Christina K. Patten, EA
Once an organization is classified by the Internal Revenue Service (IRS) as a private foundation, it remains a private foundation. While most private foundations thrive, others may struggle to maintain longevity. Some mature private foundations struggle to keep philanthropy a family endeavor and/or struggle to meet their annual distribution requirements. In addition, operational costs can be significant and the excise tax on net investment income may cut into available funds. Occasionally, an organization may have erroneously determined that it was a private foundation and wish to correct the error in classification. Issues like these can lead a private foundation to consider terminating its foundation status.
The only way an organization can terminate its private foundation status is to comply with the requirements of Internal Revenue Code (IRC) section 507, i.e., by showing that its assets are subject to public supervision, either through transfer of its assets to an IRC 509(a)(1) charity, by operation as an IRC 509(a)(1), (2) or (3) charity, or by payment of the IRC 507 tax. A termination under IRC 507 is not a dissolution of the organization. A private foundation whose status is terminated under IRC 507 is treated as a new organization created on the day after the date of such termination.
There are four ways to terminate private foundation status under section 507; the first two involve tax liability:
- Voluntary termination by notifying the IRS of intent to terminate and paying a termination tax: To voluntarily terminate under section 507(a)(1), the organization must send a statement to IRS Exempt Organizations Determinations Group of its intent to terminate its status under section 507(a)(1). The statement must provide the detailed computation and amount of private foundation termination tax. The tax must be paid simultaneously with the filed statement unless the organization requests an abatement. Abatement is generally granted if the organization distributes all its assets to one or more charitable organizations described in section 509(a)(1) that have been in existence for at least 60 months. Abatement may also be possible in situations that involve corrective action under state law.
- Involuntary termination for either willful repeated violations or a willful and flagrant violation of the private foundation excise tax provisions and becoming subject to the termination tax.
- Transfer of assets to certain public charities: A private foundation may terminate its status under section 507(b)(1)(A) by distributing all its net assets to one or more organizations with a ruling or determination letter described in section 509(a)(1). However, the organization receiving the distribution must have been in existence and so described for a continuous period of at least 60 months before the distribution. A private foundation that terminates its status in compliance with section 507(b)(1)(A) is not required to notify the IRS of its intent to terminate nor pay a termination tax.
- Operating as a public charity for a continuous period of 60 months after giving appropriate notice: An organization may terminate its private foundation status under section 507(b)(1)(B) if it meets the requirements of section 509(a)(1), (2), or (3) for a continuous 60-month period beginning with the first day of any tax year, and notifies the IRS before beginning the 60-month period that it is terminating its private foundation status.
This notification to the IRS should contain the following information:
- Name and address of the private foundation
- Its intention to terminate its private foundation status
- Code section under which it seeks classification (IRC 509(a)(1), (2), or (3))
- If IRC 509(a)(1) is applicable, the clause of IRC 170(b)(1)(A) involved
- Date its regular taxable year begins
- Date of commencement of the 60-month period
The organization also must establish, immediately after the end of the 60-month period, that it has met the requirements of section 509(a)(1), (2), or (3).
Tax-exempt organizations use Form 8940, Request for Miscellaneous Determination, to request termination of private foundation status under section 507(b)(1)(B) and again to provide the IRS with an analysis of its public support after the 60-month period following the private foundation termination period.
Section 509(a)(1) organizations primarily include churches, schools, hospitals, and other organizations that receive their public support primarily from gifts, grants and contributions from a broad group of people. An organization terminating its private foundation status to become a publicly supported organization under IRC 170(b)(1)(A)(vi) for the 60-month period will qualify only if:
- the total amount of support received from governmental units or from direct or indirect contributions from the general public during a continuous period of 60 calendar months equals one-third or more of its total support for the period, or
- the organization meets the “facts and circumstances” test provided in the regulations under IRC 170(b)(1)(A), for a continuous period of 60 calendar months.
Section 509(a)(2) organizations are those in which support is received from a combination of gifts, grants and contributions and fees for their exempt services. An organization will be considered an IRC 509(a)(2) organization for the purposes of a 60-month termination only if the organization meets the support requirements set forth in IRC 509(a)(2)(A) and (B) for the continuous period of 60 calendar months.
IRC 509(a)(3) organizations support other organizations described in IRC 509(a)(1) and (2). An organization will be considered an IRC 509(a)(3) organization for the purpose of a 60-month termination only if the organization satisfies the organizational and operational test and other requirements of IRC 509(a)(3) on or before the commencement of the 60-month period and continuously thereafter during such period.
Most Common Termination Method:
IRC 507(b)(1)(B) is the most common way of terminating private foundation status where the organization will continue in existence. To meet the requirements for successful termination under this section an organization may have to change its organizational structure, operations, sources of support, or any combination thereof.
A private foundation wishing to begin a 60-month termination immediately may choose to change its accounting period to start a 60-month period rather than wait until the end of its current taxable year. In determining whether the organization has met the requirements for a successful 60-month termination as a public charity, its combined sources of support are considered. Successful termination occurs only when the final informational requirements are met at the end of the 60-month period and the termination is retroactive to the beginning of the 60-month period.
During the 60-month termination period, the terminating private foundation must file Form 990-PF with the IRS and check Header Box F indicating that it is terminating its private foundation status under IRC 507(b)(1)(B).
The organization generally will be treated as a public charity during the 60-month termination period; grantors and contributors can rely on that classification for charitable deduction purposes except in certain circumstances. The organization, however, will remain liable for the private foundation excise taxes under Chapter 42 of the Code (other than the tax on net investment income) until it receives a final determination from the IRS that its conversion is successful. If the conversion is unsuccessful, the organization will not incur penalties for its nonpayment of the Section 4940 excise tax during the 60-month period, but will be required to pay interest on any late payments it must make when the transition period ends.
If the organization pays private foundation excise taxes (e.g., the tax on excess business holdings or taxable expenditures) during the 60-month period but is successful in the conversion, it should be entitled to a refund of the taxes paid. The organization will continue to file IRS Form 990-PF for each year in the 60-month period, if that period has not expired before the due date of the return.
This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Summer 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com
Update to Terminating Your Private Foundation
Here are a few twists an organization may wish to consider when terminating pursuant to IRC §507(b)(1)(B).
As discussed in the article, you need to notify IRS Determinations of your intent to operate as a public charity in advance of a 60-month termination period. While the organization may be regarded as a public charity for certain purposes, during the termination period, it still must file a Form 990-PF and pay the excise tax on net investment income during this period. If the organization wishes to file Form 990-PF without paying the excise tax on net investment income, it must enter into a consent (Form 872-B) to extend the statute of limitations under IRC § 6501(c)(4) with IRS Determinations. In the last tax year of the 60-month termination period, the organization may file a Form 990 to show that the organization passed the public support test in Schedule A for the 60-month period. Within 90 days after the 60-month period, the organization should file a Form 8940 with sufficient information to allow the IRS to determine that they met the requirements to be classified as a public charity.
The twist is you may also request an advance ruling from IRS Determinations (using Form 8940) that the organization can be expected to satisfy the requirements to be treated as a public charity during the 60-month termination period along with the notification of its intention to operate as a public charity. If the advance ruling is granted, contributors may generally treat the organization as a public charity, and the organization will not be assessed penalties for not paying the excise tax on net investment income. The advance ruling doesn’t mean the organization necessarily will qualify as a public charity during the 60-month period. Only that contributors can rely on them qualifying and there are no penalties for contributors if they do not. The organization will continue to file a Form 990-PF until the final tax year of the 60-month period without paying the excise tax on net investment income. Within 90 days after the 60-month period, the organization should file a Form 8940 with sufficient information to allow the IRS to determine that they met the requirements to be classified as a public charity.
This update originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Fall 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com