16. Private Foundations and Donor Advised Funds, Part 1 of 3

16. Private Foundations and Donor Advised Funds, Part 1 of 3

Article posted in General on 31 August 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 2 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 1 of 3

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

Some prior chapters covered topics, such as Charitable Gift Annuities, that are of interest mostly to nonprofits and nonprofit fundraisers.  In contrast, private foundations and donor advised funds are more centrally important in the world of financial advisors.  Financial advisors are naturally interested in these structures as they allow for compensated financial management and they contain the bulk of managed private charitable wealth.  Private foundations are, by far, the largest sophisticated charitable planning instrument as measured by total assets and charitable distributions.  Donor advised funds are, by far, the fastest growing charitable planning instrument.  Both structures are covered in the same chapter as both share some common characteristics and, in many circumstances, are potential substitutes for each other.
The core purpose of both private foundations and donor advised funds is to hold wealth and distribute grants to public charities.  They are, essentially, containers for wealth designated – at some point – to benefit charity.  In this chapter, “private foundation” refers to a non-operating private foundation.  The adjective “non-operating” points out that, although contributions to private foundations can generate charitable tax deductions, these organizations do not themselves conduct charitable activities.  They simply hold wealth and distribute grants to charities that actually conduct charitable operations.  Although not common, there are entities known as operating private foundations.  These are more similar in function to regular public charitable organizations, are not typically used as a charitable planning vehicle, and will not be discussed in this chapter.  Another relatively rare entity is called a “supporting organization.”  This entity functions similarly to a private foundation, but typically delivers support to a specific public charity.  With the increased restrictions on supporting organizations brought about by the Pension Protection Act of 2006, these entities are relatively less attractive, less common, and, consequently, will not be covered in this chapter.
In terms of relative size, private foundations are the “Big Kahuna” of charitable planning.  The accompanying chart demonstrates that.  Private foundations hold more than four times the assets and make more than four times the charitable distributions of all Charitable Remainder Trusts, Charitable Lead Trusts, and donor advised funds combined.  Despite the relatively small share of all assets held by donor advised funds (5%), these funds are responsible for an outsized portion of all charitable distributions (14%).  This reflects the frequent use of such funds as a temporary pass-through mechanism, rather than an instrument for long-term wealth holding.  Despite this common short-term use, donor advised funds can also be used for long-term, even multi-generational, holding of wealth. 
Another reason for interest in donor advised funds is their rapid growth.  Donor advised funds have existed since the 1930’s.  Traditionally, they were operated by community foundations as a way to encourage giving that supported the local community.  The dramatic growth in donor advised funds began with the creation of Fidelity Charitable Gift Fund in 1991.  For the first time, this provided a nationally available means for donors to establish low-cost accounts where their financial advisors could continue to manage the funds and collect the associated management fees.  This brought more financial advisors into the charitable planning arena than ever before.  Since then, the dramatic growth in donor advised funds has been driven predominantly by growth in those funds affiliated with financial institutions.  The accompanying chart shows the continued dramatic growth of the three largest financial-institution-affiliated donor advised funds. 
Other charitable planning devices that hold wealth are typically designed to end after a few years or at the death of the donor.  Charitable Gift Annuities, Charitable Remainder Trusts and Charitable Lead Trusts rarely exist much beyond the life of the donor, or perhaps the donor and the donor’s spouse.  Private foundations are different.  These entities are often designed to last indefinitely and many have existed for numerous generations.  In large part, private foundations are intended to be permanent entities.

The permanence of private foundations can make them particularly psychologically attractive to some donors.  A branch of psychology, referred to as terror management theory, rigorously examines the effects of personal mortality reminders.  Among other things, these reminders generate a psychological defense expressed as seeking symbolic immortality.  Symbolic immortality is the idea that something important about one’s self, e.g., one’s name, impact, story, family, culture, community, or values, will live beyond one’s death.  This attraction towards symbolic immortality is particularly important in the context of charitable estate planning, when personal death reminders are particularly strong.  (For a more extensive review of the psychology and neuroscience of charitable estate planning see the book, Inside the Mind of the Bequest Donor: A Visual Presentation of the Neuroscience and Psychology of Effective Planned Giving Communication by Russell James, ISBN 978-1484197837.)

The private foundation provides an ideal charitable structure for achieving this psychologically attractive symbolic immortality.  The foundation typically bears the name of the founder or the founder’s family.  Unlike its mortal founder, the private foundation can live indefinitely.  For generations after the death of the founding donor, the private foundation can continue to carry the founder’s name and will be legally bound by the founder’s values and desires. It is necessarily required to continue impacting the world within the parameters established by the founder.  In this way, the private foundation can serve as a partial substitute for the deceased founder, indefinitely exhibiting to the public the positive and pro-social aspects of his or her character.

This continuation of the founder’s name and ideals is not merely a theoretical idea, but one that can be readily seen in many of today’s most important grant-making foundations.  Although the founders of these famous foundations may have been deceased for many generations, their name and impact continues to this day.  Such symbolic immortality becomes particularly attractive in an estate planning context as the client contemplates his or her personal mortality.
The private foundation’s most attractive feature is its permanence.  Not only can the foundation last indefinitely, but the rules established by the founding donor can also last indefinitely.  Almost all other forms of transfers are subject to rapid dissipation in both finance and purpose.  A wealthy business owner may leave behind an important company bearing his or her name, but the company can quickly change names and reject the values established by the founder.  Leaving an inheritance to heirs is subject both to substantial taxation and to expenditures reflecting values contrary to the decedent’s values.  The private foundation offers a unique vehicle to preserve and protect the founder’s wealth, name, and values. 
Although a private foundation ultimately makes distributions to charitable organizations, it often involves the participation and substantial control of the founder’s family both during and after the founder’s life.  The founder’s family can be appointed to have the power to decide how the money will be invested and who (within the limits of the foundation guidelines) will receive distributions.  In addition to controlling the wealth (largely undiluted by taxation either at transfer or on subsequent growth) within the parameters of the private foundation’s purpose and guidelines, family members can receive benefits such as being reimbursed for their associated travel and expenses as well as being employed for reasonable compensation in some professional and managerial tasks necessary for operation of the foundation.  These tangible benefits come in addition to the intangible social benefits (i.e., “soft power”) that can accrue to those who – within the parameters of foundation rules – control the investment and distribution of large sums of money.
The private foundation can also serve as a way for the founder to transmit his or her values to later generations.  These descendants may be appointed as trustees of the foundation and be given authority to make charitable distributions amongst the causes permitted by the founding donor.  For example, a donor who wanted to pass along his love of nature might limit the charitable purposes to supporting nature organizations.  Administration of such a foundation would likely increase trustees’ involvement with the various related causes and organizations vying for the foundation’s grants.
There are three large classes of charitable organizations that can generate charitable tax deductions for donors: public charities, supporting organizations, and private foundations.  Due to the relatively rare creation of supporting organizations (wealth-holding entities designed to support a single or single set of public charities), this chapter will focus on public charities and private (non-operating) foundations.  Public charities are typically the organizations that actually do charitable work.  Private foundations simply hold wealth and distribute grants to these public charities.
In tax law a charitable organization is, by default, treated as a private foundation.  All 501(c)3 charitable organizations not meeting the guidelines for public charities (or supporting organizations) are automatically private foundations.  Only if the charitable entity can prove it is a public charity (or supporting organization) will it be classified as such.  The two ways in which an organization can prove it is a public charity is by showing that it actually engages in charitable operations (e.g., running a church, hospital, school, or homeless shelter) or by showing that it receives widespread financial support from the public.  Although most public charities actually engage in charitable activity, it is possible for grant-making bodies to be public charities if they receive widespread financial support.  For example, community foundations and united appeals (such as the United Way) can be public charities even if they do not engage in charitable operations but instead only make grants to other public charities.
Most private foundations have similar characteristics.  They are usually funded by a single person, family, or corporation.  They don’t do charitable work, but instead make grants to charities.  Usually financial returns on their invested assets serve as the source of their charitable grants, rather than ongoing gifts from fundraising.  This idea of a pool of assets, set aside by one person, with charitable activity limited to issuing grants funded predominantly from investment income is the classic concept of the private foundation.  The ways in which a charitable organization can avoid the default classification as a private foundation largely center on demonstrating a divergence from these classic elements of a private foundation.  There are four approved pathways through which a charitable organization can qualify as a public charity.
Traditional charities qualify as public charities because they are primarily engaged in the day-to-day operation of delivering charitable services.  In sharp contrast to a typical private foundation, these organizations do not simply make grants to others engaged in charitable operations.  Churches, hospitals, schools, and other traditional operating charities qualify as public charities rather than private foundations due to the nature of their operations. 

Another way that a charitable entity can be classified as a public charity is by having widespread financial support.  Even if the charity is simply making grants and is not directly engaging in charitable operations, widespread financial support will cause it to be a public charity rather than a private foundation.  In this first methodology, the concept of widespread financial support is a purely mathematical issue.  The test is met if the support from those who individually give 2% or less of the total support (a.k.a. small donors) sums to at least one-third of all support given to the charity.  In other words, if there are a lot of small donors who, when combined, are financially important to the organization, then the organization isn’t a private foundation.  Instead, it is a public charity.

Suppose a grant-making charity received total support of $100,000.  If 35 donors gave $1,000 a piece and the charity’s founder gave $65,000, this charity would still pass the test for being a public charity, because more than 1/3 of all support came from small donors (those giving 2% or less of the total support). 

There are two additions to this rule that prevent the charity from being disqualified due to financial support from government or an unusual large gift from an outside donor.  Government support is treated as small donor support (i.e., less than 2% of total support), regardless of how large a share the government support actually constitutes.  For example, if a non-operating, grant-making charity had $100,000 of total support consisting of a $65,000 gift from the charity founder and a $35,000 grant from government, the charity would qualify as a public charity.  Additionally, unusual large gifts from an outside donor (i.e., not from the organization’s founding donor, trustees, managers or their families) can be ignored.  Suppose a non-operating, grant-making organization that otherwise would have had total support of $1,000 a piece from 35 donors and $65,000 from the founding donor received an additional one-time $100,000 gift from a wealthy donor unrelated to any of the organization’s insiders.  If this unusual gift were included in the calculation, it would disqualify the organization from being a public charity, because the small donor support of $35,000 would then constitute only 17.5% of total support.  For this reason, such an unusual gift from an outsider can be excluded from the calculation.

A more subjective rule allows for small donor support (including government support) to constitute as little as 10% of the organization’s total support.  However, in order to take advantage of this lower limit, the charity must also fulfill two subjective requirements.  First, the charity must be operated in such a way as to be intentionally attempting to attract new public or government support.  In other words, the charity is not yet at the 1/3 level, but it is at 10% and appears to be working to grow that 10%.  Finally, the “facts and circumstances” must suggest that it is appropriate to treat the organization as a public charity.  In a sense, a charity (other than a traditional operating charity) with small donor (and government) support between 1/10 and 1/3 of total support is in a “maybe” zone for qualification as a public charity.  This subjectivity allows for open consideration of any circumstances that might make the charity appear more like a classic private foundation or more like a public charity.  Because of the subjectivity, it may be useful to think of this as a “smell” test asking, “Does this smell more like a private foundation or a public charity?”

Finally, a charity can qualify as a public charity based upon not only its small donor support, but also its income from memberships and any charitable operations.  If these sum to at least 1/3 of total support and the charity receives no more than 1/3 of total support from investment income, then the charity will qualify as a public charity.

For example, if a local parent-teacher association received $10,000 in total income from $4,000 in memberships, $4,000 in bake sale profits, and $2,000 in investment returns, with no donations and no income from charitable operations, the organization would qualify as a public charity.  This is because at least 1/3 of total support came from memberships ($4,000, which is 40% of total support), small donations ($0), and income from charitable operations ($0).  Additionally, no more than 1/3 of total support came from investment income (in this case $2,000, which is 20% of total support).

If instead, the organization received its $10,000 of total support from $4,000 in memberships and $6,000 in investment returns, then it would not qualify under this rule.  This large investment income (more than 1/3 of all support) shades the organization more into the appearance of a private foundation.

A charitable organization can qualify as a public charity through any of these four rules.  However, if the charitable organization does not qualify under these rules (nor under rules for supporting organizations), then the default classification as a private foundation remains.

In order to receive tax treatment as a private foundation, the organization must first be brought into existence under state law.  A private foundation can be structured as either a nonprofit corporation or a charitable trust.  Charitable trusts allow for more founder control in that the trust document can be specific and restrictive as to the permitted activities of the trust.  The corporate structure offers flexibility to future directors, allowing amendments that can alter the corporation’s goals, structure, and operation.  The corporate structure may offer some additional tax benefits, such as lower tax rates for unrelated business income.  Additionally, gifts by corporations to a nonprofit trust that makes international grants are not deductible, but gifts by corporations to a nonprofit corporation that makes international grants are deductible.  So, if the founder intends for the foundation to both receive gifts from corporations and make grants in other nations, the corporate form will be preferred over the trust form.

Once the foundation organization has been created under state law, it can then seek recognition as a tax-exempt organization for federal tax purposes.  This begins with the filing of IRS Form 1023.  Granting of this tax exempt status will be retroactive to the date the private foundation was created if Form 1023 is filed within 15 months of the creation date.  Once granted, continuing tax exempt status requires the annual filing of IRS Form 990-PF.  This process is similar to that required of all nonprofit organizations (except churches), which are required to annually file the IRS Form 990.  States differ as to their requirements for getting recognition as a nonprofit organization for state tax purposes, with some accepting the federal recognition and others having their own separate processes.

As stand-alone organizations, private foundations require various forms of administration such as accounting, annual tax filings, recordkeeping, and, in the case of corporate foundations, regular annual meetings.  Combining this with the cost of creating the initial organization suggests that the hassle might not be justified for relatively small amounts.  Nevertheless, of the more than 83,000 non-operating private foundations holding assets in the year 2010, more than one-fourth held less than $100,000, and nearly two-thirds held assets less than one million dollars.

The board of the foundation is typically selected by the founding donor.  As a result, it is most common for the foundation creator to select like-minded individuals, usually family members.  The selection of family members can serve several purposes.  Involving family members in the operation of the board can help to transmit the founder’s charitable values.  Additionally, travel and expenses to attend board meetings or visit current or potential grantee sites can be reimbursed for board members.  Board members may also benefit from the prestige and influence that comes from being an important decision-maker regarding distribution of funds.

There is no set requirement for how a board must function.  It is possible to have different voting rights and different terms for different types of board members.  Rules for continuation as a board member, especially in the context of a charitable trust, may be as unique as each founder.  Although minor children cannot make legal decisions that would bind the organization, they can serve on an advisory “junior board” that considers some types of grants or other issues.  This junior board concept can be used to aid in the training of a younger generation of future board members and to justify reimbursement of the travel expenses of such junior members’ travel to board meeting locations.

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