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Should Your Client Start a Foundation?
By Roger D. Silk, PhD, CFA
and CEO of Sterling Foundation Management
December 12, 2001 6:00 am ET
Private foundations can prove an optimal solution for a high-net-worth client intent on pursuing charitable goals while reducing his tax bills. Here's an overview of four basic alternatives.
Establishing a private foundation can more than double the total assets controlled by a client (i.e., personal assets plus foundation assets) over his expected lifetime. This can certainly prove compelling to the client. And it also means doubling his value to your business.
To best serve the high end of the individual, family, and closely held corporate market, you'll need to familiarize yourself with the basic philanthropic tools-especially the private foundation. Understanding your clients' philanthropic alternatives is crucial to taking advantage of the opportunities-and avoiding the pitfalls-of charitable giving.
The four basic philanthropic alternatives
Clients with significant charitable goals can follow one of these four basic philanthropic paths. They can:
- Create their own private foundation
- Give money outright to a charity or charities of their choice
- Endow a "supporting organization" for a charity of their choice
- Contribute to a "donor-advised fund"
Each of these alternatives has its advantages and disadvantages. But when feasible, establishing a private foundation is usually the option of choice. The reason is simple: a private foundation maximizes your client's control, and most clients wealthy enough to consider a foundation care a great deal about control. Over three-quarters of the wealthiest families on the Forbes list have private foundations. The private foundation is, quite simply, the gold-standard philanthropic planning tool.
Nevertheless, it is valuable to understand how private foundations fit into the universe of alternatives. The four major options, including private foundations, are examined below in a table that compares the key tax, control, and compliance features of each:
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Private Foundation | Outright Gift | Supporting Organization | Donor-Advised Fund | | Immediate Income Tax Deduction | Yes | Yes | Yes | Yes | | Gifts Are Not Subject to Estate Tax | Yes | Yes | Yes | Yes | | Donor Retains Legal Control | Yes | No | No | No | | Organization Can Be Legally Controlled by Donor's Family in Perpetuity | Yes | No | No | No | | Donor Is Responsible for Annual Compliance With Relevant Rules | Yes | No | No | No | | When to Use Each Type of Entity | In most cases | In special situations | In special situations | When amounts are small; when control doesn't matter | | Ability to Change Into One of the Other Alternatives | Yes. A private foundation can contribute some or all of its assets to any of the other alternatives. | No | No | No |
As this table demonstrates, only the private foundation offers both tax and control benefits. The price is the somewhat burdensome paperwork and compliance required for operating a foundation. In the past, this has been a major reason that advisors and donors have sometimes hesitated to go the foundation route. But with the advent of comprehensive professional management, a private foundation is a very simple alternative.
Private foundations
A private foundation is a tax-exempt charity funded and controlled by an individual, family, or small group. The founder and his family may make tax-deductible gifts to the foundation, and there is no tax on the income earned by the foundation. In return for these significant tax benefits, the foundation must distribute a certain minimum amount each year, generally 5%, to public charities. Most foundations function as general-purpose funds used by the families to make their charitable contributions.
Private foundations are controlled by their directors or trustees. The founder can be the sole director, or he can have as many other directors as he desires. He can maintain complete control over the foundation during his lifetime, hand-select his successors, and control the activities of the foundation-even, to a certain extent, after his death.
Private foundations are the most flexible of the alternatives. In addition to giving the founder complete control, they also allow him the option to devote the foundation's assets to any of the other three alternatives in the future, should he so desire.
Outright gifts
Donors typically make large outright gifts to endow a charity, rather than for the organization's immediate use. Although some donors will wish to make such endowment grants from time to time, such gifts are often not the best strategy for a long-term, effective charitable-giving program.
There are several reasons that endowment grants are not optimal for achieving the donor's goals. First, once a donor has made an endowment grant, she no longer has any control over how the funds are used. Historically, charities with large endowments tend to be relatively indifferent to the wishes of the donors who provided the initial funds. Depending on the situation, this may be positive or negative. Watching a charity change its charitable mission after making a large endowment gift can be extremely frustrating for some donors.
Second, when a charity has a large endowment, the people running the charity sometimes focus on protecting their own positions, rather than on meeting the needs of the charity's beneficiaries.
Third, it can be very difficult for the donor to exercise effective oversight after he has made an endowment grant. Of course, the donor no longer has any legal control once the gift has been made. We are aware of a number of instances in which donors have made endowment grants (ranging in size from a few hundred thousand to millions of dollars), in which the recipient charity clearly and willfully violated the donor's intent in making the gift. In these cases, the charities did nothing illegal, or even close to the line. They simply exercised the ownership over the funds the donors had given them by making an endowment grant.
For these reasons, we urge donors to weigh their decision carefully before making endowment grants to charities. We believe that there are usually better alternatives.
Often, a program of annual giving is a far more effective means for the donor to achieve her charitable goals. When asked why they need endowment gifts, charities typically respond that they must build up their capital base to ensure sufficient funding for long-term programs. And this logic is sometimes justified. However, in many cases, the donor can arrange with the charity to provide long-term funding on an annual basis, provided the program in fact does what it set out to do. A private foundation is an ideal way for a donor to get the immediate tax benefits that come from an endowment level gift, but still exercise the control and judgment that can so benefit the recipient charities over the long run.
And finally, for advisors, a client's large outright gift to charity means a loss in assets under management.
Supporting organizations
A supporting organization is a tax-exempt entity that has some of the characteristics of a private foundation and some of a public charity. Like a private foundation, a supporting organization is a separate legal entity, and the founder can often be on the board. Unlike a private foundation, however, control must rest with one or more public charities rather than with the founder.
Recently, a number of fund-raising organizations-such as community foundations, some universities, and faith-based fund-raising organizations-have been aggressively marketing supporting organizations as "family foundations." They reason that, since they will allow the donor's name to be attached to the fund and since the donor may be allowed to sit on the board, the organization resembles a private foundation. And since there is no legal definition of the term family foundation, this practice is legal, although it may mislead some donors.
If your client is considering any vehicle that purports to offer the benefits of a private foundation without the restrictions that apply to private foundations, you owe it to your client to make sure he fully understands what he's getting. If it's a supporting organization, regardless of any assurances given him by the sponsoring organization, your client must give up control. Instead of "family foundation," perhaps a more informative name for such an entity might be "donor-named, charity-controlled fund." Then again, that probably wouldn't sell as well.
In practice, a supporting organization is much like an outright endowment gift in that the donor is not allowed to maintain control. When a private foundation is an alternative, a supporting organization is not usually recommended. That said, we have recommended supporting organizations and created them for clients with unique circumstances. In each case, the client already had at least one private foundation, and the supporting organization was necessary to achieve some additional purpose.
Donor-advised funds
Donor-advised funds are public charities that give donors the ability to make a large current gift to charity, and then "advise" (without the legal right to actually direct) the fund on how and when to make specific gifts to other public charities. Several donor-advised funds have been very successful in raising money on a commercial basis. In addition, some community foundations offer donor-advised funds.
There is sometimes confusion about what a donor-advised fund actually is. A donor-advised fund is itself a charity. It's not a mutual fund, although some look a bit like mutual funds. When your client gives money to a donor-advised fund, he is giving away his money-irrevocably. The charity to which he makes his contribution-the donor-advised fund-then owns the money. "Once a contribution is accepted, it's an irrevocable charitable contribution to the Gift Fund, to be owned and held by our Trustees," says the fine print in the documents pitching Fidelity's Gift Fund, the nation's largest donor-advised fund.
A donor-advised fund will generally take a donor's advice, but is not required to do so. In fact, the IRS takes a negative view of any pledge by a donor-advised fund to follow donor advice.
For those willing to live with their limitations, donor-advised funds make sense under a few circumstances. These include: 1) when the donor has appreciated property that is not publicly traded stock (and hence would be deductible only at cost basis if given to a private foundation), and you can find a donor-advised fund which will accept the property; 2) when the client is planning to donate a small amount of money, for example $50,000, which simply does not justify the fixed costs of creating a private foundation; and 3) when the client plans to give 50% of his income to charity for the foreseeable future and wants to be able to deduct it all.
In any event, you must be very comfortable that your client understands the limited control donors are allowed by law over a donor-advised fund. Given the availability of cost-effective, comprehensive private foundation management services, the bottom line is that donor-advised funds probably make sense only when one of the above conditions exists, and for some good reason outright gifts are not desired.
Income tax deduction limitations, estate tax, and excise tax treatment
We all know that contributions to charity are deductible. But, like so many things having to do with taxes, this apparently simple proposition becomes more complicated when looked at up close. Let's get the simple part out of the way: all gifts to charity, whether outright gifts, private foundations, donor-advised funds, or supporting organizations, are deductible for estate tax purposes.
The charitable deduction rules for income taxes are more complex. The following table reviews the limitations on deductions for each alternative.
| | Private Foundation | Outright Gift | Supporting Organization | Donor-Advised Fund | | Tax Deduction for Contributions of Capital Gain Property | 20% AGI Limit (only appreciated publicly traded stock qualifies) | 30% AGI Limit | 30% AGI Limit | 30% AGI Limit | | Tax Deduction for Cash Contributions | 30% AGI Limit | 50% AGI Limit | 50% AGI Limit | 50% AGI Limit | | Donor Retains Legal Control | Yes | No | No | No | | Tax on Investment Income | 2% or 1% Excise Tax on Net Income | No | No | No |
As the table shows, all charitable contributions are subject to limitations on the amount that can be deducted for income tax purposes. The basic income tax deduction rule is simple: there is an overall limitation of 50% of adjusted gross income (AGI). This means that the most a donor can ever deduct in a single year is 50% of his AGI. For example, if a client's gross income were $1 million, his maximum deductible contribution would be $500,000.
But from here on, the rules become somewhat complicated. There are two sets of limitations: one for public charities, and one for private foundations. For public charities, the overall limit of deductibility is 50% of AGI. Of this 50%, up to 30% of AGI may be in the form of long-term capital gain property (e.g. appreciated stock, unleveraged real estate, closely held stock, etc., held for over a year). The other 20% may be in the form of cash (or basis property). A donor could also give up to 50% of his AGI in cash and deduct it.
If a donor gives more than 50% of his AGI in a year, he may carry forward the amount over 50% and deduct it up to five years later. The AGI limitations apply in subsequent years as well.
Deductions for contributions to private foundations are limited to 30% of AGI. Of this 30%, up to 20% may be in the form of appreciated publicly traded stock held for over a year.
A donor may deduct contributions to both a private foundation and a public charity. For example, a donor may give 30% of his income, in cash, to his private foundation, and another 20% in cash to a public charity. This would all be deductible in the year the contributions were made.
The interplay of the rules can become complex, and donors considering their options may wish to seek expert advice. In considering the tradeoff between control with a private foundation and the 30% limit, and lack of control with a public charity and the 50% limit, donors may wish to keep in mind two points. These are:
- Carry-forwards. Because unused contribution deductions can be carried forward for up to five years, usually the limitation means a deduction is deferred, not lost. So, for example, if a donor usually earns $1 million a year and wants to contribute $1 million to his foundation and deduct it all, the carry-forward rules allow him to do this. In year one, he contributes the $1 million. He would then deduct $300,000 (i.e. 30%) in years one, two, and three. In year four, he would deduct the remaining $100,000. Alternatively, he could contribute the $1 million to a public charity. He would then be able to deduct $500,000 a year for two years. In either case, the donor gets the same tax deductions. The only difference is that he gets the deductions sooner with the gifts to public charity.
- "Mix and match." A donor wishing to maintain maximum control and still take advantage of the 50% limitation should consider contributing 30% to a private foundation, and 20% to a public. This gives the donor control over the 30%, and also allows him to deduct 50%.
Year-end is peak giving season
As you know, this year has been one of the toughest in a very long time. Many people felt shell-shocked by the markets even before the terrorist attacks in September. However, the attacks triggered an interesting occurrence. Many people-particularly high-net-worth investors-have begun to rethink their priorities, seriously reassessing what they really want to achieve with their money. And often, they've concluded that they want to use their money to make a difference.
As the year draws to a close, tax planning comes to the fore. The combination of a desire to make a difference and to pay as little in taxes as possible points directly to philanthropy as a possible solution.
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