By: John A. Rouchell
Article Last Updated: October 22, 2012
As long as we live in a world in which death taxes can equal or exceed 60% and federal and state income taxes can exceed 40%, those families which have achieved the American dream often have three estate beneficiaries – family members, charities or the IRS, with the IRS often receiving the lion’s share.
Many successful families have turned to private family foundations to achieve significant income and transfer tax savings while providing the family with a structured mechanism for achieving worthwhile, long-term philanthropic goals under the family’s control and direction for many generations. Those of us who view public television are familiar with private family foundations with names like Rockefeller, Ford, Getty and Gates, but family private foundations are valuable estate planning tools
for many families considerably less fortunate. For example, there are now more than 18,000 family foundations organized in the United States, an increase of 50% in the last decade. Perhaps a family private foundation would be a benefit in your family’s estate planning.
What Is A Private Family Foundation?
A private family foundation is a tax exempt organization formed under Internal Revenue Code Section 501(c)(3) and, like publicly supported charities, must be organized and operated:
Family foundations generally are classified as private foundations under the Internal Revenue Code because most, if not all, of the organization’s financial resources come from the family itself rather than from public gifts, grants, membership fees or other sources of public support. Since such private foundations are managed by the family members with little or no public oversight, to achieve tax exempt status, the Internal Revenue Code requires the foundation’s organizational documents to contain language requiring it to distribute certain amounts of its income each year for charitable purposes and which prohibit the foundation from engaging in certain activities, including self-dealing with related parties, retaining excess business holdings, making certain prohibited investments and certain proscribed expenditures.
Family foundations fall within two categories for tax compliance purposes, namely, operating and non-operating foundations.
Most family foundations are non-operating foundations. Generally, they are created and funded by a small group of donors within the family and do not directly engage in any independent charitable activities, but rather make grants to public charities. Non-operating family foundations are formed for a number of purposes, including:
Private operating foundations utilize contributed assets for directed activities in many respects similar to public charities. Often a family foundation begins as a non-operating foundation, but evolves into an operating foundation by directly performing the functions of a public charity rather than merely directing grants to public charities. Private operating foundations are given certain advantages over non-operating private foundations such as relaxation of the annual requirement of distributions to public charities and less restrictive limitations on the deductibility of contributions by donors for federal income tax purposes. In order to satisfy the Internal Revenue Code requirements for private operating foundation status, the foundation must utilize virtually all of its annual revenue in the active conduct of its charitable purposes and one of three other tests must be satisfied requiring devotion of the organization’s assets, endowments and support directly to its exempt purposes.
What Are The Tax Benefits of A Private Family Foundation
Contributions to a private family foundation are deductible for both gift and estate tax purposes.
Contributions to private family foundations also are deductible for income tax purposes, depending upon the type of property contributed and the donor’s “contribution base” (the donor’s adjusted gross income with certain adjustments). For example, cash and non-appreciated property contributed to private non-operating foundations are limited to the donor’s adjusted basis and to 30% of the donor’s contribution base. Contributions of long-term capital gain property to private non-operating foundations are deductible at the donor’s adjusted basis but subject to a limit of 20% of the donor’s contribution base. Deductions for contributions of qualified appreciated stock to private non-operating foundations are made at fair market value, subject to a 20% contribution base limitation. Contributions of ordinary income or short-term capital gain property to private non-operating foundations are limited to the contributor’s adjusted basis and 30% of his contribution base. Contributions of tangible personal property to a private non-operating foundation are limited to the donor’s adjusted basis and 20% of the donor’s contribution base.
Donors may carry over charitable contributions to the next five (5) tax years to the extent contributions exceed a donor’s contribution base.
Charitable contributions, as itemized deductions, also are subject to partial dilution for high bracket income taxpayers.
Contributions to private family foundations are subject to all of the same substantiation requirements applicable to contributions to public charities. Cash gifts must be substantiated through cancelled checks or receipts. Contributions of assets which are not cash or publicly traded securities worth more than $5,000 must be substantiated through a qualified appraisal.
How do I form a Private Family Foundation?
Private family foundations may be structured either as trusts or as non-profit corporations. In recent years, most foundations have been formed as non-profit corporations because corporations provide greater flexibility and ease of amendment in response to future changes in circumstances, greater flexibility for delegation of management responsibilities and protection from personal liability of foundation managers.
The initial step is the execution and filing with the Louisiana Secretary of State of the Articles of Incorporation and associated documents. A copy, certified by the Secretary of State, is then filed with the parish of the non-profit corporation’s registered office.
The initial meeting of the incorporator and initial board of directors is evidenced by appropriate corporate minutes adopting by-laws and authorizing the opening of a bank account in the name of the organization.
An application for a tax identification number is applied for with the Internal Revenue Service (“IRS”) and, shortly thereafter, an application for recognition of the tax exemption of the organization under Internal Revenue Code Section 501(c)(3) is filed with IRS on Form 1023 and associated forms. Additionally, Form 8718 must be filed with IRS along with the payment of a user fee. IRS Form 1023 requires a projection of revenue and expenses of the organization for a four year period and, consequently, you may need the assistance of your accountant. If Form 1023 is filed with IRS within fifteen months of the date the foundation is organized, IRS will grant tax exempt status to the organization retroactive to its date of formation, thereby protecting the deductibility of contributions to the organization during the interim period.
What must I do to properly operate the foundation?
Family foundations should maintain separate bank accounts, books and records, including minutes of meetings of its members and board of directors, in order to assure that the non-profit corporate form is respected for all legal purposes, including insulation of its members and directors from personal liability.
It may be appropriate to develop a written policy and procedure for the making of grants to public charities, setting forth the types of philanthropic objectives that are desirable, appropriate charitable recipients and monetary levels for grants.
The foundation should create an established procedure for providing each donor with a letter when contributions are made, acknowledging receipt by the foundation of the contribution, confirming its value and the fact that it was or was not part of a payment to the foundation for any goods or services provided to the donor.
Each year, the foundation is required to file with IRS Form 990-PF on or before the 15th day of the 5th month following the close of its fiscal year. There is no analogous tax reporting form for Louisiana income tax purposes. However, the foundation is required to file a copy of its federal form 990-PF with the Louisiana Attorney General’s office.
The Internal Revenue Code requires that the foundation make IRS Form 990-PF available for inspection at the foundation’s principal office during regular business hours or give a free copy to anyone who requests it. Furthermore, the foundation must publish a notice in the newspaper of general circulation in the parish in which the principal office of the foundation is located stating that the return is available and providing the address and telephone number of the principal office and the name of the foundation’s manager. Such notice must be published by the due date for filing the annual return with IRS, including any extensions, and a copy of the notice must be attached to IRS Form 990-PF when it is filed.
Additionally, the foundation may be required to file normal payroll tax withholding and reporting forms if it has employees and pays wages.
The operations of the foundation can give rise to certain penalty excise taxes.
The foundation and its managers should seek competent legal advice before entering any transaction which might constitute self-dealing or before making any investments which could jeopardize its charitable purpose, result in a taxable expenditure or otherwise expose the foundation or its managers to penalty taxes.
What are some of the Income and Estate Tax Planning Uses of Private Family Foundations?
As previously discussed, there are three possible beneficiaries of your wealth —– your family, charities or the IRS. If you plan to sell your business, the IRS may take 20 – 40% of your profit. When you die, the IRS can take 55% or more of your accumulated wealth. Instead of naming the IRS as your favorite charity, you can create your own family foundation and reap substantial tax and non-tax benefits.
A charitable remainder trust permits you or your designee to retain a stream of income from the property you donate to the trust for a number of years or for your life. When the trust terminates, the trust assets (and any growth) are transferred to the family foundation. The charitable remainder trust is tax-exempt. You are entitled to a charitable income tax deduction for your contributions to the trust based upon the actuarial value of the interest ultimately passing to the family foundation.
In a charitable lead trust, the family foundation can receive the income (instead of the principal) for a term of years. When the trust terminates, the trust assets (and any growth) passes to family members, such as children or grandchildren. This technique allows you to discount the value of the property ultimately passing to your family for gift and estate tax purposes based upon the actuarial value of the foundation’s income interest. This approach is particularly suited to discounting the death tax value of the remainder interest in favor of grandchildren within the applicable lifetime exemption from the tax on generation skipping transfers.
You don’t have to be a Bill Gates to take advantage of a family foundation. In addition to tax savings, the family foundation can provide you and your family with a wonderful vehicle to engage in charitable pursuits while maintaining control and flexibility over your charitable endeavors.
Our office has assisted numerous clients in establishing family foundations and can assist you in exploring the many ways that a family private foundation may facilitate your planning.