Estate Planning Examples Articles – Estate Planning Using Private Foundations2021-03-13T06:26:23-07:00

Estate Planning Examples Articles
Estate Planning Using Private Foundations

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Private Foundations2020-02-20T17:06:06-07:00

1. Introduction.

In recent years, several private foundations have gained prominence in the media, and raised public awareness of their causes. Foundations, including the Bill and Melinda Gates Foundation, are often created with one (1) philanthropic goal in mind. However, as the grantors often realize, establishing your own foundation can often make money sense, as well.

Your last name does not have to be Rockefeller or Getty to start your own and derive the economic and other benefits involved. There are significant tax, estate planning, asset protection planning, family charitable and legacy objectives that can be accomplished with a Private Family Foundation.

A private family foundation is a vehicle designed to allow families to achieve their philanthropic goals in a tax efficient manner.

A family foundation has an initial board of directors which typically includes the family patriarch and/or matriarch. Subsequent or additional board members usually consist of family members or close personal advisors that are familiar with the Founders’ goals and aspirations for the Foundation. When established, a private family foundation is funded with cash, appreciated securities, or other assets. The Foundation then reinvests these assets to fit the investment goals set forth by the board. It then uses the investment income and appreciated assets to make future donations or grants to charities approved by the Foundation Board.

There are several primary benefits to having family members on the board of the Foundation. Most clearly, it allows a high level of control for the Founder with the Foundation’s investment assets, and its charitable giving processes and decisions. A secondary but equally important benefit of the private family foundation, are its educational capabilities in serving as a training base for younger family members. It can teach invaluable lessons in charitable giving, handling money, choosing investments, articulating family values, and managing intra-family relations.

The tax benefits include income and estate tax benefits in one (1) vehicle. All contributions to a private foundation provide immediate income tax deductions during the donors’ life. A private foundation will also provide estate tax benefits when receiving gifts at death. These gifts at death can include an IRA, a life insurance policy, or a charitable remainder trust, all of which pass onto the Foundation without incurring any estate tax.

The IRS imposes a tax of 2% per annum on the net investment income of the Foundation, which creates an excellent tax break when contributing appreciated assets that normally incur a 15% capital gains tax upon their sale. Additionally, the IRS requires that the Foundation distribute a minimum of 5% of its total assets every year.

Setting up private family foundations and administering them is complex. See Section 15 below.

As long as we live in a world in which death taxes can equal or exceed 60% and federal and state income taxes can exceed 40%, those families which have achieved the American dream often have three (3) estate beneficiaries – family members, charities or the IRS, with the IRS often receiving the lion’s share.

Many successful families have turned to private family foundations to achieve significant income and transfer tax savings while providing the family with a structured mechanism for achieving worthwhile, long-term philanthropic goals under the family’s control and direction for many generations. Those of us who view public television are familiar with private family foundations with names like Rockefeller, Ford, Getty and Gates, but family private foundations are valuable estate planning tools for many families considerably less fortunate. For example, there are now more than 18,000 family foundations organized in the United States, an increase of 50% in the last decade. Perhaps a family private foundation would be a benefit in your family’s estate planning.

2. What is a Private Family Foundation?

A private family foundation is a tax exempt organization formed under Internal Revenue Code Section 501(c)(3) and, like publicly supported charities, must be organized and operated:

• Exclusively for religious, charitable, scientific, testing for public safety, literary or educational purposes, to foster national or international amateur sports competition or for the prevention of cruelty to children or animals;

• No part of the organization’s earnings must inure to the benefit of any private shareholder or individual; and

• No substantial part of the organization’s activities must consist of lobbying, either for a particular candidate for public office or for legislation.

Family foundations generally are classified as private foundations under the Internal Revenue Code because most, if not all, of the organization’s financial resources come from the family itself rather than from public gifts, grants, membership fees or other sources of public support. Since such private foundations are managed by the family members with little or no public oversight, to achieve tax exempt status, the Internal Revenue Code requires the foundation’s organizational documents to contain language requiring it to distribute certain amounts of its income each year for charitable purposes and which prohibit the foundation from engaging in certain activities, including self-dealing with related parties, retaining excess business holdings, making certain prohibited investments and certain proscribed expenditures.

Family foundations fall within two (2) categories for tax compliance purposes, namely, operating and non-operating foundations.

Most family foundations are non-operating foundations. Generally, they are created and funded by a small group of donors within the family and do not directly engage in any independent charitable activities, but rather make grants to public charities. Non-operating family foundations are formed for a number of purposes, including:

• Formation of a permanent entity to facilitate lifetime and testamentary gift giving by the family for many future generations.

• Facilitation of the education of successive younger generations in the philanthropic goals of the founders by including them as managers of the organization and involving them in periodic discussions concerning appropriate recipients of grants.

• Creation of a perpetual fund as a “monument” to the memory of the founders.

• Control of annual contributions, investments and accumulations of organization funds for future charitable projects while obtaining current income tax benefits.

• Promotion of planning flexibility if the family’s philanthropic goals change over succeeding generations.

Private operating foundations utilize contributed assets for directed activities in many respects similar to public charities. Often a family foundation begins as a non-operating foundation, but evolves into an operating foundation by directly performing the functions of a public charity rather than merely directing grants to public charities. Private operating foundations are given certain advantages over non-operating private foundations such as relaxation of the annual requirement of distributions to public charities and less restrictive limitations on the deductibility of contributions by donors for federal income tax purposes. In order to satisfy the Internal Revenue Code requirements for private operating foundation status, the foundation must utilize virtually all of its annual revenue in the active conduct of its charitable purposes and one (1) of three (3) other tests must be satisfied requiring devotion of the organization’s assets, endowments and support directly to its exempt purposes.

3. What Are The Tax Benefits of a Private Family Foundation.

Contributions to a private family foundation are deductible for both gift and estate tax purposes.

Contributions to private family foundations also are deductible for income tax purposes, depending upon the type of property contributed and the donor’s “contribution base” (the donor’s adjusted gross income with certain adjustments). For example, cash and non-appreciated property contributed to private non-operating foundations are limited to the donor’s adjusted basis and to 30% of the donor’s contribution base. Contributions of long-term capital gain property to private non-operating foundations are deductible at the donor’s adjusted basis but subject to a limit of 20% of the donor’s contribution base. Deductions for contributions of qualified appreciated stock to private non-operating foundations are made at fair market value, subject to a 20% contribution base limitation. Contributions of ordinary income or short-term capital gain property to private non-operating foundations are limited to the contributor’s adjusted basis and 30% of his contribution base. Contributions of tangible personal property to a private non-operating foundation are limited to the donor’s adjusted basis and 20% of the donor’s contribution base.

Donors may carry over charitable contributions to the next five (5) tax years to the extent contributions exceed a donor’s contribution base.

Charitable contributions, as itemized deductions, also are subject to partial dilution for high bracket income taxpayers.

Contributions to private family foundations are subject to all of the same substantiation requirements applicable to contributions to public charities. Cash gifts must be substantiated through cancelled checks or receipts. Contributions of assets which are not cash or publicly traded securities worth more than $5,000 must be substantiated through a qualified appraisal.

4. The Role of the Foundation.

A Private Family Foundation (PFF) is a separate entity, privately funded by you. It is created with the specific purpose of contributing to various charitable causes that you choose.

As a distinct legal entity, the Private Family Foundation:

1) Allows you to contribute to a charitable cause and take a tax deduction, while relinquishing personal control over your gift.

2) Can be combined with a Charitable Trust to create a cash flow for you.

3) Minimizes or reduces your estate tax liability.

4) Avoids capital gains tax on the sale of appreciated property contributed to your Family Foundation or Charitable Trust.

5) Provides continuing employment and activity for your family members.

6) Identifies and preserves your family name for years to come.

7) Protect assets from creditors.

5. Create and Control Your PFF.

Any Private Family Foundation must be created with a charitable “intent.” The Foundation is managed by a trustee or executive director that oversees the Foundation’s investments and distributes the Foundation’s assets.

You can even appoint yourself as the trustee of your own Foundation. This way, you maintain control over the assets contained in the Foundation. Instead of making a one-time gift to a public charity (and losing control of that gift), you can monitor your favorite charities. If one non-profit changes its focus, or if a more meaningful cause comes along, you can reallocate your Foundation’s support.

6. Special Tax Advantages.

Private Family Foundations have special tax advantages, because they are considered “charitable organizations” themselves. Because of this classification, any earnings on Foundation assets are tax-exempt, and can be distributed to the charities you choose.
If established properly, a Private Family Foundation can often avoid capital gains taxes on highly-appreciated assets (see below). In addition, interest and investment earnings that are not hit with an income tax can instead be used to help the charities or causes you support.

7. Immediate Tax Benefits for You.

If you have highly-appreciated assets that you’re holding to avoid steep capital gains taxes, a Private Family Foundation could help. Any appreciated assets that you transfer to a Private Family Foundation can be sold by the Foundation with no capital gains taxes. This is because of the Foundation’s charitable status.

Second, you can get an immediate tax deduction for any money or property you gift to the Foundation. This deduction can equal up to 30% of your adjusted gross income (20% for appreciated property). Any income tax deduction not used in your contribution year may be carried forward over the next five (5) years.

The valuation of these deductions depends on a number of things, including original cost and the type of property being transferred. Combining the Private Family Foundation with a Charitable Trust for your lifetime benefit, can generate a fixed cash to you for the rest of your life. Combining a Charitable Trust with life insurance can create even more tax and economic benefits including serving as a pension plan substitute or compliment.

8. Estate Tax Benefits.

Every dollar that you contribute to your Private Family Foundation means one less dollar that is included in your estate. Gifts that are regularly made to charities can instead be used to fund your Private Family Foundation. And if you are in a higher tax bracket, that could ultimately save up to 45% in estate taxes.

Best of all, you can make such contributions to a Private Family Foundation without affecting the $14,000 annual gift tax exclusion (2016) or the current $5.45 million Gift Tax Exemption ($10.9 million for a married couple).

9. Required Distributions to Charities.

Private Family Foundations have certain laws they must abide by, because they are a legal entity. For instance, by law, a Private Family Foundation must distribute at least five percent (5%) of its assets each year to public charities.

Let’s suppose you contribute $2,000,000 to your Private Family Foundation. The IRS says you must distribute at least $100,000 (or 5%) to recognized charities in order for the Foundation to qualify for its special tax advantages. Of course, you can select a higher payout if you choose. But five percent (5%) is the absolute minimum.

The annual payout is established when you first sit down with this office. The difference between what the assets earn (e.g. 6% per year) and the mandatory payout can be put back into the Foundation.

10. Employment for the Family.

You may arrange for your heirs and descendants to receive salaries as “employees” of your Foundation. Simply name family members as replacement trustees to succeed you after death or resignation.

Many Foundations pay their directors using the difference between their required distributions and their annual income. If your Foundation is earning 10% annually on its assets, but only paying 5% annually to charities, the difference can be distributed for legitimate expenses, including salaries for the directors of the Foundation.

11. Ensuring Children Do Not Lose Out.

While charities will definitely benefit from your Foundation, your children are deprived of the donated assets, after estate taxes are accounted for. To remedy this situation, some individuals also choose to establish a generation-skipping dynasty trust to avoid estate taxes for up to three (3) generations.

Such a Trust also acts as a shield for assets (subject to variations in state law). When properly drafted and implemented, the Dynasty Trust can also help place assets outside your estate, outside the reach of creditors, judgments, malpractice and divorce.

The Dynasty Trust can also provide a substantial benefit for your heirs, particularly through the use of cash-rich life insurance. After funding The Dynasty Trust with annual gifts, it can purchase insurance payable to your heirs (as beneficiaries of The Dynasty Trust). The children would then receive a lump-sum when you pass away, or you could have The Dynasty Trust support grandchildren (or even great-grandchildren). All of these benefits are usually 100% estate tax- and income tax-free if structured properly.

12. Foundations and Charitable Trusts.

Private Family Foundations can also be combined with what are called Charitable Remainder and Charitable Lead Trusts. By doing so, you may able to draw a significant income for your lifetimes and earn significant tax savings, while still maintaining a large degree of control of your assets.

13. Drawbacks.

As with any estate planning strategy, there are drawbacks. There are up-front legal costs. It usually costs $20,000-$30,000 to create and implement the Private Family Foundation.

Your Private Family Foundation must also be legitimate, like a real business. You must keep books and records to show how you arrived at your decisions, and establish strict rules prohibiting self-dealing. Salaries must be earned, with enough documentation to show that work was actually performed. Your CPA can assist you there.

There are also potential excise taxes, and significant penalties if the minimum 5% annual distribution is not adhered to. Nonetheless, after seeking professional tax advice, you may be able to meet your objectives through your own Private Family Foundation.

14. Starting a Foundation: Summary of Advantages and Disadvantages.

a. Advantages of Starting a Foundation.

1) Effective Philanthropy. The foundation vehicle may facilitate organized, systematic, and targeted giving.

2) Expanded Giving Opportunities. Individuals may not claim charitable deductions for grants made to other individuals, foreign nonprofit organizations, or non-charitable organizations. An individual, however, may achieve these expanded giving objectives by first making tax-deductible donations to a family foundation which may then in turn, once certain IRS procedures are followed, make such grants.

3) Deductibility Plus Control. Donors may make tax-deductible donations to their own family foundation and still, as foundation trustees, remain in control of the investment and management of the funds as well the final charitable disposition of the gifts.

4) Sheltered Income Plus Control. Foundation investment income, held by the foundation’s trustees, is exempt from taxation (with the exception of the 1-2% excise tax described below).

5) Consistency in Giving. Under normal circumstances, foundations may accumulate and hold a portion of their funds. Foundations may also choose if and when to distribute such accumulated funds (or the income earned on accumulations). Thus, even though yearly contributions to the foundation may vary, giving levels are able to remain constant. Such consistency may be particularly helpful to grantees that rely on level funding from year to year.

6) Payment of Reasonable Compensation. Under normal circumstances, family members and others may receive reasonable compensation from the foundation in return for services rendered.

7) Reimbursement of Travel and Other Expenses. Reasonable and direct costs of site visits and board meetings may be paid by the foundation to family members, employees, and trustees.

8) Double Capital Gains Tax Benefits. First, no capital gain is realized when appreciated property is donated to a foundation. Second, donors may claim a charitable deduction for the full market value of appreciated stock held in publicly traded companies.

9) Estate Tax Reduction. Assets transferred to family foundations are generally not subject to estate taxes. This may provide triple tax savings when combined with the benefits above.

10) Public and Community Relations. If desired, foundation grantmaking may bring recognition to family members.

11) Privacy Concerns. On the other hand, individuals who are already subject to continuous fundraising appeals and interruptions at home and work may wish to increase their privacy by referring all such inquiries to the family foundation.

b. Disadvantages of Starting a Foundation.

1) Initial Time Commitment and Costs, including legal and accounting fees.

2) Excise Tax. Private foundations are subject to a 1-2% annual excise tax on net income depending on the level of grantmaking from year to year. The tax, ostensibly, defrays the costs incurred by the government in regulating private foundations.

3) Recordkeeping Requirements. At a minimum, family foundations should properly document grants and keep regular meeting minutes, which for small foundations may require an investment of 2-6 hours per grantmaking cycle.

4) Regulatory Requirements. There are two (2) main classes of tax-exempt charitable organizations: public charities (funded by a variety of public sources) and private foundations (privately funded or endowed). Private foundations are required to distribute at least 5% of their net investment assets annually in the form of charitable grants and are subject to tighter scrutiny than public charities.

5) Annual Reporting Requirements. Tax filings required by the IRS and most states typically require 4-8 hours to complete each year by an accountant or attorney.

6) Lower Deductibility Caps. Individuals may receive tax deductions for donations to public charities to the extent of 50% of their adjusted gross income (AGI) for cash gifts and 30% of AGI for gifts of appreciated property. For gifts to private foundations, however, the limits are 30% of AGI for cash gifts and 20% of AGI for appreciated property.

7) Less Favorable Treatment of Some Capital Gain Gifts. Gifts to public charities of appreciated property are deductible at fair market value. To private foundations, gifts of appreciated property are deductible on a cost basis only (with the exception of publicly traded stock which is deductible at fair market value).

15. Creating the Family Foundation.

a. Introduction.

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, we 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 Guide 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 helps us 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 (1) or more charitable activities), supporting organizations (organized and operated to support one (1) 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 is 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 Guide describes the major considerations in the planning, creation, and operation of private non-operating foundations.

b. 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 (1) 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 (1) of the four (4) types of organizations described above, then it is a private foundation. Private foundations themselves can be divided into two (2) 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 Guide.

c. 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.)

d. 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.

e. 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 Guide, 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.

f. 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 (5) 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.

g. 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:

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

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

• Furnishing 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);

• Payment 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);

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

• Agreement 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 (1) foundation manager is liable under this Section, such persons are jointly and severally liable.

h. 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.

i. 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 (5) 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.

j. 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.

k. 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 www.irs.gov), (3) review the grantee’s current Form 990, Schedule A, Part IV, to review its proof of non-private 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.

l. 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 (5) 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 (5) years. But there is an exception to the 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 made to 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 showing that the foundation made the appropriate qualifying distributions. Pass-through treatment of a foundation 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.

m. 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 (1) 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.

1. Get an Immediate Tax Deduction, but Give Later: You get the tax deduction when the foundation is funded, then make your charitable gifts over time.

2. Leave a Lasting Legacy: Foundations set up in perpetuity can burnish your name far beyond your lifetime. Because gifts are made from an endowment that generates investment revenue, the total gifts made by the foundation can far surpass the actual funding.

3. Be Taken More Seriously as a Philanthropist: A foundation imparts a gravitas that causes people to take your philanthropy more seriously, due to the structured, organized approach you employ for your giving.

4. Sidestep Unsolicited Requests: When you focus your foundation on specific giving areas, your mission statement can be used to politely turn down off-target funding requests.

5. Deepen and Focus Your Philanthropy: Whereas individual donors often spread their giving among as many causes as possible, the formalized structure of a foundation often encourages donors to narrow their focus to specific causes.

6. Build a Better Family: As family members take on philanthropic research, present their findings to the board, participate in the decision-making process, and track results, they hone skills that will serve them for years to come.

7. Tax-Deductible Grants to Individuals in Need: A private foundation allows you to provide emergency assistance directly to individuals using dollars for which you’ve already received a tax deduction.

8. Run Charitable Programs Without Setting Up a Separate Nonprofit: Direct charitable activities are IRS-approved programs that permit foundations to directly fund and carry out their own projects.

9. Pay Charitable Expenses: All legitimate and reasonable expenses incurred in carrying out the foundation’s charitable mission can be paid by the foundation and will count toward the annual minimum distribution requirement.

10. Provide Loans Instead of Grants: When used to support a charitable purpose, private foundations can employ loans, loan guarantees, and even equity investments, which are paid back (potentially with interest), so you can recycle your philanthropic capital for other charitable causes.

16. How do I Form a Private Family Foundation?

Private family foundations may be structured either as trusts or as non-profit corporations. In recent years, most foundations have been formed as non-profit corporations because corporations provide greater flexibility and ease of amendment in response to future changes in circumstances, greater flexibility for delegation of management responsibilities and protection from personal liability of foundation managers.

The initial step is the execution and filing with the California Secretary of State of the Articles of Incorporation and associated documents. A copy, certified by the Secretary of State, is then filed with the parish of the non-profit corporation’s registered office.

The initial meeting of the incorporator and initial board of directors is evidenced by appropriate corporate minutes adopting by-laws and authorizing the opening of a bank account in the name of the organization.

An application for a tax identification number is applied for with the Internal Revenue Service (“IRS”) and, shortly thereafter, an application for recognition of the tax exemption of the organization under Internal Revenue Code Section 501(c)(3) is filed with IRS on Form 1023 and associated forms. Additionally, Form 8718 must be filed with IRS along with the payment of a user fee. IRS Form 1023 requires a projection of revenue and expenses of the organization for a four (4) year period and, consequently, you may need the assistance of your accountant. If Form 1023 is filed with IRS within fifteen months of the date the foundation is organized, IRS will grant tax exempt status to the organization retroactive to its date of formation, thereby protecting the deductibility of contributions to the organization during the interim period.

17. What Must I do to Properly Operate the Foundation?

Family foundations should maintain separate bank accounts, books and records, including minutes of meetings of its members and board of directors, in order to assure that the non-profit corporate form is respected for all legal purposes, including insulation of its members and directors from personal liability.

It may be appropriate to develop a written policy and procedure for the making of grants to public charities, setting forth the types of philanthropic objectives that are desirable, appropriate charitable recipients and monetary levels for grants.

The foundation should create an established procedure for providing each donor with a letter when contributions are made, acknowledging receipt by the foundation of the contribution, confirming its value and the fact that it was or was not part of a payment to the foundation for any goods or services provided to the donor.

Each year, the foundation is required to file with IRS Form 990-PF on or before the 15th day of the 5th month following the close of its fiscal year.

The Internal Revenue Code requires that the foundation make IRS Form 990-PF available for inspection at the foundation’s principal office during regular business hours or give a free copy to anyone who requests it. Furthermore, the foundation must publish a notice in the newspaper of general circulation in the parish in which the principal office of the foundation is located stating that the return is available and providing the address and telephone number of the principal office and the name of the foundation’s manager. Such notice must be published by the due date for filing the annual return with IRS, including any extensions, and a copy of the notice must be attached to IRS Form 990-PF when it is filed.

Additionally, the foundation may be required to file normal payroll tax withholding and reporting forms if it has employees and pays wages.

The operations of the foundation can give rise to certain penalty excise taxes.

(a) Tax on Investment Income. Internal Revenue Code Section 4940 levies a tax equal to 2% of a private foundation’s net investment income, including interest, dividends, capital gains, rents and royalties, reduced by applicable expenses. The tax may be reduced to 1% if the foundation spends enough of its resources for charitable purposes. Quarterly estimated tax payments must be made by the foundation if this tax equals or exceeds $500 a year.

(b) Self-Dealing. Internal Revenue Code Section 4941 levies a penalty tax on certain self-dealing transactions with disqualified persons, including substantial contributors, foundation officers or directors, controlling persons, family members of any of the foregoing or other entities controlled by any of the foregoing. Certain transactions are exempt from the self-dealing rules such as the payment of reasonable compensation and reimbursement of reasonable expenses to foundation managers and directors. A tax of 10% of the amount of the transaction involved is imposed on the disqualified person and a tax of 5% of the amount of the transaction is imposed on the applicable foundation manager involved. Once the tax is imposed, if the transaction is not quickly corrected, additional penalty taxes at the rate of 200% are imposed on the disqualified person and 50% on the foundation manager. Continued non-compliance could result in loss of the foundation’s exempt status. Self-dealing transactions can involve virtually any type of commercial transaction between a disqualified person and the foundation, including sales, leases, loans and the furnishing of goods, services or facilities, even if on an arms length, fair market value basis.

(c) Failure to Distribute Income. Internal Revenue Code Section 4942 requires non-operating private foundations to make qualifying charitable distributions each year of at least 5% of the foundation’s net assets that are not used directly in the operation of its own charitable activities. Failure to distribute the appropriate 5% minimum amount will result in a tax of 30% of that amount. Once again, after the initial tax is imposed, the penalty will increase to 100% of the undistributed amount if the error is not corrected promptly.

(d) Excess Business Holdings. Internal Revenue Code Section 4943 prohibits a private foundation and its disqualified persons from holding more than 20% of the stock, partnership interests or trust interests in any active business. Failure to comply will result in an excise tax equal to 10% of such total business holdings, which will increase to 200% if the excess holdings are not disposed of promptly. If a third party other than the foundation and its disqualified persons controls the business enterprise, then the percentage of permissible ownership is increased from to 20 % to 35%. This particular penalty tax should be carefully monitored since it can be triggered inadvertently by provisions in Wills of family members. Fortunately, Internal Revenue Code Section 4943 permits the foundation to escape the tax by disposing of the excess business holdings within prescribed time periods.

(e) Investments Jeopardizing Charitable Purposes. Internal Revenue Code Section 4944 levies a 10% tax on the foundation and a 10% tax on a foundation manager for any investment that jeopardizes the foundation’s charitable purpose, if there is a failure to exercise ordinary business care and prudence under the facts and circumstances prevailing at the time of the investment. If the problem is not promptly corrected, an additional 25% tax is imposed on the foundation and an additional 5% tax on the foundation manager.

(f) Taxable Expenditures. Internal Revenue Code Section 4945 prohibits certain activities of a foundation that promote the contributor’s interests rather than the interest of the public. The tax is 20% imposed on the foundation and 5% on the foundation manager on each such taxable expenditure. If not corrected in the appropriate period of time, an additional tax of 100% is imposed on the foundation and 50% on the manager. Such expenditures include prohibited political activities, such as attempts to influence a political election, to influence legislation, or making grants to private individuals (unless the foundation uses objective and non-discriminatory procedures that have been approved in advance by IRS), making grants to entities other than public charities (unless the foundation exercises expenditure responsibility over the grants), and making grants for non-charitable purposes.

The foundation and its managers should seek our advice before entering any transaction which might constitute self-dealing or before making any investments which could jeopardize its charitable purpose, result in a taxable expenditure or otherwise expose the foundation or its managers to penalty taxes.

18. What are Some of the Income and Estate Tax Planning Uses of Private Family Foundations?

As previously discussed, there are three (3) possible beneficiaries of your wealth – your family, charities or the IRS. If you plan to sell your business, the IRS may take 20 – 40% of your profit. When you die, the IRS can take 55% or more of your accumulated wealth. Instead of naming the IRS as your favorite charity, you can create your own family foundation and reap substantial tax and non-tax benefits.

(a) Direct Bequests. Beginning in 2013, unless Congress changes the laws, Federal estate taxes will, once again, range from 37% – 60%, depending upon the size of your estate. Certain assets, such as IRA’s, U. S. savings bonds, and annuities, also may be subject to income taxes upon death, raising the total tax burden to 70% or more. If you leave assets to your family foundation, your family will avoid both estate and income taxes, retain control over the investment of the funds and will be able to trickle out distributions for favorite charitable activities for many years to come.

(b) Retirement Plan Contingent Beneficiaries. A family foundation is an excellent choice as a secondary beneficiary to the surviving spouse of the death benefits of qualified retirement plans and IRA. The designation of the surviving spouse as primary beneficiary will defer death tax through the federal estate tax marital deduction for transfers to spouses. The designation of the family foundation by the surviving spouse will eliminate all death and income taxes on the plan death benefits.

(c) Sale of Family Business. Before you enter into a legally binding agreement to sell a family business, you can donate some of your business interest, such as closely-held stock, to your family foundation and generate an income tax charitable deduction. The prospective purchaser can acquire the foundation’s interest, thereby funding your foundation with cash or traded stock free of tax.

(d) Charitable Trusts. Family foundations often are used as the charitable beneficiary of charitable remainder trusts or charitable lead trusts created during lifetime or by Will to save death taxes.

A charitable remainder trust permits you or your designee to retain a stream of income from the property you donate to the trust for a number of years or for your life. When the trust terminates, the trust assets (and any growth) are transferred to the family foundation. The charitable remainder trust is tax-exempt. You are entitled to a charitable income tax deduction for your contributions to the trust based upon the actuarial value of the interest ultimately passing to the family foundation.

In a charitable lead trust, the family foundation can receive the income (instead of the principal) for a term of years. When the trust terminates, the trust assets (and any growth) passes to family members, such as children or grandchildren. This technique allows you to discount the value of the property ultimately passing to your family for gift and estate tax purposes based upon the actuarial value of the foundation’s income interest. This approach is particularly suited to discounting the death tax value of the remainder interest in favor of grandchildren within the applicable lifetime exemption from the tax on generation skipping transfers.

19. Conclusion.

You do not have to be a Bill Gates to take advantage of a family foundation. In addition to tax savings, the family foundation can provide you and your family with a wonderful vehicle to engage in charitable pursuits while maintaining control and flexibility over your charitable endeavors.

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