Different Types of Foundations
Many different types of nonprofit organizations call themselves a “foundation,” or use the word in their names. Here are some examples:
A “public foundation” is just another term for a public charity. (Examples of public charities with the word “foundation” in their names include the Make-A-Wish Foundation and The Susan G. Komen Foundation.) These nonprofit organizations rely on donations from individuals, the government, corporations, and private foundations to fund their operations and programs.
A private foundation, like a public charity or public foundation, is dedicated to carrying out a charitable mission. However, a private foundation is not a public charity because, instead of receiving public support, it is funded and controlled by an individual, family, or corporation. Examples of private foundations include The Bill and Melinda Gates Foundation, the Walton Family Foundation, and the Coca-Cola Foundation, Inc.
All private foundations share these commonalities:
- They are established for charitable purposes and to provide donors with a tax deduction for their contributions.
- They are managed by their own board of directors.
- They receive most of their financial support from and are normally controlled by their founders.
- They must make charitable distributions throughout their taxable year.
- They are tax-exempt organizations, but must pay a nominal excise tax of 1.39% on their net investment income.
- Although they typically make grants to public charities, they can also:
– Run programs, provide services, and conduct direct charitable activities.
– Provide aid to individuals and families for disaster relief and hardship assistance.
Non-Operating vs. Operating Foundations
There are two distinct categories of private foundations:
- Non-Operating Foundations
- Operating Foundations
At the most basic level, the primary difference between non-operating foundations and operating foundations is the extent to which a foundation’s resources and operations are dedicated directly to charitable activities and services, and whether such operations are carried on continuously or merely sporadically.
Non-Operating Foundations: These foundations typically make grants to public charities, and they make up the vast majority of the private foundation community. They can conduct their own direct charitable activities (and make grants to individuals, award scholarships, make grants to international organizations that aren’t recognized as 501(c)(3) charities, etc.), but running their own programs is not their primary focus. Generally, a non-operating foundation must make an annual distribution equal to roughly 5% of its prior year’s average net investment assets. Distributions that count toward this requirement include grants to charities, certain related expenses, and, with the exception of investment expenses, necessary and reasonable administrative costs (including Foundation Source’s annual fee). These foundations are the kind that Foundation Source establishes and supports.
Operating Foundations: An operating foundation predominantly undertakes charitable activities and must be significantly involved in its own projects in a continuing and sustaining fashion. (Examples might include the operation of a museum, zoo, library, or research facility.) To ensure that operating foundations are adequately engaged in directly carrying out their charitable activities, each year, they are required to spend the major portion of their investment income (85%) directly on the active conduct of their charitable operations (direct charitable expenditures). Essentially, an operating foundation makes direct charitable expenditures by conducting its own charitable projects rather than by making grants to other organizations. (For instance, rather than give a grant to a food bank, an operating foundation might purchase food directly and hire a driver to deliver it.)
Private Foundation Rules
Because private foundations are established for charitable purposes, they must comply with IRS rules to ensure that they are active, and their expenditures benefit the public. A private foundation is therefore required to make an annual distribution equal to roughly 5% of its prior year’s average net investment assets. Distributions that count toward this requirement include grants to charities, certain related expenses, and, with the exception of investment expenses, necessary and reasonable administrative costs (including Foundation Source’s annual fee).
In exchange for complying with these requirements, private foundation donors enjoy full control over how the foundation’s charitable assets are invested and granted (and pass this control to subsequent generations in perpetuity). They are also entitled to significant tax benefits.
A donor may be able to take advantage of three main tax benefits when he or she gives to a private foundation:
- Reduction of the donor’s income tax for each year in which a contribution is made;
- Avoidance of capital gains taxes depending on the characteristics of property contributed; and
- Reduction or elimination of potential estate taxes.
Income Tax Savings
One of the more immediate tax benefits is that a donor will receive an income tax deduction for any amount he or she contributes to a private foundation up to 30% of the donor’s adjusted gross income (AGI).
Capital Gains Tax Savings
In addition to a deduction for income taxes on gifts to a private foundation, donors may also be able to avoid paying capital gains taxes by donating highly appreciated assets to a private foundation. For example, if a donor were to give appreciated stock to a foundation, he or she would be entitled to receive an income tax deduction for the full, fair-market value of the stock. When the foundation decides to sell the stock in the future, it will pay only the nominal excise tax of 1.39% on the net capital gains.
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.
Benefits of a Private Foundation vs. a Public Charity
According to the National Center for Charitable Statistics, there are approximately 1,097,689 public charities in the United States, and perhaps just 90,000 private foundations. The reason why public foundations vastly outnumber private foundations is largely explained by financial considerations: A public charity can solicit support from the general public, government, and private foundations whereas a private foundation is funded by an individual, family, or corporation. Although Foundation Source has lowered the cost of starting and managing a private foundation, making it practical to establish a private foundation with less than $1 million in initial funding, public charities often have lower start-up costs and no minimal revenue requirements.
Tax Deductible Giving Limits of Public Charities and Private Foundations
Public charities must pass various support tests to qualify for their IRS status. However, compared to private foundations, public charities do have a somewhat higher limit on how much a donor may give and still receive a tax deduction.
A donor may receive up to 60% of his or her adjusted gross income (AGI) for cash donations to a public charity, and up to 30% AGI for donations to a private foundation. In practice, however, tax deduction limitations rarely present a barrier to private foundation donors. First, many donors do not reach AGI limits on tax deductions. If they do, however, contributions that exceed annual limits may be carried over to subsequent years. Second, contributions may be made both to a private foundation and a public charity, so if the maximum 30% AGI limit of cash contributions to a private foundation is reached, additional cash contributions of up to 30% AGI can be made directly to one or more public charities.
Advantages of Private Foundations over Public Charities
Beyond these differences, private foundations enjoy important advantages over public charities. The most important one of these is control. Unlike public charities, which are governed by diversified boards of directors, private foundations are independent legal entities controlled exclusively by their donors. The donors have the final say on how foundation assets are invested and spent; which charities to support; whether others share in foundation governance; and if so, how.
Moreover, because private foundations are given very broad latitude by the IRS to pursue their missions, they can effect change in many ways beyond granting to public charities. A private foundation is empowered to work through almost any entity, public or private, to accomplish its charitable objectives. In addition to supporting U.S. public charities, a private foundation may:
- Make international grants.
- Award scholarships (and choose the recipients).
- Give funds directly to individuals for disaster relief and hardship assistance.
- Make Program-Related Investments including loans, loan guarantees, and even investments in for-profit businesses.
- Run their own charitable programs.
A private foundation provides both control and flexibility, making it an ideal charitable vehicle for donors who want to transform equity into purpose.