Despite many people’s belief that grantmaking is restricted to entities known as foundations, public charities can and many do engage in grantmaking. This post focuses on grantmaking by public charities and generally does not address the more restrictive rules applicable to private foundations.
Part of the confusion lies with how we colloquially refer to grantmaking organizations as foundations. We have private foundations, corporate foundations, community foundations, related foundations, and operating foundations, among others. Meanwhile we may refer to typical grant recipients as nonprofits and consider them as entities that do not engage in grantmaking.
The law actually distinguishes between two types of 501(c)(3) organizations: private foundations and public charities. While both are subject to the general laws governing 501(c)(3) organizations, there are also different sets of laws applicable to each. Generally, the laws applicable only to private foundations are more strict than those applicable to public charities, including with respect to grantmaking. So, if anything, it’s easier for public charities to engage in grantmaking that it is for private foundations.
Further, the word “foundation” in and of itself does not indicate whether an organization is a private foundation or a public charity. Community foundations (not a legal term) are almost always public charities and engage in substantial grantmaking, either directly or through special restricted funds known as donor-advised funds.
Reasons for Making a Grant
If a public charity is planning to engage in grantmaking for the first time, it should consider whether and how the grant furthers (1) its 501(c)(3)-consistent purpose, which should be expressed in its articles of incorporation among other places; and (2) its core values. These factors will help determine how a grantee is selected, how the grant may or may not be restricted, and how much the grant will be for.
Grant or Contract?
Before determining to make a grant, a public charity may also want to first consider whether the funds to be transferred should be characterized as a grant or a contract. There are tensions on this distinction as the determining factors may differ depending on the context. Generally, a grant will be a transfer of funds or other assets where the party making such transfer (the grantor) does not receive return value for its own use or benefit; and a contract will involve a transfer of funds or other assets where the party making such transfer (the payor) does receive return value for its own use or benefit (e.g., to support the payor’s own activities and affairs). The Mott Foundation provides further explanation of these general differences here.
Pre-Grant Processes and Due Diligence
There are a wide variety of ways grantors use to select and approve their grantees. Some solicit grant applications; others select their grantees based on pre-existing relationships or biases. Some require board approval; others require only staff approval (on some or all of their grantees, which may be based in part on the size of the grant). Some repeatedly fund the same grantees; others limit the number or amount of grants any single grantee can receive. Some fund only public charities; others also fund other types of tax-exempt and taxable organizations (exclusively for charitable purposes). Some fund only locally; others fund nationally or internationally. Some fund lobbying; others don’t.
Regardless of the way a grantor may use to select and approve a grantee, a reasonable level of due diligence (research and analysis) should be performed prior to making the grant. A grantor’s board members have fiduciary duties to act with due care, including reasonable inquiry, in the best interests of the organization. Such duties can be expressed by the board carefully developing systems and processes to provide some assurance that the grant will be properly used in furtherance of the grant purposes (which should be consistent with the grantor’s purposes or mission). Taking it a step further, those systems and processes might support finding a grantee that can most effectively and efficiently further the grant purposes, but this is no easy determination. Time horizons, the value of experimentation and innovation, and the broader consequences and results of the grant should all be considered.
Minimally, a grantor might simply check that the grantee meets any minimal criteria. If a grantee must be a public charity, the grantor may check the IRS Tax Exempt Organization Search (TEOS) site. The grantor might also check to see if the grantee is properly qualified to do business and registered in the state(s) in which it is or will be operating to further the grant purposes. A review of the grantee’s governing documents also makes sense to ensure its purpose statement allows it carry out the contemplated activities.
The larger the grant and the more unfamiliar the grantor is with the grantee, the more due diligence should be performed. This may involve a review of the grantee’s leadership team and board; analysis of the grantee’s ability to carry on the types of activities contemplated based in part on past performance, personnel, and existing resources and infrastructure; research of the grantee’s reputation and compliance issues; and examination of its information returns and public communications.
Grants to Foreign Organizations
Unlike private foundations, public charities are not required to exercise expenditure responsibility or obtain an equivalency determination in order to make a grant to a foreign organization.
Expenditure responsibility (“ER”) requires that the foundation exerts all reasonable efforts and establishes adequate procedures:
- To take certain precautions to ensure that the grant funds will be spent for proper purposes (in connection with this requirement the foundation must conduct a pre-grant inquiry concerning potential grantees and make all its grants subject to a certain type of written grant agreement with the grantee);
- To obtain full and complete reports from the grantee on how the funds are spent; and
- To make full and detailed reports to the IRS on the expenditures.
An equivalency determination (“ED”) generally refers to the review and evaluation by a private foundation of whether a potential grantee is the foreign equivalent to a U.S. public charity. This involves a review of the foreign grantee’s organization (governing documents) and operations to ensure it meets the following requirements:
- It is organized exclusively for a charitable, educational, or other 501(c)(3) exempt purpose;
- It is operated primarily for a qualified exempt purpose;
- It does not engage in any transactions that would result in private inurement or a prohibited private benefit;
- Its assets, upon dissolution, would be distributed to another nonprofit for a qualified exempt purpose or a government instrumentality;
- It does not engage in substantial lobbying;
- It does not engage in prohibited political campaign intervention; and
- It would qualify as a public charity (and not a private foundation) if it were to apply for IRS recognition of exemption under 501(c)(3).
While a public charity isn’t formally required to exercise ER or conduct ED in making a grant to a foreign organization, its board should still take reasonable steps to ensure that the grant complies with applicable laws (including the laws of the foreign country in which the grant is to be made), that the grant will be properly expended and not be diverted from its intended purposes, and that the grantee can provide evidence (e.g., report) of the grant’s use and impact. Consequently, many professionals encourage public charities to exercise ER (or in some cases, conduct ED, particularly where the grantee will receive repeated grants) in making a grant to a foreign organization.
In addition to the tax law due diligence for grants to foreign organizations, grantmaking charities should consider the anti-terrorism laws and associated risks. The following resources may be helpful in providing some background on these issues:
- Nonprofits – International Charity Activities
- Public charity grantmaking—Protecting tax-exempt status (RSM)
- IRS Updated Procedures for Terrorism Screening of Exemption Applications
Grants to For-Profit Organizations
Similar to the case of making grants to foreign organizations, private foundations, but not public charities, are required to exercise ER for grants made to for-profit organizations. Nevertheless, a charity’s board should still take reasonable steps to ensure that the grant complies with applicable laws, that the grant will be properly expended and not be diverted from its intended purposes, and that the grantee can provide evidence (e.g., report) of the grant’s use and impact.
An often challenging issue to consider in making a grant to a for-profit is the avoidance of a prohibited private benefit that at worst could jeopardize the charity’s tax-exempt status. The private benefit prohibition is derived from the requirement under IRC Section 501(c)(3) that an organization be organized exclusively and operated primarily for one or more qualifying exempt purposes (e.g., religious, educational, or charitable). Although “private benefit” is not explicitly referenced in the statute, an organization will fail this requirement if it confers private benefits upon an individual that are more than incidental, quantitatively and qualitatively, to the furthering of its exempt purposes. The following resources may be helpful in providing some background on this issue, which can get much more complicated if a board member or other disqualified person is a party receiving the private benefit (e.g., private inurement, excess benefit transaction, self-dealing):
- Private Benefit Rules – Part I: Private Benefit Doctrine
- Private Benefit Rules – Part II: Private Inurement Doctrine
- Private Benefit Rules – Part III: Excess Benefit Transaction Rules
- Private Benefit Doctrine – A Few Examples
- California Nonprofit Law: The Self-Dealing Prohibition
Generally, a charity should conduct greater due diligence when granting to a for-profit and ensure that the grant agreement includes proper restrictions on the grant purposes and uses. The risk of a for-profit misusing grant funds is inherently higher than the risk of another charity misusing such funds because the laws governing the grantee are much mores strict for the charity grantee. Accordingly, unlike the case where the grantee is another charity, the grant to a for-profit should never be unrestricted. And in many cases, it may be appropriate to require that the grant be segregated from the grantee’s general funds, not only on paper, but also by maintaining the grant funds in a separate bank account to prevent them from being commingled with the grantee’s general funds.