A tax-exempt entity operated for charitable purposes
Private foundations are tax-exempt entities, just like hospitals or universities. What makes them different from organizations that are known as public charities is that private foundations are set up, funded, and controlled by a single individual, family, or corporation. By contrast, public charities derive a significant percentage of their revenue from the general public and cannot be under the control of any one individual or family.
Do you have to be fabulously wealthy to establish a private foundation? No, but a certain amount of wealth is a prerequisite, of course. The private foundation vehicle is a good tool that serves the interests of affluent individuals.
Private foundations have been around for 150 years
Private foundations trace their lineage back to the mid-19th century, and in some ways, they go back further than that. Anglo-Saxon law recognized private foundations as legal entities and the American legal system initially encouraged them through charitable trusts. Some of the early 19th century industrialists established private foundations that are still known today. Private foundations proliferated after WWII, mainly because of good economic conditions and favorable tax treatment. The Ford Foundation is probably the best-known example of a private foundation in the U.S. today.
1969 was start of modern era
The year 1969 was critical in the development of today’s private foundation law. Incredibly, there was no workable definition of a private foundation until then. After well-publicized abuses and congressional hearings concerning private foundations’ attention to noncharitable interests, Congress passed the Tax Reform Act of 1969.
The anti-private foundation sentiment in the late 1960’s caused Congress to draft curious laws. Today, all charitable organizations are presumed to be private foundations unless they can qualify otherwise. Most do, so they are known as public charities. Those confirmed as private foundations usually share four characteristics:
- They demonstrate charitable intent
- Their funds come from one source, such as an individual, family, or company
- Their operations are funded by investments
- They make grants to other charitable organizations rather than operate the programs themselves
More heavily regulated than public charities
As a direct result of the 1969 tax reforms, private foundations are more heavily regulated than their public charity counterparts. They must pay certain taxes, keep up a mandated level of charitable activity, and be scrupulous in their transactions with their founders. This regulatory treatment stands in stark contrast to public charities, which, in some cases, may be carrying out quite similar charitable activities.
May be good estate planning vehicle
For those with sufficient resources and a charitable impulse, a private foundation may be a good estate planning vehicle. Funders enjoy wide latitude in their charitable activities, family members can be paid salaries for their work on the governing board, and the foundation can be an excellent income and estate planning vehicle.
Comes in different flavors
- Standard or family foundations–The most common type of foundation is the standard private foundation or family foundation. Generally, family foundations do not engage in charitable activities. Rather, they give grants to public charities. Analysts estimate there are approximately 35,000 to 45,000 such entities in the United States. The Ford Foundation is a well-known example.
- Private operating foundations–Private operating foundations themselves engage in charitable activities (e.g., museums, nursing homes, and libraries). There are an estimated 2,000 private operating foundations and a comparable number of corporate foundations. Probably the best-known operating foundation is the J. Paul Getty Trust.
- Community foundations–A related type of organization is called a community foundation, of which there are about 500 across the United States. A community foundation concentrates its activities within a defined geographic area and is typically controlled by a representative group of community members. In practice, a community foundation is a public charity, though it appears to share some of the characteristics of a private foundation. The New York Community Trust is an example of a private foundation.
Why would you want to establish a private foundation?
Gives a high degree of control over your charitable dollar
The essence of a private foundation is that a single person, family, or corporation generally controls it. This is the complete opposite of other public charities, and represents the only substantive way that donors of significant means can exercise such control over their charitable contributions.
Can help minimize capital gain taxes
Private foundations are usually set up as part of a strategy known as planned giving, a concept at the heart of sophisticated charitable activity. Planned giving normally involves assets that have appreciated in value, as opposed to cash.
There are two ways to make a planned gift. The first is during your lifetime, when you, the donor, create a trust or some other form of agreement. The second is through a will. Planned giving takes advantage of the idea that a piece of property contains an income interest and a remainder interest. An income interest consists of the income the property produces, while a remainder interest is the projected value of the property at some later point, based on actuarial and other computations. The majority of planned gifts split these two interests by granting a remainder interest to a charitable entity, such as a private foundation. These gifts are made by using charitable remainder trusts. Typically, individuals receive the income interest. The way that private foundations can help minimize capital gain taxes relates to the appreciated value of the donated property. Ordinarily, when appreciated property is sold, the amount of appreciation is subject to capital gain tax. Donating the property to a private foundation allows the donor to escape taxation on the appreciated value and provides a charitable contribution deduction.
Tax rules governing this area have changed frequently in recent years, often renewing existing provisions for a fixed period of time. Consult your tax advisor for the most recent changes.
Can increase the value of your estate by reducing income taxes
If a private foundation is created while the donor is living, contributions to the foundation are income tax deductible, subject to certain limitations. This can increase the value of your estate.
How do you establish a private foundation?
There are five steps to follow in establishing a private foundation. Some of these steps may include additional tasks that depend on your individual circumstances, but generally this is the road map. Of course, it is important to consult with qualified legal and financial advisors familiar with your situation.
Prepare a written plan
It’s a good idea to write down what you plan to do and how you plan to do it. The IRS will request this information later on anyway, but at this stage, you need to have a clear idea for yourself. Start with the foundation’s mission, which is its larger overall purpose. Spell out how you expect to accomplish this mission, including the programs you plan to fund or operate, and the staff you think you will need. This is where you’ll consider the details that you will need to have firmly in mind when things start rolling.
Set up a corporation or trust whose assets will be exclusively dedicated to charitable purposes
There are eight categories of activity that make an entity eligible to receive charitable donations, the first step in becoming a private foundation: charitable, educational, religious, scientific, literary, testing for public safety, fostering national or international amateur sports programs, and preventing cruelty to children or animals.
Trusts have historically been the vehicle of choice for creating private foundations, but today it is also common to set up a corporation for this purpose. Why? Because nonprofit corporations offer some protection against liability for the principals. Also, the corporation’s governing provisions can be changed by its existing directors. There are organizations accessible to potential donors that offer much help and advice for this stage of the process. One of them is The Council on Foundations in Washington, DC (www.cof.org). Another is BoardSource (www.boardsource.org). There also may be a regional association of grantmakers in your area.
Prepare financial projections
Now that you have a plan, the next logical step is to figure out how much it’s all going to cost. Here is where you show the cash or assets you will give to the foundation and any other revenue you expect.
A reason for financial projections is that they will help you work out the specifics of your situation and their relationship to the private foundation laws.
Request tax-exempt status from the IRS
Your hard work is about to pay off because the IRS wants to see evidence of planning and preparation before it issues tax-exempt status. Complete IRS Form 1023 (Application for Recognition of Exemption) to begin the whole process in the federal government’s eyes.
Like most IRS forms, this one is long and tedious but fairly straightforward. It will ask you for your basic identifying information, activities and operational information, technical (legal) requirements, and the financial projections you prepared in the steps discussed above. Now you’re doing the financial projections to prove you’re qualified for tax-exempt status instead of for your own internal planning.
Fund the entity and set up financial record-keeping systems
The final step is to transfer the donated property to the new private foundation. At the same time, you need to set up adequate accounting and internal controls. Although you funded this organization, the federal government has given it tax-exempt status based, in part, on the premise that you will manage it properly. Considering the number of requirements unique to private foundations and the close link between your tax status and this new entity, it’s hard to underestimate the importance of having good systems in place.
File Form 990-PF annually
All private foundations are required to file an annual return, Form 990-PF (Return of Private Foundation), with the IRS.
What are the pitfalls related to private foundations?
It should come as no surprise that there are possible legal and financial pitfalls related to the creation and management of private foundations. The close relationship between a private foundation and the founder’s tax obligations is fertile ground for missteps. Qualified professional advice can help you overcome any problems that might arise along the way, but the best approach is to avoid problems before they arise. The following is an overview of some major pitfalls–private inurement, self-dealing, distribution requirements, excess business holdings, jeopardizing investments, investment excise tax, and banned activities–and how to handle them.
Private inurement relates to the improper use of the net earnings from a tax-exempt organization by a related private party for nonexempt purposes. It is strictly prohibited for all tax-exempt entities, including private foundations. The most common form of private inurement is excessive or unreasonable compensation. Unreasonable rental and borrowing arrangements are two other examples.
Persons who control and run the foundation are referred to as disqualified persons, and certain transactions between them and the private foundation are prohibited. The law specifically prohibits six types of self-dealing transactions: property-related, money lending, furnishing of goods or services, payment of compensation, transfer or use of assets, and agreements to pay government officials.
The economic measurement of the transaction is irrelevant. If a disqualified person sells a valuable building for $1 to a private foundation, it is still not a permissible transaction.
Beginning in 1969, Congress required private foundations to transfer some mixture of either money or property to charitable purposes each year. There are different types of distribution requirements for different types of private foundations, but the underlying concept is that a private foundation must give away an amount equal to 5 percent of average fair market value of its investment assets, less any debt incurred to acquire the property. The key here is to make a distinction between assets needed directly for carrying out the foundation’s exempt purposes and those held to produce income.
Excessive business holdings
Some private foundations want to own a business that is unrelated to the foundation’s exempt purpose. While this is permissible, it is severely limited so as to preserve the charitable intent of the organization. Generally, the total ownership of a business by a private foundation and its disqualified persons is limited to 20 percent. Under some circumstances, the limit is slightly higher.
Sometimes a private foundation is the beneficiary of a donation by a business entity. When this happens, the private foundation has a limited period of time to dispose of the asset.
Private foundation managers must see to it that the foundation’s assets are not invested unwisely. Ordinary business practices should be enough to satisfy this requirement. In practical terms, private foundations usually avoid these pitfalls by delegating asset management duties to professional managers.
A private foundation must pay an excise tax of 2 percent each year on net investment income, which gives it the dubious distinction of being one of the very few types of tax-exempt organizations to have to do so. The reason for the tax is to cover the extra governmental costs of regulating private foundations (the original 4 percent tax was actually reduced in 1978 because it was producing more money than the actual regulation costs). Although this amount is minimal, good planning offers the chance of reducing the excise tax slightly.
There are a number of activities that can cause a private foundation to be taxed. The primary banned activities are: lobbying, partisan political activity, making grants to individuals without an IRS-approved plan, making grants to organizations other than public charities or tax-exempt operating foundations, and making grants where the grantor retains responsibility for expenditures under the grant.
How do private foundations end?
A private foundation can terminate its existence, but the rules require payment of a termination tax to do so. To voluntarily terminate, a private foundation has to give the IRS a full explanation of its plan to terminate. It can transfer both its assets and its obligations to another private foundation or public charity. It can also choose to become a public charity. Finally, the IRS has the right to terminate private foundation status in the event of repeated and flagrant disregard of private foundation provisions.
The termination tax is stringent. It will be the lower of the aggregate tax benefit resulting from the foundation’s tax exempt status or the total value of the net assets of the foundation. However, the tax is not imposed when a private foundation converts to public charity status (by either transferring all of its assets to an existing public charity or becoming a public charity itself). The IRS also has the authority to abate this tax in certain other circumstances.