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Private Foundations 501
When to use these instruments and the rules that apply.
Roger Silk | 06-19-01
In my previous article on private foundations, I detailed some of the aspects of these charitable tools. In this column, I'm going to talk about when advisors should recommend private foundations and the main rules governing them.
When To Use Private Foundations
In evaluating whether a foundation might be appropriate for a client, it's important to consider the client's charitable goals and financial situation.
Many clients, particularly those who have not previously considered a private foundation, may possess unclear charitable goals. But here are some client attitudes that could tip an advisor to consider a private foundation:
- A desire to create a unique and perhaps permanent legacy;
- A desire to teach their values and share their vision with children/grandchildren;
- A desire to maintain flexibility to adapt charitable activities as the client learns more and as circumstances change;
- An interest in maintaining legal control over charitable assets;
- The desire to give, yet remain anonymous;
- A desire, whether clearly articulated or not, to "make a difference."
Generally speaking, I've found that in most cases a client must have a net worth of at least $5 million, or an annual income of at least $500,000, to be a likely candidate. Clients who experience any of these economic situations should at least consider a private foundation.
- A particularly high income in a year;
- Steady, or growing, income above personal needs;
- An intent to endow a private foundation at death;
- They currently give a significant amount to charity each year;
- They own highly appreciated, publicly traded stock;
- Their net worth exceeds the amount they anticipate needing;
- Ownership of the appreciated stock of a particularly volatile company;
- Ownership of a large block of appreciated, thinly traded public stock;
- A plan to leave a substantial amount of assets to charity upon death.
Due to the costs involved in running a foundation, the client should expect to contribute at least $500,000, though not necessarily at once.
Key Rules Regarding Private Foundations
Suppose you've decided that a private foundation is appropriate for your client. Now what? Although a private foundation offers compelling benefits, its compliance and accounting requirements can be burdensome. Here's a list of the most important requirements and restrictions.
- A prohibition on "self-dealing";
- A prohibition on "excess business holdings";
- A prohibition on "jeopardy investments";
- Required annual distributions.
Broadly speaking, the prohibition on self-dealing means that disqualified people--generally the founder, his family, and employees--may not engage in any transactions with the foundation. For example, a disqualified person may not:
- Use the foundation's assets or its income for his or her own personal use;
- Borrow money from the foundation;
- Buy things from the foundation or sell things to it;
- Keep foundation assets (e.g., paintings) on his or her premises.
A disqualified person is permitted to have certain arm's-length dealings with the foundation. For example, the founder and his or her family may receive reasonable director's fees, and the foundation may employ the donor and/or family members.
The rules against excess business holdings are designed to keep a private foundation from owning a significant stake in a family business. In general, founders should not allow their foundation to own more than 2% of the family (or other closely held) business.
To prevent private foundations from jeopardizing their principal through excessively risky investments, the law prohibits so-called jeopardizing investments. This rule isn't especially stringent, though, and will usually allow any reasonably prudent, diversified investment approach.
Finally, private foundations are generally required to distribute 5% of assets to qualified public charities each year.
Reporting Requirements for Private Foundations
When a foundation makes a gift to a charity, it must follow certain, specific documentation requirements. Like many bureaucratic procedures, these are not difficult, but they can be frustrating for someone not familiar with them.
A foundation must:
- Maintain all required foundation records, including grant documentation;
- Provide donor with proper donation acknowledgements from their foundation;
- Ascertain and document proper charitable status of grant recipients;
- Provide for performance of all non-profit bookkeeping and accounting;
- Calculate each year's minimum required distribution;
- Ensure preparation and filing of annual federal and state tax returns;
- Ensure compliance with restrictions against self-dealing and excess business holdings;
- Confirm observance of fiduciary duty against jeopardizing investments;
- Monitor changes to IRS provisions regulating private foundations;
- Prepare required letters to grant recipients with required language as specified by Internal Revenue Code;
- Prepare and transmit grants to recipients.
Moreover, even though charities aren't subject to income tax, they still must file income tax returns with the IRS. Private foundations must file a form 990-PF annually, in addition to certain other forms that may be required from time to time.
If the client retains a professional firm to provide turn-key management, the process of setting up and running a foundation can be a simple one for both advisor and client. Indeed, with a professional manager, the client needs only to make three decisions to create a foundation: Choose a name for the foundation, settle on the board members, and decide how much to contribute. That's all.
For qualified clients, a private foundation offers benefits ranging from immediate income tax advantages to the unparalleled satisfaction of helping make the world a better place. While the regulations regarding private foundations are extensive, a professionally managed private foundation will allow your client to obtain the benefits while avoiding the hassles.
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