IRS Drives Home Rules Regarding Transactions With Foreign Entities
In recently released PLR 201539032, the IRS addressed the consequences of a U.S. nonprofit maintaining a poorly run foreign grant program.
An organization was formed to provide financial support for a separate foreign organization as well as provide support for needy individuals, provide student stipends, support Jewish education and outreaches and provide room and board for students attending Jewish institutions. During the process of applying for exempt status, the IRS initially determined that due to the specific support of a foreign organization, the organization could qualify as a tax exempt organization, but donations to it would not be deductible. However, after agreeing to change its operations to not specifically support the foreign entity, the IRS agreed to allow the organization to receive tax deductible gifts.
Unfortunately the organization did provide support to a specific foreign organization and stated on its Form 990 its purpose was raising funds for the foreign organization. Based on the information provided on Form 990, the IRS initiated inquiries as to the organization's foreign grant procedures.
Inquiries revealed the following:
- The organization did not screen grant recipients through the Office of Foreign Asset Control Specially Designated Global Terrorist list to determine if the recipient was included on the watch list;
- No application or other documentation was requested from the grantee;
- Scholarships made directly to students were based on teacher recommendations;
- No detailed description of any specific projects were required;
- All of the grants were to persons connected with one particular organization;
- All grants were intended for educational purposes, but no follow up was conducted to determine if those goals were being met;
- Students provided direct scholarships were not required to provide any proof of educational expenses;
- The grants were approved by the board of directors, but always in the amount requested;
- The foreign organization did not provide any financial reports or accounting to the U.S. organization for any of its operations;
- There were no agreements that reflected the organization's discretion to withdraw funds in the event the charitable purposes were not met and no follow up evaluation was conducted; and
- The organization's review of the effectiveness of the grants was limited to its on-site visits.
Legal Issues to Consider
Few U.S. organizations, including churches, realize the restrictions on supporting foreign organizations. There are two primary issues that must be addressed in working with foreign individuals and foreign organizations;
- Tax Deductible Gifts; U.S. tax law does not allow a U.S. taxpayer to deduct contributions to foreign organizations outside of limited exceptions with neighboring countries. In the same manner, a U.S. organization that is merely a conduit or a fundraising organization for the foreign organization may operate as a tax exempt entity in the U.S., but its donors are not allowed to make tax deductible gifts to the U.S. organization. In order for the U.S. organization to not operate as a conduit for the foreign organization, it must maintain control over its operations and its funds. The IRS detailed examples of the application of these principles in Revenue Rulings 63-252 and 66-79.
- Private Benefit vs. Charitable Purposes: A tax exempt entity must operate for its specific exempt purposes and not for private purposes. Any activity that is not clearly documented to be an exempt activity is considered to be a private benefit activity or a nonexempt activity. The existence of a single nonexempt purpose can destroy an organization's exemption. Better Business Bureau v. U.S. 34 AFTR 5 & American Campaign Academy v. Comm., 92 TC 1053
If a U.S. organization is going to actively support a foreign organization and avoid being considered a conduit, then it must control over all funds provided to the foreign organization. If a U.S. organization is going to provide support to a foreign organization or to an individual, it must be able to prove that assisting the recipient is an exempt purposes. Both of these goals are addressed and met through a concept known as expenditure responsibility. (This private letter ruling describes the classic case of failing to meet both of these requirements. The result was revocation of the organization's exempt status. The IRS also noted that in the event the exempt status was retained, the organization would be considered a conduit and would not be able to receive tax deductible contributions.)
Expenditure responsibility isn't one set item or circumstance, but it is combination of several items indicating the U.S. organization is in control of the funds and is assured its funds are used for its charitable purposes. If the funds are not being used for charitable purposes, then the presumption is they are being used for private purposes. Items or actions that create expenditure responsibility may include, but are not limited to:
- Predetermined grant requirements
- Grant applications
- Project budgets
- Proof of actual expenditures
- For scholarships, proof of fulfillment of educational requirements
- Proof of financial need
- Overall financial information of the organization
- On-site visits by U.S. representatives
- Direct accounting of expenditures
- Compliance with anti-terrorism procedures
- Personal involvement in project planning or fulfillment
- Periodic reporting of a project's progress
Take A Ways from PLR 201539032
This ruling provides an excellent analysis of what the IRS expects from an organization to be able to address the two issues described above. An organization actively operating in foreign countries should us this guidance to review its own policies and procedures to avoid any threat to its own exempt status. Different organizations may have different specific ways to achieve expenditure responsibility, but the goal of an organization's grant making program should be to:
- Know who is receiving the funds - Through applications, interviews and hands on knowledge, this information should be well documented.
- Know the purposes for the funds - Require budget proposals or other financial information in the decision making process to allow for an educated decision as to the amount of funds to be made available.
- Make clear the expectations - Grant recipients need to know what is expected out of them and the consequences of failing those expectations.
- Know the end result of the funds - Don't assume the funds are used correctly, follow up to determine if the end result has been accomplished.
- Avoid designated funds - Don't become a conduit for a well intended donor. Refuse contributions earmarked for a foreign entity that is not participating in the organization's established foreign grant program. Donations to foreign organizations and individuals are clearly not deductible if not controlled by the U.S. organization.
Organizations filing Form 990 are required to disclose a synopsis of foreign grant making procedures on Schedule F. A poor disclosure may lead to an IRS inquiry as it did in this ruling. A church is still subject to all of these rules, but avoids the natural oversight that comes through the Form 990. Therefore, it is important that churches realize the rules involved in foreign grant activity and build programs that will comply and protect the church's exempt status. If an organization's foreign grant program closely resembles the one described in PLR 201539032, then it is time to dust off those policies and procedures and take a fresh look at it. Instituting changes may be difficult, but it is necessary to protect the organization's exempt status and the donors' tax deductible donations.