Form 990-PF: Navigating Common Pitfalls
Form 990-PF is a crucial document and every private foundation, regardless of its financial size or activities, is required to file this form with the IRS each year. This applies to all foundations, from those with large endowments and extensive financial transactions to those more modest in means, with limited assets and few activities. Form 990-PF encompasses a wide range of information, including general activities, charitable distributions, legal compliance, revenue, expenses, grants, and net assets.
In the current digital era, the significance of Form 990-PF has increased dramatically. Its online availability on platforms such as Candid and ProPublica makes it readily accessible, often in less than a minute. This increased transparency means that the form is now more public than ever, subjecting it to scrutiny from a diverse group of stakeholders including media, researchers, donors, grant-seekers, and regulatory authorities. Consequently, a well-prepared Form 990-PF is not merely a compliance document but a reflection of the foundation's public image and integrity.
However, preparing Form 990-PF can be complex and intimidating, posing challenges even for experienced tax professionals. Its detailed nature requires a deep understanding to avoid common pitfalls. This responsibility for preparing the form extends beyond tax preparers to foundation leaders - directors, trustees, and managers - who are ultimately accountable for its accuracy. And so, adequate knowledge of the form is essential for foundation leaders to maintain the foundation’s credibility and uphold its reputation in the public domain. In the following discussion, we will explore some of the common issues and errors found in poorly prepared 990-PF tax returns, providing insights to help avoid these mistakes. It's important to mention that the analysis below is grounded in the specifics of the 2023 version of Form 990-PF.
Correctly Reporting Operating and Administrative Expenses
When preparing or reviewing Form 990-PF, it's essential for private foundations to accurately report their administrative and operating expenses. These expenses should be recorded on the first page of the return, with special attention to consistency and correctness in different columns. Here are a few key areas to scrutinize carefully that oftentimes have errors:
• Consistency with Financial Statements: Part I, column (a) is for reporting the foundation’s revenue and expenses per its books. The figures in column (a) should match those in the foundation's financial statements. The amounts in column (a) are distributed across other columns, but in some cases, they require adjustments during this process. Additionally, it's important to note that the totals in the other columns are not designed to directly tally with the amounts in column (a) - meaning, they aren't intended to sum up exactly to the figures in column (a).
• Purpose of Columns (b) and (d): Column (b) is designated for recording the foundation's net investment income, focusing exclusively on expenses related to the management of its investments. Typical expenses reported in this column include investment advisory fees, custodial fees, and taxes paid on foreign dividends.
In contrast, column (d) is specifically for tracking disbursements made for charitable purposes, such as grants to public charities, grant research expense, legal fees, costs associated with running direct charitable programs, and general administrative expenses (like website operation costs for instance). However, it is not uncommon for some foundations to mistakenly overlook some charitable expenditures which should rightfully be allocated to this column – in fact, most foundation operating costs belong in column (d). There's a common misunderstanding that only charitable grants contribute to a foundation's minimum distribution requirement. In reality, various operating expenses including administrative expenses also play a crucial role in meeting this threshold. Overlooking these expenses can lead foundations to hurriedly issue grants, potentially leading to misallocated funds, just to dodge shortfall penalties.
Maintaining a clear distinction between columns (b) and (d) is essential – expenses reported in column (b) should not be duplicated in column (d), and vice versa. For expenses that serve dual purposes, both investment-related and charitable, an equitable allocation between the two columns is necessary. For instance, if a foundation's president divides their time between managing investments and overseeing grant-making activities, their compensation should be proportionally split between columns (b) and (d) based on the time dedicated to each activity.
• Limited Use of Column (c): Column (c) generally sees limited use, often marked as N/A by most foundations. However, it is relevant to operating foundations and non-operating foundations that generate income through their own charitable activities. These foundations use column (c) to report "Adjusted Net Income," a specific category of income used in determining whether a foundation qualifies as an operating foundation under the IRS's Income Test. So, column (c) becomes relevant only in scenarios where a foundation wants to be classified as an operating foundation or it actively generates income through its own direct charitable operations, rather than receiving income solely through investments or donations. It's important to note that this column is not used for the vast majority of private foundations.
• Using the Cash Method for Column (d): Column (d), which is reserved for recording charitable disbursements, should be filled out only following the cash method of accounting. This means that only actual cash expenditures made within the fiscal year are to be included. Therefore, if a foundation keeps its books on an accrual basis, it should adapt them to the cash method for column (d). Additionally, it's important to note that future payments, which would be accounted for under the accrual method, do not qualify for inclusion in column (d). It is essential for foundations to record all charitable expenses in this column, as they contribute to fulfilling the foundation's minimum distribution requirement.
• Accurate Reporting of Taxes: The excise tax on net investment income and any unrelated business tax incurred by a foundation should be reported in column (a), specifically on line 18 labeled 'Taxes'. This is because these taxes are recognized as expenses of the foundation. However, it's important to note that these specific taxes should not be recorded in column (b), as they do not relate to the management of the foundation's investments. Similarly, they do not belong in column (d) either, since they are not categorized as charitable expenses. The appropriate place for these taxes is exclusively in column (a) of the form.
On a related note, the employer’s portion of federal, state, and local payroll taxes should be reported on line 15, which is designated for pension plans and employee benefits, rather than on line 18, which is reserved for taxes more generally. These payroll taxes include contributions to social security, Medicare, FUTA, and state unemployment compensation. It's important to note that taxes withheld directly from employee salaries are not itemized separately on the form. Instead, they are incorporated into the overall earnings amounts listed on line 13 or 14, representing compensation to foundation management and other employees, respectively.
• Correct Line for Professional Fees: When reporting professional fees, it's essential to ensure they are categorized correctly on line 16. Specific categories of professional fees are allocated as follows: legal fees are reported on line 16a, accounting fees on line 16b, and all other professional fees, such as investment manager fees and independent consulting fees, are listed on line 16c. Additionally, it's important to consider the nature of these professional fees. In cases where the fees relate to both investment income and charitable purposes, they should be allocated between column (b) and column (d) using a reasonable and consistent method. For instance, accounting fees often pertain to both tracking investment account transactions and general operating transactions of the foundation, which are typically charitable in nature. In such scenarios, a portion of the accounting fees that are investment-related should be allocated to column (b), while the portion related to charitable activities should be allocated to column (d).
• Appropriate Use of ‘Other Expenses’ Line: Line 23, titled "Other Expenses", functions as a comprehensive category for reporting any disbursements that don't align with the specified categories of other lines. Essentially, this line is a catch-all for operating expenses that don't have a predefined place elsewhere on the form. It's a common mistake to incorrectly report expenses like compensation or professional fees here. Some examples of expenses that belong on Line 23 could include costs associated with special events, certain administrative expenses like website operating expense, certain specialized software costs, association memberships, and other unique operational expenses. It's essential for foundations to use this line judiciously, ensuring that only those expenses that truly do not fit into other designated lines are included here.
Correctly Recording Charitable Use Assets
It's a widespread misunderstanding that only cash grants to other charities fulfill the 5% distribution requirement for private foundations. However, a variety of expenses and investments, including assets used directly in a foundation's charitable activities, are also eligible. For example, when a foundation invests in a computer for its grant-making program, this purchase counts as a charitable use asset and actively contributes towards meeting the 5% requirement. Charitable use assets can take a variety of items, from buildings and furnishings to operational equipment like computers. These assets are recognized as qualified distributions in the year they are put into service and should be documented in Part XI, line 2 of Form 990-PF.
Recovery of Qualifying Distributions: Addressing Amounts Previously Counted
Private foundations occasionally find themselves in a position to recover funds that were initially designated as qualifying distributions, which previously counted towards meeting the 5-percent minimum distribution requirement in a previous year. Examples of such recoveries include reclaiming part or the entirety of a prior charitable grant, receiving repayments or distributions from program-related investments, or regaining proceeds from property sales where the acquisition cost was initially treated as a qualifying distribution (e.g., computer equipment utilized in charitable activities). In the 2023 version of Form 990-PF, accurately capturing these recovery adjustments is achieved by entering the recovered amounts in Part X, line 4.
As an illustration, consider the hypothetical recovery of a program-related investment that was made in a previous year. Picture a scenario where a foundation extended a loan to support affordable housing several years ago. In the year the loan was initiated, the loaned amount was recognized as a qualifying charitable distribution, contributing to meeting the minimum distribution requirement for that specific year. Nevertheless, as the loan's principal is repaid in increments over subsequent years, in line with an amortization schedule, these incremental principal repayments are categorized as recoveries. With each occurrence of recovery, the foundation's required minimum distribution increases by the same amount that year.
Avoiding Miscalculation of the Excess Charitable Distribution Carryover
In instances where a private foundation grants significantly more than its minimum distribution requirement in any given year, the excess can be "saved" as grant carryover. This carryover can be used to fulfill the minimum distribution requirement in future years, but it's important to note that it expires if not used within a five-year period. Incorrect calculations or applications of these carryovers can lead to significant issues. Not only does this result in a missed opportunity to leverage these excess fund distributions and preserve the endowment, but it also casts doubt on the actual fulfillment of the private foundation’s minimum distribution requirement. Worse still, such miscalculations might create a misleading sense of compliance, falsely indicating that the minimum distribution requirement has been met when, in reality, it hasn't. On the 2023 version of Form 990-PF, the excess distribution carryover is calculated and tracked in Part XII for Undistributed Income.
Reporting Direct Charitable Activities on Form 990-PF
Accurately reporting direct charitable activities on Form 990-PF is an important yet frequently mishandled task among private foundations. These activities are characterized by programs that a foundation directly manages using its own resources like staff, facilities, technology, and equipment, rather than just funding grants to external charities. Common examples include operating a museum or conducting medical or scientific research. This hands-on approach to philanthropy is distinct from grant-making and must be accurately documented.
Expenses related to direct charitable activities are initially noted in Part I’s Analysis of Revenue and Expenses, alongside other expenses of the foundation. However, detailed itemization and summary of these costs in this section are uncommon, except in cases where these activities generate revenue (Note: if receipts are received, the revenue and associated expenses are reported in column (c) for adjusted net income). Given the infrequency of detailed categorization in Part I, Form 990-PF offers a specialized section, Part VIII-A in its 2023 version, dedicated specifically to providing a detailed summary of direct charitable activities and their related expenses.
Key Schedules in Form 990-PF: Ensuring Compliance and Transparency
When preparing Form 990-PF for a private foundation, it is important to ensure that all necessary schedules are accurately completed and attached. Attention to detail is key, especially for certain schedules that are frequently overlooked or prone to errors.
• Schedule B - Reporting Significant Contributions: This schedule is a crucial yet often overlooked part of Form 990-PF. The accurate completion of Schedule B is required for foundations that receive donations of $5,000 or more from an individual contributor. This includes all types of contributors, such as individuals, fiduciaries, partnerships, corporations, associations, trusts, and exempt organizations. Schedule B requires detailed information about each donor, such as their names, addresses, the nature of contributions, and descriptions and valuations for property donations.
• Investment Listings - Detailing Foundation Assets: Another essential component is the comprehensive listing of all year-end investments, which encompasses stocks, bonds, real estate, and other varied assets. For foundations with extensive portfolios, this task can be particularly time-consuming. It's important to avoid summarizing or bucketing these investments, except in certain cases like for specific debt securities. Detailed reporting here is key to presenting a full financial picture of the foundation's assets.
• Grants Paid and Approved - Accurate Grant Reporting: Form 990-PF requires a detailed list of all grants paid and approved during the year. This section is often completed without the sufficient level of required detail. A complete and accurate grant listing should include each grantee's name and address, the grant amount, the recipient's organizational status, and the purpose of the grant. The instructions for Form 990-PF emphasize the importance of detail in describing the purpose of grants. General terms such as "charitable," "educational," "religious," or "scientific activities," as well as vague descriptions like "grant" or "contribution," are considered inadequate. Instead, precise descriptions, such as "alleviating hunger," "university scholarships," or "medical research," are preferred.
Disclosures About Foundation Leaders, Highly Paid Employees, and Contractors on Form 990-PF
Form 990-PF requires private foundations to disclose detailed compensation information on their leadership, highly compensated employees, and contractors. These disclosures often attract substantial external attention, including attention from the media, as it provides a glimpse into the financial workings of the foundation. The form specifically demands detailed information about officers, directors, trustees, managers, and the five highest-compensated employees. The required information includes not only their salaries but also contributions to benefit plans, deferred compensation, and a range of allowances and expense accounts. The IRS specifies that all types of fringe benefits—whether taxable or nontaxable, such as indemnification payments, club memberships, and personal use of foundation assets—must be included in the “expense account, other allowances” category.
Unlike the disclosures for all foundation leadership positions, it's important to note that disclosure of the top five highest-compensated employees is only required if the individual receives more than $50,000 in compensation. Furthermore, if there are more than five employees compensated with amounts greater than $50,000, the form necessitates disclosing the total number of other employees compensated above this threshold (this is easy to miss).
Regarding personal addresses of the aforementioned individuals, only the foundation's address is required. The form also asks for an estimated average of hours per week dedicated to the foundation's work for each role. General descriptions like “as needed” or “part-time” should be avoided in these estimations. Reviewers of the return often use this information to evaluate the appropriateness of compensation levels relative to the hours worked.
In addition to individuals directly employed by the foundation, Form 990-PF mandates the disclosure of the five highest-compensated contractors whose compensation exceeds $50,000. This disclosure should include details about the type of services provided by these contractors and the exact amounts of their compensation. Among these top-paid contractors, investment advisors are frequently included, with attorneys and foundation operations consulting companies also making appearances. It's worth mentioning that those unfamiliar with Form 990-PF often overlook the disclosure of highly paid contractors altogether.
Reporting Tax Violations on Form 990-PF
Form 990-PF is strategically designed to incorporate a significant self-regulation component for foundations to self-report certain tax law violations. In the event that violations occur during the year, whether intentional or inadvertent, the foundation is legally obligated to disclose such violations and take necessary corrective measures.
An unintentional violation may occur if a foundation president mistakenly charges a personal expense to the foundation's credit card, violating the self-dealing rules. Despite prompt repayment within a few weeks, this unintended use establishes a transaction with the president, constituting a short-term loan. Such a violation, though very temporary, should be self-reported on the foundation’s tax return.
There is a dedicated section on Form 990-PF where foundations are prompted to self-report any violations. In the 2023 version of the form, this section is located in Part VI-B, titled "Statements Regarding Activities for Which Form 4720 May Be Required.” If violations are identified, the foundation must mark the corresponding question in the affirmative. Should a question indicate a violation, the foundation may be required to submit Form 4720 to evaluate and assess specific excise taxes as a consequence.
One common error often occurs in Part VI-B, line 1a(4), where the question asks if the foundation paid compensation to a disqualified person. Foundations may mistakenly check the "No" box, especially when a disqualified person, like the foundation president, receives a salary. Notably, reasonable compensation falls under an exception to self-dealing rules. To rectify this, the foundation can offset their affirmative response in line 1a(4) by indicating an exception to the self-dealing rules applies on line 1b. By marking line 1b with a "No," the foundation signals that the compensation was paid within the permissible exception criteria.
Another frequent oversight occurs in Part VI-B line 5a(4), which pertains to grant payments made to entities other than public charities and certain specified foreign organizations. For such grants, there are additional disclosure requirements, like providing expenditure responsibility statements. However, it's common to find these critical disclosures omitted.
Reporting Changes in Governing Instruments
Changes in the foundation's governing instruments, including the articles of incorporation, bylaws, or trust instrument necessitate acknowledgment and attachment on Form 990-PF. In the 2023 version of the form, signaling a change involves marking the "Yes" box in Part VI-A, line 3. Providing a "conformed" copy of the changes is required, which means an authorized officer must provide a signed declaration attesting to the updated documents' completeness and accuracy. This disclosure is important as it ensures the IRS possesses the most up-to-date governing documentation of the foundation. Failure to report a change in governing instruments is a commonly overlooked preparation error.
Conclusion
Accurate and diligent filing of Form 990-PF is not just a regulatory necessity for private foundations; it is a public document that reflects their commitment to transparency and compliance. By avoiding common pitfalls, foundations can not only comply with tax laws but also strengthen their commitment to responsible governance. As always, consulting with a tax advisor or accountant specializing in nonprofit tax law is advisable to ensure accuracy and compliance.
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