Some public charities lose their tax-exempt status for failure to meet ongoing public support tests over a moving 5-year window.1 If such a public charity fails to meet the applicable support test for two consecutive years, Treasury regulations provide that it be treated as a private foundation (PF)—but only for certain purposes—as of the beginning of that second consecutive year (the “transition year”). Of course, a public charity may not know if it will fail the public support test for a second consecutive year until that year is over. Given the uncertainty regarding its tax classification at the beginning of the transition year, it’s understandable why the regulations provide relief from the immediate application of nearly all the PF rules until the following year.
Presently, Form 990-PF, the annual information return a PF must file, treats transitioning organizations no differently than established PFs, and the instructions to such form provide very little guidance. As a result, transitioning organizations are required to fill out sections of the return that are inapplicable to them, unnecessarily subjecting themselves to a distribution requirement for the following year.
Inapplicable Questions
As mentioned above, the regulations provide that a transitioning organization is treated as a PF in the transition year only for purposes of Internal Revenue Code Sections 507, 4940 and 6033.2 Generally, IRC Section 507 relates to termination of PF status, Section 4940 subjects the organization to a 1.39% excise tax on its net investment income and Section 6033 requires a PF to provide certain information on IRS Form 990-PF.
Section 6033 requires a transitioning organization to file Form 990-PF, beginning with the transition year, and the instructions to such form explicitly acknowledge that only Sections 507, 4940 and 6033 apply to the organization in that year. As an information return, Form 990-PF requires a PF to provide information addressing Chapter 42 compliance rules, such as self-dealing
(IRC Section 4941), minimum annual distributions (IRC Section 4942), excess business holdings (IRC Section 4943), jeopardizing investments (IRC Section 4944) and taxable expenditures (IRC
Section 4945)—none of which apply to a transitioning organization in its transition year. Unfortunately, neither the return nor its instructions direct a transitioning organization to skip inapplicable sections of the transition year return. In fact, a transitioning organization filing its transition year return would be expected to complete Form 990-PF in its entirety. By contrast, operating and foreign foundations are instructed to skip the sections of the return that don’t apply to them, evidencing the fact that Treasury is willing and able to customize the instructions under certain circumstances.
Specifically, it seems that a transitioning organization would be required to complete five sections (Part VII-B, and Parts X through XIII), spanning four pages of the transition year return, to report its compliance with the Chapter 42 rules and to calculate its minimum distribution requirement (MDR) for the following year.3 However, a transitioning organization shouldn’t be required to complete sections of the return that are geared towards compliance with Sections 4941, et. seq., which are generally inapplicable to the transitioning organization in the transition year.4
For instance, most of the questions posed in Part VII-B are aimed at unearthing PF-oriented compliance lapses, such as self-dealing. These questions are typically coupled with follow-up questions asking whether the organization qualified for an exception specifically pertaining to PFs. As we noted above, these sections are inapplicable to a transitioning organization in its transition year. Therefore, the transitioning organization should be excused from completing the PF compliance questions in Part VII-B. At the very least, the section should be revised to indicate that the organization either qualified for a special exception to the rule or that the rule didn’t apply to the organization because the return year was its transition year.
Why Satisfy an MDR?
Aside from the administrative burden of preparing inapplicable sections of the return, why should the organization be expected to satisfy an MDR arising from its transition year when Section 4942 doesn’t apply in such year? After all, an organization that has insufficient liquid assets may need to sell assets that it would otherwise retain to satisfy an artificial MDR. To add insult to injury, if the organization fails to satisfy this artificial MDR, it could be subject to underdistribution penalties. A less obvious, but potentially more serious, problem is what happens on the flipside—when the transitioning organization makes substantial enough qualifying distributions (QDs) in the transition year to generate excess grant carryover (EGC), which can be carried forward for up to five years to satisfy its MDR. In fact, having spoken with a number of practitioners in the sector, transitioning organizations often find themselves in this situation. Because EGC, like MDR, is governed by Section 4942, it stands to reason that just as transition year MDR is artificial, so too are any transition year QDs and resulting EGCs.
The concern here is that any such EGCs could be invalid and, therefore, unavailable for application towards the transitioning organization’s MDR for any future tax years.5 For instance, suppose that an organization generates EGCs in the transition year—and relies on them in good faith to satisfy its MDR for one or more future years.6 Doing so could subject the organization to an underdistribution penalty in each such future year if the EGCs are, in fact, determined to be invalid. To make matters worse, even though the organization likely would be unaware of any underdistribution, any such penalty could be reassessed each year until the underdistribution has been corrected.7
Essentially, tracking transition year QDs and calculating the next year’s MDR are two sides of the same coin, as they’re both governed by different provisions of Section 4942. Therefore, if the IRS were to expect a transition year organization to calculate its MDR for the following year, the PF, in all fairness, should be entitled to count its transition year QDs towards generating valid ECGs that may be used to satisfy its MDR in future years without fear of lurking underdistribution penalties.
Form 990-PF and its instructions need to do much more than merely acknowledge the limited application of the PF rules to an organization in its transition year. The suspension of these rules must be incorporated into the instructions and the form itself. Currently, the form and instructions create the expectation that certain transitioning organizations must meet an MDR they shouldn’t have to satisfy, while others may rely on transition year ECGs that are invalid. In the absence of such long overdue revisions, transitioning organizations—and the IRS—are in the unenviable position of wasting time and resources.
Endnotes
1. The moving 5-year window is composed of the return year and the immediately preceding four years.
2. See Internal Revenue Code Sections 170(b)(1)(A)(vi) and 509(a)(2).
3. As used in this article, the term “minimum distribution requirement” (MDR) means the minimum amount of qualifying distributions (QDs) that must be distributed before the end of a private foundation’s (PF) current tax year to avoid an underdistribution penalty. The Internal Revenue Service, however, uses a different term—”undistributed income”—which means the amount of QDs that must be distributed before the end of the PF’s next tax year to avoid a penalty. Therefore, a PF’s undistributed income for a given year is its next year’s MDR.
4. The only Chapter 42 provision that would apply to a transitioning organization in its transition year is IRC Section 4940, which imposes a tax on a PF’s net investment income.
5. Applying transition year QDs to the next year’s MDR shouldn’t expose the organization to a penalty because the organization would be applying artificial QDs toward an artificial MDR. The real danger would be in applying artificial transition year QDs toward a “real” (post-transition year) MDR.
6. Because current year QDs are always applied before excess grant carryovers (EGCs), a transitioning organization that draws on EGCs to satisfy its MDR necessarily would suffer an underdistribution penalty if the EGCs were determined to be invalid because it wouldn’t have enough current year QDs to satisfy its MDR.
7. An underdistribution isn’t automatically corrected by making additional QDs in the following year; instead, the organization must make an election pursuant to IRC Section 4942(h)(2) and Treasury Regulations Section 53.4942(a)-3(d)(2) to avoid having the penalty reassessed for multiple years.