Expenditure responsibility

What Is Expenditure Responsibility?

Expenditure responsibility is a federally mandated set of procedures that U.S. private foundations and certain other grantmaking entities, such as donor-advised funds, must follow when making grants to organizations that are not recognized as public charities by the Internal Revenue Service (IRS). Within the broader field of philanthropy and nonprofit finance, this framework ensures that funds distributed are used exclusively for charitable purposes and not diverted for private benefit or non-exempt activities. It acts as a critical oversight mechanism, compelling grantors to exert "reasonable efforts" and establish "adequate procedures" to monitor how grant funds are spent³³, ³⁴. The goal of expenditure responsibility is to prevent "taxable expenditures," which are grants or amounts paid by a private foundation for non-charitable purposes, or without proper oversight, and can incur excise tax penalties³¹, ³².

History and Origin

The concept of expenditure responsibility emerged from the Tax Reform Act of 1969, a landmark legislative change that significantly reshaped the regulatory landscape for charitable organizations in the United States. Prior to this act, the distinction between public charities and private foundations was less defined, and concerns arose regarding potential abuses by private foundations, including their use to shield assets from taxation or serve private interests³⁰. Congress introduced a new framework, imposing stricter duties and obligations on private foundations. Specifically, the 1969 Act addressed issues where private foundations made grants without sufficient conditions or controls to ensure the money served charitable purposes. The legislative intent was to ensure accountability for funds disbursed, particularly after incidents such as certain grants raising scrutiny from congressional committees²⁹. The Pension Protection Act of 2006 further expanded the application of expenditure responsibility to certain grants made from donor-advised funds, underscoring its continued importance in charitable oversight²⁷, ²⁸.

Key Takeaways

• Expenditure responsibility is a regulatory requirement for private foundations making grants to non-public charities.
• It necessitates specific due diligence steps, a formal grant agreement, regular financial reporting by the grantee, and proper reporting to the IRS.
• The primary aim is to ensure grant funds are used solely for charitable purposes, preventing "taxable expenditures" and associated penalties.
• Compliance allows private foundations to broaden their grantmaking reach while maintaining adherence to federal tax laws.
• Failure to exercise expenditure responsibility can result in excise tax penalties for the foundation and its managers.

Interpreting Expenditure Responsibility

Expenditure responsibility is not a calculation but rather a procedural requirement that ensures accountability in grantmaking. Interpreting expenditure responsibility means understanding and implementing a series of steps designed to provide oversight. The IRS outlines key elements, including a pre-grant inquiry into the potential grantee's ability to carry out the charitable project, a written grant agreement, and obtaining detailed financial reporting from the grantee²⁵, ²⁶. The grantor, typically a private foundation, must assess if these steps provide adequate assurance that the funds will be used for the agreed-upon charitable purposes. This ongoing oversight distinguishes it from a one-time transaction; it requires a continuous relationship and monitoring until the grant funds are fully expended and reported.

Hypothetical Example

Consider the "Generous Heart Foundation," a U.S. private foundation, that wishes to provide a $100,000 grant to "Innovate Global," an international non-governmental organization (NGO) that is not recognized as a public charity under U.S. tax law. Since Innovate Global is not a U.S. public charity, Generous Heart Foundation must exercise expenditure responsibility.

Here’s how they would proceed:

1. Pre-Grant Inquiry: Generous Heart Foundation conducts a thorough due diligence inquiry into Innovate Global. This involves reviewing Innovate Global's organizational structure, financial statements, and past project successes to reasonably determine that it can effectively use the $100,000 for the stated charitable purposes, such as a literacy program in a developing country.
   ²⁴2. Written Grant Agreement: A formal grant agreement is drafted and signed by both parties. This agreement specifically details that the $100,000 is to be used exclusively for the literacy program, prohibits its use for political activities, requires Innovate Global to repay any unused or misspent funds, and mandates regular financial reporting on the use of the grant funds.
   ²³3. Grantee Reporting: Innovate Global agrees to submit annual reports detailing how the $100,000 was spent, providing receipts, and outlining the progress of the literacy program. These reports are submitted to Generous Heart Foundation.
   ²¹, ²²4. Reporting to IRS: Generous Heart Foundation then reports this expenditure responsibility grant on its annual IRS Form 990-PF, including information about the grant amount, purpose, and the status of the funds, as long as grantee reporting is required.
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   By following these steps, Generous Heart Foundation ensures that its grant to Innovate Global is a qualified charitable distribution, avoiding potential taxable expenditures and excise tax penalties.

Practical Applications

Expenditure responsibility is primarily applied in the context of philanthropy and nonprofit organizations, ensuring regulatory compliance and safeguarding charitable assets. Private foundations regularly use expenditure responsibility when making grants to a diverse range of entities that do not hold public charity status. This includes, but is not limited to, grants to other private foundations, certain foreign organizations, and even some non-exempt entities or for-profit companies for specific charitable projects. ¹⁸, ¹⁹For instance, a private foundation might make a grant to a foreign non-governmental organization (NGO) to fund a humanitarian project abroad, requiring the foreign NGO to adhere to expenditure responsibility guidelines for proper oversight. ¹⁷It is also crucial for community foundations managing donor-advised funds, particularly when grants from these funds are directed towards organizations that do not qualify as public charities. ¹⁶The framework ensures that the grantmaking process maintains integrity and that funds ultimately serve their intended charitable purposes, aligning with the stringent oversight required by the IRS.
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Limitations and Criticisms

While essential for regulatory compliance, expenditure responsibility does present certain limitations and can draw criticism for its administrative burden. The process requires significant due diligence from the grantor, including a pre-grant inquiry, the creation of a detailed grant agreement, and ongoing financial reporting and monitoring. ¹⁴This can be particularly challenging for smaller private foundations with limited administrative staff or for those making numerous smaller grants. Critics sometimes argue that the stringent requirements can deter foundations from funding innovative or nascent organizations that may not yet have robust financial reporting systems, even if they have strong charitable potential. Additionally, ensuring compliance, especially with international grantees, can involve complex legal and accounting considerations. Failure to properly implement expenditure responsibility can lead to severe consequences, including excise tax penalties on the foundation and its managers if a grant is deemed a "taxable expenditure". ¹², ¹³Despite these challenges, the framework is a fundamental component of U.S. tax law, designed to uphold the integrity of the charitable sector.

Expenditure Responsibility vs. Equivalency Determination

Expenditure responsibility and equivalency determination are two distinct methods U.S. private foundations use to ensure their grants to non-public charities comply with IRS regulations. The primary difference lies in who bears the burden of proving the charitable status and how that status is established for the grantee.

Expenditure Responsibility places the burden of oversight directly on the grantor, typically the private foundation. The foundation must undertake proactive steps, including a pre-grant inquiry, a written grant agreement, obtaining regular financial reports from the grantee, and reporting these details to the IRS. ¹⁰, ¹¹This process focuses on ensuring the specific grant funds are used for charitable purposes, even if the grantee itself is not a U.S. public charity.
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In contrast, Equivalency Determination is a process where the grantor (or a third-party expert) assesses whether a foreign organization is equivalent to a U.S. public charity under IRS rules. If determined to be equivalent, the grant is treated as if it were made to a U.S. public charity, and the ongoing monitoring requirements of expenditure responsibility are generally not necessary. ⁷, ⁸This method focuses on the status of the grantee organization itself, rather than the specific expenditure of the grant. Confusion can arise because both aim to validate the charitable nature of a grant, but they do so through different legal and administrative pathways, with expenditure responsibility often being the default or simpler option for non-public charities.

FAQs

What is the main purpose of expenditure responsibility?

The main purpose of expenditure responsibility is to ensure that grants made by private foundations to organizations not recognized as U.S. public charities are used exclusively for charitable purposes, thereby preventing "taxable expenditures" and avoiding IRS penalties.

Which organizations must exercise expenditure responsibility?

U.S. private foundations are typically required to exercise expenditure responsibility when making grants to organizations that are not public charities, such as other private foundations, foreign organizations, or non-exempt entities receiving grants for charitable projects. ⁵, ⁶Some donor-advised funds also have this requirement.

What are the key steps involved in expenditure responsibility?

The core steps include conducting a pre-grant inquiry into the grantee, establishing a written grant agreement with specific terms, requiring and obtaining regular financial reporting from the grantee on the use of funds, and reporting the grant to the IRS on Form 990-PF.
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Can a private foundation make a grant to a for-profit company?

Yes, a private foundation can make a grant to a for-profit company, but it must exercise expenditure responsibility to ensure the funds are used solely for charitable purposes and not for the company's private benefit or commercial activities.
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What happens if a foundation fails to follow expenditure responsibility rules?

Failure to properly exercise expenditure responsibility can result in the grant being classified as a "taxable expenditure," leading to excise tax penalties imposed on the private foundation and potentially on its managers who approved the non-compliant grant.¹