Chapter 3
International Grantmaking by Private Foundations
The term private foundation is a U.S. federal tax law concept. It does not designate a form of nonprofit organization under U.S. state laws. Tax-exempt organizations that can receive tax-deductible contributions from U.S. taxpayers are formed under the laws of a state of the United States (or of the District of Columbia or a U.S. possession). They are typically formed as nonprofit corporations, charitable trusts, or unincorporated associations. See Chapter 5. Any of these forms of tax-exempt organization may be classified for U.S. federal (and often state) tax purposes as a so-called private foundation.
3.1 What is a Private Foundation?
Typically, a private foundation is a 501(c)(3) organization that has a small number of funders, such as a family foundation. Technically, a private foundation is any 501(c)(3) organization that does not qualify as a so-called public charity. There are several ways an organization can qualify as a public charity, and these are described in Chapter 2.
In general, the consequences of being treated as a private foundation, rather than a public charity, are:
The organization must comply with additional restrictions on operations. Notably, the so-called self-dealing rules prohibit a private foundation from providing any benefits to, or entering into transactions (such as sales, leases, or loans) with significant contributors and others (so-called disqualified persons) who have certain insider relationships to the organization.1 Steep penalties, in the form of excise taxes, can be imposed on an organization and/or individuals for failure to comply with this and other restrictions. To avoid incurring this tax, it is critical to know who the disqualified persons are with respect to your organization. The organization is subject to an excise tax on investment income. Donors receive less generous tax deductions for contributions to private foundations than they receive when contributing to public charities.A private foundation may be further classified as a non-operating foundation or an operating foundation.
Private Non-Operating Foundations
Most private foundations are classified as non-operating foundations. These foundations typically function as grantmakers, and do not directly provide services or conduct other charitable (501(c)(3)) activities.
Every private non-operating foundation is required to disburse a minimum amount each year, in the form of so-called qualifying distributions. This minimum is approximately equal to 5 percent of the foundation's investment assets, although computing the required amount can be rather complex. A private foundation that does not distribute the minimum amount within a specified time period is subject to an excise tax.2
Qualifying distributions consist generally of grants, gifts, and so-called program related investments (described later) made for charitable purposes. These distributions may be to 501(c)(3) public charities, private operating foundations, governments, and to other organizations and individuals, subject to additional requirements. Qualifying distributions also include reasonable administrative expenses incurred by the private foundation in carrying out its charitable purposes and amounts paid to acquire assets used in carrying out the foundation's exempt purposes. If a private foundation has control over another 501(c)(3) organization, its grants to the controlled organization are qualifying distributions only if additional requirements are met.3
Private Operating Foundations
A special type of private foundation is the so-called private operating foundation.4 This is a 501(c)(3) organization that does not qualify for public charity status, typically because it has limited sources of support. However, unlike the typical family foundation, a private operating foundation directly conducts activities, such as providing charitable services, rather than functioning solely as a grantmaker. To qualify as a private operating foundation, an organization must not only be involved in some charitable activities beyond grantmaking, but also must meet certain technical tests.
Private operating foundations are subject to some, but not all of the restrictions that apply to non-operating foundations. For example, they are not required to make minimum distributions. In addition, contributions to private foundations are eligible for the more generous income tax deductions that apply to contributions to public charities.
3.2 Should a Private Foundation Make Cross-Border Grants?
Private foundations (including operating foundations) making grants to foreign organizations are subject to rather onerous requirements aimed at ensuring that the funds are used for 501(c)(3) purposes. Indeed, it has been suggested that smaller private foundations, such as family foundations, should limit their foreign grantmaking to organizations that have obtained IRS recognition of their 501(c)(3) status.5
If you are managing a private foundation that has an international purpose, you should carefully weigh the cost of compliance with these rules. You may decide that your resources are most efficiently used by granting to U.S.-based public charities that serve international purposes. If, on the other hand, you decide that it is important to maintain control over your foreign grantmaking, you will need to be prepared to devote additional resources toward complying with cumbersome U.S. tax requirements.
3.3 Permitted Grants and Disbursements
The focus of this chapter is on the U.S. tax rules that apply specifically to cross-border grantmaking by private foundations. This book does not delve into all of the other requirements and restrictions applicable to private foundations, as there are many resources available.6 However, to set the stage for a discussion of cross-border grantmaking, we start with a brief overview of some fundamental rules that apply generally to grantmaking by private foundations.
While public charities are permitted to devote a minor portion of their resources toward noncharitable purposes, private foundations are subject to steep penalties, in the form of excise taxes, if any resources are considered used for noncharitable purposes.
One of these excise taxes is imposed on so-called taxable expenditures.7 In general, a taxable expenditure is a grant that does not satisfy certain safeguards to ensure that it will be used exclusively for 501(c)(3) purposes. Reasonable administrative expenses, and expenses of acquiring and maintaining investments held for the foundation's charitable purposes, are not treated as taxable expenditures.
Taxable expenditures include distributions for purposes of influencing legislation (that is, lobbying, as defined for federal tax law purposes), for influencing the outcome of any public election, or carrying on any voter registration drive, subject to certain exceptions. These prohibitions on lobbying and election-related activities apply equally to domestic and foreign activities. While it is not always easy to apply these rules in the context of a foreign political regime, it is critical to make sure that foreign grantees do not use grant funds for any activity that could be considered lobbying or political activity for this purpose.
Another excise tax is triggered by so-called jeopardizing investments, such as equity investments or loans that are not made on commercially reasonable terms, thereby putting the foundation's financial health at risk.
To avoid being treated as a taxable expenditure or jeopardizing investment, a grant or investment of funds must fall into one of the following categories.
Grants to 501(c)(3) Public Charities
A private foundation may make grants to any organization that has received an IRS determination letter confirming its status as a 501(c)(3) public charity (or private operating foundation), or that falls into a category of organizations that qualify for 501(c)(3) public charity status without obtaining an IRS determination letter.8
Many private foundations restrict their grantmaking to public charities because this allows them to focus resources on furthering their purposes without having to comply with the additional administrative requirements that come into play when making grants to other kinds of grantees. These requirements are discussed in the following paragraphs.
Grants to Organizations Other Than Public Charities
A private foundation is also permitted to make grants to organizations that are not 501(c)(3) public charities, as long as the private foundation takes certain steps to ensure that the funds are used exclusively for 501(c)(3) purposes. The required procedure is referred to as the exercise of expenditure responsibility. Expenditure responsibility, which is used with respect to both domestic and foreign grantees, is explained in section 3.4. In addition, when a grantee does not qualify as a public charity (either by having an IRS determination letter or through equivalency determination described later), a grant will not be considered toward meeting the private foundation grantor's minimum distribution requirement unless the grantee also satisfies certain distribution requirements.
Grants to Governments and Government Units
A private foundation may make grants to domestic and foreign government units, as long as the terms of the grant require that the funds be used solely for charitable purposes.
Scholarships and Other Grants and Gifts to Individuals
A private foundation that makes grants to individuals for travel, study, or similar purposes must satisfy certain requirements to avoid the excise tax on taxable expenditures.9 The grant must be a scholarship or fellowship, a prize or award, or a grant that has a specific objective such as the production of a report or improvement of a literary, artistic, or musical skill of the grantee. It must be awarded on an objective, nondiscriminatory basis, and the private foundation must obtain advance IRS approval of the grantmaking procedure.
Charitable gifts to individuals, other than for travel, study, and similar purposes, may be made without the need to obtain advance IRS approval. For example, a private foundation may provide relief from poverty or disaster directly to individuals. It is critical that the private foundation maintain detailed records to establish that the funds were used for charitable purposes.
Program-Related Investments
A program-related investment (PRI) is typically a loan or equity investment (and may take other forms of investment) made by a private foundation or public charity, primarily for charitable purposes. While the private foundation typically expects to earn a return on the investment, the anticipated return is less, or the risk is greater, than that which a business entity would demand because the primary purpose for making the investment is charitable. As with grantmaking, a private foundation that makes a program-related investment in a foreign organization is required to make an equivalency determination or exercise expenditure responsibility. See section 3.4.10
A private foundation that contemplates making a program-related investment should seek legal advice in advance of doing so. IRS guidelines can be difficult to apply, and a program-related investment that fails to qualify can trigger an excise tax.
3.4 International Grantmaking: Special Requirements for Private Foundations
Most foreign organizations do not apply to the IRS for recognition of 501(c)(3) public charity status. When a U.S.-based private foundation makes a grant to a foreign organization that has not obtained an IRS determination of 501(c)(3) public charity status, the U.S. private foundation must take additional steps to make sure that the grant will not trigger an excise tax as a taxable expenditure. These additional steps take the form of so-called equivalency determination or expenditure responsibility, described in the following paragraphs.
In addition, for purposes of satisfying the minimum distribution requirement (described in section 3.1), a private foundation that makes a grant to a foreign organization may rely on an affidavit or opinion of counsel to determine that the foreign grantee meets the requirements for 501(c)(3) public charity status. The affidavit or opinion must set forth sufficient facts to allow the IRS to conclude that the organization meets those requirements.11 See equivalency determination, following.
Grants to Foreign Organizations: Equivalency Determination or Expenditure Responsibility
Assuming a prospective foreign grantee organization has not obtained an IRS determination of its public charity status, the private foundation may make the grant (and thereby avoid a tax on taxable expenditures) only if it either makes a so-called equivalency determination or exercises expenditure responsibility. An equivalency determination requires reaching the conclusion that the foreign organization would qualify as a 501(c)(3) public charity if it were established in the United States. The exercise of expenditure responsibility entails taking certain steps to see that the grant is used solely for charitable purposes.
A private foundation may choose whether to make an equivalency determination or exercise expenditure responsibility. Of course, if a prospective grantee does not meet the requirements for 501(c)(3) public charity status, expenditure responsibility will be the only option. Regardless of which one you choose, you will need to engage an attorney.
Grants to foreign governments are exempt from these requirements, but a private foundation contemplating such a grant must proceed with caution. Grants to certain international organizations designated by Executive Order are also exempt from these requirements. These special cases are discussed later.
It is important to keep in mind that the prohibitions against the use of grant funds for lobbying or election-related activities, or for any other noncharitable uses, apply in all cases. In addition, all cross-border grants and program-related investments must satisfy anti-terrorism requirements, discussed later in this chapter.
Equivalency Determination
A private foundation may make a grant to a foreign organization that has not received an IRS determination of 501(c)(3) public charity status if it makes a good faith determination that the grantee would qualify. The determination must be based on either an affidavit of the grantee or an opinion of counsel of the grantor or grantee. The affidavit or opinion must set forth sufficient facts such that the IRS can determine whether the foreign grantee meets the requirements for 501(c)(3) public charity status.
This determination typically involves both legal and factual analyses. It is necessary to review the foreign organization's organizational documents (such articles of association and bylaws, or the foreign country's equivalent). You may need to have the documents translated into English. You may also need to obtain a translation and analysis of applicable foreign law. For example, if organizational documents do not sufficiently restrict the organization's activities or disposition of funds, you will need to look into whether those restrictions are imposed under applicable local laws. Determining whether an organization qualifies for public charity status may require an analysis of its support over a period of years. This can be a challenge where different accounting methods are used.12
Even after a thorough analysis of the facts, law, and numbers, it is not always clear whether a foreign organization meets the requirements for 501(c)(3) public charity status. Where there is ambiguity, even a carefully drafted legal opinion may not protect you from an IRS challenge and potential excise tax liability. For that reason, you may well prefer to exercise expenditure responsibility when the conclusion regarding equivalency is less than clear.
Expenditure Responsibility
Making an equivalency determination is often difficult, and many private foundations find it easier to satisfy the alternative expenditure responsibility requirement. A private foundation that diligently complies with the expenditure responsibility procedures set forth in U.S. Treasury regulations will generally not be subject to penalties if the grantee misuses funds.13
At the same time, complying with the expenditure responsibility requirements for a foreign grantee, particularly drafting the required written agreement, will entail engaging an attorney familiar with applicable U.S. law, and possibly also consulting a foreign lawyer. Translation services may also be needed. Of course, all of this adds expense to your grantmaking process.
Expenditure responsibility can only be used when a grant is made for a specific, preapproved project. You can include an allowance for administrative expenses to be incurred by the grantee in connection with the project. However, you cannot make a general operating grant using expenditure responsibility. If you want to make a general operating grant, you should explore whether an equivalency determination is possible. Note also that, while exercising expenditure responsibility ensures that a grant will not be a taxable expenditure, additional steps may be required in order for the grant to count toward the private foundation's minimum distribution requirement. This is the case if the grantee is classified as a private foundation (a foreign organization that does not establish public charity status), or if the grantee is controlled by the private foundation.
There are three parts to the exercise of expenditure responsibility:
To use grant funds exclusively for charitable (501(c)(3)) purposes. To repay any funds not used for the purposes of the grant. To submit full and complete annual reports. To maintain records of receipts and expenditures and to make its books and records available to the grantor. Not to use grant funds for purposes of lobbying (as defined in the Treasury regulations). Not to use grant funds for purposes of influencing any election or carrying on any voter registration drive. Not to make any grant that is not permitted to be made by a domestic private foundation.Grants to Foreign Intermediaries
If a U.S. private foundation is making grants to an intermediary organization that does not qualify as a public charity (by having an IRS determination letter or through equivalency determination), that U.S. grantor must require that the grantee comply with 501(c)(3) requirements for private foundation grantmaking, and this may include a requirement that the grantee exercise expenditure responsibility in making its own grants.
Grants to Foreign Governments or Government Units
The equivalency determination and expenditure responsibility requirements do not apply to grants made to units of foreign governments. It is critical, however, to enter into a written agreement that prohibits the use of grant funds for any noncharitable purposes. Foreign laws, culture, and language differences can make it difficult to draft such an agreement. In addition, it is not always clear whether a foreign entity is a governmental unit. For example, a foreign university or hospital may or may not qualify as such. You will need to understand its legal structure to make that determination, and for that reason it is advisable to seek legal advice before making a grant to a foreign government unit.
Grants to International Organizations Designated by Executive Order
A private foundation may make grants to certain international organizations designated by an Executive Order without the need to make an equivalency determination or exercise expenditure responsibility. This category includes the World Health Organization (WHO) and World Trade Organization (WTO), among others.15
Cross-Border Program-Related Investments
A private foundation that makes a cross-border program-related investment is required to comply with expenditure responsibility procedures, assuming the investee does not qualify as a 501(c)(3) public charity (through an IRS determination letter or an equivalency determination). Treasury regulations set forth the specific items required to be included in a program-related investment agreement.16
If your private foundation is contemplating making a program-related investment, you should also consider whether any payments of interest or dividends from the investee will be subject to foreign withholding taxes, which could reduce your investment return. Many countries impose a withholding tax on outbound transfers of interest and dividends. If a withholding tax does apply, you should determine whether there is a bilateral income tax treaty between the United States and the investee's country of residence that would eliminate or reduce the tax. If a treaty provision applies, you may need to provide the foreign government with certain required documentation.
Anti-Terrorism Compliance
Every grant and program-related investment made to a foreign organization or individual is subject to the U.S. anti-terrorism rules. Private foundations, like public charities, must take appropriate steps to minimize the risk that any cross-border distribution could be used to support any terrorist activity. This requires additional due diligence, which can be quite cumbersome. See section 8.1. Moreover, even if an organization takes appropriate steps to avoid inadvertently funding terrorist activities, it can still face government sanctions if its grant funds fall into the hands of terrorists. This is in contrast to the expenditure responsibility procedures, which if followed, protect a private foundation from penalties in the event that a grantee misuses funds.
3.5 U.S. Withholding Tax on Disbursements of Grant Funds
A private foundation or public charity that makes a cross-border grant may, under some circumstances, be required to withhold U.S. tax from the grant funds. A grantmaking organization that wants to avoid any potential withholding requirement can do so by including a provision in the grant agreement that prohibits the use of any grant funds for travel to or use in the United States. Withholding taxes are discussed further in section 8.11.
3.6 Review and Further Considerations
Chapters 2 and 3 have focused on U.S. federal tax requirements related to cross-border grantmaking by the two types of 501(c)(3) organization: public charities and private foundations. We have seen that it's critical to know whether your organization is a public charity or a private foundation because private foundations are subject to more rigorous requirements.
Public charities and private foundations alike need to be mindful of additional (non-tax) U.S. and foreign laws when making cross-border grants. Chapters 8 and 9 address additional U.S. and foreign legal requirements that may apply to grantmaking activities.
If your organization's international activities are confined to grantmaking, you may decide to skip Chapters 4 through 7. On the other hand, if you are contemplating moving beyond grantmaking by operating your own programs in a foreign country, you are well advised to continue to Chapter 4 and beyond. Whether you're staffing a foreign school, or merely sending a few volunteers or employees overseas for limited periods, it's important to be aware of the various legal and practical considerations that may affect your international activities.
In the next two chapters, we look at how to achieve the optimal legal structure for your organization in order to further your mission, while making the most efficient use of your resources and minimizing legal risks and liabilities.
Notes
1. I.R.C. §§ 4941, 4946.
2. I.R.C. § 4942; Treas. Reg. § 53.4942.
3. I.R.C. §§ 4942(g), 4946. The controlled grantee organization must be a 501(c)(3) organization, and the grantmaking foundation must make sure that the grantee uses the funds within a specified period of time. This rule also applies when individuals that have certain relationships to the private foundation (so-called disqualified persons) have control over the grantee.
4. I.R.C. § 4942(j)(3).
5. See McCoy, Jerry J. and Kathryn W. Miree, Family Foundation Handbook, (Chicago, IL: CCH 2012), ¶7.02[B][3].
6. See Appendix B for a list of resources.
7. I.R.C. § 4945; Treas. Reg. § 53.4945. Other excise taxes are: a tax on net investment income (imposed on all private foundations), a tax on excess business holdings, and a tax on so-called self-dealing.
8. You should always obtain confirmation of a prospective grantee's public charity status. Note also grants to certain supporting organizations do not qualify. If a prospective grantee qualifies for public charity status as a supporting organization, you should seek professional guidance before moving forward.
9. IRC § 4945.
10. IRC § 4944(c); Treas. Reg. § 53.4944-3. In April 2012, the U.S. Department of Treasury issued proposed regulations to provide more guidance for organizations wishing to make program-related investments. These proposed regulations provide nine new examples, and may be relied on by grantmaking organizations even before they become final. Prop. Treas. Reg. § 53.49-44-3(b), examples 11–19 (April 19, 2012).
11. Treas. Reg. § 53.4942(a)-3(a)(6).
12. The IRS has set forth the required elements of an equivalency determination in Rev. Proc. 92-94, 1992-2 C.B. 507. Various grantmaker groups have called upon the IRS to update this Revenue Procedure in light of intervening changes of law. In addition, these groups have urged the IRS to approve, and allow grantmakers to rely upon, one or more central databases (referred to as equivalency determination information repositories, or EDIRs) of foreign organizations for which equivalency determinations have been made. This would make foreign grantmaking significantly more feasible for smaller private foundations. As of this book's publication, the IRS has not sanctioned any EDIRs. However, Proposed Regulations issued in 2012 would allow a private foundation to rely on opinions issued by certain advisors other than the foundation's (or the grantee's) own counsel. This may open the door to the use of a repository for equivalency determinations.
13. The requirements for exercising expenditure responsibility are set forth in Treas. Reg. § 53.4945-5(b).
14. Treas. Reg. § 53.4945-5(d).
15. These are organizations designated by Executive Order pursuant to the federal statute 22 U.S.C. § 288.
16. Treas. Reg. § 53.4945-5(b)(4).