private foundations
DESCRIPTION
An overview of private foundations (non-operating) for the financial advisor, planned giving officer, or philanthropist interested in learning about the legal and tax structure.TRANSCRIPT
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.
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Graduate Studies in
Charitable Financial Planningat Texas Tech University