The Private Foundation - A Practitioner’s Guide

Robert A Kosicki and Bonnie Leibowitz-Carchi Although private foundations have enjoyed considerable press lately because of potential abuses, they continue to provide a valuable opportunity for families. When establishing a private foundation, the practitioner must not run afoul of the complex rules for creating, maintaining, and terminating a private foundation.

Most people recognize a private foundation₁ as a charitable entity, but qualification is not automatic. The entity must meet certain requirements under Internal Revenue Code (I.R.C.) Section 501(c)(3).

A charitable entity is classified as:

[a corporation], and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation …, and which does not participate in, or intervene in, any political campaign on behalf of any candidate for public office.₂ Once classified as an I.R.C. § 501(c)(3) organization, the entity enjoys tax-exempt status.₃

What is a Private Foundation?
The I.R.C. defines a private foundation by exclusion.₄ Every I.R.C. § 501(c)(3) organization is either a public charity or a private foundation. Public charities include churches, schools, hospitals and medical research organizations, colleges and university support organizations, governmental units and charitable purpose organizations that satisfy the public donations test (i.e., donative public charities).₅ If the entity’s operations do not fall into one of the enumerated categories, it is a private foundation by default.

Generally, a private non-operating foundation is funded by the income it generates from its investments and endowments. This provides funding for grants that are generally made to public charities.₆

What Tax Deductions are Available to the Individual Contributor/Supporters?
Income Tax
Internal Revenue Code §170 provides for an income tax deduction for a cash contribution to a private foundation. Gifts of cash are deductible up to 30 percent of the donor’s contribution base for the tax year, or “the excess of fifty percent of the taxpayer’s contribution base for the taxable year over the amount of charitable contributions.”₇ Gifts of qualified appreciated stock, and other capital gain property, are subject to a 20 percent limitation.₈ Lifetime gifts may be carried forward over five years following the date of transfer.₉ New Jersey does not authorize a charitable deduction from its income tax base.₁₀

Transfer Tax
A donor making a lifetime gift to a private foundation is entitled to an unlimited federal gift tax deduction. Currently, New Jersey does not impose a gift tax.

If a decedent makes a donation to a private foundation at death, then the decedent’s estate is entitled to a federal estate tax deduction.₁₁ New Jersey classifies certain charitable organizations as Class E beneficiaries, which are fully exempt from the New Jersey inheritance tax.₁₂ The New Jersey estate tax is calculated in accordance with the I.R.C. as it existed on Dec. 31, 2001; therefore, a New Jersey estate tax charitable deduction would be authorized for the full amount of the bequest.₁₃

What are the Organizational Structures?
A private foundation can be established during the founder’s lifetime, or at death in a testamentary instrument. Most foundations are formed as either a charitable trust or a nonprofit corporation under state law. To establish a private foundation as a nonprofit corporation under New Jersey law, articles of incorporation must be filed with the New Jersey Department of Treasury, and a filing fee must be paid. New Jersey’s Nonprofit Corporation Act can be found at N.J.S.A. 15A:1-1 et seq.

The salient features of the certificate of incorporation for IRS purposes are the charitable purpose clause and the distribution clause.₁₄ The typical certificate of incorporation will not provide for members, and will provide that the method for selecting trustees will be set forth in the bylaws. The certificate of incorporation will also contain the other provisions typically included in the certificate of incorporation of a for-profit corporation. An original and one copy is sent out to the office of the Department of Treasury with the filing fee.₁₅

Bylaws also need to be drafted. The bylaws are not sent to the state, but will be sent to the IRS. Besides the usual forprofit bylaw provisions, nonprofit bylaws typically provide for a self-perpetuating board of trustees, and often incorporate the IRS model conflict of interest policy, which is not mandatory but is frequently a subject of inquiries by an IRS reviewer of the application for exemption.₁₆

A board is called self–perpetuating when it elects the successor trustees, who are usually the initial trustees, and are generally family members. Moreover, family members are usually the president, treasurer and secretary, the three officers mandated by the New Jersey Nonprofit Corporation Act.₁₇ An organizational meeting should be held to adopt the certificate of incorporation and bylaws, and elect officers.

In order to create a private foundation by trust, a trust document is necessary.₁₈ The salient features of the trust are just like that of the nonprofit corporation namely—the charitable purpose clause and the distribution clause. The practitioner should also consider incorporating a conflict of interest policy into the trust documents.

The trust document identifies the grantor, who is the founder, and the trustees. As is typical with the nonprofit corporation, the founder is usually named as a trustee along with family members. The trust often is drafted to allow acting trustees to nominate and appoint successor trustees, who can also be family members. After the trust document is executed, the founder transfers property (the trust res) in trust to one or more trustees.

Once the foundation is formed, the practitioner must make sure a taxpayer identification number₁₉ is obtained, and a checking account or brokerage account is established. Then the foundation should be funded with the desired assets.

A nonprofit corporation is in many respects similar to the business corporation. Many practitioners are already familiar with New Jersey’s statutory requirements for business corporations. The most notable variation for a nonprofit corporation is that there are no shareholders (owners). Since there are no shareholders, the directors may not pay any dividends or distribute any part of the nonprofit corporation’s income or profits to its trustees, officers, members, directors, etc.₂₀ There is an exception, however, for the payment of reasonable compensation and employment benefits.

In any event, whether operating as a trust foundation or nonprofit corporation, directors and officers (D&O) insurance should be considered, as well as a general liability policy. A general policy can protect against a variety of business losses. D&O insurance covers the acts or omissions of the trustees, directors and officers.

The gap between the two forms of private foundations seems to be narrowing. ₂₁ The corporate form may cost a few more dollars in state filing fees in contrast to the trust. A corporate foundation may have more administrative functions to perform, such as annual meetings and filing annual reports. The family may prefer a corporate form because the strategy of the company can be separated from the management. A trust may be a more suitable option if the family desires greater control by the grantor, with his or her preferences expressed in the trust document even after the grantor’s death. With the corporate form, there may be more opportunities to involve the entire family.

A benefit of the trust is that it requires a relatively simple trust document. However, depending on how the trust document is drafted, it can be harder to change terms, which can either be a benefit or a detriment, depending on the situation.

What Additional Filings are Required?
The practitioner must file the following forms with the IRS: 1) Form 1023 together with the certificate of incorporation, bylaws and unanimous consent adopting the bylaws, if formed as a nonprofit corporation; or if formed under a trust agreement, a copy of the trust document; 2) Form 8718, the user fee and a check for the appropriate amount, and 3) Form 2848, power of attorney form, which allows the IRS to contact the practitioner directly.₂₂ For ease, the IRS makes available to the practitioner a checklist of items required to be submitted to secure tax-exempt status.

Form 1023 must be filed with the IRS to confirm the organization’s taxexempt status. Internal Revenue Code § 508(a) requires that organizations desiring to be treated as an I.R.C. § 501(c)(3) organization file IRS Form 1023 within 15 months of formation.₂₃ There is a safe harbor by which the IRS will consider an incomplete filing as timely. Generally, once the tax-exempt status is obtained, it is effective as of the time-stamped date on the certificate of incorporation, or the later of the trust execution date or funding date.

The IRS notifies the practitioner upon receipt of the application, and assigns a document locator number. They will also indicate that all applications are divided into three classes: 1) those that can be processed immediately based on information submitted, 2) those that need minor additional information to be resolved, and 3) those that require additional development. If the application falls into the first or second group, the IRS will send a determination letter attesting to the tax-exempt status. If the application falls into the third category, an exempt organization specialist is assigned to the application to conduct a technical review. Processing time varies between four and 12 months. Generally, applications are rejected for failure to state a charitable purpose, failure to pay the appropriate filing fee or failure to include a dissolution provision.

Most applications are acted on in a timely fashion, with the applicant receiving a determination letter stating that the organizational requirements of the I.R.C. have been met. Recent favorable letters have included Publication 4221-PF as an enclosure, which sets forth the operational requirements for a private foundation. The favorable determination letter from the IRS is the practitioner’s proof that the organizational requirements for a private foundation have been satisfied. The favorable determination letter will also enclose the IRS requirements for operational activities.

In the rare case, if the practitioner does not receive a response after 270 days have passed, then a request for a declaratory judgment may be filed with the U.S. tax court.₂₄

What are the Operational Rules?
A charity of any kind should benefit the interests of the general public as a class. This premise is particularly important with regard to private foundations. Private foundations may not inure to the benefit of a private person or group. No amount of money may be paid to or for the benefit of a shareholder or individual.₂₅ Although the I.R.C. allows monies to be paid to private persons as compensation for services provided to the foundation, the amount of compensation must be reasonable.₂₆

The IRS’s enforcement mechanism is a series of excise taxes or, as a last resort, revocation of exemption. Some of the excise taxes are designed to raise revenue to defer auditing expenses; others are designed to prevent certain behaviors: The latter are punitive in amount. When dealing with punitive measures, often the defense that the transaction was for fair market consideration is not recognized as valid.

There are several sanctions that may be levied against private foundations and their managers to punish and prevent certain investment behaviors. Private foundations and their managers may be liable for a two-tiered excise tax if they violate certain restrictions. The excise taxes are found at I.R.C. §§ 4940, Investment Income Tax; 4941, Self- Dealing; 4942, Undistributed Income; 4943, Excess Business Holdings; 4944, Jeopardizing Investments; and 4945, Taxable Expenditures.

In accordance with I.R.C. § 4940, private foundations are required to pay a tax equal to two percent, as a net investment income of such foundation for the taxable year. The tax is reduced where the private foundation meets certain distribution requirements, and is reported on Form 990-PF. The form is due the 15th day of the fifth month following the end of the fiscal year.

A tax is imposed on acts of self-dealing, which is defined by the Internal Revenue Code Section 4941(d). The tax is imposed on the self dealer and private foundation manager. Due to its broad scope, it can be a trap to the unwary.

There are minimum required distributions pursuant to I.R.C. § 4942 that mandate a private foundation distribute five percent of the fair market value of its net investment assets each year, regardless of the income. Once the amount is determined, the distribution must be made no later than one year from the end of the fiscal year. If this amount is not distributed, there is a tax levied equal to 30 percent of the net of the income remaining undistributed at the beginning of the one-year period.₂₇ There are several exceptions to the 30-percent tax. Internal Revenue Code § 4943 restricts a private foundation’s business holdings. For example, a private foundation may not hold large blocks of stocks in one or more compa- nies. This rule limits the types of businesses that can be engaged by the foundation.

Internal Revenue Code § 4944 safeguards against jeopardizing investments, described as follows:

An investment shall be considered to jeopardize the carrying out of the exempt purposes of a private foundation if it is determined that the foundation managers, in making such investment, have failed to exercise ordinary business care and prudence, under the facts and circumstances prevailing at the time of making the investment, in providing for the long and short-term financial needs of the foundation to carry out its exempt purposes.₂₈

Jeopardizing investments put the foundation’s exempt status at risk.

Finally I.R.C. § 4945 applies to taxable expenditures. A taxable expenditure is any amount paid or incurred by a private foundation for political purposes, for example to influence elections, influence legislation, promote propaganda and/or pay for an individual’s travel expenses (there is a narrow exception).

As previously mentioned in this article, private foundations tend to make grants to public charities to avoid the requirements under this provision. Nevertheless, while a private foundation is not limited to making grants to public charities, it must stay mindful of the taxable expenditure limitations. In making grants, the foundation should always obtain the public charity’s certificate of good standing and confirm its continued tax-exempt status. A trap for the unwary is when the foundation grants money to an individual in the form of a scholarship; this may be done only with the advanced approval of the IRS.

If any of the above-referenced rules are violated, the foundation and/or managers can be subject to stiff penalties and fines. In addition, status as a private foundation may be revoked.

What are the Rules for Terminating a Private Foundation?

Unfortunately if the client no longer desires to keep the foundation, he or she cannot just undo it. There are basically four ways to terminate a private foundation. Two of the methods are without a levy of a termination tax, while the other two are subject to a termination tax.₂₉

What is the State Attorney General’s Role, and What Information Must Be Disclosed to the Public?
Due to the foundation’s status as a charitable entity, the attorney general will have a role in overseeing its proper administration.

A private foundation must make its exemption application and tax returns (i.e., Form 1023 and Form 990-PF) available for public inspection and copying upon request, without charge (except for recovery of out-of-pocket costs incurred in duplicating forms). The IRS also makes these documents available for public inspection and copying.

Who is the Right Client for Establishing a Private Foundation?
How do you know when a private foundation is a viable option for a client? Often, wealthy clients take the guesswork out of answering this question, since they tend to approach you with an existing idea. Often, they like the prestige associated with the establishment of a private foundation. Sometimes clients are seeking tax benefits.

The right client must understand that the day-to-day running of a private foundation requires a considerable commitment of time. The client must consider whether he or she really has the time to devote to the operation of the organization.

As far as dollar amounts are concerned, donors come with all different sized piggy banks. Some private foundations have been established by multibillionaires. Others have been established by people with $500,000. The spectrum is vast.

Conclusion
In summary, the private foundation may be best suited for the client who is charitably inclined and has a taxable estate. A client who is solely looking for a tax advantage should discuss other options.

Creating a private foundation can be an enriching experience for a family, although the laws governing them are complex and harsh. The practitioner must be familiar with, and must keep up to date with, numerous tax, administrative and regulatory requirements in accordance with both state and federal law. One misstep and a client lands in a quagmire of undesirable consequences, such as excise taxes, involuntary termination, or both, and the practitioner may be thrown into a malpractice suit. Therefore, it is important to keep an ongoing dialogue with the client during the foundation’s operation, and advisable to consult with accountants who can help navigate the myriad of tax forms and reporting requirements. This article, intended as an introduction, has only scratched the surface of issues relating to private foundations; many complexities still remain to be explored by the practitioner.



ENDNOTES

1. There are generally three types types of private foundations mentioned: operationg, non-operating, and conduit. However this article will only discuss non-operating private foundation because it is the most commonly used form of the three.
2. I.R.C. § 509(c)(3) Treas. Reg. § 1.501(c)(3)-1
3. IRS Form 1023 must be filed with the IRS and accepted byt he IRS confirm tax-exempt status.
4. I.R.C. § 509(a).
5. I.R.C. § 170(b)(1)(A).
6. Grants may be made to other corporations or individuals provided certain restrictions and supervisory procedures are maintained and followed.
7. I.R.C. § 170(b)(1)(B).
8. I.R.C. § 170(b)(1)(D).
9. I.R.C. § 170(b)(1)(B). The practitioner should also consult the various basis rules.
10. N.J.S.A. 54A:2-1 et seq.
11. I.R.C. §§ 2055(a), 2522(a).
12. N.J.A.C. 18:26-1.1.
13. N.J.S.A. 54:38-1.
14. The IRS has made the practitioner’s life easy by including sample forms for articles of incorporation and charitable trust documents. See IRS Publication 557. In addition, the New Jersey Practice Series, Volume 15A §§ 26.8 and 26.9 may serve as a good reference when drafting the nonprofit corporation’s organizational documents. See N.J.S.A. 15A:2-1 et seq. for requirements under New Jersey law.
15. N.J.S.A. 15A:15-1 provides for a $75 filing fee.
16. Internal Revenue Service Instructions for Form 1023, Appendix A.
17. N.J.S.A. 15A:6-15.
18. See note 17
19. A taxpayer identification number may be obtained by completing and submitting IRS Form SS-4.
20. N.J.S.A. 15A:2-1(d).
21. If the trust or nonprofit expects to have unrelated business taxable income (UBTI), then a trust may be more suitable. This is because of the difference in tax rates. The trust may have a favorable capital gain rate whereas the nonprofit is taxed like a corporation. Corporations do not benefit from the capital gain rates.
22. IRS Form 1023.
23. Treas. Reg. § 1.508-1(e)(2)(i).
24. I.R.C. § 7428.
25. Treas. Reg. § 1.501(c)(3)-1(c).
26. I.R.C. § 4941(d)
27. I.R.C. § 4942.
28. Treas. Reg. §53.4944-1.
29. I.R.C. § 507.