LegalEASE - Notes from the Legal Experts: Expenditure Responsibility

Expenditure responsibility, or ER, describes a set of monitoring and oversight procedures that a U.S. private foundation or donor advised fund (DAF) must follow when making grants to organizations that are not 501(c)(3) public charities or their foreign equivalents. The purpose of ER is to ensure that the grantor's funds are used exclusively for charitable purposes.

Why Do Grantmakers Exercise ER?

The IRS exacts a penalty tax on certain expenditures that are not considered to be exclusively for charitable purposes or not considered to be sufficiently accountable to the public. These are known as taxable expenditures. Private foundations and DAFs exercise ER in order to avoid incurring penalties for taxable expenditures.

Grants to organizations that the IRS recognizes as 501(c)(3) public charities are not considered taxable expenditures. They are presumed to be exclusively for charitable purposes. Grants to most other organizations, however, do not benefit from this presumption. Therefore, in order to avoid a taxable expenditure, the IRS requires that the private foundation or DAF take added precautions to ensure that its funds will only be used for charitable purposes.

When Is ER Required?

Any of the following situations would require that a private foundation or DAF grantor exercise ER.

  • A grant or program-related investment to another private foundation.
  • A grant or program-related investment to any U.S. entity that has not been recognized by the IRS as a 501(c)(3) public charity. These could include for-profit entities, other categories of nonprofit entities, or units of government, for example.
  • A grant or program-related investment to any non-U.S. entity that has neither been recognized by the IRS as a 501(c)(3) public charity nor been determined by the grantmaker to be the equivalent of a 501(c)(3) public charity or a unit of government.

When Is ER Not Required?

The following situations would not require ER.

What Does ER Actually Entail?

The U.S. Treasury Regulations provide that a private foundation or DAF

will be considered to be exercising "expenditure responsibility" … as long as it exerts all reasonable efforts and establishes adequate procedures — (i) To see that the grant is spent solely for the purpose for which made, (ii) To obtain full and complete reports from the grantee on how the funds are spent, and (iii) To make full and detailed reports with respect to such expenditures to the Commissioner [of the IRS].

Treas. Reg. §53.4945-5(b).

A private foundation or DAF will generally satisfy these three obligations by

1. Conducting a pre-grant inquiry on the identity, prior history, and experience (if any) of the grantee organization and its managers. The inquiry will include any other information that is readily available concerning the organization's management, activities, and practices.

2. Entering into a grant agreement with the grantee that includes specific restrictions delineated in the regulations. Notably, the grantee must commit to

  • Use the funds exclusively for charitable purposes
  • Repay any portion of the amount granted that is not used for the purposes of the grant
  • Submit full and complete annual reports to the grantor on the manner in which the funds are spent and the progress made in accomplishing the purposes of the grant
  • Maintain records of receipts and expenditures
  • Use none of the funds for specifically enumerated noncharitable purposes

3. Reporting on the grant in the grantmaker's annual IRS information return.

The regulations also require that the grantee agree to continuously maintain the grant funds in a separate, dedicated fund and to take steps to investigate potential diversions on the use of the funds.

When Can a Grantmaker Rely on Equivalency Determination Instead of ER?

Equivalency determination, or ED, is only available to an organization formed outside of the U.S. that has not been recognized by the IRS as a 501(c)(3) public charity. ED permits private foundations and DAFs to treat such an organization as a public charity if the grantmaking entity has made a good faith determination that the grantee organization meets all the requirements of a public charity under section 501(c)(3). "A determination ordinarily will be considered a good faith determination if the determination is based on current written advice received from a qualified tax practitioner." See Treas. Reg. §53.4945-5(a)(5).

For more detail on the requirements of ED, see NGOsource's e-book, Guide to Equivalency Determination.

Other Issues

Expenditure responsibility can be a thorny issue for grantmakers, with various exceptions and applications. This post addresses only the basic tenets of ER. It does not cover the specific language required in an ER grant agreement. Also beyond its scope are issues like reporting on capital expenditures, applying the out of corpus rules (PDF), terms required for program-related investments, exercising ER on subgrantees, handling potential violations, and other related rules.

If you are a private foundation or DAF and you believe you have made or will make grants that require ER, we encourage you to seek the advice of qualified counsel. If you already know that you need to exercise ER on a future grant and are looking for ER services, please contact us for more information.

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