Foundation basics

‍How do you start a private foundation?

Starting a private foundation is a complex endeavor, not suited for a do-it-yourself approach. The intricate nature of filings and paperwork typically necessitates the expertise of a specialist. A private foundation can be set up as either a nonprofit corporation or a legal trust. Although both routes lead to the creation of the same basic entity, they are regulated by different legal statutes, and these varying details can be significant. In practice, forming a nonprofit corporation is the more commonly chosen structure for a private foundation.

Define the Charitable Purpose

To qualify as a tax-exempt organization, a foundation must align its purpose with those outlined in Section 501(c)(3) of the Internal Revenue Code. This means its purpose should fall into one of the following categories: charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, or preventing cruelty to children or animals. The foundation has the flexibility to define its purpose either broadly, encompassing a wide range of activities, or narrowly, concentrating on specific causes.

Check Name Availability

An early step in establishing a foundation is to verify the availability of your chosen name in your state. This is typically accomplished by consulting the Secretary of State's office. Generally, it's permissible to have a name similar to an existing foundation. For instance, if a state already has a "Kirk Foundation" registered, you would likely be allowed to name your foundation the "James T. Kirk Foundation". Although foundations organized as trusts typically aren't required to undergo this step, it's still advisable to consider it. Foundations organized as trusts can easily distinguish their name, for instance, by adding a date stamp to it.

Legal Formation  

To legally establish the organization, it typically involves incorporation, which means creating a corporation. In cases where the foundation is set up as a trust, a trust document is required. Corporations are the more prevalent structure and necessitate articles of incorporation as their foundational document. This document legally institutes the foundation in its home state and must be drafted in compliance with the relevant state law. The date of incorporation is significant as it marks the 'birthdate' of the foundation.

Apply for a Federal Employment Identification Number (EIN)

The foundation requires a federal identification number, akin to an individual's social security number, for identification purposes. Applying for an Employer Identification Number (EIN) is a straightforward process that can be completed online with the IRS. It's important to note that obtaining an EIN is necessary for the foundation, even if there are no plans to hire employees.

Draft Bylaws

The bylaws serve as the guiding rules for the foundation's daily operations. They usually encompass details like meeting protocols, roles and responsibilities of officers and directors, terms of service, and other key governance aspects. It's essential that these bylaws adhere to both IRS regulations and state laws. It's worth noting that trusts, unlike corporations, don't operate under bylaws. Instead, they are governed by a trust agreement or deed of trust.

Draft Conflict-of-Interest Policy

The IRS highly recommends adopting a conflict of interest policy to ensure that its board members, officers, and management act in the organization's best interest rather than in their personal interest. While not a strict legal necessity, the application for 501(c)(3) status does inquire if such a policy is in place. The lack of a conflict of interest policy can lead to scrutiny during the IRS review process and may even jeopardize the approval of the organization's 501(c)(3) status.

Having such a policy in place is seen as part of good governance practices. It helps in maintaining public trust and ensures that decisions are made in alignment with the organization's mission and not influenced by personal gain. This policy typically includes procedures for disclosing potential conflicts, steps for managing these conflicts, and often a requirement for annual statements from board members and key employees to disclose any potential conflicts.

Application for 501(c)(3) status

Applying for 501(c)(3) status requires private foundations to complete and submit Form 1023 to the IRS, accompanied by the necessary user fee. The application must be submitted online. After submission, Form 1023 is reviewed by an IRS agent, a process that generally takes six to 12 months and rarely concludes in under six months. During the review it is common for the IRS to request additional information from the organization. It's important to ensure that the foundation's organizing documents include the following key elements:

1. Charitable Purpose Clause: This clause should clearly state the charitable activities the foundation plans to undertake.

2. Limitation on Lobbying Clause: The foundation is prohibited from engaging in substantial lobbying activities or any political activities, such as endorsing specific political candidates.

3. Private Inurement Clause: The foundation's income and assets must be dedicated exclusively to charitable purposes, ensuring no individual benefits privately.

4. Charitable Dissolution Clause: In the event of dissolution, the foundation’s assets must be distributed to another 501(c)(3) organization.

Once the IRS approves the application, it issues a determination letter that officially acknowledges the organization as a private foundation, classified under 501(c)(3). This letter, along with the Form 1023 application, are essential throughout the organization's existence and should be safely stored. They are important documents for both donors and the public, who may request to see them to confirm the organization's tax-exempt status or for any other reason.

State Tax Exemption

Once the IRS grants 501(c)(3) status to the foundation, additional steps may be required in certain states, like California and Texas, involving filings with the state's department of revenue to secure state-level tax-exempt recognition. The specifics of this requirement can differ significantly from state to state.

State Fundraising Registration

Most states mandate registration for private foundations if they intend to solicit contributions or donations from the public. However, substantial donations from family members usually do not necessitate such registration. It's important to note that there is considerable variation in fundraising registration requirements at the state level.

Ongoing requirements

The ongoing requirements for managing foundations are quite complex, with significant penalties for non-compliance. For the vast majority of private foundations, there is an obligation to annually distribute or expend approximately 5% of the foundation's assets towards its charitable mission. Additionally, these foundations must also fulfill the requirement of annual reporting to the IRS using Form 990-PF.

Additionally, most private foundations are liable for an excise tax on their net investment income, including items such as interest, dividends, capital gains, and royalties. This tax is determined when filing the annual tax return via Form 990-PF

Moreover, compliance with state-specific regulations is crucial. This can encompass a range of obligations, such as additional state filings, registration for fundraising activities, and adherence to laws specifically governing charitable organizations within the state. These state-level requirements can vary significantly and require careful attention.

Given the complexity of these federal and state requirements, seeking professional assistance is highly recommended to ensure thorough compliance and to navigate the intricate landscape of foundation management effectively.

Seeking expert guidance? We're here to help!

At CPA KPA, we're passionate about magnifying the positive impact of private foundations. Feel free to reach out to us anytime at 888-402-1780 for a complimentary and obligation-free conversation. You can also conveniently submit your questions and inquiries through our contact page. Let's connect today and explore how we can help your foundation have a lasting and meaningful impact!

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Foundation basics