A lot of people who want to do good causes want to know how private foundations work. You might be wondering if giving money to charity through a private foundation could help your family, business, or group make a bigger difference.
There are a lot of tax laws and options, such as public charities and donor-advised funds, that can quickly make things hard to understand.
A private foundation is a 501(c)(3) nonprofit that gets most of its money from one source, which is usually a family, person, or business. It gives you more freedom than most public charities to choose how to use the money for charity.
This article talks about what makes a private foundation different and why some people choose to leave their money to a private foundation. We talk about the different types of private foundations, the rules for taxes and reporting that you need to follow when you use IRS Form 990-PF, and how to make sure your board of directors stays on track with compliance.
Key Points
- A private foundation is a 501(c)(3) nonprofit that gets most of its money from one person, family, or business. For instance, the Bill & Melinda Gates Foundation and the Ford Foundation.
- When people give money to private foundations, they have a lot of say over how it is used for charity. Donors can pick board members, set rules, and choose causes, which are usually family members.
- The IRS has rules that these groups must follow. They fill out Form 990-PF every year and pay an excise tax of 1% to 2% on their net investment income. If you break the rules too many times, you could have to pay a fine of up to 200%.
- You can take up to 30% off your adjusted gross income (AGI) for cash gifts to private foundations. The limit for gifts of property is 20%. Limits are higher for public charities.
- There are many types of private foundations. The Gates Foundation, for example, gives out grants. Pass-through foundations pay out money quickly. Operating foundations run their own programs, like museums. Pooled common funds are for planned giving after death.
What is a private foundation, and how do they work?
Private foundations and public charities are not the same because they get money in different ways and have different people in charge of their money. Section 501(c)(3) of the IRS lists a number of different types of organizations. There are family-run groups and well-known groups like the Bill & Melinda Gates Foundation. There are different rules for tax exemption, charitable giving, and reporting for each type.
Traditional Private Foundations
The traditional private foundation is the most common type of foundation. The Ford Foundation and the Bill & Melinda Gates Foundation are two well-known examples. They usually get all the money they need at the beginning or get money every year from one main source, like a family or a business.
These private foundations don’t have their own programs for giving to charity. Instead, they give money to other charities and nonprofits that are registered.
People who give money to traditional private foundations that are 501(c)(3) organizations can deduct up to 30% of their adjusted gross income. When you give property, the limit drops to 20% of your adjusted gross income. Donors can usually only write off their cost basis, unless they are long-term capital gains on corporate stock.
The tax rules here are stricter than those for charities that are open to the public. This means that there are fewer tax breaks, but the board of directors or trust advisors can still choose grantmaking activities and scholarship programs that help charities.
Pass-Through or Conduit Foundations
Pass-through or conduit foundations are places where charitable money can sit for a while. People give these foundations money, and they have to get it out quickly. All donations and related income must be given out within two and a half months of the end of the fiscal year.
The IRS keeps a close eye on this by looking at each foundation’s IRS Form 990-PF.
This type of private foundation doesn’t keep money for long-term giving. Instead, it helps the nonprofit organization make grants right away and stops them from getting rich.
If donors use a pass-through structure, they can get bigger tax breaks, like what public charities offer. This is especially true for deductions from your adjusted gross income (AGI) for your annual income tax.
You can only get those higher limits on how much you can deduct if you give the money away right away. Gifts that come late don’t count. This quick distribution lets you take full advantage of both tax breaks and the good that comes from giving to charity in one step.
Operating Foundations
Foundations that run businesses also have their own charitable programs, like museums, libraries, or scholarship programs. These groups don’t just give money to other groups; they use most of their money and property directly for charitable purposes.
A family foundation that runs its own science center, for example, would be an operating foundation.
The IRS sometimes treats these private foundations more like public charities. People who give money can write off more of it on their taxes. This means that giving to an operating foundation often has the same benefits as giving to a public charity.
The group needs to focus on direct action and follow special reporting rules under section 501(c)(3) instead of just giving money away. They are not as common as non-operating foundations, and they have to show that they are using their money for good.
Next are pooled common funds, which are funds that many people give to to help with the same charitable goals.
Pooled Common Funds: Donors can give money to a private foundation and then choose which public charity will get the money each year. These distributions can only go to charities that are open to the public. The main gift, or principal, goes to a charity that the donor chooses after they die or their spouse dies. The person who gave the money can’t get it back.
This setup is popular for planning for the future because it lets families give money to charity even after they die.
The IRS has clear rules about when and how distributions must be made. Donors get tax breaks like those of other private foundations, such as limits based on adjusted gross income and capital gains tax breaks.
These pooled funds help with both yearly giving control and long-term charitable goals without donors having to manage them after they die. A lot of people use these instead of a regular family foundation or donor-advised fund to plan their giving in a way that follows section 501(c)(3).
Characteristics of Private Foundations
Donors can still run private foundations, run charitable programs with their own board of directors, and deal with special tax rules. Read on to learn how these traits affect each foundation.
Control of Donors
A private foundation needs to have donor control. People who start foundations, like Bill Gates at the Bill & Melinda Gates Foundation, have a lot of say over how the foundation’s money is spent and who receives grants.
Unlike public charities, which have to answer to a lot of outside donors or board members, this is not the case. Family foundations often choose their own boards of directors and hire family members to be directors or trustees.
Donors can choose how to give, what causes to support, and who will be in charge for a long time.
This setup lets people change the foundation’s charitable mission and programs over time, which is something that public foundations don’t usually do. For example, families might make rules about how to run their lives so that their wishes last longer than one lifetime.
Most people think that this strict control is a good thing because it lets people leave a lasting charitable legacy while still following the rules for federal income tax. These groups are different from other types of charities because they don’t rely on donations from outside sources.
Lack of Reliance on External Donors
Private foundations don’t have to follow the rules of their donors, which is different from public charities and public foundations. Most of the time, they get the money for their charitable programs from one place, like the Ford Foundation or the Bill & Melinda Gates Foundation. Most of the time, the first gifts come from a person, a family business, or a company.
These kinds of foundations don’t need a lot of help or money from other groups.
The board of directors doesn’t have to ask the community for money to keep tax-exempt status under section 501(c)(3) because they are independent. It’s easier to report in some places because they don’t have to worry about getting money. This lets them follow a mission that fits with the founder’s goals instead of trying to balance the needs of different groups of people.
Family members are often the only ones who keep family foundations going. This setup gives more direct control, but the long-term strength of the group depends more on the original donors’ ability to give money than on the many small gifts.
Scrutiny and Taxation
The IRS keeps a close eye on private foundations. The government has strict rules to make sure these groups stay focused on helping others. Private foundations that break the rules can get hit hard by excise taxes. Rates can go up to 200% if they make risky investments or do business with themselves, for instance.
Every year, the board of directors of each private foundation has to fill out IRS Form 990-PF to tell the IRS about the foundation’s activities and finances.
Most private foundations have to pay an excise tax of 1–2 percent on the money they make from investments. They also need to stay away from too many business holdings, give the required grants for their charitable mission, and not spend money on things that are against the law.
If a foundation doesn’t follow these rules, it could lose its tax-exempt status or have to pay a lot of money. These strict checks show that following the rules is just as important as doing good things…
Next, we’ll talk about how excise taxes work and how much money private foundations can give.
Taxation and Compliance for Private Foundations
Private foundations have to follow strict rules set by the IRS, and they have to file Form 990-PF every year. They have to pay an excise tax on their net investment income, which can change how they give money to charities and run their programs.
Excise Taxes
Private foundations have to follow strict rules when it comes to excise taxes. The IRS charges most family foundations and non-operating foundations an excise tax of 1% to 2% on their net investment income.
This includes money from stocks, bonds, real estate, or any other capital gains that make an investment worth more. These taxes don’t apply to public charities or donor-advised funds.
If a charitable foundation doesn’t follow the rules, it might have to pay a lot more in excise taxes—up to 200% in some cases. The IRS will charge these penalties if insiders and the foundation’s board of directors do business with each other, the group doesn’t pay enough for charitable programs, or it owns too much business stock.
If you spend money you shouldn’t or make risky investments, you could also get these fines. Foundations could lose their tax-exempt status under section 501(c)(3) if they keep breaking the rules. All activities must follow the rules for IRS Form 990-PF reporting and the laws that say assets can only be used for approved charitable purposes.
Contribution Limits
When someone gives money to a private foundation, they can deduct up to 30% of their adjusted gross income (AGI) from their taxes for cash gifts. For things like real estate or stocks, the limit goes down to 20% of AGI.
These rules apply to both family foundations that follow section 501(c)(3) rules and traditional private foundations.
You can give more to public charities than to private ones. You can give cash gifts up to 50% of your AGI and property gifts up to 30%. When you give property directly to a private foundation, it usually only counts for the original cost basis, not the current market value.
There is an exception for some long-term capital gains on corporate stock, but it is very rare. Like public charity limits, pass-through and operating foundations have better rules for deductions.
People who want bigger tax breaks might choose these charities over nonprofits that don’t do anything.
Conclusion
Donors have a lot of say over their charitable goals when they give to a private foundation. This makes it easy for them to support causes that matter to them. The Bill & Melinda Gates Foundation and the Ford Foundation are two groups that give people tax breaks and a way to leave a legacy of giving.
Follow the IRS rules, use Form 990-PF to pay your excise taxes, and stay up to date on what you need to do to keep your tax-exempt status. It might be hard to start a family or business foundation at first, but with the help of nonprofit advisors or information on section 501(c)(3), it gets a lot easier.
This action helps people make real changes. One small act of giving can change the future and give people hope.
Questions and Answers
1. What is a private foundation?
Families or people often start private foundations, which are a type of charity. It gives money to charities and causes that it believes in. It doesn’t need a lot of public support like public charities do.
2. What sets a private foundation apart from a public charity?
A private foundation gets money from one person, family, or business. Many people and donors give money to charities that are open to the public. The IRS has stricter rules for private foundations, but they can choose how to spend their money.
3. What are the differences between foundations that run businesses and those that don’t?
An operating foundation runs its own charitable programs, such as research projects or scholarship programs. A non-operating foundation mostly gives money to other registered charities so they can do their work.
4. Do you get tax breaks if you start a private foundation?
Yes, people who give to the foundation can get tax breaks on their gifts, but only up to a certain amount based on their adjusted gross income (AGI). The foundation’s assets can also grow without paying capital gains taxes or estate taxes if they are used for approved charitable purposes.
5. What kinds of reports do private foundations need to send?
Every year, each private foundation fills out IRS Form 990-PF, which shows how much money they gave away, how much money they made from investments, how much money they spent, and how they reported on what their board of directors did.
6. Can you list some well-known foundations?
Of course, the Bill & Melinda Gates Foundation and the Ford Foundation are two well-known ones that focus on giving on a large scale with clear charitable goals that shape their philanthropic legacy around the world.
Ellis Carter is a nonprofit lawyer with Caritas Law Group, P.C. Ellis advises nonprofit and socially responsible businesses on corporate, tax, and fundraising regulations. Ellis is licensed to practice in Washington and Arizona and advises nonprofits on federal tax and fundraising regulations nationwide. Ellis also advises donors with regard to major gifts. To schedule a consultation with Ellis, call 602-456-0071 or email us through our contact form.