September 01, 2003

Creating a Family Foundation (2003, 17:05)

Creating a Family Foundation

Probate and Property, September/October 2003

By Michelle Coleman-Johnson

Michelle Coleman-Johnson is an associate with Bourland, Wall & Wenzel, P.C., in Fort Worth, Texas.

The "family foundation" has become the latest accessory for the philanthropic wealthy family. Interest in this charitable giving vehicle has become widespread, to include families of moderate wealth, in addition to the more traditional "foundation" family, but clients rarely have prior knowledge or understanding of the private foundation rules and restrictions. In this planning process, the practitioner should help the client determine if a private foundation is a good fit for the client and his or her philanthropic goals, giving due consideration to the restrictions and excise taxes associated with this form of entity.


An initial inquiry should address the client's vision for this new foundation. Will it seek contributions from the public or be funded by one family? Does the client wish to retain control? Private foundations best suit clients who plan to fund the foundation themselves and control its operations. Although this article focuses on the formation and operation of a private non-operating foundation, several alternatives to a private foundation may be a better fit for an individual client. An understanding of the client's intentions and goals for the future can help the practitioner properly advise the client and guide the client to the appropriate vehicle for its philanthropic vision. These alternatives include private operating foundations (created to directly carry on one or more charitable activities), supporting organizations (organized and operated to support one or more public charities), and publicly supported charities (which must meet specific support tests to maintain favorable public charity status). Another consideration is for the client to establish a donor advised fund with a community foundation. With a donor advised fund, a donor has the ability to recommend the charitable recipients of its fund without the burdens associated with the administration of a private foundation.

The client should be advised that the private foundation requires ongoing monitoring and administration and that many transactions between the donor and the foundation will be prohibited. Despite the restrictions, the advantages of the private foundation make it attractive to the wealthy client. The most important advantage is the degree of control the client can exert over the foundation. The private foundation is also a great method to involve family members who may or may not be involved in the family business, and it can be drafted to involve the younger generation at an early age as junior advisors. In this regard, the private foundation is an effective estate planning tool to integrate members of the family who might not otherwise be involved. This article describes the major considerations in the planning, creation, and operation of private non-operating foundations. As such, it is an introduction for the practitioner in advising on the operation of such an entity.

Presumption of Private Foundation Status

An organization organized and operated for charitable purposes is presumed to be a private foundation unless it demonstrates that it fits one of the exceptions listed in Code§ 509(a): (1) organizations that are, by definition or activity, public charities (described in Code § 509(a)(1) and Code § 170(b)(1)(A)(i)-(v)); (2)publicly supported charities (Code§ 509(a)(2) or Code § 170(b)(1)(A)(vi)); (3) supporting organizations (Code § 509(a)(3)); or (4) organizations organized and operated exclusively to test for public safety (Code§ 509(a)(4)).

If a charitable organization does not qualify as one of the four types of organizations described above, then it is a private foundation. Private foundations themselves can be divided into two groups: (1) private operating foundations that directly carry out a charitable activity and are exempt from certain distribution and other requirements and (2) private non-operating foundations, which do not directly perform any charitable programs or services, but rather receive charitable gifts, invest the funds, and make grants to other charitable organizations. It generally receives its funding from one primary source, such as an individual, a family, or a corporation. The most common type of private foundation is the non-operating foundation, and it is the focus of this article.

Organization of a Private Foundation—Form of Entity

The foundation is established by the creation of a nonprofit entity under applicable state law. A corporation is generally the preferred entity for the private foundation, because it provides greater protection from liability for the organization's officers and directors, but the foundation can also be in the form of a charitable trust. The decisions of directors in a corporate structure are usually evaluated according to the business judgment rule, as opposed to the more strict fiduciary standards applicable to trustees of trusts. Careful drafting of corporate documents can provide for family line succession as members or directors of the foundation. A trust format can be made very inflexible, which may be advantageous for a founder who wants the tightest control possible after his or her death or incapacity.

The foundation may be created during life or by testamentary disposition. The preferred method is to create the foundation during the founder's life and obtain the tax exemption from the IRS. If the foundation is not fully funded during life, it can be funded at the founder's death. If created at death, organizational documents may need to be revised to obtain exempt status, and a trust format may require court approval. Exempt status at death is needed to obtain the estate tax charitable deduction, and if a defect in the document precludes the relation back of exemption to death, the estate tax charitable deduction could be denied.

Organizational documents should be in compliance with applicable state law. To comply with federal law, the organizational documents should state that the organization is organized and operated exclusively for its exempt purpose and should define the exempt purpose (charitable, educational, or similar charitable purpose). There should be a prohibition upon the earnings of the foundation inuring to any insider and a prohibition upon private benefit. The document should contain a statement that no part of the foundation's activities shall consist of attempts to influence legislation and that it shall not participate in political campaigns. In addition, there should be a statement that the corporation will comply with the requirements of Code §§ 4941 through 4945. (Sample language for these trust or corporate provisions can be found in IRS Publication 557, Tax-Exempt Status for Your Organization.)

Application for Exempt Status

Form 1023, Application for Recognition of Exemption Under § 501(c)(3) of the Internal Revenue Code, should be filed within 15 months from the end of the month of the foundation's organization. An automatic extension allows filing within 27 months of the foundation's organization. Further extension may be granted for reasonable action, good faith, and a showing of no prejudice to the government. If Form 1023 is timely filed, exempt status will relate back to the date of organization. Otherwise, exempt status relates back only to the date of filing of Form 1023. Occasionally, the IRS will request supplemental information about the foundation, especially if the foundation has been funded before the application for exempt status has been filed. For this reason, the author advises clients not to fund until a determination letter is received.

If Form 1023 is approved, the IRS will issue a "determination letter" as evidence that the foundation is exempt as organized under Code§ 501(c)(3). Once exempt status is granted, many states grant exemption from state income and franchise taxes once they are provided with a copy of the IRS determination letter. Procedures vary from state to state.

Operation of a Private Foundation—Restrictions

Private foundations are subject to the following restrictions: (1) a tax of 2% (can be reduced to 1%) of the net investment income of a private foundation for the taxable year (not applicable to operating foundations),(2) restrictions on acts of self-dealing, (3) minimum requirements for distribution of income, (4) restrictions on retention of "excess business holdings," (5) restrictions on investing assets in a manner that jeopardize the carrying out of the exempt purposes, (6) restrictions on expenditures, and (7) tax upon termination of status as a private foundation, unless certain requirements are met. Private foundations are not subject to the intermediate sanctions rules applicable to public charities under Code § 4958. Although beyond the scope of this article, private foundations are subject to other rules related to Code § 501(c)(3) organizations, such as prohibitions upon private inurement or private benefit and taxes on unrelated business income.

Excise Tax on Investment Income (Code § 4940)

Private foundations are subject to several excise taxes. One of these excise taxes, which cannot be avoided but can be reduced, is the excise tax on investment income. The private foundation is usually subject to an excise tax of 2% of its net investment income. If the private foundation distributes to qualified charities a total amount for the year that exceeds the sum of (1) the product of the current value of the foundation assets times the average percentage payout during the preceding five years (which is the average of the qualifying distributions for each year divided by the value of the foundation assets for that year) and (2) 1% of the foundation's net investment income for the year, the tax may be reduced to 1% for that year.

Excise Tax on Acts of Self-Dealing (Code § 4941)

In addition to the excise tax on investment income, the private foundation is subject to excise taxes on certain prohibited transactions.

Because of the retention of control by a donor over a private foundation, there are prohibitions upon acts of self-dealing between a disqualified person and a private foundation. These prohibitions are not limited to one-sided transactions but (subject to certain exceptions described below) apply to all dealings between the private foundation and "disqualified persons," regardless of whether the private foundation is harmed by the transaction. Self-dealing can be direct or indirect and includes:

oany sale, exchange, or lease of property between the private foundation and the disqualified person;

olending of money or extension of credit between a private foundation and a disqualified person;

ofurnishing of goods, services, or facilities between a private foundation and a disqualified person (unless such goods, services, or facilities are made available to the general public on at least as favorable a basis as they are made to the disqualified person);

opayment of compensation (or payment or reimbursement of expenses) by a private foundation to a disqualified person (unless for personal services reasonable and necessary to carry out the exempt purposes and not excessive);

otransfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation; and

oagreement by a private foundation to make any payment of money or other property to a government official other than an agreement to employ such individual for any period after determination of his government service if such individual is terminating his government service within a 90-day period.

Caution should be taken in reimbursing directors for travel expenses or other out-of-pocket expenses. Such reimbursement of expenses will not be taxed as self-dealing if the expenses are reasonable and necessary to carrying out the exempt purposes of the foundation and are not excessive.

Disqualified persons include substantial contributors, foundation managers (officer, director, or trustee of the foundation or an individual having duties similar to those of officer, director, or trustee), persons owning more than 20% of an entity that is a substantial contributor to the foundation, a member of the family (spouse, descendants, and spouses of descendants), or an entity in which any of the above persons own more than 35%. A substantial contributor to the foundation is an individual, trust, estate, corporation, or partnership that contributes an aggregate amount of more than $5,000 to the foundation, if such amount is more than 2% of the total contributions and bequests received by the foundation (from its inception) before the close of the taxable year in which the contribution is received.

For any act of self-dealing, the disqualified person who engages in this self-dealing is assessed an excise tax of 5% of the amount involved in the transaction for each year that the transaction is uncorrected. In addition, a foundation manager who willingly participates in the act, knowing it is prohibited, is subject to a tax of 2.5% of the amount involved (not to exceed $10,000 for each such act) for each year that the transaction is uncorrected. If the transaction is not timely corrected and the 5% is initially assessed, the disqualified person is subject to an additional tax of 200% of the amount involved. Any foundation manager who does not correct the transaction may be subject to an additional assessment of 50% of the amount involved (not to exceed $10,000 for each such act). If more than one foundation manager is liable under this section, such persons are jointly and severally liable.

Excise Tax on Failure to Distribute Income(Code § 4942)

Code § 4942 imposes a tax on the undistributed income of a private foundation. To avoid this penalty, a private foundation must generally make qualifying distributions of a "distributable amount" that is based on a minimum investment return of 5%. If the "distributable amount" is not distributed by the close of the following taxable year, the foundation is assessed a penalty of 15% of the difference between the distributable amount and the amount actually distributed. An additional penalty of 100% of the undistributed amount is assessed if the original penalty is assessed and the distribution is not timely made. Penalties apply only to the foundation and not to the foundation manager.

Qualifying distributions include grants to charities and noncharities for charitable purposes, costs of all direct charitable activities (such as running a library or art gallery, providing technical assistance to grantees, and maintaining a historical site, among other things), amounts paid to acquire assets used directly in carrying out charitable purposes, set asides, program-related investments, and all reasonable administrative expenses necessary for the conduct of the charitable activities of the foundation.

Excise Tax on Excess Business Holdings (Code § 4943)

To prevent private foundations from having an advantage over other businesses that operate in the taxable income sector, there are restrictions on a private foundation's ability to engage in certain business activities. The Code defines these holdings in terms of permitted holdings. The foundation may own 20% of the voting stock in a corporation, reduced by the percentage of voting stock held by all disqualified persons. If the control of the entity can be shown to be held by nondisqualified persons, the foundation and the disqualified persons may own 35% of the entity's voting interest. The foundation may hold a nonvoting interest, but only if all disqualified persons together hold 20% or less of the voting interest. The private foundation has five years to dispose of these excess business holdings acquired by gift or bequest. The disposal must be to a nondisqualified person. In addition, during the five-year period, the excess business holdings will be treated as held by a disqualified person, rather than by the foundation. A de minimis rule allows the private foundation to own at least 2% of a business entity. Other exceptions apply to unusual gifts and bequests for which a private foundation may be granted an additional five-year period to dispose of an excess business holding, if certain conditions are met.

The foundation is taxed on its excess business holdings in the amount of 5% of the value of each excess business holding. A penalty of 2% is imposed on the foundation if the initial penalty is assessed and the excess business holding is not timely corrected. A private foundation has a five-year time period to dispose of the excess business holding, but the disposition of such holding is subject to the restrictions against acts of self-dealing.

Excise Tax on Jeopardizing Investments (Code § 4944)

The foundation is not allowed to invest its funds in investments that could jeopardize the foundation's ability to carry on its exempt purpose. If it does, a tax is imposed on the foundation equal to 5% of the amount of the improperly invested assets. In addition, each foundation manager who willfully participated in the making of the investment knowing that it jeopardized the carrying out of the foundation's exempt purposes is assessed a tax of 5% of the amount of the improper investment (not to exceed $5,000 for each such act). If the jeopardizing investment is not disposed of within the taxable period, the foundation is assessed an additional tax of 25% of the amount improperly invested and each foundation manager who willfully participated in the making of the investment knowing that it jeopardized the carrying out of the foundation's exempt purposes is assessed an additional tax of 5% of the amount of the improper investment (not to exceed $10,000 for each such act). The taxable period begins on the date of investment and ends the earlier of (1) the date of the mailing of a deficiency, (2) the date on which the tax is assessed, or (3) the date on which the investment is removed from jeopardy.

Although there is no per se jeopardy investment, some examples of investments that warrant close scrutiny are trading in securities on margin, trading in commodity futures, investments in working interests in oil and gas wells, the purchase of puts, calls, and straddles, the purchase of warrants, and selling short. The jeopardy investment rule requires close scrutiny of foundation managers' standard of care. The foundation managers will be held to a "prudent investor" standard of care. Caution should be exercised in the consideration of speculative or high-risk investments. This restriction applies to investment actions by the foundation managers and does not apply to assets received by a private foundation by gift or bequest.

Excise Tax on Taxable Expenditures (Code § 4945)

The foundation is subject to a 10% tax on each "taxable expenditure," and any foundation manager who willingly participates in making the distribution knowing it is a taxable expenditure, without reasonable cause, is subject to a 2.5% tax on such taxable expenditure. If the expenditure is not corrected within the taxable period, the foundation is subject to a tax of 100% of the amount of the taxable expenditure, and the foundation manager is subject to a tax of 50% of the amount of the taxable expenditure if the foundation manager refuses to correct the transaction. The taxable period is the date starting when the expenditure is made and ending on the earlier of the date (1) of mailing a notice of deficiency or (2) when the tax is assessed.

Taxable expenditures include payments for noncharitable purposes or to nonqualifying recipients, including political campaigns and lobbying and certain grants to individuals. If a foundation makes a distribution to an individual or to a for-profit entity (or a tax-exempt entity that is not charitable under Code § 501(c)(3)), it must exercise expenditure responsibility (that is, it must monitor the use of the grant) to avoid a penalty. Expenditure responsibility includes conducting a pre-grant inquiry concerning grantee's management and programs, obtaining a written agreement from the grantee before making the grant, obtaining regular written status reports from the grantee regarding its progress in using the grant, and filing reports regarding the grant's status with the private foundation's annual information return. Grants must be awarded on an objective and nondiscriminatory basis.

Grants to individuals for study, travel, or similar purposes are taxable expenditures unless certain requirements are met, including prior approval by the IRS. See Code § 4945 and related Treasury Regulations. Grants to individuals for charitable purposes do not require IRS approval, but diligent record keeping of the decision-making process and monitoring of the use of the grant is highly recommended for the foundation to demonstrate that the grant served a public and not a private interest.

As part of its grant making procedures, the private foundation should (1) obtain a copy of the grantee organization's determination letter granting exempt status as a public charity, (2) verify that the grantee is listed in the most current Publication 78, Cumulative List of Exempt Organizations (a searchable version is available online at ), (3) review the grantee's current Form 990, Schedule A, Part IV, to review its proof of nonprivate status, and (4) file reports, if necessary, regarding the grant's status with the private foundation's annual information return, checking the appropriate box pertaining to expenditure responsibility.

Limitations on Donor's Income Tax Charitable Deduction

In addition to the restrictions and excise taxes imposed on private foundations, other rules and limitations regarding private foundations make them less attractive to donors. For gifts of cash and non-appreciated property, a donor's income tax deduction is limited to an amount equal to 30% of the donor's adjusted gross income in the taxable year, as opposed to 50% for gifts of cash and other non-appreciated property to public charities and to other foundations that qualify as public charities. Any excess can be carried forward for the next five years. The deduction may be zero, however, if the donor has contributed capital gain property to public charities in excess of the 30% deduction limitation. Corporate contributions are limited to 10% of taxable income with a five-year carry forward of excess contributions. For gifts of appreciated property, a donor's income tax deduction is limited to 20% of the donor's adjusted gross income, as opposed to 30% for gifts of appreciated property to public charities. In addition, gifts of appreciated assets are limited to a deduction of only the donor's basis in the asset, unless the asset is publicly traded stock. Any excess can be carried forward for the next five years. But there is an exception tothe deduction rules for gifts to certain private foundations that are treated as pass-through foundations. If a foundation meets the criteria of Code § 170(b)(1)(E)(ii) (pass-through foundation), the donor may receive a deduction as if the gift were madeto a public charity. A pass-through foundation is described as any foundation which makes qualifying distributions in an amount equal to 100% of the foundation's contributions for the year before the fifteenth day of the third month following the close of the foundation's taxable year. No special election is necessary; the foundation should just make the appropriate qualifying distributions. To substantiate the higher deduction, the taxpayer must obtain adequate records or other sufficient evidence from the foundation showingthat the foundation made the appropriate qualifying distributions.Pass-through treatment of afoundation may be an attractive planning tool for a founder who would be willing to make the required distributions from the foundation during his or her life to receive the 50% deduction, and then further endow the foundation at his or her death.

Advantages of a Private Foundation

The private foundation provides more control to the donor than does a donation to a community foundation or supporting organization, because the donor has the right to distribute the foundation assets to organizations (public charities) he or she prefers and because he or she can stay in control of the foundation's investments. The foundation often makes the donations for the family. This is efficient for the philanthropic family: it designates one entity to receive all requests for donations, creating a "family office" that can field requests for funds. The establishment of grant procedures and review of grant applications by the board of directors or a committee of the board makes the grant approval process more objective, since applications must meet pre-set criteria. This can alleviate pressure placed on family members by grant-seeking organizations or individuals. In addition, special drafting of the organizational documents can maintain the family line as members or directors of the foundation. The family foundation can give younger family members an opportunity to participate in a meaningful endeavor and become familiar with the charitable goals, intentions, and business management philosophies of the foundation's creator.

In short, the private foundation is a useful tool that can be integrated with a client's estate and wealth migration plan. If a client is willing to "play by the rules," a family foundation can be a successful and enjoyable endeavor for the entire family.