A private foundation is a charitable trust or nonprofit corporation which must be organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes. The foundation’s charitable purpose may be as broad or as specific as the founder wishes. Generally, the foundation will fund the charitable activities of other organizations through a program of annual grants. However, in some cases, the foundation may actually engage in the conduct of charitable activities directly, thus qualifying for special tax treatment as a private operating foundation.

For many families, establishing a private foundation offers a number of significant advantages which cannot be realized by the more common program of annual charitable gifts to various organizations. However, in exchange for these benefits, the foundation must strictly adhere to a variety of rules and requirements. Although these restrictions do not pose serious problems for most donors, they should be taken into account in deciding whether to establish a foundation. These advantages and restrictions are briefly summarized below.

ADVANTAGES OF CHARITABLE GIVING THROUGH FAMILY FOUNDATIONS.

A. Structure and Control.

Unlike many other charitable vehicles, establishing a private foundation permits the founder to exercise substantial control over the foundation’s activities. For example, the founder can appoint the board of directors, and the founder can develop and implement a systematic plan for charitable giving, targeting areas of personal interest. In addition, the founder can and should prepare a succession plan for the foundation. This can be done through the appointment and removal process, and by cultivating future board members within the family.

B. Family Involvement.

The founder may often choose to appoint other members of his or her family, such as children and/or grandchildren, to the foundation’s board. As a result, the foundation can provide an opportunity to involve the family in a common interest and concern. In addition, by involving younger family members early on, continuity in the foundation’s management can be ensured. The family members may also appreciate the prestige and community recognition that often comes with the establishment of a foundation. Finally, a foundation may receive contributions from a number of family members, thus consolidating and enhancing the effectiveness of the family’s charitable giving.

C. Flexibility.

Because the foundation makes grants annually, rather than making a one-time lump-sum donation, it can be more flexible over time. As the family’s charitable interests evolve and the charitable recipients’ needs and effectiveness change, the foundation’s program of grants can and should be modified.

D. Optimization of Charitable Effect.

Because the contributions to the foundation establish an endowment which can appreciate in a tax-protected environment, the amount received by charity over time will far exceed that which would have been received if a one-time direct gift were made.

E. Determination of Appropriate Recipients.

Through its program of annual grants, the foundation can request grant proposals which require applicants to provide detailed information regarding their suggested programs and their management in general. The foundation’s evaluation of these proposals will permit the allocation of the charitable funds in an efficient and productive manner and will relieve the founder of the need to personally investigate potential charitable recipients. As an added benefit of this process, other family members are able to take a more active and rewarding role in the management of the foundation’s grant program.

F. Managing Charitable Solicitations.

Members of wealthier families are frequently besieged by charitable solicitations. The presence of a family foundation enables the family member to refer such solicitations to the foundation manager. The foundation can then systematically review and evaluate the solicitations and the individual family member may be relieved of the need to deal personally with the solicitors.

RESTRICTIONS APPLICABLE TO PRIVATE FOUNDATIONS.

A. Limitations on Charitable Income Tax Deduction.

Donors receive an immediate deduction for either the fair market value of their gift, or their tax basis in the property donated to a private foundation (depending upon the type of property donated), subject to certain percentage ceilings. A cash gift to a private non-operating foundation is deductible for income tax purposes up to a maximum of 30% of the donor’s adjusted gross income (“AGI”), and property gifts are deductible up to a maximum of 20% of AGI. A gift to a foundation which exceeds these percentages may be carried forward over the next five years.
In the case of a testamentary gift, however, an unlimited charitable deduction is available for estate tax purposes regardless of whether the recipient is a private foundation or public charity.

B. Minimum Distribution Requirement.

The Internal Revenue Code requires a private foundation to distribute a minimum amount annually for charitable purposes equal to approximately 5% of the average fair market value of the foundation’s assets. Thus, if a foundation’s assets were valued at $1 million, it would be required to distribute approximately $50,000 that year. These distributions generally include foundation administrative expenses and distributions to public charities. The initial penalty for failing to do so is a 30% tax on the undistributed income, and the penalty may increase to 100% of the undistributed income.

C. Tax on Net Investment Income.

A private foundation must pay a 2% tax (or 1% tax if certain requirements are met) each year on its “net investment income.” Net investment income includes the dividends, interest, rents, royalties and capital gains received by the foundation, reduced by the foundation’s expenses related to the production of such income (e.g., investment advisor fees).

D. Self-Dealing.

A private foundation is severely restricted in its ability to transact business with “disqualified persons.” Generally, a disqualified person is a member of the family, the foundation manager, someone who is a substantial contributor (generally, someone contributing more than $5,000 if that amount exceeds 2% of the cumulative contributions), or a person who owns more than 20% of a business or trust which is a substantial contributor.
Examples of acts of self-dealing include leases between the foundation and a disqualified person and sales of assets by the foundation to a disqualified person. The foundation officer or director, and any disqualified person who willingly participated in self-dealing, is subject to severe penalties and fines for acts of self-dealing. Penalties range from 5% to 10% initially, and up to 200% if the transaction is not
rescinded.

E. Excess Business Holdings.

Other rules limit the types of investments which a private foundation may hold. In particular, subject to certain narrow exceptions, a foundation and its officers, directors and substantial contributors cannot in the aggregate hold more than 20% of the voting stock (or equivalent partnership interest) in an active business enterprise. (The 20% amount can be raised to 35% if it can be shown that control is possessed by persons who are not disqualified persons.)
For purposes of determining whether the 20% limit has been exceeded, the holdings of all disqualified persons must be aggregated with the foundation’s holdings. The initial penalty for excess business holdings is a 10% tax on the value of such holdings, and the penalty may increase to 200% of such value.

F. Jeopardy Investments.

A penalty excise tax can be imposed on a private foundation if it invests in such a manner as to jeopardize the carrying out of the foundation’s exempt purpose. No investment is specifically designated a “jeopardy investment.” Instead, whether or not this rule is violated is determined based upon a “prudent trustee” standard. Generally, a jeopardy investment is identified as one in which foundation managers showed a lack of reasonable business care and prudence in providing for the foundation’s financial needs. The initial penalty is 10% of the jeopardy investment, and this amount can increase if the investment is not timely removed from jeopardy status.

G. Restricted Expenditures for Non-Charitable Purposes.

A 20% tax can be imposed on a private foundation if it engages in a prohibited “taxable expenditure,” and an additional tax of 100% can be imposed if the taxable expenditure is not corrected. These include amounts paid by a private foundation for lobbying, electioneering, grants to individuals (unless awarded on a nondiscriminatory basis with prior IRS approval) and, in certain situations, grants to nonpublic charity organizations.

H. Annual Reporting Requirements.

Private foundations are required to file an annual informational tax return with the Internal Revenue Service.

CREATING A FAMILY FOUNDATION – FORM AND JURISDICTION.

A family foundation may be established either as a trust or as a corporation. The founder should think carefully about which type of legal entity to establish as there are important differences between the two.

If the founder chooses to incorporate the family foundation, he or she must file articles (or a certificate) of incorporation with the state of incorporation. There may also be requirements to maintain and comply with state law. The use of a corporation (as opposed to a trust) may allow for greater flexibility in future generations, as the bylaws may be amended if necessary. Further, state law may require certain attributes and provide guidance and/or default provisions.

If the foundation is established as a trust, the founder only needs to sign the trust documents and transfer assets to the trust. The use of a trust may be less flexible than the use of a corporation, but this may be beneficial in some instances. For example, if the founder does not contemplate future changes or development, or wishes to ensure that specific aspects of the foundation cannot be changed, it is much more difficult to make changes to a trust agreement than to a corporation’s bylaws. Thus, if a founder wishes to narrowly tailor the vision of the foundation (i.e., to only be used for religious purposes), it may be advantageous to establish the foundation as a trust.
Regardless of which form the founder chooses, the state in which the foundation is established will be another important consideration. For example, Delaware has accumulated a long and favorable history in the fields of trust and corporate law. Its corporate laws allow the founder of a foundation more flexibility in crafting important operational procedures such as appointment and removal of board members. In addition, different states’ laws may provide different limitations on liability and compensation for board members, volunteers, and third parties, and these factors should be considered when selecting the foundation’s jurisdiction.