Private Family Foundations – Naples Estate Planning
Private foundations are being established, with increasing frequency, by individuals and families to supplement charitable programs sponsored by the government and such multi-donor charitable organizations as the Red Cross, Americares and the United Way. But how much do you really know about private family foundations? Let’s look at the most common questions about these private foundations.
Q: HOW LARGE DOES A FOUNDATION HAVE TO BE BEFORE IT IS COST EFFECTIVE?
A: There are no minimums under either state law or federal tax law. However, the costs of setting up a Foundation and the annual paperwork involved in reporting Foundation activities to the government suggest that there are better alternatives for charitable giving if the initial contribution amount is less than $500,000 (unless further annual giving, or gifts by others, is anticipated). A lesser amount may be considered if the family is willing to take on certain tax, accounting and investment responsibilities.
Q: FOR WHAT PURPOSES CAN A FOUNDATION BE ESTABLISHED?
A: Generally, a Foundation can be established for any recognized charitable purpose. Federal law requires that a Foundation be organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, to prevent cruelty to children or animals, or to foster national or international amateur sports competition (but not to provide athletic facilities or equipment).
A Foundation’s charitable purposes and activities must be described in its application for recognition as a tax-exempt organization, and must satisfy the statutory test. If a Foundation’s only activity will be making grants to public charities, then often only a broad general statement of purposes, such as that set forth in the statute, is included in the organizational documents and exemption application.
A Foundation can also be established to provide services directly to a charitable class, or conduct a charitable activity. For example, a Foundation can operate a museum, arboretum, homeless shelter, Meals on Wheels program, scholarship awards program, etc. If a Foundation’s assets or income are devoted to the active conduct of charitable operations, it may be appropriate to apply for tax-exempt status as a Private Operating Foundation.
Q: HOW DO I CREATE A FOUNDATION?
A: A Foundation can be created as a not-for-profit corporation, or as a charitable trust. Generally, it is easier to form and administer a trust than a corporation. Certain powers (termination, amendment) should be spelled out in the trust agreement, however, to make the trust as flexible as a corporation, and the trustees should be given the power to incorporate the Foundation if at some future time that becomes desirable.
The corporate form is normally chosen if a Foundation will actively conduct any charitable operations which expose the Foundation managers to a greater risk of liability, e.g., a museum, arboretum, homeless shelter, Meals on Wheels program, or any other services provided to or facilities held open to the public. The trust form is often used when a Foundation will carry out its tax-exempt purposes by making grants to other charitable organizations.
Q: WHO CAN MANAGE THE FOUNDATION?
A: There are few restrictions on who can be the trustees or directors (the managers) of a Foundation, but all such managers are subject to the excise tax rules on self-dealing and other prohibited activities. (See subsequent question regarding restrictions on the way a Foundation is operated.)
If a Foundation is created as a Florida not-for-profit corporation, a minimum of three directors and two officers: a President and a Secretary/Treasurer will be required. The same person can be both an officer and a director.
If a Foundation is created as a charitable trust, the person establishing the Foundation can be the sole Trustee and have complete control over all functions of the Foundation, including distributions.
However, there may be advantages to naming several Trustees. Consider the following:
- Would you like to have your children or other family members become involved in the process of philanthropy? This is an opportunity for you to involve them in the joys of participatory philanthropy while you are still alive and able to guide them.
- Would the process of selecting charitable recipients of Foundation grants benefit from the involvement of persons with different backgrounds and areas of expertise?
- Do your professional advisors share your interest in the Foundation? If so, would their professionalism coupled with their knowledge of your family’s goals and objectives be helpful in guiding the Foundation?
- If you plan to focus the Foundation’s grants on one or two charities, would it be helpful to have members of their Boards serve as trustees of your Foundation?
Q: WHAT TAX BENEFITS MAY I RECEIVE FROM FORMING A FOUNDATION AND MAKING GIFTS TO IT?
A: Your income tax charitable deduction for any cash you contribute to a Foundation is based on the amount contributed. For gifts of property, other than certain marketable securities, the deduction is based on the lesser of your tax basis in, or the fair market value of, the property contributed. Gifts of appreciated unrestricted marketable securities held long-term are deductible at their full fair market value.
The income tax charitable deduction is an itemized deduction and may be subject to cutback, depending on your adjusted gross income and other deductions. The amount you can deduct in the year you make a contribution to a Foundation is limited to 30% of your contribution base for cash gifts, and 20% of your contribution base for capital gain property. Excess deductions can be carried forward for five years. The deduction rules for gifts to Public Charities and Private Operating Foundations are more favorable to donors than the rules for gifts to Private Foundations.
The rules in this area of tax law are complex and should be reviewed with your tax attorney or accountant before proceeding.
Q: WHAT ARE THE REPORTING REQUIREMENTS FOR A FOUNDATION?
A: Each year a Foundation must file an annual return, Form 990-PF, with the federal government, setting forth its assets and liabilities, its taxable income, and information regarding the donations received and the grants and expenditures made during the year. Federal law requires a Foundation to file a copy of its annual return with the Attorney General’s office in the state in which it is organized and any other state in which it conducts activities.
Corporate-form foundations generally have some ongoing state reporting obligations and filing fees that must be paid to maintain their corporate status in the states in which they are incorporated and authorized to do business. In order to have their corporate form recognized for liability purposes, they must also observe the corporate formalities required under state law, including holding directors’ meetings and keeping written minutes of all meetings.
Q: ARE THERE ANY TAXES PAYABLE BY A FOUNDATION?
A: Yes. A Foundation’s annual net investment income (ordinary income and capital gains) is subject to a 2% tax. If a Foundation maintains a certain level of charitable distributions, the tax is reduced to 1%. If a Foundation has unrelated business taxable income, it must pay tax on that income at regular trust or corporate rates. Unrelated business taxable income includes income from an interest in a partnership that carries on a trade or business that is not related to the Foundation’s exempt purposes, income and gains attributable to S-Corporation stock, certain kinds of rental income, and income attributable to property that is subject to debt.
Other “excise taxes,” that are really penalty taxes, are assessed if a Foundation engages in certain prohibited transactions described below.
Q: MUST A FOUNDATION MAKE DISTRIBUTIONS?
A: Federal law requires a Foundation to distribute an amount equal to roughly 5% of the average fair market value of its investment assets to other charitable organizations or to expend that amount directly for charitable purposes each year. This requirement is satisfied as long as the amount required to be distributed or expended for any year is distributed or expended by the end of the following tax year. With advance approval from the Internal Revenue Service, the distribution requirement can be satisfied by setting aside an amount for a future project for which immediate expenditure is not feasible (e.g., building a museum). There are substantial penalties for failure to make timely distributions.
Q: ARE THERE ANY RESTRICTIONS WITH RESPECT TO THE WAY A FOUNDATION IS OPERATED?
A: Yes. A Foundation must be operated as the charitable organization that it is and not for private benefit. In addition, excise (penalty) taxes are imposed against a Foundation and certain “disqualified persons” for the following prohibited transactions:
Self-Dealing Certain transactions between a Foundation and a substantial donor, a Foundation manager (trustee or director), their family members, and certain trusts, partnerships and corporations in which they have an interest (“Disqualified Persons”) are prohibited. Prohibited transactions include any sale,exchange or leasing of property, any loan or extension of credit, and any furnishing of goods,services or facilities between a Foundation and a Disqualified Person, as well as the payment of compensation or reimbursement for expenses by a Foundation to a Disqualified Person and any transfer to or use by a Disqualified Person of a Foundation’s assets or income-whether or not the transaction is fair or beneficial to the Foundation. There are some narrow exceptions provided by For example, a Foundation may pay a Disqualified Person reasonable compensation for personal services to the Foundation that are necessary to carry out its exempt purposes. Also, a Disqualified Person may make an interest-free loan to a Foundation or provide a Foundation, at no charge, with goods, services or facilities to be used by the Foundation exclusively for its charitable purposes. Any transaction between a Foundation and a Disqualified Person should be reviewed carefully in advance.
Failure to Make Annual Qualifying Distributions See previous question.
Excess Business Holdings The interests a Foundation and its Disqualified Persons can hold in a business enterprise cannot, inthe aggregate, exceed 20% of the voting stock of a corporation or the profits interests in a This limit is increased to 35% if one or more persons who are not Disqualified Personshave effective control of the business. Interests in excess of these limitations are referred to as“excess business holdings.”A Foundation must dispose of excess business holdings it receives by gift or bequest within fiveyears. If excess business holdings are created because a Disqualified Person purchases additionalholdings, the Foundation has 90 days to dispose of its excess business holdings. A Foundation maynot invest its assets in any excess business holdings. A Foundation will not be treated as havingexcess business holdings if the interest it holds does not exceed 2%, or if the business is one whichgenerates at least 95% of its gross income from passive investments.
Investments Which Jeopardize Charitable Purpose A Foundation is also prohibited from investing its assets in a manner that jeopardizes its ability tocarry out its exempt functions. The statute does not prohibit any particular investment. Rather, itimposes a duty to use ordinary business care and prudence to provide for a Foundation’s long-termand short-term needs. Diversification is prudent; speculation must be avoided. The statute applies toinvestments, not to assets received by contribution.
Taxable Expenditures A Foundation is prohibited from lobbying or otherwise attempting to influence legislation, fromparticipating in or intervening in any political campaign on behalf of or in opposition to anycandidate for public office, from operating a voter registration drive (unless certain requirements aresatisfied), from making scholarship grants to individuals (unless certain requirements are satisfied),from making grants to an organization that is not a public charity (unless the Foundation exercisesexpenditure responsibility), and from making any expenditure that is not for one or more of itsexempt purposes.
Q: WHAT CAN I NAME MY FOUNDATION?
A: Many Foundations are named for the individual or family that contributed the funds or in whose memory the Foundation is created (e.g., “The Jane Jones Family Foundation”). There are no special restrictions on the selection of an appropriate name, other than the requirement that a corporate-form Foundation include the word “Company,” “Corporation,” “Incorporated,” or an abbreviation thereof in its name.
Q: CAN I RETAIN FLEXIBILITY IN CHOOSING CHARITABLE RECIPIENTS?
A: You need not name or limit the charities to be benefited or limit the Foundation’s charitable purposes. It may even be inadvisable to do so since organizations and society’s needs change over time so that a particular purpose may become inappropriate as years pass. You may state a “general purpose” for your Foundation and, if you wish, add nonbinding guidance as to particular charities and purposes you would like the Foundation’s future managers to consider when making distributions. If you wish to place binding restrictions on the use of your contributions, you must do so at the time you make your contribution to the Foundation.
If you intend to benefit a particular Public Charity or Charities and are willing to involve those organizations in operating your Foundation, then you may want to consider creating a Supporting Organization instead of a Foundation. A Supporting Organization is itself a Public Charity. Therefore, contributions to a Supporting Organization are treated more favorably for purposes of the income tax charitable deduction, and a Supporting Organization is not subject to the excise tax rules that govern a Foundation. However, the organizational and operational requirements for a Supporting Organization can be as or more cumbersome to deal with than a Foundation’s excise tax rules. Further, although you may participate in the administration of your Supporting Organization, you and your family members may not control your Supporting Organization as you can your Foundation.
Q: HOW LONG CAN MY FOUNDATION EXIST?
A: Under Florida law, a charitable trust can be perpetual, as can a not-for-profit corporation. Given the difficulty in foreseeing the future, it generally makes sense to give the Foundation managers the discretion to terminate a Foundation for any appropriate reason (e.g., it ceases to be economic to continue administering it as a separate charitable organization).
Q: WHAT ARE THE ALTERNATIVES TO A FOUNDATION?
A: We have mentioned above some circumstances that indicate when a Private Operating Foundation or a Supporting Organization might be an appropriate alternative to a Foundation.
Another alternative is a Donor-Advised Fund with your local Community Foundation. With a
Donor-Advised Fund, you or persons named by you have the right to advise the Community Foundation on grants to be made from your Fund. Your Fund can be either unrestricted as to charitable purposes served or limited to certain types of programs (e.g., education, medical research, the arts) and/or a particular neighborhood, city or region within the geographic area served by the Community Foundation. Your recommendations regarding the grants the Community Foundation makes from your Donor-Advised Fund are not binding, but Community Foundations will generally give full and careful consideration to their donors’ wishes. Community Foundations can provide you with valuable information regarding community needs and the programs available to meet them, and can follow up on grants made from your Fund. Since the Community Foundation is the owner of your Fund’s assets, it handles all investment, administrative and reporting duties. Alternatively, you can create a Donor-Designated Fund to benefit specific organizations you name when you create your Fund with the Community Foundation.
Since Community Foundations are Public Charities, contributions to your Fund are treated more favorably for purposes of the income tax charitable deduction than contributions to a Foundation, and your Fund and the Community Foundation are not subject to the excise tax rules that govern a Foundation.
If you decide to create a Foundation, your local Community Foundation can be a source of important information to your Foundation regarding organizations and programs in your community that need your Foundation’s support. By working with your local Community Foundation, your Foundation can help ensure that its efforts and activities are coordinated with the philanthropic activities of other organizations and individuals to better serve your community.