There are methods private foundations can use to grow their endowments and minimize their tax liability. However, there are at least as many ways for private foundations to jeopardize their exempt status and incur Internal Revenue Service (IRS) penalties. This article will discuss the top five do’s and don’ts for private foundations.
1. Do donate qualified appreciated stock to the foundation.
Although noncash donations are typically limited to the donor’s cost basis, this form of charitable deduction is reported at the fair market value. The donor avoids paying tax on the capital gains and moves the appreciated assets out of his or her estate. Although the donor’s deduction is limited to 20% of the adjusted gross income, the unused deduction can be carried forward for five years.Only qualified appreciated stock is allowed this fair market value treatment. Qualified appreciated stock is publicly traded stock that has been held for at least one year, qualifies for capital gains treatment, and is not subject to restrictions at the time of the donation.
2. Don’t engage in self-dealing.
Transactions between a private foundation and disqualified persons are considered self- dealing. Examples of ‘disqualified persons’ are directors, officers, trustees, foundation managers, substantial contributors, and family members of any of the previously mentioned persons. Examples of transactions include rent paid to a family member, excessive compensation, loans, or goods furnished by the foundation. These transactions are prohibited and are subject to an excise tax. A disqualified person cannot receive payment for rent, even if it is below market value, or personally benefit from the Foundation.
3. Do step up your cost basis in capital assets.
A private foundation cannot carry forward a capital loss. Unlike most other taxpayers, a private foundation cannot deduct capital losses beyond the capital gains realized in the current year. There is no $3,000 per year deduction and no carry-forward. Rather than allowing the losses to disappear forever, it is a good idea for a private foundation to try to even out its gains and losses. For example, if a private foundation sells an asset for $5,000 with a cost basis of $8,000, the foundation sustains a loss of $3,000. This loss is only deductible to the extent of capital gains in the current year. So, at this time, the private foundation would consider selling an appreciated asset to realize the gain and thereby offset the loss. Otherwise, the loss is lost.
4. Don’t satisfy personal or corporate pledges.
Private foundations are organized to provide funds for specified charitable activities and are required to meet minimum distribution requirements annually in order to avoid an excise tax. On occasion, the board members or trustees of private foundations are involved in various activities and may make personal pledges of funds to those entities. A private foundation cannot fulfill the personal pledge of a disqualified person even if that pledge would otherwise be allowed as a distribution. The pledge of the disqualified person satisfied by the private foundation creates an act of self-dealing and should always be avoided.
5. Do reduce your excise tax rate.
Private foundations can reduce the tax they pay on net investment income from 2% to 1% by making enough qualifying distributions during the year. How much is enough? The amount is recalculated each year and is based on net investment income. In order to qualify for the lower rate, the foundation cannot have incurred any penalties for the past five years. The 1% rate is not available in the first year the foundation is in existence.
6. Don’t attend fundraisers for a charity in exchange for a grant.
Certain organizations may provide tickets to its fundraisers after receiving or in hopes of receiving a grant from a private foundation. Disqualified persons cannot accept these invitations or attend these events unless it is specifically required for their jobs. As we have stated earlier, family members of disqualified persons are also considered disqualified persons. The foundation cannot accept the invitation and transfer it to a family member of someone at the organization. Nor can the foundation accept the tickets and give them to someone outside the organization. That is considered using the foundation for a non-exempt purpose (the purpose being to get tickets to a fundraiser). The foundation can be listed, however, as a contributor on the fundraising program.
7. Do preserve assets with program-related investments.
Private foundations have the option of making program-related investments to help satisfy their minimum distribution requirement. Program-related investments often take the form of zero interest or low interest loans to qualified organizations. The loan is charitably motivated and is made in place of a traditional grant. At some future time, the organization pays back the loan to the foundation and the foundation can pay the money out again as a grant or another program-related investment. In this way, the foundation can use the same money to satisfy its minimum distribution requirement in different years.
8. Don’t hire family members.
Hiring family members as staff is considered self-dealing. The only time a private foundation can pay compensation to a disqualified person is when that person provides ‘personal services’ and is paid ‘reasonable compensation’. Reasonable compensation is the amount a non-related person would be paid in the same circumstances. The ‘personal service’ must be reasonable and necessary for carrying out the foundation’s exempt purpose. Some examples of these are legal fees and investment services. Because of the delicacy of the issue, it is recommended that legal counsel be obtained before entering into compensation agreements with family members or other disqualified persons.
9. Do consider liquidity so the foundation can make distributions.
While this may seem obvious, it should be mentioned. The foundation’s portfolio must be structured so that it can meet its annual minimum distribution requirements.
10. Don’t engage in lobbying activities.
Punitive damages are assessed at the foundation level as well as at the management level for private foundations that engage in lobbying activities. However, the IRS does allow relief should a foundation pursue legislative reform under certain conditions, generally when the effort is nonpartisan or relating to legislation impacting foundation programs.
If you have questions regarding these do’s and don’ts for private foundations, please contact Nika Carter at ncarter@windes.com or (562) 435-1191.