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Beyond the Private Foundation

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Beyond the Private Foundation Beyond The Private Foundation March 2018 Martin Hall, Ropes & Gray LLP ¶ 100 Introduction ¶ 101 Private Foundations ¶ 101.1 Overview ¶ 101.2 Organization, Operation and Administration ¶ 101.3 Income Tax Treatment of Contributions ¶ 101.4 Estate and Gift Tax Treatment of Contributions ¶ 101.5 Taxation of the Private Foundation ¶ 101.6 Regulatory Restrictions and Excise Taxes ¶ 102 Private Operating Foundations ¶ 103 Donor Advised Funds ¶ 103.1 Overview ¶ 103.2 Organization, Operation and Administration ¶ 103.3 Income Tax Treatment of Contributions ¶ 103.4 Estate and Gift Tax Treatment of Contributions ¶ 103.5 Taxation of DAFs ¶ 103.6 Regulatory Restrictions and Excise Taxes ¶ 104 Supporting Organizations ¶ 104.1 Overview ¶ 104.2 Organization, Operation and Administration ¶ 104.3 Income Tax Treatment of Contributions ¶ 104.4 Estate and Gift Tax Treatment of Contributions ¶ 104.5 Taxation of SOs ¶ 104.6 Regulatory Restrictions and Excise Taxes ¶ 105 501(c)(4) Organizations ¶ 105.1 Overview ¶ 105.2 Organization, Operation and Administration ¶ 105.3 Income Tax Treatment of Contributions ¶ 105.4 Estate and Gift Tax Treatment of Contributions ¶ 105.5 Taxation of Organization ¶ 105.6 Regulatory Restrictions and Excise Taxes ¶ 106 Comparative Analysis ¶ 106.1 Deductibility of Contributions ¶ 106.2 Formation and Operation ¶ 106.3 Scope of Philanthropic Mission ¶ 106.4 Control and Intent – How Much Can Be Exerted and How Can Intent Be Preserved? ¶ 106.5 Planning with Business Interests ¶ 107 Conclusion and Postscript ¶ 108 Author Biography ¶ 109 Appendix A: Chart Summary of the Principal Differences Between Charitable Entities 1-1 66897082_11 66897082_11 ¶ 100 Introduction “I need a foundation” is the classic refrain from a donor who wants to fund and operate a long term charitable goal. A foundation, or more correctly, a private foundation is not the only option to consider, however, and may not be the most appropriate. This paper will review the tax consequences of establishing a private foundation and the tax rules that apply to its operation. It will then compare alternatives that enable the activities of the entity to be operated in an environment which, for the most part, will be free of income tax liability. None of these options imposes any tax liability upon funding by the donor. All but one provides the donor with tax benefits in the form of a deduction that may be claimed in the year of contribution against the donor’s taxable income, in each case on terms more generous than those applicable when funding a private foundation. ¶ 101 Private Foundations ¶ 101.1 Overview Private foundations are defined in the Internal Revenue Code through an exclusionary definition.1 A private foundation means a domestic or foreign organization described in Internal Revenue Code section 501(c)(3) other than one of the following five types of organization: (1) Certain status-based organizations defined in Internal Revenue Code section 170(b)(1)(A)(i) through (v), namely, churches, schools and other educational organizations, hospitals and medical research organizations, organizations supporting state universities and colleges, and governmental units; (2) Organizations that are publicly supported with gifts, grants and contributions, as defined in Internal Revenue Code section 170(b)(1)(A)(vi); (3) Organizations that are publicly supported with exempt purpose gross receipts, as defined in Internal Revenue Code sections 509(a)(2) and 509(d); (4) Supporting organizations (SOs), as defined in Internal Revenue Code sections 509(a)(3) and 509(f); and, (5) Organizations operated exclusively for testing for public safety. Organizations described in these five categories are referred to in federal tax parlance as public charities. This nomenclature should not be confused with terminology used in other contexts. For example, state regulation of public charities ordinarily covers the otherwise mutually exclusive subsets of public charities and private foundations under the federal tax system. In practice, a typical private foundation has the following three characteristics. First, a private foundation has a single or concentrated source of contributions, in the guise of a single individual or corporate donor, one family of individual donors, or a discreet group of individual donors. Secondly, it relies on income earned by an endowed fund to support the charitable activities of the organization, as opposed to annual fundraising. Thirdly, the private foundation carries out its charitable purposes primarily through grantmaking as opposed to the direct operation of specific charitable programs. 1 I.R.C. § 509(a). 1-2 66897082_11 66897082_11 Private foundations are ideal charitable planning vehicles for donors who want to commit significant funds to charity now (and thereby obtain immediate income tax benefits), but who are not ready to relinquish control over the eventual charitable use of the property. Property contributed to a private foundation may be retained by the private foundation and put to charitable uses in subsequent years. However, since the Tax Reform Act of 19692, private foundations have been subject to more stringent regulatory oversight than public charities, namely, with regard to self-dealing, minimum distribution requirements, taxable expenditures, investments and business holdings. These restrictions aim to prevent abuse of the private foundation system by ensuring that an organization does not receive the benefit of tax-exempt status if it is primarily operating for a non-charitable purpose.3 ¶ 101.2 Organization, Operation and Administration Private foundations may be formed as corporations, limited liability companies (LLCs), trusts or unincorporated associations. The corporate and trust forms are the most common because they offer the directors or trustees of the foundation liability protection. Because corporations are generally required to register with the state in which the corporation is formed and to make annual filings, trusts may provide additional benefits of privacy and lower organizational and administration expenses. In terms of funding, a private foundation created by an individual can be funded during the individual’s lifetime or at her death and may also receive support from other donors. Additionally, many different types of property, including cash, marketable or unmarketable securities, real estate, artwork and other property may be used to fund the private foundation. Certain assets, however, such as business interests and property subject to debt, may create administrative and tax issues for the private foundation. Private foundations obtain tax-exempt status by filing with the IRS a Form 1023, Application for Recognition of Exemption under Code section 501(c)(3) of the Internal Revenue Code. The private foundation must file its Form 1023 before the end of the 15th month (or, in many cases, extended to the 27th month by an automatic statutory extension) from its date of organization if tax-exempt status is to be retroactive to the date of organization.4 On accepting the application, the Internal Revenue Service generally issues a determination letter.5 Private foundations must also file a Form 990-PF with the IRS annually, on or before the 15th day of the fifth month after the close of the private foundation’s taxable year.6 This filing requirement is applicable even if the private foundation’s application for tax exemption is pending.7 In addition to federal requirements, private foundations may have state-specific filing requirements, such as filing requirements with the Secretary of State’s office (typically, in the case of a corporation) and with the Attorney General’s office or other state agency that oversees charitable organizations. ¶ 101.3 Income Tax Treatment of Contributions A donor to a private foundation is entitled to an income tax charitable contribution deduction for her contribution to the entity.8 Furthermore, a contribution of appreciated assets to a private foundation does not constitute a sale or exchange and thus does not give rise to gain or loss that is recognized for regular tax purposes.9 The calculation of the deduction and the amount that may be deducted in the year of contribution varies based on the type of property contributed and the income tax character (i.e., capital gain or ordinary 2 P.L. No. 91-172, 85 Stat. 487. 3 See General Explanation of the Tax Reform Act of 1969, prepared by the Staff of the Joint Committee on Internal Revenue Taxation, December 3, 1970 (Joint Committee Explanation), 30-41. 4 Treas. Reg. §§ 1.508-1(a)(2) and 301.9100-2(a)(2)(iv). 5 Treas. Reg. § 601.201(a)(3); Rev. Proc. 90-27, 1990-1 C.B. 514. 6 I.R.C. § 6033(a)(i). 7 Treas. Reg. § 53.6011-1(e). 8 I.R.C. § 170. 9 Campbell v. Prothro, 209 F.2d 331, 335 (5th Cir. 1954). 1-3 66897082_11 66897082_11 income) of the property. As described in more detail below, deductions for contributions of cash and property are subject each year to overall percentage limitations measured with reference to the donor’s income, which are typically more restrictive than those permitted for contributions to public charities. It should be noted that contributions to public charities are counted first before contributions to private foundations in applying overall deduction limits.10 The deduction for gifts of cash and ordinary income property is limited in any year to the lesser of 30 percent of the donor’s contribution base or 50 percent of her contribution base reduced by cash gifts to public charities.11 The deduction for
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