by Steve Goodman
CPA, MBA – President & Chief Executive Officer
Contact Steve today for more info.
When people make philanthropy a part of their lives, and their estate plans, they have choices in how and to whom they donate. Most people opt to contribute to a public charity, be it a church, university, or a service-oriented charity such as the American Diabetes Association or United Way. Some choose to establish their own private or family foundation. This paper provides an overview of how these foundations work, why people create them, and the pros and cons of financing and managing a private foundation.
The IRS does not recognize the term ‘foundation’ in the tax code. Yet the term is common in philanthropic circles. The IRS recognizes public charities and private charities. As a rule, public charities receive their funding from multiple sources. Family foundations are private charities. Within the private charity category, there are operating private charities and regular private charities. Regular private charities must spend no less than 5% of their previous year’s endowment on charitable activities. Operating charities are devoted to a specific task or line of charitable effort. These charities may include think tanks, medical research facilities, builders of low-income homes, or soup kitchen, operators. The IRS has separate requirements for these organizations.
Within the charitable foundation trade, private foundations fall into one of five categories:
- Independents – These are charities governed by someone who is not a donor. They may be funded by an individual or a group of individuals.
- Family – The funding family usually plays a significant role in the management of the foundation.
- Corporate (or company sponsored) – These are separate legal entities typically established by a company to either promote or assist with some facet of the company’s business or the to provide social assistance in the region(s) of large company offices and operations.
- International – These foundations make grants overseas. Under US tax law, US donors may not take a charitable donation for funds donated to a charity that does not have a US office registered with the US as a charity. Many international charities will have an office in Washington DC or another major US city.
- Private Operating Foundations – These charities can provide grants to other charities, but their primary purpose is to operate charitable programs. The IRS has special rules concerning the operations policies of these charities.
The IRS recognizes differences in how it treats contributions to public and private charities. On the public side, donors may receive tax deductions up to 60% of the AGI for cash gifts and 30% of AGI for gifts of appreciated property. The IRS limits deductions for gifts to private foundations at 30% of AGI for cash and 20% of AGI for appreciated property.
The government in 1969 came to the realization that some private foundation operators were attempting to game the system. Regulators established policies that place limits on the following:
- Financial transactions between the foundation and major donors, management, and other decision makers.
- Costs that can be paid for by the foundation.
- Salaries and other compensation paid to managers and employees.
- Foundation investments, especially risky investments and those tied to major donors.
- Grants and payments to non-charity organizations.
Each charity must maintain records that can show auditors that the charity is compliant with government concerns.
Pros and Cons of Establishing a Private Foundation
There are many reasons to establish a private foundation.
Tax Reasons – The IRS offers unique incentives to people forming a private foundation. When one donates to a public charity, timing matters. Only contributions made in the calendar year count as deductions in the current year. Private foundation giving allows the donor to spread out the donation over time. When a donor makes a commitment to fund a private foundation in Year X, he/she does not need to contribute all the funding in Year X to take the deduction in Tax Year X.
One Year of No Forced Distributions – The IRS requires a non-operating private charity to have qualifying distributions of at least 5% of the prior year’s average net assets. Due to this ruling, a private charity does not need to make a qualifying distribution in its initial year of operation.
Control of Assets plus an Exemption from Estate and Gift Taxes – When one contributes stock or cash to a private foundation, the managers of the charity determine how those assets will be invested. The donor and/or the donor’s family typically runs private foundations. While the contributions are irrevocable, the foundation managers determine how to vote any shares they hold and where to make the foundation’s charitable contributions. Meanwhile, all charitable deductions reduce one’s estate.
Family Members Can Work for the Foundation – Provided that the family members are ‘qualified’ for their positions, they are eligible to be paid by the charity. Administration expenses count towards the 5% qualifying distribution requirement.
Family Commitment – Family foundations are effective in keeping families together while they work in charity, often for many generations. Most private foundations are perpetual organizations with a long-term vision of philanthropy. Working in a private charity helps to build family values in caring for others while teaching family members how to function in a modern organization.
Donations can Eliminate Capital Gains Taxes – If one donates appreciated property or securities, the donor can reduce the need to eventually pay capital gains taxes. The donor takes a deduction based on the market value of an asset at the time of the donation, not its cost basis. There are exceptions for stock in non-public companies.
Legacy Building – A donor has the option to maintain a low profile or promote the existence of private charity. If the donor so decides, a private foundation can be a unique and attractive ‘asset’ for a person’s reputation.
Avoid Unwanted Charity Solicitations – Private foundations are the perfect excuse for avoiding unwanted solicitations. One can defer all requests to the charity’s board who must approve all distributions.
Work on Pet Projects – The IRS gives private foundations wide latitude in operations. Direct charitable activities (DCA’s) are IRS approved projects. These projects can range from helping people recuperate from a natural disaster to fund college scholarships to sending school books to overseas schools. Using IRS approved program-related investments (PRI’s), the charity can extend loans to other nonprofits. These can be used to build charter schools, churches, and support for other nonprofits.
Attend Conferences and Training Programs – Foundation funds are counted towards the qualified distribution total if spent training and researching staff on charity-related issues. These training sessions can provide technical information or simply educate future generations in charity operations.
The negative aspects of establishing a private foundation include the following:
Time and Cost – Even if one hires lawyers and accountants to assist in establishing a private foundation, setting up a private foundation requires considerably more time and cost than just donating to existing charities.
Excise Taxes – Private charities are required to pay 1% to 2% of net income each year to the IRS. The fee is a function of annual grantmaking. The government requires the fee as compensation for monitoring and regulating these organizations.
Paperwork – The government requires that private charities submit filings and stand ready to justify their expenses and grant-making projects. Documentation adds considerably to administrative costs
Lower Tax Deductibility – As previously discussed, the same asset donated to a public charity brings a higher deduction than a donation to a private foundation.
CPA, MBA – President & Chief Executive Officer
About Steve Goodman
For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.
He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.