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&p h i l a n t h r o p y p u b l i c t r u s t

FREQUENTLYASKED LEGALQUESTIONS

WHATEVERY

GRANTMAKERSHOULDKNOW

a community of grantmakers

2009UPDATE

What EveryGrantmaker Should Know

Frequently Asked Legal Questions

SPONSORS

The Council thanks threegrantmakers for financialsupport of the Philanthropy& Public Trust initiative forthe production and printingof this publication and itscompanion piece, Principlesfor Grantmakers & PracticeOptions for PhilanthropicOrganizations.

David BiemesderferConsultant, DJB Consulting (former MCF staff memberwho wrote the original seriesin MCF Notes newsletter)

J. Hazen GravesPartner, Health Care andNonprofit OrganizationsGroupFaegre & Benson LLP

SPONSOR ($6,000)

Northwest Area Foundationidentifies, shares andadvocates “what’s working”to reduce poverty for thelong term, partnering withselect communities inMinnesota, Iowa, NorthDakota, South Dakota,Montana, Idaho,Washington and Oregon.

Gina KastelPartner, Health Care andNonprofit OrganizationsGroupFaegre & Benson LLP

Mary E. ProbstShareholderLeonard, Street and DeinardP.A.

PARTNER ($2,500)

SUPPORTER ($1,000)

West Central InitiativeFoundation

PLEASE NOTE:None of the material in thispublication should beconstrued as offering legaladvice. Seeking legalcounsel is recommendedbefore acting on any matterdescribed in this publication.

Claire Harkrider ToppPartner and Chair, Nonprofit& Tax Exempt OrganizationsPractice GroupDorsey & Whitney LLP

UNDERWRITER

The Council also thanks theForum of RegionalAssociations of Grantmakersfor underwriting thedistribution of thispublication and Principlesfor Grantmakers & PracticeOptions for PhilanthropicOrganizations to all 1,300grantmakers in the state ofMinnesota.

GRANT ($5,000)

Acknowledgments

KEY CONTRIBUTORS


WHATEVERY


FREQUENTLYASKEDLEGALQUESTIONS

ForewordLetter to Colleagues and Friends . . . . . . . . iii Principles for Grantmakers . . . . . . . . . . . . iv

What Every Grantmaker Should Know

Board Fiduciary Duties . . . . . . . . . . . . . . . 1 Conflicts of Interest . . . . . . . . . . . . . . . . . 12Private Foundation Self-Dealing . . . . . . . . . 4 Reporting and Disclosure . . . . . . . . . . . . 14Excess Benefit Transactions. . . . . . . . . . . . . 6 Investments . . . . . . . . . . . . . . . . . . . . . . 18Board Compensation. . . . . . . . . . . . . . . . 9 Grantmaking . . . . . . . . . . . . . . . . . . . . 23Staff Compensation . . . . . . . . . . . . . . . . 11 Public Policy Engagement . . . . . . . . . . . . 27

Frequently Asked Legal Questions

Lobbying . . . . . . . . . . . . . . . . . . . . . . . 31 Private Foundations vs. Public Charities . . . 44Endowment Funds . . . . . . . . . . . . . . . . . 33 5% Payout Rule . . . . . . . . . . . . . . . . . . . 46Community Foundations . . . . . . . . . . . . . 35 Grantmaking . . . . . . . . . . . . . . . . . . . . 47Private Foundation Self-Dealing . . . . . . . . 37 Annual Reporting and Public Disclosure . . . 50Board Fiduciary Duties . . . . . . . . . . . . . . 41 Financial Audits . . . . . . . . . . . . . . . . . . 52Investments . . . . . . . . . . . . . . . . . . . . . . 43

Accountability Self-Assessment Tool for Private Foundations. . . . . . . . . . . . . . . . . . . . . . . . . . . 53

Philanthropy & Public Trust Series:What Every Grantmaker Should Know & Frequently Asked Legal Questions

© 2007, 2009 Minnesota Council on Foundations

ALL RIGHTS RESERVED

This publication is intended to raise the level of practice among foundations and, therefore, may be reproduced andtransmitted to those involved with this work in the field of philanthropy, providing there is full credit to the copyright owner.

Printed in the United States of America.

This publication and subsequent updates are available online at www.mcf.org/publictrust.

Table of Contents


As part of our continuing efforts to help foundations maintainand improve the effectiveness of their work, the MinnesotaCouncil on Foundations has prepared this comprehensiveresource to help private, corporate and community/publicfoundations understand their legal requirements andobligations. This publication and its companion piece,Principles for Grantmakers & Practice Options for PhilanthropicOrganizations, are key publications in MCF’s Philanthropy &Public Trust series.

Since its founding in 1969, the Council has offered numerousseminars and publications, drawing on the expertise ofmember law firms and other interested and informed members.MCF also has fielded frequent legal-related questions from itsfoundation members every year. This guidebook comprises twospecific Council efforts:

� Information around key foundation topics, which areimportant for every grantmaking organization to know,was developed in seven 2004-2005 issues of MCFNotes newsletter in its previous print format.

� Answers to the most common legal questions that theCouncil had received over the years were originallypresented online in 2003 as “Answers to Frequently Asked Questions on Foundation Law.”

The information in this combined publication has beenexpanded and updated, reflecting changes in law and specificprovisions of the Pension Protection Act of 2006. Thesedocuments will continue to be updated as legal requirementschange. Look for the most up-to-date versions on www.mcf.org/publictrust.

We have many individuals to thank. An MCF task forceoriginally laid out the scope of Legal FAQs project. A majorityof the work presented here derives from four of Minnesota’s topfoundation legal experts: Hazen Graves, Gina Kastel, MaryProbst and Claire Topp. We also laud the singular contributionof former MCF vice president David Biemesderfer in draftingthe original “What Every Grantmaker Should Know” series. Heis now a consultant working with grantmakers and grantmakerassociations around the country.

We would be remiss if we did not call attention to thegenerous contributions of three member foundations insupporting our Philanthropy & Public Trust work. NorthwestArea Foundation, among the Council’s charter members, hasbeen the major financial supporter of the public trust work,together with Cargill and Duluth Superior Area CommunityFoundation. Finally, the Forum of Regional Associations ofGrantmakers provided a grant that has allowed us to sendthese two publications to every grantmaker in the state ofMinnesota.

We commend this work to you and wish you well in all yourefforts to embrace public trust.

Sincerely,

William R. KingPresidentMinnesota Council on Foundations

iii

Foreword

DEAR COLLEAGUES AND FRIENDS:

Prior to a reprinting in December 2009, this publicationwas reviewed and updated to reflect changes in law sinceits first printing in 2007. As always, we encouragegrantmakers to seek legal counsel before acting on anymatter described in this publication.

Principles for Grantmakers

The desire to give is a defining humancharacteristic. As members of the MinnesotaCouncil on Foundations, we honor diversecharitable expressions across the wideeconomic, racial, ethnic and socialspectrum. We celebrate new and traditionalforms of giving that respond to humanneeds, build community, increase knowledgeand promote creative expression. Weacknowledge the fundamental roles andresponsibilities of engaged individuals andthe public, private and nonprofit sectors in ajust and equitable society.

PREAMBLE PRINCIPLES

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PREAMBLE PRINCIPLES

As a community of grantmakers, weembrace philanthropy’s role in a civil society.We are leading advocates for public policyto sustain robust philanthropy. We workstrategically through grantmaking and othermeans to improve the vitality and health ofour communities, to educate our membersand the field, and to achieve our collectivemission of strengthening and expandingphilanthropy. We express a sharedcommitment to excellence by formallysubscribing to the Principles for Grantmakers.

1. Ethics and Law PrincipleTo sustain public trust by adhering to the highest ethicalprinciples and practices and abiding by all state andfederal laws that govern philanthropy.

2. Effective Governance PrincipleTo achieve effective governance by ensuringperformance in the areas of stewardship of assets,donor intent, fiduciary responsibility and sound decision-making.

3. Mission and Goals PrincipleTo be purposeful in our philanthropy by having aclearly stated mission and explicit goals.

4. Engaged Learning PrincipleTo foster continuous learning and reflection byengaging board members, staff, grantees and donors inthoughtful dialogue and education.

5. Respectful Relationships PrincipleTo build constructive relationships with applicants,grantees and donors by ensuring mutual respect,candor, confidentiality and understanding.

6. Transparency PrincipleTo achieve transparency in our relationships with thepublic, applicants, grantees and donors by being clear,consistent and timely in our communications with them.

7. Diversity PrincipleTo reflect and engage the diversity of the communitieswe serve in our varying roles as grantmakers, boardsand employers, economic entities and civic participants.

8. Self-Assessment & Commitment PrincipleTo uphold the highest standards by regularly assessingourselves against these principles and committing toimplement them.

Adopted by the MCF Board of Directors in 2006;developed from the original 1996 version.

None of the material in this publication should be construedas offering legal advice, and seeking legal counsel isrecommended before acting on any matter discussed


WHATEVERY


Becoming a foundation board member, whether for acommunity, private or corporate foundation, brings with it legaland ethical duties and responsibilities. Foundation boardmembers and officers must fully understand their duties andalways uphold the public trust in their role as stewards of thefoundation. Here are things all grantmakers should know aboutboard fiduciary duties.

Basic Fiduciary Duties

Foundations can be organized as either trusts or corporations,and the fiduciary standards applicable to trusts andcorporations have developed somewhat separately under statelaw. Essentially, however, directors, trustees and officers of afoundation owe three fiduciary duties to the foundation:

� Duty of Care, which requires the individual todischarge duties in good faith, in a manner onereasonably believes to be in the best interests of theorganization, and with the care an ordinarily prudentperson in a like position would exercise under similarcircumstances. The individual must devote the time,attention and resources necessary to understand andprudently oversee the affairs of the foundation.

� Duty of Loyalty, which requires the individual, whenmaking a decision or acting on behalf of the foundation,to set aside personal or conflicting interests and act solelyin the best interest of the foundation.

� Duty of Obedience, which requires the individual toobey all laws pertaining to foundations and act infurtherance of the foundation’s charitable purposes.

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WHAT EVERY GRANTMAKER SHOULD KNOW:

Board Fiduciary Duties

Board members must always uphold the public

trust in their role as stewards of the foundation.

Meeting Fiduciary Duties

The following steps can be taken to help ensure compliancewith fiduciary duties.

DUTY OF CARE

Active Participation: Board members should activelyparticipate in the management of the organization, includingattending board meetings, evaluating reports, reading minutesand reviewing, if applicable, the executive director’sperformance and compensation.

Committees: The board should ensure committees operateunder the direction and control of the board. Board membersare responsible for committees and should regularly receivecommittee reports and scrutinize their work.

Board Actions: Directors should understand that for purposesof determining whether a director met the duty of care, a boardmember who is present at a meeting when an action isapproved is presumed to have agreed to the action unless (a)he or she objects to the meeting because it was not lawfullycalled or convened and does not participate in the meeting, (b)he or she votes against the action, or (c) he or she is prohibitedfrom voting on the action due to a conflict of interest.

Minutes of Meetings: Written minutes should be taken atevery board meeting. The minutes should accurately reflectboard discussions as well as actions taken at meetings.Minutes should be distributed to board members and formallyapproved at a subsequent board meeting.

Books and Records: Board members should have accessto, and general knowledge of, the organization’s books andrecords (articles, bylaws, accounting records, tax returns,voting agreements, minutes, etc.).

Accurate Recordkeeping: Board members should notonly be familiar with the content of the books and records, butalso should make sure that the organization’s records andaccounts are accurate. This may require independent auditsand/or the implementation of appropriate internal controls.

Trust Property: Board members should protect, preserve,invest and manage the foundation’s property, and do soconsistent with donor restrictions and legal requirements.

Investigations: Allegations of misconduct should beinvestigated and addressed.

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WHAT EVERY GRANTMAKER . . .

Board Fiduciary Duties (continued)

DUTY OF LOYALTY

Generally: Board members should avoid using theirpositions or the organization’s assets in a way that would resultin inappropriate financial gain for themselves or any memberof their family.

Conflicts of Interest: Board members should ensure thatconflicts of interest are appropriately addressed and theorganization’s conflicts of interest policy are followed (seeConflicts of Interest, page 12).

Loans: A director of a Minnesota nonprofit corporationshould not permit loans to directors and officers unless the loanmay reasonably be expected, in the judgment of the entireboard, to benefit the foundation.

DUTY OF OBEDIENCE

State and Federal Statutes: Board members should begenerally aware of state and federal statutes and laws relatingto nonprofit corporations or trusts, tax-exempt status, charitablesolicitations, sales and use taxes and employment matters andensure the organization follows them.

Filing Requirements: The board must ensure that theorganization complies with deadlines for tax and financialreporting, including filings with the Secretary of State, AttorneyGeneral and IRS.

Governing Documents: Board members should befamiliar with their foundation’s governing documents andshould follow the provisions of those documents.

Outside Help: When appropriate, board members shouldobtain opinions of legal counsel, accountants, appraisers orother professionals.

Board Member Liability

In general, only a corporation’s or trust’s own assets are at riskfor actions taken by or on behalf of the corporation or trust.Nevertheless, the act or failure to act by a board member orofficer of a foundation may sometimes result in personalliability. Actions or omissions that constitute a breach offiduciary duty or breach of a personal contractual obligation,or that cause physical injury or death, may cause personalliability. Actions or omissions that are considered reckless orcriminal may also give rise to personal liability. Individualdirectors and officers may also be held personally liable for afoundation’s failure to withhold and pay certain federal taxes.

Both federal law and Minnesota state law afford someprotection against personal liability to individuals serving asunpaid officers and directors of charitable organizations,including foundations. Under Minnesota law, such a persongenerally is not liable under civil law for acts taken in goodfaith, within the scope of the person’s responsibilities, andwhich do not constitute willful or reckless misconduct. Federallaw provides volunteers with somewhat duplicative immunityfrom both federal and state civil liability.

For More Information

See also Frequently Asked Legal Questions: Board FiduciaryDuties, pages 41-42. 3


Foundation abuses that reach public notice are often related toapparent violations of federal self-dealing laws by foundationofficials. Because self-dealing transactions involve individualswith influence over a foundation using charitable assets forpersonal gain, they can erode public trust in the field. Self-dealing transactions can also carry serious tax penalties.

Here are things all grantmakers should know about the self-dealing prohibition, which applies to private foundations (mostcorporate foundations, family foundations and independentfoundations). For a description of tax laws barring similartransactions involving community foundations and other publiccharities, see Excess Benefit Transactions, page 6.

Self-Dealing Defined

Self-dealing laws prohibit financial transactions between aprivate foundation and its “disqualified persons.” The definitionof a disqualified person includes the foundation’s officers,directors, trustees, key employees, substantial contributors, theirfamily members, corporations, partnerships, trusts or estates inwhich any of the foregoing has more than 35 percent of thevoting power, profits or beneficial interest, and any owner ofmore than 20 percent of a corporation, partnership or trust thatis a substantial contributor.

The definition of self-dealing is broad and includes thefollowing transactions involving foundations and theirdisqualified persons: (a) sales, exchanges or leases ofproperty; (b) loans; (c) the provision of goods, services orfacilities; and (d) transfers of foundation assets. In addition,most payments to government officials — regardless of theirrelationship to the foundation — are considered self-dealing.

Self-dealing laws prohibit these transactions even though theymay be fair to the foundation. It is therefore important forfoundation managers to know who the foundation’s disqualifiedpersons are and carefully evaluate every transaction betweenthe foundation and a disqualified person.

Self-Dealing Exceptions

There are exceptions to the definition of self-dealing, whichinclude the following:

Gifts to the Foundation: A disqualified person maytransfer or furnish goods, services or facilities to a privatefoundation without charge.

Reasonable Compensation: A private foundation maypay reasonable compensation to a disqualified person forproviding necessary professional services to the foundation.The compensation for such services must be reasonable inamount. For example, a foundation can pay an accountantwho serves on the foundation’s board of directors reasonablefees for accounting services provided to the foundation.

Meals and Lodging: A private foundation may providetransportation, meals and lodging (or reimbursement for suchexpenses) to a disqualified person to the extent the expenses arereasonable and necessary for the foundation to conduct business.


Private Foundation Self-Dealing

Self-dealing can carry serious tax penalties.

4

Comparable to Public Availability: A privatefoundation may furnish goods or facilities to a disqualifiedperson on terms that are no more favorable than those on whichit makes the goods or services available to the general public.For example, a disqualified person may enjoy a museumoperated by the foundation on the same terms as the public.

Incidental Benefits: Self-dealing does not include“incidental and tenuous benefits” derived by a disqualifiedperson from a private foundation’s use of its income or assets.For example, public recognition or goodwill afforded to thedisqualified person as a result of a foundation grant willnormally be considered an incidental or tenuous benefit.

Penalties for Self-Dealing Violations

The Internal Revenue Service may impose substantial excise(penalty) taxes on disqualified persons who engage in self-dealing transactions under a two-tier tax system. The first-tiertaxes are imposed on disqualified persons who engage in theself-dealing transaction with the private foundation. The amountof the first-tier tax on disqualified persons is 10 percent of theamount involved.

In addition, a foundation manager is subject to first-tier taxes ifhe or she participated in a self-dealing transaction knowing thatit was self-dealing, unless the participation was not willful andwas due to reasonable cause. The amount of the first-tier tax fora foundation manager is 5 percent of the amount involved.

If a self-dealing transaction is not undone or “corrected” within acertain period of time, the IRS may impose confiscatory second-tier taxes of 200 percent of the amount involved on thedisqualified person, and 50 percent of the amount involved on afoundation manager who refused part or all of the correction.

Self-Dealing Pitfalls to Avoid

Private foundations that violate the self-dealing rules often do sounknowingly. Here are some common self-dealing pitfalls to avoid:

Paying for Spouse Travel: Generally, travel expensesincurred by the spouse or family member of a foundationemployee or board member are not “reasonable andnecessary” expenses incurred in connection with thefoundation’s charitable activities. Thus, payment of such

expenses by the foundation will constitute self-dealing (and mayalso be a taxable expenditure), unless (a) the spouseindependently performs necessary services on behalf of thefoundation, or (b) the payment is treated as compensation forservices to the board member or employee, and the totalcompensation paid to that individual is reasonable.

Fulfilling Personal Charitable Pledges: A foundationcannot satisfy a legally binding personal charitable pledge ofa disqualified person. A pledge is treated like any other legalobligation of the disqualified person and therefore cannot bepaid by the foundation.

Buying Tickets to Fundraising Events: A privatefoundation cannot purchase tickets to a charitable fundraisingevent and then provide the tickets to disqualified persons or tothird parties if doing so benefits a disqualified person. There isan exception that permits foundation managers to use thetickets if attending the event furthers their duties for thefoundation. This issue arises most frequently with corporatefoundations, which may wish to make tickets available to thecorporation’s employees or customers. Such uses of the ticketsare barred by the self-dealing rules. Tickets for fundraisersshould be purchased by the corporation or the individualattendees.

Using Credit Cards: If a disqualified person uses afoundation credit card for personal expenses and laterreimburses the foundation for the expenses, this is considered aloan and a form of self-dealing, even if the person reimbursesthe full amount within a month of the transaction.

Paying Rent: If a foundation pays any type of rent to adisqualified person, even at below-market rates, this isconsidered self-dealing.

Related Matters

Even if a transaction is acceptable under the self-dealing rules,it may present a conflict of interest. See Conflicts of Interest,page 12.

See also Frequently Asked Legal Questions: Private FoundationSelf-Dealing, pages 37-40.

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The federal self-dealing rules apply only to private foundations;however, community foundations and other public charities aresubject to similar rules prohibiting excess benefit transactionswith disqualified persons. These rules are sometimes referred toas the “intermediate sanctions” law. Here are things allgrantmakers that are public charities should know about excessbenefit transactions.

Excess Benefit Transactions Defined

The excess benefit transactions rules provide for a penalty taxon “disqualified persons” who receive an “excess benefit” froma public charity. Generally, an excess benefit transaction is atransaction in which a public charity provides an economicbenefit to a disqualified person and receives less than thevalue of the benefit in return.

The definition of “disqualified persons” under the excess benefittransactions rules is different from the one used for privatefoundations under the self-dealing rules. In this context, adisqualified person is anyone who, during the five yearspreceding a transaction, was in a position to exercisesubstantial influence over the affairs of the organization. Theterm includes directors and high-level officers. With respect tocommunity foundations or other organizations that sponsordonor-advised funds, the term also includes investmentadvisors, their family members and entities for which theycontrol 35 percent of voting power, profits or beneficialinterest.

Excess benefit transactions may include unreasonablecompensation arrangements, leases, loans and sales betweenan exempt organization and a disqualified person. Excessbenefit transactions can also arise indirectly throughintermediary entities such as an exempt organization’s taxablesubsidiary.

The penalties for violations of the intermediate sanctions rulescan be greater than for violations of the self-dealing rules.Disqualified persons who receive excess benefits must pay atax equal to 25 percent of the amount of the excess benefit. Ifthe transaction is not corrected, an additional penalty of 200percent of the excess benefit is assessed.

Managers who knowingly approve an excess benefittransaction are also subject to an excise tax unless theirparticipation in the transaction was not “willful” and was dueto “reasonable cause.” Managers are subject to a tax equal to10 percent of the value of the excess benefit.

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Public charities are subject to rules prohibiting excess

benefit transactions withdisqualified persons.


Excess Benefit Transactions

Rebuttable Presumption Procedure

The intermediate sanctions rules include a procedure by whichthe charity may establish a “rebuttable presumption ofreasonableness” for a transaction involving a disqualifiedperson. A charity’s appropriate use of the procedure shifts theburden to the IRS to prove that the charity’s transactions with adisqualified person are not reasonable. Under the regulationsimplementing the intermediate sanction rules, three conditionsmust be satisfied to take advantage of the rebuttablepresumption rules:

Approval by Disinterested Governing Board: Thetransaction must be approved in advance (before anypayment) by the governing body or a committee of theorganization composed entirely of individuals who do not havea conflict of interest with respect to the arrangement.

Reliance on Comparable Data: The board must obtainand rely on appropriate comparability data prior to making itsdetermination. Relevant information for compensationarrangements includes, but is not limited to, currentcompensation surveys compiled by independent firms,compensation levels paid by similarly situated organizations forfunctionally comparable positions, and written offers fromsimilar institutions competing for the services of the personunder consideration. Most foundations rely heavily on salaryand compensation surveys to guide them in finding areasonable level of compensation. Commonly used surveysinclude the national Council on Foundations’ annualgrantmaker salary survey. It is common for foundations tocompare compensation levels with specific foundations ofsimilar size, operations and geographic location. It is notnecessary to look only at nonprofit data. Data fromcomparable for-profit organizations may also be used.

For sales or leases, independent appraisals may be used.

Concurrent Documentation: The board must documentthe basis for its determination concurrently with making thatdetermination (within 60 days of the decision or the date ofthe next meeting of the board, whichever is later). To qualify asconcurrent documentation, written or electronic records of theboard (such as meeting minutes) must note:

� The terms of the transaction and the date it was approved.

� The board members who were present during the debateand those who voted on it.

� The comparability data used and how the data wereobtained.

� Any actions taken with respect to consideration of thetransaction by anyone who is a board member but whohad a conflict of interest with respect to the transaction.

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Special Rules for Donor-Advised Funds andSupporting Organizations

With respect to a donor-advised fund, the definition of anexcess benefit transaction includes any grant, loan,compensation or similar payment from the donor-advised fundto the fund’s donors, persons appointed by the donor as fundadvisors, and entities in which such persons control 35 percentor more of the voting power, profits interest or beneficialinterest. The amount of the excess benefit equals the entirepayment, not only the amount that exceeds fair market value.

With respect to supporting organizations, excess benefittransactions include (a) any grant, loan, compensation orsimilar payment provided by the organization to a substantialcontributor, family member of a substantial contributor, or a 35percent controlled entity; and (b) any loan provided by theorganization to a disqualified person. The excess benefittransaction is equal to the entire payment or loan amount, notmerely any portion that exceeds fair market value.

Grantmakers should note that the rebuttable presumptionprocedure may not be used for transactions involvingsupporting organizations and donor-advised funds asdescribed in this section. The transaction will be treated as anexcess benefit even if it is fair and reasonable.

Related Matters

In addition to considering the tax implications, public charitiesshould keep in mind applicable conflicts of interest laws andtheir own internal policies and procedures regarding conflictsof interest when considering transactions involving adisqualified person (see Conflicts of Interest, page 12).


See “Determining Reasonable Compensation for FoundationDirectors and Trustees” and “Recommended Best Practices inDetermining Reasonable Executive Compensation” atwww.mcf.org/publictrust.

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Excess Benefit Transactions (continued)

The Facts

Three-quarters of grantmakers do not compensate boardmembers, according to a 2007 national Council onFoundations (COF) survey. Board compensation is mostcommon for independent foundations, of which 60 percentprovide compensation to some or all board members,compared to 28 percent of family foundations, 12 percent ofpublic foundations and just 1 percent of communityfoundations.

Board compensation is more common for larger organizations,especially for family and independent foundations. Ninety-twopercent of independent foundations with assets of $500 millionor more compensate some or all board members, compared to43 percent of those with assets under $5 million, according tothe COF survey. Half of family foundations with assets of$500 million or more provide some board compensation,compared to 16 percent of those with assets under $10million.

The Law

Federal self-dealing rules allow a private foundation to pay itsboard members reasonable compensation for their personalservice on the board. For community and other publicfoundations, there is a similar requirement for reasonablecompensation under the intermediate sanctions regulations.

Board compensation must not be excessive, and should beevaluated for reasonableness based on the functions orservices required and actually performed by board members;the level of skill and experience necessary for board membersto fulfill their duties; and the amount of time spent by boardmembers in fulfilling their duties. The payment of excessive orunreasonable compensation can result in IRS-imposed excisetaxes against a foundation’s participating board members.

Federal law requires that all board compensation be reportedon the IRS form 990 or 990-PF. Foundations should also notethat payment of compensation to board members may causethem to lose immunity from liability under Minnesota andfederal volunteer protection statutes.

What Is Reasonable?

Current law leaves open to interpretation what is consideredreasonable compensation for a foundation’s board members. Afoundation may want to use the rebuttable presumptionprocedure described in the excess benefit transaction ruleswhen setting board compensation. Although doing this will notgive a private foundation the benefit of a rebuttablepresumption, it will provide good evidence that the board tookappropriate steps to ensure the compensation is reasonable(see Excess Benefit Transactions, page 6).

9


Board Compensation

Board compensation cannot be excessive.


Procedures

Of those grantmakers that provide board compensation, 60percent compensate all their board members and 40 percentcompensate just some members, according to the COF survey.For grantmakers that compensate selected board members, themost common people to be compensated are the boardchair/president (23 percent), non-family members (20 percent)and staff members who are also board members (20 percent).

Most foundations that compensate their directors use somecombination of set fees, including per meeting or annual fees. COF advises against the practice of compensating boardmembers by providing a fee based on a percentage of assetsor income, utilized by a few foundations, because thatpractice provides much greater potential for excessivecompensation.

Reimbursement and Fees for Service

Aside from compensating board members for their service onthe board, some grantmakers pay board members forprofessional services they provide to the organization, such asaccounting, investment, legal and public relations. However,the COF survey shows that many grantmakers (59 percent)receive such services from board members on a pro bonobasis. If a foundation pays its board members for professionalservices, this is another situation in which it will be advisableto follow the rebuttable presumption procedures that areapplicable to community foundations and other public charities(see Excess Benefit Transactions, page 3).

Although most grantmakers do not compensate their boardmembers, a larger number have determined that it isappropriate to reimburse board members for certain expenses.According to the COF survey, more than half of grantmakers(53 percent) reimburse board members for expenses tied tofoundation business activities such as site visits, and 40percent reimburse for expenses incurred to attend boardmeetings.

Developing a Policy

Foundations that compensate and/or reimburse boardmembers should consider developing a compensation andreimbursement policy. Although having such a policy does notguarantee that the reasonable compensation requirement ismet, a policy will provide clear documentation of how theorganization handles such matters, and can help bring clarityto the issue for the board.

A compensation and reimbursement policy may include thefollowing components:

� A brief rationale for the policy.

� Position descriptions for board members and staff.

� A detailed explanation of how compensation will bedetermined.

� Details on which expenses will and will not be reimbursed,and limits on reimbursed expenses.

� Identification of the decision-makers for compensation matters.

Alternatives to Compensation

As an alternative to board compensation, some grantmakersuse one or more of the following options to honor andencourage their board members’ service:

Discretionary Grants: Foundations may permit boardmembers to make a small number of discretionary grants tononprofits of their choice, within stated guidelines, or provide asmall discretionary grants budget to each board member. One-fourth of all grantmakers (and nearly half of family foundations)allow discretionary grants for board members, according to aCOF survey.

Matching Grants: Some grantmakers make matchinggrants in recognition of a board member’s personal gift to anonprofit, up to a certain amount each year. Matching grantsare more common for larger organizations. A COF surveyshows that about half of grantmakers with assets of $500million or more provide board matching grants, compared to10 percent of organizations with assets under $5 million.

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Board Compensation (continued)

The Law

As described in the sections of this booklet on self-dealing andexcess benefit transactions, the Internal Revenue Code imposesexcise tax penalties when unreasonable or excessivecompensation is paid to high-level employees of charitableorganizations. Examples of excessive staff compensation thatget the most attention by elected officials and the media tendto involve compensation paid to the president or CEO.

What Is Reasonable?

Generally, reasonable staff compensation is defined as whatsimilar persons in similar positions with similar duties at similarorganizations are paid.

Both private foundations and public charities may determineappropriate staff compensation, particularly for senior-levelpositions, using the guidance provided by the rebuttablepresumption procedure described in the excess benefittransaction rules. Although these rules only apply to communityfoundations and other public charities, the rules offer usefulguidance for all foundations on best practices to follow forcompensation decisions.

Although private foundations may wish to use the rebuttablepresumption procedure as a matter of good governance, it isimportant to note that only public charities currently get thebenefit of the rebuttable presumption.

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Staff Compensation

Reasonable staffcompensation is what

similar positions at similar organizations are paid.


Conflicts of interest are a matter of both legal and ethicalconcern for foundations and other grantmakers. A strongconflict of interest policy not only helps promote compliancewith the law, but also helps a grantmaker develop a consistentapproach to actual and perceived conflicts of interest. Hereare things all grantmakers should know about conflicts ofinterest.

Conflicts of Interest Defined

For foundations, a conflict of interest arises when a boardmember or officer has a personal interest in a transaction thatconflicts, or may conflict, with the best interests of the foundation.Under fiduciary standards, the duty of loyalty (see page 3)requires the director or officer to set aside personal or conflictinginterests and act solely in the best interest of the foundation whenmaking a decision or acting on behalf of the foundation.

Transactions where conflicts may arise include the sale orpurchase of goods, services or rights; the provision or receiptof a grant or loan; or the establishment of any other type offinancial relationship with the foundation.

Conflicts of interest may arise directly in a transaction betweenthe foundation and a director or officer, or indirectly intransactions between the foundation and family members ofdirectors or officers, or entities in which these individuals have amaterial financial interest or a management or oversight role.Although the Minnesota statute does not define a “materialfinancial interest,” this term generally includes a financial interestthat an ordinarily prudent person in a similar position wouldreasonably conclude could affect one’s judgment in makingdecisions about a transaction with that entity. The definition of afamily member varies by law. For purposes of the MinnesotaNonprofit Corporation Act, a family member includes a spouse,parent, child, sibling, or spouse of a child or sibling.

For grantmakers organized as nonprofit corporations, the lawgenerally requires that a conflicting interest transaction be fairand reasonable to the grantmaker at the time it occurs. Fairand reasonable transactions generally are not void orvoidable. The individual with the conflict of interest has theburden to prove the fairness of the transaction.

Minnesota law also provides a “safe harbor” for approval ofconflicting interest transactions. Under the safe harbor, atransaction in which a nonprofit director has a conflict of interestis not void or voidable if the director’s interest is fully disclosed tothe board, and the transaction is approved by a majority of thedisinterested directors, without counting the vote the interesteddirector might otherwise have, and without counting theinterested director in determining the presence of a quorum. It isadvisable to use this procedure whenever possible.

More stringent conflict of interest standards may apply to grantmakersorganized as trusts. These requirements will vary from state to state.



Conflicts of Interest

Conflicts of interest are a matter of both legal

and ethical concern.

Managing Conflicts

Although the law does not require a grantmaker to adopt aconflict of interest policy, doing so can help the organizationensure that it handles conflicts of interest appropriately. (IRSForm 990, which is filed by public charities but not privatefoundations, asks whether the organization has a conflict ofinterest policy, leading many organizations to believe that apolicy is required under the tax laws. It is not.) Having a policyis also advisable in the event that transactions are scrutinizedby the IRS, the State Attorney General or the media. Ofcourse, a conflict of interest policy is useful only if agrantmaker follows the policy consistently.

A good policy should address conflicts involving directors,officers and staff, and should provide a process for theseindividuals to disclose potential conflicts of interest. It iscommon to require annual written disclosures of business andfinancial interests, in addition to requiring disclosures aspotential conflicts arise in the course of business.

The policy should also provide a process for the board (or inthe case of staff conflicts, the president or chief executiveofficer) to address conflicts of interest. Common mechanismsinclude requiring full disclosure of the conflict, prohibiting theinterested individual from participating in discussion and votingon the affected transaction, requiring documentation in theminutes of all votes concerning the transaction, and giving thechair of the meeting the power to ask the interested individualto leave the room during discussion and voting.

Other provisions that some grantmakers choose to include intheir conflicts of interest policies:

� Requirements that alternatives to the conflicted transactionbe explored.

� Requirements that the rebuttable presumption procedure forexcess benefit transactions be used where applicable.

� Procedures for acceptance or offering of gifts or gratuities.

� Procedures to address outside activities, such asconsulting, speaking or service as a director on otherboards.

Sample Policies

If your foundation needs to prepare a conflict of interest policy,or is interested in reviewing or revamping your policy, severalexamples and templates of conflicts of interest policies areavailable. Find more information and sample policies atwww.mcf.org/publictrust.

13

Foundations focus on annual reporting not just for taxrequirements but also for the purpose of community relations,transparency and accountability. Here are things allgrantmakers should know about reporting and disclosure.

Annual Reporting

INTERNAL REVENUE SERVICE

All private foundations, regardless of income or asset size, arerequired to annually file IRS Form 990-PF. Public charities,including community foundations, are generally required to fileIRS Form 990 if their annual gross receipts are normally morethan $25,000; however, some organizations may file thesimpler Form 990-EZ. For tax year 2009, public charities withgross receipts of less than $500,000 and assets of less than$1.25 million are eligible to file Form 990-EZ. For subsequenttax years, the ceilings are reduced to $200,000 and$500,000, respectively.

Forms 990-PF, 990 and 990-EZ must be filed by the 15th dayof the fifth month after the end of an organization’s fiscal year.For example, a private foundation with a fiscal year endingDec. 31 must file its Form 990-PF by May 15 of the followingyear. Form 8868 may be used to request an automatic three-month extension.

Public charities with gross receipts normally $25,000 or lessmust file an annual report with the IRS that provides basicinformation about the organization, such as its name, address,web address, principal officer and evidence of its continuingeligibility for exemption from Form 990 filing requirements.

STATE CORPORATE FILINGS

Foundations organized as nonprofit corporations generally mustfile annually with the Secretary of State in their state ofincorporation and other states where they are qualified to dobusiness. Minnesota nonprofit corporations are required to filea Nonprofit Corporation Renewal form with the MinnesotaSecretary of State by Dec. 31 of each year. Failure to file theform results in dissolution of the corporation without furthernotice.


Reporting and Disclosure


Annual reporting is done not just for tax requirements

but also for community relations, transparency

and accountability.

CHARITABLE SOLICITATION FILINGS

Most states require charitable organizations that solicit funds toregister with the appropriate state regulatory agency. Forinstance, charitable organizations that solicit contributions fromthe public in Minnesota must register and report annually to theMinnesota Attorney General’s Office. The initial CharitableOrganization Registration Statement for such organizationsmust be filed with the appropriate attachments and $25 feewithin 30 days after the organization’s total contributionsexceed $25,000. In each subsequent year, solicitingorganizations must file a Charitable Organization AnnualReport with the appropriate attachments and $25 fee by the15th day of the seventh month following the close of its fiscalyear.

Certain charitable organizations are exempt from the state’sregistration and reporting requirements. For example,organizations are exempt if they receive less than $25,000 inannual contributions and do not use paid staff members orprofessional fundraisers.

Private foundations and other Minnesota charities that do notsolicit contributions from the public (and have gross assets of$25,000 or more at any time during the year) must file withthe Minnesota Attorney General’s Office a Charitable TrustRegistration Statement, with the appropriate attachments and$25 fee within three months after the organization receivesassets. Such organizations are not required to submit annualreports; however, they must submit copies of their Forms 990,990-EZ or 990-PF each year.

Disclosures

DISCLOSURES REQUIRED BY THE IRS

Federal law requires public charities and private foundations tomake available for public inspection, without charge, copies oftheir original and amended annual tax returns (Forms 990,990-EZ or 990-PF) for the last three years. Public charities arenot required to publicly disclose the portions of the returns thatinclude the names and addresses of contributors to theorganization, but private foundations are required to publiclydisclose this information. Form 990-T, on which charities reportunrelated business taxable income, must also be madeavailable to the public.

Charities also must make available for public inspection,without charge, copies of their exemption applications, alongwith the accompanying attachments and amendments, andany documents issued by the IRS concerning the application.The organization may request that certain proprietaryinformation, such as trade secrets, be withheld from publicinspection.

Foundations and public charities must make their annual returnsand exemption application materials available at theirprincipal, regional and district offices during regular businesshours. If the organization does not maintain a permanentoffice, it must make the information available for inspection ata reasonable location of its choice or mail the information.Requested copies must be made available on a same-daybasis for walk-in requests, and within 30 days for mail-inrequests. An organization may set reasonable costs forcopying these materials, including staff time and actual costs.

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A foundation or public charity is exempt from the requirementto provide copies of its tax returns and exemption materials if itmakes them “widely available” by posting these materials on awebsite and directing requestors to the appropriate web page,provided that the online forms are exact images of theoriginals and can be downloaded free of charge.

GuideStar (www.guidestar.org) and the Foundation Center(www.foundationcenter.org) post the 990 and 990-PF forms forthousands of public charities and foundations in the easilydownloadable PDF format. There is some disagreement amonglegal analysts as to whether posting a tax form on either sitewill satisfy a foundation’s federal disclosure requirement, sinceboth sites block out some or all signatures on the online formsdue to privacy concerns. Some analysts have expressedconcerns because the regulations require the posting of exactduplicates of returns on the websites and do not expresslypermit the removal of signatures. But other analysts believe thata publicly available and otherwise unrevised return meets thespirit of the law.

PROACTIVE PUBLIC COMMUNICATIONS

Forms 990-PF and 990: Grantmakers have traditionallytreated the 990-PF and 990 tax forms solely as vehicles forreporting their financial information to the IRS, but mandatoryreporting and the greater accessibility of 990s through theInternet have made the 990 forms an important means ofcommunication with a much broader audience. Anyone with acomputer and Internet connection has easy access to the taxreturns of most foundations free of charge.

This newfound transparency means that grantseekers, reporters,colleagues and researchers alike will look to a foundation’s990-PF or 990 as one more tool in researching andevaluating the organization. The foundation’s accountant andCEO should not be the only people who pay much attention tothe 990-PF or 990. The board, program and communicationsstaff should also be familiar with the return and may be helpfulin adding more detailed information that adds context to theform.

Annual Report: The annual report is another commonvehicle grantmakers use to report their financial informationand grantmaking accomplishments. Grantmakers are notrequired by law to produce an annual report, but thegrantmaking field has encouraged funders to distribute annualreports as a way to improve the sector’s openness andaccountability.

Annual reports can include an organization’s financialhighlights, a complete list of grants for the previous year, andfunding highlights and grantee accomplishments. Grantmakerscan also consider including grant guidelines and applicationprocedures in the report.


Reporting and Disclosure (continued)

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Traditionally, grantmakers’ annual reports have been printeddocuments, but with the advent of the Internet, a growingnumber of grantmakers are making the information in theirannual reports available on their website. This can limit printingand mailing costs, and makes the report accessible to peoplewhen and where they want it.

For a corporate grantmaker, the only legal reportingrequirements are for the portion of giving from the company’sfoundation (if it has a foundation), and it must follow the samereporting requirements as any other 501(c)(3) organization.However, many companies issue annual reports on their fullcontributions program, including contributions made directly bythe company, which is a proactive approach that helps buildcommunity relations and can help minimize calls for greaterreporting and oversight.

Other Reporting Options: Aside from 990s and annualreports, other common reporting vehicles for grantmakersinclude grant application and guidelines brochures, newslettersand general websites.

The Minnesota Council on Foundations also provides severalcommunications vehicles that can help members be open andaccountable about their giving:

� MCF’s Minnesota Grantmakers Online (www.mcf.org/mngrants), the largest online database of Minnesotagrantmakers and grants, allows foundations to provide aprofile (which can be updated online anytime) with basicinformation about the organization’s programs, applicationprocedures, recent grants, staff, directors/trustees andmore. A similar profile is published in MCF’s annual Guideto Minnesota Grantmakers print directory.

� MCF also broadly communicates members’ recent grants,notable accomplishments, changes in guidelines orprograms, staff/trustee news and more through GivingForum, a free quarterly newspaper distributed to more than15,000 readers in Minnesota’s nonprofit and philanthropycommunity, and MCF Giving Memo (public) and MCFNotes (member), free e-newsletters with about 3,000subscribers (www.mcf.org/enews). And mcf.org featureslinks to grantmaker websites, a grantmaker deadlinescalendar, the latest grantmaker news and much more.


990s Online:The Foundation Center’s 990-PF Search:www.foundationcenter.org/findfunders/990finder. Forinformation about posting your 990-PF on the site, go towww.foundationcenter.org/grantmakers/990pf.html.

GuideStar: www.guidestar.org. To learn more about linkingfrom your website to your 990-PF image on GuideStar, [email protected].

“Making the Most of Your Form 990-PF” tip sheet atwww.mcf.org/publictrust.

Other: See also Frequently Asked Legal Questions: Annual Reportingand Public Disclosure, pages 50-51.

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Although a foundation’s grantmaking activity typically attractsthe most attention, its investment activity is, in many ways, thetrue heart of its operations. The more successful a foundation’sinvestment returns, the more charitable funds it will haveavailable to fulfill the organization’s mission. A foundation,therefore, needs sound, effective investment policies andpractices to maximize its effectiveness as a grantmaker.

Here are things all grantmakers should know aboutinvestments.

What the Law Requires

FIDUCIARY DUTIES OF THE BOARD

The overall responsibility for a foundation’s investments restswith its board of directors or trustees. The governing board ofa foundation has a legal obligation to manage the foundation’sassets and income prudently. If a foundation is not a “pass-through” foundation but instead holds assets that it invests toproduce income for grantmaking and operational purposes, itsboard members have a fiduciary obligation to establish andmonitor prudent investment policies and oversight functions.

The board can rely either on internal board or staff expertise,or it can obtain outside expert advice, depending on thefoundation’s size, complexity and internal resources. A boardmember is entitled to rely upon information, opinions andreports from staff, board committees and outside professionalsand experts the board member reasonably believes to bereliable and competent. Even if a board uses outsideinvestment help, board members need to be familiar with thefoundation’s investment results and insist that investmentmanagers provide them with the necessary information toensure that they are properly fulfilling their legal fiduciaryresponsibility to the foundation.&p h i l a n t h r o p y p u b l i c t r u s t18


Investments

A foundation’s investmentactivity is, in many ways, the

true heart of its operations.

LAWS REGULATING INVESTMENT STRATEGY

Most states have adopted laws governing the investment ofcharitable assets, including the Uniform Prudent Investor Act(UPIA). This law embraces the concept of modern portfoliotheory, under which prudent investment policy is based ondiversification of assets, long-term performance benchmarksand the importance of a portfolio’s total return on investment.No particular category of investments is barred. Rather, aninvestment is viewed in the context of the entire portfolio, andinvestment managers are expected to balance risk and returnin making investment decisions.

Most states have also adopted the Uniform PrudentManagement of Institutional Funds Act (UPMIFA), which,among other things, makes many of the concepts in the UPIAapplicable to the investment of institutional funds, includingendowment funds, held by a charity for its own use. UPMIFAalso addresses spending from those funds.

JEOPARDIZING INVESTMENT RULES

In addition to state corporate or trust law, UPMIFA, and UPIA,private foundations are subject to the federal excise tax rulesthat bar “jeopardizing investments.” Jeopardizing investmentsare those that show a lack of reasonable business care andprudence in providing for the long- and short-term financial needs of the foundation. Although no category of investment isconsidered inherently too risky, certain types of investmentsreceive particular scrutiny, including trading in securities onmargin; trading in commodities futures; investments in workinginterests in oil and gas wells; purchase of puts, calls andstraddles; warrants; selling short; investments in junk bonds; riskarbitrage; hedge funds; derivatives; distressed real estate; andinternational equities in third-world countries.

Jeopardizing investments should be distinguished from“program-related investments,” which may take the form of afinancial investment but are made primarily for charitable ratherthan investment purposes. Examples of program-relatedinvestments include buying shares of a small business in aneconomically depressed area, micro-lending programs andproviding seed money to capitalize a community developmentloan fund. Even though they may be risky, program-relatedinvestments do not violate the jeopardizing investment rules. Inorder to qualify as a program-related investment, threeconditions must be met:

� The primary purpose of the investment must be toaccomplish the foundation’s charitable purposes.

� Production of income cannot be a significant purpose ofthe investment.

� The investment cannot involve lobbying or politicalcampaign activity.

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OTHER

Foundation board members should also be aware of otherlegal issues that may arise in the investment context, such asthe prohibition against excess business holdings, whichgenerally prevents a private foundation from holding asubstantial interest in a single company or business enterprise(although there is a five-year period for disposing of excessbusiness holdings acquired by gift or bequest). There are alsolegal and investment issues to be considered when afoundation receives contributions of specific assets subject todonor restrictions on use or sale, or assets that the donor or theboard wishes to put to use in furtherance of the foundation’scharitable purposes. In these situations, professional advice isparticularly important.

Investment Committees

Many boards delegate investment responsibilities to aninvestment committee. The majority of the committee is usuallycomprised of board members, although sometimes afoundation will also invite non-board members with particularinvestment skills and expertise to serve on the committee.

The main role of the investment committee is to recommendinvestment policies and guidelines that protect the foundation’sinvestment assets. The committee should develop an investmentstrategy and continuously monitor the foundation’s investmentportfolio through comprehensive analysis and review of theperformance of the investments and managers. Typical dutiesand responsibilities of a foundation’s investment committeeinclude the following:

� Formulate and amend, as required, the foundation’sinvestment and spending policy statements forrecommendation to the board.

� Develop and maintain an investment strategy toaccomplish the foundation’s goals.

� Adopt and revise investment management agreements asneeded with consultants, managers and custodians forapproval by the board.

� Meet periodically (at least annually is recommended) withthe investment consultants to review and assess theinvestment strategy.

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Investments (continued)

� Review the asset allocation, individual manager andcombined portfolio performance on a regularly scheduledbasis (at least quarterly is recommended), and make anycourse corrections necessary.

� Meet with each investment manager on a regular basis toreview style, performance, guidelines and objectives toensure compliance and a clear understanding of thefoundation’s position and goals.

� Recommend the addition, deletion and replacement ofinvestment managers as appropriate, consistent with thegoals and objectives of the foundation’s investment policy.

� Manage investment assets not managed by professionalinvestment managers.

� Report on a timely basis all committee findings, activitiesand recommendations to the board.

A foundation should have a written description of the roles andresponsibilities of its investment committee. Sample investmentcommittee descriptions can be found at www.mcf.org/publictrust.

The Investment Policy

A foundation should have in place a sound, effectiveinvestment policy to guide its investing activities. A foundationinvestment policy may include the following elements:

Definition of the Investment Duties: The policy shouldspell out the roles and responsibilities of the board, investmentcommittee, staff and consultants in managing investments.

Spending Policy: A spending policy describes theprocesses and procedures the foundation will follow tocalculate the percentage of its endowment or unendowedassets available for grants and operating expenses each year.In establishing a spending policy, a foundation should considersuch important issues as whether it wants to meet or exceedthe minimum 5 percent payout requirement (if it is a privatefoundation) and whether it wants to grow its endowment ormaintain the endowment at current levels (inflation-adjusted).

Performance Objectives: The policy may include astatement of long-term investment performance objectives,including a goal for the minimum annual total return thefoundation hopes to achieve over a specific period of time.The return objective for most foundations is the amount neededto maintain the value of the endowment while also meeting thefoundation’s spending objectives and the expected rate ofinflation.

Strategic Statement: The policy may include a statementof the foundation’s philosophy regarding the use of fixed-income and equity securities.

Allocation Formula: The policy may provide an assetallocation formula, including target percentages of totalinvestments in fixed-income versus equity securities, and targetpercentages in various types of equity holdings.

Manager Guidelines: The policy may include guidelineson how much managers can invest in a single stock, maximumpercentage of a company they can own, minimum number ofpositions they can have in a portfolio, maximum percentageany one company can have in the manager’s total portfolio,and areas determined off-limits (commodities, art objects, realestate, gold, etc.). Equity managers also may be told when theycan invest in fixed-income securities, how much they can havein cash, and the minimum investments quality levels (AA or Abonds, no junk bonds, no derivatives, etc.).

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Mission-Related Investing

Some foundations are exploring the concept of “mission-relatedinvesting,” sometimes known as “socially responsibleinvesting.” The Foundation Partnership on CorporateResponsibility defines mission-related investing as an integrationof the relationships among a foundation’s asset managementand charitable purpose. Mission-related investing couldinclude:

Portfolio Screening: A foundation may screen portfolios toinclude best-in-class corporations or avoid corporations thathave poor records on social issues, environmental issues orother issues of interest to the foundation.

Proxy Voting: Shareholder activity may include votingproxies on a company’s proxy statement, or developing a setof proxy voting guidelines covering issues of concern to thefoundation. These activities could also include engagingcorporations in dialogues on issues of concern, and filing andco-filing shareholder resolutions.

Early Investment: Mission-related venture capital uses thefoundation’s assets for early-stage investment in companies thatare seeking solutions to the problems that the foundation isseeking to solve through its grantmaking.

Community Investing: Community investing assistsunderserved communities in meeting their development needs.There is disagreement in the foundation field about the use ofmission-related investing. Some would argue that the board’sprimary fiduciary responsibility is to ensure the maximum returnon the foundation’s investment assets, so that the foundationhas the largest amount of financial resources possible to fulfillits mission. Others would argue that in order to fulfill itsfiduciary responsibilities, a board has a duty to considerwhether the foundation’s investment decisions will further itscharitable purposes — or at least not run counter to them.


See also Frequently Asked Legal Questions: Investments, page 43.


Investments (continued)

22

Grantmaking is the most visible activity foundations undertake.It is therefore critical to comply with applicable legalrequirements and to develop consistent practices to maintainthe public’s trust. Here are things all grantmakers should knowabout the process of making grants.

Private Foundations

Private foundations are required each year to make “qualifyingdistributions” in an amount approximately equal to 5 percent oftheir investment assets. Grants and administrative expenses(other than investment expenses) count toward this payoutrequirement. When making grants and other distributions,private foundations must take care to avoid prohibitedpayments known as “taxable expenditures.” Private foundationsthat make a taxable expenditure must pay an excise tax on theexpenditure and correct the transaction.

Taxable expenditures include amounts paid or incurred (a) tocarry on propaganda or otherwise attempt to influencelegislation; (b) to influence the outcome of public elections orcarry on voter registration drives; (c) to individuals for travel orstudy (unless requirements described below are met); (d) toorganizations other than public charities; or (e) for purposesthat are not charitable.

Grants to individuals and organizations are discussed in moredetail in the following paragraphs. For additional informationabout lobbying and public policy activities, see Public PolicyEngagement, page 27.

Grants to Individuals: Grants to individuals are generallypermissible, as long as they serve a charitable purpose. If thegrant is made for travel or study, including scholarship andfellowship grants, a private foundation may make the grant tothe individual only pursuant to a program that has beenapproved in advance by the IRS. As an alternative, thefoundation may make the grant to a school or college andallow the school to choose the scholarship recipient. Such agrant will be treated as having been made to the school,rather than the individual.

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If the grantee is not a publiccharity, the foundation must

exercise “expenditureresponsibility.”


Grantmaking


Grants to Organizations: Private foundations generallymay make grants to organizations that qualify under IRSrequirements as section 501(c)(3) public charities if the grant ismade for a charitable purpose. If the grantee organization isnot a public charity, the foundation must exercise “expenditureresponsibility.” A private foundation must also exerciseexpenditure responsibility if the grantee is a public charity thatis classified as a supporting organization described in section509(a)(3) of the Internal Revenue Code, and is considered a“Type III” supporting organization that is not “functionallyintegrated.” The process for determining the status of a publiccharity is discussed in more detail below.

Expenditure responsibility requires:

� Pre-grant inquiry: Prior to making the grant, the foundationmust conduct an inquiry that is complete enough to give areasonable person assurance that the grant will be usedfor proper purposes. If the grantee has a good trackrecord with the foundation, no pre-grant inquiry isordinarily required.

� Written grant agreement: The agreement must state thepurposes of the grant, and require the grantee to returnfunds not used for grant purposes, submit annual reports,maintain financial records, not use the funds forinappropriate purposes, and hold the funds in a separateaccount.

� Grantee reports: The grantee must submit annual reportsdescribing the use of funds, compliance with the terms ofthe grant, and progress toward achieving the objectives ofthe grant. The grantee must also submit a final reportidentifying all expenditures of grant funds.

� Report to IRS: The foundation must include informationabout the grant on its 990-PF.

� Recordkeeping: The foundation must maintain certainrecords concerning the grant and take remedial steps if itdiscovers the grantee has diverted the funds.

Determining Public Charity Status: Private foundationshave always had to undertake due diligence to confirm thatorganizational grantees are section 501(c)(3) public charities.Typically, that due diligence includes obtaining a copy of thegrantee’s IRS determination letter, obtaining confirmation fromthe grantee that its public charity status has not been revoked,and perhaps reviewing IRS Publication 78, which listsrecognized 501(c)(3) organizations.

Because private foundations are required to exerciseexpenditure responsibility with respect to grants made tocertain supporting organizations, the due diligence process forgrants to supporting organizations is somewhat complex.Private foundations must ensure that any supportingorganization they fund qualifies as a “Type I,” “Type II” or“functionally integrated Type III” organization. The IRS haspublished Notice 2006-109, which describes, among otherthings, procedures to determine the classification of asupporting organization. As of the date of this publication,Notice 2006-109 is available at www.irs.gov/eo. If afoundation determines that a supporting organization is a non-functionally integrated Type III supporting organization, itshould consider carefully whether to make the grant. Grants tosuch organizations require the exercise of expenditureresponsibility and, unlike all other grants made for charitablepurposes, do not count toward the 5-percent payoutrequirement.

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Grantmaking (continued)

Foreign Organizations: Foreign charities usually do nothave determinations from the IRS as to their 501(c)(3) andprivate foundation status. A U.S. private foundation thereforecannot easily determine whether grants to the foreignorganization will require the exercise of expenditureresponsibility. The foundation is allowed to rely on its owngood-faith determination as to the grantee’s status if it obtainsan affidavit from the grantee (or an opinion from thefoundation’s or the grantee’s legal counsel) setting forthsufficient facts about the grantee’s operations and support thatwould allow the IRS to determine that the grantee wouldqualify as a public charity. Alternatively, the foundation canchoose to exercise expenditure responsibility. Use of thisapproach was reaffirmed in an April 18, 2001, IRS letter tothe Council on Foundations. Under certain circumstances, aU.S. intermediary organization (fiscal agent) can be used toavoid expenditure responsibility or the affidavit process. Theuse of fiscal agents must be carefully managed, however, toavoid making a taxable expenditure.

Program-Related Investments: Although program-related investments often take the form of loans, they aretreated as grants for purposes of the taxable expenditure rules.If the entity in which the foundation invests is not a publiccharity, the foundation generally will have to exerciseexpenditure responsibility with respect to the investment. Forexample, if a foundation makes a loan to a small business in adistressed neighborhood, it must exercise expenditureresponsibility with respect to the loan.

Public Charities

Public charities are free from many of the proceduralrestrictions imposed on private foundations under the taxableexpenditure rules. Like private foundations, however, communityfoundations and other public charities must ensure that theirgrants are made solely for charitable purposes. In addition,certain distributions made from donor-advised funds maintainedby public charities are treated as “taxable distributions” thatare subject to excise taxes similar to those that apply to privatefoundations.

It is important to consider the definition of a donor-advised fundwhen analyzing whether a proposed grant is permissible. Adonor-advised fund is a fund or account that (a) is separatelyidentified by reference to contributions of a donor or donors;(b) is owned and controlled by a sponsoring organization(such as a community foundation); and (c) affords advisoryrights to the donor or his or her appointee with respect todistribution or investment of amounts held in the fund.

The definition of a donor-advised fund excludes (a) funds thatmake distributions only to a single identified organization, and(b) funds with respect to which a donor or person designatedby a donor makes recommendations concerning grants fortravel or study, but only if the individual makesrecommendations as part of a committee appointed by thesponsoring organization, donors and their designees do notcontrol the committee, and the grants are awarded on anobjective and nondiscriminatory basis under a procedureapproved in advance by the board of directors of thesponsoring organization.

25

A taxable distribution from a donor-advised fund includes:

� Any distribution made to an individual.

� Any distribution made for non-charitable purposes.

� Any distribution to an organization that is not a publiccharity (unless the organization that sponsors the donor-advised fund exercises expenditure responsibility).

� Any distribution to a non-functionally integrated Type IIIsupporting organization (unless the organization exercisesexpenditure responsibility).

� Any distribution to a supporting organization that iscontrolled by the donor or a donor-advisor of the fund(unless the organization exercises expenditureresponsibility).

The prohibition against distributions to individuals bars thepayment of scholarships and similar grants from donor-advisedfunds, and also prohibits such funds from reimbursingindividuals for expenses incurred for fundraising or similarevents.

Donor-advised funds are also subject to excise taxes fordistributions that result in more than an incidental benefits todonors, donor advisors and certain related parties.

Avoiding Financing Terrorist Activities

Both private foundations and public charities must take care toensure their grants do not support terrorists or terrorist activities.The U.S. Department of Treasury has issued Anti-TerroristFinancing Guidelines: Voluntary Best Practices for U.S.-BasedCharities. These guidelines recommend, in some detail, variouspractices that charities and foundations can undertake whenproviding assistance to other organizations (domestic andforeign) to minimize the risk that charitable resources will beinadvertently diverted to support terrorism. The guidelines arevoluntary and cover both grantmaking practices and corporategovernance practices.

While the guidelines are quite detailed and in some casesperhaps overly burdensome and costly, they do acknowledgethat charities and foundations may adopt a “risk-basedapproach” to investigating possible ties between recipientorganizations and terrorism. The guidelines emphasize that notevery practice identified in the guidelines will be appropriatefor every organization in every circumstance, and that theremay be exigent circumstances (such as catastrophic disasters)that make application of the guidelines impracticable. TheTreasury recommends, in those cases, that organizations take“all prudent and reasonable measures that are feasible underthe circumstances.”


See also Frequently Asked Legal Questions: Grantmaking, pages 47-49.



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Many grantmakers historically shied away from involvement inlobbying, advocacy or public policy work, prompted in largepart by strict federal laws; however, the tide appears to bechanging, as a growing number of foundations in Minnesotaand across the country have become more engaged inelevating the public dialogue on issues integral to theirmissions. Here are things all grantmakers should know aboutadvocacy and public policy.

Terms Defined

Public Policy: There is no single definition of “public policy.”In this document, public policy refers to the principles guidingany level of government or its representatives on a given topic,as expressed in laws, administrative practices, regulations,funding priorities and executive or judicial orders.

Lobbying: Lobbying is one specific form of public policyengagement that is often a key strategy for making andchanging laws. Lobbying is defined by federal tax law as anyattempt to influence specific legislation. More specifically,lobbying is any attempt to influence public officials in supportof, or in opposition to, any legislation that has beenintroduced, or any legislation that may be introduced, in anylegislative body, such as a city council, state legislature orCongress. Lobbying includes communicating with legislatorsand their staff directly, and encouraging others to contact theirlegislators.

Direct Lobbying: Direct lobbying is a communication witha member or employee of a legislative body (or certain othergovernment officials) that both (a) refers to specific legislation,and (b) reflects a view on the legislation.

Grassroots Lobbying: Grassroots lobbying is any attemptto influence the opinions of the general public about specificlegislation. In order to be grassroots lobbying, acommunication must (a) refer to specific legislation, (b) reflect aview on the legislation, and (c) encourage the recipient to takeaction, such as contacting his or her legislator.

Advocacy: The term “advocacy” covers a much broaderrange of activities to push for changes in public policy, andthese activities may or may not include lobbying. One way ofdifferentiating between lobbying and advocacy is tounderstand that lobbying always involves advocacy, butadvocacy does not necessarily involve lobbying.

27


Public Policy Engagement

The term “advocacy” coversa broad range of activities

to push for changes in public policy.


Private Foundation Rules

Private foundations are prohibited from expending funds “tocarry on propaganda, or otherwise attempt to influencelegislation.” This rule prohibits both direct lobbying activities bythe foundation and grantmaking to support lobbying.

Notwithstanding the restrictions on lobbying that apply toprivate foundations, there are many ways private foundationscan participate in public policy and advocacy. First, they canparticipate in or make grants to support the activities describedin this section that do not constitute lobbying. Here are otherexamples:

Project Support Grants: Private foundations may alsomake grants for a project that involves some lobbying activityas long as the amount of that grant, together with all othergrants by the same foundation for the same project for thesame year, does not exceed the amount budgeted by thegrantee for project activities other than lobbying. In making thisdetermination, the foundation can rely in good faith on thegrantee’s budget for the project. If, however, the foundationhas reason to doubt the grantee’s information or reasonablyshould doubt the grantee’s information, then the foundationmay not rely on the information.

General Support Grants: Another option is to make ageneral support grant to an organization that lobbies, as longas the grant is not earmarked to be used for lobbying. (A grantis earmarked if the grantee is required to use it for a specificpurpose or recipient, or if the grantor has the right to imposesuch a requirement.) A private foundation may make a generalsupport grant to a public charity even if the charity is known toengage in some lobbying activities and is likely to use some ofthe grant for that purpose. Unlike specific project grants, theregulations do not require a private foundation to seekinformation about a charity’s lobbying budget when the charityapplies for a general support grant.

Jointly Funded Programs: A narrow exception to thelobbying definition allows private foundations (but not theirgrantees) to present information to government officials about aprogram that is, or may be, funded by both the foundationand the government, provided that the communications arelimited to the program.

Exceptions to Definition of Lobbying

Foundations that are interested in public policy and advocacyshould keep in mind the following activities, which for taxpurposes are not considered to be lobbying:

Nonpartisan Analysis, Study or Research: Certaineducational or research activities are expressly excluded fromthe legal definition of lobbying. Nonpartisan analysis, study orresearch on a particular topic is not considered lobbying evenif the research or report advocates a particular viewpoint, solong as there is a sufficiently complete and balanceddiscussion to enable members of the public to form their ownopinions or conclusions on the issue. The nonpartisan analysis,study or research must be made widely available and cannotbe distributed selectively to persons on only one side of theissue.

Discussions of Broad Social Problems: A relatedexception pertains to “examinations and discussions of broadsocial, economic and similar problems.” Examinations anddiscussions of such problems do not constitute lobbying even ifthe problems are of a type with which government would beexpected to deal ultimately, and even if the communicationsare made to legislators, so long as the discussions do notaddress the merits of a specific legislative proposal and do notdirectly encourage recipients to take action with respect tolegislation.

Legislative Testimony and Technical Assistance:Providing testimony or other technical assistance togovernmental bodies or committees is not lobbying if done inresponse to a written request by the body or committee and ifthe testimony or assistance is available to every member of therequesting body or committee.

“Self-Defense” Lobbying: Communications withlegislative bodies about proposed legislation that would affectthe existence of a charity, its powers and duties, its tax-exemptstatus or the deductibility of contributions is not consideredlobbying.

Membership Communications: Communications by apublic charity to its members that refer to legislation or reflect aview of direct interest to the organization and its members, butdo not encourage the reader to lobby, are not treated aslobbying.

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Public Policy Engagement (continued)

Public Charity Requirements

Public charities, such as community foundations, operate underlobbying laws and regulations that are somewhat lessrestrictive than those for private foundations. Public charities areallowed to lobby as long as “no substantial part” of thecharity’s activities consists of lobbying.

“No Substantial Part” Test: The IRS and the courts haveconsistently declined to provide a clear rule about how muchlobbying constitutes a “substantial part” of a public charity’sactivities. Also, the “no substantial part” rule fails to defineclearly what activities are considered to be lobbying or howmuch money a charity may spend on lobbying.

501(h) Election: If a public charity (other than a church)chooses, it may avoid the uncertainties of the “no substantialpart” test altogether by making a section 501(h) election.Section 501(h) of the Internal Revenue Code sets financiallimits for lobbying activities and also defines, in considerabledetail, the activities that count against those limits. In generalterms, total direct lobbying expenses for a given year may notexceed 20 percent of the first $500,000 of an organization’sexpenses, plus 15 percent of the second $500,000, plus 10percent of the third $500,000, plus 5 percent of theremainder, subject to an overall $1 million limit. In addition,grassroots lobbying expenditures may not exceed 25 percentof the overall lobbying limit.

Advantages of 501(h) Election: The 501(h) election hasa number of advantages. First, only expenditures areconsidered when analyzing whether an organization is incompliance with section 501(h). This means that activitiesundertaken by volunteers will not count toward the 501(h)limits, nor generally will the amount of time spent on thelobbying activities be considered. Second, the regulations areclear in defining what is and is not lobbying. Third, theexpenditure limits are fairly generous. Fourth, the section501(h) election is very easy to make. The organization files asimple one-page form (IRS Form 5768) with the IRS.Regardless of the date of filing, the election is effective as ofthe first day of the tax year during which the organizationmakes the election. The election continues in effect until thebeginning of the year in which it is revoked. Finally, it is easyto revoke the section 501(h) election. The election may berevoked at any time by filing a second Form 5768.

Election-Related Activities

Private foundations and public charities are prohibited by lawfrom funding or engaging in activities that support or opposecandidates for public office. As 501(c)(3) organizations,foundations may not make campaign contributions, makeexpenditures on behalf of candidates, endorse candidates forpublic office, make resources such as space or officeequipment available to candidates, or communicate anythingthat explicitly or implicitly favors or opposes a candidate.

Election-related activities foundations may support include:

� Public education and training sessions about participationin the political process.

� Candidate education on public interest issues.

� Certain candidate debates and forums.

� Nonpartisan get-out-the-vote drives.

� Nonpartisan voter registration drives (with certainrestrictions for private foundations).

� Canvassing the public on issues.

� Ballot measure work through specific project grants.

Foundation officials and employees acting in their individualcapacities may also work on political campaigns outside ofwork hours or using their available leave, but they may not usefoundation facilities, equipment, personnel or other resources toprovide support to, or oppose, a candidate or campaign.


For a variety of resources about the federal tax and otherlobbying rules, see the Center for Lobbying in the PublicInterest at www.clpi.org or the Alliance For Justice atwww.afj.org.

For information about the Minnesota campaign financerequirements, see www.cfboard.state.mn.us.

See also Frequently Asked Legal Questions: Lobbying, pages 31-32.

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FREQUENTLYASKEDLEGALQUESTIONS

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Q1Are private foundations allowed to lobby?

No, with a few exceptions. Foundations that engage inprohibited lobbying are subject to financial penalties imposedby the Internal Revenue Service. Certain nonpartisan researchand discussions of broad social problems are not treated aslobbying even though they reflect a particular viewpoint. Undercertain conditions, foundations may also provide legislativetestimony and engage in so-called “self-defense” lobbying.

The four exceptions to lobbying restrictions for private foundations:

Nonpartisan Research: Certain educational or researchactivities are expressly excluded from the definition oflobbying. A private foundation may fund or present anindependent and objective report on a chosen subject, even ifthe report advocates a particular viewpoint on proposedlegislation, so long as there is a sufficiently complete andbalanced discussion to enable members of the public to formtheir own opinions or conclusions on the issue. This“nonpartisan analysis, study or research” must be made widelyavailable and cannot be distributed selectively to persons ononly one side of the issue.

Discussions of Broad Social Problems: A relatedexception pertains to “examinations and discussions of broadsocial, economic and similar problems.” Examinations anddiscussions of such problems do not constitute lobbying even ifthe problems are of a type with which government would beexpected to deal ultimately, and even if the communicationsare made to legislators, so long as the discussion does notaddress itself to the merits of a specific legislative proposaland does not directly encourage recipients to take action withrespect to legislation.

Legislative Testimony and Technical Assistance:The private foundation lobbying rules also permit foundationrepresentatives to provide testimony or other technical assistanceto governmental bodies or committees if the foundation is doingso in response to a written request by the body or committee,and if the testimony or assistance is available to every memberof the requesting body or committee.

“Self-defense” Lobbying: A fairly narrow exceptionpermits lobbying when proposed legislation would affectexistence of the private foundation, its powers and duties, tax-exempt status, or the deductibility of foundation contributions.

Q2Does lobbying include all activities that have todo with legislation?

No. For these purposes, an activity that has to do withlegislation is prohibited lobbying only if it constitutes “direct” or“grassroots” lobbying. The technical definitions of these termsare quite extensive.

Generally speaking, “direct” lobbying is a communication witha member or employee of a legislative body (or certain othergovernment officials) that both (a) refers to specific legislation,and (b) reflects a view on the legislation.

“Grassroots” lobbying is attempting to influence the opinions ofthe general public about specific legislation. In order to begrassroots lobbying, a communication must (a) refer to specificlegislation, (b) reflect a view on the legislation, and (c)encourage the recipient to take action, such as contacting hisor her legislator.

Legislation-related communications that do not fall within one ofthese two definitions are not prohibited by the lobbying rulesthat apply to private foundations.

Q3May a private foundation make a generalsupport grant to an organization that lobbies?

Yes, as long as the grant is not earmarked to be used forlobbying.

Lobbying by a public charity is not prohibited. In fact, theneeds and issues addressed by public charities are often well-served by the lobbying and advocacy efforts of thoseorganizations, to the extent allowed by law. A privatefoundation may make a general support grant to a publiccharity even if the public charity is known to engage in somelobbying activities and is likely to use some of the grant for thatpurpose.

FREQUENTLY ASKED LEGAL QUESTIONS:

Lobbying

Q4May a private foundation make a grant for aproject that will involve lobbying?

Yes, as long as the grant doesn’t exceed the budgeted non-lobbying expenses of the project.

When a grant is designated for a particular project, and theproject involves some lobbying activity, the grant will notviolate the private foundation lobbying prohibition as long asthe amount of that grant, together with all other grants by thesame foundation for the same project for the same year, doesnot exceed the amount budgeted by the grantee for projectactivities other than lobbying. In making this determination, thefoundation is entitled to rely in good faith on the grantee’sbudget for the project.

Q5Are public charities, including communityfoundations, allowed to lobby?

Yes, within limits. “No substantial part” of a public charity’sactivities may consist of lobbying (see next question).

Q6How much lobbying is permitted for publiccharities?

As a general rule, “no substantial part” of the activities of apublic charity may consist of lobbying. The IRS and the courtshave consistently declined to provide a clear rule about whatconstitutes a “substantial part.” To take advantage of somemore objective rules on this point, public charities (other thanchurches and certain church-related organizations) may chooseto be governed by Section 501(h) of the Internal RevenueCode, which allows the organization to expend a specifiedportion of its budget for lobbying. In general terms, totallobbying expenses for a given year may not exceed 20percent of the first $500,000 of an organization’s expenses,plus 15 percent of the second $500,000, plus 10 percent ofthe third $500,000, plus 5 percent of the remainder, subjectto an overall $1 million limit.

In addition, grassroots lobbying expenditures may not exceed25 percent of the overall lobbying limit. These rules apply onlyif the public charity has filed Form 5768 — the half-page501(h) election form — with the IRS.

Q7Is an organization that lobbies required toregister as a lobbyist?

An organization that employs an in-house lobbyist for federallobbying must register under the federal Lobbying DisclosureAct if it expects to incur, or does incur, lobbying expenses thatexceed $24,500 in a semiannual period.

A “lobbyist” is a person who is compensated for multiplelobbying contacts and whose lobbying activities constitute atleast 20 percent of his or her services for the organizationduring any six-month period. Registered organizations must filesemiannual reports with the Secretary of the Senate and theClerk of the House of Representatives. Separate requirementsapply to lobbying firms and self-employed lobbyists.

Minnesota lobbying rules require the individual lobbyist toregister, not the organization. However, organizations that paylobbyists are required to file certain reports with the MinnesotaCampaign Finance and Public Disclosure Board.


See also What Every Grantmaker Should Know: Public PolicyEngagement, pages 27-29.

FREQUENTLY ASKED...

Lobbying (continued)

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Q1What is an endowment fund?

An endowment fund is a fund held by a charitableorganization in which the donor has imposed a restriction thatprohibits some or all of the fund from being spent currently. Thiswould include, for example, a gift that is to be held “inperpetuity,” or one that must be held for 25 years before it canbe spent.

Q2How is an endowment fund created?

An endowment fund may be created by virtually any meansthat indicates that the donor intended to create an endowmentfund. Such means include a direct instruction from the donor, adonor’s gift designated for an existing endowment fund, or anotherwise undesignated gift that is received in response to arequest for an endowment gift.

Q3How must an endowment fund be invested?

In general, the board members of a foundation must performtheir duties, including their investment duties, with the care anordinarily prudent person in a like position would exerciseunder similar circumstances.

Various laws governing the investment of charitable assets —including the Uniform Prudent Management of InstitutionalFunds Act (UPMIFA), the Uniform Prudent Investor Act (UPIA),and the Third Restatement of Trusts — all embrace the conceptof modern portfolio theory. Under modern portfolio theory,prudent investment policy is based on diversification of assets,long-term performance benchmarks and the importance of aportfolio’s total return on investment.

Q4How much may be spent from an endowment?

Unless the donor specifies a particular percentage or dollaramount that is to be spent periodically from the endowment,the governing body of the foundation is responsible fordetermining the amount that may be spent currently from anendowment. In doing so, the board must act reasonably, andmust take into account the duration and preservation of theendowment fund, the purposes of the institution and theendowment fund, general economic conditions, the possibleeffect of inflation or deflation, the expected total return fromincome and the appreciation of investments, other resources ofthe institution and the investment policy of the institution.

Q5What happens if the current value of anendowment is below its original value?

Unless expressly provided for by the donor, there is noabsolute requirement that the value of an endowment fund mustnever fall below its original value. The board is givenconsiderable discretion in determining spending from anendowment, but it must always act prudently, taking intoaccount the considerations listed in Q4 above. Over the longterm, it is generally expected that a perpetual endowment fundshould maintain its value, adjusted for inflation, but short-termdeviations from this objective may sometimes be justified as“prudent,” depending on the particular circumstances. It isimportant to keep in mind that private foundations must alwayscomply with the 5-percent payout requirement imposed byfederal tax law, even if distributions at that level would causethe endowment fund to fall below its target level.


Endowment Funds

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Q6How does the endowment spending policy relateto the 5-percent payout requirement for privatefoundations?

A private foundation must meet the 5-percent payoutrequirement that is imposed by federal tax law even ifdistributions at that level would cause the endowment fund tolose value or not meet its target value. Note: The 5-percentpayout requirement applies only to organizations that areprivate foundations.

Q7How do “board-restricted” endowment fundsdiffer from “donor-restricted” endowment funds?

If, at the time a contribution is made to a foundation, the donorrestricts the type or manner of investing the assets of the gift, orrestricts the time or manner of making distributions of earningsfrom the gift, such restrictions normally can be modified oreliminated only with the written consent of a living donor orpursuant to a court proceeding. This includes restrictionsestablishing the contribution as part of the permanentendowment funds of the foundation. Restrictions placed onassets of the foundation by its governing board, however, suchas designating a portion of the foundation’s assets aspermanent or endowment funds, may usually be released ormodified by resolution of the board acting alone.

Q8Can the amount available for spending bedetermined by looking at the “unrestrictedfunds” column on a foundation’s financialstatement?

Generally, no. In many cases, there can be significantdifferences between the meaning of “unrestricted” under thefinancial accounting standards and its meaning under the legalstandards.

Q9Can endowment principal be used as a last resortif the foundation becomes insolvent?

Generally, no. Insolvency does not excuse a foundation fromits obligation to maintain an endowment fund as such. As ageneral rule, the portion of an endowment fund that is notavailable for current spending is not available to creditorsunless a court authorizes the expenditure based on certainextraordinary circumstances.

Q10What responsibilities does the board have withrespect to the endowment?

The governing board of a foundation is ultimately responsiblefor all aspects of the administration of an endowment fund,including its investment and determination of how much can bespent from year to year. In making these decisions, each boardmember must act in a manner he or she reasonably believes tobe in the best interests of the foundation, and with the care ofan ordinarily prudent person in a similar position under similarcircumstances.

FREQUENTLY ASKED...

Endowment Funds (continued)

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Q1What is a community foundation?

Community foundations come in many forms, but in generalterms, they are collections of charitable funds administered bya single board that is representative of the general public.Most, but not all, community foundations focus on a particulargeographic area. Community foundations are both fundraisingand grantmaking organizations, and they avoid privatefoundation status by virtue of the fact that they receive broadpublic support. Each fund of a community foundation generallymust be subject to a “variance power,” which allows thegoverning board to modify fund restrictions under certaincircumstances.

Q2What is the “variance power”?

Most community foundations require that each fund be subjectto a power of the governing board (usually found in thearticles of incorporation or bylaws of the foundation) to modifyany restriction that limits the fund to a particular purpose or fora particular organization if, in the sole judgment of thegoverning board, the restriction becomes unnecessary,incapable of fulfillment or inconsistent with the charitable needsof the community or area served. Donors should be madeaware of this power, and it must be exercised judiciously.

Q3How does a community foundation differ from aprivate foundation?

Because it is not classified as a private foundation, acommunity foundation is not subject to the tax on investmentincome that applies to private foundations, nor to the rules thatapply to private foundations regarding self-dealing, requireddistributions, excess business holdings, risky investments ortaxable expenditures.

Community foundations are permitted to engage in a limitedamount of lobbying (see Lobbying Q6, page 32).Contributions to community foundations under certaincircumstances receive more favorable tax deduction treatmentthan contributions to private foundations.

Q4What is a “material restriction”?

A fund intended to be part of a community foundation mayinstead be treated as a separate entity (and therefore classifiedas a private foundation that must obtain its own tax-exemptstatus and file its own tax return) if it is subject to a “materialrestriction.” A material restriction is a restriction imposed by thedonor that allows the donor to have some continuing controlover the fund.

Examples of material restrictions are the donor’s right todesignate the recipients of grants from the fund, to direct theinvestment of the fund assets, or to change the purposes of thefund. The donor’s irrevocable designation of a particularbeneficiary or purpose for the fund, however, is not a materialrestriction if it is done at the time of the gift.

Q5What are the different kinds of funds thatcommunity foundations offer?

Most community foundations maintain both endowment andnon-endowment funds. One very popular type of fund is thedonor-advised fund, in which the donor or another designatedperson has the right to make recommendations to thecommunity foundation regarding grants from the fund. Theserecommendations are not binding on the community foundation(if they were, the fund would be subject to a materialrestriction), but allow the donor to maintain involvement withthe fund after his or her gift.

Other common fund types include funds that are designated forparticular beneficiary organizations or particular charitablepurposes, and so-called “agency funds,” which are establishedwhen a charitable organization hands over its own assets tothe community foundation, to be administered for the benefit ofthe organization.


Community Foundations

Q6Are donor-advised funds required to pay out acertain amount each year?

No, not at the time of publication of these Frequently AskedQuestions; however, the Pension Protection Act of 2006 directsthe Treasury Department to study this issue and makerecommendations about a mandatory distribution requirement.From time to time, proposals have been circulated to amendthe law to require a certain minimum distribution annually fromdonor-advised funds, but no such legal requirement currentlyexists. Some community foundations have voluntarily adopted apolicy of distributing a specified percentage of a fund’s assetseach year.

Q7Are there any special limits on grants or otherpayments from donor-advised funds?

Yes. Donor-advised funds are not permitted to make grants toindividuals. Grants to private foundations and non-charitableorganizations require “expenditure responsibility” (seeGrantmaking Q7, page 48), as do grants to certain kinds of“supporting organizations” (see Private Foundations vs. PublicCharities Q1, page 44).

Donor-advised funds also must not make grants that result in abenefit to the donor or a related party (such as a “thank-yougift”) that is more than “incidental.” Payment of compensationor loans to a donor or related party is prohibited.

Not all funds that involve an ongoing role for donors are“donor-advised funds” for purposes of these restrictions. Forexample, certain funds with multiple donors or a singlebeneficiary are excluded.

FREQUENTLY ASKED...

Community Foundations (continued)

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Q1What common activities constitute self-dealingwhen undertaken between a private foundationand a disqualified person?

The definition of self-dealing covers a wide range oftransactions that are prohibited even though they may be fairto the foundation and advantageous to all parties to thetransaction. It is therefore important for private foundationmanagers to know who the foundation’s disqualified personsare and carefully evaluate every transaction between thefoundation and a disqualified person (see next question).

Common activities that a private foundation might undertakethat are generally covered by the definition of self-dealinginclude sales, exchanges or leases of property (both real estateand personal property) between a foundation and adisqualified person, most loans, and the provision of goods,services or facilities between a disqualified person and aprivate foundation. These categories of activities are generallyself-dealing regardless of whether the foundation is the provideror receiver in the transaction. Compensation paid to, orreimbursement expenses of, a disqualified person by a privatefoundation; the transfer or use of the foundation’s assets orincome by a disqualified person; and certain transactions withgovernment officials also fall within the definition of self-dealing.

Q2Who is considered a “disqualified person”?

A disqualified person is defined as:

� An officer, director or trustee of the foundation (or anindividual having powers or responsibilities similar to thoseof officers, directors or trustees of the foundation).

� A substantial contributor to the foundation. A “substantialcontributor” is defined as any person who contributed orbequeathed an aggregate amount of more than $5,000to the private foundation, if such amount is more than 2percent of the total contributions and bequests received bythe foundation before the close of the taxable year inwhich the contribution or bequest is received by thefoundation from such person. In the case of a trust, theterm “substantial contributor” also means the creator of thetrust.

� Family members of any disqualified person. This includesspouses, ancestors, children, grandchildren, great-grandchildren and the spouses of children, grandchildrenand great-grandchildren.

� A corporation of which a disqualified person owns morethan 35 percent of the total combined voting power.

� A partnership in which a disqualified person owns morethan 35 percent of the profits interest.

� A trust or estate in which a disqualified person holds morethan 35 percent of the beneficial interest.

It is important to note that this definition of “disqualified person”differs from the definition used for purposes of the “intermediatesanctions” rules that apply to public charities.

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Private Foundation Self-Dealing

Q3What are some frequently used exceptions to thedefinition of self-dealing?

A disqualified person (see previous question) may transfer orfurnish goods, services or facilities to a private foundationwithout charge. Thus, a foundation can share space or officeequipment with its corporate sponsor or family members orbusiness as long as the foundation does not pay thedisqualified person rent or other fees.

A foundation may also pay reasonable compensation to adisqualified person for personal services to the foundation,including reimbursement of expenses associated with thepersonal services. For example, a foundation can pay anaccountant who serves on the foundation’s board of directorsfor accounting services provided to the foundation.

Another exception to the self-dealing rules is that a foundationmay furnish goods or facilities to a disqualified person on abasis at least as favorable as it makes the goods or servicesavailable to the general public. For example, a disqualifiedperson may enjoy a park or museum operated by thefoundation on the same basis as these facilities are availableto the public.

Q4What are the consequences if a person doesn’tknow that an activity he or she engages in isprohibited under the self-dealing rules?

The Internal Revenue Service may impose penalty taxes(“excise taxes”) on disqualified persons who engage in self-dealing transactions, under a two-tier tax system.

First-tier taxes are imposed on disqualified persons (other thanfoundation managers acting only as such) who engage in theself-dealing transaction with the private foundation, whether ornot they knew the activity constituted self-dealing. The amountof the first-tier tax on disqualified persons is generally 10percent of the amount involved. By contrast, a foundationmanager is subject to first-tier taxes only if he or sheparticipated in the transaction knowing that it was self-dealingand the participation was willful and not due to reasonablecause. The amount of the first-tier tax for a foundation manageris 5 percent of the amount involved. It is worth noting that,unlike other private foundation excise taxes, the tax on self-dealing cannot be abated at the discretion of the InternalRevenue Service.

If the self-dealing act is not undone or “corrected” within acertain period of time, the IRS may impose confiscatorysecond-tier taxes. However, the disqualified persons will havean opportunity to correct the transaction and obtain courtreview of the issue before the second-tier taxes are imposed.38

FREQUENTLY ASKED...

Private Foundation Self-Dealing (continued)

Q5Can a private foundation pay its boardmembers?

Yes, a private foundation can pay its board membersreasonable compensation for their personal service as boardmembers. A foundation can also pay board members’reasonable and necessary expenses associated with theirservices to the foundation.

Board compensation cannot be excessive, and should beevaluated for reasonableness based on the functions orservices required and actually performed by board members;the level of skill and experience necessary for board membersto fulfill their duties; and the amount of time spent by boardmembers in fulfilling their duties. Payment of compensation toboard members may cause them to lose immunity from liabilityunder Minnesota and federal volunteer protection statutes.

For guidance on compensation for board directors and trustees,and for executives, consult the following guidance memorandafrom the board of directors of the national Council on Foundations,which can be found at www.mcf.org/publictrust: “DeterminingReasonable Compensation for Foundation Directors andTrustees” and “Recommended Best Practices in DeterminingReasonable Executive Compensation.”

Q6Can a private foundation pay for spouse travel?

Generally, travel expenses incurred by the spouse of afoundation employee or board member are not “reasonableand necessary” expenses incurred in connection with thefoundation’s charitable activities. Thus, payment of suchexpenses by the foundation will usually constitute self-dealing(and may also be a taxable expenditure), unless the spouse isalso a foundation manager or employee or independentlyperforms necessary services on behalf of the foundation.

Under some circumstances, reimbursement of spousal travelexpenses may be permissible if it is treated as compensation tothe board member rather than the spouse and if it isreasonable in amount when combined with all othercompensation provided to the board member.

Q7Can a foundation satisfy a personal charitablepledge of a family member who is a disqualifiedperson?

No. A charitable pledge is usually a binding legal obligationof the person making the pledge, and it is considered self-dealing for a foundation to make a grant or other payment tosatisfy the legal obligation of a disqualified person.

Q8Is it self-dealing for a foundation to make agrant to a charity where a family member orother disqualified person serves on the board?

Unless the grant is made by the foundation in satisfaction of anobligation of the disqualified person to the grantee, asdiscussed in the question above, such a grant does notconstitute self-dealing. There is an exception to the definition ofself-dealing for “incidental and tenuous benefits” derived by adisqualified person from a private foundation’s use of itsincome or assets. Any public recognition or goodwill affordedto the disqualified person as a result of the foundation grantwill normally be considered an incidental or tenuous benefit.However, any such grant must be made in accordance withthe foundation’s conflicts of interest policy and procedures.

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Q9Under what circumstances can a corporationprovide office space, equipment and staffservices to its corporate foundation?

A corporation can provide facilities or services to its foundationwithout charge. The corporation and the foundation may alsoshare employees under a time-sharing arrangement in whicheach pays for its respective share of the employees’ time.Finally, the corporation and its foundation may share staffservices, facilities or equipment provided by a third party,whom they each pay for their respective share of the services,facilities or equipment.

Q10Is it self-dealing for a foundation to buy tickets toa charitable fundraising event and provide themto corporate officers or staff?

Normally it is considered self-dealing for a corporatefoundation to purchase tickets to an event and then provide thetickets to corporate directors or personnel to attend the event.The corporation, as a disqualified person, is clearly prohibitedfrom receiving a tangible economic benefit, such as tickets tothe event, from the foundation. It is unclear whether allmanagers and employees of the corporation are alsodisqualified persons, but the better approach would be to havethe corporation itself or the individual attendees purchase thetickets.


See also What Every Grantmaker Should Know: PrivateFoundation Self-Dealing, pages 4-5.

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FREQUENTLY ASKED...

Private Foundation Self-Dealing (continued)

Q1What are the basic fiduciary duties of afoundation board member?

Foundations can be organized either as trusts or corporations,and the fiduciary standards for governing members of trustsand corporations have developed somewhat separately understate law. Essentially, however, a board member of afoundation owes two fiduciary duties to the foundation: a dutyof loyalty and a duty of care. A third duty is sometimesmentioned, the duty of obedience.

The Duty of Loyalty requires the board member, whenmaking a decision or acting on behalf of the foundation, to setaside personal or conflicting interests and act solely in the bestinterest of the foundation. The Duty of Care requires aboard member to devote the time, attention and resourcesnecessary to understand and prudently oversee the affairs ofthe foundation. The Duty of Obedience requires the boardmember to obey all laws pertaining to the foundation and actin furtherance of the foundation’s charitable purposes.

Q2How is a conflict of interest defined for afoundation’s board?

A conflict of interest arises when a board member has apersonal or other interest in a transaction that conflicts, or mayconflict, with the best interests or opportunities of thefoundation, and thus poses a challenge to the board member’sduty of loyalty to the foundation. Essentially, a conflict ofinterest arises when the board member has a competinginterest in a transaction with the foundation either individually,through another organization, or through a member of thedirector’s family or other personal relationship.

Q3Should a foundation have a written conflict ofinterest policy for its board?

While there is no general legal requirement that grantmakershave a written conflict of interest policy, it is generallyrecommended (including by the IRS) so that all board membersare sensitive to their fiduciary obligations to the foundation andhave standardized procedures in place to disclose and handleconflicts of interest as they arise. A written conflict of interestpolicy demonstrates good organizational fiduciary practiceand can provide legal protection both to the foundation andindividual board members. State law requirements provide agood starting place for a written conflict of interest policy.

The Minnesota Attorney General has published arecommended conflict of interest policy for nonprofitcorporations that can be viewed and downloaded atwww.ag.state.mn.us.

The Internal Revenue Service has published a sample conflictof interest policy for charitable organizations includingfoundations, as part of the Instructions to Form 1023. It can beviewed and downloaded at www.irs.gov/formspubs.

Foundations should consider whether any modifications areappropriate for their particular circumstances before adoptingeither of these policies.

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Board Fiduciary Duties

Q4In what circumstances might a foundation boardmember or officer be subject to personal liabilityfor actions taken in connection with thefoundation?

Any action or failure to act that is determined to be outside thescope of the board member’s or officer’s official responsibilitiesand capacity may create personal liability for the boardmember or officer. Actions or omissions that constitute a breachof fiduciary duty, a breach of a contractual obligation, orcause physical injury or death may create claims of personalliability. Actions or omissions that are considered negligent,reckless or criminal also are likely to raise issues of personalliability. Individual directors and officers may also be heldpersonally liable for a foundation’s failure to withhold and payfederal taxes.

Q5What special protections against personal liabilityare available for a foundation’s volunteer boardmembers and officers?

Both federal and Minnesota state law afford some protectionagainst personal liability to individuals serving as officers anddirectors of charitable organizations, including foundations, ona volunteer or unpaid basis. Under Minnesota law, such aperson generally is not liable under civil law for acts taken ingood faith, within the scope of the person’s responsibilities,and which do not constitute willful or reckless misconduct,subject to certain exceptions. Federal law provides volunteerswith somewhat duplicative immunity from both federal andstate civil liability.


See also What Every Grantmaker Should Know: BoardFiduciary Duties, pages 1-3.

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FREQUENTLY ASKED...

Board Fiduciary Duties (continued)

Q1When should a foundation’s board seek expertadvice regarding investment decisions andpayout policies?

The governing board of a foundation has a legal obligation tomanage the assets and income of the foundation prudently. If afoundation is not a “pass-through” foundation but instead holdsassets that it invests to produce income for grantmaking oroperational purposes, the board members have a fiduciaryobligation to establish and monitor prudent investment policiesand oversight functions. The board can rely either on internalboard or staff expertise, or it can obtain outside expert advice,depending on the foundation’s size, complexity and internalresources. A board member is entitled to rely upon information,opinions and reports from staff, board committees, and outsideprofessionals and experts the board member reasonablybelieves to be reliable and competent.

Q2What is the legal standard by which afoundation’s investment decisions are judged?

In general, the board members of a foundation must performtheir duties, including their investment duties, with the care anordinarily prudent person in a similar position would exerciseunder similar circumstances. Various laws governing theinvestment of charitable assets — including the Uniform PrudentManagement of Institutional Funds Act (UPMIFA), the UniformPrudent Investor Act (UPIA) and the Third Restatement of Trusts— all embrace the concept of modern portfolio theory. Undermodern portfolio theory, prudent investment policy is based ondiversification of assets, long-term performance benchmarksand the importance of a portfolio’s total return on investment.

Q3What special rules apply to investments by aprivate foundation?

In addition to state corporate or trust law, and UPMIFA orUPIA, private foundation investments are also subject to federaltax law regulations.

Federal tax law provides that certain risky investments orinvestment strategies may constitute “jeopardizing investments”that subject the foundation to private foundation excise taxes.The “prudent trustee” standard under federal tax lawemphasizes the need to consider the current and future needsof the foundation, investment risks and the importance ofdiversification. The regulations also list several categories ofinvestments that will be subject to “close scrutiny” by the IRS,including trading in securities on margin; trading incommodities futures; investments in working interests in oil andgas wells; purchase of puts, calls and straddles; warrants;selling short; junk bonds; risk arbitrage; hedge funds;derivatives; distressed real estate; and international equities indeveloping countries.

Private foundations are also subject to “excess businessholdings” rules that limit the percentage interest a foundation,together with all its “disqualified persons” (see PrivateFoundation Self-Dealing Q2, page 37), holds in a givenbusiness enterprise.

Q4What special rules apply to donor-advised fundinvestments?

Donor-advised funds are subject to the same rules that apply toprivate foundations (see Endowment Funds Q8, page 34).


See also What Every Grantmaker Should Know: Investments,pages 18-22.

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Investments

Q1What is the difference between a privatefoundation and a public charity?

All organizations that are described in Section 501(c)(3) of theInternal Revenue Code are either private foundations or publiccharities. The Internal Revenue Service classifies anorganization described in Section 501(c)(3) of the Code as aprivate foundation unless the organization can demonstrate thatit qualifies as a public charity. Because there are different rulesthat apply to public charities and private foundations, it isimportant to be able to identify whether an organization is apublic charity or a private foundation.

Unlike private foundations, which normally receive substantiallyall of their contributions from relatively few sources and oftenrely on investment earnings as their source of ongoing support,a public charity is either “publicly supported” (i.e. derives asubstantial portion of its financial support from the public) orfunctions to “support” one or more organizations that arepublic charities. Specifically, an organization may qualify as a“publicly supported” organization because it does one of thefollowing:

� Carries on specific activities identified by statute (e.g.activities carried on by churches, educationalorganizations, colleges and universities, hospitals andmedical research organizations and governmental units).

� Is supported substantially by financial support fromgovernment agencies and the general public.

� Is supported substantially by certain permitted contributionsand gross receipts from its exempt activities and does notreceive more than one-third of its support from investmentincome.

� Is organized and at all times thereafter operatedexclusively for the benefit of, to perform the functions of, orto carry out the purposes of one or more specified publiclysupported organizations. Organizations described in thisparagraph are called “supporting organizations” and areclassified as a Type I, Type II, Type III functionallyintegrated or Type III non-functionally integrated supportingorganization.

Because the private funding and private control of a privatefoundation increase the likelihood that the foundation willimproperly benefit those who control the foundation, the Codesubjects a private foundation to certain requirements andrestrictions that are not applicable to public charities. Forexample, private foundations are subject to a 2-percent tax onnet investment income that can be reduced to 1 percent if theprivate foundation makes sufficient qualifying distributions forcharitable purposes. In addition, private foundations aresubject to excise taxes for failing to take certain requiredactions or for taking certain prohibited actions; underMinnesota law, they are prohibited from engaging in conductthat would result in excise taxes being imposed.

Most notably, private foundations are required to make annualdistributions equal to 5 percent of the aggregate fair marketvalue of all investment assets of the organization (see 5%Payout Rule, page 46) and are prohibited from the following:

� Engaging in acts of “self-dealing” with certain persons (seePrivate Foundation Self-Dealing, pages 37-38).

� Having “excess business holdings” (see Investments Q3,page 43).

� Making jeopardizing investments (see Investments Q3).

� Making certain prohibited non-U.S. expenditures (seeGrantmaking Q4, page 47).

Finally, the deductibility for federal income tax purposes ofcontributions to a private foundation is subject to certainlimitations that do not apply to contributions to public charities.For example, the amount of contributions to private foundationsthat may be deducted for any year generally may not exceed30 percent of an individual’s adjusted gross income for theyear. There also are special limitations with respect to theamount of deduction that may be claimed in connection withthe contribution of appreciated property to the foundation.

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Private Foundations vs. Public Charities

Q2How do I know if a foundation is a public charityor a private foundation?

The Internal Revenue Service indicates whether an organizationis a public charity or a private foundation in the organization’sdetermination letter. The organization is required to provideyou with a copy of its determination letter upon request.

In lieu of reviewing an organization’s determination letter, youcan determine whether an organization views itself as a publiccharity or a private foundation based on its annual informationreturn filed with the IRS. All private foundations are required tofile a Form 990-PF, while a public charity files a Form 990 orForm 990-EZ (assuming it has significant enough revenues totrigger the filing requirement). If an organization files a Form990 or 990-PF, such forms are generally available atwww.guidestar.org.

Note: Often the links to such forms are labeled “Form 990”even if an organization files a Form 990-PF, so make sure tofollow the link and view an organization’s tax forms in order toverify whether an organization is a public charity or privatefoundation.

Q3How does a private foundation determinewhether a grantee is a supporting organization?

It is sometimes important to determine not only whether anorganization is a public charity, but also what kind of publiccharity it is. Specifically, the law distinguishes among fourtypes of supporting organizations (see Q1, page 44), andprovides that private foundations must exercise expenditureresponsibility over grants to certain types of supportingorganizations (see Grantmaking Q1, page 47) and may notcount such grants toward meeting the 5% minimum payoutrequirement (see 5% Payout Rule Q3, page 46).

The IRS Section 501(c)(3) determination letter for a supportingorganization will indicate that the organization is classifiedunder Section 509(a)(3) of the Internal Revenue Code of1986. In contrast, other public charities are classified underSection 509(a)(1) or Section 509(a)(2) of the Code. If you donot have a copy of the determination letter, review thegrantee’s Form 990 on www.guidestar.org.

Although you can determine whether a grantee is a supportingorganization, it is more difficult to determine the organization’s“type.” Determination letters historically have not identified anorganization’s type, and organizations completing the Form990 are not always sure which type they are, even though theannual information return now requires supportingorganizations to identify their type on Schedule A, Part I, Line11. To address this concern, the IRS has published specialprocedures for funders to determine a supporting organization’stype. As of the date of this publication, these can be found inNotice 2006-109, available at www.irs.gov/eo.

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Q1What is the 5% payout rule?

The federal tax laws require that private foundations distributea certain amount each year for charitable and administrativepurposes. That amount is equal to 5 percent of the value of thefoundation’s net investment assets.

Q25% of what?

The assets against which the 5 percent is measured include thefoundation’s investment assets, but not program-relatedinvestments or other assets that are used directly in carrying outthe foundation’s charitable mission. For example, if thefoundation owns the building that houses its offices, the valueof the building is excluded from the 5 percent calculation tothe extent the building is used directly for charitable activitiesand related administrative functions. The tax regulations containinstructions for valuation of the investment assets. For example,a foundation must use the average of the monthly values ofpublicly traded securities held during the year.

Q3What distributions count toward the 5%?

Any amount, including most grants and program-relatedinvestments, that the foundation distributes for its charitablepurposes counts toward the 5 percent. In addition, reasonableand necessary administrative expenses that relate to charitableactivities count. The tax that foundations pay on theirinvestment income does count, but expenses relating tomanagement of investments do not count. A grant or program-related investment paid to a Type III non-functionally integratedsupporting organization, to a Type I or Type II donor-controlledsupporting organization, or to another private foundation or toan organization that is controlled by the foundation, generallydoes not count. Special rules apply to payments to foreignorganizations. With the approval of the IRS, amounts set asidefor use in a future year will, under certain limitedcircumstances, count as distributions in the year of the set-aside.

Q4What is the deadline for making the requireddistributions each year?

A foundation must make the required distributions by the end ofthe year following the year on which the 5 percent calculationis based. For example, a foundation with $1 million in assetsin 2009 must make at least $50,000 of qualifyingdistributions by the end of 2010.

Q5Can extra distributions be applied to otheryears?

Excess distributions may be carried forward for up to five yearsto meet future distribution requirements. Excess distributions maynot be carried back to satisfy distribution for previous years.

Q6What are the consequences of failing to meet thepayout requirement?

If a foundation does not distribute the required amount by thedeadline, it is subject to an initial penalty equal to 30 percentof the shortfall. It must also distribute the shortfall or be subjectto a penalty equal to 200 percent of the shortfall.

Q7What about operating foundations?

Certain private foundations that actively conduct charitableactivities (as opposed to making grants) may qualify as“private operating foundations,” which are subject tosomewhat different distribution requirements. Operatingfoundations receive some of the benefits of public charitystatus, including some favorable tax deduction rules forcontributions they receive.

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5% Payout Rule

Q1Does a grantee’s tax status affect a foundation’sability to make a grant to that organization?

Public charities and private foundations are required to ensurethat any grants they make are used to further their exemptpurposes. In general, grants to other Section 501(c)(3) publiccharities and private foundations further a public charity’sexempt purposes, so a public charity can make a grant withoutany restriction; however, special rules apply to grants fromdonor-advised funds (see Community Foundations Q7, page36), and grants to and from supporting organizations (seePrivate Foundations vs. Public Charities Q1, page 44).

Subject to the exceptions noted above, a public charity canmake a grant to an organization that is not described inSection 501(c)(3) of the Internal Revenue Code (e.g., a for-profit corporation, a trade association, a social welfareorganization or a foreign charity) to perform activities thatfurther the public charity’s exempt purposes, but the publiccharity should enter into a grant restriction agreement pursuantto which the recipient agrees to use the funds in furtherance ofthe grantor public charity’s exempt purposes.

Additionally, private foundations must exercise “expenditureresponsibility” for grants to any organization that is notdescribed in Section 501(c)(3) and to Type III non-functionallyintegrated supporting organizations and to Type I and Type II“controlled” supporting organizations. To exercise expenditureresponsibility, the private foundation must establish monitoringprocedures to ensure that the grant funds are used solely forthe purpose for which the grant was made, which includes, butis not limited to, obtaining full and complete reports from thegrantee on how the funds are spent (see Grantmaking Q7,page 48).

Q2May a foundation make a grant to a privatefoundation?

In general, a public charity, as opposed to a donor-advisedfund, may make a grant to a private foundation without anyrestrictions. In contrast, a private foundation may make a grantto another private foundation only when the granting privatefoundation exercises “expenditure responsibility” over thegrantee’s use of the grant (see Grantmaking Q7, page 48).

Q3May a foundation make a grant to a tax-exemptorganization that is not tax-exempt under Section501(c)(3) of the Code (e.g. Section 501(c)(4) or501(c)(6))?

Most public charities may make a grant to an organizationthat is exempt from federal income tax under another section ofthe Code (e.g. Section 501(c)(4) social welfare organizationor Section 501(c)(6) trade association) provided the publiccharity enters into a grant restriction agreement pursuant towhich the recipient agrees to use the funds in furtherance ofthe grantor public charity’s exempt purposes. If such a grant ismade by a donor-advised fund or a private foundation, thegrantor must exercise “expenditure responsibility” over thegrantee’s use of the grant (see Grantmaking Q7, page 48).

Q4May a foundation make a grant to a foreigncharity that is not exempt under Section 501(c)(3)of the Code?

A public charity, as opposed to a donor-advised fund, maymake a grant to a foreign charity provided the public charityenters into a grant restriction agreement pursuant to which therecipient agrees to use the funds in furtherance of the grantorpublic charity’s exempt purposes.

In contrast, a private foundation may make a grant to aforeign charity provided it either (a) makes a good faithdetermination that the foreign entity could be recognized underSection 501(c)(3) as a public charity, even if it has notobtained an exemption determination; or (b) exercises“expenditure responsibility” over the grantee’s use of the grant(see Grantmaking Q7, page 48). A donor-advised fundusually must exercise expenditure responsibility to make a grantto a foreign charity.

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Grantmaking

Q5May a foundation make a grant to a for-profitcorporation?

A public charity, as opposed to a donor-advised fund, maymake a grant to a for-profit corporation, provided the publiccharity enters into a grant restriction agreement with thegrantee pursuant to which the grantee agrees to use the grantfor the public charity’s exempt purposes. If a private foundationor a donor-advised fund makes such a grant, the privatefoundation must exercise “expenditure responsibility” over thegrantee’s use of the grant (see expenditure responsibility, Q7).

Q6May a foundation make a grant to a publiccharity serving as the fiscal agent for anotherentity?

Customarily, an organization that has not yet incorporatedand/or has not yet obtained recognition as a tax-exemptorganization under Section 501(c)(3) of the Internal RevenueCode may make an arrangement with an established publiccharity to serve as its fiscal agent.

A public charity serving as fiscal agent may receive individualdonations and grants intended for the other entity. However,the donor will only receive a tax deduction if the public charitywith section 501(c)(3) status has control over the final decisionto use the funds to support the other entity. Although the donorcan indicate a preference that the donation support the otherentity, donors should be careful not to earmark theircontributions for distribution to the intended entity. As fiscalagent, the public charity manages the funds.

A public charity may make a grant to a public charity thatserves as a fiscal agent for another entity without restrictionprovided the public charity, in its capacity as fiscal agent,ensures that such funds are being used for exempt purposes.Further, as a result of the fiscal agent arrangement, privatefoundations making a charitable contribution to the fiscal agentneed not exercise “expenditure responsibility” because thegrant is given to the public charity (rather than the entityawaiting tax-exempt status).

Q7What is “expenditure responsibility”?

Private foundations must exercise “expenditure responsibility”for grants to any organization that is not described in Section501(c)(3) and to Type III non-functionally integrated supportingorganizations, and Type I and Type II “controlled” supportingorganizations are prohibited from making a grant to anorganization that is not a public charity. To exerciseexpenditure responsibility, the private foundation must establishmonitoring procedures to ensure that the grant funds are usedsolely for the purpose for which the grant was made, whichincludes, but is not limited to, obtaining full and completereports from the grantee on how the funds are spent. Inaddition, a private foundation is required to summarize thestatus of each grant over which it exercises expenditureresponsibility on its IRS Form 990-PF that is filed annually withthe Internal Revenue Service. (Preparation of this return mayrequire the assistance of an attorney or accountant.)

Given the additional documentation and reporting requirementsassociated with the exercise of expenditure responsibility, manyprivate foundations have voluntarily chosen to award grantsonly to public charities; however, such a limitation is not legallyrequired.

Q8Can a foundation make a grant for any purpose?

Public charities and private foundations are required to ensurethat any grants they make are used to further their exemptpurposes. In addition, private foundations are prohibited fromdirectly or indirectly making grants for the following purposes:

� To carry on propaganda, or otherwise to attempt toinfluence legislation.

� To influence the outcome of any specific public election, orto carry on, directly or indirectly, any voter registrationdrive, with certain very limited exceptions.

� To an individual for travel, study or other similar purposes,unless certain requirements are satisfied, including theobtaining of advance approval from the IRS.

FREQUENTLY ASKED...


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Q9May a foundation make a grant to anorganization or otherwise engage in activities to influence legislation?

See Lobbying Q3 and Q4, pages 31-32.

Q10May a foundation make a grant to a group thatlobbies?

See Lobbying Q3, page 31.

Q11May a foundation make a grant to influence theoutcome of a specific election or a voterregistration drive?

As organizations described in Section 501(c)(3), publiccharities and private foundations are prohibited fromparticipating in, or intervening in (including the publishing ordistributing of statements), any political campaign on behalf of(or in opposition to) any candidate for public office.Consequently, a public charity or private foundation is strictlyprohibited from making a grant to another entity in order tosupport that entity’s attempt to influence the outcome of anelection.

Public charities and private foundations may provide supportfor voter education or voter registration drives; however, it isimpermissible to fund such activities if they are overtly orimplicitly partisan in the persons targeted or the messagesconveyed. Voter education or voter registration activities maybe considered nonpartisan if they are carefully designed andimplemented to ensure that a) the activities are not targeted toa particular group based on the way that group tends to vote,and b) there is no express or implied support for (or oppositionto) a candidate or political party or positions associated with acandidate or political party. For example, it is not permissibleto fund a voter registration drive that encourages votes for “pro-life” candidates.

Private foundations considering providing support for votereducation or voter registration activities must be aware thatthere are very specific additional legal restrictions applicableto private foundations that impose onerous requirements onnonpartisan voter education or voter registration activities (e.g.that the activities must be carried on in five or more states).Due to the complex requirements imposed by these laws,private foundations should seek legal advice before providingany such support.

Q12May a foundation make a grant to an individualfor travel, study or similar purpose?

A public charity, as opposed to a donor-advised fund, maymake a grant to an individual provided the public charityenters into a grant restriction agreement pursuant to which therecipient agrees to use the funds in furtherance of the publiccharity’s exempt purposes.

In contrast, a private foundation is prohibited from making agrant to an individual for travel, study or similar purposes,unless the grant satisfies numerous criteria, including that thegrant is made pursuant to a procedure approved in advanceby the IRS and is used to undertake activities that are consistentwith the private foundation’s exempt purpose. A grant to anindividual for purposes other than travel, study or similarpurposes is not a taxable expenditure but must otherwisequalify as a charitable grant (e.g., a grant to an indigentindividual to meet basic needs).

A private foundation also must follow specific record retentionrequirements for grants to individuals. These requirements donot apply to other types of grants (see Annual Reporting andPublic Disclosure Q4, page 51).


See also What Every Grantmaker Should Know: Grantmaking,pages 23-26.

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Q1What annual reporting requirements apply to afoundation?

Federal Requirements: All private foundations arerequired to annually file federal income tax Form 990-PF, evenif the organization’s annual gross receipts are less than$25,000.

Public charities, including community foundations, are generallyrequired to file IRS Form 990 if their annual gross receipts arenormally more than $25,000; however, some organizationsmay file the simpler Form 990-EZ. For tax year 2009, publiccharities with gross receipts of less than $500,000 and assetsof less than $1.25 million are eligible to file Form 990-EZ. Forsubsequent tax years, the ceilings are reduced to $200,000and $500,000, respectively.

Forms 990-PF, 990 and 990-EZ must be filed by the 15th dayof the fifth month after the end of an organization’s accountingperiod. For example, a private foundation with an accountingperiod ending Dec. 31 must file its Form 990-PF by May 15of the following year. Form 8868 may be used to request anautomatic three-month extension.

Public charities with gross receipts normally $25,000 or lessmust file an annual report with the IRS that provides basicinformation about the organization, such as its name, address,web address, principal officer and evidence of its continuingeligibility for exemption from Form 990 filing requirements.

Minnesota Requirements: All Minnesota nonprofitcorporations are required to file an Annual Business Renewalwith the Minnesota Secretary of State by December 31 ofeach year. The filing is free and can be done online. Failureto file will result in dissolution of the corporation without furthernotice. During an organization’s first year of existence, theorganization itself needs to obtain the form.

Most charitable organizations that solicit contributions from thepublic in Minnesota are obligated to register and reportannually to the Minnesota Attorney General’s Office.Organizations must file a Charitable Organization RegistrationStatement with the appropriate attachments and $25 fee within30 days after the organization’s total contributions exceed$25,000. In each subsequent year, organizations must file aCharitable Organization Annual Report with the appropriateattachments and $25 fee by the 15th day of the seventhmonth following the close of its fiscal year. Certain charitableorganizations are exempt from the registration and reportingrequirements. For example, organizations are exempt if they a)do not receive, and do not expect to receive, more than$25,000 in contributions in any year, and b) do not havepaid staff members or employ a professional fundraiser..

Charitable organizations that do not solicit contributions fromthe public (if they have gross assets of $25,000 or more atany time during the year) are obligated to file a CharitableTrust Registration Statement, including the appropriateattachments and a $25 fee, with the Minnesota AttorneyGeneral’s Office within three months after the organizationreceives assets. Such organizations are not required tosubsequently submit an annual form and fee; however, suchorganizations are required to annually submit copies of theirForms 990, 990-EZ or 990-PF. The reports must be filed bythe 15th day of the fifth month following the close of theorganization’s fiscal year.

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Annual Reporting and Public Disclosure

Q2What information is a foundation required toshare with the general public?

Upon request, a public charity or private foundation must makeavailable for public inspection, without charge, a copy of itsannual returns (Forms 990, 990-EZ or 990-PF and 990-T, ifany) for three years after filing. Public charities are not requiredto publicly disclose the portions of the annual returns thatinclude the names and addresses of contributors to theorganization (whereas private foundations are required topublicly disclose such information).

A foundation also must make available for public inspection,without charge, a copy of its exemption application, alongwith the accompanying attachments and amendments, andany documents issued by the Internal Revenue Serviceconcerning the application. However, the foundation mayrequest that certain information be withheld from publicinspection on the grounds that it constitutes a trade secret orsome other form of intellectual property.

Q3What satisfies a foundation’s public informationrequirements?

Foundations and public charities must make their annual returnsand exemption application materials available for inspection,without charge, at their principal, regional and district officesduring regular business hours. If the organization does notmaintain a permanent office, it must make the informationavailable for inspection at a reasonable location of its choice;it may also mail the information.

Organizations must provide copies of their annual returns andexemption applications to anyone who requests a copy eitherin person or in writing. The organization may charge areasonable amount for copying these materials, including stafftime and actual costs. As an alternative to providing copies,an organization can make its information widely available byposting the information on a web page and directingrequestors to such page.

Q4What information must a foundation retainregarding its grants?

Private foundations that make grants to an individual for travel,study or similar purposes are required to retain the followinginformation regarding the grant: (a) all information thefoundation secures to evaluate the qualification of potentialgrantees, (b) identification of grantees (including informationregarding whether grantee is a disqualified person), (c)specification of the amount and purpose of each grant, and (d)the follow-up information that the foundation obtains incomplying with these record retention requirements. InternalRevenue Service regulations broadly require that organizationsretain records “so long as the contents thereof may becomematerial in the administration of any internal revenue law.”However, the Treasury regulations do address the issue of howlong a grant recipient must keep records: four years aftercompletion of the use of grant funds.

Q5How long must a foundation retain its records?

An annual return is required to be available until three years havepassed from the date the return was required to be filed (includingany extensions) or was filed, whichever is later.

Exemption applications (and related documents) are required to beavailable indefinitely. However, applications are not required to beavailable if they were filed before July 15, 1987, and if theorganization did not have a copy of the application on July 15, 1987.

The Internal Revenue Service does not specify exact time periodsfor which exempt organizations shall maintain general records.Rather, the Treasury Regulations broadly require that organizationsretain records “so long as the contents thereof may becomematerial in the administration of any internal revenue law.”Therefore, organizations should take a best-practices approachregarding records retention and should retain as much informationas is reasonable for a reasonable period of time. Organizationsshould consult with their attorneys regarding this issue, but it iscommonly recommended that organizations retain information fora period of seven years.

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Q1When is a foundation required by law to have itsfinancial statements audited?

An organization that is registered with the Minnesota AttorneyGeneral because it solicits charitable contributions is requiredto include audited financial statements with its annual report tothe Attorney General if its total revenue for the year exceeded$750,000. Currently, there is no federal tax law auditrequirement.

Q2Under what other circumstances might a financialaudit be recommended or required?

Financial audits are sometimes required under a foundation’sorganizational documents. In other cases, contributors, thefederal government for certain contracts, or other programpartners may require a foundation to have audited financialstatements. Other states have more stringent audit requirementsfor foundations conducting activities or organized in thosestates. A number of proposals have been made that wouldimpose a federal audit requirement on many charitableorganizations, including foundations. The trend is toward morestringent requirements for financial audits of charitableorganizations.

The preparation of audited financial statements by anindependent auditor generally improves the quality of financialinformation available, and can help foundation boardmembers fulfill their fiduciary duties to the foundation. Anindependent examination permits a competent and objectivereview of the organization’s financial affairs. It can be time-consuming for staff and expensive for smaller foundations,however, and therefore most requirements andrecommendations for independent financial audits attempt tobalance the size and complexity of the foundation with theexpense and time required to prepare audited financialstatements.

Q3What is the process for authorizing andapproving a financial audit?

Financial audits and independent auditors are normallyauthorized and selected by the foundation’s board, which mayhave a separate audit committee for this purpose. The auditorswork with the foundation’s audit committee or board and staffto conduct the audit, and normally report their results to theaudit committee or board.

Although some sources recommend periodic rotation of auditfirms or lead auditors, this is not required by law. Thefoundation’s board or audit committee is responsible forengaging the auditor and defining the scope of theengagement, reviewing the audit, responding torecommendations for changes, and addressing any significantissues that may be brought to light as a result of the audit.

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Financial Audits

MCF has made the self-assessments and related tools availablefor all grantmakers to use. Included among these useful tools:

Accountability Self-Assessment Questionnaire

The Accountability Self-Assessment Questionnaire helps assessa foundation’s compliance with legal issues and otheraccountability issues. The questionnaire comes in versions forunstaffed and staffed private foundations.

Accountability Self-Assessment Worksheet

The Accountability Self-Assessment Questionnaire isaccompanied by a Microsoft Excel spreadsheet to helptabulate responses. The worksheet comes in versions forunstaffed and staffed private foundations.

Legal Compliance Checklist

The Legal Compliance Checklist contains all legal requirementstracked in the Accountability Self-Assessment Questionnaire, toensure compliance with federal law. The checklist comes inversions for unstaffed and staffed private foundations.

Note: The Accountability Self-Assessment Tool for PrivateFoundations has been developed for grantmakers around thenation, and is not tailored specifically to Minnesota lawsgoverning foundations. The Practice Options for PhilanthropicOrganizations do cover key Minnesota laws, as well asfederal laws. Find the specific Minnesota-related requirementsin the Practice Options section of this booklet.

Additional Resources

Additional resources include a Glossary of terms used in theself-assessment tool and an extensive Accountability ResourceList, which provides more information on the topics and issuescovered in the tool.

Find these tools at www.mcf.org/publictrust.

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Accountability Self-Assessment Tool for Private FoundationsMORE ACCOUNTABILITY TOOLS

In addition to this document and the Principles for Grantmakers& Practice Options for Philanthropic Organizations, theMinnesota Council on Foundations also offers privatefoundations — family, independent and corporate —additional tools comprising an Accountability Self-Assessment.This tool was developed with the Forum of RegionalAssociations of Grantmakers, the national association of 32regional associations like the Minnesota Council onFoundations that are working collaboratively to strengthenphilanthropy throughout the country.


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CONTRIBUTING STAFF

Crystal ColbyCommunications Associate

Caren CusterAdministrative Assistant

Melissa EystadDirector of Member Services

Jane FergusonVice President of Communications and Information Services

Bill KingPresident

Megan SullivanCommunications Associate

PRODUCTION

The Design Company

About the Minnesota Council

on Foundations

Founded in 1969, the Minnesota Council on Foundations is aregional membership association of grantmakers working toimprove the health and vitality of our communities. TheCouncil’s membership includes family and other privatefoundations, community and other public foundations, andcorporate foundations and business giving programs.

The Council provides service to Minnesota philanthropy in:

� Educating the field

� Providing access to the field

� Communicating with and on behalf of the field

� Providing research and information about the field

� Protecting the field

� Expanding and leading the field

For additional information about the Council, go towww.mcf.org. For membership information, please contact the Council at 612.338.1989.

100 Portland Avenue South, Suite 225Minneapolis, MN 55401-2575

t 612.338.1989f [email protected]

www.mcf.org

a community of grantmakers
