Ideas From the Field
Streamlining Your Due Diligence
Adapted from “Guide to Due Diligence” by Project Streamline.
From Essentials, the Association of Small Foundations Quarterly Newsletter.
In many foundations, due diligence practices—the processes by which funders assess organizations before deciding to invest—have become quite elaborate over time.
The Tax Reform Act of 1969 sparked a major expansion of due diligence in grantmaking. New regulations required due diligence to protect funders from liability for grants that might later be found to violate the new rules. Grantmaking suddenly felt more complicated, and many larger foundations added the position of grants manager to ensure that they followed proper procedures.
Whereas much due diligence serves an important purpose, some practices are rooted in misunderstandings about what is required. In this article, we dispel common myths and clarify legal requirements.
Five Common Myths
Myth: We must collect the same due diligence materials from each grantee.
The one-size-fits-all myth is a common one. Many funders take a formulaic approach to due diligence, asking for the same materials from every grantee. This isn’t necessary. For many organizations—especially 501(c)(3) grantseekers that you have funded previously or know well—a more limited set of materials might well suffice.
Myth: We must complete all due diligence at the beginning of the grantmaking process.
Many funders require a full set of due diligence materials with every application. In these cases, even organizations unlikely to be selected for funding still must send their IRS letters of determination, board lists and minutes, detailed financial statements, and other due diligence documentation a grantmaker requires. Although these documents may be readily available, it still takes grantseekers time to gather and submit them to funders—time that can really add up when an organization has multiple funders.
We think there’s a better way: Staging requirements so that grantseekers send additional documentation only after the funder deems them a good fit for funding will save everyone time and effort.
Myth: We need to have a copy of a grantseeker’s IRS determination letter in every file.
In fact, a photocopy of the IRS letter of determination only tells you that the grantee was, at some point, granted a specific tax-exempt status. Because the status can change over time, or the original letter rescinded or modified, you’ll need to determine if it is still valid. To avoid multiple steps, skip the letter altogether, and check the organization’s tax status online at www.irs.gov or via a third-party source. See “Start by Verifying Tax Status” below for details.
We know that many grantmakers collect letters of determination on the advice of their auditors or legal advisors. The IRS’s description of “Reliance Criteria for Private Foundations and Sponsoring Organizations” at www.irs.gov may be useful in establishing why this is not a must do.
Myth: We’re required as grantmakers to make sure our grant doesn’t tip our grantee into private foundation status.
It’s a conscientious gesture to ensure you aren’t tipping your grantee with a grant that dominates its budget. But it’s not your job. The Council on Foundations obtained a ruling for the field in 1989 that clarified this to be the grantee’s responsibility.
The ruling states that a foundation can’t be penalized for tipping a grantee as long as (1) the grantee has a valid IRS determination of public charity status at the time the grant is made; (2) the IRS has not revoked the status, and the foundation is not aware of imminent action by the IRS to do so; and (3) the foundation does not control the grantee.
Myth: More is better.
Asking for unnecessary paperwork drains resources not only from your grantseekers but also from your foundation. As you take a fresh look at your information requirements, we suggest applying the following questions to your due diligence practices: Do we need this information to be legally compliant, or do we want it to help us determine whether this would be a prudent grant? In either case, is this information necessary at this point in the grantmaking process, or can it wait until we are closer to making a grant?
Must Do Versus Choose to Do
Over time, the distinction between two types of due diligence has become blurred:
- Must do—This is the imperative information that you must have to protect your organization from legal liability for having made a particular grant.
- Choose to do—This is the additional due diligence that your foundation opts to conduct to satisfy itself that the grant requested will prove a good investment. Because each grantmaking organization needs to establish its own tolerance for risk in its investments, it is hard to suggest categorically what a foundation might choose to do. Grantmakers for Effective Organizations provides a nuanced treatment of this question in its Due Diligence Done Well: A Guide for Grantmakers, available at www.geofunders.org.
Here, we focus primarily on what a foundation must do.
So what is required to make a grant?
The answer may surprise you. For most grantmaking by funders in the United States, very little due diligence is legally required. There is no required paperwork, no process that must be followed, and no post-grant reporting required to make a grant to most domestic public charities. In fact, for 501(c)(3) organizations with a further 509(a)(1) or (a)(2) designation, a grantmaker may simply sit down with a checkbook, pen, envelopes, and stamps and be in perfect compliance with the tax code.
The tax code also allows private foundations and public charities alike to make grants to other types of domestic organizations and organizations, governments, and entities around the world. Special procedures must be followed, however, when making grants to organizations with certain tax designations or for certain kinds of grants.
Start by Verifying Tax Status
Tax status affects what is required before, during, and after a grant term. The question is rarely whether a grant can be made, but, rather, what procedures should be followed as the grant is made.
See the box below for a four-question decision tree to follow when determining a domestic grantee’s tax status. Then choose one of the following methods to find answers to the questions:
Visit the IRS website. Go to the (somewhat cumbersome) Exempt Organization Master File (EOMF) at www.irs.gov.
Select the state and alphabetic range where the grantee is listed, and open the Excel spreadsheet link for that state and alphabetic range. (Do not attempt to open the unformatted data.) Find the listing for the organization, then scroll across to column N, which shows the Foundation Code.
If the code is 10, 11, 12, 13, 14, 15, or 16, the prospective grantee is a 509(a)(1) or 509(a)(2) organization. These are organizations your foundation may fund with no additional documentation.
If the code is one of those below, you must follow special due diligence procedures:
- 2, 3 or 4 — The prospective grantee is a private foundation, and a grant requires expenditure responsibility. See www.smallfoundations.org for the steps involved in expenditure responsibility.
- 17 — The organization is a 509(a)(3) supporting organization and special steps are required.
- 0 or 9 — You must exercise expenditure responsibility to ensure the grant is used exclusively for charitable purposes.
If you'd like to keep this record, simply save and store the pages electronically that show the organization name and column N.
Use a third-party database. Private foundations may rely on third parties such as GuideStar's Charity Check, a fee-based service that is more accessible than the IRS's EOMF, for determining whether a 501(c)(3) organization is further classified under section 509(a)(1), (2), or (3). Simply store the following information electronically:
- Prospective grantee's name
- Employer identification number
- Public charity classification under section 509(a)(1), (2), or (3)
- Statement that the information is from the most recent IRS monthly update to the Business Master File (BMF), along with the IRS BMF revision date
- Date and time of your search
Call the IRS. You may also call the IRS directly at 877-829-5500 to check on a U.S. organization’s tax status. If you do so, be sure to document the call.
Legal Due Diligence Requirements
With the tax status of a prospective grantee in hand, use this section to understand the basic legal requirements governing grantmaking. We focus here on private foundations because the legal requirements for public charities and corporate giving programs are minimal in comparison.
Grants to U.S. 501(c)(3) public charities. If a prospective grantee is determined to be a 501(c)(3) organization that is further classified as one of the following types of organizations, no additional due diligence is required:
- 509(a)(1)—schools, hospitals, churches, and other organizations that receive their public support primarily from gifts, grants, and contributions from a broad group of people
- 509(a)(2)—organizations that receive their support from a combination of gifts, grants, contributions, and fees for their exempt services (e.g., museums)
Grants to private foundations. Funding private operating foundations and private non-operating foundations requires more due diligence than funding a public charity. Here are the steps:
- You must verify that the organization has a current ruling under Internal Revenue Code Section 501(c)(3). As with public charities, this information can be found at www.irs.gov or from an authorized secondary site.
- To fund a private operating foundation or a private non-operating foundation, you are required to exercise expenditure responsibility.
- If you wish to have your grant to a private non-operating foundation count as a qualifying distribution, the grant must also satisfy an out-of-corpus requirement. Simply put, your grantee must have met its own minimum distribution requirement and distributed the full amount of your grant within a specified period.
Grants to domestic non-charities. Private foundations can fund domestic non-charities, including for-profit organizations, as long as the grant is for a discrete charitable project and all funds are used for that project. To ensure that the charitable funds are used exactly as intended, the funder must exercise expenditure responsibility.
Grants to U.S. government entities. Unlike public charities, U.S. government entities generally don’t receive rulings from the IRS as to their tax status. Although you are not required to receive or include in your files any specific documentation regarding an entity’s status as a government entity, you may want to verify its status if you are uncertain. Whereas funding a city’s health department for a project on child immunization may raise little doubt, the government connection of other entities may be less clear.
The grantseeker may seek—or may already have on file—a government affirmation letter from the IRS. In its absence, and if you don’t wish to ask the prospective grantee to obtain one, you could review the legislative act creating the entity or ask for a letter from an authorized government official confirming its status. Having confirmed the recipient’s status, remember that the grant must be for charitable and exclusively public purposes.
Grants to new entities. When considering a grant to a new entity, it may be appropriate to request a copy of the organization’s determination letter. Although all new entities receive an exemption letter if they are eligible, it will take some time for the determination to be available on the IRS website or via an outside service. Thus, it may be faster to simply request a copy. Until you receive a copy of the determination letter or otherwise verify the organization’s status, be sure to treat all new entities as if they are not charities. That is, perform expenditure responsibility as you would for any other grant to a non-charity.
Grants to 509(a)(3) supporting organizations and grants outside the United States. For the detailed rules that govern grants to supporting organizations and grants to foreign organizations, see www.smallfoundations.org and Project Streamline’s complete “Guide to Due Diligence” at www.projectstreamline.org.
ADDITIONAL RESOURCES
It’s Not Enough to Know Your Grantee Is a 501(c)(3)
www.smallfoundations.org
Get step-by-step instructions for determining a grantee’s tax status.
Project Streamline
www.projectstreamline.org
Compare your grantmaking practices to others’ and get valuable resources to support change.