One of the ways tax-exempt 501(c)(3) organizations can further their missions is through grantmaking – providing financial support to other organizations (nonprofit or for-profit) working on related initiatives. However, when 501(c)(3) organizations want to engage in grantmaking, they need to be weary of some the federal tax-exempt requirements that may affect their ability to provide grants.  In this blog post, we’ll explore the key requirements that 501(c)(3) organizations (primarily public charities) must consider when engaging in grantmaking, and will discuss suggested practices to follow to help ensure compliance with federal tax law and to maximize the positive impact of grant-funded projects.

When applying for federal tax-exempt status under Section 501(c)(3) of the Internal Revenue Code (“IRC”), a nonprofit must classify the organization as either a “private foundation” or “public charity.” Private foundations and public charities are both types of 501(c)(3) organizations and share certain features – they are both tax-exempt; organized as a corporation, unincorporated association, or trust; cannot engage in political action; cannot use their net earnings to benefit private shareholders; and are organized and operated for one of the charitable purposes established in IRC Section 501(c)(3). Private foundations are the default classification, and are explained here by the IRS. However, most nonprofits would prefer public charity status over being a private foundation because of certain differences that can make the public charity status preferable, including the ability to attract funds from wider sources, more favorable tax deduction features for donors, and less reporting obligations. For example, and relevant here, private foundations face more explicit and restrictive rules with respect to grantmaking than do public charities.[1]  This blog post will focus on grantmaking by public charities, as public charities are typically preferable as a tax-exempt entity and the IRS has less explicit grantmaking rules for public charities.

Public Charity Grantmaking

Public charity 501(c)(3) organizations are often seeking grants to fund their own operations. However, public charities may also want to engage in making grants themselves (essentially regranting the funds they received to other organizations). Importantly, public charities will have specific concerns depending on whether they are making grants to other similar nonprofits or public charities, or if they are making grants to for-profit organizations. These arise from various legal requirements that tax-exempt public charity nonprofits must comply with, such as duties of the board of directors, the requirements a 501(c)(3) tax-exempt organization be organized exclusively and operated primarily for one or more qualifying exempt purposes (e.g., religious, educational, or charitable),[2] and the prohibition against private benefit arising from such operating requirements. Importantly, a public charity will want to make sure that its grant is used for purposes consistent with its own tax-exempt purpose, otherwise it may fail to be operating primarily for its tax-exempt purpose, or it may be deemed to confer a private benefit on another party (whether or not intentionally). We briefly discuss grants to nonprofit and for-profit organizations below before discussing suggested practices that can be used to minimize the risks of failing such compliance requirements when grantmaking.

Grants to Nonprofits

If a public charity is planning to engage in grantmaking to another nonprofit, it should consider the grantee, and whether and how the grant would further the grantor’s own 501(c)(3) purpose. Accordingly, when making any grant, a grantor’s board needs to take reasonable steps to ensure that the grant is used consistently with the grantor organization’s tax-exempt charitable purpose. This is because of the IRC Section 501(c)(3) requirement for the grantor’s public charity to be operated primarily for one or more qualifying exempt purposes. Whereas, if a grantee did not use grant funds consistently with the grantor’s exempt purposes, the grantor could be at risk of not being “operated” for its exempt purpose. However, there is likely less of a concern that the grant will not be used for such tax-exempt purposes when granting to a nonprofit, especially when the nonprofit is another tax-exempt public charity. This is because nonprofits may likely have their own tax-exempt status and will likely have a specific mission or mandate in their own charter documents requiring it to be operated for a specific tax-exempt purpose. Further, because the grantee may also have an interest in obtaining or retaining its own tax-exempt status, there is a greater likelihood that the grant will be properly expended and not be diverted from its intended purposes because the grantee must also comply with the requirements in section 501(c)(3) of the Internal Revenue Code for its own purposes. Such a grantee is also likely better prepared to provide evidence to the grantor of the grant’s use and impact since it must also keep good internal records of its use of its own funds. Accordingly, grants to nonprofits are less likely to subject a grantor public charity to risk of the grant being misused. There is a risk, however, when the grantee is a nonprofit that does not explicitly have a mission consistent with the grantor public charity. Suggested practices that can be used to ensure compliance are discussed further below.

Grants to For Profits

Tax-exempt 501(c)(3) public charities may desire to make grants to for profit businesses for a variety of reasons. For example, if the public charity has a specific charitable mission related to work that primarily for-profit organizations provide, it may desire to make grants to such for profit organizations. However, the fact that for-profits lack the built-in safety guards of nonprofits makes these grants less comfortable. The primary issue to consider when a tax-exempt public charity desires to make a grant to a for-profit organization is avoiding a private benefit. The private benefit prohibition is derived from the requirement under IRC Section 501(c)(3) that an organization must be “operated” primarily for one or more qualifying exempt purposes (e.g., religious, educational, or charitable). “Private benefit” is not explicitly defined in the statute, however, the IRS has discussed it in their own publications and treasury regulations.[3] A tax-exempt organization will fail this “operating” requirement if it confers private benefits upon another organization that is more than incidental to the furthering of its exempt purposes.[4]  More guidance on the private benefit doctrine can be found in our blog post here. For purposes of this blog post, though, it is just important to note that because for-profit organizations typically do not have charitable missions (like nonprofits) and are not subject to federal tax-exemption rules requiring them to operate for charitable purposes, grants to for-profit organizations inherently carry greater risk for public charity grantors because they could result in inadvertent public benefit. Below, we discuss suggested practices that public charities can use to help minimize the possibility that their grants to for-profit organizations will jeopardize their tax-exempt status.

Suggested Practices

To make sure that grants are used in a manner that does not put the granting public charity’s tax-exempt status in jeopardy, various tools can be used to ensure that a grant is used consistently with the grantor’s tax-exempt purpose. These tools include conducting due diligence, granting restricted grants, and requiring reporting.

First, whether an organization is a nonprofit or for-profit organization, the board should conduct due diligence on the recipient of the intended grant. This is arguably within the board of directors’ duty of care – which is to exercise ordinary and reasonable care in the performance of their duties, and to act in a manner which they believe to be in the best interests of the nonprofit. Due diligence may include research into and analysis of the recipient, and should be performed prior to making the grant. At a minimum, this should include determining whether the organization is in good standing and registered to do business in the states in which it operates. A step further may be reviewing the grantee’s operating documents (such as bylaws or an operating agreement), reviewing or interviewing the leadership at the organization, and researching their professional activities and reputation. It would be prudent for the board to develop a process for its due diligence, and to develop guidelines giving directions on the types of organizations to which it would be willing to make grants.

Second, restricted grants can be a great tool to help ensure that the grant is used in furtherance of the grantor’s tax-exempt purpose.  A grant can be made as an outright transfer of funds with no requirements and with nothing provided to the grantor in return. However, unless the grantor knows the grantee will be using these funds in a manner consistent with the grantor’s tax-exempt purpose (such as when the grantee is a nonprofit with a consistent mission requiring such use), the grantor may risk failing the 501(c)(3) requirement to be operated primarily for its exempt purpose. Restricted grants can help solve this issue and can be contained in agreements between the grantor and grantee. Restricted grants are simply grants that come with requirements or involve the grantee providing something in return. For example, a restricted grant can be a written agreement requiring the grantee to use the grant for specific enumerated activities that further the grantor’s exempt purpose. It may also require the grantee to provide written reports of how it uses the funds. Finally, a restricted grant can be written to require the grantee to return funds if does not use the grant for the purposes required by the grantor.

Finally, and as alluded to above, requiring the recipient to report on how the funds are used can be an important tool to ensure the grant is used properly. This provides an obligation ahead of time that will incentivize the recipient to use the funds as intended by the grantor in the first place. However, it also gives the grantor an opportunity to monitor how a grantee is using funds, and to advise the grantee on using the funds as the organizations carry on together. Reporting obligations can also be written into the grant agreements.

Generally, a public charity should conduct greater due diligence when making a grant to a for-profit because for-profits have less strict requirements to use the funds for a purpose consistent with the grantor’s exempt purpose.  The risk of a for-profit misusing grant funds is inherently higher than the risk of another public charity misusing such funds because the laws, internally and externally, governing a public charity grantee are much more strict than those governing a for profit. Accordingly, it may be possible to make unrestricted grants to other public charities when they have aligned charitable missions. However, a grant to a for-profit should not be unrestricted. Further, a grant agreement should always be used when making a grant to a for-profit recipient, and it should include proper restrictions on the grant purposes and uses. This will help to ensure the grantor does not inadvertently fail to operate primarily for an exempt purpose or provide a private benefit to a for-profit as a result of the for-profit misusing granted funds.

Conclusion

In sum, it may be in a public charity’s interest to grant funds to other organizations whose activities will further the tax-exempt purpose of the grantor. However, to ensure that the granting organization protects its own tax-exempt status, it should be careful when making grants, especially to for-profit organizations. Granting to other nonprofit organizations may be preferable. And by engaging in proper due diligence, using restricted grants, and requiring recipients to report on their use of the funds, public charities interested in granting funds in furtherance of their own exempt purpose can help ensure funds are used effectively, and that they do not risk activities that might negatively impact their own operations or tax-exempt status.

[1] Private foundations are 501(c)(3) organizations that are established for certain tax-exempt purposes and which usually engage in granting money to other charitable causes. However, depending on who they make the grant to, the private foundation may face different amounts of scrutiny. Specifically, when making grants to organizations that are generally not public charity organizations  (i.e., recipients that are for-profit organizations), private foundations are subject to “expenditure responsibility,” which requires that the foundation exerts all reasonable efforts and establishes adequate procedures: (i) to see that the grant is spent solely for the purpose for which made; (ii) to obtain full and complete reports from the grantee on how the funds are spent; and (iii) to make full and detailed reports to the IRS on the expenditures. See IRC Section 4945; see also Treas. Reg. Section 53.4945-5.

[2] See IRC Section 501(c)(3) (emphasis added). This blog post will only be concerned with whether an organization is “operating” for one or more qualifying exempt purposes, as the “organized” requirement is assumed to be met by the organization’s charter documents.

[3] See 26 CFR 1.501(c)(3)-1.

[4] See, Private Benefit Under IRC 501(c)(3), 135-137, available at https://www.irs.gov/pub/irs-tege/eotopich01.pdf.