Thinking About Private Foundations

 

I’ll admit it: last month (October) left room for improvement. An unresponsive IRS and a dearth of hirable accounting talent is taking its toll here at Command Center. I am hoping that recent hiring at the IRS will take the edge off the former; I see little respite from the latter, however.

This month many of our nonprofit returns are due. That is OK, as those do not approach the volume of individual returns we prepare.

I find myself thinking about private foundations.

I would set-up a family foundation if I came into megabucks. It would, among other things, allow the CTG family to aggregate, review, discuss and decide our charitable giving as a family unit.  

But I have also been in practice long enough to see family foundations misused. A common-enough practice is to hire an … unmotivated … family member as a foundation employee.  

Let’s talk about the self-dealing rules and foundations.

First, let’s clarify what we mean when we use the term private (or family) foundation.

It is a charity – like the March of Dimes or United Way – but not as much. Think of foundations as the milk chocolate to the public charity dark chocolate. The dark chocolate is – let’s be frank – the better chocolate. Contributions to both are tax deductible, but there are restrictions on the private foundation that do not exist for a public charity. Why? Because a public charity tends to have a diverse and diffuse donor base. A private foundation can be one family – or one person. A private foundation can therefore be more disposed to get its nose in traps than a public charity.

Let’s introduce two terms: disqualified persons and self-dealing.

There are two main categories of disqualified persons. I will use the CTG Foundation (and its one donor – me) as an example.

·      Category One

o  A substantial contributor (that would be me)

o  Members of my family

o  A corporation, partnership or trust wherein I am at least a 35% owner

·      Category Two

o  Foundation directors and officers

o  Their families

A family foundation might keep everything in the family, in which case categories one and two are the same people. It does not have to be, though.

We have the players. Now we need an event, such as:

·      Buying or selling property from or to a disqualified (person)

·      Renting from or to a disqualified (unless from and for free)

·      Lending money to or borrowing from a disqualified (unless from and interest free)

·      Allowing disqualifieds to use the foundation’s assets or facilities, except on terms available to all members of the public

·      Paying or reimbursing unreasonable or unrelated expenses of a disqualified

·      Paying excessive compensation to a disqualified

In theory, that last one would discourage hiring the … unmotivated … family member. In reality … there is very little discouragement. The deterring effect of punishment is impacted by its likelihood: no likelihood = no deterrence.

A key thing about self-dealing transactions is that, as a generalization, the tax Code does not care whether the foundation is getting a “deal.”  Say that I own rental real estate in Pigeon Forge. I sell it to the CTG Foundation for pennies on the dollar. Financially, the foundation has received a significant benefit. Tax-wise, there is self-dealing. The Code says “NO” buying or selling to or from a disqualified. There is no modifying language for “a deal.”

So, what happens if there is self-dealing?

There are two tiers of penalties.

·      Tier One

o  A 10% annual penalty on the self-dealer. In our Pigeon Forge example, that would be me. If the violation is not cleaned-up quickly, the 10% applies every year until it is.

o  There may be a 5% penalty on a foundation manager who participated in the act of self-dealing, knowing it to be such. Again, the penalty applies annually.

·      Tier Two

o  The Code wants the foundation and disqualified to reverse and clean-up whatever they did. In that spirit, the penalty becomes severe if they blow it off:

§  The penalty on the self-dealer goes to 200%

§  The penalty on the foundation manager goes to 50%

You clearly want to avoid tier two.

What would impel the foundation to even report self-dealing and pay those penalties?

I like to think that the annual 990-PF preparation by a reputable accounting or law firm would provide motivation. I would immediately fire a private foundation client which entered into and refused to unwind a self-deal. I am more concerned about my reputation and licensure. I can always get another client.

Then there is the possibility of an IRS audit.

It happens. I was reading one where the private foundation made a loan to a disqualified. The disqualified never made payments or even paid interest, and this went on for so long that the statute of limitations expired. According to the IRS, it might not be able to get to those closed years for penalties, but it could force the foundation to increase the loan balance by the missed interest payments (even for closed tax years) when calculating penalties for the open years.

Yep, that is what got me thinking about private foundations.

For the home gamers, this time we discussed CCA 202243008.

Rental of U.S. Real Estate by a Nonresident

I was speaking with someone from overseas about buying real estate around here and renting it out. This person is a green card holder, so their tax considerations in owing rental real estate would be the same as yours or mine.

But what if they were not a green card holder?

Different set of rules. We are talking about the U.S. taxation of a nonresident alien. A nonresident alien does not have a green card or spend enough time in the U.S. to be considered a resident.

There are two ways to handle a nonresident alien’s reporting of U.S. rental real estate.

Let’s call the first one the “default” rule. This type of income is referred to as “fixed, determinable, annual or periodic” (FDAP) and carries a 30% tax rate on the gross amount of income. Examples of FDAP are interest, dividends, annuities, royalties and rents. 

Let’s use some numbers to make this concrete:

                        Rent received                                                24,000

                        Property management                                    2,400

                        Real estate taxes                                            6,000

                        Insurance                                                        1,600

                        Depreciation                                                   9,000

                        Net profit                                                        5,000

Oh, the property manager will have to withhold the 30% upfront. The manager has to, as the tax code requires the manager to pay the 30% from his/her own funds if he/she does not withhold it from you.

Under the default rule the property manager will withhold 30% of your rental income, or $7,200, and forward it to Treasury. At the end of the year the manager will send you a Form 1042-S reporting the withholding. The good news is that you do not have to file further taxes. The bad news is that it cost you 30%.

NOTE:  The 30% is not cast in stone. It can be overridden by treaty.

The second way is to make an election, so let’s call it the “election” rule. The idea here is that you have a trade or business in the United States (you do, sort of, as a landlord), and you are going to elect to have the rental property “effectively connected” to your business. The principal tax difference is that you will owe tax using graduated tax rates on your net rental income. To phrase it another way, “effectively connected income” (ECI) of a foreign person is taxed like the income of a U.S. person.

The first thing you do is file a form (Form W-8ECI) with the property manager so the manager does not have to withhold 30% from you.

The second thing you have to do is file a tax return (Form 1040NR) at the end of the year. You have to include an election in the return alerting the IRS what you are up to. You will pay tax on $5,000, which is big improvement over paying tax on $24,000. Technically, you would be paying tax on less than $5,000, as you also get a personal exemption, but you get the idea. You also have graduated tax rates – not a flat 30% like under the default rule.

By the way, if you came into our offices using the default rule, we would likely encourage you to file a return anyway under the election rule. Why? To get back some of your 30% withholding, that’s why. The government would have gotten $7,200 from you. That was more than your profit before giving the government anything! Then we would have you fill out the paperwork to have the property manager stop withholding on your rent checks.