private foundations

Private Foundations

Financial planning guidelines for permanent entities

Russell James, J.D., Ph.D., CFP®; Associate Professor & Director of Graduate Studies in Charitable Planning, Texas Tech University, EncourageGenerosity.com

A private non-operating foundation holds money and distributes charitable grants

Psychology’s “terror management theory” suggests that a defense to “mortality salience” is to focus on literal immortality (religious) or

symbolic immortality (your name/impact/story will live on)

Russell Sage has been dead well over 100 years

I still apply for research grants to the Russell Sage Foundation

Dead

• Josiah K. Lilly (1948)

• Edsel Ford (1943)

• Robert Wood Johnson II (1968)

• W.K. Kellog (1951)

• Andrew W. Mellon (1937)

• John D. Rockefeller (1937)

Alive

• Lilly Endowment

• Ford Foundation

• Robert Wood Johnson Foundation

• W.K. Kellog Foundation

• Andrew W. Mellon Foundation

• The Rockefeller Foundation

The rules of a private foundation can be permanent

This differs from an inheritance or company where later generations

make all rules

A private foundation allows donor and descendents to control the foundation

assets and charitable payouts indefinitely

A private foundation can transmit values by involving descendents in specific charitable causes for many generations

Three types of charitable organizations

Public charity

Supporting organization

Private foundation

Public Charity

• Publicly supported

OR

• Operates ongoing traditional charitable activity (e.g., hospital, church, school)

Private Foundation

• Default if charity not a public charity or supporting organization

Typical private foundation

• Funded by one person, family, or corporation

• Makes grants, rather than directly running charitable activity

• Expenditures funded by investment income

Typical private foundation

• Funded by one person, family, or corporation

• Makes grants, rather than directly running charitable activity

• Expenditures funded by investment income

If it smells like this

don’t call it a public charity

Typical private foundation

• Funded by one person, family, or corporation

• Makes grants, rather than directly running charitable activity

• Expenditures funded by investment income

Support from those1

giving <2% of totalTotal support2

≥ 1/3

This is a public charity

1 Includes support from government regardless of share of total support

2 Large unusual gifts from outsiders can be excluded

Typical private foundation

• Funded by one person, family, or corporation

• Makes grants, rather than directly running charitable activity

• Expenditures funded by investment income

Support from those1

giving <2% of totalTotal support2

≥ 1/10

This is a a public charity

+ operated to attract new public/gov’t support

+ “facts and circumstances” that it is a public charity

1 Includes support from government regardless of share of total support

2 Large unusual gifts from outsiders can be excluded

Typical private foundation

• Funded by one person, family, or corporation

• Makes grants, rather than directly running charitable activity

• Expenditures funded by investment income

Income from charitable operations + support from those1giving <2% of totalIncome from charitable

operations + total support2

≥ 1/3

This is a public charity

Investment incometotal income

≤1/3

AND

1 Includes support from government regardless of share of total support

2 Large unusual gifts from outsiders can be excluded

Publicly supported organization tests

+ organization is operated to attract new public/gov’t support + “facts and circumstances” that it should be a treated as a

public charity

Investment income is 1/3 or less of total income + above ratio would be 1/3 or more if support included income from exempt goods and services

1. Includes support from government regardless of share of total support2. Large unusual gifts from outsiders can be excluded

Support from those1 giving <2% of totalTotal support2

≥ 1/3

Support from those1 giving <2% of totalTotal support2 ≥ 1/10

or Charitable Trust

Under state law create a…

Obtain federal tax exempt status Initial Application

1023 Annual filing

990-PF

Create a Private Foundation

Flexible; lower UBIT rates

More founder control; foreign operations eliminate deductibility for corporate donors

Nonprofit Corporation

1.

2.

• Because of initial and ongoing costs, private foundations usually >$1MM. Some suggest feasible at >$100,000.

• The most common cheaper alternative is a donor advised fund.

Foundation board• Typically the donor and close family members

• Can establish rules for succession

– Descendents who meet certain criteria

– Unequal voting rights allowable

– Junior board for minors advising on small gifts

Tax rules for private foundations

Tax on net investment income

• 2% tax on net investment income

• Drops by 1% if current year charitable payout is at least 1% more than 5-year average payout percentage

Gifts to private foundations also have lower income-based deductibility limits

Current Value: $25

1990 Paid $1

Long-term capital gain (special election)

Tangible personal property

(“unrelated” use)

CashOrdinary income

property

Inventory Short-term capital gain Public

Charity

Public Charity

Current Value: $25

1990 Paid $1

Long-term capital gain (no special election)

Tangible personal property

(“related” use)

CashOrdinary income

property

Inventory Short-term capital gain

Public Charity

Private Foundation (non-operating)

Current Value: $25

1990 Paid $1

Long-term capital gain (any)

Tangible personal property (“related” or “unrelated” use)

Current Value: $25

1990 Paid $1

Private Foundation (non-operating)

Private Foundation (non-operating)

Charitable Purposes

To protect charitable distributions, many transactions are prohibited or penalized

Insider Benefits

• Self-dealing

• Failure to distribute income

• Excess business holding

• Investments that jeopardize charitable purpose

• Taxable expenditures

Insider Benefits Charitable Purposes

IRS punishments for transactions that break the rules include:

• Initial tax (10%-30%)

• Additional tax if transaction not corrected (25%-200%)

• Revoking exemption

Who is an insider (A.K.A. a “disqualified person”)?

Insider Benefits Charitable Purposes

Insider or “Disqualified Person”• Officer, director, trustee, or any employee with

responsibility for the act• Substantial contributor >2% of all contributions from foundation start

to end of tax year (+>5K total contributions) Grantors of a charitable trust

automatically qualify• Ancestor, spouse,

descendent, or spouse of descendent of above

• Corporation, trust, or partnership owned 35% or more by above

• Self-dealing• Failure to distribute income

• Excess business holding

• Investments that jeopardize charitable purpose

• Taxable expenditures

Insider Benefits Charitable Purposes

Self-Dealing

• Sell, exchange, lease, transfer or loan money, goods, services, property, or facilities to a disqualified person

• Paying a government official

Bargain sale

Suppose a disqualified person is willing to sell a $200,000 property to the foundation for $10,000?

Bargain sale

Suppose a disqualified person is willing to sell a $200,000 property to the foundation for $10,000?

Bargain saleSuppose a disqualified person gives a $200,000 property (with a recent $12,000 mortgage) to the foundation?

Bargain saleSuppose a disqualified person gives a $200,000 property (with a recent $12,000 mortgage) to the foundation?

(Payment of the insider’s debt is a benefit, but allowed if debt is 10+ years old)

Self-Dealing Penalty• Disqualified person taxed 10% of transaction (+5% tax

on foundation manager who knowingly participates)

• Must correct in 90 days of IRS notice else disqualified person taxed 200% (+50% tax on foundation manager)

•Free gifts to the foundation of money, property, or use of money or property

•Foundation can hire an insider to perform necessary professional or managerial servicesif compensation is reasonable

•Reimbursements of reasonable and necessary expenses such as meals and travel

• Self-dealing

• Failure to distribute income• Excess business holding

• Investments that jeopardize charitable purpose

• Taxable expenditures

Insider Benefits Charitable Purposes

The foundation must distribute at least 5% of non-charitable net assets under foundation’s control by the end of the following tax year

The foundation must distribute at least 5% of non-charitable net assets under its control by the end of the following tax year

5% excludesCharitable assets: used for charitable purposes, such

as paintings on loan to a museum, or office furniture used to manage the foundation

Assets not yet under the foundation’s control: a right to receive property after death, after estate administration, or after payment of a pledge.

5% payout is reduced by investment

tax and unrelated business

income tax

5% can be spent on grants to charity including designated purpose funds, but NOT

• Grants to another non-operating foundation

• Grants to charity controlled by the foundation or disqualified persons

• Donor advised funds

Buying or improving assets used directly in charitable purposes also counts

Administrative expenses for grant-making or fundraising (but not

investment management) also count as charitable

expenditures

Can the foundation postpone payouts to save up for a big gift?

Yes. If…

• It is for a project better accomplished through set aside than by immediate payout (e.g., constructing a building)

• Pay out within 60 months of first set-aside

If the foundation makes a big gift, will the amount above 5% carry over to future

years?

If the foundation makes a big gift, will the amount above 5% carry over to future

years?

Yes. Gifts above 5%

can carry forward for up to

5 years

• Self-dealing

• Failure to distribute income

• Excess business holding• Investments that jeopardize charitable purpose

• Taxable expenditures

Insider Benefits Charitable Purposes

What’s the problem with excess business holdings?

• Donor still controls the business even though he has taken a charitable deduction

• Donor decides if any profit is distributed to the foundation

• Donor controls his (and other’s) compensation at the business

Foundation

Foundation + Insiders

20%

Add If Another Has Effective

Control15%Others

65%

A private foundation cannot own more than 2% if the foundation and all disqualified persons combined own more than 20% of a company (35% if someone else has effective control)

• Charitable function such as a school or hospital

• Business run by unpaid volunteers or selling donated items

• Business for beneficiaries /employees such as a museum cafeteria

Full ownership of a charitable business is allowed

Full ownership is allowed if business is passive – simply collecting dividends, interests, royalties, or real estate rent without leverage

Time to dispose of excess business holdings• 90 days if foundation buys• 5 years if foundation

receives as a gift [and can request extension for another 5 years if unusual circumstances]

• Foundation pays a tax of 10% of highest business holdings above maximum

• Up to 200% if not corrected in 90 days of IRS notice

Excess Business Holding Penalty

• Self-dealing

• Failure to distribute income

• Excess business holding

• Investments that jeopardize charitable purpose• Taxable expenditures

Insider Benefits Charitable Purposes

Crazy investment gambles can

jeopardize the charitable purpose

Nothing is automatically

disqualified, but special attention

given to options, margin trading, short

selling, commodity futures, oil/gas

interests

Jeopardizing investments are excessively risky in the context of entire portfolio

(“fails to exercise ordinary

business care and prudence”)

High risk investments are allowed if they are primarily charitable • Needy student loans

• Low-income housing

• Urban renewal

• Foundation pays a tax of 10% of the jeopardizing investment (manager pays 5%, up to $10k)

• Another 25% if not corrected within 90 days of IRS notice (manager pays another 5%, up to $20k)

Jeopardizing Investment Penalty

• Self-dealing

• Failure to distribute income

• Excess business holding

• Investments that jeopardize charitable purpose

• Taxable expenditures

Insider Benefits Charitable Purposes

Taxable expenditures

• Non-charitable purposes

• Political campaigning or lobbying (except non-partisan research)

• Grants to individuals except – Travel, study, or similar if IRS

approves non-discriminatory award process

– Grants to impoverished persons or disaster victims

– Prizes/awards to recognize achievement with no restrictions on use of funds

• 20% of the taxable expenditure (manager pays 5%, up to $10k if no reasonable cause)

• Another 100% if not corrected within 90 days of IRS notice (manager pays another 50%, up to $20k)

Taxable Expenditures Penalty

What if creating a private foundation is just too much hassle?

I give to a donor advised fund and “advise” when and where it will be distributed to other charities

Donor Advised Fund• No minimum payout• Minimal setup &

administrative expense• Expected control of grants• Investment management

sometimes allowed• Legislatively in flux

Private foundation• 5% minimum payout• Significant setup &

administrative expense• Actual control of grants• Investment management

always allowed• Legislatively stable

Private Foundations

Financial planning guidelines for permanent entities

Russell James, J.D., Ph.D., CFP®; Associate Professor & Director of Graduate Studies in Charitable Planning, Texas Tech University, EncourageGenerosity.com

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This slide set is from the curriculum for the Graduate Certificate in Charitable Financial Planning at Texas Tech University, home to the nation’s largest graduate program in personal financial planning.

To find out more about the online Graduate Certificate in Charitable Financial Planning go to www.EncourageGenerosity.com

To find out more about the M.S. or Ph.D. in personal financial planning at Texas Tech University, go to www.depts.ttu.edu/pfp/

Graduate Studies in

Charitable Financial Planningat Texas Tech University