Good Intentions
Many successful business owners attribute some part of their success to their community. For some of these owners, it is not enough to simply acknowledge this “debt”; they feel an obligation to share some of their financial success with the community. For example, the owner or business may contribute funds to a local charity. Another may solicit the voluntary assistance of their workforce to support a local charitable organization or event.
Although these endeavors are commendable, they are of an ad hoc nature, meaning they are of limited duration and are dependent, in no small part, upon the business owner, who acts as the catalyst for the charitable activities of the business.
Recognizing these practical limitations, some business owners may seek to “institutionalize” the charitable activity of the business by establishing a private foundation.[i]Along the way, as we will see shortly, a very small number of owners may be tempted to use the foundation’s assets for other than their originally intended purpose.
Establish a Foundation
Typically, the foundation will be organized as a not-for-profit corporation, separate from the owner and the business; it may be named for the owner or the business; and it will be funded by the owner or the business, with an initial contribution of cash or property.[ii] In later years, the owner may contribute additional amounts to the foundation, often culminating with a significant bequest to the foundation upon the death of the owner.
With this funding, the foundation – which will not be financially dependent upon contributions from the general public (thus, a “private” foundation, as distinguished from a “public” charity[iii]) – will have the financial wherewithal to conduct its charitable activities.
In most cases, the foundation’s only activity will be to make grants of money to tax-exempt, publicly supported, not-for-profit organizations that are directly and actively engaged in charitable activities, provided these grants and activities are in furtherance of the foundation’s stated purposes.[iv]
Whatever the objects of the foundation’s activities, the Code prescribes a number of rules with which the founding business and its owner(s) must become familiar, and with which they and the foundation must comply, if they hope to secure and maintain tax-exempt status for the foundation, and also avoid the imposition of certain penalty (excise) taxes.
Know the Rules
Unfortunately, many business owners embark upon the establishment of a private foundation without first educating themselves as to the operation of such a tax-exempt organization; in particular, with the activities in which it is prohibited from engaging.
Of paramount importance is the requirement that the foundation be operated in furtherance of, and in accordance with, its charitable purposes as set forth in its organizational documents and described in its tax-exemption application[v] filed with the IRS. It must further a public interest, and no part of its net earnings may inure to the benefit of any private individual.
If the foundation’s activities result in any prohibited[vi] private benefit or inurement, its tax-exempt status could be revoked by the IRS, as was
illustrated by a recent ruling from the IRS’s Office of Chief Counsel.[vii]
Foundation As . . . Lender?
Foundation was incorporated under State law, was recognized[viii] by the IRS as a tax-exempt private nonoperating foundation – i.e., as a grant-making organization – and was initially funded with shares of stock[ix] by spouses, Husband and Wife (collectively, the “Managers”).[x]
The ruling does not tell us what motivated the Managers to organize Foundation, nor does it describe the organization’s charitable activities in any meaningful way.
Since its organization, the Managers served as the sole members of Foundation’s board and as its only officers,[xi] though it appeared that during the years at issue all investment decisions on behalf of Foundation – including, as we’ll soon see, whether, to whom, and on what terms to issue loans – were made at the sole discretion of Husband. What’s more, Foundation did not keep minutes of board meeting reflecting approval of such loans.
The Borrowing Business Entities
Between Year 3 and Year 14, Foundation made several, presumably not insignificant, unsecured balloon loans to two business entities: Corp and LLC.
Corp
Corp was formed by Husband, who also served as its [president].[xii] In Year 7, Husband owned more than 35 percent of Corp’s voting stock. After Year 7, Husband ‘s interest in Corp decreased below 35 percent.
In Year 15, Corp was acquired by an unrelated company.
LLC
Husband formed LLC as a State limited liability company in Year 2. Prior to Year 13, Husband owned C percent of the profits interest in LLC and served as [an officer] of the LLC. Wife was also active in LLC’s operations and managed its day-to-day operations.
In Year 13, the Managers acquired 100 percent of LLC by buying out the membership interest held by Husband’s [business partner]. Following the Managers’ acquisition of all the membership interests in LLC, it appeared that the Managers elected to treat LLC as a disregarded entity; thus, LLC’s activities,[xiii] would have been treated as activities of the Managers beginning in Year 13.
The Managers reported LLC’s income in Year 13 and Year 14 on their Form 1040 Schedule C, and LLC did not file partnership returns for those tax years. Thus, it appeared that LLC elected to be disregarded as an entity separate from its owners in Year 13, and that the Managers continued to treat LLC as a disregarded entity in Year 14.[xiv]
Lending History
The loans from Foundation to Corp and LLC were generally term loans of several years, which provided for quarterly payments of interest at fixed rate, with all the principal coming due at the maturity date.
Corp received several loans from Foundation, with the largest loans occurring in Year 6 and Year 7, well before Corp was sold.[xv] Corp paid interest quarterly and, in Year 15 (the year of its sale), had a significant outstanding principal balance owing to Foundation.
LLC also received loans from Foundation; in fact, during every year between Year 3 and Year 12. LLC failed to make interest payments on these loans in Year 4, Year 5, Year 7, Year 12, and Year 13.
By the end of Year 12, the aggregate face value of Foundation’s loans to Corp and LLC comprised substantially all of its assets.[xvi]
Hide the Loans
In Year 10, Year 12, and Year 14, Foundation agreed to extend the due dates of the loans to Corp through letters signed by Husband as Corp’s [officer]. Extensions were also granted on the LLC loans in Year 9 and Year 10. The extension letter in Year 10 was signed by Husband as LLC’s [officer].
In Year 13, Husband approached Foundation’s tax return preparer (Return Preparer) regarding his plan to purchase all of the remaining equity in LLC. Husband was concerned that purchasing additional LLC equity might cause LLC to become a disqualified person[xvii] with respect to Foundation and might violate the prohibition on self-dealing due to the outstanding loans between Foundation and LLC.
In order to remove the LLC loans from Foundation’s books, Return Preparer proposed that Foundation grant the LLC notes to public charities at a zero-dollar value.[xviii] In preparation for these transfers, Foundation and LLC agreed to modify the notes by extending the repayment periods by [several] years, and by reducing the interest rate.[xix]
Husband signed the modification agreement on behalf of both Foundation and LLC, and directed Return Preparer to assign the LLC notes to various public charities. Husband also requested that the assignments be dated as of a date [a few] months earlier.
Although Return Preparer reported the transfers on Foundation’s annual federal tax return for Year 13 as if they had occurred, the notes were never transferred. Consequently, Foundation continued to hold the LLC notes after the Managers acquired 100 percent of the equity interests in LLC, and neither Foundation nor the Managers discovered the failed transfers until the IRS initiated an examination of Foundation’s returns.
The IRS Steps In
During the course of the examination. Foundation conceded that an act of self-dealing[xx] occurred with respect to the LLC notes as of Year 13. Foundation also proposed that this act of self-dealing could be “corrected”[xxi] by having Foundation transfer the LLC notes to public charities as initially planned.
At that point, it appears the IRS examiner requested the assistance of the Office of Chief Counsel.[xxii] Specifically, the examiner asked whether Foundation’s unsecured balloon loans (collectively constituting substantially all of Foundation’s assets) to business entities founded, partially owned, and operated by a foundation manager (Husband), and the repeated extension of those loans, caused Foundation to be operated for the private benefit of the Managers and their business entities.[xxiii]
Chief Counsel’s Analysis
Chief Counsel began by discussing the statutory and regulatory framework within which organizations that have been recognized by the IRS as exempt from federal income tax are expected to operate.
Organized and Operated Exclusively
The Code exempts from federal income tax[xxiv] organizations that are organized and operated exclusively for one or more exempt purposes within the meaning of Section 501(c)(3) of the Code (e.g., religious, charitable, or educational).[xxv] Whether an organization is organized and operated exclusively for exempt purposes is determined based on the facts and circumstances of each case.
The regulations promulgated under Section 501(c)(3) elaborate on what it means to be acting “exclusively” for a charitable purpose.[xxvi] According to these regulations, an organization will be regarded as operated exclusively for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in Section 501(c)(3).[xxvii]
An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.[xxviii] Thus, the presence of a single nonexempt purpose, if it is substantial in nature, will preclude tax exemption regardless of the number or importance of truly exempt purposes for which the organization is operated.
Private Interests
In addition, an organization will not be regarded as organized and operated exclusively for exempt purposes unless it serves public rather than private interests.[xxix] To satisfy this requirement, an organization must establish that it is not organized or operated for the benefit of private interests[xxx] including, for example, a substantial contributor to the organization, a member of the contributor’s family, an officer or director of the organization, or any business controlled by any of the preceding. In other words, an organization is not operated exclusively for an exempt purpose if its net earnings inure in whole or in part to the benefit of private individuals.[xxxi]
To illustrate this point, Chief Counsel gave the example of a private foundation that was controlled by its creator’s family and operated to enable the creator and his family to engage in financial activities beneficial to them but detrimental to the foundation. This organization was operated for a substantial nonexempt purpose and served the private interests of the creator and his family. The foundation, therefore, was not entitled to exemption under Section 501(c)(3).[xxxii]
Chief Counsel then described several instances in which an organization was not entitled to tax exemption under Section 501(c)(3) because the organization had issued loans to its founder and his family, or had based its investments upon the needs of private interests, or had acted as “an incorporated pocketbook” into which the founder could transfer excess personal funds and claim tax deductions while still retaining control of the funds and using them for nonexempt purposes.
In each of the foregoing scenarios, the organization was not operated exclusively for the public benefit; instead, it served as a private source of credit for its founder and its activities resulted in the inurement of its net earnings to private individuals.
What About Foundation?
Turning to the matter of Foundation, Chief Counsel reviewed the many unsecured loans Foundation made to Corp and LLC, two companies founded, partially owned, and operated by a Foundation officer and board member – Husband.
Husband’s Control
Through his control of Foundation’s investment decisions, Chief Counsel, stated, Husband was able to direct significant amounts of capital from Foundation to his two businesses. Thus, Corp received significant loans from Foundation during its early years of existence, and LLC received regular cash infusions for almost every year of its existence.
Incorporated Pocketbook
By the end of Year 12, Foundation’s loans to Corp and LLC comprised substantially all of its assets. Therefore, it appeared that Foundation was operated by Husband as an “incorporated pocketbook” into which he could transfer assets while still retaining control over those assets and directing them toward his private business interests when he deemed necessary or advantageous.
Convenience and Cost Savings
Chief Counsel then noted that the benefits to Corp, LLC, and Husband went beyond the dollar amounts received from Foundation. By obtaining loans from Foundation rather than from a commercial lender, Corp and LLC avoided the delays, inconveniences, and formalities – not to mention the costs – of applying for commercial loans.
“Lax” Enforcement
In addition, due to Husband ‘s position on both sides of the loan transactions, it was unlikely that Foundation would take steps to enforce the loan terms if either Corp or LLC failed to honor the terms of the loan agreements. Indeed, Foundation did not seek to enforce the terms of the loan agreements when LLC failed to make interest payments. In fact, despite LLC’s failure to consistently pay interest on its existing loans, Foundation continued to make additional loans to LLC.
No Collateral
Finally, Chief Counsel observed that the Corp and LLC loans were unsecured; by leaving the business assets unencumbered, Foundation provided a further benefit to Husband and his business interests.
Unreasonable Investments
Although Husband stated that the loans to Corp and LLC were reasonable investment decisions, Husband’s significant involvement in both business entities as a founder, officer, and partial owner called into question whether the loans were reasonable investments.
The lack of any contemporaneous records or board minutes reflecting review of the loans or discussion of alternative investments further undercut the assertion that the loans to Corp and LLC, repeated loan extensions, and subsequent modifications of the loans were made in the best interests of Foundation or reflected reasonable investment decisions.
Private Interests
Under these circumstances, Chief Counsel stated, it was reasonable to conclude that Foundation’s decisions to make those loans to Corp and LLC were motivated more by the private entities’ need for funds rather than for any return on investment realized by Foundation.
When a foundation is used as a vehicle for activities advantageous to its creator and his family, and as a source of funds to finance those activities, Chief Counsel continued, that foundation is not operated exclusively for the public benefit; rather, it is operated for a substantial nonexempt purpose: serving the private financial interests of its creator. Chief Counsel stated that such an organization served private interests and did not qualify for exemption under Section 501(c)(3) of the Code.
In this case, Foundation’s board was fully controlled by the Managers, and they used this control to direct Foundation assets toward business entities in which they held interests, thereby serving the private interests of the Managers, Corp, and LLC more than insubstantially.
Taking the facts of the case as a whole, Foundation’s loans to Corp and LLC served the private interests of Foundation Managers by providing a private source of credit for their business interests. The loans, therefore, caused Foundation to be operated for a substantial nonexempt purpose and the revocation of Foundation’s tax-exempt status was appropriate.
More Than Insubstantial
Foundation asserted that the revocation of its tax-exempt status would be inappropriate because it had carried out a charitable program commensurate in scope with its resources and had made significant grants to charitable organizations during its existence.
In response, Chief Counsel pointed out that, in order for an organization to be described in Section 501(c)(3) of the Code, no more than an insubstantial part of its activities may be in furtherance of a nonexempt purpose.
Foundation’s making of unsecured balloon loans, collectively constituting substantially all of the Foundation’s assets, to business entities founded, partially owned, and operated by a foundation manager, and the repeated extension of those loans, served the private interests of the foundation manager and the associated business entities, resulting in Foundation operating more than insubstantially in furtherance of a nonexempt purpose.
Chief Counsel added that the presence of even a single nonexempt purpose, if substantial in nature, would preclude exemption under Section 501(c)(3) regardless of the number or importance of “truly exempt” activities conducted by the organization.
Therefore, revocation of Foundation’s tax-exempt status was appropriate regardless of Foundation’s other activities.
Observations
Chief Counsel was right to revoke Foundation’s tax exemption from federal income taxes – I’d be shocked if anyone thought otherwise based on these facts.
The unanswered question is why did Foundation’s Managers engage in such blatantly inappropriate conduct?
It certainly was not out of ignorance – as indicated above, Husband was concerned about the LLC’s being treated as a disqualified person for purposes of the excise tax rules applicable to private foundations, about triggering the self-dealing rules, and about correcting the offending act. After all, the Code states clearly that any lending of money or other extension of credit between a private foundation and a disqualified person is an act of self-dealing,[xxxiii]
Perhaps the businesses were unable to obtain capital elsewhere, at least not on terms that were acceptable to Husband and the businesses. We sometimes encounter closely held businesses that have diverted, toward the payment of business expenses and other expenditures, the taxes the businesses were required to collect and should have instead remitted to the government. Unfortunately for these businesses and their owners, the government is not in the business of making loans to struggling ventures.[xxxiv]
However, it may also have been the case that the Managers intended all along to abuse their private foundation by using it, in Chief Counsel’s words, as an incorporated pocketbook. They contributed shares of stock to Foundation. Assuming these were appreciated, they avoided recognition of the gain inherent in such shares, but were still able to claim a charitable contribution deduction in an amount equal to their fair market value. Foundation likely sold the shares without incurring any income tax liability. It then held the sale proceeds, and any tax-free investment return thereon, at the ready to fund Husband’s businesses.[xxxv]
Regardless of the Managers’ circumstances, or the condition of their businesses, I hope that somewhere along the way, some professionals read them the riot act.[xxxvi] It is unfortunate that others seem to have facilitated their misconduct.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Many owners and their businesses have been going a different route. For example, some are utilizing a Delaware Public Benefit LLC, which is a for profit entity “that is intended to produce a public benefit or public benefits and to operate in a responsible and sustainable manner.” See Chap. 18 of the LLCA – that’s a subject for another day.
Others are foregoing the formalities and the oftentimes complex rules of private foundations and, instead, are engaging in more direct and strategic philanthropic activities.
[ii] Usually marketable securities. The gain inherent in such securities is not recognized at the time of the contribution but the contributor is entitled to claim a FMV tax deduction. IRC Sec. 170.
[iii] IRC Sec. 509.
[iv] In some cases, the foundation may, itself, be directly and actively engaged in conducting a charitable activity. Such a foundation may qualify to be treated as an “operating foundation.” IRC Sec. 4942(j)(3).
[v] IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3).
[vi] Not all private benefit is prohibited. The classic example is reasonable compensation for services actually rendered to the foundation.
[vii] PLR 202504014 (January 24, 2025).
[viii] Under IRC Sec. 508, an organization will not be treated as one described in IRC Sec. 501(c)(3) unless it applies to the IRS for recognition of such status.
[ix] Presumably, publicly traded.
[x] Described in IRC Sec. 501(c)(3) and Sec. 509(a).
[xi] IRC Sec. 4946(b)(1) provides that the term “foundation manager” means, with respect to any private foundation, an officer, director, or trustee of the foundation (or an individual having similar powers or responsibilities). Therefore, the Managers were “foundation managers.”
[xii] Much of the information in the ruling was redacted, though enough may be gleaned from the context to surmise most of the relevant facts. Where this was done, the information has been bracketed.
[xiii] Including any “indirect” acts of self-dealing between LLC and Foundation.
[xiv] See Rev. Proc. 2002-69, 2002-2 C.B. 831, which provides that if a husband and wife as community property owners treat a limited liability company as a disregarded entity (or, alternatively, as a partnership) for federal tax purposes, the IRS will accept that position for federal tax purposes. If the LLC is treated as a partnership, appropriate partnership returns must be filed. A change in reporting position will be treated for federal tax purposes as a conversion of the entity. LLC filed partnership returns for Year 15 and Year 16; however, it did not appear that an IRS Form 8832, Entity Classification Election, was filed to change LLC’s entity classification to that of a partnership, and the ruling did not mention the admission of another member. See Reg. Sec. 301.7701-3(c)(1)(i).
[xv] Query whether Corp needed the funds at that point in its existence to fund the expansion of its business.
[xvi] As reported on its Form 990-PF, Return of Private Foundation.
[xvii] IRC Sec. 4946.
[xviii] I guess he did not expect them to be repaid. Query what public charity would have accepted the notes.
[xix] In an arm’s length setting, one would have expected the interest rate to be increased to compensate the lender for the additional period during which the lender would remain at risk. One might also have expected a payment of some principal in exchange for the extension.
[xx] Under IRC Sec. 4941(d)(1)(B). In addition to self-dealing (of both the direct and indirect variety), the IRS identified violations of the prohibition on jeopardy investments. IRC Sec. 4944. The agency also determined that the proposed method of correction was unacceptable.
[xxi] IRC Sec. 4941(e)(3). The terms “correction” and “correct” mean, with respect to any act of self-dealing, undoing the transaction to the extent possible, but in any case placing the private foundation in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.
[xxii] Taxpayers under examination may request that the IRS examiner refer an issue to Chief Counsel for technical advice. IRM 4.46.5.4.2.1 (12-13-2018). I suspect that the threatened revocation of Foundation’s exemption was the reason the Office of Chief Counsel was contacted.
[xxiii] IRC Sec. 4941(d)(1)(E).
[xxiv] Under IRC Sec. 501(a).
[xxv] Reg. Sec. 1.501(c)(3)-1(c)(1).
[xxvi] Reg. Sec. 1.501(c)(3)-1(c)(1).
[xxvii] Reg. Sec. 1.501(c)(3)-1(c)(1).
[xxviii] Reg. Sec. 1.501(c)(3)-1(c)(1).
[xxix] Reg. Sec. 1.501(c)(3)-1(d)(1)(ii).
[xxx] Reg. Sec. 1.501(c)(3)-1(d)(1)(ii). An organization claiming IRC Sec. 501(c)(3) status bears the burden of proof.
[xxxi] Reg. Sec. 1.501(c)(3)-1(c)(2).
[xxxii] Citing Rev. Rul. 67-5.
[xxxiii] The only exception is the lending of money by a disqualified person to a private foundation if the loan is without interest or other charge, and if the proceeds of the loan are used exclusively for purposes specified in IRC Sec. 501(c)(3). IRC Sec. 4941(d)(2)(B).
[xxxiv] It would be better for all concerned if a business in such circumstances just shuts its doors.
[xxxv] Conjecture or not, just writing this paragraph got my dander up.
[xxxvi] For those who practice in New York, Sec. 716 of the N-PCL reads as follows:
No loans, other than through the purchase of bonds, debentures, or similar obligations of the type customarily sold in public offerings, or through ordinary deposit of funds in a bank, shall be made by a corporation to its directors, officers or key persons, or to any other corporation, firm, association or other entity in which one or more of its directors, officers or key persons are directors, officers or key persons or hold a substantial financial interest, except a loan by one charitable corporation to another charitable corporation. A loan made in violation of this section shall be a violation of the duty to the corporation of the directors or officers authorizing it or participating in it, but the obligation of the borrower with respect to the loan shall not be affected thereby.