private foundation rules

Private Foundation Rules and Warnings for Business Owners

Private Foundations: Rules, Procedures, and Warnings Every Business Owner Should Know

Now that you’ve built a successful business, what better way to perform long-term charitable activity than by establishing a foundation? Giving money where and when you want it to go—and letting it grow tax-free in the meantime—it’s a win for everyone. 

Or, it should be. As a recent example shows, these financial strategies are best performed by a corporate attorney who knows tax law and the operational rules of private foundations.

TABLE OF CONTENTS

What Is a Private Foundation?

A private foundation is a type of nonprofit typically funded by a person, family, or corporation to make grants to public charities or individuals. Private foundations operating under Section 501(c)(3) of the Internal Revenue Code (IRC) are tax-exempt. Although a private foundation is not the same as a public charity, the IRS presumes that all 501(c)(3)s are private foundations unless they are determined to be a public charity under 509(a) of the IRC. Both require a request for a determination letter from the IRS.

Benefits of a Private Foundation

One of the biggest benefits of a private foundation is its tax advantages. Donations made to a private foundation are tax-deductible, and the foundation’s income is generally exempt from federal income tax. Transferring wealth to a foundation can also help reduce estate taxes if done within gifting parameters.

Additional benefits of forming a charitable foundation include:

  • Control. Unlike donating to a public charity, donors control how and where funds are distributed.
  • Investment Growth. The foundation’s assets can be invested, allowing growth over time. Although there are rules about minimum annual distributions, foundations can manage their funds strategically.
  • Legacy Building. A private foundation can manage a family’s charitable giving for generations, supporting causes aligning with the founder’s personal values or long-term philanthropic vision. 
  • Business Succession. A foundation can provide opportunities for family members to take on leadership roles, preparing them to run the business in the future. These positions can be compensated as long as the pay is reasonable and aligns with IRS guidelines.

Private Foundation Rules

Understandably, private foundations must adhere to strict IRS regulations to maintain their tax-exempt status. The rules imposed on private foundations ensure that assets are used solely for charitable purposes, not personal benefit. 

  • 5% Minimum Distribution. One key requirement is the minimum distribution rule, which mandates that foundations distribute at least 5% of their assets annually for charitable purposes. Failure to meet this requirement may result in penalties.
  • Excess Business Holdings. Another important private foundation rule forbids the entity from owning more than 20% of a for-profit business when combined with the holdings of disqualified persons.
  • Prohibition on Political Activities. Private foundations are also prohibited from engaging in political activities, such as supporting political candidates or campaigns. While limited lobbying efforts are permitted, they are subject to significant restrictions.
  • Required Tax Filings. To ensure transparency, private foundations must file IRS Form 990-PF annually, which details their financial activities, grants, and administrative expenses. They must also submit to a 1.39% excise tax on their net investment income.

And the most important rule: Private foundations are prohibited from engaging in self-dealing. They cannot conduct financial transactions with insiders, such as board members, substantial contributors, or their businesses. This includes selling, leasing, or lending assets to disqualified persons. Unfortunately, some businesses run afoul of the rules, using foundation funds for personal reasons.

A Real-Life Case Of Misusing a Private Foundation

In a recent IRS ruling, a private foundation came under fire for self-dealing. The Foundation’s husband and wife managers funded the tax-exempt grant-making organization with shares of stock. For nine years, the Foundation made several unsecured loans to the husband’s two business entities.

While the business entities were charged interest on these loans, a significant outstanding balance was owed to the Foundation. In addition, one of the businesses failed to make interest payments on its loan for five years. As a result of these personal loans, the value of the Foundation’s assets sank.

The year before the investigation, the husband decided to buy out his business partner. However, he was worried that owning 100% equity might constitute self-dealing—especially since there were still loans outstanding between the Foundation and his business. (We could have told him: yes, he should have been worried.)

Unfortunately, his tax preparer offered a different solution: have the Foundation grant the business’s loans to public charities at a zero-dollar value. As the manager of both the Foundation and the business, the husband reduced the interest rate and extended the repayment period on the loan notes by several years. Now, they just had to transfer the loan notes to various public charities, removing the business loans from the Foundation’s books.

As you might have guessed, the notes were never transferred—but the tax preparer did report the transfers on the Foundation’s annual federal tax return. Understandably, the IRS initiated an investigation. The husband offered to correct the error by having the Foundation transfer the notes to public charities as planned… but it turned out to be too little, too late.

When the IRS’s Office of Chief Counsel unraveled the whole story, the Foundation—what little there was left of it—had lost its tax-exempt status.

Penalties for Breaking Private Foundation Rules

Private foundations that fail to comply with IRS regulations face severe consequences. If a foundation fails to distribute the required 5% of its assets for charitable purposes, it may be subject to a 30% excise tax on the undistributed amount. Additionally, exceeding a for-profit business’s 20% ownership limit can lead to significant financial penalties. 

Loss of tax exemption is a major concern, but it’s only the tip of the iceberg should a business use a charity foundation money for personal use. In addition to revoking tax-exempt status,the prohibited transaction must be completely unwound, and the disqualified person will face a 10% excise tax. If the self-dealing is not corrected, the disqualified person l will be subject to a second-tier excise tax of 200%. Finally, the IRS and state regulators could take legal action against foundations engaging in fraud, financial misconduct, or improper use of funds. These charges and penalties may be taken against the managers, its substantial contributors, and certain related persons.

We Can Help You Avoid Mistakes From the Start

As you can see, proper management and avoiding conflicts of interest are essential to keeping a private foundation in good standing. But charitable planning isn’t just about staying out of trouble—it’s important to implement the right strategies. Before setting up your foundation, consider it from all angles to decide whether it makes sense for you.

Consider the potential pitfalls of a private foundation. For one, there’s a cap on the contribution amount a donor can take as a charitable deduction. For donations to a public charity, that limit is 50% of the donor’s adjusted gross income. For contributions to a private foundation, the limit is 30%. In addition, donors can deduct a higher percentage for contributions of capital gain property to public charities. These limits won’t impact the donations of most people, but for those they do apply to, it’s an important difference. As with many things, it’s not simple. Deciding between a private foundation and a public charity is another reason to consult an attorney. Email us at [email protected] today to discuss your charitable planning goals with our team.

Leave a Reply

Your email address will not be published. Required fields are marked *