Foundation basics

What are the tax benefits of a private foundation?

Establishing a private foundation is a meaningful way for donors to support charitable causes while also taking advantage of various tax benefits. By giving to a private foundation, donors can unlock powerful tax incentives that include immediate income tax deductions, tax-free growth of assets, and the avoidance of capital gains tax and estate and gift taxes.

Immediate Income Tax Deductions

One of the most significant benefits that donors can take advantage of when contributing to a private foundation is the potential for substantial tax savings, including the opportunity to receive immediate income tax deductions. Both federal and state tax law allow donors the ability to claim these contributions as an itemized deduction on their income tax returns, albeit with certain limitations in place. For instance, cash contributions can be deducted up to 30% of the donor's adjusted gross income (AGI), while contributions of appreciated property, such as stocks, can be deducted up to 20% of AGI. If contributions are over these limitations, a five year carry forward of the excess contribution is available.

This tax incentive markedly reduces the donor's overall tax liability, enhancing the financial attractiveness of charitable giving. Take, for example, a donor in a combined state and federal income tax bracket of 45%. Upon contributing a dollar to their private foundation, they are entitled to an immediate income tax deduction, effectively reducing their taxable income by a dollar. This reduction subsequently decreases the amount of tax they owe by 45 cents, given that their tax rate is 45%. Consequently, the net cost to the donor for their charitable donation is merely 55 cents, after factoring in the 45-cent tax savings. In essence, the donor is saving 45 cents in taxes for every dollar donated, thereby making their philanthropic gesture not only generous but also financially savvy.

Tax-Free Asset Growth Within Foundations

The ability to experience income tax-free growth on assets held within a private foundation is a highly attractive benefit. This tax-free status applies to all types of investment income, whether they come in the form of interest, dividends, capital gains, or other types of income. While there is a 1.39% excise tax on investment income, the overall impact on the foundation's returns is relatively minor. As a result, the majority of investment returns are preserved and available for the foundation's use. This tax advantage plays a significant role in magnifying the power of compounding over time.

Another important point to consider is that the tax-free growth of assets within a private foundation also applies to any reinvested earnings. This means that not only do the initial contributions grow tax-free, but so do any returns generated from those contributions when they are reinvested. This creates a snowball effect that can lead to substantial growth in the foundation's assets over time.

Minimizing Capital Gains Tax

Donating long-term appreciated assets to a foundation is a strategic way to minimize your capital gains tax liability while maximizing your charitable impact. When you contribute assets such as stocks, mutual funds, or real estate, you can deduct the fair market value of the donation from your income taxes and potentially eliminate the 20% capital gains tax and the 3.8% Medicare surtax on net investment income. It’s important to note that these assets can be publicly traded or non-publicly traded, including shares of a private business.

Let’s take a closer look at an example to fully understand the potential tax benefits of donating appreciated stock directly to a charitable foundation. In this scenario, we have a donor who is considering selling a stock worth $100,000 that has a cost basis of zero. If sold at the individual level, the gains would be subject to a combined 23.8% tax rate, which includes a 20% capital gains tax plus a 3.8% Medicare surtax on net investment income. So if the donor decides to sell the stock himself, he would be faced with a tax bill of $23,800 (23.8% of $100,000). This is a significant chunk of the stock’s value, and it would leave the donor with only $76,200 to donate to charity.

Now, let’s consider the alternative scenario where the donor contributes the stock directly to a foundation. In this case, the foundation can then sell the stock exempt from capital gains tax. However, the foundation will incur a 1.39% excise tax on the net investment income. This means that from the $100,000 proceeds of the stock sale, the foundation will pay $1,390 in excise tax (1.39% of $100,000). After paying the excise tax, the foundation is left with a net amount of $98,610 ($100,000 - $1,390). This is significantly higher than the $76,200 that would be left if the donor sold the stock and donated the after-tax proceeds. This is a win-win situation that allows the donor to maximize their charitable impact while also potentially benefiting from a tax deduction for the fair market value of the donated stock.

Estate and Gift Tax Advantages for Donors

Lastly, high net worth individuals who make contributions to a charitable foundation can reap significant benefits with respect to estate and gift taxes. By contributing assets to a private foundation, these assets are then excluded from the donor's estate, rendering them exempt from both federal and state estate taxes—a notable benefit, especially given the current federal estate tax rate of 40 percent. This rate can significantly deplete an estate's value. As of January 1, 2023, the federal estate tax exemption amount is $12,920,000 per individual or $25,840,000 for married couples. This makes donating to a foundation an especially appealing option for high net worth individuals with assets exceeding these thresholds. However, it is important to note that many states also impose their own estate taxes, often with much lower exemption thresholds than those set by the federal government. Consequently, even those with more modest estates may find that making a charitable contribution to a foundation can alleviate the burden of state-level estate taxes.

Conclusion: A Legacy of Giving and Saving

In summary, private foundations offer donors a unique opportunity to support charitable causes while reaping significant tax benefits. These benefits, which include immediate income tax deductions, tax-free growth of assets, avoidance of capital gains tax, and exemption from estate and gift taxes, can result in a substantial charitable legacy that can be passed down to future generations.

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