Be Careful When Discussing The Merits Of Private Foundations

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You hear it pretty regularly: If you want to make large tax-deductible charitable donations and yet maintain complete controlmaybe even providing salaries for your kids–then you should set up a private foundation. Like most broad statements of this sort, it contains both some truth and some falsehood.

The truth, of course, is that private foundations can be wonderful planning tools for clients with substantial assets and major donative intent. These charitable organizations can be created, funded and controlled by a single individual or that individuals family.

In fact, many parents use private foundations as a way to train their children in the responsible management of money and philanthropy. As a general rule, private foundations can give donors great flexibility over the application of charitable gifts through the years.

However, along with this flexibility comes limits. Thats where the falsehood can come in. Contrary to what some people may say or imply, there are real limits to exploiting private foundations for your own, non-charitable purposes. In response to a raft of perceived abuses, Congress has placed multiple restrictions on the use of private foundations.

Lets take a look at some of the things that you had better remember when discussing private foundations with your clients.

A private foundation is a charitable organization. To qualify for favorable tax treatment, a private foundation has to be the real thing. It isnt a family piggy bank. To that end, a private foundation must generally distribute at least 5% of its investment assets each year for charitable purposes.

Failure to make these distributions can result in substantial excise taxes. That means that you cant use the private foundation to hoard assets solely for your familyyou really must spend a portion of the foundations assets for charitable purposes every year.

There are substantial excise taxes levied on self-dealing. Self-dealing is defined as participating in a “prohibited transaction” with a “disqualified person.”

The term “disqualified person” covers a large group of people related to the foundation. For our purposes, just know that it includes the donor and the donors family.

“Prohibited transactions” include selling or leasing foundation property, loaning assets, and furnishing goods, services, or the use of the foundations facilities. The rules cover direct and indirect transfers of foundation property. This rule is meant to be broad.

All that being said, this rule makes it very difficult for a client to use the private foundations assets for his or her family. Mind you, there are exceptions for the payment of reasonable compensation to a family member.

But be aware that the family member really needs to provide services to the foundationand that you had better be able to substantiate the reasonableness of the compensation paid for the services rendered.

You cant use a private foundation to manage a closely held business. There are limits on how large a percentage of a given business the foundation can own.

If the foundation holds more than the stated percentage (20% of the voting stock of a corporation in most cases), then it will be subject to another substantial excise tax.

You cant use a private foundation to prop up a failing closely held business. Theres an excise tax on jeopardy investments. A private foundation cant invest its funds in a way that could jeopardize its ability to carry out its charitable purpose.

Investing in an ailing family business would probably violate this rule and subject the foundation to further excise taxes. The investment would probably also violate the self-dealing rules mentioned above.

You cant manage a private foundations portfolio as aggressively as you would your own. The rule regarding jeopardy investments is purposefully broad. Other potential jeopardy investments could include: trading securities on margin; trading in commodity futures; puts, calls, straddles and warrants; and selling securities short.

A donor must never forget that the investment assets of a private foundation must be managed to further the foundations charitable purpose.

Administrative costs can be hefty. Creating and running a private foundation requires a great deal of specialized legal and accounting help. A donor will need assistance organizing it, getting tax-exempt status, following all of the rules to avoid and minimize multiple excise taxes (including some not mentioned here), and filing annual returns with the IRS. The legal and accounting bills are generally substantial.

Private foundations can require a major time commitment. Even this partial list of issues demonstrates how much is involved in establishing and maintaining a private foundation. A client considering setting up a private foundation must recognize that it is a serious undertaking. You cant just set one up, make some gifts to generate income tax deductions, and walk away from it.

The next time that you hear extravagant claims made for the use of private foundations, remind yourself that the claims may be overstated. While private foundations can be powerful charitable planning tools under the right circumstances, be wary of falling for the exaggerated version. And, when you discuss private foundations with your clients, make sure that youre not exaggerating the merits of this planning device yourself.

, JD, is senior consultant, advanced markets for TIAA-CREF Life Insurance Company, New York, N.Y. He can be reached via e-mail at cannalora@tiaa-cref.org.


Reproduced from National Underwriter Life & Health/Financial Services Edition, December 3, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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