A private foundation is a great way to capture income tax savings currently, while forming a pool of assets for charitable giving. This is not for everybody, and there are alternatives. But for clients who are philanthropic and who have significant “excess” assets, high tax rates, and appreciated securities, the stars can align.
A private foundation can also become part of a broader wealth planning strategy. It gives a family a way to separate charitable assets from personal assets, create a long-term giving plan, and establish an ongoing philanthropic legacy.
The following is not a “legal” or tax discussion of the details, but rather a practical discussion of how it usually works to establish and run a private foundation. Our firm manages many foundations, both large and small, so we have perspectives on the day-to-day and ongoing aspects.
How a Private Charitable Foundation Is Structured
A private foundation is its own charitable entity. Before it can receive contributions, invest assets, or make grants, the foundation needs clear legal documents that establish its charitable purpose and explain how it will operate.
The structure does not need to be overly complicated. However, the operating documents should address the types of charitable gifts the foundation may make, who will oversee those decisions, and whether the family wants to place any long-term restrictions around its charitable mission.
Forming the Entity
The first step is to form an entity. This could be in the form of a trust or corporation. Both of these are easy structures to create. An attorney is needed for this step.
The trust document or corporate by-laws will outline how the foundation functions. The terms must be very clear that the foundation is for charitable purposes. The simplest and cleanest approach is to restrict that all distributions from the foundation must go to approved 501(c)(3) organizations. Most charities, schools, and churches are 501(c)(3) status, so this works well for most donors.
Grantmaking Guidelines and International Giving
In some cases, there is a desire for the organization to make broader distributions. A very good example of this is for international giving. Foreign charitable organizations often do not have U.S. 501(c)(3) status. Additional language can be included in the operating documents to permit granting to charities without IRS status. The document would require that a due diligence process be completed by the trustees/officers of the foundation to verify that the funds are being used for charitable purposes.
International grantmaking can involve additional compliance requirements, so this is an area where the foundation’s governing documents and due diligence process are especially important.
The operating documents can also provide for scholarship grants. However, this becomes complicated. There must be an independent board to approve the scholarships, to prevent granting scholarships to friends or family members. Considering the complexity and regulations, the foundations that we have created have not been drafted to allow scholarships (although it would be possible). However, a foundation could still choose to make a donation to a University scholarship fund, or endowment. The University would then be responsible to follow the regulations.
For families who want to support education without taking on the administrative requirements of a scholarship program, contributing to an established university scholarship fund or endowment can be a simpler option.
In some cases a client desires that funds be used for a certain charitable cause. This can be incorporated into the operating documents.
This may include supporting a specific community, educational cause, religious mission, medical research area, or other charitable priority that is meaningful to the family.
A foundation needs a name. This can be “The John and Jean Sample Foundation,” “The Sample Foundation,” or some other creative name. We just need to make sure the name has not already been used.
Applying for 501(c)(3) Status
Once formed, the foundation must complete IRS Form 1023, Application for Recognition of Exemption. This is the process that grants 501(c)(3) nonprofit status to the foundation. There is an IRS application fee of $600.
Aufman Associates assists with the preparation of the application. Usually, nonprofit status is received within a few months.
However, processing times can vary, so it is helpful to coordinate the timing of formation, the application, and the initial contribution.
Funding a Private Foundation With Appreciated Securities
Funding a foundation with appreciated securities is one of the best approaches. This provides a significant tax benefit.
For example, let’s say $100,000 of a stock or fund position is contributed to the foundation and it has a tax basis of $20,000. The tax on the capital gain would have been $19,000 if sold, considering the long-term tax rate of 20% and the net investment tax of 3.8%.
The entire $100,000 is deducted against ordinary income reducing current year taxes by $43,000.
So… total direct and indirect tax savings is $62,000.
In the above scenario, $100,000 of value is received to the foundation but it only “costs” $38,000 in real after-tax terms. This example assumes the highest tax rates combined with low basis stock, so it is the optimal conditions… but this is quite common for anybody in a position to create a foundation.
Actual tax results depend on the asset contributed, cost basis, holding period, income level, available deductions, and other parts of the client’s tax picture. The planning opportunity is that appreciated securities can be contributed without first selling the asset personally and recognizing the capital gain.
Contribution Limits and Funding Timing
The amount that can be deducted is based on Adjusted Gross Income (AGI). Donations of appreciated securities can be deducted as long as the value does not exceed 20% of AGI. In the case of cash, the deduction limit is 30% of AGI. Amounts that cannot be deducted would carry to the following year.
When funding, it is important to review projected taxes for the current year and future years. The idea would be to make multiple smaller contributions so that the deduction is always against the marginal income that is taxed at the highest rates. We would not want to contribute and deduct against lower rates if we could otherwise simply wait until the next year and get the deduction against the highest rates.
A foundation can be funded any time. For example, it could be initially funded and then funded again ten years later.
This flexibility can be useful when a client has a high-income year, a concentrated appreciated position, or a future liquidity event that creates a larger charitable planning opportunity.
Managing a Private Foundation
Operating the foundation is not complicated. The foundation can consist of an investment account with a checkbook. The foundation can be invested in the usual way.
The investment approach should reflect the foundation’s expected annual grants, long-term charitable goals, and comfort with market volatility. Our investment management process can help keep foundation assets aligned with the organization’s giving needs while supporting its ability to give over time.
Make sure you contribute only to charities or otherwise follow the rules within the operating document. Keep records on each gift including the amount, payee, purpose of grant, and nonprofit status of organization. This information is needed for the foundation tax filing each year.
At least 5% of the value of the foundation must be distributed each year. There is an annual calculation that specifically identifies the 5% value. If more than 5% is distributed, the excess carries forward. So, if 6% is distributed, the next year’s required distribution will be lower.
Private Family Foundation Tax Benefits: Annual Tax Filing and Public Disclosure
There is an annual tax return, Form 990PF. The form is complicated. Aufman Associates prepares special reports for the accountant. The accounting fees are usually about $800 per year, or a little higher if there is something more complicated. The return is due May 15.
Form 990PF is a public document that will be visible on websites such as guidestar.org. The names of major contributors are included on the 990PF.
Because the return is public, privacy is a consideration for anyone deciding between a private foundation, donor-advised fund, or a direct giving strategy.
Tax law changes in 2019 simplified the excise tax on earnings in a foundation from either 1% or 2% to a flat 1.39%. Compared to investments in a personal account at rates that could exceed 40%, the 1.39% in a private foundation is extremely tax efficient.
This potential tax efficiency should still be considered alongside the foundation’s annual filing requirements, investment costs, grantmaking obligations, and the fact that contributions are irrevocable.
Alternatives to a Private Foundation
A private foundation is not the only way to approach charitable giving. Depending on the amount being contributed, the desired level of control, and how involved a client wants to be in ongoing administration, another option may be a better fit.
The main alternatives are giving directly to charities or using a donor-advised fund. Both can provide charitable tax benefits, but they do not offer the same level of flexibility, structure, or long-term control that a private foundation can provide.
Giving Directly to Charity
A simple alternative is doing nothing. For example, appreciated stock can continue to appreciate and then can be donated directly to a charity. In this case the position is growing tax-free (because the gains are not taxed if the position is not sold), and the deduction is ultimately received when donated. However, this does not allow you to take the deduction “now” and make the distribution later, as a foundation would allow.
It also does not create a dedicated charitable pool that can be used for ongoing gifts, family philanthropy, or a longer-term legacy.
Donor-Advised Funds
Another alternative is a donor-advised fund. Donor-advised funds can make sense for smaller funds because there is not an initial setup and there is not an annual tax filing expense. However, the ongoing fees are higher and can sometimes exceed 2%.
Donor-advised funds have slightly higher contribution amounts relative to Adjusted Gross income. For example (as mentioned earlier), a contribution of appreciated securities to a private foundation is limited to 20% of AGI… it is 30% for a donor-advised fund. And, cash is 30% for the private foundation vs. 60% for the donor-advised fund. A donor-advised fund also does not have the 1.39% income/excise tax that the private foundation is subject to.
However, the higher ongoing fees in a donor-advised fund usually makes the private foundation a better choice once we are planning on a couple hundred thousand of funding. Also, clients typically favor the private foundation because there is more control/flexibility. We usually end up concluding that a private foundation is a better approach.
A private foundation can also have its own name, mission, governing documents, and grantmaking process, which may appeal to families who want a more formal philanthropic structure.
Having a “pool of money” in either a private foundation or donor-advised fund is appealing because that pool can be used for small or large gifts. If we compare this to personal giving, clients often donate appreciated securities for the larger gifts but not the smaller gifts. So, if we form a foundation with appreciated securities, there is now a pool of funds that captured all the tax benefits and this can be used for all giving… big and small. The small gifts can add up, so this can be meaningful compared to the alternative of using personal cash.
Foundations often require organizations to submit grant requests and provide reports on the use of the funds. While this level of reporting is not required, some clients like this formal process. This process can give families a more organized way to evaluate charitable opportunities and involve future generations in philanthropy.
Is a Private Foundation Right for You?
A private foundation is a great planning vehicle provided a client meets the following criteria…
- Has money that is clearly not needed personally. The transfer is irrevocable.
- Has a high income tax bracket.
- Ideally, has appreciated securities to contribute.
- Has a desire to support charitable organizations.
- Wants a more formal, long-term approach to charitable giving and family legacy planning.
- Has somebody to assist with the administrative aspects (like Aufman Associates). This helps to keep costs down because we manage it cost effectively with your other accounts.
I suppose that some of this appears “complex.” But, it really is not complicated once it is up and running. We oversee the tax filing process etc, So, it is not too much burden for the client and provides a great giving vehicle to form an ongoing legacy.
To discuss whether a private foundation, donor-advised fund, or direct charitable giving strategy fits your financial picture, contact Aufman Associates.
Frequently Asked Questions
Is a private foundation right for someone who wants to involve family members in charitable giving?
It can be. A private foundation can give a family a formal structure for charitable giving, including a name, mission, trustees, grantmaking process, and long-term charitable priorities. However, the assets transferred to the foundation are irrevocable, so it is important to fund it only with assets that are clearly not needed for personal spending, future obligations, or estate needs.
Should I fund a private foundation with appreciated securities or cash?
Appreciated securities can be especially attractive because the contribution may provide a charitable deduction while avoiding the capital gains tax that could apply if the asset were sold personally. The best asset to contribute depends on the security, cost basis, holding period, current income, available deductions, and overall tax picture.
How should a private foundation be invested when markets are volatile?
A foundation’s investment strategy should reflect its charitable time horizon, expected grantmaking needs, required annual distributions, and overall risk tolerance. Rather than reacting to every market cycle, the goal is usually to maintain a disciplined approach that supports both current grants and the foundation’s ability to give over time.
