Many private foundations and government agencies have become comfortable making grants to support fiscally sponsored projects (FSPs). Over the past decade, fiscal sponsorship has become an increasingly familiar structure and more widely recognized as a legitimate option for supporting charitable projects. But there are still many misconceptions about how fiscal sponsorship works and how funders should make grants to fiscally sponsored projects. For purposes of this post, we’ll focus on fiscal sponsorships operated through 501(c)(3) public charities.

Fiscal Sponsorship

Fiscal sponsorship describes a number of varying contractual relationships that have through custom and practice developed between tax-exempt organizations and nonexempt parties seeking to lead an exempt (e.g., charitable) project. Fiscal sponsorship allows the nonexempt party’s leaders to fundraise for the project without having formed a public charity that they control. The most common models are referenced as comprehensive (or Model A) and pre-approved grant relationship (or Model C).

There are critical differences between these two models, including regarding the entity in which the charitable project is being operated. It is therefore imperative that funders understand the distinction for purposes of properly documenting the grant. Unfortunately, I’ve seen many poorly drafted applications and grant agreements because of the lack of understanding of how fiscal sponsorship must work. And this problem plagues even some very big, well-known funders, and that may unnecessarily expose them to penalty taxes and other adverse consequences.

The Grantee is the Fiscal Sponsor

Many funders require that their grantees be 501(c)(3) organizations classified as public charities. Generally, if a private foundation makes a grant to another type of organization, even if it was exclusively for charitable purposes, it must exercise expenditure responsibility (ER), a formal set of procedures described in the Treasury regulations. If it fails to do so, the private foundation may be subject to penalty taxes for a taxable expenditure.

But that’s not all. If the private foundation was relying on that grant being a necessary part of meeting its minimum distribution requirements, because the grant would no longer be a qualifying distribution, the private foundation may also be subject to penalty taxes for failing to make the required minimum distribution. See IRS EO TG 59 Taxes on Foundation Failure to Distribute Income IRC 4942.

Yet, many foundations and other funders list the name of the FSP, instead of the fiscal sponsor, as its grantee. This can be particularly problematic because the party that enters into the fiscal sponsorship agreement with the fiscal sponsor (the “Other Party”) often has the same name as the FSP.

In a Model A fiscal sponsorship relationship, the FSP has no separate legal existence from the fiscal sponsor, and the name of the FSP may be one of the fictitious business names (DBAs) of the fiscal sponsor. If a private foundation makes a grant to a Model A FSP, that should be fine. This is simply a grant to an internal project of a fiscal sponsor. But if the private foundation identifies the fiscal sponsor as a conduit or as an entity acting on behalf of the Other Party in order to process the grant, then the private foundation may, in substance, be making a grant directly to the Other Party, which would trigger the need to exercise ER.

In a Model C fiscal sponsorship relationship, the FSP is housed in the fiscal sponsor’s grantee, which is the pre-selected Other Party. If a private foundation wants to fund the FSP, it should make a grant to the fiscal sponsor restricted to the charitable purposes of the FSP. The private foundation should not restrict the grant requiring the fiscal sponsor to regrant the funds to the Other Party. This would make the fiscal sponsor a mere conduit and the substance of the grant one from the private foundation to the Other Party.

In either a Model A or Model C relationship, only authorized agents of the fiscal sponsor are fundraising for the charitable purposes of the FSP. The Other Party is not the appropriate applicant on a grant application and should not be fundraising for itself. And just to emphasize the point, in a Model C context, the fiscal sponsor’s pre-approved grantee is not the appropriate applicant on a grant application and should not be fundraising for itself. Many find this confusing because it’s common for the same persons associated with the Other Party to be the authorized agents of the fiscal sponsor acting on behalf of the fiscal sponsor, which is the entity that has 501(c)(3) status and (presumably) is registered to engage in charitable solicitations.

Funder Due Diligence

The funder should of course take reasonable steps to make sure the fiscal sponsor is an appropriate grantee that will properly expend the grant funds in furtherance of the grant purposes. With a fiscal sponsor, that means ensuring that the fiscal sponsor has the legal ability to operate or fund the FSP, in terms of mission-consistency (check the articles and bylaws), current 501(c)(3) status (check the IRS TEOS site), and state law registration, among other things.

It also means reviewing the fiscal sponsorship agreement to ensure that the fiscal sponsorship relationship is lawfully constructed. The fiscal sponsor should have control of the grant funds (accountants will stress the fiscal sponsor’s variance power) even if the fiscal sponsor has pre-approved a grantee. The fiscal sponsorship agreement should also provide for exit rights to the Other Party, which may allow the Other Party to transfer a Model A FSP to a newly formed public charity.