Understanding Private Foundations

Wondering if a private foundation is the right avenue for you? Learn more about the different types and how to establish one.

Presented by: Kris Maksimovich, AIF®, CRPC®, CPFA®, CRC®

A private foundation is a tax-exempt entity established by an individual, family, or corporation for charitable purposes. Private foundations are overseen by a board of directors or trustees responsible for receiving donations, managing and investing assets, and making grants to other charitable organizations. The board is also responsible for filing tax returns and managing other administrative reporting duties. This is different from a donor-advised fund, in which the sponsoring organization handles administrative reporting and filing.

How Private Foundations Differ from Public Charities

The key difference between a private foundation and a public charity is the funding source. Private foundations receive most of their support from a small number of contributors and are generally controlled by their founders or substantial donors. They frequently use charitable contributions to make grants to individuals or other charities rather than directly funding their own programs. Public charities tend to use charitable contributions to directly fund programs.

Private foundations operate independently and therefore have the freedom to ignore public opinion regarding the use of the foundation’s charitable assets. In contrast, public charities must solicit donations from the community on a regular basis and thus have to appeal to public sentiment. This can influence how the charity chooses to use its funds to carry out certain programs.

Types of foundations

• Operating foundations. An operating foundation is directly involved in sponsoring and operating a charitable project or enterprise. It does not use assets to make grants to other charitable organizations.
• Nonoperating foundations. A nonoperating foundation does not provide services or conduct charitable activities but instead makes grants to public charities that operate charitable programs. Nonoperating foundations must distribute 5 percent of their net investment assets each year in the form of qualifying distributions, such as grants.

Benefits of Private Foundations

There are a number of benefits associated with starting a private foundation:

• You can establish a legacy while also involving family members by making them employees or members of the board.
• As a founder, you have full control over the creation of grants, which can be used to support organizations you care about.
• Contributions to a private foundation enable the donor to potentially receive an immediate tax deduction of up to 30 percent of adjusted gross income (AGI) for cash gifts and up to 20 percent of AGI for long-term appreciated publicly traded assets.
• Private foundations can accept many types of assets as contributions, but with gifts of long-term appreciated securities, the donor may potentially eliminate capital gains tax.

 

Tax benefits

To qualify for tax exemption, a foundation’s purpose must serve one of the following:

• Charitable
• Religious
• Educational
• Scientific
• Literary
• Testing for public safety
• Assist national or international amateur sports
• Prevent cruelty to children or animals

Since private foundations fall under charitable, section 501(c)(3) organizations, they are exempt from federal income tax, offering a one-two punch for donors. Donors can deduct their contribution to the foundation and further reduce their taxable income by donating appreciated property at fair market value because no capital gain is realized. Property must have been held more than one year prior to the contribution or it is subject to the donor’s cost basis.

Deductions are based upon the donor’s adjusted gross income, limiting them to 30 percent for cash contributions and 20 percent for capital gain property. Contributions over those limits can be carried forward up to five years to help offset future taxable income.

Private foundations also offer the ability for donors to gain a tax timing advantage. Donors can lock in their deduction in the current year or donate during a year in which they have sizable personal income, they can also direct how the foundation invests the donation and time the execution of disbursement to charities across multiple years.

How Private Foundations Work

Legal Structure. Determine how you wish to set up your foundation, either as a corporation or a trust. A corporation offers more flexibility with the ability to amend its articles, bylaws, and governance. They can also change the charitable purpose. Organizing as an irrevocable trust offers less flexibility but can help ensure that a specific charitable purpose is not changed by future generations. Consider the lifespan of the foundation. Will it exist in perpetuity, requiring a succession plan? Or will it have a sunset clause, designating a specific end date? You should discuss the multiple reasons behind these strategies with your trusted financial advisor.

Mission Statement. Create a clear mission statement that outlines the specific vision and guiding principles for donors, board members or trustees, staff, and the public. This statement should establish the goals and values and suggest what can be expected of the foundation.

Organize Board of Directors or Trustees. Only include those trusted and qualified to oversee activities and carry out the mission. Choices can consist of donors, their family members, or other qualified independent parties depending upon the scope of the foundation. For instance, a foundation that provides grants for medical research needs members with a different skill set than one that provides educational scholarships. You’ll also want to establish a variety of controlling roles that cover purpose, financial and legal aspects as well as investments, grants, and transactions.

Select Professional Advisors. Advisors you’ll work with include attorneys, tax advisors, and financial advisors. Your financial advisor can assist with planning and executing the foundation and coordinate with legal and tax advisors. They can also help with the foundation’s charitable assets and investment strategy.

Apply for Employment Identification Number (EIN). The IRS requires you to apply for an EIN, even if you do not anticipate hiring people. This number serves as your tax identification number for the foundation, much like a social security number for individuals.

Flexibility and control

Donors of private foundations can take on the role of trustee and control the timing of donated funds and disposition of gifts. For instance, donors can monitor public charities and support them during selective causes rather than offering them gifts over which you have no control.

Foundation grant-making

You’ll need to establish grant-making guidelines along with administrative support for charitable inquiries. A grant officer must manage grantmaking by reviewing applications, handling correspondence, suggesting grants, and conducting site visits to ensure funds have been used appropriately.

Grant recipients might include:

• Churches
• Colleges and universities
• Hospitals
• Medical research organizations
• Museums
• Schools
• Social service organizations

Though foundations often make grants to nonprofits, they can create their own program. Such a program must meet the IRS’s charity definition for tax purposes. Grants made to individuals for scholarships, hardship, emergency assistance, and medical assistance must also meet certain IRS criteria.

Additionally, grants made to non-charities such as a for-profit organization that employs the homeless for example, must be used solely for charitable purposes and meet IRS criteria. Your financial advisor can help you sort through these grant-making options.

Assets eligible for donation to private foundations include

• Artwork
• Jewelry
• Cash
• Closely-held business stock
• Non-publicly traded stock
• Publicly traded securities
• Mutual funds
• LLC or LP interest
• Real estate
• Life insurance policies
• Other unique assets

The IRS has rules against excessive business holdings, so it’s important to seek the advice of your trusted advisor.

How Do You Establish a Private Foundation?

If you’re seriously considering starting a private foundation, we recommend you adhere to the following steps:

1. Prepare a written plan that includes the foundation’s mission, the programs it will fund or operate, and the staff needed.
2. Set up a corporation or trust whose assets will be exclusively dedicated to charitable purposes. In addition, determine whether the entity is eligible to receive charitable donations based on the category of the corporation or trust’s activity.
3. Prepare financial projections, including the cash or assets that you will give to the foundation and any other revenue that you expect to receive.
4. Request tax-exempt status from the IRS by completing IRS Form 1023 (i.e., the Application for Recognition of Exemption).
5. Fund the entity and set up financial recordkeeping systems, such as adequate accounting and internal controls.
6. File IRS Form 990-PF (i.e., the Return of Private Foundation) annually to avoid losing tax-exempt status.

Foundation compliance requirements

Below are several important requirements for private foundations:

• Distributions. Private foundations must make an annual qualifying distribution of five percent of the fair market value of non-charitable use assets. The use of foundation assets may cover charitable grants and administration such as administrative expenses, equipment that assists in achieving the foundation’s charitable purpose, directly related charitable activities, and program-related expenses.  Some funds used for administration, however, do not count toward the IRS’s minimum required annual distribution such as investment management, salaries, and custodial fees, or for a board member’s expenses involved in overseeing investments.
• Taxes. Depending upon the value of a private foundation’s assets and amounts distributed to charities annually, they must pay a 1-2 percent excise tax on net investment income. Additionally, the IRS considers certain types of assets as excess business holdings and may have limitations on how long the foundation can hold that asset without incurring an excise tax.
• Tax Forms. Private foundations must file Form 990-PF annually with the IRS and in the state where their main office is maintained. This report supplies details of the foundation’s operations, contributions, disbursements, expenses, sales of assets, and capital gains. What’s more, if there is greater than $1,000 in unrelated business income during the year, the IRS requires the foundation to also file a Form 990-T. Each state has its own rules, and some states require private foundations to register and file annual reports with the state’s attorney general. Your professional advisors can assist you with the required forms.

Understanding the caveats

While private foundations can offer advantages that charitable contributions do not, there are strict IRS rules which can result in severe penalties for tax code violations if abused. Penalties can be levied on both the board members and the foundation and are meant to thwart the risk of abuse when interested parties control the foundation instead of an independent board. Not to mention, public scrutiny and online commentary that could also damage a foundation’s reputation.

Private foundations are prohibited from self-dealing transactions like lending or borrowing money from the foundation. Disqualified persons may not transact with the foundation other than making donations. Disqualified persons include the foundation’s officers, directors, trustees, substantial contributors, or those who own a substantial stake in a company that is a substantial contributor. Family members, spouses, and descendants of these are also disqualified along with businesses partially or wholly owned by them. Specific examples of prohibited self-dealing include:

• Providing goods and services to or from the foundation
• Borrowing funds from the foundation
• Personal use of foundation assets or income
• Leasing space to or from the foundation
• Retaining foundation assets on private property, such as artwork

Private foundations must avoid making grants to individuals and organizations that are not public charities unless they follow strict guidelines. They must also avoid making expenditures to influence elections or legislation, as well as making grants to private operating foundations and certain foreign organizations.

Make Your Vision a Reality

If you think a private foundation is right for you, you don’t have to go it alone. I can help you connect with foundation administrators who can assist you with realizing your charitable vision.

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.

Kris Maksimovich is a financial advisor located at Global Wealth Advisors 4400 State Hwy 121, Ste. 200, Lewisville, TX 75056. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network^®, Member FINRA/SIPC, a Registered Investment Adviser. Financial planning services offered through Global Wealth Advisors are separate and unrelated to Commonwealth. He can be reached at (972) 930-1238 or at info@gwadvisors.net.

© 2024 Commonwealth Financial Network^®