Private Foundations
For some donors, generally families or businesses that have a philanthropic goal, a private foundation is the preferable nonprofit charitable entity. It can be funded over time but is often created with a single endowment. The assets transferred to the foundation are invested and some of the assets must be paid out each year as grants to individuals or other charities in accordance with the foundation’s charitable purpose.
If the private foundation’s investments generate a consistent, stable and reliable return, most private foundations will grant a correspondingly consistent, stable, and reliable amount (or increasing amount) to selected charitable recipients.
Benefits of a Private Foundation
For founders who would like to maintain a high degree of control over their charity, a private foundation may be more suitable than a public charity. There are no requirements for the foundation’s board of directors. It can, if desired, consist entirely of the donor’s family members and be beholden entirely to the donor. Those responsible for running the foundation have full autonomy in deciding whom or what organizations to support and can make any and all investment decisions without oversight.
Private foundations also have expansive freedom to determine who can receive donations and how the money is distributed. The foundation can make grants to individuals or organizations, in addition to the option of directly operating its own charitable programs.
Private foundations provide specific tax savings and financial benefits for donors:
Donors receive an income tax deduction for any amount of cash they contribute to a private foundation up to 30% of adjusted gross income (AGI).
Donors may avoid paying capital gains taxes by donating highly appreciated assets to the private foundation.
Most assets contributed to a private foundation are excluded from the donor’s estate and, as a result, are not subject to either federal or state estate taxes.
Finally, private foundations can be set up with the intent to exist in perpetuity, which makes them a popular way to establish a charitable legacy.
Sounds Great, What’s the Downside?
Private foundations are subject to some strict rules. These include:
restrictions on self-dealing between private foundations and their substantial contributors and other disqualified persons;
requirements that the foundation annually distribute income for charitable purposes (minimum required distribution);
limits on their holdings in private businesses;
provisions that investments must not jeopardize the carrying out of exempt purposes; and
provisions to assure that expenditures further exempt purposes.
The repercussions for violations of these provisions have serious implications. They may give rise to taxes and penalties against the private foundation and, in some cases, its managers, its substantial contributors, and certain related persons. Before jumping into starting a private foundation, it is so important to understand the applicable rules and make sure your leadership understands them as well.
Self Dealing
A private foundation is prohibited from engaging in financial transactions with disqualified persons. A disqualified person includes directors and officers of the foundation, substantial contributors, family members, or 35% controlled entities.
Two of the terms above need further explanation:
A substantial contributor includes any person who contributes or bequeaths an aggregate amount of more than $5,000 to the private foundation, if such amount is more than 2 percent of the total contributions and bequests received by the foundation before the close of its taxable year in which the contribution or bequest is received from such person.
For a trust, the grantor, or person who set up the trust, is a substantial contributor, even though his contributions may not have exceeded the $5,000 and 2 percent limit. A donor is a substantial contributor as of the first date when he or she exceeded the $5,000 and 2 percent limit, even though the determination of the percentage of total contributions and bequests is not made until the end of the private foundation’s taxable year.
35% Controlled Entities
This applies to directors and officers of the foundation, substantial contributors, and family members. Here are the rules for different types of entities:
Corporations in which persons described above hold more than a 35 percent voting power;
Partnerships in which persons described above hold more than a 35 percent profit interest;
Trusts or Estates in which persons described above hold more than a 35 percent beneficial interest.
The Internal Revenue Code ("IRC") identifies six specific transactions that, if engaged in by the foundation and a disqualified person, constitutes an act of self-dealing:
sale or exchange, or leasing, of property between a private foundation and a disqualified person;
lending of money or other extension of credit between a private foundation and a disqualified person;
furnishing of goods, services, or facilities between a private foundation and a disqualified person;
payment of compensation (or payment or reimbursement of expenses) by a private foundation to a disqualified person;
transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation; and
agreement by a private foundation to make any payment of money or other property to a government official, other than an agreement to employ such individual for any period after the termination of his government service if such individual is terminating his government service within a 90-day period.
There are of course exceptions, which can be found here.
Minimum Required Distribution
There is a minimum amount that a foundation must distribute annually for grants and its direct charitable activities (including reasonable and necessary administrative expenses and program related investments). The minimum distributable amount is roughly 5% less some adjustments based on the prior years income. The 5% is calculated based on the foundation’s net investment assets. This means those assets which are not used, or held for use, directly in carrying out the foundation’s exempt purpose.
A foundation has 12 months after the tax year in question to satisfy the minimum distribution requirement. The purpose behind this mandatory payout is to ensure foundations are actively funding charitable programs and not holding on to charitable funds.
Limited Holdings
The combined holdings of a private foundation and all of its disqualified persons are limited to 20 percent of the voting stock in a business enterprise that is a corporation. The 20 percent limitation also applies to holdings in business enterprises that are partnerships, joint ventures, or other unincorporated enterprises. For a partnership or joint venture, profits interest is substituted for voting stock, and for any other unincorporated enterprise, beneficial interest is substituted for voting stock. A private foundation that has excess business holdings in a business enterprise may become liable for an excise tax based on the amount of the excess holdings.
Limits on Investments
Foundations have strict rules regarding what investments can and cannot be made by the foundation’s managers. Two of these rules include limits on investments in private businesses, and provisions that require that those investments not jeopardize a foundation’s exempt purpose.
It is really important that the foundation remain in compliance with these rules. Violations of these provisions give rise to taxes and penalties against the private foundation and, in some cases, its managers, its substantial contributors, and certain related persons.
Your foundation should have a written investment policy that is prepared with guidance from an attorney, accountant, and/or investment advisor that has familiarity with the complex rules surrounding investments made by foundations.
Rules for Expenditures
A private foundation must exercise expenditure responsibility when it wants to make a “grant” to certain types of organizations (typically organizations that are not 501(c)(3) public charities) without incurring an excise tax for having made a taxable expenditure.
IRC Section 4945(h) provides that expenditure responsibility means that the private foundation is responsible to exert all reasonable efforts and to establish adequate procedures:
to see that the grant is spent solely for the purpose for which made;
to obtain full and complete reports from the grantee on how the funds are spent; and
to make full and detailed reports regarding the grants to the IRS.
.A taxable expenditure includes “any amount paid or incurred” by a private foundation:
For any purpose that is not a valid charitable purpose described in Section 170(c)(2)(B);
To carry on propaganda or influence legislation, as those terms are further defined (Sections 4945(d)(1) and 4945(e));
To influence the outcome of an election or carry on a voter drive, as those concepts are further defined (Sections 4945(d)(2) and 4945(f));
To make a grant to an individual for travel, study, or other similar purposes, unless the grant satisfies certain other requirements, including IRS pre-approval of procedures (Section 4945(d)(3) and 4945(g)); or
As a “grant” to an “organization” unless the grant is made to certain types of public charity organizations or unless the foundation exercises expenditure responsibility (4945(d)(4).)
Taxable expenditures are subject to initial and additional taxes as described in Sections 4945(a) and (b), unless the grants meet certain requirements or are made to certain types of organizations. You can find more information on expenditures here.
Conclusion
This is a high level overview of the complex rules governing private foundations. It is neither comprehensive nor is it legal advice, it is just informational. Each of these topics can be discussed far more extensively.
If you are planning on starting a private foundation, I encourage you to learn as much as you can before starting and then reach out to an attorney of your choosing who can advise you based on your individual circumstances.
