What Are Taxable Expenditures for Private Foundations?

Private foundations operate under federal tax rules designed to ensure their resources are used for charitable purposes. A key part of this framework is the “taxable expenditure,” a prohibited payment that can trigger penalty taxes. The Internal Revenue Service (IRS) established these rules to prevent foundations from using their tax-advantaged status for non-charitable activities, like influencing politics or benefiting private individuals.

The rules define a boundary between permissible activities and prohibited expenditures. Navigating these requirements involves knowing what is forbidden and the specific exceptions that permit certain activities under controlled circumstances. Failure to adhere to these standards can lead to financial penalties for both the foundation and its managers.

Categories of Taxable Expenditures

Internal Revenue Code (IRC) Section 4945 defines five categories of taxable expenditures for private foundations. These rules are designed to curb potential abuses of a foundation’s tax-exempt status. Each category targets a specific activity outside the intended scope of charitable work.

Carrying on Propaganda or Influencing Legislation

This category covers activities considered lobbying. It includes any amount paid to contact, or urge the public to contact, members of a legislative body to propose, support, or oppose legislation. It also applies to advocating for the adoption or rejection of legislation. For example, a foundation paying for an ad telling citizens to call their senator about a specific bill is a taxable expenditure.

Influencing Public Elections

Private foundations are forbidden from influencing the outcome of any specific public election. This includes participation in a political campaign for or against any candidate for public office. An example would be a foundation donating funds to a candidate’s campaign committee or publishing a biased voter guide. This prohibition is absolute and separate from general lobbying activities.

Grants to Individuals

Making grants to individuals for travel, study, or similar purposes is a taxable expenditure. If a foundation awards a scholarship directly to a student without following specific protocols, it is a taxable expenditure. The concern is that such grants could benefit individuals connected to the foundation’s managers rather than serve charitable purposes based on objective criteria.

Grants to Certain Other Organizations

A grant to an organization that is not a registered public charity is a taxable expenditure unless the foundation follows specific due diligence procedures. Public charities are described in IRC Section 509. If a foundation grants to a for-profit company or a new nonprofit that has not yet received its public charity status, that grant is a taxable expenditure without special oversight.

Non-Charitable Purposes

This category is a catch-all provision. It defines a taxable expenditure as any amount paid for a purpose other than one specified in IRC Section 170, which includes religious, charitable, scientific, literary, or educational purposes. An expenditure not fitting these classes, such as paying for unreasonable administrative expenses, would fall under this provision.

Exceptions to Prohibited Expenditures

The law provides several exceptions that allow foundations to engage in activities that might otherwise be prohibited. These exceptions provide safe harbors for foundations to carry out their charitable missions. Understanding these exceptions is as important as knowing the prohibitions.

An exception relates to influencing legislation. Foundations can engage in nonpartisan analysis, study, or research and make the results widely available. They may also provide technical advice to a governmental body in response to a written request. A foundation can also lobby on legislation affecting its own existence, powers, or tax-exempt status, known as the “self-defense” exception.

For grants to individuals, an exception exists if the foundation’s grant-making procedures receive advance IRS approval. The grant program must be awarded on an objective and nondiscriminatory basis to achieve a specific charitable purpose. The procedures must also ensure the grants are used for the intended travel, study, or similar purposes.

An exception also exists for grants to organizations that are not public charities, such as a foreign organization. A foundation can make such a grant if it exercises “expenditure responsibility,” which is a set of IRS-mandated oversight procedures. These procedures ensure the grant is spent solely for its charitable purpose. Expenditure responsibility requires the foundation to conduct a pre-grant inquiry to ensure the recipient can fulfill the charitable purpose, execute a written grant agreement, and receive regular, detailed reports from the grantee on how funds were spent.

Excise Taxes on Prohibited Transactions

When a private foundation makes a taxable expenditure, it triggers a two-tier system of excise taxes. These taxes penalize the prohibited activity and encourage the foundation to reverse the action. The penalties affect both the foundation and the managers who approved the expenditure.

The first-tier tax is an initial penalty on the foundation, equal to 20% of the taxable expenditure. A separate initial tax is imposed on any foundation manager who knowingly agreed to make the expenditure. This tax on the manager is 5% of the expenditure amount, capped at $10,000 for any single expenditure.

A more severe second-tier tax is imposed if the foundation fails to correct the taxable expenditure within the “taxable period.” This period begins when the expenditure occurs and ends when the IRS mails a notice of deficiency or assesses the initial tax. If not corrected, the foundation faces an additional tax equal to 100% of the expenditure amount.

Foundation managers who refuse to agree to the correction are also subject to a second-tier tax. This tax on the manager is 50% of the expenditure amount, with a maximum penalty of $20,000 for a single expenditure. These escalating taxes create an incentive for foundations and managers to remedy prohibited transactions promptly.

Correction and Reporting Requirements

A foundation that makes a taxable expenditure must take steps to correct the action and report the associated excise taxes to the IRS. The correction process is aimed at restoring funds to the foundation and preventing future violations. Proper reporting ensures compliance with federal tax law.

Correction of a taxable expenditure involves recovering the funds to the extent possible. If full recovery is not possible, the foundation must take any additional measures the IRS prescribes. The goal is to place the foundation in a financial position no worse than it would have been otherwise. The foundation must also implement safeguards to prevent similar expenditures.

Excise taxes from a taxable expenditure are reported and paid using IRS Form 4720. This form calculates the taxes on the foundation and any participating managers and must be filed by the due date for the foundation’s annual Form 990-PF. The foundation must also disclose the expenditure on its Form 990-PF, making the transaction a matter of public record.