What is a Private Foundation or Private Family Foundation, and why do so many families seem to have them? This blog explores those questions by considering the advantages of Private Foundations, along with some of their downsides as well as the basics to establishing a Family Foundation.
I. PRIVATE FOUNDATIONS
A Private Foundation is a type of Section 501(c)(3) charitable organization that is typically established by an individual, family, or corporation to support charitable activities. For example, Coca-Cola funds the Coca-Cola Foundation. “Family Foundation” is not a legal term, but indicates a Private Foundation funded by members of a single family – like the David & Lucile Packard Foundation.
Private Foundations are distinct from Public Charities, the other type of 501(c)(3) organization. Public Charities are supported by the broader public or by government grants.
The donors who found a Private Foundation can control its mission and governance for generations, potentially establishing a perpetual legacy of family involvement in supporting specific causes.
Private Foundations hold nearly $800 billion in US assets. Private foundations include some large and familiar sounding foundations, such as the Bill & Melinda Gates Foundation, the Ford Foundation, the Getty Foundation, the W.K. Kellogg Foundation, and the Lilly Endowment. Yet there are also many smaller Private Foundations. In fact, 98% of Private Foundations in the U.S. have less than $50 million in assets, while 67% have less than $1 million in assets. Together, these foundations give billions of dollars each year to support charitable causes throughout the world.
The IRS recognizes two types of Private Foundations. The first and most common is the Private Non-Operating Foundation. Private Non-Operating Foundations make distributions to other 501(c)(3) organizations but do not operate their own charitable activities. Private Non-Operating Foundations must payout 5% of their assets annually in charitable distributions.
Private Operating Foundations, on the other hand, actively conduct their own charitable activities and may, to the public, look much like Public Charities. A Private Operating Foundation must pass a set of highly particular tests to qualify for its tax-privileged status with the IRS: the asset test, the endowment test, and the support test. Because initial and ongoing compliance with these tests is difficult, Private Operating Foundations are uncommon. Therefore, the remainder of this video considers only Private Non-Operating Foundations, referring to them generally as Private Foundations.
Families establish Private Foundations first and foremost to further their charitable purposes. There are many tax advantages to Private Foundations, which we will discuss shortly. The donors of Private Foundations enjoy more control over their giving than donors who use other types of charitable vehicles like Donor Advised Funds or direct distributions to charities. The donors determine the Private Foundation’s mission, governance or board of directors, how the funds are invested, and how and to whom the funds are distributed.
Private Foundations can potentially last perpetually as a charitable legacy managed by successive generations of family members. Thus, they enable donors to pass on their charitable values to subsequent generations.
II. TAX BENEFITS OF PRIVATE FOUNDATIONS
Private Foundations offer significant IRS-approved tax benefits.
The contributions to a Private Foundations are tax deductible. However, there are limits on the tax deduction. Donations to Private Non-Operating Foundations are deductible up to 30% of the donor’s adjusted gross income or AGI for cash gifts, and up to 20% of the donor’s AGI for most non-cash gifts. The deduction limits for donations to Private Operating Foundations and Public Charities are higher than for Private Non-Operating Foundations.
Donors can avoid paying capital gains tax and recapture of depreciation by contributing appreciated assets to a Private Foundation. Instead of owing taxes, the donor will receive a tax deduction, although that tax deduction is limited to the donor’s cost basis in the property. The deduction is also limited to a percentage of the donor’s AGI. Deductions that cannot be used in one year can be carried forward for up to five years.
Assets within the Private Foundation grow without income or capital gains tax, thereby enabling them to accumulate value largely tax-free. Furthermore, Private Foundations have many options for investing, selling, and buying assets without triggering taxable events. Private Foundations do pay an excise tax on net investment income. Net investment income includes, for example, interest, dividends, rents, royalties, and capital gains.
Private Foundations can help to reduce transfer taxes, including estate and gift taxes. Assets donated to Private Foundations are not subject to transfer taxes. Such assets are outside the donor’s estate for tax purposes. Yet the donor can control the direction of the Private Foundation, take a salary from it, or empower it to employ other family members.
III. DONOR AND FAMILY PARTICIPATION
How can the donor and the donor’s family can participate in a Private Foundation?
You as the donor can control the future of your Private Foundation. For example, you can make yourself a permanent member of the board to ensure that nobody can remove you. Note that you will have a fiduciary duty to act for the good of the Foundation and not for your own good as a board member.
You can also work for your Private Foundation when you retire. This is exactly what Bill Gates does: he retired from Microsoft to serve as co-chair of the Bill & Melinda Gates Foundation, in which capacity he shapes and approves the foundation’s strategies and sets the foundation’s overall direction. By working for your own Private Foundation, you can make the difference in the world and devote yourself full time to giving back to the community after you retire.
The donor can establish a Private Foundation to enable subsequent generations of family members to serve as board members, thereby creating a family legacy of charity and social awareness.
Family members working for a Private Foundation can be paid reasonable compensation for reasonable and necessary services in carrying out the Foundation’s charitable mission. The IRS will scrutinize these arrangements to be sure the compensation is “reasonable” and the services are “reasonable and necessary.” If family members are paid, their compensation is taxable and must be reported on a W-2 or a 1099.
IV. DOWNSIDES OF PRIVATE FOUNDATIONS
Private Foundations do have some downsides.
First, despite the name, a Private Foundation is not private. Its taxes and distributions are public records. Next, donations to Private Foundations qualify for lower tax deductions than donations to Public Charities or Donor Advised Funds.
Private Foundations also require a considerable investment. Given their administrative costs, most advisors recommend starting a Private Foundation with minimum of $1 million, whereas donations to Public Charities can start at any amount.
Finally, the administrative costs can be considerable, especially from the perspective of compliance with the laws and rules of state and federal tax agencies. In addition to start-up costs, the Private Foundation must file annual tax returns on both the state and the federal levels.
V. STARTING YOUR PRIVATE FOUNDATION
Let’s briefly consider some key steps toward creating your own Private Foundation.
First, you must decide the charitable purpose of your Private Foundation. Then, you must set up your business entity with the state. The requirements for non-profit or tax-exempt entities, including the number of directors you need, vary from state to state. But you cannot have a federal tax-exempt entity without first establishing a state entity. You must assemble and report the members of your board of directors. You must obtain an EIN from the IRS and a tax ID from the state. You must carefully prepare bylaws and other documents that determine, among other things, how the Private Foundation will be governed. Finally, you must apply for tax-exempt 501(c)(3) status with the IRS using Form 1023 – which is 28 pages long and requires multiple attachments.
The process is complex and takes some time, but the investment is worthwhile for those who have the means and the desire to establish a lasting legacy of charitable giving.
As you can see, charitable planning is extremely complicated. If you’d like to discuss your options for charitable planning, click here to schedule an appoint with Daniel Van Slyke Attorney at Law.