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Blogging from Heckerling: Post Eight

Beyond the Private Foundation

Martin Hall of Ropes & Gray LLP introduced his session with the observation that most donors revert to using a private foundation in order to accomplish their philanthropic objectives. But a private foundation is not the only option to consider—and it may not be the most appropriate. Mr. Hall provided an overview of the various charitable vehicles available to donors as a means to accomplish their charitable goals.

I. The Private Foundation is defined in IRC section 501(c)(3) as a domestic or foreign organization other than certain organizations commonly referred to as public charities. A typical private foundation has the following characteristics:

  1. A single or concentrated source of funding through contributions by an individual or corporate donor, one family of individual donors, or a discreet group of individual donors.
  2. Reliance from income earned by an endowed fund to support the charitable activities of the organization.
  3. A strategy of carrying out its charitable purposes through grant-making as opposed to direct operation of specific charitable programs. However, a private operating foundation does have direct charitable activities.

Donors prefer private foundations because they can maintain control of how foundation assets are invested, and which charitable organizations can receive grants. An independent board of directors is not required for a private foundation; in fact, many family members participate in family foundations as board directors. Indeed, for many families, the private foundation is the choice vehicle for leaving a legacy. There are several provisions which the donor must be aware of when administering a private foundation:

  1. An annual 2% tax on its net investment income, including interest, dividends, rents and royalties, and capital gains. The tax rate can be reduced to 1% if the foundation’s current year qualifying distributions exceeds its average required distributions over the past five years.
  2. An annual minimum distribution requirement of 5% of its average non-charitable assets must be met by the end of the year following the year for which the distributable amount is computed.
  3. IRC section 4941 prohibits acts of direct or indirect self-dealing between a private foundation and a disqualified person (a “DQP” is an insider of the foundation, such as a substantial contributor, founder, officers, directors, trustees, family members of such individuals and certain corporate and partnership entities). Acts of self-dealing can include any sale, exchange or leasing of property, lending of money or extension of credit, or any transfer or use or for the benefit of a DQP of the foundation’s income or assets.
  4. Private foundations are limited as to the extent to which they can own interests in business enterprises.

II. The Donor Advised Fund (“DAF”) is not a separate charitable entity but is a segregated fund or account maintained by an existing section 501(c)(3) public charity to which a donor or small group of donors can make contributions. Even though the donor transfers control over the amount donated to a DAF, he/she retains an advisory role with respect to the distribution and investment of assets held in the fund.

The DAF is very simple to set up, typically requiring nothing more than completing an account application form and making a contribution by check or wire. There are no governmental forms or returns to be filed by the donor and no administrative responsibilities. DAFs do not currently have a requirement to distribute out a certain minimum percentage of assets to public charities each year.

III. Supporting Organizations (“SO”) are organized and at all times thereafter operated for the benefit of one or more public charities. They are classified as public charities, but are not required to meet the strenuous public support tests. To qualify as an SO, an entity must meet the organizational, operational, control and relationship tests. There are three types of SOs:

  1. Type I SO: the presence of a substantial degree of direction by the publicly supported organizations over the conduct of the supporting organizations. This is typically the parent-subsidiary relationship.
  2. Type II SO: the presence of common supervision or control among the governing bodies of the organizations involved, such as the presence of common directors. This is typically a brother-sister relationship.
  3. Type III SO: while it is not required to demonstrate the same degree of supported charity involvement in governance as the other two types of SOs, it must satisfy three additional tests:
    • Responsiveness Test—responsive to the needs or demands of the public charities it supports, which can be accomplished if the public charity’s officers, directors, or trustees have a significant voice in the SO’s investment policies, timing and manner of making grants, etc.
    • Notification Test—whereby the SO provides certain information annually to each of its supported charities
    • Integral Part Test—the degree of involvement that the SO maintains in the operations of the supported organizations. There are two subcategories of Type III SOs, based on this test:
      • i. Functionally Integrated Type III SOs—engages in activities substantially all of which directly further the exempt purposes of its supported organization to which it is responsive and that, but for the involvement of the SO, would normally be engaged in by the supported organizations.
      • ii. Non-Functionally Integrated Type III SOs—those that focus on grant-making activities

IV. 501(c)(4) Organizations are typically civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare and local associations of employees. These entities are used by many advocacy groups and can also be used by families for philanthropic purposes. A donor to this type of organization is not entitled to a charitable contribution income tax deduction. Prior to 2015, there was controversy surrounding the federal gift tax consequences of contributing to 501(c)(4) organizations. The IRS had taken the position that such contributions were subject to the federal gift tax. The Protecting Americans from Tax Hikes Act of 2015 (“PATH Act”) resolved the gift tax issue and indicated that such transfers were not subject to the federal gift tax.

Donors can make use of any of these charitable vehicles depending on their philanthropic objectives.

 Blogging from Heckerling 2018

Marie Arrigo is a Tax Partner and Co-Leader of the Family Office Services Practice for the Personal Wealth Advisors Group which provides tax consulting and compliance services to family offices, individuals, trusts and estates, and closely held businesses.

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