Providing Large Grants to Small Grantees
Lawyers rarely tell foundation managers, "Relax, don’t worry so much!" But in the case of "tipping," that’s been our advice for more than 10 years. What is the so-called "tipping problem" and why are so many foundations (still) so worried about it?
Tipping occurs when a private foundation’s support tips a public charity out of compliance with the public support test, converting it into private foundation status. Many foundation managers fear that making such a grant will lead the IRS to conclude that they have made a grant to another private foundation, a grant that would require the exercise of expenditure responsibility and compliance with the out-of-corpus rules.
In reality, Rev. Proc. 89-23 (1989-1 C.B. 844), which the Council on Foundations successfully obtained in 1989 after a 10-year effort, should eliminate almost entirely both concern about tipping and the attendant paperwork that many foundations undertake. While making big grants to a small organization can wreak havoc on the grantee’s public support test calculation, foundations will generally not be held responsible for any changes their grants cause to a grantee’s tax status.
Public Support, "Substantial and Material Changes" Concern about tipping arises from the intersection of two parts of the U.S. Tax Code: the public support test and the rules about private foundation grants to other private foundations.
The Tax Code requires organizations seeking treatment as public charities based on the nature of their funding to demonstrate annually that over the past four years they have received at least one-third of their total support in contributions from the general public. The proportion of this public support can drop as low as 10 percent of total support (the total of all public support, plus endowment and other income) if the charity meets a facts-and-circumstances test that suggests it is trying to increase public support.
In this public support test calculation, a private foundation’s grant is capped like an individual’s gift, any part of the grant that is more than 2 percent of the organization’s total support will not count as public support. Since all of a foundation’s grant will count as total support, a big grant can decrease the proportion of funds considered public support and put a charity into private foundation status.
Before Rev. Proc. 89-23, Treasury regulations stated that a private foundation could be held responsible if its grant transformed a public charity into a private foundation. If a grantor was responsible for such a "substantial and material change" in a grantee’s sources of support, it could not rely on the IRS’s original determination that the grantee was a public charity. The private foundation would be required to treat the tipping grant as a grant to another private foundation. This would involve exercising expenditure responsibility (a procedure involving a pre-grant inquiry, a grant agreement and follow-up reporting) and ensuring that the out-of-corpus rules (requirements that grant funds be paid out to public charities promptly) were satisfied. Failure to undertake these procedures could result in penalty taxes.
To avoid tipping a public charity, foundation financial officers and outside counsel reviewed grantees’ finances and public support calculations. When they found that a grant was likely to tip a grantee, they would require the foundation to treat the payment as a grant to another private foundation.
Rev. Proc. 89-23: A Safe Harbor Rev. Proc. 89-23 was intended to free foundation staff (or counsel) from this review. The ruling provides that a foundation cannot be penalized for tipping a grantee so long as (1) the grantee has a valid IRS determination letter at the time the grant is made; (2) the IRS has not revoked the letter and the foundation is not aware of imminent action by the IRS to do so; and (3) the foundation does not control the grantee.
The safe harbor provided by Rev. Proc. 89-23 is broader than that provided by an earlier ruling, Rev. Proc. 81-6 (1981-1 C.B. 620). In that ruling, the IRS stated that it would not treat grantors as responsible for tipping long-established public charities into private foundation status if the grantor’s support in any year was less than 25 percent of the aggregate support received by the grantee from all sources in the preceding four years. This position, which still required extensive review of finances, was superseded for private foundations by Rev. Proc. 89-23.
How can a foundation take advantage of the protection provided by Rev. Proc. 89-23 when making a large grant to a small organization?
First, secure a copy of the grantee’s tax determination letter and verify that the organization is a public charity. In many cases, the sentence to look for states that the organization is "not a private foundation within the meaning of section 509(a) of the Internal Revenue Code because" it is described in section 509(a)(1), 509(a)(2) or 509(a)(3).
If the foundation requires a grant agreement to be signed, include a statement in which the grantee confirms its tax status as set forth in its IRS determination letter and pledges to notify the grantmaker of any change.
It is helpful for a grantmaker to inform grantees that a large grant may throw off their public support calculation and encourage them to seek other funding to offset the private foundation’s support. A private foundation does not have a legal obligation to provide this information or educate its grantees about the public support test, but concerned grantmakers may wish to provide technical assistance by reviewing grantees’ public support calculations or by referring them to the publications mentioned below. Foundations may consider paying large grants in installments, conditioned on the grantee’s meeting fundraising targets.
Grantees may be able to secure permission from the IRS to treat a foundation’s grant as an "unusual grant" and exclude it from the public support test computation. This option, described in IRS Publication 557 as well as in Rev. Proc 81-7 (1981-1 C.B. 621), may be available when the grant (1) is attracted because of the publicly supported nature of the grantee, (2) is unexpected or unusually large, and (3) would hinder the grantee in meeting the one-third public support test.
To qualify for this treatment, a grant: (1) must be made by a disinterested party, (2) may not be subject to material restrictions, and (3) must be in the form of cash, marketable securities or assets that directly further the grantee’s charitable activities. The IRS will consider additional factors such as the grantee’s record and prospects of attracting public support.
A strong record of public support can demonstrate that an organization has generated enthusiasm for its work from the community it serves. While grantmakers may continue to examine grantees’ public support history, they should keep in mind that Rev. Proc. 89-23 generally eliminates the obligation to calculate the impact of the foundation’s grant and the possibility that tipping will occur.
