Generally, under §4943 of the Internal Revenue Code, the combined holdings of a private foundation and all of its disqualified persons are limited to 20% of the voting stock in a business enterprise that is a corporation. The 20% limitation also applies to holdings in business enterprises that
are partnerships, joint ventures, or other unincorporated enterprises. For a partnership or joint venture, profits interest is substituted for voting stock, and for any other unincorporated enterprise, beneficial interest is substituted for voting stock. A private foundation that has excess business holdings in
a business enterprise may become liable for an excise tax based on the amount of the excess holdings.
Initial tax. An excise tax of 5% of the value of the excess holdings is imposed on the foundation. The tax is imposed on the last day of each tax year that ends during the taxable period.
The amount of the excess holdings is deter mined as of the day during the tax year when the foundation's excess holdings in the business were the greatest.
The initial tax may be abated if the foundation can show that the excess holdings were due to reasonable cause and not to willful neglect, and that the excess holdings were disposed of within the correction period.
Additional tax. After the initial tax has been imposed, an excise tax of 200% of the excess holdings is imposed on the foundation if it has not disposed of the remaining excess business holdings by the end of the taxable period. The additional tax will not be assessed, or if assessed will be
abated, if the excess business holdings are reduced to zero during the correction period.
The term business enterprise, in general, includes the active conduct of a trade or business including any activity that is regularly carried on for the production of income from the sale of goods or the performance of services and that constitutes an unrelated trade or business under §513 of the
Code. The term does not include a functionally related business, a trade or business that obtains at least 95% of its gross income from passive sources, or program-related investments.
EXCESS BUSINESS HOLDINGS
The excess business holdings of a foundation are the amount of stock or other interest in a business enterprise that exceeds the permitted holdings. A private foundation is generally permitted to hold up to 20% of the voting stock of a corporation, reduced by the percentage of voting stock actually
or constructively owned by disqualified persons. There are two exceptions to this rule:
First, if one or more third persons, who are not disqualified persons, have effective control of a corporation, the private foundation and all disqualified persons together may own up to 35% of the corporation's voting stock. Effective control means the power, whether direct or indirect, and whether
or not actually exercised, to direct or cause the direction of the management and policies of a business enterprise. It is the actual control which is decisive, and not its form or the means by which it is exercisable.
Second, a private foundation is not treated as having excess business holdings in any corporation in which it (together with certain other related private foundations) owns not more than 2% of the voting stock and not more than 2% of the value of all outstanding shares of all classes of stock.
Nonvoting stock (or capital interest for holdings in a partnership or joint venture) is a permitted holding of a foundation if all disqualified persons together hold no more than 20% (or 35% as described earlier) of the voting stock of the corporation. All equity interests which are not voting stock shall
be classified as nonvoting stock.
Interest in sole proprietorships. A private foundation is not permitted any holdings in sole proprietorships that are business enterprises unless they were held before May 26, 1969, or acquired by gift or bequest thereafter.
Attribution of business holdings. For determining the holdings in a business enterprise of either a private foundation or a disqualified person, any stock or other interest owned directly or indirectly by or for a corporation, partnership, estate, or trust is considered owned proportionately by
or for its shareholders, partners, or beneficiaries. (This rule does not apply to certain income interests or remainder interests of a private foundation in a split-interest trust.
Example: Tim Jones, a foundation manager of X Foundation, owns 50% of the stock of Y Corporation. (Y Corporation is not actively engaged in a trade or business.) Z Corporation is an 80%-owned subsidiary of Y Corporation. Therefore, 40% of the Z Corporation stock is considered
held by a disqualified person to X Foundation. Any holding of more than 2% of the voting stock or 2% of the value of the Z Corporation stock will result in all of the Z Corporation stock held by the foundation being treated as an excess business holding.
In making its computations, the foundation must determine its proportionate interest and that of all disqualified persons in each class of stock, in relation to the proportion that the voting interest of each class has to all votes in the corporation. For example, if the foundation owns 50% of the outstanding
shares of a class of stock that has 60% of the voting rights in a corporation, the foundation's holdings in the voting stock would be 30%.
Dispositions of certain excess holdings within 90 days. A private foundation that acquires excess business holdings, other than as a result of a purchase by the foundation, will not be subject to the taxes on excess business holdings if it disposes of the excess business holdings within 90
days from the date on which it knows, or has reason to know, of the event that caused it to have the excess holdings. This 90—day period will be extended to include the period during which a foundation is prevented by federal or state securities laws from disposing of the excess business holdings.
The 90—day disposition period applies, for example, when a disqualified person acquires additional holdings. The amount of holdings the foundation must dispose of is not affected by disposals by disqualified persons during the 90—day period.
A functionally related business is:
A trade or business the conduct of which is substantially related (aside from the mere provision of funds for the exempt purpose) to the exercise or performance by the private foundation of its charitable, educational, or other purpose or function constituting the basis for its exemption,
A trade or business in which substantially all the work is performed for the foundation without compensation,
A business carried on by the foundation primarily for the convenience of its members, students, patients, officers, or employees (such as a cafeteria operated by a museum for the convenience of its members, employees, and visitors),
A business that consists of the selling of merchandise, substantially all of which has been received by the foundation as gifts or contributions, or
An activity carried on within a larger combination of similar activities or within a larger complex of other endeavors that is related to the exempt purposes of the foundation (other than the need to simply provide funds for these purposes).
Passive income. For purposes of the definition of a business enterprise, gross income from passive sources includes:
Dividends, interest, and annuities,
Royalties (including overriding royalties), whether measured by production or by gross or taxable income from the property,
Rents from real property, and from personal property leased with real property if the rents from the personal property are an incidental amount of the total rents under the lease (determined at the time the personal property is placed in service). Rents are not considered gross income from passive sources if more than 50% of the total rent under the lease is for personal property, or if the determination of the amount of rent depends in whole or in part on the income or profits received from the leased property (unless the amount is based on fixed percentages of gross receipts or sales),
Gains from sales, exchanges, or other dispositions of property other than...
Stock in trade or property held primarily for sale to customers in the ordinary course of business, or
Gains on the lapse or termination of options written by the organization in connection with its investment activities to buy or sell securities. Gains from cutting timber, that upon election may be considered a sale or exchange, are not considered gross income from passive sources, and
Income from the sale of goods if the seller does not manufacture, produce, physically receive or deliver, negotiate sales of, or keep inventories in the goods.
Income that is otherwise considered passive will not lose its character merely because it is unrelated debt-financed income described in §514.
[Source: Internal Revenue Service, U.S. Dept. Of Treasury (IRS), http://www.irs.gov/]
