by Thomas Chomicz
Wilson & McIlvaine

Private foundations are required under various provisions of the Internal Revenue Code (Code) to distribute funds directly or to make grants solely for charitable purposes. If a foundation fails to satisfy these requirements, the foundation (and possibly its officers and directors or trustees) will be subject to penalties (in the form of excise taxes). In substance, the possible imposition of the penalties requires that foundations not make grants or disbursements other than for charitable purposes. State law may also require compliance with these requirements.

A private foundation may make a grant to a charitable organization identified as a "public charity" without being subject to penalty. If a private foundation elects to make a grant to charity that is not a "public charity" or a grant to a noncharitable organization for a charitable purpose, the foundation must exercise "expenditure responsibility" to avoid being subject to penalty. "Expenditure responsibility" may be especially useful to facilitate private foundation grantmaking in the international context.

Is the International Organization a Public Charity?

A number of technical rules determine whether an organization may be treated as a public charity and when a private foundation may rely upon that classification in making a grant to an organization. How does a private foundation determine whether an international organization is a public charity? If the international organization has received a ruling or determination letter from the Internal Revenue Service (IRS) that the international organization is a charitable organization under Section 501(c)(3) of the Code, and is not a private foundation (and therefore is a public charity), the granting foundation normally may rely on that status in making a grant.

In the absence of such a formal determination, a foundation making a grant to an international organization may determine that it may be treated as a public charity by making an "equivalency determination" that such an organization is the equivalent of a public charity (making an equivalency determination will be discussed in a future Legal Dimensions article). In the absence of an equivalency determination, the private foundation would be required to exercise expenditure responsibility, as it would with a grant to a noncharitable organization to avoid the imposition of the penalties discussed above.

Excercising Expenditure Responsibility

Regulations issued by the U.S. Treasury describe the requirements of "expenditure responsibility" in detail. The granting foundation must establish "adequate procedures," which include (1) conducting a pre-grant inquiry, (2) making expenditure responsibility grants only pursuant to written commitments by the grantees that include certain terms, (3) requiring particular reports from grantees, (4) requiring specific recordkeeping by the grantees; (5) reporting to the IRS on the status of each expenditure responsibility grant; and (6) maintaining specific records. The failure to take any of these steps will make the grant subject to a penalty tax, which may be imposed on both the foundation and, subject to certain limitations, the responsible foundation manager.

Pre-Grant Inquiry. A pre-grant inquiry requires a "limited inquiry" concerning the potential grantee, which must be complete enough to give a reasonable person assurance that the grantee will use the grant for the proper charitable purpose. The inquiry should concern itself with matters such as the prior history of the grantee and its managers, and any information the foundation has or that is readily available concerning the management practices and activities of the grantee.

Written Commitment. Each expenditure responsibility grant must be subject to a written commitment with specified terms signed by an appropriate officer, director or trustee of the grantee organization. The specific terms include, but are not limited to, an agreement to repay any portion of the grant not used for charitable purposes, and an agreement not to use the grant funds to lobby, to influence any public election, to make grants to individuals unless pursuant to a procedure approved in advance by the IRS to make grants to charitable organizations (other than public charities) or for any purpose other than a charitable one. Segregation of the grant funds by the grantee is also required if the grant is for charitable purposes but is not made to a charitable organization.

Reports. Regarding all expenditure responsibility grants, a granting foundation must require from the grantee annual reports and a final report on the use of funds, compliance with the terms of the grant, and the progress made by the grantee toward achieving the purposes for which the grant was made. The reports must include all the expenditures made from the grant funds. The granting foundation should monitor the sufficiency and timeliness of the reports.

Recordkeeping by the Grantee. Certain accounting and recordkeeping procedures are required of the grantee of the expenditure responsibility grant. The grantee may establish a separate account on its books for grant funds, but the grantee is required to keep its records of expenditures as well as copies of the reports submitted to the granting foundation for at least four years after completion of the use of the grant funds. Any grantee that is not a charitable organization (including international organizations that do not have U.S. charitable tax-exempt status or its international equivalent) must maintain the grant funds in a separate bank account or similar fund dedicated to charitable purposes.

Reporting to the IRS. The granting foundation must provide certain information with respect to each expenditure responsibility grant outstanding during the taxable year in its annual tax return filed with the IRS. The grantees’ reports and information reported in them are essential in fulfilling this reporting requirement. Any verification efforts by the foundation regarding the information contained in the reports must also be reported.

Maintenance of Records. In addition to the information provided in the tax return, the granting foundation must have the following documents available for IRS inspection: (1) a copy of the agreement covering each expenditure responsibility grant; (2) a copy of each report received during the taxable year; and (3) a copy of each report made by foundation personnel or independent auditors of any audit or investigation made with respect to any expenditure responsibility grant.

It is important that all of these documents be retained in the files of the grantor. If any foundation director, trustee or employee becomes aware of or suspects diversion of any grant funds by the grantee to any use not in furtherance of a charitable purpose specified in the grant, immediate follow-up may be required and any future payments to the grantee may need to be suspended or canceled. Also, if the foundation has evidence that there is a misuse of funds, the granting foundation is required to take reasonable steps to secure recovery of such funds.

Special Rules for Regranting by International Grantees The subject of regranting by an international grantee to individuals and other international organizations is discussed in the Fall 1997 International Dateline in the Legal Dimensions article "Private Ruling Takes a Pragmatic Approach to International Regranting" by Milton Cerny and Beth Sellers.

Procedures for International Grants

The possibility of failure to comply with all of the expenditure responsibility requirements has caused some foundations unnecessarily to avoid making grants (including grants to international organizations), which require compliance with the expenditure responsibility rules. However, a carefully designed and implemented program for exercising expenditure responsibility, which includes all of the features described above, will permit a foundation to make the international grants it wishes to. The applicable U.S. Treasury Regulations make clear that a private foundation is not ensuring compliance with the grant terms by its expenditure responsibility grantees, provided that the foundation itself has complied with the rules described above.

About the Author

Thomas Chomicz received his undergraduate degree from the University of St.Thomas (B.A. 1963) and his law degree from the University of Minnesota (J.D. 1969, cum laude). He is a Certified Public Accountant. Mr. Chomicz advises nonprofit organizations, and in particular, private foundations, on issues such as tax compliance, which includes rulings from the National Office of the IRS, passage of Congressional legislation and resolving issues with the Illinois Attorney General, such as disputes regarding alleged mismanagement of assets, division of trust assets among foundations and implementation of charitable programs within the charitable purpose. He is a frequent speaker and author on matters involving nonprofit organizations, including insurance matters for private foundations.

For copies of this article with citations to legal authority, please contact Mr. Chomicz at 312/715-5000. "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.