You’re a busy business owner, investor or executive and would like your success to translate into significant charitable achievements. You would like your success to pour over and help others. You may be looking at retirement and considering a more hands-on approach to helping others, more of an active charitable lifestyle but perhaps not operating a charity.
We trust this article will help you decide whether the private foundation is a vehicle suited to your philanthropic, business, tax and estate planning goals.
We address the philanthropist, or potential philanthropist, but include their advisors.
We will compare the private foundation with other approaches to charitable accomplishment.
The rules are complex but a public charity generally receives at least one third of its support from the general public, whereas a private foundation’s support base is normally a limited number of donors. Its funding is usually provided by a donor or a family. ((Instructions to Form 1023, p. 14.))
If funded during one’s lifetime, the private foundation can achieve lifetime benefits as a result of the income tax deduction. It is also possible to fund the private foundation at death with a focus on gaining only the estate tax charitable deduction. Our focus is more on the donor who chooses to be active during his/her lifetime.
We discuss private foundations created by individuals and corporations. Privately held corporations and public companies may form private foundations.
Working through one’s private foundation may be one of the most meaningful accomplishments of your life.
The Commitment
To this author, the “C’s” associated with private foundations are charity, commitment, complexity and control.
There are analogies to bringing children into the world and creating a private foundation given the significant, on-going commitment.
The commitment to a private foundation does become a lifestyle in the sense of resource allocation, which can be up front or long-term, and the on-going demands on one’s time and emotions. That’s not to imply the emotional aspects are other than positive, but rather to say they may be significant.
Among our goals are to give the readers a perspective of the nature of the resource and time commitment, and how much help you may need to accomplish your goals via the private foundation route.
Private foundations are hands-on, “lifestyle” in nature, and often quite personal even when they primarily involve transferring funds to public charities.
A private foundation’s goals will often be topical, such as educational, and its particular goals need to be spelled out in its formation documents. The charitable goals may be broad but they do need to be particularized in the founding documents.
Private foundations are typically grant-making organizations but your particular goal might contemplate forming an operating charity with a narrow focus. This might be classified for tax purposes as public or private charity depending on the structure and degree to which others are involved in the funding.
An operating charity that is privately funded is termed an “operating foundation,” which is basically a private foundation running, say, a library.
An “operating foundation” is hybrid organization subject to some rules that apply to private foundations and some rules that apply to public charities. Donations to such organizations are subject to the more liberal public charity income limitations; the rules are somewhat more liberal concerning deduction limits. Also, the excise tax on failure to distribute income doesn’t apply to the operating foundation. ((Section 4942(a)(1).))
An operating foundation is basically your typical charity that doesn’t meet the public funding criteria; i.e., has narrow rather than general public support. Its work may be on-going or project oriented. While beyond our scope, there are different financial tests that apply to such organizations. There is a portion of the Form 990-PF form that focuses on such organizations. ((Sec. 4942(j)(3), (5). See “Private Operating Foundations,” https://www.irs.gov/charities-non-profits/private-foundations/private-operating-foundations. ))
Our focus in this discussion is the traditional private foundation which primarily makes grants to other charities.
We will briefly outline the tax and other important considerations that enter into such a work so that the reader will better understand the path if he/she really contemplates such a commitment. A private foundation is a commitment of both resources and time.
It is rare but not impossible that an organization will become a public charity after starting out as a private foundation. (( See “Exempt Organizations – Reporting Changes to IRS,” https://www.irs.gov/charities-non-profits/exempt-organizations-reporting-changes-to-irs.))
In general, one should contemplate the long-term aspects from the beginning and address such questions as leadership after the founders become less active.
Will the private foundation be a family enterprise? A private foundation might be a vehicle to impart philanthropic values and behavior patterns to children, or help the family as a family focus greater resources on particular objectives so as to achieve identifiable results. ((See “How Can You Raise Your Child to Be a Philanthropist?,” Wall Street Journal, Veronica Dagher, March 20, 2017, p. R5.))
It is generally true that families contemplate an indefinite, long-term life for the private foundation as the family’s charitable enterprise.
But it is also possible to contemplate the private foundation’s termination after the founder’s lifetime goals are achieved, which can involve fully expending the charity’s resources or, e.g., an eventual transfer of remaining assets to a community foundation.
One will almost certainly need some professional help at the inception and termination of a private foundation.
It foregoes one of the major incentives for the private foundation, the lifetime income tax deduction, but it is also possible to contemplate the foundation as arising in a testamentary context, which also requires some planning for the entity’s long-term administration, including financial management.
Note that reading the term “foundation” in the newspaper doesn’t necessarily mean “private foundation” as defined in our tax code. A public charity may also have “foundation” in its name. In this article, we will use the terms “private foundation” and “foundation” interchangeably.
Privacy v. Publicity
Before discussing more of the particulars of the private foundation, we will touch on the privacy v. publicity aspects, which are often important considerations to major donors.
Privacy
It is quite possible that the people helped with your donations to public charities will never know you. Nor will your neighbors and friends know of your donations.
But forming a private foundation isn’t the most private vehicle for achieving charitable goals. This usually isn’t a problem but it is an issue that needs to be understood if you are to benefit others in a more hands-on, personal way.
There is an extraordinary amount of IRS scrutiny as well as disclosure to the public via the foundation’s tax return.
A private foundation’s application for exemption, Form 1023, is also available to the public. The Form 1023 application is rather complicated as well as comprehensive, and asks for responses based on “past, present and planned activities.” ((Instructions to Form 1023, p. 3.))
You might pull up Form 1023 on the internet, and look at Parts V through VIII and XV, which include information about officers, directors, trustees, their compensation, expense accounts, etc. ((See also page 5 of the Form 1023 instructions, “Public Inspection.” ))
A private foundation also discloses contributors on a Schedule B of the annual Form 990-PF. This form is open to public inspection. ((See following IRS comments on disclosures of contributors to private foundations versus nondisclosure with public charities. https://www.irs.gov/charities-non-profits/public-disclosure-and-availability-of-exempt-organizations-returns-and-applications-contributors-identities-not-subject-to-disclosure.))There is much disclosure on the Form 990-PF, including names and addresses of the trustees and directors, which may even cause some donors to steer clear of private foundations. ((Commentary by attorney, Victoria Bjorklund, reported in “Making the Transition Out of a Private Foundation,” Deborah L. Jacobs, https://www.fidelitycharitable.org/giving-strategies/give/making-transition-from-private-foundation.shtml?vm=r.))
The form is generally very vigorous and penetrating in seeking to understand the details of how the foundation really operates, and any relationships with the family and their associates. There are occasional exceptions for small foundations but in general, the reporting requirements are quite comprehensive. For example, regardless of size, all foundations have to report income and expenses, as well as a balance sheet.
Even the IRS instructions to the Form 990-PF discuss in some detail the foundation’s reporting to the Attorneys General of the states, and sundry requirements for making annual returns and exemption applications available to the general public.
If a private foundation has unrelated business income, the form reporting such income is available for public inspection. ((See IRS instructions to Form 990-T.))
Publicity
Private foundations are also used to get the family name before the community. For example, grants to a particular charity are sometimes announced in the local newspaper along with the name of the family foundation.
If the foundation funds a building for a hospital and the family name is on the building, is that a tax problem? No. The tax rules do not frown on public acknowledgement of good works and contributions. Such benefits are considered incidental, not sufficient to subtract from the charitable nature of the work.
The choice of the name of foundation can be important from this perspective also.
There is much about the private foundation that is public, sometimes beyond what the family would prefer.
The Long-Term Perspective
It isn’t that difficult to wind-down a private foundation, which is typically done by distributions to public charities, which is typically the day-to-day activity of the private foundation anyway. Yet, going-in, the donor will want to consider, and even discuss with other family members, the long-term perspective.
You may not have noticed in the instructions that the IRS says when you mail in your Form 1040, if you’re sending a check of $100 million or more, you need to send more than one check. “The IRS can’t accept a single check (including a cashier’s check) for amounts of $100,000,000 ($100 million) or more.”
Do you need this level of wealth to consider a private foundation? No. The majority of private foundations are formed by the successful but not necessarily the mega wealthy.
The most important reason for forming the private foundation is a heart’s desire to do the charitable work.
There are some scenarios in which a charitable disposition can enhance wealth; those scenarios usually entail some uncommon assumptions, and may entail partially charitable vehicles, such as a charitable remainder trust.
In general, we’d suggest you not consider a private foundation unless you have a charitable goal. They are a bit of work, and will take time even if you delegate and hire advisors. The commitment will depend a lot on your particular vision and decisions you make in the initial, design phase of your foundation, but any private foundation will be some work…. and initial and on-going expense. Some of the latter may be paid out of the foundation.
One up-front issue is the debated question of minimum size for a private foundation. As to the minimum size of funding a private foundation, we generally suggest a $500,000 foundation.
Caveat re any minimum size: It is common to significantly fund a private foundation up front. It is also possible and common to have a private foundation for on-going annual giving.
The assets of the private foundation typically come from donations and income from passive investments.
We note a private foundation is a charitable organization described in Section 501(c’)(3) of the Internal Revenue Code, and this classification doesn’t generally include an organization which has the power to tax. ((Instructions to the Form 1023, p. 7.)) In many ways, the private foundation is just a typical charity, more narrowly funded but whose funds come from voluntary decisions of those sharing the founder’s vision. It is generally up to the founder and family, and sometimes their friends, to fund the private foundation.
The donor contemplating a private foundation will want to consider generally the long-term aspects even from the beginning, and the long-term perspective of funding, if the funding isn’t contemplated to be just one up-front major contribution. Family discussions are usually appropriate.
Professional advisors sitting in on such discussions will generally advise that private foundations are long-term propositions.
A private foundation often makes sense for a philanthropically inclined family that would like a central place to filter donation requests.
One issue here is the private foundation by nature has to specify its purpose or purposes, which introduces some limitations. So for the family making major donations in a variety of areas, the private foundation may make sense but there will also likely be donations that “skip” the private foundation.
The private foundation is rarely the family’s sole means of charitable accomplishment.
Creating the Private Foundation
The structural choices are limited although somewhat broader than the two main categories of corporations or trusts.
“Only trusts, unincorporated associations, or corporations (including limited liability companies) are eligible for tax-exempt status under section 501(c)’(3) of the Code. Sole proprietorships, partnerships, or loosely affiliated groups of individuals are not eligible.” ((Form 1023 instructions, p. 6.))
For exempt organization purposes, an LLC is treated as a corporation, not a partnership, and the LLC cannot be a disregarded entity, which is sometimes possible in a for-profit context. ((Form 1023 instructions, p. 7.))
Private foundations are usually corporations, less frequently trusts. The corporate structure is easier to amend and adjust, which is normally an advantage but it also may make it possible for others to veer from the founder’s original vision.
A corporation is more of a shield from liability for officers and directors, but it may also be subject to such requirements as having an annual board meeting as well as sundry state laws governing a corporation.
Standards governing trusts tend to be more strict.
It is generally believed that either the corporate or trust structure can define the scope of the foundation’s work either broadly or narrowly as the founder prefers.
This is rarely a significant issue affecting this choice but we also note that should the private foundation incur unrelated business tax, the tax rate on such income is higher with a trust.
The concept of unrelated business tax is an important issue in any nonprofit, including a private foundation. Exempts are generally expected to invest in a passive manner but the unrelated business income tax can effectively reach passive investments. Exempts generally can incur unrelated business income tax even on real estate rental income that entails minimal supervision when there is a mortgage, or the private foundation invests in a partnership that has debts with its investments.
It is also true that related vs. unrelated issues may be affected by your organization’s declared purpose. The organizing documents of the private foundation will need to express the organization’s charitable purposes, and such declarations can sometimes affect whether an activity is an “unrelated business.”
Actual donations received by the private foundation are not subject to tax because the entity is tax exempt and the transfer is a gift. ((See Sections 102, 501(c’)(3).))
Either the corporate or trust structure can enable the founder to define his/her role as the hands-on control person of the charitable allocations, the grants, or spread those decisions among family or others.
A main reason, if not the reason, to create a private foundation is control of the philanthropic details. Philanthropic control as a goal should be explained to the founder’s legal counsel, and control as drafted in the founding documents should be explained to the founder and usually the founder’s family by counsel.
Neither the corporate or trust structure prevents the founder from hiring the help needed.
There are many compliance details that are not typically the hands-on work of the philanthropist. See the IRS Publication 4221-PF, “Compliance Guide for 501(c’)(3) Private Foundations.,” which gets into such details as the private foundation’s payroll reporting responsibilities if it is an employer.
An organizational discussion can sometimes stress organizations within the private foundation.
These discussions often address such details as whether a donated asset or group of assets might better be owned by, say, a corporation owned by the foundation rather than the private foundation. For example, a group of assets generating significant unrelated business income may even endanger the private foundation’s exempt status, or there may be realty situations where an LLC or partnership structure might be considered, particularly when the private foundation is not the only owner.
Many of the management concepts and other matters we note below concerning corporate foundations are equally applicable to the individual’s private foundation.
The Corporate Foundation
A corporation, whether public or private, will often have a giving program whereby the entity makes charitable donations and deducts the donations in its corporate return. A regular corporation, as opposed to an S corporation, deducts its donations subject generally to a limit of 10% of its income, subject to certain adjustments and carryover rules. ((See generally IRS Publication 542, Corporations. ))
A private foundation may be created by a private or publicly-traded corporation.
Among the issues that arise with corporate foundations is office space. Basically, the corporation cannot even lease part of its building to its private foundation because the transaction would fall within the self-dealing rules even if the private foundation paid below market rentals. Rent free use would not incur the excise tax that arises under the self-dealing rules of Section 4941.
Basically, the private foundation would need to enter into its own agreements, including, for example, the purchase of office supplies, paying utilities on space it gets rent free from a disqualified person, etc.
A painting of the private foundation moved to a corporate office, supplies of the foundation that get shared with the corporation, using corporate foundation assets to honor the pledge of an individual to his/her favorite charity, these become excise tax problems that not only need to be avoided but understood within the organization.
There is an exception to the self-dealing rules for personal services that are reasonable and necessary for carrying out the foundation’s exempt purpose. ((Regs. 53.4941(d)-3(c’).)) If one goes the route of charging for such services, be prepared to support the reasonableness of the expense to the charity. Detailed time records are recommended.
In general, recordkeeping by private foundations is so important that even IRS publications discuss ecords management for the private foundation. ((“Compliance Guide for 501(c)’(3) Private Foundations, “ p. 16, https://www.irs.gov/pub/irs-pdf/p4221pf.pdf.))
Although not generally required under the tax rules, private foundations have certified audits in part for added protection of the directors.
Care is needed in connection with pledges because they raise issues of self-dealing. It is generally a good idea to have corporate officials tell charities that our foundation will contact you rather than have the corporate officers making commitments. ((See Regs. 53.4941(d)-2(f).))
Conflict of interest policies and agreements are sometimes recommended.
Corporate foundations tend to be more common with public companies. Most wealthy families approach philanthropy through private foundations they create as individuals.
The Tax Savings Incentive to Creating a Private Foundation
Both the donor advised fund, a type of public charity, and private foundation qualify for unlimited estate and gift tax deductions.
It is not untypical that a wealthy family will plan for major wealth transfers to the family members along with major transfers to charity following death.
An after-death transfer to charity may qualify for an estate tax deduction but it also foregoes the benefit of a lifetime transfer; i.e., an income tax deduction which enhances wealth. Contributions may be limited and subject to a five-year carryover which expires at death. ((Regs. 1.170A-10(d)(4)(i); “Till Death Do Us Part: Dealing With Carryovers When a Spouse Dies,” Jan F. Lewis, The Tax Adviser, 1/1/17, www.thetaxadviser.com/issues/2017/jan/carryovers-death-spouse.html.))
The deduction limit on contributions to a public charity, including a donor advised fund, in a given year is 50% of adjusted gross income versus 30% for private foundations. Adjusted gross income is income just prior to the standard deduction or itemized deductions, and personal exemptions.
The deduction limit on property donations to private foundations is 20% of AGI, whether the property donations are public stock, or, e.g., real estate, versus a 30% of AGI limit for such donations to public charities.
There are certain basic rules governing charitable donations and despite the closely-knit context between the donor and the private foundation, the rules apply to private foundations in a manner similar to other charities. A private foundation receiving a contribution of $250 or more must provide a substantiation receipt acknowledging the amount of gift and whether the private foundation provided any goods or services in return for the contribution. If the private foundation receives a noncash contribution and disposes of the property, it may need to file Form 8282, the Donee Information Return.
If your propensity is big picture and you’re not careful when it comes to the details, the private foundation approach probably isn’t your vehicle unless you also get help managing the day-to-day aspects. Giving assets away in a charitable context need not be that difficult, and donating via a private foundation need not be difficult but it is a tax-technical world and one that is highly regulated.
In a public charity, quid pro quo issues come up in such instances as buying a ticket to a charity event and the donation receipt notes the value of the meal the donor received or the value of the DVDs when there’s a donation to public television.
In a private foundation context, even minor-dollar issues shouldn’t arise because the rules are so strict; e.g., the spouse flies on a trip pertaining to private foundation business and the spouse’s ticket is paid for by the foundation. This would even trigger self-dealing under the private foundation rules and the spouse who flew would be subject to an excise tax.
The private foundation documents even need to contain special provisions that don’t apply to other charities. ((See IRS Pub. 557.))
Charitable contributions that exceed the limits may generally be carried over during one’s lifetime for five years. ((See Regs. 1.170A-10(d)(4) when there are joint returns and a spouse dies when there is a charitable contribution carryover.))
Donations of publicly held stock to a private foundation qualify for deduction at fair market value, as in the case of donations of listed stock to public charities. But otherwise, the property donation rules are more restrictive with private foundations.
Notably, the deduction for real estate or closely held stock to a private foundation is limited to basis – or fair market value at death (or near death) if the property was inherited.
Charitable contributions are limited but one of the major components of itemized deductions, the other major categories often being state and local taxes and the home interest expense deduction. Donors to private foundations will often want to work with their CPAs in planning the level of funding in a given year.
Writing in early 2017, President Trump’s tax proposals may more significantly limit the charitable income tax deduction, which could be an important consideration when tax minimization is a major factor in deciding whether to form a private foundation.
Planning the Funding and Investments of the Private Foundation
It is common to contribute significant funds to the private foundation from inception but there is no requirement to do so. The donor may prefer to make annual contributions as the primary means of funding, or make annual contributions as well as an initial major gift.
Funding the foundation with cash is the easiest approach but it foregoes the advantages of donating an appreciated asset to an exempt organization. The basic incentive to funding a private foundation with appreciated assets is the donation doesn’t trigger gain and the inherent gain shifts to an exempt organization. There are decisions to be made but whether the donated assets are sold immediately, gradually, or well down the road, the gain is normally sheltered from tax because of the private foundation’s exempt status. There is also the income tax savings from the income tax deduction.
Donations of Listed Securities
The donation of publicly traded securities to a private foundation leads to a deduction measured by fair market value as does a transfer of such securities to a public charity. The percentage of income limitation is less than with a public charity but the measure of the deduction is the same.
The deduction for the transfer of other assets to a private foundation is generally limited to cost. For example, the transfer of appreciated investment real estate to a public charity yields a deduction at fair market value whereas its transfer to a private foundation yields a deduction measured by basis.
Basis is typically cost, but basis steps up (or down) to fair market value at death and both halves of community property step up at the death of the predeceasing spouse. So a widow/widower’s deduction for a transfer of assets to a private foundation is more likely to approximate current value.
Donations of Real Estate
In general, there is a fair market value rule governing the measurement of charitable donations of real estate to public charities although “dealer property” is an exception. The real estate dealer is considered akin to the grocer selling groceries. Transfers of dealer property, such as a builder’s new house (inventory), would yield a deduction measured by the lower of cost or market even if the recipient is a public charity.
But donations of appreciated realty, including investment (non-dealer) property, to a private foundation are measured by cost, or fair market value if lower.
“Cost” for this purpose should be understood as “basis” for tax purposes. For example, in California, the general rule is that community property results in step-up to fair market value upon the death of the predeceasing spouse, so in the case of a surviving spouse basis may be closer to fair market value. So if realty is the area of concentrated wealth, there may be added incentives to the private foundation alternative following the death of the predeceasing spouse in a community property state.
Transfers of realty encumbered with debt to a private foundation may also result in other issues, including “self-dealing” concerns. ((See particularly Sec. 4941(d)(2)(A).))
Most transfers of real estate do not involve these problems but transfers of raw land where it is contemplated the land will undergo extensive development can introduce the issue of it being a “business enterprise,” which introduces not only the unrelated business tax issue (Section 512) but also the excise tax on “excess business holdings.” (Section 4943; see discussion in PLR 201630009, 7/22/16). The Section 4943 tax is problematic in the case of a private foundation or donor advised fund that is treated as a private foundation for this purpose. ((Sec. 4943(e’).)) Among the complexities here is the issue of possible relief on the grounds that the activity is functionally-related or a program-related investment. ((See generally Community Foundations National Standards Board, “What are excess business holdings and how do they affect a community foundation?” http://www.cfstandards.org/FAQ/what-are-excess-business-holdings-and-how-do-they-affect-community-foundation.))
One of the potential incentives with donating real estate is property tax relief. Local rules vary and they control this issue, but generally one finds property tax relief if a charity owns the real estate and uses it in its exempt work. If the charity owns realty, uses part and rents part, one often has proration issues for purposes of the property tax; i.e., property tax relief on the portion of the realty actually used by the exempt organization.
In general, an exempt that owns personal property and rents it has to pay an unrelated business income tax on net profits but unless debt-financed, an exempt that owns and rents real estate doesn’t incur this tax. Rental of personal property that would generally be taxable would include, for example, cell towers on a building rented to a communication company. ((See generally IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations, p. 10.))
But rental of realty, even for an exempt, wouldn’t normally yield a property tax exemption.
Hotel operations are generally considered taxable and subject to the unrelated business tax because the addition of such significant services causes the activity, even though conducted by a charity, to resemble a business.
The unrelated business income tax raises such issues as whether the activity is regularly carried on and whether the activity is substantially related to the particular charity’s exempt work. For example, a pharmacy tied to a tax exempt hospital may have tax exempt income from filing prescriptions for the exempt hospital but unrelated business income when it deals with the general public. Similarly a cafeteria may qualify for exemption to the degree it is for the convenience of employees and patients of the exempt hospital but be taxable to the degree it is patronized by the general public. The convenience concept as related to exempt purpose may help explain why we don’t see strolling violinists in even the nicest hospital cafeterias. IRS rulings on the topic are more apt to examine whether the charity’s coffee shop really contributes to its exempt purpose. ((PLR 201710005, 3/10/17.))
Donations of Closely-Held Business Interests
Donating closely-held business interests encompasses Subchapter S stock, partnership interests, LLC interests, even sole proprietorships, and such issues as whether the interest is community property. Our discussion will focus mainly on traditional corporation stock.
The measure of the deduction for a transfer of closely held stock to a private foundation would generally be cost. In the case of community property, basically both halves step up to value at the time of the death of the predeceasing spouse. Occasionally, step-up may be at an alternate valuation date after death. So it is also possible that the basis of closely held stock is more than original cost because of the death of the predeceasing spouse. Such stock would then, if transferred to a private foundation, yield a deduction (subject to limits) higher than original cost, assuming appreciation during the owner’s lifetime.
Closely held stock may be considered an “excess business holding” if the foundation and related persons own more than 20% of the voting stock of the closely held business. ((Section 4943.)) Generally such closely held business stock may be held by the foundation for 5-10 years if acquired by gift or bequest, or it may also be considered an excess business holding. Planning is necessary in connection with such restricted assets. The topic is very tax technical but our point is that it may not be impossible to considered some level of funding of a private foundation with closely held stock usually followed by the redemption of the stock.
There are complex self-dealing issues and penalties that can arise but there is an important estate administration exception for certain indirect acts of self-dealing. ((See Regs. 53.4941(d)-1(b)(3); Sec. 4941(d)(2)(F), Regs. 53.4941(d)-3(d), PLR 201624013, 6/10/16. See generally “Coordinating Charitable Trusts and Private Foundations for the Business Owner: Coping with UBIT and Self-Dealing Rules,” Matthew S. Phillips, The Tax Adviser, AICPA, March 31, 2014))
It is also possible that closely held businesses or limited liability companies or limited partnership interests donated to a private foundation create ordinary income that is taxable as unrelated business income subject to corporate or trust tax rates.
Because the value of closely held business interests may be closely tied to the principals, such gifts are sometimes planned in conjunction with life insurance.
A donation of closely-held stock to a supporting organization has advantages compared to a donation of such stock to a private foundation since the supporting organization is a public charity.
The Taxable Aspects of the Private Foundation Rules
Gifts to the foundation are not taxable income or unrelated business income. ((Section 102.))
In general, the earnings on assets in the charity, including a private foundation, are exempt from income tax. This is generally true for federal and state tax purposes because with the approval as a private foundation comes tax-exempt status.
The main exceptions to this concept are that, like other charities, the private foundation is subject to tax on unrelated business income and, unlike publicly supported charities, the private foundation is subject to a special 1-2% tax on certain income. The private foundation is also subject to a complex set of excise tax rules
Unrelated Business Income Taxes Under Section 511
In the private foundation world, being exempt isn’t necessarily tax-free.
In practically any charitable context there is the potential for “unrelated” business income tax. The concept is that a charity has to be doing activities that contribute to its exempt purpose. It is permitted to earn income and would be expected to do so. But if the activity is a “business” as opposed to investment and it is “unrelated” to the work of the particular charity, it should pay income tax else for-profit companies doing the same activity are in an unfair competitive position. ((Sections 511, 512. See generally IRS Pub. 598, “Tax on Unrelated Business Income of Exempt Organizations.” See Form 990-T.))
A $1,000 deduction is allowed against the unrelated business income but it is generally recommended that the form be filed even if unrelated business income is not more than $1,000.
Too much unrelated business income endangers the private foundation’s exempt status. Unrelated business income generally needs to be “insubstantial,” but the IRS has no hard-and-fast guidelines defining the level at which such income puts the organization’s exempt status at risk.
One approach to these concerns involves planning to transfer unrelated business activities into a for-profit subsidiary which if properly structured and monitored should be able to distribute dividends (passive income) to the exempt parent. The tax rules generally permit charities to receive tax-free investment income. This general rule that exempts don’t pay tax on investment income applies to private foundations, but there is a major exception for private foundations in the 1-2% tax imposed for the purpose of generating income to oversee private foundation.
As indicated, the tax rules generally distinguish “related” and “unrelated” business income with charities. The former are tax-free.
Your definition of exempt purpose in your organizing documents can affect whether income is related to unrelated to that purpose. In planning at the inception stages, it is good to contemplate activities that might generate income yet be related to your goals. The income needs to be “substantially related” to the exempt purpose. Just producing receipts is not substantially related to the exempt purpose. ((Regs. 1.513-1(d).))
The principals should generally focus on keeping investments in the passive category versus operating business category.
The details of investment by a private foundation vest in the donor or those he/she designates, whereas the donor may choose an investment plan but the sponsoring organization really has ultimate control of investments with a donor advised fund, such as a community foundation.
The unrelated business income issues may arise with closely held businesses or a limited liability company or partnership interest.
S corporation income, even if passive by nature, would be subject to unrelated business income. ((See IRS Publication 598, “Tax on Unrelated Business Income of Exempt Organizations,” p. 13.))
Reasonable methods of allocating expenses against unrelated business income are permitted. ((Regs. 1.512(a)-1.)
Tax on Investment Income under Section 4940
In order to pay the government to watch over them and to a lesser extent to just contribute to the general tax revenue, private foundations are subject to a 2% tax on investment income. (( Sec. 4940.)) The tax can be reduced to 1% in some cases when certain distribution requirements are met. ((Sec. 4940(e’)(2).)) Related expenses can reduce the base of the tax.
Net capital gains generally count for this purpose, as do such investment income categories as dividends and interest.
Private Foundations are tax-exempt, yes, but this special tax is an exception. Income that is taxed under the unrelated business income tax rules that apply to private foundations is not again taxed under these rules.
“Ordinary and necessary” investment expenses can reduce the base of the tax. The quoted phrase mirrors the language of Section 162 that allows a deduction for business expenses in a for-profit business. Under Section 162, the phrase has been rather liberally interpreted.
One should consider planning charitable distributions to qualify for the reduction in the tax rate from 2% to 1%.
Excise Tax Overview
Excise taxes are rarely an issue with public charities, although the issue can arise in the context of political activities. Excise taxes can also be an issue with donor advised funds, though such matters are rare and the topic is one managed by the donor advised fund.
Excise tax issues arise most frequently with private foundations, and they are a main reason its budget will often need to include fees for professional advice.
The organizing documents of the private foundation need to prohibit incurring excise taxes under Sections 4941(d), 4942, 4943(c)’, 4944 and 4945(d’). ((Instructions to Form 1023, p. 14; Regs. 1.508-3.))
In general, the taxes are imposed under a two-tier system, an initial tax upon the occurrence and a second tier tax if there is lacking timely correction.
The IRS has authority to abate the taxes in most sympathetic circumstances but it doesn’t even have authority to abate the first-tier self-dealing tax. ((Sec. 4962.)) An uncorrected self-dealing transaction can result is a second-tier tax of 200% of the amount involved with the self-dealer and 50% of the amount involved, subject to a dollar limit, in the case of a foundation manager. The first-tier self-dealing excise tax is 10%, or 5% in the case of the foundation manager. (Sec. 4941).
The other areas of excise tax are tax on failure to distribute income (Section 4942), taxes on excess business holdings (Section 4943), taxes on investments which jeopardize charitable purposes (Section 4944), and taxes on taxable expenditures. (Section 4945.) The latter is particularly important in managing the day-to-day activities of the foundation.
While a public charity may at times have a for-profit subsidiary, the various excise taxes on private foundations may at times practically preclude it owning a for-profit subsidiary barring the subsidiary relating to the exempt purposes. In general, for-profit companies are welcome to form private foundations but private foundations cannot necessarily form for-profit subsidiaries even if that is considered a desirable investment approach by those controlling the foundation.
Excise Tax: Self-Dealing
Any insider or related party dealing with a private foundations needs a basic understanding of the self-dealing rules. ((Section 4941.)) The exempt nature of the vehicle presents some potential for abuse which is met with an excise tax on self-dealing.
The control theme associated with the private foundation needs to be judged in the context the realm is highly regulated, even to the point of a hands-off theme.
When the readership is the professional advisor, this is often the most comprehensive discussion because the rules are very complex.
The tax literature is replete with discussions of conspicuous self-dealing and indirect self-dealing. The tax rules in this area are generally interpreted in an expansive manner, such that managers and founders need to have a very cautious attitude in any dealings between the foundation, including those involving relatives and entities in which they have an ownership interest.
The tax comes in two-tiers and is imposed, not on the foundation, but upon a “disqualified person” or foundation manager. The tax can turn on the circumstances, and in certain circumstances is not even discretionary. Even the rate of the tax can get a bit complicated depending on the party involved, and the tier of the tax.
This excise tax generally reaches “disqualified persons,” a term which includes substantial contributors, defined generally as those contributing more than $5,000 during the year if such amount is more than two per cent of the year’s contributions.
Can contributing funds put you into a special class of persons that can incur penalties? Yes.
If you’re a substantial contributor to a private foundation, even if not directly involved in the details, you need to think generally in terms of “hands off.”
There are twenty percent and thirty-five percent ownership tests which we won’t discuss in detail but the basic idea is the tax reaches not only substantial contributors and managers but also owners of substantial contributors, related businesses and family members.
The rules reach big transactions as well as the small, such as a free chicken dinner for a family member at the foundation’s annual gathering. The rules are notoriously problematic and complex, especially when there are valuation issues.
Prohibited dealings include the sale, exchange or leasing of property, the extension of credit, furnishing goods and services of the foundation to disqualified persons, transferring foundation income or assets to disqualified persons, and even the payment of compensation. There are notable exceptions; e.g., disqualified and related parties are generally entitled to receive reasonable compensation for personal services.
Common cautions in the case of self-dealing include these scenarios.
Private foundation pays for the ticket of a spouse to attend a fundraising event and the spouse is only enjoying, not working;
Private foundation pays the travel costs of a spouse who isn’t performing services to the charity;
Private foundation rents space from the donor or a related party;
Private foundation satisfies a legally binding pledge of the donor or a related party.
There can be exceptions but generally any transactions with the private foundation, including below-market transactions, should be avoided or subject to review.
The legislative history that resulted in these notoriously strict rules reflects concern about using the private foundation’s resources for private benefit, such as loans, stock bailouts, and excessive salary considering services actually rendered to the foundation.
Could one fund a private foundation during high income years then plan on using the funds to compensate one’s self for involvement with the foundation during retirement years? The question is complex but generally, compensation to the founder or related parties needs to be handled with great care, including documenting time spent, responsibilities, etc. In general, founders and related parties usually work for free when it comes to the family’s private foundation.
Incidental benefits, such as getting the family name before the public and enhanced employee morale, are not self-dealing.
The excise tax rules generally, including particularly the self-dealing rules, need not be reasons to avoid the private foundation route to charitable accomplishment but the environment requires care and an understanding of the rules.
Excise Tax: The Private Foundation’s Distribution Requirement
The balance sheet of the private foundation may grow or diminish depending on the relationship of distributions to income and expense, and any future contributions. In any event, the tax rules dictate certain recurring minuses to the balance sheet; i.e., certain minimum distributions annually.
There is some mitigation of the following discussion of required minimum distributions for “set asides.” The basic idea is that a project is better served by scheduling payments within sixty months of the first set aside. ((https://www.irs.gov/charities-non-profits/private-foundations/set-asides.))
There are detailed rules but the general concept is to require private foundations to distribute at least five percent of their assets not already devoted to charitable work. It is possible for the donor to deduct transfers up front but there are steps within the rules to require some minimum payments from the foundation to charities. (Section 4942.)
The base for measuring required distributions is phrased in terms of the fair market value of the private foundation’s assets not devoted to its exempt work, such that difficult-to-value assets can be problematic.
There are, as usual, detailed rules. For example, assets coming from an estate are excluded prior to actual distribution. ((Regs. 53.4942(a)-2(c)(2).)) Allocations between exempt and non-exempt use of an asset may be necessary in such cases as a building used in part for the foundation’s purposes. ((Regs. 53.4942(a)-2(c)(3). See generally Part X of the Form 990-PF.))
As to what is a qualifying distribution, the rules generally look for a public charity. There is the concept of a private operating foundation, which is significantly privately funded but may be, e.g., a library, and grants to private operating foundations not controlled by the private foundation are permitted. But a grant to another charity that is controlled by the grantmaking foundation or its disqualified persons will not pass muster as a qualifying distribution.
Should the private foundation control other organizations, the distributions have to go outside of the controlled group.
Special rules apply when a foreign charitable organization is to get private foundation distributions unless the foreign organization has obtained an IRS determination letter.
Reasonable administrative expenses related to the charity’s mission also qualify as a distribution.
The foundation’s requirement to pay out in one year is measured by its assets in the prior year.
There is an excise tax, basically a penalty of 30% on undistributed income, for failure to distribute the required minimum amount. ((See “Taxes on Failure to Distribute Income – Private Foundations,” https://www.irs.gov/charities-non-profits/private-foundations/taxes-on-failure-to-distribute-income-private-foundations.))
Excise Tax: Excess Business Holdings
To preserve the charitable character of the foundation and guard against it being too involved in the insider’s business affairs, there is a general prohibition against the foundation owning more than 20% of a business enterprise. ((Section 4943.)) A 35% control test can apply in some circumstances. There is also a 2% de minimis rule; otherwise one generally starts with 20% ownership interest and subtracts the holdings of disqualified persons in relation to the private foundation.
There are certain exceptions, such as when the “business” has income that is 95% passive or when the activity furthers the work of the private foundation beyond just providing profits.
If the private foundation acquired the business interest via gift or bequest, it may have a longer period to remedy the circumstance without penalty. (( See Sec. 4943(c’). See also “Funding the Family Foundation: Considerations for Donors of Privately Held Securities,” Sonia K. Johnson, Morrison & Foerster, Feb. 1, 2011.))
It is often recommended that the foundation monitor the business holdings of disqualified persons because changes in the holdings of a disqualified person may affect the private foundation being subject to this tax.
Donor advised funds, a type of public charity, are treated as private foundations for purposes of the tax on excess business holdings. ((Section 4943(e).)) So the supporting organization and the general public charity option compare more favorably against the private foundation or donor advised fund if the goal is to donate closely-held stock. ((See “Taxes on Excess Business Holdings,” https://www.irs.gov/charities-non-profits/private-foundations/taxes-on-excess-business-holdings. See the IRS discussion more particularly focused on certain supporting organizations for purposes of Section 4943. “Supporting Organizations – Requirements and Types,” https://www.irs.gov/charities-non-profits/charitable-organizations/supporting-organizations-requirements-and-types. On supporting organizations generally, see also Schedule D of Form 1023.))
Excise Tax: Jeopardizing Investments
“If I’m going to set aside funds inside the charity, can’t I at least invest those assets any way that I want?” No.
The basic idea of the lawmakers was responsible, prudent investments that don’t put the foundation’s assets at risk because the investment asset allocations are too speculative or risky. Penalties can be incurred for investments involving commodities futures, trading securities on margin, and selling short. ((Sec, 4944.))
A private foundation borrowed funds to get heavily invested in a particular public company stock. The three trustees of the private foundation making such investment decisions had ties to the company. The IRS concluded these were jeopardizing investments. ((GCM 39537, July 18, 1986.))
Tax rates here vary but at the foundation level, the excise tax rate is generally 10%.
Program related investments are generally an exception. For example, it might be part of your charitable purpose to make risky loans within a needy group. One pronouncement found a program-related investment purpose, rather than a jeopardizing investment, when 85% of the funds focused on an economically depressed area. ((GCM 39720, March 30, 1988.))
Excise Tax: Managing the Private Foundation
Can you incur a tax for just not working hard enough? Yes, if you form a private foundation.
There’s a tax if you don’t make sufficient distributions, then there’s another tax focused on managing those distributions. So forming a private foundation and then sitting on your hands isn’t an option.
Setting your charitable goals and the particulars of your vision will have much to do with the design of the controls you will need within the organization. The concept is not just one of saying good controls are appropriate; the context is one of penalty taxes if controls aren’t in place and followed.
Grants are usually pursuant to written grant agreements which spell out the purposes, timing of payments, expectations as to the grantee, including such details as reporting, prohibited activities in so far as use of the grant money, specific goals, and the need to maintain existing exempt status.
Grant policies should generally be in place as soon as the private foundation begins its activities.
Grant policies include such matters as expectations of detailed budgets accompanying grant proposals. Grants involving real estate may entail such details as drawings and appraisals, eligible costs, and the grantee’s responsibilities.
The IRS summarizes this topic, basically one of due diligence, as follows.
“Expenditure responsibility means that the foundation exerts all reasonable efforts and establishes adequate procedures:
- To see that the grant is spent only for the purpose for which it is made,
- To obtain full and complete reports from the grantee organization on how the funds are spent, and
- To make full and detailed reports on the expenditures to the IRS.” ((“Grants by Private Foundations, Expenditure Responsibility,” https://www.irs.gov/charities-non-profits/private-foundations/grants-by-private-foundations-expenditure-responsibility.))
It continues:
“The exercise of expenditure responsibility may involve one or more of the following elements:
- Pre-grant inquiry,
- Certain commitments by the grantee,
- Requirements relating to program-related investments,
- Actions with respect to violations of expenditure responsibility requirements”
In general, the penalty under Section 4945 is not an issue when funds of the private foundation are donated to a public charity. ((See “Reliance by Grantors on Public Charity Status of Grantees,” https://www.irs.gov/charities-non-profits/private-foundations/reliance-by-grantors-on-public-charity-status-of-grantees.))
Qualifying distributions here can include program-related investments and “set asides” for particular projects as well as amounts paid to accomplish charitable or similar purposes. The latter can include administrative expenses, such as legal and accounting fees, but typically they are grants to public charities.
Fundamental to this process is determining that the grantee is a qualified charity, usually a Section 501(c)’(3) organization, recognized by the IRS. You will want to review the grantee’s work and reputation and suitability given the purpose of the donation. There will generally be contracts to review and follow-up reports.
Much of the daily work of the private foundation focuses on making grants in a manner that achieves your goals and also avoids the excise tax of Section 4945.
There are lesser penalties imposed on the foundation manager, but the basic focus of this excise tax is a 20% tax on the private foundation, then a 100% if the problem isn’t corrected.
One of the areas of focus is making political or lobbying expenditures rather than charitable donations, which is important but rarely an issue.
It is possible that the private foundation will make charitable transfers to individuals for travel and study but these are subject to such safeguards as having the foundation’s grantmaking procedures pre-approved.
Could you and your rich friends that have private foundations “swap” sending family members to college or on world cruises? No.
Foreign grants are possible but can entail their own set of issues, such as determining whether the ultimate charity is the equivalent of a public charity in the United States. The main areas of focus in the case of foreign organizations are expenditure responsibility procedures and equivalency determinations. ((See T.D. 9740, October 19, 2015; https://www.irs.gov/irb/2015-42_IRB/ar07.html.)) The latter focuses on whether a foreign charity is the equivalent of a United States public charity.
The expenditure responsibility procedures are on-going in nature. For example, the foundation can follow the procedures for a few years and incur a tax in later years for failing to request reports from the grantee.
There are procedures that contemplate not disturbing private foundation status in those unusual circumstances where the private foundation makes a gift to a small public charity, and the gift risks tipping the recipient charity into private foundation classification. A private foundation making large gifts to a small public charity may require some overview by tax professionals but we note that if they meet your charitable goals, the foundation can generally consider small charities as well as, e.g., major universities.
The founder should also consider budgets, both start-up and on-going, for projected levels of charitable donations and work contemplated.
Will the founder be able to support the level of effort required to do the foundation’s work out of the initial funding?
At what level, if any, will the foundation need funding for administrative costs?
Will you need a part-time CEO or administrator to work within the private foundation?
Such questions need to consider not only the dollar level of your charitable commitment but the complexity, or simplicity, of your charitable vision.
You will need not only to think through the budgetary issues of operating the charity, including the administrative and professional costs over and above the purely charitable distributions, but think through administrative and even Board policies, such as how many people and who should have the authority to make major administrative and charitable allocations within the private foundation.
A foundation will generally need written grant guidelines and the support staff to respond to grant submissions.
In general, a private foundation will not make grants to individuals unless pursuant to a qualified scholarship program.
A foundation should have a carefully considered mission statement that not only narrows down the charitable goals but gets down to topical and geographic particulars.
A foundation should have conflict of interest policies in place.
A foundation should have carefully considered investment guidelines.
Even after formation, even if the focus is on making grants to other charities, there is considerable time involved. Even with professional help filing tax reports and looking after the day-to-day details, there is an executive level that would normally take a few weeks a year. It is possible that less of your time might be required, but generally plan on at least a couple of weeks a year of hands-on involvement.
Running the private foundation need not be that difficult but it is a complex and highly regulated, penalty-fraught world, but the complexity also varies with the founder’s particular vision.
There is also the issue of coordination within the family. One of the decisions to be made in the early stages is the degree of involvement of others, not necessarily family but most commonly family. There are issues of other family members’ time, their expertise and availability, the logistics of coordinating among the family members, etc.
A key decision is whether you may even need a professional manager for the day-to-day operations of the charity.
Larger private foundation organized in or operating in California may also be subject to an audit requirement and be required to have an audit committee. The larger foundation concept focuses on gross revenue of $2 million or more. ((See Cal. Gov. Code §12586(e)(1).)) The California Registry of Charitable Trusts advises that if, e.g., a new private foundation is funded with $2 million and thereafter is expected to have income below the audit requirement, their policy is to entertain a request for a one-time exception to the audit requirement if the private foundation has filed the California Renewal Fee Report, RRF-1 form, and its tax return for the initial year.
In general, one has an eye on the state’s (or states’) regulatory and reporting scheme, as well as that of the IRS.
Winding Down the Foundation
If you ever decide to terminate the foundation, don’t contemplate getting back the assets.
Can you offer to “give back the deduction” and expect the IRS (not to mention the state’s charity authorities) to let you get back your donation? No.
What the charity has cannot “inure” to your benefit as donor. ((Section 501(c’)(3). See, e.g., “Inurement/Private Benefit – Charitable Organizations,” https://www.irs.gov/charities-non-profits/charitable-organizations/inurement-private-benefit-charitable-organizations.))
If the foundation was large but enters a phase when it might even be considered small, does that mean the rigors of IRS reporting and IRS scrutiny begin to fall into a lesser category of reporting and scrutiny? As to scrutiny, possibly yes, but as to reporting and the complexity of rules, generally no.
You may be used to reading that certain persons or entities are exempt from reporting due to their being relatively small. But all private foundations, including private operating foundations, regardless of size, are required to file the Form 990-PF each year. ((See page 4 of 1023 instructions.))
A foreign organization qualifying as a private foundation is also required to file annually. ((See page 5 of Form 1023 instructions.))
If you’ve ever wondered whether the U.S. ever imposes a tax saying, “We’ll just take it all,” the answer in a private foundation context is affirmative. Should there be a tax, it is basically the lesser of the value of the net assets or the benefit arising from the organization’s exempt status. ((See the IRS discussion, “Private foundation termination tax,” https://www.irs.gov/charities-non-profits/private-foundations/private-foundation-termination-tax.))
Section 507 imposes a termination tax on voluntary or involuntary terminations of the private foundation, which should be avoided. It is generally possible to avoid he termination tax by operating as a public charity for a time, or transferring the foundation’s assets to a public charity, or even another private foundation. ((See generally the IRS discussion, “Termination of Private Foundation Status,” https://www.irs.gov/charities-non-profits/private-foundations/termination-of-private-foundation-status.))
“In addition to complying with federal requirements for dissolution, foundations must observe state law formalities, which vary widely. For example, in some states (including California and New York) the foundation must give notice to the state attorney general, whose duties include making sure that the distribution of the foundation’s assets are consistent with the original donor’s intent.” ((“Making the Transition Out of a Private Foundation,” Deborah L. Jacobs, http://www.fidelitycharitable.org/giving-strategies/give/making-transition-from-private-foundation.shtm.))
Families often purpose that the private foundation go on indefinitely, although it is also possible to envision the termination of the private foundation from inception and so provide in the founding documents.
The premise of tax-exempt status and allowing the deduction for contributions is that the entity will remain devoted to its declared charitable purposes.
Comparing the Private Foundation to the Public Charity
Most charitable ambitions with a hands-on emphasis manifest in the form of publicly supported charities. The visionary or point-person forms the charitable organization, usually with others, and contemplates support and participation from others.
The organization may be large or small, but its classification as a “public charity” for tax purposes turns usually on achieving a somewhat broad base of public support. The tax and regulatory rules are not simple but the public charity approach is much less complex than the private foundation alternative.
As with forming a private foundation, there are birth-pains in getting started and garnering help but the public charity alternative also tends to be much more marketing oriented in that the vision needs to be shared and communicated broadly.
If one just wants to do the charitable work and not have to deal with broad participation in the effort, this is often the scenario in which to consider the private foundation approach, but as we outline above, there are complexities and expenses.
If your charitable vision can be tied to an existing charity, an alternative to the private foundation approach is to form a “supporting organization” for that charity.
Comparing the Private Foundation to the Supporting Organization
A supporting organization supports another named exempt organization, such as a non-profit hospital or church, community foundation or multiple other charities. Typically, but not always, the supported organization is a U.S. public charity. The supporting organization approach to philanthropy does give the founder the status of a public charity.
The IRS’ discussion of such organizations distinguishes the organizational, operational and control tests. The day-to-day activities are described as follows in the “operational test.”
“A supporting organization must engage solely in activities that support or benefit its supported organization(s). In addition to making direct grants to its supported organization(s), a supporting organization generally may make grants or provide services or facilities to:
- individual members of the charitable class benefited by its supported organization(s),
- another supporting organization that supports the same supported organization(s) or
- a state college or university….
However, any such grants or provision of services or facilities must support or benefit the supported organization(s), not just the direct recipients.” ((https://www.irs.gov/charities-non-profits/charitable-organizations/supporting-organizations-requirements-and-types.))
With a supporting organization, the donor/founder has significant say but doesn’t control. “Control” is a key element of the private foundation world we describe above but not here. The Board is linked to that of the supported organization. The supporting organization may not be controlled directly or indirectly by a “disqualified person.”
The relationship to the supported organization may be akin to parent/subsidiary or brother/sister or “operated in connection with” the charity. ((Form 1023 instructions, p. 20.))
There are aspects of the supporting organization rules akin to the private foundation rules, but the deduction limits are more liberal and the supporting organization isn’t subject to the excise tax on net investment income. It is generally subject to the excess business holdings excise tax. ((Section 4943(f).))
A supporting organization can provide certain economies of scale in that it is somewhat integrated with the existing activities of a public charity.
The scope and range of the activities of a private foundation are generally broader than that of a supporting organization tied to a particular public charity.
Before forming a private foundation, the charitably minded may also consider the donor advised fund approach to meeting their goals
Comparing the Private Foundation to the Donor Advised Fund
The donor advised fund gives the donor access to public charity status while giving the donor and those he/she chooses much say about later allocations to public charities. The donor and family don’t quite have control, which is what makes it a public charity alternative.
The donor advised fund isn’t the operating charity so it may make sense if the goal is an immediate deduction with future allocations to the charities doing the actual work.
Compared to the donor advised fund, the private foundation is much more work but it also provides more control with the donor and the family.
With a private foundation, the donor, or the family, controls investments, grants, administration and such details as filing the entity’s tax returns. The control available to a donor creating an account at a donor advised fund is much less than with a private foundation.
With a donor advised fund, there is basically the one main federal return which can encompass any number of individual accounts within the fund. The account within the donor advised fund is exempt as part of an exempt organization, whereas the foundation is an exempt organization.
A donor advised fund is a vehicle to funnel contributions to the ultimate charity. The donor advised fund will ask you what you want to do; whereas the greeting of an operating charity is, “Here is what we do.”
With the foundation, within the general limits of the tax code and state laws governing the organization, you as creator of the organization get to establish the charitable goals (e.g., education in your state) but the actual charitable work is usually done by public charities funded through the private foundation.
Both the donor advised fund and private foundation concepts typically involve large up-front contributions. Both allow up-front charitable contribution deductions upon funding, although there are differences that can affect the amount and limit on the charitable deduction. But if the concept is immediate transfers to the ultimate charity, the donor typically can skip both the donor advised fund and foundation alternatives.
Both the private foundation and donor advised fund are convenient vehicles for major donations in a big income year. The percentage of income limitations in the door’s individual return are even more liberal in the case of a donor advised fund, a public charity.
The donor advised fund alternative is much simpler. There are donor advised funds capable of accepting large up-front donations with the view of making allocations out at a later date, even in later years.
The simpler aspects of the donor advised fund are numerous.
It is in place whereas a private foundation requires planning as to scope, as well as formation as a trust or corporation. The donor advised fund is the charity, although not the operating charity, such that transfers to the donor advised fund are just reported on the donor’s tax return but the donor advised fund account per se doesn’t require any separate IRS reporting by the donor.
A private foundation has to annually file a Form 990-PF with the IRS, and comply with sundry reporting rules. There are often state and even local reporting requirements with a private foundation.
The donor advised fund may be on-going in a generational sense in that it may allow you to appoint successors for one or two generations, whereas a foundation may go on indefinitely depending on the structure.
It may be possible to vest control in even one person with a private foundation, depending on the state of formation, but private foundations often have more of a family-control personality. With a donor advised fund, there is no family Board or trustees, whereas you can name Board members with a private foundation that is an actual organization rather than an account.
Control vests with the sponsors of the donor advised fund but their goal is to accommodate within reasonable limits your charitable goals.
This alternative does not entail hiring staff and consulting help as to operation of the donor advised fund, as is often needed with private foundations. The family’s services in operating a private foundation are most commonly performed without compensation, although it is possible for the family to provide services to the foundation and be compensated if the compensation is reasonable and necessary and the work done is well documented. But these rules can sometimes be interpreted in a very restrictive manner. For example, janitorial and security services provided a private foundation by a disqualified person have been determined not to be “personal services” for purposes of avoiding self-dealing under Section 4941. ((See Madden, T. C. Memo 1997-395.))
Control fully vests with the members of the private foundation, whereas your (or your family’s) relationship with a donor advised fund is one of making recommendations.
Scholarship grants are subject to tight controls and special rules but are more often associated with private foundations, whereas donor advised funds do not make grants to individuals although they’re not necessarily prohibited from making grants to organizations that grant scholarships.
Grants to individuals and even non-profit organizations may be justified if properly structured and monitored and consistent with the private foundation’s organizing documents. Such grants typically involve such circumstances as hardship or emergencies, or, for example, a for-profit organization that employs the handicapped. It may also be possible for the private foundation to take a more direct approach to achieving its goals, such as feeding the poor in an area not currently served by public charities.
But as a matter of policy and toward the goal of simplification, a private foundation may restrict its grants to well-established, public charities whose works are consistent with its purposes.
Funds transferred to a donor advised fund may end up overseas via intermediate organizations that accept responsibility, including reporting responsibility, for international transfers. A private foundation may make grants to international organizations subject to rules governing expenditure responsibility or by making an equivalency determination.
There are complications and detailed rules but typically a foundation and a donor advised fund will both be making transfers to public charities that do the hands-on charitable work.
Minimum distributions are not an issue with the donor advised fund whereas there are such requirements for a private foundation. A private foundation is required to distribute a minimum of 5% of the fair market value of non-charitable assets each year. With a foundation, the donor or family usually control distributions subject to the minimum requirements.
A donor advised fund may also shelter the donor from publicity.
Private foundations basically have complete control over their investments, subject to rules about what they can and cannot do without jeopardizing exempt status.
A private foundation may also bring into play sundry excise taxes which are less of an issue with donor advised funds. With a donor advised fund, the organization that controls it may give a range of permitted investments, such as mutual funds.
As to the type of assets that can be transferred, the donor advised fund typically accepts cash, public securities or mutual funds.
A donor advised fund generally won’t accept ownership interests in closely held businesses, and will rarely accept real estate as a donation. For purposes of the Section 4943 tax on excess business holdings, a donor advised fund is treated like it is a private foundation. ((Section 4943(e).)) So the donor advised fund is not necessarily an avenue for side-stepping these issues in regard to closely-held business interests.
It is not uncommon for public charities to accept real estate gifts. The private foundation typically has more discretion as to what it will accept as a donation, but there are generally severe limits on the foundation accepting interests in closely held businesses.
The fees for working with a donor advised fund will typically be less than the up-front and on-going expense of forming one’s own charity, a private foundation.
The donor advised fund and private foundation alternatives are not mutually exclusive. It is possible that a major donor would have a private foundation for areas where more personal involvement is desired and a donor advised fund where there is less involvement or privacy is more of an issue.
Of course, the vast majority of charitable donations do not involve either a donor advised fund or private foundation but rather current transfers to the public operating charity. This is almost always part of the major donor’s world, continued direct gifts to public charities.
The Right Choice for Charitable Accomplishment for You
The private foundation is the more hands-on road to charitable accomplishment. While it does involve complexities and a certain tolerance for the regulatory and quasi-public environment despite the “private” element in the name, private foundations can also be richly rewarding from the personal, tax, commitment and control standpoints.
We look forward to helping the reader better understand the private foundation approach to a charitable “lifestyle.”
APPENDIX: BRIEF OVERVIEW OF TAX RATES
Donor’s Federal and California Taxes
Donor’s income tax, federal. The donor’s income tax deduction for donations may be limited but subject to carryover. The deduction saves federal tax at a range of 10% to 39.6%.
Donor’s income tax, California: The donor’s state income tax deduction for donations may be limited but subject to carryover. The deduction generally saves California tax at a range of 1% to 12.3% (plus potentially another 1% surtax on income over $1 million). The state tax cost may result in federal tax savings because state taxes generally qualify as an itemized deduction in the federal return, although no state income tax deduction is permitted if the taxpayer is in an alternative minimum tax scenario. The state tax cost is normally calculated net of federal taxes saved.
Donor’s gift tax: A charitable deduction asserted on a gift tax return normally avoids any issue of gift tax on a charitable gift. The gift tax deduction, unlike the income tax deduction, is unlimited.
Donor’s estate tax: A charitable deduction asserted on an estate tax return normally avoids any issue of estate tax on a charitable gift. The estate tax deduction, unlike the income tax deduction, is unlimited.
Private Foundation’s Federal Taxes
Private foundation’s income tax: It is tax exempt.
Private foundation’s tax on investment income, Section 4940: 1-2%.
Unrelated business income tax, Section 511, if foundation is a trust: 15% to 39.6%; the highest tax bracket is reached with income over $12,400.
Unrelated business income tax, Section 511, if foundation is a corporation: 15% to 35%; incremental rate as high as 38% on a particular range of income. Corporate rates are generally lower on any range of income compared to the trust rates.
Note that excise taxes aren’t necessarily imposed on the foundation.
Excise tax on self-dealing, Section 4941: There is generally an initial tax of 10% on the self-dealer, or 5% in the case of a foundation manager subject to some limit for each act of self-dealing. See the instructions to Form 4720, p. 7.
Excise tax on failure to distribute income, Section 4942: The initial tax on the foundation for failure to distribute sufficient income is 30%. See the instructions to Form 4720, p. 7.
Excise tax on excess business holdings, Section 4943: The initial tax on the private foundation is 10% of the value of the excess business holdings, then potentially an additional tax of 200% unless there is a disposition. See the instructions to Form 4720, p. 8.
Excise tax on investments which jeopardize charitable purposes, Section 4944: The initial tax on the foundation is 10% up to $10,000 for any one investment. See the instructions to Form 4720, p. 11.
Excise tax on taxable expenditures, Section 4945: The initial tax on the foundation is 20% of each taxable expenditure, plus potentially an addition 5% tax on the foundation manager. See the instructions to Form 4720, p. 11. Rates are somewhat less if the taxable expenditure is political in nature. See the instructions to Form 4720, p. 12.
There may be additional taxes beyond the “initial taxes” noted above.
Other taxes are possible, in addition to the main concerns above. See the instructions to Form 4720, p. 12 and following.
