IRC 507(c), Imposition of Tax Upon the Termination of a Private Foundation

 

There are four basic ways to terminate private foundation status under Internal Revenue Code (IRC) Section 507. This Issue Snapshot focuses on the two ways the tax under Section 507(c) may apply and it includes calculating the liability.

IRC Section and Treas. Regulation

  • IRC Section 507(a) General rule
  • IRC Section 507(c) Imposition of tax
  • IRC Section 507(d) Aggregate tax benefit
  • IRC Section 507(e) Value of assets
  • IRC Section 507(f) Liability in case of transfers of assets from private foundation
  • IRC Section 507(g) Abatement of taxes
  • Treas. Reg. Section 1.507-1 General rule
  • Treas. Reg. Section 1.507-2 Special rules; transfer to, or operation as, public charity
  • Treas. Reg. Section 1.507-3 Special rules; transferee foundations
  • Treas. Reg. Section 1.507-4 Imposition of tax
  • Treas. Reg. Section 1.507-5 Aggregate tax benefit; in general
  • Treas. Reg. Section 1.507-6 Substantial contributor defined
  • Treas. Reg. Section 1.507-7 Value of assets
  • Treas. Reg. Section 1.507-8 Liability in case of transfers
  • Treas. Reg. Section 1.507-9 Abatement of taxes

Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources)

In Peters v. U.S., 624 F.2d 1020 (Ct. Cl. 1980), imposing the termination tax based on the aggregate tax benefit was found by the court to be neither retroactive in application nor confiscatory.

Rev. Rul. 75–289, 1975–2 C.B. 215, held that a private foundation may terminate its private foundation status under Section 507(b)(1)(A) by distributing its total net assets to a public charity which had been in existence for 20 months, formed from the consolidation of two separate public charities, each of which would have been in existence for 60 months at the time of distribution had they not been consolidated.

Rev. Rul. 2003-13, 2003-1 C.B. 305, describes several situations involving termination of a private foundation. In Situation 1, a private foundation recognized as exempt from federal income tax under Section 501(c)(3) transfers all its net assets to a public charity, which is described in Section 509(a)(1) and has been so described for a continuous period of at least 60 calendar months immediately preceding the distribution. After the private foundation distributes all its net assets to the public charity, the private foundation files articles of dissolution with the appropriate state authority. The distribution is subject to the rules of Section 507(b)(1)(A), rather than the rules of Section 507(a)(1). Because the distribution is described in Section 507(b)(1)(A), the private foundation is terminated upon the distribution. The organization is not subject to the tax described in Section 507(c). The private foundation was not required to give notice under Section 507(a)(1) to terminate its private foundation status.

Private Foundation Termination Tax

Private Foundations

Analysis

When is tax imposed under Section 507(c) upon the termination of a private foundation?

Section 507(c) imposes a tax on terminations of private foundation status as described in Sections 507(a)(1) and 507(a)(2).

Section 507(a)(1) describes a private foundation that voluntarily notifies the IRS of its intent to terminate. Voluntary termination allows an organization to have control over whether it has net assets upon which tax under Section 507(c) can be imposed by the time the section is invoked.

Involuntary terminations are contemplated by Section 507(a)(2), which describes a private foundation that commits willful repeated acts (or failures to act) or a willful and flagrant act (or failure to act) giving rise to liability under Chapter 42, is notified by the Secretary that it is liable for the termination tax imposed under Section 507(c), and subsequently pays the tax (or such tax is abated under Section 507(g)).

Section 507(c) tax does not apply to Section 507(b)(1) or 507(b)(2) transfers unless Section 507(a) becomes applicable. See Treas. Regs. Sections 1.507-1(b) and 1.507-3(d). Section 507(b)(1) describes a private foundation which transfers its assets to a public charity which has been in existence for at least 60 months (among other requirements) or begins operating as a private charity. Section 507(b)(2) describes transfers to another private foundation.

Termination under Section 507 only terminates the private foundation status. If the private foundation has ceased activities and is terminating existence, it should also notify the appropriate office in the state where the foundation is organized about its intent to dissolve, liquidate, or terminate.

How to calculate the tax

The tax imposed under Section 507(c) is the lesser of:

  • the aggregate tax benefit resulting from the Section 501(c)(3) status of the organization, or
  • the value of the net assets of the organization.

Calculating aggregate tax benefit

Treas. Reg. Section 1.507-4 provides that a private foundation must substantiate by adequate records (or other corroborating evidence required by the Commissioner) the aggregate tax benefit resulting from the Section 501(c)(3) status of the organization. The aggregate tax benefit resulting from the Section 501(c)(3) status of a private foundation is defined in Section 507(d) as the sum of:

  1. The combined increases in income, estate, and gift taxes that would have been imposed on all substantial contributors if deductions for all contributions made by those contributors to the foundation after February 28, 1913, had been disallowed; and
  2. The combined increases in income tax that would have been imposed on the private foundation's income for tax years beginning after 1912 if:
    (a) The foundation had not been exempt from tax under Section 501(a), an
    (b) In the case of a trust, its charitable deduction had been limited to 20 percent of its taxable income; and
  3. Amounts received from private foundations to which transferee liability applies; and
  4. The interest on the tax increases in (1), (2), and (3) from the first date the increase would have been due or payable to the date the organization ceases to be a private foundation.

In calculating the combined increases in tax under (1), all deductions attributable to a particular contribution must be included. For example, if a substantial contributor had taken income tax and gift tax deductions for a charitable contribution to the foundation, the amount of each deduction must be included. The combined tax benefit may be more than the fair market value of the property transferred. See Treas. Reg. Section 1.507-5(b) for more information on calculating the combined increases in tax. For the definition of substantial contributor and its related rules refer to Treas. Reg. Section 1.507-6.

With respect to (3), Section 507(f) states that the tax is deemed to have been imposed on the first day that action is taken by the organization which culminates in its ceasing to be a private foundation. Treas. Reg. Section 1.507-8 further clarifies "the first day on which action is taken" within the meaning of Section 507(f):

  • For terminations under Section 507(a)(2), it's the date described in Section 1.507-7(b)(2).
  • For terminations under Section 507(a)(1), it's the date described in Section 1.507-7(b)(1).

Calculating the value of the net assets

Under Treas. Reg. Section 1.507-7(c), fair market value of the net assets is determined pursuant to the provisions of Treas. Reg. Section 53.4942(a)–2(c)(4).

The term net assets means the gross assets of a private foundation reduced by all liabilities of the foundation, including appropriate estimated and contingent liabilities (such as liability for tax imposed under Chapter 42). See Treas. Reg. Section 1.507-7(d).

Section 507(e) provides that the value of the net assets of the organization is the higher of:

  • the value on the first day on which action was taken by the organization which culminates in its ceasing to be a private foundation, or
  • the value on the date the organization ceased to be a private foundation.

For terminations under Section 507(a)(1), the date on which the private foundation gives notification of a voluntary termination is considered the first day action was taken to terminate private foundation status. See Treas. Reg. Section 1.507-7(b)(1).

For terminations under Section 507(a)(2), the date of the occurrence of the willful and flagrant act (or failure to act) or the first of the series of willful repeated acts (or failures to act) giving rise to liability for tax under Chapter 42 and the imposition of tax under Section 507(a)(2) is considered the first day action was taken to terminate private foundation status. See Treas. Reg. Section 1.507-7(b)(2).

Note: Special rules may apply when valuing the net assets of a trust that holds amounts segregated for use for charitable purposes. See Section 4947 for more information.

Abatement of the tax

Section 507(g) states that the tax imposed by Section 507(c) and any liability in respect thereof may be abated if:

  • the private foundation distributes all of its net assets to one or more organizations described in Section 170(b)(1)(A) (other than in clauses (vii) and (viii)), each of which has been in existence and so described for a continuous period of at least 60 calendar months, or
  • following the notification prescribed in Section 6104(c) to the appropriate State officer, such State officer within one year notifies the Secretary that corrective action has been initiated pursuant to State law to ensure that the assets of such private foundation are preserved for such charitable or other purposes specified in Section 501(c)(3) as may be ordered or approved by a court of competent jurisdiction, and upon completion of the corrective action, the Secretary receives certification from the appropriate State officer that such action has resulted in such preservation of assets.

See Treas. Reg. Sections 1.507-9(b) and (c) for more information about the procedures by which effective assurance about the preservation of assets for purposes specified in Section 501(c)(3) is given to the Service.

Issue Indicators or Audit Tips

  • Complete Form 4883, Exempt Organizations Excise Tax Audit Changes to calculate the tax liability under Section 507(c).
  • Examine the organization's financial records to identify substantial contributors (Note: In the case of a trust, also identify the creator).