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Bruce R. Hopkins

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The Tax Law of Private Foundations, 2021 Cumulative Supplement, 5th Edition Make sense of the new regulatory requirements with expert clarification and practical tools for compliance Private Foundations: Tax Law and Compliance, 5th Edition provides clarification, expert insight, and helpful instruction for executives and supporting professionals navigating extensive federal tax law requirements. Despite their relatively low numbers, private foundations are subject to complex, burdensome regulations that continue to expand; the recent tax overhaul has compounded this issue, bringing massive changes beyond the usual annual adjustments, and throwing a wrench into the status quo of compliance-as-usual. This book summarizes and clarifies the statutory regulations governing private foundations, offers expert insight into the underlying logic, and provides a host of practical tools that ease the filing process and help ensure compliance with the latest laws. Detailed explanations are bolstered by checklists, sample documents and letters, practice forms, and real-world examples in order to provide both conceptual and practical guidance for maintaining tax-exempt eligibility and tax compliance. By untangling the complex maze of constantly-evolving requirements, this book offers a much-needed resource to those tasked with ensuring compliance amidst regulatory changes year after year. * Learn how the recent changes to tax laws affect private foundations and related organizations * Understand the practical implications of maintaining compliance * Access critical tools that help streamline the filing process * Avoid mistakes and oversights with line-by-line instruction This book is updated annually to provide guidance based on the most recent iteration of the law, but this year's edition is unusually critical; federal law has undergone sweeping changes that will substantially alter filings across the board, and the complex nature of the regulations governing private foundations promises additional confusion as the new laws are applied. Private Foundations: Tax Law and Compliance, 5th Edition provides insight, clarification, and explanation from the nation's leading authority on tax-exempt organizations to help private foundations maintain compliance amidst the changes.

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Table of Contents

Cover

Title Page

Copyright

Preface

Book Citations

CHAPTER ONE: Introduction to Private Foundations

§ 1.1 PRIVATE FOUNDATIONS: UNIQUE ORGANIZATIONS

§ 1.2 DEFINITION OF PRIVATE FOUNDATION

§ 1.4 PRIVATE FOUNDATION LAW PRIMER

§ 1.5 FOUNDATIONS IN OVERALL EXEMPT ORGANIZATIONS CONTEXT

§ 1.6 DEFINITION OF CHARITY

§ 1.7 OPERATING FOR CHARITABLE PURPOSES

§ 1.9 PRIVATE FOUNDATION SANCTIONS

PRIVATE FOUNDATION LAW SANCTIONS

§ 1.10 STATISTICAL PROFILE

§ 1.11 PRIVATE FOUNDATIONS AND LAW 50 YEARS LATER

NOTES

CHAPTER TWO: Starting, Funding, and Governing a Private Foundation

§ 2.1 CHOICE OF ORGANIZATIONAL FORM

§ 2.3 ESTATE PLANNING PRINCIPLES

§ 2.4 FOUNDATIONS AND PLANNED GIVING

§ 2.5 ACQUIRING RECOGNITION OF TAX-EXEMPT STATUS

§ 2.6 SPECIAL REQUIREMENTS FOR CHARITABLE ORGANIZATIONS

§ 2.7 WHEN TO REPORT BACK TO THE IRS

NOTES

CHAPTER THREE: Types of Private Foundations

§ 3.1 PRIVATE OPERATING FOUNDATIONS

§ 3.3 CONDUIT FOUNDATIONS

§ 3.8 SPLIT-INTEREST TRUSTS

§ 3.9 FOREIGN PRIVATE FOUNDATIONS

NOTES

CHAPTER FOUR: Disqualified Persons

§ 4.1 SUBSTANTIAL CONTRIBUTORS

§ 4.2 FOUNDATION MANAGERS

§ 4.3 CERTAIN 20 PERCENT OWNERS

§ 4.4 FAMILY MEMBERS

§ 4.5 CORPORATIONS OR PARTNERSHIPS

§ 4.6 TRUSTS OR ESTATES

NOTES

CHAPTER FIVE: Self-Dealing

§ 5.1 PRIVATE INUREMENT DOCTRINE

§ 5.2 PRIVATE BENEFIT DOCTRINE

§ 5.3 DEFINITION OF SELF-DEALING

§ 5.3A EXCESS COMPENSATION TAX

§ 5.4 SALE, EXCHANGE, LEASE, OR FURNISHING OF PROPERTY

§ 5.5 LOANS AND OTHER EXTENSIONS OF CREDIT

§ 5.6 PAYMENT OF COMPENSATION

§ 5.8 USES OF INCOME OR ASSETS BY DISQUALIFIED PERSONS

§ 5.11 INDIRECT SELF-DEALING

§ 5.12 PROPERTY HELD BY FIDUCIARIES

§ 5.14 ADDITIONAL EXCEPTIONS

§ 5.15 ISSUES ONCE SELF-DEALING OCCURS

NOTES

CHAPTER SIX: Mandatory Distributions

§ 6.1 DISTRIBUTION REQUIREMENTS—IN GENERAL

§ 6.2 ASSETS USED TO CALCULATE MINIMUM INVESTMENT RETURN

§ 6.3 DETERMINING FAIR MARKET VALUE

§ 6.5 QUALIFYING DISTRIBUTIONS

NOTES

CHAPTER SEVEN: Excess Business Holdings

§ 7.1 GENERAL RULES

§ 7.2 PERMITTED AND EXCESS HOLDINGS

§ 7.3 FUNCTIONALLY RELATED BUSINESSES

§ 7.7 EXCISE TAXES ON EXCESS HOLDINGS

NOTES

CHAPTER EIGHT: Jeopardizing Investments

§ 8.2 PRUDENT INVESTMENTS

§ 8.3 PROGRAM-RELATED INVESTMENTS

NOTES

CHAPTER NINE: Taxable Expenditures

§ 9.1 LEGISLATIVE ACTIVITIES

§ 9.2 POLITICAL CAMPAIGN ACTIVITIES

§ 9.3 GRANTS TO INDIVIDUALS

§ 9.4 GRANTS TO PUBLIC CHARITIES

§ 9.5A FUNDING OF EMPLOYEE HARDSHIP PROGRAMS

§ 9.6 GRANTS TO FOREIGN ORGANIZATIONS

§ 9.8 INTERNET AND PRIVATE FOUNDATIONS

§ 9.9 SPENDING FOR NONCHARITABLE PURPOSES

§ 9.10A DISTRIBUTIONS TO GROUP EXEMPTION ORGANIZATIONS

§ 9.11 EXCISE TAX FOR TAXABLE EXPENDITURES

NOTES

CHAPTER TEN: Tax on Investment Income

§ 10.1 RATE OF TAX

§ 10.3 FORMULA FOR TAXABLE INCOME

§ 10.5 FOREIGN FOUNDATIONS

NOTES

CHAPTER ELEVEN: Unrelated Business Activity

§ 11.1 GENERAL RULES

§ 11.2 EXCEPTIONS

§ 11.3 RULES SPECIFICALLY APPLICABLE TO PRIVATE FOUNDATIONS

§ 11.4 UNRELATED DEBT-FINANCED INCOME RULES

§ 11.5 CALCULATING AND REPORTING THE TAX

NOTES

CHAPTER TWELVE: Tax Compliance and Administrative Issues

CHAPTER THIRTEEN: Termination of Foundation Status

§ 13.1 VOLUNTARY TERMINATION

§ 13.3 TRANSFER OF ASSETS TO A PUBLIC CHARITY

§ 13.4 OPERATION AS A PUBLIC CHARITY

§ 13.6 TERMINATION TAX

NOTES

CHAPTER FOURTEEN: Charitable Giving Rules

§ 14.1 CONCEPT OF GIFT

§ 14.2 BASIC RULES

§ 14.4 DEDUCTIBILITY OF GIFTS TO FOUNDATIONS

§ 14.5 QUALIFIED APPRECIATED STOCK RULE

§ 14.8 PLANNED GIVING REVISITED

§ 14.9 ADMINISTRATIVE CONSIDERATIONS

NOTES

CHAPTER FIFTEEN: Private Foundations and Public Charities

§ 15.2 EVOLUTION OF LAW OF PRIVATE FOUNDATIONS

§ 15.3 ORGANIZATIONS WITH INHERENTLY PUBLIC ATTRIBUTES

§ 15.4 PUBLICLY SUPPORTED ORGANIZATIONS—DONATIVE ENTITIES

§ 15.5 SERVICE PROVIDER ORGANIZATIONS

§ 15.7 SUPPORTING ORGANIZATIONS

§ 15.8 CHANGE OF PUBLIC CHARITY CATEGORY

§ 15.9 NONCHARITABLE SUPPORTED ORGANIZATIONS

NOTES

CHAPTER SIXTEEN: Donor-Advised Funds

§ 16.1 BASIC DEFINITIONS

§ 16.3 TYPES OF DONOR FUNDS

§ 16.7 PUBLIC CHARITY STATUS OF FUNDS

§ 16.9 STATUTORY CRITERIA

§ 16.12 TAX REGULATIONS

§ 16.13 DAF STATISTICAL PORTRAIT

§ 16.14 CRITICISMS AND COMMENTARY

NOTES

CHAPTER SEVENTEEN: Corporate Foundations

§ 17.2 REASONS FOR ESTABLISHMENT OF A CORPORATE FOUNDATION

§ 17.3 PRIVATE INUREMENT DOCTRINE

§ 17.3A PRIVATE BENEFIT DOCTRINE

§ 17.5 SELF-DEALING RULES

§ 17.6 OTHER PRIVATE FOUNDATIONS RULES

§ 17.7 TAX ON EXCESS COMPENSATION: POTENTIALLY APPLICABLE EXCEPTIONS ILLUSTRATED

NOTES

Table of Cases

Table of IRS Revenue Rulings and Revenue Procedures

Table of IRS Private Determinations Cited in Text

Table of IRS Private Letter Rulings, Technical Advice Memoranda, and General Counsel Memoranda

About the Author

About the Online Resources

Cumulative Index

End User License Agreement

Guide

Cover

Table of Contents

Title Page

Copyright

Preface

Book Citations

Begin Reading

Table of Cases

Table of IRS Revenue Rulings and Revenue Procedures

Table of IRS Private Determinations Cited in Text

Table of IRS Private Letter Rulings, Technical Advice Memoranda, and General Counsel Memoranda

About the Author

About the Online Resources

Cumulative Index

End User License Agreement

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The Tax Law of Private Foundations

2021 Cumulative Supplement

Fifth Edition

 

 

Bruce R. Hopkins, Jody Blazek

 

 

 

 

 

 

Copyright © 2022 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.

Library of Congress Cataloging-in-Publication Data is Available:

ISBN 9781119759058 (main edition)ISBN 9781119804338 (Paperback)ISBN 9781119805526 (ePDF)ISBN 9781119805533 (ePub)

Cover Design: WileyCover Image: Stucco Spira © Massimo Ravera/Getty Images

Preface

This is the third supplement to accompany The Tax Law of Private Foundations, Fifth Edition. The supplement covers events occurring from the middle of 2018 (where the main volume ended) through the middle of 2021.

Much of the law developments that have occurred during the period reflected in this supplement concern the self-dealing rules, with emphasis on the law concerning indirect self-dealing. The book's treatment of this area of private foundation law has been rewritten and expanded. Particular attention is accorded the estate administration exception, in part because of two recent significant IRS private letter rulings on the point, plus a ruling on the matter of a foundation's expectancy.

Private foundation law is not frequently the subject of court opinions. One court case emerged during the covered period: the Dieringer case. Framed as an estate tax charitable deduction valuation case, the set of facts really is a case study in indirect self-dealing. The case is treated from that perspective in this supplement.

Other interesting private letter rulings during the period include aspects of the mandatory payout rule, the law concerning functionally related businesses and program-related investments, spending for charitable purposes, and the qualified appreciated stock rule.

There was some hope that the proposed Department of the Treasury regulations concerning donor-advised funds would materialize during the period—they are likely to constitute the stuff of a supplement by themselves—but, to date, nothing in that regard has occurred.

A supplement of this nature would not be complete without an update on applicable law generated by the Tax Cuts and Jobs Act. Included in this supplement are summaries of the Treasury Department's and the IRS's regulation on the bucketing and excess compensation tax laws. Discussion of the latter has been expanded to include summaries of exceptions particularly applicable to private foundations.

Sections have been added summarizing the IRS's rules concerning private foundations' funding of disaster relief programs and the import of the prospective revision of the group exemption rules. In celebration (if that is the right word) of the 50-years' existence of the private foundation tax laws, a brief perspective on that phenomenon is included.

Thanks go to Brian T. Neill, Deborah Schindlar, and Sharmila Srinivasan at John Wiley & Sons, Inc., for their hard work and invaluable help in connection with preparation of this supplement.

Bruce R. Hopkins

Book Citations

Throughout this book, 11 books by the authors (in some instances, as co-author), all published by John Wiley & Sons, are referenced in this way:

Hopkins,

IRS Audits of Tax-Exempt Organizations: Policies, Practices, and Procedures

(2008):

IRS Audits

.

Hopkins,

The Law of Fundraising, Fifth Edition

(2013):

Fundraising

.

Hopkins,

The Law of Intermediate Sanctions: A Guide for Nonprofits

(2003):

Intermediate Sanctions

.

Hopkins,

The Law of Tax-Exempt Organizations, Twelfth Edition

(2019):

Tax-Exempt Organizations

.

Hopkins,

Nonprofit Governance: Law, Practices & Trends

(2009):

Nonprofit Governance

.

Hopkins,

Nonprofit Law for Colleges and Universities: Essential Questions and Answers for Officers, Directors, and Advisors

(2011):

Colleges and Universities

.

Hopkins,

Planning Guide for the Law of Tax-Exempt Organizations: Strategies and Commentaries

(2004):

Planning Guide

.

Hopkins,

The Tax Law of Charitable Giving, Sixth Edition

(2021):

Charitable Giving

.

Hopkins,

The Tax Law of Unrelated Business for Nonprofit Organizations

(2005):

Unrelated Business

.

Hopkins,

The Law of Tax-Exempt Healthcare Organizations, Fourth Edition

(2013):

Healthcare Organizations

.

Hopkins,

Tax-Exempt Organizations and Constitutional Law: Nonprofit Law as Shaped by the U.S. Supreme Court

(2012):

Constitutional Law

.

The second, fourth, eighth, and tenth of these books are annually supplemented. Also, updates on all of the foregoing law subjects (plus private foundations law) are available in Bruce R. Hopkins' Nonprofit Counsel, a monthly newsletter also published by Wiley.

CHAPTER ONEIntroduction to Private Foundations

§ 1.1 Private Foundations: Unique Organizations

§ 1.2 Definition of Private Foundation

§ 1.4 Private Foundation Law Primer

§ 1.5 Foundations in Overall Exempt Organizations Context

§ 1.6 Definition of Charity

§ 1.7 Operating for Charitable Purposes

§ 1.9 Private Foundation Sanctions

(a) Sanctions (a Reprise)

(b) Self-Dealing Sanctions as Pigouvian Taxes

(c) Self-Dealing Sanctions: Taxes or Penalties?

(d) Abatement

(e) Potential of Overlapping Taxes

§ 1.10 Statistical Profile

§ 1.11 Private Foundations and Law 50 Years Later

§ 1.1 PRIVATE FOUNDATIONS: UNIQUE ORGANIZATIONS

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over 1.5 million1

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§ 1.2 DEFINITION OF PRIVATE FOUNDATION

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; IRS Revenue Procedure (Rev. Proc.) 2021-5, 2021-1 I.R.B. 250, § 7.03

§ 1.4 PRIVATE FOUNDATION LAW PRIMER

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22.1IRC Chapter 42 (IRC §§ 4940–4948).

§ 1.5 FOUNDATIONS IN OVERALL EXEMPT ORGANIZATIONS CONTEXT

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§ 1.6 DEFINITION OF CHARITY

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§ 1.7 OPERATING FOR CHARITABLE PURPOSES

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88.1Reg. § 1.501(c)(3)-1(c)(1).

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A private foundation had its tax-exempt status revoked for failing to engage in any exempt activities over a long period of time (Community Education Foundation v. Commissioner, 112 T.C.M. 637 (2016), appeal dismissed due to lack of representation by legal counsel).

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In general,Tax-Exempt Organizations § 4.4.

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§ 1.9 PRIVATE FOUNDATION SANCTIONS

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PRIVATE FOUNDATION LAW SANCTIONS

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The federal tax rules pertaining to private foundations136 are often characterized in summaries as if they are typical laws, in the sense of prescriptions governing human behavior. This is not the case; these rules, comprising portions of the Internal Revenue Code, are tax provisions. Thus, this body of law states that, if a certain course of conduct is engaged in (or, perhaps, not engaged in), imposition of one or more excise taxes will be the (or a) result. For example, there is no rule of federal tax law that states that a private foundation may not engage in an act of self-dealing;137 rather, the law is that an act of self-dealing will trigger one or more excise taxes and other sanctions.138

(a) Sanctions (a Reprise)

Because of the nature of this statutory tax law structure, a person subject to an excise tax does not merely pay it and continue with the transaction and its consequences, as is the case with nearly all federal tax regimes. This structure weaves a series of spiraling taxes from which the private foundation, and/or disqualified person(s) with respect to it, can emerge only by paying one or more taxes and correcting (undoing) the transaction involved by paying or distributing assets or having the foundation's income and assets confiscated by the IRS.

The private foundation rules collectively stand as sanctions created by Congress for the purpose of curbing what was perceived as a range of abuses being perpetrated through the use of private foundations by those who control or manipulate them. These provisions comprise Chapter 42 of the Internal Revenue Code. Some of these constraints were placed on supporting organizations and donor-advised funds in 2006.139

(b) Self-Dealing Sanctions as Pigouvian Taxes

In the self-dealing context, two excise taxes are imposed on self-dealers—the initial tax140 and the additional tax.141 The first tax has a rate of 10 percent; the second a rate of 200 percent. There are also taxes on foundation managers where there is knowing participation in the self-dealing transaction (a scienter requirement).142 The foundation self-dealing tax subjects the entire amount involved in a self-dealing transaction to tax. Also, the initial self-dealing tax cannot be abated by the IRS.143 There is the correction feature, by which the self-dealer is required to pay the amount involved to the foundation.144

What has come to be known as the Pigouvian tax is the brainchild of English economist Arthur Cecil Pigou (1879–1959), a contributor to modern welfare economics. He introduced the concept of externality and the belief that externality (social problems) can be corrected by imposition of a tax. A commentator wrote that Pigouvian taxes “aim to regulate behavior by placing a small tax, usually in the form of a uniform excise tax, on the activity to be regulated because of the harm it produces for members of the public.”145

Does the federal self-dealing tax regime constitute one or more Pigouvian taxes? On the face of it, the answer would seem to be yes.146 This commentator nicely observed that the self-dealing taxes “have the Pigouvian impulse to protect the public from harm by imposing an excise tax.”147 Despite this impulse, however, three reasons were posited why the self-dealing taxes are not Pigouvian in nature. One, the additional excise tax rate of 200 percent is not “small.” Two, the initial tax subjects the entire amount involved in a self-dealing transaction to tax, “even if the transaction benefits the foundation,” so that, in those circumstances, the requisite “social costs” are not involved.148 Third, a Pigouvian tax assumes uniform social costs across all individuals and firms; the commentator mused whether “differences between large and small foundations, between corporate and family foundations, local and national foundations, old and new foundations, etc. should shape the applicable excise tax rules.”149

Yet, it is understandable why one, perhaps not an economist, would conclude that the self-dealing taxes are Pigouvian in nature, if only because the initial tax cannot be abated and because of the correction requirement. The U.S. Supreme Court stated the general rule about a tax: “Imposition of a tax nonetheless leaves an individual with a lawful choice to do or not do a certain act, so long as he is willing to pay a tax levied on that choice.”150 The self-dealing tax regime does not allow for that type of “lawful choice.”

(c) Self-Dealing Sanctions: Taxes or Penalties?

Federal constitutional law differentiates between a tax and a penalty—at least conceptually. This distinction may be drawn in determining whether the exaction passes constitutional muster. A dramatic illustration of this point occurred when a bare majority of the U.S. Supreme Court upheld the constitutionality of the Patient Protection and Affordable Care Act on the basis of Congress's taxing power, construing the health insurance individual mandate (or shared-responsibility payment) as a tax, after the decision was made that the mandate could not be justified as constitutional pursuant to the Commerce Clause.150.1 On that occasion, however, the Court observed that “Congress's ability to use its taxing power to influence conduct is not without limits.”150.2

In this opinion, the fact that there is a difference between a tax and a penalty was raised, but not resolved. The Court wrote that “there comes a time in the extension of the penalizing features of the so-called tax when it loses its character as such and becomes a mere penalty with the characteristics of regulation and punishment.”150.3 Also, the Court stated that, “[i]n distinguishing penalties from taxes, this Court has explained that ‘if the concept of penalty means anything, it means punishment for an unlawful act or omission.'”150.4 The Court concluded, having decided that the individual mandate (or shared-responsibility payment) is a tax for constitutional law purposes, wrote that “we need not here decide the precise point at which an exaction becomes so punitive that the taxing power does not authorize it.”150.5 It should be remembered that, even if an exaction is determined to be a penalty, the constitutionality of the statutory structure may be upheld under the Commerce Clause.150.6

In the opinion, the Court principally relied on two of its precedents in discussing what is and is not a tax. In one of these cases, the Court wrote that a “federal excise tax does not cease to be valid merely because it discourages or deters the activities taxed.”150.7 It was stated that a tax may have a “regulatory effect” but remains a tax if it “produces revenue.”150.8 The Court added: “It is axiomatic that the power of Congress to tax is extensive and sometimes falls with crushing effect on businesses deemed unessential or inimical to the public welfare.”150.9 In the other of these cases, the Court concluded that an ostensible tax was a penalty, because the sanction imposed a heavy burden, included a scienter requirement, and was enforced by a federal agency other than the Department of the Treasury.150.10

The Supreme Court observed, in 1974, that the Court in its “early cases” drew what it saw at the time as distinctions between regulatory and revenue-raising taxes, adding “[b]ut the Court has subsequently abandoned such distinctions.”150.11 These “early cases” included six court decisions concerning the private foundation law sanctions.

Several court opinions focus on the constitutionality of the federal self-dealing law. In one of these cases, the principal contention was that the provision is an unconstitutional extension of the congressional taxing power.150.12 That is, the allegation in that case was that the purpose of the statute is not to raise revenue but to regulate private foundations by imposing penalties on persons who use them for noncharitable, private purposes. The court involved rejected the contention, using five Supreme Court cases as precedent.

The court began its analysis by observing that, in its early decisions analyzing the constitutionality of tax statutes, the Supreme Court “often drew distinctions between regulatory and revenue raising taxes.”150.13 The court, however, wrote that the Court “has subsequently abandoned such distinctions.”150.14 The court quoted a 1937 Supreme Court opinion stating that “[i]t is beyond serious question that a tax does not cease to be valid merely because it regulates, discourages, or definitely deters the activity taxed.”150.15 In that opinion, the Court wrote that this “principle applies even though the revenue obtained is obviously negligible”150.16 “or the revenue purpose of tax may be secondary.”150.17

The Court also stated: “Nor does a tax statute necessarily fall because it touches on activities which Congress may not otherwise regulate.”150.18

The court concluded that, “[u]nder the present posture of the law, tax statutes are constitutional unless they contain provisions which are extraneous to any tax need.”150.19

This court stated that “[i]t is clear that [the self-dealing statute] is constitutional as measured by the standards set forth in [the 1953 case].”150.20 It continued: “Congress has seen fit, in enacting the internal revenue laws, to grant tax exempt status to certain entities” and “has allowed individuals, corporations, and estates the right to escape taxation of the amounts donated for charitable purposes.”150.21 “However,” the court wrote, “when Congress observed that its legislative grace was being abused, it enacted [the self-dealing statute] to insure that its original intent in granting non-taxable status was complied with.”150.22 The court concluded that, “[a]lthough [the statute] has a regulatory effect on the activities of charitable organizations and might not raise any revenue, it insures that revenue will be collected under income, estate, and gift tax laws which otherwise might have gone uncollected.”150.23

Another court case directly involving a private foundation regulatory provision in relation to the sanction's status as a tax is a challenge to the mandatory payout rule.150.24 In that case as well, the argument was that, by enacting the provision, Congress exceeded its power to lay and collect excise taxes. The contention was that the provision does not impose a tax for constitutional law purposes but “imposes a penalty measured by a prescribed rate of return on the value of the foundation's noncharitable property even though the foundation may have no income.”150.25 The court rejoined that the Supreme Court “has repeatedly rejected this argument,” citing the 1928, 1934, and 1937 cases, adding that the “tax in question is a legitimate exercise of the taxing power despite its collateral regulatory purpose and effect.”150.26

This court wrote that, “[b]y enacting [the mandatory payout rule]… Congress decided to subject tax-exempt private foundations to [the rule that the tax must be paid even though the foundation has no income] in order to deal with what it perceived to be an abuse of the foundation's tax-exemption privilege,” in that “[w]hile donors to the exempt private foundation could receive substantial current tax benefits from their contributions, charity might receive no current benefits because the foundation invested in growth assets that produce no current income but are expected to increase in value.”150.27 Although the court did not expressly so state, private foundations in this circumstance are required to dip into principal to make the required distribution.150.28

The legislative history of the self-dealing rules is replete with references to the sanctions as penalties. The report of the House Committee on Ways and Means accompanying its version of the 1969 tax legislation states that the “permissible activities of private foundations…are substantially tightened to prevent self-dealing between the foundations and their substantial contributors.”150.29 The committee added that it “has determined to generally prohibit self-dealing transactions and provide a variety and graduation of sanctions.”150.30 In this report, there are numerous references to these sanctions as constituting “prohibitions” or arising out of “prohibited” conduct. Identical or similar language appears in the report of the Senate Committee on Finance in connection with its version of the 1969 legislation.150.31 This continues to be the view of Congress on this topic, as reflected in a report issued by the Ways and Means Committee in 1996 referring to the private foundation rules as a “penalty regime.”150.32

A commentator, following a review of the case law, wrote that the “character” of the self-dealing and similar private foundation provisions “as a tax or a penalty seems uncertain” under the Supreme Court opinion upholding the Affordable Care Act.150.33 It is pointed out that the Court's most recent discussion of what constitutes a penalty “turns, at least in part, not on the purpose of or motive for an assessment, but on its level—whether it imposes a heavy burden.”150.34 Here are the features posed for such a “heavy burden” under the self-dealing sanctions regime: (1) the first-tier taxation of the entire amount of a self-dealing transaction, rather than just the amount by which the foundation is harmed; (2) the second-tier tax rate of 200 percent, which “gives a disqualified person little if any meaningful choice of whether or not to pay the tax”; (3) the implication of the scienter requirement in connection with the excise taxes on foundation managers who knowingly participate in a self-dealing transaction; (4) the court opinions that view the self-dealing sanctions as having the “regulatory purpose [of] rendering self-dealing unlawful”; and (5) the IRS's inability to abate the first-tier excise tax.150.35 A sixth indicator of penalty status in this context may be the correction requirement.

This commentator concludes that “private foundation excise taxes do not fit easily into either the category of constitutional taxes or constitutional penalties.”150.36 As to the self-dealing taxes, the commentator writes that the “status of section 4941 is uncertain under NFIB, under the private foundation cases from the 1980s, and the positions of key governmental bodies.”150.37 Nonetheless, a good case can be made, at least as to the self-dealing tax regime, that the sanctions amount to one or more penalties. The Pigouvian impulse tugs.

(d) Abatement

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(e) Potential of Overlapping Taxes

Taxes under more than one provision of the private foundation excise tax regime163 may be imposed with respect to a single transaction.164 Indeed, a tax regulation states that “[i]t is not intended that the taxes imposed under Chapter 42 be exclusive.”165 For example, if a private foundation purchases a sole proprietorship in a business enterprise,166 in addition to become subject to excess business holding taxation,167 the foundation may be liable for tax under the jeopardizing investment tax regime168 if the investment jeopardizes the carrying out of any of the foundation's exempt purposes.169

As another illustration of this topic, the IRS, having ruled that a private foundation's disaster relief and emergency hardship program170 furthered the interests of a corporation and its subsidiaries, who were disqualified persons with respect to the foundation,171 and thus that grants distributed in accordance with the program constituted acts of self-dealing,172 proceeded to rule that the grants were not qualifying distributions173 and were taxable expenditures,174 thus subjecting the foundation to both self-dealing and taxable expenditures taxes.175 Likewise, in a case involving private foundation loans to a disqualified person, the IRS ruled, of course, that the loans were acts of self-dealing,176 then added that they were also jeopardizing investments.177

§ 1.10 STATISTICAL PROFILE

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There are about 90,000 private foundations in the United States, thus accounting for a small percentage of tax-exempt charitable organizations in the sector. As of 2017, foundations held over $1 trillion in assets or about 1 percent of the net worth in the United States overall. Yet, on the basis of data for 2018, it is estimated that all nonprofit organizations had a collective net worth of $6.7 trillion, so private foundations account for about one-sixth of the nonprofit sector.178

§ 1.11 PRIVATE FOUNDATIONS AND LAW 50 YEARS LATER

Notwithstanding the passage of more than 50 years, the statutory tax law regulating private foundations that was enacted in 1969—the infamous IRC Chapter 42—has not changed much. There have, of course, been some revisions, but the basic framework remains in place. There are several reasons for this phenomenon, one of them being the excellent craftsmanship that was employed when the initial statutory regime was formulated. This body of law is tough and comprehensive, although, five decades later, probably unnecessarily rigid and inequitable in places.

Parallel to the endurance of this statutory scheme has been the steady growth of the private foundation community. Today, there are, as noted, more than 90,000 private foundations; all of the metrics reflect steady expansion: the sheer numbers of them, asset size, grant amounts, and the like. Foundations have persisted, notwithstanding this heavy mantle of statutory restrictions and penalty taxes (that essentially amount to prohibitions).179

This endurance and growth were not anticipated in all quarters in the immediate aftermath of enactment of the Tax Reform Act of 1969.180 A chronicler of this 50-year period181 collected some predictions issued in those early years. In one, two commentators characterized the effect of the Act as Congress having “thrown out the charitable baby with the dirty bathwater,” “encouraging the abandonment” of private foundations, “interfering with their effective operation, attacking their involvement in major social problems and prohibiting what are in essence equitable transactions.”182 In another, the forecast was that “[a]ll of the odds seem stacked against” the growth of foundations, “given the range of disincentives built into the law.”183 Yet, private foundations have proved resilient and remain a major force in contemporary philanthropy.184

There have, however, been two generally unanticipated consequences of enactment of Chapter 42. Congress has proved adept at extending some of the private foundation law to other types of tax-exempt charitable entities. For example, aspects of the excess business holdings rules were subsequently extended to certain supporting organizations185 and to donor-advised funds.186 The private foundation self-dealing rules heavily influenced the shaping of the excess benefit transaction rules.187 Indeed, the very concept of underlying regulatory rules with a system of excise taxes, initiated with Chapter 42, is reflected in the excess benefit transaction rules,188 public charity lobbying rules,189 public charity political campaign activities rules,190 and the donor-advised fund statutory law.191

The other unanticipated consequence of enactment of the private foundation tax laws is the rise of alternative entities. The most notable aspect of this development has been, and continues to be, the stupendous rise of the donor-advised fund.192 Donor-advised funds often are used in lieu of private foundations, for a variety of reasons, including the absence of a need to create and sustain a governing board, apply for recognition of exempt status, file annual information returns, and be subject to the unrelated business income laws, not to mention the lack of sufficient financial resources to warrant the formation and operation of a private foundation.193

The other primary alternative to the private foundation is the tax-exempt social welfare organization.194 In this context, the concept of social welfare is commensurate with the “common good and general welfare” and “civic betterments and social improvements.”195 This concept is certainly broader than the concept of what is charitable.196 A federal income tax charitable contribution deduction is not likely to be available in instances of transfers to social welfare organizations but donors may nonetheless make gifts to these entities, including gifts of appreciated property,197 and avail themselves of the federal gift tax charitable deduction.198 These entities are not required to file for recognition of exemption,199 may engage in political campaign activities, and are not subject to private foundation laws concerning self-dealing,200 mandatory payouts, excess business holdings limitations, and the like. Donors, it is said, “are flocking to 501(c)(4) organizations.”201

The previously referenced chronicler asserts that the “large number of existing private foundations and the significant value of their holdings mask a deep-seated and growing frustration with the restrictions imposed by the [Tax Reform] Act that threatens to dethrone the private foundation from its historical primacy in the field of private philanthropy.”202 The combination of various issues in play, discussed below, it is contended, have “precipitate[d] the decline of private foundations in favor of substantially—and arguably, troubling—less restrictive alternatives, which are largely structured in ways that make it less likely that they will achieve the type of broad-ranging social benefit that private foundations have historically fostered.”203

This analysis concluded that there is a “lack of public confidence in the regulatory regime” applicable to private foundations.204 Five reasons are given for this development: (1) The “single most significant source of the rules' negative consequences is their undue complexity,” which (ostensibly) leads to “an explosion in administrative costs” due to legal fees;205 (2) the dramatic decrease in IRS guidance in the private foundation field;206 (3) many of the private foundation laws are bright-line rules that, while easier to administer, lead to overinclusiveness in the form of unnecessary and often unfair penalties;207 (4) Congress and the public remain skeptical of private foundations, in part because of ongoing “undercurrents of anxiety about wealth,” foundations' “control over charitable priorities,” some well-publicized abuses, and (sometimes) lack of efficacy of the foundation laws;208 and (5) the previously discussed rise in alternatives to private foundations.209

This chronicler is of the view that what is needed is a “clean slate for foundation governance,”210 that is, foundation regulation. This is because the rules are “hopelessly complicated and penalize behavior that is not only not harmful but may in fact be beneficial for philanthropy.”211 In this regard, particular focus is placed on the self-dealing rules. Your author is of the view that such a “clean slate” is unlikely for the foreseeable future and that, while the self-dealing and other foundation rules are indeed complex, the state of affairs is not so dire as to be “hopeless.” The foundation community appears to have largely learned to accommodate the rules, advised by far more lawyers who are proficient in private foundation law than was the case many years ago. There is, however, room for more flexibility and equity in the private foundation self-dealing rules, and the IRS should be accorded authority to abate the self-dealing taxes.

This analysis raises the matter of the private foundation net investment income excise tax. As is well-known, this tax was originally touted as an “audit fee,” the purpose of which was to fund IRS oversight of private foundations and other components of the charitable sector—an outcome that never materialized. (It has never been clear as to why this earmarking of funds has never occurred.212) The analysis calls for reinstatement of this tax as an audit fee, with that law change unleashing a “cascade of benefits,” including removal of bright-line rules in the self-dealing law and enabling foundations to “engage in certain behavior that is now penalized but would ultimately be beneficial charitable causes.”213 Of course, an alternative is to repeal the tax, perhaps freeing up more funds for charitable purposes. In any event, the attitude in Congress about funding the IRS is shifting; the agency may soon have additional billions of dollars to spend on examinations and other forms of tax law enforcement.

Another area that is said to need improvement is IRS enforcement of the private foundation rules. It is common knowledge that the IRS is presently lacking in resources in this regard. The nation, however, appears to be entering an era of higher income taxes, increased funding of the IRS, and greater focus on audits of wealthy individuals. There is a correlation between this point and the prior one: “A more robust and well-resourced [IRS] audit function would allow us to move away from the bright-line rules that have proven to be overbroad and exceedingly complex.”214 One approach, as the chronicler noted, would be to return to the original concept of earmarking the funds generated by the tax on private foundations' net income for audits of foundations (and perhaps other categories of tax-exempt organizations).

This review of 50 years of experience with the private foundation tax laws observed that Congress “has the opportunity to retool the private foundation regulatory regime to ensure that private foundations maintain their place of primacy in private philanthropy and continue to deliver [their] socially-beneficial results.”215 Such a revision of this regulatory regime, however, certainly is not imminent. Indeed, the trend appears to be to leave the private foundation laws as they are and extend them to other exempt entities216 or create new forms of comparable regulation (such as in the case of donor-advised funds).

NOTES

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