Private Foundation

A private foundation is any organization described in Internal Revenue Code section 501(c)(3) that is not one of the public-charity categories listed in section 509(a). The definition works by exclusion: every 501(c)(3) is a private foundation by default unless it shows it qualifies as a public charity. In practice a private foundation is funded by a narrow source (an individual, a family, or a corporation) rather than by broad public support, and it usually gives grants to other charities and to individuals instead of operating its own charitable programs. That single-source funding is precisely why the tax law watches it more closely than a public charity.

Because a private foundation is controlled by the people who fund it, Congress built a separate enforcement regime around it in Chapter 42 of the Internal Revenue Code, a set of excise taxes that police how the foundation invests and spends:

• Section 4940 taxes the foundation's net investment income each year.

• Section 4941 taxes acts of self-dealing between the foundation and its substantial contributors, officers, and their families, even when the terms are fair.

• Section 4942 requires the foundation to pay out roughly 5 percent each year for charitable purposes. The 5 percent is measured against the fair market value of the foundation's assets other than those used, or held for use, directly in carrying out its exempt purpose, which in most grantmaking foundations means the investment portfolio. A shortfall is taxed, though not immediately: the tax attaches only to an amount still undistributed at the start of the second following year, so a foundation has the whole of the next year to catch up.

• Section 4943 taxes excess business holdings, limiting how much of a company the foundation and its insiders may own together.

• Section 4944 taxes investments that jeopardize the foundation's charitable purpose.

• Section 4945 taxes "taxable expenditures," such as lobbying, or a grant to an individual made without the advance IRS approval of the selection procedure that section 4945(g) requires.

The deduction rules are also tighter than for a public charity. Under Internal Revenue Code section 170(b)(1)(D), a donor's deduction for gifts of long-term appreciated property to a private foundation is limited to 20 percent of the contribution base (essentially adjusted gross income), against 30 percent for the same gift to a public charity, and under section 170(b)(1)(B) cash gifts are limited to 30 percent rather than 60 percent. Worse for many gifts, section 170(e)(1)(B)(ii) generally cuts the deduction for appreciated property given to a private foundation down to the donor's cost basis rather than fair market value, with a narrow exception under section 170(e)(5) for publicly traded stock, and that exception itself stops once a donor has given more than 10 percent of the corporation's outstanding stock. A gift that would earn a full-value deduction at a public charity often does not at a foundation. How the ceilings, the floor, and the five-year carryforward interact is the province of the charitable contribution deduction generally.

One category sits outside most of this. A private operating foundation, which runs its own charitable programs rather than making grants (a museum or a research library, for example), is defined in section 4942(j)(3) and is exempt from the section 4942 payout tax under section 4942(a)(1). Section 170(b)(1)(F)(i) also treats it like a public charity for the donor: the higher percentage ceilings apply and the cost-basis haircut does not. The excise taxes on self-dealing, excess business holdings, jeopardizing investments and taxable expenditures still apply to it.

A private foundation files Form 990-PF, which is public, listing its assets, grants, and the compensation it pays. Setting one up and running it well requires legal and accounting help, so foundations tend to make sense at larger asset levels where the control they provide is worth the cost and the compliance.

A private foundation moves through a predictable life cycle:

1. The founders form a nonprofit corporation or trust, apply to the IRS for 501(c)(3) recognition, and, absent public-charity status, are classified as a private foundation.

2. They fund it, often with a large one-time gift of cash, stock, or a business interest, and take a charitable deduction subject to the lower private-foundation ceilings.

3. Each year the foundation invests its assets, pays the section 4940 tax on investment income, and must distribute the required amount for charitable purposes.

4. It files Form 990-PF and stays clear of self-dealing, excess business holdings, and taxable expenditures.

A hypothetical shows the payout requirement. Suppose a foundation holds $8,000,000 of assets not used directly in its charitable programs. Its section 4942 minimum investment return is 5 percent of that, or $400,000, and its distributable amount is that figure reduced by the excise tax it owes on investment income, so a little under $400,000. Say it makes only $250,000 of qualifying grants and still has not distributed the roughly $150,000 shortfall by the start of the second following year. The initial tax under section 4942(a) is 30 percent of the undistributed amount, about $45,000, and it still owes the distribution. If any of it is still undistributed at the close of the taxable period, which ends when the IRS mails a notice of deficiency or assesses the initial tax, section 4942(b) adds a further tax of 100 percent of what remains.

Pros

• The most control of any giving vehicle: the donor's own board, investment policy, and grant decisions.
• Can pay family members reasonable compensation for real work, and can make grants and scholarships to individuals, which a donor-advised fund cannot, though section 4945(g) requires IRS advance approval of the selection procedure first.
• Creates a lasting institution that can carry a family's giving across generations.
• Provides an immediate charitable deduction in the funding year.

Cons

• Subject to the Chapter 42 excise taxes on investment income, self-dealing, excess holdings, risky investments, and improper grants.
• Must distribute roughly 5 percent of its non-program assets every year or face a penalty tax, unless it qualifies as an operating foundation.
• Lower deduction ceilings, and appreciated property is often limited to cost basis rather than market value.
• Costly to establish and administer, and its Form 990-PF is public.