What is a Private Foundation?

April 1, 2024

Have you ever wondered what a private foundation is and what makes it different from other charitable organizations?

In the following guide, learn all about private foundations, including what they are, how they work, and what sets them apart from public charities and nonprofit organizations. We also cover types of private foundations, as well as 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. A private foundation’s purpose must be “charitable, religious, educational, scientific, literary, testing for public safety, foster national or international amateur sports, or prevent cruelty to children or animals” in order to qualify for tax-exemption.

Private foundations are governed by strict rules and regulations and can be quite complex to establish and maintain, but they are favorable entities for philanthropic endeavors among affluent individuals, families, and companies.

How does a private foundation work?

A private foundation works by making donations called grants to beneficiaries or charities. Instead of conducting charitable activities of their own, private foundations typically make grants to other charitable organizations, either to a specific program or for general operating expenses. Starting a private foundation involves quite a lot:

  1. An individual, family, or business must make an initial donation called an endowment, which is invested to generate income. The investment income is then distributed to other charitable organizations in the form of grants. An endowment is at least several hundred thousand dollars.
  2. When creating a private foundation, you must choose whether to structure it as a charitable trust or a nonprofit corporation. A charitable trust can be easier to form and operate, but it does not provide the same level of legal protection to the trustees as a nonprofit corporation. Though more difficult to create, nonprofit corporations limit personal liability and afford more flexibility in the use of funds.
  3. If you structure the private foundation as a trust, then trustees must be appointed; if you structure it as a nonprofit corporation, you will need a mission/purpose statement, articles of incorporation and bylaws, officers and directors, and so on. The foundation must also be filed with the state.
  4. Next, you will need to apply for an employee identification number (EIN) which will serve as your foundation’s tax identification number (TIN).
  5. Then, you will need to file for tax-exempt status from the IRS by submitting Form 1023 (Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code), plus the required supporting documents and application fee.
  6. Finally, once the IRS approves your private foundation’s federal tax-exempt status, then you must file for tax-exempt status with your state.

Types of private foundations

Generally, private foundations can be divided into two categories: private operating foundations and private nonoperating foundations.

Private operating foundations literally run the charities or charitable activities that are funded through the investment income they generate. They are required by the IRS to spend at least 85% of their adjusted net income or their minimum investment return, whichever is less.

Private nonoperating foundations distribute funds to other charities that align with their mission or purpose. They are required by the IRS to adhere to a “distributable amount equal to the foundation’s minimum investment return with certain adjustments.” This is the more common category of private foundation.

Within these two categories, there is a variety of types of private foundations. Let’s take a look at a few of them:

Family foundation

Family members operate and govern a family foundation in accordance with the causes that mean the most to them. The Carnegie Foundation is an example of a family foundation whose reach and scope has impacted libraries and learning centers around the United States.

International foundation

An international foundation is one in which philanthropic activities cross international borders. The Bill and Melinda Gates Foundation is an example of a private foundation with a significant impact both domestically and abroad.

Corporate foundation

A corporate foundation is created by a corporation as a separate legal entity. Its purpose is to invest in the community, especially on a local level. Verizon’s Corporate Philanthropy Program is an example of a corporate foundation which has distributed millions of dollars to disaster recovery projects throughout the United States.

Private foundation, public charity, nonprofit organization – what’s the difference?

Private foundations, public charities, and nonprofit organizations are all similar in that they exist to support and advance a cause, but there are also significant differences among them.

Private foundation

As a recap, a private foundation is a 501(c)(3) tax-exempt organization that generates its funds through investment income from an endowment given by an individual, family, or corporation. The foundation then disperses the funds in the form of grants to charities and charitable activities that align with its mission.

Private foundations are subject to strict rules and regulations by the IRS, including these foundation-specific tax laws:

  • Must make grants only to other nonprofit organizations, although there are a few exceptions for individuals, such as for educational scholarships
  • Pay 1-2% in excise tax on the foundation’s net investment income
  • Avoid the following prohibited activities:
    • Permitting more than an insubstantial accrual of benefits, including monetary benefits, to individuals and organizations
    • Permitting income or assets to accrue to insiders in the form of excessive, unreasonable salaries and other means
    • Participating in any political campaign on behalf of or opposed to a candidate for public office, whether financially or otherwise
    • Self-dealing with disqualified individuals, including substantial contributors, foundation managers, and other related persons
    • Investment activity that may jeopardize the carrying out of the foundation’s mission/purpose
    • Lobbying or legislative influence of any kind

Taxes, penalties, and even the removal of tax-exempt status are consequences of participation in any IRS-prohibited activities.

Public charity

A public charity is a 501(c)(3) tax-exempt organization that raises the majority of its funds through public donations. The IRS requires that a public charity either receive at least one third of its funds through public donations or meet a 10% facts and circumstances test. Public charities may also receive a greater portion of their financial support from local, state, or federal government.

Nonprofit organization

Finally, nonprofit organizations, like private foundations and public charities, are 501(c)(3) organizations that exist to further a cause. However, a nonprofit operates out of a mindset focused on advancing its mission over making a profit. Funding comes from public donations, government funding, private foundations, and other institutions. If a surplus of donations is received, the money is used directly to further the organization’s mission rather than profit supporting individuals, including staff.

Advantages and disadvantages

As with other philanthropic entities, private foundations have their advantages and disadvantages.

Here are some advantages to consider:

  • ✅ 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 and providing cumulative benefits to recipient organizations over time
  • ✅ Disengage from reliance on public donations
  • ✅ Access a variety of tax savings

Here are a few disadvantages:

  • ⛔️ Involves a significant investment of time and money
  • ⛔️ Extensive rules, regulations, and record-keeping requirements
  • ⛔️ Excise taxes levied on net investment income
  • ⛔️ Lower deductibility limits on donations than public charities (30% of adjusted gross income (AGI) for cash gifts and 20% for gifts of appreciated assets, versus 60% and 30%, respectively)
  • ⛔️ Less advantageous treatment of gifts of appreciated property than for public charities (valued at cost basis rather than fair market value)

Now, let's take a look at some of the tax benefits available for donors to private foundations.

Tax benefits

Donors who give money to private foundations enjoy several tax advantages:

  1. Capital Gains Tax – Donors may be able to avoid capital gains tax if they give away highly appreciated assets, such as stock or real estate, instead of cash to a private foundation.
  2. Income Tax – Donors who give money to a private foundation receive an income tax deduction equal to the amount they contribute, up to 30% of their adjusted gross income (AGI)
  3. Estate Tax – Money donated to a private foundation is not included in an individual’s estate, and is therefore not subject to federal or state estate taxes

We hope this guide will help you consider 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!

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