- 7.26.6 Private Operating FoundationsIRC 4942(j)(3)
- 188.8.131.52 Overview
- 184.108.40.206 Advantages of Operating Foundation Status
- 220.127.116.11 Definition of Operating Foundation
- 18.104.22.168.1 Income Test
- 22.214.171.124.1.1 Distributions Made Directly for the Active Conduct of Exempt Activities
- 126.96.36.199.1.2 Payments to Individual or Corporate Beneficiaries
- 188.8.131.52.2 Adjusted Net Income
- 184.108.40.206.2.1 Adjusted Net IncomeIncome "Recapture" Modifications
- 220.127.116.11.2.2 Adjusted Net IncomeOther Income Modifications
- 18.104.22.168.2.3 Adjusted Net IncomeDeduction Modifications
- 22.214.171.124.3 Assets Test (First Alternative Test)
- 126.96.36.199.3.1 Devoted Directly to Exempt Functions
- 188.8.131.52.4 Endowment Test (Second Alternative Test)
- 184.108.40.206.5 Support Test (Third Alternative Test)
- 220.127.116.11.6 Certain Long-Term Care Facilities
- 18.104.22.168 Other Procedural Considerations
- 22.214.171.124.1 Periods and Methods for Calculating the Tests
- 126.96.36.199.2 Special Rules for New Organizations
- 188.8.131.52.3 Recognition of Operating Foundation Status
- 184.108.40.206.4 Reliance by Contributors
- 220.127.116.11 Digest of Published Rulings
Part 7. Rulings and Agreements
Chapter 26. Private Foundations Manual
Section 6. Private Operating FoundationsIRC 4942(j)(3)
This section describes the general requirements for operating foundations status under IRC 4942(j)(3).
Certain types of private foundations known as "private operating foundations" (or simply "operating foundations" ), while subject to most of the rules pertaining to private foundations, are treated like public charities for certain purposes.
Unlike most private foundations whose assets consist mainly of investments and whose charitable activities consist mainly of making grants, operating foundations mainly conduct direct charitable operations.
Discussed below are the advantages of operating foundation status, the definition of an operating foundation, and procedures relating to such status.
Operating foundations are eligible to receive qualifying distributions from other private foundations.
A private foundation generally can satisfy its IRC 4942 distribution requirement by making distributions directly for exempt functions or to operating foundations or public charities, but not to another private "non-operating" foundation unless the non-operating foundation makes a qualifying distribution of the grant within a certain period. See IRC 4942(g)(1)(A) and (g)(3).
A donor generally may deduct a charitable contribution to an operating foundation to the same extent as contributions to organizations described in IRC 509(a)(1), (2), or (3), for income tax purposes. See IRC 170(b)(1)(A)(vii), 170(b)(1)(E)(i), 170(e)(1)(B)(ii), 170(e)(3)(A), and 170(e)(5)(C)(i).
Operating foundations are treated like organizations described in IRC 509(a)(1), (2), or (3) for estate and gift tax purposes with respect to certain transactions involving works of art. See IRC 2055(e)(4) and 2503(g).
An operating foundation is not subject to the tax imposed by IRC 4942 on private foundations that fail to comply with the 4942 distribution requirements. See IRC 4942(a)(1).
Certain operating foundations qualify as "exempt operating foundations" under IRC 4940(d).
Exempt operating foundations are exempt from excise tax under IRC 4940, and private foundations are not required to exercise expenditure responsibility under IRC 4945(d)(4) and (h) with respect to grants to them. See IRM 7.27.14 (Tax on Net Investment Income of Private Foundations) for greater detail.
Under IRC 4942(j)(3), an operating foundation must meet an "income" test and, in addition, one of three alternative tests:
an "assets" test
an "endowment" test
a "support" test
The tests are applied each year (on the basis of operations over the past three or four years, as discussed below).
Thus, a private foundation might qualify as an operating foundation in year 1 but not year 2, in which case the foundation would need to meet the distribution requirements of IRC 4942 for year 2 or else be subject to the 4942 excise tax.
To satisfy the income test of IRC 4942(j)(3)(A), a private foundation must make qualifying distributions directly for the active conduct of the activities constituting the purpose or function for which it is organized and operated (i.e., must make direct exempt-function distributions) equal to substantially all of the lesser of —
its adjusted net income, or
its minimum investment return.
"Qualifying distributions" are defined in IRC 4942(g)(1) and (2) and generally include amounts paid or set aside to accomplish exempt purposes.
Qualifying distributions are further discussed in IRM 7.27. 16 (concerning the excise tax on the failure to distribute income).
Whether distributions are direct exempt-function distributions is discussed below.
"Substantially all" means 85% or more, for operating foundation purposes. Reg. 53.4942(b)–1(c).
"Adjusted net income" is discussed below.
"Minimum investment return" is defined in IRC 4942(e) and generally means 5% of the fair market value of the foundation’s assets, other than assets used (or held for use) directly in the foundation’s exempt functions, less related acquisition indebtedness.
Minimum investment return is further discussed in IRM 7.27.16.
If the adjusted net income exceeds the minimum investment return for the year, then substantially all of the foundation’s qualifying distributions (except any in excess of adjusted net income) must be direct exempt-function distributions. See IRC 4942(j)(3) (last sentence); Reg. 53.4942(b)–1(a)(1).
The following standards, set forth under Reg. 53.4942(b)–1(b)(1) (unless otherwise noted), apply in determining whether a foundation has made a particular distribution directly for the active conduct of activities constituting its exempt purpose or function (i.e., whether a distribution is a direct exempt-function distribution).
In general, such distributions must be used by the foundation itself—grants to other charities are generally considered an indirect rather than direct means of accomplishing exempt purposes.
Payments to individual or corporate beneficiaries may qualify as direct exempt-function distributions under circumstances discussed in IRM 18.104.22.168.1.2.
Amounts paid to acquire or maintain assets used directly in the conduct of the foundation’s exempt activities, such as the operating assets of a museum, public park, or historic site, are considered direct exempt-function distributions.
However, the depreciation of such assets is not a qualifying distribution. Rev. Rul. 74–560, 1974–2 C.B. 389.
Administrative expenses (such as staff salaries and traveling expenses) and other operating costs necessary to conduct the foundation’s exempt activities (whether direct or indirect) are treated as direct exempt-function distributions if reasonable in amount.
The administrative expenses of screening and investigating grant applicants may be treated as direct exempt-function distributions even if the grants themselves are not. Reg. 53.4942(b)–1(b)(2)(i)
Reasonable legal fees paid to determine the proper beneficiary of a foundation are administrative expenses necessary to conduct the foundation’s exempt activities. Rev. Rul. 75–495, 1975–2 C.B. 449.
Administrative expenses and operating costs not attributable to exempt activities, such as expenses in connection with the production of income, are not treated as exempt-function distributions.
Expenses attributable to both direct exempt functions and other functions or activities must be allocated between them on a reasonable and consistently applied basis.
A foundation’s setting aside of an amount for a specific project is deemed a direct exempt-function distribution if the foundation will use the funds directly in an exempt function (e.g., the acquisition of a building for the foundation’s direct use in exempt functions) and the set-aside qualifies under IRC 4942(g)(2) and Reg. 53.4942(a)–3(b).
Rev. Rul. 74–450, 1974–2 C.B. 388, holds that renovation and construction with respect to a wildlife sanctuary and public park is a specific project, for which amounts set aside are qualifying distributions.
Payment of IRC 4940 tax is deemed a direct exempt-function distribution. Reg. 53.4942(b)–1(b)(3).
Grants, scholarships, program-related investments, or other payments to individuals constitute direct exempt-function distributions only if the grantor foundation maintains some "significant involvement" in the active programs in support of which such grants are made. Reg. 53.4942(b)–1(b)(2)(i).
Significant involvement is defined as existing in two situations, set forth in Reg. 53.4942(b)–1(b)(2)(ii)(A) and (B) and described below.
There is significant involvement under Reg. 53.4942(b)–1(b)(2)(ii)(A) where all three of the following circumstances exist:
An exempt purpose of the foundation is relief of the poor or distressed, and its activities provide such relief;
The making of such grants is direct and without the assistance of an intervening organization or agency; and
The foundation maintains a staff of administrators, researchers, or other personnel who supervise and direct these activities on a continuing basis. See Example (8) of Reg. 53.4942(b)–1(d).
"Miss Elizabeth" D. Leckie Scholarship Fund v. Commissioner, 87 T.C. 251 (1986), acq. in result, 1987–1 C.B. 1, held that the requirements of this regulation were met where, in addition to granting college scholarships to county high school students largely on the basis of need, the foundation engaged in activities to induce the scholarship recipients to return to the county after completing their education, conducted county tours, and compiled data to promote the county as a desirable place to live.
There is significant involvement under Reg. 53.4942(b)–1(b)(2)(ii)(B) where all three of the following circumstances exist:
The foundation has developed some specialized skills, expertise, or involvement in a particular substantive area;
The foundation maintains a salaried staff of administrators, researchers, or other personnel who supervise and conduct programs in the foundation’s particular area of interest; and
The foundation makes grants to individuals to further their involvement in the foundation’s programs (such as grants under which the recipients, in addition to independent study, attend classes, seminars, or conferences sponsored or conducted by the foundation, or grants to engage in social work projects under the general direction and supervision of the foundation). See Examples (3)–(7) and (9) of Reg. 53.4942(b)–1(d).
Program-related investments within the meaning of IRC 4944(c) made to corporate enterprises as well as to individuals may qualify as direct exempt-function distributions if the significant involvement requirements of Reg. 53.4942(b)–1(b)(2)(ii)(A) or (B) are met (treating the corporate enterprises as individuals for such purposes). See Reg. 53.4942(b)–1(b)(2)(i).
Rev. Rul. 78–315, 1978–2 C.B. 271, holds that where a trust’s sole activity is operating a cultural center and the managing trustees form a corporation to operate the cultural center only as a corporate trustee of the trust, the trust’s distributions to the corporation are direct exempt-function distributions rather than distributions to a grantee organization.
The determination whether payments constitute direct exempt-function distributions depends on the facts and circumstances. Reg. 53.4942(b)–1(b)(2)(i).
Individual grants may qualify as direct exempt-function distributions even if more of the foundation’s funds are devoted to grants than to the active programs that such grants support. Reg. 53.4942(b)–1(b)(2)(i).
The mere selection, screening, and investigation of grant applicants is not treated as significant involvement, however. Reg. 53.4942(b)–1(b)(2)(i).
See also Examples (2) and (10) of Reg. 53.4942(b)–1(d) for payments that do not qualify as direct exempt-function distributions.
In determining whether a private foundation meets the income test of IRC 4942(j)(3)(A), it is sometimes necessary to calculate its adjusted net income.
Adjusted net income is gross income less deductions allowed to corporations subject to tax under IRC 11, with certain modifications to income and deductions. IRC 4942(f)(1).
Gross income includes all amounts derived from, or in connection with, property held by the foundation, including property used directly in an exempt function, in an unrelated trade or business, or otherwise. Regs. 53.4942(a)–2(d)(1)(i) and (2)(viii).
In computing gross income and deductions, the principles of subtitle A of the Code apply (except to the extent inconsistent with IRC 4942 or the regulations thereunder), but exclusions, deductions, and credits are not allowed unless expressly provided for under IRC 4942 or the regulations thereunder. Reg. 53.4942(a)–2(d)(1).
A foundation may deduct its amortizable bond premium deductible under IRC 171. Rev. Rul. 76–248, 1976–2 C.B. 353.
In general, amounts are included in income if they constitute the repayment of amounts previously claimed as qualifying distributions.
Amounts received or accrued as repayments of amounts which were taken into account as a qualifying distribution under IRC 4942(g)(1)(A) for any taxable year are included in income. IRC 4942(f)(2)(C)(i).
If a foundation makes an interest-free loan to a public charity in a year in which its distribution requirements are met independently of the loan and does not use the loan to reduce its distributable amount in subsequent years, then the loan is never taken into account as a qualifying distribution, and loan repayments are not included in income in determining adjusted net income. Rev. Rul. 77–252, 1977–2 C.B. 390.
Notwithstanding the general rule for capital gains, amounts received or accrued from the sale or other disposition of property are included in income to the extent that the amount paid to acquire the property was taken into account as a qualifying distribution under IRC 4942(g)(1)(B) for any taxable year. IRC 4942(f)(2)(C)(ii).
Any amount set aside under IRC 4942(g)(2) is included in income to the extent that the amount is determined not to be necessary for the purposes for which it was set aside. IRC 4942(f)(2)(C)(iii).
Amounts taken into account in a preceding taxable year as a qualifying distribution under IRC 4942(g)(3), but which are not properly redistributed by the close of the donee organization’s succeeding taxable year, are included in the donor foundation’s income for its taxable year beginning after the close of the donee organization’s taxable year following the donee organization’s taxable year of receipt. Reg. 53.4942(a)–2(d)(2)(ix).
The other income modifications in computing adjusted net income are set forth below.
Gifts, grants, and contributions to the foundation are excluded from income. Reg. 53.4942(a)–2(d)(1).
A foundation that receives a bequest of a decedent’s right to receive deferred compensation payments includes in income only the portion (if any) of each payment that exceeds the value of the right to receive the payment on the date of the decedent’s death, the remainder being treated as a gift to the foundation. Rev. Rul. 75–442, 1975–2 C.B. 448.
Interest from exempt bonds is included in income. IRC 4942(f)(2)(A).
Capital gains and losses are not taken into account, except for any net short-term capital gain (which, under IRC 1222(5), is any excess of short-term capital gain over short-term capital loss). IRC 4942(f)(2)(B).
Stanley O. Miller Charitable Fund v. Commissioner, 89 T.C. 1112 (1987), upheld this rule as applied to charitable trusts, and as against Constitutional challenges.
Net short-term capital loss is not carried back or forward to other tax years. Reg. 53.4942(a)–2(d)(2)(ii).
Since the Code treats a capital gain dividend from a regulated investment company as a gain from the sale or exchange of a long-term capital asset, such dividends are excluded from adjusted net income. Rev. Rul. 73–320, 1973–2 C.B. 385.
Similarly, net IRC 1231 gains are not taken into account, but net IRC 1231 losses (treated as ordinary under IRC 1231(a)(2)) are taken into account. Reg. 53.4942(a)–2(d)(2)(ii).
Certain amounts received by a foundation in the redemption of stock in a corporate disqualified person in order to avoid excess business holdings are treated as not essentially equivalent to a dividend under IRC 302(b)(1) (and thus as amounts received in exchange for the stock, giving rise to long-term capital gain or loss if the conditions of Reg. 53.4942(a)–2(d)(2)(iv) are met).
See also Rev. Rul. 75–336, 1975–2 C.B. 110, for the same holding.
If, as of the date of distribution of property for purposes described in IRC 170(c)(1) or (2)(B), its fair market value exceeds its adjusted basis, the excess is not deemed an amount includible in income. Reg. 53.4942(a)–2(d)(2)(v).
Income received from an estate is excluded from income unless, due to a prolonged period of administration, the estate is considered terminated under Reg. 1.641(b)–3(a). Reg. 53.4942(a)–2(d)(2)(vi).
In general, distributions received by a private foundation from a trust created and funded by someone other than the foundation itself are excluded from the foundation’s gross income. Reg. 53.4942(a)–2(d)(2)(vii).
The income portion of distributions received from IRC 4947(a)(2) trusts with respect to amounts placed in trust after May 26, 1969 are included in income. See Reg. 53.4942(a)–2(d)(2)(vii), which cross references Reg. 53.4942(a)–2(b)(2).
While Reg. 53.4942(a)–2(b)(2) was held invalid as applied to the minimum investment return requirement of IRC 4942(d) in Ann Jackson Family Foundation v. Commissioner, 15 F.3d 917 (9th Cir. 1994), affirming 97 T.C. 534 (1991), the courts did not decide whether the regulation is valid as applied to adjusted net income.
No interest is imputed under IRC 483 in an installment sale of property pursuant to a binding contract (including an irrevocable written option) made in a taxable year beginning before Jan. 1, 1970, unless a substantial change in the contract terms (determined under Reg. 1.483–1(b)(4)) is made on or after Jan. 1, 1970. IRC 4942(f)(2)(D) and Reg. 53.4942(a)–2(d)(2)(x).
However, payments expressly designated as interest on loans made before 1970 are included in income. Rev. Rul. 75–443, 1973–2 C.B. 449.
The deduction modifications in computing adjusted net income are set forth below.
In general, no deduction is allowed other than all the ordinary and necessary expenses paid or incurred for the production or collection of gross income or for the management, conservation, or maintenance of property held for the production of such income. IRC 4942(f)(3)(A).
Other deductions, such as the charitable contributions deduction under IRC 170, the net operating loss deduction under IRC 172, or the special deductions under IRC 241–249 including the dividends-received deductions, are not allowed. Reg. 53.4942(a)–2(d)(4)(i).
Deductions for depreciation and depletion are allowed as determined under IRC 4940(c)(3)(B) (straight-line depreciation, cost depletion). IRC 4942(f)(3)(A).
Since exempt-bond interest income is taken into account, related deductions are also, and IRC 265 does not apply. IRC 4942(f)(3)(B).
Where an expense relates partly to production of income and partly to the conduct of exempt functions (such as an officer’s compensation or a maintenance expense for property part of which is used for production of income), the expense must be allocated between the two functions, and only the portion relating to production of income is deductible. Reg. 53.4942(a)–2(d)(4)(i).
For a private foundation to satisfy the assets test of IRC 4942(j)(3)(B)(i) and Reg. 53.4942(b)–2(a)(1), substantially more than half of the fair market value of its assets must be:
devoted directly to exempt functions,
devoted directly to functionally related businesses,
stock of a corporation which is controlled by the foundation and substantially all of the assets of which are so devoted, or
some combination of the above.
"Substantially more than half" means 65% or more. Reg. 53.4942(b)–2(a)(5).
Fair market value is generally determined in accordance with the rules of Reg. 53.4942(a)–2(a)(4).
For assets devoted directly to exempt functions and for which neither a ready market nor standard valuation methods exist (e.g., historical objects or buildings, certain works of art, and botanical gardens), the historical cost, unadjusted for depreciation, is considered fair market value unless the foundation demonstrates a different value.
The foundation may use the substituted valuation for five years if it follows the procedures under Reg. 53.4942(a)–2(c)(4)(iv)(B). Reg. 53.4942(b)–2(a)(4).
Assets held for part of the taxable year are taken into account by multiplying the fair market value by the fraction of the number of days that the foundation held the asset, divided by the number of days in the taxable year.
Whether an asset is devoted directly to exempt functions or functionally related businesses is discussed below.
A "functionally related business" is any trade or business that is not unrelated under IRC 513, or that is an unrelated business but is carried on within a larger aggregate of similar activities or larger complex of other endeavors that is not unrelated. IRC 4942(j)(4) and Reg. 53.4942(a)–2(c)(3)(iii).
For example, a business in which substantially all the work is performed without compensation is a functionally related business. Rev. Rul. 76–85, 1976–1 C.B. 357.
Functionally related businesses are further discussed in the IRM 7.27.16 (concerning IRC 4942).
For an example of a subsidiary corporation controlled by a foundation and substantially all of whose assets are devoted to a functionally related business with respect to the parent foundation, see Example (1) of Reg. 53.4942(b)–2(a)(6).
An asset is devoted directly to exempt functions or functionally related businesses only if the foundation actually uses the asset in such manner. Regs. 53.4942(b)–2(a)(2)(i) and –2(a)(6) Examples (2) and (4).
Assets held for investment, the production of income, or similar use are not devoted directly to exempt functions. Reg. 53.4942(b)–2(a)(2)(i).
Whether an asset is held for such use is a question of fact. Reg. 53.4942(b)–2(a)(2)(i).
For example, use of an office building by endowment fund managers is not a direct exempt-function use. Reg. 53.4942(b)–2(a)(2)(i).
While the leasing of property to others is generally not a direct exempt function, property acquired for use in direct exempt functions may be considered as so used even though it is leased (in whole or part) for a limited and reasonable period of time (such as one year) during which the foundation arranges to use the property for the purpose acquired. Reg. 53.4942(b)–2(a)(2)(i).
The leasing of property by the foundation to others is considered a direct exempt function if the rental income is less than the amount required to be charged in order to recover the cost of purchase and maintenance of the property (taking into account the deductions permitted in calculating adjusted net income, such as straight-line depreciation). Regs. 53.4942(b)–2(a)(2)(i) and –2(a)(6) Example (3).
Property is considered to be used exclusively for direct exempt functions if such use is 95% or more of the total use—otherwise, if property is used only partly for direct exempt functions, allocation of the uses must be made. Reg. 53.4942(b)–2(a)(2)(i).
Where a portion of a building is used directly for exempt functions and the remainder is leased to commercial tenants, the basis of the allocation of the fair market value of the building is on the rental values of the two portions rather than the square footage. Rev. Rul. 82–137, 1982–2 C.B. 303.
For purposes of the assets test, amounts set aside are not treated as used directly for exempt functions. Reg. 53.4942(b)–2(a)(2)(ii)(B).
Similarly, assets held to extend credit or make funds available to members of a charitable class (e.g., assets set aside to guarantee student loans made by banks) are not considered as devoted directly to exempt functions. Reg. 53.4942(b)–2(a)(2)(ii)(A).
However, a foundation’s program-related investment is considered as devoted directly to exempt functions if the foundation meets the "significant involvement" requirement. Reg. 53.4942(b)–2(a)(2)(ii)(A).
IRC 4942(e)(1)(A) (pertaining to assets excluded from calculating minimum investment return) and Reg. 53.4942(a)–2(c)(3) and authorities thereunder also provide guidance on whether a foundation uses an asset directly for exempt functions or in a functionally related business, although such rules also include assets "held for use" within a reasonable period of time even if they are not actually used for such purposes in the tax year at issue.
Rev. Rul. 74–498, 1974–2 C.B. 387, holds that a foundation’s paintings loaned to museums are assets used directly for its exempt functions.
Rev. Rul. 75–207, 1975–1 C.B. 361, holds that a foundation’s island used as a wildlife and archeological preserve, to which access is limited to invited researchers, is used directly for its exempt functions.
(1) To satisfy the endowment test of IRC 4942(j)(3)(B)(ii), a private foundation must normally make qualifying distributions directly for exempt functions in an amount not less than two-thirds of its minimum investment return.
In effect, the endowment test requires direct exempt-function distributions of 31/3% (i.e., two-thirds of 5%) 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) less related acquisition indebtedness.
Congress added the endowment test alternative for the benefit of foundations that actively conduct charitable activities but need large endowments to fund their personal services. S. Rep. No. 552, 91st Cong., 1st Sess. 61 (1969).
However, the court in "Miss Elizabeth" D. Leckie Scholarship Fund v. Commissioner, 87 T.C. 251 (1986), acq. in result, 1987–1 C.B. 1, reasoned that the test applies to all foundations, and held that the foundation satisfied the test under the circumstances of that case.
See the example at Reg. 53.4942(b)–2(b) for another application of the test.
In most cases, the foundation satisfies the endowment test if it satisfies the income test. Only where the minimum investment return is markedly higher than adjusted net income does the endowment test (and thus the other alternative tests as well) have independent significance.
There are three requirements for a private foundation to satisfy the support test of IRC 4942(j)(3)(B)(iii):
Substantially all of its support (other than gross investment income as defined in IRC 509(e)) must normally be received from the general public and from 5 or more exempt organizations which are not private foundations described in IRC 4946(a)(1)(H) with respect to each other or the recipient foundation;
Not more than 25% of its support (other than gross investment income) may normally be received from any one exempt organization; and
Not more than half of its support may normally be received from gross investment income.
Support is defined at IRC 509(d). Reg. 53.4942(b)–2(c)(2)(i).
The support received from any one exempt organization may not be counted toward satisfaction of the support test unless the foundation receives support from at least five exempt organizations. Reg. 53.4942(b)–2(c)(2)(iii).
Support received from any particular individual or nonexempt organization (other than a governmental unit) is taken into account as support from the general public only to the extent that it does not exceed 1% of the foundation’s total support (other than gross investment income). Reg. 53.4942(b)–2(c)(2)(iv).
Support from two or more persons related to one another as described in IRC 4946(a)(1)(C)–(G) is treated as support from one person. Reg. 53.4942(b)–2(c)(2)(iv).
Support from a governmental unit described in IRC 170(c)(1) is treated as support from the general public but is not subject to the 1% limitation. Reg. 53.4942(b)–2(c)(2)(iv).
Congress added the support test alternative primarily for the benefit of special-purpose foundations with expertise in specialized substantive areas. H.R. Rep. No. 413 (Pt. 1), 91st Cong., 1st Sess. 42 (1969); S. Rep. No. 552, 91st Cong., 1st Sess. 61 (1969).
However, the court in "Miss Elizabeth" D. Leckie Scholarship Fund v. Commissioner, 87 T.C. 251 (1986), acq. in result, 1987–1 C.B. 1, reasoned that the alternative tests apply to all foundations.
IRC 4942(j)(5) and Reg. 53.4942(b)–1(a)(2) provide that for purposes of IRC 4942 (but no other Code provision), an operating foundation includes a foundation that meets the following three requirements:
The foundation operates and maintains (as its principal functional purpose) residential facilities for the long-term care, comfort, maintenance, or education of permanently and totally disabled persons, elderly persons, needy widows, or children;
The foundation has operated and maintained such facilities continuously from May 26, 1969 to the close of the taxable year; and
The foundation meets the endowment test of IRC 4942(j)(3)(B)(ii).
To meet the "principal functional purpose" requirement, a foundation must be organized for such principal purpose and must directly operate and maintain such facilities as its primary activity. Reg. 53.4942(b)–1(a)(2)(ii).
Operating and maintaining such facilities is treated as a foundation’s primary activity if at least 50% of its qualifying distributions are normally made to operate and maintain such facilities. Reg. 53.4942(b)–1(a)(2)(ii).
Congress enacted IRC 4942(j)(5) to relax the income test for such foundations—such foundations are not precluded from full-fledged operating foundation status under the normal rules of IRC 4942(j)(3). See H.R. Rep. No. 1800, 95th Cong., 2d Sess. 276 (1978).
Set forth below are:
The periods over which the income and alternative tests must be met, and permissible methods of calculation;
Special rules pertaining to the periods and methods for new organizations;
Procedures for obtaining recognition of operating foundation status; and
Rules for reliance by contributors on operating foundation status.
Under Reg. 53.4942(b)–3(a), a foundation generally satisfies the income test and one of the three alternative tests for the tax year in question by satisfying the tests using one of two methods:
for any 3 tax years during the last 4 tax years including the year in question, considering each of the 3 years separately (the 3-out-of-4-year method), or
for the 4-tax-year period including the year in question, by aggregating the figures for the 4 years (the aggregation method).
Thus, an organization in existence for 4 or more tax years cannot claim operating foundation status for a particular year unless it has met the income and alternative tests for at least two years prior to the year in question (using the 3-out-of-4-year method) or the 4-tax-year period ending on the year in question (using the aggregation method).
A foundation must use the same method for both the income test and the alternative test in its 3-year or 4-year calculations on Form 990–PF for a given year, but may use the other method for the two tests the following year. See Reg. 53.4942(b)–3(a).
A foundation may fail to qualify as an operating foundation in one year and qualify in the following year, but the qualification in the latter year will not serve to retroactively qualify the foundation in the former year. Reg. 53.4942(b)–3(a).
For organizations in existence for at least 1 but fewer than 4 tax years, the organization must use the aggregation method, which is applied to all of the tax years. Reg. 53.4942(b)–3(b)(1).
An organization will be treated as a operating foundation prior to the end of its first tax year if it has made a good-faith determination that it is likely to satisfy the tests for its first tax year. Reg. 53.4942(b)–3(b)(2).
The good-faith determination is ordinarily considered as made where based on an affidavit or opinion of the organization’s counsel, and must set forth sufficient facts for the Service to be able to determine that the organization is likely to satisfy the tests. Reg. 53.4942(b)–3(b)(2).
A foundation which is treated as an operating foundation for its first tax year based on the good-faith determination but actually fails to qualify will be treated as a non-operating foundation as of the beginning of its second tax year for all Code purposes, unless the foundation establishes to the satisfaction of the Service that it is likely to qualify as an operating foundation on the basis of its second, third, and fourth tax years. Reg. 53.4942(b)–3(b)(2).
If the foundation actually fails to qualify in its second, third, or fourth year, then it will be treated as a nonoperating foundation as of the beginning of the year in which it fails to qualify and until it qualifies for a particular year on the basis of the aggregation method (for a full 4 tax years) or the 3-out-of-4-year method. Reg. 53.4942(b)–3(b)(2).
Reg. 1.508–1(b)(5) and Rev. Procs. 76–34, 1976–2 C.B. 657, and 98–4, 1998–1 I.R.B. 113, 122, 125, set forth procedures for applying for and issuing, modifying, and revoking rulings and determination letters on operating foundation status.
Operating foundations may obtain the Service’s recognition of such status in the process of applying for recognition of 501(c)(3) exemption by completing Schedule E of Form 1023.
Foundations may also separately request a determination letter on operating foundation status (Schedule E of Form 1023 may be used for submitting pertinent information).
Such applications and rulings are subject to the declaratory judgment rights under IRC 7428. See IRC 7428(a)(1)(C); Rev. Proc. 90–27, 1990–1. C.B. 514, section 3.03.
A grant to a foreign organization that has not received a ruling on operating foundation status may be treated as a grant to an operating foundation if the grantor foundation makes a "good faith determination" that the grantee is an operating foundation. Reg. 53.4942(a)–3(a)(6).
Rev. Proc. 92–94, 1992–1 C.B. 507, sets forth a procedure for private foundations to make the good-faith determination.
Although rulings and determinations relating solely to operating foundation status and other nondisclosable matters (and not part of the organization’s application for tax-exempt status) are not subject to public disclosure under IRC 6104 or 6110 (Reg. 301.6104(a)–1(i)(5)), organizations recognized as operating foundations under IRC 4942(j)(3) are listed as such in Publication 78.
Also, all private foundations claiming operating foundation status must fill out the relevant schedule of Form 990–PF, which is subject to public disclosure.
Under Reg. 53.4942(b)–3(d), contributors, with respect to IRC 170, and grantors, with respect to IRC 4942 (hereafter "contributors" ), may rely on a foundation’s operating foundation classification by the Service where all of the following circumstances exist:
The Service has not published notice of the foundation’s change in status (such as in the Internal Revenue Bulletin);
The contributor has no knowledge that the Service has given notice to the foundation that it would be classified as a nonoperating foundation; and
The contributor is neither responsible for nor aware of any act or failure to act resulting in the foundation’s inability to satisfy the requirements of operating foundation status (a contributor will not be considered responsible for or aware of such an act or failure to act if the contributor makes his contribution in reliance on a written statement, described in Reg. 53.4942(b)–3(d)(2), by the grantee foundation).
Private foundation; capital gain dividends from a regulated investment company. Capital gain dividends received by a private foundation from a regulated investment company described in IRC 851 are includible in the foundation’s net investment income in the year received for purposes of determining the excise tax imposed by IRC 4940(a) but are excluded from the foundation’s adjusted net income for purposes of IRC 4942(f). Rev. Rul. 73–320, 1973–2 C.B. 385.
Operating private foundation; qualifying distribution; set-aside; wildlife sanctuary enlarged. An operating private foundation’s conversion of a portion of its newly acquired land into an extension of its existing wildlife sanctuary and the remainder into a public park under a four-year construction contract under which payments are mainly during the last two years constitutes a "specific project" and the foundation’s set-aside of all its excess earnings for four years, for which it files a timely justifying application with the Service, will be treated as a qualifying distribution under IRC 4942(g)(2), in applying the income test prescribed by IRC 4942(j)(3)(A), for each taxable year in which such earnings are set aside and remain unexpended. Rev. Rul. 74–450, 1974–2 C.B. 388.
Private foundation; minimum investment return; paintings for public exhibitions. A collection of paintings, owned by a private foundation formed to further the arts, that are loaned under an active loan program for exhibition in museums, universities, and similar institutions, are being used directly in carrying out the foundation’s exempt purposes within the meaning of IRC 4942(e)(1)(A), and the value of the paintings is excludable in computing the foundation’s minimum investment return. Rev. Rul. 74–498, 1974–2 C.B. 387.
A private foundation constructed a building for use directly in furtherance of purposes described in IRC 170(c)(2)(B). On its books the foundation recorded an amount equal to the straight line depreciation for its fiscal year subsequent to 1970 which it proposes to treat as a "qualifying distribution" within the meaning of IRC 4942(g)(1)(B). Held, the amount recorded for depreciation on the foundation’s books is not a qualifying distribution under IRC 4942(g)(1)(B). Rev. Rul. 74–560, 1974–2 C.B. 389.
Private foundation’s ownership and maintenance of island. The value of an island, owned by a private foundation dedicated to preserve the natural ecosystems and historical and archaeological remains on the island that has no residential use and to which present access is limited to invited public and private researchers, may be excluded from the foundation’s minimum investment return under IRC 4942(e). Rev. Rul. 75–207, 1975–1 C.B. 361.
Redemption of stock from private foundation. The redemption of stock from a private foundation to the extent necessary for the foundation to avoid the excess business holdings tax under IRC 4943 is a sale or exchange not equivalent to a dividend under IRC 302(b)(1) and the proceeds will be taxed neither as investment income nor as undistributed income. Rev. Rul. 75–336, 1975–2 C.B. 110.
Private foundation gross income; deferred incentive compensation plan. For purposes of IRC 4942, a private foundation receiving annual payments, as beneficiary of a decedent’s deferred incentive compensation income plan, includes each payment as gross income to the extent that it exceeds the amount attributable to the value of the right to receive the payment on the decedent’s date of death. Rev. Rul. 75–442, 1975–2 C.B. 448.
Private foundation adjusted net income; pre-1970 principal and interest received. Repayments of principal received by a private foundation in taxable years beginning after 1969 on loans made in prior years to individuals for charitable purposes are not includible in its gross income to determine its adjusted net income for purposes of IRC 4942(f); however, payments of interest on such loans are includible. Rev. Rul. 75–443, 1975–2 C.B. 449.
Private foundation; qualifying distributions; legal fees. Legal fees not excessive in amount, paid by an exempt charitable trust in a suit to determine the proper beneficiary of a portion of its net income, are qualifying distributions under IRC 4942(g)(1). Rev. Rul. 75–495, 1975–2 C.B. 449
Private foundation minimum investment return; unrelated business income. In determining its minimum investment return, a private foundation need not take into account assets used in a trade or business for which substantially all the work is performed without compensation. Rev. Rul. 76–85, 1976–1 C.B. 357.
A private foundation, exempt from Federal income tax under IRC 501(c)(3), amortizes bond premium pursuant to IRC 171. Held, the amortizable bond premium may be deducted (to the extent that it would be deductible under IRC 171) by the private foundation in computing its net investment income under IRC 4940 and in computing its adjusted net income under IRC 4942. Rev. Rul. 76–248, 1976–2 C.B. 353.
Private foundations; repayment of loan from corpus. A private foundation that made an interest-free loan from corpus to a public charity in a year in which its distribution requirements had been met and that continued to meet the distribution requirements during the five-year adjustment period without use of the excess of qualifying distributions created by the loan is not required to include in its gross income repayments on the loan and may return the payments to corpus. Rev. Rul. 77–252, 1977–2 C.B. 390.
Operating foundation; qualifying distributions; payments to corporate fiduciary. An otherwise qualifying trust whose sole activity is the operation of a cultural center makes distributions qualifying it as an operating foundation under IRC 4942(j)(3)(A) when it turns over substantially all of its adjusted net income each year to a separate corporation that, acting only in a fiduciary capacity on behalf of the trust, disburses such amount in a timely manner in the operation of the cultural center. Rev. Rul. 78–315, 1978–2 C.B. 271.
Private foundations; minimum investment return; computation; portion of building used commercially. A private foundation owns a building, a portion of which is used directly in carrying out its exempt purposes, with the remainder leased to commercial tenants. The percentage of exempt use of the building, for purposes of determining the foundation’s minimum investment return under IRC 4942(e), should be determined by dividing the fair rental value of that portion of the building used for exempt purposes by the fair rental value of the entire building. Rev. Rul. 82–137, 1982–2 C.B. 303.