A family charitable foundation can provide unique benefits to both the charities it supports and family members who direct the foundation's activities. But private family foundations are subject to complex tax regulations, which if violated can result in steep tax penalties and even revocation of the foundation's tax-exempt status.
So, if you are interested in forming a family foundation, or already part of one, it is good to be aware of these Internal Revenue Service (IRS) rules. Below are some basics about family foundations along with some practices that may incur problems with the IRS.
- Establishing a family foundation can be a great way to up your philanthropy and reduce your taxes.
- Family foundations, however, can be abused for the latter purpose of sheltering taxes and so can come under increased scrutiny by the IRS.
- Understanding the rules and the potential red flags for running a family foundation can reduce your chances of an audit and keep your charitable giving above board.
The most common form of private family foundation is a nonprofit organization that is tax exempt under section 501(c)(3) of the IRS tax code. The foundation is established by an individual, family, or 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 distribute at least 5% of its assets toward its charitable endeavor.
The benefits of family foundations are greater than those of simple charitable cash gifts:
- Because family members retain control of the foundation, there is sustained continuity of charitable giving.
- The foundation can receive tax-deductible contributions from third parties that can fund the program beyond the family’s own contributions.
- Managing the foundation can unite family members while instilling in them a spirit of community service.
- Having a family member act as administrator keeps management responsibilities within the family, and administrative costs low.
- The foundation creates a visible and lasting public legacy for the family.
- 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 imposes on 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 asset-s. Not being aware of them 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.
IRS Red Flags for Family Foundations
The list below is not exhaustive but comprises 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, plus the foundation’s managers, officers, and family members, plus 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 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 that 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. Likewise, 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 are considered acts 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, for example, providing reasonable and necessary lodging and meals to a foundation manager.
In sum, 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. But 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.