Like their for-profit counterparts, charitable organizations often enter into agreements with other individuals or organizations. But there is a complexity to how grants are described in the Internal Revenue Code (IRC), and these differences can have operational implications on charitable organizations. So charitable organizations should understand what defines a grant versus a contract, as well as how each should be classified and reported for tax purposes. (All references to the IRC refer to the Internal Revenue Code of 1986, as amended, unless otherwise noted.)

Charitable Organizations: Grants vs. Contracts

Charitable organizations engage in various agreements, ranging from simple to complex. Although organizations often accept and negotiate contracts, they often use form over substance when determining if the arrangement should be a contract or a grant. This decision can be challenging, especially for organizations and advisors accustomed to entering into contracts.

The distinction between a grant and a contract is significant for several reasons:

• Public charities may face implications related to its public support test.
• Private foundations could be subject to expenditure responsibility rules under IRC Section 4945.
• Both grants and contracts can be “qualifying distributions” for private foundations, but this characterization is important for determining private operating foundation status.
• Reporting requirements may differ under the different methods, such as whether the organization is required to issue Form 1099s and consider other reporting and backup withholding requirements.
• The nature of the relationship between the funder and recipient may change.

Grants vs. Gross Receipts Under IRC Section 509

In the context of charitable organizations, grants are for the benefit of the grantee, supporting the grantee’s exempt purposes with limited involvement from the grantor in the form of administration and monitoring. Grants are akin to gifts, with money or property transferred without adequate consideration, indicating donative intent and minimal obligation on the grantee’s part.

IRC Section 509, specifically Treasury Regulation Section 1.509(a)-3(g)(1) differentiates grants from gross receipts.

Under IRC Section 509, a grant may have the following characteristics:

1. It typically is given to support the grantee in conducting activities that align with the grantee’s exempt purposes.
2. It may include terms and conditions established by the grantor to ensure the grantee’s activities are in line with the grantor’s programs and policies and serve the public interest. Common terms and conditions for grants involve maintaining tax-exempt status, reporting back to the grantor on the use of funds and on program outcomes, and adhering to restrictions on lobbying, political activities, subgrants, grants to individuals, and other prohibitions under IRC Section 4945.
3. It may require the grantee to perform a service or produce a product that incidentally benefits the grantor, although the primary purpose is to further the grantee’s exempt activities.

Distinguishing grants from gross receipts can be challenging when both are received for conducting exempt activities. The label of “contract” or “grant” does not alone determine the classification of the payment under IRC Section 509(a)(ii). When distinguishing between “gross receipts” and “grants” for the purposes of IRC Section 509(a)(2)(A)(ii), “gross receipts” refers to amounts received from an activity that is not an unrelated trade or business, for example, when a specific service, facility, or product is provided to meet the direct and immediate needs of the payer. This type of transaction implies that the payments are made so that the payor can obtain an economic or physical benefit from what is obtained; such payments are treated as gross receipts for the recipient.

For instance, if a private foundation retains intellectual property (IP) rights from an agreement, this is an indicator that the arrangement is more akin to a contract, as the foundation is receiving an economic benefit. On the other hand, if the grant recipients are allowed to retain IP rights, this tends to suggest that the agreement is a grant, as the primary intent is not to confer an economic benefit on the funder. However, the issue of IP rights is not the sole factor in determining the nature of the agreement. Funders may also seek IP rights with the intention of benefiting other grantees or the general public therefore, each situation must be evaluated on a case-by-case basis, considering all relevant factors.

Research Activity: Contracts vs. Grants

In the realm of research contracts, the line between grants and gross receipts from mission-related activities can often become blurred. Under Treasury Regulation Section 1.509(a)-3(g)(2), research that leads to the creation of tangible products for the use or benefit of the payer typically is seen as a service that fulfills the direct and immediate needs of the payer. Such payments, which benefit the payer, are considered “contracts.” Conversely, basic research or studies in the physical or social sciences are usually viewed as activities that primarily benefit the general public rather than the payor. Therefore, income derived from activities where the funder or payer receives a direct benefit is categorized as gross receipts from mission-related activities. In contrast, income from activities that benefit the general public is more likely to be classified as a grant.

In an example provided by the Treasury Regulations:

• A 501(c)(3) organization engaged in medical research focused on cancer seeks funding from the government for a specific project related to its work.
• The government awards the organization $25,000 for this project.
• The funds are classified as a grant because the research project funded by the government is intended to primarily benefit the general public rather than fulfilling the government’s direct and immediate needs.
  

In another example from the Treasury Regulations:

• A 501(c)(3) research organization engages in contract research.
• The organization is funded by the government to develop a specific electronic device to improve space equipment, a project initiated by the government. The government could have engaged for-profit research organizations for similar work.
• The funds received by the research organization from the government are considered gross receipts, not grants within the meaning of IRC Section 509(a)(2)(A)(i). The reason for this classification is that the research organization is creating a specific product at the request of the government, thereby addressing the government’s direct and immediate needs, which aligns with the definition of gross receipts rather than grants.
  

Grants vs. Gross Receipts Under IRC Section 509 – Form 990 Schedule A

The distinction between grants and gross receipts will significantly affect the public support test under IRC Section 509 and reporting on Form 990 Schedule A.

Grants are considered contributed revenue, which is distinct from earned revenue or program service revenue. Contributed revenue comes from donations, whereas program service revenue is generated when a charitable organization charges for services that are directly related to its mission. This type of revenue is the second most common income source for not-for-profit organizations (NPOs) following charitable gifts. Examples include an animal shelter charging an adoption fee, a museum charging for admission, or a private school collecting tuition. Special considerations arise in the context of research contracts. As previously noted, the nature of the funding – whether it is a grant or gross receipts – can depend on factors such as who retains intellectual property rights or whether the research benefits the general public or the funder directly.

The Treasury Regulations provide guidance for calculating the public support test under IRC Section 509(a)(2). In the calculation, all grants received from non-disqualified persons are included as public support. However, gross receipts from non-disqualified persons are included in the calculation only to the extent that they do not exceed the greater of $5,000 or 1% of the organization’s total support. Organizations should carefully consider payments received as grants versus gross receipts as this characterization impacts the public support test and could lead to a different conclusion to the public support calculation if the grants and contracts are not properly classified.

Grants vs. Contracts under IRC Section 4945

Charitable organizations must navigate the complexities of financial transactions, including understanding the definition of grants as outlined in IRC Section 4945. The guidance provides a broad definition of grants, which encompasses scholarships, fellowships, internships, prizes and awards, certain charitable loans, program-related investments, and payments to exempt organizations that further their exempt purposes. IRC Section 4945 provides guidance to determine what constitutes a grant. However, what is not considered a grant is further clarified by Treasury Regulation Section 53.4945-4(a)(2), which states that grants typically do not include payments for personal services that assist a foundation in its program activities, such as salaries, consultant fees, and travel reimbursements.

A key differentiator is the level of discretion and control over project activities granted to the recipient. Grants usually allow the recipient organization to have control over the activities they conduct, distinguishing them from service payments where the funder retains key decision-making power. As such, understanding this distinction, as it affects the application of expenditure responsibility rules under IRC Section 4945 – which apply to grants but not to consulting contracts or similar arrangements – is important for proper reporting.

To determine whether an arrangement is a grant or a contract, organizations should consider the following factors:

• The nature of the work being funded
• Whether the work supports the recipient’s exempt purpose
• How the funding amount was determined
• Whether there is a quid pro quo, or anything provided to the funder in return for the overpayment
• Who has control over the project’s output
• Who has ownership of the work product and whether it will be used for the public’s benefit or a public purpose
  

These considerations are essential for charitable organizations to understand when negotiating terms to ensure that the arrangement aligns with the intended treatment as a grant or contract. Understanding the nuances between grants and contracts is more than an academic exercise; it has practical implications for compliance, reporting, and maintaining the integrity of the NPO’s mission and tax-exempt status.

Considerations for Private Foundations and Private Operating Foundations

Private foundations, including private operating foundations, face unique regulatory concerns that impact their grantmaking and operational status. Two issues for foundations to consider are the expenditure responsibility rules of IRC Section 4945 and the income test calculations under IRC 4942(j)(3), which determine if a foundation qualifies as a private operating foundation.

Expenditure Responsibility

Private foundations are required to exercise expenditure responsibility (ER). ER refers to the obligations foundations must fulfill when making grants to organizations that are not public charities as described in IRC Sections 501(c)(3) and 509. The purpose of exercising expenditure responsibility is to ensure that such grants do not become taxable expenditures under IRC Section 4945.

Historically, many private foundations have been wary of ER, often due to misconceptions about its complexity or associated risks. However, it is a common process that can be integrated smoothly into existing grantmaking procedures. Compliance with the ER rules is straightforward, although strict adherence is necessary to avoid penalties. A key component of ER is conducting a pre-grant inquiry. Although the IRS does not mandate specific requirements for this inquiry, it is essential for foundations to assess the grantee’s capacity to implement the proposed grant. This due diligence process also serves to identify potential financial, operational, programmatic, or reputational risks associated with the grant. Addressing these risks proactively and including language in the grant agreement can be an effective strategy to mitigate this risk. For private foundations, understanding and implementing ER is not just about compliance. Private foundations must ensure their grants achieve the intended charitable impact while maintaining the foundation’s good standing and tax-exempt status

Private foundations have a critical responsibility to ensure that their grantmaking processes adhere to standards. A fundamental component of this process is entering into a well-structured grant agreement that includes specific, mandatory language to meet ER requirements.

The grant agreement must require that a grantee do both of the following:

• Keep detailed records of receipts and expenditures and make their financial records available to the grantor for review. It is customary practice for grantors to include provisions allowing themselves or a designated third party to verify these records to ensure compliance.
  

• Refrain from using grant funds for activities such as lobbying, political campaigns, personal travel, study, or subgrants to non-public charities unless ER protocols are followed. Additionally, the funds must not be used for any activities that do not serve a charitable purpose as defined in IRC Section 170(c)(2)(B).
  

Beyond these stipulations, foundations are required to collect annual financial and programmatic reports from their grantees. Recognizing the potential administrative burden this could place on grantees, it is advisable for foundations to engage in conversations with grantees about the types of information their systems can readily produce. These discussions can help determine if existing data, already compiled for other funders, can fulfill the foundation’s reporting requirements.

Should there be any misappropriation or diversion of grant funds, the foundation must take appropriate corrective action. Moreover, foundations must diligently report all grants subject to ER on their annual Form 990-PF. It is crucial to note that missing any of these compliance steps could result in the grant not being considered properly executed under ER rules.

The obligation to report on Form 990-PF continues until the granted funds are fully expended and all required reports have been submitted to the foundation. This ongoing reporting is essential to the foundation’s commitment to transparency, accountability, and the upholding of its charitable mission. Foundations must be meticulous in crafting grant agreements and monitoring their execution to ensure grants meet the requirements of the ER rules.

ER is a powerful tool, and when a foundation has a solid grantmaking process, implementing ER should be straightforward and not burdensome. ER rules only apply to grants, so if a financial arrangement can be structured as a contract – with the situation and characteristics fitting a contract – then the ER rules do not apply. This flexibility can simplify the foundation’s operations, provided that the nature of the arrangement justifies the “contract” designation.

Private Operating Foundations

Another consideration for private foundations is determining whether they qualify as private operating foundations (POFs). To achieve this status, a foundation must pass an income test and one additional test – either the asset test, the endowment test, or the support test. POFs are distinct because they make direct expenditures for their own charitable purposes, which are counted as qualifying distributions for determining their operating status. These expenditures often resemble contracts more than grants due to the direct involvement and control the foundation has over the charitable activities.

POFs must make qualifying distributions directly for the active conduct of their charitable activities. According to Treasury Regulation Section 53.4942(b)-1(a), these distributions must equal at least 85% of the lesser of the foundation’s adjusted net income or minimum investment return. The distinction between grants and contracts becomes pivotal when considering what constitutes active conduct for the income test.

Treasury Regulation Section 53.4942(b)-1(b) states that qualifying distributions must be used by the foundation itself to count as a direct charitable activity. When distributions are made to grantees, even if they support the grantees’ charitable purposes, they are not considered as being used for the active conduct of charitable activities. Thus, while grants to other organizations may align with a foundation’s charitable mission, they do not count toward the active conduct of charitable activities in the POF’s income test. As a result, it is critical to consider how these arrangements are structured and whether they will have any impact on the POF’s income test.

In contrast, expenditures under contracts, which typically involve the foundation’s direct action, are more likely to be considered active conduct. This distinction has significant implications for a POF’s tax status. Incorrect structuring of financial arrangements can lead to penalties or jeopardize the foundation’s tax-exempt status. Foundations must exercise due diligence in structuring their agreements to ensure they meet the active conduct requirement and maintain compliance with tax regulations. Understanding these nuances is essential for POFs to conduct their charitable work effectively and avoid adverse tax consequences.

Other Operational Considerations

Charitable organizations often face challenges when distinguishing between grants and contracts, a decision that carries both operational and tax implications. Some key considerations that charitable organizations grapple with in this area:

Internal Approval Processes

Charitable organizations may have different internal procedures for approving grants versus contracts. This could be due to perceived risks, reporting requirements, or the nature of the expenses. For instance, program teams might typically oversee grants, while finance teams engage in contracts. The level of approval required also can vary; grants might need board approval, whereas contracts could require management review. These differences can affect the timing and cost of implementation and contribute to how the organization will approach the arrangement.

Financial Ratio Considerations

On financial statements, contracts often are recorded as administrative expenses, while grants are categorized as program service expenses. However, both grants and contracts that are related to the organization’s exempt purpose could be considered program service expenses. This classification can influence internal financial ratios and might lead charitable organizations to explore alternative arrangements to maintain favorable ratios.

Reporting on Annual IRS Filings

Grants require detailed reporting on IRS Forms 990 (Schedule I) or 990-PF, including information about the grantee, the amount, and the purpose of the grant. In contrast, contracts do not need to be disclosed in such detail on these forms, unless they involve payments to top-five independent contractors. Organizations also might have concerns about publicly disclosing payments to certain parties.

Additional IRS Reporting Requirements

Contracts may trigger other reporting obligations, such as issuing Forms 1099 or 1042S, and could be subject to backup withholding and other requirements, for payments to foreign individuals or entities. These additional reporting duties can influence how an organization structures its financial arrangements.

In summary, charitable organizations must carefully evaluate whether an arrangement should be treated as a grant or a contract, considering the impact on internal processes, financial reporting, IRS filings, and other operational factors. As the distinction between grants and contracts can significantly affect an organization’s tax reporting and operational issues, it is crucial to make informed decisions in this area.

Kamila Czeczot, CPA, is a manager in the exempt organization tax services group at Crowe, with over four years of experience concentrating exclusively on the exempt organization sector. She provides both tax compliance and tax consulting services to healthcare organizations, colleges and universities, private foundations, exempt trusts, membership associations, and NPOs. Kamila can be contacted at kamila.czeczot@crowe.com.