June 7, 2023
The term “501(c)(3) organization” — which refers to the Internal Revenue Code section governing not-for-profit entities — often is used interchangeably with “public charity.” But not all 501(c)(3) organizations are public charities. Some are private foundations, and they’re subject to different tax rules.
Individual and Family Charity
A private foundation is a 501(c)(3) organization created by an individual, family or corporation to support charitable causes. The Bill & Melinda Gates Foundation, the Walton Family Foundation, and the Coca-Cola Foundation are several well-known private foundations.
These foundations maintain a board of directors or trustees to oversee contributions, manage and invest assets, and make grants to other organizations. The board is also responsible for filing tax returns and meeting other IRS requirements. Public charities, by comparison, derive most of their support from the public. This includes most 501(c)(3) organizations, such as hospitals, churches, schools, and nonprofit social service organizations.
Private foundations generally take one of two forms:
- Operating. As the name implies, these organizations are directly involved in operating charitable endeavors — for example, museums or memorials.
- Nonoperating. This type of organization generally accomplishes its mission by making grants to other charities. It can operate its own philanthropic projects, but they aren’t its primary focus.
Most private foundations are nonoperating. Typically, a family foundation represents the interests and objectives of a single family, while a corporation may oversee an independent foundation.
Be careful that you don’t confuse nonoperating private foundations with donor-advised funds (DAFs). DAFs are accounts set up for charitable giving under a name chosen by the donor. They usually are managed by the charitable arms of large financial institutions such as Fidelity or Charles Schwab or by community foundations. In some cases, a DAF may be used in conjunction with a private foundation.
Setting up a private foundation isn’t simple and typically isn’t a do-it-yourself proposition. If you want to go this route, it’s best to enlist the services of professionals with nonprofit and foundation experience. Your advisors can handle nitty-gritty details, including establishing a legal entity and attaining tax-exempt status.
Once the basic legalities have been satisfied, you can move on to funding your foundation. Unlike with a public charity, the bulk (if not all) of a foundation’s money usually comes from one donor or a few family members or group of individuals. Foundations may also be funded by corporations. Contributions generally take the form of cash or cash equivalents, but they can also be publicly traded securities, life insurance or annuities, real estate, IRA assets, or private equity.
Tax ramifications may depend on the type of property contributed. For example, if property owned less than one year is donated to a foundation, the charitable deduction is limited to the donor’s basis in the property, not its current value.
In theory, a private foundation can last forever. But realistically, founders often reach a point where they no longer want to run the foundation, or they pass away. In these cases, the foundation can be legally dissolved.
Pros and Cons
A private foundation can create a long-lasting legacy for an individual, family or company. Among other benefits,
- Founders and family members often serve the foundation in leadership positions such as president or board member.
- Foundations enable individuals and companies to support causes they consider important and worthy. If foundation requirements are met, board members may, for example, establish a scholarship program to their alma mater or award grants to other 501(c)(3) organizations.
- Donors who itemize deductions can reduce their income tax liability. You typically can deduct as much as 30% of your adjusted gross income (AGI) for cash gifts and 20% of your AGI for property gifts. Any excess can be carried over for up to five years.
- Donations of appreciated property avoid capital gains tax that would apply if property was instead sold.
Note, however, that the benefits for donations made to public charities may be greater than gifts to foundations. The current deduction limit for cash (and cash equivalent) gifts to public charities is 60% of AGI.
That’s not to say that running a private foundation is easy. You must attend to potentially costly and time-consuming administrative matters and comply with IRS rules to maintain your foundation’s tax-exempt status. For example, nonoperating private foundations are required to pay out at least 5% of their assets each year in grants and charitable activities. Also, although private foundations are exempt from federal income tax, their net investment income is subject to a 1.39% excise tax. This tax doesn’t apply to public charities or DAFs.
If you’d like to create a philanthropic legacy but aren’t sure whether to establish a private foundation or DAF — or simply make direct donations to public charities, contact us. We can review your resources, goals and participation plans and help you arrive at the best choice.