Dramatic fluctuations in the stock market over the past few years have created numerous problems for charitable foundations, often resulting in reductions in both operating and program budgets. Grant-making foundations may find themselves facing difficulties in meeting their outstanding grant obligations. Internal Revenue Code Section 4942 requires a private foundation to annually distribute an amount equal to roughly 5% of its investment assets. This 5% figure is generally based on the value of the foundation’s assets during the prior taxable year. A stock market “collapse” can make it difficult for a foundation to meet its IRS-imposed distribution obligation because the value of the assets in the year of actual distribution may be significantly less than the value of the foundation’s assets at the time the prior year’s 5% computation was made.
For example, assume that a calendar year foundation’s investment assets for 2010 totaled $2 million.1 By December 31, 2011, the foundation must make “qualifying distributions” of at least $100,000. If in 2011, the stock market suffers a significant decline, then the foundation must still distribute the full $100,000 to avoid penalties despite the reduced asset base. This may create hardships for the foundation, including a need to liquidate assets at reduced prices in order to raise necessary cash to meet the distribution obligation.
A particular problem may exist in situations where a foundation made a multi-year pledge at a time when the foundation’s asset base was significantly higher. A drop in asset valuation can make it difficult to meet subsequent year installments on the pledge. The foundation may find itself in the embarrassing position where it cannot meet the current installment of the multi-year pledge, from either an economic or liquidity standpoint.
Alternatives open to such a depleted foundation may not be particularly attractive. One approach would involve restructuring a pledge to a charitable organization, by either delaying or reducing the gift or extending the period of payment.2 This approach would involve discussions with the charitable organization, which may or may not be receptive, and that would inevitably involve some degree of reputational risk for the foundation.
Second, and obviously a less desirable approach, at least with respect to multi-year pledges, would be to simply default on these remaining payments. The law varies between states on the enforceability of charitable pledges. In jurisdictions where charitable pledges have been held to be unenforceable, typically because of the lack of consideration, it is less likely that the recipient would be in a position to seek court or attorney general enforcement of the unpaid pledge. However, even in jurisdictions that do not provide for legal enforcement of charitable pledges, there is a risk that a court would seek to enforce a pledge when the recipient charity has changed its position to its detriment in reliance on the pledge. For example, in situations where: (i) a recipient charity has raised additional funds from other donors in reliance on the foundation’s pledge; (ii) based on the pledge, the recipient has undertaken legal obligations or incurred debt for a project or, in the worst case, commenced construction; (iii) the grantee established an operating program such as a scholarship fund; or (iv) the donee publicized the donor’s gift, a court might be more likely to grant equitable relief and seek to enforce a gift.3
One tool for avoiding these difficult results in times of market decline is for a foundation to establish a lending relationship with a third-party financial institution.4 This would enable the foundation to draw down on its loan to meet grant obligations without having to engage in a “fire sale” of its investment portfolio thereby avoiding embarrassing conversations with donees. This lending arrangement could be established as a “line of credit” whereby a lender provides a credit source to a foundation that can be drawn upon by the borrower as needs arise. Under a typical line of credit, a borrower foundation is permitted to request a loan advance at any time, paying interest as established in the line of credit documents only on the amounts advanced, along with other lender fees. This type of lending arrangement or any similar arrangement is a valuable aid to a foundation in dealing with market fluctuations and associated cash flow shortfalls.
A question arises how to treat loan proceeds utilized in funding charitable distributions for purposes of meeting a foundation’s “qualifying distribution” requirement under Internal Revenue Code Section 4942. For purposes of Section 4942, a qualifying distribution is defined as including any amount (including that portion of reasonable and necessary administrative expenses) paid to accomplish charitable purposes, and amounts expended to acquire an asset used (or held for use) directly in carrying out charitable purposes.5 In effect, qualifying distributions include grants by a foundation to public charities and direct foundation expenditures in the performance of charitable activity.
At issue when utilizing loan proceeds to fulfill charitable grants, is whether the loan itself should be treated as a qualifying distribution at the time the loan is incurred or whether the loan proceeds should be counted, if at all, at the time they are actually paid out for charitable purposes. The Treasury Regulations provide specific guidance on the qualifying distribution treatment afforded to the use of borrowed funds. As a general rule, when a private foundation borrows money to be used in performance of charitable purposes, the foundation’s actual distribution of the funds for exempt purposes will be deemed a qualifying distribution. By contrast, the later repayment of such borrowed funds to the lender is not deemed a qualifying distribution. Treas. Reg.
§ 4942(a)-3(a)(4)(i) states that,
… if a private foundation borrows money in a particular taxable year, to make expenditures for a specific charitable, educational, or other similar purpose, a qualifying distribution out of such borrowed funds will, except as otherwise provided in subdivision (ii) of the subparagraph [dealing with certain amounts borrowed before 1970], be deemed to have been made only at the time such borrowed funds are actually distributed for such exempt purpose.
The reference in the above-cited regulation to borrowings for a “specific charitable, educational, or other similar purpose” is a bit confusing in that this regulation might be read as providing that a general line of credit would not satisfy this requirement. This would not seem to be the intent of this regulation as Code Section 4942(g)(1) treats as qualifying distributions any amount paid to accomplish charitable purposes, without reference to source. More notable, is the proviso in this regulation that the distribution be treated as part of the 5% calculation only at the time such borrowed funds are actually distributed, rather than at the time the loan is taken or repaid. In other words, the foundation cannot count the entire loan amount as a qualifying distribution at the time the loan is taken out nor may it count the loan a second time for Section 4942 purposes at the time of repayment.
An issue left unresolved by the regulations, is whether interest repayments on a loan or line of credit can be treated as qualifying distributions. Treas. Reg. § 53.4942(a)-(3)(a)(4)(iii) provides that any payment of interest with respect to a loan shall be treated as a deduction for purposes of computing a foundation’s “adjusted net income” (which held historic relevance in determining a foundation’s distributable amount and current relevance for private operating foundations) in the taxable year in which it is made. It is unclear whether this regulation dealing with the deductibility of interest payments could also be read as an indication that payments of loan interest should be treated as qualifying distributions, perhaps as an administrative expense, in the year paid. One might argue that interest on the loan is part of the charitable distribution; although a more conservative view might conclude that loan interest is not paid to a charitable donee and does not directly accomplish charitable ends. This is an issue left unresolved by the Internal Revenue Service.
In any event, borrowings should not have an impact on the foundation’s 2% tax on net investment income under Code Section 4940. The tax on net investment is based on gross investment income and capital gain net income. Gross investment income generally includes interest, dividends, rents and royalties, but not loan amounts.6
It should be kept in mind that the use of a line of credit or other borrowings may ultimately present an additional cash flow issue for a foundation. This is because the borrowed amounts are treated as qualifying distributions when expended, but not when repaid. For example, say Foundation X borrows $100,000 from a bank in 2010 and distributes those borrowed funds to public charities, thereby meeting its distribution requirement for 2010. However, when the loan is repaid, the repayment of that loan will not count as a qualifying distribution. Thus, in the year the loan is repaid, Foundation X must meet both its distribution requirement for that year without being able to count its loan repayment as part of its distribution obligation. If Foundation X has a distribution requirement for 2012 equal to $150,000 and must repay its outstanding loan principal in that year, it will wind up expending $250,000 that year ($100,000 in repayment of its loan from the bank, as well as an additional $150,000 in qualifying distributions to satisfy its distribution requirement).
When using a line of credit, careful attention must be paid to the terms of the borrowings. Although lines of credit may be either secured or unsecured, it is possible that the lender will require and will seek some form of security interest in the borrowing foundation’s investment accounts. In addition, the lender may require that the foundation maintain a certain level of assets in its account, and the lender may go so far as to exercise some discretion over the types of assets that may be maintained by the foundation in its securities account. The lender is likely to require records of payments made from the secured account in order to protect its loan. It is also possible that the lender will require personal guarantees from representatives of the foundation, typically, members of the family.
Use of borrowings can be an effective means for a foundation to manage cash flow and avoid difficult situations in times of declining markets. At the same time, careful attention must be paid to the terms and requirements of the loan and management of repayments, so that coupled with continuing grant-making obligations, the line of credit does not create a more difficult cash drain on the foundation.
1 Internal Revenue Code Section 4942 and the regulations issued thereunder include a detailed set of rules on valuing a foundation’s assets for this purpose. See Treas. Reg. § 53.4942(a)-2(c)(4).
2 See Banjo “When Donors Can’t Keep Their Pledges,” Wall Street Journal, January 27, 2009.
3 See In Re Lipsky’s Estate, 256 N.Y.S.2d 429 (1965) for a good discussion of the enforceability of charitable pledges.
4 Care must be taken that the lending institution not be deemed a “disqualified person” under Internal Revenue Code Section 4946 so as to avoid a finding of self-dealing under Code Section 4941(d)(1)(B).
5 See § 4942(g)(1).
6 Internal Revenue Service Code Section 4940(c).
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Originally published in Family Foundation Advisor, © 2010 by Civic Research Institute, Inc., and reprinted here with permission of the publisher. All rights reserved. Family Foundation Advisor is a bimonthly report letter for foundation officers and their professionals advisors devoted to sound management practices and current legal developments for family managed foundations. For subscription information, write Civic Research Institute, 4478 U.S. Route 27, P.O. Box 585, Kingston, NJ 08528 or call 609-683-4450, or visit www.civicresearchinstitute.com