private foundations and donor advised funds

Private Foundations & Donor Advised Funds

Professor Russell JamesTexas Tech University

Private Foundations & Donor Advised Funds

1: What are PFs & DAFs?

Private foundations (non-operating)and donor advised funds hold money and distribute grants

78%

14%

5% 3%

Assets

81%

3% 14%

2%

Charitable Distributions PrivateFoundations(non-operating)

CharitableRemainderTrusts

Donor AdvisedFunds

Charitable LeadTrusts

Private Foundations are the Dominant Charitable Planning Vehicles

Combining 2010 data from IRS Statistics of Income (PF, CRT & CLT) and National Philanthropic Trust (DAF)

Psychology’s “terror management theory” suggests a defense to mortality reminders

is to create symbolic immortality (one’s name, impact, story will live on)

Dead

• Josiah K. Lilly (1948)

• Edsel Ford (1943)

• Robert Wood Johnson II (1968)

• W.K. Kellog (1951)

• Andrew W. Mellon (1937)

• John D. Rockefeller (1937)

Alive

• Lilly Endowment

• Ford Foundation

• Robert Wood Johnson Foundation

• W.K. Kellog Foundation

• Andrew W. Mellon Foundation

• The Rockefeller Foundation

The rules of a private foundation can be permanent

This differs from leaving an inheritance or

company where later generations make all rules

A private foundation allows donor and descendents to control the foundation

assets and charitable payouts indefinitely

A private foundation can transmit values by involving descendents in specific charitable causes for many generations

or Charitable Trust

Under state law create a…

Obtain federal tax exempt status Initial Application

1023 Annual filing

990-PF

Create a Private Foundation

Flexible; lower UBIT rates

More founder control; foreign operations eliminate deductibility for corporate donors

Nonprofit Corporation

1.

2.

Private foundations can be large, but most aren’t

26%

39%

28%

4% 3%

Asset Size: Non-Operating Private Foundations

$1 under $100,000

$100,000 under $1MM

$1MM under $10MM

$10MM under $25MM

$25MM or more

Source: IRS Statistics of Income for 2010. Domestic Private Foundations: Number and Selected Financial Data, by Type of Foundation and Size of End-of-year Fair Market. Excluding those not reporting any assets

Foundation board• Often the donor and close family members

• Can establish rules for succession

– Descendents who meet certain criteria

– Unequal voting rights allowable

– Junior board for minors advising on small gifts

Private Foundations & Donor Advised Funds

1: What are PFs & DAFs?

Private Foundations

2: PFs v. Public charities

Three types of charitable organizations

Public charity

Supporting organization

Private foundation

Public Charity

• Publicly supported

OR

• Operates ongoing traditional charitable activity (e.g., hospital, church, school)

Private Foundation

• Default if charity not a public charity or supporting organization

Typical private foundation

• Funded by one person, family, or corporation

• Makes grants, rather than directly running charitable activity

• Expenditures funded by investment income

Typical private foundation

• Funded by one person, family, or corporation

• Makes grants, rather than directly running charitable activity

• Expenditures funded by investment income

Traditional charity (e.g., operates church, hospital,

school)

Typical private foundation

• Funded by one person, family, or corporation

• Makes grants, rather than directly running charitable activity

• Expenditures funded by investment income

Publicly-supported

charity

At least 1/3 of total support1

from small donors2

1 Includes gifts and investment income over last 4 years. Large unusual gifts from outsiders can be excluded. 2 Gifts from those giving ≤ 2% of total support and any support from government

At least 1/10 of total support1

from small donors2

Typical private foundation

• Funded by one person, family, or corporation

• Makes grants, rather than directly running charitable activity

• Expenditures funded by investment income

operated to attract new

public or government

support

Smells like public charity

“facts and circumstances”

that it is a public charity

1 Includes gifts and investment income over last 4 years. Large unusual gifts from outsiders can be excluded. 2 Gifts from those giving ≤ 2% of total support and any support from government

Typical private foundation

• Funded by one person, family, or corporation

• Makes grants, rather than directly running charitable activity

• Expenditures funded by investment income

At least 1/3 of total support1 from memberships + charitable operations + small donors2

No more than 1/3 of total support1 from investment income

1 Includes gifts and investment income. Large unusual gifts from outsiders can be excluded 2 Includes support from government

Public charity by receipts

Private Foundations

2: PFs v. Public charities

Private Foundations

3: Tax rules

Tax rules for private foundations

Tax on net investment income

• 2% tax on net investment income

• Drops to 1% If charitable grants ≥ assets X (avg. % payout in the last five years) + 1% of net investment income

Gifts to private foundations also have lower income-based deductibility limits

Current Value: $25

1990 Paid $1

Long-term capital gain (special election)

Tangible personal property

(“unrelated” use)

CashOrdinary income

property

Inventory Short-term capital gain Public

Charity

Public Charity

Current Value: $25

1990 Paid $1

Long-term capital gain (no special election)

Tangible personal property

(“related” use)

CashOrdinary income

property

Inventory Short-term capital gain

Public Charity

Private Foundation (non-operating)

Current Value: $25

1990 Paid $1

Long-term capital gain (any)

Tangible personal property (“related” or “unrelated” use)

Current Value: $25

1990 Paid $1

Private Foundation (non-operating)

Private Foundation (non-operating)

Private Foundations

3: Tax rules

Private Foundations

4: Insider benefits

Charitable Purposes

To protect charitable distributions, many transactions are prohibited or penalized

Insider Benefits

• Self-dealing

• Failure to distribute income

• Excess business holding

• Investments that jeopardize charitable purpose

• Taxable expenditures

Insider Benefits Charitable Purposes

IRS punishments for transactions that break the rules include:

• Initial tax (10%-30%)

• Additional tax if transaction not corrected (25%-200%)

• Revoking exemption

Who is an insider (A.K.A. a “disqualified person”)?

Insider Benefits Charitable Purposes

Insider or “Disqualified Person”• Officer, director, trustee, or any employee with

responsibility for the act

• Ancestor, spouse, descendent, or spouse of descendent of above

• Corporation, trust, or partnership owned 35% or more by above

• Substantial contributor >2% of all

contributions from foundation startto end of tax year (+>5K total contributions)

Grantors of a charitable trust automatically qualify

• Self-dealing• Failure to distribute income

• Excess business holding

• Investments that jeopardize charitable purpose

• Taxable expenditures

Insider Benefits Charitable Purposes

Self-Dealing

• Sell, exchange, lease, transfer or loan money, goods, services, property, or facilities to a disqualified person

• Paying a government official

Bargain sale

Suppose a disqualified person is willing to sell a $200,000 property to the foundation for $10,000?

Bargain saleSuppose a disqualified person gives a $200,000 property (with a recent $12,000 mortgage) to the foundation?

(Payment of the insider’s debt is a benefit, but allowed if debt is 10+ years old)

Self-Dealing Penalty• Disqualified person taxed 10% of transaction (+5% tax

on foundation manager who knowingly participates)

• Must correct in 90 days of IRS notice else disqualified person taxed 200% (+50% tax on foundation manager)

Free gifts to the foundation of money, property, or use of money or property are allowed

Foundation can hire an insider to perform necessary professional or managerial services (called “personal services”) if compensation is reasonable• Investment advice• Legal work• Accounting/tax services• Banking• Administrative assistance

The Council on Foundations’ Foundation Management Report contains compensation information for various positions

Reimbursements of reasonable and necessary expenses such as meals and travel• Travel to foundation board meetings for board

members (and junior board members who perform some functions in that role)

• Travel to grantees or potential grantees sites to investigate current or potential awards

Private foundations allow for unlimited multi-generational,

nearly tax-free (1%-2%) control of wealth,

with ongoing ability to provide insider

travel and employment for

professional/ management

services, and limiting charitable activities to founder’s desires

Private Foundations

4: Insider benefits

Private Foundations

5: Distributing income

• Self-dealing

• Failure to distribute income• Excess business holding

• Investments that jeopardize charitable purpose

• Taxable expenditures

Insider Benefits Charitable Purposes

The foundation must distribute at least 5% of non-charitable net assets under its control by the end of the following tax year

Non-charitable net assets excludes charitable assets and assets not yet

under foundations’ control

No charitable assets:used for charitable purposes,

such as paintings on loan to a museum, or office

furniture used to manage the foundation

No assets not yet under foundation’s control: a right to receive property after death, after

estate administration, or after payment of a pledge

5% payout is reduced by investment

tax and unrelated business

income tax

Administrative expenses for grant-making or fundraising (but not

investment management) also count as charitable

expenditures towards the 5% minimum required

payout

5% can be spent on grants to charity including designated purpose funds, but NOT to

• Another non-operating foundation

• Charity controlled by the foundation or disqualified persons

• Donor advised funds

Buying or improving assets used directly in charitable purposes also

count towards 5%

Can the foundation postpone payouts to save up for a big gift?

Yes. If…

• It is for a project better accomplished through set aside than by immediate payout (e.g., constructing a building)

• Pay out within 60 months of first set-aside

If the foundation makes a big gift, will the amount above 5% carry over to future

years?

Yes. Gifts above 5%

can carry forward for up to

5 years.

• Foundation pays a tax of 30% of required amount not distributed

• Additional 100% if not corrected in 90 days of IRS notice

Penalty for Failure to Distribute

Private Foundations

5: Distributing Income

Private Foundations

6: Investments

• Self-dealing

• Failure to distribute income

• Excess business holding• Investments that jeopardize charitable purpose

• Taxable expenditures

Insider Benefits Charitable Purposes

What’s the problem with excess business holdings?

• Donor still controls the business even though he has taken a charitable deduction

• Donor decides if any profit is distributed to the foundation

• Donor controls his (and other’s) compensation at the business

Foundation

Foundation + Insiders

20%

Add If Another Has Effective

Control15%Others

65%

A private foundation cannot own more than 2% if the foundation and all disqualified persons combined own more than 20% of a company (35% if someone else has effective control)

• Charitable function such as a school or hospital

• Business run by unpaid volunteers or selling donated items

• Business for beneficiaries /employees such as a museum cafeteria

Full ownership of a charitable business is allowed

Full ownership is allowed if business is passive – simply collecting dividends, interests, royalties, or real estate rent without leverage

Time to dispose of excess business holdings• 90 days if foundation buys• 5 years if foundation

receives as a gift [and can request extension for another 5 years if unusual circumstances]

• Foundation pays a tax of 10% of highest business holdings above maximum

• Up to 200% if not corrected in 90 days of IRS notice

Excess Business Holding Penalty

• Self-dealing

• Failure to distribute income

• Excess business holding

• Investments that jeopardize charitable purpose• Taxable expenditures

Insider Benefits Charitable Purposes

Crazy investment gambles can

jeopardize the charitable purpose

Nothing is automatically

disqualified, but special attention given to options, margin trading,

short selling, commodity

futures, oil/gas interests

Jeopardizing investments are excessively risky in the context of entire portfolio

(“fails to exercise ordinary

business care and prudence”)

High risk investments are allowed if they are primarily charitable •Needy student loans

• Low-income housing

•Urban renewal

• Foundation pays a tax of 10% of the jeopardizing investment (manager pays 5%, up to $10k)

• Another 25% if not corrected within 90 days of IRS notice (manager pays another 5%, up to $20k)

Jeopardizing Investment Penalty

• Self-dealing

• Failure to distribute income

• Excess business holding

• Investments that jeopardize charitable purpose

• Taxable expenditures

Insider Benefits Charitable Purposes

Taxable expenditures

• Non-charitable purposes

• Political campaigning or lobbying (except non-partisan research)

• Grants to individuals except – Travel, study, or similar if IRS

approves non-discriminatory award process

– Grants to impoverished persons or disaster victims

– Prizes/awards to recognize achievement with no restrictions on use of funds

• 20% of the taxable expenditure (manager pays 5% up to $10k if no reasonable cause)

• Another 100% if not corrected within 90 days of IRS notice (manager pays another 50%, up to $20k)

Taxable Expenditures Penalty

Private Foundations

6: Investments

Private Foundations

7: v. Donor Advised Funds

What if creating a private foundation is just too much hassle?

Donor Charities

The Donor Advised Fund

Donor’s DAF

$

$

Sponsoring charity has legal ownership of DAFs

$

Gifts are to a public charity, because charity

has legal ownership

Charity follows donor advice, otherwise no one would give again

$

Donor advised fund• No minimum payout• Minimal setup &

administrative expense• Expected control of grants• Investment management

sometimes allowed• Legislatively new• High income limits &

valuations• No tax on earnings

Private foundation• 5% minimum payout• Significant setup &

administrative expense• Legal control of grants• Investment management

always allowed• Legislatively stable• Low income limits &

valuations• 1% or 2% tax on earnings

End of year DAF contributions pull forward deductions

Many use DAFs as a short-term conduit to take an earlier tax deduction for expected future gifting to charities

DAF Limitations• No benefits (grants, loans, compensation, or indirect benefit) to

donor, family, or organizations 35%+ controlled by these. Ex: no major donor event tickets

• No excess business holdings (same rule as private foundations)

• No distributions to private foundations (rare exceptions) or individuals

Private Foundations

7: v. Donor Advised Funds

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Private Foundations & Donor Advised Funds

Professor Russell JamesTexas Tech University