“A family foundation is an efficient way for a family to achieve its charitable goals while also allowing family members to take ownership of the family’s charitable efforts.”
To benefit from the exemption from taxation available under Section 501(c)(3) of the Internal Revenue Code, a private foundation should be organized as a trust or nonprofit corporation. A nonprofit corporation is formed by filing Articles of Incorporation with the state. After legal formation, the corporation’s directors adopt bylaws that govern its internal operations. While many provisions of such bylaws address common procedural issues, the bylaws can also be drafted to include any special provisions deemed appropriate by the foundation’s initial sponsors. The organization should also adopt initial policies for the organization, including a conflict of interest policy. Likewise, a trust document can address common issues and have the required IRS language; it may or may not have more specific language about how to administer the foundation. To be recognized as an exempt entity under Section 501(c)(3), an organization must submit a completed Form 1023 (Application for Recognition of Exemption Under Section 501(c) (3) of the Internal Revenue Code) to the IRS along with a $600 fee.
The family should consider developing a mission statement to guide the foundation’s charitable activities and provide the foundation’s future decision-makers with guidance about how to make future grants. The mission statement should contain the donors’ views, principles, and intentions in a way that can guide future trustees’ grant-making decisions, even as the grant requests and opportunities change with time. Often, donors create mission statements that are too broad to actually provide practical guidance to future generations in decision-making, but if the family is just starting out, a broad mission statement may provide flexibility for the family. A family foundation’s mission or purpose can be revised without filing any special documents with the IRS (the revision is noted on the annual Form 990 filing).
There are a number of ways to make the mission statement a specific guide for grant-making. The mission statement could establish that the foundation intends to primarily fund certain types of organizations, such as colleges and universities or hospitals. Alternatively, the mission statement could describe the foundation’s goals, such as universal accessibility of college, or growth of entrepreneurship in a certain region. The mission statement could also state that the foundation will focus its efforts primarily in some defined geographic area, or contain a more specific view as to the family’s philosophy toward making philanthropic gifts.
Some contributors to private foundations are very concerned about ensuring that future decisions follow closely from their donor intent (these donors usually have a specific vision). Other donors have a fairly broad charitable intent and are more content to give future decision-makers freedom to make their own grant-making choices or to follow their own philanthropic interests. If the major contributor to a private foundation is concerned about donor intent, there are mechanisms that can be used to protect intent.
The founders of a foundation will also need to select individuals to govern the foundation and make future decisions. Many donors appoint all or some of their children as directors; the donors could include provisions in the bylaws electing all of their children to the board of directors upon their death. Other donors want to include independent directors to mediate intrafamily disagreements or to ensure the on-going connection between the foundation and a specific organization, or to ensure professional foundation management.
A family foundation is a possible vehicle to drive family cohesiveness. Grant-making decisions can be the catalyst for continued family cooperation at the deaths of the family members who created the foundation. There are many potential opportunities for involving family members in a meaningful way in the foundation’s activities. In addition to service as a director, family members can be involved in reviewing grant applications, attending site visits, making grant recommendations, and working with charitable organizations to translate the foundation’s vision into practice. Some family members may find a staff role with the foundation.
A family may or may not choose to hire professional staff with experience and training to guide the foundation’s grant-making. The size of the staff may differ depending on the foundation’s exact goals for grant-making and how much of the executive duties may be undertaken by family members or members of the family office, if applicable. Because a professional staff has the time to study nonprofit organizations, a professional staff may be more likely to recommend making grants to smaller grantee organizations and to develop initiatives for identifying and solving community problems by building partnerships among nonprofit organizations and donors.
A key responsibility of professional grant-making staff is to educate and provide guidance to directors about organizations and to provide some strategic thinking about how the foundation is meeting the donor’s intent. The professional staff can also be useful in informing organizations that their grant request did not fit within the foundation’s budget.
However, many foundations do not hire full-time staff or even part-time staff. Staff may not be needed if the foundation will make many of its gifts as large capital grants to well-established and well-managed organizations with which the donor has a long-standing relationship. Furthermore, family members may see the professional staff as serving as an unwanted intermediary between the family and charitable organizations when they prefer that the family members have a direct relationship with the recipient organizations. In a number of family foundations, one or more family members dedicate substantial time and resources to the organization and so there is less need for the staff.
A family or private foundation is not restricted to only making grants to other organizations. A foundation may engage in direct charitable activities. Some family foundations operate full-on charitable activities like museums and schools. Other family foundations may host scholarship programs for students (although for ease of administration, many foundations will just make gifts to schools so that the school can administer the scholarships) or prizes. Foundations can host lectures and speakers or conduct other direct charitable activities.
For many foundations, investment review and strategy requires significant consideration and work with outside advisors. For many families, the foundation is a good way to introduce the younger generation to working with financial advisors.
Family foundations are increasingly looking to social impact investing, mission-related investing, and program-related investments as a way to simultaneously meet an investment return but also to meet the foundation’s charitable goals.
Social impact investing means making investment decisions (buying stocks and bonds) while screening out investments in certain companies based on “social impact”: environmental impact, sales of tobacco and guns, diverse hiring practices, or other criteria. Many investment advisors will offer products that take these sorts of considerations into account when making investments; each product is a little different.
Program-related investments are different. These are investments that are directly related to the foundation’s exempt purpose and are made for the primary purpose of charitable impact. The classic example is an investment in low-income housing; the foundation’s work may allow the low-income housing to be built and the foundation will receive some return, but the return may be lower than other possible investments. Many foundations are very interested in this type of activity, especially related to biotechnology research and economic development.
There is a set of complex rules governing the operation and maintenance of private foundations. Violation of the private foundation rules can result in the imposition of severe and costly taxes and penalties and, in some cases, the loss of tax-exempt status. Therefore, the private foundation rules themselves should be consulted concerning the resolution of specific questions about compliance. An overview of rules that apply to private foundations is provided below.
Self-dealing is a direct or indirect transaction, such as a sale, exchange, lease or loan, between the foundation and any “disqualified person.” A disqualified person is any foundation manager (including a director); substantial contributor (a person who contributes $5,000 or more to the foundation if that is more than 2% of total contributions during the tax year); owner of more than 20% of a business or trust that is a substantial contributor to the foundation; business, trust or estate if a disqualified person holds more than 35% of it; family member of any of the above; or a government official.
Self-dealing is prohibited for private foundations (unless the transactions fit within a specific exception). This prohibition applies regardless of the fact that the private foundation or disqualified person may pay the fair market value consideration for what is being exchanged. Self-dealing covers almost all financial transactions between a disqualified person and the private foundation. The self-dealer and foundation managers are subject to excise tax penalties when self-dealing occurs. Such penalties can be as high as 200% of the amount involved in the act of self-dealing.
There are certain specific exceptions to the self-dealing prohibition, including an exception for reasonable compensation paid to a disqualified person for personal services and an exception for a loan to the private foundation from a disqualified person without interest or other charge.
Each year, a foundation is required to distribute an amount equal to at least 5% of the aggregate fair market value of all non charitable assets held by the foundation, minus the excise taxes paid on net investment income. This amount is called the “distributable amount.” Within 12 months after the end of the private foundation’s fiscal year, the foundation must determine the distributable amount, choose recipients and make the necessary distributions. A foundation may distribute more than the distributable amount, but oftentimes a foundation prefers to retain an amount as corpus so as to generate income and make grants in future years. The foundation is subject to excise tax penalties if it fails to meet the minimum distribution requirement.
Distributions by the private foundation toward this minimum distribution requirement must be in the form of “qualifying distributions.” Only certain types of grants qualify as “qualifying distributions”, including grants to publicly supported charities, certain supporting organizations, private operating foundations, and governmental bodies. Qualifying distributions also include amounts paid to acquire assets used or held for use in directly carrying out a charitable purpose and direct payments of the foundation’s own operating or administrative expenses.
A “jeopardizing investment” is an investment that jeopardizes the foundation’s ability to carry out its charitable purposes. The foundation and foundation managers are subject to excise tax penalties if the private foundation holds jeopardizing investments. As a general matter, as long as the investment is held as part of a prudently constructed portfolio, any type of investment is acceptable.
Certain expenditures by private foundations are considered “taxable expenditures.” The foundation and foundation managers are subject to excise tax penalties on the amount of each taxable expenditure made by the foundation. These excise tax penalties exist to ensure that private foundation funds are being used for the charitable purposes described in Code Section 501(c)(3).
Taxable expenditures include amounts paid by private foundations to carry on propaganda or influence legislation; as grants to other foundations, unless the granting foundation exercises expenditure responsibility; and for any purpose other than a religious, charitable, scientific, literary, or educational purpose.
Generally, if the combined holdings of a foundation and all disqualified persons in any corporation conducting a business that is not substantially related (beyond producing revenue) to the charitable purposes of the private foundation exceed 20% of the voting stock of the corporation, an excess business holdings tax will be imposed. However, a private foundation is not treated as having excess business holdings if it owns not more than 2% of the voting stock and not more than 2% in value of all outstanding shares of all classes of stock, regardless of the holdings of disqualified persons.
Private foundations are subject to a 1.39% excise tax on net investment income (e.g., dividends, interest, royalties, and capital gains). This tax used to be assessed at either a 1% or 2% rate depending on the level of distribution, but recent tax legislation changed the tax to 1.39%.