Grant problems: Being hurt by good intentions. (Taxing Issues).

Is your organization exempt under Section 501(c)(3) of the Internal Revenue Code? Do you make grants to noncharitable organizations that are not public charities? Do you plan to make such grants in the future?

If you answered yes to any of these questions, you need to be aware of your responsibilities and the potential consequences of making such grants.

Just to review, an organization exempt under Section 501(c)(3) must be "organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals." Your organization's Articles of Incorporation must specifically include at least one of these purposes as its reason for being.

You are "operated exclusively" for exempt purposes only if you engage primarily in activities that accomplish one or more of those purposes. Your organization must also satisfy statutory language that prohibits participating in any political activity or engaging in any substantial lobbying activity. No part of your exempt organization's net earnings can inure to the benefit of any private shareholder or individual.

Finally, upon dissolution, another organization exempt under Section 501(c)(3) of the Internal Revenue Code (IRC) must receive any remaining assets.

In view of the foregoing, you must clearly direct your activities to your exempt purposes. You should document each expenditure to show how it relates. Of course, you can spend money for administration or fundraising, as these are necessary to the continued functioning of your organization. Sometimes, however, you may find that retaining another exempt organization is the best way to accomplish a given purpose. If that occurs, and the other organization is not a public charity, you can risk your exempt status if you are not careful. While these organizations can include private foundations, they are most likely to be organizations exempt under some other category of Section 501(c) or for-profit entities.

For the purpose of this article, all of these recipient organizations will be referred to as "noncharitable."

To satisfy the restriction on inurement contained in Section 501(c)(3), you must be especially careful if you contract with an entity in which someone in a position of authority in your organization owns an interest. This includes corporations or organizations that they (or their families) own or control.

In addition to inurement, the new intermediate sanction provisions may impose substantial penalties directly on persons in their individual capacity that authorized or benefited from excess benefit transactions with these entities. Affected persons may include your officers and board of directors as well as a related organization exempt under Section 501(c)(4) or Section 501(c)(6) of the IRC.

What can you do if you still believe that a grant to a noncharitable organization is the best way to accomplish your purpose? For the above reasons, it is imperative that your organization exercise expenditure authority when making such a grant. In 1968, the Internal Revenue Service (IRS) issued Revenue Ruling 68-489, 1968-2 CB 210, which discusses the basic rules governing grants by charities to noncharitable organizations. The ruling is very concise in that it provides the basic theory but little specific guidance. The pertinent text of the ruling is as follows:

"An organization exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code of 1954 distributed part of its funds to organizations not themselves exempt under that provision. The exempt organization ensured use of the funds for section 501(c)(3) purposes by limiting distributions to specific projects that are in furtherance of its own exempt purposes. It retains control and discretion as to the use of the funds and maintains records establishing that the funds were used for section 501(c)(3) purposes. Held, the distributions did not jeopardize the organization's exemption under section 501(c)(3) of the Code."

Your charitable organization is a fiduciary of its funds and must be able to control the receiving organization's use of the funds it provides. Exercising expenditure authority means that you limit grants to your organization's specific projects, retain control over the use of the grant funds, require the maintenance of records to show the use of the funds, and require the return of any unspent funds; otherwise it is likely that you will jeopardize your tax-exempt status.

Since Section 501(c)(3) organizations must not engage in any substantial lobbying activities, you must ensure that grants only support nonlobbying activities of the noncharitable organization. Restricting the grant to non-lobbying projects and having the recipient maintain records that substantiate the use of the funds for non-lobbying projects will help you avoid any problems.

Further, a Section 501(c)(3) organization cannot intervene in a political campaign. There is no de minimis level; thus, any political, intervention can result in revocation of exempt status under Section 501(c)(3) of the IRC. Therefore, you must also be careful that grants to noncharitable organizations expressly prohibit any such political activity.

Finally, the inurement and intermediate sanction rules require your organization to ensure that it exercises impartiality in the selection of the grant recipient. You should have a conflict of interest policy and you should use it make certain that no individual or group of individuals will unduly benefit from the selection of the grant recipient.

As discussed above, the IRS has provided little detailed guidance as to how you can satisfy the requirements of Rev. Rul. 68-489. Therefore, you must "go the extra mile" to ensure compliance with the general spirit of the ruling. Any grant to a noncharitable organization must be a controlled grant. You can accomplish this using four steps:

Step 1

Initially, your organization must conduct a screening process with the prospective grantee to ascertain that the noncharitable organization is capable of accomplishing the goals of the grant. Any past experience with the grantee organization will play a part in determining the scope of this initial screening.

At a minimum, a noncharitable organization must describe the proposed project in sufficient detail to enable you to determine that the project is one that helps your organization accomplish its exempt purpose. The description must include a proposed budget for the project and the relationship of expected results to the exempt purposes of the charity, (e.g., education).

Step 2

Additionally, it would be prudent for the charity to evaluate the proposed project and the budget using some form of objective cost / benefit analysis to ensure the charity is getting its money's worth.

Step 3

After making the decision to award a grant to a noncharitable organization, the appropriate officers and directors must sign a written grant agreement. This agreement must clearly state the goals and objectives of the grant. The agreement should provide that the noncharitable organization:

(1)Will return all unexpended funds at the completion of the grant;

(2) Will not use any of the grant funds for political or lobbying activities;

(3) Will not allow an of the grant funds to inure to any individual, and;

(4) Will submit annual narrative and accounting reports during the duration of the grant and a final narrative and accounting report at the completion of the grant.

The grant agreement needs to enumerate exactly when such annual and final reports are due (generally within 60 days of the end of the grantee's accounting year end). The agreement should also cover the terms and conditions of payment of the grant funds and any other prohibited grant activities.

Step 4

Finally, the annual reports submitted during the progression of the grant should be twofold in nature. The first report, a cash basis accounting, should report the revenue received and the funds expended during the reporting period. It should report expenditures by their natural expense classification, (i.e., rent, printing, salaries, postage, equipment, etc.).

The second report, a narrative, should describe the accomplishments made during the reporting period and the overall progress towards the accomplishment of the goals of the grant. The narrative needs to contain specific references as to how the grant funds contributed to accomplishing the goals of the grant. Such reports will assist your organization in evaluating the overall effectiveness of the project.

At the end of the grant, the grantee must submit a final accounting and narrative report. The final accounting report should be cumulative, listing all funds received and expended during the duration of the grant. The final narrative should describe the accomplishment of the goals.

Grantmaking can be a very effective and beneficial way to accomplish your organization's goals. With careful planning and monitoring, you can take advantage of the expertise that noncharitable organizations can provide to assist you to accomplish the goals and objectives of your organization.

Harvey Berger is a partner and national director of not-for-profit tax services in Alexandria, Va., for the accounting and management consulting firm Grant Thornton. His email address is: [e-mail]. D. Greg Goller, CPA, is a tax partner in the Alexandria, Va., office and Margaret Bradshaw is a tax manager there.