Thursday April 18, 2024

7.2.9 Private Operating Foundations

Private Operating Foundations

POFs vs. PFs:  POFs have a more favorable tax status than PFs for several reasons.

Qualification for POF Status:  To qualify as a POF, a PF must: 1) meet the income test and 2) meet one of three other tests that demonstrate its operation in furtherance of a charitable purpose.
A private operating foundation (POF) is a type of private foundation (PF) granted tax-exempt status under Sec. 501(c)(3). While PFs are nonoperating grantmaking foundations, POFs actually engage in activities in furtherance of their charitable purpose. For example, an art museum is a classic example of a POF that fulfills its charitable purpose by operating a museum to educate visitors in the arts.

POFs vs. PFs
POFs have a more favorable tax status than PFs for several reasons. POFs are not subject to some of the excise taxes imposed on PFs. POFs are exempt from the Sec. 4942 minimum charitable distribution requirements, which require PFs to disburse 5% of the fair market value of their assets annually or be taxed on the excess of the disbursable amount. POFs are subject to the remaining PF excise taxes including the taxes on net investment income, self-dealing, excess business holdings, jeopardy investments and taxable expenditures. "Exempt operating foundations" a special kind of POF, are exempt from the 2% excise tax on net investment income.

Gifts to POFs also qualify for the more favorable tax deductions characteristic of public charities. Gifts to a POF of cash or ordinary income property are deductible up to 50% of an individual's AGI, while gifts of appreciated property such as stock or real estate are deductible up to 30% of an individual's AGI. Sec. 170(b)(1)(a). Unused deductions may be carried forward for an additional five years. Gifts to PFs are less favored because deductions are limited to 30% AGI for cash gifts and 20% AGI for gifts of appreciated property. In addition, unlike PFs, all contributions to POFs are deductible by donors at fair market value rather than at cost basis.

Example 7.2.9A

Deanna Quell earned $200,000 this year. Deanna desires to make a gift of her publicly traded Wolford stock to the Glaty Private Foundation (PF). The fair market value of the stock is $60,000. After learning that her deduction for an appreciated property gift to Glaty PF would be limited to 20% of her AGI or $40,000 in the first year, Deanna considers making a gift to the Glaty Private Operating Foundation (POF) which operates a museum in Glatydom. By gifting the stock to Glaty POF, Deanna may deduct 30% of her AGI or the entire $60,000 in the first year of her gift. Deanna is happy with this result and decides to contribute to the Glaty POF rather than the PF.

Qualification for POF Status
To qualify as a POF, a PF must: 1) meet the income test and 2) meet one of three other tests that demonstrate its operation in furtherance of a charitable purpose.

The POF income test requires that the charity use "substantially all" of the lesser of its adjusted net income or its minimum investment return for charitable activities as opposed to grantmaking. Sec. 4942(j)(3)(A). For purposes of this section, the IRS has defined "substantially all" as 85% or more. Reg. 53.4942(b)-1(c). Thus, a foundation that makes qualifying distributions for the conduct of charitable activities in an amount at least equal to 85% of its adjusted net income satisfies the test, even if it engages in grantmaking with the remainder of its funds. In determining whether the amount of qualifying distributions made directly for the active conduct of exempt activities equals at least 85% of a foundation's net income, a foundation is not required to trace the source of such expenditures to determine whether they were derived from income or from contributions. Reg. 53.4942(b)-1(c).

Example 7.2.9B

Brophy Museum is an exempt museum under Sec. 501(c)(3) that was established by a grant from Adrina Brophy. The Brophy Museum uses 90% of its adjusted net income to operate the museum. If Brophy Museum satisfies one of the three remaining tests in Reg. 53.4942(b)-2, it may be classified as a POF, since "substantially all" of its funds are used directly for operation of the museum.

In addition to meeting the income test, a POF must meet one of three tests set forth in Reg. 53.4942(b)-2:
  1. Asset Test - Substantially more than half (65% or more) of the POF's assets must be devoted to the conduct of its exempt function activities or to a functionally related business, a combination of the two or a stock of a corporation controlled by the foundation and to which substantially of the assets are so devoted.

  2. Endowment Test - A POF must expend not less than two-thirds of its net investment assets for activities in furtherance of its exempt purpose.

  3. Support Test - A POF must receive substantially all of its support (at least 85%) from the general public and a minimum of five unrelated exempt organizations. A POF may not receive more than 25% of its income from any one such exempt organization. Gross investment income may not account for more than half of its support.

Example 7.2.9C

Cars for Careers is an exempt organization under Sec. 501(c)(3) that provides vehicles to welfare mothers reentering the workforce and does not meet the requirements for public charity status. 70% of Cars for Careers assets consist of vehicles used by welfare moms for transportation to their new jobs. Thus, Cars for Careers satisfies the Asset Test, since 65% or more of its assets are devoted to the conduct of its exempt function activities. If Cars for Careers can also demonstrate that 65% or more of its income is used in furtherance of its exempt purpose, it will satisfy the "income test" and may be classified as a POF.

In general, a POF may satisfy the income test and either the asset, endowment or support test in one of two ways: 1) by satisfying the tests for any three taxable years over a four year period or 2) by aggregating all pertinent items for the four-year period. It may not use one method for satisfaction of the income test and the other method for satisfaction of one of the remaining three tests. If a foundation fails to satisfy the tests either on the three out of four year basis or under the aggregation method, it will be treated as a nonoperating foundation for the taxable year(s) until it satisfies the tests. Reg. 53.4942(b)-3(b)(1). As such, contributions made to the foundation do not receive the most favorable deductions until the foundation is once again deemed a POF.

Private Letter Rulings

PLR 200512025 Golf Course Deemed Unrelated Business:   M is a non-profit that is organized for religious, charitable, educational and scientific purposes. M operates a large facility that includes a number of activities and services. Part of M's operations include an activity center where visitors can learn through workshops and hands-on interaction about various flowers, trees and fruits and vegetables. M also offers for sale produce that is grown on-site and also produce that is grown off-site. M operates a gift shop that sells a variety of items including books and Christmas decorations. As a convenience to its visitors, M has a location where it sells food and drinks. M also hosts events at its location including weddings, banquets and conferences at which it provides the catering services. To help preserve the atmosphere and overall enjoyment of the facilities for its visitors, which M states would encourage the visitors to come and increase the length of their stay, M has developed a buffer zone in the form of a golf course that completely surrounds its location.

PLR 200513030 PF Converts to Community Foundation:   Donors Alfred and Bertha created a private foundation. The private foundation was primarily designed to enhance the "physical, cultural and spiritual environment of the people of the State of M and the United States of America, and primarily of N and the area comprising O."

Related Topics on Private Operating Foundations

1.1.3  Deduction Limits - 60%, 50%, 30%, 20%:    There are several limits on deducting charitable gifts. Generally, cash gifts and appreciated gifts to public charities are deducted first. Then, cash and appreciated gifts to private foundations are deducted. If there are carry-forwards in either category, those are deducted next if the current gifts have not reached the applicable deduction limits.

7.2.1  Classification as a Private Foundation:    All Sec. 501(c)(3) charities are classified either as private foundations or as public charities. Public charities tend to be the traditional "charitable" organizations such as schools, hospitals, churches, museums and organizations that work with broad segments of the public. Typically, a single wealthy family forms a private foundation as a charity that invests money and uses it to make grants to other charities.

      Quiz-Basic



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