FAMILY FOUNDATIONS

FizerBeck
Fizer, Beck, Webster, Bentley & Scroggins
a professional corporation
1330 Post Oak Boulevard, Suite 2900
Houston, TX 77056-3022
 713-840-7710  713-840-7710
www.fizerbeck.com
 

1. WHAT IS A PRIVATE FOUNDATION?

1. All organizations that are exempt from federal income tax under §501(c)(3) of the Internal Revenue Code of 1986¹ are classified as either "private foundations" or "public charities."

2. Public charities are those organizations described in §§509(a)(l)-(4), and include organizations that are supported through public donations or that perform activities for the benefit of the general public. Examples include churches, schools, hospitals, and publicly supported organizations.

3. Private foundations are typically privately funded, privately controlled grant making organizations, with no real connection to the general public at large. Because of this "private" feature, private foundations are subject to much more stringent legislative supervision than public charities.

2. WHAT IS THE SIGNIFICANCE OF PRIVATE FOUNDATION STATUS?

1. Lifetime contributions to private foundations are not treated as favorably as lifetime contributions to public charities.

1. Except as noted below, contributions of long-term capital gain property are deductible only to the extent of the donor's adjusted basis.

2. Annual contribution limits are 30% of AGI for cash, 20% of AGI for long-term capital gain property, but there is a five-year carry-over for excess contributions.

3. Under §170(e)(5), donors of "qualified appreciated stock" (i.e., publicly traded stock held for more than one year and not subject to any resale restrictions) may deduct the full fair market value of such stock.

4. The foregoing rules apply for transfers to charitable remainder trusts if a private foundation is (or can be) a remainder beneficiary under the terms of the trust

5. Testamentary transfers to private foundations are fully deductible for estate tax purposes, regardless of the type of property.

2. A private foundation and its "disqualified persons" (substantial contributors, trustees, officers, family members, and certain business entities affiliated with the foregoing) are subject to the excise tax restrictions found in §§4940-4945. None of these provisions apply to public charities. The purpose of these rules is to legislatively mandate certain conduct on the part of private foundations that, in the belief of Congress, might not otherwise occur because of the "private" nature of the foundations. The excise tax provisions mandate conduct through (1) the levy of an initial excise tax without regard to fault, and (2) the levy of a second tier tax if the violation is not corrected in a timely fashion. Briefly, the excise taxes may be summarized as follows:

1. Private foundations must pay an excise tax on their investment income equal to 2% of the "net investment income" (§4940).

2. Virtually all transactions between disqualified persons and private foundations are prohibited as acts of self-dealing, including sales, leases, and transfers to or from private foundations. This prohibition applies notwithstanding the terms or fairness of the transaction. Notable exceptions include (1) gratuitous transfers from disqualified persons to private foundations, and (2) payment of reasonable compensation and reimbursement of expenses from foundations to disqualified persons who actually perform services on behalf of the foundation (§4941).

3. Private foundations are required to annually distribute at least 5% of their corpus for charitable purposes (§4942). The pay out for the current year is not required until the end of the following year.

4. Private foundations generally may not own more than 20% of a "business enterprise," reduced by the percentage owned by disqualified persons (§4943). There is a 2% de minimis exception, and a five-year period to dispose of "excess business holdings" acquired by gift or bequest.

5. Excise taxes are imposed on any "jeopardy investment" made by a private foundation (§4944). Risky or speculative investments are closely scrutinized, but there are no per se jeopardy investments. Consideration is given to not only the nature of the investment, but also the portion of the endowment devoted to such investment.

6. Excise taxes are imposed on any "taxable expenditures," which include expenditures for propaganda, grants for scholarships (unless approved in advance), or grants to other private foundations unless "expenditure responsibility" is exercised by the grantor foundation (§4945).

3. Private foundations and public charities are treated identically for purposes of the tax on unrelated business income (§§511-514), although the presence of an unrelated business activity for a private foundation may create additional problems under the excise tax provisions (e.g., excess business holdings). Also, the fiduciary duties applicable to directors and trustees under state law and the Attorney General's enforcement authority are applied to private foundations and public charities without distinction.

3. WHAT ARE THE ADVANTAGES OF PRIVATE FOUNDATIONS?

1. Private foundations offer flexibility in operation since foundations (a) do not have to raise money from the general public, (b) do not have to actively conduct a charitable activity, and (c) do not have to align themselves with any particular public charities. Thus, subject to compliance with the excise tax rules, grants may be made for any charitable purpose, including grants to individuals, in certain circumstances.

2. Unlike public charities, family members may control their own foundation and perpetuate this control through provisions in the bylaws and articles. There is no requirement to have outside board members or officers.

3. The creation of a private foundation may allow a donor a full deduction for a transfer to the foundation at the end of a tax year, while avoiding the actual selection of the ultimate charitable recipients until the end of the following year (and even then only 5% of the gift is required to be distributed).

4. As discussed in Section E below, private foundations can be utilized to satisfy certain estate planning goals of the donor and family members.

5. A private foundation may yield significant nontax benefits to family members participating in the management of the foundation's affairs.

6. Under § 170(e)(5), donors of qualified appreciated stock are able to deduct the full fair market value of such stock.

4. WHAT ARE THE DISADVANTAGES WITH PRIVATE FOUNDATIONS?

1. The self-dealing rules of §4941 require close supervision by qualified advisors to make certain that no inadvertent violations occur. No income or estate planning technique should be utilized with a private foundation unless all ramifications are considered under §4941.

2. Because of the contribution rules under §170, private foundations are not appropriate vehicles for lifetime transfers of closely held stock, publicly traded stock (unless such stock constitutes qualified appreciated stock within the meaning of §170(e)(5)), or appreciated real estate. However, as discussed in paragraph E below, testamentary transfers of said assets are possible.

3. Because of the contribution rules under § 170, private foundations are usually not appropriate remainder beneficiaries for charitable remainder trusts.

4. It is very complicated for a private foundation to receive a grant from another private foundation because of the excise tax rules of §§4942 and 4945.

5. Because of the excess business holdings rules of §4943, it is very difficult for private foundations to own meaningful percentages of business enterprises owned by the donor.

5. WHAT ARE SOME ESTATE PLANNING TECHNIQUES THAT CAN BE UTILIZED WITH PRIVATE FOUNDATIONS?

1. Private foundations may be used in conjunction with testamentary bequests of all types of property, including closely held stock, publicly traded stock, and real estate. Testamentary transfers to private foundations are 100% deductible for estate tax purposes. Additionally, family members of the decedent may continue to be involved with the investment and/or application of the property transferred to the private foundation by virtue of their involvement as trustees of the foundation.

1. The excise tax provisions, and in particular, the restrictions against self-dealing, must be considered prior to using this technique. Certain business arrangements that existed prior to the transfer may now be self-dealing (e.g., leases). Also, §4943 (excess business holdings) may apply to the property transferred.

2. The self-dealing rules extend to certain transactions between estates and disqualified persons.

2. A private foundation may be utilized in conjunction with a testamentary transfer of closely held stock, followed by a redemption of the stock by the corporation provided the exception to self-dealing under §4921(d)(2)(F) applies. Basically, this requires the redemption offer to be made to all security holders of the same class as that owned by the foundation and for the redemption to be at fair market value. A prior ruling from the IRS is advised.

1. There is a five-year grace period under §4943 for any excess business holdings acquired by bequest.

2. With this technique, the donor receives an estate tax deduction, the private foundation receives cash, and the corporate ownership remains in the family.

3. Under this proposal, individual family members may not purchase the stock directly from the foundation. However, if the rules of Treas. Reg. Sec. 53.494 l(d)-(3) apply, then heirs of the decedent may purchase the stock from the estate during the administration without violating the self-dealing rules under §4941.

4. Either the corporate redemption or purchase by heirs may be funded with life insurance.

3. Pursuant to §170(e)(5), donors are able to make lifetime transfers of qualified appreciated stock to private foundations, and receive an income, gift, and estate tax deduction based upon the fair market value of the property transferred. Similarly, donors are able to make lifetime transfers of qualified appreciated stock to charitable remainder trusts with private foundations as the remainder beneficiary and still receive maximum income, gift, and estate tax benefits.

1. As discussed above, the use of private foundations allows continued family control over the wealth transferred.

2. Both of these gifting techniques could be utilized in connection with a life insurance trust, designed to replace the assets gifted to the foundation without any estate tax obligations.

6. WHAT ARE SOME ALTERNATIVES TO PRIVATE FOUNDATIONS?

   Depending upon the property to be donated by the founders of a charitable organization (e.g., lifetime transfers of closely held stock, publicly traded stock, or appreciated real estate), or because of potential self-dealing issues between the newly established charity and the founder or business entities controlled by the founder, a private foundation may not be the appropriate classification for the founder's charity. Accordingly, the tax advisor must consider other possible alternatives, including the following:

1. Supporting Organizations.

1. Supporting organizations are public charities and therefore are entitled to maximum benefits for lifetime gifting under § 170 and they are not subject to the excise tax restrictions that apply only to private foundations.

2. A supporting organization operates for the exclusive benefit of one or more public charities (schools, hospitals, churches, etc.) named in its charter. There is no limit on the number of charities that can be specified in the charter.

3. The founder and family members may not control the supporting organization.

4. One or more of the named public charities must have some involvement with the governance of the supporting organization, ranging from control to occupying one position on the board of trustees.

2. Medical Research Organizations.

1. A medical research organization is also a public charity.

2. A medical research organization actively conducts medical research as opposed to supporting the research efforts of other organizations with grants.

3. The medical research must be in conjunction with a hospital with which the medical research organization is affiliated.

4. A donor may control a medical research organization.

3. Community Foundations.

1. A community foundation is a public charity consisting of a number of "donor funds." Donors who establish a fund with a community foundation may express a preference as to the disposition of the funds, but such a preference is not binding upon the community foundation directors.

2. A community foundation offers all the advantages of a public charity without many of the administrative responsibilities that are involved with a founder establishing his or her own charitable entity.

4. Private Operating Foundations.

1. A private operating foundation is a private foundation and therefore is subject to the excise tax restrictions summarized above. However, a private operating foundation is treated as a public charity for purposes of lifetime transfers under §170.

2. A private operating foundation actively and directly conducts a charitable activity as opposed to supporting the activities of other organizations with grants. Examples include museums, nature conservatories, libraries, etc.

¹ Unless otherwise indicated, all code section references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder.