A family charitable foundation can provide unique benefits to both the charities it aids and family members who direct the foundation's activities. But 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.
Here are the basic rules you need to know – and a warning list of eight of the common mistakes that create the risk of incurring problems with the IRS.
Basics and Benefits
The most common form of family foundation, discussed here, is a not-for-profit corporation that is tax exempt under section 501(c)(3) of the tax code, established by an individual, family or private business to make grants to established charities. The foundation is funded by its creators, who receive tax deductions for their donations to it. These form the foundation’s endowment, which is invested to generate income and finance the foundation’s grants to charity into the future. These grants must total at least 5% of the endowment’s value annually.
Family foundations provide benefits surpassing those of a simple gift of cash to charity:
- Family members who manage the foundation retain control over a sustained program of charitable giving that may run for many years.
- The foundation is able to receive tax-deductible contributions from third parties that can be used to fund the giving program beyond the family’s own donations.
- Managing the foundation can unite family members while instilling in them a spirit of community service.
- Family members who manage the foundation can be paid reasonable compensation for doing so, keeping these administrative cost payments within the family.
- The foundation creates a visible and lasting public legacy for the family.
Family foundations are less expensive to set up and require smaller endowments than many think. Sixty percent have endowments of less than $1 million, and while the cost of creating one varies, it can be as low as $5,000. All these facts have caused an explosion in the number of family foundations in recent years; there are now more than 42,000 in the United States.
(See also: How to Start Your Own Private Foundation.)
But Challenges, Too
The greatest difficulty in managing a family foundation may be complying with the myriad complex rules the IRS imposes on them. These are meant to avert the many conflicts of interest that may arise when family members exert close personal control over their charitable foundation’s assets. The rules can prohibit acts that seem totally fair and even commonsensical. So believing an action is fair and sensible – indeed, even if it is fair and sensible – may not prevent it from attracting attention in an IRS audit and resulting in steep penalties.
Key: The IRS rules prohibit self-dealing between a foundation and its “disqualified persons” – a far-reaching term that includes all substantial contributors to the foundation (generally those who donate more than $5,000 to it) plus the officers and managers of the foundation and of affiliated corporations, and their family members. An act of self-dealing results in a 10% penalty tax on the amount involved – rising to 200% if not corrected within a specified period.
IRS rules are so stringent that virtually any proposed transaction between a foundation and a disqualified person, no matter how seemingly reasonable, should be considered a potential act of self-dealing and checked out with an expert advisor before being acted upon.
8 Common Violations of the Rules
1. Hiring into ineligible jobs. A family foundation is permitted to employ family members and other disqualified persons to provide “personal services,” but only in “professional and managerial” jobs. The IRS says these include managing investments and reviewing grant proposals – but do not include “operational” jobs such as real estate management, secretarial, cleaning and maintenance jobs. These jobs cannot be performed by disqualified persons. In one case, using a family member’s janitorial service company to clean the foundation’s office was ruled prohibited self-dealing. Point to remember: A foundation is not a job bank for family members, even at fair wages.
2. Excess compensation. When family members are employed properly their compensation must be reasonable. Excessive compensation results in a 25% tax on the recipient. Have an independent compensation expert set and document reasonable wage amounts.
3. Sales and leases. These are prohibited between a foundation and its disqualified persons even if set on terms that are a bargain benefiting the foundation. For instance, if an asset worth $10,000 is sold to the foundation for only $1,000, or an item with a lease value of $1,000 per month is leased to the foundation for only $100 per month, it is still an act of self-dealing. Exception: It’s permissible to lease to the foundation at $0 per month; that’s not self-dealing.
4. Making loans and extending credit. When extended either way between the foundation and a disqualified person, these are acts of self-dealing even if the loan or credit agreement is fully secured and made on fair market terms.
5. Providing facilities or services. These cannot be provided by a foundation to a disqualified person unless doing so is reasonable and necessary to further the foundation’s charitable purpose. For instance, say the individual who has managed the foundation retires from doing so but wishes to still keep belongings and maintain a personal office on the foundation’s premises. This will be an act of self-dealing even if he pays market rent to do so. It's similarly self-dealing if a current officer of the foundation uses its offices for non-foundation business meetings.
6. Redeeming pledges. If a family member or other disqualified person personally pledges to make a donation to a charity, and the foundation makes the donation, the result is considered self-dealing.
7. Travel costs. Bringing a spouse or family members with you for personal reasons on a trip you take for foundation business, and having the foundation pay their travel costs, is an act of self-dealing.
8. Fund-raising rewards. When any good or service received from a charity in exchange for a grant from the foundation is used by a disqualified person the result is an act of self-dealing. For example, a foundation officer receives tickets to a charity’s gala event. Using the tickets will be self-dealing, and giving the tickets away to a third party would be a prohibited non-charitable use of them. What to do: Have the charity keep the tickets, or contribute them to another charity.
This list is not comprehensive. Again, consider any interaction between the family foundation and a family member or other disqualified person as being a potential act of self-dealing, and have your tax advisor review it accordingly.
Most important, instill in all family members the knowledge that once they have donated money to a family foundation, it is not their money any more. Too often, creators of family foundations believe that they are free to use loans, rental arrangements and other transactions with the foundation to arrange their affairs however they wish, as long as the foundation is treated fairly and charitable obligations are met. But this is just not so – and the belief that they can still make use of what they have given away is the root cause of many costly acts of self-dealing and painful IRS audit results.
The Bottom Line
A family foundation can be an excellent device for achieving long-term charitable objectives, instilling a spirit of giving among family members and creating a lasting legacy for your family. But be fully aware of the complex rules that apply, to be sure that the efforts needed to comply with them will be worth the benefits received.
You may also be interested in reading The 5 Wealthiest Private Foundations.