What is a Private Family Foundation in a General Sense?
A private family foundation is a legal entity created, funded, and operated by a single family for the primary purpose of making charitable donations.
Such foundations are given tax-exempt status due to their charitable mission, meaning that contributions to the foundation from family members are tax deductible (though to a lesser degree than they would be if given to a public charity).
Private family foundations are typically started by high-net-worth individuals and families who want to maintain control over their charitable legacies and are willing to assume significant costs and responsibilities and adhere to strict rules
Typically, private family foundations are named to honor the founders (e.g., the Ford Foundation), and their charitable grant programs continue for many years after their passing.
What is a Private Family Foundation in a Legal Sense?
Defined for tax purposes, a private family foundation is a charitable organization that isn’t a public charity. They only receive donations from family members and aren’t open to the public.
A private family foundation’s purpose is to make grants to charities. They don’t often engage in charitable services themselves, as those that do are referred to as private operating foundations.
Due to its charitable purpose, a private family foundation is given the same tax-exempt status as Section 501(c)(3)
Donors receive an immediate income tax deduction for the year they contribute property to the foundation (subject to the usual limitations), avoid capital gains tax on contributions of appreciated property, and reduce their taxable estates. However, the foundation must pay excise tax on net investment income.
The main advantage of a private family foundation is the control donors have over how contributions are invested and how grants to charities are made. Grants are often directed to the donor’s community or areas of interest (e.g., medical research, conservation).
Though a private family foundation can provide great personal satisfaction and tax benefits, there is a significant downside.
Foundations must be organized and operated according to specific sections of the Internal Revenue Code, follow special rules and requirements, and maintain many administrative functions. Violations can result in taxes and harsh penalties against the foundation, its donors, and others.
How to Set Up a Private Family Foundation
Setting up a private family foundation is complex. Seek out an attorney’s guidance at the start, and consider employing a tax professional experienced in handling nonprofit tax matters, and even other consultants, as you go along.
Below is a breakdown of the process.
Developing Mission and Guidelines
As part of creating a private family foundation, you must define the foundation’s charitable purpose, which typically reflects the donors’ values. You should publish a mission statement and guidelines for making grants, as it will help direct the foundation’s activities and inform the public about the foundation.
The foundation can be set up as a trust or a nonprofit corporation. A corporation requires more paperwork and formalities, but can provide greater personal liability protection to the donors.
If you create it as a corporation, you must:
- Establish a board of directors and elect officers to carry out the foundation’s activities.
- File articles of incorporation and bylaws with the IRS and with the state in which the foundation will operate.
If you create a trust, you must:
- Execute a trust agreement and name the trustees.
- Typically board members and officers, or trustees, are family members but non-family members and professionals can also serve.
There is another important difference to keep in mind between trusts and corporate structures: as a trust agreement is more difficult to change, donors who want flexibility regarding the foundation’s charitable purpose should choose the corporate form.
Obtaining Tax-Exempt Status
To obtain tax-exempt status, Form 1023, you must file the Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code with the IRS. The foundation may also have to apply for tax-exempt status from state income, sales, and property taxes.
Though there is no legal requirement, a rule of thumb suggests that donors contribute enough capital to generate a minimum of $25,000 annually for grants. The types of property contributed will determine the allowable tax deductions (discussed further below).
Funding can be made all at once (endowing), over some time, or annually.
The foundation must invest contributions in a prudent manner, which means it shouldn’t, for example, invest in highly speculative securities or futures.
The IRS levies a 10% tax on the foundation and a 10% tax on a foundation manager for any investment that jeopardizes the foundation’s charitable purpose, should there be a failure to exercise ordinary business care and prudence under the facts and circumstances prevailing at the time of the investment.
If the problem is not promptly corrected, an additional 25% tax is imposed on the foundation and an additional 5% tax on the foundation manager.
The IRS levies a tax equal to 2% of a private family foundation’s net investment income, including interest, dividends, capital gains, rents, and royalties, reduced by applicable expenses.
The tax may be reduced to 1% if the foundation spends enough of its resources on charitable purposes. Quarterly estimated tax payments must be made by the foundation if this tax equals or exceeds $500 a year.
A foundation must make annual distributions equal to 5% of the foundation’s net assets that are not used to operate
Grants can be made to a single charity or various charities according to the foundation’s express purpose, and the foundation can seek applications for grants or simply channel grants to appropriate recipients.
Grants to individuals must be made on an objective and nondiscriminatory basis according to procedures that have been pre approved by the IRS.
If you fail to distribute the 5% minimum amount, you must pay a tax of 30% of that amount. After the initial tax is imposed, the penalty will increase to 100% of the undistributed amount if the error is not corrected promptly.
Recordkeeping, Reporting, and Public Disclosure
A foundation should maintain separate bank accounts, books, and records, including minutes of the board of directors meetings, and must otherwise respect the foundation’s legal form.
Also keep in mind that a foundation:
- May be required to file normal payroll tax withholding and reporting forms if it has employees and pays wages.
- Must file a federal income tax return, Form 990PF, annually with the IRS.
- May also be required to file a copy of Form 990PF, and/or other reports with the state.
- Must also provide copies of Form 990PF to anyone who requests them, and other forms of disclosure may
Self-Dealing: Don’t do it
Self-dealing is strictly prohibited. This includes selling, exchanging, or leasing property between the foundation and substantial contributors or other disqualified persons.
Disqualified persons include donors, foundation managers, owners of more than 20% of a corporation, a trust, or partnership that is a substantial contributor, and certain government officials.
A foundation also can’t deal with any corporation, trust, or partnership in which a disqualified person owns an interest of 35% or more.
Other types of self-dealing transactions include lending money and extending credit. Certain transactions are exempt from the self-dealing rules, such as the payment of reasonable compensation and reimbursement of reasonable expenses to foundation managers and directors.
Acts of self-dealing are heavily taxed and penalized. A tax of 10% of the amount of the transaction involved is imposed on the disqualified person and a tax of 5% of the amount of the transaction is imposed on the foundation manager involved.
Once the tax is imposed, if the transaction is not quickly corrected, additional penalty taxes at the rate of 200% are imposed on the disqualified person and 50% on the foundation manager. Continued non-compliance could result in the loss of the foundation’s exempt status.
Private family foundations are prohibited from lobbying, attempting to influence legislation, or attempting to influence the outcome of an election. Private foundations may also incur penalties for expenditures that do not further the foundation’s charitable purposes.
A donor can generally take an immediate income tax deduction for contributions of money or property to a private family foundation if the donor itemizes deductions on his or her federal income tax return.
The amount of the deduction depends on several factors, including the amount of the contribution, the type of property donated, the donor’s basis in the property, and the donor’s adjusted gross income (AGI).
Generally, for contributions of cash and non-appreciated property, deductions are limited to 30% of the donor’s AGI. If the donor makes a gift of tangible personal property or long-term capital gain property, the deduction is limited to 20% of the donor’s AGI.
Any amount that cannot be deducted in the current year can be carried over and deducted for up to five
Keep in mind that donations of tangible personal property (not related to the charitable purpose of the foundation) or appreciated property (except stock and mutual funds that do not exceed 10% of a corporation’s outstanding stock) allow the donor a deduction of basis only, not fair market value.
Gifts and Estate Taxes
There are no federal gift tax consequences because of the charitable gift tax deduction, and federal estate tax liability is minimized with every contribution since donated assets are removed from the donor’s taxable estate.
Creating a private family foundation is a complex task that may or may not be worth it depending on your, and your family’s, financial situation and desires.
It can help a great deal to sit down with someone who knows the ins and outs to decide if it makes sense for you.
As experienced financial professionals, we help clients like you figure out the best plan for their situation, one that navigates through this complex area and balances your goals, and maximizes your means.
Please connect with us and let us help you plan your charitable endeavor. We would be delighted to go on the journey with you.