total use is for exempt purposes, a reasonable
allocation must be made between exempt and
nonexempt use. Property acquired by the founda-
tion to be used for an exempt purpose will be con-
sidered an asset used for exempt purposes even
though all or part of the property is leased for a
limited and reasonable time (generally no more
than one year) while arrangements are made to
convert it to use for exempt purposes.

Where the income-producing use continues
beyond a reasonable time, the property will not be
considered an asset used for exempt purposes.
Instead, at the time the income-producing use
becomes unreasonable, the property will be con-
sidered disposed of to the extent the acquisition
was taken into account as a qualifying distribution.
If the property is later used by the foundation for
exempt purposes, a qualifying distribution in an
amount equal to its fair market value at that time
will be considered to have been made at the time
the exempt use begins.

Assets used for exempt purposes include:

1) Administrative assets, such as office equip-
ment and supplies, used by foundation
employees and consultants to the extent
these assets are devoted to and used directly
in the administration of exempt activities,

2) Real estate or the part of a building used by
the foundation directly in its exempt activities,

3) Physical facilities used in exempt activities
such as paintings or other works of art owned
by the foundation on public display, classroom


The indemnification of a lender or guarantee of
repayment by a private foundation of a loan toa
disqualified person is treated as a use for the ben-
efit of a disqualified person of the income or
assets of a private foundation.

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

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.

Similarly, a scholarship or fellowship grant to a
person other than a disqualified person that is
paid or incurred by a private foundation according
to a program consistent with:

1) The requirements of the foundation's exempt
‘status as a charitable, educational, etc.,
organization,

2) The requirements for allowance of deductions
for charitable contributions made to the foun-
dation, and

3) The requirements of scholarship and
fellowship grants awarded on an objective
and nondiscriminatory basis under procedures
approved by the Service,

will not be an act of self-dealing merely because a
disqualified person indirectly receives a benefit
from the grant. A scholarship or fellowship grant
made by a private foundation under a program to
award scholarship or fellowship grants to the
children of employees of a substantial contributor
will not be an act of self-dealing if these three
requirements are satisfied.

Payment to a Government
Official

The agreement by a private foundation to make
any payment of money or other property to a gov-
ernment official (defined in Chapter V) will ordina-
rily be an act of self-dealing. But, see Certain
payments to government officials are not consid-
ered acts of self-dealing, later, under Exceptions
to Self-Dealing.

Indirect Self-Dealing

Certain transactions will not be treated as indirect
self-dealing.

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

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

2) 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

3) Either the organization controlled by the foun-
dation 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 con-
trolled by the foundation, the disqualified
person could not have engaged in a transac-
tion with anyone else, or could have done so
only by incurring severe economic hardship.

Grants to intermediaries. The term “indirect
self-dealing” does not include a transaction
engaged in with a government official by an inter-
mediary organization that is a recipient of a private
foundation grant and that is not controlled by the
grantor foundation, if the foundation does not

28

earmark the use of the grant for any named gov-
ernment official and there is no agreement under
which the granting foundation may cause the
selection of the government official by the inter-
mediary organization. A grant by a foundation is
earmarked if the grant is made under an agree-
ment, either oral or written, that the grant will be
used by any named individual. A grant by a private
foundation will not be an indirect act of self-
dealing even though the foundation had reason to
believe that certain government officials would
receive benefits from the grant as long as the
intermediary organization exercises control, in
fact, over the selection process and actually
makes the selection completely independently of
the private foundation.

Transactions during the administration of an
estate or revocable trust. A transaction
involving a private foundation's interest or expec-
tancy 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:

1) 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,

2) 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),

3) 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, as explained in
Chapter |),

4) 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,
ani

5) The transaction results either in the founda-
tion’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.

Transactions with certain organizations. A
transaction between a foundation and a corpora-
tion, 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.

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:

1) The transaction arises in the normal and cus-
tomary course of a retail business engaged in
with the general public,

2) 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

3) The total amounts involved in all these trans-
actions with any one disqualified person in
any one tax year is no more than $5,000.

Statutory exceptions. A transaction described
under Exceptions to Self-Dealing, later, in which a
private foundation could itself engage, involving
one or more disqualified persons but to which a

private foundation is not a party, is not indirect
self-dealing.

For example, even if a private foundation has
control of a corporation, the corporation may pay
to another disqualified person (except a govern-
ment official) reasonable compensation for per-
sonal services.

Control. An organization is considered controlled
by a private foundation if the foundation or one or
more of its foundation managers acting only in
their capacity as managers, may, only by
combining their votes or positions of authority,
require the organization to engage in a transac-
tion, which if engaged in with the private founda-
tion would be self-dealing. Similarly, an
organization is controlled by a private foundation
in the case of such a transaction between the
organization and a disqualified person, if the dis-
qualified person together with certain related
persons who are disqualified persons (as
described in Chapter V) may, only by combining
their votes or positions of authority with that of the
foundation, require the organization to engage in
such a transaction.

The controlled organization does not have to be
a private foundation. It may be any kind of exempt
or nonexempt organization including a school,
hospital, operating foundation, or social welfare
organization.

An organization will be considered controlled by
a private foundation or by a private foundation and
disqualified persons if the persons are able, in
fact, to control that organization. This control may
be present even if their combined voting power is
less than 50% of the organization’s total voting
power, or if one or more of the individuals has the
tight to exercise veto power over the actions of
the organization relevant to any potential acts of
self-dealing. However, a private foundation will not
be regarded as having control over an organiza-
tion simply because it exercises expenditure
responsibility.

Exceptions to
Self-Dealing

The following transactions between a private foun-
dation and a disqualified person are not consid-
ered self-dealing.

Providing goods, services, or facilities bya
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 (defined in
Chapter X) 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.

A private foundation that provides recreational
or park facilities to the general public may provide
those facilities to a disqualified person if they are
provided to that person on a basis no more
favorable than that on which they are provided to
the general public. Similarly, the sale of a book or
magazine to disqualified persons is not an act of
self-dealing if publishing the book or magazine is
functionally related to a charitable or educationat
activity of the foundation. The publication must be
made available to disqualified persons and the
general public at the same price. Moreover, if the
terms of the book or magazine sale require, for
‘example, payment within 60 days of delivery, and
payment is made during the 60-day period, the
transaction will not be treated as a loan or
extension of credit if these terms are consistent
with normal commercial practices.



Fair market value must be used in determining
whether 65% or more of the assets are devoted
directly to exempt purposes. However, in the case
of assets that are unique and for which no ready
market or standard valuation method exists, such
as historical objects, buildings, certain works of
art, and botanical gardens, the historical cost
(unadjusted for depreciation) will be considered
fair market value, unless the foundation can show
that fair market value is other than cost. If the
foundation can show that fair market value is
other than cost, this substituted valuation may be
used for the tax year for which the new valuation
is shown and for each of the following 4 tax years.

See Chapter VII for a discussion of valuations.

Assets maintained for extending credit or
making funds available to members of a charitable
class are not considered assets devoted directly
to the active conduct of exempt activities. For
example, assets set aside in special reserve
accounts to guarantee student loans made by
lending institutions will not be considered qualify-
ing assets. Even though amounts set aside for
specific projects may qualify (as explained earlier)
as distributions expended directly for the active
conduct of exempt activities for the income test,
they do not qualify under the assets test as assets
devoted directly to the active conduct of the foun-
dation’s exempt activities.

Assets held for less than a full tax year. In
applying the assets test, assets held for only part
of the tax year are taken into account for the year
by multiplying the fair market value of each asset
by a fraction. The numerator of the fraction is the
number of days during the year that the founda-
tion held the asset, and the denominator is the
total number of days in the year.

Endowment test. A foundation will meet the
endowment test if it normally makes qualifying dis-
tributions (defined in Chapter VII) 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 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 organiza-
tion’s minimum investment return, the organization
is not required to trace the source of the expendi-
tures to determine whether they were received
from investment income or from contributions.

Example. X foundation, created after May 26,
1969, has $400,000 of endowment funds and
other assets not directly used for its exempt
purpose. X makes qualifying distributions of
$20,000 during the year directly for the active
conduct of its exempt function. Two-thirds of X’s
minimum investment return is $13,333.33 (5% x
$400,000 = $20,000; % x $20,000 =
$13,333.33). Since the $20,000 distribution is
greater than $13,333.33, X meets the endowment
test.

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

1) Atleast 85% of its support (other than gross
investment income) is normally received from
the general public and 5 or more unrelated
exempt organizations,

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

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

Here the term support means gifts, grants, con-
tributions, membership fees, the value of services

4

or facilities furnished by a governmental unit with-
out 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.

For example, a foundation that normally
receives 20% of its support (other than gross
investment income) from each of five unrelated
exempt organizations will meet the support test
even though it receives no support from the gen-
eral public. However, if a foundation normally
receives 50% of its support (other than gross
investment income) from three foundations and
the balance of the support comes from sources
other than exempt organizations, the foundation
will not meet the 85% test.

Support from the general public includes
support received from an individual, trust, corpora-
tion, or governmental unit to the extent that the
total amount received from any one individual,
trust, or corporation does not exceed 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.

Determination of compliance with operating
foundation tests. The determination of whether
the income test and one of the three remaining
tests are met depends on whether the tests are
met in the normal and regular operation of a foun-
dation over a period of years, rather than on a
given day during the year or on a year-by-year
basis. A foundation may qualify as an operating
foundation if it meets the income test and either
the assets, endowment, or support test for any 3
years during a 4-year period, or on the basis of a
combination of all pertinent amounts of income or
assets held, received, or distributed during the
4-year period. The 4-year period consists of the
tax year in question and the 3 years immediately
before the year in question. A foundation may not
use one method for satisfying the income test and
‘the other method for satisfying one of the other
tests.

For example, if the income test is satisfied on
the 3-out-of-4-year basis, you may not use the
4-year combination method to satisfy one of the
other tests. However, the fact that the foundation
uses one method to satisfy the tests in a particular
year will not prevent it from using the other
method to satisfy the tests in a later year. Ifa
foundation fails to satisfy the income test and
either the assets, endowment, or support test for a
particular tax year under either the 3-out-
of-4-year method or the combination method, it
will be treated as a nonoperating foundation for
the tax year and for alll later tax years until it satis-
fies the tests.

New organizations. A newly organized founda-
tion generally will be treated as an operating foun-
dation only if it has satisfied the income test and
one of the three other tests for its first tax year of
existence. If so, it will be treated as an operating
foundation from the beginning of its first year. This
status will continue for its second and third tax
years of existence only if it satisfies the tests by
the combination method for all tax years of
existence.

Before the end of its first tax year, a foundation
may be treated as an operating foundation if it has
made a good faith determination that it is likely to
meet the tests for its first year. A good faith deter-
mination may be based on an affidavit or opinion
of counsel, giving enough facts concerning the
‘operations and support of the organization to
enable the Internal Revenue Service to determine
that the requirements are likely to be met. If a
foundation is treated as an operating foundation

for its first year, but actually fails to qualify for the
first year, it will be treated as a nonoperating foun-
dation as of the first day of its second year. How-
ever, such a foundation may establish to the
satisfaction of the Service that it is likely to qualify
as an operating foundation on the basis of its 2nd,
3rd, and 4th tax years. If so, it will be treated as an
‘operating foundation until the first day of a tax
year in which it fails to qualify. Status as a private
foundation that is not an operating foundation will
continue until the organization is able to satisfy
these tests by either the 3-out-of-4-year method
or the combination method.

The deductibility of grants or contributions to
an operating foundation will not be affected until
Notice of a change in the status of such an organi-
zation is made to the public (such as by
publication in the Internal Revenue Bulletin)
unless:

1) The contribution was made after the contribu-
tor acquired knowledge that the organization
would be deleted by the Service from classifi-
cation as an operating foundation, or

2) The contribution was made after an act or fail-
ure to act which caused the inability to satisfy
the tests for qualification as an operating
foundation, and the contributor was responsi-
ble for, or was aware of, the act or failure to
act. A contributor will not be considered
responsible for, or aware of, the act or failure
to act if the contributor made the contribution
relying on a written statement by the founda-
tion that the contribution would not result in
the inability to qualify as an operating founda-
tion. This statement must be signed by a foun-
dation manager and must give enough facts
concerning the operations and support of the
organization to assure a reasonably prudent
person that a contribution would not result in
disqualification as an operating foundation.

Exempt Operating Foundations

Effective for tax years beginning after 1984, cer-
tain private operating foundations, known as
exempt operating foundations, are not subject
to the tax on net investment income (Chapter IV).

To qualify as an exempt operating foundation
for a tax year, a private foundation must meet all
the following requirements:

1) It must be a private foundation (see above
discussion),

2) It has been publicly supported for at least 10
tax years or was a private operating founda-
tion on January 1, 1983, or for its last tax year
ending before January 1, 1983.

3) 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

4) It has no officer who is a disqualified individual
at any time during the tax year.

Publicly supported means that the organiza-
tion normally receives:

1) A substantial part of its support (other than
income from its exempt function) from govern-
mental units or from direct or indirect contribu-
tions from the general public, or

2) More than a third of its support from govern-
mental units, certain publicly supported chari-
ties (listed as items (1) through (7) under An
organization is not a private foundation at the
beginning of this chapter), and persons other
than disqualified persons (see Chapter V), in
any combination of gifts, grants, contributions,
membership fees, and gross receipts from
activities that are not an unrelated trade or
business (but only including such gross
receipts from any one person, or bureau or
similar agency of a governmental unit, that are
not more than the greater of $5,000 or 1% of
the foundation’s support for the tax year), and


ownership) in applying categories (5), (6), and
(7) may not be counted a second time.

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.

Voting power includes outstanding voting
power and does not include voting power obtaina-
ble, but not obtained, such as voting power obtain-
able 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.

The profits interest of a partner is the part-
ner’s distributive share of partnership income.

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.

The beneficial interest in a trust will be deter-
mined in proportion to the person’s actuarial
interest in the trust.

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.

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 contribu-
tion 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.

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, gen-
erally the person remains a substantial contributor
to the foundation.

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.

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 dis-
qualified person with respect to the contributor, as
discussed in this chapter. If the contributor is a
corporation, the term “related person” also
includes any officer or director of the corporation.

Special rules. A substantial contributor does not
include an entity that is described in section
509(a)(1), (2), or (3) or any organization wholly
owned by such an entity. In addition, only for
purposes of section 4941 excise taxes on self-
dealing, a substantial contributor does not include
any other organization described in section
501(c)(3) (other than an organization with section
509(a)(4) status).

The term contribution includes gifts, and
grants to the foundation, as well as bequests,
devises, legacies, or transfers as outlined in the
rules relating to estate and gift tax.

Entities excluded from the definition of
‘substantial contributor as discussed earlier are
also excluded from the definition of disqualified
person.

Foundation manager. A foundation manager
means:

1) An officer, director, or trustee of a foundation
(or an individual having powers or responsibili-
ties 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.

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

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

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 will be treated as a child by blood.

Government official. For the excise tax on self-
dealing (described in Chapter Vill) a government
Official also is a disqualified person.

The term government official means an indi-
vidual who at the time of the act of self-dealing
holds any of the following offices or positions:

1) An elective public office in the executive or
legislative branch of the United States
Government,

2) An office in the executive or judicial branch of
the U.S. Government, appointment to which
was made by the President,

3) A position in the executive, legislative, or judi-
cial branch of the U.S. Government—
a) Which is listed in Schedule C of Rule VI of
the Civil Service Rules, or

b) The compensation for which is at least
equal to the lowest rate prescribed for
GS-16 of the General Schedule under 5
U.S.C. 5332,

4) A position under either the U.S. House of
Representatives or the U.S. Senate, held by
an individual who receives gross annual pay
of at least $15,000 {including expense
allowances for which no accounting need be
made),

5) An elective or appointive public office in any
branch of the government of any state,
possession of the United States, or any subdi-
vision of the foregoing, or the District of
Columbia, held by an individual who receives
gross annual pay of at least $20,000, or

6) A position as personal or executive assistant
or secretary to any individual already
described.

Public office. For the purpose of (5) under Gov-
ernment official, a holder of public office must be
distinguished from a public employee. Although
the determination depends on the facts and
circumstances of each case, the essential ele-
ment is whether a significant part of the activities
of the individual is the independent performance
of policymaking functions. Among the factors to
be considered are that the office is created by the
Congress, a state constitution, or state legislature,
or by a municipality or other governmental body
under powers created in it, and the duties to be
discharged by the office are defined either directly
or indirectly by the body that created it or through
legislative authority.

Examples. The following are illustrations of
positions of public employment that do not involve
policymaking functions and are not a public office:

1) The chancellor, president, provost, dean, and
other officers of a state university who are
appointed, elected, or otherwise hired by a
State Board of Regents or equivalent public
body and who are subject to the direction and
supervision of that body,

2) The superintendent of public schools and

other public school officials who are

appointed, elected, or otherwise hired by a

Board of Education or equivalent public body

and who are subject to the direction and

‘supervision of that body, or

Members of police and fire departments,

except for department heads who, under the

facts and circumstances of the case, indepen-

dently perform policymaking functions as a

significant part of their activities.

Chapter VI

Taxes on Taxable
Expenditures

A private foundation that makes any taxable
expenditures, defined later, becomes liable for
taxes on these expenditures under section 4945
of the Internal Revenue Code. The taxes are
imposed on both the foundation and on any foun-
dation manager who knowingly and willfully agrees
to the expenditures. Both an initial tax and an
additional tax may be imposed.

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). In the case of a foundation manager who
knowingly, willfully, and without reasonable cause
agrees to the taxable expenditure, the initial tax is
2 2% of the amount expended, up to a maximum.

15

3}


1) The subject is a new program or an existing
program jointly funded by the foundation and
the government,

2) The discussions are undertaken for the
purpose of exchanging data and information
on the subject matter of the program, and

3) The discussions are not undertaken to make
any direct attempt to persuade government
officials or employees to take a particular
position on specific legislative issues other
than the program.

Certain expenditures by recipients of program-
related investments. Any amount paid or
incurred by a recipient of a program-related
investment in connection with an appearance
before, or communication with, any legislative
body on legislation or proposed legislation of
direct interest to the recipient will not be attributed
to the investing foundation if:

1) The foundation does not earmark its funds to
carry on propaganda or otherwise attempt to
influence legislation, and 7

2) A trade or business deduction is allowable to
the recipient for this expenditure.

Grants to public organizations. A grant by a
private foundation to an organization that is nota
private foundation (except certain organizations
organized and operated exclusively for testing for
public safety) is not a taxable expenditure if the
grant is not earmarked to be used for, or in a
manner outlined in, items (1) through (5) under
Taxable Expenditures, discussed earlier. In
addition, a grantor foundation may not enter into
an oral or written agreement with a grantee that
causes the grantee to engage in any prohibited
activity nor may the grantor select the recipient of
the grant. A grant is earmarked if the grant is
given under an agreement, oral or written, that the
grant be used for specific purposes.

Attempts to affect the opinion of the general
public. Generally, expenditures paid or incurred
by a private foundation in an attempt to influence
any legislation through an attempt to affect the
opinion of any segment of the general public is a
taxable expenditure. Exceptions are discussed
later in this chapter.

Lobbying activities. Generally, expenditures
paid or incurred by a private foundation to influ-
ence legislation through communication with any.
member or employee of a legislative body, or with
any government official or employee who may
participate in the formulation of the legislation is a
taxable expenditure. Exceptions are discussed
next.

Exception for nonpartisan analysis, study, and
research. Engaging in nonpartisan analysis,
‘study, or research and making the results of this
work available to the general public or to govern-
mental bodies, officials, or employees is not
carrying on propaganda, or otherwise attempting
to influence legislation. Nonpartisan analysis,
study, or research means an independent and
objective exposition of a particular subject matter,
including activities that qualify as educational
activities, Nonpartisan analysis, study, or research
may advocate a particular position or viewpoint as
long as there is a sufficiently full and fair exposi-
tion of the relevant facts to enable the public or an
individual to form an independent opinion or
conclusion. However, a mere presentation of
unsupported opinion does not qualify as nonparti-
san analysis, study, or research.

Presentation as part of a series. Normally,
whether a publication or broadcast qualifies as
nonpartisan analysis, study, or research will be
determined on a presentation-by-presentation
basis. However, if a publication or broadcast is
‘one of a series prepared or supported by a private
foundation and the series as a whole meets the
standards of nonpartisan analysis, study, or
research, then any individual publication or
broadcast in the series will not result in a taxable
expenditure even though such individual

broadcast or publication does not, by itself, meet
the standards of nonpartisan analysis, study, or
research. Whether a broadcast or publication is
considered part of a series will ordinarily depend
on all the facts and circumstances of each particu-
lar situation. However, for broadcast activities, all
broadcasts in any period of 6 consecutive months:
will ordinarily be eligible to be considered as part
of a series. If a private foundation times or
channels a part of a series in a manner designed
to influence the general public or the action of a
legislative body for a specific legislative proposal,
the expenses of preparing and distributing that
part of the analysis, study, or research are a taxa-
ble expenditure.

Making available results of analysis, study,
or research. A private foundation may choose
any suitable means, including oral or written
presentations, to distribute the results of its non-
partisan analysis, study, or research, with or with-
out charge. This may include distribution of
reprints of speeches, articles, and reports, presen-
tation of information through conferences,
meetings, and discussions, and dissemination to
‘the news media, including radio, television, and
newspapers, and to other public forums. These
presentations may not be limited to or directed
toward persons who are interested only in one
side of a particular issue.

Example 1. M, a private foundation, estab-
lishes a research project to collect information for
showing the dangers of using pesticides in
growing crops. The information collected includes
data on proposed legislation, pending before sev-
eral state legislatures, that would ban the use of
pesticides. The project takes favorable positions
on the legislation without producing a sufficiently
full and fair exposition of the relevant facts to
enable the public or an individual to form an inde-
pendent opinion or conclusion on the pros and
cons of the use of pesticides. This project is not
within the exception for nonpartisan analysis,
study, or research because it is designed to pre-
sent information only on one side of the legislative
controversy.

Example 2. N, a private foundation, estab-
lishes a research project for the apparent purpose
of examining and reporting information as to the
pros and cons of the use of pesticides in growing
crops. The information is collected and distributed
in the form of a published report that analyzes the
effects and costs of the use and nonuse of vari-
‘ous pesticides under various conditions on
humans, animals, and crops. The report also
presents the advantages, disadvantages, and eco-
nomic cost of allowing the continued use of
pesticides unabated, of controlling the use of
pesticides, and of developing alternatives to
pesticides.

Even if the report gives conclusions that the dis-
advantages, as a result of using pesticides, are
greater than the advantages of using pesticides
and that prompt legislative regulation of the use of
pesticides is needed, the project is within the
exception for nonpartisan analysis, study, or
research because it is designed to present infor-
mation on both sides of the legislative contro-
versy. In addition, the report presents a sufficiently
full and fair exposition of the relevant facts to
enable the public or an individual to form an inde-
pendent opinion or conclusion.

Exception for technical advice or assistance.
Amounts are not taxable expenditures if they are
paid or incurred in connection with providing tech-
nical advice or assistance to a governmental
body, a government committee, or a subdivision of
either, in response to a written request. Under
this exception, the request for assistance or
advice must be made in the name of the request-
ing governmental body, committee, or subdivision
rather than an individual member. Similarly, the
response to the request must be available to
‘every member of the requesting body, committee,
or subdivision.

Nature of technical advice or assistance.
Technical advice or assistance may be given as a
result of knowledge or skill in a given area.
Because this assistance or advice may be given
only at the express request of a governmental
body, committee, or subdivision, the oral or written
presentation of assistance or advice need not
qualify as nonpartisan analysis, study, or research.
Offering opinions or recommendations will ordina-
rily qualify under this exception only if the opinions
or recommendations are specifically requested by
the governmental body, committee, or subdivision
or are directly related to the materials requested.

Example 1. A Congressional committee is
studying the feasibility of legislation to provide
funds for scholarships to U. S. students attending
schools abroad. X, a private foundation that has
engaged in a private scholarship program of this
kind, is asked, in writing, by the committee to
describe the manner in which it selects candidates
for its program. X’s response, disclosing its meth-
ods of selection, is technical advice or assistance.

Example 2. Assume the same facts given in
Example 1, except that X’s response not only
includes a description of its own grant-making pro-
cedures, but also includes its views regarding the
wisdom of adopting such a program. Because
these views are directly related to the subject
matter of the request for technical advice or assis-
tance, the amount paid or incurred for the presen-
tation of these views is not a taxable expenditure.
However, the amount paid or incurred in
connection with a response that is not directly
related to the subject matter of the request for
technical advice or assistance would be a taxable
expenditure unless the presentation can qualify as
making available nonpartisan analysis, study, or
research.

Exception for decisions affecting the powers,
duties, etc., of a private foundation. Taxes on
lobbying activities, discussed earlier, do not apply
to any amount paid or incurred in connection with
an appearance before, or communication with,
any legislative body on a possible decision of the
body that might affect the existence of the private
foundation, its powers and duties, its tax-exempt
status, or the deductibility of contributions to the
foundation. Under this exception, a foundation
may communicate with the entire legislative body,
committees, or subcommittees of the legislative
body, individual congressmen or legislators, mem-
bers of their staffs, or representatives of the exec-
utive branch, who are involved in the legislative
process if the communication is limited to the pre-
scribed subjects. In addition, the foundation may
make expenditures to initiate legislation if the leg-
islation concerns only matters that might affect
the existence of the private foundation, its powers
and duties, its tax-exempt status, or the deductibil-
ity of contributions to the foundation.

Exception for examinations and discussions of
broad social, economic, and similar problems.
Expenditures for examinations and discussions of
broad social, economic, and similar problems are
not taxable expenditures even if the problems are
the type the government would be expected to
deal with ultimately.

The term “‘any attempt to influence any legisla-
tion” does not include public discussion, or com-
munications with members of legislative bodies or
governmental employees, the general subject of
which is also the subject of legislation before a
legislative body, as long as the discussion does
not address itself to the merits of a specific legis-
lative proposal.

For example, a private foundation may, without
incurring the tax on taxable expenditures, present
discussions of problems such as environmental
pollution or population growth that are being con-
sidered by Congress and various state legisla-
tures, but only if the discussions are not directly
addressed to specific legislation being considered.

7


4) The fair market value of the property on
December 31, 1969, plus or minus all
adjustments to basis after 1969, using straight
line depreciation and cost depletion, if the
foundation held the property on December 31,
1969, and continuously thereafter to the date
of sale or disposition, or

2) Adjusted basis as normally determined using
straight line depreciation or cost depletion.

For determining loss from a sale or other dispo-
sition of property, the adjusted basis as normally
determined using straight-line depreciation or cost
depletion will apply.

Example. The Morgan Foundation bought
unimproved land in January 1969, for $102,000.
On December 31, 1969, the fair market value of
the property was $110,000 and the adjusted basis
was still $102,000. The property was sold on Jan-
uary 2, 1983, for $105,000. Because the fair mar-
ket value on December 31, 1969, was greater
than the adjusted basis, the fair market value is
the adjusted basis used to determine gain. How-
ever, because the adjusted basis for determining
gain, $110,000, was greater than the sale price,
there was no gain. Moreover, because the
adjusted basis for determining loss, $102,000, was
less than the sale price, there was no loss.

Deduction modifications. Deductions gener-
ally are limited to ordinary and necessary
expenses paid or incurred for the production or
collection of gross income, or for the manage-
ment, conservation, or maintenance of property
held for the production of income. These
expenses include the part of a private foundation’s
operating expenses paid or incurred for the pro-
duction or collection of gross income. Operating
expenses include compensation of officers, other
salaries and wages of employees, interest, rent,
and taxes.

When only part of the property is income pro-
ducing or held for the production of income
subject to the provisions of section 4942 and the
remainder is used for exempt purposes, the allow-
able deductions must be divided between exempt
and nonexempt uses.

If the expenses for property used for exempt
purposes are more than the income received from
the property, the excess may not be deducted.

Allowances for straight line depreciation and
depletion (other than percentage depletion) are
deductible. Deductions will be allowed for
‘expenses and interest paid or incurred to carry
tax-exempt obligations. However, no deduction
will be allowed for amounts not paid or incurred
for purposes described earlier. For example, there
will be no deduction for:

1) Charitable contributions,
2) Net operating losses, and
3) The special deductions for corporations.

Directly for the active conduct of exempt
activities means qualifying distributions a foun-
dation 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 indi-
rectly from the foundation.

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 organiza-
tion may further the exempt activities of the gran-
tor foundation.

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 founda-
tion’s exempt activities. Likewise, 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 in amount.

However, administrative expenses and operat-
ing 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 will be allocated to each activity
ona reasonable and consistently applied basis.

Any amount set aside by a foundation for a spe-
cific project, for example to buy and restore or
build additional buildings or facilities that are to be
used by the foundation directly for the active
conduct of the foundation’s exempt activities, will
be treated as qualifying distributions expended
directly for the active conduct of the foundation's
exempt activities if the set-aside meets the
requirements described in Chapter VII.

Payments to individuals. {f a foundation makes
or awards grants, scholarships, or other payments
to individual beneficiaries (including program-
related investments as described in Chapter IX) to
support active programs to carry out the founda-
tion’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.

A foundation will be considered as maintaining a
significant involvement in grant-making it—

1) The foundation operates as follows:

a) An exempt purpose of the foundation is
the relief of poverty or human distress, and
its exempt activities are designed to
improve conditions among the poor or
distressed or in an area subject to poverty
or national disaster (such as providing
food or clothing to indigents or residents in
a disaster area),

b) The grants or other payments for the
exempt purpose are made directly by the
foundation without the help of an interven-
ing organization or agency, and

c) The foundation has a salaried or voluntary
staff of administrators, researchers, or
other personnel who supervise and direct
the exempt activities on a continuing basis,
or

2) The foundation has developed some special-
ized skills, expertise, or is involved in a partic-
ular discipline (such as scientific or medical
research, social work, education, or the social
sciences). It has a salaried staff of administra-
tors, researchers, or other personnel who
supervise or conduct programs or activities
that support the foundation's work in its par-
ticular area of interest. As part of these pro-
grams or activities the foundation makes
grants, scholarships, or other payments to
individuals to encourage their involvement in
the foundation’s area of interest and in some
segment of the activities carried on by the
foundation (such as grants under which the
recipients, in addition to independent study,
attend classes, seminars, or conferences
sponsored or conducted by the foundation, or
grants to engage in social work or scientific
research projects under the general direction
and supervision of the foundation).

Whether making or awarding grants, scholar-
ships, or other payments constitutes qualifying dis-
tributions made directly for the active conduct of
the foundation's exempt activities is determined
by the facts and circumstances of each particular
case. The test applied is a qualitative one. If the
foundation maintains a significant involvement (as
defined earlier), it will not fail to qualify solely
because more of its funds are devoted to grants,
scholarships, or other payments than to the active
programs that such grants, scholarships, or other
payments support.

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. The
administrative expenses of screening and
investigating (as opposed to the grants or scholar-
ships themselves) may be treated as qualifying
distributions made directly for the active conduct
of the foundation's exempt activities.

Only private operating foundations may treat the
payment of the tax on net investment income
(see Chapter IV) as a qualifying distribution made
directly for the active conduct of activities
constituting the foundation’s exempt purpose.

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

1) Are devoted directly to the active conduct of
its exempt activity, or to a functionally related
business (as defined in Chapter X), or a com-
bination of the two,

2) Consist of stock of a corporation that is con-
trolled by the foundation (by ownership of at
least 80% of the total voting power of all clas-
ses 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

3) Are any combination of (1) and (2).

Qualifying assets. An asset is devoted directly
to the foundation’s exempt purpose only if it is
used by the foundation in actually carrying on the
charitable, educational, or other similar function
that gives rise to the exempt status of the founda-
tion. Assets such as real property, physical facili-
ties or objects (such as museum assets,
classroom fixtures, and research equipment) and
intangible assets (such as patents, copyrights, and
trademarks) are directly devoted to the extent they
are used by the foundation in directly carrying on
its exempt activities or program. However, assets
(for example, stock, bonds, or rental property)
including endowment funds, when held primarily
for the production of income, for investment, or for
some similar use, are not devoted directly to the
active conduct of the foundation’s exempt
function, even though income from the assets is
used to carry on the foundation's exempt function.

Whether an asset is held for the production of
income, for investment, or for some similar use,
rather than being used for the active conduct of
the foundation’s exempt activities, is a question of
fact.

For example, an office building used to provide
offices for employees engaged in the manage-
ment of endowment funds of the foundation is not
devoted to the active conduct of the foundation's
exempt activities.

However, for property used both for exempt and
other purposes, if the exempt use of the property
represents at least 95% of the total use, the prop-
erty will be considered to be used exclusively for
an exempt purpose. Property acquired by a foun-
dation to be used in carrying out its exempt
purpose may be considered devoted directly to
the active conduct of that purpose even though
the property, in whole or in part, is leased for a
limited and reasonable period of time during which
arrangements are made for its conversion to the
use for which it was acquired. Generally, one year
is considered a reasonable period of time. Simi-
larly, when property is leased by a foundation in
carrying out its exempt purpose and when the
rental income received from the property by the
foundation is less than the amount that would be
required to be charged to recover the cost of
purchase and maintenance of the property, the
property will be considered devoted directly to the
active conduct of the foundation's exempt
activities.


foundation may choose to treat any part of the dis-
tribution as made out of the undistributed income
of a designated prior tax year or out of corpus.

This choice is made by filing a statement with
the IRS during the tax year in which the qualifying
distribution is made or by attaching a statement to
the foundation's annual return, for the tax year in
which it made the qualifying distribution. The
statement must contain a declaration by an appro-
priate foundation manager that the foundation is
making the choice, under Regulations section
53.4942(a)-3(d)(2) and must specify whether the
distribution is made out of undistributed income for
a designated prior tax year (or years) or is made
‘out of corpus.

When the choice is made during the tax year in
which the qualifying distribution is made, the
choice may be revoked in whole or in part by filing
a statement with the Service during the same tax
year or by attaching a statement to the founda-
tion’s annual return filed for the tax year during
which the qualifying distribution was made. The
revocation statement must contain a declaration
by the appropriate foundation manager that the
foundation is revoking the choice described above
in whole or in part, and must specify the choice or
part thereof being revoked,

Example. The Oak Foundation, a private foun-
dation, has undistributed income of $300 for 1986
and $200 for 1987. On January 14, 1988, the Oak
Foundation made its first qualifying distribution in
1988 when it set aside $700 for hospital
construction.

On February 22, 1988, a notice of deficiency for
the initial and additional excise tax on failure to
distribute income with regard to the 1986 undis-
tributed income was mailed to the Oak Founda-
tion. The Oak Foundation notified the Service in
writing on March 20, 1988, that it was making a
choice to apply the January 14, 1988, distribution
(to the extent that it exceeded 1987 undistributed
income) against the 1986 undistributed income.
The Oak Foundation is liable for an initial excise
tax of $45 (15% of $300).

Because the Oak Foundation made the choice
described, the $300 of undistributed income for
1986 is treated as distributed during the correction
period, and no additional excise tax is imposed.
Under these circumstances the $700 distribution
is treated as made first out of the undistributed
income of 1987 ($200), then out of the remaining
undistributed income of 1986 ($300). The $200
remaining may be applied against the distributable
amount for 1988 or may be treated as a distribu-
tion out of corpus.

Carryover of excess qualifying distributions.
For any tax year during which the organization is a
private nonoperating foundation, any excess quali-
fying distributions (described later) may be used to
reduce distributable amounts in any tax year of the
adjustment period.

If a private foundation that had a carryover of
excess qualifying distributions makes a section
507(b)(2) transfer of all its assets to an effectively
Controlled foundation (defined in Chapter II), the
transferee foundation may reduce its distributable
amount by the carryover.

The distributable amount for a tax year in an
adjustment period will be reduced by the lesser of:

1) The excess of qualifying distributions made in
prior tax years to which the adjustment period
applies, or

2) The remaining undistributed income at the
close of the tax year after applying any quali-
fying distributions made in that year to the dis-
tributable amount for the year.

Example. Maple Foundation, a private nonop-
erating foundation, has distributable amounts for
1983, 1984, and 1985 of $100 each. It made a
qualifying distribution in 1984 of $250 and in 1985
of $70. The qualifying distribution made in 1984
will be treated as $100 made out of the undistrib-
uted income for 1983, then as $100 made out of
undistributed income of 1984, and finally as $50

26

out of corpus in 1984. Since the total qualifying
distributions with respect to 1984 ($150) exceed
the distributable amount for 1984 ($100), a $50
excess of qualifying distributions exists which the
Maple Foundation may use to reduce its distribut-
able amounts for the years 1985 through 1989
(the tax years in the adjustment period with
respect to the 1984 excess).

Therefore, the $100 distributable amount for
1985 is reduced by $30 (the lesser of the 1984
excess ($50) and the remaining undistributed
income at the close of 1985 ($30), after the quali-
tying distributions of $70 for 1985 were applied to
the original distributable amount for 1985 of $100).
Maple Foundation then has a $20 excess of quali-
fying distributions to use for tax years in the
adjustment period. If during any tax year of the
adjustment period another excess of qualifying
distributions is created, that excess will not be
taken into account until the earlier excess has
been completely applied against distributable
amounts during its adjustment period.

An excess qualifying distribution is the
amount by which the total qualifying distributions
treated as made out of undistributed income for
any tax year beginning after 1969, or as made out
of corpus for the tax year (other than distributions
by donee organizations described in Certain con-
tributions to exempt organizations, earlier, or the
amount applied to a prior tax year by the choices
with respect to qualifying distributions) exceed the
distributable amount for that tax year.

The adjustment period is the 5 tax years
immediately following the tax year in which the
excess of qualifying distributions is created. Thus,
an excess qualifying distribution for any one tax
year may not be carried over for more than 5 tax
years. However, if during any tax year of the
adjustment period, the organization ceases to be
subject to the initial tax (such as by becoming a
private operating foundation), any portion of the
excess qualifying distributions, that, before that
tax year, has not been applied against distributa-
ble amounts may not be carried over to that tax
year or later tax years in the adjustment period,
This rule applies even though during any of those
tax years the organization again becomes subject
to the initial tax.

Chapter VIII

Taxes on
Self-Dealing

Section 4941 of the Internal Revenue Code
imposes an excise tax on certain transactions
(acts of self-dealing) between a private foundation
and disqualified persons.

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).

An excise tax of 2'-% of the amount involved is
imposed on a foundation manager who knowingly
Participates in an act of self-dealing, unless partic-
ipation is not willful and is due to reasonable
cause, for each year or part of a year in the taxa-
ble period.

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 is not cor-
rected 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 described above is imposed
on the disqualified person, an excise tax of 50%
of the amount involved is imposed on any founda-
tion manager who refuses to agree to part or all of
the correction of the self-dealing act.

Limits on liability for management. The maxi-
mum initial tax imposed on the foundation man-
ager is $10,000 and the maximum additional tax is.
$10,000 for any one act.

There is no maximum on the liability of the self-
dealer, including one who is a foundation man-
ager.

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 lia-
ble for those taxes,

Acts of self-dealing. 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.

Government officials. As noted in the
discussion of disqualified persons in Chapter V, 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.

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.

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.

Reasonable cause. Participation is due to rea-
sonable cause if the foundation manager has
exercised responsibility on behalf of the founda-
tion with ordinary business care and prudence.

Advice of counsel. A person who, after full dis-
closure 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 ordina-
rily not be liable for the initial tax imposed for self-
dealing.

Awritten legal opinion is considered reasoned
even if it reaches a conclusion that is later deter-
mined 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 par-
ticipated in the act knowingly, willfully, or without
reasonable cause.

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,


trade, or professional football leagues (How-
ever, the exempt organization benefited must
meet the support tests described in item (8),
and the organization operated to benefit such
‘organization must meet the control tests of
item (9) and must not be controlled by dis-
qualified persons other than foundation man-
agers.), or

11) An organization organized and operated to
test for public safety.

A more detailed description of the types of orga-
nizations excluded from the definition of private
foundation may be found in Publication 557.

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 notifi-
cation requirement applies to an organization
regardless of when it was organized. The only
‘exceptions to this requirement are those organiza-
tions that are excepted from the requirement of
filing Form 1023, Application for Recognition of
Exemption, Nonexempt charitable trusts.
described in section 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.

Private Foundation Status

If your organization was a private foundation on
October 9, 1969, or becomes a private foundation
on any later date, it will be treated as a private
foundation for all periods after that time unless its
status is terminated under section 507 (see Chap-
ter Ill). Therefore, if an organization was described
in section 501(c)(3) and was a private foundation
within the meaning of section 509(a) on October
9, 1969, it will be treated as a private foundation
for all periods thereafter, even though it may also
satisfy the requirements of an organization
described in some other paragraph of section
501(c).

For example, if on October 9, 1969, an organi-
zation was described in section 501(c)(3), but
because of its activities, it could also have quali-
fied as an organization described in section
501(c)(4), the organization will continue to be
treated as a private foundation if it was a private
foundation on October 9, 1969.

Taxable private foundations. |f an organization
is an exempt private foundation on or after Octo-
ber 9, 1969, but it is later determined that it is no
longer exempt as an organization described in
section 501(c)(3) as of any date after October 9,
1969, the organization, even though it may oper-
ate thereafter as a taxable entity, will continue to
be treated as a taxable private foundation unless
its status as such is terminated under section 507.

For example, X organization was an exempt
private foundation on October 9, 1969. It was later
determined that, as of July 1, 1972, X was no
longer exempt as an organization described in
section 501(c)(3) because it did not conform its
governing instrument under section 508(e). X will
continue to be treated as a private foundation
after July 1, 1972, unless its status as such is ter-
minated under section 507.

Note. {f an organization was not exempt on
October 9, 1969, it will not be treated as a private
foundation because of section 509(b), unless it
becomes a private foundation on a later date.

Status of organization after termination of
private foundation status. An organization
whose status as a private foundation is terminated
under section 507 will be treated as an organiza-
tion created on the day after the day of the termi-
nation. An organization whose private foundation
status has been terminated under the provisions
of section 507(a) will, if it continues to operate, be
treated as a new organization and must, if it wants

2

to be classified under section 501(c)(3), apply for
recognition of section 501(c)(3) status.

If the private foundation status of an organiza-
tion has been terminated under section
507(b)(1)(B) and the regulations thereunder, and

1) The organization does not continue at all
times thereafter to meet the requirements of
section 509(a)(1), (2), or (3) (and is, therefore,
no longer excluded from the definition of a
private foundation), and

2) The status of the organization as a private
foundation is thereafter terminated under
section 507(a), then for determining the tax
imposed under section 507(c)(1), the
combined tax benefit resulting from section
501(c)(3) status will be figured only from the
date on which the organization again
becomes a private foundation under item (1).

The tax imposed on termination of private foun-
dation status is imposed on the organization and
is equal to the lesser of:

1) The amount the private foundation can verity
by adequate records or other evidence as the
total tax benefit resulting from the section
501(c)(3) status of the foundation, or

2) The value of the net assets of the foundation.

Private Operating
Foundations

A private foundation may qualify for treatment as a
private operating foundation. These foundations
generally are still subject to the tax on net
investment income (Chapter !V), and to the other
requirements and restrictions that generally apply
to private foundation activity. However, operating
foundations are not subject to the excise tax on
failure to distribute income (Chapter VII). Also,
contributions to private operating foundations
described in section 4942())(3) are deductible by
the donors to the extent of 50% of the donor's
adjusted gross income, whereas contributions to
all other private foundations (except those
discussed later in this chapter under Private Non-
operating Foundation Distributing All Contributions
Received) are generally limited to 30% of the
donor's adjusted gross income. In addition, a
private operating foundation may receive qualify-
ing distributions from a private foundation if the
private foundation does not control it.

A private operating foundation is any private
foundation 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 one of the following
tests: the assets test, the endowment test, or the
support test.

Certain private foundations that provide long-
term care facilities are treated as operating foun-
dations only for the purposes of the excise tax on
failure to distribute income. These foundations are
discussed in greater detail in Chapter VII of this
publication.

Income test. To qualify as an operating founda-
tion, the organization must make qualifying distri-
butions directly for the active conduct of its
exempt activities equal to substantially all (at least
85%) of the lesser of its:

1) Adjusted net income, or
2) Minimum investment return.

If a private foundation's qualifying distributions
exceed its minimum investment return for the tax
year, but are less than its adjusted net income,
‘substantially all of the total qualified distributions
must be made directly for the active conduct of
the foundation's exempt activities. However, if the
foundation's minimum investment return is less
than its adjusted net income and its qualified dis-
tributions equal or exceed the adjusted net
income, only that part of the qualified distributions
equal to substantially all of the foundation's

adjusted net income must be made directly for the
active conduct of the foundation’s exempt
activities.

Qualifying distributions and minimum investment
return are defined in Chapter VII.

Adjusted net income is the excess of gross
income for the tax year (including gross income
from any unrelated trade or business) determined
with certain modifications (described later) over
the total deductions (including deductions directly
connected with carrying on any unrelated trade or
business) that would be allowed a taxable corpo-
ration determined with certain deduction modifica-
tions (described later).

Gross income does not include gifts, grants, or
contributions received by the private operating
foundation but does include income from a
functionally-related business. Gross income and
‘the total deductions allowable from that income
will be figured as they are normally figured for
income tax purposes except as otherwise pro-
vided. For figuring adjusted net income, there will
be no exclusions, deductions, or credits unless
provided under Income modifications and Deduc-
tion modifications.

Amounts received by the foundation in tax years
beginning after 1969 representing repayment of
principal on loans made in tax years before 1970
are not includible in gross income. However,
payments of interest on those loans are includible
in gross income.

Income modifications:

1) Interest on government obligations normally
excluded under section 103 of the Code is
included in gross income.

2) When reporting capital gains and losses from

the sale or other disposition of property, only

net short-term capital gains are included in
gross income. Long-term capital gains or
losses are not included. Neither are net
section 1231 gains included. But net section

1231 losses may be included in the computa-

tion if the losses are otherwise deductible

under these rules. Any net short-term capital
loss may not be deducted for the year in
which it occurs. This loss may not be carried
back or carried over to earlier or later tax
years regardless of whether the foundation is

a corporation or a trust. Capital gain dividends

received from a regulated investment com-

pany are excluded from the foundation’s
adjusted net income.

Gross income includes:

a) Amounts received or accrued as repay-
ments of amounts taken into account as
qualifying distributions for any tax year,

b) 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 distribution for
any tax year, and

c) Any amount set aside for a specific project
(see Set-asides, in Chapter VIl) to the
extent the amount set aside was not nec-
essary for the purposes for which it was
set aside.

4) The excess of fair market value on the date of
distribution over adjusted basis of property
distributed to a state, a U.S. possession, or
any political subdivision thereof, the United
States, or the District of Columbia for public
purposes, or to a charitable trust or corpora-
tion, will not be included in gross income.

5) The income received from an estate during
the administration period will not be included
in the operating foundation's gross income.
However, if the estate is considered termi-
nated for income tax purposes because of a
prolonged administration period, the income
will be included in gross income.

3)

For purposes of item 2, in determining gain from
the sale or other disposition of property, adjusted
basis will be the greater of:


If the taxpayer does not file a petition with the
Tax Court, the tax will be assessed.

Protest and Conference
Procedures

If, after receiving the 30-day letter, the taxpayer
wishes to appeal, the taxpayer must send a
written protest to the key District Director within 30
days from the date of the letter. The protest must
include a full and detailed statement of the facts,
law, and argument in support of the taxpayer's
position and, if desired, a request for a conference
at the regional office. Deficient protests will be
returned to the taxpayer with an explanation why
the protest cannot be accepted. Additional time
will be given to the taxpayer to perfect the protest.

Upon receipt of a taxpayer's protest and
request for a regional office conference, the key
District will review the protest and, if it maintains
its position, forward the request and the case file
to the Regional Director of Appeals which will
contact the taxpayer regarding conference rights.
In appropriate cases, the examining officer may
attend the regional office conference to clarify the
facts in the case. If additional issues are raised at
the conference, the case will be returned to the
key District Director for consideration of these
issues.

if, after consideration of the case by Appeals, a
satisfactory settlement of the issues is reached
with the taxpayer, the taxpayer will be given a
revised report of examination prepared at the

34

regional office, if necessary, and will be asked to
‘sign an appropriate agreement form.

If agreement is not reached at this stage, a stat-
utory notice of deficiency will be issued by
Appeals after consideration by the Service's

Regional Counsel. The taxpayer may then petition,

within the statutory period, the United States Tax
Court for redetermination of the deficiency.

If the case under consideration in Appeals is
docketed in the Tax Court and agreement is
reached with the taxpayer on the issues involved,
the case is disposed of by filing a stipulation of
agreed deficiency or overpayment with the Tax
Court, which will enter its order in conformity with
the stipulation.

Claims for Refund or Credit

Alter receiving a 30-day letter, the taxpayer may
pay the tax and then contest the assessment
(unless an agreement to the contrary is executed)
by filing a claim for refund or credit for all or any
part of the amount paid. However, this does not
apply to certain taxes determined by the Tax
Court, the decision of which has become final. A
claim for refund or credit is made by filing an
appropriate amended return with the Internal Rev-
enue Service Center to which the original return
was sent.

When claims for refund or credit are examined
by the key District Director, substantially the same
procedure within the Service is followed (including
appeal steps) as when original exempt organiza-
tions returns are examined. The procedure for

appealing rejected claims through the Court is
outlined in section 601.103(c)(3) of the Statement
of Procedural Rules.

Technical Advice

- While the case is under the jurisdiction of the key

district office or the Appeals office, a taxpayer
may request that an issue be referred to the
National Office for technical advice on the
grounds that a lack of uniformity exists as to the
disposition of the issue, or that the issue is so unu-
sual or complex as to warrant consideration by the
National Office. Taxpayers should make written
requests to the key district office or the Appeals
office stating the facts, law, and argument with
respect to the issue and reasons for requesting
technical advice. At the time taxpayers are
informed that the matter is being referred to the
National Office, they will also be informed of their
right to a conference in the National Office in the
event an adverse decision is indicated, and will be
asked to state whether they want such a
conference.

If, after the National Office considers the case
file on a request for technical advice, it appears
that advice adverse to the taxpayer should be
given and a conference has been requested, the
taxpayer will be notified of the time and place of
the conference. If a conference has not been
requested, the case will be decided on the basis
of the existing written records.


Payment of compensation or reimbursement
of expenses by a private foundation to a dis-
qualified person (except for a government official)
for personal services that are reasonable and nec-
essary 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.

Personal services include the services of a bro-
ker serving as the foundation's agent, but not the
services of a dealer buying from the foundation as.
a principal and reselling to a third party.

Furthermore, if a foundation makes a cash
advance to a foundation manager or employee to
cover anticipated out-of-pocket expenses, it is not
an act of self-dealing if the advance is reasonable
in relation to the duties and expense requirements
of the foundation manager. An advance ordinarily
is considered reasonable if it is not more than

For example, if a foundation makes an advance
to a foundation manager to cover anticipated out-
of-pocket current expenses for a reasonable
period (such as a month) and the manager
accounts to the foundation under a periodic reim-
bursement program for actual expenses incurred,
the foundation is not considered to have engaged
in an act of self-dealing:

1) When it makes the advance,

2) When it replenishes the fund upon receipt of
‘supporting vouchers from the manager, or

3) Ifit temporarily adds to the advance to cover
unusual expenses expected to be incurred in
carrying out a special assignment.

Any transaction between a private foundation
and a corporation that is a disqualified person is
not an act of self-dealing if the transaction is
engaged in under a liquidation, merger, redemp-
tion, recapitalization, or other corporate
adjustment, organization, or reorganization, as
long as all the securities of the same class as
those held before the transaction by the founda-
tion are subject to the same terms and the terms
provide for receipt by the foundation of at least fair
market value.

For the securities to be considered subject to
the same terms, the corporation must, in
connection with the transaction, make a bona fide
offer on a uniform basis to the foundation and
every other security holder. The fact that a foun-
dation receives property, such as debentures,
while all other persons holding securities of the
same class receive cash for their interests, will be
evidence that the offer was not made on a uniform
basis.

If no other persons hold securities of the same
class as the private foundation, the consideration
received by holders of other classes of securities,
or the interests retained by the holders of other
classes, when considered in relation to the con-
sideration received by the foundation, must indi-
cate that the foundation received at least as
favorable treatment in relation to its interests as
the holders of any other class of securities. In
addition, the foundation must receive at least the
fair market value of its interests.

Certain payments to government officials are
not considered acts of self-dealing. These
payments are:

1) A prize or award that does not have to be
included in gross income if the official receiv-
ing the prize or award 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),

2) Ascholarship or a fellowship grant that is to
be used for study at a recognized educational
‘organization. (For this purpose, there is no
requirement that the grant recipients be lim-
ited to degree candidates, nor must the grant
be limited to tuition, fees and course-required

books, supplies or equipment. It is permissible

for a recipient to use grant funds for room,

board, travel, research, clerical help, or equip-
ment, that are incidental to the purposes of
the grant.),

3) Any annuity or other payment (forming part of
a stock-bonus, pension, or profit-sharing plan)
from a qualified trust,

4) Any annuity or other payment under an
employees’ annuity plan,

5) Any contribution or gift (other than money), or
services or facilities made available, if the
total value is not more than $25 during any
calendar year,

6) Any payment made under a government
employees’ training program,

7) Any payment or reimbursement of travel
expenses, including meals and lodging, for
travel only from one point in the United States
to another in connection with charitable
purposes, but only if the payment or reim-
bursement is not more than the actual cost of
transportation plus an amount for all other
traveling expenses not greater than 125% of
the maximum payable for similar travel by U.S.
government employees (without regard to any
higher rates allowed in designated geographi-
cal areas),

8) A payment under any agreement to employ or
make a grant to a government official for any
period after the termination of government
service if the agreement is entered into within
90 days before termination, or

9) The cost of a government official's attend-
ance or participation in a conference
sponsored by the foundation in furtherance of
its exempt purposes, including—

a) The official's share of the cost of the
conference,

b) Professional and other non-monetary ben-
efits of an intellectual or psychological
nature received by the official from
attending or participating in the
conference,

c) Benefits to the official resulting from
publication or distribution of the
conference record to conference
participants, and

d) Payments, reimbursements, or reasonable
advances made to the official for
expenses in attending the conference.

Leases. 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.

The leasing of office space by a disqualified
person to a private foundation in a building with
other tenants who are not disqualified persons is.
not an act of self-dealing if:

1) The lease is pursuant to a binding contract in
effect on October 9, 1969 (or renewals
thereof),

2) The lease was not a prohibited transaction
under section 503(b) or any corresponding
provision of prior law at the time of execution,
and

3) The terms of the lease (or any renewal) reflect
an arm's length transaction.

Transitional Rules

Transactions involving securities acquired
by a foundation before May 27, 1969. Any
transaction between a private foundation and a
corporation that is a disqualified person will not be
an act of self-dealing if the transaction is under
the terms of securities of the corporation, if the
terms were in existence at the time the securities

were acquired by the foundation and if they were
acquired before May 27, 1969.

Disposition of certain business holdings.
The sale, exchange, or other disposition of prop-
erty that was owned by a private foundation on
May 26, 1969, to a disqualified person will not be
an act of self-dealing if the foundation is required
to dispose of the property so it will not be liable for
the tax on excess business holdings (discussed in
Chapter X). This rule applies only if:

1) The amount received by the private founda-
tion is at least equal to the fair market value of
the business holdings at the time of disposi-
tion or at the time a contract for disposition
was previously executed, and

2) At the time at which (1) is applied, the trans-
action would not have been a prohibited
transaction under section 503(b) or corre-
sponding provisions of prior law.

Property is considered owned by a private foun-
dation on May 26, 1969, if it is acquired:

1) Under the terms of a will executed by that
date,

2) Under the terms of a trust that was irrevoca-
ble on that date, or

3) Under the terms of a revocable trust executed
by that date if the property would have passed
under a will executed by that date, except that
the grantor died without revoking the trust.

An amendment or republication of a will that
was executed by May 26, 1969, will not prevent
any interest in a business that was to pass under
the terms of the will (in effect on May 26, 1969,
and at all times thereafter) from being treated as
‘owned by a private foundation on that date, only
because:

1) There is a reduction in the interest in the busi-
ness that the foundation was to receive,

2) The amendment or republication was neces-
sary to comply with the requirements of gov-
erning instruments as discussed in Chapter II,

3) There is a change in the executor of the will,
or

4) There is any other change that does not oth-
erwise change the foundation's rights in the
business.

If the amendment or republication increases
the business interest that the foundation was to
receive under the terms of the will in effect on
May 26, 1969, only the interest that would have
been acquired before the increase will be treated
as owned by the foundation on that date. The
increase is not so treated.

Use of property acquired before October 9,
1969. The use of property in which a private
foundation and disqualified person have a joint or
common interest is not an act of self-dealing if the
gests of both were acquired before October 9,
1

Amount Involved

The excise tax on self-dealing is figured on the
amount involved, which is the greater of the
amount of money and the fair market value of
other property given or the amount of money and
fair market value of other property received. For
payments made for services performed (to
persons other than government officials), the
amount involved is only the excess compensation
paid by the private foundation. When the use of
money or other property is involved, the amount
involved is the greater of either the amount paid
for the use or the fair market value of the use for
the period for which the money or other property
is used.

For a transaction that would not have been an
act of self-dealing had the private foundation
received fair market value, the amount involved is
the excess of the fair market value of property
transferred by the foundation over the amount
received by the foundation, but only if the parties

29


year, or at the start of the first tax year in
which any of the series of related dispositions
was made.

A significant disposition of assets may occur in
a single tax year or over two or more tax years.
The determination of whether a significant disposi-
tion has occurred through a series of related dis-
positions will be based on the facts and
circumstances of the particular case. However, if
one or more persons who are disqualified persons
(see Chapter V) with respect to the transferor's
private foundation are also disqualified persons
with respect to any of the transferee’s private
foundations, this fact will be considered as evi-
dence that the transfer is part of a series of
related dispositions. For a series of related dispo-
sitions, each transferee private foundation is con-
sidered a transferee in a section 507(b)(2)
transaction.

Example. The White Foundation is a private
foundation that had net assets of $100,000 on
January 1, 1987. In 1987, in addition to distribu-
tions made out of current income, the White Foun-
dation transferred $10,000 to the Rose
Foundation, $10,000 to the Black Foundation and
$10,000 to the Green Foundation, all of which are
private foundations. Therefore, the White Founda-
tion made a section 507(b)(2) distribution because
it disposed of more than 25% of the fair market
value of its net assets on January 1, 1987.

Section 507(a) does not apply to section
507(b)(2) transfers. A private foundation may not
terminate under section 507(a)(1) unless it volun-
tarily gives notice as required for section 507(a)(1)
terminations. The transfer must satisfy the appli-
cable requirements of Chapter 42 (discussed in
Chapters VI through X) concerning acts or failures
to act that give rise to excise tax liability. However,
if the transfer is an act or failure to act giving rise
to excise tax liability, then the transfer may be
considered an involuntary termination.

Transfers to certain section 509(a)(1), (2), or
(3) organizations will be treated as section
507(b)(2) transfers from the date a private founda-
tion transfers all or part of its assets to a section
509(a)(1), (2), or (3) organization if, within 3 years
from the date of the transfer, the transferee loses
its section 509(a)(1), (2), or (3) status and
becomes a private foundation.

If a section 507(b)(2) transfer is made during the
course of a 60-month termination under section
507(b)(1)(B), the rules governing section 507(b)(2)
transfers will apply and the transfers will not be
treated as made from a section 509(a)(1), (2), or
(3) organization.

Chapter IV

Tax on Net
Investment Income

Section 4940 imposes an excise tax of 2% on the
net investment income of most domestic tax-
exempt private foundations, including private oper-
ating foundations. Some exceptions apply. An
exempt operating foundation, defined in Chap-
ter I, is not subject to the tax. Further, the tax is
reduced to 1% in certain cases. See Reduction in
tax, below.

This tax must be reported on Form 990-PF,
Return of Private Foundation. Payment of the tax
is subject to estimated tax requirements. For more
information concerning payment of estimated tax,
see the Instructions for Form 990-PF.

Nonexempt private foundations are also subject
to this tax, but only to the extent that the sum of
the 2% tax plus tax on unrelated business income,
applied as if the foundation were tax-exempt, is
greater than income tax liability for the year.

Example. A taxable private foundation had an
income tax liability for 1985 of $10,000. If the
foundation were tax exempt, it would have a
$4,000 liability for tax on net investment income
and a $7,000 liability for tax on unrelated business

income. The foundation is liable under section
4940 for $1,000, the amount by which the sum of
the tax on net investment income and the tax on
unrelated business income ($11,000) exceeds the
amount of income tax liability ($10,000).

Reduction in tax. For tax years beginning after
1984, the tax rate on net investment income is
reduced from 2% to 1% for any private foundation
that meets the following distribution requirements:

1) The foundation makes qualifying distribu-
tions 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

2) The foundation was not liable for Chapter 42
excise taxes (see Chapters VI through X of
this publication) for any year of the base
period.

Qualifying distributions {or this purpose are
the same as those for purposes of the tax on fail-
ure to distribute income (see the discussion of
Qualifying distributions in Chapter VI).

Average percentage payout is the average
of the percentage payouts for each of the tax
years in the foundation's base period. For each
tax year, the percentage payout is figured by divid-
ing the qualifying distributions made during the
year by the foundation's assets for that year. If, for
any tax year in the foundation’s base period, the
foundation's tax rate on net investment income is
reduced to 1% by meeting these distribution
requirements, the qualifying distributions made by
the foundation during that year must be reduced
by the amount of the reduction in tax.

The assets of the foundation for any tax year
are the excess of the total fair market value of all
the foundation's assets, other than those used or
held for use directly in carrying out the founda-
tion’s exempt purpose, over the acquisition indebt-
edness with respect to those assets.

The base period with respect to any tax year
is the 5 tax years preceding that year. If an organi-
zation has not been a private foundation through-
out those 5 tax years, the base period consists of
the tax years during which the foundation has.
been in existence. However, if a private foundation
is a successor to another private foundation, it
must take into account the experience of that
other foundation.

Net investment income is the amount by which
the sum of gross investment income and the capi-
tal gain net income exceeds the allowable deduc-
tions discussed later.

Tax-exempt interest on governmental
obligations and related expenses are excluded.

Gross investment income means the total
amount of income from interest, dividends, rents,
payments with respect to securities loans (as
defined in section 512(a)(5)), and royalties
(including overriding royalties) received by a
private foundation from all sources. It does not
include any income included in figuring the tax on
unrelated business income. However, it does
include interest, dividends, rents, and royalties
received from assets devoted to charitable
activities. Therefore, interest received on a stu-
dent loan would be includible in the gross
investment income of a private foundation making
the loan.

Distributions in redemption of stock. Any dis-
tribution by a corporation that is a disqualified
person (defined in Chapter V) in redemption of
stock held by a private foundation in a business
enterprise will be treated as not essentially
equivalent to a dividend if all the following
conditions are met:

1) The stock was owned by the private founda-
tion on May 26, 1969,

2) The foundation is required to dispose of the
stock in order not to be liable for the tax on

excess business holdings (discussed in Chap-
ter X), and

3) The foundation receives in return an amount
that equals or exceeds the fair market value
of the stock at the time of disposition (or at
the time a contract for the disposition was
previously executed) in a transaction that
would not be a prohibited transaction (under
section 503(b) of the Code).

For purposes of (1) above, if a private founda-
tion acquired stock under the terms of a trust that
was irrevocable on May 26, 1969, or under the
terms of a will executed by that date, which is in
effect on that date and at all times thereafter, the
foundation will be considered as owning the stock
on that date.

Capital gains and losses. In figuring the tax on
net investment income, a private foundation must
include any capital gains and losses from the sale
or other disposition of property held for investment
purposes or for the production of income. This
includes capital gain dividends received from a
regulated investment company. If the foundation
sells or otherwise disposes of property used in the
production of income that is subject to the
unrelated business income tax, any gain or loss
from the sale of that property must be included in
net investment income, but only to the extent that
it is not included in figuring the tax on unrelated
business income. Property is treated as held for
investment purposes even though the property is
disposed of by the foundation immediately upon
its receipt, if it is the kind of property that generally
produces interest, dividends, rents, royalties, or
Capital gains through appreciation.

Property used for exempt purposes. Any gain
or loss from the sale or other disposition of prop-
erty used for the exempt purposes of the founda-
tion is not included in figuring the tax on net
investment income. If the foundation uses prop-
erty for its exempt purposes, but also incidentally
receives income from the property that is subject
to the net investment income tax, any gain or loss
from the sale or other disposition of the property
would not be subject to the tax. For example, if a
tax-exempt private foundation maintains historic
buildings that are open for public inspection, but it
requires a number of employees to live in these
buildings and charges rent, the rent is subject to
the tax on net investment income, but any gain or
loss resulting from the sale of these buildings is
not subject to the tax.

However, if a private foundation uses property
both for exempt purposes and (other than inciden-
tally) for investment purposes, (for example, a
building in which the foundation's charitable and
investment activities are carried on) that part of
the gain or loss from the sale or other disposition
of the property that is allocable to the investment
use of the property must be taken into account in
figuring the tax on net investment income.

Losses. Capital losses from the sale or other dis-
position of investment property may be subtracted
from capital gains incurred in the sale or disposi-
tion of other investment property during the same
tax year, but only to the extent of the gains. If the
capital losses are greater than the capital gains,
the excess may not be subtracted from gross
investment income, nor may the losses be carried
back or forward to other tax years regardless of
whether the foundation is a corporation or a trust.

Basis. The basis for determining gain from the
sale or other disposition of property is the greater
of:

4) The fair market value of the property on
December 31, 1969, plus or minus all
adjustments after 1969 and before the date of
disposition if the property was held by the
private foundation on that date and continu-
ously thereafter until disposition, or

2) The basis of the property on the date of dis-
position under normal basis rules (actual
basis).

13


tax of $5,000 for any one expenditure. A founda-
tion manager who acts on advice of counsel,
given in a reasoned legal opinion in writing, is not
liable for the tax.

Additional tax. If the expenditure is not cor-
rected within the taxable period (described
later), an additional tax of 100% of the amount
‘expended is imposed on the foundation. The tax
will not be assessed, or if assessed will be abated,
if the expenditure is corrected within the
correction period (described later). Any founda-
tion manager who refuses to agree to part or all of
the correction must pay an additional tax of 50%
of the expenditure, up to a maximum tax of
$10,000.

If more than one foundation manager is liable
for either the initial or additional tax, all are jointly
and severally liable.

The initial tax on foundation managers is
imposed only in cases when the following
circumstances are present:

1) The initial tax on taxable expenditures is
imposed on the private foundation making the
expenditure,

2) The foundation manager knows that the
expenditure to which he or she agrees is a
taxable expenditure, and

3) The agreement is willful and not due to rea-
sonable cause.

The tax on any particular expenditure applies
only to agreements of foundation managers with
authority to approve or to exercise discretion in
recommending approval for expenditures by the
foundation and to those foundation managers who
are members of a group authorized to make or
recommend those expenditures.

Agreement. The agreement of any foundation
manager to making a taxable expenditure consists
of any manifestation of approval of the
expenditure which is sufficient to constitute an
exercise of the foundation manager's authority to
approve or to exercise discretion in recom-
mending approval for making an expenditure by
the foundation. Whether or not the foundation
manager's action is the final or decisive approval
on behalf of the foundation is not the determining
factor.

Knowing. A foundation manager will be consid-
ered to have agreed to an expenditure knowing
that it is a taxable expenditure only if:

1) The foundation manager has actual
knowledge of enough facts so that, based
only on these facts, the expenditure would be
a taxable expenditure,

2) The foundation manager is aware that an
expenditure under these circumstances may
violate the law governing taxable expendi-
tures, and

3) The foundation manager negligently fails to
make reasonable attempts to determine
whether the expenditure is a taxable
expenditure or is in fact aware that it is a taxa-
ble expenditure.

The term knowing does not mean having rea-
son to know. However, any evidence indicating
that a foundation manager has reason to know of
a particular fact or rule is relevant in determining
whether he or she had actual knowledge of this
fact or rule.

Willful. A foundation manager's agreement to a
taxable expenditure 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 an agreement willful. How-
ever, a foundation manager's agreement to a tax-
able expenditure is not willful if he or she does not
know that it is a taxable expenditure.

Due to reasonable cause. A foundation man-
ager’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.

16

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.

A written legal opinion will be considered rea-
‘soned 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 con-
sidered reasoned if it does nothing more than
recite the facts and express a conclusion.

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.

Correction of a taxable expenditure. In cases
other than those of inadequate reporting or failure
to obtain advance approval, discussed later, a
correction is accomplished by recovering part or
all of the expenditure to the extent possible. When
full recovery is not possible, any additional
corrective action will be prescribed by the IRS.
The type of additional action depends on the
circumstances, and the Service may require any of
‘the following:

1) Withholding any unpaid funds due a particular
grantee,

2) Stopping further grants to the grantee,

3) Periodic reports to the IRS from the founda-
tion for all its expenditures,

4) Improving methods of exercising expenditure
responsibility (discussed later),

5) Improving methods of selecting recipients of
individual grants, and

6) Any other actions that the Service may pre-
scribe in a particular case.

The foundation is not required to attempt recov-
ery of the taxable expenditure by legal action if it
appears a judgment could not be satisfied.

Correction for failure to obtain advance
approval. When an expenditure is taxable as a
grant for travel, study, etc., only because of a fail-
ure to obtain advance approval of procedures for
those grants, correction may be accomplished by
obtaining approval of the grant-making procedures
and establishing to the satisfaction of the Service
that:

1) No grant funds have been diverted to any use
not for a purpose specified in the grant,

2) The grant making procedures instituted would
have been approved if advance approval of
the procedures had been properly requested,
and

3) When advance approval of grant making pro-
cedures is later required, the approval will be
properly requested.

Correction for inadequate reporting. If an
expenditure is taxable only because of a failure to
make or obtain a full and complete report as
required (discussed later in this chapter),
correction may be made by obtaining or making
the report in question.

In addition, if the expenditure is taxable only
because of a failure to obtain a full and complete
report as required and an investigation indicates
that no grant funds have been diverted to any use
not for a purpose specified in the grant, correction
will be accomplished if all reasonable efforts are
made to obtain the report and the Service is
notified of the failure to obtain the report.

The taxable period begins on the date the taxa-
ble expenditure occurs 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.

The correction period begins on the date of the
taxable expenditure and ends 90 days after a
notice of deficiency for the additional tax is
mailed. The period is extended for the time during
which a deficiency cannot be assessed under
section 6213(a) (relating to pending Tax Court and
other proceedings), and for any other period the
Service determines is reasonable and necessary
for correction of the taxable expenditure.

Taxable Expenditures

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 under Influencing elections and carrying
on voter registration drives) are satisfied,

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

4) Make a grant to an organization (other than
an organization described in section
509(a)(1), (2), or (3) or an exempt operating
foundation as defined in Chapter |), unless the
foundation exercises expenditure responsibil-
ity 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 interna-
tional amateur sports competition (with
exceptions) or the prevention of cruetty to
children or animals.

These categories of taxable expenditures are
discussed in greater detail in this chapter.

Influencing legislation

A taxable expenditure includes amounts used to
attempt to influence legislation:
1) By affecting public opinion, or
2) By communicating with any member or
employee of a legislative body, or with any
other government official or employee who
may participate in formulating the legislation.

Legislation includes action by Congress, any state
legislature, any local council or similar governing
body, or the public by way of referendum,
constitutional amendment, or the like. The word
action includes the introduction, enactment,
defeat, or repeal of legislation. Actions by execu-
tive, judicial, or administrative bodies are not legis-
lation. Therefore, expenditures made to influence
action by these bodies are not attempts to influ-
ence legislation.

School boards, housing authorities, sewer and
water districts, zoning boards, and other similar
federal, state, or local special purpose bodies,
whether elective or appointive, are considered
administrative bodies.

A proposed treaty required to be submitted by
the President to the Senate for its advice and
consent will be considered legislation being con-
sidered by, or to be submitted imminently to, a leg-
islative body at the time the President's
representative begins to negotiate its position with
the parties to the proposed treaty.

Jointly funded projects. A private foundation
will not be treated as having paid or incurred any
amount to attempt to influence legislation merely
because it makes a grant to another organization
‘on the condition that the recipient obtain a
matching support appropriation from the govern-
ment. In addition, it will not be treated as having
made a taxable expenditure of amounts paid or
incurred in carrying on discussions with govern-
ment officials if: