Foundation basics

What is a private foundation?

In essence, a private foundation is a tax-exempt organization that is funded and controlled by an individual or a family and set up to facilitate philanthropic giving. Private foundations do not typically have charitable operating programs of their own. Instead, they customarily make grants to operating charities like the American Red Cross or Habitat for Humanity. The IRS grants special tax status to a foundation only if its principal documents clearly show it is dedicated to carrying out a charitable mission and it meets certain federal and state requirements. Well known examples of private foundations include the Bill and Melinda Gates Foundation, the Ford Foundation, and the Rockefeller Foundation.

Unlike a public charity, a private foundation does not typically solicit funds from the public. Instead, private foundations are almost always funded by a private party such as a wealthy family or a successful business enterprise. As a general rule, the private party that provides the funding has control over the foundation. Oftentimes the founder makes a very large contribution at the inception of the foundation that becomes the endowment.

Private foundations can make financial investments with their endowment (stocks, bonds, mutual funds, etc.) with the intention of increasing the endowment for additional charitable giving. Non-operating foundations (i.e., grant-making foundations) pay a very modest tax rate of only 1.39% on their investment income. Grant-making foundations must annually distribute approximately 5% of their endowment through grants and foundation operating expenses.

Although private foundations do confer several benefits to the founder such as a tax deduction for contributions, experts generally agree that these benefits are not sufficient reason to create and fund a foundation. Charitable intent is considered to be the principal reason to set up a foundation.

What is the purpose of a private foundation?

Private foundations exist to support philanthropic causes and promote positive change in the world. The vast majority of private foundations make donations, called “grants,” to public charities that operate programs for the benefit of the public. It is quite rare for private foundations to conduct their own charitable operations though it is legally permissible.

What does a private foundation do?

The vast majority of private foundations are grant-making foundations. The basic idea of grant-making foundations is easy to understand—they are charitable organizations that receive contributions from private donors, accumulate the money in a big pot called an endowment, and over time distribute that money to charitable causes.

What are the basic rules for private foundations?

Private foundations are subject to many rules and restrictions under the law. The most basic and fundamental rules include:

  • Limitations on transactions known as self-dealing between the private foundation and disqualified persons (foundation insiders). These limitations include acts such as (1) the sale or leasing of property, (2) lending money or other extensions of credit, (3) providing goods, services, or facilities, (4) transferring foundation income or assets for the benefit of a foundation insider.
  • The requirement that a private foundation must annually distribute approximately 5% of its endowment for charitable purposes according to a fixed calculation.
  • Limitations on the invested endowment in so much as the investments cannot jeopardize the foundation’s exempt purpose and must be financially prudent (e.g., you shouldn’t load up on penny stocks and racehorses). Furthermore, there are explicit limits regarding the ownership of private businesses (as opposed to public securities which are generally allowable).
  • The requirement that all expenditures must relate to the private foundation’s exempt charitable purposes. Expenditures made for any kind of personal gain of foundation insiders are not allowable.
  • All private foundations must file Form 990-PF each year with the IRS—this is the foundation’s annual tax return. This form is required each year regardless of endowment size or amount of investment income.

Any violation of these restrictions can give rise to severe penalties and taxes not only against the private foundation itself, but oftentimes against foundation insiders as well.

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Foundation basics