We occasionally receive questions about charitable foundations and when it makes sense to consider a foundation for giving. We will cover some of the key factors here.
First, some nonprofit basics. Many types of nonprofit organizations are tax-exempt and do not pay federal or state tax on the income from their operations. However, not all nonprofit, tax-exempt organizations qualify for tax-deductible contributions.
Nonprofit, tax-exempt organizations that operate exclusively for charitable purposes are defined in Section 501(c)(3) of the Internal Revenue Code. Contributions to 501(c)(3) organizations are tax deductible. As a condition of qualifying for tax-deductible contributions, 501(c)(3) charitable organizations must be organized and operated exclusively for:
“… religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals …”
In addition, 501(c)(3) charities are restricted from political lobbying and from participating in or contributing to political campaigns. Importantly, any grants or other payments made from a 501(c)(3) must be for a charitable purpose and cannot be for personal or private benefit.
Private Foundations Versus Public Charities
The IRS categorizes 501(c)(3) charitable organizations as either public charities or private foundations. Charitable foundations are 501(c)(3) organizations that are private foundations. A private foundation typically receives its funding from a family, an individual or a corporation, whereas a public charity typically receives funding from multiple sources, including individuals, government agencies, private foundations and potentially other public charities. Donor-advised funds, a popular charitable giving vehicle that is an alternative to private foundations, are public charities.
Tax deductibility is a significant difference between public charities and private foundations. Donations of cash to a public charity are tax deductible up to 50% of adjusted gross income, whereas cash donations to a private foundation are tax deductible only up to 30% of adjusted gross income. Similarly, donations of publicly traded securities to a public charity are deductible up to 30% of adjusted gross income, whereas donations of publicly traded securities to a private foundation are deductible only up to 20% of adjusted gross income. There is a significant difference in the tax deductibility of contributions to a public charity versus a private foundation, with donations to public charities (including donor-advised funds) receiving the larger tax benefit.
The value of securities and other assets donated to private foundations is also different from the value of securities and other assets donated to public charities. For public charities, donors of appreciated assets held longer than one year receive a tax deduction for the full fair market value of donated assets. For private foundations, only publicly traded stock held longer than one year receives a deduction for fair market value. Other types of assets, including private stock, real estate and limited partnership interests, receive a deduction only for the cost basis of the property. The reduced value of deduction (cost basis is often much smaller than market value for appreciated assets) can be a major disadvantage for giving through a private foundation. For example, shares of a private company would be donated at their cost to a private foundation as opposed to current market value to a public charity.
Hands-on Giving Allowed
Private foundations are more flexible than public charities such as donor-advised funds in allowing donors to pursue their own charitable activities. They also provide more control to donors in how their contributions are used. While private foundations most frequently make grants to other 501(c)(3) organizations, they also can be used for hands-on charitable work directly, such as community aid work. Private foundations also allow giving internationally, which is more difficult with public charities. And private foundations allow giving to individuals, albeit under strict rules, such as for a scholarship or fellowship.
Expensive to Operate
Private foundations are expensive to run. Administrative costs include legal fees to create the foundation and obtain tax-exempt status, accounting fees to prepare required annual filings and file a Form 990-PF tax return, and ongoing staff costs to monitor compliance with complex private foundation rules and regulations that, if not followed correctly, can cause costly excise taxes for the foundation.
Due to the expense and complexity of operating a private foundation, charitable planners and estate planning attorneys recommend that private foundations have at least $3 million to $5 million of assets, and many planners argue that $10 million in assets is more appropriate.
Private charitable foundations are most often used by families with significant net worth who have already given the maximum amount they plan to leave to their heirs through a comprehensive estate and charitable plan, and have used up their lifetime estate and gift tax exemption amount. For 2017, the lifetime exemption amount for married couples is $10,980,000. Estates valued at over this approximately $11 million in 2017 will be taxed at the federal estate tax rate of 40%. Private foundation donors may prefer to give large amounts to a charitable purpose rather than lose 40% of the taxable portion of their estate to tax.
Recommended for Families with Significant Net Worth
Private foundations offer flexibility and control over the way donors pursue their charitable objectives. Tax deductibility is limited compared with public charities, particularly for private company stock and real estate. Private foundations are expensive to operate and therefore are typically recommended for donors who expect to contribute at least $10 million and who have net worth several times that amount.