Department of the TreasuryInternal Revenue ServiceCatalog Number 46586F

Publication 578(Rev. Jan. 89)

Tax Informationfor PrivateFoundationsand ,FoundationManagers

ContentsIntroduction . . . ..IChapter I, Determination of Status . . . ..l

Private Foundation Status . . ...2Private Operating Foundations . . ...2Exempt Operating Foundations . . ...4Special Rules for Certain Foundations &

Trusts . . ...5Chapter II, Filing, Notice, and Other

Requirements . . ...7Return Requirements . . ...9

Chapter III, Termination of PrivateFoundation Status . . . ..lO

Termination under Section 507(a) . . . ..I0Voluntary Termination under Section

507(b)(l) . . . ..l 1Transferee Foundations Section

507(b)(2) . . ...12Chapter IV, Tax on Net Investment

Income . . . ..I3Chapter V, Disqualified Persons . . ...14Chapter VI, Taxes on Taxable

Expenditures . . ...15Chapter VII, Taxes on Failure to Distribute

Income . . ...21Chapter VIII, Taxes on Self-Dealing . . ...26

What Is Self-Dealing . . ...27Indirect Self-Dealing . . ...28Exceptions to Self-Dealing . . ...28

Chapter IX, Taxes on JeopardizingInvestments . . ...30

Chapter X, Taxes on Excess BusinessHoldings . . ...32

Chapter XI, Excise Tax AppealProcedures . . ...33

IntroductionA private foundation is any domestic or foreignorgan iza t ion descr ibed in sec t ion 501 (c ) (3) o f theInternal Revenue Code except for an organizat ionreferred to in section 509(a)(l), (2) (3) or (4) ofthe Code. In e f fec t , the def in i t ion d iv ides organ iza-tions described in section 501 (c)(3) into two clas-ses , namely p r iva te foundat ions and pub l i ccha r i t i es .

Organizations that are not private foundationsare generally those which have broad publicsupport or actively function in a supportingrelationship to those organizations.

An excise tax is imposed on the net investmentincome of most domestic private foundations. Thisis discussed in Chapter IV of thus publication.

The Code contains five provisions that imposetwo-trer excise taxes on private foundations, foun-dation managers, or other disqualified personsthat engage in cer ta in p roh ib i ted ac ts . These f i veprovisions are discussed in Chapters VI through Xof th i s pub l i ca t ion . Founda t ion managers and d is -qua l i f ied persons are de f ined in Chapter V .

The first-tier tax (initial tax) is automaticallyimposed i f the foundat ion engages in a p roh ib i tedact. For prohibited Acts occurring after 1984, thein i t ia l tax may be aba ted (se t as ide) i f i t i s es tab-lished that the prohibited act was due to reasona-b le cause and no t to w i l l f u l neg lec t , and tha t theact was corrected within the correction period. Ifthe prohibited act is not corrected by the end ofthe taxab le per iod, the second- t ie r tax (add i t iona ltax) is imposed. Genera l ly , the taxable per iodends on the ear l ie r o f :

1 ) The da te a no t i ce o f de f i c iency fo r the in i t i a ltax i s ma i led , o r

2) The date the initial tax is assessed.

If the prohibited act is corrected during thecor rec t ion per iod , the add i t iona l tax w i l l no t beassessed. If the tax has been assessed, it will beabated . I f the tax has been co l lec ted , i t w i l l becredited or refunded as an overpayment.

The correction period begins on the date theprohibited act occurs and ends 90 days after anot i ce o f de f i c iency fo r the add i t i ona l tax i s ma i led ,extended by any per iod the Internal RevenueService determines is reasonable and necessaryto co r rec t the p roh ib i ted ac t . I f a pe t i t i on i s f i l edwith the United States Tax Court to redeterminethe tax, the correction period ends when theCourt’s decision is final. If the Court determinesthat the add i t iona l tax was proper ly imposed, i tmay determine whether the act that gave rise tothe tax was timely corrected.

In add i t ion , a pr iva te foundat ion may contes t theimpos i t i on o f the add i t i ona l tax in the Un i tedStates District Court or in the United States Courtof Claims as long as the full amount of the initialtax i s pa id . The add i t iona l tax does no t have to bepa id .

Other publ icat ions that may be of genera lin te res t a re Pub l i ca t ion 526 , Char i tab le Contr ibu-t i ons , Publ ica t ion 557, Tax-Exempt Status fo rYour Organizat ion, and Pub l i ca t ion 598 , Tax onUnrelated Business Income of ExemptOrgan iza t ions .

Chapter IDetermination ofStatusEvery organizat ion that qual i f ies for tax exempt ionas an o rgan iza t ion desc r ibed in th i s pub l i ca t i on i sa p r i va te founda t ion un less i t fa l l s in to one o f theca tegor ies spec i f i ca l l y exc luded f rom the de f in i t i onof tha t te rm. Organ iza t ions tha t fa l l in to theexcluded categories, discussed later, are generallythose that either have broad public support oractively function to support those organizations.Organizations that test for public safety also areexc luded.

An organization is not a private foundation i fit is:

1)

2)3)

4)5)

6)7)8)

9)

10)

A church or a convention or association ofchurches,A school,

An organizat ion operated for the benef i t o fce r ta in s ta te and mun ic ipa l co l l eges andun ive rs i t i es ,A hosp i t a l ,

A med ica l research organ iza t ion (opera ted incon junc t ion w i th a hosp i ta l ) ,

A governmenta l un i t ,A pub l ic ly suppor ted organ iza t ion ,

An organ izat ion that normal ly rece ives nomore than one-third of its support from grossinvestment income and income af ter tax f romunre la ted bus iness taxab le income, andreceives more than one-third of its supportfrom contributions, membership fees, andgross receipts from activities relating to itsexempt function-subject to certainexcept ions ,

An organization operated, supervised, or con-t ro l led by or in connect ion wi th one or more o fthe organizations described in items (1)through (8) but not controlled (directly or indi-rectly) by disqualified persons other than foun-dat ion managers ,An organizat ion operated so le ly for the bene-fit of one or more organizations that areexempt as civic leagues or social welfareorganizations, local associations of employ-ees , labor , agr i cu l tu ra l , o r hor t i cu l tu ra l o rgan i -zations, and business leagues, chambers ofcommerce, real estate boards, boards of

trade, or professional football leagues (How-ever , the exempt organizat ion benef i ted mustmeet the support tests described rn item (8),and the organ izat ion opera ted to benef i t suchorganization must meet the control tests ofitem (9) and must not be controlled by dis-qua l i f ied persons o ther than foundat ion man-agers), or

11) An organizat ion organized and operated totest for public safety.

A more detailed description of the types of orga-n iza t rons exc luded f rom the def in i t ion o f pr iva tefoundat ion may be found in Pub l i ca t ion 557.

Even i f an o rgan iza t ion fa l l s w i th in one o f thecategories excluded from the definrtion of privatefoundat ion , i t w i l l be presumed to be a pr iva tefoundatron, with some exceptions, unless it givest imely not ice to the In terna l Revenue Serv ice thati t i s no t a p r iva te foundat ion . The presumpt ion o fp r i va te founda t ion s ta tus i s rebu t tab le . The no t i f i -ca t ion requ i rement app l ies to an organ iza t ionregardless of when it was organized. The onlyexceotions to this reauirement are those oraaniza-tions’that are excepted from the requireme& offiling Form 1023, Application for Recognition ofExe-mption. Nonexempt charitable trustsdescribed in section 4947(a)(l) also are excepted.

I f an o rgan iza t ion i s requ i red to f i l e the no t i ce , i tmust do so within 15 months from the end of themonth in which i t was organ ized.

Private Foundation StatusI f your organizat ion was a pr ivate foundat ion onOctober 9, 1969, or becomes a private foundationon any la ter date , i t w i l l be t reated as a pr iva tefoundation for all periods after that time unless itsstatus is terminated under section 507 (see Chap-ter Ill). Therefore, if an organization was describedin sec t i on 501 (c)(3) and was a or ivate foundat ion

. :‘ ’within the meaning of section 509(a) on October9, 1969, i t w i l l be t rea ted as a pr iva te foundat ionfor all periods thereafter, eventhough it may alsosatisfy the requirements of an organizationdescribed in some other paragraph of section501 (c).

For example, i f on October 9 , 1969, an organi -zation was described in section 501 (c)(3), butbecause of its activities. it could also have auali-fied as an organization described in section’501 (c ) (4) , the organ iza t ion w i l l cont inue to betreated as a private foundation if it was a privatefoundat ion on October 9 , 1969.

Taxable private foundations. I f an organizat ionis an exempt private foundation on or after Octo-ber 9 , 1969, bu t i t i s la te r de te rmined tha t i t i s nolonger exempt as an organ iza t ion descr ibed insection 501 (c)(3) as of any date after October 9,1969, the organizat ion, even though i t may oper-a te thereaf te r as a taxab le en t i ty , w i l l con t inue tobe treated as a taxable private foundation unlessits status as such is terminated under section 507.

For example, X organizat ion was an exemptprivate foundation on October 9, 1969. It was laterdetermined that, as of July 1, 1972, X was nolonger exempt as an organ iza t ion descr ibed insection 501 (c)(3) because it did not conform itsgovern ing ins t rument under sec t ion 508(e) . X w i l lcont inue to be t reated as a pr iva te foundat ionafter July 1, 1972, unless its status as such is ter-minated under sec t ion 507.

Note. I f an organizat ion was not exempt onOctober 9 , 1969, i t w i l l no t be t reated as a pr iva tefoundation because of section 509(b), unless itbecomes a pr iva te foundat ion on a la ter date .

Status of organization after termination ofprivate foundation status. An organizationwhose status as a private foundation is terminatedunder sec t ion 507 wi l l be t rea ted as an organ iza-tion created on the day after the day of the termi-nat ion. An organ izat ion whose pr iva te foundat ionstatus has been terminated under the provisionsof sec t ion 507(a ) w i l l , i f i t con t inues to opera te , betreated as a new organization and must, if it wants

to be classified under section 501 (c)(3), apply forrecognition of section 501 (c)(3) status.

If the private foundation status of an organiza-tion has been terminated under section507(b)(l)(B) and the regulations thereunder, and

1) The oraanization does not continue at alltimes thereafter to meet the requirements ofsection 509(a)(l), (2) or (3) (and is, therefore,no longer exc luded f rom the de f in i t i on o f apr ivate foundat ion) , and

2) The status of the organization as a privatefoundation is thereafter terminated undersection 507(a), then for determining the taximposed under section 507(c)(l), thecombined tax benefit resulting from section501 (c) (3) s ta tus wi l l be f igured on ly f rom thedate on wh ich the o rgan iza t ion aga inbecomes a pr ivate foundat ion under i tem (1) .

The tax imposed on terminat ion o f pr iva te foun-dation status is imposed on the organization andIS equal to the lesser of:

1) The amount the private foundation can verifyby adequate records or other evidence as thetotal tax benefit resulting from the section501 (c)(3) status of the foundation, or

2) The value of the net assets of the foundation.

Private OperatingFoundationsA pr iva te foundat ion may qua l i f y fo r t rea tment as apr iva te ooera t ina foundat ion . These foundat ionsgenerally are sti subject to the tax on netinvestment income (Chapter IV), and to the otherrequirements and restrictions that generally applyto orivate foundation activitv. However. ooeratinafoundations are not subjeccto the excise’tax on-failure to distribute income (Chapter VII). Also,contributions to orivate ooeratinb foundationsdescribed in section 4942(j)(3) aYe deductible bythe donors to the extent of 50% of the donor’sadjusted gross income, whereas contributions toall other private foundations (except thosediscussed later in this chapter under Private Non-opera t ing Foundat ion D is t r ibu t ing A l l Cont r ibu t ionsReceived) are genera l ly l imi ted to 30% of thedonor’s adjusted gross income. In addition, apr ivate operat ing foundat ion may rece ive qual i fy -ing d is t r ibu t ions f rom a p r iva te foundat ion i f thepr iva te foundat ion does no t cont ro l i t .

A private operating foundation is any pr ivatefoundation that spends at least 85% of itsad jus ted ne t income or i t s m in imum inves tmentreturn, whichever is less, directly for the activeconduct of its exempt activities (the income test),and tha t , i n add i t ion , meets one o f the fo l low ingtests: the assets test, the endowment test, or thesupport test.

Certain private foundations that provide long-term care facilities are treated as operating foun-dations on/y for the purposes of the excise tax onfa i lu re to d is t r ibu te income. These founda t ions a rediscussed in greater detail in Chapter VII of thispub l i ca t i on .

Income test. To qua l i fy as an opera t ing founda-t ion , the o rgan iza t ion must make qua l i f y ing d is t r i -butions directly for the active conduct of itsexempt ac t i v i t i es equa l to subs tan t ia l l y a l l (a t l eas t85%) of the lesser of its:

1) Adjusted net income, or2) Minimum investment return.

I f a p r i va te founda t ion ’s qua l i f y ing d is t r ibu t ionsexceed its minimum investment return for the taxyear, but are less than its adjusted net income,subs tan t i a l l y a l l o f t he to ta l qua l i f i ed d i s t r i bu t i onsmust be made directly for the active conduct ofthe foundation’s exempt activities. However, if thefoundation’s minimum investment return is lessthan i t s ad ius ted ne t i ncome and i t s aua l i f i ed d i s -tributions equal or exceed the adjusted netincome, on ly tha t par t o f the qua l i f i ed d is t r ibu t ionsequa l to subs tan t ia l l y a l l o f t he founda t ion ’s

adjusted net income must be made directly for theactive conduct of the foundation’s exemptac t i v i t i es .

Qua l i f y ing d is t r ibu t ions and min imum inves tmentreturn are def ined in Chapter VI I .

Adjusted net income is the excess of grossincome for the tax year (including gross incomefrom any unrelated trade or business) determinedwith certain modifications (described later) overthe to ta l deduc t i ons ( i nc lud ing deduc t i ons d i rec t l yconnected with carrying on any unrelated trade orbusiness) that would be allowed a taxable corpo-ra t ion de termined w i th cer ta in deduc t ion mod i f i ca -tions (described later).

Gross rncome does not include gifts, grants, orcont r ibut ions rece ived by the pr iva te operat ingfounda t i on bu t does i nc lude i ncome f rom afunctionally-related business. Gross income andthe to ta l deduc t ions a l lowab le f rom tha t incomewi l l be f igured as they are normal ly f igured forincome tax purposes except as otherwise pro-v ided. For f igur ing ad jus ted ne t income, there w i l lbe no exclusions, deductions, or credits unlessprovided under income modifications and Deduc-t ion mod i f i ca t ions .

Amounts received by the foundation in tax yearsbeginn ing af ter 1969 represent ing repayment o fpr inc ipa l on loans made in tax years before 1970are not includible in gross income. However,payments of interest on those loans are includiblein gross income.

Income modifications:

In te res t on government ob l iga t ions normal lyexcluded under section 103 of the Code isinc luded i n g ross i ncome.When reporting capital gains and losses fromthe sale or other disposition of property, onlyne t shor t - te rm cap i ta l ga ins a re inc luded ingross income. Long-term capital gains orlosses are not included. Neither are netsec t i on 1231 ga ins i nc luded . Bu t ne t sec t i on1231 losses may be Inc luded in the computa-tion if the losses are otherwise deductibleunder these rules. Any net short-term capitalloss may not be deducted for the year inwhich it occurs. This loss may not be carriedback or carried over to earlier or later taxyears regardless of whether the foundation isa corpora t ion or a t rus t . Cap i ta l ga in d iv idendsreceived from a regulated investment com-pany are excluded from the foundation’sad jus ted ne t i ncome.Gross income includes:

Amounts received or accrued as repay-ments of amounts taken into account asqual i fy ing d is t r ibut ions for any tax year ,Amounts received or accrued from thesale or other disposition of property to theextent that the acquisition of the propertywas considered a qualifying distribution forany tax year, andAny amount set aside for a specific project(see Se t -as ides , in Chapter VI I ) to theextent the amount set aside was not nec-essary for the purposes for which it wasset aside.

The excess of fair market value on the date ofdistribution over adjusted basis of propertydistributed to a state, a U.S. possession, orany po l i t i ca l subd iv is ion thereo f , the Un i tedStates, or the District of Columbia for publicpurposes, or to a charitable trust or corpora-t ion , w i l l no t be i nc luded in g ross i ncome.The income rece ived f rom an es ta te dur ingthe admin is t ra t ion per iod w i l l no t be inc ludedin the operating foundation’s gross income.However, if the estate is considered termi-nated for income tax purposes because of apro longed admin is t ra t ion per iod , the incomewi l l be i nc luded i n g ross i ncome.

For purposes o f i tem 2, in determin ing ga in f romthe sale or other disposition of property, adjustedbas is w i l l be the g rea te r o f :

The fair market value of the property onDecember 31 , 1969, p lus o r m inus a l ladjustments to basis after 1969, using straightl i ne deorec ia t i on and cos t deo le t i on . i f t hefoundat ion he ld the proper ty on December 31,1969, and cont inuous ly thereaf ter to the dateof sale or disposition, orAdjusted basis as normally determined usingst ra igh t l i ne deprec ia t ion o r cos t dep le t ion .

For determining loss from a sale or other dispo-sition of property, the adjusted basis as normallydetermined using straight-line depreciation or costdep le t ion w i l l app ly .

Example. The Morgan Foundation boughtunimproved land in January 1969, for $102,000.On December 31, 1969, the fair market value ofthe property was $110,000 and the adjusted basiswas still $102,000. The property was sold on Jan-uary 2, 1983, for $105,000. Because the fair mar-ket value on December 31, 1969, was greaterthan the adjusted basis, the fair market value isthe adjusted basis used to determine gain. How-ever, because the adjusted basis for determiningaarn. $110.000. was areater than the sale orice.rhere was no gain. MGreover, because the’adjusted basis for determining loss, $102,000, wasless than the sale price, therewas no loss.

Deduction modifications. Deductions gener-a l ly are l im i ted to ord inary and necessaryexpenses paid or incurred for the production orcollection of gross income, or for the manage-ment, conservation, or maintenance of propertyhe ld fo r the p roduc t ion o f income. Theseexpenses include the part of a private foundation’soperating expenses paid or incurred for the pro-duction or collection of gross income. Operatingexpenses include compensation of officers, othersalaries and wages of employees, interest, rent,and taxes.

When only part of the property is income pro-duc ing or he ld fo r the produc t ion o f incomesubject to the provisions of section 4942 and theremainder is used for exempt purposes, the allow-able deduct ions must be d iv ided between exemptand nonexempt uses.

If the expenses for property used for exemptpurposes are more than the income received fromthe property, the excess may not be deducted.

Allowances for straiaht line deoreciation anddepletion (other than pkrcentage depletion) arededuc t ib le . Deduc t ions w i l l be a l l owed fo rexpenses and interest paid or incurred to carrytax-exempt obligations. However, no deductionwi l l be a l lowed fo r amounts no t pa id o r incur redfor purposes described earlier. For example, therewi l l be no deduc t ion fo r :

1) Charitable contributions,2) Net operating losses, and3) The special deductions for corporations.

Directly for the active conduct of exemptactivities means qualifying distributions a foun-dation makes that are used to conduct exemptactivities by the foundation itself, rather than by orthrough one or more grantee organizations thatrecetve the qua l i f y ing d i s t r i bu t ions d i rec t l y o r i nd i -rec t ly f rom the foundat ion.

Grants made to other organizations to assistthem in conduc t ing the i r ac t i v i t i es a re cons ideredan indirect, rather than direct, means of carryingout an exempt purpose of the pr ivate foundat ion,even though the act iv i t ies o f the grantee organiza-tion may further the exempt activities of the gran-tor foundat ion.

Amounts paid to buy or maintain assets useddirectly in the conduct of the foundation’s exemptactivities, such as the operating assets of amuseum, public park, or historic site, are directexpenditures for the active conduct of the founda-tion’s exempt activities. Likewise, administrativeexpenses (such as staff salaries and travelingexpenses) and other operating costs necessary toconduct the foundation’s exempt activities(regardless of whether they are directly for the

active conduct of exempt activities) are treated asqua l i f y ing d is t r ibu t ions expended d i rec t ly fo r theactive conduct of exempt activities if the expensesand costs are reasonable in amount.

However, administrative expenses and operat-ing costs that are not for exempt activities, suchas expenses in connection with the production ofinves tment income, are not t rea ted as qua l i fy ingdistributions. Expenses for both exempt and non-exempt ac t i v i t i es w i l l be a l l oca ted to each ac t i v i t yon a reasonable and consistently applied basis.

Any amount set aside by a foundation for a spe-cific project, for example to buy and restore orbu i l d add i t i ona l bu i l d ings o r f ac i l i t i es tha t a re to beused by the foundation directly for the activeconduct of the foundation’s exempt activities, willbe t rea ted as qua l i f y ing d is t r ibu t ions expendeddirectly for the active conduct of the foundation’sexempt activities if the set-aside meets therequirements described in Chapter VII.

Payments to individuals. If a foundation makesor awards grants, scholarships, or other paymentsto i nd i v idua l bene f i c i a r i es ( i nc lud ing program-related investments as described in Chapter IX) tosupport active programs to carry out the founda-tion’s exempt purpose, the payments will betreated as qualifying distributions made directly forthe active conduct of exempt activities only if thefoundation maintains some significantinvolvement in the active programs in support ofwhich it makes the payments.

A f ounda t i on w i l l be cons ide red as ma in ta i n i ng asignificant involvement in grant-making if-

1) The foundation operates as follows:An exempt purpose of the foundation isthe relief of poverty or human distress, andits exempt activities are designed toimprove conditions among the poor ordistressed or in an area subject to povertyor national disaster (such as providingfood or clothing to indigents or residents ina disaster area),The arants or other pavments for theexempt purpose are’made directly by thefoundat ion wi thout the he lp o f an in terven-ing organizat ion or agency, andThe foundat ion has a sa lar ied or vo luntarystaff of administrators, researchers, orother personnel who supervise and directthe exempt ac t i v i t i es on a con t inu ing bas is ,or

2) The foundation has developed some special-ized skills, expertise, or is involved in a partic-u la r d i sc ip l i ne ( such as sc ien t i f i c o r med ica lresearch, social work, education, or the socialsciences). It has a salaried staff of administra-tors, researchers, or other personnel whosupervise or conduct programs or activitiesthat support the foundation’s work in its par-ticular area of interest. As part of these pro-grams or activities the foundation makesgrants, scholarships, or other payments toind iv idua ls to encourage the i r invo lvement inthe foundation’s area of interest and in somesegment of the activities carried on by thefoundation (such as grants under which therec ip ien ts , in add i t ion to independent s tudy ,attend classes, seminars, or conferencessponsored or conducted by the foundation, orgrants to engage in social work or scientificresearch projects under the general directionand superv is ion o f the foundat ion) .

Whether making or awarding grants, scholar-ships, or other payments constitutes qualifying dis-tributions made directly for the active conduct ofthe foundation’s exemot activities is determinedby the facts and circumstances of each particularcase . The tes t app l ied i s a qua l i t a t i ve one . I f t hefoundat ion ma in ta ins a s ign i f i can t invo lvement (asde f ined ea r l i e r ) , i t w i l l no t f a i l t o qua l i f y so le l ybecause more of its funds are devoted to grants,scholarships, or other payments than to the activeprograms that such grants, scholarships, or otherpayments support.

However, if a foundation does no more thanselect, screen, and investigate applicants forgrants or scholarships, under which the recipientsperform their work or studies alone or exclusivelyunder the d i rec t ion o f some other organ izat ion,the grants or scholarships will not be treated asqua l i f y ing d is t r ibu t ions made d i rec t ly fo r the ac t iveconduct of the foundation’s exempt activities. Theadministrative expenses of screening andinvestigating (as opposed to the grants or scholar-ships themselves) may be treated as qualifyingdistributions made directly for the active conductof the foundation’s exempt activities.

Only pr ivate operat ing foundat ions may t reat thepayment of the fax on net investment income(see Chapter IV) as a qua l i f y ing d is t r ibu t ion madedirectly for the active conduct of activitiesconstituting the foundation’s exempt purpose.

Assets test. A pr iva te foundat ion w i l l meet theassets test if 65% or more of its assets:

1) Are devoted directly to the active conduct ofi ts exempt ac t iv i ty , o r to a func t iona l ly re la tedbusiness (as defined in Chapter X), or a com-bina t ion o f the two,

2) Consist of stock of a corporation that is con-trolled by the foundation (by ownership of atleast 80% of the total voting power of all clas-ses of stock entitled to vote and at least 80%of the total shares of all other classes ofstock) and at least 85% of the assets ofwhich are so devoted, or

3) Are any combination of (1) and (2).

Qualifying assets. An asset is devoted directlyto the foundation’s exempt purpose only if it isused by the foundat ion in ac tua l ly car ry ing on thechar i tab le , educa t iona l , o r o ther s im i la r func t ionthat gives rise to the exempt status of the founda-tion. Assets such as real property, physical facili-ties or objects (such as museum assets,classroom fixtures. and research eauipment) andintangible assets (such as patents, copyrights, andtrademarks) are directly devoted to the extent theyare used by the foundat ion in d i rec t ly car ry ing onits exempt activities or program. However, assets(for example, stock, bonds, or rental property)inc lud ing endowment funds , when he ld p r imar i l yfor the production of income, for investment, or forsome similar use, are not devoted directly to theactive conduct of the foundation’s exemptfunction, even though income from the assets isused to carry on the foundation’s exempt function.

Whether an asset is held for the production ofincome, for investment, or for some similar use,rather than being used for the active conduct ofthe foundation’s exempt activities, is a question offac t .

For example , an o f f i ce bu i ld ing used to prov ideof f ices fo r employees engaged in the manage-ment of endowment funds of the foundation is notdevoted to the active conduct of the foundation’sexempt ac t i v i t ies .

However, for property used both for exempt andother purposes, if the exempt use of the propertyrepresents at least 95% of the total use, the prop-erty will be considered to be used exclusively foran exempt purpose. Property acquired by a foun-dation to be used in carrying out its exemptpurpose may be considered devoted directly tothe active conduct of that purpose even thoughthe property, in whole or in part, is leased for al im i ted and reasonab le per iod o f t ime dur ing wh icharrangements are made for its conversion to theuse for which it was acquired. Generally, one yearis cons ide red a reasonab le pe r iod o f t ime . S im i -la r ly , when proper ty is leased by a foundat ion incarrying out its exempt purpose and when therental income received from the property by thefoundation is less than the amount that would berequired to be charged to recover the cost ofpurchase and maintenance of the property, theproperty will be considered devoted directly to theactive conduct of the foundation’s exemptac t i v i t i es .

3

Fai r market va lue must be used in determin ingwhether 65% or more of the assets are devoteddirectly to exempt purposes. However, in the caseof assets that are unique and for which no readymarket or standard valuation method exists, suchas historical objects, buildings, certain works ofart, and botanical gardens, the historical cost(unad jus ted fo r deprec ia t ion) w i l l be cons ideredfair market value, unless the foundation can showthat fair market value is other than cost. If thefoundation can show that fair market value isother than cost, this substituted valuation may beused for the tax year for which the new valuationis shown and for each of the following 4 tax years.

See Chapter VII for a discussion of valuations.

Assets maintained for extending credit ormak ing funds ava i lab le to members o f a char i tab leclass are not considered assets devoted directlyto the active conduct of exempt activities. Forexample, assets set aside in special reserveaccounts to guarantee student loans made bylend ing i ns t i t u t i ons w i l l no t be cons ide red qualify-inq assets. Even thouah amounts set aside forspec i f i c p ro jec ts may qua l i f y (as exp la ined ear l ie r )as distributions expended directly for the activeconduct of exempt activities for the income test,they do not qualify under the assets test as assetsdevoted directly to the active conduct of the foun-da t ion ’s exempt ac t i v i t i es .

Assets held for less than a full tax year. Inapplying the assets test, assets held for only partof the tax year are taken into account for the yearby multiplying the fair market value of each assetby a fraction. The numerator of the fraction is thenumber of days during the year that the founda-tion held the asset, and the denominator is thetota l number of days in the year .

Endowment test. A foundat ion w i l l meet theendowment test if it normally makes qualifying dis-t r ibu t ions (def ined in Chapter VI I ) d i rec t ly fo r theactive conduct of its exempt activities of at leasttwo-thirds of its mrnimum investment return. Theterm “directly for the active conduct of its exemptactivities” means the same as it does for theincome test discussed earlier.

The min imum investment re turn for any pr ivatefoundatron is 5% of the excess of the combinedfair market value of all assets of the foundation(other than those used or held for use directly inthe active conduct of its exempt purpose) over theamount of indebtedness incurred to buy thoseassets.

In determin ing whether the amount o f qua l i fy ingdistributions is at least two-thirds of the organiza-t ion ’s min imum inves tment re turn , the organ iza t ionis not required to trace the source of the expendi-tures to determine whether they were receivedfrom investment income or from contributions.

E x a m p l e . X foundat ion, created af ter May 26,1969, has $400,000 o f endowment funds andother assets not directly used for its exemptpurpose. X makes qualifying distributions of$20,000 dur ing the year d i rect ly for the act iveconduct of its exempt function. Two-thirds of X’sminimum investment return is $13,333.33 (5% x$400,000 = $20,000; */3 x $20,000 =$13,333.33). Since the $20,000 distribution isgreater than $13,333.33, X meets the endowmenttest.

Support test. A private foundation will meet thesupport test if:

1) At least 85% of its support (other than grossinvestment income) is normally received fromthe genera l pub l ic and 5 or more unre la tedexempt organizat ions,

2) Not more than 25% of its support (other thangross investment income) is normally receivedfrom any one exempt organizat ion, and

3) Not more than 50% of its support is normallyreceived from gross investment income.

Here the term support means gifts, grants, con-tributions, membership fees, the value of services

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or fac i l i t ies fu rn ished by a governmenta l un i t w i th -out charge, net income from unrelated businessactivities, and gross receipts from admissions,sales of merchandise, performance of services, orprov id ing fac i l i t i es in any ac t i v i t y tha t i s no t anunrelated trade or business.

The support received from any one exemptorganization may be counted toward satisfying the85% support test only if the foundation receivessupport from at least five exempt organizations.

For example , a foundat ion that normal lyreceives 20% of its support (other than grossinvestment income) from each of five unrelatedexempt organizations will meet the support testeven though it receives no support from the gen-era l pub l ic . However , i f a foundat ion normal lyreceives 50% of its support (other than grossinvestment income) from three foundations andthe balance of the support comes from sourcesother than exempt organizat ions, the foundat ionwill not meet the 85% test.

Suppor t f rom the genera l pub l i c inc ludessupport received from an individual, trust, corpora-t ion, or governmenta l un i t to the extent that theto ta l amount rece ived f rom any one ind iv idua l ,trust, or corporation does not exceed 1% of thefoundation’s total support (other than grossinvestment income) for the per iod. In app ly ing the1% l imi t , a l l suppor t rece ived f rom any donor andany person related to the donor is treated asreceived from one person. Support received froma governmenta l un i t i s no t sub jec t to the 1% l im i t .

Determination of compliance with operatingfoundation tests. The determination of whetherthe income test and one of the three remainingtests are met depends on whether the tests aremet in the normal and regular operat ion o f a foun-dation over a period of years, rather than on agiven day during the year or on a year-by-yearbas is . A foundat ion may qua l i f y as an opera t ingfoundation if it meets the income test and eitherthe assets, endowment, or support test for any 3years during a 4-year period, or on the basis of acombina t ion o f a l l pe r t inen t amounts o f income orassets held, received, or distributed during the4-year period. The 4-year period consists of thetax year in quest ion and the 3 years immedia te lybefore the year in quest ion. A foundat ion may notuse one method for satisfying the income test andthe other method for satisfying one of the othertests.

For example, if the income test is satisfied onthe 3-out-of-4-year basis, you may not use the4-year combination method to satisfy one of theother tests. However, the fact that the foundationuses one method to satisfy the tests in a particularyear will not prevent it from using the othermethod to satisfy the tests in a later year. If afoundation fails to satisfy the income test andeither the assets, endowment, or support test for aparticular tax year under either the 3-out-of-4-year method or the combination method, itw i l l be t rea ted as a nonopera t ing foundat ion fo rthe tax year and for all later tax years until it satis-fies the tests.

New organizations. A newly organized founda-t ion genera l ly w i l l be t rea ted as an opera t ing foun-da t ion on ly i f i t has sa t i s f i ed the income tes t andone of the three other tests for its first tax year ofexistence. If so, it will be treated as an operatingfoundat ion f rom the beg inn ing o f i t s f i r s t year . Th isstatus will continue for its second and third taxyears of existence only if it satisfies the tests bythe combination method for all tax years ofex is tence .

Before the end of its first tax year, a foundationmay be t rea ted as an opera t ing foundat ion i f i t hasmade a good fa i th de te rmina t ion tha t i t i s l i ke ly tomeet the tests for its first year. A good faith deter-minat ion may be based on an a f f idav i t o r op in ionof counsel, giving enough facts concerning theoperations and support of the organization toenable the In terna l Revenue Serv ice to determinethat the requirements are likely to be met. If afoundat ion is t rea ted as an opera t ing foundat ion

for its first year, but actually fails to qualify for thefirst year, it will be treated as a nonoperating foun-dation as of the first day of its second year. How-ever, such a foundation may establish to thesatisfaction of the Service that it is likely to qualifyas an operating foundation on the basis of its 2nd,3rd. and 4th tax years. If so. it will be treated as anopera t ing foundat ion un t i l the f i rs t day o f a taxyear in wh ich i t fa i l s to qua l i f y . S ta tus as a p r i va tefoundat ion tha t i s no t an opera t ing foundat ion w i l lcon t inue un t i l t he o rgan iza t ion i s ab le to sa t i s f ythese tests by either the 3-out-of-4-year methodor the combinat ion method.

The deductibility of grants or contributions toan opera t ing foundat ion w i l l no t be a f fec ted un t i lnotice of a change in the status of such an organr-zation is made to the public (such as bypub l i ca t i on i n t he lnternal Revenue Bu l le t in )unless:

1)

2)

The contribution was made after the contribu-tor acqui red knowledge that the organizat ionwould be deleted by the Service from classifi-ca t ion as an opera t ing foundat ion , o r

The contribution was made after an act or fail-ure to act which caused the inability to satisfythe tests for qualification as an operatingfoundation, and the contributor was responsi-ble for, or was aware of, the act or failure toact. A contributor will not be consideredresponsible for, or aware of, the act or failureto ac t i f the cont r ibu to r made the cont r ibu t ionre ly ing on a wr i t ten s ta tement by the founda-t ion tha t the con t r ibu t ion wou ld no t resu l t i nthe inab i l i t y to qua l i f y as an opera t ing founda-tion This statement must be signed by a foun-dat ion manager and must g ive enough fac tsconcerning the operations and support of theorganization to assure a reasonably prudentperson tha t a con t r ibu t ion wou ld no t resu l t i nd isqua l i f i ca t ion as an opera t ing founda t ion .

Exempt Operating FoundationsEffective for tax years beginning after 1984, cer-tain private operating foundations, known asexempt operating foundations, are not subjectto the tax on net investment income (Chapter IV).

To qua l i fy as an exempt opera t ing foundat ionfor a tax year , a pr ivate foundat ion must meet a l lthe fo l low ing requ i rements :

It must be a private foundation (see abovediscussion),

It has been publicly supported for at least 10tax years or was a private operating founda-tion on January 1, 1983, or for its last tax yearending before January 1, 1983.I ts govern ing body, a t a l l t imes dur ing the taxyear, consists of individuals less than 25% ofwhom are d i squa l i f i ed ind iv idua ls , and i sbroad ly representa t ive o f the genera l pub l ic ,a n dI t has no o f f i ce r who i s a d i squa l i f i ed ind iv idua lat any t ime dur ing the tax year.

Public/y supported means that the organiza-t ion normal ly rece ives :

1) A substantial part of its support (other thanincome from its exempt function) from govern-menta l un i ts o r f rom d i rec t o r ind i rec t cont r ibu-tions from the general public, or

2) More than a third of its suooort from oovern-mental units, certain publiciy supported chari-ties (listed as items (1) through (7) under Anorgan iza t ion i s no t a p r i va te founda t ion at thebeginning of this chapter), and persons otherthan disqualified persons (see Chapter V), inany combina t ion o f g i f t s , g ran ts , con t r ibu t ions ,membership fees, and gross receipts fromactivities that are not an unrelated trade orbusiness (but only including such grossreceiots from anv one oerson. or bureau ors im i la r agency of a governmenta l un i t , that arenot more than the greater of $5,000 or 1% ofthe foundation’s support for the tax year), and

does not normally receive more than a third ofits support from gross investment income (seeChapter IV) plus any excess of unrelated busi-ness taxable income over the tax on unrelatedbusiness income.

A “substantial part” of the foundation’s support,for purposes of (1) above, generally is a third of itstotal support, figured on a combined basis for the4 tax years immediate ly preceding the tax year inquestron. However, if the foundation does notmeet this one-third support test, it may still qualifyas deriving a substantial part of its support fromqovernmenta l un i ts and f rom the genera l pub l ic i fI’t:

1)

2)

3)

Normally receives at least 10% of its supportfrom these sources,

Satisfies the “attraction of public support”requi rement by being organized and operatedto a t t rac t new and add i t iona l pub l ic or govern-mental support on a continuous basis, andSatisfies some or all of 5 public supportfactors.

Substantial pubiic support is discussed in detailin Pub l i ca t ion 557 , Tax-Exempt S ta tus for YourOrgan iza t ion .

Disaualified individual. for ourooses of therequirements regarding composition of the gov-erning body and officers of the foundation, meansany o f the fo l lowing:

1) A substantial contributor, as defined in Chap-ter V,

2) An owner of more than 20% of-a) The total combined voting power of a

corporat ion,b) The profits interest of a partnership, orc) The beneficial interest of a trust or unin-

corporated enterprise, which is asubstantial contributor to the foundation, or

3) A member of the family (defined in Chapter V)of any ind iv idua l descr ibed in (1) or (2) .

Indirect ownership of stock in a corporation,profits interest rn a partnership, or beneficialinterest in a trust or unincorporated enterprise istaken in to account fo r de te rmin ing a d isqua l i f i edind iv idua l under (2) above, accord ing to the ru lesexpla ined under At t r ibu t ion o f ownersh ip in Chap-ter V.

Ruling letter required. A foundat ion want ingrecognition of “exempt operating foundation” sta-tus must obtain a ruling letter from the InternalRevenue Serv ice determin ing that i t has met thespecific requirements of this special status. Tocla im exempt ion f rom the tax on net investmentincome. the foundat ion shou ld a t tach a coov ofthis ruling letter to its annual returns, Form’s>990-PF, for tax years beginning after 1984 forwh ich the c la im fo r exempt ion i s made.

To ob ta in the ru l i ng le t te r , the founda t ion shou ldsubmrt its request to Internal Revenue Service,Assistant Commissioner (Emolovee Plans andExempt Organ izat ions) , 1 ‘111 ’ Const i tu t ion Avenue,Washington, DC 20224. Supporting documentsand materials with the ruling request mustdemonstrate that requirements (1) through (4)lrsted at the beginning of this discussion are met.Specifically, for purposes of requirements (3) and(4) the foundation must list all its officers andmembers of its governing body for the currentyear and Ident i fy any that are d isqua l i f iedind i v idua l s .

Special Rules for CertainFoundations and TrustsPrivate Nonoperating FoundationDistributing All ContributionsReceivedCont r ibu t ions to a pr iva te nonoperat ing foundat ionmay qua l i fy fo r the benef i t o f the 50% cont r ibut iondeduc t ion l im i t , and donors may deduc t the fu l l

va lue of apprec iated proper ty , i f the pr ivate nonop-era t ing foundat ion :

1) Distributes an amount equal in value to 100%of all contributions received in the tax year bythe 15th day of the 3rd month after the closeof its tax year,

2) Has no remaining undistributed income for theyear, and

3) Distributes only qualifying distributions thatare treated as distributions out of corpus.

Qualifying distributions cannot be made to:

1) An organization controlled directly or indirectlyby the foundat ion or by one or more d isqua l i -fied persons, or

2) A private foundation that is not an operatingfoundat ion .

To qua l i f y fo r the 50% cont r ibu t ion deduct ion ,the o rgan iza t ion mus t d is t r ibu te a l l con t r ibu t ionsreceived in any year, whether of cash or property.Distributions will be treated as made first out ofcontributions of property and second out of cashcont r ibu t ions rece ived by the foundat ion dur ingthe year , to qua l i fy fo r the deduct ion o f the fu l lvalue of appreciated property. A private founda-tion is not required to trace specific contributionsof property, or amounts into which those contribu-tions are converted, to soecific distributions. Aprivate foundation may choose to treat part or allof one or more distributions, made by the 15th dayof the 3rd month after the close of the year, asmade out of corpus. The choice is discussed inChapter VII under Treatment of qualifyingd is t r i bu t i ons .

The fair market value of contributed property,determined on the date o f the cont r ibut ion, gener-ally must be used to determine whether anamount equal to 100% of the contributionsreceived has been distributed. If the property issold. the foundation mav reduce the orooertv’s fairmarket value by any reasonable selling expensesincur red . The founda t ion mus t d is t r ibu te the ba l -ance of the fair market value of the orooertv thatwas sold to meet the 100% distribution’require-ment. However, if within 30 days after receivinqthe contributed property, the foundation sells theproperty or distributes the property to a publiccharity, the foundation may choose to treateither-

1) The gross amount received on the sale, minusreasonable selling expenses incurred, or

2) The fair market value of the contributed prop-erty at the date of its distribution to the publiccharity as the fair market value for purposesof the 100% distribution requirement.

A taxpayer c la im ing a deduc t ion fo r a char i tab lecont r ibu t ion to a pr iva te nonopera t ing foundat ionmust get adequate records or other sufficient evi-dence from the foundation showing that the foun-dat ion made the requ i red qua l i f y ing d is t r ibu t ions inthe time prescribed. Records or other evidencemust be attached to the taxpayer’s return for thetax year the char i tab le cont r ibu t ion deduc t ion isc l a imed .

Private Foundation Maintaininga Common Fund

Designation by substantial contributors.Donors to a private foundation that pools all con-t r ibu t ions rece ived in a common fund a re a lso e l i -g ib le fo r the 50% con t r ibu t ion deduc t ion l im i t , andmay deduct the fu l l va lue o f apprec ia ted proper ty(see above discussion under Private NonoperatingFoundat ion D is t r ibu t ing A l l Con t r ibu t ionsReceived), if the foundation meets certain require-ments. The foundation must be described as asupporting organization of a public charity (asdefined in section 509(a)(3) of the Internal Reve-nue Code) except for the fact that any donor (ordonor’s spouse) who is a substantial contributorhas the r igh t to des igna te annua l l y the pub l i c char -ities that are to receive the income from the

donor’s contribution to the fund and to direct (bydeed or by w i l l ) the payment to pub l ic char i t ies o fthe corpus in the common fund from the donor’scon t r ibu t ion .

Distribution requirements. To qualify, thepr ivate foundat ion must be requi red by i ts gov-e rn ing ins t rument to d i s t r i bu te , and i t mus t ac tua l l yd is t r ibu te ( inc lud ing admin is t ra t i ve expenses) :

1) All of the adiusted net income of the commonfund to one or more pub l ic char i t ies by the15th day of the 3rd month after the close ofthe tax year in wh ich the income is rea l ized bythe fund, and

2) All the corpus from any donor’s contribution tothe fund to one or more public charities notlater than one year after the donor’s death orafter the death of the donor’s survivingspouse if the surviving spouse has the right todesignate the recipients of the corpus.

Failure to designate. A private foundation willno t fa i l to qua l i f y i f a subs tan t ia l con t r ibu to r o rspouse fails to exercise the right to designate therecipients of income or corpus of the fund, as longas the income and corpus from the contributionare distributed as required.

Nonexempt Trusts

Section 4947 generally subjects trusts that are notexempt from tax to the same requirements andrestrictions that apply to private foundations if thetrusts have any unexpired interests devoted tocharitable purposes. The aim of section 4947 is toprevent a trust of this nature from being used toavoid the requirements and restrictions that applyto pr iva te foundat ions .

In th i s connec t ion , a char i tab le pu rpose inc ludesa re l i g i ous , educa t i ona l , cha r i t ab le , sc ien t i f i c , o r l i t -erary purpose, a purpose to foster national orin te rna t iona l spor ts compet i t i on (bu t on ly i f the re i sno p rov i s i on o f a th l e t i c f ac i l i t i es o r equ ipmen t ) , apurpose to prevent cruelty to children or animals,or a gift to or for the use of a state, a possessionof the Un i ted S ta tes , o r any po l i t i ca l subd iv i s ion o fthe same, the United States, or the District ofCo lumb ia , when the g i f t i s to be used exc lus ive lyfor public purposes.

Charitable trusts. A charitable trust described insection 4947(a)(l) is a trust that is not tax exempt,all of the unexpired interests of which are devotedto one or more charitable purposes, and for whicha char i tab le con t r ibu t ion deduc t ion was a l lowedunder a specific section of the Internal RevenueCode. A charitable trust is treated as a privatefoundation unless it meets the requirements forone of the exclusions that classifies it as a publicchar i t y . Thus , i t i s sub jec t to the p r i va te founda t ionexcise tax provisions described in this publicationand the other provisions that apply to exemptpr iva te foundat ions , inc lud ing te rminat ion requ i re -ments and governing instrument requirements.However, a charitable trust is not treated as achar i tab le organ izat ion for purposes o f exempt ionfrom tax. Accordingly, the trust is subject to theexcise tax on its investment income under theru les that app ly to taxab le foundat ions ra ther thanthose that apply to tax-exempt foundations.

For purposes of the organizational test, when acharitable trust seeks exemption from tax as acharitable organization, the trust is consideredorganized on the day it first becomes subject tosection 4947(a)(l). Generally, for purposes of thespecial and transitional rules for excise taxesd iscussed i n t h i s pub l i ca t i on , a cha r i t ab le t r us t w i l lbe considered organized on the first day it hasamounts in trust for which a deduction wasal lowed under the In ternal Revenue Code. Underthis rule, a trust may be treated as a private foun-dat ion in ex is tence on a date govern ing one o f theapp l i cab le spec ia l and t rans i t i ona l ru les eventhough the trust did not otherwise become subjectto the provisions that apply to private foundationsunt i l a la te r da te .

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Scope of provisions regarding charitabletrusts. These provisions apply to nonexempttrusts in which all unexpired interests arechar i tab le .

An estate from which the executor or adminis-trator is required to distribute all of the net assetsin t rus t to char i tab le bene f i c ia r ies w i l l no t be con-sidered a charitable trust during the period ofestate administration or settlement except for theconditions discussed in the next paragraph. Acharitable trust created by a will is considered acharitable trust as of the date of death of thedecedent-grantor. However, a revocable trust thatbecomes irrevocable upon the death of the dece-dent-grantor, or a trust created by will from whichthe trustee is required to distribute all of the netassets for, or free of trust to, charitable benefi-ciaries, is not considered a charitable trust for areasonable period of settlement (defined later)after becoming irrevocable. After that period, thetrust is considered a charitable trust.

Estates. When an estate from which the execu-tor or administrator is required to distribute all ofthe net assets in trust for charitable beneficiaries,or free of trust to those beneficiaries, is consid-ered terminated for federal income tax ourooses.the estate will then be treated as a chaiitable trustbetween tha t da te and the date the f ina l d is t r ibu-tion of all the net assets is made to or for the ben-e f i t o f t he char i t ab le bene f i c ia r i es . Theseprovisions do not affect the determination of thetax l i ab i l i t y o f the bene f i c ia r ies o f the es ta te .

Example. Malcolm Thorn bequeaths his entireestate, including 100% of the stock of a wholly-owned corporat ion, to M, an organizat iondescr ibed in sec t ion 501 (c ) (3 ) , under a w i l l tha tgives his executor authority to hold the stock andmanage the corporat ion for a per iod of up to 10years for the benefit of M before its ultimate dispo-sition. A deduction for the charitable bequest wasallowed to Malcolm’s estate. The executor isvested with a full range of powers, including thepower of sale. Upon Malcolm’s death, his execu-tor distributes Malcolm’s assets to M except forthe stock of the corporation, which he holds for 5years before its disposition. Because the executorheld the stock of the corporation beyond a rea-sonab le t ime fo r per fo rming a l l the ord inary dut iesof administration, the estate is considered termi-nated for federal income tax purposes and issubject to the provisions of section 4947(a)(l)from the date of this termination to the date offinal disposition of the stock of the corporation.

Certain split-interest trusts that wind up. Asplit-interest trust (defined later) in which all of theunexpired interests are charitable remainderinterests and in which the charitable beneficiarieshave become entitled to distributions of corpus intrust or free of trust will continue to be treated as asplit-interest trust until the date final distribution ofall the net assets is made. However, if after theexpiration of any intervening interests, the trust isconsidered terminated for federal income taxpurposes, the trust will then be treated as a chari-table trust rather than a split-interest trustbetween the date on which the trust is consideredtermina ted and the da te f ina l d is t r ibu t ion o f a l l thenet assets is made. These provisions do not affectthe de te rmina t ion o f the tax l i ab i l i t y o f the benef i -ciaries of the trusts.

Split-interest trusts that become charitabletrusts. A split-interest trust in which all of theunexpired interests are charitable remainderinterests and in which some or all of the charitablebene f i c ia r ies a re no t en t i t l ed to d i s t r i bu t ions o fcorpus will continue to be treated as a split-interest trust for a reasonable period of settlementa f te r the exp i ra t ion o f the nonchar i tab le in te res t . Asplit-interest trust that under its terms is to con-tinue to hold assets for charitable beneficiariesafter the expiration of the noncharitable interestrather than distributing them is allowed a reasona-ble per iod o f t ime fo r se t t lement be fore be ingtreated as a charitable trust.

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Reasonable period of settlement i s tha t per iodreasonably required (or if shorter, actuallyrequired) by the trustee to perform the ordinaryduties of administration necessary for thesettlement of the trust. For example, these dutiesinclude the collection of assets, the payment ofdebts, taxes, and distributions, and the determina-tion of the rights of the subsequent beneficiaries.

Example. On January 15, 1983, Cyril Elmwoodcreated a charitable remainder annuity trust underwhich the trustees were required to distribute$10,000 a year to Betty, Cyril’s wife, for life and tohold the remainder in trust for the use of M, anorgan iza t ion descr ibed in sec t ion 501 (c ) (3) . Cyr i lwas allowed a deduction for the amount of thecharitable interest, and the trust was treated as asplit-interest trust from the date of its creation.Bet ty d ied on February 10, 1988. On Apr i l 1 .5,1988, the trustees completed the ordinary dutiesof administration necessary for the settlement ofthe trust brought about by Betty’s death. Thesedut ies inc lude , fo r example , an account ing fo r andpayment to Betty’s estate of amounts accrued byBetty while alive during 1988. However, the trust-ees did not distribute the corpus to M by April 15,1988. The trust would continue to be treated as asplit-interest trust until April 15, 1988. After April15, 1988, the trust would be treated as a charita-b le t rus t .

Revocable trusts that become charitabletrusts. A revocable trust that becomes irrevoca-ble upon the death o f the decedent -grantor inwhich all of the unexpired interests are charitableand whose governing instrument provides that thetrustee is required to hold some or all of the netassets in trust (after becoming irrevocable) solelyfor charitable beneficiaries, is not considered acharitable trust for a reasonable period ofsettlement after becoming irrevocable, except thatcertain rules concerning self-dealing apply. Afterthat period, the trust is considered a charitabletrust.

Trust devoted to qualified charitablecontribution purposes. A trust in which all ofthe unexpired interests are devoted to war veter-ans’ organizations or certain cemetery companiesas well as the types of organizations listed earlierunder Scope o f p rov is ions regard ing char i tab letrusts will be considered a charitable trust.Payments made to veterans’ organizations andcertain cemetery companies will be consideredqualifying distributions under these circumstances.

Example. Hugo Briar creates an inter vivostrust whose governing instrument provides that M,a war veterans’ organization, and N, an organiza-tion described in section 501 (c)(3), are each toreceive 50% of the income for a period of 10years. At the end of the 1 0-vear oeriod. thecorpus IS to be distributed td 0, an organizationalso described in section 501 (c)(3). Huqo isallowed an income tax deductidn ior the value ofall interests placed in trust. The payments to Mare qualifying distributions. Accordingly, the trustwill be considered a charitable trust.

Charitable trusts that suooort public charities.Charitable trusts that quali& under section509(a)(3) (as supportinq orqanizations of publiccharit/&j are n&t.treateb ai private found&ionsand, thus, are not subject to the taxes and restric-tions that apply to private foundations. In deter-min ing whether i t qua l i f ies under sec t ion 509(a) (3) ,a char i tab le t rus t w i l l be t rea ted as i f o rgan ized onthe day it first becomes subject to section4947(a)(l). The previous relationship between thecharitable trust and the organizations it benefits orsupports may be considered. The charitable trustmay obtain recognition of its status as a section509(a)(3) organizat ion by request ing a ru l ing f romthe In ternal Revenue Serv ice.

Split-interest trusts. A split-interest trust is atrust:

1) That is not exempt from tax,

2) Not all of the unexpired interests of which aredevo ted to re l i g ious , char i tab le , sc ien t i f i c , l i t e r -ary, or educational purposes, or to fosternat iona l o r in te rna t iona l amateur spor tscompetition, or for the preventjon of cruelty toch i ld ren o r an ima ls , and

3) That has amounts in trust for which a charita-b le con t r ibu t ion deduc t ion has been a l lowed.

Also included under these provisions is a split-interest trust that is not treated as a charitabletrust during a reasonable period of settlement orwh i le i t i s i n the p rocess o f w ind ing up . See theearlier discussion under Certain split-interest truststhat wind up or Split-interest trusts that becomechar i tab le t rus ts .

A split-interest trust is subject to the followingprovisions discussed in this publication in thesame manner as is a private foundation:

1) Terminations, Chapter Ill,2) Governing instruments, Chapter II,3) Tax on self-dealing, Chapter VIII,4) Tax on excess business holdings, Chapter X,5) Tax on investments that jeopardize charitable

purpose, Chapter IX, and

6) Tax on taxable expenditures, Chapter VI.

These provisions do not apply to amounts trans-ferred in trust before May 27, 1969.

Also, the provisions do not apply to anyamounts payable under the terms of a split-interest trust to income beneficiaries, unless achar i tab le con t r ibu t ion deduc t ion was a l lowed w i threspect to the income interest of the beneficiary.For example, Hyram Jones created a split-interestt rus t tha t i s requ i red annua l ly to pay Melan ieJones 5% of the net fair market value of the trustassets , va lued annua l ly , fo r her l i fe ; and to pay theremainder to Y , a sec t ion 501 (c ) (3 ) o rgan iza t ion . Achar i tab le con t r ibu t ion deduc t ion was a l lowed fo rthe remainder in terest . Each annual amount paya-b le to Me lan ie fo r her l i fe i s no t sub jec t to the pro-visions listed earlier. These payments are not actsof self-dealing or taxable expenditures. However,with the exception of the income interest so paid,the trust IS subject to the provisions in the samemanner as if the trust were a private foundation.

Exception for certain segregated amounts.These provisions will not apply to assets held int rus t ( i nc lud ing income and cap i ta l ga ins rece ivedfrom these assets), other than assets for which achar i tab le con t r ibu t ion deduc t ion has beenallowed, if these assets are segregated from theother assets held in trust.

Segregation of amounts. Amounts generallywi l l be cons idered segrega ted i f :

1) The assets for which no deduction wasallowed are separately accounted for fromassets for which a deduction was allowed forany income or remainder in terest , and

2) Because there is a separate accounting, thetrust can be treated as two separate trusts,one devoted exc lus ive ly to nonchar i tab leincome and remainder interests and the otheras a charitable trust or a split-interest trust.

Under these circumstances, only the trust thatis devoted exc lus ive ly to nonchar i tab le incomeand remainder interests will be considered a seg-regated amount which is not subject to the restric-tions described above for split-interest trusts.

Exclusively charitable amounts. I f an amountheld in trust that is devoted exclusively to non-charitable income and remainder interests is seg-regated from an amount held in trust that isdevoted exc lus ive ly to char i tab le income andremainder in te res ts , then the la t te r amount w i l l betreated as a charitable trust.

Charitable and noncharitable amounts. I f anamount held in trust that is devoted exclusively tononchar i tab le income and remainder in te res ts i ssegregated from an amount held in trust that isdevoted to both char i tab le income or remainderinterests and noncharitable income or remainder

interests, then that latter amount will be treated as Revocable trusts that become split-interest Remainder beneficiary includes a beneficiary ofa split-interest trust. trusts. A revocable trust that becomes irrevoca- a remainder in teres t .

Accounting for segregated amounts. A trustthat has segregated amounts must separatelyaccount for the income, deductions, and otheri tems a t t r ibu tab le to each segrega ted amount inthe books of account and separately account toeach of the beneficiaries of the trust.

Separa te account ing w i l l be made accord ing tothe method regularly employed by the trust, ifthe method is reasonable. In all other cases, it willbe made in a manner tha t , in the op in ion o f theIn terna l Revenue Serv ice , is reasonable .

A method of separate accounting will be consid-ered regularly employed by a trust when themethod has been consistently followed in earliertax years or when a trust that has never beforekept segregated amounts begins a reasonablemethod of separate accounting for its segregatedamounts and consistently follows such method inthe future. The trust will keep permanent recordsand other data relating to the segregated amountsas are necessary to enable the IRS to determinethe correctness of the methods used to segregatethese amounts.

Scope of provisions regarding split-interesttrusts. The provisions generally apply to trusts inwhich some but not all unexpired interests arecharitable. An estate from which the executor oradministrator is required to distribute all of the netassets in trust or free of trust to both charitableand nonchar i tab le bene f i c ia r ies w i l l no t be cons id -ered a split-interest trust during the period ofestate administration or settlement with theexception of the provisions discussed underEstates in the next paragraph. A split-interest trustcreated by a will is considered a split-interest trustas of the date of death of the decedent-grantorexcept for the exceptions discussed under Certainrevocable and testamentary trusts that wind upl a te r in th i s chap te r .

Estates. When an estate, from which theexecutor or administrator is required to distributeall of the net assets in trust or free of trust to bothchar i tab le and nonchar i tab le bene f i c ia r ies , i s con-sidered terminated for federal income taxpurposes, then the estate will be treated as a split-interest trust or charitable trust (if applicable)between the date on which the estate is consid-ered te rmina ted and the da te on wh ich f ina l d is t r i -bution of the net assets to the last remainingchar i tab le bene f i c ia ry i s made . Th is does no ta f fec t the de termina t ion o f the tax l iab i l i t y o f e i therchar i tab le o r nonchar i tab le bene f i c ia r ies o f theestates.

fxamoie. Henrv Post d ied on Januarv 15.1983, and bequeathed $10,000 to M, an’organiza-t ion descr ibed in sec t ion 501 (c ) (3 ) , and theremainder of his estate to Wilma. his wife. Adeduction for the charitable bequest was allowedto Henry’s estate. Substantially all of Henry’sestate consisted of 100% of the stock of a whollyowned corporation, certain liquid assets such asmarketable stocks and securities and bankaccounts, and Henry’s home, automobile, andother oersonal orooertv. Henrv’s will aave hisexecutor a fu l l range of poweis, i nc lud ing thepower to sell the stock. After Henrv’s death, hisexecutor cont inued to manage the-whol ly ownedcorporation while attempting to sell the stock ofthe corporation. During this period, the executormade no d is t r ibut ions to M. On Mav 24. 1988. the

ble upon the death of the decedent-grantor andwhose governing instrument provides that thetrustee is required to hold some or all of its netassets in trust for both charitable and noncharita-ble beneficiaries after becoming irrevocable is notconsrdered a split-interest trust for a reasonableperiod of settlement after becoming irrevocable,except that the tax on se l f -deal ing may apply .

After that period, the trust is considered a split-interest trust.

For a definition of “reasonable period,” see theprevious discussion of Split-interest trusts thatbecome charitable trusts.

Certain revocable and testamentary truststhat wind up. A revocable trust that becomesirrevocable upon the death of the decedent-gran-tor, or a trust created by will, from which thetrustee is required to distribute all of the netassets in trust or free of trust to both charitableand noncharitable beneficiaries is not considereda split-interest trust for a reasonable period ofsettlement after becoming irrevocable. After thatperiod, the trust is considered a split-interest trustor a charitable trust, whichever applies.

Governing instrument requirements, charitablededuction limrtations, denial of deductions, andother provisions that apply to exempt private foun-dations also apply to charitable remainder trusts.

Application of the rules relating to terminationof private foundation status. The terminationrules discussed in Chapter Ill do not apply to acharitable or split-interest trust by reason of anypayment to a beneficiary that is directed by theterms of the governing instrument of the trust andis not discretionary with the trustee or, in the caseof a discretionary payment, because of, orfo l low ing , the exp i ra t ion o f the las t remain ing char -i tab le in te res t i n the t rus t .

Example. H creates a nonexempt charitabletrust under which the income is to be paid for 15years to R, a section 501 (c)(3) organization. After15 years, the trust is to terminate and distribute allof its assets to S, another section 501 (c)(3) organ-ization. Distribution of the corpus of the trust to Swill not be subject to the rules governrng termina-tion of private foundation status.

Limit to segregated amounts. I f any amountsheld in trust are segregated, the value of the netassets for purposes of determining the taximposed on the te rminat ion o f p r iva te foundat ionstatus under section 507(a), and for determiningthe amount o f tax to be abated , w i l l be l im i ted tothe segregated amounts for which a charitablededuc t ion was a l lowed.

Split-interest trusts are not subject to the restric-tions concerning excess business holdings (Chap-ter X) and the restrictions concerning investmentsthat jeopardize charitable purpose (Chapter IX) ifall of the trust’s income interest (and none of theremainder interest) is devoted solely to one ormore charitable purposes and all amounts forwhich a charitable deduction was allowed have acombined va lue a t the t ime o f the deduct ion o f no tmore than 60% of the fair market value of theentire trust (after the payment of estate taxes andall other Inabilities). In addition, these two restric-t ions w i l l no t app ly i f a char i tab le con t r i bu t iondeduction was allowed for amounts payable underthe terms of the trust to every remainder benefici-ary , but not to any income benef ic iary . However , inthe latter case. the trust will become a charitable

Foreign Foundations

Fore ign organizat ions that are pr ivate foundat ionsand that have been granted tax-exempt statusunder U.S. tax law are required to pay an excisetax equal to 4% of their gross investment incomereceived from sources in the United States, anyterritory, any political subdivision of a territory, orthe D is t r i c t o f Co lumb ia .

An exception to this rule is made when a taxtreaty between the United States and the foreigncountry of which the private foundation is a resi-dent specifically exempts income received bythese organizations from any tax.

Foreign private foundations receiving at /east85% of their support (excluding gross investmentincome) from sources outside the United Statesare not subject to the taxes on self-dealing, failureto distribute income, excess business holdings,investments that jeopardize charitable purposes,and taxable expenditures. Such foundations alsoare not subject to section 507, relating to termina-tion of private foundation status, and section 508,regard ing spec ia l ru les fo r g iv ing no t i ce tha t theyare applying for recognition of exempt status,wh i ch a re a l l d i scussed i n t h i s pub l i ca t i on .

An exempt o rgan iza t ion tha t i s o rgan ized in aforeign country and receives a substantial portionof its support from a foreign government is not apr ivate foundat ion.

A fore ign pr iva te foundat ion can have i tsexempt s ta tus terminated for repeated ly engagingin prohibited transactions. A prohibited transactionis an ac t or a fa i lu re to ac t by a fore ign organ iza-t ion tha t , i f engaged in by a domest ic o rgan iza t ion ,would subject the domestic organization to thetaxes and sanctions imposed on private founda-t i ons .

I f a fo re ign pr iva te foundat ion engages in onesuch act or failure to act, and has been warned bythe IRS that a second act or failure to act wouldresult in a prohibited transaction, the second actor fa i lu re to ac t w i l l be cons idered a p roh ib i tedtransaction.

The repeated act or failure to act does not nec-essarily have to be related to the earlier act or fail-ure to act that caused the Service to issue awarn ing.

Any fore ign pr ivate foundat ion whose exempt ionhas been te rminated under the prov is ions out l inedear l ier may reapply for exempt ion by f i l ing a Form1023 in the 2nd tax year fo l lowing the tax year inwh ich exempt ion was den ied.

For fur ther in format ion concern ing fore ignprivate foundations contact the District Director,Internal Revenue Serv ice, Bal t imore, MD 21201.

Chapter IIFiling, Notice,and OtherRequirementsThis chapter discusses the notice requirements,annua l f i l i ng requ i rements , and o ther ac t ions tha tmust be compl ied w i th fo r an organ iza t ion to berecognized as exempt under sect ion 501 (c) (3) .

Filing of Notice

In terna l Revenue Serv ice determined that the trust at the expiration of the income interests.administration of the estate has been unnecessa-

Except for those organizations noted later, any

rily prolonged and the estate is considered termi-Income interest includes an interest in property char i tab le organizat ion organized af ter October 9 ,

nated as of that date for federal income taxtransferred in trust that is in the form of a guaran- 1969, will not be treated as tax exempt unless it

purposes. Henry’s estate will be treated as a split-teed annuity interest or unitrust interest. app l i es fo r recogn i t i on o f exempt ion by f i l i ng a

interest trust between May 24, 1988, and the date Remainder interest includes an interest thatcurrent Form 1023, Application for Recognition of

on which the $10,000 bequest to M is satisfied. succeeds an income interest.Exempt ion, wi th the appropr ia te o f f i ce l i s ted in theInstructions to that form. A user fee must accom-

Henry’s estate will be subject to the private foun- Income beneficiary includes a recipient ofdat ion prov is ions that app ly dur inq that per iod. For

pany Form 1023 i f i t i s f i led before September 30,oavments from a oooled income fund. a recioient 1990. For more in format ion on the soecific fee

exampje, a sale of the house by the estate to anydisqualified person would be an act of self-

of payments from’a charitable remainder annuitytrust, or a recipient of payments from a charitable

appl icab le to your organ izat ion, obta in Form 8718from the IRS Forms Distribution Center for your

dea l ing . remainder un i t rus t . state.

7

An organ iza t ion w i l l no t be t rea ted as taxexempt for any period before it files Form 1023unless it files the form within 15 months from theend o f the month in wh ich i t was organ ized. I f theapp l i ca t i on i s no t t ime ly f i l ed , exempt ion w i l l berecogn ized on ly fo r the per iod fo l lowing rece ip t o fthe app l i ca t i on .

Cer ta in organ iza t ions are no t requ i red to f i leForm 1023. These mclude churches, interchurchorgan iza t ions o f l oca l un i t s o f a church ,conventions or associations of churches, or inte-grated auxiliaries of a church, such as a men’s orwomen’s organization, religious school, missionsociety, or youth group. While there are certainother exceptions to the Form 1023 filing require-ment tha t app ly to sma l l pub l i c char i t i es and tosubord inate organ iza t ions o f a cent ra l o rgan iza t ionthat has a group exemption letter, theseexceptions do not apply to private foundations.

I f an organ izat ion that is requ i red to f i le Form1023 does not comply with the filing requirements,char i tab le con t r i bu t ion deduc t ions w i l l no t beallowed for any gift or bequest made to the organi-zat ion.

Extension of time. An ex tens ion o f t ime fo r f i l i ngForm 1023 may be granted by the key DistrictDirector if your request is submitted before the15month period has passed and you demonstratetha t add i t i ona l t ime i s needed .

If the 15-month period for filing Form 1023 haspassed, an ex tens ion o f t ime to f i l e i t may begranted by the Commissioner of the Internal Reve-nue Service under section 1.9100 of the IncomeTax Regulations if you can show good cause.S ince the 15-month per iod , in wh ich t ime anorgan izat ion must f i le a Form 1023, is f i xed by theregulations, rather than by statute, an extensionmay be granted if the request meets certaincond i t i ons .

The following factors will be taken into accountin de termin ing i f good cause fo r g ran t ing theextension has been shown.

1) Due drligence of the taxpayer.2) Prompt action by the taxpayer.3) Intent of the taxpayer.4) Prejudice to the interests of the government5) Statutory and regulatory objectives.

Specific questions are to be answered for eachof these factors. These questions can be found inRevenue Procedure 79-63, 1979-2 C.B. 578:which is avarlable from the IRS. The informatronand other documents submitted must be specifi-cally responsive and relevant to answering thesequestions.

The in format ion submi t ted by the organ iza t ionshou ld i nc lude a ch rono log ica l accoun t o f t heevents lead ing to the fa i lu re to make theapplication, names and current addresses of eachperson having knowledge or information about theevents, affidavits or statements from suchpersons, and any other information bearing on theService’s consideration of the request. Therequest must be signed under penalties of perjuryby an officer of the organization who hasknowledge of the facts. Supporting affidavits orstatements must also be signed under penalties ofperjury.

The request for an extension must be sent tothe appropriate key District Director.

Appeal ProceduresIf an organization applies for tax-exempt statusand receives an adverse determination letter as totax exemption, classification as to status undersection 509(a) as an organrzation that is not aprivate foundation, classification as a private oper-at ing foundat ion , the organ iza t ion w i l l be adv isedof its riaht to orotest the determination bv reauest-ing Appeals bffice consideration. The protestmust be submitted to the key District Directorwithin 30 days from the date of the adverse deter-mination letter and must state whether it wishesan Appeals Office conference.

8

Any determination letter issued on the basis oftechnical advice from the National Office may notbe appealed to the Appeals Office for thoseissues that were the subject of the technicaladv ice .

I f an app l ica t ion is re fer red to the Nat iona lOffice for issuance of a ruling and an adverseru l ing i s i ssued , the o rgan iza t ion w i l l be in fo rmedof the basis for the conclusion, of its right to file aprotest within 30 days, and for a conference at theNat iona l Of f i ce .

Appeals Office consideration. The protest tothe Appeals Office should be filed with the keyd is t r i c t o f f i ce and con ta in the fo l l ow ingin fo rmat ion :

1)

2)

3)

4)

5)

‘3

The organization’s name, address, andemployer ident i f i ca t ion number ;

A statement that the organization wants topro tes t the determinat ion ;

The date and symbols on the de terminat ionle t te r ;

A statement of facts supporting the organiza-tion’s position in any contested factual issue;

A statement outlining the law or other author-i ty the organ izat ion is re ly ing on; and

A statement as to whether a conference atthe Appeals Office is desired.

The statement of facts (item 4) must bedeclared true under penalties of perjury. This maybe done by add ing to the pro tes t the fo l lowingsigned declaration: “Under penalties of perjury, Ideclare that I have examined the statement offacts presented in this protest and in any accom-panying schedules and statements and, to thebest of my knowledge and belief, it is true, correct,and complete.”

If the organization’s representative submits theprotest, a substitute declaration must be included,s ta t i ng :

1) That the representative prepared the protestand accompanying documents; and

2) Whether the representative knows personallythat the statements of fact contained in theprotest and accompanying documents aretrue and correct.

Be sure the protest contains all of the informa-tion requested. Incomplete protests will bereturned for comple t ion.

I f a con fe rence i s reques ted , i t w i l l be he ld a tthe Appeals Office, unless the organizationrequests that the meeting be held at a districtoffice convenient to both parties.

The Appeals Office, after considering the organ-ization’s protest as well as information presentedin any conference he ld , w i l l no t i f y the organ iza t ionof its decision and issue an appropriate determina-t ion le t te r . An adverse dec is ion may be appea ledto the courts (discussed later).

Appeals offices must request technical advicefrom the Nat ional Of f ice on any exempt organiza-t i on i ssue concern ing qua l i f i ca t ion fo r exempt ionor foundation status for which there is notpublished precedent or for which there is reasonto be l ieve that nonuni formi ty ex is ts . I f an organ iza-tion believes that its case involves such an issue,,it should ask the Appeals Office to request technr-ca l adv ice .

Representation. A principal officer or trusteemay represent an organizat ion at any level o fappeal . Or , the organizat ion may be representedby an a t to rney , cer t i f i ed pub l i c accountan t , o r ind i -vidual enrolled to practice before the Internal Rev-enue Serv ice.

If the organization’s representative attends aconference without a principal officer or trustee,the representative must file a proper power ofat torney or a tax in format ion author izat ion beforerece iv ing o r i nspec t ing con f iden t ia l i n fo rmat ion .Form 2848, Power of Attorney and Declaration

of Representative, or Form 2848-D, Tax Infor-mation Authorization and Declaration of Rep-resentative, as appropriate (or any other properlywritten power of attorney or authorization), may beused for this purpose. These forms may beobta ined f rom the IRS.

Appeal to courts. In addition to administrativeremedies , an organ iza t ion may use cer ta in jud ic ia lremedies. If the statutory prerequisites are met, anoraan iza t ion mav f i l e su i t in a Un i ted S ta tesDistrict Court or the United States Claims Court fora refund of taxes paid, or in the United States TaxCour t fo r a redeterminat ion o f any tax def ic ienc ies .For more information on these tvoes of suits. seePublication 556, Examination o?Returns, ’Appeal Rights, and Claims for Refund. Anexempt organ iza t ion may a lso f i le su i t fo r a dec lar -atory judgment (discussed later) in certain situa-tions. Any of these suits may result in a decisionthat an organization was exempt for the periodconsidered by the court.

I f t he f i na l j ud i c ia l de te rm ina t ion i s t ha t anorganizat ion is exempt f rom tax, is not a pr ivatefoundat ion , o r i s a pr iva te opera t ing foundat ion ,the Serv ice w i l l i ssue a favorab le ru l ing o r de te rmi -nation letter, under the following procedures, pro-v id ing the under ly ing fac ts and app l i cab le law arethe same as in the period considered by the court.

An organ izat ion that had prev ious ly f i led anapp l i ca t ion fo r recogn i t ion o f exempt ion and hasbeen determined to be exempt by the court doesnot need to submi t a new app l i ca t ion . The o rgan i -zation should submit a brief statement that itsactivities are the same as those in the period con-sidered by the court. The statement must bes igned by a p r inc ipa l o f f i ce r . I f t he app l i cab le lawhas not changed, the Service will issue afavorable ruling upon receipt of this statement.

An organ izat ion that had not prev ious ly f i led anapp l i ca t ion fo r recogn i t ion o f exempt ion bu t hasbeen determined to be exempt by the cour t w i l l beissued a ru l ing or de termina t ion le t te r on ly when i tmakes app l ica t ion in the appropr ia te manner . Theapp l i ca t ion shou ld con ta in a s ta tement tha t theorganization’s activities are the same as those inthe period considered by the court.

Declaratory judgments. I f an organ izat ion hasexhaus ted a l l admin is t ra t i ve remed ies , then , incertain cases, the organization may seek a declar-atory judgment from the U.S. Tax Court, the US.Claims Court, or the U.S. District Court for theDis t r i c t o f Co lumb ia . Th is remedy i s ava i lab le fo radverse determinations (or failure by the Serviceto make a determinat ion) on the in i t ia l o r cont inu-ing qua l i f i ca t i on o r c lass i f i ca t i on o f an o rgan iza t i onas an exempt organization under section501 (c) (3) , as an organ izat ion to which a deduct ionfor a contribution is allowed under section170(c)(2), as other than a private foundation undersect ion 509, o r as a pr iva te opera t ing foundat ionunder section 4942(j)(3).

The dec lara tory judgment remedy can be usedon ly a f te r a l l admin is t ra t ive remedies have beenexhausted, or, if the Service has not issued anot ice o f f ina l determinat ion, 270 days haveelapsed since the organization requested a deter-mina t ion as to the i ssue in ques t ion and the o rgan-iza t ion has taken, in a t ime ly manner , a l lreasonable steps to secure such determination.

The administrative remedies that must beexhausted wi th in the In terna l Revenue Serv iceinclude these steps:

The f i l i ng o f a subs tan t i a l l y comp le tedapp l i ca t ion Form 1023 (descr ibed ear l ie r inthis chapter) or the filing of a request for adetermina t ion o f foundat ion s ta tus ;

In the case o f a la te - f i l ed app l i ca t ion , reques t -ing re l ie f under sec t ion 1 .9100 o f the IncomeTax Regu la t ions regard ing app l i ca t ions fo rextensions of time for making an election orappl ica t ion for re l ie f f rom tax ;

The t ime ly submiss ion o f a l l add i t i ona l i n fo r -mat ion requested to per fec t an exempt ion

application or request for determination ofprivate foundation status; and

4) Exhaustion of all administrative aooeals avail-ab le w i th in the Serv ice , i nc lud ing ’p ro tes t o f anadverse ru l i ng in Na t iona l O f f i ce o r ig ina l j u r i s -d i c t i on exempt ion app l i ca t i on cases .

An organization will not be deemed to haveexhausted its administrative remedies beforethe ear l ie r o f :

1) The completion of the steps just listed and thesending by certified or registered mail of anot i ce o f f i na l de te rmina t ion , o r

2) The expiration of the 270-day period in whichthe Service has not issued a notice of finaldeterminat ton and the organizat ion has taken,in a t ime ly manner , a l l reasonab le s teps tosecure a ru l ing or de terminat ion .

The steps described earlier will not be consid-ered comple ted unt i l the In terna l Revenue Serv icehas had a reasonab le t ime to ac t upon the appea lor protest, as the case may be.

A notice of final determination to wh ich thedec lara tory judgment procedures app ly is a ru l ingor determination letter sent bv certified or reais-tered mail that holds the organization is not ”described in section 501 (c)(3) or section 170(c)(2)o f the Code. i s a o r i va te foundat ion as de f ined insection 509(a), is’not a private operating founda-t ion as de f ined in sec t ion 4942( j ) (3 ) , o r i s a pub l i ccharity described in a part of section 509 orsection 170(b)(l)(A) other than the part underwhich the organization requested classification.

The 27kfay period will be considered by theServ ice to bea in on the da te a subs tan t ia l l v com-pleted Form ib23 is sent to the appropriate keyDistrict Director. If the application does notcon ta in a l l o f the reau i red i tems. i t w i l l no t be fu r -ther processed and may be returned to theapp l i can t fo r comp le t ion . The 270- pe r iod , i n th i sevent, will not be considered as starting until thedate the app l i ca t ion i s rema i led to the Serv ice w i ththe requested information, or, if a postmark is notevident, on the date the Service receives asubs tan t i a l l y comp le ted app l i ca t i on .

The followina orocedural /imitations aoolv to asuii

1)

2)

3)

for declaraidry judgment :. I

The pe t i t ion must be f i led by the o rgan iza t ionwhose qualification for exemption or classifi-cation is at issue;

A pet i t ion fo r dec lara tory judgment must befiled with the appropriate court (as specifiedearlier in this discussion) before the 91st dayafter the date on which the internal RevenueServ ice has ma i led a no t i ce o f i t s de te rmina-t ion by cer t i f ied or reg is te red mai l ; andA dec la ra to ry judgment w i l l no t be i ssuedunless the organization has exhausted theadministrative remedies (described earlier)ava i lab le to i t w i th in the IRS.

Classification as Other Than aPrivate FoundationAny organ iza t ion descr ibed in sec t ion 501 (c ) (3) ,regardless of when it was organized, will be pre-sumed to be a private foundation unless it givest ime ly no t i ce to the IRS tha t i t i s no t a p r iva tefoundat ion

The on ly except ions to th is requ i rement app ly tothose organizations that are excepted from filingForm 1023 as stated earlier. Charitable trustsdescribed in section 4947(a)(l) also are excepted.

I f the organ izat ion rece ived a ru l ing or determi -nat ion le t ter f rom the IRS dated before Julv 14.1970. recoanizina its tax-exemot status undersection 50?(c)(3): and did not ile Form 4653, Noti-f i ca t ion Concern inq Foundat ion S ta tus , beforeMarch 22, 1973, the organizat ion is presumed tobe a pr iva te foundat ion . Th is p resumpt ion is rebut -tab le ; and i f the o rgan iza t ion i s , i n fac t , one asdescribed in section 509(a)(l), (2) (3), or (4) of

the Internal Revenue Code, it is not a private foun-dation However, for the Service to recognize thatsuch an organ iza t ion is no t a pr iva te foundat ion ,the organization must establish that status bysending a request for a determination to theDistrict Director.

Any organizatron seeking tax-exempt statusunder section 501 (c)(3) and classification as otherthan a p r i va te founda t ion shou ld f i l e i t s no t i ce bysending a completed and signed Form 1023 andprovide informatron that it is not a private founda-t ion .

The not ice may not be re l ied on by the organ i -zation or by grantors or contributors until the IRSnot i f ies the o rgan iza t ion tha t i t i s no t a p r iva tefoundat ion .

Statement that an organization is an operatingfoundation. Any organ izat ion that is app ly ing forrecogni t ion o f exempt ion under sect ion 501 (c) (3)may submi t in fo rmat ion tha t i t i s an opera t ingfoundat ion .

The opera t ing founda t ion shou ld inc lude thefo l l ow ing :

1) Necessary supporting information to confirmthe determinat ion , and

2) A written declaration by the principal officer,manager, or authorized trustee that there is areasonable basis in law and in fact that theorgan iza t ion is an opera t ing foundat ion , andthat to the best of the knowledge and belief ofthe officer, manager, or trustee, the informa-tion given is complete and correct.

The not ice may not be re l ied upon by the organ-ization or by its grantors or contributors until theIRS not i f ies the organ iza t ion tha t i t i s no t a p r iva tefoundat ion .

Additional information on applying for recogni-t ion o f exempt ion and not i f i ca t ion o f nonpr iva tefoundat ion s ta tus may be found in Pub l i ca t ion 557 ,Tax-Exempt Status for Your Organization.

Governing InstrumentsA pr ivate foundat ion cannot be tax exempt nor wi l lcontributions to it be deductible as charitable con-tributions unless its governing instrument containsspecial provisions in addition to those that gener-a l ly app ly to sect ion 501 (c ) (3) organ izat ions.These special provisions, generally, must requireor prohibit, as the case may be, the foundation toac t o r re f ra in f rom ac t ing so tha t i t w i l l no t be l i ab lefor the taxes imposed by sections 4941,4942,4943, 4944, and 4945, discussed later in thispublication. Specific reference to these sectionsgenera l ly must be inc luded in the govern inginstrument, unless equivalent language is usedthat is considered by the IRS to have the same fullforce and effect.

A private foundation’s governing instrument willbe considered to have been amended to conformto this requirement if valid provisions of state lawhave been enacted that :

1) Require the foundation to act or refrain fromact ing so tha t i t w i l l no t be l i ab le fo r any o f thetaxes imposed on the prohibited transactionsdiscussed later, or

2) Treat the required provisions as though theywere contained in the foundation’s governingins t rument .

The IRS pe r iod i ca l l y upda tes a pub l i shed l i s t o fstates with these statutes. Contact your keyDistrict Office for this information.

The following samples of governing instrumentprovisions meet the special charter requirementsthat apply to private foundations. Draft A is asample of provisions in articles of incorporation;Draft B, a trust indenture.

Draft AGeneral

1)

2)

3)

4)

5)

The co rpora t ion w i l l d i s t r i bu te i t s i ncome fo reach tax year at such time and in suchmanner so that it will not become subiect tothe tax on und is t r ibu ted income imposed bysection 4942 of the Internal Revenue Code, orcorresponding provisions of any later federaltax laws.

The corpora t ion w i l l no t engage in any ac t o fse l f -dea l ing as de f ined in sec t ion 4941 (d ) o fthe Internal Revenue Code, or correspondingprovisions of any later federal tax laws.The corooration will not retarn anv excessbusiness holdings as defined in section4943(c) of the Internal Revenue Code, or cor-responding provisions of any later federal taxlaws .The corpora t ion w i l l no t make anyinvestments in a manner that would subject itto tax under section 4944 of the Internal Rev-enue Code, or corresponding provisions ofany la ter federa l tax laws.The corpora t ion w i l l no t make any taxab leexpenditures as defined in section 4945(d) ofthe Internal Revenue Code, or correspondingprovisions of any later federal tax laws.

Draft BAny other provisions of this instrument notwith-standing, the trustees will distribute its income foreach tax year at such time and in such manner sothat it will not become subject to the tax on undis-tributed income imposed by section 4942 of theInternal Revenue Code, or corresponding provi-sions of any later federal tax laws.

Any other provisions of this instrument notwith-standing, the trustees will not engage in any act ofse l f -dea l ing as de f ined in sec t ion 4941 (d ) o f theInternal Revenue Code, or corresponding provi-sions of any later federal tax laws; nor retain anyexcess business holdings as defined in section4943(c) of the Internal Revenue Code, or corre-sponding provisions of any later federal tax laws;nor make any investments in a manner that wouldincur tax l iab i l i t y under sec t ion 4944 o f the In terna lRevenue Code, or corresponding provisions ofany later federal tax laws; nor make any taxableexpenditures as defined in section 4945(d) of theInternal Revenue Code, or corresponding provi-sions of any later federal tax laws.

Return RequirementsAl l p r i va te foundat ions ( inc lud ing nonexemptpr iva te foundat ions , and nonexempt char i tab letrusts described in section 4947(a)(l) of the Codehaving no taxable income for the tax year thatthey are treated as private foundations) arerequi red to f i le an annual re turn on Form 990-PF,Return o f Pr iva te Foundat ion. I f your organizat ionhas an app l i ca t ion fo r recogn i t ion o f exempt ionpending wi th the IRS, and you acknowledge thatyour organizat ion is a pr ivate foundat ion, youshou ld f i l e th i s re tu rn .

Split-interest trusts described in section4947(a)(2) of the Code must file Form 5227, Sp/it-Interest Trust lnformafion Return, instead of filingForm 990-PF.

When to file. Form 990-PF must be filed by the15th day o f the 5 th month fo l low ing the c lose o fthe o rgan iza t ion ’s account ing per iod .

I f the foundat ion is on a ca lendar year , o r i f i thas no established accounting period, the returnwi l l be due May 15 each year.

For a comp le te l i qu ida t ion , d i sso lu t ion , o r te rm i -nat ion, the re turn must be f i led by the 15th day o fthe 5 th mon th fo l l ow ing comp le te l i qu ida t i on , d i s -so lu t ion , o r te rmina t ion .

Form 5227 must be f i led by the 15th day of the4th month following the close of the trust’s taxyear.

Where to file. Form 990-PF or Form 5227, ifapp l i cab le , shou ld be f i l ed w i th the In te rna l Reve-nue Service Center listed in the instructions forthese forms.

Failure to file timely. If an organization fails tofile Form 990-PF by the due date (taking intoaccount any extensions granted), it will have topay $10 for each day the return is late, not toexceed the lesser of $5,000 or 5% of the organi-zation’s gross receipts, unless it can show that thefailure was due to reasonable cause. The IRS maymake wr i t ten demand that the de l inquent re turnbe f i led w i th in a reasonab le t ime a f te r the da te o fmai l ing the demand. I f the organ iza t ion does notf i l e bv the da te spec i f ied in the demand. theperson or persons responsible for the failure to filewi l l be sub jec t to a pena l ty o f $10 a day fo r eachdav a f te r the da te spec i f ied in the no t ice tha t thereturn is not filed unless it is shown that the failureto f i l e i s due to reasonab le cause . The to ta lamount imposed on all persons responsible forthe fa i l u re to f i l e i s l im i ted to $5 ,000 . The pena l t yi s a lso app l i cab le to a fa i lu re to p rov ide in fo rma-t ion requi red by the return, or a fa i lure to prov idecor rec t in fo rmat ion .

Public inspection. All the information reoortedon Form 990-PF, including attachments, will bemade ava i lab le bv the IRS fo r pub l i c i nspec t ion ,except any information the release of which wouldadverselyaffect the national defense, or informa-tion that the IRS determines relates to anv tradesecret, patent, process, style of work, or appara-tus o f the organ iza t ion .

In these cases, the organization must submit astatement, marked “Not Subject to PublicInspection,” identifying which items are to be with-held and the reasons. The schedule of contribu-to rs w i l l be ava i lab le fo r i nspec t ion on ly in thecase of private foundations.

In add i t ion , Form 990-PF must be made ava i l -ab le by the foundat ion manager fo r pub l icinspec t ion a t the ma in o f f i ce o f the founda t ion . I fthe founda t ion has no ma in o f f i ce , o r i f t he ma inoffice is in a personal residence, the manager maymake the re tu rn ava i lab le fo r pub l i c inspec t ion a tan appropriate substitute location or by furnishinga copy free of charge (including postage and cop-ying) to persons who request inspection.

The re turn must be ava i lab le dur ina reau lar bus-iness hours for inspection by any citiien iponrequest made within 180 days after the date of thepub l i ca t i on o f no t i ce o f i t s ava i l ab i l i t y . The no t i cemust be pub l ished in a newspaper hav ing genera lc i r cu la t ion in the coun ty in wh ich the founda t ion ’smain o f f i ce is loca ted , no la te r than the day pre-scribed for the filing of the return. The notice muststa te tha t the annua l re tu rn i s ava i lab le a t thefoundation’s main office for inspection during reg-ular business hours by any citizen who requestsinspection within 180 days after the date ofpublication, and must state the address and tele-phone number o f the foundat ion ’s ma in o f f i ce andthe name o f i t s p r inc ipa l manager . A copy o f th isno t i ce and p roo f o f pub l i ca t ion mus t be f i l ed w i ththe annual return. Proof of publication may consisto f a copy o f t he no t i ce as pub l i shed , a long w i th as ta tement s igned by a foundat ion manager say ingtha t the no t i ce was pub l i shed and l i s t i ng the da teo f pub l i ca t i on and the name o f t he pub l i ca t i on i nwh ich the no t ice appeared.

Penalty for failure to comply. I f the annualre tu rn i s no t made ava i lab le fo r pub l i c inspec t ionon the date and in the manner prescribed, theperson or persons responsible for failing to meetthe pub l i c i t y requ i rements w i l l be l i ab le fo r a pen-a l ty o f $10 a day for each day that the fa i lure con-tinues, not to exceed $5,000, unless the failure isdue to reasonab le cause. In add i t ion , when thefa i lu re to comply w i th the pub l i c i t y requ i rements i swillful, the person or persons responsible for thefa i lu re w i l l be l iab le fo r a pena l ty o f $1 ,000 fo reach return.

Listing of states. A private foundation isrequired to attach to its Form 990-PF a list of allstates:

1 0

1)

2)

To which the organization reports in any fash-ion concerning its organization, assets, oractivities, or

With which the organization has registered (ornot i f ied in any manner ) tha t i t in tends to be, o ris , a char i tab le organ iza t ion or a ho lder o fproperty devoted to a charitable purpose.

Providing copies to state officers. T h e founda-tron managers of a private foundation (except cer-tain forergn organizations) must provide a copy ofthe annual return to the Attorney General of:

1) Each state listed on the Form 990-PF,

2) The state in which the main office of the foun-da t i on i s l oca ted ,

3) The state in which the foundation was incor-porated or created, or

4) Any state that requests it.

The annual return must be sent to the AttorneyGeneral of these states at the same time it is filedwith the Internal Revenue Service. A copy of theForm 4720, i f any, f i led by the foundat ion for theyear must be attached to each copy of the annualreturn sent to state officers.

Form 4720. Return of Certain Excise Taxes onChar i t i es and Other Persons Under Chapters 4 1and 42 of the internal Revenue Code, is intendedprimarily for use with Form 990-PF and providesfor f igur ing and repor t ing the in i t ia l taxes imposedunder sections 4941,4942,4943,4944, and 4945on pr iva te foundat ions, foundat ion managers , anddisqualified persons. These sections arediscussed in Chapters VI through X of thispub l i ca t i on .

Paying the tax and f i l ing Form 4720 are requi redfor each year (or part of a year) in the taxableperiod applicable to the act or investment. Gener-a l ly , the taxab le per iod beg ins w i th the date o f theact or investment and ends on the earlier of thedate a no t i ce o f de f i c iency fo r the in i t i a l t ax i smailed, or the date the initial tax is assessed.

When to file. Genera l ly , Form 4720 must be f i ledby the due date for f i l ing Form 990-PF or 5227.Foundation managers and disqualified persons,whose tax Years end on the same date as that ofthe foundation, who are liable for taxes describedin Chapters VI through X, and who file separatereturns, must file their returns by the due date forfiling Form 990-PF or 5227 by the private founda-tion with respect to which they are liable for tax.However, the Form 4720 of a person whose taxyear ends on a date other than that of the founda-tion’s must be filed by the 15th day of the 5thmonth following the close of that person’s taxyear. The IRS may, in some cases, require imme-dia te f i l ing o f Form 4720 and immedia te paymentof tax by pr ivate foundat ions, foundat ion manag-ers, and disqualified persons at an earlier datedur ing the foundat ion ’s tax year .

Where to file. Form 4720 is filed at the sameplace as specified for filing Form 990-PF.

Other returns that may be required for trustsdescribed in section 4947. Forms 1041 and1041-A are not required to be filed by organiza-t ions that are exempt under sect ion 501 (a) , butthey may be requi red to be f i led by cer ta in nonex-empt trusts described in section 4947. Form 1041is reau i red to be f i l ed bv a l l nonexemot char i tab letrusts having gross income of $600 for the year,unless they owe no tax. Split-interest trusts havinggross income of $600 must file Form 1041 exceptfor charitable remainder trusts described insection 664. Charitable remainder trusts must fileForm 1041 as an attachment to Form 5227 if thev

’have unrelated business taxable income. Form1041 -A must be filed by split-interest trusts(including trusts described in section 664) that arenot required under their governing instruments tod is t r ibu te a l l o f the i r income annua l l y .

When to file. The returns must be filed by the15th day o f the 4 th month fo l low ing the c lose o fthe trust’s tax year.

Where to file. The re tu rns shou ld be f i l ed w i ththe appropriate Internal Revenue Service Centerlisted in the form instructions.

Extensions. A foundation may file applicationForm 2758 to request an extension of time to fileits return(s).

Reasonable cause for failure to file or pay tax.An organ iza t ion tha t i s in fac t a p r iva te foundat ionwill be considered to have reasonable cause forfa i lu re to meet the or iva te foundat ion f i l i ng andpayment requirements until 90 days after it isissued a le t te r f rom the Serv ice no t i f v ing i t o f thedetermination of private foundation status or adeterminat ion that the organ izat ion cannot rea-sonab ly be expected to be a pub l ic char i ty . Inorder for the organization not to be subject to thepenal t ies for fa i lu re to f i le or pay tax , the organ iza-t ion must have f i led Form 1023, c la iming no t to bea pr iva te foundat ion, before the due date for f i l ingForm 990-PF. By the end of the go-day period,the organization must file all the necessary returnsfor the pr io r years and pay a l l taxes due, inc lud inginterest. A statement explaining the basis for rea-sonab le cause fo r fa i l u re to f i l e t ime ly shou ld beattached to the returns. Revenue Procedure 79-8,1979-l C.B. 487, should also be cited in thesta tement .

Chapter IIITermination ofPrivate FoundationStatusOnce an organizat ion is determined to be a pr ivatefoundation, its status may be terminated onlyunder the provisions of section 507 of the Code.Under section 507, an organization’s status as apr ivate foundat ion may be terminated vo luntar i lyor involuntar i ly .

If the organization’s status is terminated eithervoluntar i ly or invo luntar i ly under sect ion 507(a) ,the organizatron becomes liable for tax undersection 507(c). After assessment is made, it ispossible to have the tax abated by the IRS if cer-tain actions, discussed later, are taken.

An organ izat ion may vo luntar i ly terminate i tsstatus under section 507(b)(l) and not be subjectto tax under section 507(c). This is often a majorconsideration for organizations considering a vol-untary terminat ion.

Termination underSection 507(a)Voluntarv termination. To voluntarily terminateunder se&ion 507(a)(l), the organization mustsend a statement to its District Director of itsintent to terminate its status under section507(a)(l). The statement must provide, in detail,the computat ion and amount o f tax imposed undersection 507(c). Unless the organization requestsabatement , i t must pay the tax a t the t ime thes ta tement i s f i l ed . The organ iza t ion may reques tabatement o f a l l the tax imposed under sec t ion507(c), or it may pay part of the tax and requestabatement o f the unpaid par t . However , i f theorganization’s request for abatement is denied,the organ izat ion must pay the tax in fu l l whennot i f ied by the Serv ice tha t the tax w i l l no t beabated.

Terminat ion o f p r iva te foundat ion s ta tus undersection 507(a)(l) will not relieve the foundation, orany d isqua l i f ied person, o f any l iab i l i t y fo r Chapter42 excise taxes (the taxes described in ChaptersVI th rough X o f th i s pub l i ca t ion ) .

I f an organ iza t ion that has terminated i ts pr iva tefoundation status under section 507(a) continuesin operation and wishes to be treated as a charita-b le , educa t i ona l , r e l i g i ous , sc ien t i f i c , e t c . , o rgan i -zat ion, i t must app ly for appropr ia te exempt ionrecogn i t ion . See Sta tus o f o rgan iza t ion a f te r termi-na t ion o f p r i va te foundat ion s ta tus in Chapter I.

Notice to the public. The Internal RevenueServ i ce w i l l oub l i sh i n t he internal RevenueB u l l e t i n any ’not ice i t rece ives o f vo luntary termina-tion under section 507(a)(l) (or any notice itissues of involuntary termination oi exempt status,discussed later).

No termmatron can take place under section507(a)(l) if the private foundation transfers all orpart of its assets to another private foundation orto one or more private foundations and to one ormore section 509(a)(l), (2) (3) or (4) organiza-t ions , under a l iqu ida t ion , merger , redempt ion ,recap i ta l i za t ion , o r o ther ad jus tment , o rgan iza t ion ,or reorganizat ion.

Transferee liability. A termination under section507(a) does not result from either a transfer of allits assets or a significant disposition of its assets(defined later) by a private foundation unless rtchooses to terminate under section 507(a)(l), oran invo luntary terminat ion occurs . I f a pr iva tefoundat ion incurs any l iab i l i t y fo r the Chapter 42excise taxes before or in connection with thetrans fer , t rans feree l iab i l i t y may be app l ied aga ins tthe transferee organization for payment of thosetaxes. Liability for Chapter 42 excise taxes is con-sidered to be incurred on the date the act or fail-ure to act occurs that gives rise to the initial taxliability.

A private foundation that transfers all of its netassets must file Form 990-PF, Return of PrivateFoundat ion. However, ne i ther a pr ivate foundat ionnor its managers are requrred to file this form forany tax year after the tax year in which the lasttransfer occurs if during those later years the foun-dat ion has ne i the r lega l no r equ i tab le t i t l e to anyassets nor engages in any activity.

Section 507(c) tax. The tax imposed undersection 507(c) on the termination of a privatefoundation is the lesser of:

1) The combined tax benefit resulting from thesection 501 (c)(3) status of the organization, or

2) The value of the net assets of theorganizat ion.

The combined tax benefit resu l t ing f rom thesection 501 (c)(3) status of any private foundationis the sum of:

The combined increases in income, estate,and gift taxes that would have been imposedon all substantial contributors if deductionsfor all contributions made by those contribu-tors to the foundation after February 28, 1913,had been d isa l lowed, andThe comb ined inc reases in income tax tha twould have been imposed on the pr ivatefoundation’s income for tax years beginningafter 1912 if -a) The foundat ion had not been tax exempt ,

a n db) In the case of a trust, its charitable deduc-

t ion had been l im i ted to 20% o f i t s taxab leincome, and

Amounts received from private foundations towh ich t rans fe ree l i ab i l i t y app l ies , andThe interest on the tax increases in (1) (2)and (3) from the first date the increase wouldhave been due or payable to the date theorganization ceases to be a privatefoundat ion .

In f igur ing the combined inc reases in tax under(l), all deductions for a particular contribution forincome, estate, or gift tax purposes must beinc luded. For example , i f a subs tan t ia l con t r ibu to rhad taken income tax and gift tax deductions for achar i tab le con t r ibu t ion to the foundat ion , theamount o f each deduc t ion mus t be inc luded . Thecombined tax benef i t may be more than the fa i rmarket value of the property transferred.

The value of the net assets of the organizat ionis the greater o f :

1) The value on the first day action was taken toterminate private foundation status, or

2) The va lue on the date the organizat ionceased to be a pr iva te foundat ion .

The va lua t ion da te in (1 ) i s the da te the o rgan i -zat ion gave not ice i t was terminat ing pr iva te foun-dation status.

When tax is imposed. These same dates deter-mine when l iab i l i t y fo r the sec t ion 507(c ) tax i simposed because a transfer of assets by a privatefoundat ion is invo lved.

Substantial contributors. See Chapter V for thedefinition of what is a substantial contributor.

Abatement of section 507(c) taxes. Theunpaid part of section 507(c) tax can be abated bythe IRS i f :

The private foundation distributes all of its netassets to one or more charitable organiza-tions described in section 509(a)(l) that havebeen in existence and so described for atleast 60 months, orThe Service receives effective assurancethrough corrective action taken in state pro-ceedings that assets dedicated to charitablepurposes will, in fact, be used for charitablepurposes.

Corrective action in state proceedings. Thesection 507(c) tax may be abated by the IRS if,within a year from the date of issuing a notice ofdeficiency for that tax, an appropriate state officercertifies that corrective action has been initiatedunder state law under court order or approval.

Corrective action is the vigorous enforcementof state laws sufficient to assure implementationof the excise tax provisions of Chapter 42 and toinsure that foundation assets are preserved forcharitable purposes.Involuntary termination. An organization’s sta-tus may be invo luntar i l y te rminated i f the IRSnot i f i es the o rgan iza t ion tha t , because o f w i l l f u l ,flagrant, or repeated acts or failures to act givingrise to the Chapter 42 excise taxes, the organiza-tion is liable for section 507(c) tax.

Willful repeated acts are at least two acts or fail-ures to act which are voluntarily, consciously, andknowing ly commi t ted in v io la t ion o f the exc ise taxprovisions of Chapter 42, and which appear to areasonable person to be a gross violation of theseprovisions. The act or failure to act may result intermination of the foundation’s status even thoughthe tax is imposed on the foundation’s managersrather than on the foundation itself. Furthermore,the failure to correct the act or acts (or failure orfailures to act) that gave rise to excise tax liabilityunder Chapter 42 may cause involuntary termina-t ion o f the pr iva te foundat ion . No mot ive to avo idlegal restrictions or incur tax is necessary to makethe act or failure to act willful. However, a founda-tion’s act or failure to act is not willful if the foun-dation or its manager, if applicable, does not knowthat the act or failure to act is an act of selfdea l ing , a taxab le expend i tu re , o r o ther ac t o r fa i l -u re to ac t g iv ing r i se to l i ab i l i t y fo r exc ise taxes .

In the case o f an invo luntary te rminat ion ,section 507(c) tax is computed in the samemanner as for voluntary terminations. However, indetermining the value of net assets of the founda-tion on the first day action was taken to terminateprivate foundation status, the valuation date is thedate a w i l l fu l ahd f lag ran t ac t , fa i lu re to ac t , o rseries of repeated acts or failures to act firstoccurred.

Although the section 507(c) tax resulting froman involuntary terminat ion may be abated (seeAbatement of section 507(c) taxes earlier), this isnot t rue fo r any exc ise tax l iab i l i t y a t t r ibu tab le tothe acts or failures to act that caused the involun-tary terminat ion.

Voluntary Terminationunder Section 507(b)(l)A pr iva te foundat ion may vo luntar i ly terminate i tsstatus under section 507(b)(l) by eithertransferring all its net assets to one or more public

charities, or by meeting the requirements ofsections 509(a)(l), (2) or (3) continuously for 60months beginning with the first day of any taxyear. Private foundation status may not be termi-nated under either of these methods if there havebeen either willful repeated acts (or failures to act)or a w i l l fu l and f laaran t ac t fo r fa i lu re to ac t ) tha tgives rise to liabiliry for excise taxes on transac-tions discussed in Chapters VI through X, knownas “Chapter 42” excise taxes.

Transfer of Assetsto a Public CharityA private foundation may terminate its statusunder section 507(b)(l)(A) by distributing all its netassets to one or more organizations with a rulingor determination letter described in section509(a)(l). However, the organization to which thedis t r ibu t ion i s made must have been in ex is tenceand so described for a continuous period of atleast 60 months before the distribution.

A d is t r ibu t ion to a pub l i c char i t y fo rmed f rom theconsolidation of two public charities, for the samepurpose and with the same activity, each of whichwould have met the 60-month existence require-ment , had they no t conso l ida ted , i s a qua l i f y ingd is t r i bu t i on .

A private foundation that terminates its status incompliance with section 507(b)(l)(A) is notrequ i red to not i fy the IRS o f i t s in ten t to te rminate .

An o rgan iza t ion w i l l have d is t r ibu ted a l l i t s ne tassets only if it transfers all of its right, title, andinterest in, and to, all of its net assets.

An oraanization that continues in existence aftertermina<ng its private foundation status undersection 507(b)(l)(A) must file a new application onForm 1023 in order to be treated as a section501 (c ) (3) o rgan iza t ion , un less i t i s a type o f o rgan i -za t ion tha t i s no t requ i red to f i l e Form 1023. A l i s tof these types of organizations can be found inPublication 557, Tax-Exempt Status for YourOrgan iza t ion .

Operation as a Public CharityAn oraanizat ion mav terminate i ts or ivate founda-tion sTatus under section 507(b)(l)(B) if it meetsthe requirements of section 509(a)(l), (2) or (3)for a cont inuous 60-month per iod beg inn ing w i ththe first day of any tax year, and notifies its DistrictDirector before the beginning of the 60-monthper iod tha t i t i s te rmina t ina i t s p r i va te foundat ionstatus. Also, it must establish immediately afterthe end of the 60-month period that it has met therequirements of section 509(a)(l), (2) or (3).

Notification to the Service by a foundationthat it is terminating under section 507(b)(l)(B)does not constitute notice of a section 507(a) ter-mina t ion even i f the foundat ion fa i l s to meet therequirements of section 507(b)(l)(B). However, asuccessful section 507(b)(l)(B) termination willincur no tax under section 507(c) and, therefore,wi l l requi re no abatement o f tax.

Notice of termination. The notice of termina-t i on shou ld i nc lude :

1) The name and address of the privatefoundat ion ,

2) Its intention to terminate its private foundationstatus,

3) The Code section under which it seeks classi-fication (section 509(a)(l), (2) or (3)),

4) If section 509(a)(l) applies, the specific typeof section 170(b)(l)(A) organization for whichit seeks classification,

5) The date its regular tax year begins, and6) The date the 60-month period begins,

Effect of satisfaction of termination require-ments. I f the organizat ion meets the requi re-ments of section 507(b)(l)(B) during thecontinuous 60-month period, it will be treated as asection 509(a)(l), (2) or (3) organization for theent i re go-month per iod.

1 1

Failure to meet 60-month requirements. Gen- investment income durina the 60-month termina- does not meet the definition of a substantial con-erally, any organization that does not meet section507(b)(l)(B) termination requirements during the60-month period will be treated as a private foun-dation for the entire 60-month period. Any grantsor con t r ibu t ions made to such an o rgan iza t ion w i l lbe treated as contributions made to a privatefoundat ion .

However, the organization will be treated as asection 509(a)(l), (2) or (3) organization for anytax year or years that the requirements are met.Any grants or contributions to the organizationdurina such vear or vears will be treated as madeto a section 509(a)(i), (2) or (3) organization andthe o rgan iza t ion i t se l f w i l l no t be sub jec t to Chap-ter 42taxes and restrictions for such year oryears.

In determin ing whether an organizat ion meetssection 509(a)(l), (2), or (3) requirements for anyyear in the 60-month per iod, the organ izat ion wi l lbe treated as if it were a new organization with itsfirst tax year beginning on the date the go-monthper iod beg ins .

Advance rulings for 60-month terminations.An o rgan iza t ion wh ich f i l es the no t i f i ca t ionrequired for a go-month terminat ion may rece ive,a t the d iscre t ion o f the Serv ice , an advance ru l ingthat the organization can reasonably be expectedto terminate its private foundation status over the60-month period.

To rece ive an advance ru l ing , the organ izat ionmust also agree to an extension of time to assessthe section 4940 tax on net investment income(discussed in Chapter IV) for the years in the60-month terminat ion per iod. I f an organ izat ionagrees to the ex tens ion and i t i s accep ted , i t w i l lnot have to oav the tax on net investment incomedur ing the G&month per iod . The s igned and da tedaqreement Form 872, Consent to Extend the Timet6Assess Tax, should be filed with the request forthe advance ruling. The assessment period for allyears in the termination period must be extendedto 4 years, 4 months and 15 days after the end ofthe las t year in the go-month terminat ion per iod .

The dec is ion to g ran t a favorab le ru l ing w i l l bebased on the facts and circumstances, taking intoaccount organizational structure, proposed pro-grams and activities, intended methods of opera-tion, and projected sources of support.

Grantors or contributors to an organizationthat has obta ined a favorab le advance ru l ing mayre ly on tha t ru l ing un t i l no t i ce o f revoca t ion i spub l i shed in the internal Revenue Bul le t in . How-ever, a grantor or contributor may not rely on sucha ruling if the grantor or contributor was responsi-b le fo r . o r aware o f . the ac t ion or inac t ion tha tresu l ted in the o rgan iza t ion ’s fa i lu re to meet therequirements of section 509(a)(l), (2) or (3) orknew that the Service had r&tied the organiza-tion that its advance ruling would be revoked.

A potential grantee organization may requestan advance ru l ing before rece iv ing a grant or con-t r ibu t ion , to the e f fec t tha t the grant o r cont r ibu t ionw i l l no t resu l t i n the g ran tee ’s fa i l i ng to mee tsection 509(a)(l), (2). or (3) requirements. Theru l ing request may be f i led ‘by the grantee organ i -zation with its District Director. If a favorable rulingis issued, the grantor or contributor may rely uponi t .

However , an advance ru l ing may not be re l iedupon by the organ iza t ion obta in ing that ru l ing . I ft he o rgan i za t i on l a te r f a i l s t o comp le te asuccessful termination under section 507(b)(l)(B)and was not a section 509(a)(l), (2) or (3) organi-zat ion , i t w i l l have to pay in teres t on the amount o ftax imposed on net investment income undersection 4940 that is unpaid as of the last date forpayment of that tax. However, since the failure topay the tax during the go-month period (or beforerevocat ion o f the ru l ing) i s due to reasonab lecause, no penalty will be assessed.

Organizations without advance rulings. Anorganizat ion that does not rece ive an advanceru l ing does not have to pay the tax on net

1 2

tion period if it signs the consent to extend theassessment period for the tax. The same rulesregard ing in teres t and pena l t ies app ly i f the organ-ization does not comolete a successful termina-tion of its private foundation status under section507(b)(l)@).

Transferee FoundationsSection 507(b)(2)The transfer of assets of a private foundation toanother pr iva te foundat ion in a l iqu idat ion , merger ,recap i ta l rza t ion , redempt ion, or o ther ad jus tment ,o rgan iza t ion , o r reorgan iza t ion is a sec t ion507(b)(2) transfer. A transfer under this sectionwill not cause the transferee to be treated as anewly created organization for purposes of theprivate foundation provisions. However, thetransferee may be required to reapply forexemption if it wishes to be exempt under section501 (c)(3) of the Code.

The term “other adjustment, organization, orreorgan iza t ion” inc ludes any par t ia l l i qu ida t ion , o rany other significant disposition of assets (definedlater), to one or more private foundations, otherthan transfers for full and adequate considerationor distributions out of current income (includingqua l i f y ing d is t r ibu t ions ou t o f cur ren t and ear l ie ryears’ undistributed income).

A transferee organization will succeed to thecombined tax benefit of the transferor organizationto the ex ten t o f the combined tax benef i t mu l t i -p l ied by a f rac t ion . The numera tor o f the f rac t ion isthe fair market value of the assets (minusencumbrances) transferred, and the denominatoris the fair market value of the total assets of thetransferor (minus encumbrances) immediatelybefore the transfer. Fair market value is deter-mined as of the time of the transfer. A transfereeorgan iza t ion not e f fec t ive ly cont ro l led , d i rec t ly o rindirectly, by the same person or persons whocontrol the transferor organization will notsucceed to a combined tax benefit greater thanthe fair market value of assets transferred at thetime of the transfer.

Example. In a l iqu ida t ion , the Whi te Founda-tion. a orivate foundation. transfers to the OakFoundation, a private foundation, all of its assets,which have a fair market value of $400,000. Imme-diately before the transfer the White Foundation’scombined tax benefit was $200.000. and the OakFoundation’s combined tax benefit was $300,000.After the transfer, the Oak Foundation has acombined tax benef i t o f $500,000 ($200,000+$300,000).

Except as otherwise provided in Transfer to anef fec t i ve /y con t ro l l ed founda t ion la ter , a pr ivatefoundat ion must meet the d is t r ibu t ion requ i re -ments described in Chapter VII for any year inwhich it makes a section 507(b)(2) transfer of allor part of its net assets to another private founda-t ion . The t rans fe r i t se l f w i l l be coun ted as a qua l i -f y ing d is t r ibu t ion i f i t meets the requ i rements g ivenin Chapter VII. However, when the transferor hasdisposed of all its assets, the recordkeepingrequ i rements w i l l no t app ly to any per iod in wh ichit has no assets:

Whenever a private foundation makes a section507(b)(2) transfer of all or part of its net assets toanother p r iva te foundat ion ; the app l icab le t imeper iod descr ibed in Chap te r X w i l l i nc lude therespective holding periods of both the transferorand the transferee. Exceot as otherwise orovidedin Transfer to an effectivkly controlled fob-tdation,the provisions of Chapter VI will not apply to thetransferee or to the transferor for any expenditureresponsrbility grants as discussed in Chapter VImade by the t ransferor dur ing any per iod in whichthe transferor has no assets. However, the infor-mation reporting requirements described in Chap-ter V I remain in e f fec t .

A substantial contributor of the transferor foun-dation will be considered a substantial contributorof the t ransferee organizat ion even i f the ind iv idua l

tributor with respect to the transferee organization.With respect to the transferor foundation, aoerson is a substantial contributor if the oersoncontr ibuted or bequeathed an aggregate amountof more than $5,000 to the foundat ion, prov idedthat the amount contributed is more than 2% ofthe to ta l cont r ibu t ions rece ived by the foundat ionbefore the close of the taxable year in which thecontribution or bequest is received by the founda-tion. See Chapter V for a discussion of the term“substantial contributor.”

A lso , i f a p r i va te founda t ion incurs a l i ab i l i t y fo rany excise taxes discussed in Chapters VI throughX of this publication either before a transfer or asa result of a transfer of assets, then the transfereefoundat ion w i l l be cons idered to have rece ived theassets subject to the tax to the extent that thetransferor foundation does not satisfy the liability.

Transfer to an effective/y controlled founda-tion. If a private foundation transfers all of its netassets to one or more private foundations that areef fec t ive ly cont ro l led , d i rec t ly o r ind i rec t ly , by thesame person or persons who effectively controlledthe transferor private foundation, then thetransferee foundation is treated as if it were thetransferor for purposes of all excise taxesdiscussed in this publication as well as the termi-nation provisions discussed in this chapter. Whenproportionality is appropriate, the transferee foun-dation will be treated as if it were the transferor inthe proportion that the fair market value of theassets transferred (minus encumbrances) bears tothe fair market value of the assets (minusencumbrances) of the transferor immediatelybefore the transfer. This does not relieve thetransferor pr iva te foundat ion f rom f i l ing requ i redreturns, reports, and other information.

Example. The trustees of X charitable trust, apr ivate foundat ion, form Y, a char i tab le corpora-t ion , a lso a pr iva te foundat ion , to make theconduct of their activities easier. The trustees of Xare also the directors of Y. Y has the same chari-table purposes as X. All the assets of X are trans-ferred to Y, and Y continues to carry on X’scharitable activities. Under these circumstances, Yis t rea ted as i f i t were X . Y w i l l be permi t ted totake advantage of any special rules relating toexcise tax requirements to the same extent ascou ld X i f X had con t inued in ex i s tence .

Status of transferee organization undersection 507(b)(2). A transfer of assets underany l iqu idat ion, merger , redempt ion, recapitaliza-t ion, or o ther ad justment , organizat ion, or reorgan-iza t ion to an organ iza t ion o ther than a char i tab le ,educa t iona l , re l i g ious , sc ien t i f i c , e t c . o rgan iza t i on(other than an organ izat ion engaged in tes t ing forpublic safety) or a nonexempt charitable trustdescribed in section 4947(a)(l) is a taxableexpenditure (see Chapter VI). For a transfer ofassets not to be a taxable exoenditure. it must beto one o f the organ iza t ions descr ibed ear l ie r .Unless the transferee is a section 509(a)(l), (2) or(3) organ izat ion, sect ion 507(b) (2) app l ies .

However, if the assets are transferred to atransferee organization other than a section501 (c)(3) oraanizat ion (excludina oraan iza t ions,.engaged in feesting for public saf&y)-or section4947(a)(l) organization, and the assets are thentransferred toa private foundation to correct a tax-able expenditure, section 507(b)(2) applies as ifthe transfer of assets had been made directly to apr ivate foundat ion.

A significant disposition of assets to one ormore p r i va te foundat ions inc ludes any d ispos i t ionfor the tax year when both:

1) The dispositions to one or more private foun-dations for the tax year, and

2) The total related dispositions made duringearlier tax years in which any disposition toone or more private foundations for the taxvear was Dart of a series of related disoosi-tions made during those years. These total25% or more of the fair market value of thefoundation’s net assets at the start of the tax

year, or at the start of the first tax year inwhich any of the series of related dispositionswas made.

A significant disposition of assets may occur ina single tax year or over two or more tax years.The de te rm ina t ion o f whe the r a s ign i f i can t d i spos i -tion has occurred through a series of related dis-positions will be based on the facts andcircumstances of the particular case. However, ifone or more persons who are disqualified persons(see Chapter V) with respect to the transferor’sprivate foundation are also disqualified personswith respect to any of the transferee’s privatefoundations, this fact will be considered as evi-dence that the transfer is part of a series ofrelated dispositions. For a series of related dispo-sitions, each transferee private foundation is con-sidered a transferee in a section 507(b)(2)transaction.

Example. The White Foundation is a privatefoundation that had net assets of $100.000 onJanuary 1 , 1987. In 1987, in add i t ion to’distribu-tions made out of current income, the White Foun-dation transferred $10.000 to the RoseFoundat ion, $10,000 to the B lack Foundat ion and$10,000 to the Green Foundat ion, a l l o f wh ich areprivate foundations. Therefore, the White Founda-tion made a section 507(b)(2) distribution becauseit disposed of more than 25% of the fair marketvalue of its net assets on January 1, 1987.

Section 507(a) does not apply to section507(b)(2) transfers. A private foundation may notterminate under section 507(a)(l) unless it volun-tarily gives notice as required for section 507(a)(l)terminations. The transfer must satisfv the aooli-cable requirements of Chapter 42 (discussed ‘inChapters VI through X) concerning acts or failuresto act that grve rise to excise tax I&ability. However,if the transfer is an act or failure to act giving riseto excise tax liability, then the transfer may becons idered an invo luntary te rminat ion .

Transfers to certain section 509(a)(l), (2), or(3) organizations will be treated as section507(b)(2) transfers from the date a private founda-tion transfers all or part of its assets to a section509(a)(l). (2). or (3) oraanization if. within 3 vears

I II I. I I.

from the date of t‘he trinsfer, the transferee losesits section 509(a)(l), (2) or (3) status andbecomes a pr iva te foundat ion .

If a section 507(b)(2) transfer is made during thecourse of a 60-month termination under section507(b)(l)(B), the rules governrng section 507(b)(2)transfers will apply and the transfers will not betreated as made from a section 509(a)(l), (2), or(3) organizat ion.

Chapter IVTax on NetInvestment IncomeSection 4940 imposes an excise tax of 2% on thenet investment income of most domestic tax-exempt pr iva te foundat ions, inc lud ing pr iva te oper-a t ing foundat ions . Some except ions app ly . Anexempt operating foundation, defined in Chap-ter I, is not subject to the tax. Further, the tax isreduced to 1% in certain cases. See Reduction intax, be low.

This tax must be reported on Form 990-PF,Return of Private Foundation. Payment of the taxis subject to estimated tax requirements. For moreinformation concerning payment of estimated tax,see the Instructions for Form 990-PF.

Nonexempt private foundations are also subjectto this tax, but only to the extent that the sum ofthe 2% tax plus tax on unrelated business income,appl ied as i f the foundat ion were tax-exempt , i sgreater than income tax l iab i l i ty for the year .

Example. A taxable private foundation had anincome tax l iab i l i t y fo r 1985 o f $10,000. I f thefoundat ion were tax exempt, i t would have a$4,000 l iab i l i t y fo r tax on net Inves tment incomeand a $7,000 liabrlity for tax on unrelated business

income. The founda t ion i s l i ab le under sec t i on4940 for $1,000, the amount by which the sum ofthe tax on net investment income and the tax onunrelated business income ($11,000) exceeds theamount o f income tax l iab i l i t y ($10,000) .

Reduction in tax. For tax years beginning after1984, the tax rate on net investment income isreduced from 2% to 1% for any private foundationthat meets the following distribution requirements:

1) The foundation makes qualifying distribu-tions during the tax year at least equal to thesum of (a) the assets of the foundation for thetax year multiplied by its average percentagepayout for the base period, plus (b) 1% ofthe foundation’s net investment income forthe tax year, and

2) The foundation was not liable for Chaoter 42excise taxes (see Chapters VI through X ofthis publication) for any year of the baseper iod.

Qualifying distributions for this purpose arethe same as those for purposes of the tax on fail-ure to distribute income (see the discussion ofQua l i f y i ng d i s t r i bu t i ons in Chapter VI I ) .

Average percentage payout is the averageof the percentage payouts for each of the taxyears in the foundation’s base period. For eachtax year, the percentage payout is figured by divid-ing the qua l i f y ing d is t r ibu t ions made dur ing theyear by the foundation’s assets for that year. If, forany tax year in the foundation’s base period, thefoundation’s tax rate on net investment income isreduced to 1% by meeting these distributionrequ i rements , the qua l i f y ing d is t r ibu t ions made bythe foundation during that year must be reducedby the amount of the reduct ion in tax.

The assets of the foundation for any tax yearare the excess of the total fair market value of allthe foundation’s assets, other than those used orheld for use d i rec t ly in car ry ing out the founda-tion’s exempt purpose, over the acquisition indebt-edness with respect to those assets.

The base period with respect to any tax yearis the 5 tax years preceding that year. If an organi-zat ion has not been a pr ivate foundat ion through-out those 5 tax years, the base period consists ofthe tax years during which the foundation hasbeen in ex is tence. However , i f a pr iva te foundat ionis a successor to another private foundation, itmust take into account the experience of thatother foundat ion.

Net investment income is the amount by whichthe sum of gross investment income and the capi-ta l ga in ne t i ncome exceeds the a l lowab le deduc-tions discussed later.

Tax-exempt interest on governmentalobligations and related expenses are excluded.

Gross investment income means the totalamount of income from interest, dividends, rents,payments with respect to secuntres loans (asdefined in section 512(a)(5)), and royalties( inc lud ing over r id ing roya l t i es ) rece ived by aprivate foundation from all sources. It does notinc lude any income inc luded in f igu r ing the tax onunrelated business income. However, it doesinclude interest, dividends, rents, and royaltiesreceived from assets devoted to charitableactivities. Therefore, interest received on a stu-dent loan would be includible in the grossinvestment income of a pr iva te foundat ion mak ingthe loan .

Distributions in redemption of stock. Any dis-t r ibu t ion by a corpora t ion tha t i s a d isqua l i f i edperson (def ined in Chapter V) in redempt ion o fstock held by a private foundation in a businessenterprise will be treated as not essentiallyequ iva len t to a d iv idend i f a l l t he fo l low ingcond i t ions a re met :

1) The stock was owned by the private founda-tion on May 26,1969,

2) The foundation is required to dispose of thestock in order not to be liable for the tax on

3)

excess business holdings (discussed in Chap-ter X) , and

The foundat ion rece ives in re turn an amountthat equals or exceeds the fair market valueof the stock at the time of disposition (or atthe time a contract for the disposition waspreviously executed) in a transaction thatwould not be a prohibited transaction (undersection 503(b) of the Code).

For purposes of (1) above, if a private founda-tion acquired stock under the terms of a trust thatwas irrevocable on May 26,1969, or under theterms of a will executed by that date, which is ineffect on that date and at all times thereafter, thefoundation will be considered as owning the stockon that date .

Capital gains and losses. In f igur ing the tax onnet inves tment income, a pr iva te foundat ion mustinclude any capital gains and losses from the saleor other disposition of property held for investmentpurposes or for the production of income. Thisinc ludes cap i t a l ga in d i v i dends rece i ved f r om aregu la ted investment company. I f the foundat ionsells or otherwise disposes of property used in theproduction of income that is subject to theunrelated business income tax, any gain or lossfrom the sale of that property must be included innet investment income, but on ly to the ex tent thati t i s no t inc luded in f igu r ing the tax on unre la tedbusiness income. Property is treated as held forinvestment purposes even though the property isd isposed o f by the foundat ion immedia te ly uponits receipt, if it is the kind of property that generallyproduces interest, dividends, rents, royalties, orcap i ta l ga ins th rough apprec ia t ion .

Property used for exempt purposes. Any gainor loss from the sale or other disposition of prop-erty used for the exempt purposes of the founda-t ion i s no t inc luded in f i gu r ing the tax on ne tinvestment income. If the foundation uses prop-erty for its exempt purposes, but also incidentallyreceives income from the property that is subjectto the net investment income tax, any gain or lossfrom the sale or other disposition of the propertywou ld no t be sub jec t to the tax . For example , i f atax-exempt pr iva te foundat ion main ta ins h is tor icbu i ld ings tha t a re open fo r pub l i c i nspec t ion , bu t i trequires a number of employees to live in thesebuildings and charges rent, the rent is subject tothe tax on net investment income, but any ga in orloss resulting from the sale of these buildings isnot subject to the tax.

However, if a private foundation uses propertyboth for exempt purposes and (other than inciden-tally) for investment purposes, (for example, abu i ld ing in wh ich the founda t ion ’s char i tab le andinvestment activities are carried on) that part ofthe gain or loss from the sale or other dispositionof the property that is allocable to the investmentuse of the property must be taken into account inf igur ing the tax on net inves tment income.

Losses. Capital losses from the sale or other dis-position of investment property may be subtractedfrom capital gains incurred in the sale or disposi-tion of other investment property during the sametax year , but on ly to the extent o f the ga ins. I f thecapital losses are greater than the capital gains,the excess may not be subtracted from grossinvestment income, nor may the losses be carriedback or forward to other tax years regardless ofwhether the foundation is a corporation or a trust.

Basis. The bas is fo r de te rmin ing ga in f rom thesale or other disposition of property is the greaterof :

1)

2)

The fair market value of the property onDecember 31 , 1969, p lus o r m inus a l ladjustments after 1969 and before the date ofdisposition if the property was held by thepr iva te foundat ion on that date and cont inu-ously thereafter until disposition, or

The basis of the property on the date of dis-position under normal basis rules (actualbasis).

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For purposes of determining gain on propertyacqui red by g i f t a f ter December 31, 1969, thebasis of the property is Its basis in the hands ofthe donor a t the t ime o f the g i f t .

Normal basrs rules are used in determining aloss on disposition. For purposes of determining aloss, the basis of property acquired by gift is thelesser of the donor’s basis at the time of the gift orthe fa i r market va lue a t the t ime of the g i f t .

Example 1. A private foundation held deore-c iab le rea l proper ty on December 31, 1969, thathad a basis of $127,500 and a depreciable basisof $102,000. The fair market value of the propertyon that date was $100,000. For tax years 1970throuah 1984 the foundat ion was a l lowed $61.200deprec ia t ion , f igured under the s t ra igh t l inemethod using a 25-vear useful life (4%) on the$102,000 basis. The broperty was sold on January2, 1985, for $175,000. S ince the fa i r market va lueon December 31, 1969 ($100,000) minusadjustments ($61,200 depreciation), or $38,800, isless than the actual adjusted basis on the date ofsale ($66,300 ($127,500 - $61,200)) a gain of$108,700 is recognized ($175,000 sales priceminus the greater o f $66,300 or $38,800) .

Examde 2. A orivate foundation held deore-ciable real property on December 31, 1969, val-ued a t $110 ,000 , w i th a bas is o f $102 ,000 and adepreciable basis of $82,000. It was allowed$26,240 depreciation for years 1970 through1977, f igured under the s t ra igh t l ine method us inga 25-year useful life on the $82,000 depreciablebasis. The orooertv was sold on Januarv 2. 1978.for $80,00d. The fair market value minusadjustments after 1969 ($110,000 - $26,240 =$83,760) is greater than the basis of the propertyon the date of disposition ($102,000 - $26,240 =$75,760) . The greater f igure would be used to f ig -u re a ga in . Because bas is fo r de te rmin ing a ga in i sg rea te r than the se l l i ng p r i ce , there i s no ga in . Thebasis for determining a loss is the actual basis onthe date of disposition ($75,760). Because this fig-ure is less than the selling price, there is no loss.In this situation there is no recognized gain or lossfor section 4940 purposes.

Example 3. On January 1, 1987, a privatefoundat ion rece ived a g i f t o f ren ta l p roper ty w i th afa i r market va lue of $100,000. At the t ime of thegift, the adjusted basis of the donor was $20,000.On January 2 , 1987, the pr iva te foundat ion so ldthe property for $99,000. The gain to be recog-nized from the sale of donated property is $79,000L$asysy.OO sales price minus $20,000 donor’s

Example 4. On February 1, 1987, a privatefoundat ion rece ived a g i f t o f ren ta l p roper ty w i th afa i r market va lue of $100,000. At the t ime of thegift, the adjusted basis of the donor was $105,000.On February 2 , 1987, the pr ivate foundat ion so ldthe property for $99,000. The loss to be recog-nized from the sale of donated property is $1,000b$,~clO&OOO fair market value minus $99,000 sales

Securities listed on recognized stockexchange. The fa i r market va lue for f igur ingbasis for determrning gain on the sale or exchangeof stocks and bonds traded on a stock exchange,in an over-the-counter market, or otherwise, is themean between the highest and lowest quoted sell-ing p r ices on the va lua t ion da te .

Example. A private foundation bought 100shares of common stock of the M Corporation onFebruarv 27. 1968. for $4.000. The foundat ionsold the<stock on December 27, 1987, for$10,000. At all times the stock was registered andlisted on a recognized securities exchange. OnDecember 31, 1969, sales of M Corporationcommon stock on the exchange ranged from ahrgh of $45 a share to a low of $40 a share,whereas the closing price was $44 a share. Therewere no adjustments to basis for the period thestock was held. The foundation’s capital gain netincome i s f i gu red as fo l l ows :

1 4

Amount received from sale$10,000

Minus the greater of (1) or (2):1) Fair market value as of 12/31/69

$45 I $40 x 100 shares = $ 4 , 2 5 02

2) Adjusted basis $ 4 , 0 0 0 4 , 2 5 0

Capital gain net income $ 5750A

Deductions. In determining net investmentincome, a pr ivate foundat ion may deduct f romgross investment income all the ordinary and nec-essary expenses paid or incurred for the produc-tion or collection of gross investment income orfor the management, conservation, or mainte-nance of property held for the production ofincome, sub jec t to the mod i f i ca t ions g iven la te r .Expenses include the part of the foundation’soperating expenses that is paid or incurred for theproductron or collection of gross investmentincome. A pr iva te foundat ion ’s opera t ingexpenses include compensation of officers, othersalaries and wages of employees, outside profes-sional fees, interest, rent, and taxes on propertyused in the foundation’s operations. However, thetax on net investment income may not bededucted.

If any expenses, including salaries andcompensation, are incurred for both investmentpurposes and exempt purposes, they must beallocated between the investment activities andthe exempt activities. Expenses paid or incurredfor exempt func t ions are no t deduc t ib le in f igur ingnet investment income. Also, any expenses thatare taken in to account in f igur ing the tax onunrelated business income may not be deductedin f igur ing ne t inves tment income.

No deduction is allowed for any expense thatwas not incurred for the purposes stated earlier.Thus, no deduction is allowed for charitable contri-butions, net operating losses, or any of the specialdeductions for corporations.

Deduction modifications. The following modifi-cations must be made to otherwise allowablededuct ions in a r r i v ing a t ne t inves tment income:

Depreciation is allowed only on the basis ofthe s t ra igh t l i ne method,Depletion is allowed only on the basis of thecos t dep le t ion method ,The bas is used in f i gu r ing deprec ia t ion o rdepletion is the basis determined under nor-mal basis rules, without regard to the fair mar-ket value on December 31, 1969 (see Basis,ear l ier ) , andThe deduction for expenses paid or incurredin any tax year for the production of grossinvestment income earned as an incident to acharitable function cannot be greater than theincome earned from the function that isincludible as gross investment income for thevear. For examole. when rental income is inci-denta l l y rea l i zed in 1988 f rom h is to r icbu i l d ings he ld open to the pub l i c , deduc t ionspa id orincurred in 1988 for the product ion o ftha t i ncome w i l l be l im i ted to the amount o frental income includible as gross investmentincome for 1988.

Chapter VDisqualified PersonsFor the rules discussed in this publication, thefollowing persons are considered disqualifiedpersons with respect to a private foundation:

1) All substantial contributors to the foundation(def ined la ter ) ,

3) An owner of more than 20% of-a) The total combined voting power of a

corporat ion,

2) All foundation managers of the foundation(def ined la ter ) ,

4 )

5 )

6)

7 )

‘3)

b) The profits interest of a partnership, orc) The beneficial interest of a trust or unrn-

corporated enterprise, which is (during theownership) a substantial contributor to thefoundat ion ,

A member o f the fami ly (def ined la ter ) o f anyof the individuals described in (1) (2), or (3),

A corporation of which more than 35% of thetotal combined voting power is owned bypersons described in (1), (2), (3) or (4)A partnership of which more than 35% of theprofits interest is owned by persons describedin (11, (2) (3) or (4)A trust, estate, or unincorporated enterprise ofwhich more than 35% of the beneficialinterest IS owned by persons described in (1)(2) (3) or (4)For purposes of the tax on excess businesshold ings only (Chapter X) , another pr ivatefoundat ion wh ich e i ther

i s e f fec t i ve ly con t ro l l ed , d i rec t l y o r i nd i -rectly, by the same person or persons whocont ro l the pr iva te foundat ion in ques t ion ,o r

receives substantially all of its contribu-tions, directly or indirectly, from the samepersons described in (1) (2) or (3) ormembers o f the i r fami l ies , who made,d i rec t l y o r i nd i rec t l y , subs tan t ia l l y a l l t hecon t r ibu t ions to the p r i va te founda t ion inques t ion , and

For purposes of the tax on self-dealingonly (Chapter VI I I ) , a government of f ic ia l(as def ined la ter ) .

Attribution of ownership. Indirect ownershipof stock in a corporation, profits interest in a part-nership, or beneficial interest in a trust, estate, orunincorporated enterprise is taken into account fordetermin ing whether :

1) The stockholdings, or profits or beneficialinterest, amount to more than 20% of thetotal combined voting power of the corpora-tion or more than 20% of the profits or benefi-cial interests, or

2) More than 35% of the total combined votingpower of the corporation or more than 35% ofthe profits or beneficial interests are owned bypersons described in categories (1), (2) (3), or(4).

The fo l low ing ru les app ly fo r de te rmin ing theownership of stock or profits or beneficialinterests:

4) Any stockholdings, profits interest, or benefi-c ia l in te res t , tha t have been counted once(whether because of actual or constructive

1) Stock (or profits or beneficial interests) owneddirectly or indirectly by or for a corporation,partnership, estate, or trust is consideredowned proportionately by or for its sharehold-ers, partners, or beneficiaries,

2) An individual is considered to own the stock(or profits or beneficial interests) owned,directly or indirectly, by or for his or her familymembers. An exception to this rule is that, forthe more than 35% ownership described incategories (5) (6) and (7) stock (or profits orbeneficial interests) is not treated ascons t ruc t i ve ly owned by an ind iv idua l so le lybecause tha t ind iv idua l i s a member o f thefami ly o f another d isqua l i f ied person. Forpurposes of these 35% ownership rules, anind iv idua l w i l l be t rea ted as a cons t ruc t i veowner on ly i f tha t ind iv idua l h imse l f o r herse l fi s a subs tan t ia l con t r ibu to r , a foundat ion man-ager, or a 20% owner of the combined votingpower, profits interest, or beneficial interest,of a substantial contributor.

3) An individual’s family includes only thosepersons described in A member of the family,la ter , and

ownership) in applying categories (5), (6), and(7) may not be counted a second time.

Combined voting power includes voting powerrepresented by actual or constructive holdings ofvoting stock, but does not include voting rightsheld only as a director or trustee.

Voting power includes outstanding votingpower and does not include voting power obtaina-ble, but not obtained, such as voting power obtain-able by converting securities or nonvoting stockinto voting stock, by exercising warrants or optionsto obtain voting stock, and voting power availableto preferred shareholders if dividends on preferredstock are in arrears.

The profits interest of a partner is the part-ner’s distributive share of partnership income.

The beneficial interest in an unincorporatedenterprise, other than a trust or estate, includesany right to receive a share of distributions fromthe profits of the enterprise, or if there is no profit-sharing agreement, the right to receive a share ofthe assets on liquidation of the enterprise, exceptas a creditor or employee. When no agreementf i x ing the r igh ts o f the par t i c ipan ts in theenterprise exists, the fraction of the respectiveinterests of each participant in the enterprise willbe determined by d iv id ing the to ta l investment orcontributions to capital made or obligated to bemade by the par t ic ipant by the amount o f a l li nves tments and cap i ta l con t r ibu t ions made by a l lparticrpants.

The beneficial interest in a trust will be deter-mined in proportion to the person’s actuarialinterest in the trust.

A substantial contributor includes any personwho contributed or bequeathed a total amount ofmore than $5,000 to the pr ivate foundat ion i f theamount is more than 2% of the total contributionsand bequests received by the foundation from itscreation up through the close of the tax year ofthe foundat ion in wh ich the con t r ibu t ion o rbequest is received from that person. For a trust,a substantial contributor includes the creator ofthe trust. However, in no case does the terminc lude a governmenta l un i t .

In de termin ing whether the to ta l con t r ibu t ionsand bequests from a person are more than 2% ofthe total contributions and bequests received by apr iva te foundat ion , both the to ta l o f the amountsrece ived by the foundat ion, and the to ta l o f theamounts cont r ibuted and bequeathed by theperson, are determined as of the last day of eachtax year . A l though the determinat ion is made onthe last day of the foundation’s tax year, a donoris a substantial contributor as of the first day thefoundat ion rece ives a g i f t la rge enough to makethe donor a substantial contributor. Each contribu-tion or bequest is valued at its fair market value onthe date it is received by the foundation. Gifts byan ind i v idua l i nc lude a l l con t r i bu t i ons andbequests made by that indrvidual and his or herspouse.

A determination is to be made as to whether aperson is a substantial contributor as of the end ofeach of the foundation’s tax years, based on therespective totals of all contributions received andthe total amount received from a particular personbv that date. Status as a substantial contributorwill date from the time the donor first met the$5,000 - 2% test. Once a person is a substantialcont r ibutor to a pr iva te foundat ion, genera l ly thatperson remains a substantial contributor eventhough the i nd i v i dua l m iqh t no t be so c l ass i f i ed i f adetermination were first-made at some later date.For instance, even though the total contributionsand bequests of a person become less than 2%of the to ta l rece ived by a pr ivate foundat ion, gen-erally the person remarns a substantial contributorto the foundat ion .

However, a person ceases to be a substantialcontributor as of the end of a private foundation’stax year i f :

1) That person (and all related persons) havenot made any cont r ibu t ions to the foundat ion

2)

3)

dur ing the 1 O-year per iod ending wi th that taxyear, andThat person (or any related person) was not afoundat ion manager o f the foundat ion a t anyt ime dur ing that 1 O-year per iod, andThe total contributions made by that person(and related persons) are determined by theIRS to be ins ign i f i can t compared to the to ta lcontributions to the foundation by one otherperson. For the purpose of this comparison,apprec ia t ion on con t r ibu t ions wh i le he ld bythe foundation is taken into account.

A person is related to a substantial contributor,for this rule, if that person’s relationship to thecontributor would make that other person a dis-qualified person with respect to the contributor, asdiscussed in this chapter. If the contributor is acorporation, the term “related person” alsoincludes any officer or director of the corporation.

Special rules. A substantial contributor does notinc lude an en t i t y t ha t i s desc r ibed in sec t i on509(a)(l), (2) or (3) or any organization whollyowned by such an ent i ty . In add i t ion , on ly forpurposes of section 4941 excise taxes on self-dea l ing , a subs tan t ia l con t r ibu to r does no t i nc ludeany other organization described in section501 (c) (3) (o ther than an organizat ion wi th sect ion509(a)(4) status).

The term contribution includes gifts, andgrants to the foundation, as well as bequests,devises, legacies, or transfers as outlined in theru les re la t ing to es ta te and g i f t tax .

En t i t i es exc luded f rom the de f in i t i on o fsubstantial contributor as discussed earlier area lso exc luded f rom the de f in i t i on o f d i squa l i f i edperson.

Foundation manager. A foundation managermeans:

1)

2)

An officer, director, or trustee of a foundation(or an ind iv idua l hav ing powers o r respons ib i l i -ties similar to those of officers, directors, ortrustees of the foundation), or

For anv act or failure to act. anv emplovee ofthe foundat ion hav ing f ina l au thor i ty or-respons ib i l i t y (e i ther o f f i c ia l l y o r e f fec t i ve ly ) fo rthe ac t o r fa i lu re to ac t .

A person who is specifically designated as anofficer under the incorporation certificate, bylaws,or other documents of the foundation, or who reg-ularly exercises general authority to make admin-istrative and policy decisions for a foundation isconsidered an officer of the foundation.

For any act or fa i lure to act , any foundat ionemployee who has authority merely to recom-mend par t i cu la r admin is t ra t i ve o r po l i cy dec is ions ,bu t no t to imp lement them w i thou t approva l o f asuperior, is not an officer. Independent contrac-tors, such as accountants, lawyers, andinvestment managers or advisors, acting in theircapacity as such, are not considered officers ofthe foundat ion .

A member of the family includes: a spouse,ancestors, children, grandchildren, greatgrandchildren, and spouses of children,grandchi ldren, and great grandch i ldren. A bro theror sister of an individual is not a member of thefami ly fo r th is purpose . A lega l l y adop ted ch i ld o fan ind iv idua l w i l l be t rea ted as a ch i l d by b lood .

Government official. For the excise tax on self-dealing (described in Chapter VIII) a governmento f f i c i a l a l so i s a d i squa l i f i ed pe rson .

The term government official means an i nd i -v idua l who a t the t ime o f the ac t o f se l f -dea l ingholds any of the following offices or positions:

1) An elective public office in the executive orlegislative branch of the United StatesG o v e r n m e n t ,

2) An office in the executive or judicial branch ofthe U.S. Government , appointment to whichwas made by the President,

A pos i t i on in the execu t i ve , l eg is la t i ve , o r j ud i -cial branch of the U.S. Government-a) Which is listed in Schedule C of Rule VI of

the Civil Service Rules, or

b) The compensation for which is at leastequal to the lowest rate prescribed forGS-16 of the General Schedule under 5U.S.C. 5332,

A position under either the US. House ofRepresentatives or the U.S. Senate, held byan individual who receives gross annual payof a t leas t $15 ,000 ( inc lud ing expenseallowances for which no accounting need bemade),

An e lec t i ve o r appo in t i ve pub l i c o f f i ce in anybranch of the aovernment of anv state.possession of‘ihe United State< or any subdi-vision of the foregoing, or the District ofColumbia, held by anlndividual who receivesgross annual pay of at least $20,000, orA position as personal or executive assistantor secretary to any ind iv idua l a l readydescribed.

Public office. For the purpose of (5) under Gov-ernment officral, a holder of public office must bedis t ingu ished f rom a pub l i c emp loyee . A l thoughthe determination depends on the facts andcircumstances of each case, the essential ele-ment is whether a significant part of the activitiesof the ind iv idua l i s the independent per fo rmanceof policymaking functions. Among the factors tobe considered are that the office is created by theCongress, a state constitution, or state legislature,or by a munic ipa l i ty or o ther governmenta l bodyunder powers created in it, and the duties to bedischarged by the office are defined either directlyor indirectly by the body that created it or throughleg is la t ive author i ty .

Examples. The following are illustrations ofpos i t ions o f pub l ic employment tha t do not invo lvepo l i cymak ing func t ions and a re no t a pub l i c o f f i ce :

1) The chancellor, president, provost, dean, andother officers of a state university who areappo in ted , e lec ted , o r o the rw ise h i red by aSta te Board o f Regents or equ iva len t pub l icbody and who are sub jec t to the d i rec t ion andsupervision of that body,

2) The superintendent of public schools andother public school officials who areappo in ted , e lec ted , o r o the rw ise h i red by aBoard o f Educat ion o r equ iva len t pub l i c bodyand who are subject to the direction andsupervision of that body, or

3) Members of police and fire departments,except for department heads who, under thefacts and circumstances of the case, indepen-dently perform policymaking functions as as ign i f i can t pa r t o f t he i r ac t i v i t i es .

Chapter VITaxes on TaxableExpendituresA private foundation that makes any taxableexpenditures, defined later, becomes liable fortaxes on these expenditures under section 4945of the Internal Revenue Code. The taxes areimposed on both the foundat ion and on any foun-dat ion manager who knowing ly and wi l l fu l ly agreesto the expend i tu res . Both an in i t ia l tax and anadd i t iona l tax may be imposed.

Initial tax. The in i t i a l t ax on the founda t ion i s10% of the amount expended. The foundat ion wi l lno t be l iab le fo r the tax i f i t can show tha t theexpenditus was due to reasonable cause and notto w i l l fu l neg lec t , and tha t the expend i tu re wascorrected within the correction period (describedlater ) . In the case o f a foundat ion manager whoknowing ly , w i l l fu l l y , and w i thout reasonab le causeagrees to the taxab le expend i tu re , the in i t ia l tax is2 %% of the amount expended, up to a maximum

1 5

tax of $5,000 for any one expendi ture. A founda-tion manager who acts on advice of counsel,g iven in a reasoned lega l op in ion in wr i t i ng , i s no tl iab le for the tax.

Additional tax. If the expenditure is not cor-rected within the taxable period (describedlater ) , an add i t iona l tax o f 100% of the amountexpended is imposed on the foundat ion . The taxwill not be assessed, or if assessed will be abated,if the expenditure is corrected within thecorrection period (described later). Any founda-tion manager who refuses to agree to part or all ofthe correction must pay an additional tax of 50%of the expendi ture, up to a maximum tax of$10,000.

I f more than one foundat ion manager i s l i ab lefo r e i the r the in i t i a l o r add i t i ona l tax , a l l a re jo in t l yand severa l l y l i ab le .

The initial tax on foundation managers isimposed only In cases when the followingcircumstances are present:

1) The initial tax on taxable expenditures isimposed on the pr iva te foundat ion mak ing theexpendi ture,

2) The foundation manager knows that theexpenditure to which he or she agrees IS ataxable expendi ture, and

3) The agreement is willful and not due to rea-sonable cause.

The tax on any par t icu lar expendi ture app l iesonly to agreements of foundation managers withauthority to approve or to exercise discretion inrecommending approval for expenditures by thefoundation and to those foundation managers whoare members of a group authorized to make orrecommend those expenditures.

Agreement. The agreement of any foundationmanager to making a taxable expenditure consistsof any mani fes ta t ion o f approva l o f theexpenditure which is sufficient to constitute anexercise of the foundation manager’s authority toapprove or to exercise discretion in recom-mending approval for making an expendi ture bythe foundat ion. Whether or not the foundat ionmanager’s action is the final or decisive approvalon beha l f o f the foundat ion i s no t the de termin ingfactor.

Knowing. A foundation manager will be consid-ered to have agreed to an expenditure knowingthat i t i s a taxab le expend i tu re on ly i f :

1) The foundation manager has actualknowledge of enough facts so that, basedonly on these facts, the expenditure would bea taxable expendi ture,

2) The foundation manager is aware that anexpenditure under these circumstances mayvio la te the law govern ing taxab le expendi -tures, and

3) The foundat ion manager neg l igen t ly fa i l s tomake reasonable attempts to determinewhether the expenditure is a taxableexpenditure or is in fact aware that it is a taxa-ble expendi ture .

The term knowing does not mean having rea-son to know. However, any evidence indicatingthat a foundation manager has reason to know ofa par t i cu la r fac t o r ru le i s re levant in de termin ingwhether he or she had actual knowledge of thisfac t o r ru le .

Willful. A foundation manager’s agreement to ataxab le expendi ture is wil l fu l i f i t i s vo luntary ,consc ious , and in ten t iona l . No mot ive to avo id therestrictions of the law or the incurrence of any taxis necessarv to make an aareement willful. How-ever, a fouidation manage& agreement to a tax-ab le expend i tu re i s no t w i l l f u l i f he o r she does no tknow that i t i s a taxable expendi ture .

Due to reasonable cause. A foundation man-ager’s actions are due to reasonable cause if heor she has exercised responsibility on behalf ofthe foundation with ordinary business care andprudence.

1 6

Advice of counsel. I f a foundat ion manager hasmade fu l l d i sc losu re o f t he fac tua l s i t ua t i on tolega l counse l ( i nc lud ing house counse l ) and re l i eson the advice of counsel expressed in a reasonedwr i t t en l ega l op in ion tha t an expend i tu re i s no t ataxable expendi ture and the expendi ture is la terhe ld to be taxab le , the foundat ion manager ’sagreement to the expendi ture wi l l o rd inar i ly not beconsidered knowing or willful and will ordinarilybe considered due to reasonable cause.

A wr i t ten lega l op in ion w i l l be cons idered rea-soned even if it reaches a conclusion that is laterdetermined to be incorrect as long as the opinionaddresses itself to the facts and applicable law.However , a wr i t ten lega l op in ion w i l l no t be con-sidered reasoned if it does nothing more thanrecite the facts and express a conclusion.

The absence of advice of counsel on anexpend i tu re w i l l no t , by i t se l f , g ive r i se to anyin ference that a foundat ion manager agreed tomaking the expendi ture knowing ly , w i l l fu l ly , orwithout reasonable cause.

Correction of a taxable expenditure. In casesother than those of inadequate reporting or failureto obtain advance approval, discussed later, acorrection is accomplished by recovering part orall of the expenditure to the extent possible. Whenfu l l recovery i s no t poss ib le , any add i t iona lcorrective action will be prescribed by the IRS.The type o f add i t iona l ac t ion depends on thecircumstances, and the Service may require any ofthe fo l l ow ing :

1) Wi thho ld ing any unpa id funds due a par t i cu la rgrantee,

2) Stopping further grants to the grantee,

3) Periodic reports to the IRS from the founda-t ion fo r a l l i t s expend i tu res ,

4) Improving methods of exercising expenditureresponsibility (discussed later),

5) Improving methods of selecting recipients ofind iv idua l g ran ts , and

6) Any other actions that the Service may pre-scribe in a particular case.

The foundation is not required to attempt recov-ery o f the taxab le expendi ture by lega l ac t ion i f i tappears a judgment could not be satisfied.

Correction for failure to obtain advanceapproval. When an expenditure is taxable as agrant for travel, study, etc., only because of a fail-ure to obtain advance approval of procedures forthose grants, correction may be accomplished byobtaining approval of the grant-making proceduresand establishing to the satisfaction of the Servicethat :

1) No grant funds have been diverted to any usenot for a purpose specified in the grant,

2) The grant making procedures instituted wouldhave been approved if advance approval ofthe procedures had been properly requested,a n d

3) When advance approval of grant making pro-cedures is later required, the approval will beproperly requested.

Correction for inadequate reporting. I f anexpend i tu re is taxab le on ly because o f a fa i lu re tomake or obtain a full and complete report asrequired (discussed later in this chapter),correct ion may be made by obta in ing or makingthe repor t in quest ion .

In add i t ion , i f the expend i tu re i s taxab le on lybecause o f a fa i l u re to ob ta in a fu l l and comple tereport as required and an investigation indicatesthat no grant funds have been diverted to any usenot for a purpose specified in the grant, correctionwill be accomplished if all reasonable efforts aremade to obtain the report and the Service isnot i f ied o f the fa i lu re to ob ta in the repor t .

The taxable period begins on the date the taxa-ble expenditure occurs and ends on the earlier ofe i ther :

1) The date a notice of deficiency for the initialtax i s ma i l ed , o r

2) The date the initial tax is assessed.

The correction period beg ins on the da te o f thetaxable expenditure and ends 90 days after anotice of deficiency for the additional tax ismai led . The per iod is ex tended fo r the t ime dur ingwhich a deficiency cannot be assessed undersect ion 6213(a) ( re la t ing to pending Tax Cour t andother proceedings), and for any other period theService determines is reasonable and necessaryfor correction of the taxable expenditure.

Taxable ExpendituresA taxable expenditure is an amount paid orincur red to :

1)

2)

3 )

4 )

5)

Carry on propaganda or otherwise attempt toin f l uence l eg i s l a t i on ,In f l uence the ou tcome o f any spec i f i c pub l i celection or carrv on any voter registrationdrive, unless certain requirements (explainedlater under influencing e lec t ions and ca r ry ingon voter registration drives) are satisfied,Make a grant to an indiv idual for t ravel , s tudy,or other similar purposes, unless certainrequirements (explained later under Grants toi nd i v i dua l s ) are sa t i s f i ed ,Make a grant to an organizat ion (other thanan o rgan iza t ion descr ibed in sec t ion509(a)(l), (2), or (3) or an exempt operatingfoundation as defined in Chapter I), unless thefoundation exercises expenditure responsibil-ity with respect to the grant, orCarry out any purpose other than a religious,char i tab le , sc ien t i f i c , l i t e ra ry , o r educa t iona lpurpose, the fostering of national or interna-tional amateur sports competition (withexceptions) or the prevention of cruelty toch i ld ren o r an ima ls .

These categories of taxable expenditures arediscussed in greater detail in this chapter.

Influencing legislation

A taxable expenditure includes amounts used toa t tempt to i n f l uence leg i s la t i on :

1 ) By a f fec t ing pub l i c op in ion , o r2 ) By communicat ing wi th any member or

emolovee o f a leq is la t ive body, o r w i th anyothkr governmen? official or employee whomay par t i c ipa te in fo rmu la t ing the leg is la t ion .

Legislation includes action by Congress, any stateleg is la tu re , any loca l counc i l o r s im i la r govern ingbody, or the publ ic by way of referendum,cons t i tu t iona l amendment , o r the l i ke . The wordaction includes the introduction, enactment,defeat, or repeal of legislation. Actions by execu-t i ve , j ud ic ia l , o r admin is t ra t i ve bod ies a re no t l eg is -la t ion . There fore , expend i tu res made to in f luenceaction by these bodies are not attempts to influ-ence l eg i s l a t i on .

School boards, housing authorities, sewer andwater districts, zoning boards, and other similarfederal, state, or local special purpose bodies,whether elective or appointive, are consideredadmin is t ra t i ve bod ies .

A proposed treaty required to be submitted bythe President to the Senate for its advice andconsen t w i l l be cons ide red l eg i s la t i on be ing con -s idered by , o r to be submi t ted imminent ly to , a leg-islative body at the time the President’srepresentative begins to negotiate its position withthe parties to the orooosed treaty..Jointly funded projects. A private foundationwi l l no t be t rea ted as hav ing pa id or incur red anyamount to a t tempt to in f luence leg is la t ion mere lybecause it makes a grant to another organizationon the conc@ion tha t t he rec ip ien t ob ta in amatching support appropriation from the govern-ment . In add i t ion , i t w i l l no t be t rea ted as hav ingmade a taxable expendi ture o f amounts pa id orincurred in carrying on discussions with govern-men t o f f i c i a l s i f :

The subject is a new program or an existingprogram jo in t ly funded by the foundat ion andthe government,The discussions are undertaken for thepurpose o f exchanging data and in format ionon the subject matter of the program, andThe discussions are not undertaken to makeany direct attempt to persuade governmentofficials or employees to take a particularposition on specific legislative issues otherthan the program.

Certain expenditures by recipients of program-related investments. Any amount paid orincurred by a rec ip ient o f a program-re la tedinves tment in connec t ion w i th an appearancebefore. or communication with. anv leaislatrvebody on legislation or proposed legisl&ion ofd i rec t in te res t to the rec ip ien t w i l l no t be a t t r ibu tedto the inves t ing foundat ion i f :

1) The foundation does not earmark its funds tocarry on propaganda or otherwise attempt toin f l uence l eg i s l a t i on , and

2) A trade or business deduction is allowable tothe rec ip ien t fo r th is expend i tu re .

Grants to public organizations. A g ran t by aprivate foundation to an organization that is not aprivate foundation (except certain organizationsorganized and operated exclusively for testing forpub l ic sa fe ty ) i s no t a taxab le expend i tu re i f thearant is not earmarked to be used for. or in amanner out l ined in , i tems (1) through (5) underTaxab le Expend i tu res , d iscussed ea r l i e r . I naddi t ion, a grantor foundat ion may not enter in toan oral or written agreement with a grantee thatcauses the grantee to engage in any proh ib i tedactivity nor may the grantor select the recipient ofthe grant. A grant is earmarked if the grant isgiven under an agreement , ora l or wr i t ten, that thegrant be used for specific purposes.

Attempts to affect the opinion of the genera/public. Generally, expenditures paid or incurredby a pr iva te foundat ion in an a t tempt to in f luenceany leg is la t ion th rough an a t tempt to a f fec t theop in ion o f any segment o f t he genera l pub l i c i s ataxable expenditure. Exceptions are discussedla te r in th i s chap te r .

Lobbying activities. Generally, expenditurespaid or incur red by a pr iva te foundat ion to in f lu -ence leg is la t i on th rough commun ica t ion w i th anymember or employee of a leg is la t ive body, or w i thany government o f f ic ia l or employee who maypa r t i c i pa te i n t he f o rmu la t i on o f t he l eg i s l a t i on i s ataxable expenditure. Exceptions are discussednext.

Exception for nonpartisan analysis, study, andresearch. Engaging in nonpartisan analysis,study, or research and making the results of thiswork available to the general public or to govern-mental bodies, officials, or employees is notcarrying on propaganda, or otherwise attemptingto in f l uence leg i s la t i on . Nonpar t i san ana lys i s ,study, or research means an independent andob jec t i ve expos i t ion o f a par t i cu la r sub jec t mat te r ,i nc lud ing ac t i v i t i es tha t qua l i f y as educa t iona lactivities. Nonpartisan analysis, study, or researchmay advocate a par t icu lar pos i t ion or v iewpoin t aslong as the re i s a su f f i c ien t l y fu l l and fa i r expos i -t ion o f the re levant fac ts to enab le the pub l i c o r anind iv idua l to fo rm an independent op in ion orconclusion. However, a mere presentation ofunsuppor ted op in ion does no t qua l i f y as nonpar t i -san analysis, study, or research.

Presentation as part of a series. Normally,whether a publication or broadcast qualifies asnonpartisan analysis, study, or research will bedetermined on a presentation-by-presentationbasis. However, if a publication or broadcast isone of a series prepared or supported by a privatefoundation and the series as a whole meets thestandards of nonpartisan analysrs, study, orresearch , then any ind iv idua l pub l i ca t ion o rbroadcast in the series will not result in a taxableexpendi ture even though such ind iv idua l

broadcast or publication does not, by itself, meetthe standards of nonpartisan analysis, study, orresearch. Whether a broadcast or publication isconsidered part of a series will ordinarily dependon all the facts and circumstances of each particu-lar situation. However, for broadcast activities, allbroadcasts in any period of 6 consecutive monthswi l l o rd inar i l y be e l ig ib le to be cons idered as par tof a series. If a private foundation times orchannels a part of a series in a manner designedto i n f l uence the gene ra l pub l i c o r t he ac t i on o f aleg is la t i ve body fo r a spec i f i c l eg is la t i ve p roposa l ,the expenses of preparing and distributing thatpart of the analysis, study, or research are a taxa-ble expendi ture .

Making available results of analysis, study,or research. A private foundation may chooseany su i tab le means , inc lud ing o ra l o r wr i t tenpresentations, to distribute the results of its non-partisan analysis, study, or research, with or with-ou t charge . Th is may inc lude d is t r i bu t ion o freprints of speeches, articles, and reports, presen-tation of information through conferences,meetings, and discussions, and dissemination tothe news med ia , i nc lud ing rad io , te lev is ion , andnewspapers, and to other public forums. Thesepresentations may not be limited to or directedtoward persons who are interested only in oneside of a particular issue.

Example 7. M, a private foundation, estab-lishes a research project to collect information forshowing the dangers of using pesticides ingrowing crops. The information collected includesdata on proposed legislation, pending before sev-eral state legislatures, that would ban the use ofpesticides. The project takes favorable positionson the legislation without producing a sufficientlyfull and fair exposition of the relevant facts toenab le the pub l i c o r an ind iv idua l to fo rm an inde-pendent opinion or conclusion on the pros andcons of the use of pesticides. This project is notwithin the exception for nonpartisan analysis,study, or research because it is designed to pre-sent in fo rmat ion on ly on one s ide o f the leg is la t i vecontroversy.

Example 2. N, a pr ivate foundat ion, es tab-lishes a research project for the apparent purposeof examin ina and reoor t ina in format ion as to thepros and co& of the use of pesticides in growingcrops. The information is collected and distributedin the form of a published report that analyzes theeffects and costs of the use and nonuse of vari-ous pesticides under various conditions onhumans, animals, and crops. The report alsopresents the advantages, disadvantages, and eco-nomic cost of allowing the continued use ofpesticides unabated, of controlling the use ofpesticides, and of developing alternatives top e s t i c i d e s .

Even if the report gives conclusions that the dis-advantages, as a result of using pesticides, aregreater than the advantages of using pesticidesand tha t p rompt leg is la t i ve regu la t ion o f the use o fpesticides is needed, the project is within theexception for nonpartisan analysis, study, orresearch because it is designed to present infor-mation on both sides of the legislative contro-versy. In addition, the report presents a sufficientlyfull and fair exposition of the relevant facts toenab le the pub l i c o r an ind iv idua l to fo rm an inde-penden t op in ion o r conc lus ion .

Exception for technical advice or assistance.Amounts are not taxable expenditures if they arepaid or incur red in connect ion w i th p rov id ing tech-nical advice or assistance to a governmentalbody, a government committee, or a subdivision ofeither, in response to a written request. Underthis exception, the request for assistance oradvice must be made in the name of the request-ing governmenta l body, commi t tee , o r subd iv is ionra ther than an ind iv idua l member . S imi la r ly , theresponse to the request must be available toevery member of the requesting body, committee,or subd iv i s ion .

Nature of technical advice or assistance.Technical advice or assistance may be given as aresult of knowledge or skill in a given area.Because this assistance or advice may be givenonly at the express request of a governmentalbody, commi t tee , o r subd iv is ion , the ora l o r wr i t tenpresentation of assistance or advice need notqualify as nonpartisan analysis, study, or research.Of fer ing op in ions or recommendat ions w i l l o rd ina-r i l y qua l i f y under th is except ion on ly i f the op in ionsor recommendations are specifically requested bythe governmenta l body, commi t tee, or subd iv is ionor are directly related to the materials requested.

Example 7. A Congressional committee iss tudy ing the feas ib i l i t y o f l eg is la t ion to p rov idefunds for scholarships to U. S. students attendingschools abroad. X, a private foundation that hasengaged in a private scholarship program of thiskind, is asked, in writing, by the committee todescribe the manner in which it selects candidatesfor its program. X’s response, disclosing its meth-ods of selection, is technical advice or assistance.

Example 2. Assume the same facts given inExample 1, except that X’s response not onlyincludes a description of its own grant-making pro-cedures, but also includes its views regarding thewisdom of adopting such a program. Becausethese views are directly related to the subjectmatter of the request for technical advice or assis-tance, the amount paid or incurred for the presen-tation of these views is not a taxable expenditure.However , the amount pa id or incur red inconnection with a response that is not directlyrelated to the subject matter of the request fortechnical advice or assistance would be a taxableexpenditure unless the presentation can qualify asmaking available nonpartisan analysis, study, orresearch.

Exception for decisions affecting the powers,duties, etc., of a private foundation. Taxes onlobby ing ac t i v i t i es , d i scussed ea r l i e r , do no t app lyto any amount pa id or incur red in connect ion w i than appearance before , o r communicat ion w i th ,any leg is la t i ve body on a poss ib le dec is ion o f thebody that might affect the existence of the privatefoundation, its powers and duties, its tax-exemptstatus, or the deductibility of contributions to thefoundat ion . Under th is except ion , a foundat ionmay communicate w i th the ent i re leg is la t ive body,committees, or subcommittees of the legislativebody, ind iv idua l congressmen or leg is la to rs , mem-bers of their staffs, or representatives of the exec-ut ive branch, who are invo lved in the leg is la t iveprocess if the communication is limited to the pre-sc r ibed sub jec ts . In add i t i on , the founda t ion maymake expend i tu res to in i t i a te leg is la t ion i f the leg -islation concerns only matters that might affectthe existence of the private foundation, its powersand duties, its tax-exempt status, or the deductibil-i ty o f contributions to the foundat ion .

Exception for examinations and discussions ofbroad social, economic, and similar problems.Expenditures for examinations and discussions ofbroad soc ia l , economic , and s im i la r p rob lems a renot taxable expendi tures even i f the prob lems arethe type the government would be expected todeal w i th u l t imate ly .

The te rm “any a t tempt to in f luence any leg is la -tion” does not include public discussion, or com-mun ica t ions w i th members o f l eg is la t i ve bod ies o rgovernmental employees, the general subject ofwhich is also the subject of legislation before alegislative body, as long as the discussion doesnot address itself to the merits of a specific legis-la t i ve p roposa l .

For example, a pr ivate foundat ion may, wi thoutincurring the tax on taxable expenditures, presentdiscussions of problems such as environmentalpo l lu t ion or popu la t ion growth tha t a re be ing con-sidered by Congress and various state legisla-tures, but only if the discussions are not directlyaddressed to specific legislation being considered.

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Influencing elections and carrying onvoter registration drives.Taxable expenditures Include amounts paid orincur red by a pr iva te foundat ion to in f luence theoutcome of any specific public election or to carryon, d i rec t ly or ind i rec t ly , any voter reg is t ra t iondrive. Activities that are considered participatron orin te rven t ion in a po l i t i ca l campa ign inc lude , bu t a reno t l im i ted to :

1) Publishing or distributing written or printedstatements or making oral statements onbehal f o f or In oppos i t i on to a cand ida te ,

2) Paying salaries or expenses of campaignworkers, and

3) Conducting or paying the expenses of con-ducting a voter regrstration drive limrted to thegeographic area covered by the campaign.

Exceptions. Thus rule does not apply to non-partisan activities carried on under all the followrngcond i t i ons :

1)

2)

3 )

4 )

5)

The organ izat ion mak ing the expendi ture isdescribed in section 501 (c)(3) and is exemptfrom tax,

Its activities are nonpartisan, are not confinedto one spec i f i c e lec t ion per iod , and a recarried on in at least 5 states,

The organrzation spends at least 85% of itsincome directly for the active conduct of theexempt purposes or functions for which it isorganized and operated,

The organization receives at least 85% of itssupport (other than gross investment income)from exempt organ izat ions, the genera l pub l ic ,governmenta l un i ts , o r any combinat ion o fthese; it does not receive more than 25% ofits support (other than gross investmentincome) f rom any one exempt organizat ion;and it does not receive more than 50% of itssupport from gross investment income, and

Contributions to the organization for voterregistration drives are not subject toconditions that they may be used only in spec-ified states or other localities of the UnitedStates, or that they may be used in only onespec i f i c e l ec t i on pe r i od .

In determin ing whether the organ izat ion meets thesupport test in item (4) for a tax year, the supportrece ived dur ing the tax year and the 4 immediate lypreceding tax years of the organization is takenin to accoun t .

For organizations with less than 4 years of oper-ational experience, the support test may be deter-mined by tak ing in to account a l l ava i lab le yearsthe organ iza t ion has been in ex is tence.

Advance ruling. An organ iza t ion w i l l be g iven anadvance ru l ing tha t i t qua l i f i es under theexceptions that apply to nonpartisan activities if itsubmits evidence establishing that it can reasona-bly expect to meet these tests for the year. Grant-ors or contributors to these organizations may relyon the advance ru l ing un t i l a no t i ce o f change o fs ta tus o f the o rgan iza t ion i s made to the pub l i c .This does not apply, however, if the grantor orcontributor was responsible for, or was aware of,the fac t tha t the organ iza t ion d id not qua l i fy underthese provisions at the end of the tax year forwhich i t ob ta ined an advance ru l ing or determina-tion letter, or acquired knowledge that the Servicehad g iven not ice to the organ iza t ion adv is ing tha ti t wou ld be de le ted f rom th i s c lass i f i ca t i on .

Grants to individualsGrants to individuals for travel, study, or other sim-i la r pu rposes ( i nc lud ing loans made fo r char i tab lepurposes, and program-related investments asdef ined in Chapter IX) are taxable expendi tures,unless the following conditions are met:

1) The grant must be awarded on an objectiveand nondiscriminatory basis under a proce-dure approved in advance by the Serv ice, and

2) It must be shown to the satisfaction of the

The grant is a scholarship or fellowshipand is to be used for study at an educa-

Service that one of the following requirements

t i ona l i n s t i t u t i on t ha t no rma l l y ma in ta i ns a

is met-

regu lar facu l ty and cur r icu lum and normal lyhas a regularly organized body of studentsin a t tendance a t the p lace where the edu-cational activities are carried on. For thesepurposes, there is no requirement that thegran t rec ip ien ts be l im i ted to degree cand i -dates, nor must the grant be limited to tui-tion, fees, and course-required books,supp l ies , and equ ipment . A rec ip ien t mayuse grant funds for room, board, travel,research , c le r i ca l he lp , o r equ ipment , tha tare incidental to the purposes of the schol-arship or fellowship grant.The grant qualifies as a prize or awardunder section 74(b), if the recipient isselected from the general public. For thispurpose, the recipient may keep the prizeor award, and need not authorize the foun-dation to transfer the prize or award to agovernmental uni t or to another char i ty .The grant’s purpose is to achieve a spe-cific objective, produce a report or similarproduct, or improve or enhance a literary,artistic, musical, scientific, teaching, orsimilar capacity, skill, or talent of thegrantee.

Advance approval of grant-making procedure.The grant-making procedure, to be approved inadvance by the Internal Revenue Service, mustprov ide the fo l lowing:

1) The group from which the grantees areselected must be reasonably related to thepurposes of the grant, and the group must belarge enough to constitute a charitable class(unless, taking into account the purposes ofthe gran t , on ly a few ind iv idua ls a re qua l i f iedto be grantees-as in the case of scientificresearch).

2) The criteria used in selectina arant recioientsfrom the potential grantees should be relatedto the purpose of the grant. For example,proper criteria for selecting scholarship recipi-en ts migh t inc lude (bu t a re no t l im i ted to ) thefollowing: past academic performance, per-formance on tests designed to measure abilityand aptitude for college work, recommenda-tions from instructors, financial need, and theconclusions the selection committee mightdraw from personal interviews.The person or persons who select recipientsof grants should not be in a position to receivea pr iva te benef i t , d i rec t ly o r ind i rec t ly , i f cer -tain potential grantees are selected overothers.Periodic progress reports must be made tothe foundation, at least once a year, to deter-mine whether the grantees have performedthe activities the grants are intended tof inance .When these reports are not made or there areother indications that the grants are not beingused as intended, the foundation mustinvestigate and take corrective action.The foundation must keep all records relatingto all grants to individuals, including-a) Information obtained to evaluate grantees,b) Iden t i f i ca t ion o f g ran tees , i nc lud ing any

re la t ionsh ip o f the grantee to the founda-tion sufficient to make the grantee a dis-qua l i f i ed person ,

c) Amount and purpose of each grant, andd) Fo l low-up in fo rmat ion , inc lud ing requ i red

annua l repor ts and inves t iga t ion o f jeop-ardized grants.

However, no single procedure or set of proce-dures is required. Procedures may vary depending

upon such factors as the size of the foundation,

Requests for approval of grant-making proce-

the amount and purpose of the grants, and

dures should be sent to the Drstnct Director of the

whether one or more recipients are involved.

IRS office servicing your area. If, by the 45th dayafter a request for approval of grant procedureshas been properly submitted, the foundation hasnot been notified that the procedures are unac-ceptable, they may be considered approved fromthe date of submission until receipt of actualnotice from the Service that they do not meet therequirements.

Payments o f rema in ing ins ta l lments o ffixed-sum grants awarded during the period thefoundation’s procedures were consideredapproved, a f te r the foundat ion is no t i f ied tha t theprocedures are unacceptable, are not taxableexpendi tures.

Renewals. A renewa l o f a qua l i f i ed g ran t w i l l no tbe t rea ted as a g ran t to an ind iv idua l sub jec t tothe requirements of thus chapter if:

The gran to r has no in fo rmat ion ind ica t ing tha tthe o r ig ina l g ran t i s be ing used fo r anypurpose other than that for which it wasmade,The reports due under the terms of the granthave been provided, andAny add i t iona l c r i te r ia and procedures fo rrenewal are ob ject ive and nondiscr iminatory .

Any extension of a period over which a grant isto be pa id w i l l no t by i t se l f be regarded as a grantor a renewal of a grant .

Company scholarship programs are usuallyadministered by company-created private founda-tions. These foundations may give preference inawarding scholarships to employees, the childrenor relatives of employees, or the children ofdeceased or retired employees of the company orrelated companies. Scholarship grants awardedby these private foundations are taxable expendi-tures unless the grant programs meet the require-ments for individual grants (discussed earlier) andreceive advance approval f rom the Serv ice.

Company scho la rsh ip p rograms w i l l no t qua l i f y i fgrants are essentially providing extra pay, anemployment incent ive, or an employee f r inge ben-e f i t . S im i la r l y , i f scho la rsh ip p rograms are compen-satory in nature , an organ izat ion admin is ter ingsuch a program wi l l not qua l i fy for tax exempt ionbecause it is operated for private benefit. A privatefounda t ion admin is te r ing such a p rogram cou lda lso be invo lved in d i rec t o r ind i rec t se l f -dea l ing .

Company-related scholarship programs canmeet the scholarship requirements by ensuringthat the scholarships awarded are for the mainpurpose of furthering the recipients’ educationrather than compensating company employees.gcrts-tin conditions and tests must establish three

The preferent ia l t reatment der ived f romemployment must no t have any s ign i f i cancebeyond tha t o f an in i t i a l qua l i f i e r ,The selection of scholarship grantees must becont ro l led and l im i ted by subs tan t ia lnonemployment re la ted fac to rs , inc lud ing ase lec t ion commi t tee o f i nd iv idua ls who a reindependent and separate f rom the pr ivatefoundat ion, i ts organizer , and the employerconcerned, andThere must ex is t on ly a l im i ted p robab i l i t y tha tqua l i f i ed emp loyees o r the i r ch i ld ren w i l lreceive scholarship grants.

Ruling requests for advance approval of proce-dures are to be sent to your key District Director,and should include the statements described ear-l ier under Grants to I nd i v i dua l s , i n add i t ion to in fo r -mation responsive to the seven conditions and thepercentage test described below.

Educational loans made by a pr ivate founda-t ion under an employer- re lated loan program arenot taxab le expend i tu res i f the loan program-

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1) Meets the applicable requirements for grantsto ind i v idua ls , d i scussed ea r l i e r , and

2) Satisfies the seven condrtrons and the per-centage tests described below.

The seven conditions for approval includethe fo l l ow ing i t ems :

inducement- The programs must not be usedby the employer , the pr ivate foundat ion, or theorganizer thereof, to recruit employees or toinduce emp loyees to con t inue the i remployment or otherwise follow a course ofact ion sought by the employer .Selection committee. Selection of loanrecipients must be made by a committee ofind iv idua ls who are to ta l l y independent(except fo r par t i c ipa t ion on th is commi t tee)and separate from the private foundation, itsorganizer , and the employer concerned. Anind iv idua l who is a fo rmer employee o f e i therthe foundat ion or the employer concerned wi l lno t be cons idered to ta l l v indeoendent . Thesecommittees preferably should’consist of indi-v idua ls knowledgeab le in the f ie ld o f educa-tion so that they have the background andknowledge to proper ly evaluate the potent ia lo f t he app l i can ts .

Forwarding the selections by the indepen-dent selection committee to the employer orprivate foundation only for the purpose ofverifying the elrgrbrlrty requirements and selec-t ion c r i te r ia fo l lowed by the commi t tee in con-sidering the candidates and in making itsse lec t ion w i l l no t d i squa l i f y the p rogram. Anypublic announcement of the awards, however,must be made by the selection committee orby the foundat ion. The awards may beannounced in the employer’s newsletter, if thefounda t ion o r the se lec t ion commi t tee i sclearly Identified as the grantor of the awards.

Loans must be awarded only in the orderrecommended by the se lec t ion commi t tee .The number of loans to be awarded may bereduced but may not be increased from thenumber recommended by the selection.̂committee. unly tne committee may vary theamounts of the loans awarded.

3) Higibility requirements. The program mustimpose iden t i f i ab le m in imum requ i rements fo rloan elrgrbrlrty. These requirements must berelated to the purpose of the program andmus t l im i t t he i ndependen t se lec t i oncommittee’s consideration to those employ-ees, or children of employees, who meet theminimum standards for admission to an edu-cat iona l o rgan iza t ion fo r wh ich the loans areava i l ab le . No pe rsons w i l l be cons ide red e l i g i -b le i f they would not reasonably be expectedto attend such an organization, however, eveni f they meet the min imum s tandards . I f anemployee must have been employed for someminimum per iod by the employer to which theprogram re la tes to be e l ig ib le to rece ive aloan , o r to make tha t employee ’s ch i ld ren e l i -g ib le to rece ive a loan , the min imum per iod o femployment may not be more than 3 years.Moreover, elrgrbrlrty must not be related to anyother employment-related factors, such as theemployee’s position, services, or duties,Objective basis of selection. Selection ofloan rec ip ien ts must be based on ly uponsubstantial objective standards that arecomple te ly unre la ted to the employment o fthe recipients or their parents and to theemployer’s line of business. Such standardsas past academic performance, performanceon tests designed to measure ability andapt i tude for h igher educat ion, recommenda-tions from instructors or other individuals notre la ted to the po ten t ia l awardees, f inanc ia lneed, and conclusions drawn from personalinterviews as to motivation and character,may be used.

Employment. Once a loan has beenawarded, i t may not be terminated because

the recipient or the recipient’s parent nolonger works for the employer, regardless ofthe reason for the termination of employment.If a loan is awarded for one academic yearand the recipient must reapply for anadditional loan or loans to continue studies fora later year, the recipient may not be consid-ered ine l ig ib le fo r a subsequent loan srmplybecause tha t ind iv idua l o r the ind iv idua l ’ s par -ent is no longer employed by the employer . I fa loan is awarded for a period of more thanone academic year, subject to renewal, thestandards for renewal must be based only onnonemployment related factors such as needand maintenance of scholastic standards. Atthe time the loan is awarded or renewed,there must be no requirement, condition, orsuggestion, express or implied, that the recipi-ent or parent is expected to perform futureemployment services for the foundation or theemployer , or be avai lab le for fu tureemployment , even though the futureemployment is at the discretion of the founda-t ion or the employer .

6) Course of study. The courses of study forwh ich loans a re ava i lab le mus t no t be l im i tedto those that would be of particular benefit tothe employer or to the foundat ion. I f thecourses of study for which loans are availableinc lude one or more that wou ld be o f par t icu-la r benef i t , a loan may not be cond i t ioned onthe recipient choosing such a course of study.The recipient must have free choice to usethe loan in the pursuit of a course of study forwhich the loan is otherwise available that isnot of particular benefit to the employer or tothe foundat ion .

7) Other objectives. The terms of the loan andthe courses of study for which loans are avail-able must be consistent with a disinterestedouroose of enablina the recioients to obtainan educa t ion in theTr i nd i v i dua l capac i t i es on l yfor their personal benefit. The terms of theloan and courses of studv must not includeany commi tments , unders tand ings , , o robligations, conditional or uncondrtronal, sug-gesting that the studies are undertaken by therecipients for the benefit of the employer orthe foundation or have as their objective theaccomplishment of any purpose of theemployer or the foundat ion, even thoughconsistent with its exempt status, other thanto enab le the rec ip ien ts to ob ta in an educa-t i on i n t he i r i nd i v i dua l capac i t i es .

Percentage test. For a program that awardsloans to children of employees of a particularemployer, the program meets the percentage testif the number of loans awarded under that pro-gram in any year to those children are not morethan:

1) 25% of the number of employees’ childrenw h o -a) Were e l ig ib le ,

b) Were applicants for such loans, andc) Were considered by the selection

committee in selecting the recipients ofloans in that year, or

2) 10% of the number of employees’ childrenwho can be shown to be eligible for loans(whether or not they submitted an application)in that year. For purposes of this 10% test,ch i ld ren can be shown to be e l i g ib le on ly i fthey meet the min imum elrgrbrlrty requ i rementsof the loan program and the min imum stan-dards for admission to an educationalinstitution for which grants or loans are availa-b le . A p r i va te founda t ion may inc lude as e l ig i -ble only those children who submit a writtenstatement (or on behalf of whom a statementis submitted by an authorized representative),or for whom sufficient information is main-tained to demonstrate that:a) the child meets the foundation’s elrgrbrlrty

requ i rements ; and

b) the child has enrolled in or has comoleteda course of study to prepare for admissionto an educa t iona l i ns t i tu t ion a t the leve l fo rwh ich loans a re ava i lab le and has app l ied ,or intends to apply, to such an institutionfor enro l lment in the immed ia te ly suc -ceed ing academic year w i th the expecta-t i on , i f accep ted by the ins t i t u t i on , o fa t tend ing the ins t i tu t ion ; o r

c) in lieu of b) above, the child is currentlyenro l l ed in an educa t iona l i ns t i t u t i on fo rwh ich loans a re ava i lab le and i s no t i n thef ina l year for which awards may be made.

For a program that awards loans to employ-ees of a particular employer, the programmeets the percentage test if the number ofloans awarded under that program in any yearto the employees are not more than 10% ofthe number of employees who:

a) Were e l ig ib le ,b) Were applicants for such loans, andc) Were considered by the selection

commi t tee i n se lec t i ng the rec ip ien ts o floans in tha t year .

In meetina these oercentaae tests. an emoloveeor child of a: employee will & considered eligibleon ly i f t he ind iv idua l meets a l l o f the elrgrbrlrtyrequirements imposed by the program.Renewalsof loans awarded in earlier years will not be con-s idered in de termin ing the number o f loansawarded in a current year. Loans awarded tochildren of employees and those awarded toemployees w i l l be cons idered as hav ing beenawarded under separate programs whether or notthey are awarded under separately administeredprograms.

If a private foundation’s employer-related pro-gram includes educational loans and scholarshipor fellowship grants to the same group of eligibleemployees’ children, the percentage tests apply tothe to ta l number o f ind iv idua ls rece iv ing combinedgrants of scholarship, fellowship, and educationalloans .

If the loan program satisfies the sevenconditions, but does not meet the percentage test,all the relevant facts and circumstances will beconsidered in determining the primary purpose ofthe program.

I f your pr iva te foundat ion ho lds a ru l ing le t te rissued before September 29, 1980, you may con-t inue to re ly on that ru l ing le t te r prov ided the loanprogram fully complies with the seven conditionsand the percentage tests continuously from thedate on which the ruling letter was issued. Uponwritten request, the Service will issue a currentru l ing le t te r a f f i rm ing the qua l i f i ca t ion o f the loanprogram under these requirements.Certain designated grants. A grant by a privatefoundation to another organization that makespayments to a aua l i f i ed i nd i v idua l w i l l no t betreated as a grant by the private foundation to theind iv idua l i f the foundat ion does not earmark theuse of the grant for any named ind iv idua l andthere is no agreement (oral or written) wherebythe grantor organ izat ion has any par t in se lec t ingthe ind iv idua l g ran tee .Certain grants to public charities. A g ran t by apr iva te foundat ion to a pub l ic char i ty , o ther thanan organizat ion organized and operatedexclusively for testing for public safety, that thegrantee organization uses to make payments toan ind iv idua l as a qua l i f i ed g ran t , w i l l no t betreated as a grant by the private foundation to theind iv idua l g ran tee i f the gran t i s made fo r a p ro jec tto be undertaken and controlled bv the oubliccharity. The public charity must also control these lec t ion o f the g ran tee , a l though the se lec t ionneed not be comple te ly independent o f the pr iva tefoundat ion .

Grants to governmental agencies. I f a pr ivatefoundation makes a grant to a governmentalagency, and the grant is earmarked for use by anind iv idua l fo r t rave l , s tudy , o r o ther s imi la r

19

purposes, the grant is not a taxable expenditureby the pr ivate foundat ion i f the governmenta lagency satisfies the Service in advance that itsgrant-making program:

1) Is in furtherance of exempt purposes undersect ion 501 (c ) (3) ,

2) Requires the individual grantee to submitannual progress reports, and

3) Requires the organization to investigate jeop-ard ized grants .

Earmarked grants to individuals. A grant by apr iva te foundat ion to an ind iv idua l i s a taxab leexpenditure If:

1) The grant is earmarked to be used for apurpose described earlier under TaxableExpend/tures,

2) The grantor foundation causes the grantee,through an oral or written agreement, toengage in a proh ib i ted ac t iv i ty and the grant i sin fac t a taxab le expendi ture , and

3) The grant is made for a purpose other than apurpose of an organizat ion organized andopera ted exc lus ive ly fo r re l ig ious , char i tab le ,scientific, literary, or educational purposes,the fos ter ina o f na t iona l o r in te rna t iona l ama-teur sports competition (but only if no part ofi t s ac t i v i t i es i nvo l ve p rov id ing a th le t i c f ac i l i t i esor equipment), or the prevention of cruelty toch i ld ren o r an ima ls .

A grant by a private foundation is earmarked i fit is given under an agreement (oral or written) thatthe grant will be used for specific purposes.

Grants to organizations (including loans andprogram-related investments) are taxable expendi-tures, unless the recipients are public charitiesdescribed in section 509(a)(l), (2), or (3), orunless the private foundation exercisesexpenditure responsibility with respect to thegrant. However, expenditure responsibility is notrequi red i f the grantee organ izat ion meets theexception requirements described earlier underlnfluencmg elecbons and carrying on voterreg is t ra t ion d r i ves .

Reliance by grantors on public charity statusof grantees. As discussed in the preceding para-graph, a pr ivate foundat ion need not exerc iseexoenditure resoonsibilitv with resoect to a arant i fthe g ran t i s made to a pub l i c char i t y describ:d i nsection 509(a)(l), (2), or (3). If an organization towhich a private foundation wishes tomake a granthas rece ived a f ina l ru l ing or de terminat ion le t te rclassifying it as an organization described insection 509(a)(l), (2). or (3), the treatment ofgrants and contributions and the status of grantorsand cont r ibu to rs to the o rgan iza t ion w i l l genera l l ynot be affected by reason of a later revocation bythe Service of the organization’s classification untilthe date on which notice of change of status ismade to the pub l i c ( such as by pub l i ca t ion in theinternal Revenue Bu l le t in ) or ano ther app l i cab leda te , i f any , spec i f i ed i n the pub l i c no t i ce . Inappropriate cases, however, the treatment ofgrants and contributions and the status of grantorsand contributors to an organization described insection 509(a)(l), (2), or (3) may be affectedpend ing ve r i f i ca t i on o f t he con t inued c lass i f i ca t i ono f the o rgan iza t ion . No t i ce to th is e f fec t w i l l bemade in a pub l ic announcement by the Serv ice . Inthese cases the effect of grants and contributionsmade a f te r the date o f the announcement w i l ldepend on the s ta tu to ry qua l i f i ca t ion o f the o rgan i -za t ion as an o rgan iza t ion descr ibed in sec t ion509(a)(l), P), or (3).

Note. The preceding paragraph shall not applyi f the grantor or cont r ibutor :

1) Had knowledge of the revocation of the rulingor de te rmina t ion le t te r c lass i f y ing the o rgan i -za t ion as an o rgan iza t ion descr ibed in sec t ion5Wa)Uh (2), or (3), or

2) Was in part responsible for, or was aware of,the act, the failure to act, or the substantial

20

and mater ia l change on the par t o f the organ i -zation that gave rise to the revocation.

A grantor or contributor will not be consideredresponsible for the substantial and materialchange i f :

The total support received from such grantoror contributor for a taxable year is 25% orless of the total support received by thedonee organization from all sources(excluding support provided by the grantor orcontributor or related parties) for the fourimmediate ly preceding taxable years , or

The gran t o r con t r ibu t ion qua l i f i es as an unu-sua l g ran t .

Expenditure responsibility means that thefoundation exerts all reasonable efforts and estab-lishes adequate procedures:

1) To see that the grant is spent only for thepurpose for which it is made,

2) To obtain full and complete reports from thegrantee organization on how the funds arespent , and

3) To make full and detailed reports on theexpenditures to the IRS.

Pre-grant inquiry. If expenditure responsibilitymust be exercised, the foundation should conducta l im i ted inqu i ry concern ing the po ten t ia l g ran teebefore the grant is made. The inqu i ry shou ld dea lwith matters such as the identity, past history andexperience, management, activities, and practicesof the grantee organ izat ion, and shou ld becomplete enough to give reasonable assurancethat the grantee will use the grant for the purposesfor wh ich i t i s made .

Terms of grants. To meet the expendi tureresponsibility requirements, each grant must bemade subject to a written commitment signed byan appropriate officer, director, or trustee of thegrantee organ iza t ion . Th is commi tment mustinc lude the fo l lowing agreements by the grantee:

1) To repay any amount not used for thepurposes of the grant,

2) To submit full and complete annual reports tothe grantor foundat ion on the manner in whichthe funds are spent and the progress made inaccomplishrng the purposes of the grant,

3) To keep records of receipts and expendituresand to make its books and records availableto the grantor at reasonable times, and

4) Not to use any of the funds to influence legis-la t i on , to i n f l uence the ou tcome o f e lec t i ons ,to carry on voter registration drives, to makegrants to individuals or other organizations, orto undertake any nonexempt activity, whensuch use of the funds would be a taxableexpendi ture i f made d i rec t ly by the foundat ion.

Terms of program-related investment. T omeet the expenditure responsibility requirementsin making a program-re lated investment , a pr ivatefoundation must require that each investment bemade subject to a written commitment signed byan appropriate officer, director, or trustee of therec ip ien t o rgan iza t ion .

The commitment should specify the purpose ofthe investment and should contain an agreementby the organizatron:

1) To use all amounts received from the privatefoundation only for the purposes of theinvestment and to repay any amount not usedfor those purposes, provided that, for equityinves tments , the repayment i s w i th in the l im i -tations concerning distributions to holders ofequity interests,

2) To submit, at least once a year, a full andcomple te f inanc ia l repor t o f the type ord inar i l yrequired by commercial investors under simi-lar circumstances and a statement that it hascomplied with the terms of the investment,

3) To keep adequate books and records and tomake them ava i lab le to the pr ivate foundat iona t reasonab le t imes , and

4) Not to use any of the funds to carry on propa-ganda , i n f l uence l eg i s la t i on , i n f l uence theoutcome of any public elections, carry onvoter registration drives, or, when the recipientis a private foundation, to make grants that donot comply wi th the requ i rements regard ingind iv idua l g rants or expend i tu re respons ib i l i t y .

Certain arants to foreian oraanizations.Grants made to foreign organhations, other thanan organization described in section 509(a)(l). (2),or (3);are subject to the same restrictions on’the’use of the grant as those imposed on domesticprivate foundations. These restrictions may bephrased in appropriate terms under foreign law orcustom and ordinarily will be considered sufficienti f an a f f idav i t o r op in ion o f counse l (o f the grantoror grantee) is obtained stating that, under foreignlaw or custom, the agreement imposes the samerestrictions on the use of the grant as thoseimposed on a domest ic p r iva te foundat ion .

Special rules for grants by foreign privatefoundations. The failure of a foreign privatefoundation to comply with the restrictions imposedon grants will not constitute an act or failure to actthat is a prohibited transaction under section4948(c) of the Code.

Reports from grantees. The granting privatefoundation must require reports on the use of thefunds, compliance with the terms of the grant, andthe progress made by the grantee toward achiev-ing the purposes for which the grant was made.The grantee must make an annual accounting ofthe funds at the end of its accounting period andmust make a final report on all expenditures madefrom the funds in addition to the progress madetoward the goals of the grant.

Reliance on information supplied by grantee.A pr iva te foundat ion, exerc is ing expendi tureresponsibility with respect to its grants, may relyon adequate records or other sufficient evidencesuppl ied by the grantee organ izat ion showing theinformation that the grantor must submit to theIRS.

Recordkeeping requirements. In addition to theinformat ion requ i red when f i l ing a re turn , thegrant ing foundat ion must make ava i lab le to theIRS a t i t s ma in o f f i ce each o f the fo l l ow ing i t ems :

1) A copy of the agreement covering eachexpendi ture respons ib i l i t y grant made dur ingthe year,

2) A copy of each report received during the taxyear for each grantee on any expenditurerespons ib i l i t y g ran t , and

3) A copy of each report made by the grantor’spersonnel or independent auditors of anyaudits or other investigations made during thetax year on any expendi ture respons ib i l i tygrant .

Violations of expenditure responsibilityrequirements. Any diversion of grant funds( inc lud ing income f rom an endowment g ran t ) fo r ause no t spec i f ied in the g ran t may resu l t in tha tpar t o f the grant be ing t reated as a taxab leexpenditure. If the use of the funds is consistentwith the purpose of the grant, the fact that agrantee does not use any funds as indicated in theor ig ina l budget p ro jec t ion i s no t a d ive rs ion o ffunds .

I f a grantor foundat ion determines that any par tof the grant has been used for improper purposesand the grantee has not previously diverted grantfunds , the foundat ion w i l l no t be t rea ted as hav ingmade a taxab le expendi ture i f i t :

1) Takes all reasonable and appropriate stepseither to recover the grant funds or to ensurethe restoration of the diverted funds and thededicat ion o f the o ther grant funds he ld by thegrantee to the purposes of the grant, and

2) Withholds any further payments to thegrantee, af ter being made aware that a d iver-sion of funds may have taken place, until ithas received the grantee’s assurance thatfuture diversions will not occur and requiredthe grantee to take extraordinary precautionsto prevent further diversions from occurring.

I f a founda t ion i s cons ide red to have made ataxab le expendi ture , the amount o f the taxab leexpendi ture can be the amount o f the d ivers ionplus any further payments, or just the amount offurther payments depending on the measure ofcompl iance by the foundat ion .

Grantee’s failure to make reports. A fa i lu re tomake the required reports by the grantee willresu l t in the gran t be ing t rea ted as a taxab leexpenditure by the grantor unless the grantor:

1) Awarded the grant according to theexpenditure responsibility requirementsdiscussed earlier,

2) Complied with all the reporting requirements,3) Made a reasonable effort to get the required

reports, and4) WIthholds all future payments on this grant

and on any other grant to the same granteeunt i l the repor t i s p rov ided.

Violations by the grantor. In add i t ion to thecircumstances discussed earlier concerning taxa-b le expend i tu res , a g ran t ing foundat ion w i l l bet reated as making a taxab le expendi ture i f i t :

1) Fails to make a pre-grant inquiry,2) Fails to obtain the required written

commitments described earlier, or

3) Fails to make reports to the IRS as discussedear l ie r .

The reports to the Internal Revenue Serviceby the foundation on each expenditure responsi-b i l i ty grant must be made each year that any par tof the grant remains unexpended by the granteeat any t ime dur ing the year . The requi red repor tsmust be submi t ted w i th the organ iza t ion ’s annua lreturn (Form 990-PF or Form 5227). They mustinc lude the fo l low ing in fo rmat ion on each g ran t :

1) The name and address of the grantee,2) The date and amount of the grant,3) The purpose of the grant,4) The amounts spent by the grantee (based on

the most recent report received from thegrantee),

5) Whether, to the knowledge of the grantorfoundat ion, the grantee has d iver ted anyfunds from the purpose of the grant,

6) The dates of any reports received from thegrantee, and

7) The date and results of any verification of thegrantee’s reports undertaken by or at thedi rec t ion o f the grantor foundat ion .

Exceptions to taxable expenditures. Examplesof expenditures ordinarily not treated as taxableexpend i tu res inc lude :

1) Expenditures to acquire investments that gen-erate income to be used to further thepurposes of the organization,

2) Reasonable expenses related to acquiringthese investments,

3) Payment of taxes,4) Expenses that qualify as allowable deductions

in f igur ing the tax on unre la ted bus inessincome,

5) Any payment tha t i s a qua l i f y ing d is t r ibu t ion ,6) Any deduct ion a l lowed in a r r iv ing a t taxab le

net inves tment income,7) Reasonable expenditures to evaluate,

acquire, modify, and dispose of program-related investments, and

8) Business expenses of the recipient of a pro-gram-re la ted investment .

However, payment of unreasonable administra-tive expenses, including wages, consultant fees,and other fees for services performed, ordinarilywill be taxable expenditures unless made by thefoundat ion in the good fa i th be l ie f tha t theamounts were reasonable and were consistentwith ordinary business care and prudence.

Grants to noncharitable oraanizations. Aprivate foundation cannot m<ke a grant for apurpose not described in section 170(c)(2)(B)Permitted purposes are religious, cha;iiibi&, &ien-tific, literary or educational purposes, fosteringnat iona l o r in te rna t iona l amateur spor tscompet i t ion (bu t on ly i f no par t o f the ac t i v i t i esinvo lve p rov id ing a th le t i c fac i l i t i es o r equ ipment ) ,and prevent ing c rue l ty to ch i ld ren or an imals .Section 501 (c)(3) describes organizations that areorganized and operated exclusively for thesepurposes. Grants for nonpermitted purposes aretaxable expendi tures.

Accord ingly , a pr ivate foundat ion may not makea grant to an organization that is not described insection 501 (c)(3) unless, making the grant itself isa direct charitable act or a program-relatedinvestment, or the grantor is reasonably assuredthat the grant will be used exclusively for thepurposes of an organization described here.

If a private foundation makes a grant that is nota transfer of assets resulting from any liquidation,merger , redempt ion, recap i ta l iza t ion, organ izat ion,reoraanization. or other adiustment to anv oraani-zati& (other than an orgaiization described hsection 501 (c)(3) that is not exclusively organizedand ooerated for testina for oublic safetv). thegrant& is reasonably a&u&d that the i&t will beused exclusively for section 170(c)(2)(B) purposes(described earlikr) only if the grantee organizationagrees to keep these funds in a separate funddedicated to section 170(c)(2)(B) purposes. Inadd i t ion , the grantor must comply w i th theexpenditure responsibility requirements discussedear l ie r .

If a private foundation makes a transfer ofassets under any liquidation, merger, etc., to anyoerson. the transferred assets will not be consid-bred to’be used exclusively for section170(c)(2)(B) purposes unless the assets are trans-ferred to a fund or organization described insect ion 501 (c) (3) (o ther than an organizat ionorganized and operated for testing for publicsafety).

Chapter VIITaxes on Failure toDistribute IncomeGenerally, section 4942 of the Internal RevenueCode imposes an excise tax on any undistributedincome o f a pr iva te foundat ion . An add i t iona lexc ise tax w i l l be imposed on any income remain-ing undistributed at the end of the taxable period.

The income of the foundation must be distrib-uted as qualifying distributions, defined later.Pr iva te foundat ions must make qua l i fy ing d is t r ibu-tions to the extent of their minimum investmentreturn for the year. However, a foundation mayset aside funds for periods up to 60 months forcertain major projects. Excess qualifying distri-butions may be carried forward for a period of 5tax years immedia te ly fo l lowing the tax year inwhich the excess was created. Special transitionalrules apply to foundations created before May 27,1969.

Initial tax. An excise tax of 15% is imposed onthe und is t r ibu ted income o f a p r iva te foundat ionthat has not been distributed before the first davof the 2nd (or any succeeding) tax year followingthe year earned, if the first day falls within the tax-ah/i period. A short tax year-is considered a taxyear.

The in i t ia l tax may be abated i f the foundat ioncan show that the failure was due to reasonable

cause and no t to w i l l f u l neg lec t , and tha t the fa i l -ure to distribute was corrected within thecorrection period (described later).

Additional tax. I f t he in i t i a l t ax i s imposed andthe und is t r ibu ted income has no t been d is t r ibu tedby the end of the taxable period, an add i t iona ltax of 100% of the amount remaining undistrib-u ted w i l l be imposed . The tax w i l l no t beassessed, or if assessed will be abated, if theund is t r ibu ted income is reduced to zero dur ing thecorrection period.

Payment o f the exc ise tax is requ i red in add i t ionto, rather than instead of, making required distribu-t ions o f und is t r i bu ted income.

Exceptions. The tax does not apply to the undis-t r ibu ted income of a pr iva te opera t ing foundat ionor o f an exempt operat ing foundat ion.

Certain long-established private foundationsthat have prov ided long- te rm care fac i l i t ies cont in -uously since May 26, 1969, are treated as privateoperating foundations and, therefore, are notsubject to the excise tax on failure to distributeincome.

To qua l i f y fo r th is t rea tment , the foundat ionmust, on May 26, 1969, and continuously thereaf-ter to the end of the tax year, operate and keep upfacilities for the long-term care, comfort, mainte-nance or educat ion o f the permanent ly and to ta l l ydisabled, elderly, needy widows, or children as itspr inc ipa l func t iona l purpose . In add i t ion , the foun-dation must meet the requirements of theendowment test (defined in Chapter I) thatapp l ies to p r iva te opera t ing foundat ions .

An o rgan iza t ion w i l l meet the p r inc ipa l func t ionpurpose requ i rement i f i t i s organ ized for the pr in-c ipa l purpose o f opera t ing and ma in ta in ing theseres iden t i a l f ac i l i t i es and a t l eas t 50% o f t he qua l i -fy ing d is t r ibut ions normal ly made by the organiza-tion are spent for the operation and upkeep oft h e s e f a c i l i t i e s .

These foundations are treated as private oper-ating foundations on/y for the purposes of the dis-tribution requirements of section 4942 of theCode. A l l o ther ru les govern ing nonoperat ingpr iva te foundat ions , Inc lud ing ru les govern ingdeduc t ib i l i t y o f con t r ibu t ions , app ly .

incorrect valuation of assets. The tax a lsodoes no t app ly to the und is t r i bu ted i ncome o f apr iva te foundat ion tha t fa i led to d is t r ibu te on lybecause of an incorrect valuation of assets, if:

The incor rec t va lua t ion was no t w i l l f u l andwas due to reasonable cause,The undistributed income is distributed asqua l i f y ing d is t r ibu t ions dur ing the allowabledistribution period,The foundat ion no t i f i es the Serv ice tha t theincome has been distributed to correct its ear-l ie r fa i l u re to d is t r ibu te , andThe distribution is treated as a correction ofdeficient distributions for earlier tax years thatwould otherwise be subject to this tax.

The foundation must be able to show it hasmade a l l reasonab le e f fo r ts in good fa i th to va lueits assets according to applicable rules (see Va/u-ation of assets, later).

If a foundation, after full disclosure of the facts,obtains a good faith appraisal of an asset’s fairmarket value by a qualified appraiser (whether orno t tha t appra ise r i s a d isqua l i f i ed person w i threspect to the foundat ion) , and the foundat ionre l ies on tha t appra isa l , then fa i lu re to p roper lyvalue an asset will ordinarily be regarded as notwi l l f u l and due to reasonab le cause . However , , i f afoundat ion does no t ob ta in a good fa i th appra isa l ,the lack of such an appraisal will not, by itself,imply tha t the foundat ion ’s fa i lu re to proper ly va luean asset was willful and not due to reasonablecause .

Example. In 1986 the Martin Foundation,which was established in 1985, incorrectly valuedits assets in a manner that was not willful and wasdue to reasonable cause. As a result of theincor rec t va luat ion, $20,000, wh ich shou ld have

21

been distributed bv the end of 1987. is still undis-t r ibuted as of January 1, 1988. On September 29,1988, a not ice o f tax deficiencv i s ma i l ed to t hefoundat ion .

On November 5 , 1988, (w i th in the a l lowable d is -t r ibu t ion per iod) the foundat ion makes a qua l i fy ingdistribution of $20.000 whrch is treated as madeout of the foundation’s undistributed income for1986. The founda t ion no t i f i es the Serv ice o f i t saction. Under these circumstances the foundationwould have been l iab le fo r an in i t ia l tax o f $3 ,000(15% of $20,000). However, because the founda-tion meets the exception for failure to distributebecause of an incorrect valuation of assets, it isnot l iab le fo r the taxes .

Taxable period. The taxab le per iod beg ins onthe first day of the tax year and ends on the earlierof e i ther :

1) The date a notice of deficiency for the initialtax i s ma i l ed , o r

2) The date the initial fax is assessed.

The allowable distribution period begins onthe first day of the first tax year following the taxvear in wh ich an incor rec t va lua t ion o f foundat ionassets occured. The period ends 90 days after anot i ce o f de f i c iency fo r the in i t ia l fax i s m a i l e d .Th is per iod is ex tended by any per iod in wh ich thedeficiency cannot be assessed, and any otherperiod which the IRS determines is reasonableand necessary to permit a distribution of undistrib-uted income as requ i red under sec t ion 4942.Where a no t i ce o f de f i c iency i s no t ma i ledbecause there is a waiver of restrictions onassessment and collection of a deficiency, orbecause the de f i c iency i s pa id , t he f i l i ng da te o fthe waiver or the date of payment, is treated asthe end o f the a l lowab le d is t r ibu t ion per iod .

The correction period begins with the first day ofthe tax year in which there was a failure todistribute income and ends 90 days after a noticeof deficiency for the additional fax is mailed.The correction period is extended b y a n yper iod dur ing wh ich a deficiency cannot beassessed. In addition, this period may beextended by any period that the IRS determines isreasonable and necessary to make distributions ofund is t r ibu ted income as requ i red to comply w i thsec t ion 4942 .

Example 7. In 1985 the Jones Foundation, aprivate foundation that uses the calendar year asits tax year, made an error in asset valuation thatwas not willful and was due to reasonable cause.The error caused the Jones Foundation not todistribute $25,000 that should have been distrib-uted for 1985. On March 2. 1988. a notice of defi-ciency for the initial and additional tax wasmai led to the Jones Foundat ion . For the und is t r ib -u ted 1985 income, the taxab le per iod runs f romJanuarv 1. 1985. throuah March 2. 1988. and theallowable ‘distribution period runs from January 1,1986, through May 31, 1988 (90 davs after thenot ice o f de f i c iency was ma i led) . I f the Serv icedetermines that it is reasonable and necessary toextend the d is t r ibu t ion per iod through June 15,1988, the a l lowab le d is t r ibu t ion per iod runs f romJanuary 1, 1986, through June 15,1988.

Example 2. Assume the facts given inExample 1 except that the failure to distribute wasnot due to an incorrect valuation of assets. OnApr i l 1 , 1988, a no t i ce o f de f i c iency fo r the in i t ia land additional tax was mailed to the foundation.I f the Jones Foundat ion has no t f i l ed a pe t i t i onwi th the Tax Cour t for a redeterminat ion of thedeficiency, the correction period runs from Janu-ary 1 , 1985, through June 30, 1988, un less theServrce determines it is reasonable and necessaryto extend the correction period to permit theJones Foundation to distribute the 1985 undistrib-u ted income.

Undistributed income means the amount bywhich the drstributable amount for any tax yearexceeds the qua l i f y ing d is t r ibu t ions made ou t o fthe d is t r ibu tab le amount before the end o f thefo l lowing tax year .

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Distributable amount is equal to the minimuminvestment return of a private foundation reducedby the sum of any income taxes and the tax oninvestment income, and increased by

Amounts received or accrued as repaymentsof amounts taken into account as qualifyingdistributions for any tax year,Amounts received or accrued from the sale orother disposition of property to the extent thatthe acquisition of the property was considereda qual i fy ing d is t r ibut ion for any tax year , andAny amount set aside for a specific project(see Set-asides, later) to the extent theamount set aside was not necessary for thepurposes for which it was set aside.

I f a pr iva te foundat ion has income f rom d is t r ibu-tions from a solit-interest trust (defined in ChaoterI) a t t r ibu tab le ‘ to the income por t ion o f amountsplaced in trust after Mav 26, 1969, this income isinc luded in the d is t r i bu tab le amount ,

If a split-interest trust distributes income fromamounts placed in trust both on or before andafter May 26, 1969, these distributions must beallocated between those amounts placed in trustduring these periods to determine the extent towh ich the d is t r ibu t ions a re inc luded in the founda-t i on ’s d i s t r i bu tab le amoun t .

The income portion o f a d i s t r i bu t i on f r om asplit-interest trust to a private foundation is thegreater of :

1) The amount of the distribution that is treatedas trust income (under the governinginstrument and local law that applies), or

2) The guaranteed annuity, or fixed percentageof the fair market value of the trust propertyas determined annual ly , that the pr ivate foun-da t ion I S en t i t led to rece ive fo r a par t i cu la r taxyear, regardless of when the amount isactua l ly rece ived.

Limits. A private foundation does not have todistribute an amount greater than required for anytax year (without regard to the rules discussedearlier) if for that year the entire corpus of thesplit-interest trust making distributions to the foun-dation had been taken into account by the founda-t ion as an asse t used in f i gu r ing m in imuminvestment return.

Minimum investment return. The minimuminvestment return for any private foundation is 5%of the excess of the combined fair market value ofall assets of the foundation, other than those usedor held for use for exempt purposes, over theamount of indebtedness incurred to buy theseassets.

The combined fair market value of allfoundation assets includes:

The average of the fair market values on amonthly basis of securities for which marketquota t ions are readrly ava i lab le ,The averaae of the foundation’s monthlv cashbalances (minus cash balances excluded ascash he ld fo r char i tab le and re la ted ac t i v i t i es ) ,a n dThe fair market value of all other assets(except assets excluded from the computationof minimum investment return or assets usedfor exemot ourooses) for the oeriod of timeduring the tax year those assets are held bythe foundat ion. For the determinat ion o f thefair market value of the asset, see Valuationof assets, later in this chapter.

Certain assets are not included in determin-ing min imum inves tment re tu rn . These inc lude :

1) Any future interest (such as a vested or con-t ingent remainder , whether lega l or equ i tab le)o f a foundat ion in the p r inc ipa l o r income o fany real or personal property (other than afuture interest created by the foundation after1969) un t i l a l l i n te rven ing in te res ts in , andrights to the actual possession or enjoymentof , that proper ty have expi red, or unt i l the

future interest has been constructivelyreceived by the foundat ion even though thefuture interest has not been actually reducedto possession by the foundation. Examples ofa constructively received future interest are afuture interest that has been credited to thefoundation’s account, set apart for the foun-dat ion , o r o therwise made ava i lab le so tha tthe foundat ion may acqu i re i t a t any t ime, orcou ld have acqu i red the in teres t had the foun-da t ion g iven no t i ce o f i t s i n ten t ion to acqu i re ,The assets of an estate until those assetsare d is t r ibu ted to the foundat ion o r , due to apro longed per iod o f admin is t ra t ion , the es ta teis considered terminated for federal incometax purposes,Any present foundation interest in any trustcreated and funded by another person,Any pledge of money or property to thefoundat ion , whether or not the p ledge islega l l y en fo rceab le , andAny assets used (or held for use) forexempt purposes.

Assets used for exempt purposes. An asset isused (or held for use) for exempt purposes only ifi t i s ac tua l l y used by the foundat ion in car ry ing onthe char i tab le , educa t iona l , o r s im i la r func t ion tha tgives rise to its exempt status, or if the foundationowns the asset and establishes to the satisfactionof the Serv ice tha t i t s immedia te use in exemptfunctions is not practical and that definite plansex is t to beg in the use w i th in a reasonab le per iodo f t ime.

Assets held for the production of income or forinvestment (for example, stocks, bonds, interest-bear ing notes, endowment funds, or genera l ly ,leased real estate) are not considered used orheld for use for exempt purposes even though theincome from those assets is used to carry out anexempt purpose. Whether an asset is held for theproduction of income or for investment rather thanused or held for use directly by the foundation forexempt purposes is a factual question. Forexample , an o f f i ce bu i ld ing used to p rov ide o f f i cesfor employees engaged in managing endowmentfunds for the foundation is not considered anasset used for exempt purposes.

However, where property is used both forexempt and nonexempt purposes, the propertywill be considered as being used entirely forexempt purposes if at least 95% of its total use isfor exempt purposes. But, if less than 95% of itstotal use is for exempt purposes, a reasonableal locat ion must be made between exempt andnonexempt use. Property acquired by the founda-tion to be used for an exempt purpose will be con-sidered an asset used for exempt purposes eventhough all or part of the property is leased for al imi ted and reasonab le t ime (genera l ly no morethan one year) while arrangements are made toconvert it to use for exempt purposes.

Where the income-producing use continuesbeyond a reasonable t ime, the proper ty wi l l not beconsidered an asset used for exempt purposes.Ins tead, a t the t ime the income-produc ing usebecomes unreasonable, the property will be con-sidered disposed of to the extent the acquisitionwas taken in to accoun t as a qua l i f y ing d is t r ibu t ion .If the property is later used by the foundation forexempt purposes , a qua l i f y ing d is t r ibu t ion in anamount equa l to i ts fa i r market va lue a t tha t t imewi l l be cons idered to have been made a t the t imethe exempt use begins.

Assets used for exempt purposes include:

1) Administrative assets, such as office equip-ment and supp l ies , used by foundat ionemployees and consultants to the extentthese assets are devoted to and used directlyin the admin is t ra t ion o f exempt ac t i v i t i es ,

2) Real estate or the part of a building used bythe founda t ion d i rec t l y in i t s exempt ac t i v i t i es ,

3) Physical facilities used in exempt activitiessuch as paintings or other works of art ownedby the foundat ion on pub l i c d isp lay , c lass room

fixtures and equipment, and research facilitiesand related equipment which, under the factsand circumstances, serve a useful purpose inthe conduct of the exempt activities,

4) Any interest in a functionally related business(see Chapter X), or in a program-relatedinvestment (see Chapter IX),

5) The reasonable cash balances necessary tocover current administrative expenses andother normal and current disbursementsdirectly connected with the foundation’s chari-tab le , educat iona l , o r o ther s imi la r exemptac t i v i t i es , and

6) Any property leased by a foundation incarrying out its exempt purpose at no cost, orat a nominal rent, to the lessee or for a pro-gram-related purpose such as the leasing ofrenovated apartments to low-income tenantsat a low rental as part of the lessor-founda-t ion ’s p rogram fo r rehab i l i ta t ing a b l igh tedarea of a communi ty.

Reasonable cash balance. The reasonablecash balances that a private foundation needs tohave on hand to cover current administrativeexpenses and other normal and current distribu-tions for exempt purposes generally will be con-sidered to be an amount f igured on an annualbasis equal to l’h% of the combined fair marketva lue o f a l l f ounda t ion asse ts used in f i gu r ing m in i -mum investment return (reduced by any acquisi-tion indebtedness for those assets but withoutreduction for the reasonable cash balance). Afoundation may exclude 1’12% under this rule evenif it is more than the average cash balance of thefoundat ion . However , i f an add i t iona l amount i snecessary to pay expenses and make disburse-ments, that amount does not have to be includedIn figuring mmimum investment return. All remain-ing cash ba lances w i l l be i nc luded in the compu ta -t i on .

If an amount in excess of the l’h% figure isclaimed for any year, a statement must beattached to Form 990-PF for that vear exolaininathe reasons for the larger amount.- -

Valuation of assets. When f i gu r ing the m in i -mum investment re turn, a foundat ion may use anyreasonable method to determine the fair marketva lue on a mon th ly bas is o f secur i t i es i nc lud ing ,but not limited to, common and preferred stock,bonds, and mutual fund shares, for which marketquota t ions a re read i l y ava i lab le as long as tha tmethod is consistently used. Market quotationsare cons idered read i l y ava i lab le i f a secur i t y i s :

1) Listed on the New York or American stockexchanges or any city or regional exchangefor which quotations appear on a daily basis,inc lud ing fo re ign secur i t i es l i s ted on a recog-n ized fore ign, nat iona l , o r reg iona l exchange,

2) Regular ly t raded in the nat ional or reg ionalover-the-counter market for which publishedquota t ions are ava i lab le , o r

3) Locally traded, for which quotations can read-ily be obtained from established brokeragef i rms .

For securities held in trust for, or on behalf of, afoundat ion by a bank or o ther f inanc ia l ins t i tu t ionthat values those securities periodically using acomputer, a foundation may determine the correctvalue of the securities by use of this computerpricing system if the system is acceptable to theIRS for federal estate tax purposes.

Example 1. The Young Foundation, a privatefoundation, owns 1,000 shares of Smith Corpora-tion stock, which is regularly traded on the NewYork Stock Exchange. The Young Foundation mayfollow a consistent practice of valuing Smith Cor-poration stock on the last trading day of eachmonth based on its closing price for that day.

Example 2. The Young Foundation, a privatefoundation, owns 1,000 shares of an unlisted cor-pora t ion , wh ich i s loca l l y t raded. Quota t ions on

unlisted stock can be readily obtained from estab-lished brokers. The Youna Foundation mav con-sistently value its unlisted-stock as of the i5th dayof each month by gettmg a bona fide quote of thebid and asked prices from an established broker-age firm and by taking the mean of those priceson tha t day . I f a quota t ion is no t ava i lab le on theregu lar va luat ion dates , the Young Foundat ionmay value its unlisted stock based on a bona fidequote obtained on the first day after the regularva lua t ion da te tha t the quo ta t ion i s ava i lab le .

Reductions in value for blockage or similarfactors. In de te rmin ing the va lue o f secur i t ies ,the private foundation may establish that as aresult of (1) the size of the block of securities, (2)the fact that the securities are in a closely heldcorporation, or (3) the fact that the sale of thesecurities would result in a forced or distress sale,the price at which the securities could be soldoutside the usual market may be a more accurateindication of value than market quotations. In sucha case, any reduction in value for all of these rea-sons together may not be more than 10% of thefair market value of the securities to which thed iscoun t app l i es .

Unlisted securities effectively controlled byfoundation and disqualified persons. I f thefoundation owns voting stock of an issuer ofunlisted securities and has, or together with dis-qualified persons or another private foundationhas, effective control of the issuer, then, to theextent that the issuer’s assets consist of shares oflisted securities issues, the assets shall be valuedmonthly on the basis of market quotations.

Cash. For purposes of the minimuminvestment return, a foundation figures its cashbalances on a monthly basis by averaging theamount of cash on hand on the first and last daysof each month .

Common trust funds. I f a pr iva te foundat ionowns a participating interest in a common trustfund es tab l i shed and admin is te red under a p lanprov id ing fo r the per iod ic va lua t ion o f par t i c ipa t inginterests during the fund’s tax year and reportingthese valuations to participants, the value of thefoundation’s interest in the common trust fundbased on the average of the valuations reportedto the foundat ion dur ing i t s tax year w i l l o rd inar i l ybe an acceptab le method o f va lua t ion fo rpurposes of the minimum investment return,

Other assets. The fair market value of assetsother than those described earlier is determinedannua l ly except as descr ibed la te r . The va lua t ionmay be made by pr ivate foundat ion employees orby any other person, whether or not that person isa d isqua l i f i ed pe rson . Such a va lua t ion , i faccepted by the IRS, is valid only for the tax yearfor wh ich i t i s made. A new va lua t ion i s requ i redfor the following tax year. However, the fair marketva lue o f any in te res t in rea l ty , inc lud ing anyimprovements thereon, may be determined on a5-year basis by a written, certified, independentappra isa l by a qua l i f i ed pe rson who i s ne i the r adisqualified person (see Chapter V) nor anemployee of the pr ivate foundat ion.

The appraisal must contain a statement to theeffect that, in the appraiser’s opinion, theappraised assets were valued in accordance withva luat ion pr inc ip les regu lar ly employed in mak ingappraisals of such property using all reasonablevaluation methods. The foundation must keep acopy of the independent appraisal for its records.I f a va lua t ion i s reasonab le , the foundat ion mayuse it for the tax year for which the valuation ismade and for each of the 4 fo l lowing tax years .

Any va luat ion of rea l proper ty by a cer t i f ied,independent appra isa l may be rep laced dur ing the5-year per iod by a la ter 5-year va lua t i on by acer t i f ied , independent appra isa l o r by an annualva lua t ion . The mos t recen t va lua t ion w i l l be usedin f igu r ing the foundat ion ’s m in imum inves tmentreturn.

The va luat ion must be made no la ter than thelast day of the first tax year for which the new val-ua t i on app l i es .

A va luat ion , i f p roper ly made accord ing to therules discussed here, will not be disturbed by theIRS dur ing the 5-year per iod fo r wh ich i t app l ies ,even if the actual fair market value of the propertychanges dur ing tha t per iod .

Commonly accepted valuation methods must beused in mak ing the appra isa l . A va lua t ion basedon acceptable methods of valuing property forfederal estate tax purposes is acceptable. Anappra isa l i s a determinat ion o f fa i r market va lueand should not be construed in a technical senseto be peculiar to particular property or intereststhere in as , fo r example , minera l in teres ts in rea lproperty.

Valuation date. If an asset is required to be val-ued annua l ly , the asset may be va lued as o f anyday in the pr ivate foundat ion ’s tax year i f the foun-dation follows a consistent practice of valuing theasset as of that date in all tax years. A valuation ofreal estate determined on a 5-year basis by acer t i f ied , independent appra isa l may be made asof any day in the first tax year of the private foun-dat ion to wh ich the va lua t ion i s to be app l ied .

Assets held for less than a tax year. I f anasset is held for less than one tax year, the valueof that asset is found by multiplying the fair marketvalue of the asset by a fraction. The numerator ofthe fraction is the number of days in the tax yearthat the foundation held the asset, and thedenominator i s the to ta l number o f days in the taxyear.

CIualifying distributions. A qualifying distribution

1) Any amount (including program-relatedinvestments and reasonable and necessarygrant administrative expenses, subject to thel im i t d i scussed l a te r ) pa id t o accomp l i sh re l i g -ious , char i tab le , sc ien t i f i c , l i t e ra ry , o r o therpublic purposes. Qualifying distributions donot include contributions to organizationscont ro l led by the cont r ibu t ing foundat ion or byone or more disqualified persons with respectto the foundation (see Chapter V) or to privatenonoperating foundations (with exceptions forcer ta in cont r ibu t ions to exempt o rgan iza t ions ,discussed later).

2) Any amount paid to buy an asset used (orheld for use) directly to carry out a charitableor o ther pub l ic purpose. Deprec ia t ion onthese assets, however. is not considered aqua l i f y ing d i s t r i bu t ion .

3) Any qualifying amount set aside (discussedlater ) .

In genera l , a d i s t r i bu t ion to a pub l i c char i t ydescribed in section 509(a)(l), (2) or (3) toaccomp l i sh a re l i g i ous , cha r i t ab le , sc ien t i f i c , l i t e r -ary , educat iona l , o r o ther permi t ted pub l ic purposeis a qua l i f y ing d is t r ibu t ion . See Chapter V I , underthe heading Grants to Organizations, for rules onwhen a pr ivate foundat ion may re ly on the publ iccharity status of a grantee.

The amount o f a qua l i f y ing d is t r ibu t ion o f prop-ertv is the fair market value of the oroperty on thedate i t i s made . The amoun t o f a qua l i f y ing d i s t r i -bution is determined only under the cash receiptsand disbursements method.

A private foundation that bought an asset andc la imed a aua l i f v ina d is t r ibu t ion under i tem (2 ) w i l lbe a l l owed ’a secoid qua l i f y ing d is t r ibu t ion fo r thesame asset if the asset is later given to a publiclysupported charitable organization that is not con-t ro l led by the founda t ion , and i t i s dona ted fo r apurpose described in item (1).

The amount o f the second qua l i f y ing d is t r ibu t ionwill be the difference between the fair marketvalue of the asset on the date of the contributionand the amount o f the f i r s t qua l i f y ing d is t r ibu t ion .

Limit on administrative expenses. For taxyears beginn ing af ter 1984 and before 1991, thebeginn ing amount o f grant admin is t ra t iveexpenses that may be included in any tax year asa qua l i f y ing d i s t r i bu t i on i s l im i ted to the excess o f :

23

1)

2)

0.65% of the sum of the foundation’s netassets for the tax year and the immediatelypreceding 2 tax years, over

The to ta l amount o f grant admin is t ra t iveexpenses paid during the 2 preceding taxyears that were included as qualifying distribu-tions. However, the amount of grant adminis-trative expenses taken into account for anypreceding tax year that began before 1985 isl im i ted to 0 .65% o f the foundat ion ’s ne tassets for that year.

For this purpose, “grant administrativeexpenses” are any adminrstrative expenses allo-cable to the making of contributions, gifts, orgrants that are qualifying distributions. “Netassets” are the combined fair market values of allthe foundation’s assets other than those used orheld for use in carrying out exempt purposes,minus the amount of indebtedness incurred to buythese assets.

Borrowed funds. If a private foundation borrowsmoney dur ing a tax year to make a char i tab leexpend i tu re , then a qua l i f y ing d is t r ibu t ion i s con-sidered made only at the time the borrowed fundsare actually distributed for a charitable purpose.

Control. An organizatron is controlled by a foun-dation or by one or more disqualified persons ifany of these persons may, by combining theirvotes or positions of authority, require the organi-zation to make an expenditure or prevent theorganizat ion f rom making an expendi ture, regard-less of the method by which control is exercisedor exercisable. Control of a donee organization isdetermined without regard to any conditionsimposed on the donee as part of the distribution orany other restrictions as to how the distributionmay be used unless the conditions and restric-tions are imposed on a distribution of net assets toterminate private foundation status (as discussedIn Chapter Ill).

In genera l , i t i s the donee, no t the d is t r ibu t ion ,that must be controlled by the distributing privatefoundatron to d isqua l i f y an o therw ise qua l i f y ingdistribution. If a foundation provides support to anorganization and imposes budgetary procedureson tha t o rgan iza t ion , th is will no t , o f i t se l f ,constitute control of the donee. Budgetary proce-dures include expenditure responsrbility to requirereports from the donee organization on:

1) The use of the funds,

2) Compliance with the terms of the grant, and

3) The progress made by the donee towardachieving the purposes for which the grantwas made.

The cont ro l led organ iza t ion does not have to bea pr ivate foundatron. I t may be any k ind of exemptor nonexempt o rgan iza t ion inc lud ing a schoo l ,hosp i ta l , opera t ing foundat ion , o r soc ia l we l fa reorganizatron.

Changes in asset use. If an asset not used orhe ld fo r use fo r pub l i c o r char i tab le , educa t iona l ,etc. purposes is later converted to exempt use,the foundation mav treat the conversion as a aual-i f y ing d is t r ibu t ion . The amount o f the qua l i f y ingdistribution is the fair market value of the con-verted assets on the conversion date. For deter-mining fair market value of the assets, seeVa lua t ion of A s s e t s , d iscussed ea r l i e r .

The da te a foundat ion adop ts and immed ia te lybeg ins to imp lement a p lan to conver t p roper tyfrom nonexempt to exempt uses is the conversiondate even if the actual conversion occurs later.

Payment of any Chapter 42 excise taximposed on the foundation is not considered aqua l i f y ing d i s t r i bu t ion .

Set-asides. An amount set aside for a specificpro jec t may be t rea ted as a qua l i f y ing d is t r ibu t ionin the vear set aside (but not in the vear actuallvpa id ) i f a t the t ime o f the se t -as ide the foundat ionestablishes to the satisfaction of the Service that:

1) The amount w i l l ac tua l l y be pa id fo r the spe-crfrc project within 60 months from the date ofthe frrst set-aside, and

2) The set-aside satisfies the suitability test,that is, that the project is one that can bebetter accomplished by a set-aside than byimmediate payment, or the foundation satis-fies the cash distribution test (discussedlater ) .

Suitability test. To satisfy the suitabilrty test,the foundation must show that the specific projectfor which the amount is set aside is one that canbe better accomplished by the set-aside than bythe immediate payment of funds. Such a specificp ro jec t i nc ludes , bu t i s no t l im i t ed to , s i t ua t i onswhere relatively long-term grants or expendituresmust be made to assure the continuity of particu-lar charitable projects or program-relatedinvestments, or where grants are made as part ofa matching-grant program. An example of a spe-c i f i c p ro jec t i s a p lan to bu i ld an a r t museum eventhough the exact location and architectural planshave not been finalized. For good cause shown,the period for paying the amount set aside may beextended by the Serv ice.

To qualify under the suitability test, a set-asidemust be approved by the IRS, as explained later.

Cash distribution test. The foundation satis-fies the cash distribution test if:

The specific project for which the amount isset aside will not be completed before the endof the tax year in which the set-aside is made,

The foundation actually distributes for exemptpurposes, in cash or its equivalent, the start-up period minimum amount during the foun-dation’s start-up period, andThe foundation actually distributes the full-payment period minimum amount in eachtax year of the foundation’s full-paymentper iod.

Start-up period minimum amount. General ly,the start-up period consists of the 4 tax yearsfollowing the tax year in which the foundation wascreated (or otherwise became a private founda-tion). For this purpose, a foundation is consideredcreated in the tax year in which its distributableamount first exceeds $500. The start-up periodmin imum amount , the amount that a pr ivate foun-dation must actually distribute during its start-upperiod, is not less than the sum of:

1) 20% of its distributable amount (as definedearlier) for the first tax year of the start-upper iod,

2) 40% of its distributable amount for the secondyear of the start-up period,

3) 60% of its distributable amount for the thirdyear of the start-up period, and

4) 80% of its distributable amount for the fourthyear of the start-up period.

The sum of these amounts must be distributedbefore the end of the start-up period. There is norequi rement that any par t be d is t r ibuted in any par-ticular tax year of the start-up period.

In genera l , on ly a d is t r ibu t ion ac tua l l y madeduring the start-up period is taken into account indetermining whether the foundation has distrib-uted the s tar t -up per iod min imum amount . How-ever , a d is t r ibu t ion ac tua l ly made dur ing the taxyear in which the foundation was created (the yearimmediately preceding the foundation’s start-upperiod) may be treated as made during the start-up pe r iod . A lso , a d i s t r i bu t ion ac tua l l y made w i th in5’12 months after the end of the start-up period willbe treated as made during the start-up period if (a)the foundation was unable to determine its distrib-utable amount for the fourth tax year of the start-up per iod unt i l a f ter the end of the per iod, and (b)the foundat ion ac tua l l y made d is t r ibu t ions be fo rethe end of the start-up period based on a reasona-ble estimate of its distributable amount for thatfourth tax year.

Full payment period minimum amount. T h efounda t ion ’s fu l l -payment per iod inc ludes each taxyear that begins after the end of the start-upper iod . The fu l l payment per iod min imum amount ,the amount tha t the foundat ion must ac tua l l ydistribute in cash or its equivalent in each tax yearof the full-payment period, and must be not lessthan 100% of its distributable amount, describedearlier, for that year, without regard to theCar ryover o f excess qua l i f y ing d i s t r i bu t i ons ,discussed later.

However, if the foundation distributes in a taxyear an amount in excess of the full-paymentperiod minimum amount for that year, the excessreduces the fu l l -payment per iod min imum amountfor the 5 tax years immedia te ly fo l lowing the taxyear in which the excess distribution is made. Theexcess is applied to reduce the full-paymentper iod m in imum amount in each success ive taxyear of the 5-year per iod , in o rder , un t i l comp le te lyused up .

Failure to distribute minimum amounts. I fthe foundation fails to actually distribute the start-up per iod min imum amount dur ing the s tar t -upper iod o r , genera l l y , i f i t fa i l s to d is t r ibu te the full-payment per iod min imum amount dur ing a taxyear of the full-payment period, then any set-asidemade by the foundat ion dur ing the appropr ia teper iod w i l l no t be t rea ted as a qua l i f y ing d is t r ibu-tion unless it was approved by the IRS under thesuitability test. Also, any set-aside made afterthe year o f such a fa i lu re to d is t r ibu te a min imumamount w i l l be t rea ted as a qua l i f y ing d is t r ibu t ionon ly i f the Serv ice approves i t under the su i tab i l i t ytest.

However. if the foundation’s failure to distributethe fu l l -payment pe r iod m in imum amoun t du r ing atax year o f the fu l l -payment per iod is not w i l l fu land is due to reasonable cause, the foundationmay correct the failure. To do so, it must distributewithin the correction period (discussed earlier)cash or its equivalent in an amount not less thanthe d i f fe rence between the fu l l -oavment oer iodminimum amount for the tax year and the amountac tua l ly d is t r ibu ted dur ing tha t year . The add i t iona ld i s t r i bu t ion i s t rea ted as ihough i t had been madein the year in wh ich i t o r ig ina l l y shou ld have beenmade, for purposes of meeting the cash distribu-tion test. If a foundation fails to distribute the full-payment per iod min imum amount dur ing theappropriate tax year because the amount can bedetermined only af ter the end of that tax year , no“willful failure to distribute” will occur if the foun-dat ion makes an add i t iona l d is t r ibu t ion w i th in 5%months after the end of the tax year.

Contingent set-aside. I f a pr iva te foundat ion isinvo lved in l i t i ga t ion and may no t d is t r ibu te asse tsor income because of a court order, it may seekand obtain a set-aside for the purpose of making aqua l i f y ing d is t r ibu t ion . The amount tha t may be se taside is equal to the part of the foundation’s dis-tributable amount that is attributable to the assetsor income held under the court order that wouldotherwise have been distributed.

I f the l i t iga t ion las ts more than one tax year , thefoundation may seek additional continaent set-asides. The amounts must actually bedistributedby the las t day o f the tax year fo l lowinq the taxyear in which the proceedings end. Amounts thefoundat ion does not d is t r ibu te by the end o f tha tyear will be considered gross income to the foun-dat ion for the fo l lowing tax year .

Approval of a set-aside must be obtained fromthe IRS for the set-aside to qualify under the suit-ability test. No advance approval is required forqua l i f i ca t i on unde r t he cash d i s t r i bu t i on t es t . Afoundat ion must apply for Serv ice approval by theend o f the tax year in which the amount is to beset aside. If the foundation fails to seek approvalbefore that date, an otherwise proper set-asidewi l l no t be t rea ted as a qua l i f y ing d is t r ibu t ion .

To obtain approval for a set-aside under thesuitability test, a foundation must write to the Inter-na l Revenue Serv ice, 1111 Const i tu t ion Avenue,

24

N.W., Washington, DC 20224, Attention: E:EO,and inc lude :

1) A statement describing the nature andpurposes of the specific project and theamount of the set-aside for which approval isrequested,

2) A statement describrng the amounts andapprox imate dates o f any p lanned add i t ions tothe set-aside after its initial establishment,

3) A statement of the reasons why the projectcan be better accomplished by the set-asidethan by immediate payment ,

4 ) A de ta i l ed desc r ip t i on o f the p ro jec t , i nc lud ingestimated costs, sources of any future fundsexpected to be used for comoletion of thepro jec t , and the loca t ion or loca t ions (genera lor specific) of any physical facilities to beacquired or constructed as part of the project,a n d

5) A statement by an appropriate foundationmanager that the amounts set aside willac tua l l y be pa id fo r t he spec i f i c p ro jec t w i th ina spec i f ied per iod o f t ime end ing no t morethan 60 months after the date of the first set-aside; or a statement showing good causewhy the period for paying the amount setas ide shou ld be ex tended ( i nc l ud ing ashowing that the proposed project could notbe divided into two or more projects coveringperiods of no more than 60 months each),and grving the extension of time requested.

Statement required for cash distributiontest Although Service approval is not requiredfor set asides qualifying under the cash distribu-tion test, the foundation must attach to its annualreturn for any tax year in which amounts are setas ide , the fo l l ow ing :

1) A statement describing the nature andpurposes of the specific project for whichamounts are set aside,

2) A statement that the amounts set aside willac tua l l y be pa id fo r t he spec i f i c p ro jec t w i th ina specified period that ends no more than 60months after the date of the set-aside,

3) A statement that the project will not be com-pleted before the end of the tax year in whichthe set-aside is made,

4) A statement showing the distributableamounts for any past tax years in the founda-tion’s start-up and full-payment periods, and

5) A statement showing the total amount ofactual payments in cash or its equivalent forexemot ourooses durina each tax vear in thefoundation’s start-up a;d full-payment peri-ods . Th i s s ta temen t shou ld i nc lude a de ta i l eddescription of any corrective or otherpayments that are treated, according to therules discussed earlier, as distributed during atax year prior to the tax year in which actuallymade, and should explain the circumstancesthat justify the application of those rules.

The foundat ion mus t a lso a t tach to i t s annua lreturn for each of the 5 tax years following the taxyear in which the amount is set aside (and foreach tax year in any extended per iod for payingthe amount set aside) the statements described in(4) and (5) above.

Evidence of set-aside. A set-aside approvedby the Service or that meets the cash distributiontest should be shown by entering a dollar amounton the books of the foundation as a pledge oroblrgatron to be paid at a future date or dates. Anyamount se t as ide w i l l be taken in to accoun t in f i g -ur ing the foundat ion ’s min imum inves tment re turnand any income from the set-aside should betaken in to account in f igur ing the ad jus ted ne tincome o f p r iva te opera t ing foundat ions . Theamount set aside need not reflect anaccumu la t i on o f i ncome , bu t may be abookkeeping entry that WIII require funding out ofcorpus by the end of the set-aside period.

Certain contributions to exempt organizations.A “qualifying distribution” includes a contributionto a pr ivate nonoperat ing foundat ion or to anorgan iza t ion fo rmed for cer ta in re l ig ious , char i ta -b le , sc ien t i f i c , educa t iona l , o r o ther exemptpurposes that is controlled (see Control, earlier)by the contr ibut ing foundat ion or by one or moredisqualified persons or to a private nonoperatingfoundat ion i f :

1) Not later than one year after the end of thetax year in which the donee organizat ionreceived the contribution, it makes a distribu-t ion equa l to the fu l l amount o f the cont r ibu-t i on and the d i s t r i bu t ion i s a qua l i f y ingdistribution that is treated as being made outof corpus (or would be treated as such if thedonee organization were a private nonoperat-ing foundat ion) , and

2) The private foundation making the contribu-tion obtains adequate records or enoughother ev idence f rom the donee oraanizat ionshowing that the donee organizatizn hasmade a qualifvinq d is t r i bu t ion . The ev idencemust also show the names and addresses ofthe rec ip ien ts o f the qua l i f y ing d i s t r i bu t ions ,the amount received by each, and that thedistribution is treated as being made out ofcorpus (or would be so treated if the doneeorganizat ion were a pr ivate nonoperat ingfoundat ion) .

When a distribution is for an administrativeexpense that is for public charitable purposes or ispar t o f another pub l ic char i tab le expend i tu re tha tcannot reasonably be separately accounted for,the record-keeping requirements of item (2) aresatisfied if the donee organization submits astatement giving the general purpose for which itis making the expenditure and stating that theamount was d is t r ibu ted as a qua l i f y ing d is t r ibu t ion .

If both requirements are not met, no part of thecont r ibu t ion w i l l be t rea ted as a qua l i f y ing d is t r ibu -t ion . To meet the d is t r ibu t ion requ i rements , thedonee organization must, by the close of the firsttax year after the tax year in which the contributionis rece ived , d is t r ibu te an amount equa l in va lue tothe cont r ibu t ion , and i t must have no remain ingundistributed income for the year in which the con-tribution was received.

If a donee organization redistributes less thanan amount equa l to the to ta l con t r ibu t ions f romdonor organizations that are required to be redis-tributed by the end of the first tax year after thetax year in which they were received, amountstreated as redistributions will be considered asmade pro ra ta f rom a l l con t r ibu t ions rece ived inthe prior tax year that are required to be redis-tributed by the donee organization regardless ofany earmarking or identification of the sourcemade by the donee. The amounts considered asnot to have been red is t r ibu ted w i l l be inc luded prorata in the gross income of each donor foundationin the foundation’s first tax year beginning afterthe close of the donee organization’s tax year inwhich the amount shou ld have been d is t r ibu ted .

The characterization of qualifying distributionsmade during the tax year (that is, whether out ofthe prior or current year’s undistributed income, orcorpus) is made as of the close of the tax year inquest ion, except when the donee organ izat ionchooses to treat all or part of the distribution asmade out o f a d is t r ibu t ion f rom corous m a d e i n adesignated prior tax year (see Treatment of qua/i-fying distribut/ons, discussed later). Once it isdetermined tha t a qua l i f y ing d is t r ibu t ion i s f romcorpus, that distribution will first be charged to dis-tributions that are required to be redistributed asdescr ibed ear l ie r .

A l l amoun ts con t r i bu ted to a spec i f i c cha r i t ab le ,educa t iona l . reliqious. e tc . exemot o raan iza t ion inany one tax yea; of that organizat ion will bet rea ted as a s ing le con t r ibu t ion by the con t r ibu t ingpr ivate foundat ion.

If the requirements for establishing the contribu-t ion as a qua l i f y ing d is t r ibu t ion to cer ta in exempt

organizations are not completely satisfied, thenonly that part of the contribution that was redis-t r ibu ted w i l l be t rea ted as a qua l i f y ing d is t r ibu t ion .

To satisfy distribution requirements, a doneeorgan izat ion may choose to t reat as a qua l i fy ingdistribution from corpus for the current year anyamount distributed in a prior tax year that wastreated as a distribution out of corpus if:

1) That amount has not been used for any otherpurpose (such as a carryover of excess quali-fying distributions, or a prior yearred is t r ibu t ion) ,

2) The corpus distribution occurred within thepreceding 5 years , and

3) The amount distributed is not later used foranother purpose.

The cho i ce mus t be made by a t t ach ing astatement to the Form 990-PF filed for the taxyear for which the choice is to apply. Thestatement must contain a declaration by theappropr ia te foundat ion manager that the founda-tion is making a choice under these provisions,and must specify that the distribution is to betreated as hav ing been made out o f a d is t r ibu t ionfrom corpus in a designated prior tax year oryears.

Example. In 1987, the Miller Foundation, apr iva te foundat ion , made a cont r ibu t ion out o f1986 income to the James Foundat ion , a pr iva tenonopera t ing foundat ion . The cont r ibu t ion was theon ly one rece ived by the James Foundat ion in1987. In 1988 the James Foundat ion made a qua l -i f y ing d is t r ibu t ion to an a r t museum main ta ined byan opera t ing foundat ion in an amount equa l to thecont r ibut ion rece ived f rom the Mi l le r Foundat ion.The James Foundation also distributed all of itsund is t r ibu ted 1987 and 1988 income for o therchar i tab le , educa t iona l , re l i g ious , e tc . pu rposes .The distribution to the art museum is treated asmade out of corpus.

The Mi l le r Foundat ion ’s con t r ibu t ion to theJames Founda t ion i s a qua l i f y ing d is t r ibu t ion ou to f t he M i l l e r Founda t i on ’ s 1986 i ncome. Th i s i s aqua l i f y ing d i s t r i bu t ion i f i t ob ta ins adequa terecords or enouah other evidence from the JamesFoundat ion showing the nature and amount o f thed is t r i bu t ion , the rec ip ien t ’ s i den t i t y , and the fac tthat the distribution is treated as made out ofcorpus. If the James Foundation’s qualifying distri-but ions dur ing 1988 had been equa l on ly to thecont r ibu t ion rece ived f rom the Miller Foundat ionand its 1988 undistributed income, the JamesFoundation could have chosen to treat theamount distributed in excess of its 1987 undistrib-u ted income as a qua l i f y ing d is t r ibu t ion made ou tof corpus (see Special choice, later) and thus sat-is fy the qua l i f y ing d is t r ibu t ion requ i rements .

L imi t . A con t r ibu t ion by a p r i va te founda t ion to arec ip ien t o rgan iza t ion , wh ich the rec ip ien t uses tomake payments to a secondary recipient, is not acontribution by the private foundation to the sec-ondary rec ip ien t i f the foundat ion does notearmark the use of the contribution for any namedsecondary recipient, and does not keep the powerto control the selection of the secondary recipientby the organ izat ion to wh ich the foundat ion hascont r ibu ted .

Treatment of qualifying distributions. Anyqual i fy ing d is t r ibu t ion made dur ing the tax year w i l lbe t reated as be ing made:

1) First, out of undistributed income of the imme-diate ly preceding tax year ( i f the pr ivate foun-dation was subject to the initial excise tax forthe prior tax year) to the extent thereof,

2) Second, out of undistributed income for thecurrent tax year to the extent thereof, and

3) Then, out of corpus.

Distributions are taken into account in the order oft ime in wh ich made.

Special choice. I f any qua l i f y ing d is t r i bu t ion i snot t rea ted as be ing made out o f und is t r ibu tedincome of the immedia te ly preced ing tax year , the

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foundation may choose to treat any part of the dis-t r ibu t ion as made ou t o f the und is t r ibu ted incomeof a designated prior tax year or out of corpus.

Th is cho ice i s made by f i l i ng a s ta temen t w i ththe IRS dur ing the tax year in which the qua l i fy ingdistribution is made or by attaching a statement tothe foundation’s annual return, for the tax year inwh ich i t made the qua l i f y ing distributron. Thestatement must contain a declaration by an appro-pr ia te foundat ion manager tha t the foundat ion ismaking the choice, under Regulations section53.4942(a)-3(d)(2) and must specify whether thedis t r ibu t ion i s made ou t o f und is t r ibu ted income fo ra designated prior tax year (or years) or is madeout of corpus.

When the cho ice is made dur ing the tax year inwh ich the qua l i f y ing d is t r i bu t ion i s made , thechoice may be revoked in whole or in par t by f i l inga statement with the Service during the same taxyear or by attaching a statement to the founda-t ion ’s annual re turn f i led for the tax year dur ingwh ich the qua l i f y ing d is t r ibu t ion was made. Therevocation statement must contain a declarationby the appropr ia te foundat ion manager that thefoundation is revokrng the choice described abovein whole or in part, and must specify the choice orpart thereof being revoked.

Example. The Oak Foundation, a private foun-dat ion , has und is t r ibu ted income o f $300 fo r 1986and $200 for 1987. On January 14,1988, the OakFounda t ion made i t s f i r s t qua l i f y ing d i s t r i bu t ion in1988 when it set aside $700 for hospitalconstruction.

On February 22, 1988, a not ice of def ic iency forthe in i t i a l and add i t i ona l exc ise tax on fa i l u re todistribute income with regard to the 1986 undis-tributed income was mailed to the Oak Founda-t ion . The Oak Foundat ion no t i f ied the Serv ice inwriting on March 20, 1988, that it was making achoice to aoolv the Januarv 14. 1988. distribution(to the extent ihat it exceeded i 987 undistributedincome) aga ins t the 1986 und is t r ibu ted income.The Oak Founda t ion i s l i ab le fo r an in i t i a l exc isetax of $45 (15% of $300).

Because the Oak Foundation made the choicedescribed, the $300 of undistributed income for1986 is treated as distributed during the correctionper iod , and no add i t iona l exc ise tax i s imposed.Under these circumstances the $700 distributionis treated as made first out of the undistributedincome of 1987 ($200) then out of the remainingundistributed income of 1986 ($300) . The $200rema in ing may be app l ied aga ins t the d is t r ibu tab leamount for 1988 or may be treated as a distribu-tion out of corpus.

Carryover of excess qualifying distributions.For any tax year dur ing wh ich the organ iza t ion is apr iva te nonopera t ing foundat ion , any excess qua l i -fying distributions (described later) may be used toreduce d is t r ibutab le amounts in any tax year o f thead jus tment per iod .

If a private foundation that had a carryover ofexcess qualifying distributions makes a section507(b)(2) transfer of all its assets to an effectivelycont ro l led foundat ion (de f ined in Chapter I l l ) , thetransferee foundation may reduce its distributableamount by the carryover.

The d is t r ibu tab le amount for a tax year in anadjustment period will be reduced by the lesser of:

1) The excess of qualifying distributions made inprior tax years to which the adjustment periodapp l ies , o r

2 ) The remain ina und is t r ibu ted income a t thec lose o f the tax year a f ter app ly ing any qua l i -f y ing d is t r ibu t ions made in tha t year to the d is -t r ibutable amount for the year .

Example. Maple Foundation, a private nonop-era t ing foundat ion , has d is t r ibu tab le amounts fo r1983, 1984, and 1985 o f $100 each. I t made aqua l i f y ing d is t r ibu t ion in 1984 o f $250 and in 1985of $70 . The qua l i f y ing d is t r ibu t ion made in 1984WIII be treated as $100 made out of the undistrib-uted income for 1983, then as $100 made out o fund is t r ibu ted Income o f 1984, and f ina l l y as $50

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out o f co rpus in 1984 . S ince the to ta l qua l i f y ingdistributions with respect to 1984 ($150) exceedthe distributable amount for 1984 ($100) a $50excess of qualifying distributions exists which theMaple Foundation may use to reduce its distribut-able amounts for the years 1985 through 1989(the tax years in the adjustment period withrespect to the 1984 excess).

Therefore, the $100 distributable amount for1985 is reduced by $30 (the lesser of the 1984excess ($50) and the remaining undistributedincome at the close of 1985 ($30) after the quali-fying distributions of $70 for 1985 were applied tothe or ig ina l d is t r ibu tab le amount fo r 1985 o f $100) .Maple Foundation then has a $20 excess of quali-fying distributions to use for tax years in theadjustment per iod. I f dur ing any tax year o f theadjustment period another excess of qualifyingdistributions is created, that excess will not betaken into account until the earlier excess hasbeen comp le te l y app l i ed aga ins t d i s t r i bu tab leamounts dur ing i t s ad jus tment per iod .

An excess qualifying distribution i s t heamount by wh ich the to ta l qua l i f y ing d is t r ibu t ionstreated as made out of undistributed income forany tax year beginning af ter 1969, or as made outof corpus for the tax year (other than distributionsby donee organizations described in Certain con-t r i bu t ions to exempt organ iza t ions , ear l ie r , or theamount applied to a prior tax year by the choiceswith respect to qualifying distributions) exceed thedis t r ibutab le amount for that tax year .

The adjustment period is the 5 tax yearsimmedia te ly fo l lowing the tax year in wh ich theexcess of qualifying distributions is created. Thus,an excess qualifying distribution for any one taxyear may not be carried over for more than 5 taxyears. However, if during any tax year of theadjustment period, the organization ceases to besubject to the initial tax (such as by becoming apr ivate operat ing foundat ion) , any por t ion of theexcess qualifying distributions, that, before thattax year, has not been applied against distributa-ble amounts may not be carried over to that taxyear or later tax years in the adjustment period.Th is ru le app l ies even though dur ing any o f thosetax years the organization again becomes subjectto the in i t ia l tax .

Chapter VIIITaxes onSelf-DealingSect ion 4941 of the In terna l Revenue Codeimposes an excise tax on certain transactions(acts of self-dealing) between a private foundationand d i squa l i f i ed pe rsons .

Initial tax. An excise tax of 5% of the amountinvolved (described later) in the act of self-dealingis imposed on the disqualified person, other than afoundat ion manager ac t ing on ly as a manager , fo reach year or part of a year in the taxable period(discussed later).

An excise tax of 2’/2% of the amount involved isimposed on a foundat ion manager who knowing lyparticipates in an act of self-dealing, unless partic-ipa t i on i s no t w i l l f u l and i s due to reasonab lecause, for each year or part of a year in the taxa-b le per iod .

Addkipnal tax. An excise tax of 200% of theamount invo lved i s imposed on the d isqua l i f i edperson, o ther than a foundat ion manager ac t ingon ly as a manager , who par t i c ipa ted in the ac t o fself-dealing, if the act of self-dealing is not cor-rec ted w i th in the taxab le per iod . The add i t iona l taxwill not be assessed, or if assessed will be abated,if the act of self-dealing is corrected during thecorrection period (described later).

I f the add i t iona l tax descr ibed above i s imposedon the disqualified person, an excise tax of 50%of the amount invo lved is imposed on any founda-tion manager who refuses to agree to part or all ofthe correction of the self-dealing act.

Limits on liabilitv for manaaement. The maxi-mum in i t i a l tax imposed on tk foundat ion man-ager i s $10,000 and the max imum add i t iona l tax is$10,000 for any one act .

There i s no max imum on the l iab i l i t y o f the self-dea le r , inc lud ing one who is a foundat ion man-ager.

I f more than one person is l i ab le fo r the in i t ia land additional taxes imposed for any act of self-dea l ing , a l l pa r t i es w i l l be jo in t l y and severa l l y l i a -ble for those taxes.

Acts of self-dealing. The following transactionsare generally considered acts of self-dealingbetween a pr iva te foundat ion and a d isqua l i f iedperson:

1)2)3)

4)

5)

6)

Sale, exchange, or leas ing of proper ty ,Lending money or other extensions of credit,Providing goods, services, or facilities,

Pay ing compensat ion or re imburs ingexpenses to a disqualified person,Transferring foundation income or assets to,or fo r the use o r benef i t o f , a d isqua l i f iedperson, andCertain agreements to make payments ofmoney or property to government officials.

Government officials. As noted in thediscussion of disqualified persons in Chapter V, agovernment o f f i c ia l may be a d isqua l i f ied personfor the tax on self-dealing. However, the tax will beimposed only if the government official knows thatthe ac t i s an ac t o f se l f -dea l i ng .

Participation. A disqualified person whoengages or takes part in a transaction alone orwith others, or directs any person to do so will bet rea ted as par t i c ipa t ing in an ac t o f se l f -dea l ing .

Participation by a foundation managerincludes silence or inaction on the manager’s partwhere there is a duty to speak or act, as well asany af f i rmat ive act ion by the manager. However, afoundat ion manager w i l l no t have par t i c ipa ted inan act of self-dealing when the manager hasopposed the act in a manner consistent withcarrying out the manager’s responsibilities to thepr ivate foundat ion.

Willful. Par t i c ipa t ion by a foundat ion manager i sw i l l f u l i f i t i s vo lun ta ry , consc ious , and i n ten t i ona l .No motive to avoid the restrictions of the law orthe incurrence of any tax is necessary to make thepar t i c ipa t ion w i l l fu l . However , par t i c ipa t ion by thefoundat ion manager i s no t w i l l fu l i f the managerdoes not know (discussed later) that participationin the t ransac t ion i s an ac t o f se l f -dea l i ng .

Reasonable cause. Participation is due to rea-sonable cause if the foundation manager hasexercised responsibility on behalf of the founda-tion with ordinary business care and prudence.

Advice of counsel. A person who, after full dis-closure of the factual situation to legal counsel(including house counsel), relies on the advice ofcounsel expressed in a reasoned written legalooinion that a transaction is not an act of self-dea l ing under the law, a l though the t ransac t ion i sla te r he ld to be an ac t o f se l f -dea l inq , w i l l o rd ina-r i l y no t be l iab le fo r the in i t i a l tax imposed fo r self-dea l i ng .

A wr i t ten lega l op in ion i s cons idered reasonedeven if it reaches a conclusion that is later deter-mined to be incorrect as long as it addresses itselfto the facts and applicable law. However, a writtenlega l op in ion w i l l no t be cons ide red reasoned i f i tdoes nothing more than recite the facts andexpress a conclusion. The absence of advice ofcounse l w i l l no t , by i t se l f , imp ly tha t a person par -t i c ipa ted in the ac t knowing ly , w i l l fu l l y , o r w i thou treasonable cause.

Knowing. A person will be considered to havepar t i c ipa ted in a t ransac t ion knowing tha t i t i s anac t o f se l f -dea l ing on ly i f :

1) The person has actual knowledge of enoughfacts so that, based only upon those facts, thet ransac t ion wou ld be an ac t o f se l f -dea l ing ,

2) The person is aware that such an act mayviolate the provisions of federal tax law gov-ern ing se l f -dea l ing , and

3) The person negligently fails to make reasona-ble attempts to learn whether the transactionis an act of self-dealing, or the person isaware that the transaction is an act of self-dea l i ng .

The term “knowing” does not mean having rea-son to know. However, evidence tending to showthat a person had reason to know of a particularfact or rule IS relevant in determining whether thatperson has actual knowledge of the fact or rule.The burden of proof that a foundat ion managerhas knowing ly par t i c ipa ted in an ac t o f se l f -dea l ingis on the IRS.

Taxable period. The tax on self-dealing isimposed for each year or part of a year within thetaxab le per iod . The taxab le per iod beg ins on thedate the act of self-dealing occurs and ends onthe ear l i es t o f :

1) The date a notice of deficiency for the initialtax i s m a i l e d ,

2) The date the initial tax IS assessed, or3) The date correction of the act of self-dealing

is comp le ted .

Example 7. On July 2, 1986, Joe Jones, amanager o f p r iva te foundat ion X, ac t ing on beha l fof the foundation. knowina the act to be one ofse l f -dea l i ng , w i l l f u l l y and iithout reasonab le causeso ld ce r ta in rea l es ta te to Pau l Smi th , a d i squa l i -fied person. On March 1, 1988, the IRS mailed ano t i ce o f de f i c iency to Smi th fo r the in i t i a l andadd i t iona l tax imposed by sec t ion 4941 on thesa le . The taxab le per iod fo r bo th Jones and Smi this Ju ly 2 , 1986, through March 1, 1988.

Example 2. The facts are the same as inExamole 1 exceot tha t on Ju lv 2 . 1987. cor rec t ionof the’act of self-dealing is cdmpleted.‘The taxa-b le per iod fo r bo th Jones and Smi th i s Ju ly 2 ,1986, through Ju ly 2 , 1987.

The in i t ia l tax is f igured based on the tax year o fthe d isqua l i f ied person l iab le fo r the tax , ra therthan the tax year of the pr ivate foundat ion.

An act of self-dealing occurs on the da te a l lthe terms and conditions of the transaction andthe l iab i l i t i es o f the par t ies a re f i xed . For example ,i f a p r i va te foundat ion g ives a d isqua l i f i ed persona brndina ootion on June 17. 1985. to buv orooertvowned by the foundation at any time before June’16, 1986, the act of self-dealing has occurred onJune 17, 1985.

Correction period. The correction period startson the day the act of self-dealing occurs and ends90 days after a notice of deficiency for theadditional tax is mailed.

The correct ion per iod may be extended by:

1) Any period in which the deficiency cannot beassessed because of a petition to the TaxCourt, or

2) Any period the IRS determines is reasonableand necessary.

What Is Self-DealingThe term, self-dealing includes the followingtransactions whether direct or indirect. However,see Indirect Self-Dealing, Exceptions to Self-Dea l ing , and Trans i t i ona l Ru les , fo r spec ia l ru les .

Sales or Exchanges ofPropertyAny sale or exchange of property between apr iva te foundat ion and a d isqua l i f i ed person i s anac t o f se l f -dea l ing . For example , the sa le o f i nc i -den ta l supp l i es by a d i squa l i f i ed pe rson t o apr iva te foundat ion is an ac t o f se l f -dea l ing regard-less o f the amount pa id to the d isqua l i f i ed person .Similarly, the sale of stock or other securities by ad isqua l i f i ed pe rson to a p r i va te founda t ion in abargain sale is an act of self-dealing regardless of

the amount paid. However, see Exceptions toSe l f -Dea l ing l a te r in th i s chap te r .

The transfer of real or personal property by ad isqua l i f i ed person to a p r i va te foundat ion i streated as a sale or exchange if the foundationassumes a mortgage or similar lien, which wasplaced on the property before the transfer, ortakes the property subject to a mortgage or similarl ien tha t a d isqua l i f i ed person p laced on the p rop-er ty in the 1 O-year per iod ending on the date oft rans fe r . A s im i l a r l i en i nc ludes , bu t i s no t l im i tedto, deeds of trust and vendors’ liens, but does notinc lude any o the r l i en i f i t i s i ns ign i f i can t i n re la t i onto the fair market value of the property transferred.

Example. On May 17, 1988, the Gray Founda-t ion , a p r i va te founda t ion , rece ived a dona t ion o f al i f e i nsu rance po l i cy f rom Joe Brown, a d i squa l i f i edperson. The po l i cy , wh ich had a face va lue o f$100,000, was subject to an outstanding loan of$46,000 that was made to Joe by the insurerwi th in the 1 O-year per iod ending on the date of thedonation. The cash surrender value of the policywas $50,000 on May 17, 1988. Under the terms ofthe po l i cy , fa i lu re to repay the pr inc ipa l o r in te res ton the policy loan reduces the proceeds that arepayable to the beneficiary upon voluntary surren-der of the policy or upon the death of the insured.The dona t ion i s an ac t o f se l f -dea l i ng .

LeasesThe leas ing o f p roper ty be tween a d isqua l i f iedperson and a private foundation is an act of self-dealing. But see Leases, under Exceptions to Self-Dea l ing , l a te r in th i s chap te r .

LoansLending money or other extension of creditbetween a pr iva te foundat ion and a d isqua l i f iedperson is an act of self-dealing. However, thisdoes no t inc lude loan ing money by a d isqua l i f i edperson to a private foundation without interest orother charge if the proceeds of the loan are usedexclusively for purposes specified in section501 (c)(3) of the Code. For these purposes, a loanby a d isqua l i f ied person to a pr iva te foundat ion a tbelow-market interest rates is treated as an act ofself-dealing to the same extent as a loan at mar-ket interest rates.

An act of self-dealing occurs when a third partybuys property and assumes a mortgage, the mort-gagee o f wh ich is a pr iva te foundat ion , and la te rthe third party transfers the property to a disquali-fied person who either assumes liability under themortgage or takes the property subject to themortgage. In this transaction the foundation iscons idered to have made a loan to the d isqua l i f i edperson in the amount of the unpaid indebtednesson the property at the time of the transfer.

Mak ing a promise, p ledge, or s imi la rarrangement regarding money or property to apr iva te foundat ion by a d isqua l i f ied person,whether by an oral or written agreement, a promis-sory note, or other instrument of indebtedness, isnot an extension of credit before the date ofmatur i ty to the ex tent tha t i t i s mot iva ted by char i -table intent and is unsupported by consideration.

Performing trust functions and certain generalbanking services by a bank or trust company,which is a disqualified person, is not an act of self-dealing if the services are reasonable and neces-sary in carrying out the exempt purposes of thepr iva te foundat ion and the compensat ion pa id tothe bank or trust company is not excessive (con-sidering the fair interest rate for the use of thefunds by the bank or trust company).

The general banking services that are not self-dea l ing are :

1) Checking accounts, as long as the bank doesnot charge interest on any overdrafts or aservice fee greater than the actual cost ofprocessing the amount overdrawn,

2) Savings accounts, as long as the foundationmay withdraw its funds on no more than 30days notice without subjecting itself to a loss

of interest on its money for the time themoney was on deposit, and

3) Safekeeping activities.

The purchase of certificates of deposit thatprovide a reduced rate of interest if not held tomatur i t y f rom a bank ing ins t i tu t ion , a d isqua l i f i edperson with respect to the private foundation,does not fall within the scope of the generalbanking services permitted, and is an act of self-dea l i ng .

Providing Goods, Services, orFacilitiesGenerally, providing goods, services, or facilitiesbetween a pr iva te foundat ion and a d isqua l i f iedperson is an act of self-dealing. This applies toproviding goods, services, or facilities, such asoffice space, cars, auditoriums, secretarial help,mea ls , l i b ra r ies , pub l i ca t ions , l abora to r ies , o rparking lots. However, it is not self-dealing if a dis-qua l i f ied person prov ides them to a foundat ionwithout charge and the goods, services, or facili-ties are used exclusively for purposes specified insect ion 501 (c ) (3) o f the Code. A lso , p rov id inagoods, services, or facilities to a foundation man-ager, to an employee, or to an unpaid worker, isno t an ac t o f se l f -dea l ing i f the va lue o f the i temsprovided is reasonable and necessary to the per-formance of the tasks involved in carrying out theexempt purpose of the foundation and is notexcessive.

For examp le , i t i s no t an ac t o f se l f -dea l ing i f apr iva te foundat ion prov ides meals and lodg ingwhich are reasonable and necessary (but notexcessive) to a foundation manager. This is truewhether or not the va lue o f the meals and lodg ingis excludable from the manager’s gross income.

Paying CompensationPaying compensation or reimbursing expenses bya pr i va te foundat ion to a d isqua l i f i ed person i s anact of self-dealing. But see Exceptions to Self-Dealing, discussed later.

Use of Income or AssetsTransfer to, or use by or for the benefit of, a dis-qualified person of the income or assets of apr iva te foundat ion is an ac t o f se l f -dea l ing . Forexample , an ac t o f se l f -dea l ing inc ludes paymentby a pr ivate foundat ion of any exc ise tax imposedon a disqualified person for any prohibited trans-actions discussed in this publication.

Simi la r ly , payment o f p remiums for an insurancepo l i cy p rov id ing l i ab i l i t y insurance to a founda t ionmanager for excise taxes on prohibited transac-tions is an act of self-dealing unless the premiumsare treated as compensation to the manager. Inaddition, the purchase or sale of stock or othersecurities by a private foundation is an act of self-dea l ing i f t he purchase o r sa le i s made in anattempt to manipulate the price of the stock orother secur i t i es to the advantage o f a d isqua l i f i edperson.

Indemni f i ca t ion by the foundat ion o f i t s manag-ers against reasonable expenses (other thantaxes, penalties, and expenses of correction)incur red in an IRS or cour t p roceed ing invo lv ingthe imposition of the excise taxes described in thispub l i ca t ion on the foundat ion manager w i l l no t bean ac t o f se l f -dea l i ng i f :

1) The manager is successful in the defense, orthe proceed ing is ended by se t t lement , and

2) The manager has no t ac ted w i l l fu l l y and w i th -out reasonable cause in the act or failure toac t g iv ing r i se to l i ab i l i t y fo r the exc ise taxes .

S imi la r l y , i ndemni f i ca t ion o f a foundat ion man-ager for reasonable expenses incurred forde fense in a jud ic ia l o r admin is t ra t i ve p roceed ingre la t ing to the mismanagement o f funds o f a char i -tab le o rgan iza t ion i s no t an ac t o f se l f -dea l ing i fthe app l i cab le p reced ing cond i t i ons a re met .

27

The indemni f i ca t ion o f a lender o r guarantee o frepayment by a pr iva te foundat ion o f a loan to adisqualified person is treated as a use for the ben-efit of a disqualified person of the Income orassets of a private foundation.

A grant or other payment made by a foundat ionto sa t i s f y t he l ega l ob l i ga t i on o f a d i squa l i f i edperson is an act of self-dealing.

Incidental benefits. The fact that a disqualifiedperson receives an incidental or slight benefit fromthe use by a foundation of its income or assets willnot, by itself, make the use an act of self-dealing.Pub l i c recogn i t i on tha t a subs tan t ia l con t r ibu to rmay receive, ansing from charitable activities of apr iva te foundat ion , does no t in i t se l f resu l t i n anac t o f se l f -dea l ing s ince genera l l y the bene f i t i sinc iden ta l and tenuous .

S im i l a r l y , a scho la rsh ip o r f e l l owsh ip g ran t t o aperson other than a disqualrfied person that ispaid or incur red by a pr iva te foundat ion accord ingto a program consistent with:

The requirements of the foundation’s exemptstatus as a charitable, educational, etc.,organizat ion,The requirements for allowance of deductionsfor charitable contributions made to the foun-dat ion , andThe requirements of scholarship andfellowship grants awarded on an objectiveand nondrscnminatory basis under proceduresapproved by the Service,

w i l l no t be an ac t o f se l f -dea l i ng mere l y because ad isqua l i f i ed person ind i rec t l y rece ives a bene f i tfrom the grant. A scholarship or fellowship grantmade by a pr ivate foundat ion under a program toaward scholarship or fellowship grants to thechildren of employees of a substantial contributorwi l l no t be an ac t o f se l f -dea l ing i f t hese th reerequirements are satisfied.

Payment to a GovernmentOfficialThe agreement by a pr ivate foundat ion to makeany payment of money or other property to a gov-ernment o f f i c ia l (de f ined in Chapter V) w i l l o rd ina-r i l y be an ac t o f se l f -dea l ing . Bu t , see Cer ta inpayments to government officials are not consid-ered ac ts o f se l f -dea l ing , la ter , under Excep t i onsto Self-Deahng.

Indirect Self-DealingCertain transactions will not be treated as indirectse l f -dea l i ng .

Certain business transactions. A transactionbetween a d isqua l i f ied person and an organ iza t ioncont ro l led by a p r iva te foundat ion is no t ind i rec tse l f -dea l i ng i f :

The transaction arose from a businessrelationship established before the transactioncould be considered an act of self-dealing,The transaction was at least as favorable tothe organ izat ion cont ro l led by the foundat ionas an arm’s length transaction with anunre la ted person, andEi ther the organ izat ion cont ro l led by the foun-dation would have suffered severe economichardsh ip by engag ing in a t ransac t ion w i thsomeone other than a disqualified person, orbecause of the uniaue nature of the productor services provided by the organization con-t ro l led by the foundat ion , the d isqua l i f i edperson could not have engaged in a transac-tion with anyone else, or could have done soonly by incurring severe economic hardship.

Grants to intermediaries. The term “indirectself-dealing” does not include a transactionengaged in w i th a government o f f ic ia l by an in ter -mediary organrzation that is a recipient of a privatefoundat ion grant and tha t i s no t cont ro l led by thegrantor foundat ion , i f the foundat ion does not

28

earmark the use of the grant for any named gov-ernment official and there is no agreement underwhich the granting foundation may cause theselection of the government official by the inter-mediary organizat ion. A grant by a foundat ion isearmarked if the grant is made under an agree-ment , e i ther ora l o r wr i t ten , tha t the grant w i l l beused by any named ind iv idual . A grant by a pr ivatefounda t ion w i l l no t be an ind i rec t ac t o f self-dea l ing even though the foundat ion had reason tobe l ieve tha t ce r ta in government o f f i c ia ls wou ldreceive benefits from the grant as long as thein termed iary o rgan iza t ion exerc ises cont ro l , infact, over the selection process and actuallymakes the selection completely independently ofthe pr iva te foundat ion.

Transactions during the administration of anestate or revocable trust. A transactioninvolving a private foundation’s interest or expec-tancy in property held by an estate (or revocabletrust, including a trust that has become irrevocableon a grantor’s death), regardless of when title tothe property vests under local law, is not indirectse l f -dea l i ng i f :

1)

2)

3)

4)

5)

The administrator, executor, or trustee has thepower to sell the property or to reallocate theproperty to another beneficiary, or is requiredto sell the property under the terms of anyoption to which the property was subjectwhen acquired by the estate or trust,The transaction is approved by the probatecourt having jurisdiction over the estate (or byanother court having jurisdiction over theestate, trust, or private foundation),

The transaction occurs before the estate isconsidered terminated for federal income taxpurposes (or for a trust, before it is considereda trust that is not tax exempt, as explained inChapter I ) ,The estate (or trust) receives an amount atleast equal to the fair market value of thefoundation’s interest or expectancy in theproperty, considering any option to which theproperty was subject when it was acquired,a n d

The transaction results either in the founda-tion’s receiving an interest or expectancy atleas t as l i qu id as the one i t gave up , o r in thefoundation’s receiving an asset related to theactive carrying out of its exempt purpose, orthe transaction is required under the terms ofany opt ion b ind ing on the es ta te or t rus t .

Transactions with certain organizations. Atransaction between a foundation and a corpora-tion, partnership, estate, or trust not controlled bythe founda t ion i n wh ich d i squa l i f i ed pe rsons ho ldno more than 35% of the total voting power orprofits or beneficial interest, is not an indirect actof self-dealing solely on the basis of ownership.

Certain transactions involving limitedamounts. The term “indirect self-dealing” doesnot inc lude any t ransac t ion be tween a d isqua l i f i edperson and an organizat ion cont ro l led by a pr ivatefoundation or between two disqualified personswhen the foundation’s assets may be affected bythe t ransac t ion i f :

1) The transaction arises in the normal and cus-tomary course of a retail business engaged inwi th the genera l pub l i c ,

2) In a transaction between a disqualified personand an organizat ion cont ro l led by a pr ivatefoundation, the transaction is at least asfavorab le to the organizat ion cont ro l led by thefoundation as an arm’s length transaction withan unre la ted person, and

3) The total amounts involved in all these trans-ac t ions w i th any one d i squa l i f i ed pe rson inany one tax year is no more than $5,000.

Statutory exceptions. A transaction describedunder Excep t ions to Se l f -Dea l ing , l a t e r , i n w h i c h apr iva te foundat ion cou ld i t se l f engage, invo lv ingone or more disqualified persons but to which a

pr iva te foundat ion is no t a par ty , i s no t ind i rec tse l f -dea l i ng .

For example, even i f a pr ivate foundat ion hascontrol of a corporation, the corporation may payto another disqualified person (except a govern-ment official) reasonable compensation for per-sonal services.

Control. An organization is considered controlledby a pr ivate foundat ion i f the foundat ion or one ormore o f i t s foundat ion managers ac t ing on ly intheir capacity as managers, may, only bycombining their votes or positions of authority,requ i re the organ iza t ion to engage in a t ransac-t ion , wh ich i f engaged in w i th the pr iva te founda-t ion wou ld be se l f -dea l ing . S im i la r l y , anorgan iza t ion is cont ro l led by a pr iva te foundat ionin the case of such a transaction between theorgan iza t ion and a d isqua l i f i ed person , i f t he d is -qua l i f ied person together w i th cer ta in re la tedpersons who are disqualified persons (asdescr ibed in Chapter V) may, on ly by combin ingtheir votes or positions of authority with that of thefoundat ion , requ i re the organ iza t ion to engage insuch a transaction.

The cont ro l led organ iza t ion does not have to bea private foundation.,It may be any kind of exemptor nonexempt o rgan iza t ion inc lud ing a schoo l ,hosp i ta l , opera t ing foundat ion , o r soc ia l we l fa reorganizat ion.

An o rgan iza t ion w i l l be cons idered con t ro l led bya pr ivate foundat ion or by a pr ivate foundat ion anddisqualified persons if the persons are able, infact, to control that organization. This control maybe present even if their combined voting power isless than 50% of the organization’s total votingpower, or if one or more of the individuals has theright to exercise veto power over the actions ofthe organization relevant to any potential acts ofse l f -dea l ing . However , a pr iva te foundat ion w i l l no tbe regarded as having control over an organiza-tion simply because it exercises expenditurerespons ib i l i t y .

Exceptions toSelf-DealingThe following transactions between a private foun-dat ion and a d isqua l i f i ed person a re no t cons id -e red se l f -dea l ing .

Providing goods, services, or facilities by apr iva te foundat ion to a d isqua l i f i ed person i s no tself-dealing if the goods, services, or facilities aremade ava i lab le to the genera l pub l i c on a t leas t asfavorable a basis as they are made available tothe disqualified person and the goods, services, orfacilities are functionally related (defined inChapter X) to the exercise or performance by aprivate foundation of its exempt purpose.

The term “general public” includes thosepersons who reasonably would be expected touse the foundation’s goods, services, or facilities.This does not apply, however, unless a substantialnumber of persons other than disqualified personsactually use the goods, services, or facilities.

A pr ivate foundat ion that prov ides recreat iona lor park fac i l i t ies to the genera l pub l ic may prov idethose fac i l i t i es to a d i squa l i f i ed pe rson i f t hey a reprovided to that person on a basis no morefavorable than that on which they are provided tothe genera l pub l i c . S imi la r l y , the sa le o f a book ormagaz ine to d isqua l i f i ed persons i s no t an ac t o fse l f -dea l ing i f pub l i sh ing the book o r magaz ine i sfunc t iona l l y re la ted to a char i tab le o r educat iona lac t i v i t y o f the foundat ion . The pub l i ca t ion mus t bemade ava i lab le to d isqua l i f i ed persons and thegenera l pub l ic a t the same pr ice . Moreover , i f theterms of the book or magazine sale require, forexample, payment wi th in 60 days of de l ivery , andpayment is made dur ing the 60-day per iod, thetransaction will not be treated as a loan orextension of credit if these terms are consistentwith normal commercial practices.

Payment of compensation or reimbursementof expenses by a pr iva te foundat ion to a d is -qua l i f ied person (except fo r a government o f f i c ia l )for personal services that are reasonable and nec-essary to carry out the exempt purpose of theprivate foundation is not considered an act of self-dea l ing i f the compensat ion o r re imbursement i snot excessive.

Personal services include the services of a bro-ker serving as the foundation’s agent, but not theservices of a dealer buying from the foundation asa pr inc ipa l and rese l l ing to a th i rd par ty .

Furthermore, if a foundation makes a cashadvance to a foundat ion manager or employee tocover anticipated out-of-pocket expenses, it is notan act of self-dealing if the advance is reasonablein relation to the duties and expense requirementsof the foundat ion manager . An advance ord inar i l yis considered reasonable if it is not more than$500.

For example, if a foundation makes an advanceto a foundation manager to cover anticipated out-of-pocket current expenses for a reasonableperiod (such as a month) and the manageraccounts to the foundation under a periodic reim-bursement program for actual expenses incurred,the foundat ion is no t cons idered to have engagedin an ac t o f se l f -dea l ing :

1) When it makes the advance,2) When it replenishes the fund upon receipt of

supporting vouchers from the manager, or3) If it temporarily adds to the advance to cover

unusual expenses expected to be incurred incarrying out a special assignment.

Any transaction between a private foundationand a corporation that is a disqualified person isnot an act of self-dealing if the transaction isengaged in under a l iqu idat ion, merger , redemp-t ion , recap i ta l i za t ion , o r o ther corpora tead jus tment , organ izat ion, or reorgan izat ion, aslong as all the securities of the same class asthose held before the transaction by the founda-tion are subject to the same terms and the termsprovide for receipt by the foundation of at least fairmarket value.

For the securities to be considered subject tothe same terms, the corporation must, inconnection with the transaction, make a bona fideoffer on a uniform basis to the foundation andevery other security holder. The fact that a foun-dation receives property, such as debentures,while all other persons holding securities of thesame class receive cash for their interests, will beevidence that the offer was not made on a uniformb a s i s .

If no other persons hold securities of the sameclass as the private foundation, the considerationreceived by holders of other classes of securities,or the interests retained by the holders of otherclasses, when considered in relation to the con-srderation rece ived by the foundat ion , must ind i -cate that the foundation received at least asfavorable treatment in relation to its interests asthe holders of any other class of securities. Inadd i t ion , the foundat ion must rece ive a t leas t thefair market value of its interests.

Certain payments to government officials arenot considered acts of self-dealing. Thesepayments are:

1) A prize or award that does not have to beinc luded in g ross i ncome i f t he o f f i c i a l rece iv -ing the prize or award is selected from thegeneral public (for this purpose, the recipientmay keep the prize or award, and need notauthorize the foundation to transfer the prizeor award to a governmental unit or to anotherchar i ty) ,

2) A scholarship or a fellowship grant that is tobe used for s tudy a t a recognized educat iona lorganization. (For this purpose, there is norequ i rement tha t the grant rec ip ien ts be l im-ited to degree candidates, nor must the grantbe l im i ted to tu i t ion , fees and course- requ i red

books, supplies or equipment. It is permissiblefor a recipient to use grant funds for room,board, travel, research, clerical help, or equip-ment, that are incidental to the purposes ofthe grant . ) ,

3) Any annuity or other payment (forming part ofa stock-bonus, pension, or profit-sharing plan)f rom a qua l i f ied t rus t ,

4) Any annuity or other payment under anemployees ’ annu i ty p lan ,

5) Any contribution or gift (other than money), orserv i ces o r fac i l i t i es made ava i l ab le , i f t heto ta l va lue is no t more than $25 dur ing anycalendar year ,

6) Any payment made under a governmentemployees ’ t ra in ing program,

7) Any payment or reimbursement of travelexpenses , inc lud ing mea ls and lodg ing , fo rt rave l on ly f rom one po in t in the Uni ted Sta testo ano ther i n connec t ion w i th char i tab lepurposes, but only if the payment or reim-bursement is not more than the actual cost oftransportation plus an amount for all othertraveling expenses not greater than 125% ofthe maximum payable for s imi lar t rave l by U.S.government employees (without regard to anyhigher rates allowed in designated geographi-

8)

9)

cal areas),A payment under any agreement to employ ormake a grant to a government official for anyper iod af ter the terminat ion of governmentservice if the agreement is entered into within90 days before termination, orThe cost of a government official’s attend-ance o r par t i c ipa t ion in a con fe rencesponsored by the foundation in furtherance ofits exempt purposes, including-

The official’s share of the cost of theconference,Professional and other non-monetarv ben-e f i t s o f an in te l l ec tua l o r psycho log ica lnature rece ived by the o f f ic ia l f romat tend ing o r par t i c ipa t ing in theconference,Bene f i t s to the o f f i c ia l resu l t i ng f rompub l i ca t ion o r d i s t r i bu t ion o f theconference record to conferencepar t i c ipan ts , andPayments, reimbursements, or reasonableadvances made to the official forexpenses in attending the conference.

Leases. The leas ing o f p roper ty by a d isqua l i f iedperson to a private foundation is not an act of self-dea l i ng i f t he l ease i s w i thou t cha rge . The leasewill be considered without charge even though thefoundation agrees to pay for janitorial expenses,utilities, or other maintenance costs it incurs aslong as payment i s no t made d i rec t l y o r ind i rec t l yto a d i squa l i f i ed pe rson .

The l eas ing o f o f f i ce space by a d i squa l i f i edperson to a p r iva te foundat ion in a bu i ld ing w i thother tenants who are not disqualified persons isno t an ac t o f se l f -dea l ing i f :

1) The lease is pursuant to a binding contract ineffect on October 9, 1969 (or renewalsthereof),

2) The lease was not a prohibited transactionunder section 503(b) or any correspondingprov is ion o f p r io r law a t the t ime o f execut ion ,a n d

3) The terms of the lease (or any renewal) reflectan arm’s length transaction.

Transitional RulesTransactions involving securities acquired

by a foundation before May 27, 1969. A n ytransaction between a private foundation and acorpora t ion tha t i s a d i squa l i f i ed person w i l l no t bean act of self-dealing if the transaction is underthe terms of securities of the corporation, if theterms were in existence at the time the securities

were acquired by the foundation and if they wereacquired before May 27, 1969.

Disposition of certain business holdings.The sale, exchange, or other disposition of prop-erty that was owned by a private foundation onMay 26, 1969, to a d isqua l i f ied person w i l l no t bean ac t o f se l f -dea l ing i f the foundat ion i s requ i redto dispose of the property so it will not be liable forthe tax on excess business holdings (discussed inChapte r X) . Th is ru le app l ies on ly i f :

1) The amount received by the private founda-tion is at least equal to the fair market value ofthe business holdings at the time of disposi-tion or at the time a contract for dispositionwas previously executed, and

2) At the time at which (1) is applied, the trans-act ion wou ld not have been a oroh ib i tedtransaction under section 503(b) or corre-sponding provisions of prior law.

Property is considered owned by a private foun-dat ion on May 26, 1969, i f i t I S acqu i red :

1)

2)

3)

Under the terms of a will executed by thatdate ,Under the terms of a trust that was irrevoca-ble on that date , orUnder the terms of a revocable trust executedby that date if the property would have passedunder a wi l l executed by that date , except thatthe grantor died without revoking the trust.

An amendment o r repub l i ca t ion o f a w i l l tha twas executed by May 26, 1969, will not preventany interest in a business that was to pass underthe terms of the will (in effect on May 26, 1969,and at all times thereafter) from being treated asowned by a pr ivate foundat ion on that date , on lybecause :

1) There is a reduction in the interest in the busi-ness that the foundation was to receive,

2) The amendment or republication was neces-sary to comply with the requirements of gov-erning instruments as discussed in Chapter II,

3) There is a change in the executor of the will,o r

4) There is any other change that does not oth-erwise chance the foundation’s rights in thebusiness. -

I f the amendment or repub l ica t ion increasesthe business interest that the foundation was toreceive under the terms of the will in effect onMay 26, 1969, only the interest that would havebeen acqu i red before the increase w i l l be t rea tedas owned by the foundat ion on that date . Theincrease is not so treated.

Use of property acquired before October 9,7969. The use o f prooertv in wh ich a pr iva tefoundat ion and d isqua l i f ied person have a jo in t o rcommon interest is not an act of self-dealing if theinterests of both were acquired before October 9,1969.

Amount InvolvedThe exc ise tax on se l f -dea l ing i s f i gu red on theamount invo lved, wh ich is the greater o f theamount of money and the fa i r market va lue ofother property g iven or the amount of money andfair market value of other property received. Forpayments made for services performed (topersons other than government officials), theamount involved is only the excess compensationpaid by the pr iva te foundat ion. When the use o fmoney or other property is involved, the amountinvo lved is the greater o f e i ther the amount pa idfor the use or the fair market value of the use forthe period for which the money or other propertyi s used .

For a transaction that would not have been anact o f se l f -dea l ing had the pr iva te foundat ionreceived fa i r market va lue, the amount invo lved isthe excess of the fair market value of propertytransferred by the foundation over the amountrece ived by the foundat ion, but on ly i f the par t ies

29

have made a good fa i th e f for t to determine fa i rmarket va lue. Ord inar i ly a good fa i th ef for t todetermine fa i r market va lue wi l l be cons ideredmade when:

other than money or the fair interest rate for theuse..of money) a t the t ime o f se l f -dea l ing , or therate at the time of correction of the act of self-dea l ing . In (2), the fa i r ren ta l va lue o f the use o fproper ty w i l l be the ra te a t the t ime o f cor rec t ion .

Excessive compensation paid by a privatefoundat ion to a d isqua l i f ied person fo r per fo rmingpersonal services that are reasonable and neces-sary to carry out the exempt purpose of the foun-dation may be corrected by repaying to thefoundat ion any excess ive amount . Terminat ion o fthe employment or independent contractorre la t ionsh ip i s no t requ i red .

Correction of valuation errors. I f , but for anerror in the valuation of property, a transactionwould not have been an ac t o f se l f -dea l ing hadthe founda t ion rece ived fa i r marke t va lue , acorrection of the transaction means that the foun-dation is paid an amount equal to the excess ofthe fair market value of the property transferredover the amount that the foundation received forthe property (assuming a good faith effort to deter-mine fa i r market va lue) . In add i t ion , the foundat ionmust receive the amount necessary tocompensate it for the loss of the use of the moneyor other proper ty dur ing the per iod beginning onthe da te o f the ac t o f se l f -dea l ing and end ing onthe date the transaction is corrected.

Number of ActsIf a transaction is determined to be an act of self-dea l ing , there is genera l l y on ly one ac t o f self-dea l ing . I f the t ransac t ion invo lves leas ing p rop-er ty , lend ing money or o ther extens ion of cred i t ,other use of money or property, or payment ofcompensation, the transaction will be treated asan act of self-dealing on the day the transactionoccurs plus an act of self-dealing on the first dayof each tax year or part of a year within the taxa-ble per iod that beg ins a f ter the tax year in wh ichthe transaction occurs.

I f a t ransac t ion invo lves jo in t pa r t i c ipa t ion bytwo or more disqualified persons, the transactionwill be treated as a separate act of self-dealing foreach ind iv idua l invo lved .

However, for purposes of terminating tax-exempt status and for purposes of determining afoundat ion manager ’s l i ab i l i t y fo r pena l t ies fo rrepeated, willful or flagrant disregard of self-dea l ing p roh ib i t i ons , the t ransac t ion w i l l be t rea tedas on ly one ac t o f se l f -dea l ing . An ind iv idua l andone or more members o f the ind iv idua l ’ s fami ly w i l lbe treated as one person regardless of whether amember o f the fami l y i s a d isqua l i f i ed person asde f i ned i n Chap te r V . The l i ab i l i t y imposed on adisqualified person and one or more members ofthe ind iv idua l ’ s fami l y fo r j o in t pa r t i c ipa t ion in anac t o f se l f -dea l ing i s j o in t and severa l .

Fair market value of a specific asset is deter-mined under the same rules discussed in ChapterVI I under Va lua t i on o f Asse ts .

Chapter IXTaxes onJeopardizingInvestmentsIf a private foundation makes any investments thatwou ld f inanc ia l l y jeopard ize the car ry ing ou t o f i t sexempt purposes, both the foundation and theind iv idua l founda t ion managers may become l iab lefor taxes on these jeopardizing investments undersec t ion 4944 .

Initial tax. An excise tax of 5% of the amountinvo lved ( the jeopard iz ing investment ) i s imposedon the foundation for each tax year, or part of ayear , in the taxab le per iod (descr ibed la ter ) . Thefounda t ion w i l l no t be l i ab le fo r the tax i f i t canshow that the jeopardizing investment was due toreasonab le cause and no t w i l l f u l neg lec t , and tha tthe jeopardizing investment was corrected withinthe correction period (described later).

The person making the valuation is not a dis-qualified person with respect to the founda-t ion , i s competent to make the va lua t ion , andis not in a position, whether by stockownership or otherwise, to receive an eco-nomic benef i t f rom the va lue used, andThe va lua t ion i s made us ing a genera l l yaccepted method fo r va lu ing comparab leproperty, stock, or securities in arm’s lengthbusiness transactions when valuation is a sig-n i f i can t fac to r .

For example , i f a corpora t ion tha t i s a d isqua l i -fied person (as to the foundation) undertakes arecapi ta l iza t ion re fer red to ear l ie r under theexceptions to the self-dealing rule, but the founda-tion receives stock worth $95,000 in exchange forstock worth $100,000, the amount involved wouldbe $5,000 i f a good fa i th e f for t was made to va luethe stock.

Time for determining fair market value. T h efair market value of property or the use thereof, asthe case may be, for purposes of the initial taxesis the value as of the date the act of self-dealingoccurred and for purposes of the additional taxesis the h ighest fa i r market va lue dur ing the taxab leper iod.

CorrectionCorrec t ion w i l l be accompl ished by undo ing thetransaction that constituted the act of self-dealing,to the extent possible, but in no case placing thefounda t ion in a worse f i nanc ia l pos i t i on than tha tin wh ich i t wou ld have been had the d isqua l i f i edperson acted under the highest fiduciary stan-dards. For example, when a disqualified personsells property to a private foundation for cash,correction may be accomplished by recasting thetransaction in the form of a gift by returning thecash to the foundat ion .

The fo l low ing paragraphs g ive examples o f m in i -mum standards of correction in the case of certainspecific acts of self-dealing. Use similar principlesand apply them to other acts of self-dealing. Anycorrection under these standards is not an act ofse l f -dea l i ng .

Sales by foundation. In a sale of property by aorivate foundation to a disaualified oerson forcash, undoing the transact/on includes, but is notlimited to, rescinding the sale if possible. However,to avo id p lac ing the- foundat ion in a pos i t ion worsethan that in which it would be if rescission werenot requ i red , the amount re turned to the d isqua l i -fied person may not be greater than the lesser ofthe cash received by the foundation or the fairmarket value of the property received by the dis-qua l i f i ed person .

Fair market value I S determined e i ther a t thet ime o f the ac t o f se l f -dea l ing o r a t the t ime o frescission, whichever results in the lesser fair mar-ke t va lue . In add i t ion , the d isqua l i f i ed person mustpay the foundat ion any net prof i ts rea l ized f romthe p roper ty wh i le i t was in the d isqua l i f i edperson’s possession. For example, the disqualifiedperson must pay the foundation any net profitsrealized from the property during the correctionperiod, but only to the extent the income is greaterthan the income rece ived by the foundat ion dur ingthe cor rec t ion per iod f rom the cash o r ig ina l l y pa idto the foundat ion .

If, before the end of the correction period, thedisqualified person resells the property in an arm’slength transaction to a bona fide buyer who is notthe foundat ion or another d isqua l i f ied person, norescrssion I S requ i red . The d isqua l i f i ed personmust pay the foundation the excess (if any) of thegreater of the farr market value of the property onthe date o f cor rec t ion or the amount rea l ized inthe arm’s length resale over the amount thatwould have been re turned to the d isqua l i f iedperson i f resc iss ion had been requ i red . In add i t ion ,

the d isqua l i f ied person must pay the foundat ionany net profits realized as described in the pre-ceding paragraph.

Sales to foundation. I f a d i saua l i f i ed oe rsonsells property to a private foundation, undoing thet ransac t ion inc ludes , bu t i s no t l im i ted to , requ i r i ngrescission of the sale if oossible. However. toavo id p lac ing the foundat ion in a worse pos i t ionthan it would be in if rescission were not required,the amount to be rece ived f rom the d isqua l i f iedperson will be the greatest of:

1) The cash paid to the disqualified person,2) The fair market value of the property at the

t ime o f the o r ig ina l sa le , o r3) The fair market value of the property at the

time of rescission.

In add i t i on , the d isqua l i f i ed person i s requ i red topay the pr ivate foundat ion any net prof i t rea l izedaf ter the or ig ina l sa le f rom the amount rece ivedfrom the sale, to the extent the net profit duringthe correction period is greater than the incomereceived by the foundation from the propertydur ing the cor rec t ion per iod .

If, before the end of the correction period, thefoundation resells the property in an arm’s lengthtransaction to a bona fide buyer who is not a dis-qualified person, no rescission is required. But, thedisqualified oerson must oav the foundation theexcess (if any) of the amount that would havebeen pa id to the foundat ion i f the o r iq ina l sa le hadbeen rescinded over the amount reanzed by thefoundation upon the resale of the property. Inadd i t ion , the d isqua l i f i ed person mus t pay thefoundat ion any net pro f i ts rea l ized f rom theamount rece ived f rom the or ig ina l sa le , descr ibedear l ie r .

Use of property by a disqualified person. I f adisqualified person uses property owned by apr iva te foundat ion , undo ing the t ransact ioninc ludes , bu t i s no t l im i ted to , t e rm ina t ing the useof the proper ty . In add i t ion , the d isqua l i f ied personmust pay the foundation the excess (if any) of:

1) The fair market value of the use of the prop-er ty over the amount pa id by the d isqual i f iedperson fo r the use un t i l te rminat ion , and

2) The amount that would have been paid by thedisqualified person for the use of the propertyon or after the date of termination, for theper iod the d isqua l i f ied person would haveused the property (disregarding furtherextensions or renewals of the period) were itnot for termination, over the fair market valueof the use for the period.

In (1) the fair market value of the use of theproper ty wi l l be the greater o f the rate at the t imeof self-dealing, or the rate at the time of correctionof the act of self-dealing. In (2), the fair marketvalue of the use of property will be the rate at thet ime o f cor rec t ion .

The rate for use of property other than moneywi l l be the fa i r renta l va lue per per iod. For use o fmoney, the ra te w i l l be the fa i r in teres t ra te .

Use of the property by a private foundation. I fa private foundation uses property that is ownedby a d isqua l i f i ed person , undo ing the t ransac t ioninc ludes , bu t i s no t l im i ted to , t e rm ina t ing the useof the proper ty . In add i t ion , the d isqua l i f ied personmust pay the foundation the excess (if any) of:

1) The amount paid to the disqualified person forthe use until termination over the fair marketvalue of the use of the property, and

2) The fair market value of the use of the prop-erty, for the per iod the foundat ion would haveused the property (disregarding extensions orrenewals of the period) had use not been ter-minated over the amount that would havebeen pa id to the d isqua l i f i ed person on o rafter the date of termination for use duringthat per iod.

In (1) the fair market value of the use of theproperty will be the lesser of the rate (that is, thefair rental value per period for use of property

An excise tax of 5% of the amount rnvolved ISalso imposed on any foundat ion manager whoknowing ly , w i l l fu l l y , and w i thout reasonab le causepar t i c ipa ted in mak ing the jeopard iz inginvestment .

This tax applies to investments of erther incomeor p r inc ipa l .

Additional tax. I f a pr ivate foundatron i s l i ab l e f o rthe In i t ia l tax and has not removed the investmentf rom jeopardy wi th in the taxable per iod, anadditional excise tax of 25% of the amountinvo lved w i l l be imposed on the foundat ion . Theadditional tax will not be assessed, or if assessedwi l l be abated, i f the inves tment is removed f romjeopardy w i th in the cor rec t ion per iod .

In each case where this additional tax ISimposed on the foundat ion , an add i t iona l exc isetax of 5% of the amount involved is imposed onany foundation manager who refuses to agree toal l or par t o f the removal f rom jeopardy wi th in thecor rec t ion per iod .

I f more than one ind iv idua l manager i s l iab le fo rthe exc ise tax on jeopard iz ing inves tments , a l lpa r t i es w i l l be jo in t l y and severa l l y l i ab le .

Limits on liabilitv for manaaement. For anvone jeopard iz ing investment,the maximum iniiialtax that may be imposed is $5,000, and the max i -mum add i t iona l tax i s $10 ,000.

Willful. A manaaer’s oarticioation in makina aninvestment is williul if ii is voiuntary, conscio‘;s,and in ten t iona l . However , i t i s no t w i l l f u l i f t hemanager does not knowing ly par t ic ipa te in a jeop-ard iz ing investment .

Due to reasonable cause. A foundat ion man-ager’s actions are due to reasonable cause if heor she has exercised responsibility on behalf ofthe foundation with ordinary business care andprudence.

Advice of counsel. A manager ’ s ac t i on w i l l beconsidered due to reasonable cause if the man-ager relies on advice of counsel expressed in areasoned written legal opinion (discussed underAdv i ce o f counse l , i n Chap te r V I I I ) . I n add i t i on , afoundat ion manager may re ly on the adv ice o f aqua l i f i ed inves tmen t counse lo r , g i ven in wr i t i ng inaccordance with generally accepted practices,that a particular investment will provide for thelong and short-term financial needs of the founda-t ion .

Participation. The participation of any founda-t ion manager in the mak ing o f an inves tment sha l lconsist of any manifestation of approval of theinvestment .

Knowing. Foundation managers will be consid-ered to have par t ic ipated in mak ing an investmentknowing that i t i s jeopard iz ing the car ry ing out o fany of the foundation’s exempt purposes only if:

They have actual knowledge of enough factsso that, based only on those facts, theinvestment wou ld be a jeopard iz inginvestment ,

They are aware that an investment underthese circumstances may violate the provi-sions of federal tax law governrng jeopardizinginvestments, and

They neg l igen t l y fa i l to make reasonab leattempts to learn whether the investment is ajeopard iz ing investment , or in fac t are awarethat it is such an investment.

The term “knowing” does not mean “havingreason to know.” However, evidence tending toshow that a foundation manager has reason toknow of a particular fact or particular rule is rele-vant in determin ing whether ac tua l knowledge ofsuch fact or rule is present.

Jeopardizing investments generally are thosethat show a lack of reasonable business care andprudence in providing for the long and short-termfinancial needs of the foundation for it to carry outits exempt function. No single factor determines ajeopard iz ing investment .

No category of investments is treated as anin t r i ns i c v io la t i on , bu t ca re fu l sc ru t i ny i s app l i ed to :

1) Trading in securities on margin,2) Trading in commodity futures,3) Investing in working interests in oil and gas

we l l s ,

4) Buying “puts, ” “calls,” and “straddles,”5) Buying warrants, and6) Selling short.

In dec id ing whether the investment o f anamount jeopardizes the carrying out of the exemptpurposes, the determination must be made on aninvestment-by-investment basis taking intoaccount the foundation’s portfolio as a whole. It ispermissible for the foundation managers to takeinto account expected returns, risks of rising andfa l l i ng p r i ces , and the need fo r d i ve rs i f i ca t ionwithin the investment portfolio. But to avoid thetax on jeopardizing investments, a careful analysisof potential investments must be made and goodbusiness judgment must be exercised.

Whether an investment jeopardizes the founda-tion’s exempt purposes is determined at the timeof making the investment. If the investment isproper when made, it will not be considered ajeopard iz ing inves tment even i f i t l a te r resu l t s inloss.

These rules do not exempt or relieve anyperson from compliance with any federal or statelaw impos ing any ob l iga t ion , du ty , respons ib i l i t y , o rother standard of conduct on the operation oradministration of an organization or trust. Nor shallany state law exempt or relieve any person fromany obligation, duty, responsibility, or other stan-dard of conduct provided in these rules.

The tax on ieopardizinq investments does notapply to investments oric$ally made by a personwho later transferred them as gifts to the founda-tion. However, if the person receives any consid-eration from the foundation on the transfer, thefoundat ion w i l l be t rea ted as hav ing made aninves tment in the amount o f the cons idera t ion .

The tax on jeopardizing investments does notapply to Investments that are acquired by thefoundation as a result of a corporate reorganiza-tion nor does the tax apply to investments madebefore 1970 unless the form or terms of theinvestments are later changed, or they areexchanged for other investments.

Program-related investments are not subject tothe tax on jeopardizing investments. Program-related investments are those in which:

1) The primary purpose is to accomplish one ormore of the foundation’s exempt purposes,

2) Production of income or appreciation of prop-erty is not a significant purpose, and

3) In f luenc ing leg is la t ion o r tak ing par t i n po l i t i ca lcampaigns on behalf of candidates is not apurpose.

In determining whether a significant purpose ofan investment is the production of income or theappreciation of property, it is relevant whetherinvestors who engage in investments only forprofit would be likely to make the investment onthe same terms as the private foundation.

I f an inves tmen t i nc iden ta l l y p roduces s ign i f i -cant Income or capital appreciation, this is not, inthe absence of other factors, conclusive evidencethat a significant purpose is the production ofincome or the apprec iat ion of proper ty .

The investments, to be program related, mustsignificantly further the foundation’s exemptactivities. They must be investments that wouldnot have been made except fo r the i r re la t ionsh ipto the exempt purposes. The investments includethose made in functionally related activities(described in Chapter X) that are carried on withina la rger comb ina t ion o f s im i la r ac t i v i t i es re la ted tothe exempt purposes.

The following are some typical examples of pro-gram-related investments:

1)

2)

3)

4)

5)

Low-interest or interest-free loans to needystudents,

High-risk investments in nonprofit low-incomehousing projects,Low-interest loans to small businesses ownedby members o f economica l ly d isadvantagedgroups, where commercial funds at reasona-ble in te res t ra tes are no t read i ly ava i lab le ,Investments in businesses in deterioratedurban areas under a p lan to improve theeconomy of the area by prov id ing employmentor t ra in ing for unemployed res idents , andInvestments in nonprofit organizationscombat ing communi ty de ter io ra t ion .

If a foundation changes the form or terms of aninves tment , and i f the inves tment no longer qua l i -fies as program-related, it then must be deter-mined whether or not the investment jeopardizescarrying out its exempt purposes.

Once an investment is determined to be pro-gram-re la ted , i t w i l l con t inue to qua l i f y as a pro-gram-related investment if changes in the form orterms of the investment are made primarily forexempt purposes and not for any significantpurpose invo lv ing the product ion o f income or theapprec ia t ion o f proper ty . A change made in theform or terms of a program-related investment forthe prudent protection of the foundation’sinves tment w i l l no t o rd inar i l y cause the inves tmentto cease to qualify as program-related. Under cer-tain conditions a program-related investment maycease to be program-related because of a criticalchange in circumstances, such as serving anillegal purpose or serving the private purpose ofthe foundation or its managers.

An investment that ceases to be program-re la ted because o f a c r i t i ca l change i ncircumstances does not subiect the foundationmaking the investment to the tax on jeopard iz inginvestments before the 30th dav after the date onwhich the foundation (or any of-its managers) hasac tua l know ledge o f the c r i t i ca l change incircumstances.

The taxable period beg ins w i th the da te o f theinvestment and ends on the earliest of:

1) The date of removal from jeopardy, or2) The date a notice of deficiency for the initial

tax i s ma i l ed , o r3) The date the initial tax is assessed.

I t may inc lude more than one tax year of thefoundat ion .

Example. The Wilson Foundation has the cal-endar year as its tax year. It makes a jeopardizinginvestment on November 28.1988. and does notremove the investment f rom jeopardy unt i l Janu-ary 15, 1989. The taxable per iod is f rom Nov-ember 28, 1988, to January 15, 1989. I t thereforeis l i ab le fo r a to ta l i n i t i a l tax o f 10% o f the amountinvested (5% for each tax year or part of a year inthe taxable per iod) .

Removal from jeopardy. The foundationremoves an investment from jeopardy when itsells or otherwise disposes of it, and the proceedsof the sale or other disposition are not themselvesjeopard iz ing inves tments .

A change by a foundation in the form or termsof a jeopard iz ing investment resu l ts in the removalof the investment from jeopardy if, after thechange, the investment no longer jeopard izes thecarrying out of the foundation’s exempt purposes.Making one jeopard iz ing investment and la terexchanging this investment for another jeopardiz-ing inves tment w i l l be t rea ted as on ly one jeopard-iz inq inves tment . A ieopard iz ina inves tment i s no tremoved from jeopardy by a transfer to anotherprivate foundation related to the transferor foun-dation unless the investment is a program-relatedinvestment in the hands of the transfereefoundat ion .

The correction period beg ins w i th the da te o fthe investment and ends 90 days after a notice ofdeficiency for the additional tax is mailed. This

3 1

per iod i s ex tended by any per iod dur ing wh ich adeficiency cannot be assessed because ofpending Tax Cour t proceedings, and any otherperiod the IRS determines is reasonable andnecessary.

Chapter XTaxes on ExcessBusiness HoldingsGenerally, under section 4943 of the Internal Rev-enue Code, the combined ho ld ings o f a pr iva tefounda t ion and a l l o f i t s d i squa l i f i ed pe rsons a relimited to 20% of the voting stock in a businessenterprise (described later) that is a corporation.The 20% l im i t a t i on a l so app l i es t o ho ld ings i n bus -iness enterprises that are partnerships, jointventures, or other unincorporated enterprises. Fora partnership or joint venture, profits interest issubstituted for voting stock, and for any otherunincorporated enterprise, beneficial interest issubstituted for voting stock. A private foundationthat has excess business holdings (describedla te r ) , i n a bus iness en te rp r i se may become l i ab lefor an excise tax based on the amount of theexcess holdrngs.

Ini t ial tax. An excise tax of 5% of the value ofthe excess holdings is imposed on the foundation.The tax is imposed on the last day of each taxyear that ends dur ing the taxable per iod(described later).

The amount of the excess holdings is deter-mined as of the day dur ing the tax year when thefoundation’s excess holdings in the business werethe greatest.

The in i t ia l tax may be abated i f the foundat ioncan show that the excess holdings were due toreasonab le cause and no t to w i l l f u l neg lec t , andthat the excess holdings were disposed of withinthe correction period (described later).

Additional tax. After the initial tax has beenimposed, an excise tax of 200% of the excessho ld ings i s imposed on the founda t ion i f i t has no tdisposed of the remaining excess businesshold ings by the end o f the taxab le per iod . Theadditional tax will not be assessed, or if assessedwill be abated, if the excess business holdings arereduced to zero during the correction period(described later).

Business enterprise. The term “businessenterprise,” in general, includes the activeconduct of a trade or business including anyactrvity that is regularly carried on for the produc-tion of income from the sale of goods or the per-formance of services and that constitutes anunrelated trade or business under section 513 ofthe Code. The term does not include afunctionally related business, a trade or busi-ness that obtains at least 95% of its gross incomefrom passive sources, or program-relatedInvestments as discussed in Chapter IX.

A functionally related business is:

1)

2)

3)

4)

32

A trade or business the conduct of which issubstantially related (aside from the mere pro-vision of funds for the exempt purpose) to theexercise or performance by the private foun-dat ion o f i t s char i tab le , educa t iona l , o r o therpurpose or function constituting the basis fori ts exempt ion ,

A trade or business in which substantially allthe work is performed for the foundation with-out compensat ion ,A business carried on by the foundation pri-marily for the convenience of its members,students, patients, officers, or employees(such as a cafeteria operated by a museumfor the convenience of its members, employ-ees, and visitors),A business that consists of the selling of mer-chandise, substantially all of which has beenreceived by the foundation as gifts or contri-bu t ions , o r

5) An activity carried on within a larger combina-t ion o f s im i la r ac t i v i t i es o r w i th in a la rgercomplex of other endeavors that is related tothe exempt purposes of the foundation (otherthan the need to simply provide funds forthese purposes).

Gross income from passive sources includes:

5)

Div idends , in te res t , and annu i t ies ,

Roya l t ies ( inc lud ing over r id ing roya l t ies ) ,whether measured by production or by grossor taxable income from the property,

Rents from real property, and from personalproperty leased with real property if the rentsfrom the personal property are an incidentalamount of the total rents under the lease(determined at the time the personal propertyis placed in service). Rents are not consideredgross income from passive sources if morethan 50% of the total rent under the lease isfor personal property, or if the determinationof the amount of rent depends in whole or inpart on the income or profits received fromthe leased property (unless the amount isbased on fixed percentages of gross receiptsor sales),

Gains from sales, exchanges, or other dispo-sitions of property other than-

a)

b)

Stock in trade or property held primarily forsale to customers in the ordinary course ofbusiness, or

Gains on the lapse or termination ofopt ions wr i t ten by the organ iza t ion inconnection with its investment activities tobuy or sell securities. Gains from cuttingt imber , tha t upon e lec t ion may be cons id -ered a sale or exchange, are not consid-ered gross income from passive sources,a n d

Income from the sale of goods if the sellerdoes not manufacture, produce, physicallyreceive or deliver, negotiate sales of, or keepinventor ies in the goods .

Income that is otherwise consideredpassive will not lose its character merelybecause i t i s un re la ted deb t - f i nanced incomedescribed in section 514.

Excess business holdings. The excess busi-ness holdings of a foundation are the amount ofstock or other interest in a business enterprisethat exceeds the permitted holdings. A privatefoundat ion is genera l l y permi t ted to ho ld up to20% of the voting stock of a corporation, reducedby the percentage of voting stock actually orconstructively owned by disqualified persons(def ined in Chapter V , o f th is pub l i ca t ion) . Thereare two exceptions to this rule.

First, if one or more third persons, who are notdisaualified oersons. have effective control of acorporation,‘the pr i va te founda t ion and a l l d i squa l -ified persons together may own up to 35% of thecorporation’s voting stock. Effective controlmeans the power, whether direct or indirect, andwhether or not actually exercised, to direct orcause the d i rec t ion o f the management and po l i -cies of a business enterprise. It is the actualcontrol which is decisive, and not its form or themeans by which it is exercisable.

Second, a private foundation is not treated ashaving excess business holdings in any corpora-t ion in wh ich i t ( together w i th cer ta in o ther re la tedprivate foundations) owns not more than 2% ofthe voting stock and not more than 2% of thevalue of all outstanding shares of all classes ofstock.

Nonvoting stock (or capital interest for holdingsin a par tnersh ip or jo in t venture) is a permi t tedho ld ing o f a founda t ion i f a l l d i squa l i f i ed pe rsonstogether hold no more than 20% (or 35% asdescribed earlier) of the voting stock of the corpo-ra t ion . A l l equ i ty in te res ts wh ich are no t vo t ingstock shall be classified as nonvoting stock.

Interest in sole proprietorships. A pr ivate foun-da t ion i s no t permi t ted any ho ld ings in so le p ropr i -etorships that are business enterprises unlessthey were held before May 26, 1969, or acquiredby gift or bequest thereafter. See the discussionon these special rules later.

Attribution of business holdings. For determin-ing the holdings in a business enterprise of eithera.pr iva te foundat ion or a d isqua l i f ied person, anystock or other interest owned directly or indirectlyby or for a corporation, partnership, estate, or trustis considered owned proportionately by or for itsshareholders, partners, or beneficiaries. (This ruledoes not apply to certain income interests orrema inder in te res ts o f a p r i va te founda t ion in asplit-interest trust, which are discussed in Chapter1).

Example. Tim Jones, a foundation manager ofX Foundation, owns 50% of the stock of Y Corpo-ra t ion . (Y Corpora t ion i s no t ac t i ve ly engaged in atrade or business.) Z Corooration is an80%-owned subsidiary of Y Corporation. There-fore, 40% of the Z Corporation stock is consid-e red he ld by a d i squa l i f i ed pe rson to XFoundat ion. Anv ho ld ina of more than 2% of thevoting stock or 2% of thk value of the Z Corpora-tion stock will result in all of the Z Corporationstock held by the foundation being treated as anexcess business holding.

In mak ing i t s computa t ions , the foundat ion mustde termine i t s p ropor t iona te in te res t and tha t o f a l ldisqualified persons in each class of stock, inre la t ion to the propor t ion that the vot ing in teres t o feach class has to all votes in the corporation. Forexample, if the foundation owns 50% of theoutstanding shares of a class of stock that has60% of the voting rights in a corporation, the foun-dation’s holdings in the voting stock would be30%.Dispositions of certain excess holdings within90 days. A private foundation that acquiresexcess business holdings, other than as a resulto f a purchase by the foundat ion , w i l l no t besubject to the taxes on excess business holdingsif it disposes of the excess business holdingswithin 90 davs from the date on which it knows. orhas reason to know, of the event that caused it tohave the excess holdings. This go-day period willbe ex tended to i nc lude the pe r iod du r ing wh ich afoundation is prevented by federal or state securi-ties laws from disposing of the excess businessho ld ings . The go-day d i spos i t i on pe r i od app l i es ,fo r example , when a d isqua l i f ied person acqu i resadd i t i ona l ho ld ings . The amoun t o f ho ld ings thefoundation must dispose of is not affected bydisposals by disqualified persons during thego-day per iod.

The taxable period begins on the first day thatthe foundation has excess business holdings andends on the ear l ie r o f e i ther :

1) The date a notice of deficiency for the initialfax i s ma i l ed , o r

2) The date the initial tax is assessed.

Example. The Y private foundation files taxreturns on a calendar vear basis. It acauiresexcess business holdings on July 7, 1987, anddoes not dispose of them until after the Servicemai l s a no t i ce o f de f i c iency fo r t he i n i t i a l andadditional tax on December 10. 1988. For Y’sexcess business holdings, the taxable periodbegins on July 7,1987, and ends on December10,1988. Because the 1987 tax year of the foun-dat ion ended in the taxab le per iod , the foundat ionis liable for a tax of 5% of the largest amount ofexcess ho ld ings i t had a t any t ime dur ing tha tyear.

The correction period begins on the first daythat the foundation has excess business holdingsand ends 90 days after a notice of deficiency forthe additional fax is mailed.

This per iod is ex tended by any per iod dur ingwhich a deficiency cannot be assessed orbecause o f pend ing Tax Cour t p roceed ings . Inaddi t ion, the cor rec t ion per iod may be extended

by any other period the Service determines is rea-sonable and necessary.

Gifts or bequests of business holdings. I fthere is a change in a foundation’s businessholdings (other than by purchase by the founda-tion or by disqualified persons) such as throughgi f t o r beques t , and the add i t i ona l ho ld ings resu l tin the foundation having excess businessholdings, the foundation in effect has 5 years toreduce these holdings or those of its disqualifiedpersons to permissible levels. The excess busi-ness holdings (or the increase in excess businessholdings) resulting from the gift or bequest aret rea ted as be ing he ld by a d isqua l i f i ed person ,ra ther than by the foundat ion i tse l f , dur ing the5-year per iod beg inn ing on the date the founda-t i on ob ta ins the ho ld ings .

Additional time to dispose of laroe sifts orbequests. The IRS may.grant the f&niation anadd i t i ona l 5year ex tens ion (beyond the i n i t i a l 5years) to reduce excess business holdings to per-missrble levels, if these holdings result from anunusually large gift or bequest of diverse businessholdings or holdings with complex corporatestructures. To receive this extension:

1) The foundation must establish that it made dil-igent efforts to dispose of the holdings withinthe in i t ia l 5 -year per iod , and cou ld no t do so(except at a price substantially below fair mar-ket value) because of the size and complexityor diversity of the holdings,

2) The foundation must submit to the IRS, beforethe end o f the in i t i a l 5year per iod, a p lan fordisposing of all the excess business holdingsinvo lved in the ex tens ion, and

3) The IRS must determine that the foundation’splan for disposal can reasonably be expectedto be carried out before the end of theadd i t i ona l 5-year per iod.

The foundat ion mus t a lso submi t the p lan men-tioned in (2) above to the state Attorney General(or o ther appropr ia te o f f ic ia l ) hav ing admin is t ra t iveor supervisory authority or responsibility for thefoundation’s disposition of the excess businessho ld ings invo lved . The foundat ion must then sendto the IRS any response it receives from the Attor-ney Genera l (or o ther o f f ic ia l ) regard ing i ts p lan.

A request for extension of the period for disposi-tion, as well as the copy of any response receivedfrom state officials, should be addressed to theAssistant Commissioner (Employee Plans andExempt Organizat ions) , 1111 Const i tu t ion Ave. ,NW, Washington, DC 20224.

Business holdings on May 26, 1969.Transitional rules are provided to prevent holdingsof a foundat ion as of May 26, 1969, that areareater than the 20% (or 35%) limits oermitted;nder the general rules of section 4943(c)(2), frombe ing sub jec t t o the i n i t i a l t ax . The founda t ion i sgrven time, in three phases, to dispose of itsexcess business holdings.

First, the transitional rules provide that, all foun-dat ion ho ld ings on May 26, 1969, are t reated asheld by disqualified persons for a certain period oftime (the “first phase”). Second, the percentageof permitted holdtngs in a business enterprise isinitially increased to a percentage equal to thedifference between -

1) The percentage of combined holdings of thefounda t ion and a l l d i squa l i f i ed pe rsons onMay 26, 1969 (up to a 50% maximum), and

2) The pe rcen tage o f ho ld ings o f a l l d i squa l i f i edpersons.

The percentage in (1) is called the “substitutedlevel” and it applies to both the voting stock, and,separately, to the value of all outstanding sharesof all classes of stock.

The main purpose of the substituted level is toind ica te what the permi t ted ho ld ings w i l l be imme-diately after the end of the first phase, when theho ld ings a re no longer t rea ted as he ld by d isqua l i -fied persons.

The substituted level is reduced bv disoositionsof ho ld ings by the foundat ion o r d isqua l i f i edpersons (but not below 20% or 35%) after May26, 1969.

Example. On May 26,1969, the Watson Foun-dation and its disqualified persons owned 49% ofthe voting stock of the Brown Corporation. Thefoundation could continue to hold its stock duringthe first phase. However, if the foundationdisposes of 10% of its Brown Corporation stock,its permitted holdings could then not be greaterthan 39% of the stock.

Holdings on May 26, 1969, include businessinterests acauired later bv the foundation underthe terms of ‘a trust irrevocable on that date, orunder the terms of a wi l l executed before Mav 27,1969.

Genera l l y , an ac t i ve co rpora t ion in wh ich aprivate foundation has excess stock held sinceMay 26, 1969, may acquire new subsidiaries orassets without creating excess business holdingsfor the foundat ion.

The first phase i s 20 years i f the foundat ionand a l l d isqua l i f i ed persons owned more than95% of the votina stock of a coroorate business(or more than 95% of comparable interests in anunincorporated business) on May 26, 1969.

The first ohase is 15 Years if the foundation(and its disqualified persons) owned on that datemore than 75% of either the voting stock or thevalue of all outstanding shares of all classes ofstock of a corporation, or more than 75% of theprofits or capital interests of an unincorporatedbusiness.

The first phase is 10 years in all other cases.Phase one i s suspended dur ing the t ime a jud i -

cial proceeding is pending, for the purpose ofreformina or excusina the foundation from comolv-ing with ‘zs governinginstrument or any other ’ ’ins t rument in e f fec t on May 26 , 1969, to a l low d is -position of excess business holdings.

During the first phase, business interests ownedby the foundat ion on May 26, 1969, are t reated ashe ld by a d isqua l i f ied person, ra ther than by thefoundat ion . The combined ho ld ings o f the founda-tion and its disqualified persons must be reducedso that by the end of the first phase they are notgreater than either 50% of the voting stock or50% of the value of all outstanding shares of acorporation (or 50% of comparable interests in anunincorporated enterprise).

Also for holdings acquired under the terms of awi l l ex is t ing before May 27, 1969, or under theterms of a trust irrevocable before May 27, 1969,the first phase begins on the date of actual distri-bution of the holdings. However, only the 15-yearand 1 O-year first phase periods apply in thesecircumstances.

Present holdings greater than 20% but lessthan 50% need not be decreased durina the firstphase, but also may not be increased. -

The second phase is the 15-year period imme-diately following the first phase. During the secondphase, the foundation’s ownership of businessinterests that it held on May 26, 1969, must bereduced so that by the end of the phase thecomb ined ho ld ings o f t he founda t ion and i t s d i s -qualified persons are not greater than 35% of thevoting stock of a corporation (or 35% of the valueof all outstanding shares of all classes of stock, or35% of comparable interests in an unincorporatedenterprise).

I f , a t any t ime dur ing the second phase, theho ld ings o f a l l d i squa l i f i ed persons toge ther a regreater than 2% of the voting stock, the holdingsof the foundation itself may not be more than 25%of the voting stock or 25% of the value of alloutstanding shares of all classes of stock.

The third phase i s the en t i re per iod fo l low ing thesecond phase. If a foundation enters the thirdphase with not more than 2% of the voting stockhe ld by a l l d isqua l i f i ed par t ies , and any t ime a f te rthe beginning of the third phase these holdingsexceed 2%, then the 25% rule applies.

Separation of phases and special rules. Apr iva te founda t ion may acqu i re o the r i n te res ts i n abusiness enterprise, which are also entitled to betreated as held by disqualified persons for varyingho ld ing per iods (cer ta in ho ld ings acqu i red underthe terms of a trust or will in effect on May 26,1969 , and the in i t i a l and add i t i ona l 5-year per iodsto dispose of certain gifts, bequests, etc.). Thephase periods for each different interest acquiredwork indeoendentlv of one another. For examole.the phases for cegain holdings acquired under theterms of a trust or will in effect on May 26, 1969,start independently from those for certain otherinterests of the foundation in the same enterprise.In any case, however, holdings the private founda-tion disposes of are charged first against thoseholdings it must dispose of in the shortest periodto avo id the in i t ia l tax thereon.

In ce r ta in s i tua t ions , ho ld ings dur ing the phaseperiods may become so reduced that they wouldbe permi t ted ho ld ings sub jec t to the genera l ru lesof section 4943 instead of the transitional rules.For example, when the combined vot ing leve lshave been reduced to 20%, the provisionsconcerning nonvoting stock as permitted holdingsgeneral ly apply.

There is a l im i ted except ion f rom the taxes onself-dealing for private foundations that dispose ofcertain excess business holdings to disqualifiedpersons as long as the sales price at least equalsthe fa i r market va lue.

The excess business holdings involved arethose interests that are subject to the transitionalru les and tha t wou ld be sub jec t to the in i t i a l tax i fthe required reductions in amount were notaccomp l i shed .

Chapter XIExcise Tax Appeal ProceduresThis chapter explains the procedures an organiza-t ion mus t fo l l ow in appea l ing the impos i t i on o f theexcise taxes explained in Chapters VI through X.Appeals of these taxes are handled by theAppea ls D iv i s ion in each o f the reg iona l o f f i ces o fthe In ternal Revenue Serv ice.

For appeal procedures that apply to casesinvolving issues subject to the declaratoryjudgment provisions of section 7428 of the Code,see Pub l i ca t ion 557 and Chapte r I I o f th ispub l i ca t i on . These i s sues i nc l ude qua l i f i ca t i onunder sect ion 501 (c) (3) or as an operat ing founda-t i on , c lass i f i ca t i on as a p r i va te founda t ion , and e l i -g ib i l i t y to rece ive deduc t ib le con t r ibu t ions .

Thirty-Day LetterUpon conc lus ion o f an examina t ion tha t resu l t s i na proposed tax def ic iency, the taxpayer wi l l beissued a 30 -dav letter includina a reoort of theexamina t ion tha t ind ica tes the p roposed tax de f i -ciency and the reasons for it. The letter will alsoadvise the taxpayer o f the r ight to appeal theproposed action if the taxpayer does not agreewi th i t .

The taxpayer may, wi th in 30 days of the date ofthe letter, request consideration by the RegionalDirector of Appeals for the region that has jurisdic-tion over the case. The procedures regarding theregional consideration and claims for refund orcredit are discussed later. In situations where theexo i ra t ion o f the s ta tu te o f l im i ta t ions fo rassessment and collection of tax is imminent,extensions of time to file a 30-day protest will begranted only if the taxpayer signs-a consent toex tend the s ta tu te o f l im i ta t ions .

If the taxpayer does not respond in 30 days,a statutory notice of deficiency will be issued bythe key District Director of the Internal RevenueService. The taxpayer has 90 days (150 days if thenotice is mailed to a person outside of the Statesof the Un ion and the D is t r i c t o f Co lumb ia ) to f i l e ape t i t i on w i th the Un i ted S ta tes Tax Cour t fo r aredeterminat ion o f the def ic iency.

33

I f the taxpayer does not f i le a pet i t ion w i th theTax Court, the tax will be assessed.

Protest and ConferenceProceduresIf, after receivina the 30-dav letter. the taxoaverwishes to appeal, the taxpayer must send a 1written protest to the key District Director within 30days from the date of the letter. The protest mustinc lude a fu l l and de ta i l ed s ta tement o f the fac ts ,law, and argument in support of the taxpayer’sposition and, if desired, a request for a conferenceat the regional office. Deficient protests will bereturned to the taxpayer wrth an explanation whythe protest cannot be accepted. Additional timewill be given to the taxpayer to perfect the protest.

Upon receipt of a taxpayer’s protest andrequest for a regional office conference, the keyDis t r i c t w i l l rev iew the p ro tes t and , i f i t ma in ta insits position, forward the request and the case fileto the Reg iona l D i rec to r o f Appea ls wh ich w i l lcontact the taxpayer regarding conference rights.In appropriate cases, the examining officer mayattend the regional office conference to clarify thefacts in the case. If additional issues are raised atthe conference, the case will be returned to thekey District Director for consideration of theseissues.

If, after consrderation of the case by Appeals, asatisfactory settlement of the issues is reachedwi th the taxpayer , the taxpayer w i l l be g iven arevised report of examination prepared at the

regional office, if necessary, and will be asked tosign an appropr ia te agreement form.

If agreement is not reached at this stage, a stat-utory notice of deficiency will be issued byAooeals after consideration bv the Service’sRegiona l Counse l . The taxpayer may then pet i t ion ,withrn the statutorv period. the United States TaxCour t for redeterminat ion of the def ic iency.

If the case under consideration in Appeals isdocketed in the Tax Court and agreement isreached with the taxpayer on the issues involved,the case is disposed of by filing a stipulation ofagreed deficiency or overpayment with the TaxCourt, which will enter its order in conformity withthe s t i pu la t i on .

Claims for Refund or CreditAfter receiving a 30-day letter, the taxpayer maypay the tax and then contest the assessment(unless an agreement to the contrary is executed)by f i l i ng a c la im fo r re fund or c red i t fo r a l l o r anypart of the amount paid. However, this does notapply to certain taxes determined by the TaxCourt, the decision of which has become final. Ac la im fo r re fund or c red i t i s made by f i l i ng anappropriate amended return with the Internal Rev-enue Serv ice Center to which the or ig ina l re turnwas sent.

When claims for refund or credit are examinedby the key District Director, substantially the sameprocedure w i th in the Serv ice i s fo l lowed ( inc lud ingappeal steps) as when original exempt organiza-tions returns are examined. The procedure for

appea l ing re jec ted c la ims th rough the Cour t i sou t l i ned i n sec t i on 601.103(c)(3) o f the Sta tementof Procedural Rules.

Technical AdviceWhile the case is under the jurisdiction of the keydistrict office or the Appeals office, a taxpayermay request that an issue be referred to theNat iona l Of f i ce fo r techn ica l adv ice on thegrounds that a lack of uniformity exists as to thedisposition of the issue, or that the issue is so unu-sual or complex as to warrant consideration by theNational Office. Taxpayers should make writtenrequests to the key district office or the Appealsoffice stating the facts, law, and argument withrespect to the issue and reasons for requestingtechnical advice. At the time taxpayers areinformed that the matter is being referred to theNat iona l O f f i ce , they w i l l a l so be in fo rmed o f the i rr igh t to a con ference in the Nat iona l Of f i ce in theeven t an adverse dec is ion i s ind ica ted , and w i l l beasked to state whether they want such aconference.

If, after the National Office considers the casefile on a request for technical advice, it appearsthat advice adverse to the taxpayer should begiven and a conference has been requested, thetaxpayer w i l l be no t i f ied o f the t ime and p lace o fthe conference. If a conference has not beenrequested, the case will be decided on the basisof the existing written records.

34

IndexAbatement o f sec t ion 507(c) taxes . . . . . I IAppea l p rocedures . . . . .8 . 33Assets:

For exempt purposes . . . . .22Use of (self-dealing) . . ...27Valuation of . . ...23

Asse ts tes t , p r i va te foundat ions . . . . .3Capital gains and losses . . ...13Charitable trusts . . ...5Claims for refund or credit . . ...34Classification as other than a private

foundation . . ...9Govern ing ins t ruments . . . . .9

Common t rus t funds . . . . .23Company scho larsh ip programs . . . . .18Compensatron (self-dealing) . . ...27Conference and protest procedures . . . . .34Correct ion of a taxable expendi ture . . . . .16Credit, claims for . . ...34Dec lara tory judgments . . . . .8Deduc t ion Mod i f i ca t ions . . . . .3 . 14Disqualified persons: . . ...14

Foundat ion managers . . . . .15Government o f f i c ia ls . . . . .15Subs tan t ia l con t r ibu to rs . . . . .15

Dis t r ibu tab le amount . . . . .22Elections, influencing . . ...18Endowment tes t . . . . .4Estates . . ...6. 7Except ions (se l f -dea l ing) . . . . .28Excess bus iness ho ld ings tax . . . . . 32Exempt opera t ing foundat ions . . . . .4Filing of notice . . ...7Filing requirements . . ...7Fore ign foundat ions . . . . .7Form 990-PF . . ...9Form 4720 . . . ..lOForm 5227 . . ...9Govern ing ins t ruments . . . . .9Government o f f i c ia ls (se l f -dea l ing) . . . . .28

Government o f f i c ia l s as d isqua l i f i ed persons . . . . .15 Self-dealinq: . . ...26Grants:

To individuals . . ...18To organizations 17, 20, 21

Gross inves tment income . . . . .13Income mod i f i ca t i ons . . . . . 2Income test . . ...2Indirect self-dealing . . ...28Investments:

Jeopardizing . . ...31Program-re lated . . . . .31Tax on jeopardizing . . ...30

Investment re turn , min imum . . . . .22Involuntary termination . . . ..llLeases (se l f -dea l ing) . . . . .27 . 29Legislation, influencing . . ...16Loans (se l f -dea l ing) . . . . .27Min imum investment re turn . . . . .22Net inves tment income . . . . .13Nonexempt t rus ts . . . . .5Not ice requ i rements . . . . .7Penalties . . . ..lOPercen tage tes t , g ran ts to ind iv idua ls . . . . .19Polrtical:

Influencing elections . . ...18Influencing legislation . . ...16

Pr iva te nonoperat ing foundat ion . . . . .5Pr iva te opera t ing foundat ions . . . . .2Program-re la ted investments . . . . .31Publrc inspection . . . ..lOQualifying distributions . . ...23Refund, claims for . . ...34Revocable trusts . . ...6. 7Ru l ing reques ts , g ran ts to ind iv idua ls . . . . .18Sales or exchanges of proper ty . . . . .27Scho larsh ip programs, company . . . . .18Sec t ion 507 :

Section 507(a)(l) . . . ..lOSection 507(b)(l) . . . ..llSect ion 507(b) (2) . . . . .12Section 507(c) . . . ..lO. 11

Compensat ion . . . . .27Exceptions . . ...28Indirect self-dealing . . ...27Leases . . ...27Loans . . ...27Payment to a government o f f ic ia l . . . . .28Prov id ing goods , se rv ices , o r fac i l i t i es . . . . . 27Sales or exchanges of proper ty . . . . .27Use of income or assets . . ...27

Self-dealing tax . . ...26Set-asides . . ...24. 25

Cash distribution test . . ...24Suitability test . . ...24

Split-interest trusts . . ...6Status:

Determination of . . . ..lTerminat ion o f p r iva te foundat ion . . . ..lO. 11

Support test . . ...4Tax:

On excess bus iness ho ld ings . . . . . 32On failure to distribute income . . ...21On jeopard iz ing investments . . . . .30On net investment income . . . . .13On self-dealing . . ...26On taxable expendi tures . . . . .15

Taxab le expendi tures . . . . .16Termina t ion :

Involuntary . . . ..llOf private foundation status . . . ..lO. 11Operation as a public charity . . . ..l 1Under Section 507(a) . . . ..lOVoluntary . . . ..lO

Transfer of assets to a public charity . . . ..llT rans feree foundat ions . . . . .12Valuation of assets: . . ...23

Common t rus t funds . . . . .23Voluntary terminations: . . . ..lO

Section 507(b)(l) . . . ..l 1Transfer of assets . . . ..ll

35

List of Tax Publications for Business Taxpayers

General Guides

I Your Rights as a Taxpayer17 . _ Your Federal Income Tax

(For lndlvlduals)2 2 5 Farmer ’s Tax Guide334 .._.__. Tax Guide for Small Busmess5 0 9 Tax Calendars for 1991553 .,...,. HIghlIghts of 1990 Tax Changes595 ,. Tax Guide for Commercial Fishermen910 Guide to Free Tax Services

Employer’s Guides

1 5 ......5 1 ........

8 0 ......

Employer’s Tax Guide (Circular E)Agricultural Employer’s Tax Guide(Circular A)Federal Tax Guide for Employers in theVirgin Islands. Guam, American Samoa,and the Commonwealth of the NorthernMariana Islands (Circular SS)

Specialized Publications

349 ...... Federal Highway Use Tax on HeavyVehicles

370 . . . . . . . Fuel Tax Credits and Refunds463 ....... Trave l , Entertamment, and Gift

E x p e n s e s5 0 5 ....... Tax Wtthholdmg and Est imated Tax5 1 0 ....... Excise Taxes for 1991515 ....... WIthholdIng of Taxon Nonresident

Aliens and Foreign Corporations517 ....... Social Security for Members of the

Clergy and Religious Workers527 ....... Residential Rental Property533 . . . . . . . Sel f -Employment Tax534 ....... Depreciation535 ....... Business Expenses536 . . . . . . . Net Operating Losses537 ....... Instal lment Sales

538 .......5 4 1 .......542 .......544 .......5 5 1 .......556 .......

5 5 7 .......5 6 0 .......5 6 1 .......

578 .......

583 .......586A ...

507 .......589 .......594 .......

597 .......

598 .......

686 .......

908 .......

909 .......9 1 1 .......917.. .....924 .......

925 .......926 ......

937 .......

1 5 4 4 ...

Accounting Periods and MethodsTax InformatIon on PartnershIpsTax InformatIon on CorporationsSales and Other Dlspositlons of AssetsBasis of AssetsExamination of Returns, Appeal Rights,and Claims for RefundTax-Exempt Status for Your OrganizationRetirement Plans for the Self-EmployedDetermIning the Value of DonatedPropertyTax InformatIon for Private Foundationsand Foundation ManagersTaxpayers Starttng a BusmessThe CollectIon Process (Income TaxAccounts)Business Use of Your HomeTax InformatIon on S CorporattonsThe CollectIon Process (Employment TaxAccounts)InformatIon on the United States-CanadaIncome Tax TreatyTax on Unrelated Busmess Income ofExempt OrganizationsCertif ication for Reduced Tax Rates inTax Trea ty CountriesBankruptcy and Other DebtCancellationAlternatIve Minimum Tax for IndividualsTax Information for Direct Sel lersBusiness Use of a CarReportmg of Real Estate Transactions toI R SPassive Activity and At-Risk RulesEmployment Taxes for HouseholdEmployersBusmess Report ing (Employment Taxesand InformatIon Returns)Reporting Cash Payments of Over$ 1 0 , 0 0 0

Spanish Language Publications

1s179

556S.....

5798.....

586S.....

594s.....

8 5 0 . .

Derechos del ContrlbuyenteGuia Contnbutlva Federal Para PatronosPuertornquefios (Circular PR)Rev&n de las Declaraclones deImpuesto, Derecho de ApelaclCIn yReclamaciones de ReembolsosComo Preparar la Declaration delmpuesto FederalProceso de Cobro (Deudas del lmpuestoSobre Ingreso)Proceso de Cobro (Deudas del lmpuestopor RazCln del Empleo)English-Spanish Glossary of Wordsand Phrases Used In Publlcatlons Issuedby the Internal Revenue Service

How to Get IRS Forms and Publications

You can order tax forms andpublications from the IRS FormsDistribution Center for your stateat the address below. Or, if youprefer, you can photocopy taxforms from reproducible copieskept at many participating publiclibraries. In addition, many of theselibraries have reference sets of IRSpublications which you can reador copy.

Send to“Forms Dist r ibut ion

Center”ff you are located in: for your state

Alaska, Arizona,California, Colorado,Hawaii, Idaho,Montana, Nevada, Ranch0 Cordova,New Mexico, Ca. 95743-0001Oregon, Utah,Washington, Wyoming

Alabama, Arkansas,Illinois, Indiana, Iowa,Kansas, Kentucky,Louisiana, Michigan,Minnesota,Misslsslppi, Missouri, P.O. Box 9903,Nebraska, North Bloomington, ILDakota, Ohlo, 61799Oklahoma, SouthDakota, Tennessee,Texas, Wisconsin

Connecticut, Delaware,District of Columbia,Florida, Georgia,Maine, Maryland,Massachusetts, New P.O. Box 25866,Hampshire, New Richmond, VA 23289Jersey, New York,North Carolina,Pennsylvania, RhodeIsland, South Carolina,Vermont, Vlrglnia, WestVirginia

Foreign Addresses-Taxpayerswith mailing addresses in foreigncountries should send their re-quests for forms and publicationsto: Forms Distribution Center,P-0. Box 25866, Richmond, VA23289; Forms DistributionCenter, Ranch0 Cordova, Ca.95743-0001, whichever is closer.

Puerto Rico-Forms DistributionCenter, P.O. Box 25866, Rich-mond, VA 23289

Virgin Islands-V. I. Bureau ofInternal Revenue, LockhartsGarden, No. 1 A, CharlotteAmalie, St. Thomas, VI 00802