There is some confusion about what it means for an organization to be a private foundation. As a practical matter, any organization can use the word foundation in its name. We are even aware of one philanthropic individual who has simply filed a trade name for the John Doe Foundation. He makes annual gifts in the name of the foundation. No muss no fuss.
Federal tax law, however, classifies as private foundations only those 501(c)(3) organizations that typically obtain their funding from a single funder or a small group of funders ”usually gifts from one individual, family or corporation, rather than funding from the general public.
In practice, private foundations generally fall into one of four sub-categories:
- Traditional private foundations. This is the most familiar type of private foundation. The foundation may be fully funded (endowed) or it may receive its funding annually from its funder. Typically, the focus of a traditional private foundation is making grants.
- Pass-through or conduit foundations. This type of private foundation is designed to hold the donor’s contribution for a short period of time. The donor’s contribution (and any income earned on it) must be distributed within two and one-half months after the close of the year in which the contribution was made. A donor to a pass-through foundation is entitled to the more advantageous deduction limitations available to public charities.
- Operating foundations. A private operating foundation is a private foundation that behaves like a public charity in that it runs its own charitable activities (e.g.,a museum or library) instead of making grants for charitable activities conducted by other organizations. A private operating foundation has more leeway to engage in operating programs, but less flexibility to engage in passive grant-making. A donor to an operating foundation is also entitled to the more advantageous deduction limitations available to public charities.
- Pooled common funds. The donor and the donor’s spouse may retain the right annually to designate the recipients of income earned from the donor’s prior contributions. The recipients must be public charities. At the end of the donor’s or surviving spouse’s life the corpus goes to a charity that they have designated. A donor to a pass-through foundation is entitled to the more advantageous deduction limitations available to public charities.
The defining characteristic of a private foundation is donor control. Private foundations are usually privately created, funded, and operated by a single individual, family, or company. As a result, private foundations are generally not dependent upon the support of outside donors and are therefore not subject to the same degree of public scrutiny as public charities that depend on outside funding for their survival.
In the absence of intense public scrutiny, Congress feared founders of private foundations might divert or use foundation assets for their own benefit at the expense of charitable beneficiaries. To reduce this risk, Congress subjected private foundations to a series of strict excise taxes imposed at rates up to 200 percent. These excise taxes are designed to encourage private foundations to fulfill their charitable missions and to punish those that do not. Excise taxes are imposed on “self-dealing” transactions, failure to distribute sufficient income for charitable purposes, excess business holdings, jeopardizing investments, and on certain types of prohibited expenditures. There is also a 1-2% tax on the foundation’s net investment income. These rules are complex to comply with and an be counter intuitive, increasing the compliance burden for private foundations.
In addition, contributions to traditional private foundations are more limited than those to public charities. For example, individual donors may generally deduct up to 30% of their adjusted gross income for cash contributions to traditional private foundations (as opposed to 50% of adjusted gross income for gifts to public charities). Similarly, donors may generally deduct up to 20% of their adjusted gross income for property contributions to traditional private foundations (as opposed to 30% of adjusted gross income for gifts to public charities).Also, for contributions of property to private foundations, donors may normally deduct only their cost (or “basis”) in the property contributed. An exception is provided for the long-term capital gain component of certain donations of corporate stock.
While the compliance burden is high for private foundations, many donors consider these additional limits and rules a small price to pay for the ability to exercise control over the foundation’s activities and investments.
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.