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Mark Powell is a partner in the Irvine, California, firm of Albrecht & Barney.
Sometimes the best advice you can give a client is to get out--out of a bad marriage, out of a bad business deal, out of any bad situation that is not going to get better. When it comes to private foundations, a client may want out for many reasons. The foundation's purposes may have been achieved. The board of directors may have splintered, and the organization may be paralyzed by the resulting in-fighting. The founders may have lost interest or, more commonly, may have grown weary of administering such a complex organization.
For a client, the decision to get out of a private foundation often gets made in the back of the client's mind, then drifts up in plumes of doubts about the organization's efficacy, then eventually coalesces into a desire to do something different. This is probably much like the decision to get out of other kinds of ventures. For an advisor, though, getting a client out of a private foundation can seem like a daunting task, because it requires coordinating state and federal laws and regulations. With this article in hand, an advisor should be ready to start the conversation with a client who wants out of a private foundation--although the clever advisor will tell the client straightaway that getting out of a private foundation will require the services of an accountant (to handle the tax returns), an attorney (or maybe two--to handle the corporate filings and possibly the creation of a new tax-exempt organization if reorganization turns out to be a better answer), and a financial advisor (to coordinate the transfer of assets from the foundation to the recipient charities).
Start by Understanding the Termination Tax
When an organization's status as a private foundation terminates, it faces the termination tax imposed by Code § 507(c). In creating this tax, Congress reasoned that private foundations receive assets through donations based on their tax-exempt status, which is derived from their promise to use the assets for charitable purposes. If they later terminate their private foundation status, the assets must remain subject to the charitable promises; otherwise, the situation amounts to an abuse of the tax laws. Code § 507 avoids this "abuse" by imposing a tax on a private foundation when it terminates. The tax is equal to the lesser of the total amount of tax benefits that resulted from the favored status or the net assets of the organization. The tax benefits over the course of a foundation's existence usually outweigh the ending assets of a dying foundation, so the tax is generally considered to be a tax of the organization's net assets. An onerous tax, indeed.
Read the first sentence of the last paragraph again carefully. "When an organization's status as a private foundation terminates, it faces the termination tax imposed by Code § 507(c)." Note that the triggering event is termination of private foundation status.
What does that really mean?
"Termination" is a term of art. It has nothing to do with the organization's legal existence. After termination under Code § 507, the organization may continue to exist under state law. To be rid of the underlying corporation, for example, the founder will need to dissolve it through the appropriate secretary of state. For Code § 507, "termination" only means that something has changed in the organization's life so the IRS will no longer classify the organization as a private foundation. It is this re-classification by the IRS that triggers the termination tax. If the change in the organization's life is handled so the assets remain subject to the charitable promises under which they were contributed, the tax may never be imposed or it may be abated under Code § 507(g).
Distributing the Foundation's Assets to Public Charities Is a Clean But Not Always the Best Choice
Once the foundation's managers have determined that something has to change, they have a fundamental choice to make--should they call it quits or should they reorganize the foundation?
Calling it quits is the easiest way to terminate private foundation status. It avoids the termination tax and requires the fewest number of filings with the IRS, which recently confirmed the various aspects of this type of termination in Rev. Rul. 2003-13. In that ruling, the IRS also tried to alleviate some concerns that had been lingering under earlier pronouncements about the process.
"Calling it quits" means transferring all of the foundation's assets to a broad group of public charities, as long as the recipient or its predecessor has been in existence for more than 60 months. Code § 507(b)(1)(A). Termination is automatic if the foundation's assets are disposed of this way; no separate notice of intent to terminate is required. Id. No prior approval of the distribution plan is necessary; the foundation would explain the change in its circumstances and outline the distributions in its final U.S. Treasury Form 990-PF, Return of Private Foundation. See Section T of IRS instructions to Form 990-PF. Most important, a termination under Code § 507(b)(1) does not trigger the termination tax. Code § 507(c).
Of course, the board must remember that the IRS is concerned with making sure that all of the assets contributed for charitable purposes are available for tax-exempt purposes. Consequently, any restriction or condition that prevents a recipient organization from freely employing the assets for its own tax-exempt purposes may shoot the arrangement out of the water. Treas. Reg. § 1.507-2(a)(7). For example, it is okay to ask the recipient organization to identify the donor from whom the assets were received, but it is unacceptable to give the donor control, directly or indirectly, over the timing of the recipient organization's use of income from the assets.
Reorganizing the Foundation Is Also an Option
In some circumstances, a foundation's managers would be happy to pursue the organization's charitable purposes if only--if only the organization were organized under another state's laws, if only the organization were combined with another organization whose purpose is substantially similar, if only the organization were operating in corporate form and not under a trust agreement, if only that noisy splinter group on the board were out of the picture, and so on.
Just as mergers and spin-offs are vital in the for-profit sector, the same concepts can be useful in managing tax-exempt organizations. The risk is that these changes may result in the termination of private foundation status and the imposition of the termination tax. Luckily, the Internal Revenue Code allows for reorganization, and the IRS has recently given guidance on how this can be accomplished.
From a statutory point of view, reorganization does not automatically mean that a termination will occur. When one private foundation transfers its assets to another private foundation "pursuant to any liquidation, merger, redemption, recapitalization, or other adjustment, organization or reorganization, the [recipient] foundation shall not be treated as a newly created foundation." Code § 507(b)(2). Because of this provision, reorganization does not automatically result in termination of private foundation status under Code § 507(a)(1). See Treas. Reg. §§ 1.507-1(b)(6) and 1.507-3(d). In effect, the tax attributes and characteristics of the transferred assets carry over to the transferee organization. Treas. Reg. § 1.507-3(a)(1).
In 2002, the IRS issued Rev. Rul. 2002-28, giving guidance on the process a private non-operating foundation should follow in making a significant disposition of its assets to another effectively controlled foundation. Before looking at that process, the scope of the ruling must be determined.
First, the ruling only addresses situations that involve a "significant disposition of assets," which includes any disposition (or series of related dispositions) of 25% or more of the fair market value of the net assets of the transferor foundation. Treas. Reg. § 1.507-3(c)(2).
Second, the ruling repeatedly refers to transferee private foundations that are "effectively controlled" by transferor private foundations, and "effectively controlled" is simply defined as being "within the meaning of the regulations of § 507." Those regulations refer to other regulations, and the implication is that control exists when at least 50% of the transferor foundation managers are either (1) managers of the transferee foundation or (2) selected by the managers of the transferor foundation.
Finally, the ruling deals only with private grant-making foundations, not private operating foundations. Private operating foundations are much less common than grant-making foundations, so it is not surprising that the IRS would address the situations most likely to occur. Still, advisors should make note of this limitation.
With these limitations in mind, the IRS ruling answers several important questions that had been left lingering from earlier rulings.
Code § 507(a)(1) mentions notifying the IRS of intent regarding a private foundation's status, and confusion had developed about whether a private foundation needed to give advance notice of its intent to reorganize under Code § 507(b)(2). As a result, many foundations had sought private letter rulings to confirm that they would not owe a termination tax as a result of reorganization. Rev. Rul. 2002-28 clarified this issue. The IRS held that it is primarily a decision for the foundation, but the implications make it an easy decision. If a private foundation decides to give notice of its intent to reorganize, then the notice will cause termination of the organization's private foundation status and the termination tax will apply on the date it gives notice. Consequently, the organization should transfer all of its assets and give notice after the transfer so the termination tax will be zero. If, on the other hand, the foundation decides not to give notice, then the transfer does not cause termination of the organization's private foundation status so the termination tax does not apply.
The ruling also answered questions about a private foundation's reporting obligations after reorganization. For the year of disposition, the transferor private foundation must file a Form 990-PF explaining the liquidation, dissolution, or termination. Code § 6034; see also General Instruction T for Form 990-PF. If the foundation ceases to exist under state law, that Form 990-PF should be a "final" return. If the foundation remains in existence under state law but is dormant, the foundation does not need to file a Form 990-PF for any year in which it does not hold equitable title to any assets and is without any other activity to report. If it later receives assets or otherwise becomes active, it must resume filing Form 990-PF.
Steps in Reorganizing
The IRS having clarified the question of advance notice of intent to reorganize, thereby removing the biggest doubt many foundation managers faced (whether a termination tax would be imposed as a result of the reorganization), the steps in reorganizing are relatively simple.
1. Develop a Plan
Reorganization usually means that one organization will cease to exist and its assets will be transferred to one or more other organizations. A prerequisite for getting tax-exempt status is including a provision in an organization's governing instruments providing that, on dissolution, the organization's assets will be distributed to another tax-exempt organization. Consequently, the reorganization plan must satisfy this provision. The new tax-exempt organization must be established or due diligence regarding the transferee organization must be completed.
2. Submit the Plan to the Appropriate State Authorities for Review
In most states, the transferor foundation must notify the appropriate state authority (typically the Attorney General's office) of the planned reorganization. This is often more of a notification process than an approval process, so the transfer can happen in a relatively short time once the plan is finalized. Because this aspect of the process depends entirely on state law, it is important for the foundation's managers to consult with local counsel.
3. Transfer the Assets
With the plan approved by both the transferor and the transferee foundations and notice given to the appropriate state authority, the assets can be transferred as soon as the foundation managers have been given clearance by their local counsel.
4. Decide Whether the Transferor Foundation Needs to Continue to Exist
As discussed above, a private foundation's status with the IRS is completely separate from its existence under state law. If there is no need for the transferor foundation to continue to exist under state law, it can be dissolved or terminated after its assets have been transferred.
5. Plan for Final Year Reporting Obligations
The transferor private foundation will need to file a Form 990-PF for the year the transfer of assets takes place, as discussed above. The organization will also need to comply with any similar state tax agency reporting requirements. Whether that year's Form 990-PF will be the "final" 990-PF depends on whether the organization is actually dissolved under state law.
Other obligations may exist. For example, if any expenditure responsibility requirements were in place at the time of the transfer of assets, the transferee foundation must make plans to satisfy those requirements in place of the transferor foundation. Similarly, if the transferor foundation was under an existing obligation to rid itself of excess business holdings or address any other excise tax issues, the transferee foundation must make certain to deal with those issues.
6. Follow Up with the Appropriate State Agencies
Once the transferor organization has filed a Form 990-PF showing zero assets on hand, it will probably need to file a copy of that return with the appropriate state agency. Again, this varies by state, and local counsel should be consulted to ensure that any other final reporting obligations are met.
It is well worth remembering that most clients establish their private foundations with considerable thought. If a client has asked you to terminate his foundation, ask why. Foundations are among the most complicated organizations to run effectively--and, by effectively, I mean in compliance with applicable state and federal rules as well as in a manner that satisfies the psychological reasons that led the client to establish the organization. In some circumstances, it may become obvious that trying to sustain a foundation will be detrimental. A client, for example, whose health is failing and whose family has repeatedly failed to show interest in the organization does not need the extra burden of running a tax-exempt organization. But in other circumstances, you may find that reorganizing a foundation not only solves a family problem but reinvigorates the spirit behind the original organization. Indeed, a splintered board threatening to bring down a single organization as a result of in-fighting may turn into several very effective separate organizations.Return To Issue Index