Private Foundation

What Is a Private Foundation?

A private foundation can be a charitable organization that, while serving a good cause, does not qualify as a public charity by government standards. Private foundations can also be nonprofit organizations whose trustees or directors manage funds and programs. They are usually created via a single primary donation, called an endowment, from an individual, a family, or a business.

As such, rather than funding its ongoing operations through periodic donations as a public charity does, a private foundation generates income by investing its endowment and disbursing a portion of its investment income each year to desired charitable activities.

How a Private Foundation Works

In the eyes of the Internal Revenue Service (IRS), private foundations are classified as 501(c)(3) organizations, which are tax exempt, as are donations to them. They generally fit into two categories: private operating foundations and private nonoperating foundations.

Private operating foundations actually run the charitable activities or organizations that they fund with their investment income. In so doing, they must spend either at least 85% of their adjusted net income or their minimum investment return, whichever is less.

Private nonoperating foundations simply disburse funds to other charitable organizations in accordance with their purpose, and the IRS requires an annual “distributable amount,” which “is equal to the foundation’s minimum investment return with certain adjustments.” While they can also operate programs, that isn’t their main function. They are the most common type of private foundation.

There is a limit on the business holdings of a private foundation, which is generally “up to 20% of the voting stock of a corporation, reduced by the percentage of voting stock actually or constructively owned by disqualified persons.” Also, the investments made by private foundations must not put at risk the execution of the organization’s exempt purpose.

Private Foundations and the IRS

If any organization qualifies as 501(c)(3), it is by default considered to be a private foundation by regulators unless it is better classified under a different category that is explicitly excluded from being called a private foundation. Excluded entities include universities, hospitals, and organizations and their support elements that hold wide public support.

The majority of domestic private foundations are subject to an excise tax on their net investment income. There also may be taxes for some foreign private foundations that draw gross investment income from U.S. sources.

The IRS also holds private foundations to a number of other requirements and rules. For instance, there are restrictions on private foundations that bar self-dealing or acting for personal benefit rather than for the interests of beneficiaries, between the foundation and substantial contributors. In other words, the administrators of a foundation cannot use their positions to make deals to enrich themselves at the expense of the foundation’s beneficiaries.

Tax Savings

There are three main tax-saving advantages available to donors who give money to private foundations:

• Estate tax—Money donated to a private foundation is not included in a donor’s estate, thus making any donated assets free from state or federal estate taxes. Wealthy individuals can fulfill their philanthropic desires while saving money on estate taxes.
• Income tax—Any individual who donates to a private foundation receives an income tax deduction for the amount that they contribute, allowable up to 30% of the donor’s adjusted gross income (AGI).
• Capital gains tax—Donors may sidestep having to pay capital gains taxes if they give away highly appreciated assets, such as stock or real estate, instead of cash to a private foundation.
  

Types and Examples of Private Foundations

There are many different kinds of IRS-approved private foundations, and each differs in how it is governed and funded. The various kinds are not necessarily legal classifications.

• Family foundation—This is created by family members who operate and govern the organization for the benefit of a philanthropic cause or causes near and dear to them. An example is the Walton Family Foundation, which works in three areas: “improving K–12 education, protecting rivers and oceans and the communities they support, and investing in our home region of Northwest Arkansas and the Arkansas-Mississippi Delta.”
• International foundation—This is a private foundation (usually based overseas) that makes grants and engages in cross-border philanthropic endeavors. An example is the Mastercard Foundation, which works largely in its home base of Canada and in Africa “to advance learning and promote financial inclusion in developing countries and to support Indigenous youth.”
• Corporate foundation—This is an organization created and supported by a corporation as a separate legal entity, though tied to the company, that is intended to give back to society, especially local communities. An example is the Prudential Foundation, an arm of the life insurance company, which makes “grants to nonprofit organizations that help close the financial divide by creating inclusive workplaces and communities, and accelerating economic mobility for all,” including in its home base of Newark, N.J.

Instead of forming a corporate foundation, some companies choose to set up a corporate giving program, which may dole out money in cash or grants to charitable organizations.

The largest U.S. private foundation

The largest private foundation in the United States is the Bill & Melinda Gates Foundation, which provided $5.8 billion in direct grantee support in 2020. The goals of this foundation are to expand educational opportunities and access to information technology in the U.S. as well as reduce extreme poverty and enhance healthcare worldwide.

Some of its activities include bringing access to financial services, such as savings accounts and insurance, to people living in extreme poverty around the world, as well as funding improved sanitation, agricultural development, and other important initiatives in the developing world.

Private Foundations vs. Public Charities

Both private foundations and public charities do good works, but they operate in different ways, and each has its own set of tax laws. A public charity usually raises its funds through donations from the public, while a private foundation is funded by investing its endowment or sometimes from a limited group of specific donors.

Federal law requires a public charity to either receive one-third or more of its assets from contributions from the general public or meet the 10% facts and circumstances test given by the IRS.

Benefits of a Private Foundation

The benefits of private foundations include:

• Greater control over charitable giving
• Greater consistency in charitable giving over time, as the foundation can last in perpetuity
• Creating a visible and lasting legacy for the founding individual, family, or corporation
• Eligibility for a variety of tax savings
• No need to constantly seek donations from the public
  

Disadvantages of a Private Foundation

The disadvantages of private foundations include:

• Costly to start in terms of both money and time
• Onerous regulatory and record-keeping requirements
• Lower deductibility limits on donations than for public charities (30% of adjusted gross income for cash gifts and 20% for gifts of appreciated assets vs. 60% and 30%, respectively)
• Less favorable treatment of gifts of appreciated property than for public charities (valued at cost basis as opposed to fair market value)
• Excise taxes levied on excess business holdings