A “Watch-Out” for Private Foundations Offering Prizes

Imagine a poet who receives a call out of the blue informing him that he has been selected as a MacArthur Fellow because of his track record of exceptional creativity and will receive a $625,000 stipend paid over the next five years. Or imagine a scientist who receives a similar call congratulating her on being selected as a recipient of a $3 million Breakthrough Prize for her transformative advances in the field of life sciences. No strings attached.

Awards like these, given in recognition of past achievements, help establish the importance and legitimacy of a field, and also compel other individuals (beyond award recipients) to pursue their own creative activities. A 2012 review of the MacArthur Fellows Program found that the awards not only increased the capacity of recipients to pursue creative ideas and projects, but also inspired members of the public to think about how they can use their own skills and ideas to make the world a better place, and to take action.

Private foundations need to be cognizant of IRS rules when designing such award programs, because the IRS imposes harsh excise taxes on any taxable expenditure made by a private foundation, and may classify a prize as such if it is not in furtherance of the foundation’s charitable, scientific, or educational purposes.

Private foundations should also keep in mind that grants paid to an individual for travel, study, or a similar purpose (for example, scholarships) are taxable expenditures unless the foundation has obtained advance approval of its award procedures from the IRS. Grants to individuals for other purposes are not taxable expenditures, however, and don’t require advance approval from the IRS.

The good news is that prizes a private foundation awards as part of a contest or in recognition of past achievements are not considered taxable expenditures if they are not tied to future travel or study. However, the private foundations awarding recognition prizes must be careful not to: impose restrictions on how recipients should use awards, request that the recipients use the funds to finance future activities, or require any future commitment from the recipients.

For example, the MacArthur Foundation website explicitly states that the MacArthur Fellowship money has no strings attached, and that the foundation neither imposes any restrictions on how the recipient can spend the money nor enforces reporting obligations. Essentially, if the private foundation seeks to control the recipient’s behavior or future use of the funds, then the IRS would not consider the prize as recognizing past achievement and it would become a taxable expenditure (unless the foundation obtained advance approval of its award procedures from the IRS).

IRS rulings suggest that foundations can usually frame contests geared toward specific educational, charitable, or scientific matters in such a way as to avoid taxation. Even if a foundation hopes that the recipient will use prize funds for a specific research purpose, or if the contest sets forth a discrete problem for solution, the foundation may structure the contest in a way that does not place conditions on the recipient’s behavior or use of the award.

If the contest will involve awards to individuals for travel, study, or similar purposes, then the foundation will need to obtain IRS approval of its procedures for awarding prizes prior to implementing the program. Alternatively, foundations may avoid the taxable expenditure penalties by awarding prizes to organizations, if they are 501(c)(3) public charities, or if the prizes are for charitable purposes and the foundation exercises expenditure responsibility. In such a case, however, the foundation should be sure that it does not earmark the prizes for payment to a particular individual or individuals.

Foundations developing prize programs must also be wary of stringent self-dealing rules, which impose harsh penalty taxes on most transactions entered into with people who are “disqualified persons” as defined in the tax laws.  Disqualified Persons include directors, officers, trustees, and other foundation managers (this might include the people charged with selecting prize recipients), substantial contributors, persons related to any of the above, and (subject to certain exceptions) government officials. Monitor the selection processes!

Other factors to consider:

• Foundations must structure their programs such that the competition cannot be classified as a lottery or raffle; for nonprofit organizations, these are either prohibited altogether, or, in some cases, permissible but tightly regulated.
• Contests that require submissions or solutions to a problem will raise questions about the ownership of intellectual property.
• A foundation will need to consider tax-withholding obligations with respect to the payment of cash prizes.
• And finally, there are numerous non-legal issues involved in structuring a prize program, including establishing rules and selection procedures, communicating the program to the appropriate communities, celebrating the prize winners, and ensuring the fair administration of the program.

These cautions are real, but they shouldn’t be daunting. A private foundation can easily navigate through the pitfalls we’ve described if it structures its prize program carefully, does not restrict the future use of the funds, and carefully monitors its nomination and selection process.

Read more stories by Susan L. Abbott & Alyssa C. Fitzgerald.