Shortcomings in U.S. federal tax regulatory regime of private foundations: insights for Australia.

Author:Crimm, Nina J.
 
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ABSTRACT

This Article addresses the need for a more comprehensive regulatory scheme of Australia's nonprofit organizations, particularly its private foundation type structures. By considering the strengths, and more importantly, the weaknesses of the U.S. tax regime of private foundations, Australia can avoid pitfalls that accompany the development of Australia's laws and regulations. The Article begins by exploring the history, nature, and culture of Australia's nonprofit sector. After outlining the structure of the sector, the Article focuses on the potential for abuses if prescribed private funds are not given appropriate attention to avoid such abuses. Then, the Author details the U.S. nonprofit sector by looking briefly at the history and development of U.S. private foundations, as well as actual and perceived improprieties perpetrated throughout the regime by private individuals, nonprofit organizations, and Congress. Finally, the Article applies lessons learned from the U.S. regime to Australia. The Article concludes by discussing the need for effective regulation strategy for Australia's nonprofit sector. Such strategy, according to the Author, is essential to protect the tax base and to guard against major improprieties and scandals.

  1. INTRODUCTION

    A successful innovation is usually the outcome of an evolutionary process that depends on ideas that in large part result from collected and evolved knowledge. During the development of the innovation, missteps may be taken and intermittent failures may occur. Viewing new legislation and regulations as innovations, their final governance successes depend initially on the breadth and depth of the knowledge base brought to their drafting. Ultimately, politics, economics, and enforcement capabilities play a role in their effectiveness and successes. If one focuses on the knowledge base that drafters of legislation and regulations can bring to the table, that knowledge base can be enhanced by an understanding of the strengths and weaknesses of relevant statutes and regulations of other countries. The most effective knowledge base understands those strengths and shortcomings in the contexts of the development and the application of the pertinent comparative laws and regulations, the financial and political environments in which the regulatory regime was developed and operates, and the similarities and differences inherent in the cultures of the countries.

    The time is ripe for consideration of a more comprehensive regulatory regime of Australia's nonprofit organizations, and particularly of its private foundation-type structures. For the most part, Australia's nonprofit sector currently enjoys the positive and important societal "halo" perception that its charitable organizations are "providers of good," "trustworthy institutions," "altruistic, compassionate, or caring in nature," "benevolent," and "beyond reproach." (1) This perception helps to engender viable and thriving institutions. Retention of the halo should be a priority of nonprofit organizations and the sector. The halo effect plays an important role in fundraising strategy, as its existence and the concepts on which it is based stimulate donors to financially contribute to nonprofit organizations. (2) The halo effect also increases the demand of beneficiaries for nonprofit institutions perceived as able to provide trusted services. (3) As one Australian scholar has stated: (4)

    The importance of the halo can be appreciated by the consequences of its destruction. Loss of trust means that the ability of the nonprofit entity to attract donors is vastly reduced and may even result in the death of the entity. Examples abound of such charities whose trustworthiness has been questioned resulting in dire financial consequences. (5) Protecting the halo becomes more difficult as Australia's nonprofit sector and its philanthropic vehicles expand in numbers and dimension. Opportunities increase for wrongdoing to occur, such as tax abuse or fiduciary breaches. As nonprofit organizations' decision-makers are well aware, negative publicity of one or more improprieties may taint or even destroy the halo perception enjoyed by the individual nonprofit institutions, or indeed more global]y, by the nonprofit sector. To reduce the possibility of a blemished image, decision-makers within the nonprofit sector and the Australian Tax Office (A.T.O.), as well as legislators, should have an effective knowledge base permitting reassessment and perhaps reformation of Australia's tax regulatory regime for the nonprofit sector.

    Australia's nonprofit sector dates back to the beginning of the country's colonial settlement, (6) and its tax regulation of the sector dates back to the late-1800s. (7) Nonetheless, its nonprofit sector, its nonprofit institutions, and its tax regulatory regime currently appear to be developmentally in infancy stages. For example, perhaps because the formation of private foundations in Australia has not been tax driven until relatively recently, the number of such institutions is limited. Although Australia provided a tax incentive to support the creation of nonprofit institutions, through state gift and inheritance tax relief for charitable giving, the gift and inheritance tax provisions were abolished in the 1980s. It was not until 1999 that the Australian federal government enacted tax deductions and tax exemptions as incentives that would directly encourage the creation of nonprofit institutions similar to U.S. private foundations. (8)

    Prior to July 1, 1999, the Australian structure sanctioned by its federal tax statutes closest to--but not the same as--the U.S. private foundation was the "ancillary fund." Australia's ancillary fund is a public fund (9) that must operate on a nonprofit basis and must seek public donations. It must be established under a will or trust deed solely for the purpose of providing grants to establish or benefit other deductible gift recipients. It must be controlled by persons accountable to the community and not associated with the founder of the ancillary fund. An ancillary fund is a type of investment vehicle that can invest its funds only as permitted under Australian law, but cannot carry on any other activities. The ancillary fund is not statutorily required to disburse a set percentage of income each year.

    As of July 1, 1999, individuals, families, and corporations can give an income tax deductible gift of assets to a "prescribed private fund" without seeking broad public financial support. (10) Otherwise, the requirements applicable to public funds must be satisfied. (11) As with public funds, founding documents must provide that the controlling body of the fund must have at least one "responsible person," a person who has general responsibility to the community and not associated with the fund's settlor or donor in any capacity other than professional. (12) The documents must prohibit direct or indirect benefit to the settlor or donor or any associate of that person. (13) A trust fund to retain the assets of the prescribed private fund must be established, and a nondistribution constraint is imposed on the trust fund. (14) In other words, there is an absolute prohibition against any part of the trust fund being paid, transferred, or distributed, by bonus, fee, or otherwise, to the trustee, any member, director, or person who would be considered a related party to a transaction. The prescribed private fund is not required to distribute a particular percentage of its assets annually to further its tax-exempt public purpose.

    The U.S. nonprofit sector, which dates back to the early 1700s, (15) is composed of many types of nonprofit institutions. The largest group is its [section] 501(c)(3) organizations, which consist of both public charities and private foundations. A private foundation, as defined in Internal Revenue Code (I.R.C.) [section] 509, is not financially supported by a broad public--as is a public charity--but rather is supported by one--individual, family, or corporation--or few sources. (16) For donations to be tax deductible to a private foundation and for the private foundation to be tax-exempt from federal income taxes, it must comply with the statutory requirements of I.R.C. [section] 501(c)(3). It must be organized and operated exclusively for "religious, charitable, scientific ... or educational purposes...." (17) No part of its earnings can inure to the benefit of a private individual. (18) Substantial lobbying activities and campaign activities to support or oppose a candidate for public office are prohibited. (19) A private foundation also must comport with the judicially developed public policy doctrine. (20) Additional]y, special rules attempt to ensure that a private foundation's, funds are utilized for charitable-type public purposes rather than merely retained by the foundation. Those rules require a private foundation to distribute annually for its tax-exempt purposes at least five percent of the fair market value of its assets--as reduced by debt used to acquire its assets. (21) U.S. private foundations' funding, governance, and management are intimate and private, often controlled by their founders. Nonetheless, the foundations must pursue public benefits. (22) The Internal Revenue Service (I.R.S.) is responsible for monitoring all tax-exempt organizations, (23) including private foundations, to assure they continue to deserve the tax privileges of exemption from income taxation and of recipients of deductible charitable contributions.

    For many years, U.S. private foundations were largely self-regulating. Over time, in an effort to curb the perceived and actual abuses permitted by an under-regulated environment, (24) Congress created a federal tax regulatory regime applicable specifically to private foundations. (25) The process was arduous, time-consuming, and often contentious. The process was riddled with various types of...

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