If you regularly give large sums of money, you might be wondering whether there's a benefit to starting your own private foundation. Or perhaps you're intrigued by the prestige associated with starting and running a charitable foundation in your own name. In this article, we'll tell you how to do it and help you evaluate whether it's worth the effort.
What Is a Private Foundation?
There are three types of private foundations. This article covers the most common type: grant-making foundations. This type of private foundation is a not-for-profit organization primarily funded by one individual, married couple, family or corporation. The private foundation's assets are called an endowment. This endowment is invested to generate income for the foundation, which it uses to fund its operations and make grants.
Like public charities, private foundations are defined under section 501(c)(3) of the Internal Revenue Code. In fact, "private foundation" is the default status given to organizations granted 501(c)(3) status. Unlike a public charity, a private foundation typically makes donations, called grants, to other charities; it does not conduct its own charitable operations (private operating foundations, not discussed in this article, are an exception). Private foundations make grants either to fund an organization's general operating expenses or to fund a specific program. They can also make grants to individuals if they follows IRS rules. The activities of a private foundation, like those of a public charity, must benefit the public in order for the foundation to maintain its tax-exempt status.
Benefits of Having a Private Foundation
If you want to give to a good cause, the easiest way to do it is to write a check. So why do tens of thousands of people go to the trouble of starting up and operating private foundations?
According to the Association of Small Foundations, one reason for starting a private foundation is permanence. A foundation can consistently fund a select cause or group of causes and provide cumulative benefits to the recipients over many years of donations.
The ASF also says that some families start foundations to create a legacy. A foundation established in a loved one's name is a way to honor that individual even after he or she has passed away. Establishing a foundation in a family name can also encourage family members other than the founders to participate and provide a common cause around which to bond.
Tax benefits are another reason for starting a private foundation. When organized as a 501(c)(3), private foundations are tax exempt. They can collect contributions of cash and appreciated property without paying taxes on those contributions, and the contributors can claim their donations as tax deductions (with some restrictions). To qualify for the tax exemption, the foundation's purpose must be charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competitions, or preventing cruelty to children or animals. For example, the foundation may assist the poor, advance education or maintain a public building.
The IRS defines three key differences between a public charity and a private foundation. Private foundations must make grants worth at least 5% of the foundation's investment assets each year, they must provide grants only to other nonprofits (though under some circumstances it is possible to make grants to individuals, such as for educational scholarships), and they must pay a 1 to 2% excise tax on the organization's investment assets.
How to Establish Your Foundation
First, you'll need to define your private foundation's purpose and the guidelines it will follow in making its grants. This definition will not only guide your organization's activities, it is also necessary to gaining tax exempt status.
Next, you'll need to decide whether to structure your foundation as a charitable trust or a nonprofit corporation. According to the Association of Small Foundations, a charitable trust can be easier to establish and operate, but may not provide the trustees with as much legal protection as a nonprofit corporation. Nonprofit corporations have stricter operating requirements, but are more common than charitable trusts since they limit personal liability and have more flexibility in how they may use their funds. If you decide to organize as a trust, you'll need to appoint trustees; if you decide to organize as a corporation, you'll need to follow the usual steps for establishing a corporation, including writing your articles of incorporation and bylaws, naming officers and directors, and filing with the state.
Regardless of how you decide to structure your private foundation, you'll need to apply for an employer identification number (EIN). The IRS requires you to have an EIN even if you don't anticipate hiring employees. This number will act as a tax identification number for your foundation (like a Social Security number for an individual).
The next step is to file organizing documents with the IRS. You'll need to fill out Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, and prepare all of its required supporting documentation. This form asks for the basic identifying information about your foundation and how it will be organized and operated. It also requires applicants to pay a fee.
Finally, once the IRS approves your tax-exempt status, you'll need to file any additional required paperwork to obtain tax-exempt status from your state.
Is It Worth the Trouble?
Setting up your private foundation is a lot of work. So is maintaining it.
Your foundation must avoid prohibited activities, which the IRS defines as follows:
- allowing more than an insubstantial accrual of benefits, including non-monetary benefits, to individuals or organizations
- allowing income or assets to accrue to insiders (for example, paying an unreasonable salary to an officer, director or key employee)
- participating in any political campaign on behalf of (or in opposition to) a candidate for public office, including making campaign contributions and making official public statements
Your foundation also must limit restricted activities, which the IRS defines as follows:
- self-dealing with disqualified persons (defined as substantial contributors, foundation managers and certain other related persons)
- investment activity that might jeopardize the carrying out of exempt purposes
- attempting to influence legislation through actions or spending (lobbying)
Both the foundation and any entity that improperly benefits from a prohibited or restricted activity may face taxes and penalties for violating these rules. The foundation could even lose its tax-exempt status.
Running a private foundation also entails many of the same responsibilities and expenses as running a business. You must keep records, file annual tax returns using form 990-PF (a detailed, 13-page document) and hire and manage employees (who may be your family members). Most people will also want to hire legal and accounting professionals to handle startup and ongoing regulatory and compliance matters like bookkeeping, tax preparation and corporate filings. Many aspects of starting and running a private foundation are governed by complex rules and/or require specialized knowledge.
How much money do you need to be donating for it to be worth the effort to start and maintain a foundation? There is no hard and fast rule here, but most family foundations have assets of at least a few hundred thousand dollars according to the Council on Foundations. Some foundations have more than a billion dollars in assets, but 60% have fewer than $1 million.
The Bottom Line
While private foundations can be time consuming and expensive to set up and operate, the thousands of individuals, families and corporations who have established private foundations clearly think that these sacrifices are worthwhile. If you're not sure whether a private foundation is the most effective way to meet your philanthropic goals, however, you can always engage in simpler alternatives to giving, including writing a check to your favorite nonprofit, donating your time or contributing to a donor advised fund.
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