Those responsible for managing a private foundation’s investment assets may not always understand the unique fiduciary and tax constraints imposed on private foundations and their managers by both state and federal law.

Why is this important? 

Running afoul of the rules can result in costly excise taxes that can be imposed on both the foundation and its managers, and in the most extreme cases, can lead to revocation of tax-exempt status.

Further, navigating the range of investment options in consideration of these rules should be a thoughtful and coordinated effort that can help achieve the foundation’s mission in tandem with its investment policy.

Every foundation manager should be aware of these six key legal constraints:

1. State Prudent Investor Laws
2. Jeopardizing Investments
3. Excess Business Holdings
4. Self-Dealing
5. 5% Payout Requirement
6. Unrelated Business Income Tax

1. State Prudent Investor Laws

Foundation managers’ investment conduct is governed by provisions of the Internal Revenue Code (IRC) and by laws of the state of incorporation (if a corporation) or governing law provided for in the trust instrument (if a trust).  The prudent investor rules in your state, and the Uniform Prudent Investor Act (UPIA) set out the standards for fiduciaries to follow when implementing an investment strategy. Foundation managers generally have a fiduciary duty to administer foundation assets in a prudent manner, including a potential duty to diversify the foundation’s assets. Failure to fulfil this duty, or to delegate the duty to experienced investment managers, can result in managers’ negligence liability.   There are no per se prohibited investments, but each investment must be reviewed on its own.  The key consideration is whether the entire portfolio is prudent in light of the organization’s needs and tolerance for risk.

2. Jeopardizing Investments

IRC Section 4944 imposes a tax on any private foundation that invests in a manner that jeopardizes its exempt purposes. In other words, investments that create unnecessary risk that are not prudent under the facts and circumstances at the time of the investment. If the private foundation’s overall assets are not sufficiently diversified or the investments put the private foundation’s charitable assets at risk due to a requirement to outlay significant funds, the private foundation could be subject to the jeopardizing investment rules.

No specific category or type of investment is treated as a per se violation of Section 4944; however, the following investments have historically been closely scrutinized:

• trading in securities on margin,
• trading in commodity futures,
• investments in working interests in oil and gas wells,
• the purchase of puts calls and straddles, and
• the purchase of warrants.

In consideration of IRC Section 4944, private foundation investors need to take into account the expected return (including both income and appreciation of capital), the risks of rising and falling price levels, and the need for diversification within the investment portfolio (e.g., with respect to type of security, type of industry, maturity of company, degree of risk and potential for return).

The jeopardizing investment tax is equal to 10% of the amounts invested for each year, or part thereof, in a taxable period.  The tax is intended to punish both the foundation that makes the investments and the foundation managers who approve them.   Therefore, if a private foundation is subject to the tax, any director, officer, or other foundation manager who participates in making the investment may be subject to a 10% tax (up to $10,000 per jeopardy investment) if that person knew the investment would jeopardize the foundation’s exemption and the participation was willful and not due to reasonable cause.

3. Excess Business Holdings

In general, private foundations are prohibited from controlling any “business enterprise”.  The penalty excise tax on excess business holdings punishes those private foundations that own too great an interest in an operating business.  IRC Section 4943 imposes a tax on the “excess business holdings” of a private foundation.  For this purpose, a “business holding” is any business enterprise, any stock or other interest owned, directly or indirectly, by or for a corporation, partnership, estate or trust.  The term “business enterprise” means the active conduct of a trade or business, including any activity which is regularly carried on for the production of income and which constitutes an unrelated trade or business under IRC Section 513.

In most circumstances, a private foundation is permitted to hold not more than a 20% ownership interest in a business enterprise.  For purposes of these rules, in the case of a corporation, “ownership interest” means voting stock; in the case of a partnership “ownership interest” means capital interest.  Those permitted holdings are reduced, however, by the ownership interests of all disqualified persons.

“Disqualified persons” includes:

1. “foundation managers,” a category which includes trustees, directors, officers and other persons with similar authority,
2. substantial contributors (whether individuals or entities) to the foundation,
3. family members of such persons, and
4. entities controlled by such persons.

The permitted holdings may be increased under certain circumstances, and if the private foundation holds less than 2% of the ownership interests of a business enterprise, the holdings of all disqualified persons are ignored.

Per IRC Section 4943(a), a foundation that has any excess business holdings is subject to an initial tax equal to 10% of those excess holdings, based on their value on the day during the tax year when those holdings were the greatest.  If the foundation fails to timely correct its holdings, an additional 200% tax is imposed.

4. Self-Dealing

IRC Section 4941(a) imposes an excise tax on each act of self-dealing between a “disqualified person” (described above) and a private foundation.  This prohibition applies without regard to whether the transaction is fair or generous to the foundation.  Self-dealing transactions include a wide range of potential arrangements between the foundation and its disqualified persons, and may arise in many disguised contexts.  Any direct or indirect transaction with a disqualified person may result in the imposition of self-dealing taxes on the foundation managers and the disqualified person.

Transactions that may be self-dealing include any sale, exchange or leasing of property, the lending of money or extension of credit, the furnishing of goods, services or facilities, the payment of compensation (or payment or reimbursement of expenses) of a disqualified person, or transfer to or use by or for the benefit of a disqualified person of the income or assets of a private foundation.  Thus, any transaction between the Foundation and any of the business enterprises in which it owns an interest will need to be tested to ensure that there is no self-dealing.

While an exception to the self-dealing prohibition covers services by an investment manager who is a disqualified person of the foundation, the rule does prohibit the use of foundation resources to leverage a disqualified person’s investments.  One way in which a foundation may inadvertently engage in self-dealing when making investments is if a disqualified person makes side-by-side investments with the foundation.  Self-dealing may occur if the disqualified person is able to reduce his investment costs because of the foundation’s investment or if the disqualified person would not have access to the investment opportunity, but for the additional investment made by the foundation.

Per IRC Section 4941, the initial tax on “disqualified persons” is equal to 10 percent of the “amount involved with respect to the self-dealing”; the initial tax on “foundation managers” is 5 percent, with a $20,000 maximum per act of self-dealing. A confiscatory second tier tax is imposed if the parties fail to correct the self-dealing within the time provided by the statute.

5. 5% Payout Requirement

Foundation managers should be aware that the foundation must pay out 5% of the average fair market value of the foundation’s non-charitable use assets, computed on an average monthly basis.  This amount must be distributed for charitable purposes by the end of the following tax year, and should be evaluated and considered with regard to the foundation’s investment decisions on an ongoing basis.  Failure to do so could have a significant impact on the value of the foundation’s assets over time.  For example, distributing more than 5% over for a prolonged period can negatively impact a foundation’s ability to meet its charitable obligations and can even jeopardize its ability to exist in perpetuity.

6. Unrelated Business Income Tax

Private foundations may be exempt from paying regular federal income tax, but they are subject to the excise tax on net investment income, and the unrelated business income tax.   The excise tax on net investment income is a 2% tax on interest, dividends, capital gains, rents, royalties, etc., then reduced by any expenses incurred to generate the income.  The rate can be reduced to 1% in years when the foundation’s charitable grants exceed its average distribution level for the prior five years. IRC Section 511 imposes a tax on the unrelated business income of private foundations.  The unrelated business income tax (UBIT) is a tax at corporate rates imposed on the income of private foundations that is generated from a “trade or business” that is regularly carried on, and that is not related to the organization’s charitable purposes.  In general, passive investments such as dividends, interest, capital gains and rents are not UBIT because the activities do not constitute a “trade or business”.

The foundation may not treated as participating in an active “trade or business” through its participation in certain investment vehicles.  Thus, in some cases, the income generated by the partnership may be passive income that is not subject to this tax.  A careful review is necessary, however, because a foundation may be a limited partner in a partnership that earns income that would be UBIT if the organization earned it directly, therefore resulting in UBIT to the foundation as a partner, whether or not that income is actually distributed to it by the partnership.

Please note that the rules governing private foundations are complex, with many exceptions and exclusions.  Any of the above-noted discussion is intended to be general in nature to assist you in basic application of the prohibitions on certain investments and the special income taxes that could be applicable to private foundations.  We recommend that you contact an attorney to discuss any specific proposed investments to obtain the best desired result.

*Compliance Tip:

Foundation managers should create a written investment policy statement with the guidance of attorneys and investment advisors that is regularly reviewed to ensure compliance with its terms (and revised should there be changes to the law, the organization’s mission, or investment markets).

The written policy statement can further:

• Provide a roadmap for all investment decisions,
• Demonstrate compliance with prudent investor standards,
• Assist managers and investment advisors in addressing the foundation’s short and long-term financial needs,
• Provide guidance for the hiring, monitoring, and removal of investment managers, and
• Establish internal procedures to ensure compliance with tax laws and proper annual reporting on Form 990-PF and Form 990-T, as needed.