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Guidelines for Setting up a Private Foundation
By Roger D. Silk, PhD, CFA
and CEO of Sterling Foundation Management
February 15, 2002 5:00 am ET
A private foundation can be an elegant solution for clients with charitable inclinations and big tax bills.
Do you have clients who are philanthropically inclined? If your clients are financially qualified to set up private foundations-but don't-they could be wasting precious dollars by paying too much in taxes. Here are some guidelines for evaluating whether private foundations are appropriate for your clients.
Charitable inclinations
Many clients have good intentions, but are somewhat hazy on their specific philanthropic aims. To help them determine whether their goals fit with the foundation structure, consider this list of the most common motivations for setting up a private foundation:
- A desire to create a unique and perhaps permanent legacy
- A desire to teach values and share vision with children and grandchildren
- A desire to maintain the 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 articulated or not-to make a difference
Financial qualification
A private foundation is a very powerful tax-saving tool-but it's not for everybody. In most cases, a client must have a net worth of at least $5 million or an annual income of at least $500,000. Additionally, due to the costs involved, a client should expect to fund his foundation with at least $500,000, although he does not need to supply the full half-million immediately.
Compelling circumstances
The following is a list of specific economic situations that might prompt a client to create and fund 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
- Significant charitable donations each year
- Ownership of highly appreciated, publicly traded stock
- Net worth that exceeds the amount the client anticipates 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
Key rules
Although the benefits of a private foundation are compelling and the activity conceptually simple, the compliance and accounting aspects can actually be quite burdensome. And the penalties for failing to comply with all the relevant requirements can be severe. For these reasons, professional management may be advisable. In any case, you'll need to familiarize yourself with the most important of these requirements and restrictions:
- A prohibition on "self-dealing"
- A prohibition on "excess business holdings"
- A prohibition on "jeopardy investments"
- Required annual distributions
Generally, these limitations do not affect the achievement of the founder's goals, provided that the rules are followed. The rules are quite complex, and the following is intended as an outline only; it should not be relied upon as legal advice.
Rules against self-dealing
Broadly speaking, the prohibition on self-dealing means that disqualified persons-generally the founder, his family, and his 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 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 premises
A disqualified person is permitted to have certain arm's-length dealings with the foundation. For example, the founder and his family may receive reasonable director's fees, and the donor and/or family members may be employed.
Excess business holdings and jeopardy investments
The rules on "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.
Prohibition on jeopardy investments
The rules against "jeopardizing investments" help prevent private foundations from endangering their principal through excessively risky investments. While the law does not provide a bright line test, this rule is not especially stringent, and usually will not constrain any reasonably prudent, diversified investment approach.
Requirement to distribute income
Private foundations are generally required to distribute 5% of assets to qualified public charities each year. The distributions must be made in the year following the year upon which they are based.
There are a number of additional rules and requirements regarding how a foundation is operated, what tax and other reporting it must do, etc.
Tax returns
Even though charities generally pay no income tax, they are still required to file income tax returns with the IRS. Private foundations must file a form 990-PF annually, in addition to certain other forms, which may be required from time to time.
Documentation requirements
When a foundation makes a gift to a charity, there are specific documentation requirements that the foundation must follow. Like many bureaucratic procedures, these are not difficult, but they can be frustrating for someone not familiar with them.
While these rules are complex, a professionally managed foundation should have no problem complying. The following is a brief outline of the major tasks that a manager will need to perform on an annual basis to ensure compliance and smooth running:
- 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
- Assure 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
Turnkey professional management
The administrative and compliance burden of a private foundation can be considerable. However, turnkey management can make establishing a foundation very simple for both you and your clients.
To create a foundation, the client only needs to make three decisions. She needs to choose a name, decide whom she want to serve on the board, and set an initial funding amount. That's all.
Conclusion
For qualified clients, setting up a private foundation can have tremendous benefits, ranging from immediate income-tax advantages to the unparalleled satisfaction of making the world a better place. A private foundation can add structure and purpose to a donor's charitable activity, allow him to involve family and other important people in the charitable process, and give the donor permanent control over his assets. While the regulations regarding private foundations are extensive, professionally managed private foundations allow clients to obtain all the benefits-while avoiding the hassles. That's why more and more people are creating their own private foundations.
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