by Kevin R. Laskowski

Imagine a family foundation board after a long, and perhaps trying, grant proposal process.  The family has read, discussed, argued, and finally agreed on a number of grant proposals from local nonprofits.  Some will receive grants.  Others will not.  Still others will be asked to apply next year.  All that is left now is to actually make the grants.  But after a few words from legal counsel, the entire process is thrown into confusion.

According to several regional association staff members, this was the scene last summer at some family foundations and funds across the country after the passage of the Pension Protection Act.  One provision, for instance, requires private foundations to exercise expenditure responsibility when making grants to Type III supporting organizations that are not "functionally integrated."  Giving families simply didn't know whether or not some of their Type III supporting organization grantees fit that description.  Complicating matters was the fact that, as one regional association staff member noted, "the nonprofits didn't always know themselves."  Even now, the Council on Foundations reports, many organizations are struggling to comply with this requirement, because it remains unclear which organizations meet that description and which do not and why.  Although most family foundations and virtually all community foundations routinely require an IRS letter certifying tax-exempt status before making any grants to the organization, the issue of functional integration has proved puzzling.

Overnight, the Pension Protection Act changed the contours of charitable giving for many of today's family philanthropists.  Passed last August, the Act took many by surprise, introducing a host of reforms--including new charitable incentives, numerous changes to donor-advised funds and supporting organizations, and increases in penalties for certain offenses--in a bill otherwise concerned with pension reform.

Last October, Family Giving News reviewed the Act's major provisions.  This month, a new year, a new Congress, and a tax return later, Family Giving News revisits the Pension Protection Act and investigates its effects on giving families.  After interviewing donor families and staff members of family foundations, community foundations, and regional associations, Family Giving News has found that, since the Act's passage, families are looking to take full advantage of a new giving opportunity, the IRA charitable rollover, while taking care to avoid some crucial pitfalls and the increased penalties that come with them.

A New Opportunity

Donors and charities alike cheered the Pension Protection Act's IRA charitable rollover provision.  This provision permits individuals age 70˝ and older to make charitable donations of up to $100,000 from Individual Retirement Accounts (IRAs) and Roth IRAs without having to count the distributions as taxable income.  As of May 7, 2007, the National Committee on Planned Giving has tracked more than 3,719 individual distributions, with a total value of more than $67 million.

The rollover is not without its limitations though.  As Independent Sector outlines:

Finally, only contributions made between January 1, 2006 and the end of this year are eligible for the benefit, but legislation has been introduced that would expand and extend the charitable rollover.  The hope is that, by making the rollover permanent, with a lower age limit, and no cap on the distributed amount, more donors and charities will be able to access the benefit of these rollovers.  As one community foundation reported, the biggest beneficiaries of the rollovers to date have been universities, hospitals, and other well-positioned organizations with the resources to educate donors about this option and encourage them to take advantage of it.  The hope is that with more time and more options, more donors will take advantage of it and more donors and charities will benefit from this additional tool in the philanthropic toolbox.

More information on the IRA charitable rollover, including resources for both donors and charities, is available on Independent Sector's website.

A "Minefield"

Despite the opportunity afforded by the IRA charitable rollover, many family foundations and funds are struggling to comply with the Act's requirements.  In the words of one community foundation staff person, "It's just a minefield."

For example, tucked away in the Act is a provision that concerns charitable use assets.  Like many foundations and groups around the country, a family foundation in the Southwest generously operates a rent-free campus for other nonprofit organizations.  The President remarks, "If we were to dispose of any part of this real estate project, it would be subject to excise tax. Though like exchanges are available, this part of the legislation directly impacts our family foundation."  It would be easy for a family fund to inadvertently run afoul of the Act, tucked away as these provisions are in a 907-page bill "to provide economic security to all Americans."

No provisions, however, have proved more tricky than those concerning Type III supporting organizations that are not "functionally integrated."  According to the Internal Revenue Service, a supporting organization is "functionally integrated" if its activities on behalf of its supported organization are activities that carry out the purpose of the supported organization, activities that but for the work of the supporting organization, the supported organization would have to do itself.  For instance, a university press operating as a Type III supporting organization might be considered functionally integrated because it publishes books that the university (the supported organization) would have to publish some other way if it were not for the activities of the press (the supporting organization).  In essence, the Act states that private foundations must exercise expenditure responsibility when making a grant to a Type III supporting organization that is not functionally integrated.  Additionally, that grant cannot count toward the foundation's minimum payout.  Donors have discovered two problems with this provision:  first, it can be difficult to determine which nonprofits meet this description and why; and, second, the penalties for making such a mistake can be very costly. 

Suppose that a family foundation approves a grant for a Type III supporting organization that is not functionally integrated, and, because these distributions cannot count toward the foundation's minimum payout, the foundation fails to make the required distribution.  The Pension Protection Act increased the initial penalty excise tax for failure to distribute the minimum amount to 30% of the undistributed amount.  

John Edie, Director of PricewaterhouseCoopers' Exempt Organizations Tax Services and author of Family Foundations and the Law, warns, "The largest pitfall here is that [a foundation] could inadvertently make a grant to a Type III supporting organization that is not functionally integrated and get whacked three ways:  a 30% penalty for not exercising expenditure responsibility, a penalty for failing to meet its 5% payout requirement, and a doubling of its excise tax on investment income from 1% to 2% if the ineligible grant causes it to fail the test for paying only 1%."

Edie recalls, "The Senate Finance Committee had teed up for examination disallowing trustee fees, limiting administrative costs, limiting the amounts that could count toward the payout for travel reimbursement, paying family members as staff.  None of those showed up in the Act."  One interpretation of this situation, he says, is "that the more they looked at those issues, the more difficult they became to legislate, so...instead of changing the rules in some cases, they doubled the penalties."  Grantmakers are, thus, in a tough position:  it can be very easy to make a very costly mistake. 

An Uncertain Future

Edie maintains that it's "very hard to predict" where Congress will head from here, but, in the opinion of many, the Pension Protection Act is a sign of things to come.  The Act itself required a study of donor-advised funds and supporting organizations be done and presented to the House Ways and Means and Senate Finance Committees within a year of the Act's passage, guaranteeing a revisiting of the issues.  The philanthropic sector can expect the conversation around donor-advised funds and supporting organizations to heat up again in August as the findings are presented. 

(The public comment period for that study wrapped up in April.  You can read comments from organizations like the Council on Foundations, National Committee for Responsive Philanthropy, United Jewish Communities, and New York State Bar Association at their respective websites.) 

Many expect a technical corrections bill to clear up the vagaries and unintended consequences of the Pension Protection Act, even as Congress revisits some of the larger issues it avoided in the Act.  The Forms 990 are to be redrafted.  The House Ways and Means Committee has announced its intention to hold new hearings on nonprofit organizations.  Committee Chair Charlie Rangel wants nonprofits, foundations and charities alike, to justify their tax-exempt status, which may lead to the conversations Congress avoided in the Pension Protection Act, for example, issues surrounding payout and executive and trustee compensation.

Giving families should be encouraged to get engaged and stay engaged in these policy discussions.  As Edie warns, “family funds are not the center of attention at the moment…but all you need is one other major scandalous story about private foundations, and they’ll be back on the front burner again.”  Stay in touch with trusted legal counsel, with local community foundations and regional associations, and with the national donor networks of which you may be a member to learn more about current and pending policy decisions that may affect you or your colleague organizations.  Even with the most conscientious due diligence, these things can and do change overnight.

 

Please note that the information presented in this edition of Family Giving News is subject to change, and is not a substitute for expert legal, tax, or other professional advice.  This information may not be relied upon for the purposes of avoiding penalties that may be imposed under the Internal Revenue Service.  For more on the Pension Protection Act and its provisions, consult summaries from the National Center's Family Giving News, as well as resources from the National Committee on Planned Giving, Council on Foundations, and Independent Sector. 

Family Giving News is published monthly by the
 national center for family philanthropy
1818 N Street NW,  Suite 300, Washington, DC 20036
http://www.ncfp.org
please be advised that the content of family giving news is for informational purposes only, and is not intended to constitute legal advice.