At the end of 2019, the Taxpayer Certainty and Disaster Relief Act of 2019 (“the Act”) was signed into law. One of the provisions that this legislation contained was a simplification to the excise tax on net investment income that is assessed against private foundations for tax years beginning after December 20, 2019. Prior to the Act, private foundations either paid tax at a rate of two percent (2%) or one percent (1%). To qualify for the one percent (1%) tax rate, a foundation needed to meet certain distribution requirements during the tax year. Under the Act, private foundations now pay an excise tax equal to 1.39% of their net investment income.

Net Investment Income

Net investment income is broadly defined under the Internal Revenue Code (“IRC”) as gross investment income plus capital gain net income, less any allowable deductions. Gross investment income generally includes interest, dividends, rents, and royalties, though income that is taxed under the unrelated business tax provisions is excluded from the excise tax. Capital gain net income includes capital gains and losses from the sale of investment assets. To the extent that any investment assets are donated to the foundation, gain or loss is calculated by using the donor’s adjusted basis.

Expenses that are typically allowed as deductions against investment income are any ordinary and necessary expenses that were paid for the production of the investment income, or the management, maintenance, or conservation of the investment property. A foundation can allocate a portion of its operating expenses, including salaries, professional fees, and occupancy expenses, that may be attributable to the foundation’s investment activities. While there is no required allocation method, the allocation should be reasonable and used consistently from year to year.

Taxable vs. Tax-Exempt Private Foundations

The rules detailed above apply to both taxable and tax-exempt private foundations, with some caveats. A tax-exempt private organization is a charitable organization that does not meet the definition of a public charity. Most individuals are familiar with a tax-exempt private foundation that is funded by one donor or family. A taxable private foundation is an entity that no longer meets the charitable requirements of a tax-exempt private foundation, and therefore it has lost its tax-exempt status. These taxable entities are subject to the excise tax on net investment income to the extent the excise tax plus any unrelated business income tax for the year exceed the entity’s regular income tax liability for the year.

Planning for the Excise Tax

Private Foundations should be aware of the excise tax and ensure that they are making estimated tax payments if the total tax liability exceeds $500. To ensure an accurate excise tax calculation, foundations should make sure they properly characterize the income they receive during the year. If income relates to a charitable activity performed by the foundation, it should not be included in net investment income. Foundations should also pay close attention to how they are allocating their operating expenses between net investment income and disbursements for charitable purposes. Since there is no required method for allocation, the foundation should spend some time coming up with a reasonable method for allocation and should use this same method consistently from year to year.

The HBK Nonprofit Solutions Group works with many private foundations to plan for this excise tax. Please reach out to a member of the HBK Nonprofit Solutions Group for more information.

Of all the rules and regulations private foundations are subject to, those addressing self-dealing may be the most complex. Violating those self-dealing rules can result in substantial tax consequences. While publicly supported organizations can engage in transactions with persons related to the organization, as long as certain rules and guidance are followed, private foundations are prohibited from engaging in any transactions with disqualified persons.

In order to be considered a disqualified person the individual must either be; a substantial contributor or a foundation manager. Certain individuals who own an entity that is considered to be a substantial contributor are also considered disqualified persons, as are family members of substantial contributors or foundation managers.

In order for an act of self-dealing to occur, there must be a direct or indirect transaction between a private foundation and a disqualified person. Indirect transactions can occur when the foundation engages in a business deal with an entity that is owned 20% or more by a disqualified person. Examples of self-dealing include:

• Selling, exchanging, or leasing of property
• Lending money or extending credit
• Furnishing goods, services, or facilities
• Paying compensation or reimbursing expenses to a disqualified person
• Transferring a foundation’s income or assets to, or allowing their use by, a disqualified person

An excise tax is imposed on self-dealing transactions. The taxes imposed on these types of transactions can be substantial and it is possible for one transaction to result in multiple acts of self-dealing. For example, if a foundation lends money to a foundation manager then there will be tax assessed in the year the loan was entered into, and in every year thereafter until the act is corrected.

There are some exceptions to the self-dealing rule, one being compensation to a disqualified person for personal professional services necessary to carrying out the foundation’s exempt purpose, as long as the compensation paid is not excessive. Typically this is seen when a foundation manager is paid a fee for managing the exempt activities of the foundation and/or overseeing the grant-making process. Other exceptions to the self-dealing rule include:

• Transactions that result in an individual being classified as a disqualified person
• Transactions with former disqualified persons (i.e. previous foundation managers who were not otherwise disqualified persons)
• Interest free loans made to a private foundation by a disqualified person, as long as no other charges are incurred and the proceeds are used exclusively for the foundation’s exempt purpose
• Incidental benefits to a disqualified person

For questions or additional guidance, please contact your HBK Advisor or a member of the HBK Non-Profit Solutions Group.