What constitutes a private foundation or private family foundation?
A private foundation for the purposes of the Internal Revenue Code is an entity created for the purpose of advancing a permitted charitable purpose. Such an organization granted exempt status as a charitable organization, under Section 501c3 under the Internal Revenue Code, enjoys certain tax and asset protection benefits that inure both to the organization and generally its creators, but also certain restrictions and prohibitive conduct levied upon the same organization and its creators, administrators, family members, disqualified persons, or insiders.
The Internal Revenue Code enumerates various forms of charitable purposes, including lessening neighborhood tensions, eliminating prejudice and discrimination, defending civil and human rights, combating juvenile delinquency and community deterioration, aiding the poor, distressed, and underprivileged, the advancement of religion, education or science, erecting or maintaining public buildings and monuments, preventing cruelty to children or animals, promoting or encouraging international amateur sports competition, testing for public safety, and certain literary endeavors.
The most commonly used example of a private foundation is the “Bill and Melinda Gates Foundation,” which is an entity granted 501(c)(3) status pursuant to provisions of the Internal Revenue Code and which, in recognition of certain tax and estate planning benefits enjoyed by such entity, must devote a portion of the capital of the foundation in pursuit of a charitable purpose.
A 501c3 public charity, while identical in its tax status, is different from a private foundation in numerous respects, including where the entity derives its operational income. A public charity generally derives its income from grants, donations, and other external sources, whereas a private foundation derives its income from the grantor and the income derived from the investments and property of the private foundation.
The private foundation can determine who is included on its board, and often, in the case of a private foundation, such would include the family members of its founder. The board and its President can determine where monies or funds of the foundation shall be invested, what funds shall be used in accomplishing the charitable purposes of the foundation, whether such funds are directly contributed to a recognized 501c3 organization, a non-recognized organization, or used operationally, wherein the foundation directly provides services in furtherance of its charitable goal and purpose.
All 501c3 organizations receive a “foundation classification” by the IRS. This is called the Determination Letter. A section of the Internal Revenue Code additionally grants public charities such status.
The private foundation can exist in perpetuity, meaning theoretically, infinitely, and can be “passed” to successive generations. As such generations continue the legacy of the private foundation, varying charitable goals can be modified or added.
The maximum amount of a contribution to the 501c3 public charitable organization as a charitable deduction is 50% of the donor’s adjustable gross income, whereas, for private foundations, the maximum contribution is 30%.
Public charities are generally classified as those that derive at least 30% of their revenue from the general public, including other public and private charities, governmental grants or funding, and corporations.
Contributor donations are individually limited to 2% of the public charity’s total support.
A grant will more likely be viewed as an unusual grant if the grant comes from a disinterested person- someone other than the creator, a person who was a substantial contributor in the past, or someone who is in a position of authority within the organization. The IRS is also more likely to view a contribution as an unusual grant if the:
- grant is unrestricted.
- grant is made in cash, liquid assets, or as a bequest.
- organization has a representative board or
- organization has previously met the 1/3 support test, actively solicited contributions from the public, and can be expected to attract public support in the future.
If the public support calculation results in a percentage of more than 10% but is not quite all the way up to 33 1/3%, the facts and circumstances present in the operation of the public charity may support the continuing status of the public charity if the organization:
- maintains a bona fide fund-raising program that is reasonable considering the scope of its charitable activities.
- has support from more than members of one family.
- has a governing body representative of the general public.
- makes its facilities available to the public on a regular basis.
- receives a significant part of its support from a governmental unit or public charity to which it is in some way accountable and
- conducts programs designed to address real community needs – like a slum clearance program or an employment development program.
The above is referred to as the 10% fact and circumstances test.
Organizations that qualify for public charity status as publicly supported under Internal Revenue Code sections 509(a)(1) and 170(b)(1 )(A)(vi). Code section 509(a)(2) includes only up to the greater of $5000 or 1 % of gross receipts from one individual or government source.
Disqualified persons” are substantial contributors, foundation managers, and persons and entities related to them. Such disqualified persons are excluded from an organization’s public support. However, 509(a)(1) public charities and governmental units are never considered to be “disqualified persons.”
To qualify under 509(a)(2), an organization needs to show public support – taking into account those limitations – that is at least 1/3 of its gross receipts. All the organization’s income, from whatever source, is included in gross receipts for the 509(a)(2) calculation.
These rules regarding disqualified persons are intended to preclude “self-dealing” between the organization and such entities or persons.
The IRS definition of a disqualified person contemplates anyone who is a substantial contributor to the organization, the administrators and managers of the organization, family members, and affiliated corporations and their family members. Such concepts are similar to those in bankruptcy law, for example, in terms of treatment of “insiders”.
A private or family foundation, however, may employ such family members or disqualified persons, but such positions must be reasonable and necessary to the mission of the foundation. Such compensation must be comparable to that commanded by persons fulfilling similar roles outside the organization. Any excessive compensation may be taxed at a rate of 25% of such excessive compensation.
Other examples of what may constitute self-dealing between a private foundation and disqualified persons include the selling or leasing of property between foundations and such persons, the provision of goods, facilities, and services, and the granting of loans.
If the foundation pays for the costs relating to travel incurred by a disqualified person, such expenditures may be considered self-dealing; however, the necessary and reasonable travel costs relating to foundation activities should be permitted.
Activities that may subject an organization to scrutiny, whether a public charity or private foundation, include the compensation of the board members and administrators, management and personnel, the amounts expended towards operational costs, charitable grants and programs, and financial transactions between the organization and its insiders, and the actual assets or holdings of the organization.
Private foundations are generally created and governed by the benefactor or his family, whereas independent foundations are generally provided for by grants or endowments from groups of disparate sources. Corporate foundations are created by and support the corporation, especially if they are substantially publicly supported.
Corporate foundations are generally formulated as private foundations but can stand as public foundations.
Private operating foundations may be distinguished from private non-operating foundations in that private operating foundations contain their own charitable programs but also make grants or contributions in furtherance of the organization’s charitable purpose.
A private operating foundation must expend a certain portion of its assets in the provision of its charitable duties, whereas a non-operating foundation must distribute at least 5% of its assets annually in grants.
Statutory public charities are deemed charities as a matter of law and are generally operational as opposed to non-operational. Common examples of statutory public charities include non-profit hospitals, medical research institutions, universities, schools, and churches. Provisions for statutory public charities are also found in the Internal Revenue Code [Sections 170(b)(1)(A)(i) through (v)].
Public charities, by contrast, receive their support from a wide range of public sources, and to retain their status, must satisfy the “public support test”. Known examples of such organizations include the Goodwill, YMCA, and the American Red Cross.
Public charities may receive a significant percentage of support from charging fees or admissions from the services they provide, the selling of tickets, etc. Such public charities may not derive more than 33% of their support from investment income, as opposed to such activities. A good example of such a public charity may be a museum, perhaps an amusement park.
A foundation is private if it receives less than 33% of its support from the general public. As such funding is largely “private” rather than “public,” private foundations historically have been subject to less scrutiny by the state.
The private foundation, however, must meet the “five percent rule,” which holds that the private foundation must contribute at least 5% of the average fair market value of its assets annually in furtherance of the charitable purpose of the private foundation.
The contribution may be made non-operationally in the form of grants or donations or operationally in the form of the administrative costs of operating the foundation and costs incurred in providing such charitable endeavors.
The private family foundation and the public charitable foundation both have benefits and disadvantages. The choice of creation will depend upon the goals and circumstances of the creator.
Although Weller Legal Group is prepared to offer planning and execution of plans for the creation of public charities, the promise of the offerings bestowed upon a private foundation or a private family foundation may be more enticing to many persons.
As an asset protection tool, a private or private family foundation is one of the more formidable devices. A private family foundation incorporates the elements of an irrevocable trust in that the assets are firmly protected from creditors, as the donor no longer “owns” the assets or corpus of the trust, and the elements of a revocable trust, which offers minimal protection of such assets from attacking creditors but offers the grantor almost unrestricted power over the management, or disposal or sale of such assets.
Secondly, a private family foundation presents numerous tax reduction benefits, including the provision that income contributed to the private family foundation will receive a 30% taxable reduction.
There is no “step-up” for properties, monies, and investments that contribute to the private or private family foundation. For example, if the donor contributes a portion of the real estate originally purchased at $100,000 but now valued at $1,000,000, the contribution to the foundation is a non-taxable event; there is no capital gains tax or charge. If the foundation later sells such property, the foundation would not be subject to the same capital gains tax, although the foundation would be subject to an excise tax of 1-2%.
Most family foundations in the United States are not nearly as sizable as those created by Bill and Melinda Gates. Most private or family foundations do not approach even one million dollars of available assets. The predominant family foundation in the United States holds assets of less than $100,000 USD.
For an individual with an income approaching or exceeding $100,000 per year, under the current tax scheme, a private family foundation may offer immediate tax advantages to such individual or family, as such tax benefits may be achieved immediately by the diversion of a portion of the individual or family income to the private family foundation.
Such tax benefits may then be distributed to charitable endeavors that the founder and his family deem worthy or used in the performance of such charitable purposes.
The foundation or family foundation can target such monies and efforts to programs and charitable purposes that are considered important by the foundation and its founders, and the tax advantages provide the financial necessities instrumental in the accomplishment of such purposes.
The private foundation or private family foundation should be an essential consideration in any undertaking involving estate planning, asset protection, and tax reduction, as the private family foundation encompasses all of these benefits, together with the promise that the charitable endeavors of the organization will align and further the charitable interests and passions of its founders.