What Are the IRC Section 508(e) Requirements?

Internal Revenue Code (IRC) Section 508(e) requires a private foundation’s organizing documents to include specific language that prevents certain actions. The purpose of these provisions is to prohibit the foundation from engaging in activities that would trigger penalty excise taxes. This ensures the foundation’s assets are used for charitable purposes and not for the private benefit of its founders, managers, or substantial contributors.

Required Prohibitions for Governing Instruments

A private foundation’s governing instrument, such as its articles of incorporation or trust agreement, must explicitly forbid the organization from engaging in five specific acts detailed in the Internal Revenue Code. The governing document must contain language that prevents the foundation from participating in any activity that would trigger these excise taxes, ensuring its operations remain aligned with its charitable mission.

The first required prohibition is against acts of self-dealing under IRC Section 4941. This rule prevents financial transactions between the foundation and its “disqualified persons,” which include its founders, substantial contributors, managers, and their family members. Prohibited transactions include the sale or leasing of property, lending money, and furnishing goods or services. An initial tax of 10% of the amount involved is imposed on the self-dealer, with a potential additional tax of 200% if the transaction is not corrected.

A second prohibition relates to the failure to distribute income as mandated by IRC Section 4942. Private foundations are required to distribute a minimum amount, roughly 5% of the fair market value of their investment assets, for charitable purposes each year. This rule ensures that foundations actively use their funds for their exempt purpose. A foundation that fails to meet this payout requirement faces an initial excise tax of 30% on the undistributed income, with a potential additional tax of 100% if the failure is not corrected in a timely manner.

The governing documents must also forbid retaining excess business holdings, a restriction outlined in IRC Section 4943. A private foundation and its disqualified persons combined cannot own more than 20% of the voting stock of a corporation or a similar interest in a partnership or other business enterprise. This rule prevents foundations from controlling commercial businesses. An initial tax of 10% is imposed on the value of the excess holdings, and a 200% additional tax can apply if the holdings are not divested.

Another prohibition is against making jeopardy investments under IRC Section 4944. This rule forbids a foundation from making investments that could jeopardize its ability to carry out its exempt purposes. Foundation managers must exercise ordinary business care and prudence, avoiding highly speculative investments that could risk the foundation’s principal assets. Violations can result in a 10% tax on the foundation based on the investment amount and a separate 10% tax on any manager who knowingly participated, with the manager’s tax capped at $10,000. If the investment is not corrected, the foundation faces an additional tax of 25%, and any manager who refuses to agree to the correction is subject to an additional 5% tax, capped at $20,000.

Finally, the governing instrument must prohibit making taxable expenditures as defined in IRC Section 4945. This category includes payments for lobbying, influencing the outcome of a public election, or making grants to individuals for travel or study without pre-approved IRS procedures. It also restricts grants to organizations that are not public charities unless the foundation exercises “expenditure responsibility.” A 20% tax is imposed on the foundation for any taxable expenditure, with a 5% tax on any manager who agreed to it.

Satisfying the Requirement with State Law

Organizations can satisfy the Section 508(e) requirements without including explicit language in their governing documents if they are organized in a state with appropriate legislation. Many states have enacted laws that automatically impose the five prohibitions of IRC Sections 4941 through 4945 on any private foundation created within their jurisdiction. These state statutes effectively treat the required provisions as if they were part of the foundation’s own charter or trust agreement.

To determine if a particular state has such a law, foundation organizers can consult official IRS resources, such as the instructions for Form 1023. The IRS has noted that these state laws can be amended or repealed, so it remains the foundation’s responsibility to verify that the state law is still in effect. The foundation must also confirm the law is applicable to its specific type of organization, whether it is a trust or a nonprofit corporation.

Amending Governing Documents

If a private foundation is established in a state that lacks a statute automatically incorporating the Section 508(e) prohibitions, the organization must amend its governing documents directly. This process involves adding the required language to its articles of incorporation or trust agreement. The bylaws of an organization are not considered its governing instrument for this purpose.

For a nonprofit corporation, the amendment process begins with the board of directors drafting and approving a resolution to adopt the necessary provisions. Once the board approves the amendment, the revised articles of incorporation must be filed with the appropriate state agency, usually the Secretary of State, to become legally effective.

For a charitable trust, the procedure for amendment is dictated by the terms of the trust document itself and relevant state law. The trustee would need to follow these specified steps to incorporate the mandatory prohibitions. In some cases, this may require petitioning a local court to approve the reformation of the trust instrument.

Demonstrating Compliance on Form 1023

When applying for tax-exempt status, an organization must demonstrate its compliance with Section 508(e) on Form 1023, the Application for Recognition of Exemption. This is addressed in a specific section of the application where the organization attests that its governing documents meet the requirements.

If the organization is relying on state law, it will indicate this on the form. A question on the form requires the applicant to confirm that its organizing document meets the Section 508(e) requirements by operation of state law. The organization would check the box and provide a statement referencing the applicable state statute.

If the organization is in a state without such a law, it must rely on explicit provisions in its governing documents. In this scenario, the applicant supports its attestation by attaching a copy of its governing document, such as the certified articles of incorporation or the trust agreement. It must also include a statement that points to the specific article or section containing the required prohibitions.