Publication 578 Tax Information for Private Foundations and Foundation Managers

A private foundation is any domestic or foreign organization described in section 501(c)(3) of the Internal Revenue Code except for an organization referred to in section 509(a)(1), (2), (3), or (4) of the Code. In effect, the definition divides organizations described in section 501(c)(3) into two classes, namely private foundations and public charities.

Organizations that are not private foundations are generally those which have broad public support or actively function in a supporting relationship to those organizations.

An excise tax is imposed on the net investment income of most domestic private foundations. This is discussed in Chapter IV of this publication.

The Code contains five provisions that impose two-tier excise taxes on private foundations, foundation managers, or other disqualified persons that engage in certain prohibited acts. These five provisions are discussed in Chapters VI through X of this publication. Foundation managers and disqualified persons are defined in Chapter V.

The first-tier tax (initial tax) is automatically imposed if the foundation engages in a prohibited act. For prohibited Acts occurring after 1984, the initial tax may be abated (set aside) if it is established that the prohibited act was due to reasonable cause and not to willful neglect, and that the act was corrected within the correction period. If the prohibited act is not corrected by the end of the taxable period, the second-tier tax (additional tax) is imposed. Generally, the taxable period ends on the earlier of:

THE CORRECTION PERIOD begins on the date the prohibited act occurs and ends 90 days after a notice of deficiency for the additional tax is mailed, extended by any period the Internal Revenue Service determines is reasonable and necessary to correct the prohibited act. If a petition is filed with the United States Tax Court to redetermine the tax, the correction period ends when the Court's decision is final. If the Court determines that the additional tax was properly imposed, it may determine whether the act that gave rise to the tax was timely corrected.

In addition, a private foundation may contest the imposition of the additional tax in the United States District Court or in the United States Court of Claims as long as the full amount of the INITIAL TAX is paid. The additional tax does not have to be paid.

Other publications that may be of general interest are Publication 526, Charitable Contributions, Publication 557, Tax- Exempt Status for Your Organization, and Publication 598, Tax on Unrelated Business Income of Exempt Organizations.

CHAPTER I, DETERMINATION OF STATUS

Every organization that qualifies for tax exemption as an organization described in this publication is a private foundation unless it falls into one of the categories specifically excluded from the definition of that term. Organizations that fall into the excluded categories, discussed later, are generally those that either have broad public support or actively function to support those organizations. Organizations that test for public safety also are excluded.

AN ORGANIZATION IS NOT A PRIVATE FOUNDATION if it is:

Even if an organization falls within one of the categories excluded from the definition of private foundation, it will be presumed to be a private foundation, with some exceptions, unless it gives timely notice to the Internal Revenue Service that it is not a private foundation. The presumption of private foundation status is rebuttable. The notification requirement applies to an organization regardless of when it was organized. The only exceptions to this requirement are those organizations that are excepted from the requirement of filing Form 1023, Application for Recognition of Exemption. Nonexempt charitable trusts described in section 4947(a)(1) also are excepted.

If an organization is required to file the notice, it must do so within 15 months from the end of the month in which it was organized.

PRIVATE FOUNDATION STATUS

If your organization was a private foundation on October 9, 1969, or becomes a private foundation on any later date, it will be treated as a private foundation for all periods after that time unless its status is terminated under section 507 (see Chapter III). Therefore, if an organization was described in section 501(c)(3) and was a private foundation within the meaning of section 509(a) on October 9, 1969, it will be treated as a private foundation for all periods thereafter, even though it may also satisfy the requirements of an organization described in some other paragraph of section 501(c).

For example, if on October 9, 1969, an organization was described in section 501(c)(3), but because of its activities, it could also have qualified as an organization described in section 501(c)(4), the organization will continue to be treated as a private foundation if it was a private foundation on October 9, 1969.

TAXABLE PRIVATE FOUNDATIONS. If an organization is an exempt private foundation on or after October 9, 1969, but it is later determined that it is no longer exempt as an organization described in section 501(c)(3) as of any date after October 9, 1969, the organization, even though it may operate thereafter as a taxable entity, will continue to be treated as a taxable private foundation unless its status as such is terminated under section 507.

For example, X organization was an exempt private foundation on October 9, 1969. It was later determined that, as of July 1, 1972, X was no longer exempt as an organization described in section 501(c)(3) because it did not conform its governing instrument under section 508(e). X will continue to be treated as a private foundation after July 1, 1972, unless its status as such is terminated under section 507.

NOTE. If an organization was not exempt on October 9, 1969, it will not be treated as a private foundation because of section 509(b), unless it becomes a private foundation on a later date.

STATUS OF ORGANIZATION AFTER TERMINATION OF PRIVATE FOUNDATION STATUS. An organization whose status as a private foundation is terminated under section 507 will be treated as an organization created on the day after the day of the termination. An organization whose private foundation status has been terminated under the provisions of section 507(a) will, if it continues to operate, be treated as a new organization and must, if it wants to be classified under section 501(c)(3), apply for recognition of section 501(c)(3) status.

If the private foundation status of an organization has been terminated under section 507(b)(1)(B) and the regulations thereunder, and

A private foundation may qualify for treatment as a private operating foundation. These foundations generally are still subject to the tax on net investment income (Chapter IV), and to the other requirements and restrictions that generally apply to private foundation activity. However, operating foundations are not subject to the excise tax on failure to distribution income (Chapter VII). Also, contributions to private operating foundations described in section 4942(j)(3) are deductible by the donors to the extent of 50% of the donor's adjusted gross income, whereas contributions to all other private foundations (except those discussed later in this chapter under Private Nonoperating Foundation Distributing All Contributions Received) are generally limited to 30% of the donor's adjusted gross income. In addition, a private operating foundation may receive qualifying distributions from a private foundation if the private foundation does not control it.

A PRIVATE OPERATING FOUNDATION IS any private foundation that spends at least 85% of its adjusted net income or its minimum investment return, whichever is less, directly for the active conduct of its exempt activities (the income test), and that, in addition, meets one of the following tests: the assets test, the endowment test, or the support test.

Certain private foundations that provide long-term care facilities are treated as operating foundations ONLY for the purposes of the excise tax on failure to distribute income. These foundations are discussed in greater detail in Chapter VII of this publication.

INCOME TEST. To qualify as an operating foundation, the organization must make qualifying distributions directly for the active conduct of its exempt activities equal to substantially all (at least 85%) of the lesser of its:

Qualifying distributions and minimum investment return are defined in Chapter VII.

ADJUSTED NET INCOME is the excess of gross income for the tax year (including gross income from any unrelated trade or business) determined with certain modifications (described later) over the total deductions (including deductions directly connected with carrying on any unrelated trade or business) that would be allowed a taxable corporation determined with certain modifications (described later).

Gross income does not include gifts, grants, or contributions received by the private operating foundation but does include income from a functionally-related business. Gross income and the total deductions allowable from that income will be figured as they are normally figured for income tax purposes except as otherwise provided. For figuring adjusted net income, there will be no exclusions, deductions, or credits unless provided under Income modifications and Deduction modifications.

Amounts received by the foundation in tax years beginning after 1969 representing repayment of principal on loans made in tax years before 1970 are not includible in gross income. However, payments of interest on those loans are includible in gross income.

INCOME MODIFICATIONS:

EXAMPLE. The Morgan Foundation bought unimproved land in January 1969, for $102,000. On December 31, 1969, the fair market value of the property was $110,000 and the adjusted basis was still $102,000. The property was sold on January 2, 1983, for $105,000. Because the fair market value on December 31, 1969, was greater than the adjusted basis, the fair market value is the adjusted basis used to determine gain. However, because the adjusted basis for determining gain, $110,000, was greater than the sale price, there was no gain. Moreover, because the adjusted basis for determining loss, $102,000, was less than the sale price, there was no loss.

DEDUCTION MODIFICATIONS. Deductions generally are limited to ordinary and necessary expenses paid or incurred for the production or collection of gross income, or for the management, conservation, or maintenance of property held for the production of income. These expenses include the part of a private foundation's operating expenses paid or incurred for the production or collection of gross income. Operating expenses include compensation of officers, other salaries and wages of employees, interest, rent, and taxes.

When only part of the property is income producing or held for the production of income subject to the provisions of section 4942 and the remainder is used for exempt purposes, the allowable deductions must be divided between exempt and nonexempt uses.

If the expenses for property used for exempt purposes are more than the income received from the property, the excess may not be deducted.

Allowances for straight line depreciation and depletion (other than percentage depletion) are deductible. Deductions will be allowed for expenses and interest paid or incurred to carry tax-exempt obligations. However, no deduction will be allowed for amounts not paid or incurred for purposes described earlier. For example, there will be no deduction for:

GRANTS MADE TO OTHER ORGANIZATIONS to assist them in conducting their activities are considered an indirect, rather than direct, means of carrying out an exempt purpose of the private foundation, even though the activities of the grantee organization may further the exempt activities of the grantor foundation.

AMOUNTS PAID TO BUY OR MAINTAIN ASSETS used directly in the conduct of the foundation's exempt activities, such as the operating assets of a museum, public park, or historic site, are direct expenditures for the active conduct of the foundation's exempt activities. Likewise, administrative expenses (such as staff salaries and traveling expenses) and other operating costs necessary to conduct the foundation's exempt activities (regardless of whether they are directly for the active conduct of exempt activities) are treated as qualifying distributions expended directly for the active conduct of exempt activities if the expenses and costs are reasonable in amount.

However, administrative expenses and operating costs that are not for exempt activities, such as expenses in connection with the production of investment income, are not treated as qualifying distributions. Expenses for both exempt and non-exempt activities will be allocated to each activity on a reasonable and consistently applied basis.

Any amount set aside by a foundation for a specific project, for example to buy and restore or build additional buildings or facilities that are to be used by the foundation directly for the active conduct of the foundation's exempt activities, will be treated as qualifying distributions expended directly for the active conduct of the foundation's exempt activities if the set-aside meets the requirements described in Chapter VII.

PAYMENTS TO INDIVIDUALS. If a foundation makes or awards grants, scholarships, or other payments to individual beneficiaries (including program-related investments as described in Chapter IX) to support active programs to carry out the foundation's exempt purpose, the payments will be treated as qualifying distributions made directly for the active conduct of exempt activities only if the foundation maintains some SIGNIFICANT INVOLVEMENT in the active programs in support of which it makes the payments.

A foundation will be considered as maintaining a SIGNIFICANT INVOLVEMENT in grant-making if --

However, if a foundation does not more than select, screen, and investigate applicants for grants or scholarships, under which the recipients perform their work or studies alone or exclusively under the direction of some other organization, the grants or scholarships will not be treated as qualifying distributions made directly for the active conduct of the foundation's exempt activities. The administrative expenses of screening and investigating (as opposed to the grants or scholarships themselves) may be treated as qualifying distributions made directly for the active conduct of the foundation's exempt activities.

Only private operating foundations may treat the PAYMENT OF THE TAX ON NET INVESTMENT INCOME (see Chapter IV) as a qualifying distribution made directly for the active conduct of activities constituting the foundation's exempt purpose.

ASSETS TEST. A private foundation will meet the assets test if 65% or more of its assets:

Whether an asset is held for the production of income, for investment, or for some similar use, rather than being used for the active conduct of the foundation's exempt activities, is a question of fact.

For example, an office building used to provide offices for employees engaged in the management of endowment funds of the foundation is not devoted to the active conduct of the foundation's exempt activities.

However, for property used both for exempt and other purposes, if the exempt use of the property represents at least 95% of the total use, the property will be considered to be used exclusively for an exempt purpose. Property acquired by a foundation to be used in carrying out its exempt purpose may be considered devoted directly to the active conduct of that purpose even though the property, in whole or in part, is leased for a limited and reasonable period of time during which arrangements are made for its conversion to the use for which it was acquired. Generally, one year is considered a reasonable period of time. Similarly, when property is leased by a foundation in carrying out its exempt purpose and when the rental income received from the property by the foundation is less than the amount that would be required to be charged to recover the cost of purchase and maintenance of the property, the property will be considered devoted directly to the active conduct of the foundation's exempt activities.

Fair market value must be used in determining whether 65% or more of the assets are devoted directly to exempt purposes. However, in the case of assets that are unique and for which no ready market or standard valuation method exists, such as historical objects, buildings, certain works of art, and botanical gardens, the historical cost (unadjusted for depreciation) will be considered fair market value, unless the foundation can show that fair market value is other than cost. If the foundation can show that fair market value is other than cost, this substituted valuation may be used for the tax year for which the new valuation is shown and for each of the following 4 tax years.

See Chapter VII for a discussion of valuations.

Assets maintained for extending credit or making funds available to members of a charitable class are not considered assets devoted directly to the active conduct of exempt activities. For example, assets set aside in special reserve accounts to guarantee student loans made by lending institutions will not be considered qualifying assets. Even though amounts set aside for specific projects may qualify (as explained earlier) as distributions expended directly for the active conduct of exempt activities for the income test, they do not qualify under the assets test as assets devoted directly to the active conduct of the foundation's exempt activities.

ASSETS HELD FOR LESS THAN A FULL TAX YEAR. In applying the assets test, assets held for only part of the tax year are taken into account for the year by multiplying the fair market value of each asset by a fraction. The numerator of the fraction is the number of days during the year that the foundation held the asset, and the denominator is the total number of days in the year.

ENDOWMENT TEST. A foundation will meet the endowment test if it normally makes qualifying distributions (defined in Chapter VII) directly for the active conduct of its exempt activities of at least two-thirds of its minimum investment return. The term "directly for the active conduct of its exempt activities" means the same as it does for the income test discussed earlier.

The minimum investment return for any private foundation is 5% of the excess of the combined fair market value of all assets of the foundation (other than those used or held for use directly in the active conduct of its exempt purpose) over the amount of indebtedness incurred to buy those assets.

In determining whether the amount of qualifying distributions is at least two-thirds of the organization's minimum investment return, the organization is not required to trace the source of the expenditures to determine whether they were received from investment income or from contributions.

EXAMPLE. X foundation, created after May 26, 1969, has $400,000 of endowment funds and other assets not directly used for its exempt purpose. X makes qualifying distributions of $20,000 during the year directly for the active conduct of its exempt function. Two-thirds of X's minimum investment return is $13,333.33 (5% x $400,000 = $20,000; 2/3 x $20,000 = $13,333.33). Since the $20,000 distribution is greater than $13,333.33, X meets the endowment test.

SUPPORT TEST. A private foundation will meet the support test if:

The support received from any one exempt organization may be counted toward satisfying the 85% support test only if the foundation receives support from at least five exempt organizations.

For example, a foundation that normally receives 20% of its support (other than gross investment income) from each of five unrelated exempt organizations will meet the support test even though it receives no support from the general public. However, if a foundation normally receives 50% of its support (other than gross investment income) from three foundations and the balance of the support comes from sources other than exempt organizations, the foundation will not meet the 85% test.

Support from the general public includes support received from an individual, trust, corporation, or governmental unit to the extent that the total amount received from any one individual, trust, or corporation does not exceed 1% of the foundation's total support (other than gross investment income) for the period. In applying the 1% limit, all support received from any donor and any person related to the donor is treated as received from one person. Support received from a governmental unit is not subject to the 1% limit.

DETERMINATION OF COMPLIANCE WITH OPERATING FOUNDATION TESTS. The determination of whether the income test and one of the three remaining tests are met depends on whether the tests are met in the normal and regular operation of a foundation over a period of years, rather than on a given day during the year or on a year-by-year basis. A foundation may qualify as an operating foundation if it meets the income test and either the assets, endowment, or support test for any 3 years during a 4-year period, or on the basis of a combination of all pertinent amounts of income or assets held, received, or distributed during the 4-year period. The 4-year period consists of the tax year in question and the 3 years immediately before the year in question. A foundation may not use one method for satisfying the income test and the other method for satisfying one of the other tests.

For example, if the income test is satisfied on the 3-out-of-4-year basis, you may not use the 4-year combination method to satisfy one of the other tests. However, the fact that the foundation uses one method to satisfy the tests in a particular year will not prevent it from using the other method to satisfy the tests in a later year. If a foundation fails to satisfy the income test and either the assets, endowment, or support test for a particular tax year under EITHER the 3-out-of-4-year method or the combination method, it will be treated as a nonoperating foundation for the tax year and for all later tax years until it satisfies the tests.

NEW ORGANIZATIONS. A newly organized foundation generally will be treated as an operating foundation only if it has satisfied the income test and one of the three other tests for its first tax year of existence. If so, it will be treated as an operating foundation from the beginning of its first year. This status will continue for its second and third tax years of existence only if it satisfies the tests by the combination method for all tax years of existence.

Before the end of its first tax year, a foundation may be treated as an operating foundation if it has made a good faith determination that it is likely to meet the tests for its first year. A good faith determination may be based on an affidavit or opinion of counsel, giving enough facts concerning the operations and support of the organization to enable the Internal Revenue Service to determine that the requirements are likely to be met. If a foundation is treated as an operating foundation for its first year, but actually fails to qualify for the first year, it will be treated as a nonoperating foundation as of the first day of its second year. However, such a foundation may establish to the satisfaction of the Service that it is likely to qualify as an operating foundation on the basis of its 2nd, 3rd, and 4th tax years. If so, it will be treated as an operating foundation until the first day of a tax year in which it fails to qualify. Status as a private foundation that is not an operating foundation will continue until the organization is able to satisfy these tests by either the 3-out-of-4-year method or the combination method.

THE DEDUCTIBILITY OF GRANTS OR CONTRIBUTIONS to an operating foundation will not be affected until notice of a change in the status of such an organization is made to the public (such as by publication in the Internal Revenue Bulletin) UNLESS:

Effective for tax years beginning after 1984, certain private operating foundations, known as EXEMPT OPERATING FOUNDATIONS, are not subject to the tax on net investment income (Chapter IV).

To qualify as an exempt operating foundation for a tax year, a private foundation must meet all the following requirements:

DISQUALIFIED INDIVIDUAL, for purposes of the requirements regarding composition of the governing body and officers of the foundation, means any of the following:

RULING LETTER REQUIRED. A foundation wanting recognition of "exempt operating foundation" status must obtain a ruling letter from the Internal Revenue Service determining that it has met the specific requirements of this special status. To claim exemption from the tax on net investment income, the foundation should attach a copy of this ruling letter to its annual returns, Forms 990-PF, for tax years beginning after 1984 for which the claim for exemption is made.

To obtain the ruling letter, the foundation should submit its request to Internal Revenue Service, Assistant Commissioner (Employee Plans and Exempt Organizations), 1111 Constitution Avenue, Washington, DC 20224. Supporting documents and materials with the ruling request must demonstrate that requirements (1) through (4) listed at the beginning of this discussion are met. Specifically, for purposes of requirements (3) and (4), the foundation must list all its officers and members of its governing body for the current year and identify any that are disqualified individuals.

SPECIAL RULES FOR CERTAIN FOUNDATIONS AND TRUSTS

PRIVATE NONOPERATING FOUNDATION DISTRIBUTING ALL CONTRIBUTIONS RECEIVED

Contributions to a private nonoperating foundation may qualify for the benefit of the 50% contribution deduction limit, and donors may deduct the full value of appreciated property, if the private nonoperating foundation:

The fair market value of contributed property, determined on the date of the contribution, generally must be used to determine whether an amount equal to 100% of the contributions received has been distributed. If the property is sold, the foundation may reduce the property's fair market value by any reasonable selling expenses incurred. The foundation must distribute the balance of the fair market value of the property that was sold to meet the 100% distribution requirement. However, if within 30 days after receiving the contributed property, the foundation sells the property or distributes the property to a public charity, the foundation may choose to treat either --

PRIVATE FOUNDATION MAINTAINING A COMMON FUND

DESIGNATION BY SUBSTANTIAL CONTRIBUTORS. Donors to a private foundation that pools all contributions received in a common fund are also eligible for the 50% contribution deduction limit, and may deduct the full value of appreciated property (see above discussion under Private Nonoperating Foundation Distributing All Contributions Received), if the foundation meets certain requirements. The foundation must be described as a supporting organization of a public charity (as defined in section 509(a)(3) of the Internal Revenue Code) except for the fact that any donor (or donor's spouse) who is a substantial contributor has the right to designate annually the public charities that are to receive the income from the donor's contribution to the fund and to direct (by deed or by will) the payment to public charities of the corpus in the common fund from the donor's contribution.

DISTRIBUTION REQUIREMENTS. To qualify, the private foundation must be required by its governing instrument to distribute, and it must actually distribute (including administrative expenses):

NONEXEMPT TRUSTS

Section 4947 generally subjects trusts that are not exempt from tax to the same requirements and restrictions that apply to private foundations if the trusts have any unexpired interests devoted to charitable purposes. The aim of section 4947 is to prevent a trust of this nature from being used to avoid the requirements and restrictions that apply to private foundations.

In this connection, a charitable purpose includes a religious, educational, charitable, scientific, or literary purpose, a purpose to foster national or international sports competition (but only if there is no provision of athletic facilities or equipment), a purpose to prevent cruelty to children or animals, or a gift to or for the use of a state, a possession of the United States, or any political subdivision of the same, the United States, or the District of Columbia, when the gift is to be used exclusively for public purposes.

CHARITABLE TRUSTS. A charitable trust described in section 4947(a)(1) is a trust that is not tax exempt, all of the unexpired interests of which are devoted to one or more charitable purposes, and for which a charitable contribution deduction was allowed under a specific section of the Internal Revenue Code. A charitable trust is treated as a private foundation unless it meets the requirements for one of the exclusions that classifies it as a public charity. Thus, it is subject to the private foundation excise tax provisions described in this publication and the other provisions that apply to exempt private foundations, including termination requirements and governing instrument requirements. However, a charitable trust is not treated as a charitable organization for purposes of exemption from tax. Accordingly, the trust is subject to the excise tax on its investment income under the rules that apply to taxable foundations rather than those that apply to tax-exempt foundations.

For purposes of the organizational test, when a charitable trust seeks exemption from tax as a charitable organization, the trust is considered organized on the day it first becomes subject to section 4947(a)(1). Generally, for purposes of the special and transitional rules for excise taxes discussed in this publication, a charitable trust will be considered organized on the first day it has amounts in trust for which a deduction was allowed under the Internal Revenue Code. Under this rule, a trust may be treated as a private foundation in existence on a date governing one of the applicable special and transitional rules even though the trust did not otherwise become subject to the provisions that apply to private foundations until a later date.

SCOPE OF PROVISIONS REGARDING CHARITABLE TRUSTS. These provisions apply to nonexempt trusts in which all unexpired interests are charitable.

An estate from which the executor or administrator is required to distribute all of the net assets in trust to charitable beneficiaries will not be considered a charitable trust during the period of estate administration or settlement except for the conditions discussed in the next paragraph. A charitable trust created by a will is considered a charitable trust as of the date of death of the decedent-grantor. However, a revocable trust that becomes irrevocable upon the death of the decedent-grantor, or a trust created by will from which the trustee is required to distribute all of the net assets for, or free of trust to, charitable beneficiaries, is not considered a charitable trust for a reasonable period of settlement (defined later) after becoming irrevocable. After that period, the trust is considered a charitable trust.

ESTATES. When an estate from which the executor or administrator is required to distribute all of the net assets in trust for charitable beneficiaries, or free of trust to those beneficiaries, is considered terminated for federal income tax purposes, the estate will then be treated as a charitable trust between that date and the date the final distribution of all the net assets is made to or for the benefit of the charitable beneficiaries. These provisions do not affect the determination of the tax liability of the beneficiaries of the estate.

EXAMPLE. Malcolm Thorn bequeaths his entire estate, including 100% of the stock of a wholly-owned corporation, to M, an organization described in section 501(c)(3), under a will that gives his executor authority to hold the stock and manage the corporation for a period of up to 10 years for the benefit of M before its ultimate disposition. A deduction for the charitable bequest was allowed to Malcolm's estate. The executor is vested with a full range of powers, including the power of sale. Upon Malcolm's death, his executor distributes Malcolm's assets to M except for the stock of the corporation, which he holds for 5 years before its disposition. Because the executor held the stock of the corporation beyond a reasonable time for performing all the ordinary duties of administration, the estate is considered terminated for federal income tax purposes and is subject to the provisions of section 4947(a)(1) from the date of this termination to the date of final disposition of the stock of the corporation.

CERTAIN SPLIT-INTEREST TRUSTS THAT WIND UP. A split-interest trust (defined later) in which all of the unexpired interests are charitable remainder interests and in which the charitable beneficiaries have become entitled to distributions of corpus in trust or free of trust will continue to be treated as a split-interest trust until the date final distribution of all the net assets is made. However, if after the expiration of any intervening interests, the trust is considered terminated for federal income tax purposes, the trust will then be treated as a charitable trust rather than a split-interest trust between the date on which the trust is considered terminated and the date final distribution of all the net assets is made. These provisions do not affect the determination of the tax liability of the beneficiaries of the trusts.

SPLIT-INTEREST TRUSTS THAT BECOME CHARITABLE TRUSTS. A split-interest trust in which all of the unexpired interests are charitable remainder interests and in which some or all of the charitable beneficiaries are not entitled to distributions of corpus will continue to be treated as a split-interest trust for a reasonable period of settlement after the expiration of the noncharitable interest. A split-interest trust that under its terms is to continue to hold assets for charitable beneficiaries after the expiration of the noncharitable interest rather than distributing them is allowed a reasonable period of time for settlement before being treated as a charitable trust.

REASONABLE PERIOD OF SETTLEMENT is that period reasonably required (or if shorter, actually required) by the trustee to perform the ordinary duties of administration necessary for the settlement of the trust. For example, these duties include the collection of assets, the payment of debts, taxes, and distributions, and the determination of the rights of the subsequent beneficiaries.

EXAMPLE. On January 15, 1983, Cyril Elmwood created a charitable remainder annuity trust under which the trustees were required to distribute $10,000 a year to Betty, Cyril's wife, for life and to hold the remainder in trust for the use of M, an organization described in section 501(c)(3). Cyril was allowed a deduction for the amount of the charitable interest, and the trust was treated as a split-interest trust from the date of its creation. Betty died on February 10, 1988. On April 15, 1988, the trustees completed the ordinary duties of administration necessary for the settlement of the trust brought about by Betty's death. These duties include, for example, an accounting for and payment to Betty's estate of amounts accrued by Betty while alive during 1988. However, the trustees did not distribute the corpus to M by April 15, 1988. The trust would continue to be treated as a split- interest trust until April 15, 1988. After April 15, 1988, the trust would be treated as a charitable trust.

REVOCABLE TRUSTS THAT BECOME CHARITABLE TRUSTS. A revocable trust that becomes irrevocable upon the death of the decedent-grantor in which all of the unexpired interests are charitable and whose governing instrument provides that the trustee is required to hold some or all of the net assets in trust (after becoming irrevocable) solely for charitable beneficiaries, is not considered a charitable trust for a reasonable period of settlement after becoming irrevocable, except that certain rules concerning self-dealing apply. After that period, the trust is considered a charitable trust.

TRUST DEVOTED TO QUALIFIED CHARITABLE CONTRIBUTION PURPOSES. A trust in which all of the unexpired interests are devoted to war veterans' organizations or certain cemetery companies as well as the types of organizations listed earlier under Scope of provisions regarding charitable trusts will be considered a charitable trust. Payments made to veterans' organizations and certain cemetery companies will be considered qualifying distributions under these circumstances.

EXAMPLE. Hugo Briar creates an inter vivos trust whose governing instrument provides that M, a war veterans' organization, and N, an organization described in section 501(c)(3), are each to receive 50% of the income for a period of 10 years. At the end of the 10-year period, the corpus is to be distributed to O, an organization also described in section 501(c)(3). Hugo is allowed an income tax deduction for the value of all interests placed in trust. The payments to M are qualifying distributions. Accordingly, the trust will be considered a charitable trust.

CHARITABLE TRUSTS THAT SUPPORT PUBLIC CHARITIES. Charitable trusts that qualify under section 509(a)(3) (as supporting organizations of public charities) are not treated as private foundations and, thus, are not subject to the taxes and restrictions that apply to private foundations. In determining whether it qualifies under section 509(a)(3), a charitable trust will be treated as if organized on the day it first becomes subject to section 4947(a)(1). The previous relationship between the charitable trust and the organizations it benefits or supports may be considered. The charitable trust may obtain recognition of its status as a section 509(a)(3) organization by requesting a ruling from the Internal Revenue Service.

SPLIT-INTEREST TRUSTS. A split-interest trust is a trust:

A split-interest trust is subject to the following provisions discussed in this publication in the same manner as is a private foundation:

Also, the provisions do not apply to any amounts payable under the terms of a split-interest trust to income beneficiaries, unless a charitable contribution deduction was allowed with respect to the income interest of the beneficiary. For example, Hyram Jones created a split-interest trust that is required annually to pay Melanie Jones 5% of the net fair market value of the trust assets, valued annually, for her life; and to pay the remainder to Y, a section 501(c)(3) organization. A charitable contribution deduction was allowed for the remainder interest. Each annual amount payable to Melanie for her life is not subject to the provisions listed earlier. These payments are not acts of self-dealing or taxable expenditures. However, with the exception of the income interest so paid, the trust is subject to the provisions in the same manner as if the trust were a private foundation.

EXCEPTION FOR CERTAIN SEGREGATED AMOUNTS. These provisions will not apply to assets held in trust (including income and capital gains received from these assets), other than assets for which a charitable contribution deduction has been allowed, if these assets are segregated from the other assets held in trust.

SEGREGATION OF AMOUNTS. Amounts generally will be considered segregated if:

EXCLUSIVELY CHARITABLE AMOUNTS. If an amount held in trust that is devoted exclusively to noncharitable income and remainder interests is segregated from an amount held in trust that is devoted exclusively to charitable income and remainder interests, then the latter amount will be treated as a charitable trust.

CHARITABLE AND NONCHARITABLE AMOUNTS. If an amount held in trust that is devoted exclusively to noncharitable income and remainder interests is segregated from an amount held in trust that is devoted to both charitable income or remainder interests and noncharitable income or remainder interests, then that latter amount will be treated as a split-interest trust.

ACCOUNTING FOR SEGREGATED AMOUNTS. A trust that has segregated amounts must separately account for the income, deductions, and other items attributable to each segregated amount in the books of account and separately account to each of the beneficiaries of the trust.

Separate accounting will be made according to the method REGULARLY EMPLOYED by the trust, if the method is reasonable. In all other cases, it will be made in a manner that, in the opinion of the Internal Revenue Service, is reasonable.

A method of separate accounting will be considered REGULARLY EMPLOYED by a trust when the method has been consistently followed in earlier tax years or when a trust that has never before kept segregated amounts begins a reasonable method of separate accounting for its segregated amounts and consistently follows such method in the future. The trust will keep permanent records and other data relating to the segregated amounts as are necessary to enable the IRS to determine the correctness of the methods used to segregate these amounts.

SCOPE OF PROVISIONS REGARDING SPLIT-INTEREST TRUSTS. The provisions generally apply to trusts in which some but not all unexpired interests are charitable. An estate from which the executor or administrator is required to distribute all of the net assets in trust or free of trust to both charitable and noncharitable beneficiaries will not be considered a split-interest trust during the period of estate administration or settlement with the exception of the provisions discussed under Estates in the next paragraph. A split- interest trust created by a will is considered a split-interest trust as of the date of death of the decedent-grantor except for the exceptions discussed under CERTAIN REVOCABLE AND TESTAMENTARY TRUSTS THAT WIND UP later in this chapter.

ESTATES. When an estate, from which the executor or administrator is required to distribute all of the net assets in trust or free of trust to both charitable and noncharitable beneficiaries, is considered terminated for federal income tax purposes, then the estate will be treated as a split-interest trust or charitable trust (if applicable) between the date on which the estate is considered terminated and the date on which final distribution of the net assets to the last remaining charitable beneficiary is made. This does not affect the determination of the tax liability of either charitable or noncharitable beneficiaries of the estates.

EXAMPLE. Henry Post died on January 15, 1983, and bequeathed $10,000 to M, an organization described in section 501(c)(3), and the remainder of his estate to Wilma, his wife. A deduction for the charitable bequest was allowed to Henry's estate. Substantially all of Henry's estate consisted of 100% of the stock of a wholly owned corporation, certain liquid assets such as marketable stocks and securities and bank accounts, and Henry's home, automobile, and other personal property. Henry's will gave his executor a full range of powers, including the power to sell the stock. After Henry's death, his executor continued to manage the wholly owned corporation while attempting to sell the stock of the corporation. During this period, the executor made no distributions to M. On May 24, 1988, the Internal Revenue Service determined that the administration of the estate has been unnecessarily prolonged and the estate is considered terminated as of that date for federal income tax purposes. Henry's estate will be treated as a split-interest trust between May 24, 1988, and the date on which the $10,000 bequest to M is satisfied. Henry's estate will be subject to the private foundation provisions that apply during that period. For example, a sale of the house by the estate to any disqualified person would be an act of self-dealing.

REVOCABLE TRUSTS THAT BECOME SPLIT-INTEREST TRUSTS. A revocable trust that becomes irrevocable upon the death of the decedent-grantor and whose governing instrument provides that the trustee is required to hold some or all of its net assets in trust for both charitable and noncharitable beneficiaries after becoming irrevocable is not considered a split-interest trust for a reasonable period of settlement after becoming irrevocable, except that the tax on self- dealing may apply.

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

For a definition of "reasonable period," see the previous discussion of SPLIT-INTEREST TRUSTS THAT BECOME CHARITABLE TRUSTS.

CERTAIN REVOCABLE AND TESTAMENTARY TRUSTS THAT WIND UP. A revocable trust that becomes irrevocable upon the death of the decedent-grantor, or a trust created by will, from which the trustee is required to distribute all of the net assets in trust or free of trust to both charitable and noncharitable beneficiaries is not considered a split-interest trust for a reasonable period of settlement after becoming irrevocable. After that period, the trust is considered a split-interest trust or a charitable trust, whichever applies.

Governing instrument requirements, charitable deduction limitations, denial of deductions, and other provisions that apply to exempt private foundations also apply to charitable remainder trusts.

APPLICATION OF THE RULES RELATING TO TERMINATION OF PRIVATE FOUNDATION STATUS. The termination rules discussed in Chapter III do not apply to a charitable or split-interest trust by reason of any payment to a beneficiary that is directed by the terms of the governing instrument of the trust and is not discretionary with the trustee or, in the case of a discretionary payment, because of, or following, the expiration of the last remaining charitable interest in the trust.

EXAMPLE. H creates a nonexempt charitable trust under which the income is to be paid for 15 years to R, a section 501(c)(3) organization. After 15 years, the trust is to terminate and distribute all of its assets to S, another section 501(c)(3) organization. Distribution of the corpus of the trust to S will not be subject to the rules governing termination of private foundation status.

LIMIT TO SEGREGATED AMOUNTS. If any amounts held in trust are segregated, the value of the net assets for purposes of determining the tax imposed on the termination of private foundation status under section 507(a), and for determining the amount of tax to be abated, will be limited to the segregated amounts for which a charitable deduction was allowed.

Split-interest trusts are not subject to the restrictions concerning excess business holdings (Chapter X) and the restrictions concerning investments that jeopardize charitable purpose (Chapter IX) if all of the trust's income interest (and none of the remainder interest) is devoted solely to one or more charitable purposes and all amounts for which a charitable deduction was allowed have a combined value at the time of the deduction of not more than 60% of the fair market value of the entire trust (after the payment of estate taxes and all other liabilities). In addition, these two restrictions will not apply if a charitable contribution deduction was allowed for amounts payable under the terms of the trust to every remainder beneficiary, but not to any income beneficiary. However, in the latter case, the trust will become a charitable trust at the expiration of the income interests.

INCOME INTEREST includes an interest in property transferred in trust that is in the form of a guaranteed annuity interest or unitrust interest.

REMAINDER INTEREST includes an interest that succeeds an INCOME INTEREST.

INCOME BENEFICIARY includes a recipient of payments from a pooled income fund, a recipient of payments from a charitable remainder annuity trust, or a recipient of payments from a charitable remainder unitrust.

REMAINDER BENEFICIARY includes a beneficiary of a remainder interest.

FOREIGN FOUNDATIONS

Foreign organizations that are private foundations and that have been granted tax-exempt status under U.S. tax law are required to pay an excise tax equal to 4% of their gross investment income received from sources in the United States, any territory, any political subdivision of a territory, or the District of Columbia.

An exception to this rule is made when a tax treaty between the United States and the foreign country of which the private foundation is a resident specifically exempts income received by these organizations from any tax.

Foreign private foundations receiving AT LEAST 85% of their support (excluding gross investment income) from sources outside the United States are not subject to the taxes on self-dealing, failure to distribute income, excess business holdings, investments that jeopardize charitable purposes, and taxable expenditures. Such foundations also are not subject to section 507, relating to termination of private foundation status, and section 508, regarding special rules for giving notice that they are applying for recognition of exempt status, which are all discussed in this publication.

An exempt organization that is organized in a foreign country and receives a substantial portion of its support from a foreign government is not a private foundation.

A foreign private foundation can have its exempt status terminated for repeatedly engaging in prohibited transactions. A prohibited transaction is an act or a failure to act by a foreign organization that, if engaged in by a domestic organization, would subject the domestic organization to the taxes and sanctions imposed on private foundations.

If a foreign private foundation engages in one such act or failure to act, and has been warned by the IRS that a second act or failure to act would result in a prohibited transaction, the second act or failure to act will be considered a prohibited transaction.

The repeated act or failure to act does not necessarily have to be related to the earlier act or failure to act that caused the Service to issue a warning.

Any foreign private foundation whose exemption has been terminated under the provisions outlined earlier may reapply for exemption by filing a Form 1023 in the 2nd tax year following the tax year in which exemption was denied.

For further information concerning foreign private foundations contact the District Director, Internal Revenue Service, Baltimore, MD 21201.

CHAPTER II, FILING, NOTICE, AND OTHER REQUIREMENTS

This chapter discusses the notice requirements, annual filing requirements, and other actions that must be complied with for an organization to be recognized as exempt under section 501(c)(3).

FILING OF NOTICE

Except for those organizations noted later, any charitable organization organized after October 9, 1969, will not be treated as tax exempt unless it applies for recognition of exemption by filing a current Form 1023, Application for Recognition of Exemption, with the appropriate office listed in the instructions to that form. A user fee must accompany Form 1023 if it is filed before September 30, 1990. For more information on the specific fee applicable to your organization, obtain Form 8718 from the IRS Forms Distribution Center for your state.

An organization will not be treated as tax exempt for any period before it files Form 1023 unless it files the form within 15 months from the end of the month in which it was organized. If the application is not timely filed, exemption will be recognized only for the period following receipt of the application.

Certain organizations are not required to file Form 1023. These include churches, interchurch organizations of local units of a church, conventions or associations of churches, or integrated auxiliaries of a church, such as a men's or women's organization, religious school, mission society, or youth group. While there are certain other exceptions to the Form 1023 filing requirement that apply to small public charities and to subordinate organizations of a central organization that has a group exemption letter, these exceptions do not apply to private foundations.

If an organization that is required to file Form 1023 does not comply with the filing requirements, charitable contribution deductions will not be allowed for any gift or bequest made to the organization.

EXTENSION OF TIME. An extension of time for filing Form 1023 may be granted by the key District Director if your request is submitted before the 15-month period has passed and you demonstrate that additional time is needed.

If the 15-month period for filing Form 1023 has passed, an extension of time to file it may be granted by the Commissioner of the Internal Revenue Service under section 1.9100 of the Income Tax Regulations if you can show good cause. Since the 15-month period, in which time an organization must file a Form 1023, is fixed by the regulations, rather than by statute, an extension may be granted if the request meets certain conditions.

The following factors will be taken into account in determining if good cause for granting the extension has been shown.

The information submitted by the organization should include a chronological account of the events leading to the failure to make the application, names and current addresses of each person having knowledge or information about the events, affidavits or statements from such persons, and any other information bearing on the Service's consideration of the request. The request must be signed under penalties of perjury by an officer of the organization who has knowledge of the facts. Supporting affidavits or statements must also be signed under penalties of perjury.

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

APPEAL PROCEDURES

If an organization applies for tax-exempt status and receives an adverse determination letter as to tax exemption, classification as to status under section 509(a) as an organization that is not a private foundation, classification as a private operating foundation, the organization will be advised of its right to protest the determination by requesting APPEALS OFFICE consideration. The protest must be submitted to the key District Director within 30 days from the date of the adverse determination letter and must state whether it wishes an Appeals Office conference.

Any determination letter issued on the basis of technical advice from the National Office may not be appealed to the Appeals Office for those issues that were the subject of the technical advice.

If an application is referred to the National Office for issuance of a ruling and an adverse ruling is issued, the organization will be informed of the basis for the conclusion, of its right to file a protest within 30 days, and for a conference at the National Office.

APPEALS OFFICE CONSIDERATION. The protest to the Appeals Office should be filed with the key district office and contain the following information:

If the organization's representative submits the protest, a substitute declaration must be included, stating:

If a conference is requested, it will be held at the Appeals Office, unless the organization requests that the meeting be held at a district office convenient to both parties.

The Appeals Office, after considering the organization's protest as well as information presented in any conference held, will notify the organization of its decision and issue an appropriate determination letter. An adverse decision may be appealed to the courts (discussed later).

Appeals offices must request technical advice from the National Office on any exempt organization issue concerning qualification for exemption or foundation status for which there is not published precedent or for which there is reason to believe that nonuniformity exists. If an organization believes that its case involves such an issue, it should ask the Appeals Office to request technical advice.

REPRESENTATION. A principal officer or trustee may represent an organization at any level of appeal. Or, the organization may be represented by an attorney, certified public accountant, or individual enrolled to practice before the Internal Revenue Service.

If the organization's representative attends a conference without a principal officer or trustee, the representative must file a proper power of attorney or a tax information authorization before receiving or inspecting confidential information. Form 2848, POWER OF ATTORNEY AND DECLARATION OF REPRESENTATIVE, or Form 2848-D, TAX INFORMATION AUTHORIZATION AND DECLARATION OF REPRESENTATIVE, as appropriate (or any other properly written power of attorney or authorization), may be used for this purpose. These forms may be obtained from the IRS.

APPEAL TO COURTS. In addition to administrative remedies, an organization may use certain judicial remedies. If the statutory prerequisites are met, an organization may file suit in a United States District Court or the United States Claims Court for a refund of taxes paid, or in the United States Tax Court for a redetermination of any tax deficiencies. For more information on these types of suits, see Publication 556, EXAMINATION OF RETURNS, APPEAL RIGHTS, AND CLAIMS FOR REFUND. An exempt organization may also file suit for a declaratory judgment (discussed later) in certain situations. Any of these suits may result in a decision that an organization was exempt for the period considered by the court.

If the final judicial determination is that an organization is exempt from tax, is not a private foundation, or is a private operating foundation, the Service will issue a favorable ruling or determination letter, under the following procedures, providing the underlying facts and applicable law are the same as in the period considered by the court.

An organization that had previously filed an application for recognition of exemption and has been determined to be exempt by the court does not need to submit a new application. The organization should submit a brief statement that its activities are the same as those in the period considered by the court. The statement must be signed by a principal office. If the applicable law has not changed, the Service will issue a favorable ruling upon receipt of this statement.

An organization that had not previously filed an application for recognition of exemption but has been determined to be exempt by the court will be issued a ruling or determination letter only when it makes application in the appropriate manner. The application should contain a statement that the organization's activities are the same as those in the period considered by the court.

DECLARATORY JUDGMENTS. If an organization has exhausted all administrative remedies, then, in certain cases, the organization may seek a declaratory judgment from the U.S. Tax Court, the U.S. Claims Court, or the U.S. District Court for the District of Columbia. This remedy is available for adverse determinations (or failure by the Service to make a determination) on the initial or continuing qualification or classification of an organization as an exempt organization under section 501(c)(3), as an organization to which a deduction for a contribution is allowed under section 170(c)(2), as other than a private foundation under section 509, or as a private operating foundation under section 4942(j)(3).

The declaratory judgment remedy can be used only after all administrative remedies have been exhausted, or, if the Service has not issued a notice of final determination, 270 days have elapsed since the organization requested a determination as to the issue in question and the organization has taken, in a timely manner, all reasonable steps to secure such determination.

THE ADMINISTRATIVE REMEDIES that must be exhausted within the Internal Revenue Service include these steps:

A NOTICE OF FINAL DETERMINATION to which the declaratory judgment procedures apply is a ruling or determination letter sent by certified or registered mail that holds the organization is not described in section 501(c)(3) or section 170(c)(2) of the Code, is a private foundation as defined in section 509(a), is not a private operating foundation as defined in section 4942(j)(3), or is a public charity described in part of section 509 or section 170(b)(1)(A) other than the part under which the organization requested classification.

THE 270-DAY PERIOD will be considered by the Service to begin on the date a substantially completed Form 1023 is sent to the appropriate key District Director. If the application does not contain all of the required items, it will not be further processed and may be returned to the applicant for completion. The 270- period, in this event, will not be considered as starting until the date the application is remailed to the Service with the requested information, or, if a postmark is not evident, on the date the Service receives a substantially completed application.

The following PROCEDURAL LIMITATIONS apply to a suit for declaratory judgment:

Any organization described in section 501(c)(3), regardless of when it was organized, will be presumed to be a private foundation unless it gives timely notice to the IRS that it is not a private foundation.

The only exceptions to this requirement apply to those organizations that are excepted from filing Form 1023 as stated earlier. Charitable trusts described in section 4947(a)(1) also are excepted.

If the organization received a ruling or determination letter from the IRS dated before July 14, 1970, recognizing its tax-exempt status under section 501(c)(3), and did not file form 4653, Notification Concerning Foundation Status, before March 22, 1973, the organization is presumed to be a private foundation. This presumption is rebuttable; and if the organization is, in fact, one as described in section 509(a)(1), (2), (3), or (4) of the Internal Revenue Code, it is not a private foundation. However, for the Service to recognize that such an organization is not a private foundation, the organization must establish that status by sending a request for a determination to the District Director.

Any organization seeking tax-exempt status under section 501(c)(3) and classification as other than a private foundation should file its notice by sending a completed and signed form 1023 and provide information that it is not a private foundation.

The notice may not be relied on by the organization or by grantors or contributors until the IRS notifies the organization that it is not a private foundation.

STATEMENT THAT AN ORGANIZATION IS AN OPERATING FOUNDATION. Any organization that is applying for recognition of exemption under section 501(c)(3) may submit information that it is an operating foundation.

ADDITIONAL INFORMATION on applying for recognition of exemption and notification of nonprivate foundation status may be found in Publication 557, Tax-Exempt Status for Your Organization.

GOVERNING INSTRUMENTS

A private foundation cannot be tax exempt nor will contributions to it be deductible as charitable contributions unless its governing instrument contains special provisions in addition to those that generally apply to section 501(c)(3) organizations. These special provisions, generally, must require or prohibit, as the case may be, the foundation to act or refrain from acting so that it will not be liable for the taxes imposed by sections 4941, 4942, 4943, 4944, and 4945, discussed later in this publication. Specific reference to these sections generally must be included in the governing instrument, unless equivalent language is used that is considered by the IRS to have the same full force and effect.

A private foundation's governing instrument will be considered to have been amended to conform to this requirement if valid provisions of state law have been enacted that:

The following samples of governing instrument provisions meet the special charter requirements that apply to private foundations. Draft A is a sample of provisions in articles of incorporation; Draft B, a trust indenture.

DRAFT A

GENERAL

Any other provisions of this instrument notwithstanding, the trustees will distribute its income for each tax year at such time and in such manner so that it will not become subject to the tax on undistributed income imposed by section 4942 of the Internal Revenue Code, or corresponding provisions of any later federal tax laws.

Any other provisions of this instrument notwithstanding, the trustees will not engage in any act of self-dealing as defined in section 4941(d) of the Internal Revenue Code, or corresponding provisions of any later federal tax laws; nor retain any excess business holdings as defined in section 4943(c) of the Internal Revenue Code, or corresponding provisions of any later federal tax laws; nor make any investments in a manner that would incur tax liability under section 4944 of the Internal Revenue Code, or corresponding provisions of any later federal tax laws; nor make any taxable expenditures as defined in section 4945(d) of the Internal Revenue Code, or corresponding provisions of any later federal tax laws.

RETURN REQUIREMENTS

All private foundations (including nonexempt private foundations, and nonexempt charitable trusts described in section 4947(a)(1) of the Code having no taxable income for the tax year that they are treated as private foundations) are required to file an annual return on Form 990-PF, Return of Private Foundation. If your organization has an application for recognition of exemption pending with the IRS, and you acknowledge that your organization is a private foundation, you should file this return.

Split-interests trusts described in section 4947(a)(2) of the Code must file Form 5227, Split-Interest Trust Information Return, instead of filing Form 990-PF.

WHEN TO FILE. Form 990-PF must be filed by the 15th day of the 5th month following the close of the organization's accounting period.

If the foundation is on a calendar year, or if it has no established accounting period, the return will be due May 15 each year.

For a complete liquidation, dissolution, or termination, the return must be filed by the 15th day of the 5th month following complete liquidation, dissolution, or termination.

Form 5227 must be filed by the 15th day of the 4th month following the close of the trust's tax year.

WHERE TO FILE. Form 990-PF or Form 5227, if applicable, should be filed with the Internal Revenue Service Center listed in the instructions for these forms.

FAILURE TO FILE TIMELY. If an organization fails to file Form 990-PF by the due date (taking into account any extensions granted), it will have to pay $10 for each day the return is late, not to exceed the lesser of $5,000 or 5% of the organization's gross receipts, unless it can show that the failure was due to reasonable cause. The IRS may make written demand that the delinquent return be filed within a reasonable time after the date of mailing the demand. If the organization does not file by the date specified in the demand, the person or persons responsible for the failure to file will be subject to a penalty of $10 a day for each day after the date specified in the notice that the return is not filed unless it is shown that the failure to file is due to reasonable cause. The total amount imposed on all persons responsible for the failure to file is limited to $5,000. The penalty is also applicable to a failure to provide information required by the return, or a failure to provide correct information.

PUBLIC INSPECTION. All the information reported on Form 990-PF, including attachments, will be made available by the IRS for public inspection, except any information the release of which would adversely affect the national defense, or information that the IRS determines relates to any trade secret, patent, process, style of work, or apparatus of the organization.

In these cases, the organization must submit a statement, marked "Not Subject to Public Inspection," identifying which items are to be withheld and the reasons. The schedule of contributors will be available for inspection only in the case of private foundations.

In addition, Form 990-PF must be made available by the foundation manager for public inspection at the main office of the foundation. If the foundation has no main office, or if the main office is in a personal residence, the manager may make the return available for public inspection at an appropriate substitute location or by furnishing a copy free of charge (including postage and copying) to persons who request inspection.

The return must be available during regular business hours for inspection by any citizen upon request made within 180 days after the date of the publication of notice of its availability. The notice must be published in a newspaper having general circulation in the county in which the foundation's main office is located, no later than the day prescribed for the filing of the return. The notice must state that the annual return is available at the foundation's main office for inspection during regular business hours by any citizen who requests inspection within 180 days after the date of publication, and must state the address and telephone number of the foundation's main office and the name of its principal manager. A copy of this notice and proof of publication must be filed with the annual return. Proof of publication may consist of a copy of the notice as published, along with a statement signed by a foundation manager saying that the notice was published and listing the date of publication and the name of the publication in which the notice appeared.

PENALTY FOR FAILURE TO COMPLY. If the annual return is not made available for public inspection on the date and in the manner prescribed, the person or persons responsible for failing to meet the publicity requirements will be liable for a penalty of $10 a day for each day that the failure continues, not to exceed $5,000, unless the failure is due to reasonable cause. In addition, when the failure to comply with the publicity requirements is willful, the person or persons responsible for the failure will be liable for a penalty of $1,000 for each return.

LISTING OF STATES. A private foundation is required to attach to its Form 990-PF a list of all states:

FORM 4720, Return of Certain Excise Taxes on Charities and Other Persons Under Chapters 41 and 42 of the Internal Revenue Code, is intended primarily for use with Form 990-PF and provides for figuring and reporting the initial taxes imposed under sections 4941, 4942, 4943, 4944, and 4945 on private foundations, foundation managers, and disqualified persons. These sections are discussed in Chapters VI through X of this publication.

Paying the tax and filing Form 4720 are required for each year (or part of a year) in the taxable period applicable to the act or investment. Generally, the taxable period begins with the date of the act or investment and ends on the earlier of the date a notice of deficiency for the initial tax is mailed, or the date the initial tax is assessed.

WHEN TO FILE. Generally, Form 4720 must be filed by the due date for filing Form 99-PF or 5227. Foundation managers and disqualified persons, whose tax years end on the same date as that of the foundation, who are liable for taxes described in Chapters VI through X, and who file separate returns, must file their returns by the due date for filing Form 990-PF or 5227 by the private foundation with respect to which they are liable for tax. However, the Form 4720 of a person whose tax year ends on a date other than that of the foundation's must be filed by the 15th day of the 5th month following the close of that person's tax year. The IRS may, in some cases, require immediate filing of Form 4720 and immediate payment of tax by private foundations, foundation managers, and disqualified persons at an earlier date during the foundation's tax year.

WHERE TO FILE. Form 4720 is filed at the same place as specified for filing Form 990-PF.

OTHER RETURNS THAT MAY BE REQUIRED FOR TRUSTS DESCRIBED IN SECTION 4947. Forms 1041 and 1041-A are not required to be filed by organizations that are exempt under section 501(a), but they may be required to be filed by certain nonexempt trusts described in section 4947. Form 1041 is required to be filed by all nonexempt charitable trusts having gross income of $600 for the year, unless they owe no tax. Split-interest trusts having gross income of $600 must file Form 1041 except for charitable remainder trusts described in section 664. Charitable remainder trusts must file Form 1041 as an attachment to Form 5227 if they have unrelated business taxable income. Form 1041-A must be filed by split-interest trusts (including trusts described in section 664) that are not required under their governing instruments to distribute all of their income annually.

WHEN TO FILE. The returns must be filed by the 15th day of the 4th month following the close of the trust's tax year.

WHERE TO FILE. The returns should be filed with the appropriate Internal Revenue Service Center listed in the form instructions.

EXTENSIONS. A foundation may file application Form 2758 to request an extension of time to file its return(s).

REASONABLE CAUSE FOR FAILURE TO FILE OR PAY TAX. An organization that is in fact a private foundation will be considered to have REASONABLE CAUSE for failure to meet the private foundation filing and payment requirements until 90 days after it is issued a letter from the Service notifying it of the determination of private foundation status or a determination that the organization cannot reasonably be expected to be a public charity. In order for the organization not to be subject to the penalties for failure to file or pay tax, the organization must have filed Form 1023, claiming not to be a private foundation, before the due date for filing Form 990-PF. By the end of the 90-day period, the organization must file all the necessary returns for the prior years and pay all taxes due, including interest. A statement explaining the basis for reasonable cause for failure to file timely should be attached to the returns. Revenue Procedure 79-8, 1979-1 C.B. 487, should also be cited in the statement.

CHAPTER III, TERMINATION OF PRIVATE FOUNDATION STATUS

Once an organization is determined to be a private foundation, its status may be terminated only under the provisions of section 507 of the Code. Under section 507, an organization's status as a private foundation may be terminated voluntarily or involuntarily.

If the organization's status is terminated either voluntarily or involuntarily under section 507(a), the organization becomes liable for tax under section 507(c). After assessment is made, it is possible to have the tax abated by the IRS if certain actions, discussed later, are taken.

An organization may voluntarily terminate its status under section 507(b)(1) and not be subject to tax under section 507(c). This is often a major consideration for organizations considering a voluntary termination.

TERMINATION UNDER SECTION 507(a)

VOLUNTARY TERMINATION. To voluntarily terminate under section 507(a)(1), the organization must send a statement to its District Director of its intent to terminate its status under section 507(a)(1). The statement must provide, in detail, the computation and amount of tax imposed under section 507(c). Unless the organization requests abatement, it must pay the tax at the time the statement is filed. The organization may request abatement of all the tax imposed under section 507(c), or it may pay part of the tax and request abatement of the unpaid part. However, if the organization's request for abatement is denied, the organization must pay the tax in full when notified by the Service that the tax will not be abated.

Termination of private foundation status under section 507(a)(1) will not relieve the foundation, or any disqualified person, of any liability for Chapter 42 excise taxes (the taxes described in Chapters VI through X of this publication).

If an organization that has terminated its private foundation status under section 507(a) continues in operation and wishes to be treated as a charitable, educational, religious, scientific, etc., organization, it must apply for appropriate exemption recognition. See Status of organization after termination of private foundation status in Chapter I.

NOTICE TO THE PUBLIC. The Internal Revenue Service will publish in the Internal Revenue Bulletin any notice it receives of voluntary termination under section 507(a)(1) (or any notice it issues of involuntary termination of exempt status, discussed later).

No termination can take place under section 507(a)(1) if the private foundation transfers all or part of its assets to another private foundation or to one or more private foundations and to one or more section 507(a)(1), (2), (3), or (4) organizations, under a liquidation, merger, redemption, recapitalization, or other adjustment, organization, or reorganization.

TRANSFEREE LIABILITY. A termination under section 507(a) does not result from either a transfer of all its assets or a significant disposition of its assets (defined later) by a private foundation unless it chooses to terminate under section 507(a)(1), or an involuntary termination occurs. If a private foundation incurs any liability for the Chapter 42 excise taxes before or in connection with the transfer, transferees liability may be applied against the transferee organization for payment of those taxes. Liability for Chapter 42 excise taxes is considered to be incurred on the date the act or failure to act occurs that gives rise to the initial tax liability.

A private foundation that transfers all of its net assets must file Form 990-PF, Return of Private Foundation. However, neither a private foundation nor its managers are required to file this form for any tax year after the tax year in which the last transfers occurs if during those later years the foundation has neither legal nor equitable title to any assets nor engages in any activity.

SECTION 507(c) TAX. The tax imposed under section 507(c) on the termination of a private foundation is the lesser of:

THE VALUE OF THE NET ASSETS of the organization is the greater of:

WHEN TAX IS IMPOSED. These same dates determine when liability for the section 507(c) tax is imposed because a transfer of assets by a private foundation is involved.

SUBSTANTIAL CONTRIBUTORS. See Chapter V for the definition of what is a substantial contributor.

ABATEMENT OF SECTION 507(c) TAXES. The unpaid part of section 507(c) tax can be abated by the IRS if:

CORRECTIVE ACTION is the vigorous enforcement of state laws sufficient to assure implementation of the excise tax provisions of Chapter 42 and to insure that foundation assets are preserved for charitable purposes.

INVOLUNTARY TERMINATION. An organization's status may be involuntarily terminated if the IRS notifies the organization that, because of willful, flagrant, or repeated acts or failures to act giving rise to the Chapter 42 excise taxes, the organization is liable for section 507(c) tax.

Willful repeated acts are at least two acts or failure to act which are voluntarily, consciously, and knowingly committed in violation of the excise tax provisions of Chapter 42, and which appear to a reasonable person to be a gross violation of these provisions. The act or failure to act may result in termination of the foundation's status even though the tax is imposed on the foundation's managers rather than on the foundation itself. Furthermore, the failure to correct the act or acts (or failure or failures to act) that gave rise to excise tax liability under Chapter 42 may cause involuntary termination of the private foundation. No motive to avoid legal restrictions or incur tax is necessary to make the act or failure to act willful. However, a foundation's act or failure to act is not willful if the foundation or its manager, if applicable, does not know that the act or failure to act is an act of self dealing, a taxable expenditure, or other act or failure to act giving rise to liability for excise taxes.

In the case of an involuntary termination, section 507(c) tax is computed in the same manner as for voluntary terminations. However, in determining the value of net assets of the foundation on the first day action was taken to terminate private foundation status, the valuation date is the date a willful and flagrant act, failure to act, or series of repeated acts or failures to act first occurred.

Although the section 507(c) tax resulting from an involuntary termination may be abated (see Abatement of section 507(c) taxes earlier), this is not true for any excise tax liability attributable to the acts or failures to act that caused the involuntary termination.

VOLUNTARY TERMINATION UNDER SECTION 507(b)(1)

A private foundation may voluntarily terminate its status under section 507(b)(1) by either transferring all its net assets to one or more public charities, or by meeting the requirements of sections 509(a)(1), (2), or (3) continuously for 60 months beginning with the first day of any tax year. Private foundation status may not be terminated under either of these methods if there have been either willful repeated acts (or failures to act) or a willful and flagrant act (or failure to act) that gives rise to liability for excise taxes on transactions discussed in Chapters VI through X, known as "Chapter 42" excise taxes.

TRANSFER OF ASSETS TO A PUBLIC CHARITY

A private foundation may terminate its status under section 507(b)(1)(A) by distributing all its net assets to one or more organizations with a ruling or determination letter described in section 509(a)(1). However, the organization to which the distribution is made must have been in existence and so described for a continuous period of at least 60 months before the distribution.

A distribution to a public charity formed from the consolidation of two public charities, for the same purpose and with the same activity, each of which would have met the 60-month existence requirement, had they not consolidated, is a qualifying distribution.

A private foundation that terminates its status in compliance with section 507(b)(1)(A) is not required to notify the IRS of its intent to terminate.

An organization will have distributed all its net assets only if it transfers all of its right, title, and interest in, and to, all of its net assets.

An organization that continues in existence after terminating its private foundation status under section 507(b)(1)(A) must file a new application on Form 1023 in order to be treated as a section 501(c)(3) organization, unless it is a type of organization that is not required to file Form 1023. A list of these types of organizations can be found in Publication 557, Tax-Exempt Status for Your Organization.

OPERATION AS A PUBLIC CHARITY

An organization may terminate its private foundation status under section 507(b)(1)(B) if it meets the requirements of section 509(a)(1), (2), or (3) for a continuous 60-month period beginning with the first day of any tax year, and notifies its District Director before the beginning of the 60-month period that it is terminating its private foundation status. Also, it must establish immediately after the end of the 60-month period that it has met the requirements of section 509(a)(1), (2), or (3).

NOTIFICATION TO THE SERVICE by a foundation that it is terminating under section 507(b)(1)(B) does not constitute notice of a section 507(a) termination even if the foundation fails to meet the requirements of section 507(b)(1)(B). However, a successful section 507(b)(1)(B) termination will incur no tax under section 507(c) and, therefore, will require no abatement of tax.

NOTICE OF TERMINATION. The notice of termination should include:

FAILURE TO MEET 60-MONTH REQUIREMENTS. Generally, any organization that does not meet section 507(b)(1)(B) termination requirements during the 60-month period will be treated as a private foundation for the entire 60-month period. Any grants or contributions made to such an organization will be treated as contributions made to a private foundation.

However, the organization will be treated as a section 509(a)(1), (2), or (3) organization for any tax year or years that the requirements are met. Any grants or contributions to the organization during such year or years will be treated as made to a section 509(a)(1), (2), or (3) organization and the organization itself will not be subject to Chapter 42 taxes and restrictions for such year or years.

In determining whether an organization meets section 509(a)(1), (2), or (3) requirements for any year in the 60-month period, the organization will be treated as if it were a new organization with its first tax year beginning on the date the 60-month period begins.

ADVANCE RULINGS FOR 60-MONTH TERMINATIONS. An organization which files the notification required for a 60-month termination may receive, at the discretion of the Service, an advance ruling that the organization can reasonably be expected to terminate its private foundation status over the 60-month period.

To receive an advance ruling, the organization must also agree to an extension of time to assess the section 4940 tax on net investment income (discussed in Chapter IV) for the years in the 60-month termination period. If an organization agrees to the extension and it is accepted, it will not have to pay the tax on net investment income during the 60-month period. The signed and dated agreement Form 872, Consent to Extend the Time to Assess Tax, should be filed with the request for the advance ruling. The assessment period for all years in the termination period must be extended to 4 years, 4 months and 15 days after the end of the last year in the 60-month termination period.

The decision to grant a favorable ruling will be based on the facts and circumstances, taking into account organizational structure, proposed programs and activities, intended methods of operation, and projected sources of support.

GRANTORS OR CONTRIBUTORS to an organization that has obtained a favorable advance ruling may rely on that ruling until notice of revocation is published in the Internal Revenue Bulletin. However, a grantor or contributor may not rely on such a ruling if the grantor or contributor was responsible for, or aware of, the action or inaction that resulted in the organization's failure to meet the requirements of section 509(a)(1), (2), or (3) or knew that the Service had notified the organization that its advance ruling would be revoked.

A POTENTIAL GRANTEE ORGANIZATION may request an advance ruling before receiving a grant or contribution, to the effect that the grant or contribution will not result in the grantee's failing to meet section 509(a)(1), (2), or (3) requirements. The ruling request may be filed by the grantee organization with its District Director. If a favorable ruling is issued, the grantor or contributor may rely upon it.

However, an advance ruling may not be relied upon by the organization obtaining that ruling. If the organization later fails to complete a successful termination under section 507(b)(1)(B) and was not a section 509(a)(1), (2), or (3) organization, it will have to pay interest on the amount of tax imposed on net investment income under section 4940 that is unpaid as of the last date for payment of that tax. However, since the failure to pay the tax during the 60-month period (or before revocation of the ruling) is due to reasonable cause, no penalty will be assessed.

ORGANIZATIONS WITHOUT ADVANCE RULINGS. An organization that does not receive an advance ruling does not have to pay the tax on net investment income during the 60-month termination period if it signs the consent to extend the assessment period for the tax. The same rules regarding interest and penalties apply if the organization does not complete a successful termination of its private foundation status under section 507(b)(1)(B).

TRANSFEREE FOUNDATIONS SECTION 507(b)(2)

The transfer of assets of a private foundation to another private foundation in a liquidation, merger, recapitalization, redemption, or other adjustment, organization, or reorganization is a section 507(b)(2) transfer. A transfer under this section will not cause the transferee to be treated as a newly created organization for purposes of the private foundation provisions. However, the transferee may be required to reapply for exemption if it wishes to be exempt under section 501(c)(3) of the Code.

The term "other adjustment, organization, or reorganization" includes any partial liquidation, or any other significant disposition of assets (defined later), to one or more private foundations, other than transfers for full and adequate consideration or distributions out of current income (including qualifying distributions out of current and earlier years' undistributed income).

A transferee organization will succeed to the combined tax benefit of the transferor organization to the extent of the combined tax benefit multiplied by a fraction. The numerator of the fraction is the fair market value of the assets (minus encumbrances) transferred, and the denominator is the fair market value of the total assets of the transferor (minus encumbrances) immediately before the transfer. Fair market value is determined as of the time of the transfer. A transferee organization not effectively controlled, directly or indirectly, by the same person or persons who control the transferor organization will not succeed to a combined tax benefit greater than the fair market value of assets transferred at the time of the transfer.

EXAMPLE. In a liquidation, the White Foundation, a private foundation, transfers to the Oak Foundation, a private foundation, all of its assets, which have a fair market value of $400,000. Immediately before the transfer the White Foundation's combined tax benefit was $200,000, and the Oak Foundation's combined tax benefit was $300,000. After the transfer, the Oak Foundation has a combined tax benefit of $500,000 ($200,000 + $300,000).

Except as otherwise provided in Transfer to an effectively controlled foundation later, a private foundation must meet the distribution requirements described in Chapter VII for any year in which it makes a section 507(b)(2) transfer of all or part of its net assets to another private foundation. The transfer itself will be counted as a qualifying distribution if it meets the requirements given in Chapter VII. However, when the transferor has disposed of all its assets, the recordkeeping requirements will not apply to any period in which it has no assets.

Whenever a private foundation makes a section 507(b)(2) transfer of all or part of its net assets to another private foundation, the applicable time period described in Chapter X will include the respective holding periods of both the transferor and the transferee. Except as otherwise provided in Transfer to an effectively controlled foundation, the provisions of Chapter VI will not apply to the transferee or to the transferor for any expenditure responsibility grants as discussed in Chapter VI made by the transferor during any period in which the transferor has no assets. However, the information reporting requirement described in Chapter VI remain in effect.

A substantial contributor of the transferor foundation will be considered a substantial contributor of the transferee organization even if the individual does not meet the definition of a substantial contributor with respect to the transferee organization. With respect to the transferor foundation, a person is a substantial contributor if the person contributed or bequeathed an aggregate amount of more than $5,000 to the foundation, provided that the amount contributed is more than 2% of the total contributions received by the foundation before the close of the taxable year in which the contribution or bequest is received by the foundation. See Chapter V for a discussion of the term "substantial contributor."

Also, if a private foundation incurs a liability for any excise taxes discussed in Chapters VI through X of this publication either before a transfer or as a result of a transfer of assets, then the transferee foundation will be considered to have received the assets subject to the tax to the extent that the transferor foundation does not satisfy the liability.

TRANSFER TO AN EFFECTIVELY CONTROLLED FOUNDATION. If a private foundation transfers all of its net assets to one or more private foundations that are effectively controlled, directly or indirectly, by the same person or persons who effective controlled the transferor private foundation, then the transferee foundation is treated as it it were the transferor for purposes of all excise taxes discussed in this publication as well as the termination provisions discussed in this chapter. When proportionality is appropriate, the transferee foundation will be treated as if it were the transferor in the proportion that the fair market value of the assets transferred (minus encumbrances) bears to the fair market value of the assets (minus encumbrances) of the transferor immediately before the transfer. This does not relieve the transferor private foundation from filing required returns, reports, and other information.

EXAMPLE. The trustees of X charitable trust, a private foundation, form Y, a charitable corporation, also a private foundation, to make the conduct of their activities easier. The trustees of X are also the directors of Y. Y has the same charitable purposes as X. All the assets of X are transferred to Y, and Y continues to carry on X's charitable activities. Under these circumstances, Y is treated as if it were X. Y will be permitted to take advantage of any special rules relating to excise tax requirements to the same extent as could X if X had continued in existence.

STATUS OF TRANSFEREE ORGANIZATION UNDER SECTION 507(b)(2). A transfer of assets under any liquidation, merger, redemption, recapitalization, or other adjustment, organization, or reorganization to an organization other than a charitable, educational, religious, scientific, etc., organization (other than an organization engaged in testing for public safety) or a nonexempt charitable trust described in section 4947(a)(1) is a TAXABLE EXPENDITURE (see Chapter VI). For a transfer of assets not to be a taxable expenditure, it must be to one of the organizations described earlier. Unless the transferee is a section 509(a)(1), (2), or (3) organization, section 507(b)(2) applies.

However, if the assets are transferred to a transferee organization other than a section 507(c)(3) organization (excluding organizations engaged in testing for public safety) or section 4947(a)(1) organization, and the assets are THEN transferred to a private foundation to correct a taxable expenditure, section 507(b)(2) applies as if the transfer of assets had been made directly to a private foundation.

A SIGNIFICANT DISPOSITION OF ASSETS to one or more private foundations includes any disposition for the tax year when both:

EXAMPLE. The White Foundation is a private foundation that had net assets of $100,000 on January 1, 1987. In 1987, in addition to distributions made out of current income, the White Foundation transferred $10,000 to the Rose Foundation, $10,000 to the Black Foundation and $10,000 to the Green Foundation, all of which are private foundations. Therefore, the White Foundation made a section 507(b)(2) distribution because it disposed of more than 25% of the fair market value of its net assets on January 1, 1987.

SECTION 507(a) DOES NOT APPLY to section 507(b)(2) transfers. A private foundation may not terminate under section 507(a)(1) unless it voluntarily gives notice as required for section 507(a)(1) terminations. The transfer must satisfy the applicable requirements of Chapter 42 (discussed in Chapters VI through X) concerning acts or failures to act that give rise to excise tax liability. However, if the transfer is an act or failure to act giving rise to excise tax liability, then the transfer may be considered an involuntary termination.

TRANSFERS TO CERTAIN SECTION 509(a)(1), (2), or (3) ORGANIZATIONS will be treated as section 507(b)(2) transfers from the date a private foundation transfers all or part of its assets to a section 509(a)(1), (2), or (3) organization if, within 3 years from the date of the transfer, the transferee loses its section 509(a)(1), (2), or (3) status and becomes a private foundation.

If a section 507(b)(2) transfer is made during the course of a 60-month termination under section 507(b)(1)(B), the rules governing section 507(b)(2) transfers will apply and the transfers will not be treated as made from a section 509(a)(1), (2), or (3) organization.

CHAPTER IV, TAX ON NET INVESTMENT INCOME

Section 4940 imposes an excise tax of 2% on the net investment income of most domestic tax-exempt private foundations, including private operating foundations. Some exceptions apply. An EXEMPT OPERATING FOUNDATION, defined in Chapter I, is not subject to the tax. Further, the tax is reduced to 1% in certain cases. See Reduction in tax, below.

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

Nonexempt private foundations are also subject to this tax, but only to the extent that the sum of the 2% tax plus tax on unrelated business income, applied as if the foundation were tax-exempt, is greater than income tax liability for the year.

EXAMPLE. A taxable private foundation had an income tax liability for 1985 of $10,000. If the foundation were tax exempt, it would have a $4,000 liability for tax on net investment income and a $7,000 liability for tax on unrelated business income. The foundation is liable under section 4940 for $1,000, the amount by which the sum of the tax on net investment income and the tax on unrelated business income ($11,000) exceeds the amount of income tax liability ($10,000).

REDUCTION IN TAX. For tax years beginning after 1984, the tax rate on net investment income is reduced from 2% to 1% for any private foundation that meets the following distribution requirements:

AVERAGE PERCENTAGE PAYOUT is the average of the percentage payouts for each of the tax years in the foundation's base period. For each tax year, the percentage payout is figured by dividing the qualifying distributions made during the year by the foundation's assets for that year. If, for any tax year in the foundation's base period, the foundation's tax rate on net investment income is reduced to 1% by meeting these distribution requirements, the qualifying distributions made by the foundation during that year must be reduced by the amount of the reduction in tax.

THE ASSETS of the foundation for any tax year are the excess of the total fair market value of all the foundation's assets, other than those used or held for use directly in carrying out the foundation's exempt purpose, over the acquisition indebtedness with respect to those assets.

THE BASE PERIOD with respect to any tax year is the 5 tax years preceding that year. If an organization has not been a private foundation throughout those 5 tax years, the base period consists of the tax years during which the foundation has been in existence. However, if a private foundation is a successor to another private foundation, it must take into account the experience of that other foundation.

NET INVESTMENT INCOME is the amount by which the sum of gross investment income and the capital gain net income exceeds the allowable deductions discussed later.

Tax-exempt interest on governmental obligations and related expenses are excluded.

GROSS INVESTMENT INCOME means the total amount of income from interest, dividends, rents, payments with respect to securities loans (as defined in section 512(a)(5)), and royalties (including overriding royalties) received by a private foundation from all sources. It does not include any income included in figuring the tax on unrelated business income. However, it does include interest, dividends, rents, and royalties received from assets devoted to charitable activities. Therefore, interest received on a student loan would be includible in the gross investment income of a private foundation making the loan.

DISTRIBUTIONS IN REDEMPTION OF STOCK. Any distribution by a corporation that is a disqualified person (defined in Chapter V) in redemption of stock held by a private foundation in a business enterprise will be treated as not essentially equivalent to a dividend if all the following conditions are met:

CAPITAL GAINS AND LOSSES. In figuring the tax on net investment income, a private foundation must include any capital gains and losses from the sale or other disposition of property held for investment purposes or for the production of income. This includes capital gain dividends received from a regulated investment company. If the foundation sells or otherwise disposes of property used in the production of income that is subject to the unrelated business income tax, any gain or loss from the sale of that property must be included in net investment income, but only to the extent that it is not included in figuring the tax on unrelated business income. Property is treated as held for investment purposes even though the property is disposed of by the foundation immediately upon its receipt, if it is the kind of property that generally produces interest, dividends, rents, royalties, or capital gains through appreciation.

PROPERTY USED FOR EXEMPT PURPOSES. Any gain or loss from the sale or other disposition of property used for the exempt purposes of the foundation is not included in figuring the tax on net investment income. If the foundation uses property for its exempt purposes, but also incidentally receives income from the property that is subject to the net investment income tax, any gain or loss from the sale or other disposition of the property would not be subject to the tax. For example, if a tax-exempt private foundation maintains historic buildings that are open for public inspection, but it requires a number of employees to live in these buildings and charges rent, the rent is subject to the tax on net investment income, but any gain or loss resulting from the sale of these buildings is not subject to the tax.

However, if a private foundation uses property both for exempt purposes and (other than incidentally) for investment purposes (for example, a building in which the foundation's charitable and investment activities are carried on), that part of the gain or loss from the sale or other disposition of the property that is allocable to the investment use of the property must be taken into account in figuring the tax on net investment income.

LOSSES. Capital losses from the sale or other disposition of investment property may be subtracted from capital gains incurred in the sale or disposition of other investment property during the same tax year, but only to the extent of the gains. If the capital losses are greater than the capital gains, the excess may not be subtracted from gross investment income, nor may the losses be carried back or forward to other tax years regardless of whether the foundation is a corporation or a trust.

BASIS. The basis for determining gain from the sale or other disposition of property is the greater of:

Normal basis rules are used in determining a loss on disposition. For purposes of determining a loss, the basis of property acquired by gift is the lesser of the donor's basis at the time of the gift or the fair market value at the time of the gift.

EXAMPLE 1. A private foundation held depreciable real property on December 31, 1969, that had a basis of $127,500 and a depreciable basis of $102,000. The fair market value of the property on that date was $100,000. For tax years 1970 through 1984 the foundation was allowed $61,200 depreciation, figured under the straight line method using a 25-year useful life (4%) on the $102,000 basis. The property was sold on January 2, 1985, for $175,000. Since the fair market value on December 31, 1969 ($100,000) minus adjustments ($61,200 depreciation), or $38,800, is less than the actual adjusted basis on the date of sale ($66,300 ($127,500 - $61,200)), a gain of $108,700 is recognized ($175,000 sales price minus the greater of $66,300 or $38,800).

EXAMPLE 2. A private foundation held depreciable real property on December 31, 1969, valued at $110,000, with a basis of $102,000 and a depreciable basis of $82,000. It was allowed $26,240 depreciation for years 1970 through 1977, figured under the straight line method using a 25-year useful life on the $82,000 depreciable basis. The property was sold on January 2, 1978, for $80,000. The fair market value minus adjustments after 1969 ($110,000 - $26,240 = $83,760) is greater than the basis of the property on the date of disposition ($102,000 - $26,240 = $75,760). The greater figure would be used to figure a gain. Because basis for determining a gain is greater than the selling price, there is no gain. The basis for determining a loss is the actual basis on the date of disposition ($75,760). Because this figure is less than the selling price, there is no loss. In this situation there is no recognized gain or loss for section 4940 purposes.

EXAMPLE 3. On January 1, 1987, a private foundation received a gift of rental property with a fair market value of $100,000. At the time of the gift, the adjusted basis of the donor was $20,000. On January 2, 1987, the private foundation sold the property for $99,000. The gain to be recognized from the sale of donated property is $79,000 ($99,000 sales price minus $20,000 donor's basis).

EXAMPLE 4. On February 1, 1987, a private foundation received a gift of rental property with a fair market value of $100,000. At the time of the gift, the adjusted basis of the donor was $105,000. On February 2, 1987, the private foundation sold the property for $99,000. The loss to be recognized from the sale of donated property is $1,000 ($100,000 fair market value minus $99,000 sales price).

SECURITIES LISTED ON RECOGNIZED STOCK EXCHANGE. The fair market value for figuring basis for determining gain on the sale or exchange of stocks and bonds traded on a stock exchange, in an over-the-counter market, or otherwise, is the mean between the highest and lowest quoted selling prices on the valuation date.

EXAMPLE. A private foundation bought 100 shares of common stock of the M Corporation on February 27, 1968, for $4,000. The foundation sold the stock on December 27, 1987, for $10,000. At all times the stock was registered and listed on a recognized securities exchange. On December 31, 1969, sales of M Corporation common stock on the exchange ranged from a high of $45 a share to a low of $40 a share, whereas the closing price was $44 a share. There were no adjustments to basis for the period the stock was held. The foundation's capital gain net income is figured as follows:

 Amount received from sale                                   $10,000

If any expenses, including salaries and compensation, are incurred for both investment purposes and exempt purposes, they must be allocated between the investment activities and the exempt activities. Expenses paid or incurred for exempt functions are not deductible in figuring net investment income. Also, any expenses that are taken into account in figuring the tax on unrelated business income may not be deducted in figuring net investment income.

No deduction is allowed for any expense that was not incurred for the purposes stated earlier. Thus, no deduction is allowed for charitable contributions, net operating losses, or any of the special deductions for corporations.

DEDUCTION MODIFICATIONS. The following modifications must be made to otherwise allowable deductions in arriving at net investment income:

For the rules discussed in this publication, the following persons are considered disqualified persons with respect to a private foundation:

VOTING POWER includes outstanding voting power and does not include voting power obtainable, but not obtained, such as voting power obtainable by converting securities or nonvoting stock into voting stock, by exercising warrants or options to obtain voting stock, and voting power available to preferred shareholders if dividends on preferred stock are in arrears.

THE PROFITS INTEREST of a partner is the partner's distributive share of partnership income.

THE BENEFICIAL INTEREST IN AN UNINCORPORATED ENTERPRISE, other than a trust or estate, includes any right to receive a share of distributions from the profits of the enterprise, or if there is no profit-sharing agreement, the right to receive a share of the assets on liquidation of the enterprise, except as a creditor or employee. When no agreement fixing the rights of the participants in the enterprise exists, the fraction of the respective interests of each participant in the enterprise will be determined by dividing the total investment or contributions to capital made or obligated to be made by the participant by the amount of all investments and capital contributions made by all participants.

THE BENEFICIAL INTEREST IN A TRUST will be determined in proportion to the person's actuarial interest in the trust.

A SUBSTANTIAL CONTRIBUTOR includes any person who contributed or bequeathed a total amount of more than $5,000 to the private foundation if the amount is more than 2% of the total contributions and bequests received by the foundation from its creation up through the close of the tax year of the foundation in which the contribution or bequest is received from that person. For a trust, a substantial contributor includes the creator of the trust. However, in no case does the term include a governmental unit.

In determining whether the total contributions and bequests from a person are more than 2% of the total contributions and bequests received by a private foundation, both the total of the amounts received by the foundation, and the total of the amounts contributed and bequeathed by the person, are determined as of the last day of each tax year. Although the determination is made on the last day of the foundation's tax year, a donor is a substantial contributor as of the first day the foundation receives a gift large enough to make the donor a substantial contributor. Each contribution or bequest is valued at its fair market value on the date it is received by the foundation. Gifts by an individual include all contributions and bequests made by that individual and his or her spouse.

A determination is to be made as to whether a person is a substantial contributor as of the end of each of the foundation's tax years, based on the respective totals of all contributions received and the total amount received from a particular person by that date. Status as a substantial contributor will date from the time the donor first met the $5,000 - 2% test. Once a person is a substantial contributor to a private foundation, generally that person remains a substantial contributor even though the individual might not be so classified if a determination were made at some later date. For instance, even though the total contributions and bequests of a person become less than 2% of the total received by a private foundation, generally the person remains a substantial contributor to the foundation.

However, a person ceases to be a substantial contributor as of the end of a private foundation's tax year if:

SPECIAL RULES. A substantial contributor does not include an entity that is described in section 509(a)(1), (2), or (3) or any organization wholly owned by such an entity. In addition, only for purposes of section 4941 excise taxes on self-dealing, a substantial contributor does not include any other organization described in section 501(c)(3) (other than an organization with section 509(a)(4) status).

The term CONTRIBUTION includes gifts, and grants to the foundation, as well as bequests, devises, legacies, or transfers as outlined in the rules relating to estate and gift tax.

Entities excluded from the definition of substantial contributor as discussed earlier are also excluded from the definition of disqualified person.

FOUNDATION MANGER. A foundation manager means:

For any act or failure to act, any foundation employee who has authority merely to recommend particular administrative or policy decisions, but not to implement them without approval of a superior, is not an officer. Independent contractors, such as accountants, lawyers, and investment managers or advisors, acting in their capacity as such, are not considered officers of the foundation.

A MEMBER OF THE FAMILY includes: a spouse, ancestors, children, grandchildren, great grandchildren, and spouses of children, grandchildren, and great grandchildren. A brother or sister of an individual is not a member of the family for this purpose. A legally adopted child of an individual will be treated as a child by blood.

GOVERNMENT OFFICIAL. For the excise tax on self-dealing (described in Chapter VIII) a government official also is a disqualified person.

THE TERM GOVERNMENT OFFICIAL means an individual who at the time of the act of self-dealing holds any of the following offices or positions:

EXAMPLES. The following are illustrations of positions of public employment that do not involve policymaking functions and are not a public office:

A private foundation that makes any TAXABLE EXPENDITURES, defined later, becomes liable for taxes on these expenditures under section 4945 of the Internal Revenue Code. The taxes are imposed on both the foundation and on any foundation manager who knowingly and willfully agrees to the expenditures. Both an initial tax and an additional tax may be imposed.

INITIAL TAX. The initial tax on the foundation is 10% of the amount expended. The foundation will not be liable for the tax if it can show that the expenditure was due to reasonable cause and not to willful neglect, and that the expenditure was corrected within the CORRECTION PERIOD (described later). In the case of a foundation manager who knowingly, willfully, and without reasonable cause agrees to the taxable expenditure, the initial tax is 2-1/2% of the amount expended, up to a maximum tax of $5,000 for any one expenditure. A foundation manager who acts on advice of counsel, given in a reasoned legal opinion in writing, is not liable for the tax.

ADDITIONAL TAX. If the expenditure is not corrected within the TAXABLE PERIOD (described later), an additional tax of 100% of the amount expended is imposed on the foundation. The tax will not be assessed, or if assessed will be abated, if the expenditure is corrected within the CORRECTION PERIOD (described later). Any foundation manager who refuses to agree to part or all of the correction must pay an additional tax of 50% of the expenditure, up to a maximum tax of $10,000.

If more than one foundation manager is liable for either the initial or additional tax, all are jointly and severally liable.

THE INITIAL TAX ON FOUNDATION MANAGERS is imposed only in cases when the following circumstances are present:

AGREEMENT. The agreement of any foundation manager to making a taxable expenditure consists of any manifestation of approval of the expenditure which is sufficient to constitute an exercise of the foundation manager's authority to approve or to exercise discretion in recommending approval for making an expenditure by the foundation. Whether or not the foundation manager's action is the final or decisive approval on behalf of the foundation is not the determining factor.

KNOWING. A foundation manager will be considered to have agreed to an expenditure KNOWING that it is a taxable expenditure only if:

WILLFUL. A foundation manager's agreement to a taxable expenditure is WILLFUL if it is voluntary, conscious, and intentional. No motive to avoid the restrictions of the law or the incurrence of any tax is necessary to make an agreement willful. However, a foundation manager's agreement to a taxable expenditure is not willful if he or she does not know that it is a taxable expenditure.

DUE TO REASONABLE CAUSE. A foundation manager's actions are DUE TO REASONABLE CAUSE if he or she has exercised responsibility on behalf of the foundation with ordinary business care and prudence.

ADVICE OF COUNSEL. If a foundation manager has made full disclosure of the factual situation to legal counsel (including house counsel) and relies on the advice of counsel expressed in a reasoned written legal opinion that an expenditure is not a taxable expenditure and the expenditure is later held to be taxable, the foundation manager's agreement to the expenditure will ordinarily not be considered KNOWING or WILLFUL and will ordinarily be considered due to reasonable cause.

A written legal opinion will be considered reasoned even if it reaches a conclusion that is later determined to be incorrect as long as the opinion addresses itself to the facts and applicable law. However, a written legal opinion will not be considered reasoned if it does nothing more than recite the facts and express a conclusion.

The absence of advice of counsel on an expenditure will not, by itself, give rise to any inference that a foundation manager agreed to making the expenditure knowingly, willfully, or without reasonable cause.

CORRECTION OF A TAXABLE EXPENDITURE. In cases other than those of inadequate reporting or failure to obtain advance approval, discussed later, a correction is accomplished by recovering part or all of the expenditure to the extent possible. When full recovery is not possible, any additional corrective action will be prescribed by the IRS. The type of additional action depends on the circumstances, and the Service may require any of the following:

CORRECTION FOR FAILURE TO OBTAIN ADVANCE APPROVAL. When an expenditure is taxable as a grant for travel, study, etc., only because of a failure to obtain advance approval of procedures for those grants, correction may be accomplished by obtaining approval of the grant- making procedures and establishing to the satisfaction of the Service that:

In addition, if the expenditure is taxable only because of a failure to obtain a full and complete report as required and an investigation indicates that no grant funds have been diverted to any use not for a purpose specified in the grant, correction will be accomplished if all reasonable efforts are made to obtain the report and the Service is notified of the failure to obtain the report.

THE TAXABLE PERIOD begins on the date the taxable expenditure occurs and ends on the earlier of either:

TAXABLE EXPENDITURES

A TAXABLE EXPENDITURE is an amount paid or incurred to:

INFLUENCING LEGISLATION

A taxable expenditure includes amounts used to attempt to influence legislation:

School boards, housing authorities, sewer and water districts, zoning boards, and other similar federal, state, or local special purpose bodies, whether elective or appointive, are considered administrative bodies.

A proposed treaty required to be submitted by the President to the Senate for its advice and consent will be considered legislation being considered by, or to be submitted imminently to, a legislative body at the time the President's representative begins to negotiate its position with the parties to the proposed treaty.

JOINTLY FUNDED PROJECTS. A private foundation will not be treated as having paid or incurred any amount to attempt to influence legislation merely because it makes a grant to another organization on the condition that the recipient obtain a matching support appropriation from the government. In addition, it will not be treated as having made a taxable expenditure of amounts paid or incurred in carrying on discussions with government officials if:

ATTEMPTS TO AFFECT THE OPINION OF THE GENERAL PUBLIC. Generally, expenditures paid or incurred by a private foundation in an attempt to influence any legislation through an attempt to affect the opinion of any segment of the general public is a taxable expenditure. Exceptions are discussed later in this chapter.

LOBBYING ACTIVITIES. Generally, expenditures paid or incurred by a private foundation to influence legislation through communication with any member or employee of a legislative body, or with any government official or employee who may participate in the formulation of the legislation is a taxable expenditure. Exceptions are discussed next.

EXCEPTION FOR NONPARTISAN ANALYSIS, STUDY, AND RESEARCH. Engaging in nonpartisan analysis, study, or research and making the results of this work available to the general public or to governmental bodies, officials, or employees is not carrying on propaganda, or otherwise attempting to influence legislation. Nonpartisan analysis, study, or research means an independent and objective exposition of a particular subject matter, including activities that qualify as educational activities. Nonpartisan analysis, study, or research may advocate a particular position or viewpoint as long as there is a sufficiently full and fair exposition of the relevant facts to enable the public or an individual to form an independent opinion or conclusion. However, a mere presentation of unsupported opinion does not qualify as nonpartisan analysis, study, or research.

PRESENTATION AS PART OF A SERIES. Normally, whether a publication or broadcast qualifies as nonpartisan analysis, study, or research will be determined on a presentation-by-presentation basis. However, if a publication or broadcast is one of a series prepared or supported by a private foundation and the series as a whole meets the standards of nonpartisan analysis, study, or research, then any individual publication or broadcast in the series will not result in a taxable expenditure even though such individual broadcast or publication does not, by itself, meet the standards of nonpartisan analysis, study, or research. Whether a broadcast or publication is considered part of a series will ordinarily depend on all the facts and circumstances of each particular situation. However, for broadcast activities, all broadcasts in any period of 6 consecutive months will ordinarily be eligible to be considered as part of a series. If a private foundation times or channels a part of a series in a manner designed to influence the general public or the action of a legislative body for a specific legislative proposal, the expenses of preparing and distributing that part of the analysis, study, or research are a taxable expenditure.

MAKING AVAILABLE RESULTS OF ANALYSIS, STUDY, OR RESEARCH. A private foundation may choose any suitable means, including oral or written presentations, to distribute the results of its nonpartisan analysis, study, or research, with or without charge. This may include distribution of reprints of speeches, articles, and reports, presentation of information through conferences, meetings, and discussions, and dissemination to the news media, including radio, television, and newspapers, and to other public forums. These presentations may not be limited to or directed toward persons who are interested only in one side of a particular issue.

EXAMPLE 1. M, a private foundation, establishes a research project to collect information for showing the dangers of using pesticides in growing crops. The information collected includes data on proposed legislation, pending before several state legislatures, that would ban the use of pesticides. The project takes favorable positions on the legislation WITHOUT producing a sufficiently full and fair exposition of the relevant facts to enable the public or an individual to form an independent opinion or conclusion on the pros and cons of the use of pesticides. This project is not within the exception for nonpartisan analysis, study, or research because it is designed to present information only on one side of the legislative controversy.

EXAMPLE 2. N, a private foundation, establishes a research project for the apparent purpose of examining and reporting information as to the pros and cons of the use of pesticides in growing crops. The information is collected and distributed in the form of a published report that analyzes the effects and costs of the use and nonuse of various pesticides under various conditions on humans, animals, and crops. The report also presents the advantages, disadvantages, and economic cost of allowing the continued use of pesticides unabated, of controlling the use of pesticides, and of developing alternatives to pesticides.

Even if the report gives conclusions that the disadvantages, as a result of using pesticides, are greater than the advantages of using pesticides and that prompt legislative regulation of the use of pesticides is needed, the project is within the exception for nonpartisan analysis, study, or research because it is designed to present information on both sides of the legislative controversy. In addition, the report presents a sufficiently full and fair exposition of the relevant facts to enable the public or an individual to form an independent opinion or conclusion.

EXCEPTION FOR TECHNICAL ADVICE OR ASSISTANCE. Amounts are not taxable expenditures if they are paid or incurred in connection with providing technical advice or assistance to a governmental body, a government committee, or a subdivision of either, in response to a WRITTEN REQUEST. Under this exception, the request for assistance or advice must be made in the name of the requesting governmental body, committee, or subdivision rather than an individual member. Similarly, the response to the request must be available to every member of the requesting body, committee, or subdivision.

NATURE OF TECHNICAL ADVICE OR ASSISTANCE. Technical advice or assistance may be given as a result of knowledge or skill in a given area. Because this assistance or advice may be given only at the express request of a governmental body, committee, or subdivision, the oral or written presentation of assistance or advice need not qualify as nonpartisan analysis, study, or research. Offering opinions or recommendations will ordinarily qualify under this exception only if the opinions or recommendations are specifically requested by the governmental body, committee, or subdivision or are directly related to the materials requested.

EXAMPLE 1. A Congressional committee is studying the feasibility of legislation to provide funds for scholarships to U.S. students attending schools abroad. X, a private foundation that has engaged in a private scholarship program of this kind, is asked, in writing, by the committee to describe the manner in which it selects candidates for its program. X's response, disclosing its methods of selection, is technical advice or assistance.

EXAMPLE 2. Assume the same facts given in Example 1, except that X's response not only includes a description of its own grant-making procedures, but also includes its views regarding the wisdom of adopting such a program. Because these views are directly related to the subject matter of the request for technical advice or assistance, the amount paid or incurred for the presentation of these views is not a taxable expenditure. However, the amount paid or incurred in connection with a response that is not directly related to the subject matter of the request for technical advice or assistance would be a taxable expenditure unless the presentation can qualify as making available nonpartisan analysis, study, or research.

EXCEPTION FOR DECISIONS AFFECTING THE POWERS, DUTIES, ETC., OF A PRIVATE FOUNDATION. Taxes on lobbying activities, discussed earlier, do not apply to any amount paid or incurred in connection with an appearance before, or communication with, any legislative body on a possible decision of the body that might affect the existence of the private foundation, its powers and duties, its tax-exempt status, or the deductibility of contributions to the foundation. Under this exception, a foundation may communicate with the entire legislative body, committees, or subcommittees of the legislative body, individual congressmen or legislators, members of their staffs, or representatives of the executive branch, who are involved in the legislative process if the communication is limited to the prescribed subjects. In addition, the foundation may make expenditures to initiate legislation if the legislation concerns only matters that might affect the existence of the private foundation, its powers and duties, its tax-exempt status, or the deductibility of contributions to the foundation.

EXCEPTION FOR EXAMINATIONS AND DISCUSSIONS OF BROAD SOCIAL, ECONOMIC, AND SIMILAR PROBLEMS. Expenditures for examinations and discussions of broad social, economic, and similar problems are not taxable expenditures even if the problems are the type the government would be expected to deal with ultimately.

The term "any attempt to influence any legislation" does not include public discussion, or communications with members of legislative bodies or governmental employees, the general subject of which is also the subject of legislation before a legislative body, as long as the discussion does not address itself to the merits of a specific legislative proposal.

For example, a private foundation may, without incurring the tax on taxable expenditures, present discussions of problems such as environmental pollution or population growth that are being considered by Congress and various state legislatures, but only if the discussions are not directly addressed to specific legislation being considered.

INFLUENCING ELECTIONS AND CARRYING ON VOTER REGISTRATION DRIVES.

Taxable expenditures include amounts paid or incurred by a private foundation to influence the outcome of any specific public election or to carry on, directly or indirectly, any voter registration drive. Activities that are considered participation or intervention in a political campaign include, but are not limited to:

For organizations with less than 4 years of operational experience, the support test may be determined by taking into account all available years the organization has been in existence.

ADVANCE RULING. An organization will be given an advance ruling that it qualifies under the exceptions that apply to nonpartisan activities if it submits evidence establishing that it can reasonably expect to meet these tests for the year. Grantors or contributors to these organizations may rely on the advance ruling until a notice of change of status of the organization is made to the public. This does not apply, however, if the grantor or contributor was responsible for, or was aware of, the fact that the organization did not qualify under these provisions at the end of the tax year for which it obtained an advance ruling or determination letter, or acquired knowledge that the Service had given notice to the organization advising that it would be deleted from this classification.

GRANTS TO INDIVIDUALS

Grants to individuals for travel, study, or other similar purposes (including loans made for charitable purposes, and program-related investments as defined in Chapter IX) are taxable expenditures, UNLESS the following conditions are met:

Requests for approval of grant-making procedures should be sent to the District Director of the IRS office servicing your area. If, by the 45th day after a request for approval of grant procedures has been properly submitted, the foundation has not been notified that the procedures are acceptable, they may be considered approved from the date of submission until receipt of actual notice from the Service that they do not meet the requirements.

Payments of remaining installments of fixed-sum grants awarded during the period the foundation's procedures were considered approved, after the foundation is notified that the procedures are unacceptable, are not taxable expenditures.

RENEWALS. A renewal of a qualified grant will not be treated as a grant to an individual subject to the requirements of this chapter if:

COMPANY SCHOLARSHIP PROGRAMS are usually administered by company- created private foundations. These foundations may give preference in awarding scholarships to employees, the children or relatives of employees, or the children or deceased or retired employees of the company or related companies. Scholarship grants awarded by these private foundations are taxable expenditures unless the grant programs meet the requirements for individual grants (discussed earlier) and receive advance approval from the Service.

Company scholarship programs will not qualify if grants are essentially providing extra pay, an employment incentive, or an employee fringe benefit. Similarly, if scholarship programs are compensatory in nature, an organization administering such a program will not qualify for tax exemption because it is operated for private benefit. A private foundation administering such a program could also be involved in direct or indirect self-dealing.

Company-related scholarship programs can meet the scholarship requirements by ensuring that the scholarships awarded are for the main purpose of furthering the recipients' education rather than compensating company employees. Certain conditions and tests must establish three facts:

EDUCATIONAL LOANS made by a private foundation under an employer- related loan program are not taxable expenditures if the loan program --

If a private foundation's employer-related program includes educational loans and scholarship or fellowship grants to the same group of eligible employees' children, the percentage tests apply to the total number of individuals receiving combined grants of scholarship, fellowship, and educational loans.

If the loan program satisfies the seven conditions, but does not meet the percentage test, all the relevant facts and circumstances will be considered in determining the primary purpose of the program.

If your private foundation holds a ruling letter issued before September 29, 1980, you may continue to rely on that ruling letter provided the loan program fully complies with the seven conditions and the percentage tests continuously from the date on which the ruling letter was issued. Upon written request, the Service will issue a current ruling letter affirming the qualification of the loan program under these requirements.

CERTAIN DESIGNATED GRANTS. A grant by a private foundation to another organization that makes payments to a qualified individual will not be treated as a grant by the private foundation to the individual if the foundation does not earmark the use of the grant for any named individual and there is no agreement (oral or written) whereby the grantor organization has any part in selecting the individual grantee.

CERTAIN GRANTS TO PUBLIC CHARITIES. A grant by a private foundation to a public charity, other than an organization organized and operated exclusively for testing for public safety, that the grantee organization uses to make payments to an individual as a qualified grant, will not be treated as a grant by the private foundation to the individual grantee if the grant is made for a project to be undertaken and controlled by the public charity. The public charity must also control the selection of the grantee, although the selection need not be completely independent of the private foundation.

GRANTS TO GOVERNMENTAL AGENCIES. If a private foundation makes a grant to a governmental agency, and the grant is earmarked for use by an individual for travel, study, or other similar purposes, the grant is not a taxable expenditure by the private foundation if the governmental agency satisfies the Service in advance that its grant- making program:

GRANTS TO ORGANIZATIONS (including loans and program-related investments) are taxable expenditures, unless the recipients are public charities described in section 509(a)(1), (2), or (3), or unless the private foundation exercises expenditure responsibility with respect to the grant. However, expenditure responsibility is not required if the grantee organization meets the exception requirements described earlier under Influencing elections and carrying on voter registration drives.

RELIANCE BY GRANTORS ON PUBLIC CHARITY STATUS OF GRANTEES. As discussed in the preceding paragraph, a private foundation need not exercise expenditure responsibility with respect to a grant if the grant is made to a public charity described in section 509(a)(1), (2), or (3). If an organization to which a private foundation wishes to make a grant has received a final ruling or determination letter classifying it as an organization described in section 509(a)(1), (2), or (3), the treatment of grants and contributions and the status of grantors and contributors to the organization will generally not be affected by reason of a later revocation by the Service of the organization's classification until the date on which notice of change of status is made to the public (such as by publication in the Internal Revenue Bulletin) or another applicable date, if any, specified in the public notice. In appropriate cases, however, the treatment of grants and contributions and the status of grantors and contributors to an organization described in section 509(a)(1), (2), or (3) may be affected pending verification of the continued classification of the organization. Notice to this effect will be made in a public announcement by the Service. In these cases the effect of grants and contributions made after the date of the announcement will depend on the statutory qualification of the organization as an organization described in section 509(a)(1), (2), or (3).

NOTE. The preceding paragraph shall not apply if the grantor or contributor:

TERMS OF GRANTS. To meet the expenditure responsibility requirements, each grant must be made subject to a written commitment signed by an appropriate officer, director, or trustee of the grantee organization. This commitment must include the following agreements by the grantee:

The commitment should specify the purpose of the investment and should contain an agreement by the organization:

SPECIAL RULES FOR GRANTS BY FOREIGN PRIVATE FOUNDATIONS. The failure of a foreign private foundation to comply with the restrictions imposed on grants will not constitute an act or failure to act that is a prohibited transaction under section 4948(c) of the Code.

REPORTS FROM GRANTEES. The granting private foundation must require reports on the use of the funds, compliance with the terms of the grant, and the progress made by the grantee toward achieving the purpose for which the grant was made. The grantee must make an annual accounting of the funds at the end of its accounting period and must make a final report on all expenditures made from the funds in addition to the progress made toward the goals of the grant.

RELIANCE ON INFORMATION SUPPLIED BY GRANTEE. A private foundation, exercising expenditure responsibility with respect to its grants, may rely on adequate records or other sufficient evidence supplied by the grantee organization showing the information that the grantor must submit to the IRS.

RECORDKEEPING REQUIREMENTS. In addition to the information required when filing a return, the granting foundation must make available to the IRS at its main office each of the following items:

If a grantor foundation determines that any part of the grant has been used for improper purposes and the grantee has not previously diverted grant funds, the foundation will not be treated as having made a taxable expenditure if it:

GRANTEE'S FAILURE TO MAKE REPORTS. A failure to make the required reports by the grantee will result in the grant being treated as a taxable expenditure by the grantor unless the grantor:

GRANTS TO NONCHARITABLE ORGANIZATIONS. A private foundation cannot make a grant for a purpose not described in section 170(c)(2)(B). Permitted purposes are religious, charitable, scientific, literary or educational purposes, fostering national or international amateur sports competition (but only if no part of the activities involve providing athletic facilities or equipment), and preventing cruelty to children or animals. Section 501(c)(3) describes organizations that are organized and operated exclusively for these purposes. Grants for nonpermitted purposes are taxable expenditures.

Accordingly, a private foundation may not make a grant to an organization that is not described in section 501(c)(3) unless, making the grant itself is a direct charitable act or a program-related investment, or the grantor is reasonable assured that the grant will be used exclusively for the purposes of an organization described here.

If a private foundation makes a grant that is not a transfer of assets resulting from any liquidation, merger, redemption, recapitalization, organization, reorganization, or other adjustment to any organization (other than an organization described in section 501(c)(3) that is not exclusively organized and operated for testing for public safety), the grantor is reasonably assured that the grant will be used exclusively for section 170(c)(2)(B) purposes (described earlier) only if the grantee organization agrees to keep these funds in a separate fund dedicated to section 170(c)(2)(B) purposes. In addition, the grantor must comply with the expenditure responsibility requirements discussed earlier.

If a private foundation makes a transfer of assets under any liquidation, merger, etc., to any person, the transferred assets will not be considered to be used exclusively for section 170(c)(2)(B) purposes unless the assets are transferred to a fund or organization described in section 501(c)(3) (other than an organization organized and operated for testing for public safety).

CHAPTER VII, TAXES ON FAILURE TO DISTRIBUTE INCOME

Generally, section 4942 of the Internal Revenue Code imposes an excise tax on any undistributed income of a private foundation. An additional excise tax will be imposed on any income remaining undistributed at the end of the TAXABLE PERIOD.

The income of the foundation must be distributed as QUALIFYING DISTRIBUTIONS, defined later. Private foundations must make qualifying distributions to the extent of their MINIMUM INVESTMENT RETURN for the year. However, a foundation may SET ASIDE funds for periods up to 60 months for certain major projects. EXCESS QUALIFYING DISTRIBUTIONS may be carried forward for a period of 5 tax years immediately following the tax year in which the excess was created. Special transitional rules apply to foundations created before May 27, 1969.

INITIAL TAX. An excise tax of 15% is imposed on the undistributed income of a private foundation that has not been distributed before the first day of the 2nd (or any succeeding) tax year following the year earned, if the first day falls within the TAXABLE PERIOD. A short tax year is considered a tax year.

The initial tax may be abated if the foundation can show that the failure was due to reasonable cause and not to willful neglect, and that the failure to distribute was corrected within the CORRECTION PERIOD (described later).

ADDITIONAL TAX. If the initial tax is imposed and the undistributed income has not been distributed by the end of the TAXABLE PERIOD, an additional tax of 100% of the amount remaining undistributed will be imposed. The tax will not be assessed, or if assessed will be abated, if the undistributed income is reduced to zero during the CORRECTION PERIOD.

Payment of the excise tax is required in addition to, rather than instead of, making required distributions of undistributed income.

EXCEPTIONS. The tax does not apply to the undistributed income of a private operating foundation or of an exempt operating foundation.

Certain long-established private foundations that have provided long-term care facilities continuously since May 26, 1969, are treated as private operating foundations and, therefore, are not subject to the excise tax on failure to distribute income.

To qualify for this treatment, the foundation must, on May 26, 1969, and continuously thereafter to the end of the tax year, operate and keep up facilities for the long-term care, comfort, maintenance or education of the permanently and totally disabled, elderly, needy widows, or children as its principal functional purpose. In addition, the foundation must meet the requirements of the ENDOWMENT TEST (defined in Chapter I) that applies to private operating foundations.

An organization will meet the principal function purpose requirement if it is organized for the principal purpose of operating and maintaining these residential facilities and at least 50% of the qualifying distributions normally made by the organization are spent for the operation and upkeep of these facilities.

These foundations are treated as private operating foundations ONLY for the purposes of the distribution requirements of section 4942 of the Code. All other rules governing nonoperating private foundations, including rules governing deductibility of contributions, apply.

INCORRECT VALUATION OF ASSETS. The tax also does not apply to the undistributed income of a private foundation that failed to distribute only because of an incorrect valuation of assets, if:

If a foundation, after full disclosure of the facts, obtains a good faith appraisal of an asset's fair market value by a qualified appraiser (whether or not that appraiser is a disqualified person with respect to the foundation), and the foundation relies on that appraisal, then failure to properly value an asset will ordinarily be regarded as not willful and due to reasonable cause. However, if a foundation does not obtain a good faith appraisal, the lack of such an appraisal will not, by itself, imply that the foundation's failure to properly value an asset was willful and not due to reasonable cause.

EXAMPLE. In 1986 the Martin Foundation, which was established in 1985, incorrectly valued its assets in a manner that was not willful and was due to reasonable cause. As a result of the incorrect valuation, $20,000, which should have been distributed by the end of 1987, is still undistributed as of January 1, 1988. On September 29, 1988, a notice of tax deficiency is mailed to the foundation.

On November 5, 1988 (within the allowable distribution-period), the foundation makes a qualifying distribution of $20,000 which is treated as made out of the foundation's undistributed income for 1986. The foundation notifies the Service of its action. Under these circumstances the foundation would have been liable for an initial tax of $3,000 (15% of $20,000). However, because the foundation meets the exception for failure to distribute because of an incorrect valuation of assets, it is not liable for the taxes.

TAXABLE PERIOD. The taxable period begins on the first day of the tax year and ends on the earlier of either:

The correction period begins with the first day of the tax year in which there was a failure to distribute income and ends 90 days after a notice of deficiency for the ADDITIONAL TAX is mailed.

THE CORRECTION PERIOD IS EXTENDED by any period during which a deficiency cannot be assessed. In addition, this period may be extended by any period that the IRS determines is reasonable and necessary to make distributions of undistributed income as required to comply with section 4942.

EXAMPLE 1. In 1985 the Jones Foundation, a private foundation that uses the calendar year as its tax year, made an error in asset valuation that was not willful and was due to reasonable cause. The error caused the Jones Foundation not to distribute $25,000 that should have been distributed for 1985. On March 2, 1988, a notice of deficiency for the INITIAL and ADDITIONAL tax was mailed to the Jones Foundation. For the undistributed 1985 income, the taxable period runs from January 1, 1985, through March 2, 1988, and the allowable distribution period runs from January 1, 1986, through May 31, 1988 (90 days after the notice of deficiency was mailed). If the Service determines that it is reasonable and necessary to extend the distribution period through June 15, 1988, the allowable distribution period runs from January 1, 1986, through June 15, 1988.

EXAMPLE 2. Assume the facts given in Example 1 except that the failure to distribute was not due to an incorrect valuation of assets. On April 1, 1988, a notice of deficiency for the INITIAL and ADDITIONAL tax was mailed to the foundation. If the Jones Foundation has not filed a petition with the Tax Court for a redetermination of the deficiency, the correction period runs from January 1, 1985, through June 30, 1988, unless the Service determines it is reasonable and necessary to extend the correction period to permit the Jones Foundation to distribute the 1985 undistributed income.

UNDISTRIBUTED INCOME MEANS the amount by which the distributable amount for any tax year exceeds the qualifying distributions made out of the distributable amount before the end of the following tax year.

DISTRIBUTABLE AMOUNT is equal to the minimum investment return of a private foundation reduced by the sum of any income taxes and the tax on investment income, and increased by:

If a split-interest trust distributes income from amounts placed in trust both on or before and after May 26, 1969, these distributions must be allocated between those amounts placed in trust during these periods to determine the extent to which the distributions are included in the foundation's distributable amount.

THE INCOME PORTION of a distribution from a split-interest trust to a private foundation is the greater of:

MINIMUM INVESTMENT RETURN. The minimum investment return for any private foundation is 5% of the excess of the combined fair market value of all assets of the foundation, other than those used or held for use for exempt purposes, over the amount of indebtedness incurred to buy these assets.

THE COMBINED FAIR MARKET VALUE OF ALL FOUNDATION ASSETS includes:

Assets held for the production of income or for investment (for example, stocks, bonds, interest-bearing notes, endowment funds, or generally, leased real estate) are not considered used or held for use for exempt purposes even though the income from those assets is used to carry out an exempt purpose. Whether an asset is held for the production of income or for investment rather than used or held for use directly by the foundation for exempt purposes is a factual question. For example, an office building used to provide offices for employees engaged in managing endowment funds for the foundation is not considered an amount used for exempt purposes.

However, where property is used both for exempt and nonexempt purposes, the property will be considered as being used entirely for exempt purposes if at least 95% of its total use is for exempt purposes. But, if less than 95% of its total use is for exempt purposes, a reasonable allocation must be made between exempt and nonexempt use. Property acquired by the foundation to be used for an exempt purpose will be considered an asset used for exempt purposes even though all or part of the property is leased for a limited and reasonable time (generally no more than one year) while arrangements are made to convert it to use for exempt purposes.

Where the income-producing use continues beyond a reasonable time, the property will not be considered an asset used for exempt purposes. Instead, at the time the income-producing use becomes unreasonable, the property will be considered disposed of to the extent the acquisition was taken into account as a qualifying distribution. If the property is later used by the foundation for exempt purposes, a qualifying distribution in an amount equal to its fair market value at that time will be considered to have been made at the time the exempt use begins.

Asset used for exempt purposes include:

In an amount in excess of the 1-1/2% figure is claimed for any year, a statement must be attached to Form 990-PF for that year explaining the reasons for the larger amount.

VALUATION OF ASSETS. When figuring the minimum investment return, a foundation may use any reasonable method to determine the fair market value on a monthly basis of securities including, but not limited to, common and preferred stock, bonds, and mutual fund shares, for which market quotations are readily available as long as that method is consistently used. Market quotations are considered readily available if a security is:

EXAMPLE 1. The Young Foundation, a private foundation, owns 1,000 shares of Smith Corporation stock, which is regularly traded on the New York Stock Exchange. The Young Foundation may follow a consistent package of valuing Smith Corporation stock on the last trading day of each month based on its closing price for that day.

EXAMPLE 2. The Young Foundation, a private foundation, owns 1,000 shares of an unlisted corporation, which is locally traded. Quotations on unlisted stock can be readily obtained from established brokers. The Young Foundation may consistently value its unlisted stock as of the 15th day of each month by getting a bona fide quote of the bid and asked prices from an established brokerage firm and by taking the mean of those prices on that day. If a quotation is not available on the regular valuation dates, the Young Foundation may value its unlisted stock based on a bona fide quote obtained on the first day after the regular valuation date that the quotation is available.

REDUCTIONS IN VALUE FOR BLOCKAGE OR SIMILAR FACTORS. In determining the value of securities, the private foundation may establish that as a result of (1) the size of the block of securities, (2) the fact that the securities are in a closely held corporation, or (3) the fact that the sale of the securities would result in a forced or distress sale, the price at which the securities could be sold outside the usual market may be a more accurate indication of value than market quotations. In such a case, any reduction in value for all of these reasons together may not be more than 10% of the fair market value of the securities to which the discount applies.

UNLISTED SECURITIES EFFECTIVELY CONTROLLED BY FOUNDATION AND DISQUALIFIED PERSONS. If the foundation owns voting stock of an issuer of unlisted securities and has, or together with disqualified persons or other private foundation has, effective control of the issuer, then, to the extent that the issuer's assets consist of shares of listed securities issues, the assets shall be valued monthly on the basis of market quotations.

CASH. For purposes of the minimum investment return, a foundation figures its cash balances on a monthly basis by averaging the amount of cash on hand on the first and last days of each month.

COMMON TRUST FUNDS. If a private foundation owns a participating interest in a common trust fund established and administered under a plan providing for the periodic valuation of participating interests during the fund's tax year and reporting these valuations to participants, the value of the foundation's interest in the common trust fund based on the average of the valuations reported to the foundation during its tax year will ordinarily be an acceptable method of valuation for purposes of the minimum investment return.

OTHER ASSETS. The fair market value of assets other than those described earlier is determined annually except as described later. The valuation may be made by private foundation employees or by any other person, whether or not that person is a disqualified person. Such a valuation, if accepted by the IRS, is valid only for the tax year for which it is made. A new valuation is required for the following tax year. However, the fair market value of any interest in realty, including any improvements thereon, may be determined on a 5- year basis by a written, certified, independent appraisal by a qualified person who is neither a disqualified person (see Chapter V) nor an employee of the private foundation.

The appraisal must contain a statement to the effect that, in the appraiser's opinion, the appraised assets were valued in accordance with valuation principles regularly employed in making appraisals of such property using all reasonable valuation methods. The foundation must keep a copy of the independent appraisal for its records. If a valuation is reasonable, the foundation may use it for the tax year for which the valuation is made and for each of the 4 following tax years.

Any valuation of real property by a certified, independent appraisal may be replaced during the 5-year period by a later 5-year valuation by a certified, independent appraisal or by an annual valuation. The most recent valuation will be used in figuring the foundation's minimum investment return.

The valuation must be made no later than the last day of the first tax year for which the new valuation applies.

A valuation, if properly made according to the rules discussed here, will not be disturbed by the IRS during the 5-year period for which it applies, even if the actual fair market value of the property changes during that period.

Commonly accepted valuation methods must be used in making the appraisal. A valuation based on acceptable methods of valuing property for federal estate tax purposes is acceptable. An appraisal is a determination of fair market value and should not be construed in a technical sense to be peculiar to particular property or interests therein as, for example, mineral interests in real property.

VALUATION DATE. If an asset is required to be valued annually, the asset may be valued as of any day in the private foundation's tax year if the foundation follows a consistent practice of valuing the asset as of that date in all tax years. A valuation of real estate determined on a 5-year basis by a certified, independent appraisal may be made as of any day in the first tax year of the private foundation to which the valuation is to be applied.

ASSETS HELD FOR LESS THAN A TAX YEAR. If an asset is held for less than one tax year, the value of that asset is found by multiplying the fair market value of the asset by a fraction. The numerator of the fraction is the number of days in the tax year that the foundation held the asset, and the denominator is the total number of days in the tax year.

QUALIFYING DISTRIBUTIONS. A qualifying distribution is:

The amount of a qualifying distribution of property is the fair market value of the property on the date it is made. The amount of a qualifying distribution is determined only under the cash receipts and disbursements method.

A private foundation that bought an asset and claimed a qualifying distribution under item (2) will be allowed a second qualifying distribution for the same asset if the asset is later given to a publicly supported charitable organization that is not controlled by the foundation, and it is donated for a purpose described in item (1).

The amount of the second qualifying distribution will be the difference between the fair market value of the asset on the date of the contribution and the amount of the first qualifying distribution.

LIMIT ON ADMINISTRATIVE EXPENSES. For tax years beginning after 1984 and before 1991, the beginning amount of grant administrative expenses that may be included in any tax year as a qualifying distribution is limited to the excess of:

BORROWED FUNDS. If a private foundation borrows money during a tax year to make a charitable expenditure, then a qualifying distribution is considered made only at the time the borrowed funds are actually distributed for a charitable purpose.

CONTROL. An organization is controlled by a foundation or by one or more disqualified persons if any of these persons may, by combining their votes or positions of authority, require the organization to make an expenditure or prevent the organization from making an expenditure, regardless of the method by which control is exercised or exercisable. Control of a donee organization is determined without regard to any conditions imposed on the donee as part of the distribution or any other restrictions as to how the distribution may be used unless the conditions and restrictions are imposed on a distribution of net assets to terminate private foundation status (as discussed in Chapter III).

In general, it is the donee, not the distribution, that must be controlled by the distributing private foundation to disqualify an otherwise qualifying distribution. If a foundation provides support to an organization and imposes budgetary procedures on that organization, this will not, of itself, constitute control of the donee. Budgetary procedures include expenditure responsibility to require reports from the donee organization on:

CHANGES IN ASSET USE. If an asset not used or held for use for public or charitable, educational, etc. purposes is later converted to exempt use, the foundation may treat the conversion as a qualifying distribution. The amount of the qualifying distribution is the fair market value of the converted assets on the conversion date. For determining fair market value of the assets, see Valuation of Assets, discussed earlier.

The date a foundation adopts and immediately begins to implement a plan to convert property from nonexempt to exempt uses is the conversion date even if the actual conversion occurs later.

PAYMENT OF ANY CHAPTER 42 EXCISE TAX imposed on the foundation is not considered a qualifying distribution.

SET-ASIDES. An amount set aside for a specific project may be treated as a qualifying distribution in the year set aside (but not in the year actually paid) if at the time of the set-aside the foundation establishes to the satisfaction of the Service that:

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

CASH DISTRIBUTION TEST. The foundation satisfies the cash distribution test if:

In general, only a distribution actually made during the start-up period is taken into account in determining whether the foundation has distributed the start-up period minimum amount. However, a distribution actually made during the tax year in which the foundation was created (the year immediately preceding the foundation's start-up period) may be treated as made during the start-up period. Also, a distribution actually made within 5-1/2 months after the end of the start-up period will be treated as made during the start-up period if (a) the foundation was unable to determine its distributable amount for the fourth tax year of the start-up period until after the end of the period, and (b) the foundation actually made distributions before the end of the start-up period based on a reasonable estimate of its distributable amount for that fourth tax year.

FULL PAYMENT PERIOD MINIMUM AMOUNT. The foundation's full-payment period includes each tax year that begins after the end of the start- up period. The full payment period minimum amount, the amount that the foundation must actually distribute in cash or its equivalent in each tax year of the full-payment period, and must be not less than 100% of its distributable amount, described earlier, for that year, without regard to the Carryover of excess qualifying distributions, discussed later.

However, if the foundation distributes in a tax year an amount in excess of the full-payment period minimum amount for that year, the excess reduces the full-payment period minimum amount for the 5 tax years immediately following the tax year in which the excess distribution is made. The excess is applied to reduce the full-payment period minimum amount in each successive tax year of the 5-year period, in order, until completely used up.

FAILURE TO DISTRIBUTE MINIMUM AMOUNTS. If the foundation fails to actually distribute the start-up period minimum amount during the start-up period or, generally, if it fails to distribute the full- payment period minimum amount during a tax year of the full-payment period, then any set-aside made by the foundation during the appropriate period will not be treated as a qualifying distribution unless it was approved by the IRS under the SUITABILITY TEST. Also, any set-aside made after the year of such a failure to distribute a minimum amount will be treated as a qualifying distribution only if the Service approves it under the suitability test.

However, if the foundation's failure to distribute the full- payment period minimum amount during a tax year of the full-payment period is not willful and is due to reasonable cause, the foundation may correct the failure. To do so, it must distribute within the correction period (discussed earlier) cash or its equivalent in an amount not less than the difference between the full-payment period minimum amount for the tax year and the amount actually distributed during that year. The additional distribution is treated as though it had been made in the year in which it originally should have been made, for purposes of meeting the cash distribution test. If a foundation fails to distribute the full-payment period minimum amount during the appropriate tax year because the amount can be determined only after the end of that tax year, no "willful failure to distribute" will occur if the foundation makes an additional distribution within 5-1/2 months after the end of the tax year.

CONTINGENT SET-ASIDE. If a private foundation is involved in litigation and may not distribute assets or income because of a court order, it may seek and obtain a set-aside for the purpose of making a qualifying distribution. The amount that may be set aside is equal to the part of the foundation's distributable amount that is attributable to the assets or income held under the court order that would otherwise have been distributed.

If the litigation lasts more than one tax year, the foundation may seek additional contingent set-asides. The amount must actually be distributed by the last day of the tax year following the tax year in which the proceedings end. Amounts the foundation does not distribute by the end of that year will be considered gross income to the foundation for the following tax year.

APPROVAL of a set-aside must be obtained from the IRS for the set- aside to qualify under the SUITABILITY TEST. No advance approval is required for qualification under the cash distribution test. A foundation must apply for Service approval by the end of the tax year in which the amount is to be set aside. If the foundation fails to seek approval before that date, an otherwise proper set-aside will not be treated as a qualifying distribution.

To obtain approval for a set-aside under the suitability test, a foundation must write to the Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC 20224, Attention: E:EO, and include:

EVIDENCE OF SET-ASIDE. A set-aside approved by the Service or that meets the cash distribution test should be shown by entering a dollar amount on the books of the foundation as a pledge or obligation to be paid at a future date or dates. Any amount set aside will be taken into account in figuring the foundation's minimum investment return and any income from the set-aside should be taken into account in figuring the adjusted net income of private operating foundations. The amount set aside need not reflect an accumulation of income, but may be a bookkeeping entry that will require funding out of corpus by the end of the set-aside period.

CERTAIN CONTRIBUTIONS TO EXEMPT ORGANIZATIONS. A "qualifying distribution" includes a contribution to a private nonoperating foundation or to an organization formed for certain religious, charitable, scientific, educational, or other exempt purposes that is controlled (see Control, earlier) by the contributing foundation or by one or more disqualified persons or to a private nonoperating foundation if:

If both requirements are not met, no part of the contribution will be treated as a qualifying distribution. To meet the distribution requirements, the donee organization must, by the close of the first tax year after the tax year in which the contribution is received, distribute an amount equal in value to the contribution, and it must have no remaining undistributed income for the year in which the contribution was received.

If a donee organization redistributes less than an amount equal to the total contributions from donor organizations that are required to be redistributed by the end of the first tax year after the tax year in which they were received, amounts treated as redistributions will be considered as made pro rata from all contributions received in the prior tax year that are required to be redistributed by the donee organization regardless of any earmarking or identification of the source made by the donee. The amounts considered as not to have been redistributed will be included pro rata in the gross income of each donor foundation in the foundation's first tax year beginning after the close of the donee organization's tax year in which the amount should have been distributed.

THE CHARACTERIZATION OF QUALIFYING DISTRIBUTIONS made during the tax year (that is, whether out of the prior or current year's undistributed income, or corpus) is made as of the close of the tax year in question, except when the donee organization chooses to treat all or part of the distribution as made out of a distribution from corpus made in a designated prior tax year (see Treatment of qualifying distributions, discussed later). Once it is determined that a qualifying distribution is from corpus, that distribution will first be charged to distributions that are required to be redistributed as described earlier.

All amounts contributed to a specific charitable, educational, religious, etc. exempt organization in any one tax year of that organization will be treated as a single contribution by the contributing private foundation.

If the requirements for establishing the contribution as a qualifying distribution to certain exempt organizations are not completely satisfied, then only that part of the contribution that was redistributed will be treated as a qualifying distribution.

To satisfy distribution requirements, a donee organization may choose to treat as a qualifying distribution from corpus for the current year any amount distributed in a prior tax year that was treated as a distribution out of corpus if:

EXAMPLE. In 1987, the Miller Foundation, a private foundation, made a contribution out of 1986 income to the James Foundation, a private nonoperating foundation. The contribution was the only one received by the James Foundation in 1987. In 1988 the James Foundation made a qualifying distribution to an art museum maintained by an operating foundation in an amount equal to the contribution received from the Miller Foundation. The James Foundation also distributed all of its undistributed 1987 and 1988 income for other charitable, educational, religious, etc. purposes. The distribution to the art museum is treated as made out of corpus.

The Miller Foundation's contribution to the James Foundation is a qualifying distribution out of the Miller Foundation's 1986 income. This is a qualifying distribution if it obtains adequate records or enough other evidence from the James Foundation showing the nature and amount of the distribution, the recipient's identity, and the fact that the distribution is treated as made out of corpus. If the James Foundation's qualifying distributions during 1988 had been equal only to the contribution received from the Miller Foundation and its 1988 undistributed income, the James Foundation could have chosen to treat the amount distributed in excess of its 1987 undistributed income as a qualifying distribution made out of corpus (see Special choice, later) and thus satisfy the qualifying distribution requirements.

LIMIT. A contribution by a private foundation to a recipient organization, which the recipient uses to make payments to a secondary recipient, is not a contribution by the private foundation to the secondary recipient if the foundation does not earmark the use of the contribution for any named secondary recipient, and does not keep the power to control the selection of the secondary recipient by the organization to which the foundation has contributed.

TREATMENT OF QUALIFYING DISTRIBUTIONS. Any qualifying distribution made during the tax year will be treated as being made:

SPECIAL CHOICE. If any qualifying distribution is not treated as being made out of undistributed income of the immediately preceding tax year, the foundation may choose to treat any part of the distribution as made out of the undistributed income of a designated prior tax year or out of corpus.

This choice is made by filing a statement with the IRS during the tax year in which the qualifying distribution is made or by attaching a statement to the foundation's annual return, for the tax year in which it made the qualifying distribution. The statement must contain a declaration by an appropriate foundation manager that the foundation is making the choice, under Regulations section 53.4942(a)-3(d)(2) and must specify whether the distribution is made out of undistributed income for a designated prior tax year (or years) or is made out of corpus.

When the choice is made during the tax year in which the qualifying distribution is made, the choice may be revoked in whole or in part by filing a statement with the Service during the same tax year or by attaching a statement to the foundation's annual return filed for the tax years during which the qualifying distribution was made. The revocation statement must contain a declaration by the appropriate foundation manager that the foundation is revoking the choice described above in whole or in part, and must specify the choice or part thereof being revoked.

EXAMPLE. The Oak Foundation, a private foundation, has undistributed income of $300 for 1986 and $200 for 1987. On January 14, 1988, the Oak Foundation made its first qualifying distribution in 1988 when it set aside $700 for hospital construction.

On February 22, 1988, a notice of deficiency for the initial and additional excise tax on failure to distribute income with regard to the 1986 undistributed income was mailed to the Oak Foundation. The Oak Foundation notified the Service in writing on March 20, 1988, that it was making a choice to apply the January 14, 1988, distribution (to the extent that it exceeded 1987 undistributed income) against the 1986 undistributed income. The Oak Foundation is liable for an initial excise tax of $45 (15% of $300).

Because the Oak Foundation made the choice described, the $300 of undistributed income for 1986 is treated as distributed during the correction period, and no additional excise tax is imposed. Under these circumstances the $700 distribution is treated as made first out of the undistributed income of 1987 ($200), then out of the remaining undistributed income of 1986 ($300). The $200 remaining may be applied against the distributable amount for 1988 or may be treated as a distribution out of corpus.

CARRYOVER OF EXCESS QUALIFYING DISTRIBUTIONS. For any tax year during which the organization is a private nonoperating foundation, any excess qualifying distributions (described later) may be used to reduce distributable amounts in any tax year of the adjustment period.

If a private foundation that had a carryover of excess qualifying distributions makes a section 507(b)(2) transfer of all its assets to an effectively controlled foundation (defined in Chapter III), the transferee foundation may reduce its distributable amount by the carryover.

The distributable amount for a tax year in an adjustment period will be reduced by the lesser of:

Therefore, the $100 distributable amount for 1985 is reduced by $30 (the lesser of the 1984 excess ($50) and the remaining undistributed income at the close of 1985 ($30), after the qualifying distributions of $70 for 1985 were applied to the original distributable amount for 1985 of $100). Maple Foundation then has a $20 excess of qualifying distributions to use for tax years in the adjustment period. If during any tax year of the adjustment period another excess of qualifying distributions is created, that excess will not be taken into account until the earlier excess has been completely applied against distributable amounts during its adjustment period.

AN EXCESS QUALIFYING DISTRIBUTION is the amount by which the total qualifying distributions treated as made out of undistributed income for any tax year beginning after 1969, or as made out of corpus for the tax year (other than distributions by donee organizations described in Certain contributions to exempt organizations, earlier, or the amount applied to a prior tax year by the choices with respect to qualifying distributions) exceed the distributable amount for that tax year.

THE ADJUSTMENT PERIOD is the 5 tax years immediately following the tax year in which the excess of qualifying distributions is created. Thus, an excess qualifying distribution for any one tax year may not be carried over for more than 5 tax years. However, if during any tax year of the adjustment period, the organization ceases to be subject to the initial tax (such as by becoming a private operating foundation), any portion of the excess qualifying distributions, that, before that tax year, has not been applied against distributable amounts may not be carried over to that tax year or later tax years in the adjustment period. This rule applies even though during any of those tax years the organization again becomes subject to the initial tax.

CHAPTER VIII, TAXES ON SELF-DEALING

Section 4941 of the Internal Revenue Code imposes an excise tax on certain transactions (acts of self-dealing) between a private foundation and disqualified persons.

INITIAL TAX. An excise tax of 5% of the amount involved (described later) in the act of self-dealing is imposed on the disqualified person, other than a foundation manager acting only as a manager, for each year or part of a year in the taxable period (discussed later).

An excise tax of 2 1/2% of the amount involved is imposed on a foundation manager who knowingly participates in an act of self- dealing, unless participation is not willful and is due to reasonable cause, for each year or part of a year in the taxable period.

ADDITIONAL TAX. An excise tax of 200% of the amount involved is imposed on the disqualified person, other than a foundation manager acting only as a manager, who participated in the act of self- dealing, if the act of self-dealing is not corrected within the taxable period. The additional tax will not be assessed, or if assessed will be abated, if the act of self-dealing is corrected during the correction period (described later).

If the additional tax described above is imposed on the disqualified person, an excise tax of 50% of the amount involved is imposed on any foundation manager who refuses to agree to part or all of the correction of the self-dealing act.

LIMITS ON LIABILITY FOR MANAGEMENT. The maximum initial tax imposed on the foundation manager is $10,000 and the maximum additional tax is $10,000 for any one act.

There is no maximum on the liability of the self-dealer, including one who is a foundation manager.

If more than one person is liable for the initial and additional taxes imposed for any act of self-dealing, all parties will be jointly and severally liable for those taxes.

ACTS OF SELF-DEALING. The following transactions are generally considered acts of self-dealing between a private foundation and a disqualified person:

PARTICIPATION. A DISQUALIFIED PERSON who engages or takes part in a transaction alone or with others, or directs any person to do so will be treated as participating in an act of self-dealing.

Participation by a FOUNDATION MANAGER includes silence or inaction on the manager's part where there is a duty to speak or act, as well as any affirmative action by the manager. However, a foundation manager will not have participated in an act of self- dealing when the manager has opposed the act in a manner consistent with carrying out the manager's responsibilities to the private foundation.

WILLFUL. Participation by a foundation manager is willful if it is voluntary, conscious, and intentional. No motive to avoid the restrictions of the law or the incurrence of any tax is necessary to make the participation willful. However, participation by the foundation manager is not willful if the manager does not KNOW (discussed later) that participation in the transaction is an act of self-dealing.

REASONABLE CAUSE. Participation is due to reasonable cause if the foundation manager has exercised responsibility on behalf of the foundation with ordinary business case and prudence.

ADVICE OF COUNSEL. A person who, after full disclosure of the factual situation to legal counsel (including house counsel), relies on the advice of counsel expressed in a reasoned written legal opinion that a transaction is not an act of self-dealing under the law, although the transaction is later held to be an act of self-dealing, will ordinarily not be liable for the initial tax imposed for self- dealing.

A written legal opinion is considered reasoned even if it reaches a conclusion that is later determined to be incorrect as long as it addresses itself to the facts and applicable law. However, a written legal opinion will not be considered reasoned if it does nothing more than recite the facts and express a conclusion. The absence of advice of counsel will not, by itself, imply that a person participated in the act knowingly, willfully, or without reasonable cause.

KNOWING. A person will be considered to have participated in a transaction knowing that it is an act of self-dealing only if:

TAXABLE PERIOD. The tax on self-dealing is imposed for each year or part of a year within the taxable period. The taxable period begins on the date the act of self-dealing occurs and ends on the earliest of:

EXAMPLE 2. The facts are the same as in Example 1 except that on July 2, 1987, correction of the act of self-dealing is completed. The taxable period for both Jones and Smith is July 2, 1986, through July 2, 1987.

The initial tax is figured based on the tax year of the disqualified person liable for the tax, rather than the tax year of the private foundation.

AN ACT OF SELF-DEALING OCCURS on the date all the terms and conditions of the transaction and the liabilities of the parties are fixed. For example, if a private foundation gives a disqualified person a binding option on June 17, 1985, to buy property owned by the foundation at any time before June 16, 1986, the act of self- dealing has occurred on June 17, 1985.

CORRECTION PERIOD. The correction period starts on the day the act of self-dealing occurs and ends 90 days after a notice of deficiency for the ADDITIONAL TAX is mailed.

The correction period may be extended by:

The term, SELF-DEALING includes the following transactions whether direct or indirect. However, see Indirect Self-Dealing, Exceptions to Self-Dealing, and Transitional Rules, for special rules.

SALES OR EXCHANGES OF PROPERTY

Any sale or exchange of property between a private foundation and a disqualified person is an act of self-dealing. For example, the sale of incidental supplies by a disqualified person to a private foundation is an act of self-dealing regardless of the amount paid to the disqualified person. Similarly, the sale of stock or other securities by a disqualified person to a private foundation in a bargain sale is an act of self-dealing regardless of the amount paid. However, see Exceptions to Self-Dealing later in this chapter.

The transfer of real or personal property by a disqualified person to a private foundation is treated as a sale or exchange if the foundation assumes a mortgage or similar lien, which was placed on the property before the transfer, or takes the property subject to a mortgage or similar lien that a disqualified person placed on the property in the 10-year period ending on the date of transfer. A similar lien includes, but is not limited to, deeds of trust and vendors' liens, but does not include any other lien if it is insignificant in relation to the fair market value of the property transferred.

EXAMPLE. On May 17, 1988, the Gray Foundation, a private foundation, received a donation of a life insurance policy from Joe Brown, a disqualified person. The policy, which had a face value of $100,000, was subject to an outstanding loan of $46,000 that was made to Joe by the insurer within the 10-year period ending on the date of the donation. The cash surrender value of the policy was $50,000 on May 17, 1988. Under the terms of the policy, failure to repay the principal or interest on the policy loan reduces the proceeds that are payable to the beneficiary upon voluntary surrender of the policy or upon the death of the insured. The donation is an act of self- dealing.

LEASES

The leasing of property between a disqualified person and a private foundation is an act of self-dealing. But see Leases, under Exceptions to Self-Dealing, later in this chapter.

LOANS

Lending money or other extension of credit between a private foundation and a disqualified person is an act of self-dealing. However, this does not include loaning money by a disqualified person to a private foundation without interest or other charge if the proceeds of the loan are used exclusively for purposes specified in section 501(c)(3) of the Code. For these purposes, a loan by a disqualified person to a private foundation at below-market interest rates is treated as an act of self-dealing to the same extent as a loan at market interest rates.

An act of self-dealing occurs when a third party buys property and assumes a mortgage, the mortgagee of which is a private foundation, and later the third party transfers the property to a disqualified person who either assumes liability under the mortgage or takes the property subject to the mortgage. In this transaction the foundation is considered to have made a loan to the disqualified person in the amount of the unpaid indebtedness on the property at the time of the transfer.

Making a promise, pledge, or similar arrangement regarding money or property to a private foundation by a disqualified person, whether by an oral or written agreement, a promissory note, or other instrument of indebtedness, is not an extension of credit before the date of maturity to the extent that it is motivated by charitable intent and is unsupported by consideration.

Performing trust functions and certain general banking 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 necessary in carrying out the exempt purposes of the private foundation and the compensation paid to the bank or trust company is not excessive (considering the fair interest rate for the use of the funds by the bank or trust company).

The general banking services that are not self-dealing are:

PROVIDING GOODS, SERVICES, OR FACILITIES

Generally, providing goods, services, or facilities between a private foundation and a disqualified person is an act of self-dealing. This applies to providing goods, services, or facilities, such as office space, cars, auditoriums, secretarial help, meals, libraries, publications, laboratories, or parking lots. However, it is not self- dealing if a disqualified person provides them to a foundation without charge and the goods, services, or facilities are used exclusively for purposes specified in section 501(c)(3) of the Code. Also, providing goods, services, or facilities to a foundation manager, to an employee, or to an unpaid worker, is not an act of self-dealing if the value of the items provided is reasonable and necessary to the performance of the tasks involved in carrying out the exempt purpose of the foundation and is not excessive.

For example, it is not an act of self-dealing if a private foundation provides meals and lodging which are reasonable and necessary (but not excessive) to a foundation manager. This is true whether or not the value of the meals and lodging is excludable from the manager's gross income.

PAYING COMPENSATION

Paying compensation or reimbursing expenses by a private foundation to a disqualified person is an act of self-dealing. But see Exceptions to Self-Dealing, discussed later.

USE OF INCOME OR ASSETS

Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation is an act of self- dealing. For example, an act of self-dealing includes payment by a private foundation of any excise tax imposed on a disqualified person for any prohibited transactions discussed in this publication.

Similarly, payment of premiums for an insurance policy providing liability insurance to a foundation manager for excise taxes on prohibited transactions is an act of self-dealing unless the premiums are treated as compensation to the manager. In addition, the purchase or sale of stock or other securities by a private foundation is an act of self-dealing if the purchase or sale is made in an attempt to manipulate the price of the stock or other securities to the advantage of a disqualified person.

Indemnification by the foundation of its managers against reasonable expenses (other than taxes, penalties, and expenses of correction) incurred in an IRS or court proceeding involving the imposition of the excise taxes described in this publication on the foundation manager will not be an act of self-dealing if:

The indemnification of a lender or guarantee of repayment by a private foundation of a loan to a disqualified person is treated as a use for the benefit of a disqualified person of the income or assets of a private foundation.

A grant or other payment made by a foundation to satisfy the legal obligation of a disqualified person is an act of self-dealing.

INCIDENTAL BENEFITS. The fact that a disqualified person receives an incidental or slight benefit from the use by a foundation of its income or assets will not, by itself, make the use an act of self- dealing. Public recognition that a substantial contributor may receive, arising from charitable activities of a private foundation, does not in itself result in an act of self-dealing since generally the benefit is incidental and tenuous.

Similarly, a scholarship or fellowship grant to a person other than a disqualified person that is paid or incurred by a private foundation according to a program consistent with:

PAYMENT TO A GOVERNMENT OFFICIAL

The agreement by a private foundation to make any payment of money or other property to a government official (defined in Chapter V) will ordinarily be an act of self-dealing. But, see Certain payments to government officials are not considered acts of self-dealing, later, under Exceptions to Self-Dealing.

INDIRECT SELF-DEALING

Certain transactions will not be treated as indirect self-dealing.

CERTAIN BUSINESS TRANSACTIONS. A transaction between a disqualified person and an organization controlled by a private foundation is not indirect self-dealing if:

TRANSACTIONS DURING THE ADMINISTRATION OF AN ESTATE OR REVOCABLE TRUST. A transaction involving a private foundation's interest or expectancy in property held by an estate (or revocable trust, including a trust that has become irrevocable on a grantor's death), regardless of when title to the property vests under local law, is not indirect self-dealing if:

CERTAIN TRANSACTIONS INVOLVING LIMITED AMOUNTS. The term "indirect self-dealing" does not include any transaction between a disqualified person and an organization controlled by a private foundation or between two disqualified persons when the foundation's assets may be affected by the transaction if:

For example, even if a private foundation has control of a corporation, the corporation may pay to another disqualified person (except a government official) reasonable compensation for personal services.

CONTROL. An organization is considered controlled by a private foundation if the foundation or one or more of its foundation managers acting only in their capacity as managers, may, only by combining their votes or positions of authority, require the organization to engage in a transaction, which if engaged in with the private foundation would be self-dealing. Similarly, an organization is controlled by a private foundation in the case of such a transaction between the organization and a disqualified person, if the disqualified person together with certain related persons who are disqualified persons (as described in Chapter V) may, only by combining their votes or positions of authority with that of the foundation, require the organization to engage in such a transaction.

The controlled organization does not have to be a private foundation. It may be any kind of exempt or nonexempt organization including a school, hospital, operating foundation, or social welfare organization.

As organization will be considered controlled by a private foundation or by a private foundation and disqualified persons if the persons are able, in fact, to control that organization. This control may be present even if their combined voting power is less than 50% of the organization's total voting power, or if one or more of the individuals has the right to exercise veto power over the actions of the organization relevant to any potential acts of self-dealing. However, a private foundation will not be regarded as having control over an organization simply because it exercises expenditure responsibility.

EXCEPTIONS TO SELF-DEALING

The following transactions between a private foundation and a disqualified person are not considered self-dealing.

PROVIDING GOODS, SERVICES, OR FACILITIES by a private foundation to a disqualified person is not self-dealing if the goods, services, or facilities are made available to the general public on at least as favorable a basis as they are made available to the disqualified person AND the goods, services, or facilities are FUNCTIONALLY RELATED (defined in Chapter X) to the exercise or performance by a private foundation of its exempt purpose.

The term "general public" includes those persons who reasonably would be expected to use the foundation's goods, services, or facilities. This does not apply, however, unless a substantial number of persons other than disqualified persons actually use the goods, services, or facilities.

A private foundation that provides recreational or park facilities to the general public may provide those facilities to a disqualified person if they are provided to that person on a basis no more favorable than that on which they are provided to the general public. Similarly, the sale of a book or magazine to disqualified persons is not an act of self-dealing if publishing the book or magazine is functionally related to a charitable or educational activity of the foundation. The publication must be made available to disqualified persons and the general public at the same price. Moreover, if the terms of the book or magazine sale require, for example, payment within 60 days of delivery, and payment is made during the 60-day period, the transaction will not be treated as a loan or extension of credit if these terms are consistent with normal commercial practices.

PAYMENT OF COMPENSATION OR REIMBURSEMENT OF EXPENSES by a private foundation to a disqualified person (except for a government official) for personal services that are reasonable and necessary to carry out the exempt purpose of the private foundation is not considered an act of self-dealing if the compensation or reimbursement is not excessive.

Personal services include the services of a broker serving as the foundation's agent, but not the services of a dealer buying from the foundation as a principal and reselling to a third party.

Furthermore, if a foundation makes a cash advance to a foundation manager or employee to cover anticipated out-of-pocket expenses, it is not an act of self-dealing if the advance is reasonable in relation to the duties and expense requirements of the foundation manager. An advance ordinarily is considered reasonable if it is not more than $500.

For example, if a foundation makes an advance to a foundation manager to cover anticipated out-of-pocket current expenses for a reasonable period (such as a month) and the manager accounts to the foundation under a periodic reimbursement program for actual expenses incurred, the foundation is not considered to have engaged in an act of self-dealing:

For the securities to be considered subject to the same terms, the corporation must, in connection with the transaction, make a bona fide offer on a uniform basis to the foundation and every other security holder. The fact that a foundation receives property, such as debentures, while all other persons holding securities of the same class receive cash for their interests, will be evidence that the offer was not made on a uniform basis.

If no other persons hold securities of the same class as the private foundation, the consideration received by holders of other classes of securities, or the interests retained by the holders of other classes, when considered in relation to the consideration received by the foundation, must indicate that the foundation received at least as favorable treatment in relation to its interests as the holders of any other class of securities, In addition, the foundation must receive at least the fair market value of its interests.

CERTAIN PAYMENTS TO GOVERNMENT OFFICIALS ARE NOT CONSIDERED ACTS OF SELF-DEALING. These payments are:

The leasing of office space by a disqualified person to a private foundation in a building with other tenants who are not disqualified persons is not an act of self-dealing if:

TRANSACTIONS INVOLVING SECURITIES ACQUIRED BY A FOUNDATION BEFORE MAY 27, 1969. Any transaction between a private foundation and a corporation that is a disqualified person will not be an act of self-dealing if the transaction is under the terms of securities of the corporation, if the terms were in existence at the time the securities were acquired by the foundation and if they were acquired before May 27, 1969.

DISPOSITION OF CERTAIN BUSINESS HOLDINGS. The sale, exchange, or other disposition of property that was owned by a private foundation on May 26, 1969, to a disqualified person will not be an act of self- dealing if the foundation is required to dispose of the property so it will not be liable for the tax on excess business holdings (discussed in Chapter X). This rule applies only if:

USE OF PROPERTY ACQUIRED BEFORE OCTOBER 9, 1969. The use of property in which a private foundation and disqualified person have a joint or common interest is not an act of self-dealing if the interests of both were acquired before October 9, 1969.

AMOUNT INVOLVED

The excise tax on self-dealing is figured on the amount involved, which is the greater of the amount of money and the fair market value of other property given or the amount of money and fair market value of other property received. For payments made for services performed (to persons other than government officials), the amount involved is only the excess compensation paid by the private foundation. When the use of money or other property is involved, the amount involved is the greater of either the amount paid for the use or the fair market value of the use for the period for which the money or other property is used.

For a transaction that would not have been an act of self- dealing had the private foundation received fair market value, the amount involved is the excess of the fair market value of property transferred by the foundation over the amount received by the foundation, but only if the parties have made a good faith effort to determine fair market value. Ordinarily a good faith effort to determine fair market value will be considered made when:

TIME FOR DETERMINING FAIR MARKET VALUE. The fair market value of property or the use thereof, as the case may be, for purposes of the initial taxes is the value as of the date the act of self-dealing occurred and for purposes of the additional taxes is the highest fair market value during the taxable period.

CORRECTION

Correction will be accomplished by undoing the transaction that constituted the act of self-dealing, to the extent possible, but in no case placing the foundation in a worse financial position than that in which it would have been had the disqualified person acted under the highest fiduciary standards. For example, when a disqualified person sells property to a private foundation for cash, correction may be accomplished by recasting the transaction in the form of a gift by returning the cash to the foundation.

The following paragraphs give examples of minimum standards of correction in the case of certain specific acts of self-dealing. Use similar principles and apply them to other acts of self-dealing. Any correction under these standards is not an act of self-dealing.

SALES BY FOUNDATION. In a sale of property by a private foundation to a disqualified person for cash, undoing the transaction includes, but is not limited to, rescinding the sale if possible. However, to avoid placing the foundation in a position worse than that in which it would be if rescission were not required, the amount returned to the disqualified person may not be greater than the lesser of the cash received by the foundation or the fair market value of the property received by the disqualified person.

Fair market value is determined either at the time of the act of self-dealing or at the time of rescission, whichever results in the lesser fair market value. In addition, the disqualified person must pay the foundation any net profits realized from the property during the correction period, but only to the extent the income is greater than the income received by the foundation during the correction period from the cash originally paid to the foundation.

If, before the end of the correction period, the disqualified person resells the property in an arm's length transaction to a bona fide buyer who is not the foundation or another disqualified person, no rescission is required. The disqualified person must pay the foundation the excess (if any) of the greater of the fair market value of the property on the date of correction or the amount realized in the arm's length resale over the amount that would have been returned to the disqualified person if rescission had been required. In addition, the disqualified person must pay the foundation any net profits realized as described in the preceding paragraph.

SALES TO FOUNDATION. If a disqualified person sells property to a private foundation, undoing the transaction includes, but is not limited to, requiring rescission of the sale if possible. However, to avoid placing the foundation in a worse position than it would be in if rescission were not required, the amount to be received from the disqualified person will be the greatest of:

If, before the end of the correction period, the foundation resells the property in an arm's length transaction to a bona fide buyer who is not a disqualified person, no rescission is required. But, the disqualified person must pay the foundation the excess (if any) of the amount that would have been paid to the foundation if the original sale had been rescinded over the amount realized by the foundation upon the resale of the property. In addition, the disqualified person must pay the foundation any net profits realized from the amount received from the original sale, described earlier.

USE OF PROPERTY BY A DISQUALIFIED PERSON. If a disqualified person uses property owned by a private foundation, undoing the transaction includes, but is not limited to, terminating the use of the property. In addition, the disqualified person must pay the foundation the excess (if any) of:

The RATE for use of property other than money will be the fair rental value per period. For use of money, the rate will be the fair interest rate.

USE OF THE PROPERTY BY A PRIVATE FOUNDATION. If a private foundation uses property that is owned by a disqualified person, undoing the transaction includes, but is not limited to, terminating the use of the property. In addition, the disqualified person must pay the foundation the excess (if any) of:

EXCESSIVE COMPENSATION paid by a private foundation to a disqualified person for performing personal services that are reasonable and necessary to carry out the exempt purpose of the foundation may be corrected by repaying to the foundation any excessive amount. Termination of the employment or independent contractor relationship is not required.

CORRECTION OF VALUATION ERRORS. If, but for an error in the valuation of property, a transaction would not have been an act of self-dealing had the foundation received fair market value, a correction of the transaction means that the foundation is paid an amount equal to the excess of the fair market value of the property transferred over the amount that the foundation received for the property (assuming a good faith effort to determine fair market value). In addition, the foundation must receive the amount necessary to compensate it for the loss of the use of the money or other property during the period beginning on the date of the act of self-dealing and ending on the date the transaction is corrected.

NUMBER OF ACTS

If a transaction is determined to be an act of self-dealing, there is generally only one act of self-dealing. If the transaction involves leasing property, lending money or other extension of credit, other use of money or property, or payment of compensation, the transaction will be treated as an act of self-dealing on the day the transaction occurs plus an act of self-dealing on the first day of each tax year or part of a year within the taxable period that begins after the tax year in which the transaction occurs.

If a transaction involves joint participation by two or more disqualified persons, the transaction will be treated as a separate act of self-dealing for each individual involved.

However, for purposes of terminating tax-exempt status and for purposes of determining a foundation manager's liability for penalties for repeated, willful or flagrant disregard of self-dealing prohibitions, the transaction will be treated as only one act of self-dealing. An individual and one or more members of the individual's family will be treated as one person regardless of whether a member of the family is a disqualified person as defined in Chapter V. The liability imposed on a disqualified person and one or more members of the individual's family for joint participation in an act of self-dealing is joint and several.

Fair market value of a specific asset is determined under the same rules discussed in Chapter VII under Valuation of Assets.

CHAPTER IX, TAXES ON JEOPARDIZING INVESTMENTS

If a private foundation makes any investments that would financially jeopardize the carrying out of its exempt purposes, both the foundation and the individual foundation managers may become liable for taxes on these jeopardizing investments under section 4944.

INITIAL TAX. An excise tax of 5% of the amount involved (the jeopardizing investment) is imposed on the foundation for each tax year, or part of a year, in the taxable period (described later). The foundation will not be liable for the tax if it can show that the jeopardizing investment was due to reasonable cause and not willful neglect, and that the jeopardizing investment was corrected within the correction period (described later).

An excise tax of 5% of the amount involved is also imposed on any foundation manager who knowingly, willfully, and without reasonable cause participated in making the jeopardizing investment.

This tax applies to investments of either income or principal.

ADDITIONAL TAX. If a private foundation is liable for the initial tax and has not removed the investment from jeopardy within the taxable period, an additional excise tax of 25% of the amount involved will be imposed on the foundation. The additional tax will not be assessed, or if assessed will be abated, if the investment is removed from jeopardy within the correction period.

In each case where this additional tax is imposed on the foundation, an additional excise tax of 5% of the amount involved is imposed on any foundation manager who refuses to agree to all or part of the removal from jeopardy within the correction period.

If more than one individual manager is liable for the excise tax on jeopardizing investments, all parties will be jointly and severally liable.

LIMITS ON LIABILITY FOR MANAGEMENT. For any one jeopardizing investment, the maximum initial tax that may be imposed is $5,000, and the maximum additional tax is $10,000.

WILLFUL. A manager's participation in making an investment is willful if it is voluntary, conscious, and intentional. However, it is not willful if the manager does not knowingly participate in a jeopardizing investment.

DUE TO REASONABLE CAUSE. A foundation manager's actions are due to reasonable cause if he or she has exercised responsibility on behalf of the foundation with ordinary business care and prudence.

ADVICE OF COUNSEL. A manager's action will be considered due to reasonable cause if the manager relies on advice of counsel expressed in a reasoned written legal opinion (discussed under Advice of counsel, in Chapter VIII). In addition, a foundation manager may rely on the advice of a qualified investment counselor, given in writing in accordance with generally accepted practices, that a particular investment will provide for the long and short-term financial needs of the foundation.

PARTICIPATION. The participation of any foundation manager in the making of an investment shall consist of any manifestation of approval of the investment.

KNOWING. Foundation managers will be considered to have participated in making an investment knowing that it is jeopardizing the carrying out of any of the foundation's exempt purposes only if:

JEOPARDIZING INVESTMENTS generally are those that show a lack of reasonable business care and prudence in providing for the long and short-term financial needs of the foundation for it to carry out its exempt function. No single factor determines a jeopardizing investment.

No category of investments is treated as an intrinsic violation, but careful scrutiny is applied to:

Whether an investment jeopardizes the foundation's exempt purposes is determined at the time of making the investment. If the investment is proper when made, it will not be considered a jeopardizing investment even if it later results in loss.

These rules do not exempt or relieve any person from compliance with any federal or state law imposing any obligation, duty, responsibility, or other standard of conduct on the operation or administration of an organization or trust. Nor shall any state law exempt or relieve any person from any obligation, duty, responsibility, or other standard of conduct provided in these rules.

The tax on jeopardizing investments does not apply to investments originally made by a person who later transferred them as gifts to the foundation. However, if the person receives any consideration from the foundation on the transfer, the foundation will be treated as having made an investment in the amount of the consideration.

The tax on jeopardizing investment does not apply to investments that are acquired by the foundation as a result of a corporate reorganization nor does the tax apply to investments made before 1970 unless the form or terms of the investments are later changed, or they are exchanged for other investments.

PROGRAM-RELATED INVESTMENTS are not subject to the tax on jeopardizing investments. Program-related investments are those in which:

If an investment incidentally produces significant income or capital appreciation, this is not, in the absence of other factors, conclusive evidence that a significant purpose is the production of income or the appreciation of property.

The investments, to be program related, must significantly further the foundation's exempt activities. They must be investments that would not have been made except for their relationship to the exempt purposes. The investments include those made in FUNCTIONALLY RELATED ACTIVITIES (described in Chapter X) that are carried on within a larger combination of similar activities related to the exempt purposes.

The following are some typical examples of program-related investments:

Once an investment is determined to be program-related, it will continue to qualify as a program-related investment if changes in the form or terms of the investment are made primarily for exempt purposes and not for any significant purpose involving the production of income or the appreciation of property. A change made in the form or terms of a program-related investment for the prudent protection of the foundation's investment will not ordinarily cause the investment to cease to qualify as program-related. Under certain conditions a program-related investment may cease to be program-related because of a critical change in circumstances, such as serving an illegal purpose or serving the private purpose of the foundation or its managers.

An investment that ceases to be program-related because of a critical change in circumstances does not subject the foundation making the investment to the tax on jeopardizing investments before the 30th day after the date on which the foundation (or any of its managers) has actual knowledge of the critical change in circumstances.

THE TAXABLE PERIOD begins with the date of the investment and ends on the earliest of:

EXAMPLE. The Wilson Foundation has the calendar year as its tax year. It makes a jeopardizing investment on November 28, 1988, and does not remove the investment from jeopardy until January 15, 1989. The taxable period is from November 28, 1988, to January 15, 1989. It therefore is liable for a total initial tax of 10% of the amount invested (5% for each tax year or part of a year in the taxable period).

REMOVAL FROM JEOPARDY. The foundation removes an investment from jeopardy when it sells or otherwise disposes of it, and the proceeds of the sale or other disposition are not themselves jeopardizing investments.

A change by a foundation in the form or terms of a jeopardizing investment results in the removal of the investment from jeopardy if, after the change, the investment no longer jeopardizes the carrying out of the foundation's exempt purposes. Making one jeopardizing investment and later exchanging this investment for another jeopardizing investment will be treated as only one jeopardizing investment. A jeopardizing investment is not removed from jeopardy by a transfer to another private foundation related to the transferor foundation unless the investment is a program-related investment in the hands of the transferee foundation.

THE CORRECTION PERIOD begins with the date of the investment and ends 90 days after a notice of deficiency for the ADDITIONAL tax is mailed. This period is extended by any period during which a deficiency cannot be assessed because of pending Tax Court proceedings, and any other period the IRS determines is reasonable and necessary.

CHAPTER X, TAXES ON EXCESS BUSINESS HOLDINGS

Generally, under section 4943 of the Internal Revenue Code, the combined holdings of a private foundation and all of its disqualified persons are limited to 20% of the voting stock in a business enterprise (described later) that is a corporation. The 20% limitation also applies to holdings in business enterprises that are partnerships, joint ventures, or other unincorporated enterprises. For a partnership or joint venture, profits interest is substituted for voting stock, and for any other unincorporated enterprise, beneficial interest is substituted for voting stock. A private foundation that has excess business holdings (described later), in a business enterprise may become liable for an excise tax based on the amount of the excess holdings.

INITIAL TAX. An excise tax of 5% of the value of the excess holdings is imposed on the foundation. The tax is imposed on the last day of each tax year that ends during the taxable period (described later).

The amount of the excess holdings is determined as of the day during the tax year when the foundation's excess holdings in the business were the greatest.

The initial tax may be abated if the foundation can show that the excess holdings were due to reasonable cause and not to willful neglect, and that the excess holdings were disposed of within the correction period (described later).

ADDITIONAL TAX. After the initial tax has been imposed, an excise tax of 200% of the excess holdings is imposed on the foundation if it has not disposed of the remaining excess business holdings by the end of the taxable period. The additional tax will not be assessed, or if assessed will be abated, if the excess business holdings are reduced to zero during the correction period (described later).

BUSINESS ENTERPRISE. The term "business enterprise," in general, includes the active conduct of a trade or business including any activity that is regularly carried on for the production of income from the sale of goods or the performance of services and that constitutes an unrelated trade or business under section 513 of the Code. The term does NOT include a FUNCTIONALLY RELATED BUSINESS, a trade or business that obtains at least 95% of its gross income from passive sources, or program-related investments as discussed in Chapter IX.

A FUNCTIONALLY RELATED BUSINESS IS:

EXCESS BUSINESS HOLDINGS. The excess business holdings of a foundation are the amount of stock or other interest in a business enterprise that exceeds the permitted holdings. A private foundation is generally permitted to hold up to 20% of the voting stock of a corporation, reduced by the percentage of voting stock actually or constructively owned by disqualified persons (defined in Chapter V, of this publication). There are two exceptions to this rule.

First, if one or more third persons, who are not disqualified persons, have effective control of a corporation, the private foundation and all disqualified persons together may own up to 35% of the corporation's voting stock. Effective control means the power, whether direct or indirect, and whether or not actually exercised, to direct or cause the direction of the management and policies of a business enterprise. It is the actual control which is decisive, and not its form or the means by which it is exercisable.

Second, a private foundation is not treated as having excess business holdings in any corporation in which it (together with certain other related private foundations) owns not more than 2% of the voting stock and not more than 2% of the value of all outstanding shares of all classes of stock.

Nonvoting stock (or capital interest for holdings in a partnership or joint venture) is a permitted holding of a foundation if all disqualified persons together hold no more than 20% (or 35% as described earlier) of the voting stock of the corporation. All equity interests which are not voting stock shall be classified as nonvoting stock.

INTEREST IN SOLE PROPRIETORSHIPS. A private foundation is not permitted any holdings in sole proprietorships that are business enterprises unless they were held before May 26, 1969, or acquired by gift or bequest thereafter. See the discussion on these special rules later.

ATTRIBUTION OF BUSINESS HOLDINGS. For determining the holdings in a business enterprise of either a private foundation or a disqualified person, any stock or other interest owned directly or indirectly by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries. (This rule does not apply to certain income interests or remainder interests of a private foundation in a split-interest trust, which are discussed in Chapter I).

EXAMPLE. Tim Jones, a foundation manager of X Foundation, owns 50% of the stock of Y Corporation. (Y Corporation is not actively engaged in a trade or business.) Z Corporation is an 80%-owned subsidiary of Y Corporation. Therefore, 40% of the Z Corporation stock is considered held by a disqualified person to X Foundation. Any holding of more than 2% of the voting stock or 2% of the value of the Z Corporation stock will result in all of the Z Corporation stock held by the foundation being treated as an excess business holding.

In making its computations, the foundation must determine its proportionate interest and that of all disqualified persons in each class of stock, in relation to the proportion that the voting interest of each class has to all votes in the corporation. For example, if the foundation owns 50% of the outstanding shares of a class of stock that has 60% of the voting rights in a corporation, the foundation's holdings in the voting stock would be 30%.

DISPOSTIONS OF CERTAIN EXCESS HOLDINGS WITHIN 90 DAYS. A private foundation that acquires excess business holdings, other than as a result of a purchase by the foundation, will not be subject to the taxes on excess business holdings if it disposes of the excess business holdings within 90 days from the date on which it knows, or has reason to know, of the event that caused it to have the excess holdings. This 90-day period will be extended to include the period during which a foundation is prevented by federal or state securities laws from disposing of the excess business holdings. The 90-day disposition period applies, for example, when a disqualified person acquires additional holdings. The amount of holdings the foundation must dispose of is not affected by disposals by disqualified persons during the 90-day period.

THE TAXABLE PERIOD begins on the first day that the foundation has excess business holdings and ends on the earlier of either:

THE CORRECTION PERIOD begins on the first day that the foundation has excess business holdings and ends 90 days after a notice of deficiency for the ADDITIONAL TAX is mailed.

This period is extended by any period during which a deficiency cannot be assessed or because of pending Tax Court proceedings. In addition, the correction period may be extended by any other period the Service determines is reasonable and necessary.

GIFTS OR BEQUESTS OF BUSINESS HOLDINGS. If there is a change in a foundation's business holdings (other than by purchase by the foundation or by disqualified persons) such as through gift or bequest, and the additional holding result in the foundation having excess business holdings, the foundation in effect has 5 YEARS to reduce these holdings or those of its disqualified persons to permissible levels. The excess business holdings (or the increase in excess business holdings) resulting from the gift or bequest are treated as being held by a disqualified person, rather than by the foundation itself, during the 5-year period beginning on the date the foundation obtains the holdings.

ADDITIONAL TIME TO DISPOSE OF LARGE GIFTS OR BEQUESTS. The IRS may grant the foundation an additional 5-year extension (beyond the initial 5 years) to reduce excess business holdings to permissible levels, if these holdings result from an unusually large gift or bequest of diverse business holdings or holdings with complex corporate structures. To receive this extension:

A request for extension of the period for disposition, as well as the copy of any response received from state officials, should be addressed to the Assistant Commissioner (Employee Plans and Exempt Organizations), 1111 Constitution Ave., NW, Washington, DC 20224.

BUSINESS HOLDINGS ON MAY 26, 1969. Transitional rules are provided to prevent holdings of a foundation as of May 26, 1969, that are greater than the 20% (or 35%) limits permitted under the general rules of section 4943(c)(2), from being subject to the initial tax. The foundation is given time, in three phases, to dispose of its excess business holdings.

First, the transitional rules provide that, all foundation holdings on May 26, 1969, are treated as held by disqualified persons for a certain period of time (the "first phase"). Second, the percentage of permitted holdings in a business enterprise is INITIALLY increased to a percentage equal to the difference between --

The main purpose of the substituted level is to indicate what the permitted holdings will be immediately after the end of the first phase, when the holdings are no longer treated as held by disqualified persons.

The substituted level is reduced by dispositions of holdings by the foundation or disqualified persons (but not below 20% or 35%) after May 26, 1969.

EXAMPLE. On May 26, 1969, the Watson Foundation and its disqualified persons owned 49% of the voting stock of the Brown Corporation. The foundation could continue to hold its stock during the first phase. However, if the foundation disposes of 10% of its Brown Corporation stock, its permitted holdings could then not be greater than 39% of the stock.

Holdings on May 26, 1969, include business interests acquired later by the foundation under the terms of a trust irrevocable on that date, or under the terms of a will executed before May 27, 1969.

Generally, an active corporation in which a private foundation has excess stock held since May 26, 1969, may acquire new subsidiaries or assets without creating excess business holdings for the foundation.

THE FIRST PHASE is 20 years if the foundation and all disqualified persons owned more than 95% of the voting stock of a corporate business (or more than 95% of comparable interests in an unincorporated business) on May 26, 1969.

The first phase is 15 years if the foundation (and its disqualified persons) owned on that date more than 75% of either the voting stock or the value of all outstanding shares of all classes of stock of a corporation, or more than 75% of the profits or capital interests of an unincorporated business.

The first phase is 10 years in all other cases.

Phase one is suspended during the time a judicial proceeding is pending, for the purpose of reforming or excusing the foundation from complying with its governing instrument or any other instrument in effect on May 26, 1969, to allow disposition of excess business holdings.

During the first phase, business interests owned by the foundation on May 26, 1969, are treated as held by a disqualified person, rather than by the foundation. The combined holdings of the foundation and its disqualified persons must be reduced so that by the end of the first phase they are not greater than either 50% of the voting stock or 50% of the value of all outstanding shares of a corporation (or 50% of comparable interests in an unincorporated enterprise).

Also for holdings acquired under the terms of a will existing before May 27, 1969, or under the terms of a trust irrevocable before May 27, 1969, the first phase begins on the date of actual distribution of the holdings. However, only the 15-year and 10-year first phase periods apply in these circumstances.

Present holdings greater than 20% but less than 50% need not be decreased during the first phase, but also may not be increased.

THE SECOND PHASE is the 15-year period immediately following the first phase. During the second phase, the foundation's ownership of business interests that it held on May 26, 1969, must be reduced so that by the end of the phase the combined holdings of the foundation and its disqualified persons are not greater than 35% of the voting stock of a corporation (or 35% of the value of all outstanding shares of all classes of stock, or 35% of comparable interests in an unincorporated enterprise).

If, at any time during the second phase, the holdings of all disqualified persons together are greater than 2% of the voting stock, the holdings of the foundation itself may not be more than 25% of the voting stock or 25% of the value of all outstanding shares of all classes of stock.

THE THIRD PHASE is the entire period following the second phase. If a foundation enters the third phase with not more than 2% of the voting stock held by all disqualified parties, and any time after the beginning of the third phase these holdings exceed 2%, then the 25% rule applies.

SEPARATION OF PHASES AND SPECIAL RULES. A private foundation may acquire other interests in a business enterprise, which are also entitled to be treated as held by disqualified persons for varying holding periods (certain holdings acquired under the terms of a trust or will in effect on May 26, 1969, and the initial and additional 5- year periods to dispose of certain gifts, bequests, etc.). The phase periods for each different interest acquired work independently of one another. For example, the phases for certain holdings acquired under the terms of a trust or will in effect on May 26, 1969, start independently from those for certain other interests of the foundation in the same enterprise. In any case, however, holdings the private foundation disposes of are charged first against those holdings it must dispose of in the shortest period to avoid the initial tax thereon.

In certain situations, holdings during the phase periods may become so reduced that they would be permitted holdings subject to the general rules of section 4943 instead of the transitional rules. For example, when the combined voting levels have been reduced to 20%, the provisions concerning nonvoting stock as permitted holdings generally apply.

There is a limited exception from the taxes on self-dealing for private foundations that dispose of certain excess business holdings to disqualified persons as long as the sales price at least equals the fair market value.

The excess business holdings involved are those interests that are subject to the transitional rules and that would be subject to the initial tax if the required reductions in amount were not accomplished.

CHAPTER XI, EXCISE TAX APPEAL PROCEDURES

This chapter explains the procedures an organization must follow in appealing the imposition of the excise taxes explained in Chapters VI through X. Appeals of these taxes are handled by the Appeals Division in each of the regional offices of the Internal Revenue Service.

For appeal procedures that apply to cases involving issues subject to the declaratory judgment provisions of section 7428 of the Code, see Publication 557 and Chapter II of this publication. These issues include qualification under section 501(c)(3) or as an operating foundation, classification as a private foundation, and eligibility to receive deductible contributions.

THIRTY-DAY LETTER

Upon conclusion of an examination that results in a proposed tax deficiency, the taxpayer will be issued a 30-day letter including a report of the examination that indicates the proposed tax deficiency and the reasons for it. The letter will also advise the taxpayer of the right to appeal the proposed action if the taxpayer does not agree with it.

The taxpayer may, within 30 days of the date of the letter, request consideration by the Regional Director of Appeals for the region that has jurisdiction over the case. The procedures regarding the regional consideration and claims for refund or credit are discussed later. In situations where the expiration of the statute of limitations for assessment and collection of tax is imminent, extensions of time to file a 30-day protest will be granted only if the taxpayer signs a consent to extend the statute of limitations.

IF THE TAXPAYER DOES NOT RESPOND IN 30 DAYS, a statutory notice of deficiency will be issued by the key District Director of the Internal Revenue Service. The taxpayer has 90 days (150 days if the notice is mailed to a person outside of the States of the Union and the District of Columbia) to file a petition with the United States Tax Court for a redetermination of the deficiency.

If the taxpayer does not file a petition with the Tax Court, the tax will be assessed.

PROTEST AND CONFERENCE PROCEDURES

If, after receiving the 30-day letter, the taxpayer wishes to appeal, the taxpayer must send a written protest to the key District Director within 30 days from the date of the letter. The protest must include a full and detailed statement of the facts, law, and argument in support of the taxpayer's position and, if desired, a request for a conference at the regional office. Deficient protests will be returned to the taxpayer with an explanation why the protest cannot be accepted. Additional time will be given to the taxpayer to perfect the protest.

Upon receipt of a taxpayer's protest and request for a regional office conference, the key District will review the protest and, if it maintains its position, forward the request and the case file to the Regional Director of Appeals which will contact the taxpayer regarding conference rights. In appropriate cases, the examining officer may attend the regional office conference to clarify the facts in the case. If additional issues are raised at the conference, the case will be returned to the key District Director for consideration of these issues.

If, after consideration of the case by Appeals, a satisfactory settlement of the issues is reached with the taxpayer, the taxpayer will be given a revised report of examination prepared at the regional office, if necessary, and will be asked to sign an appropriate agreement form.

If agreement is not reached at this stage, a statutory notice of deficiency will be issued by Appeals after consideration by the Service's Regional Counsel. The taxpayer may then petition, within the statutory period, the United States Tax Court for redetermination of the deficiency.

If the case under consideration in Appeals is docketed in the Tax Court and agreement is reached with the taxpayer on the issues involved, the case is disposed of by filing a stipulation of agreed deficiency or overpayment with the Tax Court, which will enter its order in conformity with the stipulation.

CLAIMS FOR REFUND OR CREDIT

After receiving a 30-day letter, the taxpayer may pay the tax and then contest the assessment (unless an agreement to the contrary is executed) by filing a claim for refund or credit for all or any part of the amount paid. However, this does not apply to certain taxes determined by the Tax Court, the decision of which has become final. A claim for refund or credit is made by filing an appropriate amended return with the Internal Revenue Service Center to which the original return was sent.

When claims for refund or credit are examined by the key District Director, substantially the same procedure within the Service is followed (including appeal steps) as when original exempt organizations returns are examined. The procedure for appealing rejected claims through the Court is outlined in section 601.103(c)(3) of the Statement of Procedural Rules.

TECHNICAL ADVICE

While the case is under the jurisdiction of the key district office or the Appeals office, a taxpayer may request that an issue be referred to the National Office for technical advice on the grounds that a lack of uniformity exists as to the disposition of the issue, or that the issue is so unusual or complex as to warrant consideration by the National Office. Taxpayers should make written requests to the key district office or the Appeals office stating the facts, law, and argument with respect to the issue and reasons for requesting technical advice. At the time taxpayers are informed that the matter is being referred to the National Office, they will also be informed of their right to a conference in the National Office in the event an adverse decision is indicated, and will be asked to state whether they want such a conference.

If, after the National Office considers the case file on a request for technical advice, it appears that advice adverse to the taxpayer should be given and a conference has been requested, the taxpayer will be notified of the time and place of the conference. If a conference has not been requested, the case will be decided on the basis of the existing written records.