From the June 2009 issue of Wealth Manager Web • Subscribe!

Keep On Giving

When a client contemplates setting up a private foundation, make sure you spend time with them on the "softer" issues, and that they are able to answer the following questions:

? What is their underlying motivation?

? What is the defined mission?

? What is the future vision for the foundation?

? How do they see family members being involved?

? Will the foundation have a specified time frame?

The last question requires some thought--it can only be answered after your client is confident in his or her answers to the previous four questions. The answer to this question is more important than ever--especially in light of the 5% distribution requirement and expected market returns. A number of donors are rethinking the need for perpetuity and are designing foundations with limited life spans that are event driven or time driven, for example.

In addition to all the soft issues, one of the biggest decisions to make is what type of legal entity to adopt for this foundation: Should it be a trust or a corporation? Before your clients can answer, you must help them consider the effects of their choice by examining such issues as:

? Creation process

? Ongoing compliance

? Liability considerations

? Tax considerations

? Succession and investment considerations

The creation process

Let's begin with what the two entities have in common in terms of forming a foundation. First, they both require confirmation of their tax-exempt status through filings with the IRS and applicable state tax authorities. Next, initial and periodic filings with the state attorney general may be required and last, legal costs are pretty similar for both structures. (For a more detailed look at the way foundations differ from trusts, see the table below.)

Ongoing compliance

The easiest way to think about the differences between the two structures in regard to ongoing compliance is by formality. A corporation is formal, whereas a trust tends to be more informal.

We say that corporate foundations are "formal" because they are subject to certain continuing legal formalities under state laws such as annual board meetings. In addition, a corporate foundation's oversight is the responsibility of the board of directors, while its management rests with its officers. Trusts, on the other hand, have fewer formal requirements than a corporation and traditionally do not separate oversight from management; the trustee is often responsible for both.

Generally speaking there are state-level differences of compliance requirements for trusts versus corporations, whereas federal law imposes a uniform set of compliance requirements for all foundations.

Liability considerations under state law

Both trusts and corporations impose minimum duties of loyalty and care on their trustees or directors. The fiduciary duties of a trustee are to the charitable purposes of the trusts, however, whereas the duties of corporate directors are to the corporation.

Both trust and corporate documents can be drafted to minimize risk of liability for breach of duties. For example, the bylaws of most corporate foundations contain indemnification provisions. Trust instruments can employ similar language as well as be established in states such as Delaware that provide more explicit protection to trustees and authority to limit trustee liability.

Tax considerations

While foundations are typically referred to as tax exempt, that is not technically true. All foundations pay an annual excise tax on net investment income equal to 2% (or 1% when the foundation's distributions meet certain requirements).

However, the tax on unrelated business taxable income (UBTI) is another matter. If the foundation is a nonprofit corporation, then its UBTI tax is computed under the corporate rate schedule; a foundation in trust form is taxed under the rate schedule applicable to trusts. The maximum marginal rates on ordinary income are comparable under these two schedules, but the maximum rates on long-term capital gains are strikingly different--currently 15% for a trust, but up to 35% for a corporation. Foundations typically try to avoid taxes on UBTI, but if they fail in that intention, a trust can be advantageous, particularly when the UBTI is long-term capital gain.

Succession considerations

One of the main benefits of nonprofit corporations is their flexibility in adapting to changing circumstances after the death of the original donor. Since the charitable mission can easily be changed by a vote of the directors and filing the proper legal documents with the appropriate state agency, future generations are free to pursue their own charitable goals.

However, this flexibility can be as much a curse as a blessing. If your client truly wants to control his or her legacy over the long term, a trust is the clear choice. A trust can be drafted for flexibility during the donor's lifetime, but may become more difficult to change--even unamendable--after the donor's death. Moreover, trust instruments can provide more certainty in the appointment of successor trustees, who continue to have a fiduciary obligation to the trust instrument and donor intent. A properly drafted trust agreement can ensure that the grantor's vision is carried out after death. A trust can be enforced in the courts and, under the cy pres doctrine (staying close to a gift's intent), courts are usually loathe to allow deviation from the donor's clearly expressed vision--absent illegality, impossibility or impracticability of the charitable purpose.

Investment considerations

As a practical matter, the principles governing investments are the same for corporate foundations and trusts, although they may derive from different statutes. Traditionally, corporate foundations looked to the Uniform Management of Institutional Funds Act (UMIFA), while trusts were governed by the Uniform Prudent Investor Act (and perhaps UMIFA as well).

There is one investment area where the rules are somewhat different. Over the past decade or two, alternative investments such as private equity and hedge funds have become a significant part of foundation endowments. The rules for such investments require that the investor meet the standards governing "qualified person" and "accredited investor" rules.

The decision to create a private foundation requires thoughtful consideration about the donor's goals--as well as important factual considerations regarding compliance, governance, liability, taxation, succession and investments. If you are not familiar with these issues, reach out to your firm's specialists or use this as a way to network with attorneys and accountants. Becoming an expert on foundations will enhance your value to the high-net-worth community.

Susan L. Hirshman CFA, CPA, CFP (sheltd1@gmail.com), is a managing director and wealth advisor at JPMorgan Private Wealth Management in New York.

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