Private foundations that make grants are generally very familiar with the expenditure responsibility rules, which require a heightened level of due diligence for certain grants and program-related investments. Expenditure responsibility is a fairly cumbersome process, and most foundations would prefer to avoid it—which is possible by making grants only to recipients that do not require it. One such type of recipient—a political subdivision—is the subject of recently released proposed regulations by the IRS.
As background, a private foundation needs to exercise expenditure responsibility for grants to organizations that do not qualify as a public charity under 509(a)(1), (2) or (3) of the Internal Revenue Code. However, certain recipients will be treated as a 509(a)(1) organizations, including political subdivisions that are described under section 170(c)(1), so long as any grants to the political subdivision are made exclusively for charitable purposes.
A key issue to keep in mind, though, is that the concept of a “political subdivision” is much narrower under federal tax law than under state law. The Tax Court has held, in Texas Learning Tech. Group v. Comm’r, 96 TC 686 (1989), that the standard for determining a political subdivision is the same under Section 170(c)(1) as Section 103 (the power to issue tax-exempt bonds). The rulings and cases under Section 103 clearly require an organization to have at least one of three sovereign powers (which are distinct from governmental functions), and the sovereign power must be substantial. Those include: (1) the power of eminent domain; (2) the power levy or collect taxes; and (3) police powers.
The proposed regulations do not make any changes to the requirement that a political subdivision under Section 103 (and under Section 170(c)(1) by extension) exercise at least one of three classic sovereign powers. However, they do add to the overall requirements for qualifying as a political subdivision, by also requiring an entity to serve a governmental purpose and to be controlled by a state or local governmental unit. All an all, a political subdivision now needs to meet three requirements under these proposed regulations, taking into account all facts and circumstances:
- The proposed regulations keep in place the three long-recognized sovereign powers: tax, eminent domain and police. An entity must meet at least one.
- Factors that will be considered in determining if an entity serves a governmental purpose include whether the entity carries out the public purposes set forth in the entity’s enabling legislation, and whether the entity operates in a manner that provides significant public benefit with no more than incidental private benefit. It does look like case law has considered whether an entity serves a public purpose in determining whether an entity is a political subdivision, though this hasn’t been incorporated into the regulations.
- Governmental control means an ongoing right or power to direct significant actions of the entity. The proposed regulations give examples of an ongoing ability to exercise the following significant rights or powers: (1) the right or power both to approve and to remove a majority of the entity’s governing body; (2) the right or power to elect a majority of the entity’s governing body in periodic elections of reasonable frequency; and (3) the right or power to approve or direct the significant uses of funds or assets of the entity in advance of that use. Further, control must be vested in a state or local governmental unit or electorate established under state or local law, provided the electorate is not a private faction (i.e., the outcome of the exercise of control is determined solely by the votes of an unreasonably small number of private persons). The private faction issue depends on facts and circumstances, but there is a safe harbor that states an electorate is not a private faction if the smallest number of private persons who can combine votes to establish a majority of votes necessary to determine the relevant exercise of control is more than 10 persons. For example, if there is an electorate of 20 with equal 5 percent share of votes, there is not a private faction because a minimum of 11 members is necessary to have a majority of votes. In contrast, if the electorate consists of 20 persons with unequal voting shares, the electorate would not qualify for safe harbor treatment because some combination of 10 or fewer can exercise control.
The regulations have an effective date of 90 days after they are finalized. There is a hearing set for June 6, 2016.
For more information on private foundations and grantmaking, see our prior post here.