Should I Use a Private Foundation?

What is a Private Foundation?

A private foundation is a charitable organization that you can create to accomplish your charitable giving goals. The foundation can be created either as a corporation or as a trust. 

Although there are private operating foundations which conduct their own direct charitable functions (such as a museum, or an organization that provides housing to the homeless), most private foundations are charitable organizations that (generally) make cash grants to public charities.

Because this is your private charity, you, and perhaps your family, may direct the foundation’s operations.

How Does It Work?

To start a private foundation, you (using an attorney) would create either a trust or corporation (for ease of reference, we will refer to either type of organization generically as a foundation). As the foundation is organized, you will create its governing structure. Because this is your foundation, you may choose the board of directors or trustees. You can serve as the sole director or trustee should you desire. The board of directors and trustees may, depending on the structure, choose officers to manage the day-to-day operations of the foundation. It is common for the donor, the donor’s spouse and sometimes the donor’s other family members to run the operations of the foundation.

The officers/directors/trustees of your foundation would ask the Internal Revenue Service (IRS) to grant the foundation tax-exempt status under Internal Revenue Code (IRC) § 501(c)(3) by filing Form 1023. The default categorization for a tax-exempt organization qualified under IRC § 501(c)(3) is a private foundation. However, if such an organization is broadly supported by the public, and if it meets certain financial tests, it can qualify as a public charity (like the American Red Cross or the American Cancer Society). Alternatively, if the private foundation operates a specific charitable project or mission (like a museum) it can qualify as a private operating foundation. Public charities and private operating foundations are beyond the scope of this article.

Once the foundation qualifies as a tax-exempt entity, it may receive tax-deductible contributions. The foundation is also subject to the somewhat complicated rules and regulations governing private foundations. These rules are designed to ensure that tax-exempt money inside the foundation is used for charitable purposes. For example, a private foundation cannot give money to political causes. Also, the private foundation cannot engage in acts of self-dealing with disqualified persons (such as substantial donors or their family members). The rules are very stringent. For example, if your private foundation purchases a table with a meal at a charity event, you (as a significant donor and, therefore, disqualified person) could not attend the dinner, because you would be receiving a benefit from your foundation. Under current law, foundation managers are entitled to receive reasonable compensation for services rendered to the foundation. Failure to follow the private foundation rules could result in severe excise taxes on the foundation and the foundation managers.

To ensure that private foundations don’t warehouse tax exempt funds, the private foundation rules generally require the foundation to distribute at least 5% of its value each year to other charitable organizations. The officers/directors/trustees of the foundation determine the process for making grants, which charitable organizations will receive those grants and the method and timing of grant payment. To ensure that the funds distributed are used for charitable purposes, unless a distribution is made to a public charity, the foundation must remain responsible for determining that the distributed funds are used for the intended charitable purpose. Failure to do so could result in severe excise taxes on both the foundation and the foundation managers.

As a so-called 501(c)(3) organization, money or property given to your foundation could entitle you (or any other donor) to a federal income tax deduction. To be eligible to receive such deduction, you must itemize deductions on your federal income tax return. There are also limitations on how much of a contribution is deductible (discussed below).

Of course, the foundation must file an annual tax return using Form 990-PF. This form is open to inspection by the public (and many websites make them available). This tax return lists information about the foundation’s finances, managers (and their salaries), grant distributions, and donors.

Why Should I Do This?

A private foundation is a way to make gifts to charitable organizations that you wish to support now and in the future. By giving to a private foundation today, you can set aside amounts that the foundation managers, perhaps you and your family, can invest for future gifts to charitable organizations. If you and your family are the foundation managers, you control which charities will receive grants from your foundation and when such charities will receive those gifts. You can also set conditions governing the recipient’s use of those gifts.

If you itemize deductions for federal income tax purposes, the IRC may allow you to take a deduction from adjusted gross income (AGI) when calculating taxable income for gifts made to charitable organizations. Your ability to deduct the amount you give to charity may be limited depending upon the type of charitable organization that receives your gift, the amount of your AGI and the type of property (including cash) that you give. In general, there are higher limits for gifts made to public charities and lower limits for gifts made to private foundations. For example, if you make a gift of cash to a private foundation, you may be able to deduct up to 30% of your AGI on your federal income tax return for the year of the gift. A lower limit of 20% of AGI applies if you give capital gain property. The income tax charitable deduction is generally based on the value of the property given to the foundation. Gifts of cash and publicly traded securities are based on their fair market value on the date of the gift. An exception applies to gifts of securities that are not publicly traded. The value of the deduction with respect to a gift of securities that are not publicly traded is, generally, based on such property’s tax cost basis. You should consult your tax advisor to determine the tax impact in your particular circumstances.

Giving to a foundation may allow you to receive an income tax deduction today for gifts to charitable organizations in the future.

For example, assume you would like to receive an additional income tax deduction this year. To obtain a deduction you would like to give to charity, but don’t yet know which charitable organizations should receive your gifts. You could give cash or property to a foundation this year and, up to the limits of the IRC, receive a deduction for the gift on this year’s income tax return. In later years, after you have determined which charities should receive your gifts, if you are the foundation manager you would cause your foundation to make grants to those charities.

Another attractive feature of a private foundation is the ability to involve family members in your overall philanthropic program. Many families include children and other descendants as foundation managers. In this way junior generations can learn about investing, budgeting, organizational governance and the like without having access to the family’s entire wealth. Additionally, including family members in the operation of the foundation provides the entire family with an opportunity to work together both while the senior generation is alive and after the senior generation has passed on. Perhaps most importantly, a family may have a charitable vision and mission for at least some of its wealth. A private foundation allows the entire family to learn about and become intimately involved in this mission and to expand it as a family legacy over the course of many generations.

What Are the Downsides?

A private foundation is formal structure, such as a trust or corporation, that requires an attorney to create and request qualification as a tax-exempt entity. Additionally, the foundation should retain an accountant to ensure that the foundation maintains proper financial records and files the appropriate tax returns. Also, some states’ attorneys general require private foundations to file a report with their offices. Accordingly, there are professional costs necessary to create and maintain a foundation that other private charitable vehicles, like donor-advised funds, do not have. The large professional fees to create and maintain a private foundation may suggest that the initial contribution to the foundation be substantial.

A private foundation’s tax return is open to public inspection. In fact, there are many websites that post private foundation returns. A great deal of information about the foundation is open to the public, including the names and addresses of the foundation’s managers and their salaries, the names and addresses of large donors and the amount of their contributions, and the grants made by the foundation to other charitable organizations.

A private foundation is subject to many rules designed to prevent abuse. There are rules preventing self-dealing, requiring annual distributions, prohibiting investments in things that could jeopardize the foundation’s charitable purpose, requiring expenditure responsibility over gifts to non-public charities and prohibiting political activity. Violation of any of these rules could result in the foundation and the foundation managers being subjected to onerous excise taxes.

Subject to limited exceptions, you and members of your family cannot receive a personal benefit from your private foundation. One exception is payment of reasonable compensation for services rendered to the foundation. According to the IRS, “Paying compensation or reimbursing expenses by a private foundation to a disqualified person is generally an act of self-dealing. The general rule does not apply, however, to the extent the payments, which cannot be excessive, are for personal services that are reasonable and necessary to carry out the foundation’s exempt purposes. Thus, it is not an act of self-dealing for a private foundation to pay reasonable compensation to a foundation manager, who is an investment advisor, for managing the private foundation’s investment portfolio. Also, paying reasonable compensation to trustees of a trust would not constitute self-dealing, because their services are necessary.”

Generally, a private foundation must distribute at least 5% of its value each year. Failure to do so could result in the imposition of onerous excise taxes on the foundation and the foundation manager. If you would like your foundation to provide scholarships, there must be established criteria for their award which is approved in advance by IRS.

Should I Do This?

A private foundation can be a good way to create a charitable giving program and may allow you to receive tax benefits as well. Additionally, it may be a way for you to leave a charitable legacy for future generations to maintain and follow. As described above, there are limits, but with a private foundation you can control the investment and distribution of the foundation’s funds.

As with any giving and tax strategy, you should consult your attorney, accountant or other tax advisors to determine if a private foundation is the right giving strategy for you.

To learn more about private foundations please contact your PNC Private Bank team; we would be glad to discuss with you and your advisors whether a private foundation is appropriate for you.

For more information, please contact your PNC Private Bank Hawthorn advisor.