What are the excess business holding rules for private foundations?
The excess business holding rules are designed to prevent private foundations from owning large, controlling stakes in privately held businesses while still allowing them to hold small, non-controlling stakes as passive investors. The purpose of these rules is to ensure that private foundations remain focused on their charitable missions and avoid exerting undue influence over for-profit enterprises. If a private foundation and its disqualified persons (foundation insiders) collectively own too much of a business, the foundation violates the rules and may face severe financial penalties.
Foundations most commonly find themselves exceeding ownership limits when they inherit a large stake in a business as a bequest from the estate of a deceased business owner. However, any form of acquisition can lead to excessive ownership. The excess business holding rules, codified in Section 4943 of the Internal Revenue Code, apply to the ownership of all business entities, including corporations, partnerships, and LLCs.
Ownership Thresholds and Compliance Rules
The excess business holding rules assess whether a private foundation, along with its disqualified persons, collectively own voting control of a business enterprise beyond certain thresholds. Generally, the foundation and its disqualified persons are permitted to own up to 20% of the voting ownership in a business enterprise. Ownership exceeding this 20% threshold typically violates the rules and oftentimes triggers financial penalties.
These rules also extend to other business entities such as partnerships, substituting "profits interest" for voting ownership when determining excess holdings. Importantly, the focus is on voting ownership interests—nonvoting ownership interests generally do not count toward the threshold. This means that as long as the foundation and its disqualified persons stay within the voting ownership limit, the foundation can typically own an unlimited amount of nonvoting ownership in the business enterprise.
Lastly, ownership of sole proprietorships is generally prohibited under the excess business holding rules unless the holdings were acquired before May 26, 1969, or through a gift or bequest.
IRS Attribution Rules
When complex business and ownership structures are present, the IRS applies detailed attribution rules to evaluate total ownership connected to the foundation. Stock or other interests owned directly or indirectly by a corporation, partnership, estate, or trust are proportionately attributed to the respective shareholders, partners, or beneficiaries. This proportional attribution ensures that indirect ownership and intricate organizational charts are accurately accounted for and evaluated. While the IRS has established comprehensive guidelines for attributing business holdings in complex ownership scenarios, a deeper exploration of these rules is beyond the scope of this article.
Key Exceptions to the Excess Business Holding Restrictions
There are two important exceptions to the excess business holding rules:
1. Effective Control Exception: If an unrelated third party has effective control of a business, a private foundation and its disqualified persons may collectively own up to 35% of the voting ownership in the business. Effective control refers to the direct or indirect ability to direct the management and policies of the business, even if that authority is not actively exercised.
2. De Minimis Exception: A private foundation does not violate the excess business holding rules if, for a given business, it owns less than 2% of the voting ownership and less than 2% of the overall value ownership. Under this exception, the amount of ownership held by disqualified persons is irrelevant, as long as the foundation itself meets the de minimis thresholds.
Businesses Exempt from the Excess Business Holding Rules
Certain types of businesses are exempt from the excess business holding rules, allowing private foundations greater flexibility in specific circumstances. These exempt businesses include:
• Passive Income Businesses: Private foundations are not subject to ownership restrictions for businesses that derive 95% or more of their gross income from passive sources such as interest, dividends, royalties, and capital gains. For instance, a family investment partnership that earns income solely from mutual funds qualifies as a passive income business and is exempt.
• Functionally Related Businesses: Foundations may own unrestricted stakes in businesses whose operations are substantially related to their exempt charitable missions. For example, a foundation with a mission to support the integration of mentally handicapped adults into society can own a large share of a for-profit business like a car wash that primarily employs individuals with disabilities. The key factor is that the business directly advances the foundation’s charitable goals.
• Program-Related Investments (PRI): PRIs are investments made by private foundations to primarily advance their charitable purposes rather than to generate financial returns. Because their primary purpose is to achieve exempt, mission-driven objectives, PRIs are specifically excluded from the excess business holding rules. Unlike traditional investments, which focus on financial gain, PRIs prioritize outcomes that align with the foundation’s charitable goals. For example, a foundation might invest in a company developing low-cost generic medicines for underserved populations, where financial return is minimal or secondary to the charitable benefit.
Avoiding Noncompliance
Excess business holding issues can be easy to overlook, particularly when the financial affairs of the foundation and its disqualified persons involve overlapping investments or are managed in similar ways. To reduce the risk of inadvertent violations, foundations should implement clear monitoring and recordkeeping procedures. This includes circulating updated lists of private company investments among disqualified persons and requiring them to certify whether any overlapping ownership exists.
Note that these rules normally pertain only to privately held businesses. Mainstream investments like mutual funds and publicly traded stock mostly fall outside the domain of the excess business holding rules because of the structure of the investment funds and the massive market capitalization of publicly traded companies. So private foundations can, by and large, pay almost no attention to the excess business holding rules if their endowments are invested in standard vehicles like stocks, bonds, mutual funds, and ETFs. Private foundations should focus their safeguards and monitoring programs on privately owned businesses instead of publicly traded investments. If a foundation is considering making an investment in a privately owned business, it should first check with all its associated disqualified persons to verify there are no excess business holding ownership issues.
It’s important to note that these rules primarily apply to privately held businesses. Investments in mainstream vehicles like mutual funds and publicly traded stocks generally fall outside the scope of the rules, due to the diversified structure of these funds and the vast market capitalization of publicly traded companies. As a result, private foundations with endowments invested in traditional vehicles such as stocks, bonds, mutual funds, and ETFs can typically operate without significant concern for these rules.
Instead, foundations should focus their compliance efforts on privately owned businesses. If a foundation is considering an investment in a privately held business, it must first confirm with all disqualified persons that no excess business holding ownership issues exist. Taking these steps helps ensure compliance and prevents potential penalties.
Potential Grace Periods for Corrective Action
Private foundations that violate the excess business holding rules may be eligible for a grace period to resolve the issue. Oftentimes, a foundation is granted a 90-day grace period to sell or otherwise dispose of excess holdings. This period begins when the foundation either becomes aware of the excess holding or reasonably should have known about it. It’s important to understand that negligence or inadequate internal controls do not excuse a foundation from identifying excess holdings, and the grace period will not be extended due to such oversights.
For excess holdings acquired through a gift or bequest, the rules are more lenient. Foundations are generally allowed five years to dispose of these holdings. Additionally, the IRS may approve a further extension of up to five years if the foundation demonstrates a good faith effort to divest the excess holdings. This extension is discretionary and requires the foundation to provide evidence of diligent attempts to comply with the rules. This extended timeframe recognizes the challenges foundations may face when handling inherited assets, such as the need for careful planning to minimize disruptions or maximize proceeds from a sale.
However, stricter rules apply to violations arising from direct acquisitions by the foundation, whether through intentional purchases or other means. In such cases, no grace period is granted, and financial penalties are typically imposed immediately. This strict approach reflects the IRS's expectation that foundations conduct thorough due diligence before making any direct purchases that could lead to a violation. Direct acquisitions, which result in an immediate violation with no grace period, contrast with situations where a foundation receives an ownership stake as a gift or through actions taken by disqualified persons, where grace periods typically apply.
Penalties for Noncompliance
Private foundations that fail to reduce their excess business holdings to permissible levels within any applicable grace period face significant financial penalties. Initially, the IRS imposes an excise tax of 10% on the value of the excess holdings. This tax is calculated based on the highest value of the excess holdings during the period of noncompliance.
If the foundation does not address the violation promptly and continues to hold the excess business interests beyond the allowable timeframe, an additional penalty of 200% of the excess holding’s value can be imposed. However, the foundation can often avoid the 200% penalty by correcting the violation promptly after the initial penalty is assessed. This secondary penalty is designed to strongly deter prolonged noncompliance and encourages foundations to take corrective action as quickly as possible.
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