You are conducting an estate planning meeting. The clients' estate exceeds $2,500,000, which includes a tax qualified plan or IRA rollover of $500,000. The clients currently contribute to charity and want to continue their charitable giving after death.
To achieve their goals, should the clients designate public charities in their will/trust or should they create their own private foundation to receive their charitable bequest?
A private foundation is a separate legal entity that commonly bears the donors' name and is recognized as a charitable organization by the Internal Revenue Service. The foundation is created for charitable purposes specified by the donors (example: grants for cancer research, scholarships for the needy, support of religious goals).
During lifetime, the donors continue their charitable giving by making tax deductible contributions to their own foundation which then distributes grants to recipients consistent with its charitable purposes. At death, the foundation is then funded with a bequest from the donors' will/trust or receives funds as the primary or secondary beneficiary of their qualified plan or IRA.
A. Control. The donors maintain control over their charitable giving by specifying the purposes of the foundation and then making grants consistent with its charitable purposes. For example, the foundation may be established to advance medical treatment for the poor. Beneficiaries of such grants are then determined by the foundation's Board of Directors, which would include the donors and their family. The Board of Directors is also responsible for investing the foundation's assets.
B. Flexibility. A foundation provides flexibility in making distributions since gifts are made in accordance with its charitable objectives rather than pre-selecting named charities which may not be in favor or in existence at the time of death. When the foundation receives its funds, the Board of Directors would then determine which recipients qualify to receive a distribution.
C. Family Involvement. Many clients find it important to encourage family involvement in their charitable goals. With a foundation, family members could serve on the Board of Directors. The family participates in implementing the charitable objectives and continues the family's role in the community. Family members may even receive compensation for their services.
D. Continuity. By establishing a foundation, the donors' charitable goals continue. The donors' name is associated with the foundation's charitable purposes in perpetuity.
E. Tax Advantages. Private foundations receive favorable tax treatment. Donors receive an income tax deduction for lifetime contributions and an unlimited estate tax deduction for bequests at death. In addition, the earnings grow tax free.
The income tax deduction is subject to certain percentage limitations against adjusted gross income and is dependent upon whether the gift is cash or appreciated property. It is helpful to compare the income tax treatment of contributions to private foundations with public charities.
1. General Rule.
a. Cash. A donor can deduct cash gifts to a private foundation up to 30% of adjusted gross income. Cash gifts to a public charity are deductible up to 50%.
b. Appreciated Property. Gifts of appreciated property to a private foundation (stock, real estate) are deductible up to 20% of adjusted gross income. The amount of the deduction is generally limited to basis. By contrast, the fair market value of appreciated property donated to a public charity is deductible up to 30% of adjusted gross income. The Taxpayer Relief Act of 1997 granted private foundations favorable tax treatment (deduction equal to fair market value vs. basis) if publicly-traded stock is contributed to a private foundation by June 30, 1998.
c. Carryover. The donor is entitled to a 5-year carryover in excess of the percentage limitations following the year of contribution.
2. Exception - Pass-Through Foundation. Clients that want to enjoy the benefits of a private foundation and also want to take advantage of the more favorable deduction limits of a public charity can annually elect pass-through status. A pass-through foundation must distribute its tax deductible contributions no later than the 15th day of the 3rd month after the close of the foundation's taxable year in which contributions are received by the foundation.
After a trust or non-profit corporation is created, the foundation's purpose clause is further developed in the Bylaws. As with any enterprise, it is important to designate a Board of Directors and develop a succession plan. The client must file the Charitable Solicitation Questionnaire with the State of Michigan to inform the Attorney General whether the foundation intends to solicit funds from the public. An Application for Recognition of Exemption/Form 1023 is then submitted to the IRS. It takes approximately 3 months for the IRS to grant written approval of the foundation as a tax-exempt organization. Annually, Form 990PF must be submitted to the IRS to report financial information, including contributions received, income and expenses.
EXCISE TAX PROVISIONS
There are a number of excise tax provisions that are imposed on private foundations and its managers to make sure the foundation is operated properly.
A. Minimum Payout. A private foundation is required each year to make qualifying distributions for charitable purposes equal to or exceeding 5% of the fair market value of its net investment assets. Payment must be made prior to the following taxable year in which the contribution is made. If the foundation exceeds the 5% payout, the excess reduces the required distribution over the next 5 years. Newly-created foundations may have 5 years to satisfy minimum payout distribution requirement.
Failure to distribute the minimum payout results in a 15% excise tax with an additional excise tax of 100% if the foundation fails to correct the deficiency in a timely manner.
B. Net investment income. Foundations must pay an excise tax equal to 2% of its net investment income. The excise tax is reduced to 1% if the foundation makes qualifying distributions in excess of its average distribution over the prior 5 years.
C. Self-dealing. If a a disqualified person engages in self-dealing, a 5% excise tax is imposed of the amount involved on each act of self-dealing per year which increases to 200% if not timely corrected. Self-dealing includes the following acts between the foundation and a disqualified person: sale or lease of property, furnishing goods or services, and payment of compensation. A disqualified person includes substantial contributors (more than $5,000 during the year) and family members.
D. Jeopardy Investments. If the foundation invests its assets in a manner that jeopardizes its exempt purposes, a 5% excise tax is imposed increasing to 25% if not timely corrected. No investment is per se unacceptable but the following types of investments are carefully scrutinized: margin trading, commodity futures, warrants, and selling short.
E.Taxable Expenditures. A foundation is precluded from making taxable expenditures to influence legislation and distributing grants to individuals (unless prior IRS approval is obtained), and other private foundations (unless procedures are established that the grant will be used for its designated purpose). The excise tax is 10% of the taxable expenditures increasing to 100% if not timely corrected.
F.Excess Business Holdings. A 5% excise tax is imposed on the foundation's excess business holdings increasing to 200% if the deficiency is not timely corrected. Under these provisions, a private foundation and all disqualified persons cannot own more than 20% of a business not substantially related to its charitable purpose. The percentage can increase to 35% if a third person other than disqualified persons control the business. If the foundation acquires the business by gift, it has 5 years to dispose of the enterprise without tax.
A private foundation is an excellent technique for clients to control their charitable giving and to promote family involvement in the community. With favorable tax treatment, clients who are charitably inclined should consider the benefits of a private foundation.