There are many philanthropic reasons why a donor might establish a private foundation, but there are also short-term and longterm tax benefits to consider. Donors may be able to take advantage of four main tax benefits when making donations to a private foundation:
- Reduction of income tax liability;
- Tax-advantaged growth of assets contributed to the foundation;
- Avoidance of capital gains taxes for appreciated assets; and
- Reduction or elimination of potential estate taxes.
Income Tax Savings
One of the more immediate tax benefits is an income tax deduction for any amount contributed to a private foundation of up to 30% of the donor’s adjusted gross income (AGI).
Example: Consider the case of Jack, a successful businessman working in finance in a high-tax state like New York and earning an adjusted gross income of $1 million each year. His combined federal and state income tax rate is approximately 47%. Jack plans to retire in five years but wants to establish a private foundation now and contribute $200,000 to it each year until he retires. Jack is single and has no children but sees an opportunity to make his retirement productive by spending it managing a private foundation and pursuing his charitable interests.
Jack will owe nearly $470,000 a year in income taxes based on his adjusted gross income. If he establishes a private foundation and contributes $200,000 to it, he will get a tax deduction for the full amount of the contribution (since it is less than 30% of his AGI), reducing his taxable income to $800,000. If his income tax rate remains approximately the same, he will now owe $376,000 a year in taxes.
By making an annual contribution of $200,000, Jack will save nearly $94,000 per year in income taxes over a five-year period. After five years, he will have contributed $1,000,000 to his foundation at a net personal cost of $530,000, saving $470,000 in taxes.
Income-Tax-Free Growth Of Assets
Let’s assume that Jack follows through with his plan to contribute $200,000 to his private foundation every year over the course of five years. Because Jack’s assets will be able to grow in the tax-advantaged environment of the private foundation, after assuming an 8% growth rate and taking into account a 1.39% excise tax, the private foundation’s endowment will have increased by nearly $150,000 despite having made over $111,000 of charitable grants in satisfaction of the Minimum Distribution Requirement (MDR) during these years. By the time Jack retires, his foundation will be worth $1,143,118, and he can focus on creating a lasting charitable legacy.
|YR. 1||YR. 2||YR. 3||YR. 4||YR. 5|
|1.39% Excise Tax||-$222||-$462||-$709||-$963||-$1,225|
Capital Gains Tax Savings
In addition to a deduction for income taxes on contributions to a private foundation, donors may also be able to avoid paying capital gains taxes by donating highly appreciated assets to a private foundation.
Example: Jack’s sister, Christine, founded her publicly traded technology company on the West Coast and became very successful. Her adjusted gross income each year is $3,000,000. Because Christine lives in a high-tax state like California, her combined federal and state tax rate is 47% (a combined rate of 29% on capital gains). Christine has seen Jack’s personal satisfaction and philanthropic success with his private foundation and is interested in establishing a foundation of her own. She’s particularly interested in instilling philanthropic values in her children and providing them and her husband with a worthwhile activity. Instead of making annual gifts to the foundation, Christine wants to make one initial gift at the outset. She has $2,000,000 in stock in her company with a cost basis of $500,000. She does not want to incur high capital gains taxes.
If Christine sells the stock, she will owe $435,000 in combined state and federal capital gains taxes. If she establishes a private foundation instead and donates the stock to it, she will receive an income tax deduction for the full fair market value of the stock ($2,000,000). Although this exceeds 20% of her AGI, she can carry this deduction forward for five years and, over time, she will save $940,000 in income taxes. In addition, she will not pay any capital gains taxes. When the foundation decides to sell the stock in the future, it will pay only the nominal excise tax rate of 1.39% on the net capital gains. Additionally, because Christine can pass the foundation down to her children, they can become stewards of a significant charitable legacy and further Christine’s good works well beyond her lifespan.
1.39%Instead of capital gains taxes, private foundations pay a nominal excise tax on the sale of appreciated assets.
Estate Tax Savings
When assets are contributed to a private foundation, they are excluded from the donor’s estate and, as a result, are not subject to either federal or state estate taxes. For high-net-worth individuals who have a strong charitable interest, private foundations offer an opportunity to avoid paying estate taxes while simultaneously creating a lasting philanthropic legacy.
Consider Jack and Christine’s parents, Mr. and Mrs. Abbott, who are proud to see that both of their children have been not only financially successful, but have also developed strong charitable interests. Mr. and Mrs. Abbot have combined assets of $40,000,000 and want to leave a portion of their wealth to their children but are also interested in leaving some of their assets to charity. Mr. and Mrs. Abbott are retired and have moved to a state like Florida that has no state level income tax or estate tax. Their assets are largely tied up in real estate and art such that their adjusted gross income is not large enough to justify a charitable gift simply for income tax reduction.
If Mr. and Mrs. Abbott decide to pass all of their assets to their family, after applying a combined federal estate tax exemption of $23.4 million ($11.7 million each), their combined estates will owe approximately $6.6 million in estate taxes. (Tax liability calculated using 2021 federal and state tax rates.)
- Tax-advantaged asset growth
- Five-year income tax deduction carry forward
- Exist in perpetuity
If instead the Abbotts decide to leave the combined federal exemption amount ($23.4 million) to their children and the balance of their estate ($16.6 million) to a private foundation that is funded when the second of them dies, they can entirely avoid paying federal estate taxes. In addition, they will have created a foundation that will preserve and promote the family’s charitable legacy and will instill these values in future generations of Abbotts who will have the opportunity to come together over their common philanthropic goals. Because their children have already established their own foundations, the Abbots could instead simply leave the taxable portion of their assets to those foundations.
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The information provided in this document is for general information purposes only, and does not constitute legal, tax or investment advice.