by Milton Cerny and Doug Varley

Like most aspects of contemporary life, philanthropy is becoming more international. Nations all around the globe are eagerly trying to create (or revive) vital nonprofit sectors as an essential ingredient in a genuinely civil society. Russia and many of the other former Soviet block countries have enacted new nonprofit laws or are well into the process of doing so. Mexico's new tax law provides for an array of tax-exempt organizations, including charities eligible to receive tax-deductible contributions. South Africa, too, is in the process of crafting laws to govern its voluntary sector, as it struggles to overcome the legacy of apartheid. Even China has just issued new regulations for its fledgling voluntary sector.

These legal developments parallel an unprecedented growth in the number and diversity of nongovernmental organizations working in emerging democracies and throughout the developing world. This growing nonprofit sector in other countries presents an important opportunity for U.S. foundations to directly support efforts by local citizens working to improve life in their countries. Not surprisingly, foundations are taking increasing advantage of this opportunity. According to the Foundation Center's International Grantmaking: A Report on U.S. Foundation Trends (1997), between 1990 and 1994, international grants (i.e., domestic grants for international purposes and direct cross-border grants) by U.S. foundations grew by 34 percent.

The growth in interest among foundations in funding charitable work abroad through direct grants to foreign organizations indicates the importance of understanding the federal tax rules governing such grants. One of these rules, the so-called "out of corpus" rule is a potential obstacle to understanding and working around the challenges in the development of cross-border grantmaking.

In general, the Internal Revenue Code requires private foundations to meet a 5 percent payout requirement. That is, a foundation must make "qualifying distributions"—expenditures for charitable purposes—equal to 5 percent of its net investment each year. Most foundations meet this requirement by making grants to other organizations. Grants to organizations that qualify as "public charities" automatically count as qualifying distributions. Examples include grants to churches, schools, hospitals, or to other organizations exempt under section 501(c)(3) which, like the YMCA or Red Cross, receive a substantial part of their support from public sources.

Grants to other organizations that are not public charities are more complex. If the grantee is described in section 501(c)(3) but is not a public charity, it is treated as a private foundation for tax purposes. For such grantees, a technically intricate procedure known as the out of corpus rule must be complied with if the grant is to be taken as a qualifying distribution. Under this procedure, the grantee must demonstrate that it has expended the grant in question within a defined period after receipt. If the grantee is not a charitable organization at all (i.e., not an organization described in section 501(c)(3)), then the out of corpus rule does not apply. However, in either case, the grantor must exercise "expenditure responsibility" over the grant and in the case of a grant to a noncharity, the noncharity generally must maintain the grant funds in a separate fund dedicated to charitable purposes. Expenditure responsibility is discussed in the November 1998 International Dateline Legal Dimensions article "Grantmaking by Private Foundations in the International Arena" by Thomas Chomicz.

Unfortunately, the application of this three-category scheme—public charity, private foundation, noncharity—to foreign organizations is not always easy. In the relatively rare case, the grant applicant will have made things simple by obtaining a ruling from the IRS that it is a public charity. But what if it hasn't?

One option is for the foundation to make its own determination that the applicant is the "equivalent" of a public charity, a procedure which is discussed in the January 1999 International Dateline Legal Dimensions article "What's Behind the Foreign Public Charity Equivalence Affidavit?" by Betsy Adler and Ingrid Mittermaier.

As you might have guessed, another option would be to take the position that the foreign grantee is not a charitable organization at all and to exercise expenditure responsibility over the grant. After all, the out of corpus rule only applies to private foundations (and organizations controlled by the grantor).

Wouldn't this be the simplest solution?

Unfortunately, this option is, strictly speaking, not available under current law. No provision of the Internal Revenue Code, or its interpreting regulations, gives a foundation the prerogative to treat a foreign grantee as not a charity, if the grantee, in fact, would qualify as such under U.S. law. And, as previously discussed, all charities, foreign and domestic, are presumed to be private foundations unless they can show they are public charities. Accordingly, a foundation that wants to be sure that its grant will be a qualifying distribution needs to either make an equivalency determination or satisfy the out of corpus rule. Otherwise, unless it is certain that the grantee is not a charity at all—and this will rarely be the case—current law leaves open the possibility that the Internal Revenue Service (IRS) will assert that the grant was not a qualifying distribution because the grantee was a private foundation and did not provide the information necessary to satisfy the out of corpus rule.

The out of corpus rule is not really about how organizations use grant funds. It is about when they use grant funds. Congress enacted the mandatory 5 percent payout requirement in response to concerns that private foundations, in contrast to public charities, often retained their assets for extended periods of time; thus, the IRS asserted, they were unduly delaying the use of those assets for charitable purposes. The out of corpus requirement was intended to prevent foundations from avoiding the requirement that they distribute a percentage of their assets for charitable activity each year by making grants to other foundations which would simply continue to hold the grant funds. The rule accomplishes this result by requiring a private foundation that receives a grant from another private foundation to satisfy its own qualifying distribution payout requirement and distribute the full grant amount (within the next year) if the grantor is to take a qualifying distribution. In addition, the rule requires the grantor to obtain adequate records from the grantee indicating that the grantee has made the required distribution. (For an example of how the rule works see Beyond Our Borders: A Guide to Making Grants outside the United States , Second Edition, 1999.)

Of the three kinds of organizations that may receive private foundation grants—public charities, other private foundations and noncharities—only private foundations (and organizations under the control of the grantor) were perceived as presenting the special risk of delayed use that the out of corpus rule was designed to address. Foreign charitable organizations are subject to the rule merely because the tax law assumes all charities are private foundations unless they can prove otherwise, even though these organizations are no more likely to delay the use of grant funds for charitable purposes than any other category of grantee. Nevertheless, unless a U.S. private foundation grantor is able to make a determination with respect to a foreign charitable grantee that it is the equivalent of a public charity, a grant made to that grantee must comply with the out of corpus rule in order for the grant to be considered a qualifying distribution of the grantor.

Hopefully, Congress or the IRS will act in the near future to eliminate this unnecessary complication to foreign grantmaking by exempting foreign grantees from the out of corpus rule on the same basis as domestic noncharitable organizations. Foundations would still exercise expenditure responsibility to see that their funds are used for proper purposes, but the foreign grantees could devote their energy to carrying out the charitable purposes of the grant—not demonstrating compliance with the technical nuances of U.S. tax law.

About the Authors

Milton Cerny is a partner in the law firm of Caplin & Drysdale, Chartered in Washington, D.C. He was formerly Technical Advisor to the Assistant Commissioner for Employee Plans and Exempt Organizations at the Internal Revenue Service. Doug Varley is an associate at Caplin & Drysdale, specializing in private foundation and public charity issues.

For copies of this article with citations to legal authority, please contact Mr. Cerny at 202/862-5000. Legal Dimensions articles are edited by an editorial board in which the following firms are represented: International Center for Not-for-Profit Law; Silk, Adler & Colvin; Day, Berry & Howard; and Caplin & Drysdale.