Charitable Foundations

Client Advisory

February 7, 2001
by M. Antoinette Thomas
A lot of attention has been focused on the immediate income tax benefit resulting from a gift of appreciated publicly-traded stock to a private foundation. Congress has made permanent a provision in the Internal Revenue Code which permits a donor to claim a charitable income tax deduction for the fair market value of such appreciated stock to a foundation. This memorandum discusses several issues concerning the creation of a family charitable foundation, including the benefits and drawbacks of a foundation, the choices involved in setting one up, and some planning opportunities which are particularly attractive if a family has a foundation.

Benefits and Drawbacks of a Foundation as a Recipient of Charitable Contributions

Tax Consequences. A donor may deduct from his income tax the full fair market value of a contribution to a private foundation of appreciated publicly-traded stock, thereby avoiding the taxation of capital gains. The provision permits a substantial charitable contribution deduction in the year of the gift while retaining the charitable disposition of the property in the control of the contributor. The capital gains benefit of such a gift is not unique to foundations and could also be achieved by a gift to a public charity (which would transfer control of the asset to that charity), to a donor-advised fund (either as part of a community fund or privately sponsored), or to a charitable remainder trust (see below).

Gifts to private foundations are subject to stricter deduction limitations under the tax laws than are similar gifts to public charities and donor-advised funds. Contribution deductions for gifts of appreciated stock to a private foundation are limited in any one year to 20% of the taxpayer's "contribution base" (basically, the taxpayer's adjusted gross income), instead of the 30% limit on the same gifts to public charities. There is, however, a five-year carry forward of any excess contribution deduction that cannot be used in the year of the contribution, which in most cases permits a donor to use all of the deduction. The overall contribution deduction to private foundations is limited to 30% of a taxpayer's contribution base in any year, with a five-year carry forward for all excess deductions.

Full gift and estate tax deductions are available for the fair market value of property given to a charitable foundation, which makes their treatment for gift and estate tax purposes the same as gifts to a public charity.

Other Benefits. The private foundation permits charitably-minded persons to build a fund from which monies can be given to public charities on an annual basis, giving the donor or his family continuing control over the basic fund and the charitable uses of the money. This allows a donor to create a long-lived organization which can involve other family members, especially younger generations, in charitable giving, familial cooperation, and assist them in gaining experience in investments, money management and responsible expenditures.

Once the foundation is in place and successful for a family, it becomes a receptacle for other contributions in the future, and can turn into a substantial endowment fund as it grows through appreciation and further gifts. It can, therefore, become a family memorial for long-term charitable giving and generate respect for the family in a community or an area of charitable endeavor. Oversight by the foundation on the use of its funds by donee charities can permit significant involvement by the family in certain areas of charitable work. Many foundations become instrumental in carrying out certain kinds of activities for the public good and even become identified with those objectives.

Furthermore, when a successful foundation is available for further contributions, it enhances charitable giving as a tool for long-term estate planning. Some of these ideas are discussed in greater detail below in Part III of this memorandum.

Private foundations are heavily regulated by the IRS and therefore are undertakings which entail ongoing expense and attention. The initial organizational documents (discussed in Part II below) are generally straightforward, but involve some expense. After the entity is set up, an application must be filed with the IRS to qualify for tax exemption. This exemption application process generally requires an attorney or accountant and involves both professional fees and a payment to the IRS ($465). It can take several months for the IRS to issue an exemption letter, which is retroactive if the application was filed within 15 months of the foundation's creation.

In addition, an annual return must be filed with the IRS (Form 990-PF), which is one of the more complicated tax returns and requires professional preparation. This return, which includes the names and mailing addresses of the contributors and foundations managers, is not a confidential document, and must be made available to the public on demand. The return must be filed not only with the IRS, but also with the Attorney General in the state in which the foundation's office is located and the state of its incorporation, which may also result in a filing fee and additional reporting schedules depending upon the states involved.

The IRS filing requirements are a result of the substantial federal regulation of private foundations. These rules include the following:
  1. A 2% excise tax is payable annually on the foundation's investment income, which must be paid quarterly by depository coupon method. The tax can be reduced to 1% under some circumstances.
  2. There are strict prohibitions and penalties on self-dealing transactions which proscribe nearly all financial relations between the foundation and its creator and his family members. Even innocuous transactions, such as splitting the costs of office space between a family office and a foundation, or receiving a thank-you benefit from a donee organization, are considered to be prohibited, so the rules in this area must be well understood.
  3. Private foundations are obliged to distribute annually, as "qualified distributions", 5% of the value of their assets. "Qualified distributions" are grants to public charities (i.e., not to other private foundations, individuals or foreign organizations) and certain expenses that are allocable to the charitable activities of the foundation.
  4. Closely-held business interests of a foundation are limited so that the foundation and all related individuals and entities cannot together own more than 20% of a business.
  5. Foundations are not allowed to hold "jeopardizing" investments that threaten their financial well-being. Undiversified holdings or speculative investments can constitute jeopardizing investments.
  6. Certain kinds of distributions or expenditures, such as political expenditures and grants to individuals, are prohibited and are subject to penalty taxes. Due diligence procedures to verify the status of grantees are mandated even for contributions to public charities.
  7. Income from unrelated business activities is subject to tax at corporate income tax rates.
  8. Termination of a private foundation is also regulated, and is accomplished by contributions of all the foundation's property to public charities.
In addition to IRS Regulations, private foundations are subject to state regulation as charities and most states have registration and reporting requirements as well as a body of regulatory law.

Creating a Private Foundation

A private foundation can be set up as either a not-for-profit corporation or as a trust. The differences in the forms are chiefly in management and administration of the foundation, and the choice depends upon the objectives of the foundation's creator. They are treated the same for purposes of the IRS rules discussed above.

Corporation. A foundation can be quickly and easily established in corporate form. Incorporation requires a certificate of incorporation which is filed with the Secretary of State. The easiest state in which to incorporate is Delaware, and if the foundation carries out no activities other than investments and grant making in the founder's domicile state, then the corporation will generally not have to register or report in that state unless its official "office" is there. In addition to the certificate of incorporation, corporate form requires by-laws, which describe the internal workings of the organization. Annual meetings are required, with minutes and financial reports to the Board of Directors.

A not-for-profit corporation operates in much the same manner as a business corporation, except that there are no shareholders. That role may be taken by members, who elect the Board of Directors, which in turn appoints the officers, or, in the alternative, there can be no members and the Board of Directors will elect its own successors.

The chief advantage to corporate form, limited liability for officers and directors, is not particularly important to a private family foundation whose chief activity is grant making. The other advantages of the corporate form are its ability to be adaptable in its management by amending the by-laws. This allows for family participation on a regularized, but changeable basis. In addition, the corporate form allows for change in the grant-making objectives of the foundation. If the family's interests change, changes in the corporate documents permit the organization to change its focus too. These benefits (or drawbacks, depending on the founder's objectives) can also be achieved through a trust instrument, but the corporate form is designed for perpetual life and adaptability and accommodates change more easily than the trust form.

Corporations are managed by their directors or officers, who may delegate investment and other responsibilities to advisors who are paid by the corporation. Officers and, less commonly, directors, may receive reasonable compensation for services they actually provide to the corporation. The drawbacks of the corporate form are the formalities required for corporate bookkeeping, i.e., the annual meetings and the minutes. Even these can be a benefit, however, if the desire is to involve family members and create an active foundation.

Trust. A foundation in trust form can also be formed immediately by a grantor and trustee. The trust, which is a contract between the grantor and trustee, provides for payments to charities selected by the trustee. The state of situs of the trust is a matter of the donor's choice, so long as the chosen state has some relationship to the trust itself (for instance, it is the domicile of the donor or the trustee). A New Jersey or New York trust creating a private foundation must be registered with the respective state's Attorney General, and copies of the annual report must be filed with him. Other bookkeeping requirements, such as minutes, are optional in the case of a trust.

With some restrictions, the terms of the trust can be as broad or narrow as the founder desires. As a result, trusts are attractive to founders who want to limit the purposes of a foundation, by circumscribing the scope of the distributions to certain kinds of projects or organizations. It is also a good form to keep control of the management in only one person. It is not necessary, however, for there to be any such limitations, and a trust may be set up with open-ended terms for its charitable goals.

A trust is managed and administered by a trustee, who may be more than one person. It may also have advisory committees or other mechanisms to involve family members, much like a corporation's Board of Directors. Trustees are entitled to reasonable compensation for their services to the trust. If the trust is a New Jersey trust, the compensation is dependent on what is generally considered to be reasonable. If it is a New York trust, compensation for individual trustees is set out in statutes. Trustees may hire investment advisors and pay them out of the trust, but since investment is the legal duty of a trustee, their compensation may be correspondingly reduced.

As a matter of law, trustees are held to a slightly higher standard of care (a fiduciary duty toward the trust beneficiaries) than are directors of a corporation (the business judgment rule in their actions). As a practical matter, because foundations are regulated entities, both forms are held to high standards and there is no obvious discernable differences.

The choice of a corporate or trust form, then, depends largely on the founder's desires in creating a form of organization and how he sees the organization operating in the future. We have clients with strong preferences for one form or the other, and other clients who do not.

Estate planning. Charitable contributions can be used for estate planning. The opportunities are not unique to contributions to a private foundation and are also available for gifts to public charities, but the existence of the foundation enhances the desirability of the planning devises because significant funds will eventually go to the foundation to build up an endowment. As a result, if the foundations turns out to be successful for the family, it is a vehicle to receive charitable gifts and bequests which can be used to reduce transfer taxes and to keep control of the charitable giving in the family.

In addition to direct gifts to the foundation, which now qualify for non-taxation of gains and for estate, gift, and income tax deductions, there are significant planning opportunities in the use of split-interest charitable trusts (charitable remainder trusts and charitable lead trusts). Such trusts provide a stream of income to be paid to one party for a set term, and for the trust principal to be paid to another party when the term is up. In the case of a charitable remainder trust, the stream of payments is made to a non-charitable beneficiary (typically, the grantor or his family members) and the balance of the principal is paid to charity. In a charitable lead trust, the payments are reversed.

Charitable Remainder Trusts. Under the terms of a charitable remainder trust, the trustee pays either a fixed amount (an "annuity trust") or a fixed percentage of the annual principal value (a "unitrust") to a person for his life or for set terms of years (up to twenty years). At the end of the trust term, the remaining trust property passes to a charity, which may be the family private foundation. The planning advantages are as follows:
  1. If the charitable remainder trust is set up during life, capital gains can be avoided on contributions of appreciated property to the trust. This is because the trust itself is exempt from income tax, and therefore any capital gains which are not distributed as part of the payments to the income beneficiaries belong to the exempt trust. If the rate of income produced by the trust exceeds the stated pay-out percentage, then the capital gains will not be paid out to the beneficiaries and will not be taxed. As a result, a contribution to the charitable remainder trust permits diversification of assets and a stream of income to a beneficiary without recognizing capital gains on the contributed assets.
  2. An income tax deduction is available for the value of the charitable portion of the trust upon the trust's creation. The deduction is computed as the actuarial present value of the charitable remainder based on IRS tables. The actual charitable contribution deduction will depend upon the details of the trust payments as set out in the trust agreement (amount, timing, duration), and the applicable federal interest rate in the month the trust is created.
  3. In addition to the income tax deduction for the value of the charitable remainder, there is also an estate or gift tax deduction for that value. This enables a donor to provide a stream of income to a family member and pay a transfer tax only on the present value of that stream since the remainder value is deductible. An example of the estate planning potential is as follows:
A donor gives a $1,000,000 contribution to a charitable remainder trust of property which has a tax basis of $100,000. He provides that 5% of that $1,000,000 will be paid to his son every year for twenty years and that the remainder will go to his family foundation. The tax consequences of the trust are as follows: (a) the $900,000 of capital gain will not be taxable to the donor; (b) his children will receive a total of $1,000,000 over the twenty-year period (.05 x $1,000,000 x 20); © at the end of the twenty years, the trust principal (which may have shrunk or grown) will pass to the private foundation; (d) the gift of the stream of payments to the children is valued (in February, 2001) at about $564,300, which is covered by the $675,000 lifetime unified credit against estate and gift taxes; (e) there is a gift tax charitable deduction and an income tax charitable deduction in the amount of about $435,700.

Charitable remainder trusts may be created under wills as well as trusts to provide for testamentary transfers to offspring at a reduced cost.

Charitable Lead Trust. The charitable lead trust, while not providing the same tax advantages as the remainder trust, can provide significant benefits if regular contributions to the foundation are planned, especially after the founder's death. Under the terms of a charitable lead trust, the annual annuity or unitrust amount is paid to the charity for a term of years, and the remainder is paid to family members. The treatment of the lead trust is as follows:
  1. The trust can be structured in a way to qualify the donor for a charitable deduction in the first year of the trust for the present value of the stream of payments to the charity. The income from the trust, however, will be taxable to the grantor in each of those years. Thus, the charitable lead trust is a way to accelerate a charitable deduction for a year in which it is needed, at the cost of income taxes in later years. There is no capital gain benefit from the use of the charitable lead trust.
  2. The same leverage effect can be used for estate and gift planning as is available for the charitable remainder trust. In the case of the charitable lead trust, the interests are reversed so that the gift of the $1,000,000 to the trust would result in an estate or gift tax deduction of $564,300, and the gift portion would be $435,700.
  3. If a family has a private foundation, lead trusts are better as testamentary devices because a grantor of a lead trust should have no power to distribute the charitable funds out of his foundation.

In addition to this general outline, there are variations on these trust arrangements that permit specific tax advantages in certain circumstances to enhance the planning capabilities of these planning devises. In any case, they are very effective if the foundation becomes the object of future giving on a regular basis.

For further information about foundations, contact M. Antoinette Thomas (212-238-8713,

Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2018 Carter Ledyard & Milburn LLP.
© Copyright 2001

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