On March 1, 2022, the IRS published its 129-page Exempt Organizations Technical Guide TG 62 Excise Taxes on Taxable Expenditures. While not authoritative or controlling, the guidance addresses in great detail the definitions applicable to taxable expenditures, common areas of potential excise tax triggers, and excise taxes that may be imposed on an organization and its managers who approve a transaction that constitutes a taxable expenditure.
This article provides an overview of the concept of “taxable expenditures” for private foundations.
What is a “taxable expenditure”?
“Private foundations” are those organizations that are exempt from taxation under Section 501(c)(3) and do not meet the requirements of public charity status under Section 509(a). Private foundations and their officers, directors, and managers must remain vigilant to avoid transactions that involve improper self-dealing as well as transactions that constitute “taxable expenditures.”
A “taxable expenditure” is any amount paid or incurred by a private foundation to or for any of the following:
- Carry on propaganda or to influence legislation;
- Influence outcome of any specific public election or voter drive;
- Grant to an individual for travel, study or other similar purposes, unless approved in advance by the IRS;
- Grant to an organization unless:
- such organization (i) is described in §509(a)(1) or (2) (ii) is described in §509(a)(3) (not clause (i) or (ii) of §4942(g)(4)(A)) or (iii) is an exempt operating foundation (§4940(d)(2)); or
- The private foundation exercises expenditure responsibility according to §4945(h); or
- “for any purpose other than one specified in” §170(c)(2)(B).
See 26 U.S.C. § 4945(d)-(d)(5).
With respect to subparagraph (5) above, Section 170(c)(2)(B) of the Code provides a definition for “charitable contribution,” being a contribution to a “corporation, trust, or community chest, fund, or foundation organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals[.]” See 26 U.S.C. 170(c)(2)(B). Contributions to “individuals” is not a purpose specified in section 170(c)(2)(B).
What is a “grant”?
For purposes of §4945, grants include such expenditures as: (1) amounts spent by the recipient organization to carry out a charitable activity; (2) scholarships, fellowships, internships, prizes, and awards; (3) loans for purposes described in §170(c)(2)(B); and (4) program-related investments (investments in small businesses in central cities or for neighborhood renovation). See Treas. Reg. § 53.4945-4(a)(2). Grants do not include: (1) salaries or other compensation to employees; (2) educational payments to employees which are includible in the employees’ incomes per §61; or (3) payments (including salaries, consultants’ fees and reimbursement for travel expenses) to persons for personal services in assisting a foundation in planning, evaluating or developing projects or areas of program activity of the foundation. See 26 C.F.R. § 53.4945-4(a)(2).
When will a grant not constitute a taxable expenditure?
As noted above, a grant to an organization will not be considered a taxable expenditure if the recipient organization (i) is described in §509(a)(1) or (2); (ii) is described in §509(a)(3) (not clause (i) or (ii) of §4942(g)(4)(A)); or (iii) is an exempt operating foundation (§4940(d)(2)). See 26 U.S.C. § 4945(d)-(d)(4)(A).
The analysis of organizations described in section 509(a)(1) or (2) is technical but important.
Section 509(a)(1) defines “private foundation”, meaning a domestic or foreign organization described in §501(c)(3) other than an organization described in §170(b)(1)(A), with two exceptions.
Section §170(b)(1)(A) provides definitions applicable for “charitable contributions” to (i) churches, (ii) educational organizations, (iii) organizations operated for medical care or research, (iv) public charity supporting organizations, (v) governmental unit, (vi) public charities, (vii) private foundations, (viii) organizations described in §509(a)(2) or (3), and (ix) agriculture-related research organizations. See 26 U.S.C. § 509(a)(1).
Section 509(a)(2) describes, essentially, public charities, being organizations that normally receive more than one-third of support from other than from disqualified persons, governmental units, or from organizations described in §170(b)(1)(A).
If a recipient of a grant is not qualified as required by section 4945(d)(4)(A), what must the private foundation do to comply with “expenditure responsibility”?
As noted above, a grant to an organization that is not qualified pursuant to section 4945(d)(4)(A) will not constitute a taxable expenditure if the granting foundation exercises expenditure responsibility over the grant. See 26 U.S.C. § 4945(d)-(d)(4)(B).
Expenditure responsibility basically “means that the private foundation is responsible to exert all reasonable efforts and to establish adequate procedures–(1) to see that the grant is spent solely for the purpose for which made, (2) to obtain full and complete reports from the grantee on how the funds are spent, and (3) to make full and detailed reports with respect to such expenditures to the Secretary.” Id. at §§ 4945(h)-(h)(3); see 26 C.F.R. § 53.4945-5(b)-(b)(iii).
Expenditure responsibility includes the following:
- Pre-grant inquiry that satisfies Treas. Reg. § 53.4945-5(b)(2).
- Written agreement that satisfies Treas. Reg. 53.4945-5(b)(3).
- Reports from grantee that satisfy Treas. Reg. 53.4945-5(c)(1).
- Reporting to the IRS in compliance with Treas. Reg. § 53.4945-5(d)(1)-(2).
- Recordkeeping requirements in compliance with Treas. Reg. 53.4945-5(d)(3).
Violations of the expenditure responsibility requirements usually fall into three categories: (1) the grantee diverts grant funds from grant purposes; (2) the grantee fails to make reports as required; and (3) the grantor fails to follow expenditure responsibility requirements properly. See id. § 53.4945-5(e)(1)-(3). If a grantee fails to make the required reports (or makes inadequate reports), the grant will likely constitute a taxable expenditure unless the grantor: (1) conducted a proper pre-grant inquiry; (2) made the grant with a proper grant agreement; (3) properly reports the grant to the IRS; (4) makes a reasonable effort to obtain the required report; and (5) withholds all future payments to the grantee until the proper reports are obtained. See id. §§ 53.4945-5(e)(2)-(e)(2)(iv).
If a granting foundation discovers that a grantee has diverted grant funds from grant purposes, the granting foundation may avoid a taxable expenditure by: (1) taking all reasonable and appropriate steps to recover the diverted funds, and ensure the grantee’s proper use of remaining grant funds; and (2) withhold any future payments to the grantee until adequate assurance of performance is obtained by virtue of “extraordinary precautions” instituted by grantee. See id. §§ 53.4945-5(e)(1)(iii)-(iii)(b)(2).
What are the tax consequences for authorizing or engaging in a taxable expenditure?
High-Level Summary of Tax Consequences:
- An excise tax may be levied against a granting private foundation and its foundation managers involved in the decision.
- 20% tax assessed to the foundation;
- 5% (up to $10,000) on managers for “knowingly” approving a taxable expenditure.
- If not corrected within tax period, a tax equal to 100% of expenditure must be paid by the foundation; 50% in case of manager (up to $20,000).
The Code and Treasury Regulations
If a private foundation engages in a transaction that results in a taxable expenditure, the foundation will be assessed a tax equal to 20% of the amount of the grant. See 26 U.S.C. § 4945(a)(1). In any case in which an initial tax is imposed by subsection (a)(1) on a taxable expenditure and such expenditure is not corrected within the taxable period, there is imposed a tax equal to 100 percent of the amount of the expenditure. Id. at § 4945(b)(1).
In addition, there is imposed on the agreement of any “foundation manager” to the making of an expenditure, “knowing that it is a taxable expenditure, a tax equal to 5 percent of the amount thereof, unless such agreement is not willful and is due to reasonable cause.” Id. at § 4945(a)(2). “[T]he tax with respect to any particular expenditure applies only to the agreement of those foundation managers who are authorized to approve, or to exercise discretion in recommending approval of, the making of the expenditure by the foundation and to those foundation managers who are members of a group (such as the foundation’s board of directors or trustees) which is so authorized.” 26 C.F.R. § 53.4945-1(a)(2)(i)(c). The tax imposed by section 4945(a) shall be paid by any foundation manager who agreed to the making of the expenditure. 26 U.S.C. § 4945(a)(2).
The agreement of a foundation manager to the making of a taxable expenditure “shall consist 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 recommending approval of, the making of the expenditure by the foundation, whether or not such manifestation of approval is the final or decisive approval on behalf of the foundation.” 26 C.F.R. § 53.4945-1(a)(2)(i)(c).
In any case in which an additional tax is imposed on a foundation manager, “if a foundation manager refused to agree to part or all of the correction, there is hereby imposed a tax equal to 50 percent of the amount of the taxable expenditure. The tax imposed by this paragraph shall be paid by any foundation manager who refused to agree to part or all of the correction.” 26 U.S.C. § 4945(b)(2). The maximum amount that may be imposed under subsections 4945(a)(2) and (b)(2) is $10,000 and $20,000, respectfully. See id. at § 4945(c)(2).
When is a foundation’s manager considered to have “knowingly” agreed to a taxable expenditure?
The term “foundation manager” means, with respect to any private foundation—“(1) an officer, director, or trustee of a foundation (or an individual having powers or responsibilities similar to those of officers, directors, or trustees of the foundation), and (2) with respect to any act (or failure to act), the employees of the foundation having authority or responsibility with respect to such act (or failure to act).” See id. at § 4946(b)-(b)(2).
A foundation manager shall be considered to have agreed to an expenditure “knowing” that it is a taxable expenditure only if: (a) the person has actual knowledge of sufficient facts so that, based solely upon such facts, such expenditure would be a taxable expenditure, (b) the person is aware that such an expenditure under these circumstances may violate the provisions of federal tax law governing taxable expenditures, and (c) the person negligently fails to make reasonable attempts to ascertain whether the expenditure is a taxable expenditure, or the person is in fact aware that it is such an expenditure. 26 C.F.R. § 53.4945-1(a)(2)(iii)(a)-(c).
For purposes of this analysis, the term “knowing” does not mean “having reason to know.” See id. at § 53.4945-1(a)(2)(iii)(c). The critical determination is of what facts regarding the expenditures the foundation manager had actual knowledge, not whether the foundation manager actually knew that the grants were taxable expenditures. Thorne v. Comm’r, 99 T.C. 67, 104-105 (T.C. 1992) (holding that a foundation did not make a good faith determination and thus a grant to a foreign organization without exercise of expenditure responsibility was a taxable expenditure). Evidence tending to show that a foundation manager has reason to know of sufficient facts so that, based solely upon such facts, an expenditure would be a taxable expenditure is relevant in determining whether the manager has actual knowledge of such facts. See 26 C.F.R. § 53.4945-1(a)(2)(iii)(c).
When is a foundation manager’s conduct “willful” for purposes of excise tax liability?
“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. However, a foundation manager’s agreement to a taxable expenditure is not willful if he does not know that it is a taxable expenditure.” 26 C.F.R. §§ 53.4945-1(a)(2)(iv).
“[I]f a foundation manager has knowledge of sufficient facts concerning a grant to enable [the manager] to determine that it would be a taxable expenditure, and if he agrees to the making of the grant in a ‘voluntary, conscious, and intentional’ manner, then he has done so willfully.” Thorne, 99 T.C. at 107.
The court in Thorne concluded as follows: “As we have found that petitioner had actual knowledge of sufficient facts concerning the grants in question to determine that they were taxable expenditures and voluntarily, consciously, and intentionally agreed to the making of such grants, we conclude that petitioner’s conduct was willful.” Id.
When is a taxable expenditure made “due to reasonable cause” as defined in Section 4945(a)(2)?
As noted above, there is imposed on the agreement of any “foundation manager” to the making of an expenditure, “knowing that it is a taxable expenditure, a tax equal to 5 percent of the amount thereof, unless such agreement is not willful and is due to reasonable cause.” 26 U.S.C. § 4945(a)(2) (emphasis added).
“A foundation manager’s actions are due to reasonable cause if he has exercised his responsibility on behalf of the foundation with ordinary business care and prudence.” 26 C.F.R. § 53.4945-1(a)(2)(v).
In addition, if a foundation manager relies on the advice of legal counsel with respect to a transaction that ultimately proves to be a taxable expenditure, the manager may be deemed to have acted “due to reasonable cause” for purposes of excise tax assessment. The applicable Treasury Regulation provides, in relevant part, as follows:
“If a foundation manager, after full disclosure of the factual situation to legal counsel (including house counsel), relies on the advice of such counsel expressed in a reasoned written legal opinion that an expenditure is not a taxable expenditure under section 4945 (or that expenditures conforming to certain guidelines are not taxable expenditures), although such expenditure is subsequently held to be a taxable expenditure . . . , the foundation manager’s agreement to such expenditure . . . will ordinarily not be considered “knowing” or “willful” and will ordinarily be considered “due to reasonable cause” within the meaning of section 4945(a)(2). For purposes of the subdivision, a written legal opinion will be considered “reasoned” even if it reaches a conclusion which is subsequently determined to be incorrect so long as such opinion addresses itself to the facts and applicable law. However, a written legal opinion will not be considered “reasoned” if it does nothing more than recite the facts and express a conclusion. . . .”
26 C.F.R. § 53.4945-1(a)(2)(vi).
What are other consequences to a private foundation that engages in taxable expenditures?
The status of a private foundation may be terminated where there have been “either willful repeated acts (or failures to act), or a willful and flagrant act (or failure to act), giving rise to liability for tax under chapter 42[.]” See 26 U.S.C. § 507(a)(2)(A)-(B).
The term “willful repeated acts (or failures to act)” means “at least two acts or failures to act both of which are voluntary, conscious, and intentional. 26 C.F.R. § 1.507-1(c)(1). For purposes of section 507(a)(2)(A), a “willful and flagrant act (or failure to act)” is one which is “voluntarily, consciously, and knowingly committed in violation of any provision of chapter 42 . . . and which appears to a reasonable [person] to be a gross violation of any such provision.” Id. at § 1.507-1(c)(2). “An act (or failure to act) may be treated as an act (or failure to act) by the private foundation for purposes of section 507(a)(2) even though tax is imposed upon one or more foundation managers rather than upon the foundation itself.” Id. at § 1.507-1(c)(3).
For purposes of section 507(a)(2), the failure to correct the act or acts (or failure or failures to act) which gave rise to liability for tax under any section of chapter 42 by the close of the correction period for such section may be a willful and flagrant act (or failure to act).” Id. at § 1.507-1(c)(4).
May penalties be assessed for excise taxes associated with taxable expenditures?
Yes. If any person becomes liable for tax under any section of chapter 42—which includes taxes assessed for taxable expenditures and for self-dealing transactions—by reason of any act or failure to act which is not due to reasonable cause and either: (1) such person has theretofore been liable for tax under chapter 42, or (2) such act or failure to act is both willful and flagrant, then such person shall be liable for a penalty equal to the amount of such tax. See 26 U.S.C. § 6684; see also Thorne, 99 T.C. at 107 (concluding that, based on the “willful” and “knowing” conduct, the foundation manager was also liable for the penalties assessed for the taxable expenditures).
As use in section 6684, the term “willful and flagrant” has the same meaning as in section 507(a)(2)(A) and the regulations thereunder, which are mentioned above. See 26 C.F.R. § 301.6684-1(c).
The penalty imposed by section 6684 shall not apply to any person with respect to a violation of any section of chapter 42 if it is established to the satisfaction of the applicable IRS representative that such violation was due to reasonable cause. An affirmative showing of reasonable cause must be made in the form of a written statement, containing a declaration by such person that it is made under the penalties of perjury, setting forth all the facts alleged as reasonable cause. See id. at § 301.6684-1(b).
What can a private foundation do to correct a transaction that is a taxable expenditure?
Except where a taxable expenditure occurs as a result of inadequate reporting or for failure to obtain advance approval (such as for grants to individuals for travel or study), correction of a taxable expenditure shall be accomplished by recovering part or all of the expenditure to the extent recovery is possible, and, where full recovery cannot be accomplished, by any additional corrective action which the IRS may prescribe. See 26 C.F.R. § 53.4945-1(d)(1)(i)-(vi). Such additional corrective action is to be determined by the circumstances of each particular case and may include the following:
- requiring that any unpaid funds due the grantee be withheld;
- requiring that no further grants be made to the particular grantee;
- requiring periodic reports from the foundation for all expenditures;
- requiring improved methods of exercising expenditure responsibility;
- requiring improved methods of selecting recipients of individual grants; and
- requiring such other measures as the IRS may prescribe in a particular case.
See id. The foundation making the expenditure is generally not be under any obligation to attempt to recover the expenditure by legal action if such action would in all probability not result in the satisfaction of execution on a judgment. Id. at § 53.4945- 1(c)(4)(iv).
The taxable expenditure rules applicable to private foundations are complex and, if not honored, can result in substantial tax liabilities to the private foundation and its officers, directors, or managers who authorize a transaction that constitutes a taxable expenditure. Woven into the taxable expenditure rules are other complex rules for expenditure responsibility, rules for qualifying grantee organizations, reporting requirements, and requirements to manage grants and other use of assets in compliance with the Code and Treasury Regulations so as to avoid excise taxes.
The IRS’s recently-issued Technical Guide on Taxable Expenditures is a useful tool, but, as the Guide expressly states on page 1: “This document is not an official pronouncement of the law or the position of the IRS and cannot be used, cited, or relied upon as such.” Thus, the Code, the Treasury Regulations, and judicial authorities—as well as competent legal counsel—on the subject should be carefully consulted with respect to any transaction that may constitute a taxable expenditure.
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