If you are thinking of making substantial contributions to charity over time but currently are not sure which individual charities should benefit from your gifts, you should consider organizing a foundation through which you will funnel your charitable giving. When you consider the creation of a foundation you seek two tax benefits: an income tax exemption for the organization, and tax deductions for contributions to the organization.
To obtain these benefits it is necessary to comply with the Internal Revenue Code and with state laws that govern the formation and regulation of the activities of foundations.
A foundation may serve as a way for a family to centralize its charitable activities, and to associate the family name with charitable projects on a continuing basis. It is often used by a family as a vehicle for encouraging the younger generation to continue the charitable activities initiated by the parents.
The most common types of foundations are the "operating" foundation and the "conduit" foundation.
The "operating" foundation does not make grants to other organizations but actually carries on one or more specific tax-exempt activities. For example, it might carry on qualified medical research or be responsible for the maintenance of a small wildlife preserve. An operating foundation has tax benefits not available to a conduit foundation but its status is more difficult to achieve. A private operating foundation must spend at least 85% of its adjusted net income or its minimum investment return, whichever is less, directly for the conduct of the charitable activity and, in addition, meet either the asset test, endowment test or the support test. This summary focuses on the conduit foundation.
The "conduit" foundation would typically be formed by a wealthy donor or a family of wealthy donors to serve as the central repository for all of the family's charitable contributions, or to fund some particular charitable project (such as a scholarship program or a medical or conservation project). In establishing the foundation, the donors may make large contributions with a view to forming an endowment or may make smaller periodic contributions.
The sole purpose of the conduit foundation typically is grantmaking. It operates no programs and does no or very limited public fund-raising; rather, it makes grants and pays expenses solely from contributions and the endowment's investment income (if any). Control of the foundation will lie completely in the hands of the donors who choose the other members of the small board of directors. A family foundation is generally a conduit foundation.
Public vs. Private
One of the most important distinctions in tax-exempt organization law is the difference between public and private organizations. The term "private foundation" suggests that the organization has three distinct features:
1. There is one source of funding - usually one person, one family, one corporation;
2. The organization does not engage in direct charitable activities but instead makes grants to other qualified charities to perform the service or activity; and
3. The funds available for grants and necessary administrative expenses come from contributions and endowment income.
All foundations are private foundations unless they can establish that there is a public involvement of the kind recognized by the Treasury Department. Examples of public foundations include a church, a school, a hospital or an organization actually conducting qualified medical research. One way of establishing public involvement is to have the foundation receive at least one-third of its support from the "public" and normally not more than one-third of its support from investment income.
Forming a Private Foundation
The actual mechanics of starting a private foundation are relatively straightforward. There are several decisions that will have to be made. What legal form should be used? Should it be a trust or a "not-for-profit" corporation? Generally speaking, the requirements for a trust are less formal both in the formation and in operation but a not-for-profit corporation is more flexible when it comes to daily activities and the law of indemnifying the officers and directors of a corporation is more developed.
In order to form a corporate foundation, articles of incorporation, by-laws, regular meetings, minutes, state filings and other reporting requirements are necessary for most states. This kind of record-keeping, however, is generally necessary in order to maintain the tax-exempt status of the organization if challenged by an IRS audit or by a similar examination by state officials, which can happen to trust as well as a corporation.
Further, the not-for-profit corporation provides greater protection from personal liability for the directors. The corporate form also provides greater advantages in its adaptability to changing circumstances. Corporate by-laws can be drafted to facilitate amendments and by-laws usually decide how directors and successor directors are selected. In short, the governing instruments of the corporation can be more readily altered to reflect changing charitable needs of the donor group and the donor's charitable interests.
For instance, donors who wish to maintain control of a charitable corporation but limit their own day-to-day involvement may name themselves as members with the power to elect directors who then run the organization. Also, powers can be easily delegated to one or two board members or officers, if permitted by the by-laws.
There are certain other advantages to the use of a not-for-profit corporation - certain indemnification rights and the right to receive tax-deductible donations, even if grants are to be made to foreign grantees.
The business of organizing the corporate foundation is not appreciably different than organizing any corporation, except that some additional governmental approvals may be needed (usually routine). The corporate foundation can be organized in any state selected.
Every charitable organization, whether public or private, needs to obtain recognition of exemption from federal income tax. This is done by filing a formal application for exemption with the IRS, in which it is shown that the organization is organized, and expects to be operated for, charitable purposes. The application must be filed by the end of the 15th month after the month in which the organizational documents are officially approved. When the tax-exempt status of the foundation is approved by the IRS, it will be retroactive to the date of formation of the organization.
Other Tax Considerations
One of the major objectives of establishing a foundation is to create an organization to which contributions can be made which qualify as charitable deductions on the donor's tax return. How much the donor may deduct may depend on whether the donee organization is classified as public or private. The following discussion applies to gifts to a private "conduit" foundation.
1. Contributions. In any given tax year, an individual donor may contribute cash to a tax-exempt charitable organization and treat the gift as a charitable contribution which is deductible in calculating his or her income tax. If the organization is a private foundation, the annual deduction for cash contributions may not exceed 30% of the donor's "contribution base" (i.e., gross income less certain expenses attributable to business, rents and royalties, and losses) approximately equal to “adjusted gross income”. A donor can make annual contributions to a private foundation so as to make maximum use of the donor's contribution base without parting with control over the contribution all at once; it is not necessary for the foundation to make corresponding contributions to outside charities in the same year.
2. Gifts of appreciated property. Appreciated property is long term capital gain property such as stocks, bonds, land or tangible personal property (paintings, manuscripts, etc.). If the donee is a private foundation, the deduction limit is 20% of the donor's adjusted gross income.
If in any year the donor exceeds either the 20% or the 30% limit, he or she may carry over the excess contributions for the next five tax years.
3.Value of gifts of appreciated property. If appreciated property is given to a private foundation, the donor may only deduct his tax basis (i.e., cost) of the property unless the deduction is for publicly traded stock held for the long term capital gains (currently 1 yr.) period (not closely-held stock, not bonds, not land, not tangible personal property), in which case the donor may deduct the fair market value of the property and thereby avoid the capital gains tax as well as obtaining a charitable deduction. Gifts and bequests to private foundations are also exempt from gift and estate taxes.
Taxation of Foundation
An exempt foundation is not subject to income tax on its investment income, such as interest, dividends, capital gains, and most real estate rentals. However, a foundation will be taxed on its "unrelated business taxable income," which means the income derived from a trade or business which is unrelated to the organization's exempt purpose. The tax is imposed at corporate rates.
Restrictions apply to private foundations. There are certain and potentially severe penalty taxes that may be levied against the private foundation and in some instances against the private foundation managers. These are:
1. Excise tax on investment income. In order to pay for the additional cost of auditing and monitoring private foundations, the law requires each private foundation to pay an annual excise tax equal to 2% of net investment income. Net investment income includes interest, dividends, rents, and capital gains, less applicable expenses. A private foundation may, under some circumstances, reduce its excise tax to 1% if in a particular year it meets certain requirements.
2. Excise tax on self-dealing. A private foundation is generally prohibited from entering into any financial transaction with certain related persons defined in the law as "disqualified persons". This prohibition applies whether or not the transaction is fair and reasonable or benefits the private foundation. Disqualified persons include trustees, directors, foundation managers with similar powers, substantial contributors to the foundation and certain family members of the above including spouses and children.
The prohibited transactions include (i) the sale, exchange or leasing of property, (ii) the lending of money or extension of credit and (iii) the furnishing of goods, services or facilities. The payment of compensation to a trustee, director, officer or foundation manager is permissible as an exception to the prohibition against self-dealing if the compensation is necessary and reasonable.
3. Required payout. Every private foundation is required to pay out annually, in the form of "qualifying distributions," an amount equal to 5% of its net investment assets. For example, in very general terms, a private foundation with investment assets of $1 million is required to make qualifying distributions equal to $50,000 for that year (5% of $1 million). Failure to meet this payout requirement will result in an initial penalty tax of 15% of the shortfall.
"Qualifying distributions" include actual grants to and amounts set aside for qualified charities as well as all necessary and reasonable administrative costs to make these grants.
There are various other restrictions on what private foundations can do. For example, they are specifically prohibited from controlling any business and they are prohibited from making an investment that may jeopardize the carrying out of their exempt purposes and they are prohibited from engaging in political activities.
The foregoing is only a brief summary of the rules affecting the formation and administration of private foundations.
The above is intended to provide general information, not specific legal advice or a recommendation. Legal advice can only be rendered to clients who have a retainer relationship with the law firm. To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication (including any attachments), unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein.