Relationship of a Domestic Charity Organization to Certain Charitable Foreign Activities
Can a domestic charity, as an IRC Section 501(c)(3) tax-exempt organization, fund the activities of national charity offices and other foreign projects in such a way that its exempt status is not jeopardized and donor deductibility is fully preserved, without the domestic charity exercising legal control over such organizations or projects? The short answer is "yes."
The domestic charity is a Section 501(c)(3) charitable organization that has significant foreign involvement in charitable activities. Currently, the domestic charity donors are solicited for donations to be used in foreign locations and at times are asked to support foreign staff, some of whom are on the domestic charity payroll and some of whom are not. Most donations are made with a designation of intended use (name of country) and most such donations are used by the domestic charity to compensate international personnel. Funds are transferred from the central office to accounts of various regional offices which then disburse funds to each national charity office for staff support and other purposes.
Although exempt status of a Section 501(c)(3) organization is not jeopardized by the transmission of a portion or all of its funds to assist foreign charitable activities, the IRS has disallowed charitable deductions where domestic exempt organizations do not exercise adequate discretion and control over grants made to foreign organizations. The IRS has recognized periodic reporting requirements and other monitoring of foreign grantees as elements of requisite discretion and control. The domestic charity can adopt and apply foreign funding guidelines which have been prepared to comply with these requirements. Neither legal control of the foreign organization nor an independent presence by the domestic charity in the foreign country is required to assure charitable deductions to donors. The domestic charity may even accept designated contributions for foreign charitable activities as long as the domestic charity board follows certain guidelines.
The IRS looks at four criteria in foreign funding situations to determine if contributions to the domestic charity are deductible: (1) the specific project to be carried out by the foreign organization must fulfill the exempt purposes of the domestic charity; (2) the board of the domestic charity must review and approve the specific foreign project; (3) the domestic charity must maintain full control and discretion over the donated funds; and (4) the domestic charity must not be a passive conduit of earmarked funds. The test is whether the domestic charity is the real recipient of the contributions, and demonstrates bona fide control and discretion over how the funds are disbursed by it to foreign projects. The IRS has pointed to such factors as the following to indicate that these requirements are met:
The domestic charity legally controls and operates the foreign organization to which it channels funds. (Satisfaction of this factor alone would be sufficient without any others to justify deductibility of U.S. donations.)
The domestic charity's board reviews and approves the project in the foreign country for which funds will be spent.
The domestic charity monitors and oversees the foreign project through appropriate field review.
The domestic charity retains full control of the donated funds and exercises discretion as to their use (even to the point of retaining the right to terminate further funding and withdraw unspent funds at any time) so as to ensure they will be used to carry out the domestic charity's function and purposes.
The domestic charity receives periodic accountings of all funds to assure compliance these unique discretionary duties.
The Funding of Foreign Charitable Organizations
The IRS will disallow a tax deduction for contributions to domestic charities if the domestic charities are "mere conduits" of funds to foreign organizations. To determine whether the charity is more than a mere conduit, the IRS looks carefully at whether the domestic charity exercises sufficient "discretion and control" over contributed funds. The issue of the required control by a Section 501(c)(3) organization over charitable projects in foreign countries sufficient to protect tax deductibility is not addressed in the Internal Revenue Code or its regulations. The IRS, however, has addressed this issue in individual revenue rulings regarding charitable gifts channeled to foreign countries. It has developed a set of guidelines to determine whether a gift to a U.S. charity is tax deductible when it is ultimately used to further charitable purposes in another country. Analysis and application of these guidelines will enable a domestic charity to channel a portion or all of its charitable funds to foreign charitable entities or projects while still preserving for its U.S. donors full tax deductibility treatment.
Contributions to Foreign Charities are not Deductible. The IRS and courts have consistently held that contributions to foreign charities are not deductible on U.S. tax returns. See e.g., M. ErSelcuk, 30 T.C. 962 (1958); L.K. Herter, 20 T.C.M. 78; R. Hess, 30 T.C.M. 1043. Even contributions made to a binational charitable foundation which was created by executive agreement between the U.S. and a foreign country, financed by property contributed equally by the two countries and whose assets were to be equally divided between the U.S. and the foreign country, were not deductible. Rev. Rul. 76-195, 1976-1 C.B. 61. The question then becomes whether a charitable deduction would be allowed if made to a bona fide tax-exempt entity in the U.S. which then expends its funds for activities in a foreign country.
Contributions to U.S. Charities which Operate in a Foreign Country are Deductible. A domestic charity that conducts a part or all of its charitable activities in a foreign country is not precluded under Section 501(c)(3) from exemption. Rev. Rul. 71-460, 1971-2 C.B. 231. The IRS permits deductibility for contributions to Section 501(c)(3) organizations created in the U.S. but which operate to some extent in foreign countries as long as two requirements are met:
The domestic charity must qualify under Section 170(c)(2)(A) of the Internal Revenue Code which requires an exempt organization to be created or organized in the U.S. or in its possessions. Rev. Rul. 63-252, 1963-2 C.B. 101.
The domestic charity must be organized and operated exclusively for one of the purposes stated in Section 170(c)(2)(B) of the Code, such as religious, charitable, scientific, literary, or educational and it must also meet the other requirements of Section 170(c)(2) of the Code (no private inurement, no impermissible political activity, etc.).
The domestic charity could operate under this model and assure full donor deductibility provided all foreign activities were conducted under its full organizational control, either under the auspices of its domestic entity or through a subsidiary foreign entity. However, other alternatives will also be examined.
Contributions to U.S. Charities which in Turn Make Grants to Foreign Charities are Deductible in Limited Circumstances. Under this alternative, the domestic charity could fund foreign charity through grants to compatible but separate organizations. There are several variations:
A deduction will be disallowed for contributions made to a U.S. tax-exempt organization which turns over 100 percent of its charitable contributions to a foreign charity. Rev. Rul. 63-252, 1963-2, C.B. 10. The IRS reasons that the requirements of Section 170(c)(2)(A) described above would be "nullified if contributions inevitably committed to go to a foreign organization were held to be deductible solely because, in the course of the transmittal to the foreign organization, they came to rest momentarily in a qualifying domestic organization. In such cases, the domestic organization is only nominally the donee; the real donee is the ultimate foreign recipient." Rev. Rul. 63-252, 1963-2 C.B. 101. This is what is called the "passive conduit" model.
Contributions to a domestic charity that are solicited for a specific project of a foreign charitable organization are deductible where the domestic charity has reviewed and approved the project as being in furtherance of its own exempt purposes and has control and discretion as to the use of the contributions. Rev. Rul. 66-79, 1966-1 C.b. 48, amplifying Rev. Rul. 63-252. This is the category under which most of the domestic charity's gifts and grants to a foreign charitable organization would occur.
This underscores the importance of the budgetary process for maintaining the requisite control. In addition to listing the directors' exclusive authority to make grants, their responsibility to review specific projects in advance of funding, and absolute discretion to refuse to render financial assistance and refuse earmarked or designated funds, the IRS noted approvingly that the directors required the grantees to "furnish a periodic accounting to show that the funds were expended for the purposes which were approved by the board of directors," and that the board retained at all times the right to withdraw approval of the grant. Rev. Rule 66-79, 1966-1 C.B. 48.
It is important to note that the IRS has not established any one or several of these criteria as essential for proving that a domestic charity has exercised sufficient discretion and control. Neither has the IRS defined how much monitoring would be sufficient to establish the requisite control. Given that IRS rulings also cite the ability of a board to cease funding if exempt purposes are not being pursued as expected, it is desirable that a domestic charity require sufficient monitoring to determine whether funding should be continued. It is recommended that periodic accounting and monitoring be undertaken with each grant in excess of a minimal amount (e.g., $5,000) to ensure "full control of the donated funds, and discretion as to their use." Rev. Rul 66-79.
Whether the proper amount of control has been exercised is determined by the IRS on a case-by-case basis as shown in the following rulings.
Where a domestic charity received contributions in furtherance of its exempt purposes and made grants from its general funds to various foreign organizations to support restoration work in the foreign country, a deduction for the contributions was allowed. The IRS found the proper control was exercised since: 1) the trustee reviewed and approved the project and contributions were solicited specifically for this project and receipted through a special committee set up for this purpose; and 2) the domestic charity retained full control of the donations for this project and discretion as to their particular use as evidenced by its reservation of the right to designate the specific renovation to be made, to receive periodic accounting of all funds, and to withdraw its support at any time at its discretion. PLR No. 8408062.
Similarly, where a domestic charity received contributions in keeping with its educational purpose for the restoration and rehabilitation of the birthplace of "A" in a foreign country, the IRS allowed a deduction for the contributions. The domestic charity demonstrated its control by: 1) board review and approval of the project; 2) the establishment of a special committee to assist in the management of contributions made to the domestic charity for the project; 3) the establishment of a separate bank account; 4) separate financial and administrative records of such contributions; 5) supervision of the expenditure of the funds in a manner consistent with the charter and policies of the domestic charity; 6) retention of absolute discretion to withdraw the special funds for use toward other exempt purposes of the domestic charity; and 7) advising potential contributors of this discretionary duty. PLR No. 8346038.
In another private letter ruling, the IRS held contributions to a domestic charity for use by a foreign organization deductible when the following limitations were present: 1) no member of the domestic charity's board of directors was a member of the foreign organization's board; 2) the domestic charity's decisions as to the disposition of contributions were wholly independent of the foreign organization; 3) the domestic charity's board reviewed and approved each specific project; and 4) the domestic charity monitored the use of funds given to the foreign organization. PLR No. 8340031.
Rev. Rul. 66-79, 1966-1 C.B. 48 again illustrates the IRS's willingness to allow a deduction for contributions made to the domestic charity for use by a foreign organization so long as certain safeguards are present. Here, the domestic charity had been organized with a goal of raising funds for specific projects, such as science research projects, to be carried out by the foreign organization. Therefore, the bylaws stipulated the following: 1) the board of directors has exclusive control over the making of grants or other financial assistance; 2) the board has power to make grants in furtherance of the exempt purposes of the domestic charity; 3) the board reviews, approves and authorizes each grant; 4) there must be a periodic accounting to show the funds are being used appropriately; 5) the board has absolute discretion to refuse to make any such grants and can at any time withdraw approval of a grant; 6) all of the pertinent facts shall be made available to any contributor upon request. The IRS identified in this revenue ruling the test as to whether the domestic organization has "full control of the donated funds, and discretion as to their use, so as to ensure that they will be used to carry out [the domestic charity's] functions and purposes." In this instance because the bylaws outlined the conditions of review, control and discretion, the IRS permitted the deduction of charitable contributions to that domestic charity.
Revenue Ruling 66-79 described above amplified Rev. Rul. 63-252, 1963-2 C.B. 101, in which the IRS first outlined its requirements for the allowance of contributions made to a domestic charity for use by a foreign entity. In Rev. Rul. 63-252, the IRS outlined five examples to illustrate its requirements:
A foreign organization desiring to solicit funds causes a domestic charity to be formed and proposes the domestic charity conduct a fundraising drive, pay the administrative expenses from collected funds and remit the balance to the foreign organization.
U.S. citizens desiring to assist a foreign organization's work from a domestic charity whose charter provides it will receive contributions and send them periodically to the foreign organization.
A foreign organization agrees with the domestic charity that the domestic charity will conduct a fundraising campaign on its behalf and remit to it the net funds raised.
A domestic charity conducts a variety of charitable activities in a foreign country. When its purposes can be furthered by granting funds to charitable groups organized in the foreign country, the domestic charity makes grants for purposes it has reviewed and approved. The domestic charity makes grants from its general funds. No special fund is raised by solicitation on behalf of particular foreign organizations.
A domestic charity conducting charitable work in a foreign country formed a subsidiary there to facilitate its operations. The domestic charity controls every facet of its operations and the foreign organization is merely an administrative arm of the domestic charity. The domestic charity solicits funds specifically for its foreign work.
Rev. Rul. 63-252 held that contributions to organizations described in the first three examples were not deductible and that contributions to the organizations described in examples four and five were deductible. In the last two examples, the three main characteristics of furtherance of exempt purposes, review and approval, and control and discretion are present. However, the IRS also noted that these contributions were either not specifically earmarked or where they were, the true recipient was found to be the domestic charity.
Conclusion. The domestic charity may make grants or transmit funds to a charitable organization in a foreign country without jeopardizing its tax-exempt status. However, the IRS regulates such transactions not through its tax exemption authority under IRC Section 501(c)(3) but rather through its charitable deduction authority under IRC Section 170. By placing requirements on the transfer of funds from a domestic charity to a foreign organization which are necessary to secure deductibility of contributions, the IRS effectively regulates the charitable activities of U.S. exempt organizations in foreign countries. As long as the domestic charity follows the guidelines described herein, it may properly devote some or all of its funds to projects of foreign charitable organizations without jeopardizing the charitable tax deduction of its U.S. donors.
Adoption of the attached Guidelines and pre-approval of specific projects by the domestic charity Board of Directors will demonstrate that the domestic charity acts independently of its grantees in determining how funds will be expended. Periodic accounting as required by the Guidelines together with receipt and review of reports from grantees by a subcommittee of the board or officers of the domestic charity also provides evidence of requisite discretion and control.
Independent Presence of the Domestic Charity Not Required. One proposed solution to the problem of funding national charity offices is to place the domestic charity staff in countries where all of the domestic charity's operations are currently performed by resident nationals. However, requisite expenditure control does not require making this type of oversight. The domestic charity agents or employees could make periodic visits or the domestic charity could delegate to a responsible foreign agent the oversight responsibility to observe and report on the work of the national charity offices.
Donor Designation Not Necessarily Forbidden. While it is true that the donor designations must not be allowed to short circuit proper board oversight and control, such designations are wholly proper if the board has previously evaluated, selected and presented through informed decision making, a buffet of foreign projects for donor selection. Additionally, donor designations for projects outside the current buffet of board approved projects may be considered for funding provided the board adheres to its "control and discretion" guidelines.
Legal Control by the Domestic Charity Over National Charity Offices is Not Required. Finally, it is not necessary for the domestic charity to exercise legal control over the national charity offices. Proper expenditure control as proposed in the Guidelines is sufficient to meet IRS requirements. Often, there is concern that due to the nature of the domestic charity goals and philosophy, the decentralized emphasis of indigenous national charity offices would be threatened by the domestic charity having to exert legal control over the entities to meet IRS requirements for donor deductibility of contributions. Many of the field offices in foreign countries incorporate in the foreign country out of their own initiative, not a the domestic charity direction or mandate.
As explained above, legal control is not required. In fact, the stringent expenditure control required of private foundations is not required for public foundations. As long as the domestic charity follows the attached Guidelines regarding proper discretion and control, the domestic charity may offer donors full tax deductibility without exercising legal control of its national charity offices.
The Funding of Foreign Staff
The domestic charity receives donations for foreign staff, some of whom are on the payroll of the domestic charity and some of whom are not. Resident nationals are typically on the payroll of the national charity office and not the domestic charity. The question arises whether the domestic charity may ensure the charitable deduction for a donor who designates a contribution for a specific individual who is on foreign staff of a national charity office or for a the domestic charity employee working in a particular foreign country.
Funding of Resident Nationals. As explained above, the domestic charity can make a grant to a national charity office that would cover a number of budgetary items, including salaries. As long as the requisite discretion and control is maintained, the domestic charity can receive designated contributions for pre-budgeted, board approved expenditures including resident nationals' salary requirements and fund those through grants to the national charity office.
Funding of the Domestic Charity Staff in Foreign Countries. The domestic charity employees who are operating in a foreign country are essentially missionaries of the domestic charity to that foreign country. The ability of the domestic charity to accept designated contributions for these missionaries depends on the domestic charity's exercise of discretion and control over donated funds. The domestic charity generally may honor designated contributions for particular staff as long as the domestic charity retains full discretion over the ultimate expenditure or use of those contributions. This can be accomplished by following the Guidelines (i.e., board preapproval of budgets, including salaries, and of the activities and mission statement of each approved foreign staff, together with regular monitoring of financial, comparing actual with budget figures, program review, etc.).
The domestic charity is not required by current IRS Code, regulations or case law to exercise legal control over national charity offices, have an independent presence in countries where national charity offices exist, or prohibit designated contributions for these foreign charities to ensure donor deductibility of contributions for foreign charitable activities. The domestic charity is required to exercise requisite discretion and control as outlined above. Generally, the IRS will conclude that boards of directors have exercised sufficient control and discretion over foreign grants and projects if at least 1-4 of the following board practices are implemented:
Board review, approval and authorization of each grant proposal to ensure compliance with the charter and policies of the domestic charity.
Adequate periodic reporting requirements to demonstrate satisfaction of agreed standards of performance and accountability.
Board retention of full control and absolute discretion over use of all donated funds, including the right to discontinue further funding of foreign projects that fail to satisfy standards of performance or accountability.
Board disclosure to contributors that it, and not the foreign organization, has complete discretion over the use of funds contributed.
Special board committee to monitor and oversee foreign projects.
Maintenance of special bank account and separate financial records of contributions for foreign projects.
These practices have been incorporated into Guidelines for Funding Foreign Charities which the domestic charity Board should review, adopt and implement.