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With the rise of the commercial donor-advised funds (DAFs) during the past decade, traditional community foundations (CFs) have sought to remain relevant by offering extra services to local donors and charitable organizations. A recent private letter ruling sets the parameters for what services CFs can offer to local private foundations for a fee -- without incurring unrelated business income tax. In PLR 200832027, issued Aug 8, 2008, a CF sought to provide, for a fee, a broad menu of back office services to private foundations located in the same locality, including help with grant making, grant administration and general clerical work. The ruling was requested by a CF. Like most CFs, CF's primary purpose is to support charitable activities benefiting its community through grant-making activities within its region. CF leaders may believe that they need to offer a wide array of services to compete effectively for charitable dollars that might otherwise pass into commercial DAFs or private foundations.

Copyright Penton Media, INC. Oct 2008

With the rise of the commercial donoradvised funds (DAFs) during the past decade, traditional community foundations have sought to remain relevant by offering extra services to local donors and charitable organizations. A recent private letter ruling sets the parameters for what services community foundations can offer to local private foundations for a fee-without incurring unrelated business income tax (UBIT).

In PLR 200832027, issued Aug. 8, 2008, a community foundation sought to provide, for a fee, a broad menu of back office services to private foundations located in the same locality, including help with grant making, grant administration and general clerical work. The Service ruled that fees received for services directly related to grant-making activities would not be subject to tax as the community foundation's unrelated business income (UBI).

But, beware, the Service also ruled that fees received for clerical and administrative services would be taxed, because they're no different from services offered by numerous other for-profit providers and such services were not directly related to the community foundation's charitable purpose.

The ruling was requested by a community foundation, which we'll refer to as "CF." Like most community foundations, CF's primary purpose is to support charitable activities benefiting its community through grant-making activities within its region. And, like most community foundations, CF has a well-developed administrative staff that does all kinds of work to support and carry out CF's charitable purposes, including research on potential grant recipients, establishing, operating and monitoring grant-making programs, and administrative, accounting and clerical tasks necessary for the daily operation of CF.

CF proposed to the Service the idea of offering its grant-making and administrative "back office" services to other foundations in the local area for a fee. CF's primary goal in offering the services wasn't to generate a revenue stream. Instead, CF said it wanted to add value to the community by helping to educate and assist local foundations to provide better support for charitable activities in the region. CF also said it believed that providing these services would strengthen its relationship with private foundations in the region, resulting in more cooperation between CF and the region's private foundations in doing coordinated grant making in the region. CF proposed to charge a fee for its services based on the hourly rates of its administrative staff.

The specific services to be offered included grantmaking services, clerical services and grant administration services. The grant-making services included:

(1) assisting with the establishment of a grantmaking program;

(2) reviewing and evaluating grant requests and preparing written reports on findings;

(3) researching specific grant making areas of interest and identifying nonprofits conducting programs in specific areas of interest;

(4) designing and maintaining a system of monitoring funded programs; and

(5) identifying opportunities for collaborating with other sources of charitable funds.

The clerical services included:

(1) handling inquiries from potential grant recipients;

(2) printing checks to be reviewed and signed by representatives of the private foundations served by the program; and

(3) arranging meetings of the private foundations' board and grant committees.

The grant administration services included tracking all applications for grants to the local private foundation as well as grants awarded, and then generating related reports.

The Service ruled that fees received by CF for grant-making services would not constitute UBI subject to tax but that fees received for clerical and grant administration services would.

Congress enacted the tax on UBI in 1950 to level the playing field between business entities and charities that offer private sector services. The idea behind the tax is that if a charity is competing with private businesses in offering services to the public for a fee, it's not fair to exempt the charity's income from those services from tax-unless the services provided are directly related to the charity's exempt function in the community. A charity has UBI subject to the tax if three conditions are met:

(1) The charity must be engaged in a trade or business that produces income.

(2) That trade or business must be regularly carried on.

(3) That trade or business must be unrelated to the organization's exempt purpose or function.

The IRS easily determined that the services met the first two tests. The Service spent the bulk of the ruling discussing why the grant-making services were directly related to CF's exempt purposes and why the administrative and clerical services were not.

The Service began by noting that there are dozens of for-profit companies that provide services similar to those that CF intended to sell. According to the ruling, these services include policy development; grant making and screening; foundation accounting; asset management; regulatory matters; and many other services. As a result, the Service determined that by offering its menu of services, CF would be "in direct competition" with the for-profit foundation management industry and, hence, squarely within the scope of activities the UBI tax was created to tax.

But the Service noted that even services that are in direct competition with for-profit businesses are not always subject to UBI tax if the provision of the service "contributes importantly to benefiting the charitable class served by an organization's activities" and there is a substantial causal relationship between the services and the achievement of the charitable organization's exempt purpose.

The Service ruled that CF's grantmaking services contributed importantly to benefiting the charitable class served by CF and that there was a substantial causal relationship between such services and CF's exempt purpose. According to the Service, the grant-making services help direct charitable giving in the CF's community more efficiently and have the effect of augmenting CF's own knowledge regarding charitable causes and programs in the community, which CF could use to better coordinate its grant-making program and the grantmaking of founders in the community. The Service emphasized that the grant-making services were specifically developed by CF and uniquely developed to benefit CF's local community. This distinguished such services from those offered by the for-profit foundation administration community.

Also important to the IRS was the fact that the services were not any more extensive than necessary to serve CF's own community. Had CF, for example, sought to offer such services to foundations outside its local area, the IRS might have reached a different result on the taxability of fee income from such services. This approval, though, shouldn't be viewed as a complete green light for community foundations to offer all kinds of services to local foundations for a fee. The IRS was careful to say that its approval was limited to the narrow class of services directly related to supporting grant-making activities within CF's community.

As for the administrative and clerical services, the IRS' view was that the skills necessary to provide these services was not unique to CF or even to charitable organizations generally, and "do not contribute importantly to accomplishing [CF's] exempt purpose." Instead, the Service characterized the administrative and clerical services as "back office administration," services which are conducted routinely by most organizations, and do not require any specific knowledge of the charitable community. Accordingly, the Service said, providing administrative and clerical services to local private foundations for a fee did not contribute importantly to accomplishing CF's charitable purposes and should be subject to the tax on UBI.

The ruling is a mixed blessing for community foundations. These entities exist in an already crowded marketplace, including commercial DAFs and forprofit providers of foundation administration services. Community foundation leaders may believe that they need to offer a wide array of services to compete effectively for charitable dollars that might otherwise pass into commercial DAFs or private foundations. Community foundations can take comfort from the ruling that offering their core services of assisting local private foundations with research on grant recipients and with brokering grants is something for which they can charge a fee without fear of UBI tax. By the same token, if a community foundation ventures too far into offering services to private foundations that are readily available from for-profit providers, such as grant administration, check writing, accounting and other back office services, the community foundation must be ready to pay tax on any income generated from those services.