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A Close Look at Private Foundations
The advantages to using these charitable tools.
Roger Silk | 05-23-01
My previous column outlined the four major alternatives available to clients interested in philanthropy. This article reviews in greater depth the basics of private foundations, how they can be used, and the benefits they offer. My next article will address when private foundations should be recommended.
What Is a Private Foundation?
A private foundation is a separate legal entity, either a not-for-profit corporation or a tax-exempt trust, which has received tax-exempt status as a private foundation from the IRS. Most private foundations are funded and controlled by an individual or a family. The founder and his or her family may make tax-deductible gifts to the foundation, and there is no income tax on the income earned by the foundation. The foundation must distribute a certain minimum amount each year, generally 5% of assets, to public charities. Most foundations function as general-purpose endowment funds that the families use to make their charitable contributions.
Private foundations, and their ancestors that predate the income tax, have long been the vehicles of choice with which the extremely wealthy have conducted their charitable activities. Among the best known, and largest, private foundations are the Ford Foundation, the Bill and Melinda Gates Foundation, and the Rockefeller Foundation. But there are also thousands of smaller, lesser-known private foundations in existence, controlling in aggregate billions of dollars.
Private foundations have been responsible for some of the great gifts that society now enjoys. These include life-saving medical breakthroughs such as the Salk polio vaccine, the yellow fever vaccine, and the green revolution in third-world agriculture. Perhaps more importantly, private foundations play a primary role in improving the quality of millions of lives through strategic local initiatives.
The basic activity of a private foundation is simple. It consists of four elements:
- Receiving donations (usually from the founder).
- Managing its assets (done by directors, or by a professional advisor).
- Complying with the relevant tax and other governmental requirements.
- Making contributions to charities in at least the minimum required amount each year.
Advantages of Private Foundations
While private foundations offer a number of tax benefits, taxes are not a sufficient reason to create a foundation. A would-be foundation creator must be interested in supporting charity, either immediately or at some future time. Given some charitable intent on the part of the founder, a private foundation can help a donor establish a legacy, save taxes, maintain flexibility and control, become closer to his children and grandchildren, and, ultimately of most importance, improve and even save lives.
Establish a Legacy
In almost every case, the creator of a private foundation has a deep-seated desire to help make the world, or a small part of it, a better place. This might take the form of alleviating specific ills such as homelessness, treating a certain disease, helping the disadvantaged, preserving and protecting the environment, fostering the arts, etc. The range is wide, and limited only by the imagination of donors and the constraints of what is legally considered charitable.
Moreover, though few donors will come right out and admit it, most tend to be very appreciative of the attention, social status, and other intangible rewards that are associated with being known in the community as a significant donor.
Immediate Income Tax Savings
Contributions to charity are tax deductible, and contributions to private foundations are no exception. While most advisors are aware that charitable-contribution deductions are subject to limitations, there is some confusion about the application of the charitable contribution limits. Generally speaking, donors can cut their income tax bills immediately by up to 30% by creating a private foundation. (Please see my for more detail on the deduction limitations.)
Avoidance of Transfer Taxes
All contributions to qualified charities are exempt from transfer taxes. This includes contributions to private foundations. Hence, all contributions, whether made during life or upon death, to private foundations are outside of the donor's estate, and therefore free of any gift tax, estate tax, or generation skipping tax. This is particularly important when considering the long-term intergenerational accumulation of wealth for charitable use.
Maintain Flexibility
Unlike all other alternatives for charitable giving, private foundations allow their creators to maintain maximum flexibility. Since donors retain control over the way that their assets are invested, when money will be given to charity, which charities to support and by how much, the private foundation enables donors to adapt their charitable behavior as their needs and circumstances dictate.
A private foundation also makes it possible to give money to charity now, thus getting an immediate tax deduction, yet decide later (even years from now) how to best spend those charitable dollars.
Maintain Control
Control is very important for most high-net-worth individuals. In many cases, this carries over into their charitable activities as well. The private foundation rules allow a foundation creator to retain complete legal control over the foundation during his lifetime and to pass that control to his chosen successors in perpetuity. It is probably for this reason, more than any other, that private foundations continue to be the vehicle of choice for most wealthy donors.
Involving Children and Grandchildren
A private foundation can provide an excellent vehicle for involving children and/or grandchildren in the founder's charitable activity. The formal structure of a private foundation provides a very natural framework for involving children, for example, as directors. Many foundation creators choose to involve their children informally for a period during which they evaluate each child's level of interest, involvement, and commitment.
There are, of course, many different approaches, and no single approach can be said to be right for all founders. In some cases, the children may become seriously involved and the foundation directors may choose to pay these children reasonable salaries for the work they perform.
Some Caveats
Despite the many advantages offered by private foundations, they are not for everybody, nor do they fit every circumstance. There are some important limitations on private foundations that potential founders need to be aware of. These include a requirement to distribute at least 5% of their assets to charity each year, prohibitions on self dealing, a general prohibition on the foundation owning all or a significant part of the founder's company, and the desirability of avoiding imprudent investments which would jeopardize the foundation's assets.
In my next column, I will look more specifically at the questions of when to consider recommending a private foundation, and I'll cover some of the most important do's and don'ts, as well as additional detail on the limitations that need to be considered up-front.
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