The question before the house today is this: Why does America hate its charitable foundations? With apologies in advance for the length of this post, let’s look into the issue.
On the surface this might seem like an odd inquiry. As I’ve written about many times,(1) private philanthropy is one of the great glories of American civilization. Organized, disciplined philanthropy as it is practiced by charitable foundations was invented in the US by Andrew Carnegie in the early Twentieth Century and today virtually every country in the world is green with envy. Indeed, scores of countries, from Britain to China, have tried to encourage the formation of charitable foundations.
So important is organized philanthropy that virtually every wealthy American family eventually gets around to forming a foundation (or charitable trust), and tens of thousands of mass affluent folks have done the same via donor advised funds established at community foundations or commercial operations like Fidelity, Schwab and Vanguard.
Finally, Americans across the political spectrum (ex extreme left and right) love their foundations. I recently stepped down as chair of the board of the Pittsburgh Foundation, the community foundation for our region. Every year, surveys show that the Pittsburgh Foundation is the city’s favorite charity, ranking ahead even of heart-tuggers like the children’s hospital.
So how can I suggest that America hates its foundations? Because all this Kumbaya affection for foundations dissipates completely by the time it reaches the US Congress. Congress, it’s fair to say, views foundations as quasi-criminal organizations which have to be taxed, regulated and monitored to within an inch of their lives. This is especially true of “private foundations.”
Over the course of my professional lifetime – beginning, say, with the Tax Reform Act of 1969 – whenever Congress has taken up the subject of foundations, punitive legislation almost inevitably results. Unlike most other nonprofit organizations, foundations are taxed out the Wazoo: taxes on net investment income (IRC §4940); taxes on self-dealing (IRC §4941); taxes on the failure to distribute sufficient income (IRC §4942); taxes on excess business holdings (IRC §4943); taxes on so-called jeopardizing investments (IRC §4944); taxes on “taxable expenditures” (IRC §4945).
Let’s look at this sordid Congressional record in more detail.
Excise taxes
While other endowed nonprofits – colleges, universities, the World Wildlife Fund – are fully tax-exempt, foundations must pay an excise tax on their net investment income. Congress initially justified this tax as being necessary to fund the costs of auditing foundations (they had to be audited because of all the restrictions Congress had placed on them), but over the years the tax has raised many times those costs. It’s just a penalty for being a foundation.
And while the excise tax is modest, it’s insulting. Foundations support a huge variety of deserving nonprofit activities, from local dance groups to the Girl Scouts to major universities to pioneering medical research, thus contributing across-the-board to civic improvement. The endowment of a small college in Georgia supports… a small college in Georgia. Yet the foundations pay taxes and the college doesn’t.(2)
Limits on grants to individuals
Almost everything of any importance that happens in the world starts with an idea by an individual or individuals. Thus, the most efficient way for a foundation to support terrific new ideas would be for the foundation to fund the individual who has the idea. But Congress, in its wisdom, has seen fit to make it very difficult for foundations to fund individuals, and therefore most foundations won’t even think of it. Instead, the foundation has to direct its funds through a 501(c)(3) organization with all its associated overhead and inefficiency.
If a foundation wants to do something really outrageous – like set up a program to award scholarships to deserving high school students, for example – it can’t do it without getting approval from the IRS in advance.
Self-dealing restrictions
Foundation “managers” (trustees, directors, senior staff) are subject to penalties in the event they violate obscure rules against “self-dealing.” Here’s a common example. Mrs. Moneybags gets a call from the local opera company, which, like all opera companies, is desperate for cash. “Oh, ok,” says Mrs. M, “Put me down for $10,000.” Two weeks later, the Moneybags Foundation meets and approves a $10,000 grant to the opera. Result – penalties all around! If Mrs. M had only had the presence of mind to say, “Oh, ok, put our foundation down for $10,000,” all would have been well. Harsh penalties for such innocuous slips of the tongue can only happen in the foundation world.
Or consider this. The Moneybags family office is paying $40/square foot for its office space – the going rate. It sets aside one office for the Moneybags Foundation, charging the Foundation $30/square foot with the right to use phones, conference rooms etc. at no additional charge. Result: self-dealing! Penalties all around! According to Congress, the Moneybags Foundation should simply go out into the world and pay $25/square foot, plus extra for utilities and conference rooms, thus having much less money to give away.
Expenditure responsibility
A nonprofit organization can be a public charity or not. Some public charities are in the business of wasting donations, while some non-public charities are doing essential work. Yet, as long as an organization is categorized by the IRS as a public charity a foundation can make grants to it all day long, no matter how much of the money is wasted. But if the organization isn’t a public charity, the foundation finds itself in the position of being in loco parentis.
This is the so-called “expenditure responsibility” rule. Suppose a foundation wants to support a newer nonprofit that is doing a terrific job but is struggling to attract funding. According to Congress, the foundation must jump through hoops of fire to do it: making a pre-grant inquiry to ensure that the grant will be used for proper purposes; specifically flagging the grant on the foundation’s 990-PF (its tax return); maintaining a bunch of records; taking remedial steps if the nonprofit has somehow diverted the funds; and getting a written grant agreement requiring the nonprofit to return any funds not used for the grant’s purposes, to submit annual reports, to maintain financial records, not to use the funds for inappropriate purposes, and, bizarrely, to hold the funds in a separate account.(3)
Needless to say, foundations almost never make grants to organizations not already qualified as public charities. This ensures that an IRS decision regarding the public charity status of an organization is a life or death decision, which is just how the IRS likes it.
Intermediate sanctions
While all nonprofits are subject to strict rules against so-called “excessive” compensation – as though the giving public were so stupid it couldn’t control this issue – most nonprofits can take steps to create a “rebuttable presumption” that their compensation is reasonable.(4) Foundations can’t – no matter what they do, the IRS can challenge compensation of staff and executives.
Limits on business holdings
I’ve already teed-off on this issue (Things That Annoy Me, Part 4, post of 4/11/13), so I’ll merely point out that IRC §4943 taxes a private foundation if it owns (generally) more than 20% of the voting stock of any corporation. This provision doesn’t apply to other endowed nonprofits.
Prohibitions on lobbying activity
Although as far as I know the First Amendment is still the law of the land, private foundations are prohibited from spending money “to carry on propaganda, or otherwise attempt to influence legislation.” Such spending is known as a “taxable expenditure,” and is, naturally, heavily taxed. No other nonprofit is so restricted, and when Congress has tried to gag organizations such as corporations, the courts have struck down the restrictions.
Limits on so-called “jeopardizing investments”
I’ve already vented on this subject – see Things That Annoy Me, Part 1, post of 3/20/13 – but in essence the IRS has decided to ignore fiduciary rules and common sense and determine for itself how a private foundation can invest its assets. As I noted in the post just alluded to, every example of a “jeopardizing investment” the IRS cites is already included in the portfolios of most well-managed nonprofit organizations.
Limits on contributions
As everyone knows, gifts to private foundations are discouraged. Cash gifts to public charities are deducible up to 50% of AGI, but only 30% of AGI for private foundations. Gifts of appreciated property are deductible up to 30% of AGI for public charities, but only 20% for private foundations.
Very high annual spending requirements
Private foundations are required each year to make “qualifying distributions” in an amount approximately equal to 5 percent of their investment assets. Grants and administrative expenses (but not investment expenses!) count toward this payout requirement. Other endowed nonprofits, and even private trusts, can decide for themselves – within fiduciary limits – how much to spend. Not private foundations.(5)
As anyone who has tried to invest the endowment of a private foundation knows, it’s not possible to generate 5% annual returns net of all costs and taxes via any investment strategy that would pass fiduciary muster. Moreover, almost every foundation actually spends considerably more than 5%: since it can’t spend less, it must err on the upside; some expenses don’t count against the 5% but are still costs; many foundations are so focused on their missions they forget that they are chronically over-spending. As a result, 90% of America’s foundations – that is, the smallest 90% – are in permanent liquidation mode.(6)
Summary
It’s possible for fair-minded people to agree or disagree about this or that of the above-described restrictions on foundations, but viewed in the aggregate they can only be seen as seriously punitive. In other words, Big Mac(7) may be trying to “build a more just, verdant [verdant!] and peaceful world,” but not if the US Congress has anything to say about it.
In my next post we’ll take a look at why Congress should want to penalize such a revered sector of the American polity.
(1) E.g., The Stewardship of Wealth, p. 34 ff., American Exceptionalism: Giving Back – The Remarkable Power of Private Philanthropy, blog post of 5/10/13.
(2) The excise tax also operates perniciously when (say, during economic downturns) a foundation significantly boosts its giving in order to respond to the increased need. As soon as the giving returns to normal the foundation’s excise tax will double.
(3) If a foundation decides to make a grant to an organization the IRS has classified as a “non-functionally integrated Type III supporting organization” (don’t ask), the foundation must not only exercise expenditure responsibility, but the grant won’t count toward the 5-percent payout requirement.
(4) The potential excessive compensation issue is referred to in the nonprofit world as the “intermediate sanctions” issue. The term arose because, originally, a nonprofit that paid excessive compensation had its charitable status revoked – the death penalty. Now they just get the hell taxed out of them – an “intermediate” sanction.
(5) The 5% spending rule also operates counterproductively. When times are good and stock markets are strong, foundation giving is high. But when recessions hit (and markets fall), foundation giving declines just when it’s needed most.
(6) Very large foundations can invest in such “aspirational” assets as venture capital, leveraged buyouts, and private real estate and, therefore, possibly net more than 5%. In other words, the 5% spending rule penalizes smaller foundations and rewards the giants.
(7) That is, The John D. and Catherine T. MacArthur Foundation ($6 billion), as opposed to Little Mac, the J. Roderick MacArthur Foundation ($13 million).
Next up: America and Its (Charitable) Foundations (Part 2)
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