Grantmaking is the most visible activity foundations undertake. It is therefore critical to comply with applicable legal requirements and to develop consistent practices to maintain the public's trust. Here are things all grantmakers should know about the process of making grants.
Private foundations are required each year to make "qualifying distributions" in an amount approximately equal to 5 percent of their investment assets. Grants and administrative expenses (other than investment expenses) count toward this payout requirement. When making grants and other distributions, private foundations must take care to avoid prohibited payments known as "taxable expenditures." Private foundations that make a taxable expenditure must pay an excise tax on the expenditure and correct the transaction.
Taxable expenditures include amounts paid or incurred (a) to carry on propaganda or otherwise attempt to influence legislation; (b) to influence the outcome of public elections or carry on voter registration drives; (c) to individuals for travel or study (unless requirements described below are met); (d) to organizations other than public charities; or (e) for purposes that are not charitable.
Grants to individuals and organizations are discussed in more detail in the following paragraphs. For additional information about lobbying and public policy activities, see Public Policy Engagement.
Grants to Individuals: Grants to individuals are generally permissible, as long as they serve a charitable purpose. If the grant is made for travel or study, including scholarship and fellowship grants, a private foundation may make the grant to the individual only pursuant to a program that has been approved in advance by the IRS. As an alternative, the foundation may make the grant to a school or college and allow the school to choose the scholarship recipient. Such a grant will be treated as having been made to the school, rather than the individual.
Grants to Organizations: Private foundations generally may make grants to organizations that qualify under IRS requirements as section 501(c)(3) public charities if the grant is made for a charitable purpose. If the grantee organization is not a public charity, the foundation must exercise "expenditure responsibility." A private foundation must also exercise expenditure responsibility if the grantee is a public charity that is classified as a supporting organization described in section 509(a)(3) of the Internal Revenue Code, and is considered a "Type III" supporting organization that is not "functionally integrated." The process for determining the status of a public charity is discussed in more detail below.
Expenditure responsibility requires:
Determining Public Charity Status: Private foundations have always had to undertake due diligence to confirm that organizational grantees are section 501(c)(3) public charities. Typically, that due diligence includes obtaining a copy of the grantee's IRS determination letter, obtaining confirmation from the grantee that its public charity status has not been revoked, and perhaps reviewing IRS Publication 78, which lists recognized 501(c)(3) organizations.
Because private foundations are required to exercise expenditure responsibility with respect to grants made to certain supporting organizations, the due diligence process for grants to supporting organizations is somewhat complex. Private foundations must ensure that any supporting organization they fund qualifies as a "Type I," "Type II" or "functionally integrated Type III" organization. The IRS has published Notice 2006-109, which describes, among other things, procedures to determine the classification of a supporting organization. As of the date of this publication, Notice 2006-109 is available at www.irs.gov/irb/. If a foundation determines that a supporting organization is a non-functionally integrated Type III supporting organization, it should consider carefully whether to make the grant. Grants to such organizations require the exercise of expenditure responsibility and, unlike all other grants made for charitable purposes, do not count toward the 5-percent payout requirement.
Foreign Organizations: Foreign charities usually do not have determinations from the IRS as to their 501(c)(3) and private foundation status. A U.S. private foundation therefore cannot easily determine whether grants to the foreign organization will require the exercise of expenditure responsibility. The foundation is allowed to rely on its own good-faith determination as to the grantee's status if it obtains an affidavit from the grantee (or an opinion from the foundation's or the grantee's legal counsel) setting forth sufficient facts about the grantee's operations and support that would allow the IRS to determine that the grantee would qualify as a public charity. Alternatively, the foundation can choose to exercise expenditure responsibility. Use of this approach was reaffirmed in an April 18, 2001, IRS letter to the Council on Foundations. Under certain circumstances, a U.S. intermediary organization (fiscal agent) can be used to avoid expenditure responsibility or the affidavit process. The use of fiscal agents must be carefully managed, however, to avoid making a taxable expenditure.
Program-Related Investments: Although program-related investments often take the form of loans, they are treated as grants for purposes of the taxable expenditure rules. If the entity in which the foundation invests is not a public charity, the foundation generally will have to exercise expenditure responsibility with respect to the investment. For example, if a foundation makes a loan to a small business in a distressed neighborhood, it must exercise expenditure responsibility with respect to the loan.
Public charities are free from many of the procedural restrictions imposed on private foundations under the taxable expenditure rules. Like private foundations, however, community foundations and other public charities must ensure that their grants are made solely for charitable purposes. In addition, certain distributions made from donor-advised funds maintained by public charities are treated as “taxable distributions” that are subject to excise taxes similar to those that apply to private foundations.
It is important to consider the definition of a donor-advised fund when analyzing whether a proposed grant is permissible. A donor-advised fund is a fund or account that (a) is separately identified by reference to contributions of a donor or donors; (b) is owned and controlled by a sponsoring organization (such as a community foundation); and (c) affords advisory rights to the donor or his or her appointee with respect to distribution or investment of amounts held in the fund.
The definition of a donor-advised fund excludes (a) funds that make distributions only to a single identified organization, and (b) funds with respect to which a donor or person designated by a donor makes recommendations concerning grants for travel or study, but only if the individual makes recommendations as part of a committee appointed by the sponsoring organization, donors and their designees do not control the committee, and the grants are awarded on an objective and nondiscriminatory basis under a procedure approved in advance by the board of directors of the sponsoring organization.
A taxable distribution from a donor-advised fund includes:
The prohibition against distributions to individuals bars the payment of scholarships and similar grants from donor-advised funds, and also prohibits such funds from reimbursing individuals for expenses incurred for fundraising or similar events.
Donor-advised funds are also subject to excise taxes for distributions that result in more than an incidental benefits to donors, donor advisors and certain related parties.
Both private foundations and public charities must take care to ensure their grants do not support terrorists or terrorist activities. The U.S. Department of Treasury has issued Anti-Terrorist Financing Guidelines: Voluntary Best Practices for U.S.-Based Charities. These guidelines recommend, in some detail, various practices that charities and foundations can undertake when providing assistance to other organizations (domestic and foreign) to minimize the risk that charitable resources will be inadvertently diverted to support terrorism. The guidelines are voluntary and cover both grantmaking practices and corporate governance practices.
While the guidelines are quite detailed and in some cases perhaps overly burdensome and costly, they do acknowledge that charities and foundations may adopt a "risk-based approach" to investigating possible ties between recipient organizations and terrorism. The guidelines emphasize that not every practice identified in the guidelines will be appropriate for every organization in every circumstance, and that there may be exigent circumstances (such as catastrophic disasters) that make application of the guidelines impracticable. The Treasury recommends, in those cases, that organizations take "all prudent and reasonable measures that are feasible under the circumstances."