A Little Due Diligence Goes a Long Way to Avoid Triggering Taxable Expenditures

Most grants that are awarded by private foundations don’t carry significant legal risks. For instance, consider a grant proposal for $150,000 from a local homeless shelter to allow the shelter to start a housing-first program. No big deal, right? But what if, buried in the grant application, was a one-sentence output proposal that indicated the shelter staff was planning to ask the city council to change the city’s restrictions on low-income housing? Or what if the homeless shelter was run by volunteers and had operated on a $50,000 annual budget for the last several years? Or what if the shelter was a new organization and had not yet received its 501(c)(3) designation? Or what if the shelter wasn’t a nonprofit at all but actually a government-run agency? Should any of these situations be true, a seemingly straightforward grant proposal could potentially lead to trouble for the private foundation.

Private foundations are subject to several unique rules imposed by the federal government via the Internal Revenue Code. Grants managers, program officers, and other operations staff need to be aware of such rules to ensure that their foundation doesn’t unwittingly run afoul of the Internal Revenue Service (IRS). The consequences of violating the tax code prohibitions could be significant: hefty taxes might be imposed not only on the foundation, but also on the individual staff members who approved the grants, and, at the most extreme, the IRS could initiate an audit that may result in the forfeiture of the foundation’s 501(c)(3) status.

Section 4945 of the Internal Revenue Code describes several instances in which a grant by a private foundation would constitute a taxable expenditure. These are situations in which a private foundation spends money—for instance, on a grant—that triggers a tax burden on the foundation. The foundation must pay a tax of 20 percent of the expenditure, and any foundation manager who approved the expenditure while knowing that it was a taxable expenditure will be taxed at a rate of 5 percent of the expenditure. On top of paying the taxes, the private foundation must “correct” the expenditure, which usually involves getting the money back. If the expenditure isn’t corrected within a certain time, then there is an additional tax imposed on the private foundation of 100 percent of the expenditure and an additional 50 percent tax on the foundation manager.

Cleary, the IRS is not messing around. Fortunately, however, with due diligence procedures in place, these potential problems can be identified and avoided prior to any grants being awarded.

Grants to influence legislation

When a private foundation awards a programmatic grant that funds lobbying as part of the grant activities, that constitutes a taxable expenditure. So, in the example above where the homeless shelter staff is seeking to change the city’s restrictions on low-income housing, before awarding the grant, the private foundation would need to ensure that the homeless shelter will not use any of the foundation’s grant dollars for such lobbying activities. While it’s likely that the foundation’s grant agreement already includes a provision that indicates no dollars can be used for lobbying activities, foundation staff should nonetheless follow up with a representative from the shelter to ensure that the shelter understands these restrictions.

There are ways that private foundations can work around the prohibitions on lobbying. For instance, if a private foundation awards a general operating grant, then it doesn’t need to worry about the lobbying restrictions—the grantee is free to use the grant funds however they please as long as the activities funded by the grant are charitable in nature. Alternatively, if the foundation wants to award a programmatic grant that includes lobbying activities in the program, the foundation must ensure that the grant amount does not exceed the non-lobbying portion of the program budget (this will usually require obtaining an updated program budget from the potential grantee that breaks out the lobbying and non-lobbying portions of the budget). The advisors at Bolder Advocacy have many helpful resources to guide private foundations in how to avoid taxable expenditures while working with grantees who are engaged in lobbying activities.

Grants to for-profit companies or other non-501(c)(3) organizations

Another situation that results in a taxable expenditure is when a private foundation awards a grant to an organization that is not a public charity under sections 501(c)(3) and 509(a) of the Internal Revenue Code, unless the foundation exercises expenditure responsibility for the grant. So, in the example above where the homeless shelter had not yet received its 501(c)(3) determination from the IRS, the private foundation would need to exercise expenditure responsibility when making the grant.

Expenditure responsibility isn’t particularly challenging. In fact, most foundations already follow most of the requirements when conducting their due diligence on regular grants. The tax code and the corresponding regulations impose the following requirements for expenditure responsibility:

• Conduct a pre-grant inquiry to ensure that the grant will further charitable purposes.
• Obtain annual reports from the grantee about how the grant funds were spent.
• Utilize a grant agreement with certain commitments.
• Require the grantee to maintain funds in a segregated account.
• Report the grants on the foundation’s Form 990-PF filing.

At the foundation where I work, we have provided grants to two, local, for-profit newspapers to fund their environmental reporting for the past several years. We exercise expenditure responsibility for the grants and have found the grants to be a great way to help raise the public’s awareness of environmental issues and to encourage the public to protect environmental resources.

As you can see, while grants may trigger taxable expenditures for a private foundation, careful due diligence and planning will protect the foundation so that it can avoid any tax consequences.