Trending in Legal Affairs - Halloween Edition: Exorcising Expenditure Responsibility

An inexperienced grants manager was nervous, dreadfully nervous.

One dark evening, a spirited major donor appeared at the community foundation. The donor, wanting to assist with local community improvements, recommended a grant from his donor advised fund (DAF) to the chamber of commerce, a 501(c)(6) non-charitable organization, for a street clean-up initiative.

The grant manager’s heart stopped. She was new to her role, but heard the harrowing tales of the Pension Protection Act’s ghastly shackles on DAFs. And while she understood DAFs could make grants to non-charities, she knew there was something lurking in the dark recesses of the tax code:  expenditure responsibility.

Unfamiliar with the folklore of this federally-mandated procedure that has tormented many grant managers before her, she knew who she was going to call:  The Council’s Legal Affairs team!

Armed with their sixth sense—legal expertise in foundation management—Council lawyers unearthed the cryptic process of due diligence and oversight for this grant manager.

Under Internal Revenue Code (IRC) section 4945(h) a private foundation must exercise expenditure responsibility to avoid a taxable expenditure when making grants to organizations that are not recognized by the IRS as public charities. Where this is applicable to public charities, including community foundations, is when a DAF makes a grant to a non-charity, because IRC § 4966, the section on DAF taxable distributions, incorporates the private foundation rule by reference. Pursuant to the rule, it is the sponsoring organization’s responsibility to exert all reasonable efforts to establish adequate procedures to see that the grant is spent solely for the purpose for which it is made and to obtain full and complete reports from the grantee on how the funds are spent.

The legal team further broke the rule down into five basic steps: 

1. Pre-grant Inquiry. The foundation must make a reasonable investigation of the grantee to make sure that the grantee is capable of performing the charitable activity that is to be funded.
2. Written Agreement. The grantee must sign a written agreement with the foundation that specifically sets out what charitable activities are to be accomplished with the funds to be granted.
3. Separate Accounts. The grantee must establish a separate account for the funds. Charitable dollars cannot be commingled with non-charitable dollars.
4. Regular Reports. The grantee must provide regular status reports on the expenditure of the funds and the progress made in fulfilling the charitable purpose for which the funds are earmarked.
5. Report to IRS. When filing tax returns for any year in which a payment for an expenditure responsibility grant is made, the foundation must indicate that expenditure responsibility payments were made. 

With the grant manager’s fear of expenditure responsibility properly exorcised, the legal team turned its attention to another horrifying issue it received, political campaign activity.