Expenditure Responsibility: Rules for Private Foundations — Course Transcript

Introduction

Maya: Hi, if we haven’t already met, I’m Maya! Today I’m here to find out about the rules for expenditure responsibility.

Narrator: Great, I’ll help you along the way!

Maya: Thanks!

Narrator: I’m excited you want to learn about the rules for expenditure responsibility. Expenditure responsibility is an important legal tool for making grants to organizations that are not public charities, governments or similar entities.

Maya: I can’t wait to get started and I think the timing is perfect! I’ve been here a few months, and I just got back from an amazing international conference where I met people from several great organizations who I think will help further the initiatives I’m working on. On my list is to follow‐up with a public charity, a government agency, a for‐profit consulting firm, a private foundation, a foreign organization…..Yikes, I guess I have a lot to do!

Narrator: I’m glad to hear the conference was a success! It sounds like you met some great people from diverse  organizations. This would be a great time for us to dive into the rules for expenditure responsibility because grants to some of those organizations will require “ER”.

Maya: “ER”?? I keep hearing everyone talk about “ER”?!?!

Narrator: Sorry! “ER” stands for “expenditure responsibility.” Expenditure responsibility refers to some required oversight and monitoring procedures that permit a private foundation to make grants to certain types of organizations.

ER applies in cases where the grantee is not a U.S. public charity, government, or similar entity, and the foundation has to make sure that grant funds are used for a charitable purpose. The foundation exercises expenditure responsibility as a way of helping to make sure that its funds are properly used.

This course will help you better understand:

• When ER is required
• How ER is exercised; and
• How to handle complicating issues in ER grants

Maya: Great! So after this training, I’ll have all the information I need to make ER grants?

Narrator: Well, this will be a really good start, but foundations often have additional requirements for ER grants depending on the size of the grant, duration of the grant, and country where the grantee is located. This means that before making an ER grant, and as sticky situations come up, you should always seek assistance. Depending on your organization, assistance could come from: Grants Management, Legal, or the department in your organization that handles compliance issues.

Narrator: If you’re taking this course for the first time, it’s best that you go through the course in order.

If you’re returning to the course and using it as a reference, you can click any of the Topics in the course map and jump right to your specific area of interest.

Here’s how to control your training experience.

When you’re in a Module, you can use the navigation bar to move around.

To mute the sound, click the Mute button. To pause or play, click the …well, pause or play buttons.

To view a transcript of what’s being said, click the Transcript button. You can also skip to a particular section by clicking a Topic link.

Well, that’s it – pretty simple. When you’re ready, go ahead and click to launch the first Topic.

 

Module 1: When is ER Required

Maya: I’m so excited! I just got a proposal from a for‐profit organization I met at the conference.  I heard that expenditure responsibility is required for grants to for‐profits…but I can’t remember off the top of my head…

Narrator: Good memory Maya! ER is required for grants to for‐profits.

Narrator: Let’s start by talking about when ER is not required. There are five types of organizations to which a private foundation can make a grant without exercising expenditure responsibility. ER is not required for grants or program related investments to the following types of organizations:

1. Section 501(c)(3) public charities
2. Units of government (domestic and foreign)
3. International organizations designated by executive order
4. Exempt operating foundations
5. Foreign organizations with an “equivalency determination” ER also does not apply to

A grant or program related investment to any organization that is not one of these five types requires ER.

These types can be very technical, and you will often need to seek further assistance from your Grants Management or Legal Department to determine an organization’s type. To learn more, hover your cursor over each type to read a brief description. When you’re done, press the pulsing “play” button to continue.

Narrator: This means that ER is required for grants and PRIs to for‐profit companies, private foundations, foreign organizations without an “equivalency determination”, new organizations waiting for their IRS “determination letters” recognizing their section 501(c)(3) public charity status, and section 501(c)(4), section 501(c)(6), and all other section 501(c) tax‐exempt organizations that are not section 501(c)(3) public charities.

These are just some examples of when ER is required. Remember, ER is required unless the grantee is one of the five types of organizations we discussed where ER is not required.

These examples of types of organizations can also be very technical. To learn more, hover your cursor over each type. After you’ve had a chance to read each description, press the pulsing “play” button to continue.

Narrator: Now let’s test your understanding of when ER is required. Take a look at these potential grantees. For each type of organization, decide whether ER is required or not.

Drag and drop each image to the correct category. If you forget which types of organizations require ER, click on the “information” icon. If you’re not sure what type of organization a grantee is, hover your cursor over the organization’s name for information on its type.

When you are done, click “Continue.”

The chart below summarizes all of the answers from the previous exercise and should give you some examples of when ER is, and is not, required.

 

Module 2: How ER is Exercised

Maya: Ok, I’ve learned that some of the grants I want to make will require ER. Let’s see (looks at proposal) a grant to a government agency (thinks) won’t require ER (puts in pile) but a grant to this for‐profit and this new organization waiting for its public charity status from the IRS will (puts in another pile)! Now that I know when ER is required, I guess I need to know  what is required!

Narrator: I can help with that. ER requires a private foundation to establish adequate procedures to make sure the grantee uses grant funds solely for the charitable purposes outlined in a project; receive full and complete reports on how the funds are spent; and report the grantee’s expenditures to the IRS.

Maya: Hum, I know my foundation has grantmaking policies and procedures. How do I know if they are “adequate”?

Narrator: Another great question, Maya. I think this would be a good time to walk through the steps of how a private foundation properly exercises expenditure responsibility.

Maya: Ok!

Narrator: There are six steps to exercising ER: Step 1, conduct a pre‐grant inquiry (this is a way of ensuring that you gather basic information about the potential grantee and conduct some due diligence before you make the grant); Step 2, enter into a written grant agreement (signed by both the funder and the grantee); Step 3, require the grantee to keep and track grant funds in a separate fund or account dedicated to the charitable purposes of the grant; Step 4, obtain annual reports from the grantee; Step 5, report the grant to the IRS on the foundation’s tax return until all grant funds are spent, and Step 6, investigate all potential diversions.

Maya: I think I can handle this! Where do we start?

Narrator: Let’s start with step one, the pre‐grant inquiry.

Before we dive‐in, remember that the goal of ER is to make sure foundation grant funds, when granted to non‐charitable organizations, are spent solely for the charitable purposes for which they are granted.

A pre‐grant inquiry or “PGI” is the due diligence that must be conducted by the private foundation on the organization to assess its capacity to use and report on the grant funds. The PGI must give a reasonable person assurance that the potential grantee will use the grant for proper purposes.

Staff may complete the PGI or it may be outsourced to a consultant; either way, the results of the PGI must be documented in writing and the scope of the inquiry must fit the size and scope of the grant, the period over which it is to be paid, and  whether the foundation has made any prior grants to the same organization sufficient to establish a reasonable track record.

The PGI should concern matters such as: the identity, prior history and experience (if any) of the organization and its managers; and any knowledge that the private foundation has about the organization’s management, activities and practices.

In order to conduct the pre‐grant inquiry (PGI), a private foundation will typically request and review the following types of documents, if they are available:

• Evidence of the legal status of the organization
• Governing documents
• A list of the governing board members, key officers and key project participants
• An organization chart
• An annual report for the prior year or a brief description of the organization’s history, goals, mission, recent activities and future plans
• A budget for the current year
• Financial statements; and
• Evidence of grants made to the organization by other foundations or the

Maya: That’s a lot of documents!

Narrator: I can see how it would seem like that, but keep in mind that these are just examples of documents a private foundation may review. The IRS regulations don’t require the review of any particular documents. The regulations just require that the inquiry be complete enough to give the foundation assurance that the grantee will use the grant for the proper purpose. In fact, it’s quite common for foundations to do more pre‐grant due diligence for programmatic reasons than are required by the ER rules.

Maya: That makes more sense ‐ I think I’m starting to get the gist… The pre‐grant inquiry (PGI) is all about getting to know the grantee!

Narrator: Let’s take a minute to test your new knowledge about the requirements for the ER pre‐grant inquiry (PGI). Read each scenario about real‐life questions that come up in ER grants. Choose the best response and then select “Submit” for feedback.

Narrator: Now that we’ve covered the basics of the pre‐grant inquiry (PGI), let’s move on to the second step. Step two requires that all ER grants to be made pursuant to a written grant agreement. Each ER grant agreement must include very specific legal language. Take minute to read the list of required provisions.

• Specifies the charitable purposes of the grant Governing documents
• Requires the grantee to maintain the grant funds in a separate account or fund dedicated to charitable purposes
• Requires the grantee to maintain records of receipts and expenditures, and make its records available to the foundation for inspection
• Requires the grantee to repay grant funds if not used for the purposes of the grant (even if otherwise charitable)
• Requires the grantee to provide annual reports and a final report (on a fiscal year basis) on how it used the grant funds
• Prohibits use of grant funds for lobbying, political activity, re‐granting (with some exceptions) and non‐charitable uses; and
• Is signed by the foundation and grantee

Maya: There are a lot of requirements for ER grant agreements!

Narrator: That’s right, but the ER grant agreement requirements are fairly easily satisfied once you get used to them. It is recommended that you seek assistance before executing an ER grant agreement and use a standardized template that includes all of the requirements. Today we will discuss the first two of these requirements in more detail.

Maya: I’m following …

Narrator: The grant agreement must specify the charitable purposes of the grant. All grant funds and income generated from the grant fund must be used solely for the charitable purposes that are specified in the grant agreement.

ER grants cannot support projects that include lobbying. We’ll talk more about ER grants that support advocacy when we talk about how to handle complicating issues in ER grants, or you can skip ahead now by clicking on the link on your screen.

Also, it is generally prohibited to make an ER grant for general operating support.

Narrator: So the grant agreement must specify the charitable purposes of the grant…and all grant funds must be used solely for the charitable project purposes specified in the grant agreement.

Let me give you an example of how this works. Say the foundation is funding a conference dedicated to the prevention of AIDS. The budget lists foundation funds as supporting the cost of employee A and B to plan for the conference, the venue, and conference speakers. It would not be permissible for the grantee to use grant funds to pay for the time these employees spend on other projects. The foundation’s funds must be only used to pay for the portion of staff time actually spent on the AIDS conference.

Because general operating support grants are not restricted to a specific charitable project, they are not good candidates for ER grants. For our purposes, we will consider ER grants for general operating support prohibited, but you should seek assistance if the proposal you are considering includes this type of support.

Narrator: The next step I’d like to cover with you is step three, which is the requirement that the grantee maintain the grant funds in a separate account. One way to satisfy this requirement is to require the grantee to maintain the funds in a physically separate bank account restricted to the charitable purposes outlined in the grant agreement; another option is to record and maintain the funds in a separate bookkeeping account. You should seek assistance to determine the approach your  Foundation takes.

In either case, the grantee must be able to separately track grant funds in order to comply with the ER rules. For example, the grantee must track any interest earned on the grant funds and, if it’s not spent on the project, return it to the foundation at the end of the grant. Interest cannot be used for anything other than the grant project.

Maya: Okay, so these sound like good grantmaking practices? Aren’t these requirements in all foundation grant agreements?

Narrator: You’re right Maya, these are good grantmaking practices. Some private foundations include these requirements in all of their grant agreements, even for grants that don’t require ER. The important thing to remember is that for non‐ER grants, these requirements are optional; they are often included as a matter of good grantmaking practice, but in ER grants, these requirements are mandatory, and must be included in each ER grant agreement.

Narrator: Here’s a quick question to test your knowledge about the requirements for the written grant agreement. Read the question and choose the best response and then select “Submit” for feedback on your response.

Narrator: Now let’s talk about the fourth step. Step four requires the private foundation to obtain certain grant reports from the grantee. The IRS regulations specify both what must be in the reports and how often they must be received.

Let’s cover the substance of the reports first. Private foundations must require ER grantees to report on (a) the use of the funds, (b) progress made by the grantee toward achieving the purposes for which the grant was made, and (c) compliance with the terms of the grant agreement.

Maya: Great, I’ll be sure our ER grant agreement includes these reporting requirements so that our grantees understand up front what must be in their ER grant reports.

Narrator: That’s a great idea, Maya. Your grant agreement will also need to specify when the ER reports are due, so let’s talk about that next.

Narrator: The foundation must obtain an annual report for the year in which the first payment is made, and for all subsequent years until grant funds are fully spent by the grantee, or the grant is otherwise terminated.

In addition, the foundation must obtain a final report after all grant funds have been spent. The final report must cover the same substance as the annual report, but cover the entire grant period.

The IRS rules say that ER reports must be received “within a reasonable period of time” after the end of the grantee’s fiscal year. The IRS regulations are not precise with respect to how much time after the fiscal year end is “reasonable”. For the purposes of this course, we’ll say that reasonable is within 90 days or 3 months after the end of the grantee’s fiscal year, but you should seek assistance regarding your Foundation’s specific deadlines for ER reports as they may vary from this timeframe.

Sometimes it can be tricky to determine whether or not a grantee has spent all of the grant funds. It’s best to seek assistance when questions arise about remaining funds. If funds do remain at the end of the project (either grant funds or interest earned on them), the grantee must either return the funds to the foundation or the foundation and the grantee must collaborate to find an alternative use for such funds related to the charitable project. This is another instance when it’s a good idea to seek assistance.

Narrator: Determining when ER reports are due can be tricky. Let’s go over a few examples together.

Let’s say a foundation makes a grant to a grantee whose fiscal year ends December 31st. If the foundation makes its first payment on October 15th in Year 1, the first annual report must cover the period between October 15th and December 31st. The first annual report must be received by the private foundation “within a reasonable period of time” after the end of the grantee’s fiscal year, which, for the purpose of this course, we’ll say is three months, which in this case is March 30th of Year 2.

This example only shows when the first annual report is due. Additional annual reports and the final report will be due depending on when the grant funds are fully spent.

Maya: I think I understand? But what if I want to make a short grant and all of the funds are spent in six months?

Narrator: If ER grant funds are fully spent during the same year in which the grant funds were received, the annual and final report are one and the same! Grants that span multiple accounting years require an initial annual report, a final report, and potentially additional annual reports if there are other accounting years that occur between the initial and final accounting years.

Let’s look at another example using the same scenario we just discussed where the foundation makes a grant to a grantee whose fiscal year ends December 31st. If the first grant payment is made on February 1st of Year 1, and fully spent by June 30th of the same year, the annual and final report will be one and the same!

If, however, the first payment is not made until November 15th and it is not fully spent until October 15th of the Year 2, the annual report should cover the period from November 15th to December 31st and the final report should cover the entire grant period, or from November 15th to October 15th and be due “within a reasonable period of time” after the end of the grantee’s fiscal year end, which in this case is March 30th of Year 3.

Maya: Okay, so I think I understand when ER reports are due, but what happens if a grantee fails to submit a report, either an annual report or a final report?

Narrator: This is a really important question Maya. If a grantee fails to submit a required report, the foundation must make a reasonable effort to obtain the required report, and withhold any future payments on the grant or any other grant to the same grantee until the report is furnished. Since it is not always clear what constitutes “reasonable efforts”, it is best to seek assistance if your grantee fails to meet a reporting requirement. If the foundation fails to take the appropriate steps, the foundation will be subject to a penalty, so it’s really important that you take appropriate action when ER reports are late.

Narrator: Let’s take another minute to test your new knowledge about the requirements for ER reports. Read each scenario, choose the best response, and then select “Submit” for feedback on your response.

Maya: Hello. Oh hello Akiki. It’s great to hear from you. Yes, I remember you from the international conference that I attended a while back. I’m thrilled that we were able to provide funding to your organization through an ER grant. Yes, I see you do have a report due next year on the grant we gave to fund a teacher training course in Uganda. What? You have unspent funds and would like to use some of the funds for an additional purpose?  Hmmmm.

Narrator: Maya, you look concerned. Let me see if I can help. First off, remember that all funds must be used for the charitable project purposes specified in the grant agreement. In this case, the grantee’s organization must use the funds for the educational course that was proposed in the organization’s grant proposal.

Maya: But, the course has already taken place and Akiki’s organization still has funds remaining. Does that mean that the organization has to return funds to us? Isn’t there something we can do to help?

Narrator: Remember, if a grantee does not use ER grant funds for the specific charitable project specified in the grant agreement, it may be a diversion of funds. We’ll talk more about diversions later; in the meantime, it may be possible for Akiki’s organization to use remaining funds in ways that would not constitute a diversion if the proposed use fits within the original scope and purposes of the specific charitable project.

You should always seek assistance from the appropriate person in your organization to determine whether a proposed use of funds fits within the scope and purposes of the charitable project specified in the grant agreement and what documentation may be required in these cases, but let’s take a look at some examples that may help to explain this a bit better.

Narrator: In this case, remember, the charitable project specified in the grant agreement was to fund a teacher training course in Uganda. Drag and drop the various additional uses of the remaining funds into the correct box. Is such use permissible, or does is represent a possible diversion of funds?

Narrator: Now let’s talk about step five, reports to the IRS on the foundation’s tax return. In addition to receiving reports from the grantee, the foundation must report annually to the IRS on every ER grant made, paid, or for which a report is outstanding during the foundation’s fiscal year.

The foundation’s report to the IRS must include the items listed on the screen.

Narrator: Click the button on the screen to download an actual example of a foundation’s report to the IRS. This report is part of a Form 990‐PF, which is the tax return that is filed annually with the IRS by all private foundations and is made publicly available on websites like guidestar. Depending upon how many ER grants a private foundation makes, a foundation’s report to the IRS on its ER grants could be hundreds of pages.

Maya: Great, ER is really starting to make sense!

Narrator: There is one more part of ER that is really important for you understand. If the grantee uses all or any portion of the funds for any non‐charitable purpose, or for any purpose that is inconsistent with the purposes that were agreed to in the grant agreement, we call it a “diversion” of grant funds and the foundation must investigate.

Maya: Uh oh. That sounds serious.

Narrator: It can be, but the important thing for you to understand is what to do. First, it’s really important that the   foundation reviews each ER grant reports soon after it has been received to determine whether there appears to be any diversion of grant funds. Second, the foundation must take appropriate steps if it suspects a diversion of grant funds. Click the button on your screen to learn more about what you have to do if you suspect a diversion. When you are done reading, click “Next”.

Maya: Hello. Oh hi Akiki. Yes, we did receive your report for our grant to fund the teacher training course in Uganda. Thank you for submitting it. In fact I have it here in front of me and was just about to call you. Yes, it all looks good except for one thing. I notice from the fiscal year financial report that there is $25,000 that is unaccounted for. Oh, I see; you weren’t aware of this. Yes, it would be great if you could check on this and get back to me. Now what am I going to do?

Narrator: Don’t worry, Maya. I’m here to help. How about we run through the following questions, which illustrate what we just learned about investigations of diversions and will help you to deal appropriately with the report from Akiki’s organization.

Read the questions below and choose the best response and then select “Submit” for feedback on your responses.

Narrator: Well Maya, that brings us to the end of this Module. We’ve covered the six steps on how ER is exercised. Before you go on to the last Module, I have a present for you: a printable takeaway sheet that summarizes the steps for exercising ER. Click the button on your screen to download and print a copy for future reference.

When you’re ready to move on, click “Next” to continue on to the next Module, or click any of the Topics in the Topic Bar to review the Steps we covered in this Module again.

 

Module 3: How to Handle Complicating Issues in ER Grants

Maya: Well that wasn’t so bad. I’m going to review my proposal again with these six steps in mind. I’m really excited because I think the potential grantee is going to be buying a really cool state‐of‐the‐art microscope, and they’re thinking about subgranting some of the grant funds to another for‐profit that I’ve always wanted to work with.

Narrator: That reminds me…there are a few complicating issues in ER grants that you should be aware of. These issues come up when there is an ER grant that contains subgrants or when the ER grant is to a private foundation; for capital expenditures; or to support advocacy activities. We’ll talk about each of these in more detail in this Module.

In addition, many foundations have their own internal policies about making, or prohibiting, ER grants that present these types of complicating issues, so you always should seek assistance when these issues arise.

Narrator: Let’s start with grants that include subgrants. Remember, some private foundations prohibit ER grants with subgrants as a matter of internal policy, but may offer alternative ways to support the same charitable project, such as by making an equivalency determination or using a fiscal sponsor.

If your foundation’s internal policies permit ER grants with subgrants, then under the IRS rules the grantee must exercise ER with respect to each subgrantee that is not a US public charity, government or similar entity.

A helpful way to think about how the ER rules apply to subgrants, is to remember that the ER rules follow the foundation’s funds, so if the funds are subgranted by the primary grantee to a secondary grantee where ER is required, the primary grantee has to exercise ER over the subgrant to make sure the foundations funds are still used for a charitable purpose. Click the  button on your screen to learn more about the specific requirements for ER grants with subgrants.

Narrator: Now let’s do a quick knowledge check on ER grants with subgrants, as this issue can be tricky. Read the scenario, select the best response, and click “Submit” for feedback on your answer.

Narrator: Next, let’s talk about grants to private foundations. Remember, a grant from one private foundation to another private foundation requires ER.

The main complicating issue with respect to grants to other private foundations is something called the “out of corpus” rule. The “out of corpus” rule is one of the most complicated rules in ER. You can click on the button on your screen to learn more about the “out of corpus” rule, but you should always seek further assistance before making a grant to a private foundation.

Narrator: The next complicating issue we’re going to discuss is ER grants for capital expenditures. In general, a capital expenditure is an expenditure to purchase an asset that is useful for a period of time and, therefore, has a value that depreciates over time. Examples of capital expenditures might include expenditures on automobiles and boats. The purchase of real estate and land is also considered a capital expenditure.

Any capital purchased with ER grant funds must be used exclusively for the charitable purpose of the project. Depending on the type of ER grantee and your foundation’s internal practice for reporting on capital equipment, special – and sometimes extensive – reporting may be required.

You should seek further assistance on your organization’s tracking and reporting requirements if your grant contains capital expenditures.

Narrator: The last complicating issue we’re going to discuss comes up in ER grants that support advocacy. Sometimes the line between advocacy and lobbying can be tricky. Remember, ER grant funds may only be used for charitable purposes, which means that ER grant funds are strictly prohibited from being used for “lobbying” as defined by the IRS. For more information on the advocacy and lobbying rules for private foundations, and what constitutes advocacy versus lobbying, you can check‐out the course linked on your screen. For those of you who have taken this course, or are familiar with the lobbying rules for private foundation, you should note that the Project Grant Rule and use of an allocated budget may not be used in an ER  grant.

If you’re making an ER grant that supports advocacy, you should make sure that the grantee understands that the grant agreement prohibits the use of grant funds for lobbying, and check each ER report to make sure that the grantee hasn’t inadvertently used any grant funds for lobbying. If grant funds are used for lobbying, it’s considered a diversion and you should seek further assistance to make sure the foundation takes the appropriate steps to restore the diverted funds.

Narrator: You’ve learned a lot this course. Let’s do a final knowledge check to make sure you leave this course understanding the basics of ER. Read each question and choose the best response. Click “submit” for feedback on your response.