What Is a Private Foundation? A Complete Guide

Have you ever wondered what a private foundation is? More specifically, what makes it different from other charitable organizations, such as those focused on non-profit childcare?

In this guide, you’ll learn all about private foundations. We cover what they are, how they work, and what sets them apart from public charities and nonprofit organizations. Additionally, you’ll discover types of private foundations, advantages and disadvantages, and tax benefits. Keep reading to learn more.

What Is a Private Foundation?

According to the IRS, a private foundation is a 501(c)(3) tax-exempt charitable organization that does not meet federal requirements for a public charity.

To qualify for tax-exemption, a private foundation’s purpose must fall into specific categories. Acceptable purposes include charitable, religious, educational, scientific, or literary activities. In addition, testing for public safety, fostering amateur sports, and preventing cruelty to children or animals also qualify.

While private foundations are governed by strict rules and regulations, they remain favorable entities for philanthropic endeavors. As a result, affluent individuals, families, and companies often choose this structure despite its complexity.

How Does a Private Foundation Work?

A private foundation works by making donations called grants to beneficiaries or charities. Rather than conducting charitable activities of their own, these organizations typically make grants to other entities. Consequently, the grants may support a specific program or cover general operating expenses.

Making the Initial Endowment

Starting a private foundation requires an initial donation called an endowment. Once established, this endowment is invested to generate income. Subsequently, the investment income is distributed to other charitable organizations as grants. Generally, an endowment is at least several hundred thousand dollars.

Choosing Your Foundation Structure

When creating a private foundation, you must choose between two structures: a charitable trust or a nonprofit corporation.

On one hand, a charitable trust can be easier to form and operate. However, it does not provide the same legal protection to trustees as a nonprofit corporation. On the other hand, nonprofit corporations limit personal liability despite being more difficult to create. Furthermore, they afford more flexibility in the use of funds.

Establishing Governance and Filing

For a trust structure, you must appoint trustees. Alternatively, if you choose a nonprofit corporation, you’ll need several things:

• A mission/purpose statement

• Articles of incorporation and bylaws

• Officers and directors

After completing these steps, the foundation must also be filed with the state.

Obtaining Tax-Exempt Status

First, apply for an employer identification number (EIN), which will serve as your foundation’s tax identification number (TIN).

Next, file for tax-exempt status from the IRS by submitting Form 1023 (Application for Recognition of Exemption Under Section 501(c)(3)). Be sure to include the required supporting documents and application fee.

Finally, once the IRS approves your federal tax-exempt status, proceed to file for tax-exempt status with your state.

Types of Private Foundations

Generally, private foundations fall into two main categories: private operating foundations and private nonoperating foundations.

Private Operating Foundations

Operating foundations literally run the charities or activities they fund using investment income they generate. According to IRS requirements, these foundations must spend at least 85% of their adjusted net income or minimum investment return—whichever is less.

Private Nonoperating Foundations

In contrast, nonoperating foundations distribute funds to other charities that align with their mission or purpose. Under IRS rules, they must adhere to a distributable amount equal to the foundation’s minimum investment return, with certain adjustments. Notably, this is the more common category.

Family Foundations

Family members operate and govern these foundations in accordance with causes that mean the most to them. For example, the Carnegie Foundation has impacted libraries and learning centers across the United States through its extensive reach and scope.

International Foundations

When philanthropic activities cross international borders, the organization is classified as an international foundation. Perhaps the most well-known example is the Bill and Melinda Gates Foundation, which has significant impact both domestically and abroad.

Corporate Foundations

Corporations sometimes create separate legal entities known as corporate foundations. Primarily, their purpose is to invest in the community, especially at the local level. For instance, Verizon’s Corporate Philanthropy Program has distributed millions of dollars to disaster recovery projects throughout the United States.

Private Foundations vs. Public Charities vs. Nonprofits

Although private foundations, public charities, and nonprofit organizations share similarities, there are significant differences among them. All three exist to support and advance a cause; however, their structures and funding sources vary considerably.

Private Foundations

As noted earlier, a private foundation is a 501(c)(3) tax-exempt organization that generates funds through investment income from an endowment. Typically, an individual, family, or corporation provides this initial funding. Then, the foundation disperses funds as grants to charities that align with its mission.

These foundations are subject to strict IRS rules, including foundation-specific tax laws:

• Must make grants only to other nonprofit organizations (with few exceptions, such as educational scholarships)

• Pay 1-2% in excise tax on net investment income

Moreover, private foundations must avoid these prohibited activities:

• Permitting more than an insubstantial accrual of benefits to individuals and organizations

• Allowing income or assets to accrue to insiders through excessive salaries or other means

• Participating in any political campaign for or against a candidate

• Self-dealing with disqualified individuals, including substantial contributors and foundation managers

• Engaging in investment activity that may jeopardize the foundation’s mission

• Conducting lobbying or legislative influence of any kind

As a consequence, violating these rules can result in taxes, penalties, and removal of tax-exempt status.

Public Charities

Unlike private foundations, a public charity is a 501(c)(3) tax-exempt organization that raises the majority of its funds through public donations.

Specifically, the IRS requires a public charity to meet certain funding tests. Either it must receive at least one third of its funds through public donations, or it can meet a 10% facts and circumstances test. Additionally, public charities may receive significant support from local, state, or federal government sources.

Nonprofit Organizations

Similarly, nonprofit organizations are 501(c)(3) entities that further a cause. Nevertheless, a nonprofit operates with a focus on advancing its mission over making a profit.

Funding typically comes from multiple sources:

• Public donations

• Government funding

• Private foundations

• Other institutions

When a surplus of donations is received, the money goes directly toward furthering the organization’s mission rather than profiting individuals, including staff.

Advantages and Disadvantages of Private Foundations

Like other philanthropic entities, private foundations have both pros and cons worth considering.

Advantages

✅ Create a lasting legacy for an individual, family, or corporation

✅ Gain greater control and flexibility over charitable giving

✅ Establish a permanent giving vehicle for supporting beloved causes

✅ Provide cumulative benefits to recipient organizations over time

✅ Eliminate reliance on public donations

✅ Access a variety of tax savings

Disadvantages

⛔️ Requires a significant investment of time and money

⛔️ Involves extensive rules, regulations, and record-keeping requirements

⛔️ Subject to excise taxes levied on net investment income

⛔️ Offers lower deductibility limits on donations than public charities (30% of AGI for cash gifts, 20% for appreciated assets)

⛔️ Provides less advantageous treatment of gifts of appreciated property (valued at cost basis rather than fair market value)

Tax Benefits of Donating to Private Foundations

Donors who contribute to private foundations enjoy several notable tax advantages.

Capital Gains Tax

By donating highly appreciated assets such as stock or real estate, donors may avoid capital gains tax entirely. As a result, giving assets instead of cash can provide significant savings.

Income Tax

When donors give money to a private foundation, they receive an income tax deduction equal to the amount contributed. However, this deduction is limited to 30% of their adjusted gross income (AGI).

Estate Tax

Because money donated to a private foundation is not included in an individual’s estate, it is not subject to federal or state estate taxes. Therefore, charitable giving can serve as an effective estate planning tool.

Conclusion

We hope this guide helps you weigh the benefits and drawbacks of creating or donating to private foundations. If you would like to discuss your options for philanthropic giving, please reach out to the accounting experts at Honest Buck. Contact us today!