Private Foundations: A Powerful Tool for Wealth Management and Charitable Giving
- Anatoly Iofe
- Aug 22, 2024
- 6 min read
When high-net-worth individuals think about their wealth, they often consider not just how to grow and protect it, but also how to use it for the greater good. In fact, a significant majority, around 95% of wealthy individuals, engage in charitable activities, often making philanthropy a core part of their financial planning. As a trusted advisor, our role is crucial in guiding clients to meet their charitable goals efficiently. One of the effective ways to give back while managing their wealth is through the creation of a private foundation.
What is a Private Foundation?
A private foundation is a type of nonprofit organization that is primarily funded by a single source, such as an individual, family, or corporation. Unlike public charities, which rely on public fundraising, private foundations usually have a steady source of funding and are often managed by the founding family or individual. This structure allows for a high level of control over how the foundation’s funds are invested and distributed.
Why Consider a Private Foundation?
Private foundations offer a range of benefits for high-net-worth clients looking to make a lasting impact through philanthropy. They provide a way to:
Reduce tax obligations: Donating assets to a private foundation can offer significant tax deductions.
Maintain control: The foundation’s board or trustees have the final say on how the foundation’s assets are managed and distributed.
Create a lasting legacy: A private foundation can continue to support charitable causes for generations to come.
Key Scenarios Where a Private Foundation Shines
There are several specific scenarios where a private foundation can be particularly advantageous. Let’s explore these situations in more detail.
1. Donating Low-Basis, Publicly Traded Stock
If you own publicly traded stock that has appreciated significantly in value, selling it could trigger substantial capital gains taxes. However, by donating this stock directly to a private foundation, one can avoid these taxes and receive a charitable income tax deduction based on the stock’s fair market value. The foundation can then either hold onto the stock or sell it, though a small excise tax of 1.39% may apply to any gains.
2. Managing Illiquid Assets
Many wealthy individuals hold assets that are not easily converted to cash, such as privately held stock or restricted shares. These illiquid assets can still be valuable contributions to a private foundation. Once donated, the foundation can decide to either hold onto these assets or sell them, potentially creating a diversified portfolio. However, it's important to note that certain types of assets, like S Corporation stock, may incur additional taxes.
3. Alternative Assets in a Foundation’s Portfolio
For clients interested in diversifying their investments, private foundations offer the flexibility to include alternative assets, such as real estate, commodities, or hedge funds, in their portfolio. These assets can provide higher returns and reduce risk through diversification. However, the foundation must ensure it complies with IRS regulations to avoid issues like Unrelated Business Income Tax (UBIT) and excess business holdings.
4. Donating Real Estate
Real estate can be an excellent asset to donate to a private foundation, especially if it is expected to appreciate in value or generate rental income. By donating real estate, clients can avoid paying capital gains taxes and potentially reduce their estate tax liabilities. The foundation can then use the property to generate income or sell it to fund its charitable activities. However, the donation must be carefully structured to avoid self-dealing violations, where the donor or related parties benefit directly from the foundation's transactions.
5. Contributing Tangible Assets
Tangible assets, such as artwork, jewelry, or collectibles, can also be donated to a private foundation. These items can either be sold to fund the foundation's activities or held as long-term investments. The tax deduction for these donations is typically based on the item's cost basis rather than its current market value. Additionally, if the donated item is used directly for the foundation’s charitable purposes, it may not be counted in the foundation's required annual distributions.
Tax and Estate Planning with Private Foundations
Private foundations are not just tools for charitable giving; they also play a significant role in tax and estate planning. Let’s explore some scenarios where a private foundation can help your clients achieve their financial goals.
1. Managing a High-Income Year
When your client experiences a year with unusually high income—perhaps from a business sale, stock options, or other windfall—establishing a private foundation can help manage the tax impact. Contributions to the foundation can be deducted from the client’s taxable income, up to 30% of their adjusted gross income (AGI) for cash donations, or 20% for non-cash donations. This strategy not only reduces the current year's tax burden but also allows for the carry-forward of excess deductions for up to five years.
2. Selling a Business
Selling a business can result in a significant tax liability. By donating shares of the business to a private foundation before the sale, one can reduce or eliminate capital gains taxes on the donated portion. The foundation then sells the shares, with the proceeds going towards charitable activities. This approach not only reduces taxes but also removes the value of the donated shares from the client’s taxable estate.
3. Minimizing Estate Taxes
Private foundations can be instrumental in reducing estate taxes. Assets donated to the foundation are removed from the client’s estate, lowering the overall estate tax liability. This strategy is particularly effective for clients who wish to leave a philanthropic legacy while reducing the tax burden on their heirs. However, it’s important to remember that this is an irrevocable transfer, meaning the assets will no longer be available to the donor’s beneficiaries.
Enhancing Charitable Planning
For clients who are already actively engaged in charitable giving, a private foundation can enhance their philanthropic strategy.
1. Using an Existing Life Insurance Policy
If your have a life insurance policy that is no longer needed for family financial security, you can use it to benefit their private foundation. One option is to name the foundation as the policy's beneficiary. Upon the client’s death, the policy's death benefit is paid to the foundation, and the estate may receive a charitable deduction. Alternatively, the client can transfer ownership of the policy to the foundation, potentially receiving a charitable income tax deduction.
2. Combining a Private Foundation with a Donor-Advised Fund
Some clients already have a donor-advised fund (DAF) but are looking for more control over their philanthropic activities. A private foundation can work alongside a DAF, offering the best of both worlds. While the foundation provides control and flexibility, the DAF offers anonymity for certain grants and can help meet the foundation's minimum distribution requirements.
3. Supporting Active Involvement in Charitable Activities
For clients who wish to be more hands-on with their philanthropy, a private foundation offers great flexibility. Whether it's setting up scholarship programs, making grants to individuals, or even running their own charitable initiatives, foundations can engage in a wide range of activities. This active involvement can be deeply rewarding and allows clients to see the direct impact of their contributions.
4. Reimbursing Charitable Expenses
Running a foundation often involves expenses, such as travel for charitable purposes or costs associated with running programs. The good news is that a private foundation can reimburse these expenses, making it easier for clients to manage the costs of their philanthropic work. If a client prefers to cover these expenses personally, they can still receive a charitable income tax deduction for the unreimbursed amounts.
5. Hiring Family Members
Unlike donor-advised funds, private foundations can hire family members to help manage the foundation’s activities. This not only provides employment opportunities for the family but also helps ensure that the foundation remains a family-led endeavor. However, it’s crucial that any compensation is reasonable and based on the services provided, in line with IRS guidelines.
Important Considerations
While private foundations offer numerous benefits, they also come with responsibilities and limitations:
Irrevocable Donations: Contributions to a private foundation are irrevocable and must be used solely for charitable purposes.
Managing Illiquid Assets: Foundations must ensure they have enough liquidity to meet their annual distribution requirements and cover operating expenses.
Compliance: Foundations must comply with IRS regulations, including filing annual tax returns and adhering to rules against self-dealing.
Conclusion: A Lasting Legacy of Philanthropy
Private foundations are a powerful tool for wealthy individuals and families who want to make a difference in the world. By carefully planning and structuring their foundation, clients can reduce tax burden, maintain control over their charitable giving, and create a legacy that lasts for generations.
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Sources*:
*These organizations are not affiliated with IFG. IFG does not endorse, support, or recommend any information that is not provided by its affiliates or representatives.
Disclaimer:
Information provided is for informational purposes only, and does not constitute an offer or solicitation to sell, a solicitation of an offer to buy, any security or any other product or service. Accordingly, this document does not constitute investment advice or counsel or solicitation for investment in any security. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation.
