IRC = "Internal Revenue Code of 1986", as amended. This is a very technical area - please consult your tax advisor with any questions. Please note that the "Pension Protection Act of 2006" contains several new restrictions on the ability of some private foundations to make contributions to certain other types of entities, including but not limited to "donor advised funds" and "Type III supporting organizations". As a consequence, before you form a private foundation, you should consult a tax attorney and/or CPA who is well versed in the rules governing the formation and operation of a private foundation to make sure you are aware of what types of transactions are prohibited and/or subject to the various "excise taxes" imposed on private foundations.
Because they are not funded by a broad cross-section of the public, private foundations generally do not receive a high degree of public scrutiny. Due to the lack of public oversight, Congress believed that some private foundations routinely engaged in non-charitable activities, including activities designed to benefit the foundation's officers, trustees, and contributors. Consequently, in 1969, Congress amended the Internal Revenue Code to set certain standards for the operation of private foundations.
A private foundation can be an operating foundation or a nonoperating foundation. An operating foundation donates its assets directly to the active conduct of exempt activities. A nonoperating foundation uses its assets to fund other charities.
When an organization is granted exemption from income taxes under Code sec. 501(c)(3), it is further subclassified as either a private foundation or as a public charity. A private foundation is, in general, a tax-exempt charity that receives most of its funds from a relatively small group of donors, often a single corporation or members of a single family. Although generally exempt from income taxes, private foundations are subject to a host of excise taxes, discussed in more detail below.
In contrast, "public charities" are not subject to the private foundation excise taxes. Congress apparently believed that charities which receive broad public support, or which carry out certain functions, are not subject to the same perceived abuses as privately-funded charities. Consequently, a charitable organization may be classified as a public charity if:
Foundations are required to file Form 990-PF, Return of Private Foundation, with the IRS annually. The return is due within 4-1/2 months after the end of the foundation's tax year (e.g., May 15 for a calendar year foundation). The foundation is not required to have any particular fiscal year. In addition, a foundation may have other tax reporting requirements such as estimated tax payments, state tax returns, and unrelated business income tax returns. Form 4720 is used to report certain of the excise taxes.
A private foundation may be legally formed as either a corporation or a trust. The foundation must qualify the charitable organization as a tax-exempt organization to which deductible contributions may be made by preparing and filing with the Internal Revenue Service the entity's Form 1023 (Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code), along with Form SS-4 (Application for Employer Identification Number). The application for exemption must be accompanied by a user fee.
The Entity's Governing Instrument (articles of incorporation or trust agreement) will be its governing document. To obtain exemption from the Federal income tax the Governing Instrument must contain certain clauses which are designed to ensure that the Entity is organized for charitable purposes and its assets and earnings will be used for such purposes. The Governing Instrument will be attached to, and submitted to the IRS with the Form 1023. The Entity also should adopt rules which will set forth rules governing the internal affairs of the Entity, such as how trustees and/or officers are selected and when meetings are held.
Substantial contributors and foundation managers are considered "disqualified persons." This term merely identifies persons whose activities with the foundation must be carefully observed to avoid many of the excise taxes that are imposed on foundations that enter into certain transactions. In addition, "disqualified persons" include family members, businesses, and other entities related to a foundation manager or a substantial contributor.
A contributor or members of their family may serve as a "foundation manager" for the foundation. Management of the foundation should be very simple and will not normally consume much time. There are annual reports and tax returns to file, and charitable donations must be distributed each year. Contributions received by the foundation must be recorded and invested. The foundation managers are responsible for having these tasks completed.
In their discretion, the foundation managers may decide to make principal distributions to qualified charities from time to time. Depending on the fund balances, these can be sizable donations, and the foundation managers or contributors may wish to spend considerable time screening and selecting charitable recipients. Charitable organizations may, in fact, solicit the foundation with proposals once it is well-established. Within these guidelines, principal distributions are within the control of foundation management and should be timed to coincide with good investment planning.
If, however, certain other actions occur, additional taxes may be imposed on both the foundation and the foundation managers responsible for such actions. It is generally possible and advisable to avoid all of these taxes, but they are summarized below:
* Tax on self-dealing - On transactions that constitute "self-dealing" between the foundation and disqualified persons, an initial tax of 5 percent of the net amount of the transaction is imposed on the self-dealer and 2-1/2 percent on the participating foundation manager. If the transaction is not corrected within the taxable year, an additional tax of 200 percent and 50 percent, respectively, is imposed on the self-dealer and manager. "Self-dealing", has many rules and exceptions, but principally relates to the following transactions between foundations and disqualified persons:
Note, however, that a disqualified person may not sell property to a private foundation, even if the foundation pays substantially less than fair market value. While a disqualified person may donate property to a private foundation, the property may generally not be subject to a mortgage or other liability. A disqualified person may not lease office space to a foundation, even though the rent is set well below fair market value. However, a disqualified person may provide a foundation with free office space. A disqualified person may not lend money to a foundation unless the loan is interest-free. Although an interest-free loan will not constitute an act of self-dealing, in some cases the lender may be forced to recognize imputed interest income from the loan due to the provisions of Code sec. 7872.
* Tax on Failure to Distribute Income - In general, a foundation is required to annually distribute an amount equal to 5 percent of the aggregate value of its assets less any acquisition debt. There is an initial 15 percent tax on the undistributed income of a foundation which remains on hand beyond the time it is to be distributed to charity. An additional tax of 100 percent is imposed if the income remains undistributed. (IRC Section 4942). Although referred to as a failure to distribute income, the required distribution amount is actually based on the average fair market value of the foundation's net assets. The excise tax will apply if the foundation spends less than 5% of the fair market value of its assets each year in the form of "qualifying distributions." The distributions must be made by the close of the foundation's next tax year.
Qualifying distributions, in general, are funds spent to accomplish a charitable purpose. Qualifying distributions include amounts paid to public charities to accomplish a charitable purpose. With some limited exceptions, qualifying distributions generally do not include:
* Tax on Excess Business Holdings - An initial 5 percent tax is imposed if a foundation, together with all disqualified persons, owns more than 20 percent of the stock of a corporation, or more than 35 percent of the stock of a corporation if non-disqualified persons have effective control of the corporation. Similar rules apply to partnerships. A foundation may not have an interest in a proprietorship. The tax increases to 200 percent if excess business holdings are not eliminated. Business holdings received as contributions may be disposed of over several years without being taxed. (IRC Section 4943).
* Tax on Investments which Jeopardize Charitable Purpose - A foundation manager has a fiduciary responsibility to carry out the purpose of the foundation. An initial tax of 5 percent on the foundation and foundation managers is imposed on the amount invested which may jeopardize the carrying out of the foundation's charitable purposes. There is an additional tax of 25 percent and 5 percent, respectively, on the foundation and its managers until the investment is removed. This provision is designed to discourage investments in speculative or risky trading vehicles or securities. (IRC Section 4944).
* Taxes on Taxable Expenditures - An initial tax of 10 percent on the foundation, and 2-1/2 percent on the managers, which increases by 100 percent and 50 percent if not corrected, is imposed on certain expenditures which foundations are restrained from making. These include expenditures for:
In addition to the excise taxes themselves, a penalty equal to 100% of the excise tax may also be assessed. When an excise tax results from an act that was not subject to a reasonable cause exception, the 100% penalty may be imposed if either:
* Tax on Invalid Termination of Private Foundation Status - A tax is imposed if a private foundation terminates and fails to distribute its assets for exempt purposes. (IRC Section 507).
Although the above list of taxes can be intimidating, none of them apply to a foundation that is properly managed. If such taxes are imposed, many can be abated if the event which caused the tax was due to a reasonable cause and not willful neglect, and the transaction is promptly corrected.
Deductible charitable contributions are generally limited to 50 percent of adjusted gross income for federal income tax purposes. (IRC Section 170(b)(1)). Amounts not deductible by reason of these limitations can be deducted in five future years subject to a similar limitation for each year; however, if a contributor dies with charitable loss carryovers unutilized, they will be lost.
The deduction a contributor may claim for a contribution to a private foundation is more limited than that they may claim for a contribution to a public charity. They can contribute marketable securities to the private foundation and receive a tax deduction equal to the fair market value of the security (generally subject to a limit of 20 percent of adjusted gross income). For example, if their tax basis in stock (or other property) is $50,000 which has fair market value of $100,000 and the stock (or other property) is long-term capital gain property, their charitable contribution would be the fair market value, or $100,000.
If they were to contribute securities whose tax basis is in excess of the fair market value, the charitable deduction will be limited to the fair market value and the decline in value will not be deductible (as a capital loss subject to the limitations on deductibility of capital losses). If this is the case, the contributor would be better advised to sell the security and contribute the cash so as to recognize the capital loss for tax purposes (again subject to the limitations on the deductibility of capital losses).
Return to 990PF homepage