International philanthropy is heartily encouraged under US tax laws, which generously allow section 501(c)(3) nonprofits to financially support other organizations and projects operating entirely outside the United States.[1] But foreign grantmaking rules for 501(c)(3) organizations differ depending on whether an organization is a public charity, a private foundation, or a sponsoring organization for donor advised funds (DAFs).[2] Nonprofit leaders should therefore understand not only what rules apply, but also available compliance options.
Key point: When making foreign grants, private foundations and DAFs must undertake more extensive procedures than other public charities per applicable federal tax laws. To avoid significant adverse financial consequences and to promote optimal tax compliance, private foundations and DAFs that engage in foreign grantmaking should therefore implement one of two processes: (1) make equivalency determinations; or (2) exercise expenditure responsibility. This article is the first in a two-part series on international grantmaking considerations for private foundations and DAFs, focusing on equivalency determinations.
What is an Equivalency Determination?
An equivalency determination is a good-faith determination that the foreign grantee organization is equivalent to a US public charity under section 501(c)(3). An equivalency determination is specifically utilized for a foreign organization that has not itself applied and secured an IRS determination recognizing tax-exempt status under section 501(c)(3). Since most foreign organizations are not subject to US tax laws, they have no reason to apply to the IRS for tax-exempt status. The equivalency determination gathers similar organizational and operational information to a Form 1023 Application and allows a US grantmaking organization to work with a qualified tax practitioner to determine whether the structure of the grantee organization, its operations, and the local country laws result in the grantee being organized and operated as an “equivalent” to a public charity for purposes of US tax laws.
Why is an Equivalency Determination Important?
An equivalency determination is a helpful tool that can be utilized by private foundations or sponsoring organizations of DAFs for purposes of documenting that grants made to foreign organizations were properly made and not subject to an excise tax under Sections 4945 and 4966 of the Internal Revenue Code.[3] Excise taxes are essentially financial penalties imposed on an organization and an organization’s managers when they engage in activities that are not permitted under section 501(c)(3). In this case, 4945 and 4966 of the Code each impose an excise tax on a private foundation or sponsoring organization to a DAF when they make a grant to an organization that is not recognized by the IRS as tax-exempt public charity unless the grantor relies on an equivalency determination or exercises expenditure responsibility over the grant. Thus, an equivalency determination provides an extremely important tax compliance tool for a private foundation or DAF to grant funds to a foreign organization.
How does a Grantmaking Organization seek to make an Equivalency Determination?
The grantmaking organization may rely in good faith on an equivalency determination made by a “qualified tax practitioner,” typically an attorney or CPA licensed in a US jurisdiction able to issue written advice on whether the foreign recipient organization is equivalent to a US public charity under section 501(c)(3).
The IRS requires the qualified tax practitioner’s written advice to include many very specific details and evaluations regarding the grantee, based on an affidavit from the foreign entity, governing documents, law from the foreign country governing the grantee, and other program and financial information provided by the foreign grantee—all to make sure that the grantee is eligible to receive charitable grants under US tax law. Specifically, the grantee organization must demonstrate through their governing documents, laws, and other program and financial information that they are organized and operated exclusively for charitable purposes, that their income is drawn from a broad base of public support, and that they are otherwise restricted in the use of charitable assets in a manner equivalent to those imposed on a US public charity.
The process is very fact-specific and can be quite intensive for each grantee—even for different grantees from the same foreign country! Just as the US has many different types of charitable entities, from nonprofit corporations to unincorporated associations, charitable trusts, and even LLCs, with different laws applicable to each, other countries may have different entity types. For example, attorneys at our firm dealing with equivalency determinations know the difference between recognized and unrecognized associations of Italy, what a Stichting is (roughly equivalent to the English term “foundation,” but with variations depending on the country), and that Colombian legal references often use the term “association” as an alternate term for a nonprofit corporation.
When should a Grantmaking Organization seek to make an Equivalency Determination Review?
A grantmaking organization must seek to make an equivalency determination of a foreign grantee prior to making any distributions to that grantee. A grantmaking organization may rely on the QTP’s written advice and equivalency determination for up to two of the grantee’s consecutive tax periods, however. Thus, repeated grants from the same grantmaking organization need not require a subsequent equivalency determination during that period.
This two-year reliance period is one of the key benefits of an equivalency determination. When a private foundation or DAF exercises expenditure responsibility (the alternative option), the grantor is required to undertake additional administrative burdens to continually monitor the use of the funds, collect reporting, and document how the funds were properly expended. In some cases, these steps are easy for a grantmaking organization, and they might prefer expenditure responsibility to securing an equivalency determination. However, for organizations granting funds to a significant number of grantees or simply without the staff or administrative support to regularly monitor and oversee the grant projects with a single grantee, the equivalency determination process might be the best tool for optimal tax compliance.
[1] For a primer on the basics of international grantmaking for 501(c)(3) organizations, see our blog article here.
[2] Donor advised funds are a special fundraising or giving tool which enables a public charity under Internal Revenue Code section 501(c)(3) and 509(a)(1) to receive gifts from a donor, which are separately accounted for and over which the donor is permitted to have limited advisory privileges as to how the funds will be used to further charitable, educational, or religious purposes. The funds, known as DAFs, are under the full control and discretion of the public charity. Consequently, the charity that is serving as the sponsor of the DAFs is subject to heightened federal tax rules to ensure that the funds are properly used to support other public charities. The rules in many ways mirror those imposed on private foundations.
[3] Code section 4945 imposes a tax on certain taxable expenditures, including amounts paid or incurred: a) to carry on propaganda, or otherwise, to attempt, to influence legislation; b) to influence the outcome of any specific public election, or to carry on any voter registration drive; c) as a grant to an individual for travel, study, or other similar purposes, unless certain requirements related to the provision of scholarships are met; and d) as grants to other organizations unless such organization is (i) a public charity described that receives a substantial part of its support from the general public or program-related revenue, (ii) a supporting organization other than a non-functionally integrated supported organization or a supporting organization controlled by a disqualified person, (iii) an exempt operating private foundation, or (iv) a private foundation exercising expenditure responsibility with respect to such grant. Potential tax penalties can be quite punitive. The tax imposed by section 4945 is equal to 20% of the amount of the taxable expenditure. A tax equal to 5% of the taxable expenditure is also imposed on any foundation manager that knowingly approved such expenditure. If the expenditure is not corrected, Code section 4955 imposes an additional tax equal to 100% of the expenditure on the foundation and another tax equal to 50% of the expenditure is imposed on managers who refuse to agree to all or part of the corrective measures.
