Tab 32: Policy or Documented Procedures
for Due Diligence

Required Document

• Due diligence policy

 

Why is confirming 501(c)(3) status not enough to meet compliance with this standard?

The Pension Protection Act created new requirements and restrictions on donor advised funds. The largest source of confusion for community foundations is that grants to certain supporting organizations require expenditure responsibility although these supporting organizations are Section 501(c)(3) public charities. Consequently, even if the foundation's policies limit grants to Section 501(c)(3) public charities, the foundation will need to determine if the potential grantee is a supporting organization - a type of public charity - to determine if expenditure responsibility will be required. For this reason, it is prudent for a community foundation to establish procedures to determine whether grants require the expenditure responsibility process. The National Standards for U.S. Community Foundations require that a community foundation have due diligence policies that include such procedures.

What grants are specifically prohibited?

The PPA specifically prohibits several types of grants from donor advised funds:

• Grants to individuals
• Grants to donors, advisors, or related parties
• Grants for non-charitable purposes

Another source of confusion is that grants to individuals include both grants made directly to an individual and grants made to an organization, such as a school, for the benefit of a specified individual. For example, a grant to the local university for the benefit of student Susie Standards would be prohibited from a donor advised fund because such a grant would be treated as a grant to an individual. In contrast, a grant to a university for a scholarship program where the university selects and awards the scholarships would be permissible as a grant to the university and not a grant to an individual.

Grants to donors, advisors, or related parties include a prohibition against grants to donors that are not individuals. It is currently unclear if a donor advised fund could make a grant back to the donor if the donor is a public charity.

To implement these provisions, community foundations should consider both how to communicate the information about prohibited grants to fund advisors, and what additional grant recommendation review processes the community foundation should institute for donor advised funds. The standards require that prohibitions against grants to individuals and to donors, advisors, or related parties appear in either donor advised fund agreements or donor advised fund guidelines. Community foundations should also consider going further to include the prohibitions in its internal grants processing procedures to avoid making a prohibited grant.

What is expenditure responsibility and is there a procedure for exercising expenditure responsibility?

Certain grants from donor advised funds are taxable unless the community foundation follows a due diligence process called "expenditure responsibility." Briefly, expenditure responsibility is designed to ensure that a grant is used for charitable purposes and that the community foundation maintains appropriate oversight and documentation of certain grants from donor advised funds. While the IRS has not issued guidance to define the expenditure responsibility steps for grants from donor advised funds, the private foundation rules provide some guidance.[4] Specifically, the private foundation rules define expenditure responsibility as the following five-step process:

• Conducting a pre-grant inquiry - including a reasonable investigation of the grantee - to ensure that the proposed activity is charitable and that the grantee is able to perform the proposed activity
• Executing a written agreement with the grantee that specifies the charitable purposes of the grant, includes provisions that prohibit use of the funds for lobbying activities, and requires the grantee to return any funds not used for the designated purposes
• Requiring the grantee to maintain the grant funds in a separate fund so that charitable funds are segregated from non-charitable funds
• Requiring the grantee to provide regular reports on the use of the funds and the charitable activity supported by the grant
• Including a report on Form 990-PF about the grant with a brief description of the grant, the amount, the charitable purpose, and the current status of the grant (Note that the current and revised Form 990 for public charities do not have instructions indicating that such information should be reported on the Form, so the application of this requirement to community foundations with donor advised funds is unclear at this time)

What grants require expenditure responsibility?

Grants to organizations not described in Section 170(b)(1)(A) of the Internal Revenue code require expenditure responsibility. Common examples of such grants include:

• Grants to non-charities
• Grants to international organizations unless equivalency determination is followed
• Grants to private non-operating foundations
• Grants to certain supporting organizations (Section 509(a)(3) public charities)

Community foundations should already have procedures in place to determine whether a grantee is a public charity, such as a supporting organization. However, a community foundation may choose to combine the determination of whether the grantee is a public charity with the next FAQ described below of determining whether a public charity is a supporting organization.

How do you determine whether a public charity is a supporting organization?

As mentioned above, a supporting organization is a type of public charity. A supporting organization receives a determination of public charity rather than private foundation status from the IRS because the organization has a particular relationship with another publicly supported charity or government unit. Based on the relationship, a supporting organization is defined as Type I, Type II, or Type III. Type III supporting organizations are further broken down into "functionally integrated" or "non-functionally integrated". Descriptions of supporting organizations can be found following this article in "Supporting Organizations Definitions."

Grants to the following supporting organizations require expenditure responsibility:

• Type III supporting organizations that are not "functionally integrated"
• Any type of supporting organization (even a functionally integrated Type III) if the organization that is being supported is controlled directly or indirectly by either the donor, donor advisor, or related party

What types of due diligence policies should we have for staff to follow?

A community foundation should work to develop policies and procedures to address the new rules for grants from donor advised funds that will guide staff in following the law. At minimum, these policies should include provisions for determining whether potential grantees are non-charities, private foundations, or supporting organizations. Beyond those steps, policies may vary among community foundations.

For example, some community foundations may determine that the foundation makes so few grants to supporting organizations that it will exercise expenditure responsibility with regard to all such grants rather than proceeding through an inquiry about supporting organization type or control relationships. Others will develop processes that walk through all the steps to determine if expenditure responsibility is required and only exercise expenditure responsibility in cases where absolutely required by law. Still others may choose to make a grant directly to a supported organization rather than exercise expenditure responsibility over a grant to an affected supporting organization. Regardless of the foundation's policy, each community foundation should review their donor advised fund policies and procedures to ensure that the policy is designed to ask all of the necessary questions about the grantee's charitable status.

What is a supporting organization?

To oversimplify, a supporting organization is a Section 501©(3) organization that qualifies as a public charity (and not a private foundation) because it has a close relationship with another publicly supported Section 501©(3) organization. Usually, in order to qualify as a public charity, an organization must receive at least one-third (or in special cases as little as ten percent) of its support each year from gifts, grants, and contributions from a variety of sources. A "supporting organization" is not required to meet this "public support test" on its own if it provides meaningful support (financial, programmatic, or both) and gives some degree of structural and operational control to another organization that is already classified as a public charity, rather than a private foundation. Based upon the relationship of the supporting organization to the public charity it supports, a supporting organization will be classified as a Type I, II, or III. A supporting organization may not be controlled by someone who is a disqualified person with respect to the supporting organization.

What are the different classifications of supporting organization?

As a general overview, supporting organizations fall into three categories: Type I, Type II, and Type III. The type refers to the nature of the relationship between the supporting organization and the charity being supported.

• Type I: By far the most common, this type is often described as a parent-subsidiary relationship and generally involves the charity appointing a majority of the board of the supporting organization.
• Type II: The least common of the three, this type usually involves an overlapping board relationship where at least a majority of the members of the supporting organization board are also members of the supported charity's board.
• Type III: This type operates with a greater degree of independence from the organization it supports. Typically the supported organization appoints one member of the governing board of the supporting organization and institutes other procedures designed to ensure that the supporting organization is responsive to it. Type III supporting organizations may provide financial support to their supported organization or they may directly carry out a program or function for it.

How do you determine support organization type and status?

IRS issued guidance (Notice 2006-109) to help organizations with donor advised funds determine whether an organization is a supporting organization and, if the organization is a supporting organization, how to determine the type of supporting organization. This guidance, broken down into steps below, should help community foundations develop procedures to determine whether expenditure responsibility is required.

STEP 1: Determining Whether a Public Charity Is a Supporting Organization
IRS guidance states that donor advised fund grantmakers may rely on information from either of the following sources to determine whether a public charity is a supporting organization:

• The IRS Business Master File (BMF) [8]
• The potential grantee's IRS determination letter
• A report from a third party that includes the following:
  • The grantee's name, Employer Identification Number, and public charity classification under Section 509(a)(1), (2), or (3)
  • A statement that the information is from the most currently available IRS monthly update to the BMF, along with the IRS BMF revision date
  • The date and time of the grantmaker's search

Note: The grantmaker must retain the report in electronic or hard-copy form.

STEP 2: Determining the Type of Supporting Organization
If an organization is a supporting organization, grantmakers must next determine its type. The IRS guidance prescribes one process for organizations with Type I or Type II status and a more complex one for those that are Type III. In all cases, the grantmaker must first verify that the organization is a public charity by checking either the organization's determination letter or its status in IRS Publication 78.

Basis for Determining that an Organization Is a Type I or II Supporting Organization:
Grantmakers may rely on a written representation signed by an officer, director, or trustee of the grantee if both of the following are true:

• The representation describes the process used for selecting the grantee's officers, directors, or trustees and references the pertinent provisions of the grantee's organizing documents that establish the grantee's relationship to its supported organizations.
• The grantmaker collects and reviews copies of the grantee's governing documents. If the grantee's organizing documents are not sufficient to establish the relationship, the grantmaker must also collect organizing documents from the supported organization.

Basis for Determining that an Organization is a Functionally Integrated Type III Supporting Organization:

• The grantee's written representation identifies the organizations it supports.
• The grantmaker collects and reviews the grantee's organizing documents (and those of the supported organizations if necessary).
• The grantmaker collects a written representation signed by an officer, director, or trustee of each supported organization stating that the supporting organization is functionally integrated and that but for the involvement of the supporting organization, the supported organization normally would engage in those activities itself.

Alternative: Grantmakers may also rely on a reasoned written opinion of counsel of either the grantee or the grantmaker in making the determination that a supporting organization is a Type I, Type II, or functionally integrated Type III supporting organization.

STEP 3: Determining Whether a Supported Organization is Controlled by a Donor, Advisor, or Related Party
If the foundation has determined that the potential grantee is a supporting organization and determined that the supporting organization is not a Type III non-functionally integrated supporting organization (where expenditure responsibility is automatically required), the community foundation will need to determine whether the donor, donor advisor, or related parties control the supported organization. This final step is required to make a determination about whether expenditure responsibility is required.

While guidance from the IRS on this subject is still anticipated, the current guidance states that a supported organization is controlled by a donor, donor advisor, or related party if "any such persons may, by aggregating their votes or positions of authority, require a supported organization to make an expenditure, or prevent a supported organization from making an expenditure." For example, if a member of the donor's family is the executive director of the supported organization of a Type I supporting organization, the supported organization would likely be considered controlled by the donor, donor advisor, or related party. In this case, expenditure responsibility would be required for the grant even though the grantee is a Type I supporting organization.

The available IRS guidance (Notice 2006-109) also suggests one method for determining whether control is present. Specifically, if the community foundation is considering a grant from a donor advised fund to a Type I, Type II, or functionally integrated Type III supporting organization, the community foundation may need to request a list of the organizations that the potential grantee supports. Then the community foundation would likely need to work with the donor(s) and advisors to determine whether any of those supported organizations are controlled by the donor, advisor, or related party. For example, the community foundation may seek a certification from the donor or advisor regarding whether they control a supported organization directly or indirectly. Other foundations may choose to seek a certification directly from the supported organization directly indicating that the donor, advisor, or related parties do not control the supported organization. In either case, the community foundation will need to work with the donors and donor advisors to determine the class of individuals and entities that qualify as donors, donor advisors, and related parties. At some point, the IRS may issue guidance to make the steps clear. However, until that time, a community foundation should work with its local counsel to determine policies and procedures that adhere to the law.

A community foundation may find that only a few grants are affected by these new rules. However, the key is having a process in place to identify those grants. While the IRS has yet to issue significant guidance in this area, the available guidance does provide a road map for establishing appropriate processes for determining if expenditure responsibility is required.

Disqualified person
As applied to public charities, the term disqualified person includes (1) organization managers, (2) any other person who, within the past five years, was in a position to exercise substantial influence over the affairs of the organization, (3) donors and donor advisors with regard to transactions with a particular donor advised fund, (4) investment advisors to assets of donor advised funds, (5) family members of the above, and (6) businesses they control. In the case of a supported organization, disqualified persons of the supporting organization are also disqualified persons of the supported organization. Paying excessive benefits to a disqualified person will result in the imposition of penalty excise taxes on that person, and, under some circumstances, on the charity's board of directors. In the case of donors and donor advisors and disqualified persons of supporting organizations, stricter rules sometimes apply.

Donor advised funds
A fund may be classified as donor advised if it has at least three characteristics: (1) a donor or person appointed or designated by the donor has, or reasonably expects to have, advisory privileges with respect to the fund's distributions or investments, (2) the fund is separately identified by reference to contributions of the donor(s), and (3) the fund is owned and controlled by a sponsoring organization, such as a community foundation. A fund possessing these characteristics may be exempt from the donor advised fund classification if it grants to one single public charity or government unit or if the fund meets certain requirements applicable to scholarship funds.

Due diligence
In grantmaking, this speaks to the practices one applies to reviewing grant requests prior to approving them. It generally includes establishing the charitable status of the grantee, the charitable purpose of the grant, and the financial and organizational capacity of the organization to undertake the proposed activities.

Expenditure responsibility
A process that sponsoring organizations must follow when making grants from a donor advised fund to organizations not described in Section 170(b)(1)(A) of the Internal Revenue Code and some supporting organizations.

Grants
The award of funds for charitable purposes.

IRS Business Master File
The IRS Business Master File (BMF) lists all tax-exempt organizations registered with the IRS. The IRS has specified that grantmakers can use BMF data to verify a grantee's public charity classification under section 509(a) (1), (2) or (3).

IRS Letter of Determination
A letter issued by the IRS documenting the organization's charitable status.

IRS Publication 78
IRS Publication 78, also known as Cumulative List of Organizations, is a quarterly publication that lists all organizations to which charitable contributions are tax deductible. Inclusion of an organization in Publication 78 signifies that it has received a ruling or determination letter from the IRS. To remain listed in Publication 78, an organization's status must not be suspended or revoked.

Pension Protection Act
The Pension Protection Act of 2006 was signed into law on August 17, 2006. Among its many provisions, it legally defined and regulated donor advised funds for the first time.

Supported organization
An organization supported by a Section 509(a)(3) supporting organization.

Supporting organization
A section 501(c)(3) organization that qualifies as a public charity (and not a private foundation) because it has a close relationship with another publicly supported section 501(c)(3) organization. Usually, in order to qualify as a public charity, an organization must receive at least one-third (or in special cases as little as 10 percent) of its support each year from gifts, grants and contributions from a variety of sources. A supporting organization is not required to meet this public support test on its own if it provides meaningful support (financial, programmatic or both) and gives some degree of structural and operational control to another organization that is already classified as a public charity, rather than a private foundation. Based upon the relationship of the supporting organization to the public charity it supports, a supporting organization will be classified as a type I, II or III. A supporting organization may not be controlled by someone who is a disqualified person with respect to the supporting organization.

Type I supporting organization
A Section 509(a)(3) supporting organization that is often described as indicating a parent-subsidiary relationship and generally involves the supported charity (or charities) appointing a majority of the board of the supporting organization. This is the most common type of supporting organization.

Type II supporting organization
A Section 509(a)(3) supporting organization that usually involves an overlapping board relationship where at least a majority of the members of the supporting organization's board are also members of the supported charity's board.

Type III supporting organization
A Section 509(a)(3) supporting organization that operates with a greater degree of independence from the organization they support than other types of supporting organizations. Typically the supported organization appoints one member of the governing board of the supporting organization and institutes other procedures designed to ensure that the supporting organization is responsive to it. Type III supporting organizations may provide financial support to their supported organization or they may directly carry out a program or function for it.