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Also, the capital gains and losses to be taken into account are only those on capital assets used to produce income subject to this tax or used to produce unrelated business income (except to the extent such gains and losses are used to compute the tax on unrelated business income.)

Effective date.-This provision applies to taxable years beginning after December 31, 1969.

Revenue effect.-The revenue increases under these amendments are estimated at $65 million in the first year, $85 million in the fifth year and $100 million in the 10th year of operation.

2. Prohibitions on self-dealing (sec. 101 (b) of the bill and new sec. 4941 of the code)

Present law.-Section 501 (c) (3) of the code and its predecessors impose upon every "(c) (3)" organization the requirement that "no part of the net earnings of [the organization] inures to the benefit of any private shareholders or individual

The 1950 amendments to the exempt organizations provisions (now sec. 503 of the code), set forth specifically a number of prohibited types of self-dealing transactions which apply generally to what we now call "private foundations" in it. Arms-length standards are imposed with regard to loans, payment of compensation, preferential availability of services, substantial purchases or sales, and substantial diversions of income or corpus to (or from, as the case may be) creators and substantial donors and their families and controlled corporations.

The only sanctions provided are loss of exemption for a minimum of 1 taxable year, and loss of charitable contributions deductions under certain circumstances.

General reasons for change. Arm's-length standards have proved to require disproportionately great enforcement efforts, resulting in spo

radic and uncertain effectiveness of the provisions. On occasion the sanctions are ineffective and tend to discourage the expenditure of enforcement effort. On the other hand, in many other cases the sanctions are so great in comparison to the offense involved as to create reluctance in enforcement, especially in view of the element of subjectivity in applying arm's-length standards. Where the Internal Revenue Service does not seek to apply sanctions in such circumstances, the same factors encourage extensive litigation and sometimes reluctance by the courts to uphold severe sanctions.

Therefore, as a practical matter, current law frequently has not preserved the integrity of private foundations, even where the terms of the law apply. Also, your committee has concluded that even arm's-length standards often permit use of a private foundation to improperly benefit those who control the foundation. This is true, for example, where a foundation (1) purchases property from a substan- [21] tial donor at a fair price, but does so in order to provide funds to the donor who needs access to cash and cannot find a ready customer; (2) lends money to the donor with adequate security and at a reasonable rate of interest, but at a time when the money market is too tight for the donor readily to find an alternate source of funds; or (3) makes commitments to lease property from the donor at a fair rental when the donor needs such advance leases in or

der to secure financing for construction or acquisition of the property.

In order to minimize the need to apply subjective arm's-length standards, to avoid the temptation to misuse private foundations for noncharitable purposes, to provide a more rational relationship between sanctions and improper acts, and to make it more practical to properly make it more practical to properly enforce the law, your committee has determined to generally prohibit

self-dealing transactions and to provide a variety and graduation of sanctions, as described below.

Explanation of provisions.-The bill removes private foundations from the provisions of section 503 (described above) and, in place of those limitations, prohibits certain acts of self-dealing and provides for a graduated series of sanctions against the self-dealer and a founda. tion manager who willfully engages in them. In the case of willful repeated acts or a willful and flagrant act, the Internal Revenue Service can require the foundation to pay back to the Government all the income, estate, and gift tax benefits (with interest) which the foundation and all its substantial contributors had received since 1913, or else to distribute all its assets to a public charity or for a 60-month period to operate as a public charity itself. Appropriate opportunities for court review are provided. In addition foundation charters are required to prohibit the foundation from engaging in self-dealing acts.

The bill prohibits the following transactions between a private foundation and a disqualified person: (1) sale or exchange, or leasing, of property (except for sales at fair market value of property owned on May 26, 1969, and required to be disposed of under the business holding limitations, described below 1); (2) lending of money or other extension of credit; (3) furnishing of goods, services, or facilities; (4) payments of compensation or expenses by the foundation to a disqualified person; and (5) transfer to or use by a disqualified person, of the foundation's income or assets.

A "disqualified person", for purposes of this provision on self-dealing as well as the provisions (dis

1 Where a foundation is required to dispose of its existing excess stock holdings, the selfdealing rules do not prohibit a direct sale back to the corporation whose stock is excess at fair market value, even though neither the foundation nor the corporation pays a brokerage commission.

cussed below) regarding excess business holdings and mandatory payouts, is a substantial contributor (anyone who has contributed more than $5,000 in any one calendar year or more than any other contributor in any one calendar year), a foundation manager, an individual who owns more than 20 percent of a corporation which is a substantial contributor, a general partner in a partnership which is a substantial contributor, a holder of more than 20 percent of the beneficial interest of a trust or unincorporated enterprise which is a substantial contributor, a member of the family (under the personal holding company and collapsible corporation attri- [22] bution rules) of any such person, or a corporation, partnership, trust, or estate as to which all such persons own in the aggregate more than 35 percent.

A contribution of property is a prohibited act if the foundation assumes a mortgage on the property or takes subject to a mortgage placed on the property by a disqualified person within 10 years before the transfer. A loan or the furnishing of goods, services or facilities to the foundation is permitted if no interest or other charge is imposed and if the loan proceeds or the goods, services, or facilities are used exclusively for certain exempt purposes. The furnishing of goods, services, or facilities by the foundation is permitted if it is not on a basis

more favorable than that available

per

to the general public. Payment by the foundation of compensation and expenses that is not excessive is mitted if the services are reasonable and necessary for the foundation's exempt purposes. Certain transactions regarding corporate stock are permitted if done on a uniform basis at fair market value.

For purposes of the self-dealing provisions, Government officials are

disqualified persons. A Government official is a person who, at the time of the self-dealing act, holds any of

the following offices or positions: elective public office in the executive or legislative branch of the U.S. Government; a Presidentially appointed offfice in the executive or judicial branch of the U.S. Government; a position in any branch of ment; a position in any branch of the U.S. Government under civil schedule C or which is paid at least as much as the lowest "supergrade" (GS-16) salary (at present $25,044 per year), a position under the U.S. House of Representatives at a salary of at least $15,000 per year; an elective or appointive public office in the executive, legislative, or judicial branch of a State or local government, a U.S. possession, or the District of Columbia, at a salary of at least $15,000 per year; or a position as personal or executive assistant or secretary of any of the foregoing.

However, a Government official who is a "special Government employee"-a temporary employee (less than 130 days a year), parttime U.S. commissioner or magistrate, part-time local representative of a Member of Congress in the Member's home district, Reserve or National Guard officer on active

study at educational institutions, and annuity or other payments under certain stock-bonus, pension, and profit-sharing plans. Also permitted are contributions or gifts (other than of money) to, or services or facilities made available to, a Government official, but only if their aggregate value in any one year does not exceed $25, [23] and payments made under the Government employees training program authorized by chapter 32 of title 5, United States Code. These provisions are not to interfere with legitimate activities by private foundations in connection with Government officials, while at the same time they minimize the possibility of improper influencing of the attitude or conduct of such policy-making level officials.

If there has been a prohibited act of self-dealing, then a three-level set of sanctions is to be applied. The first level of sanctions is relatively light. This tax is imposed on the self-dealer at a 5-percent rate on the amount involved in the self-dealing for each year (or part thereof) from the date of the self-dealing until the duty for training or involuntarily self-dealing is corrected (or the

is not a Government official for these purposes2

Acts that constitute self-dealing for other disqualified persons have been modified in several respects with regard to Government officials. Compensation and reimbursement of expenses are prohibited (whether reasonable in amount or not, except that domestic travel expenses may be reimbursed within specified limits). On the other hand certain specified items may be received by a government official: certain nontax

Internal Revenue Service mails a deficiency notice regarding the involved is the greater of the value transaction if sooner). The amount of what the foundation gave or what it received at the time of the self-dealing (in the case of personal services by other than government officials, it is only the excess compensation).

Where this first-level tax

is

imposed, there will also be a tax of 22 percent on the foundation manager, but only if the manager knowable prizes and awards if the recipi-ingly participated in the self-dealents are selected from the general ing. The tax on the manager may public, nontaxable scholarships and fellowship grants to be used for

2 Military officers (other than those des

cribed above) who receive Presidential ap

pointments are Government officials regardless of the amount of their compensation.

not exceed $10,000. In the case of the self-dealer, the tax is to be imposed automatically, without regard to whether the violation was inadvertent. If the self-dealer is a

disqualified person only because he is a government official, then the

tax on self-dealing is imposed only if he knowingly participated in the self-dealing.

The second level of tax applies if the self-dealing is not "undone" or (if undoing is not possible) the foundation is not made whole or given the benefit of the bargain within 90 days after the mailing of the deficiency notice with respect to the first level of tax. At the second level, the tax on the self-dealer is 200 percent of the amount involved. A second-level tax is also imposed on the foundation manager if he refuses to agree to any part of the correction. This tax is at the rate of 50 percent of the amount involved. Again, this tax on the manager may not exceed $10,000. For purposes of this sanction, the amount involved is the highest fair market value of the property during the period within which the transaction may be undone. This provision is intended to impose all market fluctuation risks upon the self-dealer who refuses to comply and to give the foundation the benefit of the best bargain it could have made at any time during the period.

The second-level sanction, imposed only after a notice of deficiency and adequate opportunity for court review and undoing the self-dealing transaction, is intended to be sufficiently heavy to compel voluntary compliance (at least, after court review). Your committee expects application of this sanction to be rare, but where the parties refuse to undo the transaction, it is expected that this sanction will be applied.

A penalty doubling the amount of the first or second level of tax would be imposed in the case of repeated violations, or a willful and flagrant violation.

The 90-day period for the second level of tax is extended to provide an opportunity for court review and could be extended if the Service believes that would be conducive to

correcting the self-dealing. For

example, extensions would be granted if State officials took appropriate equity or other action to correct the self-dealing and preserve the assets for charity.

[24] A third level of tax applies if there have been willful repeated acts or a flagrant and willful act to which the self-dealing rules apply. In such a case, the foundation could be forced to repay (with interest) to the Government all the income, estate, and gift tax benefits received by it and by any substantial contributors since 1913, except that this tax could be abated if the foundation distributed all its assets to one or more "public charities" (in general, charities of the type donations to which are presently eligible for the 30-percent charitable contributions deductions limit) or if the foundation has operated as a public charity for at least 60 consecutive months.

The first- and second-level taxes are treated like income, estate, and gift taxes in the sense that the Internal Revenue Service is required to send deficiency notices to the self-dealer and the founda

tion manager, who then have 90 days to petition the Tax Court. The usual statute of limitations for assessment applies-3 years unless there is a substantial omission of tax on the return filed by the foundation (6-year statute of limitations) or no return has been filed (assessment at any time) .3

The third-level tax is an income tax. As in the case of fraud, it may be assessed at any time. The 90-day period for petitioning the Tax Court and the statute of limitations for assessing and collecting the tax

3 Your committee understands that the exempt organization information return will be revised to have one or more questions on it regarding the first- and second-level taxes, sufficient so it will constitute an excise tax return. This procedure is followed because the first- and second-level taxes are excise taxes, under subtitle D,

and the statute of limitations provisions regarding such taxes depend upon the filing of a return of subtitle D taxes.

are suspended during any extension by the Service of the time for correcting the self-dealing.

Refund suits for first- or second level taxes may be brought in the Court of Claims or in a district court (but only if there has been no prior court review of the prohibited act). Also, any refund suit will be treated as disposing of all issues relating to any first or second-level tax arising out of that prohibited act. An opportunity is provided for one court review of a self-dealing transaction, but no more than one review.

To limit opportunities for improper self-dealing, and to facilitate appropriate action by State officials to supervise private foundations, the bill requires, as a condition of tax exemption, that the foundation's governing instrument prohibit it from engaging in self-dealing. Existing organizations are given until 1972 to modify their governing instruments or longer if the court proceedings to modify the instru ments have not been able to be completed by December 31, 1971.

Effective date.-The self-dealing provisions apply to taxable years beginning after December 31, 1969; however, they do not apply to (1) transactions pursuant to the terms of certain securities (such as callable preferred stock) acquired by the foundation before May 27, 1969, (2) required dispositions, at fair market value or better, of property held by the foundation on May 26, 1969, and (3) use of property in which the foundation and a disqualified person have joint interests, but only if both parties acquired their interests before May 27, 1969.

[25] 3. Distributions of income

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amount or duration in order to carry out the charitable, educational, or other purpose or function constituting the basis for exemption under section 501 (a) of an organization described in section 501 (c) (3)."

General reasons for change.-Under present law, if a private foundation invests in assets that produce no current income, then it need make no distributions for charitable purposes. As a result, while the donor may receive substantial tax benefits from his contribution currently, charity may receive absolutely no current benefit. In other cases even though income is produced by the assets contributed to charitable organizations, distributions may not be required. In such circumstances, no current distribution is required until the accumulations become "unreasonable." Although a number of court cases have begun to set guidelines as to the circumstances under which an accumulation becomes unreasonable, in many cases the determination is essentially subjective. More over, as is the case with self-dealing, it frequently happens that the only available sanction (loss of exempt status) either is largely ineffective or else is unduly harsh.

Your committee has concluded that substantial improvement in the present situation can be achieved by providing sanctions if income is not distributed currently. A graduation of sanctions, designed to produce current benefits to charity, is provided.

Explanation of provisions.-The bill provides that to avoid tax private foundations must distribute all income currently (but not less than 5 percent of investment assets), and imposes graduated sanctions in the event of failure to distribute. Provisions are made to extend the time within which the distributions must

4 The bill also repeals section 504 since with the change referred to above this is no longer needed.

be made in certain circumstances and to allow a carry-forward of "excess" distributions.

Under the bill, to avoid tax a private foundation must distribute currently all of its net income (including the excess of exempt interest over the expenses of earning the interest), other than net long-term capital gains. To prevent avoidance of the "current-benefits-to-charity" purpose of this provision by investments in growth stock or nonproductive land, the bill requires a foundation to pay out at least a specified percentage of its average noncharitable assets. The minimum payout is set at 5 percent for 1970 and the Secretary or his delegate is authorized to adjust this rate prospectively from time to time based upon money rates and investment yields as they compare to the rates and yields for 1969.

Assets used directly for the foundation's exempt purposes are not to be included in the base upon which the 5-percent (or other rate) is to apply. Assets which can be easily valued will be valued on a monthly basis. Other assets will be values as frequently as may be appropriate. The base upon which the 5-percent (or other rate) is to apply is the average value of the noncharitable assets during the taxable year. [26] For the purpose of this mandatory payout requirement, qualifying distributions include distributions to "public charities" and to private operating foundations, direct expenditures for charitable purposes, and expenditures for assets to be used for charitable purposes. A contribution to another private foundation is not forbidden, private foundation is not forbidden, but (except in the case of a contribution to a private operating foundation) it may be made only in addition to qualified distributions that meet the minimum payout requirement. Essentially the same rules apply as to foreign expenditures; that is, a payment does not qualify if made to a foreign organi

zation which would be a private foundation under our law if it were a domestic organization. This rule is intended to prevent several foundations from distributing their income to each other without the income being used for charitable purposes.

These distribution requirements do not apply to a private operating foundation and, as indicated above, a private operating foundation is a qualified recipient of such distributions. A private operating foundation is defined as an organization substantially all of the income (at least 85 percent) of which is spent directly for the charitable purposes for which it was organized and either (a) substantially more than half the assets (at least 65 percent) of which are devoted directly to such activities or to functionally related activities, or (b) the foundation derives its support from at least five independent exempt organizations or the general public and not more than 25 percent of these distributions are received from any one exempt organization. The latter alternative has been added because it has come to the attention of your committee that a number of charitable foundations are regularly used by many private foundations to funnel charitable contributions into certain areas. The operating foundations, in such circumstances, have developed an expertise which permits them to make effective use of the money through grant programs or otherwise.

Under the bill, payouts must be made in the year in which the money is received or in the next year, except to the extent that the foundation is permitted to set aside funds for periods of up to 5 years for certain major projects. Any such set-asides must be approved in advance by the Internal Revenue Service. The Service may extend the 5-year period if good cause is shown. This exception is intended to apply to those situations where relatively long term grants must be

made in order to assure continuity of particular charitable projects or where the grants are made as part of a matching grant program. This exception will not apply unless it is established that the amount set aside will in fact be paid out for the specific project within 5 years. It is expected that such set-asides will be approved where the State attorney general undertakes appropriate action to insure that the funds will be timely and charitably distributed.

A further exception is provided where a private foundation spends more than the minimum required payout in a given year. Such excess expenditures may be applied against required payouts in the next 5 years.

Failure to comply with the minimum payout requirements will result in sanctions against the foundation. The first level of sanction is a tax of 15 percent of the amount that should have been, but was not, paid out. This tax is imposed for each year until the private [27] foundation is notified of its obligation or until the foundation itself corrects its earlier failure by making the necessary payouts.

As is the case with self-dealing, within 90 days after notification by the Internal Revenue Service the foundation must correct its failure to make the appropriate charitable distributions. This 90-day period is extended as described above, under the self-dealing provision. If the necessary distributions are not made within the appropriate period, the second level of sanctions is imposed

-a tax of 100 percent of the amount required to be paid out.

Provisions regarding penalties for repeated or flagrant violations, court review, the third level of sanctions, and the governing instrument are the same as those described under self-dealing.

Effective date. The payout requirements apply to taxable years

beginning after December 31, 1969. However, in the case of an existing organization, the minimum payout (the 5-percent rule described above) will not apply until taxable years beginning after December 31, 1971. The payout requirements will not apply to the extent that the foundation's existing governing instrument requires income to be accumulated, provided that this requirement would not have caused the organization to lose its exempt status under present law. This exemption, too, will continue after 1971 only to the extent necessary to expeditiously complete court proceedings to reform the organization's governing instrument.

4. Stock ownership limitation (sec. 101 (b) of the bill and new sec. 4943 of the code)

Present law.-Present law does not deal directly with the subject of foundation ownership of business interests, although some cases have held that business involvement can become so great as to result in loss of exempt status.

General reasons for change.-The use of foundations to maintain control of businesses, particularly small increasing. It is unclear under presfamily corporations, appears to be ent law at what point such noncharitable purposes become sufficiently great to disqualify the foundation from exempt status. Moreover (as indicated above under self-dealing), the sanction under present law is apt to be too harsh.

Those who wish to use a foundation's stock holdings to retain business control in some cases are relatively unconcerned about producing income to be used by the foundation for charitable purposes. Even when the foundation attains a degree of independence from its major donor, there is a temptation for the foundation's managers to divert their interest to the maintenance and improvement of the business and away from their charitable duties. Where

the charitable purposes predominate, the business may be run in a way which unfairly competes with other businesses whose owners must pay taxes on the income that they derive from the businesses. To deal with these problems, your committee has concluded it is desirable to limit the extent to which a business may be controlled by a private foundation.

Explanation of provisions.-The bill limits to 20 percent the combined ownership of a corporation's voting stock which may be held by a foundation and all disqualified persons. If someone else can be shown to have control of the business, the 20-percent limit is raised [28] to 35 percent. Existing excess holdings must be disposed of within 10 years; excess holdings acquired by gift or bequest in the future generally must be disposed of within 5 years. Exceptions are provided in the case of related businesses, and a series of graduated sanctions are provided.

Under the bill, a foundation and all disqualified persons together may not hold more than 20 percent of the voting stock of a corporation. If more is held, then the foundation must reduce its holdings to the extent necessary to bring the combined holdings down to 20 percent. If more than 20 percent of the combined voting stock is held by disqualified persons, then the foundation must dispose of its nonvoting stock as well as its voting stock. The 20-percent limit, however, may be increased to 35 percent if it can be demonstrated that an unrelated party has effective control over the corporation.

Your committee has used only

5 A de minimis rule permits the founda tion to retain not more than 2 percent of the voting stock, notwithstanding this limitation, but the holdings of related private foundations are aggregated for the purpose of this exception. This is done to avoid the use of "multiple foundations" to convert the de minimis rule into a method of evading the basic rule of this provision.

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