Expenditure Responsibility

You’re responsible for the grant making functions of a private foundation. It’s getting close to year end and you have to complete the yearly grant payout cycle. You have an idea of where you want to distribute funds and every organization on your list is a 501(c)(3) organization of some kind. You’re all set to distribute funds, right? Well, not all 501(c)(3) organizations are built the same and granting funds to certain kinds may have significant and unforeseen tax consequences to both you and your organization.

You’re probably aware that grants to non-501(c)(3) public charities, including other private foundations, require that you follow what is known as “expenditure responsibility” – an administrative burden that most organizations try to avoid. However, you may not be aware that grants to certain 501(c)(3) organizations whose public charity status is that of a “supporting organization” also require that the foundation exercise expenditure responsibility. The supporting organizations in question are:

  • Type III supporting organizations that are not “functionally integrated” with their supported organization(s); and
  • Supporting organizations that are controlled by certain insiders of the private foundation, or whose supported organizations are controlled by those insiders.

Expenditure responsibility is a requirement the IRS put in place to ensure that grant-making organizations follow due diligence so that the funds they pay out are being used appropriately. The IRS outlines that in order to meet the expenditure responsibility requirements, organizations must conduct a pre-grant inquiry – essentially an interview-like process –to find out more about the recipient organization’s past, its management, the purpose as to why it is seeking funds, etc. Furthermore, the private foundation must formalize the process with a written grant agreement, and also follow up with the recipient to make sure that the funds are being used appropriately. Lastly, there must also be a policy in place to correct the grant (in other words, have the money refunded) should any diversion of funds be discovered. Failure to exercise expenditure responsibility carries with it significant tax ramifications including, but not limited to, a 20% initial tax penalty to the foundation and a 5% initial tax to the foundation manager (up to a maximum of $10,000) on the amount granted. In addition, the recipient organization must return the funds to the foundation. If the grant is not corrected within one year’s time, the penalties can escalate to 100% and 50% to the foundation and foundation manager, respectively.

So, how do you check to see if an organization is a Type III supporting organization that is not functionally integrated with its supported organization? One way is to go to the IRS’s “Select Check” website and do a search for the intended recipient. Unfortunately, this website is limited to just being able to tell you if the organization you want to award a grant to is a public charity in good standing. To find out if an organization’s exempt purpose is as a supporting organization or not, you’ll have to dig a little deeper. The intended recipient’s IRS Business Master File contains more information than what is provided on the Select Check site and will contain the pertinent information. However, this report is somewhat difficult to navigate through. You could also contact the organization directly, but it might be easiest to access the organization’s tax return on another website, Guidestar. At this website, you can sign up for free and have access to the most recently filed tax return for all tax-exempt organizations. Simply run a search, download a PDF of the Form 990, and flip to the first page of Schedule A of that return. If any box is checked other than Line 11d, that organization is not a supporting organization and you are good to go.

The IRS has been investigating the charitable giving of private foundations more in recent months. Due to the workload associated with expenditure responsibility and the hefty consequences of failing to do so, we strongly recommend private foundations avoid awarding grants to any specific individuals, foreign entities, political activities, fundraisers/kick starters, or non-501(c)(3) public charities. Moreover, we strongly recommend exercising due care when granting funds to 501(c)(3) organizations to ensure that they are not a non-functionally integrated supporting organization.

For more information on expenditure responsibility or how to check the tax-exempt designation of a particular organization contact your BNN tax advisor.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.

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