Wealth of Knowledge - Spring 2012 - A Primer on Private Foundations
A private non-operating foundation is appropriate for individuals who are philanthropic but want flexibility in managing and structuring their charitable gifts, as well as controlling the investments of the foundation. The foundation is an attractive option for someone who desires maximum control over future charitable gifts while enjoying a current charitable income tax deduction. This is how it works: A donor makes a substantial contribution to a private foundation, but the foundation isn’t required to immediately distribute the full amount of that contribution to charity. As a foundation director/trustee, the donor can manage and invest the funds, and select the eventual charitable recipients over a period of years.
Because of the complexity as well as the annual costs of maintaining a private foundation, it may not be appropriate for individuals who don’t plan on making charitable contributions of more than $2 million. Although a private foundation does provide the donor with maximum control over the entity’s eventual charitable distributions, the trade-off is that the charitable income tax deduction for contributions to a private foundation is far less generous than for contributions to a public charity; in addition, stringent rules must be observed to make sure that the foundation – and its founder – comply with the law. A simpler alternative is to make a direct gift to the charity or to establish a donor-advised fund. Assuming that the potential donor is not deterred by these caveats, however, the private foundation may be the right charitable vehicle for him or her. Accordingly, this article will discuss some of the tax considerations, administrative responsibilities and planning opportunities associated with implementing, funding and operating a private non-operating foundation.
FORMING A PRIVATE FOUNDATION
To implement a private foundation, the founder must legally form a non-profit entity under state law (e.g., a corporation or trust) that is organized and operated exclusively for one or more tax-exempt purposes, such as promoting religion, science, education or health, and that is specifically barred from certain activities, such as participating in political campaigns, lobbying or benefitting the founder or the founder’s family. The entity then must obtain an identification number from the Internal Revenue Service (“IRS”). Next, the entity applies for tax-exempt status with the IRS. Assuming the IRS approves the entity’s application, it issues a “determination letter” to the foundation indicating that the entity is classified as a private foundation and has exempt status. The foundation may also need to register with the Attorney General’s office in the state(s) in which it is conducting activities.
CHARITABLE INCOME TAX DEDUCTION FOR CONTRIBUTIONS TO THE PRIVATE FOUNDATION
Once the private foundation has its determination letter, all contributions to the foundation, retroactive to the date of its organization, may be eligible for a charitable income tax deduction. However, just as a public charity has its own deduction limitations, private foundations do as well.
To illustrate, a donor can deduct cash contributions to a public charity up to 50% of his or her “adjusted gross income” (AGI); by contrast, cash contributions to a private non-operating foundation are generally limited to 30% of the donor’s AGI. Similarly, the deduction for a contribution of appreciated publicly traded stock to a public charity is its fair market value at the time of the gift and is limited to 30% of the donor’s AGI, whereas the same contribution to a private foundation is generally limited to 20% of the donor’s AGI. Contributions to either public charities or private foundations in excess of the AGI limitation can be carried forward and may be used by the donor for the next five (5) years. Note that regardless of whether a donor contributes appreciated tangible personal property (such as artwork) to either a public charity or a private foundation, his or her deduction will be limited to the cost basis unless the property is “related to” the charity’s exempt purpose (e.g., a painting donated to a museum would be a “related use;” a violin donated to a food kitchen would not be).
ANNUAL TAX FILING REQUIREMENTS
Although private foundations are generally exempt from income tax, annual federal returns (Form 990-PF) are still required, along with possible state returns. A private foundation must also make its exemption application and annual Form 990-PF available for public inspection.
TAXES ON PRIVATE FOUNDATIONS
There is a federal excise tax on the foundation’s net investment income. Although it is 2%, it can be reduced to 1% if the foundation’s qualified distributions to charities during the tax year exceed a certain dollar amount, which is calculated on the Form 990-PF. The amount is generally based on the average distribution ratio for the year as compared to the net value of the foundation’s non-charitable use assets for the last five years (or the number of years the foundation has been in existence, if fewer than five years). This effectively means that a private foundation cannot qualify for the reduced 1% rate during its initial tax year.
There are additional excise taxes if private foundations, foundation managers and “disqualified persons” engage in certain prohibited acts. (“Disqualified persons” include substantial contributors to the foundation, as well as foundation directors, trustees, managers and certain relatives, family members and related entities.) Some of the prohibited acts include self-dealing, failure to make the required annual distribution to charity, certain “excess holdings” in private businesses, investments that jeopardize the foundation’s ability to carry out its exempt purpose, and expenditures that do not further the foundation’s charitable purpose. For instance, fulfilling a personal pledge to a public charity or funding a personal acquisition with private foundation funds is an act of self-dealing, subject to penalty. The penalties for violating any of these prohibited acts can be quite severe (up to a 100% tax on the offending transaction if it is not timely cured) and can threaten the foundation’s tax-exempt status. Needless to say, it is important to be mindful of these rules, as it is possible to inadvertently trip them. Finally, to the extent the foundation has “unrelated business taxable income,” it could be subject to the same income tax rates as for-profit entities. This topic will be discussed in a future article.
A private non-operating foundation must distribute at least 5% of its adjusted average market value annually (note that reasonable overhead expenses incurred for charitable purposes is included as part of the 5% distribution). As mentioned above, failure to make this distribution will trigger an excise tax, which is initially assessed at 30% of the difference between what was required to be distributed and what actually was distributed. The 5% minimum distribution is computed on the foundation’s annual Form 990-PF and must be distributed before the close of the following tax year to avoid this excise tax. An additional excise tax of 100% can be assessed if the foundation fails to correct the distribution shortfall in a timely manner.
MANAGING PRIVATE FOUNDATION ASSETS AND INVESTMENTS
The foundation’s managers have a fiduciary obligation to manage the foundation’s assets. This means, for example, that when receiving a gift of appreciated stock, the managers must decide whether to keep the stock, or sell some or all of it, and re-invest the proceeds in a diversified portfolio. If they sell the stock, the foundation will be subject to an excise tax on the gain, computed as the difference between the sales proceeds and the donor’s cost basis.
The foundation’s directors and trustees may consist of the founder and multiple generations of the founder’s family, all of whom can help control the foundation’s investment decisions and select the charitable recipients. Family participation on the foundation’s Board and Investment Committee can foster the founder’s philanthropic values within the family and help him or her pass them on to heirs.
It goes without saying that efficient and responsible foundation management will result in greater benefits to charity, and will thereby better serve the founder’s philanthropic goals.
A Wealth of Knowledge - Spring 2012 Issue