I deeply doubt that I will ever fund a private foundation. However, all things are possible until they are not, so it may yet happen.
And private foundations have been in the news recently, as you know.
What are these things, and how are they used?
Let us start with what a private foundation is.
First, the terms “private foundation” and “family foundation” are often interchanged. If it is private enough, the only donors to the foundation are one family.
Second, it is a type of tax-exempt. It can accept tax-deductible donations, but the overall limit on the deduction is lower than for donations to a 501(c)(3). It is not completely tax-exempt, however, as it does have to pay a 2% tax annually. I suspect however most of us would leap at an opportunity to pay a 2% tax. Depending on what the foundation does, it may be possible to reduce that tax further to just 1%.
Third, what is the word “private” doing in there?
That “private” is the big difference from a (c)(3).
Generally speaking, a private foundation does not even pretend that it is broadly supported. To contrast, a (c)(3) has to show on its Form 990 that it is publicly-supported, meaning that it receives donations from a large number of people. Calling it a private – or family - foundation clues you that it is disproportionately funded by one family. When I hit the lottery there will be a Hamilton Family Foundation, funded by one family – mine.
There are two key reasons that someone would establish a private foundation:
(1) one has accumulated wealth and wants to give back through philanthropy; and
(2) to provide income for someone.
The first reason is quite common, and the private foundation has a lot to commend it. Let’s say that I sign an NFL contract and receive a $25 million signing bonus. That is an excellent year to fund the Hamilton Family Foundation, as (i) I have the cash and (ii) I could use the tax deduction. An additional attractive feature is that I could fund the foundation in one year but spread the charitable distributions over many years. The tax Code requires a foundation to distribute a minimum amount annually, generally defined as 5% of assets. Assuming no rate of return on investments, I could keep the Hamilton Family Foundation functioning for 20 years off that one-time infusion.
I have had clients that use a foundation as a focal point for family giving. It allows multiple generations to come together and decide on causes and charities, and it helps to instill a spirit of giving among the younger family members.
The second reason is to provide an income stream to someone, such as an unemployable family member or friends and associates that one wants to reward. An easy enough way to do so is to put them on the Board – and then pay trustee fees. This is more the province of the larger foundations, as it is unlikely that a foundation with $2 million or $3 million in investments could sustain such payouts. I myself would not be interested in providing an income stream, but I might be interested in a foundation that provided college grants to students who are residents of Kentucky, attend the University of Tennessee and and have the last name "Hamilton."
The ongoing issue with private foundations is the outsized influence of one family on a tax-favored entity. Congress has tried over the years to tighten the rules, resulting in a bewildering thicket of rules:
(1) There is a tax if the foundation owns 20% or more of a business. Congress does not want foundations running a business.
(2) The foundation managers have to exercise common sense and business prudence when selecting investments. Stray too far and there is a penalty on investments which “jeopardize” the charitable purpose.
Note the reference to the 'charitable purpose'. Let’s say the Romanov Foundation’s purpose is to promote small business in economically disadvantaged areas. Let’s say it made a high-risk loan to business-people interested in opening a shopping center in such an area. Most likely, that loan would not jeopardize its exempt purpose, whereas the same loan by the Hamilton Family Foundation would.
(3) Generally speaking, foundations that make grants to individuals must seek advance approval from the IRS and agree to maintain detailed records including recipient names, addresses, manner of selection, relationship with foundation insiders and so forth. As a consequence, it is common for foundations to not make contributions to a payee who is not itself a 501(c)(3). Apparently Congress realized that - if it did not impose this restriction - someone would claim a charitable deduction for sending his/her kids through college.
(4) Certain transactions between the foundation and disqualified persons are prohibited. Prohibited transactions include the sale or leasing of property, the loaning of money, the use of foundation property (if unrelated to carrying out the exempt purpose of the foundation), paying excessive compensation or reimbursing unreasonable or unnecessary expenses.
Who are disqualified persons? The group would include officers, directors, foundation managers (a term of art in this area), substantial contributors and their families. I would be a disqualified person to the Hamilton Family Foundation, for example, as I would be a substantial contributor.
Would prohibited transactions include the travel and entourage expenses of an ex-President and politico spouse receiving speaking and appearance fees not otherwise payable to their foundation? Tax law is ... elastic on this point. I am thinking of including a tax education purpose for the Hamilton Family Foundation so I can, you know, travel the world researching blog topics and have my expenses paid directly or otherwise reimbursed to me.
For many years the IRS enforced compliance by wielding the threat of terminating the tax-favored status. It did not work well, frankly, as the IRS was hesitant to sign a death sentence unless the foundation had pushed the matter beyond all recognizable limits.
Congress then expanded the panoply of tax penalties applicable to tax-exempts, including both (c)(3)’s and private foundations. These penalties have come to be known as the “intermediate” sanctions, as they stop short of the death sentence. Penalties can be assessed against both the foundation and its officers or managers. There can even be a second round of penalties if the foundation does not correct the error within a reasonable period of time. Some of these penalties can reach 200% and are not to be taken lightly.
There is wide variation in the size of private foundations, by the way. Our hypothetical Hamilton Family Foundation would be funded with a few million dollars. Contrast that with the Bill and Melinda Gates Foundation, with net assets over $40 billion. It is an aircraft carrier in the marina of foundations, yet it is considered "private" because of its disproportionate funding by one or a limited number of families.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.