Lisa M. Rico is a partner at McCarter & English LLP in Boston. She concentrates her practice on estate, gift, generation-skipping transfer and income tax planning for high net worth individuals, estate and trust administration, and the representation of nonprofit organizations and charitable trusts.
The Pension Protection Act of 2006, P.L. 109-280 (the “2006 Pension Act”), signed into law by the president on Aug. 17, 2006, has a number of provisions affecting private foundations and donor advised funds. This article provides an overview of several of the changes affecting private foundations and donor advised funds.
Increases to the Penalties Under the Private Foundation Rules
Private foundations are defined under Section 509(a) of the Internal Revenue Code of 1986, as amended (the “code”), as Section 501(c)(3) organizations (organizations organized and operated for charitable, religious, educational, scientific or literary purposes, testing for public safety, to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals) that are not public charities. Public charities are publicly supported organizations that receive a certain amount of their support from governmental units or contributions from the general public or organizations that provide support to a public charity (a “supporting organization”). Unlike public charities, private foundations usually receive their support from and are controlled by a limited number of contributors. Due to this nature of private foundations and the potential for abuse, Sections 4940-4945 of the code impose a number of anti-abuse rules and excise taxes on private foundations (the “private foundation rules”) that are not applicable to public charities. The 2006 Pension Act has added more sting to the private foundation rules by increasing the amount of certain excise taxes effective for tax years beginning after Aug. 17, 2006.
Section 4941 of the code imposes an excise tax on each act of self-dealing on a disqualified person (which includes but is not limited to substantial contributors and foundation managers) who participated in the act. The initial tax on the self-dealer has been increased from 5 percent to 10 percent of the amount involved. If a tax is imposed on the self-dealer, a tax may also be imposed upon a foundation manager who knowingly and willfully participated in the act of self-dealing. The tax on the foundation managers for acts of self-dealing is increased from 2.5 percent to 5 percent of the amount involved and such tax is limited to $20,000 per act (up from $10,000 per act prior to the 2006 Pension Act).
Section 4942 of the code imposes a tax on a private foundation’s undistributed income that has not been distributed before the first day of the second (or any succeeding) taxable year following the relevant taxable year. The tax on the amount of such undistributed income at the beginning of such second (or succeeding) taxable year has been increased from 15 percent to 30 percent.
Section 4943 of the code imposes an initial tax on a private foundation’s excess business holdings of any functionally unrelated business enterprise during the taxable year. The initial tax on excess business holdings has been increased from 5 percent to 10 percent of the value of such holdings.
Section 4944 of the code imposes a tax on a private foundation if the foundation makes investments that jeopardize the organization’s charitable purposes. The initial tax imposed on foundations for jeopardizing investments has been increased from 5 percent to 10 percent of the amount of the investment. A foundation manager who knowingly participates in the making of jeopardizing investments is also liable for a 10 percent (increased from 5 percent) tax on the amount of the investment. In addition, the dollar limitation on the initial tax on the foundation managers has increased from $5,000 to $10,000 per investment. While the additional tax on foundation managers has not been increased under the 2006 Pension Act, the 2006 Pension Act has increased the dollar limitation of the additional tax on a foundation manager from $10,000 to $20,000 per investment.
Section 4945 of the code imposes a tax on certain taxable expenditures of private foundations. Under the 2006 Pension Act, the initial tax on the foundation for taxable expenditures has increased from 10 percent to 20 percent of the amount of the expenditure and the initial tax on the foundation manager is increased from 2.5 percent to 5 percent of the amount of the expenditure. The 2006 Pension Act also increases the dollar limitation on the initial tax on foundation managers from $5,000 to $10,000 as well as increases a dollar limitation on the additional tax on foundation managers from $10,000 to $20,000.
New Taxes Imposed on Taxable Distributions from Donor Advised Funds
As an alternative to establishing a private foundation to reduce administrative costs, many individuals gift to donor advised funds. A donor advised fund is a fund where a donor contributes funds into an account with a sponsoring organization and pursuant to an agreement with the donee sponsoring organization, retains the right to recommend, but not direct, how contributions from the donor’s account are to be distributed to charities. The agreement between the donor and the sponsoring organization may include the retained right in the donor or in the members of the donor’s family. The donor advised fund’s directors or trustees have final authority over how the funds in the account are ultimately distributed. Donor advised funds have been established by community foundations and commercial institutions. Generally, donor advised funds have qualified as public charities.
Prior to the 2006 Pension Act, there were no special rules for or excise taxes imposed with respect to donor advised funds. The 2006 Pension Act imposes excise taxes and anti-abuse rules for donor advised funds. Beginning with tax years after Aug. 17, 2006, new Section 4966 of the code imposes a 20 percent excise tax on the donor advised fund’s sponsoring organization for each taxable distribution made from a donor advised fund. An additional tax equal to 5 percent of the amount of each taxable distribution is imposed on any fund manager that agreed to the making of a distribution knowing that it was a taxable distribution. The fund manager under Section 4966(d)(3) includes, among others, any officer, director or trustee of the sponsoring organization. A fund manager’s liability as to any one taxable distribution is limited to $10,000. Section 4966(c) provides that a taxable distribution is any distribution from a donor advised fund to a natural person or to any other person if (1) the distribution is for any purpose other than religious, charitable, scientific, literary or educational, or to foster national or international amateur sports competition, or for the prevention of cruelty to children and animals, or (2) the sponsoring organization does not exercise expenditure responsibility for the distribution and conformity with the taxable expenditure rules under Section 4945(h) of the code. A taxable distribution does not include any distribution from a donor advised fund to (1) any public charity (including most supporting organizations), private operating foundation or conduit foundation, (2) the sponsoring organization of the donor advised fund, or (3) any other donor advised fund.
The new Section 4966 of the code also includes definitions for the terms donor advised fund and sponsoring organization. Under Section 4966(d)(2) of the code, a donor advised fund is a fund or account (hereinafter referred to collectively as an “account”) (1) which is separately identified by a reference to contributions of a donor or donors, (2) which is owned and controlled by a sponsoring organization, and (3) as to which a donor (or the donor’s designee) has, or reasonably expects to have, advisory privileges as to the distribution or investment of amounts held in the fund or account by reason of the donor’s status as the donor. All three prongs of this test must be met for a fund to be treated as a donor advised fund.
A sponsoring organization, as defined by Section 4966(d)(1) of the code, is an organization (1) to which deductible charitable contributions may be made other than a code Section 170(c)(1) governmental entity and without regard to the code Section 170(c)(2)(A) requirement that the organization be organized in the United States, (2) which is not a private foundation, and (3) which maintains one or more donor advised funds.
The Joint Committee on Taxation Technical Explanation of the Provisions of the Pension Protection Act of 2006 (the “committee report”) provides insight into the requirements necessary to be treated as a donor advised fund. The committee report indicates that the first prong of the test is not met unless the account refers to contributions of a specific donor, such as by naming the account after the donor or by accounting separately for such account on the books of the sponsoring organizations as funds contributed by a specific donor. A fund or account that pools contributions of multiple donors will generally not meet this prong of the test. With respect to the second prong of the donor advised fund test, the committee report indicates that if a donor or person other than the sponsoring organization controls the funds deposited into an account, such fund is not a donor advised fund. The third prong requirement of advisory privileges exists if both the donor (or the donor’s designee) and the sponsoring organization have reason to believe that the donor (or the donor’s designee) will provide advice and that the sponsoring organization generally will consider such advice. An actual provision requiring advisory privileges is not required. The committee report also indicates that the advisory privilege must be as result of the donor status as donor and not by reason of a donor’s services to the organization.
Section 4966(d)(2)(B) of the code specifically excludes certain accounts from treatment as donor advised funds. A donor advised fund shall not include any account (1) which makes distributions only to a single identified organization or governmental entity, or (2) with respect to which the donor (or the donor’s designee) advises as to which individuals receive grants for travel, study or other similar purposes, if (a) such person’s advisory privileges are performed exclusively by such person in the person’s capacity as a member of a committee, all of the members of which are appointed by the sponsoring organization, (b) no donor or donor’s designee (or persons related to such persons) directly or indirectly control such committee, and (c) all grants from such account are awarded on an objective and non-discriminatory basis pursuant to a procedure approved in advance by the board of directors of the sponsoring organization, and such procedure is designed to ensure that all such grants meet the requirements for individual grants under Section 4945(g)(1), (2), or (3) of the taxable expenditure rules.
In addition, the secretary may exempt any account not otherwise excluded from treatment as a donor advised fund (1) if the committee advising with respect to the distributions from such account is not directly or indirectly controlled by the donor or the donor’s designee (or any related party), or (2) if such account benefits a single identified charitable purpose.
New Taxes Imposed on Prohibited Benefits from a Donor Advised Fund
For tax years beginning after Aug. 17, 2006, the 2006 Pension Act also imposes new taxes on distributions from any donor advised fund which results in a donor, donor advisor or a related person (hereinafter referred to together as the “donor advisor”) receiving directly or indirectly a more than incidental benefit as a result of such distribution. New Section 4967 of the code imposes a tax on any donor advisor equal to 125 percent of the amount of any benefit received by such donor advisor due to such donor advisor’s advice to a sponsoring organization to make such distribution. There is also a tax equal to 10 percent of the amount of the benefit received by the donor advisor imposed on any fund manager who agrees to the making of such distribution knowing that the distribution would confer a benefit on a donor advisor. The tax on the fund manager is limited to $10,000 as to any one distribution. The committee report indicates that there is more than incidental benefit if, as a result of the distribution from a donor advised fund, a donor advisor as to the account receives a benefit that would have reduced, or eliminated, a charitable contribution deduction if the benefit was received as part of the contribution by the donor advisor to the sponsoring organization. If, however, a tax is imposed under the excess benefit transaction rules of Section 4958 of the code, as to any distribution, the tax under Section 4967 of the code will not be imposed. A donor advisor is any person who is the donor or any person appointed or designated by the donor who has, or reasonably expects to have, advisory privileges as to the distribution or investment of amounts held in the fund or account by reason of the donor’s status as donor, or a member of the family of such donor or designee of the donor, or a 35 percent controlled entity of such person.
Extension of Excise Tax on Excess Business Holdings to Donor Advised Funds
The 2006 Pension Act extends the excise tax on private foundations’ excess business holdings under Section 4943 of the code to donor advised funds by providing that for the purposes of this excise tax, a donor advised fund is treated as a private foundation. In applying the rules under Section 4943 of the code to any donor advised fund, the term “disqualified person” will include any person who is a donor advisor, who has, or reasonably expects to have, advisory privileges regarding the distribution or investment of amounts held in a donor advised fund by reason of such donor advisor’s status as donor, a member of the donor’s family, or a 35 percent controlled entity of any such person.
Donor Advisors and Investment Advisors are Disqualified Persons for Excess Benefit Transactions
The 2006 Pension Act adds two new categories to code Section 4958’s definition of disqualified person for the purpose of the excess business benefits transaction tax. The first category provides that for any transaction that involves a donor advised fund, the donor advisor is treated as a disqualified person with respect to that donor advised fund. The second category is for any transaction which involves a sponsoring organization, any investment advisor, a member of the family of an investment advisor, or certain controlled entities of an investment advisor is treated as a disqualified person. An investment advisor is any person (other than an employee of the sponsoring organization) compensated by such organization for managing the investment of, or providing investment advice with respect to, assets maintained in donor advised funds owned by such organization.
Under new Section 4958(c)(2) an excess benefits transaction will include any grant, loan, compensation or other similar payment from an account to any donor advisor with respect to such account. In such a transaction, excess benefit includes the amount of any such grant, loan, compensation, or other similar payment.
The 2006 Pension Act now provides guidance as to what constitutes a donor advised fund while at the same time imposing stricter rules. In addition to the above changes regarding private foundations and donor advised funds, the 2006 Pension Act includes changes to supporting organization rules, disclosure rules for exempt organization returns and other rules affecting exempt organizations and charitable contributions. These rules should be considered when advising clients regarding their charitable giving alternatives.