This article is the third in a series on Canadian Charities Working Internationally.
SUMMARY : The principal type of grantmaking charity in the United States is the private foundation. When these foundations make international grants, they must comply with certain rules under the IRS tax code or face a penalty. In 1972, Treasury Department issued regulations that set out and explain the key elements of expenditure responsibility: a complete but” limited” pre-grant inquiry; written grant agreements that clearly spell out the terms of the grant; regular reporting and filing with the IRS, including information on expenditure responsibility for international grants; and record keeping. Penalties are in the form of a series of escalating excise taxes, the severity depending on the nature of the offense.These two measures together, according to an IRS report, have proved to be effective in ensuring that international grantmaking accomplishes its stated charity goals.
RESUME : Aux États-Unis, le principal type d’organisme de charité octroyant des subventions est la fondation privée. Lorsqu’une telle fondation accorde des subventions internationales, elle doit respecter certaines règles contenues dans le code de la loi de l’impôt de l’IRS (Internal Revenue Service), sans quoi elle s’expose à une pénalité. En 1972, le Département du Trésor a émis un règlement qui énonce et explique les éléments clés de la responsabilité en matière de dépenses : une enquête complète mais de portée « limitée » avant l’octroi de la subvention; des conventions de subvention écrites qui énoncent clairement les modalités de la subvention, les exigences en matière de production régulière de déclarations auprès de l’IRS, notamment de l’information sur la responsabilité en matière de dépenses pour les subventions internationales; et la tenue de dossiers. Les pénalités prennent la forme d’une série de taxes d’accise progressives, dont la gravité dépend de la nature de l’infraction. Selon un rapport de l’IRS, ces deux mesures combinées ont démontré leur efficacité pour faire en sorte que l’octroi de subventions internationales atteigne les objectifs visés sur le plan caritatif.
Introduction and legal context
This article will review the origins and the current nature of rules governing international grantmaking by private foundations, the principal type of grantmaking charity in the United States. The general rules at the federal level governing the activities of charities are found in the Internal Revenue Code of 1986 and its predecessor statutes.[1] The predecessor of section 501(c)(3) of the Code, the provision that provides for the exemption of charities from federal income tax, first appeared in essentially its current form in the Revenue Act of 1913, the first federal income tax statute to be enacted after the U.S. Constitution was amended to permit taxes based on income. Section 501(c)(3) of the Code provides, as did its predecessors, for the exemption from income tax of organizations “organized and operated exclusively for… charitable purposes.” Congress did not, however, provide a definition of charity, nor an explanation of what was meant by the “operated exclusively” language, leaving it to the U. S. Treasury Department, which addressed both those points in regulations. Specifically, Treas. Reg. §1.501(c)(3)-1(d)(2) states that “charitable,” as used in section 501(c)(3), is defined in its “generally accepted legal sense,” and in homage to English legal heritage, follows that statement with a list of examples that mirrors the Preamble to the Statute of Charitable Uses, passed by the English Parliament in 1601.[2] A companion regulations section, Treas. Reg. §1.501(c)(3)-1(c)(1), addresses the “operated exclusively” phrase by essentially noting that “exclusive” means, effectively, “primarily,” qualified by further noting that an organization will not be regarded as “operated primarily” for exempt purposes if more than an insubstantial part of its activities is not in furtherance of an exempt purpose. Importantly, neither section 501(c)(3), nor the regulations interpreting the provision, draw a distinction between activities undertaken domestically or those undertaken outside the United States.[3] The absence of such a distinction did not reflect the absence of international grantmaking by private foundations at the time; indeed, the Rockefeller Foundation, which was formed in 1913, immediately began making grants to foreign organizations for charitable purposes.[4]
Shortly after the enactment of the 1913 Act, the Internal Revenue Service (“IRS”) began issuing more specific standards for charity behavior, including international activities, albeit not in a systematic or comprehensive manner and in less formal form than regulations. The lack of a systematic approach with regard to private foundation oversight in particular, among other matters, eventually led Congress to enact a series of penalty excise taxes in 1969 to more effectively and precisely channel foundation activities, including grantmaking.[5] Because the private foundation excise taxes are widely and accurately viewed as a more specific and rigorous standard for institutional behavior than the charity tax rules in general, compliance with the excise tax rules effectively serves as a safe harbor for all charities, whether classified as private foundations or charities more broadly, a group referred to as “public charities.”
Private foundations and international grantmaking
The particular excise tax that governs grantmaking by private foundations is found in section 4945 of the Code, which requires that private foundations pay a tax of 20% of the amount involved in a “taxable expenditure.” If a particular taxable expenditure is not timely corrected, an additional second tier tax of 100% of the amount involved is imposed. In addition to the excise tax paid by the foundation, an excise tax of 5% of the amount involved is also applied to any foundation manager who approved the taxable expenditure knowing it to be impermissible, with an additional second tier tax of 50% of the amount involved applied against any foundation manager who refuses to agree to part or all of an appropriate corrective action..[6] While the section 4945 excise taxes seem sufficient to trigger appropriate conforming behavior regarding grantmaking by private foundations and their managers, Congress enacted a third tier tax that applies in the case of willful, repeated violations of the foundation excise taxes or a willful and flagrant violation. The third tier tax is an amount equivalent to the net assets of the foundation..[7]
Clearly, failure to adhere to the excise tax-based rules on international grantmaking can have dramatic consequences for a private foundation. However, Congress modulated the import of the rules, perhaps to prevent the wholesale abandonment of international grantmaking by foundations, by noting in the legislative history of the provision that the rule “is not to be interpreted as making the granting foundation an insurer of the activity of the organization to which it makes a grant, so long as the granting foundation uses reasonable efforts and establishes adequate procedures so that the funds will be used for proper charitable purposes. In effect, ‘prudent man’ standards are required in such cases.”[8]
Structure of the rules for international grantmaking
In 1972, the Treasury Department issued regulations setting forth greater detail with regard to components of expenditure responsibility and set the tone for the administration of the rule by beginning the relevant regulations section with the sentence from the legislative history of the statute; “a private foundation is not an insurer of the activity of the organization to which it makes a grant.”[9] The regulations then go on to enumerate key elements of expenditure responsibility: Section 4945(d) of the Code defines the proscribed taxable expenditure, for purposes of this discussion, as a grant to any entity other than a public charity recognized as such by the IRS or, if made to an entity that is not a recognized public charity, a grant that is not made employing a procedure known as “expenditure responsibility.” In contrast to the lack of guidance regarding the term “charity,” Congress did provide an overview of its thinking with regard to expenditure responsibility, leaving it to the Treasury Department to expand on the details in regulations. Section 4945(h) of the Code provides that expenditure responsibility means that a private foundation “is responsible to exert all reasonable efforts and to establish adequate procedures” to (1) see that a grant is spent solely for the purpose for which it is made, (2) obtain full and complete reports from the grantee on how the funds were spent, and (3) make full and detailed reports with respect to the grants.
- Pre-grant inquiry: the regulations direct the foundation to make a pre-grant inquiry – characterized as “limited” – that “should be complete enough to give a reasonable man assurance that the grantee will use the grant for the proper purposes.”[10] The inquiry should focus on basic information about the proposed grantee, including its identity, its prior history and the experience of its managers, including a review of “readily available” information about the grantee’s management, activities, and practices. The scope of the pre-grant inquiry should be commensurate with the size and purpose of the planned grant, the period over which it is to be paid ,and the historical relationship, if any, between the grantor and the grantee organizations
- Terms of the grant: grants should be made pursuant to a written grant agreement that is signed by an appropriate officer, director, or trustee of the grantee organization and which clearly sets forth the purpose of the grant. The agreement should also require that the grantee organization (a) repay any unused grant funds, (b) submit annual reports to the grantor foundation that describe the uses made of the funds and the progress towards accomplishing the purposes of the grant, (c) maintain financial records and make them available to the grantor foundation at reasonable times, (d) agree not to use any of the grant funds for purposes that are not charitable. With regard to the annual reports, the regulations specify that the grantor foundation need not conduct any independent verification of the reports unless it has reason to doubt the accuracy or reliability of them.
- Reporting to the IRS: the grantor foundation is required to include pertinent information about expenditure responsibility grants on its annual information return filed with the IRS. The specific information to be reported consists of the grantee’s name and address, the date and amount of the grant, the purpose of the grant, the amounts that have been expended by the grantee to date (based on the latest annual grantee report), the dates of any grantee reports, the dates and results of any efforts at verification of the information in the grantee reports, and whether the grantor foundation is aware of any diversions of grant funds for purposes not set forth in the grant agreement.
- Foundation recordkeeping: the grantor foundation is required to maintain a copy, in its records, of the expenditure responsibility grant agreement, copies of grantee reports regarding the grant, and copies of any reports of inquiries or investigations by the grantor foundation’s personnel or independent auditors into the grant
Violations of the expenditure responsibility rules
In addition to the elements of expenditure responsibility, the Treasury regulations address the situation in which the grantee has violated the terms of the written expenditure responsibility agreement.[11] The regulations contemplate two types of violations: (1) diversions of grant funds for unapproved purposes, and (2) the grantee’s failure to furnish reports. With regard to diversions, the grantor foundation must take “all reasonable and appropriate steps” to recover the misused funds or have the funds redirected to an appropriate purpose, and suspend further grants until the situation is resolved. “All reasonable and appropriate steps” includes legal action, assuming that legal action would in all probability result in satisfaction on a judgment, thus factoring in the legal context of the grant recipient’s jurisdiction. If the violation involves a failure to furnish reports, assuming that the grantor foundation has followed the requirements for expenditure responsibility grants, the grantor foundation is required to make reasonable efforts to obtain the missing report and to withhold further grants until the report is forthcoming. Failure by the grantor foundation to follow the expenditure responsibility rules, including appropriate efforts to address misused grants, will result in the grant in question being treated as a taxable expenditure.
Effectiveness of the expenditure responsibility rules
Over the years since the enactment of the private foundation excise tax rules in 1969, the IRS has periodically reviewed the activities of private foundations. While the results of specific audits are not released, at least one court challenge has arisen to the IRS assessment of excise taxes against a private foundation for making taxable expenditures based on a failure to follow the documentation and reporting aspects of the expenditure responsibility rules (and not the actual misuse of grant funds). In that case, Hans S. Mannheimer Charitable Trust v. Commissioner,[12] the Trust failed to comply with any of the elements of expenditure responsibility, defending its failure by asserting that it was not the sort of abusive situation that Congress intended to address with the excise taxes. The Tax Court deemed that argument irrelevant, noting that the “all-embracing” and “deliberately strict” provisions were intended to apply to every private foundation, and proceeded to find for the IRS. And, “ Overall, we found that private foundations are in substantial compliance with the provisions of the tax laws that apply to them.”In sum, the IRS study concludes that the expenditure responsibility rules for grantmaking, with their enumerated steps, coupled with the excise tax consequences of a failure to comply, have served an effective mechanism for ensuring that international grantmaking accomplishes appropriate charitable goals. “Our examinations found that the foundation excise tax provisions contained in sections 4914, 4943, 4944, and 4945 of the Code have a deterrent effect against abuses by private foundations and furnish adequate, effective, and equitable remedies.” In addition to individual cases, the IRS has occasionally undertaken special audit projects designed to evaluate tax compliance levels by foundations more generally. While the agency doesn’t regularly release reports on its audit programs, a report on one project was released in January 1990.[13] That report was of a review of the grant-making administrative expenses of a stratified random sample of private foundations, and included a review of compliance with the full array of private foundation excise taxes. The report concluded with the following observations:
“Our examinations found that the foundation excise tax provisions contained in sections 4914, 4943, 4944, and 4945 of the Code have a deterrent effect against abuses by private foundations and furnish adequate, effective, and equitable remedies.” And, “ Overall, we found that private foundations are in substantial compliance with the provisions of the tax laws that apply to them.”
In sum, the IRS study concludes that the expenditure responsibility rules for grantmaking, with their enumerated steps, coupled with the excise tax consequences of a failure to comply, have served an effective mechanism for ensuring that international grantmaking accomplishes appropriate charitable goals.
Notes
[1] The operative language in section 501(c)(3) first appeared in the Revenue Act of 1913, which reimposed a federal income tax after the passage of the Sixteenth Amendment to the U.S. Constitution. An earlier income tax statute had been declared unconstitutional by the U.S. Supreme Court. [2] Treas. Reg. §1.501(c)(3)-1(d)(2) provides, in pertinent part, that the term “charity” includes: “relief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening the burdens of Government; and promotion of social welfare by organizations designed to accomplish any of the above purposes, or (i) to lessen neighborhood tensions; (ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights secured by law; or (iv) to combat community deterioration and juvenile delinquency.” [3] In fact, in Revenue Ruling 71-460, 1971-2 C.B. 231, the IRS specifically stated that if activities qualify as charitable when carried on within the U.S., the fact that the activities are conducted outside of the U.S. does not change that conclusion. [4] Mary E. Ferguson, China Medical Board and Peking Union Medical College, (New York: China Medical Board of New York, 1970) , p. 16. [5] The legislative history of the private foundation excise tax regime sets out the express concern that “prior law did not effectively limit the extent to which foundations could use their money for ‘educational’ grants to enable people to take vacations abroad…” Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1969 H.R. 13270, 91st Congress, Public Law 91-172, p.48. [6] The first tier excise taxes are set forth in section 4945(a) and the second tier excise taxes appear in section 4945(b). [7] Section 507 of the Code. [8] Ibid, 5, p. 51.[9] Treas. Reg. §53.4945-5(b)(1). [10] Treas. Reg. §53.4945-5(b)(2)(i). [11] Treas. Reg. §53.4945-5(e). [12] 93 T.C. 35 (July 12, 1989). [13] Internal Revenue Service, Private Foundation Grant-Making Administrative Expenses Study, (January 1990).
