16. Private Foundations and Donor Advised Funds, Part 2 of 3

16. Private Foundations and Donor Advised Funds, Part 2 of 3

Article posted in General on 14 September 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 15 September 2016

An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

16. Private Foundations and Donor Advised Funds, Part 2 of 3

Links to previous sections of book are found at the end of each section.

Once a private foundation has been successfully created, the primary guidelines for its operation come from federal tax law.  Tax law affects private foundations indirectly, through the deductibility of gifts, and directly, through taxation of investment income and levying of penalties for violations of IRS rules.

Unlike other charitable entities, private foundations do pay taxes on net investment income and capital gains.  However, this tax is relatively minimal, typically charged at the 2% rate.  This 2% rate will drop to 1% if the foundation distributes charitable grants at least equal to its assets multiplied by its average percentage payout for the last five years (or less if the foundation is not that old) plus 1% of its net investment income.  For a private foundation intending to distribute the same percentage of assets in charitable grants as it had done over the previous five years, this rule means that the payment of 1% of net investment income can go either to the IRS (by payment of the full 2% standard excise tax) or to a public charity (thus reducing the IRS excise tax by 1% of net investment income).  Although private foundations are not completely tax exempt, the burden of a 1% or 2% tax is relatively minimal.

This tax is paid on net investment income and net capital gains.  However, the tax is not paid on any unrelated business income, which is taxed at different rates.  Net investment income allows for the reduction of gross investment income by any ordinary and necessary expenses incurred in generating the income (such as investment management fees, real estate management fees, or the share of officer or employee compensation related to investment and investment management).
As discussed in the chapter on that topic, gifts to private foundations have lower income limitations for charitable deductions than do gifts to public charities.  The highest (50%) limitation is never available for deductions from gifts to private foundations, which are instead limited to 30% or 20% of adjusted gross income (slightly modified) for individual taxpayers, and 10% of taxable income for corporations.  Any deductions from charitable gifts in excess of the maximum percentage of the donor’s income cannot be deducted in the year of the gift, but must instead be carried forward until such time as they can be used without causing the total deductions to exceed the relevant limitation.  Carryover deductions that cannot be used in the five tax years following the year of the gift will expire.
As discussed in a previous chapter, gifts that may be deducted up to 50% of income are all gifts to public charities.
Gifts to private foundations of cash, inventory, short-term capital gain or ordinary income may be deducted up to 30% of the donor’s income, with the remainder carried forward.
Any gifts of long-term capital gain to a private foundation may be deducted only up to 20% of the donor’s income, with the rest carried forward into future years.  This is true regardless of whether or not the gift can be valued at fair market value or the lower of basis or fair market value. 
The underlying reason for many of the tax rules for private foundations is the desire to insure that the foundations appropriately pursue a charitable purpose and do not use their resources to provide inappropriate benefits to insiders.  Prior to the passage of these rules many private foundations were used in such a way as to provide excessive benefit to those who created and operated the foundations.
Private foundations receive highly favorable tax treatment for the purpose of encouraging charitable activity.  The rules designed to prevent insider benefits and insure that the charitable purposes are being accomplished fall into the five categories of (1) self-dealing, (2) failure to distribute income, (3) excess business holding, (4) jeopardizing investments, and (5) taxable expenditures.
A range of penalties can arise for violating these tax rules, from an initial tax to additional taxes if the violation is not corrected to revocation of the exempt status of the foundation.  Previous to this legislation the only penalty was revocation of the tax exempt status.  Due to the harshness of the penalty, it was rarely enforced, leading to the need for the current system allowing for intermediate penalties.
As mentioned above, a wide range of rules protects against giving excess benefits to insiders.  Enforcement of these rules requires a definition for who is and who is not an insider.  The tax code uses the term “disqualified person” to designate a foundation insider.

The definition of a disqualified person is, in most respects, extraordinarily broad.  Naturally, the people running the foundation are insiders.  This includes officers, directors, and trustees of the foundation.  However, it can also include any employee of the foundation if the employee has responsibility for the act under consideration as a potential violation of the rules.  In addition to those who run the foundation, those who create or significantly support the foundation are also insiders.  The original founder (grantor) of a charitable trust is automatically an insider regardless of whether or not he or she is a substantial donor.  Additionally, any donor who has given more than 2% of the total contributions ever given to the foundation is also an insider (assuming that the donor’s contributions are greater than $5,000 in total).

The designation of “disqualified person” applies not only to these donors or managers, but also to all of their ancestors, descendants, spouses, or spouses of descendants.  Curiously, this definition – although broad reaching – does not include the siblings of insiders.  Additionally, organizations significantly controlled by disqualified persons are also disqualified persons.  Specifically, any corporation, trust, or partnership that is owned or controlled 35% or more by all disqualified persons combined is also a disqualified person.  For example if a corporation is owned 10% by the founding donor’s grandson, 10% by the founding donor’s grandson’s wife and 15% by the mother of an unrelated foundation trustee, then the corporation is itself a disqualified person.

This first set of rules designed to limit insider benefits is a prohibition against self-dealing.  Self-dealing rules prohibit most transactions between the private foundation and a disqualified person.

Self-dealing rules prohibit the private foundation from selling, exchanging, leasing, transferring or loaning money, goods, services, property or facilities to a disqualified person.  Correspondingly, they also prohibit disqualified persons from selling, exchanging, leasing, transferring or loaning money, goods, services, property or facilities to the private foundation except when this occurs as a free gift.  Rather than investigating the propriety of each individual transaction with disqualified persons, this rule simply prohibits all of them.

Prior legislation permitted self-dealing transactions if they were completed under reasonable terms comparable to an “arm’s length” transaction.  However, this previous rule made enforcement difficult and permitted substantial benefits to insiders.  For example, a private foundation might purchase property from an insider for fair market value, but provide benefit by offering the insider a source for an immediate sale, whereas selling in the market could require much time.  Or, a private foundation might offer a loan to an insider at market interest rates, but during a time when financial liquidity was tight and other sources of credit were unavailable.  None of these transactions are permitted under the current rules, because their relative benefit to the foundation is now irrelevant.  All such transactions are simply prohibited.

In addition to the prohibition against transactions with disqualified persons, this section also prohibits transactions with government officials – primarily those with a policymaking role.  This rule relates to the core idea that private foundations should not be used for political purposes.  Further, an insider could benefit through gaining political influence by using the foundation to influence government officials.
These transactions with disqualified persons are categorically prohibited and this prohibition does not depend upon the relative benefit given to the foundation.  For example, a donor could sell a $200,000 property to a public charity for $10,000.  Under the bargain sale rules, this would generate a $190,000 deductible charitable gift.  However, if the donor completed the identical transaction with a private foundation for which the donor was a disqualified person the transaction would be a prohibited act of self-dealing.  The fact that the private foundation received a $190,000 benefit is irrelevant; the exchange is still prohibited.
In an attempt to circumvent this rule against bargain sales, a disqualified person might be tempted to simply take out a mortgage, take the money, and then donate both the property and the mortgage to the private foundation.  However, the private foundation’s acceptance of the debt incurred by the insider is considered to be a benefit to the insider and, consequently, the transaction is prohibited.  As before, this is true regardless of how beneficial the transaction is to the private foundation.  Even if the mortgage is less than, say, 10% of the value of the property donated, it is still a prohibited act of self-dealing.  This rule has one exception which permits the private foundation to accept a property that an insider has encumbered with debt if the debt is at least ten years old.
Self-dealing transactions generate a 10% penalty for the disqualified person and an additional 5% penalty for the foundation manager who knowingly participates in such a transaction.  (Given the broad definition for disqualified persons, it is possible, for example, that the foundation manager was unaware that the person was a disqualified person.)  In addition to this penalty, the transaction must be undone.  This correction is required within 90 days of the IRS notice, otherwise the foundation is subject to an additional tax of 200% of the transaction amount, and the foundation manager is subject to an additional tax of 50% of the transaction amount.  An excessive degree of self-dealing could, in extreme cases, also lead to the removal of the foundation’s tax exempt status.
Despite this blanket prohibition on transactions with insiders, the rules do permit some exceptions.  These permitted transactions include, obviously, the ability of disqualified persons to make gifts to the foundation.  Thus free gifts (e.g., not bargain sales or debt-encumbered property) of money, property, or the use of money or property are allowed.  However, these gifts cannot require the foundation to make any payments back to a disqualified person.  For example, a disqualified person cannot give free rent of office space to the charity with the requirement that the foundation must pay the disqualified person for utilities, insurance, or maintenance.  A gift of free rent is allowed if such payments are not made to the disqualified person, but are instead made to an outside utility company, insurance company, or maintenance company.
Despite this prohibition on self-dealing, some transactions with benefit to insiders are specifically allowed.  In particular, a foundation can hire an insider to perform necessary professional and managerial services so long as the compensation is reasonable.  The official term for these permitted services is “personal services,” and it includes investment advice, legal services, accounting, tax services, banking, and administrative assistance.  This does not include non-professional or non-managerial services such as janitorial work.  The compensation for such services must be reasonable.  In order to assist foundation managers in knowing and demonstrating what compensation is reasonable, The Council on Foundations publishes the Foundation Management Report giving compensation information for a variety of positions for foundations of different sizes.  So long as the payments to insiders are for services necessary for the operation of the charity and fall within these reasonable guidelines, the foundation is allowed to hire these disqualified persons.
In addition to the ability of the foundation to hire and pay reasonable compensation to disqualified persons for necessary professional and managerial services, the foundation may also reimburse the reasonable travel expenses of insiders necessary for the operation of the foundation.  For example, reimbursing travel and meal costs for board members to attend a board meeting of the foundation is a commonly accepted foundation expenditure.  The foundation may not reimburse expenses for other family members to travel when those family members are not a necessary part of the foundation’s activities.  So, the travel expenses of a board member’s spouse may not be reimbursed unless the spouse is also a board member (or is filling some other necessary function for the foundation).  As discussed previously, a private foundation may have a junior board, including minors, which is allowed to make recommendations for grants and gradually learn about foundation management in potential preparation for a future appointment to the regular board.  The use of such boards can make the travel of minor children to board meetings a reasonable and necessary expense.  In addition to travel to board meetings, travel to investigate current or potential grant recipients is also a commonly accepted activity, and thus reimbursement of reasonable expenses are also appropriate.  Some founders have employed these travel reimbursements for necessary board functions as a way to pay for family gatherings in attractive locations.

A wealthy donor may choose to ignore sophisticated planning and simply leave the estate to his or her children (perhaps with some donation to charity).  This type of traditional inheritance typically results in dissipation of the family’s wealth.  The wealth is dissipated first by division among heirs at each generation, leaving smaller and smaller separate amounts.  Additionally, the wealth is subject to 40% estate taxes at every generation, further reducing remaining wealth.  Beyond this, investment returns in the intervening years are subject to constant annual taxation.  All of this dissipation by division and taxation occurs even if every heir in every generation is completely responsible and consumes none of the original inheritance.  The likelihood of a spendthrift heir – or one who is attracted to highly risky investments – dramatically increases the likelihood of rapid dissipation.  (One national U.S. study showed that 1/3 of all heirs receiving inheritances spend their entire inheritance within a few months.  In addition, among all heirs, about half of the typical inheritance has been spent within 12 months.  See Zagorsky, J.  L.  (2012).  Do people save or spend their inheritances?  Understanding what happens to inherited wealth.  Journal of Family and Economic Issues.)  The typical pattern of family wealth accumulation and dissipation has generated such common descriptions as “from shirtsleeves to shirtsleeves in three generations,” to reflect its temporary nature.

In contrast, a private foundation can provide an excellent means to keep the family’s wealth completely intact across many generations and still provide some attractive benefits to heirs.  The use of the family foundation means that there is no dissipation by division at each generation, no estate taxes at each generation, no annual taxes on earning and gains (beyond the 1% or 2% excise tax), and no temptation for spendthrift heirs to benefit themselves by consuming all of the assets.  Even excessively risky investments are prohibited by tax law.  Although some transfers (discussed below) must be made to charitable organizations, these are typically less than the investment income generated by the foundation’s assets.  Heirs who are involved with the work of the foundation have the benefit of employment (assuming some professional or managerial skills) and travel.  Additionally, those controlling significant distribution decisions often enjoy the less documented benefits of this financial power.  Managers of recipient nonprofits may be more than happy to provide favors in order to build good relationships with those who make substantial funding decisions.  Although such favors cannot be direct transfers to disqualified persons, the ability to subtly influence organizational decisions (including hiring decisions) of recipient nonprofit organizations may be indirectly valuable.

The private foundation offers a means by which a donor’s wealth can remain intact, and growing, for indefinite generations serving only the causes the donor has selected and benefitting subsequent generations of managing heirs both directly and indirectly.  The donor’s financial managers can also benefit substantially by keeping the wealth intact, undivided, and largely untaxed across generations.
Private foundations are, of course, charitable entities.  These entities do not engage in charitable activities directly; i.e., these are non-operating private foundations.  The charitable nature of a private foundation depends entirely upon its distributions to operating charities.  Consequently, a private foundation is required to make a minimum amount of distributions (i.e., gifts or grants) to public charities. 
A private foundation is required to distribute at least 5% of all non-charitable net assets (i.e., investment assets) under its control at the end of the tax year.  This distribution must be made by the end of the following tax year.  Violating this requirement to make charitable distributions is sometimes referred to as a failure to distribute income, although the required distributable amount is based entirely upon the foundation’s non-charitable assets.  (The term comes from previous legislation when distributions were based, in part, upon income.)
The value of non-charitable net assets is reduced by any debt used by the foundation to purchase investment assets.  These assets do not include charitable assets, i.e., assets being used in a charitable operation such as a painting being loaned without charge to a public charity art museum.  This charitable exclusion also excludes assets being used by the foundation to carry out its own exempt purposes, but not those being used by the foundation for investment management purposes.  (This distinction would require a foundation that owns the building in which it operates to allocate the value between charitable and other functions.)  Non-charitable net assets exclude assets that, even though they are booked as assets, are not yet under the control of the foundation such as pledges to make a gift or a remainder interest in real estate.
The 5% required distributable amount is reduced by the taxes paid to the government either as the 1% or 2% net investment income tax or any unrelated business income tax paid by the foundation.  There is, however, no reduction in the required distributable amount due to penalty taxes paid for violating any of the private foundation rules discussed in this chapter.  (Note that the 2% net investment income tax would not lower the 5% minimum payout to 3%.  The minimum payout is 5% of non-charitable net assets, where the tax is 2% of net investment income.)
The 5% requirement does not mean that the entire 5% (less the unrelated business income tax and net investment income tax) must actually be distributed to charity.  Any reasonable and necessary administrative expenses incurred for grant-making or fundraising are themselves considered to be charitable expenditures.  Thus, the 5% would be reduced by reasonable and necessary expenses for administration costs related to soliciting and evaluating grant applications (such as travel to meet with grant applicants), supervising the use of funds granted (such as travel to review the use of funds), and general administration of the charitable functions of the foundation (such as employee salaries, office rent, utilities, IRS form 990-PF preparation fees, and legal fees related to charitable functions).  These expenses do not include any expenses associated with managing the foundation’s investments.  Due to the reductions for expenses and taxes, the actual amount distributed to public charities may be far less than 5% of non-charitable assets held by the foundation.  The limitation is that these operational expenses must be reasonable and necessary to accomplish the charitable functions of the foundation.

The charity receiving the funds cannot be controlled, either directly or indirectly, by the foundation or by any disqualified persons.  In this case, control means that any combination of disqualified persons could, working together, require or prevent the recipient charity from making an expenditure.  Although disqualified persons may not control the recipient charity, the private foundation is allowed to make a restricted gift which the recipient charity must use for the designated purposes.

It appears (PLR 200009048, 9807030) that the private foundation may also make a qualified distribution to a donor advised fund, even when such fund is advised by disqualified persons.  This would be remarkable in that the funds in a private foundation may thereby presumably be kept indefinitely from actual public charitable use.  In apparent recognition of this potential, the mandatory annual filings for private foundations (IRS Form 990-PF) added the following disclosure requirement in 2011: Did the foundation make a distribution to a donor-advised fund over which the foundation or a disqualified person had advisory privileges? If “Yes,” attach a statement. The statement must report whether the foundation treated the distribution as a qualifying distribution and how the distribution will be used for §170(c)(2) purposes.  In other contexts, a private foundation may not make a qualified distribution to a charitable entity that simply holds and distributes funds to other charities such as to another non-operating private foundation or a supporting organization.

The private foundation need not make transfers only as cash gifts to public charities, but may also purchase or improve assets used directly in charitable purposes.  This could include assets transferred to a public charity, or assets used by the private foundation for charitable purposes.  Thus, the purchase of a building to be used exclusively by the foundation in its charitable purposes (e.g., soliciting and evaluating grant applications and evaluating grant expenditures, but not investment management) is a qualifying distribution.

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