Issue Title: Request for Private Operating Foundation Classification under IRC 4942(j)(3) Description: There are certain advantages in being classified as a private operating foundation described in section 4942(j)(3) as opposed to being classified as a general non-operating private foundation. For example, a private operating foundation is eligible to receive qualifying distributions from private grant-making foundations similar to public charities. A private non-operating foundation can request classification and IRS recognition as a private operating foundation in a couple different manners. A new organization may request a foundation status of private operating foundation using Form 1023, Application for Recognition of Exemption Under Section 501(c)(3). The organization will submit activity information and financial information if in existence longer than a year or an opinion of counsel explaining how they meet the requirements to be a private operating foundation. An organization that has been determined to be a private foundation may request a foundation status change by submitting Form 8940, Request for Miscellaneous Determination. A private operating foundation must meet an income test and one of three alternative tests: the assets test, the endowment test, or the support test. There are different rules for satisfying the tests when an organization has been in existence for less than one year, for more than one but less than four years, and for four or more years. IRC Section and Treas. Regulation: IRC Section 4942(j)(3) Treas. Reg. Section 53.4942(b)-1 Treas. Reg. Section 53.4942(b)-2 Treas. Reg. Section 53.4942(b)-3 Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources): Miss Elizabeth D. Leckie Scholarship Fund v. Commissioner, 87 T.C. 251 I.R.M. 7.26.6, Private Operating Foundations - IRC Section 4942(j)(3) Analysis: There are several advantages to having a private operating foundation status as opposed to that of a private non-operating foundation, i.e. a traditional grant making private foundation. Operating foundations are not subject to the tax imposed on the undistributed income of a private foundation under 4942(a) and 4942(b). Contributions by individuals to private operating foundations described in 4942(j)(3) are deductible by the donors to the extent of 50% of the donor’s adjusted gross income, whereas contributions to most other private foundations are generally limited to 30%of the donor’s adjusted gross income. A private operating foundation may generally receive qualifying distributions from a private non-operating foundation. To qualify as a private operating foundation, an organization must meet an income test and one of three alternative tests. The alternative tests include an assets test, an endowment test and a support test. The tests are applied each year so it is possible a private foundation could meet the requirements in one year and not in the next. Income Test: To meet the income test, a foundation must make qualifying distributions directly for the active conduct of the activities that comprise their exempt purpose equal to substantially all of the lesser of their adjusted net income or their minimum investment return. The term “qualifying distribution” is defined in 4942(g) and Reg. Section 53.4942(a)-3(a)(2). Qualifying distributions are amounts paid to accomplish exempt purposes or to acquire an asset used (or held for use) directly in carrying out an exempt purpose, and amounts properly set aside for a specific project that is for an exempt purpose. Substantially all means 85% or more. Minimum investment return generally means 5% of the excess of the aggregate fair market value of the foundation’s assets (other than assets used or held for use directly in the foundation’s exempt functions) over the amount of the acquisition indebtedness with respect to such assets. See Treas. Reg. Section 53.4942(a)-2(d) for a discussion on adjusted net income. See Treas Reg. Section 53.4942(b)-1(b) for a discussion of when qualifying distributions are made directly for the active conduct of the foundation’s exempt activities. Generally a foundation that provides scholarships or grants will not be considered an operating foundation unless it maintains significant involvement in the active programs in support of which such grants or scholarships were made or awarded. An example of a private operating foundation is an exempt museum described in 501(c)(3) which was founded by the gift of an endowment from a single contributor and uses 90 percent of its adjusted net income to operate the museum. If the museum satisfies one of the three alternative tests, it may be classified as an operating foundation since substantially all of its qualifying distributions are used directly for the active conduct of its exempt activities. See Treas. Reg. Section 53.4942(b)-1(d), Ex. 1. Assets Test (first alternative test): For a foundation to meet the assets test, substantially more than half of the fair market value of its assets (a) must be devoted directly to the active conduct of activities constituting the foundation’s exempt purpose or to functionally related businesses, (b) be stock of a corporation which is controlled by the foundation and substantially all of the assets of which are so devoted, or (c) some combination of the above. “Substantially more than half” means 65% or more. Assets such as real estate, equipment, facilities, and intangible assets such as patents, copyrights, and trademarks can be considered “devoted directly to exempt functions” if they are used directly for the direct conduct of the foundation’s exempt activities. Assets held for production of income or for investments such as stocks, bonds, or endowment funds are usually not considered to be devoted directly to the active conduct of a foundation’s exempt activities. See Treas. Reg. Sec. 53.4942(b)-2(a)(2)(i) for more information on assets considered to be devoted directly to the active conduct of exempt activities. Endowment Test (second alternative test): To satisfy the endowment test, a foundation must normally make qualifying distributions directly for exempt functions of an amount not less than two-thirds of its minimum investment return. In effect, the endowment test requires qualifying direct distributions of 3 1/3% (2/3 of 5%) of the excess of the fair market value of the foundation’s assets, other than assets used or held for use directly in carrying out the foundation’s exempt purposes, over the amount of acquisition indebtedness with respect to such assets. Usually a foundation with a minimum investment return that is less than its adjusted net income will satisfy the endowment test if it satisfies the income test. Support Test (third alternative test): There are three requirements in order for a foundation to meet the support test: (a) substantially all of its support, other than gross investment income as defined in IRC Section 509(e); must normally be received from the general public and from 5 or more exempt organizations that are not related to each other or to the recipient foundation; (b) not more than 25% of its support, other than gross investment income, may normally be received from any one such exempt organization; and, (c) not more than half of its support may normally be received from gross investment income. The support test is intended primarily for the benefit of special-purpose foundations with expertise in specialized areas, but it applies to any foundation meeting its standards. Its intricacies are defined in Treas. Reg. Section 53.4942(b)-2(c). Determining Compliance: In order to qualify for private operating foundation status, a foundation has to satisfy the tests, i.e., income test and one of the three alternative tests, in one of two methods. The first is the 3 out of 4 year method which requires meeting the income test and one of the alternative tests for any three taxable years during a four-year period consisting of the taxable year in question and the three immediately preceding taxable years. This method considers each year separately. The second method is the aggregation method which aggregates all pertinent amounts of income or assets held, received or distributed during the 4 year period including the year in question. A foundation may not use one method to satisfy the income test and another method to satisfy one of the alternative tests. Thus, if a foundation satisfies the income test using the three out of four year method, it may not use the aggregation method to satisfy one of the alternative tests. However, the fact that a foundation has chosen one method for satisfying the income test and one of the alternative tests in one taxable year does not preclude it from satisfying such tests by the alternative method in a subsequent taxable year. Rules for Newer Organizations: An organization that satisfies the income test and one of the alternative tests for its first taxable year of existence will be treated as a private operating foundation from the beginning of its first taxable year. The organization will be treated as an operating foundation for its second and third taxable year only if it satisfies the tests by the aggregation method for all such taxable years that it has been in existence. An organization that has not yet completed its first taxable year will be treated as an operating foundation if the organization has made a good faith determination that it is likely to satisfy the income test and one of the alternative tests for its first taxable year. A good faith determination will be considered to be made where the determination is based on an affidavit or opinion of counsel of the organization that the requirements will be satisfied. The affidavit or opinion must set forth sufficient facts about the operations and support of the organization for the IRS to be able to determine that the organization is likely to satisfy the requirements. An organization may ask to be classified as a private operating foundation as part of its Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. Otherwise, an organization seeking operating foundation status must submit Form 8940 along with all information, documentation, and other materials required by Form 8940 and the instructions thereto. Issue Indicators or Audit Tips: Private Operating Foundations submit information to calculate their ongoing qualification based on their qualifying distributions, income and assets. So consider review and substantiation of Form 990-PF, Part XIV computations to ensure the organization meets Private Operating Foundation status. If a private foundation is not an operating foundation, then consider whether it has distributed sufficient amounts in qualifying distributions. If not, then seek to impose the section 4942 excise tax for failure to distribute income.
