Section 4940 imposes an excise tax on the net investment income of most domestic tax-exempt private foundations, including private operating foundations. On December 20, 2019, new legislation was signed that changed the excise tax rates of net investment income for most domestic tax-exempt private foundations, including private operating foundations. For tax years beginning Jan. 1, 1985 through Dec. 20, 2019, the excise tax was 2% of net investment income, but was reduced to 1% in certain cases. Effective for tax years beginning after Dec. 20, 2019, Section 4940(a) was amended to use a single tax rate of 1.39% on net investment income and Section 4940(e) was repealed. For tax years beginning after Dec. 20, 2019, all private foundations subject to the Section 4940 excise tax on net investment income will calculate the tax using the 1.39%. A private operating foundation can avoid the excise tax on net investment income if it meets the criteria to be an exempt operating foundation. IRC Section and Treas. Regulation IRC Section 4940(d)(1) In general IRC Section 4940(d)(2) Exempt operating foundation IRC Section 4940(d)(3) Definitions Resources (court cases, Chief Counsel Advice, Revenue Rulings, internal resources) Definition of Exempt Operating Foundation "Publicly Supported" - Exempt Operating Foundation "Disqualified Individual" - Exempt Operating Foundation Analysis How does a private foundation establish exemption from the excise tax on net investment income under Section 4940(a)? Section 4940(d), added by The Deficit Reduction Act of 1984, is effective for taxable years beginning after December 31, 1984. According to the legislative history of Section 4940, Congress believed that private operating foundations which have substantial public involvement and are not controlled by disqualified persons should be exempt from the excise tax on net investment income, and that other foundations making grants to such organizations should not be required to comply with the expenditure responsibility rules in Section 4945. The changes were intended to assist such public-involvement operating foundations in making direct expenditures for the active conduct of their charitable activities. See Staff of the J. Comm. On Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 670-671 (JCS-41-84). Section 4940(d) provides that a private foundation that qualifies as an exempt operating foundation under Section 4940(d)(2) for the taxable year is exempt from the excise tax on net investment income imposed by Section 4940(a). Section 4940(d) also explains that the term "exempt operating foundation", with respect to any taxable year, applies to any private foundation if: Such foundation is an operating foundation as defined in Section 4942(j)(3); Such foundation has been publicly supported for at least 10 taxable years, or was a private operating foundation described in Section 4942(j)(3) on January 1, 1983; At all times during the taxable year, the governing body of the such foundation consists of individuals at least 75% of whom are not disqualified individuals, as defined in Section 4940(d)(3)(B), and is broadly representative of the general public; and, At no time during the year does such foundation have an officer who is a disqualified person. Operating Foundation: The first requirement is that the organization qualify as a private operating foundation as defined in Section 4942(j)(3). Generally, that means the foundation devotes most of its resources to the active conduct of its exempt activities. Publicly Supported: Section 4940(d)(3)(A) provides that a private foundation is publicly supported for a taxable year if it meets the requirements of Section 170(b)(1)(A)(vi) or Section 509(a)(2) for such taxable year. A foundation is publicly supported if it normally receives a substantial part of its support from governmental units or from direct or indirect contributions from the general public, or the foundation both normally receives more than a third of its support from governmental units, certain publicly supported charities, and persons other than disqualified persons, in gifts, grants, contributions, membership fees, and gross receipts from activities that are not an unrelated trade or business, and does not normally receive more than a third of its support from gross investment income plus any excess of unrelated business taxable income over the tax on unrelated business income. Governing Body: Section 1.170A-9(f)(3)(v) provides that the governing body of the organization may be considered to represent a broad interest of the public if it is composed of persons having special knowledge or expertise in the particular field or discipline in or appointed officials, clergymen, educators, civic leaders, or other such persons representing a broad cross-section of the views and interests of the community. Disqualified Individual: For purposes of Section 4940(d), a "disqualified individual" means an individual who is a substantial contributor to the foundation (as defined in Section 507(f)(2)); an individual described in Section 4946(a)(1)(C) (relating to 20 percent ownership in a corporation or enterprise that is a substantial contributor); or a member of the family of either of the above. The term "disqualified individual" is narrower than "disqualified person" because it does not include foundation managers, exempt organizations, or nonexempt organizations. Requesting a determination on exempt operating foundation status A foundation seeking recognition of exempt operating foundation status must obtain a favorable determination letter from the Internal Revenue Service. To request the determination letter, the foundation must submit a completed Form 8940, Request for Miscellaneous Determination, and pay the required user fee. The current user fee amount can be found in Appendix A (schedule of user fees) of Revenue Procedure 2020-5 (updated annually). Supporting documents and materials submitted with the ruling request must demonstrate that the four requirements listed above are met. For purposes of requirements three and four, the foundation must list all officers and members of its governing body for the current year and identify any who are disqualified individuals. Additional information regarding this type of request can be found in Revenue Procedure 2020-5 (updated annually). Claiming exemption from the tax on net investment income on Form 990-PF The first year the foundation must attach a copy of its exempt operating foundation status determination letter to Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Trust Treated as Private Foundation. It is possible that a private foundation may qualify for this exemption in one taxable year and not in another. Issue indicators or audit tips Review the Form 990-PF because an exempt operating foundation must attach a copy of its favorable determination letter to its initial return after securing the status. The organization should complete Part VI by checking the box and entering the date of the ruling or determination letter on line 1a and entering “N/A” on line 1. The rest of Part Vl should be blank. As long as the organization retains this status, it is not required to attach a copy of the letter to subsequent returns. See Form 990-PF Instructions for more details. Review Statements Regarding Activities, and Private Operating Foundations, of Form 990-PF to confirm the applicant meets the requirements of private operating foundation status. Tour the organization’s facility. Perform initial interview with someone that is knowledgeable of the organization’s exempt activity. Calculate public support under Section 170(b)(1)(A)(vi) and/or Section 509(a)(2). Review the foundation’s governing body and inquire about disqualified individuals and persons. Review Form 990-PF Instructions, Information About Officers, Directors, Trustees, Foundation managers, Highly Paid Employees and Contractors. If a private foundation is not an operating foundation, consider whether it has distributed sufficient amounts in qualifying distributions. If not, seek to impose the Section 49
