What Are Excess Business Holdings for a Private Foundation?

Private foundations must follow specific rules to maintain their focus on charitable causes. One of the most significant is the prohibition on excess business holdings, governed by Internal Revenue Code (IRC) Section 4943. These regulations were created to prevent foundations from being used as a tool to control active commercial enterprises, ensuring their assets are deployed for charitable good. By limiting a foundation’s ownership stake in a company, the law encourages the foundation to maintain a portfolio of passive investments and use its resources for grants and direct charitable work. This framework helps preserve the integrity of the foundation’s mission.

Defining Excess Business Holdings

A “business enterprise” refers to the active conduct of a trade or business, including corporations and partnerships. It is distinguished from passive investment activities, such as holding bonds, mutual funds, or stock in widely-held public companies. The rules specifically target situations where a foundation could exert influence over a company’s operations. A private foundation is not allowed to have any holdings in a sole proprietorship that qualifies as a business enterprise.

For other business types, the foundation’s ownership is aggregated with that of its “disqualified persons” to determine compliance. The holdings of all disqualified persons are added to the foundation’s direct holdings, and this total is measured against the legal limits. A “disqualified person” is a broad term for individuals and entities with close ties to the foundation, including:

• Substantial contributors, who are the individuals or corporations that provided significant funding.
• Foundation managers, such as directors, trustees, and officers.
• An individual who owns more than 20% of a business enterprise that is a substantial contributor.
• Family members of the individuals above, including spouses, ancestors, children, grandchildren, great-grandchildren, and the spouses of these descendants.

The purpose of this extensive definition is to prevent indirect control of a business through relatives or related entities.

Calculating Permitted Holdings

The calculation of permitted holdings hinges on specific ownership thresholds that a private foundation and its disqualified persons, as a group, must not exceed. The general rule states that a foundation and its disqualified persons together cannot own more than 20% of the voting stock of an incorporated business enterprise. For unincorporated businesses like partnerships, this 20% limit is applied to the profits interest, and for other entities, it applies to the beneficial interest.

A more generous limit is available under certain circumstances. The permitted ownership threshold can increase to 35% if the foundation can demonstrate to the IRS that an unrelated third party has “effective control” over the business. Effective control is the actual power to direct the management and policies of the business.

A separate de minimis rule provides a safe harbor for small ownership stakes. A foundation is not considered to have excess business holdings if its ownership of voting stock is 2% or less, and its ownership of all classes of stock by value is also 2% or less, regardless of how much stock is owned by disqualified persons.

To illustrate, consider a foundation that owns 15% of the voting stock of a corporation, while a foundation manager owns 10%. Their combined holding is 25%, which exceeds the 20% limit. The foundation has an excess business holding of 5% that must be divested, assuming the 35% effective control test is not met.

The Tax on Excess Business Holdings

When a private foundation violates the ownership limits, the Internal Revenue Code imposes a two-tier excise tax. The first-tier tax is an initial penalty of 10% on the value of the excess holdings. This tax is imposed on the foundation for each tax year that the excess holding exists, and its value is determined on the day during the tax year when the holdings were at their greatest. The tax is reported on Form 4720, Return of Certain Excise Taxes.

The recurring nature of this tax creates a strong incentive for the foundation to address the issue promptly. If the foundation fails to dispose of the excess business holdings within a specified timeframe, a much more severe second-tier tax is imposed. This additional tax amounts to 200% of the value of the remaining excess holdings.

Foundation managers can also be held personally responsible. A separate tax may be imposed on a foundation manager who knowingly, willfully, and without reasonable cause agrees to the foundation acquiring or retaining an excess business holding. This personal liability ensures that those in charge of the foundation’s governance have a direct stake in complying with the law.

Correcting Excess Holdings

The rules provide specific timelines for a foundation to dispose of excess business holdings. The most common situation occurs when a foundation acquires an interest through a gift or bequest. In these cases, the law recognizes the foundation did not proactively purchase the holding and provides a 5-year period to dispose of the excess holding without penalty. This window allows the foundation sufficient time to manage an orderly sale of the asset.

The goal is to facilitate a smooth transition back into compliance after an unplanned acquisition. If a holding is not corrected within the 5-year period, or becomes excess for other reasons, different timelines apply. Once the IRS assesses the initial 10% tax, a “taxable period” begins. This period starts on the first day the foundation has an excess holding and ends on the date the IRS mails a notice of deficiency for the tax.

The foundation must then correct the holding within a “correction period,” which generally ends 90 days after the notice of deficiency is mailed. Failure to dispose of the holding by the end of this period triggers the 200% second-tier tax. The IRS can extend the correction period if the foundation demonstrates it is actively trying to dispose of the asset.

Exceptions to the Holding Rules

The excess business holdings rules include several exceptions for specific types of business activities that align with a foundation’s charitable mission.

• A “functionally related business” is a trade or business where its conduct is directly related to the accomplishment of the foundation’s exempt purposes, aside from the need for income. A classic example is a museum gift shop that sells reproductions of art from its collection.
• “Program-related investments” (PRIs) are investments made primarily to accomplish a charitable purpose, rather than to generate income. For instance, a foundation might make a low-interest loan to a company developing affordable housing in a low-income community.
• Holdings in a passive holding company are also an exception. If a foundation owns an interest in a company whose income is derived almost exclusively from passive sources—such as dividends, interest, rents, and royalties—it is not considered a business enterprise for these rules.