7.27.18  Taxes on Investments Which Jeopardize Charitable Purposes

7.27.18.1  (04-30-1998)
Overview

  1. This section concerns the rules under IRC 4944 pertaining to private foundations. In order, this section:

    • provides a historical background to and an outline of the basic framework of IRC 4944.

    • describes in detail the definition of jeopardizing investments.

    • discusses investments not subject to the provisions of IRC 4944.

    • discusses program-related investments.

    • discusses the removal of investments from being classified as jeopardizing investments.

    • describes in detail the sanctions, including first-tier and second-tier taxes, that may be imposed on private foundations and their managers for making jeopardizing investments. Also described are steps private foundations and their managers may take to avoid the imposition of sanctions.

    • discusses the liabilities of foundation managers.

    • describes in detail other sanctions that may be imposed on private foundation and their managers for making jeopardizing investments.

    • provides a summary of relevant revenue rulings that are applicable to IRC 4945.

7.27.18.1.1  (04-30-1998)
Historical Background

  1. Congress enacted the Tax Reform Act of 1969 (P.L. 91–172) (hereinafter referred to as "TRA ’69" ) in an effort to put an end, as far as it reasonably could, to the abuses and potential abuses connected with private foundations. These perceived abuses included the following:

    1. investing in warrants

    2. futures

    3. options

    4. securities

    5. engaging in speculative practices that jeopardized a private foundation’s assets.

  2. Under IRC 504, the predecessor of IRC 4944, a private foundation would lose its exemption if it invested its accumulated income in a manner that jeopardized the carrying out of its exempt purposes. No similar limitations applied to an organization’s principal. Congress concluded that IRC 504 was not sufficiently effective to deter a private foundation manager from engaging in the aforementioned abuses.

  3. The House of Representatives’ TRA ’69 bill proposed the following changes to the Internal Revenue Code.

    1. Repeal IRC 504 and add IRC 4944.

    2. Extend the prohibition on jeopardy investment to include all assets of a foundation.

    3. A violation would not result in the loss of exemption. Rather, the private foundation would be taxed on the amount held to be a jeopardizing investment.

    4. A foundation manager who knowingly participated in the making of a jeopardizing investment would be taxed on the amount so invested.

  4. The Senate modified the House’s Tax Reform bill, adopted by Congress as part of the TRA ’69, which contained the present IRC 4944. See background and general explanation of IRC 4944 in S. Rep. No. 91–552, 91st Cong., 1st Session 45, 46 (1969), 1969–3 C.B. 453, 454. The 1969 Tax Reform Act took effect on January 1, 1970.

7.27.18.1.2  (04-30-1998)
IRC 4944 Framework

  1. IRC 4944 was enacted to tax private foundations making investments that jeopardize the carrying out of their exempt purposes. The deterrence is an excise tax imposed on private foundations and their managers for making investments that fall within the definition of jeopardizing investments. However, "program-related" investments (such as low-interest or interest-free loans to needy students, high risk investments in low-income housing) do not fall within this definition.

  2. If a private foundation makes an investment that is determined to be a jeopardizing investment, IRC 4944(a)(1) imposes an excise tax that is to be paid by the private foundation. When the private foundation is subject to the IRC 4944(a)(1) tax, its managers may also be subject to the excise tax under IRC 4944(a)(2) if he/she knowingly participated in the making of that jeopardizing investment. The taxes described in IRC 4944(a)(1) and (a)(2) are known as "first-tier" taxes.

  3. An additional excise tax of much greater severity is imposed under IRC 4944(b)(1) on the private foundation when it fails to correct the jeopardizing investment within the taxable period. IRC 4944(b)(2) taxes are imposed on managers if they refuse to take action to correct the situation. If the private foundation repeatedly or flagrantly violates IRC 4944, its status may be terminated by the Service. Such action will make that private foundation liable for the termination tax under IRC 507(c).


7.27.18.2  (04-30-1998)
Jeopardizing Investments Defined

  1. Reg. 53.4944–1(a)(2)(i) provides that an investment is a jeopardizing investment if it is determined that the foundation managers, in making the investment, have in providing for the long- and short-term financial needs of the foundation to carry out its exempt purposes failed to exercise ordinary business care and prudence under the facts and circumstances prevailing at the time of making the investment.

  2. These criteria reflect a "prudent trustee" approach to determine whether an investment jeopardizes the carrying out of a private foundation’s charitable purposes. See the General Explanation of the Tax Reform Act of 1969, prepared by the staff of the Joint Committee on Internal Revenue Taxation, December 3, 1970, page 46.

7.27.18.2.1  (04-30-1998)
Ordinary Business Care and Prudence

  1. In exercising the requisite standard of ordinary business care and prudence, private foundation managers may take into account the:

    • expected return (including both income and appreciation of capital);

    • risks of rising and falling price levels; and

    • need for diversification within the investment portfolio (e.g., with respect to type of security, type of industry, maturity of company, degree of risk, and potential for return).

  2. Reg. 53.4944–1(a)(2)(i) specifically provides that the determination should be made on an investment-by-investment basis, in each case taking into account the foundation’s portfolio as a whole.

7.27.18.2.2  (04-30-1998)
Time of Making Investment

  1. The investment must be examined under the facts and circumstances existing at the time the foundation makes the investment. A review on the basis of hindsight (whether the investment was an actual success or failure) is not relevant to this determination. Once it has been ascertained that a particular investment is not one that jeopardizes the exempt purposes of the foundation, subsequent losses that may result from the investment will not be considered for purposes of IRC 4944. See Reg. 53.4944–1(a)(2)(i).

  2. In light of the aforementioned criteria, the Service cannot issue a ruling that a proposed investment procedure governing investments by a private foundation will preclude imposition of a tax under IRC 4944 on the private foundation. See Rev. Rul. 74–316, 1974–2 C.B. 389.

7.27.18.2.3  (04-30-1998)
Close Scrutiny of Certain Investments

  1. No category of investments is to be treated as a per se violation of IRC 4944. Thus, there are no specific investments that are treated as jeopardizing investments. There are, however, examples of types or methods of investments which require close scrutiny to determine whether foundation managers have met the requisite standard of ordinary business care and prudence. See Reg. 53.4944–1(a)(2)(i).

  2. Examples of types or methods of transactions in the regulations which require close scrutiny are:

    • Trading in securities on margin

    • Trading in commodity futures

    • Investments in working interests in oil and gas wells

    • Purchase of "puts," "calls," and "straddles"

    • Purchase of warrants

    • Selling short

  3. Other recent investment strategies that deserve close scrutiny are:

    • Investment in "junk" bonds

    • Risk arbitrage

    • Hedge funds

    • Derivatives

    • Distressed real estate

    • International equities in third world countries

  4. Guarantees or collateralizations are a type of a lending of money or an extension of credit and, thus, are forms of investment activity. Such investments also deserve close scrutiny. See Janpol v. Commissioner, 101 T.C. 518 (1993).

7.27.18.2.4  (04-30-1998)
Examples: Jeopardizing and Non-Jeopardizing Investments

  1. Example 1: A is a foundation manager of B, a private foundation with assets of $100,000. A approves the following three investments by B after taking into account with respect to each of them B’s portfolio as a whole, an investment of:

    $5,000 in the common stock of corporation X
    $10,000 in the common stock of corporation Y
    $8,000 in the common stock of corporation Z

    1. Corporation X has been in business a considerable time, its record of earnings is good, and there is no reason to anticipate a diminution of its earnings. Corporation Y has a promising product, has had earnings in some years and substantial losses in others, has never paid a dividend, and is widely reported in investment advisory services as seriously undercapitalized. Corporation Z has been in business a short period of time and manufactures a product that is new, is not sold by others, and must compete with a well-established alternative product that serves the same purpose. Z’s stock is classified as a high-risk investment by most investment advisory services with the possibility of substantial long-term appreciation but with little prospect of a current return. A has studied the records of the three corporations and knows the foregoing facts. In each case the price per share of common stock purchased by B is favorable to B.

    2. Under the standards of Reg. 53.4944–1(a)(2)(i), the investment of $10,000 in the common stock of Y and the investment of $8,000 in the common stock of Z may be classified as jeopardizing investments, while the investment of $5,000 in the common stock of X will not be so classified.

  2. Example 2: Assume the facts of Example 1, except that in the case of: (a) corporation Y, B’s investment will be made for new stock to be issued by Y and there is reason to anticipate that B’s investment, together with investments required by B to be made concurrently with its own, will satisfy the capital needs of corporation Y and will thereby overcome the difficulties that have resulted in Y’s uneven earnings record; and (b) corporation Z, the management has a demonstrated capacity for getting new businesses started successfully and Z has received substantial orders for its new product.

    1. Under the standards of Reg. 53.4944–1(a)(2)(i), neither the investment in Y nor the investment in Z will be classified as a jeopardizing investment.

  3. Example 3: D is a foundation manager of E, a private foundation with assets of $200,000. D was hired by E to manage E’s investments after a careful review of D’s training, experience and record in the field of investment management and advice indicated to E that D was well qualified to provide professional investment advice in the management of E’s investment assets. D, after careful research into how best to diversify E’s investments, in order to provide for E’s long-term financial needs, and to protect E against the effects of long-term inflation, decided to allocate a portion of E’s investment assets to unimproved real estate in selected areas of the country where population patterns and economic factors strongly indicate continuing growth at a rapid rate. D determines that the short-term financial needs of E can be met through E’s other investments.

    1. Under the standards of Reg. 53.4944–1(a)(2)(i), the investment of a portion of E’s investment assets in unimproved real estate will not be classified as a jeopardizing investment. See Reg. 53.4944–1(c).

  4. Example 4: A private foundation received a donation of a whole-life insurance policy. At the time of the donation, the policy was subject to a policy loan that the insurer had made to the donor. The policy provided that, upon the death of the insured, the foundation would receive insurance proceeds in an amount equal to the face value of the policy reduced by the sum of the outstanding principal of the loans and any unpaid interest thereon. At the time the policy was donated, the life expectancy of the insured-donor was 10 years. Instead of immediately surrendering the policy to the insurer for its cash surrender value, the foundation retained the policy as an investment and annually pays the premiums and interest due on the policy and the policy loan, respectively. The combined premium and interest payments are of such an amount that, by the end of eight years, the foundation will have invested a greater amount in premiums and interest than it could receive as a return on this investment, i.e., in the form of insurance proceeds upon the death of the insured. Thus, the insurance policy will produce a financial loss to the foundation at the end of eight years.

    1. Under the facts and circumstances, the foundation managers, by investing at the projected rate of return prevailing at the time of the investment, failed to exercise ordinary business care and prudence in providing for the long-term and short-term financial needs of the foundation in carrying out its exempt purposes. Thus, each payment made by the private foundation for a premium on the insurance policy and the interest on the policy loan is a jeopardizing investment. See Rev. Rul. 80–133, 1980–1 C.B. 258.

  5. Example 5: The manager of a private foundation invested the entire corpus of the foundation in a foreign bank without inquiring into the integrity of the banks. The manager did not know that the bank’s license to do business and its charter had been revoked. Interest payments received by the foundation were irregular. The Tax Court agreed with the Service that the investment was a jeopardizing investment. See Thorne v. Commissioner, 99 T.C. 67 (1992). See IRM 7.27.18.6.2.2 for a discussion of advice of legal or qualified investment counsel; and IRM 7.27.18.6.2.6 for additional examples of the application of first-tier taxes.


7.27.18.3  (04-30-1998)
Pre-1970 Investments

  1. Investments made by private foundations prior to January 1, 1970, will not be subject to the provisions of IRC 4944, unless the form or terms of the investment have been changed or the investment has been exchanged. See Reg. 53.4944–6.

7.27.18.3.1  (04-30-1998)
Investments Received as Gifts or Acquired through Corporate Reorganizations

  1. Investments originally made by any party who later gratuitously transferred them to a private foundation are not subject to the provisions of IRC 4944. However, if the foundation furnishes any consideration to that party upon the transfer, the foundation will be treated as having made an investment (within the meaning of IRC 4944(a)(1)) in the amount of the consideration. See Reg. 53.4944–1(a)(2)(ii)(a).

  2. Investments that are acquired by a private foundation solely as a result of a corporate reorganization within the meaning of IRC 368(a) are not subject to the provisions of IRC 4944. See Reg. 53.4944–1(a)(2)(ii)(b).


7.27.18.4  (04-30-1998)
Program-Related Investments

  1. IRC 4944(c) provides that program-related investments do not fall within the definition of jeopardizing investment.

7.27.18.4.1  (04-30-1998)
Definition

  1. A program-related investment is an investment which possesses the following characteristics:

    1. The primary purpose is to accomplish one or more of the purposes described in IRC 170(c)(2)(B),

    2. No significant purpose of which is the production of income or the appreciation of property, and

    3. No purpose of which is to accomplish one or more purposes described in IRC 170(c)(2)(D), relating to legislative or political activities. See Reg. 53.4944–3(a).

7.27.18.4.2  (04-30-1998)
Primary Purpose

  1. An investment is a program-related investment if the primary purpose is to accomplish a IRC 170(c)(2)(B) purpose, and such investment would not have been made except for the relationship between the investment and the accomplishment of these exempt purposes.

  2. These IRC 170(c)(2)(B) purposes include the following:

    • Religious

    • Charitable

    • Scientific

    • Literary

    • Educational purposes

    • Prevention of cruelty to children or animals

    • Fostering national or international amateur sports competition without providing athletic facilities or equipment.

  3. In addition, for purposes of IRC 4944, investments described in IRC 4942(j)(4) (relating to functionally-related businesses) are to be considered as being made primarily to accomplish IRC 170(c)(2)(B) purposes. See Reg. 53.4944–3(a)(2)(ii).

  4. IRC 170(c)(2)(B) purposes may be carried out by organizations not described in IRC 170(c) or exempt under IRC 501(a). See Reg. 53.4944–3(a)(2)(i).

7.27.18.4.3  (04-30-1998)
No Significant Purpose, Production of Income or Appreciation of Property

  1. A program-related investment must not have a significant purpose of production of income or the appreciation of property. However, an investment that produces significant income or capital appreciation is not conclusive evidence of a significant purpose of production of income or the appreciation of property. In determining the aforementioned, a consideration is whether a profit-motivated investor would be likely to make the investment on the same terms as those made by the foundation. See Reg. 53.4944–3(a)(2)(iii).

7.27.18.4.4  (04-30-1998)
Prohibited Purposes

  1. An investment is not a program-related investment if it accomplishes any of those purposes described in IRC 170(c)(2)(D). See Reg. 53.4944–3(a)(1)(iii).

  2. IRC 170(c)(2)(D) purposes include the following:

    • Attempting to influence legislation;

    • Participating in or intervening in (including the publishing or distributing of statements) any political campaign on behalf of (or in opposition to) any candidate for public office.

  3. However, in the case of an investment whose recipient appears before or communicates with a legislative body with respect to legislation or proposed legislation of direct interest to that recipient and if the expenses thereof qualify as business expenses deductible under IRC 162, such investment is not considered to have been made to accomplish IRC 170(c)(2)(D) purposes. See Reg. 53.4944–3(a)(2)(iv).

7.27.18.4.5  (04-30-1998)
Changes in Program-Related Investments

  1. Changes in the form or terms of a program-related investment will not cause it to lose that status, provided that—

    • the changes are made primarily in furtherance of exempt purposes.

    • they are designed to protect the foundation’s investment status.

  2. However, under certain conditions, a program-related investment may cease to be a program-related investment because of critical changes in circumstances such as serving illegal or private purposes.

  3. In such an event, the private foundation will become subject to the tax imposed by IRC 4944(a)(1) no earlier than the 30th day after the date on which the foundation (or any of its managers) have actual knowledge of such critical changes in circumstances. See Reg. 53.4944–3(a)(3)(i).

7.27.18.4.6  (04-30-1998)
Examples: Program-Related and Non-Program-Related Investments

  1. Example 1: X is a small business enterprise located in a deteriorated urban area and owned by members of an economically disadvantaged minority group. Conventional sources of funds are unwilling or unable to provide funds to X on terms it considers economically feasible. Y, a private foundation, makes a loan to X bearing interest below the market rate for commercial loans of comparable risk. Y’s primary purpose for making the loan is to encourage the economic development of such minority group. The loan has no significant purpose involving the production of income or the appreciation of property. The loan significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the loan and Y’s exempt activities. Accordingly, the loan is a program-related investment even though Y may earn income from the investment in an amount comparable to or higher than earnings from conventional portfolio investments.

  2. Example 2: Assume the facts as stated in Example 1, except that after the date of execution of the loan, Y extends the due date of the loan. The extension is granted in order to permit X to achieve greater financial stability before it is required to repay the loan. Since the change in the terms of the loan is made primarily for exempt purposes and not for any significant purpose involving the production of income or the appreciation of property, the loan shall continue to qualify as a program-related investment, even though Y may realize a profit if X is successful and the common stock appreciates in value.

  3. Example 3: X is a small business enterprise located in a deteriorated urban area and owned by members of an economically disadvantaged minority group. Conventional sources of funds are unwilling to provide funds to X at reasonable interest rates unless it increases the amount of its equity capital. Consequently, Y, a private foundation, purchases shares of X’s common stock. Y’s primary purpose in purchasing the stock is to encourage the economic development of such minority group, and no significant purpose involves the production of income or the appreciation of property. The investment significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the investment and Y’s exempt activities. Accordingly, the purchase of the common stock is a program-related investment, even though Y may realize a profit if X is successful and the common stock appreciates in value.

  4. Example 4: X is a business enterprise which is not owned by low-income persons or minority group members, but the continued operation of X is important to the economic well-being of a deteriorated urban area because X employs a substantial number of low-income persons from such area. Conventional sources of funds are unwilling or unable to provide funds to X at reasonable interest rates. Y, a private foundation, makes a loan to X at an interest rate below the market rate for commercial loans of comparable risk. The loan is made pursuant to a program run by Y to assist low-income persons by providing increased economic opportunities and to prevent community deterioration. No significant purpose of the loan involves the production of income or the appreciation of property. The investment significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the loan and Y’s exempt activities. Accordingly, the loan is a program-related investment.

  5. Example 5: X is a business enterprise which is financially secure and the stock of which is listed and traded on a national exchange. Y, a private foundation, makes a loan to X at an interest rate below the market rate in order to induce X to establish a new plant in a deteriorated urban area which, because of the high risks involved, X would be unwilling to establish absent such inducement. The loan is made pursuant to a program run by Y to enhance the economic development of the area by, for example, providing employment opportunities for low-income persons at the new plant, and no significant purpose involves the production of income or the appreciation of property. The loan significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the loan and Y’s exempt activities. Accordingly, even though x is large and established, the investment is program-related.

  6. Example 6: X is a business enterprise which is owned by a nonprofit community development corporation. When fully operational, X will market agricultural products, thereby providing a marketing outlet for low-income farmers in a depressed rural area. Y, a private foundation, makes a loan to X bearing interest at a rate less than the rate charged by financial institutions which have agreed to lend funds to X if Y makes the loan. The loan is made pursuant to a program run by X to encourage economic redevelopment of depressed areas, and no significant purpose involves the production of income or the appreciation of property. The loan significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the loan and Y’s exempt activities. Accordingly, the loan is a program-related investment.

  7. Example 7: S, a private foundation, makes an investment in T, a business corporation, which qualifies as a program-related investment under IRC 4944(c) at the time that it is made. All of T’s voting stock is owned by S. T experiences financial and management problems which, in the judgment of the foundation, require changes in management, in financial structure or in the form of the investment. The following three methods of resolving the problems appear feasible to S, but each of the three methods would result in reduction of the exempt purposes for which the program-related investment was initially made:

    • Sale of stock or assets—The foundation sells its stock to an unrelated person. Payment is made in part at the time of sale; the balance is payable over an extended term of years with interest on the amount outstanding. The foundation receives a purchase-money mortgage.

    • Lease—The corporation leases its assets for a term of years to an unrelated person, with an option in the lessee to buy the assets. If the option is exercised, the terms of payment are to be similar to those described in (a) of this example.

    • Management contract—The corporation enters into a management contract which gives broad operating authority to one or more unrelated persons for a term of years. The foundation and the unrelated persons are obligated to contribute toward working capital requirements. The unrelated persons will be compensated by a fixed fee or a share of profits, and they will receive an option to buy the stock held by S or the assets of the corporation. If the option is exercised, the terms of payment are to be similar to those described in (a) of this example. Each of the three methods involves a change in the form or terms of a program-related investment for the prudent protection of the foundation’s investment. Thus, under Reg. 53.4944–3(a)(3)(i), none of the three transactions (nor any debt instruments or other obligations held by S as a result of engaging in one of these transactions) would cause the investment to cease to qualify as program-related.

  8. Example 8: X is a socially and economically disadvantaged individual. Y, a private foundation, makes an interest-free loan to X for the primary purpose of enabling X to attend college. The loan has no significant purpose involving the production of income or the appreciation of property. The loan significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the loan and Y’s exempt activities. Accordingly, the loan is a program-related investment.

  9. Example 9: Y, a private foundation, makes a high-risk investment in low-income housing, the indebtedness with respect to which is insured by the Federal Housing Administration. Y’s primary purpose in making the investment is to finance the purchase, rehabilitation, and construction of housing for low-income persons. The investment has no significant purpose involving the production of income or the appreciation of property. The investment significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the investment and Y’s exempt activities. Accordingly, the investment is program-related.

  10. Example 10: X, a private foundation, invests $100,000 in the common stock of corporation M. The dividends received from such investment are later applied by X in furtherance of its exempt purposes. Although there is a relationship between the return on the investment and the accomplishment of X’s exempt activities, there is no relationship between the investment per se and such accomplishment. Therefore, the investment cannot be considered as made primarily to accomplish one or more of the purposes described in IRC 170(c)(2)(B) and cannot qualify as program-related. See Reg. 53.4944–3(b).

  11. Example 11: Similar to the facts in Example 10, X invests $100,000 in a commodity futures partnership whose earnings (aside from a priority allocation made to X) will be distributed to Z, a public charity, for use in Z’s exempt purpose programs. As in (10), there is no relationship between X’s investment and the accomplishment of X’s (or Z’s) exempt purposes, except for the use of the earnings. Thus, the investment cannot qualify as program-related.

7.27.18.4.7  (04-30-1998)
Significance of Program-Related Investments

  1. A determination that an investment is program-related will exclude the investment from consideration as a business enterprise under IRC 4943 (Reg. 53.4943–10) or as a taxable expenditure under IRC 4945 so long as expenditure responsibility requirements are met. See Reg. 53.4945–5(b)(4) and Reg. 53.4945–6(b)(vi).

  2. Program-related investments are also treated as qualifying distributions under IRC 4942 in many circumstances. See Reg. 53.4942(a)–3(a)(2(i).


7.27.18.5  (04-30-1998)
Removal from Jeopardy

  1. IRC 4944(e)(2) provides that a private foundation has removed a jeopardizing investment from jeopardy when:

    • it sells or otherwise disposes of the investment, and

    • the proceeds of such are not investments which jeopardize the carrying out of exempt purposes.

  2. Reg. 53.4944–5(b) provides that if a private foundation changes the form or terms of a jeopardizing investment, such a change constitutes a removal of the investment from jeopardy if, after such change, the investment no longer jeopardizes the carrying out of such private foundation’s exempt purposes.

  3. If, after making a jeopardizing investment, a foundation subsequently exchanges that investment for another jeopardizing investment, it will be treated as only one jeopardizing investment for purposes of IRC 4944. See Reg. 53.4944–5(b)(2).

7.27.18.5.1  (04-30-1998)
Transfer to Another Private Foundation

  1. A jeopardizing investment cannot be removed from jeopardy by the transfer thereof to another private foundation if the recipient is related to the transferor foundation within the meaning of IRC 4946(a)(1)(H)(i) or (ii). The exception is where the jeopardizing investment would be a program-related investment in the hands of the transferee private foundation. See Reg. 53.4944–5(b).

7.27.18.5.2  (04-30-1998)
Examples: Removal From Jeopardy

  1. Example 1: Assume that both C and D are investments which jeopardize exempt purposes. X, a private foundation, purchases C in 1971 and later exchanges C for D. Such exchange does not constitute a removal of C from jeopardy. In addition, no new taxable period will arise with respect to D, since, for purposes of IRC 4944, only one jeopardizing investment has been made.

  2. Example 2: Assume the facts as stated in Example 1 above, except that X sells C for cash and later reinvests such cash in D. Two separate investments jeopardizing exempt purposes have resulted. Since the cash received in the interim is not of a jeopardizing nature, the amount invested in C has been removed from jeopardy and, thus, the taxable period with respect to C has been terminated. The subsequent reinvestment of such cash in D gives rise to a new taxable period with respect to D.

  3. Example 3: X, a private foundation on a calendar-year basis, makes a $1,000 jeopardizing investment on January 1, 1970. X thereafter sells the investment for $1,000 on January 3, 1971. The taxable period is from January 1, 1970 to January 3, 1971. X will be liable for an initial tax of $100, that is, a tax of 5% of the amount of the investment for each year (or part thereof) in the taxable period. For a detail discussion of taxable period, see IRM 7.27.18.6.2.4. See Reg. 53.4944–5(c).


7.27.18.6  (04-30-1998)
IRC 4944 Sanctions

  1. IRC 4944 imposes a multi-level tax designed to deter private foundations from making jeopardizing investments.

    1. On making a jeopardizing investment, a first-tier tax is imposed on the private foundation and perhaps managers for each year or part thereof.

    2. A severe second-tier tax could be imposed on the foundation and the managers for failure to remove that investment from jeopardy within the "correction period." If correction has been made, however, the second-level tax will not be imposed.

  2. In addition, repeated willful or flagrant violations of IRC 4944 by a private foundation may result in the termination of its private foundation status as well as the imposition of excise tax pursuant to IRC 507. Also, the foundation managers may be subject to an excise tax under IRC 6684.

7.27.18.6.1  (04-30-1998)
First-Tier Tax

  1. A private foundation that made a jeopardizing investment, whether from income or corpus, is subject to a tax equal to 5% of the amount of the jeopardizing investment as of the time the investment is made. The foundation pays the tax. See IRC 4944(a)(1).

7.27.18.6.2  (04-30-1998)
First-Tier Tax on Foundation Managers

  1. The managers of a private foundation are subject to a 5% tax if they knowingly participate in making the jeopardizing investment, unless their participation is not willful and is due to reasonable cause. See IRC 4944(a)(2). Foundation manager tax liability is limited. See IRM 7.27.18.8.

7.27.18.6.2.1  (04-30-1998)
Definitions and Special Rules

  1. To be held liable for first-tier tax under IRC 4944(a)(2), a foundation manager must have knowingly participated in making the jeopardizing investment.

  2. Participation must have been willful and not due to reasonable cause.

7.27.18.6.2.1.1  (04-30-1998)
Knowing Defined

  1. A foundation manager, according to Reg. 53.4944–1(b)(2)(i), is considered to have participated in the making of a jeopardizing investment knowingly only if the foundation manager:

    • has actual knowledge of sufficient facts so that, based solely upon such facts, such investment would be a jeopardizing investment,

    • is aware that such an investment under these circumstances may violate the provisions of IRC 4944, and

    • negligently fails to make reasonable attempts to ascertain whether the investment is a jeopardizing investment, or is in fact aware that it was such an investment (see IRM 7.27.18.2.3 for discussion of burden of proof).

  2. For purposes of IRC 4944 and Chapter 42, the definition of knowing does not include "having reason to know." However, evidence showing that a foundation manager has reason to know of a particular fact or particular rule is relevant in determining whether the manager had actual knowledge of such fact or rule.

7.27.18.6.2.1.2  (04-30-1998)
Participation Defined

  1. A foundation manager must have participated in the making of the jeopardizing investment to be held liable for the first-tier tax.

  2. Reg. 53.4944–1(b)(2)(iv) defines participation as any manifestation of approval of the investment by that foundation manager in the making of the investment.

7.27.18.6.2.1.3  (04-30-1998)
Willful Defined

  1. A foundation manager’s participation in making a jeopardizing investment not only must be knowing, but also must be willful. Reg. 53.4944–1(b)(2)(ii) provides that participation is willful if it is:

    • voluntary,

    • conscious, and

    • intentional.

  2. Motive is not a necessary requirement to show willfulness. However, if a foundation manager does not know that the investment is a jeopardizing investment (as defined in IRC 4944(a)(1) and Reg. 53.4944–(a)(2)), then his/her participation will not be considered willful. See Reg. 53.4944–1(b)(2)(ii).

7.27.18.6.2.1.4  (04-30-1998)
Reasonable Cause Defined

  1. If a foundation manager participates in the making of a jeopardizing investment, but such participation is due to reasonable cause, he/she is not subject to the 5% tax.

  2. A foundation manager’s actions are due to reasonable cause if he/she has exercised responsibility on behalf of the foundation with ordinary business care and prudence. See Reg. 53.4944–1(b)(2)(iii); see also United States v. Boyle, 469 U.S. 241 (1985) for general discussion on "reasonable cause."

7.27.18.6.2.2  (04-30-1998)
Advice of Counsel

  1. A foundation manager is not subject to the tax if he/she relies on the advice of legal or qualified investment counsel in making an investment that later becomes a jeopardizing investment.

  2. For a foundation manager to demonstrate reliance upon the advice of legal counsel, he/she must have fully disclosed the factual situation to legal counsel. Advice received from legal counsel must be communicated in a reasoned written legal opinion that a particular investment would not jeopardize the carrying out of the foundation’s exempt purposes.

  3. A written legal opinion is considered "reasoned" even if it reached an erroneous conclusion, provided that it addressed relevant facts and applicable law. If a written legal opinion merely recites the facts and expresses a conclusion, it is not considered "reasoned." See Reg. 53.4944–1(b)(2)(v).

  4. For a foundation manager to demonstrate reliance upon the advice of qualified investment counsel, he/she must have:

    • fully disclosed the factual situation to qualified investment counsel

    • received advice derived in a manner consistent with generally accepted practices of persons who are qualified investment counsels, and

    • communicated in writing that a particular investment will provide for the long- and short-term financial needs of the foundation. See Reg. 53.4944–1(b)(2)(v).

  5. If reliance to advice of legal counsel or qualified investment counsel is shown by a foundation manager, his/her participation in making a jeopardizing investment is not considered "knowing" or "willful" and will ordinarily be considered "due to reasonable cause."

7.27.18.6.2.2.1  (04-30-1998)
Absence of Advice

  1. Absence of advice of legal counsel or qualified investment counsel will not, by itself, give an inference that a foundation manager’s participation was knowing, willful, or without reasonable cause. See Reg. 53.4944–1(b)(2)(v).

7.27.18.6.2.3  (04-30-1998)
Burden of Proof

  1. The burden of proof is on the government to show that a foundation manager has knowingly participated in the making of a jeopardizing investment. See IRC 7454(b).

7.27.18.6.2.4  (04-30-1998)
Taxable Period

  1. The first-tier taxes of IRC 4944(a)(1) and (2) are imposed on private foundations and foundation managers for each year or portion thereof in the taxable period.

  2. The taxable period, as defined by IRC 4944(e)(1), is the period beginning with the date on which the jeopardizing investment is made and ending on the earliest of the date:

    1. of mailing of a notice of deficiency with respect to the tax imposed by IRC 4944(a);

    2. on which the tax imposed by IRC 4944(a) is assessed; or

    3. on which the amount so invested is removed from jeopardy.

  3. If the notice of deficiency is not mailed because of a waiver of the restrictions on assessment and collection of a deficiency, or because the deficiency is paid, the date of filing of the waiver or the date of such payment, respectively, will be treated as the end of the taxable period. See Reg. 53.4944–5(a)(2).

7.27.18.6.2.5  (04-30-1998)
Abatement of First-Tier Tax

  1. IRC 4962 grants the Service discretionary authority to abate certain Chapter 42 first-tier taxes including taxes under IRC 4944(a) for taxable events ( i.e. making jeopardizing investments) occurring after December 31, 1984. See IRC 4962(a) & (b). In effect, this provision gives a private foundation and its managers a chance to avoid having the first-tier tax imposed under IRC 4944(a).

  2. Abatement is available to a foundation or its managers only if it is established to the satisfaction of the Service that the making of a jeopardizing investment:

    • was due to reasonable cause,

    • was not due to willful neglect, and

    • has been corrected within the correction period.

  3. Detailed discussions of the definitions of "reasonable cause" and "willful neglect" (as well as abatement in general) are in IRM 7.27.16, Taxes on Failure to Distribute Income.

7.27.18.6.2.5.1  (04-30-1998)
Correction Period

  1. A private foundation and its managers may abate the first-tier tax by removing the investment from jeopardy within the "correction period."

  2. The correction period begins with the date on which the taxable expenditure was made and ends 90 days after the mailing of a notice of deficiency with respect to the second-tier tax. See IRC 4963(e)(1) and Reg. 53.4963–1(d).

  3. The correction period can be extended by the Service if certain requirements are met. See Reg. 53.4963–1(e)(3). See also IRM 7.27.16, Taxes on Failure to Distribute Income, for a discussion of the correction period and the requirements for extending the correction period.

7.27.18.6.2.5.2  (04-30-1998)
Authority to Abate

  1. Under Delegation Order No. 237, the authority to abate substantial first-tier excise taxes is delegated to the Division Commissioner (TEGE) and Director, Exempt Organizations.

  2. Authority to abate "other than substantial" qualified first-tier excise tax amounts was delegated to TEGE Directors, Area Managers of TEGE Technical Staffs, EO Examinations, etc.

  3. "Substantial qualified first tier tax amount" is described as a sum exceeding $200,000 for all such tax payments or deficiencies (excluding interest, other taxes, and penalties) involving all related parties and transactions arising from Chapter 42 taxable events within the statute of limitations as determined by the KDO involved.

7.27.18.6.2.6  (04-30-1998)
Examples: First Tier Tax

  1. Example 1: A is a foundation manager of B, a private foundation with assets of $100,000. A approves the following three investments by B after taking into account with respect to each of them B’s portfolio as a whole: (1) An investment of $5,000 in the common stock of corporation X; (2) an investment of $10,000 in the common stock of corporation Y; and (3) an investment of $8,000 in the common stock of corporation Z. Corporation X has been in business a considerable time, its record of earnings if good, and there is no reason to anticipate a diminution of its earnings. Corporation Y has a promising product, has had earnings in some years and substantial losses in others, has never paid a dividend, and is widely reported in investment advisory services as seriously undercapitalized. Corporation Z has been in business a short period of time and manufactures a product that is new, is not sold by others, and must compete with a well-established alternative product that serves the same purpose. Z’s stock is classified as high-risk investment by most investment advisory services with the possibility of substantial long-term appreciation but with little prospect of a current return. A has studied the records of the three corporations and knows the foregoing facts. In each case the price per share of common stock purchased by B is favorable to B.

    1. Under the standards of Reg. 53.4944–1(a)(2)(i), the investment of $10,000 in the common stock of Y and the investment of $8,000 in the common stock of Z may be classified as jeopardizing investments, while the investment of $5,000 in the common stock of X will not be so classified. B would then be liable for a first-tier tax of $500 (5% of $10,000) for each year (or part thereof) in the taxable period for the investment in Y, and a first-tier tax of $400 (5% of $8,000) for each year (or part thereof) in the taxable period for the investment in Z. Further, since A had actual knowledge that the investments in the common stock of Y and Z were jeopardizing investments, A would then be liable for the same amount of first tier taxes as B.

  2. Example 2: Assume the facts in Example 1, except that: (a) in the case of corporation Y, B’s investment will be made for new stock to be issued by Y and there is reason to anticipate that B’s investment, together with investments required by B to be made concurrently with its own, will satisfy the capital needs of corporation Y and will thereby overcome the difficulties that have resulted in Y’s uneven earnings record; and (b) in the case of corporation Z, the management has a demonstrated capacity for getting new businesses started successfully and Z has received substantial orders for its new product.

    1. Under the standards of Reg. 53.4944–1(a)(2)(i), neither the investment in Y nor the investment in Z will be classified as a jeopardizing investment, and neither A nor B will be liable for a first-tier tax on either of such investments.

  3. Example 3: D is a foundation manager of E, a private foundation with assets of $200,000. D was hired by E to manage E’s investments after a careful review of D’s training, experience and record in the field of investment management and advice indicated to E that D was well qualified to provide professional investment advice in the management of E’s investment assets. D, after careful research into how best to diversify E’s investments, in order to provide for E’s long-term financial needs, and to protect E against the effects of long-term inflation, decided to allocate a portion of E’s investment assets to unimproved real estate in selected areas of the country where population patterns and economic factors strongly indicate continuing growth at a rapid rate. D determines that the short-term financial needs of E can be met through E’s other investments.

    1. Under the standards of Reg. 53.4944–1(a)(2)(i), the investment assets in unimproved real estate will not be classified as a jeopardizing investment, and neither D nor E will be liable for a first-tier tax on such investment. See Reg. 53.4944–1(c).

7.27.18.6.3  (04-30-1998)
Second-Tier Tax

  1. The second-tier tax of IRC 4944(b)(1) is imposed on a private foundation if:

    • a first-tier tax has been imposed on that private foundation for making a jeopardizing investment and

    • it is not removed from jeopardy within the taxable period

  2. The rate of the second-tier tax is 25% of amount of the jeopardizing investment.

7.27.18.6.3.1  (04-30-1998)
Taxable Period

  1. A private foundation may avoid the second-tier tax if it removes the jeopardizing investment from jeopardy within the taxable period. Taxable period is defined in IRC 4944(e)(1). See also IRM 7.27.18.6.2.4.

7.27.18.6.3.2  (04-30-1998)
Tax on Foundation Managers

  1. IRC 4944(b)(2) imposes a tax upon any foundation manager if two conditions exist:

    1. The second-tier tax has been imposed on the foundation pursuant to IRC 4944(b)(1); and

    2. That foundation manager refuses to agree to the removal of all or part of the jeopardizing investment from jeopardy.

    Note:

    Imposition of the IRC 4944(a)(2) first-tier tax on foundation managers is not a prerequisite for the imposition of the second-tier tax. The only conditions needed to trigger the imposition of the second-tier tax are the two aforementioned requirements.

  2. A foundation manager must refuse a request to remove the investment from jeopardy to trigger imposition of the second-tier tax of IRC 4944(b)(2). Such a request can be made by a fellow foundation manager or the Service. See Thorne v. Commissioner, 99 T.C. 67 (1992).

    1. According to Thorne, the Service must make a formal written request to the foundation manager to remove the investment from jeopardy.

    2. Otherwise, the foundation manager cannot be considered as having refused to make the correction.

    3. The written request for correction must be made within a reasonable period of time prior to the issuance of a statutory notice of deficiency for the second-tier tax of IRC 4944(b).

  3. The rate of second-tier tax is 5% of the amount of the jeopardizing investment. The foundation manager pays the tax due.

7.27.18.6.3.3  (04-30-1998)
Abatement of Second-Tier Tax

  1. IRC 4961(a) provides that if a jeopardizing investment is removed from jeopardy during the correction period, the second-tier tax imposed will not be assessed, and if assessed, it will be abated.

7.27.18.6.3.4  (04-30-1998)
Correction Period

  1. The second-tier tax imposed and assessed under 4944(b) is abated if a jeopardizing investment is removed from jeopardy during the correction period. See IRC 4963(e)(1). Also, see IRM 7.27.18.6.2.5.1 for the definition of correction period.

7.27.18.6.3.5  (04-30-1998)
Examples: Second-Tier Taxes

  1. Example 1: X is foundation manager of Y, a private foundation. On the advice of X, Y invests $5,000 in the common stock of corporation M in 1981. Assume that both X and Y are liable for the taxes imposed by IRC 4944(a) on the making of the investment. Assume further that no part of the investment is removed from jeopardy within the taxable period and that X refused to agree to such removal. Y will be liable for an additional tax of $1,250 ($5,000 x 25%). X will be liable for an additional tax of $250 ($5,000 x 5%). See also the Thorne case noted in IRM 7.27.18.6.3.2.

  2. Example 2: Assume the facts as stated in Example 1, except that X is not liable for the tax imposed by IRC 4944(a)(2) because his participation was not willful and was due to reasonable cause. X will nonetheless be liable for the tax of $250 imposed by IRC 4944(b)(2) since an additional tax has been imposed upon Y and since X refused to agree to the removal of the investment from jeopardy.

  3. Example 3: Assume the facts as stated in Example 1, except that Y removes $2,000 of the investment from jeopardy within the taxable period, with X refusing to agree to the removal from jeopardy of the remaining $3,000 of such investment. Y will be liable for an additional tax of $750, imposed upon the portion of the investment which has not been removed from jeopardy within the taxable period ($3,000 x 25%). Further, X will be liable for an additional tax of $150, also imposed upon the same portion of the investment ($3,000 x 5%). See Reg. 53.4944–2(c).


7.27.18.7  (04-30-1998)
Joint and Several Liability

  1. If more than one foundation manager is liable for the first-tier tax imposed under IRC 4944(a)(2) or the second-tier tax under IRC 4944(b)(2), all foundation managers are jointly and severally liable for the tax imposed under each provision with respect to any one jeopardizing investment. See IRC 4944(d)(1) and Reg. 53.4944–4(a).


7.27.18.8  (04-30-1998)
Liability Limits of Foundation Managers

  1. The maximum aggregate amount of tax all participating foundation managers are liable with respect to any one jeopardizing investment under the first-tier tax of IRC 4944(a)(2) may not exceed $5,000. See IRC 4944(d)(2) and Reg. 53.4944–4(b).

  2. The maximum aggregate amount of tax all participating foundation managers are liable with respect to any one jeopardizing investment under the second-tier tax of IRC 4944(b)(2) may not exceed $10,000.

7.27.18.8.1  (04-30-1998)
Examples: Management Liability

  1. Example 1: A, B, and C are foundation managers of X, a private foundation. Assume that A, B, and C are liable for both initial and additional taxes under IRC 4944(a)(2) and 4944(b)(2), respectively, for the following investments by X: an investment of $5,000 in the common stock of corporation M, and an investment of $10,000 in the common stock of corporation N. A, B, and C will be jointly and severally liable for the following initial taxes under IRC 4944(a)(2): a tax of $250 (5% of $5,000) for each year (or part thereof) in the taxable period (as defined in IRC 4944(e)(1)) for the investment in M, and a tax of $500 (5% of $10,000) for each year (or part thereof) in the taxable period for the investment in N. Further, A, B, and C will be jointly and severally liable for the following additional taxes under IRC 4944(b)(2): a tax of $250 (5% of $5,000) for the investment in M, and a tax of $500 (5% of $10,000) for the investment in N.

  2. Example 2: Assume the facts as stated in Example 1, except that X has invested $500,000 in the common stock of M, and $1 million in the common stock of N. A, B, and C will be jointly and severally liable for the following initial taxes under IRC 4944(a)(2): a tax of $5,000 for the investment in M, and a tax of $5,000 for the investment in N. Further, A, B, and C will be jointly and severally liable for the following additional taxes under IRC 4944(b)(2): a tax of $10,000 for the investment in M, and a tax of $10,000 for the investment in N. See Reg. 53.4944–4(c).


7.27.18.9  (04-30-1998)
IRC 507 Termination and Other Sanctions

  1. If a private foundation willfully and repeatedly or willfully and flagrantly violates IRC 4944 (or any other Chapter 42 provisions), the status of that organization as a private foundation may be terminated by the Service pursuant to IRC 507(a)(2). Also, such private foundation may be subject to the termination tax imposed by IRC 507(c). See Handbook IRM 7.26.7, Termination of Private Foundation Status.

  2. Under IRC 6684, if a foundation manager is liable for the tax under IRC 4944, he/she may be liable for an additional tax equal to that amount if:

    • the act or failure to act that causes the IRC 4944 tax liability is not due to reasonable cause, and

    • such person has theretofore been liable for the IRC 4944 tax, or

    • the act or failure to act was both willful and flagrant. See also Reg. 301.6684–1(a)—(d).


7.27.18.10  (04-30-1998)
Effect of State or Other Federal Laws

  1. IRC 4944 will not exempt or relieve any party from compliance with any State or Federal law imposing any obligation, duty or responsibility, or other standard of conduct with respect to the operation and administration of an organization or trust to which IRC 4944 applies. Conversely, no State law can exempt or relieve any person from any obligation, duty, responsibility or other standard of conduct under IRC 4944. See Reg. 53.4944–1(a)(2).

  2. Taxes imposed under each provision of Chapter 42 are not exclusive. See Reg. 53.4944–1(a)(2)(iv). See also Kermit Fischer Foundation v. Commissioner, 59 T.C.M. 898 (1990).

    • For example, if a foundation purchases a sole proprietorship in a business enterprise within the meaning of IRC 4943(d)(3), in addition to tax under IRC 4943, the foundation may be liable for tax under IRC 4944 if the investment jeopardizes the carrying out of any of its exempt purposes.

7.27.18.11  (04-30-1998)
Digest of Published Rulings

  1. Rev. Rul. 74–316, 1974–2 C.B. 389 holds that the Service cannot issue a ruling that a proposed investment procedure governing investments by a private foundation will preclude imposition of tax under IRC 4944. The rationale is that the determination of whether an investment is a jeopardizing investment is (1) to be made on an investment by investment basis and (2) is to be made as of the time of the investment. An approval of an investment procedure governing investments to be made in the future is not possible because it would constitute a determination prior to the investment and also would not be on an investment by investment basis. Furthermore, advance approval of such procedures would necessarily preclude application of the ‘prudent trustee’ approach of Reg. 53.4944–1(a)(2)(i).

  2. Rev. Rul. 80–133, 1980–1 C.B. 258, holds that, under the circumstances, a private foundation’s payments by a private foundation of premiums on a life insurance policy and the interest on a loan secured by the policy are jeopardizing investments under IRC 4944. A whole-life insurance policy was donated to the foundation. At the time of the donation, the policy was subject to a policy loan that the insurer has made to the donor. The policy provided that, upon the death of the insured, the foundation would receive insurance proceeds in an amount equal to the face value of the policy reduced by the sum of the outstanding principal of the loan and any unpaid interest thereon. At the time the policy was donated, the life expectancy of the insured-donor was 10 years. Instead of immediately surrendering the policy to the insurer for its cash surrender value, the foundation retained the policy as an investment and annually pays the premiums and interest due on the policy and the policy loan, respectively. The combined premium and interest payments are of such an amount that, by the end of eight years, the foundation will have invested a greater amount in premiums and interest that it could receive as a return on this investment, i.e., in the form of insurance proceeds upon the death of the insured.

  3. The Service's reasoning in Rev. Rul. 80-133 follows. Under the facts and circumstances, the foundation managers, by investing at the projected rate of return prevailing at the time of the investment failed to exercise ordinary business care and prudence in providing for the long-term and short-term financial needs of the foundation in carrying out its exempt purposes. Therefore, each payment made by the private foundation for a premium on the insurance policy and the interest on the policy loan is a jeopardizing investment under IRC 4944.


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