Case of the Week

Case:

Lucky Lucy Lindstrom finished college and headed west. She started as a financial analyst with a large company in Seattle. After just four years, she became a Registered Investment Advisor (RIA) and began advising clients. Lucy also managed her own investments. With her keen insight into financial markets, Lucy soon began to move from traditional stocks and bonds into futures and commodities markets. Lucy was so successful in these markets that she now only manages her own large personal portfolio.

Somewhat late in life, Lucy discovered the wonderful world of philanthropy. She volunteered at her favorite charity and learned that giving someone in need a helping hand is even more gratifying than making another million in the futures market. Lucy had invested $1,000,000 in a "penny stock" company. Recently, the stock rose from the $1 per share that she paid to over $5 per share. Lucy was delighted with her gain and decided to give the $5,000,000 in stock to a charitable foundation to help those in need.

Lucy discussed several options with her attorney and her favorite charity. One of the options that Lucy was very interested in was a private foundation (PF). She asked her attorney for reasons to select a private foundation. Her attorney noted that private foundations are more expensive to operate, appreciated gifts are deductible only to 20% of AGI, deductions for gifts of real estate to a PF are limited to basis, there is usually a 2% excise tax on investment income and the PF is subject to various rules on self-dealing, minimum distributions and excess business holdings. However, a private foundation would give Lucy full control. This is important to Lucy since she wants to make grants for disaster relief directly to those in need.

Question:

Lucy said, "Wow! There are a lot of negatives about private foundations. So why set up a private foundation? And if I fund a private foundation, can I make grants to people who suffered so greatly in a hurricane?"

Solution:

Her attorney responded that private foundation grants are subject to the expenditure responsibility rules. These rules will require Lucy to take specific steps; her attorney explained the process. First, her private foundation must make a pre-grant inquiry before making a grant where expenditure responsibility is required. The purpose of the pre-grant inquiry is to ensure that the recipient will use the grant for proper exempt purposes.

Second, a grant agreement must be executed and the recipient must agree to repay any unused portion of the grant, provide reports to Lucy's private foundation on the use of funds, maintain records and receipts of expenditures and make its books and records available to the private foundation. The recipient must also agree not to use the funds for prohibited lobbying or political purposes, not to use the funds to make grants to individuals and not to use the funds for any non-charitable activity.

Next, Lucy's private foundation must obtain follow-up reports from the recipient indicating how the funds were used, the progress being made in achieving the grant purpose and confirming that the grant terms were followed. Finally, the private foundation must report to the Internal Revenue Service that it made an expenditure responsibility grant. Reg. 53.4945-5(b).

These are rather stringent and expensive administrative requirements. After considering the options, Lucy realized that there are many qualified Sec. 501(c)(3) nonprofits that make grants directly to those in need. Lucy decided that the best solution is for her private foundation to work together with public relief charities after each hurricane, rather than sending funds directly to individuals. She still will be able to assist those in need with grants to public charities and will avoid the potential costs with expenditure responsibility.