Private foundations are a meaningful way to support charitable goals and build a long‑term legacy, yet the rules that govern them can be nuanced and easy to overlook. Even organizations that operate with care can run into federal compliance issues with financial consequences. Foundation board members, officers, and advisors must stay informed about these requirements and ongoing compliance efforts. Regular governance reviews, clear documentation, and thoughtful oversight can help a foundation stay apprised of applicable regulations. Below are five focal points for foundation professionals to consider as they move forward.
1. Grantmaking
Grantmaking errors are a leading cause of taxable expenditures under Internal Revenue Code (IRC) Section 4945. Most issues stem from two places: giving to recipients who aren’t eligible or failing to obtain the IRS-required documentation.
The table below summarizes the permissible recipient types and the required safeguards.
| Recipient Type | Permitted? |
|---|---|
| 501(c)(3) Public Charities | Yes |
| Governmental Units | Yes |
| Foreign Organizations | Must obtain equivalency determination or follow expenditure responsibility procedures (pre‑grant inquiry, written agreement, and monitoring/reporting) |
| Individuals | Must obtain IRS pre-approval |
| Scholarship/Fellowship Grants | Must obtain IRS pre-approval |
| Supporting Organizations (509(a)(3)) | Allowed, but verify type; Type III non-functionally integrated requires expenditure responsibility |
| Private Foundations | No |
| Noncharitable Organizations e.g., 501(c)(4), 501(c)(6) | Generally not permitted, unless expenditure responsibility applies and purpose is exclusively charitable |
| Donor-Advised Funds (DAFs) | Generally not permitted |
Best Practice
- Verify each recipient’s tax-exempt status using IRS Publication 78 data and retain the documentation for three to seven years.
- For foreign or noncharitable grantees, complete all required expenditure responsibility steps: pre-grant inquiry, written agreement with restrictions, and grantee reporting.
- Obtain IRS pre-approval for grants to individuals, scholarships, and fellowship programs.
- Maintain written grant approvals and establish an annual “status-refresh” process for recurring grantees.
Avoid
- Assuming last year’s verification or a grantee’s donation receipt is still accurate (an organization’s status can change without warning).
- Making grants without clearly documenting the grantee’s status, charitable purpose, and any required expenditure responsibility steps.
- Funding private foundations, DAFs, or noncharitable organizations without appropriate safeguards.
- Using autopay for any foundation payments, including grants, as this reduces review and increases risk of error.
2. Self-Dealing Transactions
Under IRC §4941, self-dealing is one of the most common and costly issues for private foundations. Penalties apply even to inadvertent transactions and have no de minimis threshold. Self-dealing includes most transactions between the foundation and “disqualified persons” (DPs), such as substantial contributors, board members, family members, and related entities.
Best Practice
- Review every transaction for possible self‑dealing, including anything involving a related or controlled entity.
- Use distinctly labeled or color-coded checkbooks and payment cards to avoid accidental use of foundation funds.
- Pay only for reasonable, necessary services that directly benefit the foundation and document board approval.
- Require an annual DP disclosure form to gather information on new businesses, board service, or family relationships that may affect compliance.
Avoid
- Loans, leases, property transfers, or personal use of foundation assets by DPs.
- Reimbursing travel that is not 100% related to administering charitable activities.
- Receiving benefits from a grantee funded by the foundation, e.g., reduced tuition, priority enrollment, or other preferential treatment, by any DP, including related family members.
- Using foundation staff for personal or unrelated business activities of a DP.
Penalty reminder: There is a 10% initial tax on the self‑dealer (5% on knowing managers), increasing to 200% (and 50% on managers who refuse to correct) if this is not corrected promptly. There is no de minimis rule.
3. Excess Business Holdings
Private foundations are limited in the extent to which they may own a business enterprise. Business enterprises include active trade or business operated through a corporation, partnership, or limited liability company (LLC). Typically, passive investments are excluded. A foundation’s ownership is measured together with all DP holdings and attribution rules, which often causes inadvertent excess holdings.
Best Practice
- Confirm whether an investment is a business enterprise before accepting or purchasing it.
- Maintain current records of DP ownership and any attribution relationships.
- Document the basis for any applicable exception (de minimis, minority-threshold, functionally related, or program-related investment (PRI) exceptions).
- If excess arises, implement a sell‑down or disposal plan within the applicable disposition period, and request an extension if needed.
Avoid
- Accepting or purchasing closely held interests without performing an attribution analysis.
- Missing recapitalizations or redemptions that silently increase combined ownership.
- Retaining governance rights that imply control (board seats, veto rights, or special voting power) without confirmation that they do not create control under IRC §4943.
4. Tickets, Galas, & Fundraising Events
Tangible economic benefits can include tickets, tables, gala invitations, and similar benefits. For private foundations, DP attendance using tickets purchased by or given to the foundation is generally considered self‑dealing. In addition, unused tickets can create a compliance issue. Holding tickets (whether or not they are used) may also be viewed as a benefit to the individual, triggering self‑dealing under IRS rules. Unlike individual donors or public charities, private foundations cannot “net” the charitable portion against the value of benefits received.
Best Practice
- When supporting an event, issue the payment as a true grant and explicitly decline all benefits or tickets in writing.
- Use personal funds or corporate giving programs instead when attendance is desired.
- If attendance is necessary to monitor or gauge a grantee, document the specific administrative purpose and make certain that DPs personally pay for any noncharitable portion.
- Add event-related benefits to the foundation’s self-dealing pre-check and maintain a standard declination template for quick use.
Avoid
- Allowing any DP (including family members) to attend an event paid for by the foundation.
- Retaining unused tickets or accepting incidental benefits tied to an event.
- Accepting advertising, sponsorship visibility, or promotional value in exchange for a foundation donation.
- Treating event payments as grants without formally declining all benefits.
5. Minimum Distribution Requirement
Annually, private foundations must distribute at least 5% of their average net investment assets for charitable purposes. Misclassification of expenses, timing issues, and untracked carryforwards often result in shortfalls that trigger excise taxes.
Best Practice
- Maintain a running payout ledger that tracks current-year distributions, prior-year excess distribution carryforwards (with their five-year expiration dates), and remaining payout requirements.
- Review all expenses to confirm they qualify under Treasury Regulation §53.4942(a)‑3.
- Conduct quarterly payout reviews to prevent year-end shortfalls and to time set-asides when appropriate.
- Establish grant-timing goals, e.g., completing 50% of the annual payout by midyear, to avoid fourth-quarter congestion.
Avoid
- Assuming all expenses automatically qualify as charitable expenditures.
- Relying on outdated, expired, or undocumented carryforwards.
- Failing to distribute the required amount each year.
Penalty reminder: There is a 30% excise tax on undistributed income; 100% if not corrected within 90 days of IRS notice.
Conclusion
Private foundation rules are complex, and even well-intentioned foundations can encounter issues without strong controls in place. Proactive governance, clear documentation, and periodic compliance reviews are essential to maintain private foundations. Furthermore, states may impose more compliance obligations beyond federal rules. Thus, it is encouraged to consult a tax advisor to help ensure compliance with both federal and state requirements.
For more information, please reach out to a professional at Forvis Mazars.
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