Effective Use of Private Foundations

The concept of many charitable estate plans is to pass to one's heirs the maximum amount of tax-free value possible through a combination of lifetime annual gift tax exclusion amounts (either outright or in trust) and the equivalent unified transfer tax credit amounts, and leave the remainder to charity outright through a will, or through a family private foundation.  Since charitable contributions are fully deductible against the estate tax without annual limits that occur under the income tax system, the donors create a non-tax philanthropic estate that effectively cuts Uncle Sam out.  This is the concept of social capital.  (Note, some income tax might still arise if income in respect of a decedent assets (profit-sharing, section 403(b), and section 401(k) plans, IRAs, or installment obligations are passed to non-charitable beneficiaries).  The presence of these assets should be carefully considered to ensure the result is a no-tax, philanthropic estate plan that additionally cares for natural heirs.

Although family foundations are frequently established at death of the primary grantor, we advocate setting them up and operating them to a limited extent during the life (lives) of the primary grantor(s).  This provides an opportunity for the donors to establish the parameters under which the foundation will operate, the types of organizations it will support consistent with family values they desire to perpetuate, and allows the donors and their families to enjoy some of the fruits of significant lifetime philanthropy knowing that both the foundation and the family values will be preserved through multiple generations of family members long after the original grantors are gone.

There are fundamentally two types of private foundations.  Most are grant making entities, supported and sustained by income generated from transferred wealth of the family.  Few additional contributions are solicited from the general public, although other family members may add to the family foundation through annual gifts or testamentary transfers.  Grant making foundations typically accept grant requests from public charities to assist the charities in carrying out their tax-exempt functions.  Another type of family foundation, the private operating foundation, conducts a broad range of charitable programs of its own, but lacks a broad base of financial support from the general public typically found in a public charity.

Both grant making and private operating foundations have minimum annual distribution requirements that are to be spent or granted to carry out viable programs that meet charitable needs throughout the nation or the world.  These required distributions or expenditures are a specified percentage of the foundation's non-charitable (i.e., investment) assets.  Contributions in excess of the required amount carryover for a five-year period and may be drawn upon to support distribution requirements in subsequent years.  Private grant making foundations are subject to an annual excise tax of 1 or 2 percent of their net investment income.  They may also be subject to the tax on unrelated business taxable income.

Family private foundations are an excellent tool to educate younger generations in the needs of the community and the foundation's ability to mitigate those needs in the name of the family.  Frequently, foundation documents specify multiple targets for distributions corresponding to the desires and favor of various members of the family board of trustees.  In this way, family values are preserved, younger generations are able to assist compassionate activities of their choice, and the whole community benefits.

Regrettably, recent years have seen a lack of appropriate oversight of foundation management by both family and non-family trustees and outside board members.  Excessive compensation, personal use of foundation assets (airplanes, resort property, excessive travel, to name a few) and other excess personal benefits have drawn attention of the media and the ire of Congress.  Foundations can anticipate greater internal disclosure, and oversight by both the attorneys general of the various states as well as the Internal Revenue Service, the United States Congress, and local media.  A properly established and well maintained and run foundation need not fear this greater transparency; their boards will continue to exercise prudent management and stewardship for which they were formed.

To ensure compliance and prevent unwarranted private benefit, private foundations are subject to a series of potentially expensive (and occasionally confisitory) penalty taxes on both the foundations and the individuals who participated in the prohibited transactions.  Significantly, rates for these excise taxes were doubled by the Pension Protection Act of 2006, effective for taxable years beginning after August 17, 2006.  The ultimate penalty is fatal; the foundation's exempt status may be revoked by the Internal Revenue Service and its assets distributed to other charitable organizations.  The costs of compliance are complexity, visibility, and monetary expense.  It is not inexpensive to establish and maintain a private foundation, even if the maintains no fulltime staff.

Alternatives to a private foundation that may achieve essentially the same objectives include a donor-advised fund maintained by a public charity, or an organization the sole mission of which is to support one or more designated public charities (both discussed elsewhere on this website).

If you are philanthropically inclined and are otherwise able to plan for ongoing support of your surviving family members and their offspring, a private family foundation may be just the vehicle you need to deliver you to your personal and philanthropic, tax and non-tax goals.

©2008 Ronnie C. McClure, PhD, CPA