Conferences of grantmaker organizations focus on many critically important topics. But I have noticed that nonprofit and exempt organizations law tends to be an underappreciated area of coverage, even when it might inform several areas of focus. And for those willing to make the investment in learning and managing nuances and complexities, a better understanding of the law may help in the creation of new strategies.

Of course, several attendees to these conferences may have in-house legal counsel with such expertise. But many do not. Or they may not regularly confer with their legal counsel. This post seeks to provide some high level information to supplement the learnings to be gained at grantmaker conferences and other convenings.

For purposes of this post, all references to grantmakers are to grantmakers that are recognized as tax-exempt under Section 501(c)(3) of the Internal Revenue Code, and all references to grants are to grants made by such grantmakers.

1. How much money can a community foundation (public charity) or a private foundation grant out in a single year? How much money must a private foundation grant out?

Private foundations are sometimes criticized for limiting their grantmaking to 5% of their investment assets, generally the minimum required under the applicable minimum distribution law. Public charities, including (for now) the funds they hold that fall within the definition of a donor-advised fund (DAF), are not subject to any minimum grantmaking requirements.

Whether a community foundation or private foundation can grant more than the 5% minimum amount depends in part on what portion of those investment assets are held in an endowment fund. An endowment fund is a donor-restricted fund that, under the terms of a gift instrument, is not wholly expendable by the institution (whether a private foundation or public charity) on a current basis. Further, an endowment fund is subject to spending restrictions under UPMIFA, the law in 49 states and DC. In California, granting more than 7% of the fair market value of an endowment fund is presumptively imprudent and can result in fines or penalties to the institution and/or its board members and managers. See California UPMIFA.

A fund referred to by the institution as an endowment fund may not fall within the legal definition of an endowment fund if the spending limitation is not imposed by the donor and is instead self-imposed by the board. Such a fund is often called a quasi-endowment, and, generally, the applicable spending restriction may be amended or removed by the board at any time.

For advocates who call on private foundations to increase their grantmaking, awareness and consideration of these laws will make their arguments more informed and persuasive. And if they call for change to the spending laws, they should first consider how that will impact donations and the relative pros and cons for such change.

2. Who can be a grantee? Can grantmakers fund for-profits?

Grantmakers can make grants to different types of organizations, including for-profits and foreign organizations, but such grants must be used to advance one or more 501(c)(3) purposes (e.g., charitable, educational, religious, scientific) and comply with additional requirements, including those described below.

3. What restrictions apply to grantmaking?

Grants must not be used in a manner that would be contrary to the requirements under Internal Revenue Code Section 501(c)(3). For example, a grantee could not lawfully use grant funds to support or oppose a candidate for public office or to convey a prohibited private benefit to any person or entity.

Private foundation grantmakers are subject to additional laws regarding their grantmaking. Very generally speaking, a private foundation can only make a grant to an entity that is not classified as a domestic public charity if it meets a series of requirements referred to in the law as expenditure responsibility. If the grantee is a foreign nongovernmental organization (NGO), a private foundation is permitted to substitute an equivalence determination in lieu of exercising expenditure responsibility.

Public charity grantmakers are not subject to the expenditure responsibility requirements. However, fiduciaries of a public charity may use expenditure responsibility requirements as guidance in observing their fiduciary duties when approving grants to be made to entities other than 501(c)(3) organizations, including for-profits (exclusively for exempt purposes) and foreign NGOs.

Unlike a private foundation, a public charity may make grants to support a grantee’s lobbying activities so long as the public charity’s total lobbying activities (including its funding of lobbying by other organizations) remain insubstantial under the applicable lobbying test. In contrast, A private foundation cannot make a grant to specifically fund a grantee’s lobbying activities (but see below for how a private foundation can otherwise fund and support a grantee’s advocacy activities).

4. Are grant agreements necessary?

Generally, grant agreements are required under federal tax law only for expenditure responsibility grants made by private foundations. However, whether a grant agreement is required to evidence proper observation of fiduciary duties or to help assure that the grants are spent consistent with applicable laws may depend on the facts and circumstances. For example, charitable trust laws may require that a grant only be used to advance the grantmaker’s stated mission, and a grantee may not recognize that restriction unless captured in a grant agreement. In addition, grants from a 501(c)(3) organization cannot be used to engage in political campaign intervention or to confer a prohibited private benefit. If the grant comes from a donor advised fund (DAF), there may be additional restrictions on their use by a grantee.

5. What reports, if any, must be required of grantees? What reports, if any, should be required of grantees?

Generally, reports are required under federal tax law only for expenditure responsibility grants made by private foundations. However, whether grant reports are required to evidence proper observation of the grantmaker leaders’ fiduciary duties may depend on the facts and circumstances and applicable state laws. For example, a $100 grant to a well-established domestic charity may not require a grant agreement, but a $10 million grant to a pharmaceutical company to develop drugs for charitable purposes may.

Grant reports are helpful for grantmakers to evidence that they have met their responsibilities in having reasonable assurance that their grants have been expended in a manner consistent with their intended purpose and with applicable laws.

6. How can grantmakers collaborate with each other?

Grantmakers may collaborate with each other in various ways. They may look to participate in funders collaboratives, which are sometimes housed and operated through one of the participating funders or a third party fiscal sponsor. They may jointly sponsor convenings, trainings, conferences, and other events. They may coordinate their advocacy activities and disseminate joint communications. And they may support the formation of new nonprofits and broader collaborations. See Funder Collaboratives: Why and How Funders Work Together (Grant Craft); The Philanthropic Collaborative Landscape (Bridgespan Group).

7. How can grantmakers collaborate with their grantees?

Of course, there are myriad ways grantmakers can (and often should) collaborate with their grantees beyond the making of grants. Directly related to the grant, grantmakers can listen to and learn from their grantees about what resources are needed, what strategies have been and not been effective, and how the grantmaker and grantee can better understand and help the communities they hope to serve. Grantmakers can also design their grants and grant agreements in ways that allow for continuing interactions that do not perpetuate harmful power dynamics.

Separate from the grant, grantmakers and grantees can collaborate on strategy convenings, conferences, educational materials, presentations, marketing, incubated test projects, fiscal sponsorship, fundraising, and governance. See also Collaborative Map (La Piana Consulting).

From a legal perspective, grantmakers must be careful of collaborations that engage in activities which the grantmaker could not do itself. So, a grantmaker should seriously consider whether it can join a coalition that may be engaged in partisan political activities. On the other hand, private foundation grantmakers may be able to lawfully support charities that engage in certain activities that the private foundation would like to support but cannot engage in or fund directly so long as the grants are not directed to such activities. The grant may be used to support the charities other activities, allowing the charity to use other funds to engage in the activities that grant cannot support.

8. How can grantmakers engage in advocacy?

Many grantmakers regularly engage in advocacy to help create the desired impacts that advance their missions. They may do so through educational materials, convenings to discuss policies, public appeals for behavioral changes, calls for governmental hearings and investigations, litigation, boycotts, drives to get-out-the-vote, demonstrations, and research. For some grantmakers, fundraising is driven by advocacy messages regarding the grantmaker’s mission, vision, strategies, and impact. Lobbying is also a critically important form of advocacy. While private foundations are not allowed to engage in or fund lobbying, public charities are permitted to lobby so long as their lobbying activities are insubstantial.

Despite the substantiality threshold that appears to unnecessarily scare most public charities from engaging in any lobbying, the limits may be very generous, signaling Congress’s support of lobbying by public charities to advance their charitable missions. For public charities that make the very simple 501(h) election, 20 percent of their first $500,000 in exempt purpose expenditures is not considered substantial and may be expended on lobbying. For very large public charities, the 501(h) election may not be advantageous because of the $1 million cap on total lobbying and $250,000 cap on grassroots lobbying. They may instead prefer to measure their lobbying activities under the substantial part test, for which some advisors believe up to 3-5 percent of total resources spent on lobbying would be insubstantial. For more on Section 501(h), see Taking the 501(h) Election (National Council of Nonprofits).

See also Nonprofit Advocacy is More Than Lobbying; Private Foundations May Advocate (Alliance for Justice, Bolder Advocacy).

9. How can grantmakers support BIPOC-led organizations and BIPOC leaders? What risks are involved?

Grantmakers can support BIPOC-led organizations and BIPOC leaders by first embracing and understanding the needs for diversity, equity, and inclusion, no matter the chosen terminology. There is work to be done to ensure that the grantmaker’s support is coming from the right place and with the right goals. This may involve an investment in continual organization-wide education.

Grantmakers whose missions incorporate values of diversity, equity, and inclusion can and should support BIPOC-led organizations and BIPOC leaders, particularly in areas in which there is an underrepresentation and underinvestment in BIPOC communities and individuals. Common forms of support include general operating grants, capacity building support, and technical assistance. Grantmakers can also help build a grantee’s network, amplify its voices, and fund programs and advocacy in support of the grantee’s mission.

With all of the news regarding the attacks on affirmative action and on programs to increase BIPOC representation (including the recent Fearless Fund litigation), it should not be lost that eliminating prejudice and discrimination is a valid charitable purpose under IRC Section 501(c)(3). See Charitable: Eliminating Prejudice and Discrimination. However, grantmakers must be careful of such attacks based on purported violations of Section 1981 of the 1866 Civil Rights Act. See Anti-Discrimination Laws – Section 1981.

If a grantmaker includes race as a qualifying criteria for a grant, and the grant is made pursuant to a contract, the 11th Circuit Fearless Fund decision (which is only binding precedent for the 3 states in the 11th Circuit – Alabama, Florida, and Georgia) supports the argument that such grant is a violation of Section 1981. In my opinion and that of many others, this is not supported by the purpose of Section 1981, which was to protect Black Americans from economic exclusion in the making and enforcing of contracts, and is inconsistent with the First Amendment rights of a charity to use private funds to advance a valid charitable purpose. See How the Fearless Fund Ruling Distorts Charity, History — and Law (Roger Colinvaux, Chronicle of Philanthropy). The 11th Circuit decision also concluded that affirmative action is not a defense to a Section 1981 claim where there is an “absolute bar” to members who don’t identify with a particular race. See Eleventh Circuit: Grant Program for Black Female Entrepreneurs is Likely Unlawful (Emily Cuneo Desmedt and Stephanie Schuster, Morgan Lewis).

10. Can board members of grantmakers get in trouble?

Board members have fiduciary duties and can get in trouble for breaching their fiduciary duties. Generally, it may be rare for a government regulator to hold a board member personally liable for harm partly caused by a board member’s negligence unless there was a self-dealing transaction, failure to pay payroll taxes, or other egregious circumstances.

However, it is possible for a penalty tax to be imposed on board members of a public charity who either benefited from an excess benefit transaction or knowingly participated in an excess benefit transaction. Further, it is possible for penalty taxes to be imposed on board members of a private foundation who either benefited from a self-dealing transaction or knowingly participated in a self-dealing transaction (IRC 4941), or who knowingly participated in a jeopardizing investment (IRC 4942) or taxable expenditure (IRC 4945).

In addition, state charities regulators may impose penalties on board members. For example, the California Attorney General’s Guide for Charities provides:

It is important to ensure the organization has satisfied and continues to satisfy all filing, registration, permit, and licensing requirements. These filing requirements are not optional; they are legal requirements mandated by law. The failure to abide by these requirements may lead to the assessment of late fees and penalties, the loss of tax- exempt status, and the forfeiture of corporate status. Avoidable penalties generally constitute waste of charitable assets and damage to the charity. Also, a director who has committed a breach of fiduciary duty or breach of trust by allowing avoidable penalties may be liable for any damage to the charity.

https://www.oag.ca.gov/system/files/media/Guide%20for%20Charities.pdf (p. 11)

Also, plaintiffs harmed by some action or omission of the grantmaker may sue the grantmaker’s board members for, among other things, breach of fiduciary duties, if they have standing. For example, an unpaid creditor of the organization might sue the board members for not preventing the organization from taking on debt and obligations it reasonably should have known it would have no capacity to pay. Similarly, a person harmed at an organization’s event might sue the board members for being negligent in not reasonably ensuring the safety of attendees.

11. What are program-related investments (PRIs)?

Program-related investments are those in which:

• The primary purpose is to accomplish one or more of the foundation’s exempt purposes,
• Production of income or appreciation of property is not a significant purpose, and
• Influencing legislation or taking part in political campaigns on behalf of candidates is not a purpose.

Because a grantmaker can recover the funds used on a PRI, it has the opportunity to use those funds over and over again (if the investment is not lost). And a PRI may count as part of a private foundation’s qualified distributions to meet its minimum distribution requirement and doesn’t count as part of the assets included in determining such minimum distribution requirement.

PRIs commonly take on the form of a loan or a loan guaranty to a charity or to another type of entity with a charitable venture. And in some cases, a PRI may be in the form of an equity investment.

12. What are mission-related investments (MRIs)?

As far as I’m aware, the term mission-related investment (MRI) is not defined by applicable tax or charitable trust laws. Colloquially, an MRI may refer to an investment which is motivated in part by its impact in advancing the investor’s social mission and in part by its income generation or appreciation potential. Many think of MRIs only in the context of investments that will produce a market rate of return. But MRIs may also include investments that forgo market rate returns because of their potential for social impact.

Because such description might also describe PRIs, private foundations typically speak of MRIs as investments that would not otherwise qualify as PRIs, perhaps because the production of income or appreciation potential is a significant purpose for the investment, even if it may be below market rate. The IRS, in Notice 2015-62, recognized that an MRI (though not identified by that term) could also be an exception to a jeopardizing investment and therefore permitted for a private foundation.

13. What is a set-aside?

A private foundation may meet its minimum distribution requirement in part through a set-aside, an amount that is set aside for accumulation and payment in the future. A set-aside may be treated as a qualifying distribution in the year set aside if at the time of the set-aside the foundation establishes to the satisfaction of the IRS that:

• The amount will actually be paid for the specific project within 60 months from the date of the first set-aside, and
• The set-aside satisfies the suitability test, that is, that the project is one that can be better accomplished by a set-aside than by immediate payment, or the foundation satisfies the cash distribution test.

To qualify under the suitability test, a set-aside must be approved by the IRS through a private letter ruling.

14. How can a grantmaker diversify its board?

A grantmaker may have a goal of diversifying its board composition with a focus on race, gender, age, or other characteristic. But for many grantmakers, this may not be a high priority. They may instead focus on family or company affiliations, specific skills, networks, and the capacity and willingness to make substantial contributions to the organization.

Current board members may of course be diligent about diversifying their board with respect to the desired characteristics, and this is likely the most common way boards become more diverse. However, organizations can also create governance provisions to better assure diversity. Such provisions may be controversial with several pros and cons. For example, a required quota might succeed in achieving greater diversity but might not address other issues, including those relating to inclusion and belonging.

Other provisions might require a buildout over time. For example, relationships can be created with other organizations that might serve as a resource for potential future board members. Such other organizations might later be given the authority to appoint one or more board members of the grantmaker organization on an ongoing basis.

Committees composed of employees, board members, and others might also be given director-appointment authority. Or, if a board is more cautious about delegating such powers, it can allow for a diversely composed nominations committee to provide a list of nominees from which the board will select.