IRS Red Flags for Family Foundations

How to avoid an expensive tax audit

A charitable private foundation set up by a family can provide welcome benefits to both the charities it supports and the family members who direct the foundation’s activities. However, private family foundations are subject to complex tax regulations, which, if violated, can result in steep penalties and even revocation of the foundation’s tax-exempt status. 

If you are interested in forming a family foundation or are already part of one, it is good to be aware of these Internal Revenue Service (IRS) rules. Below are the basics about family foundations along with some practices that may incur problems with the IRS.

Key Takeaways

  • Establishing a family foundation can be a great way to increase your philanthropy and reduce your taxes.
  • Family foundations, however, can be abused for the purpose of sheltering taxes and so are highly scrutinized by the IRS.
  • Understanding the rules and potential red flags for running a family foundation can reduce your chances of an audit and keep your charitable giving above board.

How Does a Private Family Foundation Work?

The most common form of a private family foundation is a nonprofit organization (NPO) that is tax exempt under section 501(c)(3) of the Internal Revenue Code (IRC). The foundation can be established by an individual, a family, or a private business to support one or more charitable activities.

The foundation is funded by its creator(s), who receive tax deductions for their contributions. These funds form the foundation’s endowment, which is invested in ways that will generate income to finance the foundation’s charities into the future. The foundation must annually distribute at least 5% of its assets toward its charitable endeavor. A foundation generally distributes funds as grants to individuals or other charities, while a public charity funds specific charitable endeavors directly.

5%

The percentage of its assets that a private foundation must pay out annually to further its charitable goals

Benefits of Family Foundations

The benefits of family foundations are greater than those of simple charitable cash gifts. Here are half a dozen of them.

  1. Because family members retain control of the foundation, there is sustained continuity of charitable giving.
  2. The foundation can receive tax-deductible contributions from third parties that can fund the program beyond the family’s own contributions.
  3. Managing the foundation can unite family members while instilling in them a spirit of community service.
  4. Having a family member act as administrator keeps management responsibilities within the family and administrative costs low.
  5. The foundation creates a visible and lasting public legacy for the family.
  6. Establishing a family foundation is less expensive and requires a smaller endowment than many people would think.

Potential Stumbling Blocks

One of the greatest difficulties in managing a family foundation might be trying to unravel the complicated rules that the IRS sets for them. These rules are meant to avert potential conflicts of interest that could arise when family members work together closely to manage their foundation’s assets.

Not being aware of the rules could get you into deep trouble with the IRS, which has an entire section on its website devoted to private foundations. If you are interested in establishing a private family foundation, it’s also important to seek professional guidance—for example, from a tax lawyer who specializes in foundations.

Family Foundation IRS Rules

The list below is not exhaustive but includes some of the more common sticking points of section 501(c)(3) with regard to family foundations. View these topics as red flags if you’re involved in a foundation or thinking about creating one.

Understand the terms "self-dealing" and "disqualified persons"

Central to all of the regulations below is a concept that prohibits self-dealing between a foundation and its disqualified persons. Here is what you need to know about these terms: Although self-dealing can take many forms, it basically refers to an individual who benefits from a transaction. And although the IRS’s definition of a disqualified person is in itself complicated, it generally means anyone who is a substantial contributor to the foundation; the foundation’s managers, officers, and family members; and any affiliated corporations and their family members. 

  • Hiring family members/disqualified persons: A family foundation is permitted to employ family members and other disqualified persons. However, their roles must be deemed as reasonable and necessary to the foundation’s purpose.
  • Offering compensation: Pay for disqualified persons should be in line with comparable data for similar positions. If the IRS believes that you’re paying a disqualified person more than the going rate for a job, then that person would be penalized 25% of the excess monetary benefit they received.
  • Selling or leasing: The IRS does not permit sales or leases between foundations and their disqualified persons. For example, if a family member were to sell the foundation a piece of office equipment that is worth $10,000 but receives only $1,000 for it, then the IRS still would consider it an act of self-dealing. The same would apply if a disqualified person were to rent the foundation a car for only $100 per month when the actual price for renting the same car is $1,000 per month.
  • Granting loans: Extending loans or credit either way between the foundation and a disqualified person is considered an act of self-dealing by the IRS, even if the loan or credit agreement is fully secured and made via fair-market terms.
  • Providing facilities, goods, and services: The IRS does not allow these kinds of transactions between a foundation and its disqualified persons in exchange for pay. However, if these transactions are freely given, then they are allowed, as long as the disqualified person does not benefit.
  • Traveling: Bringing disqualified persons on a trip for foundation business and having the foundation pay for their travel costs is generally an act of self-dealing. However, this doesn’t include providing reasonable and necessary lodging and meals to a foundation manager.

The Bottom Line

A family foundation can be an excellent way to achieve long-term charitable objectives while enjoying the zeal of giving and creating a lasting legacy for your family. However, if not done correctly, a family foundation can be an all-consuming, frustrating, and costly enterprise. Perhaps it would be helpful to remember that once you have donated to a family foundation, it’s no longer your money—there are new rules of the game.

What Is a Private Family Foundation?

A private family foundation is a charitable organization set up and controlled by a family to promote specific philanthropic causes. It is funded by an endowment, which is invested to generate operating funds, and it usually has nonprofit status under section 501(c)(3) of the Internal Revenue Code.

How Does a Private Foundation Distribute Funds?

A private foundation gives grants of money to individuals or organizations that pursue its philanthropic goals. This differs from a public charity, which directly funds its charitable pursuits.

Can a Private Family Foundation Employ Family Members?

Yes. However, their compensation must not be excessive, meaning that it must be in line with what others are being paid in similar positions, and the jobs must be necessary and reasonable to the foundation’s purpose.

What Are the Pitfalls of Running a Private Family Foundation?

In order to avoid conflicts of interest, the IRS regulates private foundations pretty heavily. In particular, it is necessary to understand the concepts of self-dealing and what constitutes a disqualified person in order to comprehend the tax regulations. For this reason, it is usually wise to employ a tax lawyer for guidance when creating and/or running a private family foundation.

Article Sources
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  1. Internal Revenue Service. "Compliance Guide c)(3) for 501(c)(3) Private Foundations," Pages 6, 9.

  2. Internal Revenue Service. "Private Foundations."

  3. Foundation Source. "What Is a Private Foundation?."

  4. Internal Revenue Service. "Publication 557: Tax-Exempt Status for Your Organization." Pages 45, 46.

  5. Internal Revenue Service. "Acts of Self-Dealing by Private Foundation."

  6. Internal Revenue Service. "IRC Section 4946 – Definition of Disqualified Person."

  7. Internal Revenue Service. "IRC Section 4941(d)(2)(E) – Taxes on Self-Dealing, Special Rules."

  8. Internal Revenue Service. "Publication 557: Tax-Exempt Status for Your Organization," Page 61.

  9. Internal Revenue Service. "Self-Dealing by Private Foundations: Sales or Exchanges of Property."

  10. Internal Revenue Service. "Loans."

  11. Internal Revenue Service. "Self-Dealing by Private Foundations: Providing Goods, Services or Facilities."

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