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Private Foundations What is a Private Foundation In technical terms, a Private Foundation is a not-for-profit entity that can be controlled by a person, a family or a business. It is organized exclusively for charitable, educational, religious, scientific or literary purposes under Section 501(c)(3) of the Internal Revenue Code. The foundation must be officially recognized by the IRS in order for contributions to it to be deductible. In practice, a Private Foundation can be a planning tool that empowers a family to be philanthropically involved with its community and with the world. It is a vehicle that fosters family involvement, provides significant control over asset investments and distributions, and allows donors to receive a charitable income tax deduction for foundations created during lifetime and a charitable estate tax deduction for foundations created upon death. Its benefits are many, and include the following:
A typical Private Foundation has three fundamental characteristics:
The Internal Revenue Code (IRC) defines a Private Foundation as any domestic or foreign charitable organization other then the four categories of organizations described within Sections 509(a)(1), 509(a)(2), 509(a)(3) and 509(a)(4). It is described not by what a private foundation is, but by what it is not. In essence, every charitable organization is a Private Foundation, unless it is one of the following:
Creation of the Private Foundation A Private Foundation can be created as a corporation under the laws of a particular state or as a trust, governed by trust law. The advantages of the not-for-profit corporation structure are that it offers more flexibility because the corporate directors may easily amend it, including changes in the corporate structure, election of new officers, etc. Depending on state law, various approvals from state officials may be required if and when the corporate directors amend the corporate articles. In addition, the standard of care to which the law holds a director is often less than that of a trustee. The advantages of a trust are that it can be established more quickly than a not-for-profit corporation, thus often helping with end of year planning. It is often the given as an option for Private Foundations created upon death. It is important to check state law when creating a Private Foundation. Many states are now enacting the uniform trust code (UTC), and these laws may give greater flexibility for trust planning than was historically available. Form 1023 — Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code must be submitted to the IRS. Once created as a valid entity at the state level, either as a corporation or a trust, this form must be submitted to achieve its tax exempt status by the IRS. Income Tax Rules for Contributions to Private Foundations A donor is entitled to take a charitable income tax deduction for transfers of property to a Private Foundation made during life. The deductions allowed are generally less generous than gifts made to public charities or supporting organizations.
Estate and Gift Tax Rules for Contributions to Private Foundations Under I.R.C. §2055, Congress allows estates of residents or citizens an unlimited deduction from the gross estate for bequests, devises, legacies, and other transfers to, or for the use of, qualified charitable organizations, including Private Foundations. The same rule applies under I.R.C. §2522 for intervivos gifts to qualified charitable organizations. Administration and Taxation of Private Foundations The need to comply with the complex Private Foundation rules may discourage some individuals from establishing their own foundation. These rules must be carefully reviewed by the client with the attorney. If the client and/or his family either have difficulty grasping all the complexity of these requirements or the desire to deal with the rules, another form of charitable giving should be considered. Detailed Annual Reporting Requirements. Private Foundations are required to file several forms with the Internal Revenue Service and/or with state agencies for the jurisdictions in which the foundation has its jurisdiction.
Minimum Payout Provisions: I.R.C. §4942. The Internal Revenue Code requires that every Private Foundation pay out annually as a minimum an amount equal to 5% of its net investment assets as qualifying distributions. Qualifying distributions include actual grants made to qualified charities and all necessary and reasonable administrative costs to make the grants. Qualifying distributions may also include costs to provide direct charitable activities, and costs to acquire assets used directly in the conduct of the foundation's exempt activities.
Private Foundation Prohibitions The Internal Revenue Code regulates Private Foundations through the imposition of excise taxes on certain prohibited activities. Self-Dealing Prohibitions: LR.C. §4941. The Internal Revenue Code generally prohibits a Private Foundation from entering into any financial transaction with certain related persons defined in the law as "disqualified persons." Disqualified persons are:
Prohibited Transactions under the Self Dealing Rules Prohibited transactions between a Private Foundation and a disqualified person include:
Motive is immaterial to the Internal Revenue Service. The Code in its language, and the Service in its interpretation, is rigid in application of the self-dealing rules; it is immaterial whether a self-dealing transaction results in a benefit or detriment to the Private Foundation. In addition, if an act is an indirect act of self dealing, it is also prohibited. There is an exception for acts that occur only upon creation of the Private Foundation. The self-dealing rules do not apply if disqualified person status arises only because of the transaction that results in the creation of the Private Foundation. See Treas. Reg. § 53.4941(d)-l(a). For example, a transfer of the debt-encumbered property to a Private Foundation by a "disqualified person" is an act of self-dealing, and in such case the encumbrance must have been in existence for more ten years to avoid imposition of the excise tax. I.R.C. §§ 4946(a)(l) and 4941(d)(2)(A). However, this rule does not apply if the contribution was the initial gift used to create the Private Foundation. See PLR 7807041. Instances In Which There Are Self-Dealing Concerns There are several areas of concern involving certain transactions commonly contemplated by Donors:
fair market value. This standard will only be met if (i) the person making the valuation is not a disqualified person with regard to the foundation and is both competent to make the valuation and not in a position, whether by stock ownership or otherwise, to derive an economic benefit from the amount realized; and (ii) the method used in making the valuation is a generally accepted method for valuing comparable property, stock, or securities for purposes of arm's length business transactions where valuation is a significant factor. Treas. Reg. Sec.
corporation can retire the acquired stock to Treasury stock. A corporation with a retained earnings problem can use this "charitable bailout" to reduce retained earnings. This contribution of stock followed by corporate redemption reduces the Donor's ownership in the company and may allow the Donor to obtain a minority discount.
Excess Business Holdings: I.R.C. §4943 The Internal Revenue Code specifically prohibits Private Foundations from controlling any business. Generally, a Private Foundation may not own 20% or more of the voting stock of a corporation or the interests in an unincorporated business. I.R.C. §4943(d). Excess holdings acquired by purchase must be disposed of within 90 days. Excess holdings acquired by gift must be disposed of within five years. Holdings acquired from an estate after a reasonable period of administration may be treated as acquired on the date of distributions from the estate rather than the date of death. Treas. Reg. §53.4943-6(b)(l). The penalty can be severe. The Internal Revenue Code imposes an initial tax on the excess business holdings of a Private Foundation that is equal to 5% of the value of such excess business holdings for the taxable year. I.R.C. §4943(a). If the Private Foundation still has such excess business holdings after the close of the taxable period in which the initial tax was imposed, the Code imposes an additional tax on the Private Foundation equal to 200% of the value of such business holdings. I.R.C. §4943(b). Jeopardy Investments: I.RC. §4944 The Internal Revenue Code prohibits Private Foundations from making any investments (income or principal) which might jeopardize the exempt purpose of the Private Foundation. I.R.C. §4944(a)(l). Generally, an investment is considered a "jeopardy investment" if the foundation manager failed to exercise ordinary business care and prudence under the facts and circumstances prevailing at the time of the investment. Treas. Reg. §53.4944-l(a)(2)(i). The law will permit certain investments if they fail to produce income but meet a charitable objective (i.e., "program-related investments"). I.R.C. §4944(e). Penalty: The Internal Revenue Code levies an initial excise tax equal to 5% of the amount of the investment on the Private Foundation, and a tax of 5% of the investment may be levied against the foundation manager knowingly involved. I.R.C. §4944(a)(l) and (e)(l). If the Private Foundation still has such jeopardy holdings after the close of the taxable period in which the initial tax was imposed, the Code imposes an additional tax on the Private Foundation equal to 25% of the value of such jeopardy holdings, and an additional tax of 5% may be imposed on the foundation manager knowingly involved. For any single jeopardizing investment, the maximum initial tax that may be imposed is $5,000, and the maximum additional tax is $10,000. Restrictions on Expenditures: I.R.C. §4945 The Internal Revenue Code prohibits a Private Foundation from engaging in certain types of grant activity. This includes amounts paid for:
The penalty is an initial excise tax equal to 10% of the amount spent is imposed on the Private Foundation, and an additional tax equal to 2 1/2% is imposed on a foundation manager knowingly involved. I.R.C. §4945(a). If the taxable expenditure is not corrected within the taxable period in which the initial tax was imposed, the Internal Revenue Code will impose an additional tax that is equal to 100% of the amount in question, and an additional tax equal to 50% of the amount involved will be imposed on the foundation manager. I.R.C. §4945(b). Excise Tax on Net Investment Income The Internal Revenue Code requires that each Private Foundation pay an annual excise tax equal to 2% of its net investment income. I.R.C. §4940. However, Section 4940(e) permits a reduction in the excise tax to 1% under certain situations. Termination Tax If a Private Foundation is terminated, a tax is imposed equal to the lower of (a) the amount that the organization substantiates by adequate records or other corroborating evidence as the aggregate tax benefit from the tax-exempt status of the organization as a "charitable" entity (typically the aggregate increases in taxes if the organization had not enjoyed 501(c) (3) status), or (b) the value of the net assets of the organization. I.R.C. §507(d); Treas. Reg. §1.507-5(a). This tax is most commonly imposed when Private Foundation status is revoked due to willful and repeated, or willful and flagrant violations of the Private Foundation prohibition rules. There are exceptions to the tax under I.R.C. §507(b):
Alternatives to Private Foundations. Sometimes our clients are very philanthropically minded, but do not want to have the complexity of the Private Foundation and its many rules and administration requirements. For those clients, there are alternatives. 1. An Endowment.
do so in the simplest manner possible, an endowment should be considered instead of a Private Foundation. Very briefly stated, an endowment is a special fund of a public charity, the income (and sometimes principal) of which is used for a particular purpose. Many clients contribute (either by a lifetime gift or testamentary distribution) to an existing endowment that meets their charitable purposes, or create an endowment with a public charity. The endowment fund is sometimes named after the donor. If a donor desires to place a restriction on an endowment, the Service has stated that a restriction is permissible and the contribution deductible unless the general class benefited is so small that the community as a whole will not benefit. See PLR 8424022 (Internal Revenue Service approved as deductible a gift to a university's general scholarship fund conditioned on scholarship preference given to employees of a certain corporation or their dependents); PLR 7923001 (Internal Revenue Service approved as deductible a scholarship for persons having the same surname as the donor, but if none having his surname were available, the trustee could withhold distributions or make distributions to others). See also GCM 3908212 (private scholarship for Caucasian students approved); GCM 39117 (scholarship for minority students approved). 2. The Community Foundation.
property to a variety of charities in perpetuity, but does not have the financial resources or the desire for the complexity for a Private Foundation, or does not want his or her fund to be subject to the restrictions and the potential for special excise taxes applicable to Private Foundations. A community foundation is a grant-making organization structured as an amalgamation of separate grant-making funds and accounts. Treas. Reg. §1.170A-9 (e)(l l)(ii). Community foundations are generally treated as public charities for tax purposes. Treasury regulations give the community foundation the ability to treat multiple accounts and funds as part of the community foundation, rather than as separate Private Foundations. Community foundations have become very popular, and there are community foundations in most major cities. A. Contributions. Contributions are made to the community foundation by Donors who generally create separate funds (i.e., the "John Smith Fund"). Many funds are endowment type funds, but these funds may also permit grants from principal. The donors may impose restrictions on the fund. There are essentially four types of funds created within a community foundation:
B. Advantages of a Community Foundation. A community foundation offers several advantages over the Private Foundation:
3. The Supporting Organization
an organization is a public charity organized and always operated, supervised or controlled "by" or "in connection with" a public charity or public charities. The supporting organization receives the income tax benefits of a public charity. The specifics of a supporting organization are beyond the scope of this seminar. Pursuant to recently-enacted U.S. Treasury Department Regulations, we are now required to advise you that, unless otherwise expressly indicated, any federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. |
GONNELLA & MAJORS, PC
Attorneys and Counselors at Law
Attorneys in Our Office Carol H. Gonnella, J.D. M. Jason Majors, J.D., LL.M. Stephen P. Adamson, Jr., J.D. David I. Beckett, J.D., LL.M. |
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