Imagine a newly formed nonprofit is organized to help end poverty internationally. The foundation’s board aims to accomplish its charitable purpose in many different ways, including funding local organizations in foreign countries. The grant-related tax concept of “expenditure responsibility” is vital if the new organization is a private nonoperating foundation, and it is also quite helpful for other Section 501(c)(3) organizations.
In our previous blog article on international philanthropy, we addressed equivalency determinations, a common tool for giving on a global scale. Foreign grantmaking rules for 501(c)(3) organizations differ depending on the nature of the grant-maker (a public charity vs. a private foundation), so nonprofit leaders should understand the rules that apply and available compliance options.
Unlike equivalency determinations, which are used solely in the context of international grants by private foundations and donor advised funds (DAFs) to foreign charitable organizations, the alternative tool of expenditure responsibility is useful in more diverse situations, including when any type of charity makes a grant.
Key point: Expenditure responsibility is a useful tool for any grant-making endeavor and may be required in many cases.
What is Expenditure Responsibility?
Expenditure responsibility is a process described in U.S. Treasury regulations and undertaken by 501(c)(3) grantmaking organizations, to show that they have exercised oversight to ensure proper use of charitable funds by grantees. While the regulations apply specifically to private nonoperating foundations, the concepts and procedures are commonly utilized by public charities too that engage in international grantmaking as a best practice. As further described below, practicing expenditure responsibility involves actions before providing a grant, follow-up with the grantee, and reporting to the IRS.
Why is Expenditure Responsibility Important?
Expenditure responsibility is particularly important for private foundations, which are legally obligated to make qualifying distributions each tax year. At a minimum, qualifying distributions generally equal to 5% of the net fair market value of a foundation’s assets that are not directly used to carry out its exempt purposes. Additionally, private foundations must undertake more extensive procedures than public charities when making certain grants, including those to foreign organizations. Failure to follow these procedures may subject the foundation and its leaders to excise taxes under section 4945 of the Code.
To avoid significant adverse financial consequences, private foundations that engage in foreign grantmaking should therefore implement one of two processes: (1) make equivalency determinations; or (2) exercise expenditure responsibility. Like an equivalency determination, private foundations can use the expenditure responsibility process to reflect that grants made to foreign organizations were qualifying distributions rather than transactions subject to excise taxes. (Note that sponsoring organizations of donor advised funds are also subject to similar excise taxes under IRC section 4966 and can similarly use expenditure responsibility to meet requirements in the foreign grant-making arena.)
Additionally, expenditure responsibility is important almost any time a private foundation makes a grant to an organization that is not a public charity. This applies for grants to foreign organizations but also includes grants to other private foundations, to other types of non-profit organizations such as trade associations or social clubs, or even to for-profit businesses. Like foreign grants, these grants are subject to section 4945 excise taxes if the granting organization does not properly exercise expenditure responsibility. Because equivalency determinations only apply to grants to foreign charities, though, such tool is not available for other types of grants, making expenditure responsibility the only option.
While the expenditure responsibility process is not required for most public charities (except as noted above for DAF sponsors), many of its pieces remain helpful for such organizations as best practices to ensure that charitable funds truly are being expended exclusively for charitable purposes. Additionally, although public charities do not have to delineate as much detail about grants on the annual IRS Form 990 as private foundations do on the 990-PF, public charities should always be prepared to provide documentation about the charitable nature of their grants in case of an audit.
How Does a Grantmaking Organization Conduct Expenditure Responsibility?
The expenditure responsibility process involves:
- A pre-grant inquiry;
- A written grant agreement;
- Reports from the grantee;
- Reports to the IRS; and
- Action upon noncompliance by the grantee.
Step one is to obtain information from any potential grantee in the form of a “pre-grant inquiry.” The grantor must ask the potential grantee questions about its identity, activities, and other information that will help the organization determine that the grantee will use the grant funds to further the grantor’s exempt purposes. The amount of information needed will vary depending on the nature of the grant and any prior relationship between the granting organization and the potential grantee. Of particular importance for foreign grantees are English translations of the grantee’s governing documents so that the grantor understands the type of organization it is funding.
Step two is to create a written grant agreement ensuring that the grantee will used the funds properly. It should require the grantee to maintain proper documentation, make reports on the use of funds, and segregate grant funds in some cases. Additionally, the grantee should agree to only use the funds for the intended purpose of the grant (typically on a project by project basis), return any funds not used for such purposes, and refrain from certain prohibited activities.
Once a grant is made, steps three and four involve reporting. Grantmaking organizations must obtain reports from grantees at least annually during the term of use of the grant, including a final report once all funds are used for the grant project(s) or the grant is terminated. Reports should address use of funds and progress toward the covered project or intended outcome of the grant. The organization in turn will need to report information about all grants to the IRS on its annual information return (for private foundations, the 990-PF).
Finally, should something go wrong, the grantmaking organization will need to take action to correct the issue. Such corrective action may include terminating the grant and taking appropriate steps to attempt to recover any funds that were not properly used.
Underlying each of these steps is the importance of documentation. The grantor should document its compliance with each step of the expenditure responsibility process. Additionally, the grantor organization should work closely with legal counsel to create appropriate grantmaking policies and IRS-compliant forms for pre-grant inquiries, grant agreements, and grantee reports that are carefully tailored to the scope of the grant program. Additional requirements may apply under IRS regulations.
When Should a Grantmaking Organization Consider Exercising Expenditure Responsibility instead of Obtaining an Equivalency Determination?
As explained above, both public charities and private foundations can exercise expenditure responsibility in a variety of different grantmaking situations. When a private foundation or DAF sponsor is considering grants to foreign charities, though, the question often arises as to which is the better option: expenditure responsibility or equivalency determinations? In other words, when should organization leaders choose expenditure responsibility?
A key benefit to exercising expenditure responsibility is that the process helps ensure funds are being used as the grant-making organization intends. This makes the expenditure responsibility process the best tool for organizations that want to provide grants for very specific projects or want to establish healthy and transparent long-term relationships with their grantees.
Additionally, because obtaining an equivalency determination involves obtaining written advice from a qualified tax practitioner for each new grantee, such process can be quite expensive and even cost-prohibitive if the grants are small. Expenditure responsibility, on the other hand, may be conducted almost entirely by the organization’s own staff or volunteers. Organizations should still work with legal counsel initially to establish grant-making policies and to create form documents for use in the process, but they should otherwise be able to handle most of the process internally unless specific compliance issues arise with a particular grantee. Thus, expenditure responsibility may save the organization money in the long run if it has a high volume of grantmaking activity and if an in-house team is able to conduct the process effectively and efficiently.
Note also that small grantees in other countries may face difficulty in meeting the strenuous IRS requirements for an equivalency determination. Essentially, the grantee must show that they meet requirements of US law even though they are not organized in the US, including drafting their governing documents in certain ways not typical in their home country. Expenditure responsibility provides a viable alternative for grants to such foreign grantees.
What Else Should Grantmaking Organizations Know About Expenditure Responsibility?
Grantmaking can be a complex process, and many considerations are involved with how to apply expenditure responsibility. For example, if a private foundation gives a foreign organization a grant to acquire an appreciable asset (e.g., a building), a question arises as to how long the grantee should continue reporting on the use of that asset, to ensure that it continues to be used exclusively for charitable purposes. Organization leaders thus should work closely with legal counsel as their grant-making programs expand or change.
Establishing an organization’s expenditure responsibility policies and procedures takes some front-end work and required ongoing attentiveness. But these measures are well worth the effort to ensure legal compliance, to make a difference around the world!
 A qualifying distribution includes the following: (a) an amount, including reasonable and necessary administrative expenses, paid to accomplish tax exempt purposes, other than to: (i) a non-operating private foundation, (ii) an organization controlled by the distributing private foundation or its disqualified persons, (iii) a non-functionally integrated Type III supporting organization, or (iv) a Type I, Type II, or functionally integrated Type III organization if a disqualified person of the private foundation directly or indirectly controls such organization; (b) an amount paid to acquire an asset used, or held for use, directly in carrying out exempt purposes; or (c) qualified set-asides for specific projects.
If a foundation fails to make such distributions in a given year, Internal Revenue Code section 4942 imposes an initial excise tax of 30% of the amount by which distributions for the year are below the minimum amount. If the private foundation continues to fail to make its required distributions, section 4942 imposes an additional tax equal to 100% of the amount of minimum distributions that remains undistributed.