Summary: Private Family Foundations work by supporting outside charities or running charitable programs of their own. These foundations provide a number of tax benefits and help create philanthropic legacies, however, there are a number of issues to consider related to regulations, fees, time commitments, and organizational structures.
If you or your family are interested in pursuing charitable projects or want to create a philanthropic legacy for future generations, you may consider including a private family foundation in your estate plan. These foundations can provide a number of benefits to family members, as well as valuable tax incentives. But there are a few challenges to be aware of, as well.
Private Family Foundation – Defined
The phrase “Private Foundation” first appeared in the IRS Code in 1969, as a type of charity qualifying as tax exempt, under Section 501(c)(3). In a general sense, Private Foundations are independent legal entities which support outside charities, or run charitable programs of their own. Private Foundations are typically controlled by one source, whether that be an individual, a family, or a company. The bulk of the foundation’s income comes from investment assets (known as “endowments”) which are tax deductible. A private foundation can hold assets including: cash, publicly traded securities, private equity, real estate, tangible property (art, jewelry, collectibles, etc.), intangible property (copyrights, patents, etc.), or annuities. The foundation’s income or assets are then spent on grants to other charitable organizations.
The phrase “Family Foundation” is not a legal term, and, therefore, it does not have a precise legal definition. But approximately two-thirds of private foundations are, in fact, family foundations or family managed.
Creating a Private Family Foundation
Starting a Private Family Foundation is a several-step process. First, the person or group who wants to create the foundation should create a document specifically defining the purpose of the foundation and outlining any guidelines for the grant-making or selection process. Second, they need to draft the foundation bylaws, which set forth the foundation’s structure (ex: a charitable trust or nonprofit corporation) and create a governing board. Third, the person or group should incorporate in their chosen state as a non-profit corporation. It is also recommended to apply for an employee identification number (EIN) at this time – the EIN will act as the foundation’s tax identification number. Fourth, the person or group should file the appropriate paperwork for obtaining tax-exempt status from the IRS. Finally, they may need to complete additional required documents, such as state compliance forms, IRS compliance forms, annual reports, or other necessary record keeping.
Benefits to Creating a Private Family Foundation
There are a number of financial incentives and benefits to creating a Private Family Foundation, with the primary advantage being the ability to pursue philanthropic projects or create charitable opportunities. Also, these family foundations are a family affair: those who establish the foundation can include family members on the board, create a positive legacy, and pass along philanthropic values to younger generations. There is also a high degree of control concerning the grant selection and foundation employees. Another of the major benefits of Private Family Foundations are the tax incentives. With a foundation, you can make tax-deductible grants directly to individuals in need. Foundation income is tax exempt (with the exception of a 1-2% excise tax). There are also double capital gains benefits, current tax year deductions, and estate tax reductions (assets transferred to foundations are typically not subject to estate tax).
Challenges Related to Private Family Foundations
Whereas Private Family Foundations do present a number of benefits concerning charity, family, and tax incentives, there are also a few challenges or issues to be aware of. Some individuals or groups may find the initial time commitment or fees to be prohibitive. Also, foundations come with a number of regulatory requirements. Foundations, for example, must distribute at least 5% of their net investment assets each year in the form of charitable grants. There are also significant requirements related to recordkeeping and annual reporting. Private Family Foundations are subject to annual excise tax on their net income, depending on the annual level of grantmaking. Two other issues include lower deductibility caps for gifts to the foundation and less favorable treatment of some capital gains gifts.
Private Family Foundations and Estate Planning
In addition to the general benefits and challenges related to Private Family Foundations, there are also issues to keep in mind concerning foundations and estate planning. If an individual or family is interested in charitable giving, they can create a Private Family Foundation during the donor’s lifetime by testamentary disposition. Donors can then make tax-deductible contributions to the foundation which will, in turn, be distributed to grant recipients. Private Family Foundations can also be created at death by a bequest from the donor’s (or multiple donors’) will or trust; the foundation will receive funds as a primary or secondary beneficiary.
Individuals or families may be interested in creating a foundation because of the degree of control related to foundation employees and grantmaking guidelines, as well as the opportunity to create a philanthropic legacy. However, those creating the foundation need to be aware of a few potential issues. First, if an individual wishes to create a Private Family Foundation by trust, that trust may require court approval. Also, the foundation’s organizational documents have to be drafted so as to obtain a tax exemption status. (If a defect in the document precludes the relation back of exemption to death, the state may deny the estate tax charitable deduction). Third, concerning foundations and estate planning, there are a number of transactions between the donor and the foundation which court and the government deem “prohibited.” These prohibitions apply to acts of self-dealing and other transactions between a private foundation and a disqualified person (ex: substantial contributors, foundation managers, family members, individuals owning more than 20% of an entity which is a substantial contributor, or an entity in which the above persons own more than 35%). The Private Family Foundation may be subject to excise tax on these such prohibited transactions.
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