Creating a Private Foundation to Achieve Your Charitable and Financial Goals

William M. Yates

William M. Yates

September 5, 2018

Investing & Economy

If you have assets that you do not need and are considering leaving to charity at your death, you might want to think about establishing a private foundation during your lifetime that holds these assets for the future. Creating a private foundation can yield significant income, capital gains, and estate tax benefits.
 
For example, when you fund or make additions to a private foundation:
 
  • You can receive a tax deduction in the year of your gift for the fair market value of your contribution, up to 30% of your adjusted gross income (AGI) for gifts of cash and up to 20% for gifts of securities or other types of property. If you give more than the limits of AGI, you may carry the excess deductions forward for the following five tax-years.
 
An income tax deduction can be especially useful if you have had a high-income year, received a substantial bonus, or exercised stock options — and want to minimize your tax liability.
 
  • If you contribute appreciated assets to your private foundation, you can eliminate capital gains taxes on any unrealized profits.
 
Transferring these assets to a private foundation also makes it possible to diversify your portfolio without paying any capital gains taxes (although there is a relatively small excise tax involved, as discussed below).  In addition, the donated assets can grow in perpetuity, free from income tax and capital gains tax on appreciation until the funds are distributed as grants.
 
  • If your estate is substantial and susceptible to possible federal or state estate taxes, contributing a portion of your estate to your private foundation during your life, or at your death, can remove the donated assets (and any future appreciation on them) from your gross estate. This can reduce your estate tax liability while it adds funds to your foundation so it can continue making charitable distributions.
 
Below are more details on the characteristics of a private foundation, the trustees’ responsibilities, and regulatory requirements.

 

A Tax-Exempt Organization with a Clear Mission and Purpose

 
A private foundation is a type of tax-exempt organization operated exclusively for charitable purposes.  Its activities generally include: 
  • Receiving charitable contributions
  • Managing its charitable assets
  • Making grants to other charitable organizations that support the foundation’s charitable mission
 
Foundations are typically established with a clear charitable purpose expressed in a brief two- or three- sentence mission statement and are overseen by a board of directors or trustees. (Sometimes referred to as “the board,” we use “trustees” in this article to refer to this group.)
 
The trustees typically include the donor or donors who established the foundation, family members (if it is a family foundation), and professional advisors who are responsible for:
 
  • Overseeing the affairs of the foundation, including the investment of foundation assets
  • Determining the required minimum distributions each year (see more on this below)
  • The timing, amount, and recipients of foundation grants
  • Reporting and filing annual tax returns for the foundation 
 
The foundation may include a professional within the trustee group to help carry out these responsibilities or employ outside professional advisors for some of these tasks. 

 

Guidance from Trustees Who Must Act as Fiduciaries

 
Individuals asked to serve as trustees of a foundation often believe their primary responsibility will be directing the distribution of grants to non-profit organizations. Although grant-making is certainly an important function, trusteeship actually entails much more.
 
Trustees of a foundation are considered fiduciaries, with the duty to act prudently and in good faith to protect the foundation. This duty applies to all aspects of managing the foundation, from avoiding self-dealing to approving the Investment Policy Statement (IPS) that directs the foundation’s investments. 
 
As a result, a trustee’s administrative responsibilities include:
  • Determining the foundation’s mission
  • Ensuring legal and tax compliance
  • Overseeing reporting and recordkeeping
  • Managing foundation assets, including approval of its Investment Policy Statement (IPS)
  • Setting grant-making policy
  • Making and monitoring use of grants
  • Securing and managing advisors to the foundation
  • Ensuring ongoing leadership
 
Trustees/fiduciaries who fail to fulfill these responsibilities can be personally liable for any damage they have caused the foundation. If their actions are criminal, they can be prosecuted under state law, and also can be jointly liable under federal law for certain excise taxes if the entity has engaged in prohibited transactions.
 
Given the nature of these responsibilities, private foundation trustees/boards typically hire a professional advisor or include among the trustees an advisor skilled in asset management, administration, and compliance for private foundations, such as Cambridge Trust Company.

 

A Well-Conceived Investment Strategy to Help Protect and Grow Assets

 
A private foundation typically holds its assets in a diversified portfolio of securities and cash. Achieving appropriate risk-adjusted returns for those assets means paying attention to time-tested investment principles and best practices for charitable organizations that include:
  • Adopting an Investment Policy Statement (IPS) to document investment objectives, cash flow, spending and saving goals, and risk tolerance
  • Maintaining appropriate asset allocation and diversification of the portfolio among asset classes, sectors, and individual investments as outlined in the IPS
 

Attention to Regulatory Requirements

 
Not surprisingly, the government regulates private foundations as a class to ensure that they are entitled to their tax-exempt status. Among the myriad of requirements and potential pitfalls are:
 
  • The 5% Distribution Requirement
Section 4942 of the Internal Revenue Code requires a private foundation to distribute a minimum amount of its funds each year, equal to 5% of the fair market value of the foundation's net investment assets at the close of the tax year (average fair market value, less 1.5% of fair market value allowed for expenses). A private foundation has up to twelve months from the end of its tax year to make at least the required minimum distribution.
 
  • A Tax on Investment Income
Private foundations must pay an annual excise tax on their net investment income, ordinarily 2%, which is very small relative to income and capital gains taxes paid by individuals. The tax applies to interest, dividends and other types of income, including capital gains from the sale or disposition of property used for the production of that income.
 
In calculating net investment income, a foundation can deduct all of the "ordinary and necessary" expenses of producing or collecting that income such as fees such as for investment management, tax and custody services, and brokerage fees. In certain years when foundations can make extra qualifying distributions, the 2% excise tax may be reduced to 1%.
 
  • Eligible Grant Recipients
Private foundations must make grants only to organizations that are eligible to receive them (typically 501(c)(3) public charities), and may not make grants to individuals without following prescribed procedures.
 
Grants made outside of these restrictions will not count toward the foundation's minimum distribution requirements. They also will be subject to an initial excise tax of 10% of the amount involved, and the grant will have to be repaid. In addition, any foundation manager who knowingly approves an ineligible/taxable expenditure must personally pay a 2% excise tax (not to exceed $5,000) on the amount involved.


These are only a few of the strict rules and regulations that prompt many individuals to seek professional guidance in establishing and managing their private foundations.
 
The Cambridge Trust Wealth Management team can help you explore how a private foundation and other types of charitable trusts can help you meet your philanthropic and financial goals. Contact your Cambridge Trust Private Banker to set up a conversation with us.
 
To learn more about how a private family foundation can help you pass your values on to the next generation, read How A Private Family Foundation Sustains Your Values While Giving to Others 
 
This article is for informational purposes only and should not be construed as investment or legal advice.