As a starting point in understanding private foundations, it is important to note that there are two (2) types of private foundations.

Operating vs. Non-operating Foundation

A private operating foundation is directly involved in the operation of a charitable project, such as a museum. A private non-operating foundation has as its primary purpose the making of disbursements to charities.

As it is the more common type of private foundation, all references in this article to “private foundation” are intended to refer to the private non-operating foundation.

Private Non-operating Foundation

To further understand private foundations, it is helpful to compare the private foundation to another common type of charitable entity, the public charity (such as, for example, American Cancer Society). First, on the issue of funding, while a public charity receives its charitable transfers from the general public, a private foundation typically receives its charitable transfers from a single individual or family. Second, on the issue of management, while the charitable donor generally has no management rights over a public charity, the charitable donor typically manages the private foundation (such as, for example, if the private foundation is established as a non-profit corporation, the single individual or family funding the private foundation typically serves as directors and officers of the non-profit corporation). Third, on the issue of timing of charitable distributions, while the public charity generally makes immediate full use of its funding for a specific charitable distribution without the charitable donor’s involvement, there is greater flexibility, within the discretion of the single individual or family funding the private foundation, for the private foundation to retain its funding and not immediately fully use it for a specific charitable distribution.

These distinctions between a private foundation and a public charity help to explain the structural advantages of using a private foundation to make charitable transfers. First, by managing the private foundation, you can maintain control over the activities, including the charitable disbursements, of the private foundation. Second, this control over the private formation, combined with the flexibility over the timing of charitable distributions from the private foundation, enables the private foundation to continue over generations and both (a) serve as a “legacy” vehicle and (b) encourage a “junior” generation to engage in charitable decision-making (both together with the “senior” generation while the “senior” family members are alive, and then on its own (or perhaps together with the next “junior” generation) after the deaths of the ”senior” family members). This point can make the private foundation very effective in estate planning, including as the remainder beneficiary of a charitable remainder trust. Third, flexibility over the timing of charitable distributions from the private foundation provides the opportunity to pay “reasonable” compensation to family members who manage or otherwise perform services for the private foundation. While a public charity may offer certain more favorable tax benefits than are available to a private foundation (the tax benefits of a private foundation are described below), these structural advantages of a private foundation also should be considered in each specific situation in deciding whether a charitable transfer should be made to a public charity or a private foundation (and may nevertheless suggest that a private foundation is the preferred structure).

Private Non-operating Foundation Tax

The structural advantages of a private foundation described above can make a private foundation an attractive charitable entity to achieve its various tax benefits. These tax benefits include:

• Except for an excise tax of 1.39% on net investment income, which is still a significantly lower tax rate than would be applicable to income for most taxpayers, and the taxation of “unrelated business income”, a private foundation generally is exempt from income taxation. Both in terms of providing favorable “after-tax” growth on income and reducing tax liability on the sale or other transfer of assets, the private foundation can be a “tax-effective” entity;
• Cash charitable contributions to a private foundation generally can be deducted up to 30% of a taxpayer’s adjusted gross income. Please note that based on the flexibility regarding timing of charitable distributions from private foundations described above, while the cash charitable contribution must be received by the private foundation in a taxable year to be deducted in such taxable year, it does not need to be fully disbursed for a specific charitable distribution in such taxable year;
• Property charitable contributions to a private foundation generally can be deducted up to 20% of a taxpayer’s adjusted gross income (deduction generally based on fair market value for certain publicly-traded stock and tax basis for other property). Again, please note that based on the flexibility regarding timing of charitable distributions from private foundations described above, while the property charitable contribution must be received by the private foundation in a taxable year to be deducted in such taxable year, it does not need to be fully disbursed for a specific charitable distribution in such taxable year; and
• Charitable transfers to a private foundation on death can create estate tax deductions and reduce estate tax liabilities.

While these structural advantages and tax benefits of a private foundation are significant, they should not be viewed in a vacuum. There also are various possible penalties (in the form of additional excise taxation) that can apply to the operation of a private foundation and need to be understood.

Private Non-operating Foundation Penalty Actions To Avoid

Self dealing: One important private foundation penalty is the “self-dealing” penalty under Internal Revenue Code Section 4941. It generally imposes excise taxation of (a) 10% of the amount involved with respect to the “act of self-dealing” (as described below) on a “disqualified person” (as described below), (b) 5% of the amount involved with respect to such “act of self-dealing” on a manager of a private foundation who knowingly (that it is such an “act of self-dealing”) participates in such “act of self-dealing”, (c) 200% of the amount involved with respect to such “act of self-dealing” on such “disqualified person” if such “act of self-dealing” is not “corrected” within the “taxable period” (for purposes of this penalty, generally ending on the earlier of the date of mailing of a notice of deficiency with respect to, or the date of assessment of, the above-described 10% excise tax), and (d) 50% of the amount involved with respect to such “act of self-dealing” on such private foundation manager if such private foundation manager refused to agree to part or all of the “correction”.

An “act of self-dealing” generally includes the sale, exchange, or leasing of property, the lending of money or other extension of credit, the furnishing of goods, services, or facilities, or the payment of compensation or reimbursement of expenses, between a private foundation and a “disqualified person”. A “disqualified person” generally includes a private foundation director, officer, trustee, or other individual with similar powers or responsibilities, and such person’s family members, a “substantial contributor” (generally a person who aggregately contributes more than $5,000 to a private foundation if such amount is more than 2% of total contributions since such private foundation’s inception), and such substantial contributor’s family members, a person who owns more than 20% of a “substantial contributor” business entity, and such person’s family members, and a business entity more than 35% owned by disqualified persons. There are exceptions from the “self dealing” penalty, including for certain gifts, property leased without charge for private foundation use, interest-free loans, “reasonable” compensation, and goods, services, or facilities that are provided to a disqualified person on the same basis as they are made available to the general public.

Failure to distribute: A second key private foundation penalty is the “failure to distribute” penalty under Internal Revenue Code Section 4942. A private foundation generally must distribute for each taxable year 5% of the excess of (a) the aggregate fair market value of the private foundation’s assets that are not used to carry out the private foundation’s charitable purpose, over (b) the “acquisition indebtedness” with respect to such assets, for “qualifying distributions”. “Qualifying distributions” generally include charitable transfers and “reasonable and necessary administrative expenses”. An insufficient amount of qualifying distributions by the private foundation is known as “undistributed Income”. The “failure to distribute” penalty generally imposes excise taxation of (i) 30% of the amount of undistributed income for any taxable year on the private foundation, which has not been distributed before the first day of the second (or any succeeding) taxable year following such taxable year if such first day falls within the “taxable period” (for purposes of this penalty, generally ending on the earlier of the date of mailing of a notice of deficiency with respect to, or the date of assessment of, the above-described 30% excise tax), and (ii) 100% of the remaining amount of undistributed income for any taxable year on the private foundation, if any portion of such undistributed income remains undistributed at the close of the “taxable period” (as described above) .

Excess business holdings: A third noteworthy private foundation penalty is the “excess business holdings” penalty under Internal Revenue Code Section 4943. It generally imposes excise taxation of (a) 10% of the value of “excess business holdings” in a business enterprise during any taxable year which ends during the “taxable period” (for purposes of this penalty, generally ending on the earlier of the date of mailing of a notice of deficiency with respect to, or the date of assessment of, the above-described 10% excise tax) on the private foundation, and (b) 200% of such “excess business holdings” on the private foundation, if, at the close of the “taxable period” (as described above), the private foundation still has “excess business holdings”. “Excess business holdings” generally exist if the private foundation owns more than either (i) the net amount of 20%, less the percentage owned by disqualified persons (generally as described above), of the voting stock, profits interest, or beneficial interest in a business enterprise, or (ii) if one or more persons who are not disqualified persons (generally as described above) have effective control of the business enterprise, the net amount of 35%, less the percentage owned by disqualified persons (generally as described above), of the voting stock, profits interest, or beneficial interest in such business enterprise. There is an exception to the “excess business holdings” penalty generally if the voting stock, profits interest, or beneficial interest of the business enterprise is 100% held by the private foundation, the net operating income of the business enterprise is fully distributed to the private foundation, and the business enterprise is subject to independent operation (including that it is not managed by a substantial contributor (generally as described above)).

Other possible penalties (excise taxation) that may apply to a private foundation include the “investments which jeopardize charitable purpose” penalty under Internal Revenue Code Section 4944, and the “taxable expenditures” penalty under Internal Revenue Code Section 4945.

It is certainly possible for a private foundation to structure its operations to avoid the possible penalties described above, but the potential application of these various penalties requires careful review and analysis (often involving complex issues and calculations) before making any charitable transfers to a private foundation. You should not simply focus on the advantages and benefits of a private foundation, without also considering the possible penalties.

If you have any questions concerning private foundations, please discuss them with your advisers.

Note – Ryan LLC Case and “Non-Compete” Provisions in Contracts

On August 20, 2024, in the case of Ryan LLC v. Federal Trade Commission, Civil Action No. 3:24-CV 00986-E, the United States District Court for the Northern District of Texas struck down a proposed Federal Trade Commission rule, which was otherwise scheduled to take effect on September 4, 2024, that would have banned most “non-compete” provisions in contracts. The court ruled against the Federal Trade Commission rule because “the FTC exceeded its statutory authority in implementing the Rule, and the Rule is arbitrary and capricious”. The court’s ruling applies on a nationwide basis. While the Federal Trade Commission may appeal the Ryan LLC ruling, for the time being, the Federal Trade Commission rule has no force or effect, and “non-compete” provisions can continue to be used in contracts (subject to prior applicable state or other law).

If you have any questions concerning the Ryan LLC decision, or the use of “non-compete” provisions in contracts, please discuss them with your advisers.

If you wish to discuss any of the above, find Pen Pal Gary’s contact info here.

Disclaimer: please note that nothing in this article is intended to be, or should be relied on as, legal advice of any kind. Neither LHBR Consulting, LLC nor Gary Stern provides legal services of any kind.