1. Taxation of
Investments for
Private Foundations
Frank H. Smith, Partner & Dennis
Gogarty, Raffa Wealth Management
February 22, 2012
Thrive. Grow. Achieve.

2. NET INVESTMENT INCOME
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3. NET INVESTMENT INCOME
• Capital losses from the sale of foundation investments can only be used to
offset capital gains in the same tax year. They cannot be used to offset other
investment income, nor can they be carried back or forward to other tax years.
• When possible, foundation managers and investment advisors should manage
the sale of such investments to avoid large losses in one year and large gains in
another year.
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4. NET INVESTMENT INCOME
• A foundation can qualify for a reduced tax rate of 1% if it makes qualifying
distributions during a tax year that is at least equal to a certain amount that is
based on the average percentage of assets distributed in the prior five tax years.
• A private foundation does not qualify for the 1% rate in it’s first year. For the
second through fourth years, the average is calculated for the period of time the
foundation has been in existence.
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5. NET INVESTMENT INCOME
• The 1% rate is not available if a private foundation was liable for tax under the
mandatory payout rules with respect to any year in the measuring period.
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6. QUALIFYING DISTRIBUTIONS
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7. QUALIFYING DISTRIBUTIONS
• Private foundations often receive highly appreciated stock from its donors. Sale
of such appreciated property would normally generate net investment income
that is taxable to the foundation.
• If a foundation contributes appreciated property to a public charity, the
foundation gets a qualified distribution for the full fair market value of the
property, but does not have to pay taxes on the amount of the appreciation
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8. PROGRAM RELATED INVESTMENTS
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9. PROGRAM RELATED INVESTMENTS
AMOUNTS PAID TO ACQUIRE OR OPERATE PROGRAM-RELATED
INVESTMENTS ARE TREATED AS QUALIFYING DISTRIBUTIONS FOR
SATISFYING THE MINIMUM DISTRIBUTION REQUIREMENTS. IT IS NOT
CLASSIFIED AS A JEOPARDIZING INVESTMENT.
• A program-related investment should possess the following
characteristics:
̵ Primary purpose is to accomplish a charitable, educational, or similar purpose
̵ Production of income or appreciation of property is not a significant purpose of the
investment
̵ Investment is not made in order to influence legislation or campaign on behalf of a
candidate for public office
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10. PROGRAM RELATED INVESTMENTS
EXAMPLES OF PROGRAM RELATED INVESTMENTS INCLUDE:
• Low-interest or interest-free loans to needy students.
• High-risk investments in nonprofit low-income housing projects.
• Low-interest loans to small business owned by members of economically
disadvantaged groups, where commercial funds at reasonable interest rates are not
readily available.
• Investments in businesses in deteriorated urban areas under a plan to improve the
economy of the area by providing employment or training for unemployed
residents.
• Investments in nonprofit organizations combating community deterioration.
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11. JEOPARDIZING INVESTMENTS
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12. JEOPARDIZING INVESTMENTS
• While the IRS has noted that it will not consider any type of investment a
“jeopardizing investment” per se, there are certain categories of investments that it
will closely scrutinized, such as puts, calls, warrants, etc. An investment would be
considered to be a jeopardizing investment if the foundation managers, in making
the investment, fail to exercise ordinary business care in providing for the long and
short-term financial needs of the foundation.
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13. JEOPARDIZING INVESTMENTS
• An initial tax of 5% is imposed for making the investment. The IRS has discretionary
authority to reduce this initial tax.
• The taxable period is the period beginning with the date on which the amount is
invested in a jeopardizing manner and ending on the earliest of the following dates:
̵ Date on which the IRS mails a notice of deficiency with respect to the initial tax imposed on the
foundation.
̵ Date on which initial tax is assessed, or
̵ Date on which the amount invested is removed from jeopardy.
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14. EXCESS BUSINESS HOLDINGS
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15. EXCESS BUSINESS HOLDINGS
• Generally, excess business holdings would exist if a private foundation and all
disqualified persons combined own over 20% of the voting stock of an incorporated
business enterprise. Under certain circumstances, this percentage may increase to
35%. In addition, there is a 2% de minimis rule in situations where the foundation
itself owns 2% or less of both the voting stock and value of all outstanding shares
of the business enterprise. There is also a 5-year grace period for business
holdings that are obtained through gift or bequest.
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16. DISQUALIFIED PERSONS
• Disqualified persons are individuals or organizations a private foundation is
deemed to be related to and with which the private foundation is limited from
engaging in transactions which may create self-dealing or excess business holding
issues (discussed below).
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17. DISQUALIFIED PERSONS
DISQUALIFIED PERSONS INCLUDE THE FOLLOWING:
• Officers, directors or trustees of the foundation
• A substantial contributor to the foundation
• Companies or partnership substantially owned by disqualified persons
• Spouse and families of any of the above (family in this instance includes ancestors,
children, grandchildren, great-grandchildren and their spouses, but not siblings)
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18. DEBT FINANCED INCOME
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19. DEBT FINANCED INCOME
• Private foundations must include income from debt-financed property in their
calculation of unrelated business income.
• Debt-financed property is any property that is held to produce income and has
acquisition indebtedness at any time during the year.
• Any property that is disposed of during the year may be subject to tax if there was
acquisition indebtedness with regards to the property at any time during the 12
months prior to the disposal.
• Depending on the facts and circumstances, the use of margin accounts in a private
foundation’s investment portfolio may cause the organization to be subject to
taxation.
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20. ALTERNATIVE INVESTMENTS
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21. ALTERNATIVE INVESTMENTS
• Activities engaged in by a partnership in which a private foundation is a partner
(whether a general or limited partner) is considered to be engaged in directly by the
foundation. A foundation needs to pay attention to the activities of such
organizations, because the activities can inadvertently cause many problems for
the foundation.
• A partnership is a disqualified person if more than 35% of the profits interest in the
partnership is owned by substantial contributors, foundation mangers, 20%
owners, or members of the family of any of these individuals.
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22. SPENDING POLICY VS. INVESTMENT POLICY
Permanent Sustainability vs. Target Date
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23. SPENDING POLICY VS. INVESTMENT
POLICY
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24. SPENDING POLICY VS. INVESTMENT
POLICY
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25. SPENDING POLICY VS. INVESTMENT
POLICY
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26. FIDUCIARY RESPONSIBILITY
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27. FIDUCIARY RESPONSIBILITY
Prudent Practices for Investment Stewards (The Fiduciary Handbook) Written by
Fiduciary 360, 2006; Technical Review by American Institute of Certified Public
Accountant; Legal substantiations by Reish, Luftman, Reicher, & Cohen
ROLES AND RESPONSIBILITIES OF ALL INVOLVED PARTIES ARE
DEFINED, DOCUMENTED, AND ACKNOWLEDGED.
• The fiduciary may delegate certain decisions to professional money
managers, investment advisors and consultants. But even when decisions have
been delegated to a professional, a fiduciary can never fully abdicate these
primary responsibilities:
– Determining investment goals and objectives
– Choosing an appropriate asset allocation strategy
– Establishing an explicit, written investment policy consistent with the goals and objectives
– Approving appropriate money managers, mutual funds, or other “prudent experts” to implement
the investment policy
– Monitoring the activities of the overall investment program for compliance with the investment
policy
– Avoiding conflicts of interest and prohibited transactions
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28. FIDUCIARY RESPONSIBILITY
“The Handbook was developed specifically for Investment Stewards –
trustees, investment committee members, attorneys, accountants, institutional
investors, and anyone else involved in managing investment decision-making. The
Handbook will serve as a foundation for prudent investment fiduciary practices. It
provides investment fiduciaries with an organized process for making informed and
consistent decisions.” ~ Excerpt from the AICPA Editorial Statement to Readers
APPLICABLE “SAFE HARBOR” PROVISIONS ARE
FOLLOWED.
• When adopted, liabilities associated with the Investment Steward’s
management of the portfolio’s assets may be reduced. If investment
decisions are being managed by a committee, there are five generally
recognized provisions to the Safe Harbor rules:
– Use prudent experts (registered investment adviser, bank, or insurance company) to
make the investment decisions.
– Demonstrate that the prudent expert was selected by following a due diligence
process.
– Give the prudent expert discretion over assets.
– Have the prudent expert acknowledge their co-fiduciary status.
– Monitor the activities of the prudent expert to ensure that the expert is performing the
agreed upon tasks
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29. PORTFOLIO OVERSIGHT
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30. OVERSIGHT
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31. OVERSIGHT
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32. PORTFOLIO OVERSIGHT
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33. PORTFOLIO OVERSIGHT
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34. PORTFOLIO OVERSIGHT
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35. PORTFOLIO OVERSIGHT
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36. ASSET ALLOCATION: BENCHMARKING
DESIGNED TO MATCH THE APPROPRIATE LEVEL
OF RISK
Indices are not available for direct investment and performance does not reflect expenses
of an actual portfolio. Past performance is not a guarantee of future results.
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37. ASSET ALLOCATION VS. MANAGER
SELECTION
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38. PORTFOLIO OVERSIGHT
SUMMARY
• Fixed income
̵ Credit quality and maturity matter
• Equity
̵ Size and price (style) matter
• International
̵ Developed or emerging market matters
• Diversified or concentrated
• Investors require greater than benchmark performance for assuming greater than
benchmark risk.
Indices are not available for direct investment and performance does not reflect
expenses of an actual portfolio. Past performance is not a guarantee of future
results.
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39. PORTFOLIO OVERSIGHT
APPROPRIATE BENCHMARKS MAY LEAD TO:
• Peace of Mind
• Accountability
• Greater Attention
• A more level the playing field
• Bottom line improvements
Indices are not available for direct investment and performance does not reflect
expenses of an actual portfolio. Past performance is not a guarantee of future
results.
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40. OTHER CONSIDERATIONS
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41. INTERNAL REVENUE CODE
IRC 4940 EXCISE TAX BASED ON INVESTMENT INCOME.
IRC 4941 TAXES ON SELF-DEALING.
IRC 4942 TAXES ON FAILURE TO DISTRIBUTE INCOME.
IRC 4943 TAXES ON EXCESS BUSINESS HOLDINGS.
IRC 4944 TAXES ON INVESTMENTS WHICH JEOPARDIZE CHARITABLE PURPOSE.
IRC 4945 TAXES ON TAXABLE EXPENDITURES.
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42. RESOURCES
FORM 990-PF INSTRUCTIONS
PUBLICATION 578
WWW.IRS.GOV
20 QUESTIONS
PPC DESKBOOK
BNA PORTFOLIOS
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43. Q&A
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44. THANK YOU!
Health Care Reform/ Page 44