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private foundations A. Overview A private foundation is a tax-exempt organization, with funds and programs managed by its own trustees or directors, established and operated to maintain or aid social, educational, charitable, religious, or other activities serving the common welfare. It is usually supported and controlled by a single individual or family, who may receive reasonable salaries and directors' fees for their efforts. Private foundations enable individuals or small groups to establish new charitable endeavors and to express their own bents, concerns, and experience. Moreover, because their funds are frequently free of commitment to specific operating programs, they can shift the focus of their interest and their financial support from one charitable area to another. Private foundations help make possible many useful public services that would in most cases otherwise have to be provided by tax monies. B. Tax Aspects Publicly traded stock and equity mutual funds contributed to a private foundation give rise to a Federal charitable contribution deduction equal to the current fair market value of the stock or mutual fund. The deduction for other assets contributed to a private foundation generally is limited to the asset's tax basis, except for contributions to operating foundations. The charitable contribution deduction available to the donor in the year of contribution is limited to a specified percentage of the donor's adjusted gross income (AGI): the deduction for appreciated assets such as stock to an operating foundation is limited to 30 percent of the donor's AGI; for appreciated assets contributed to a private foundation that isn't an operating foundation, the deduction limitation is 20 percent of AGI. If the current year's contribution exceeds the percentage limitation, the excess is carried over to each of the next 5 years. Example: Donor has $1 million of publicly traded stock with a tax basis of $50,000. If he or she sells the stock, taxable gain will be $950,000. Combined federal and California capital gain tax of about 23 percent would be $218,500, leaving net proceeds of $781,500. Instead, the donor establishes a private foundation and contributes $1 million of stock to the foundation. Donor will receive a $1 million charitable contribution deduction, limited to 20% or 30% of current year's AGI, with a 5-year carryover. To fully use the deduction in the 6-year allowable period, donor's average annual AGI must be about $550,000 for an operating foundation, or $830,000 for a non-operating foundation. If the donor is in a marginal 41% income tax bracket, the $1 million contribution will reduce federal and California taxes $410,000. When the foundation sells the stock, there will be no capital gain tax. The net result is that, instead of the taxpayer without a foundation having net sale proceeds of $781,000 in his pocket, the taxpayer who established the foundation has $410,000 of tax savings in her pocket, plus $1 million of cash in the foundation. C. Exempt Purpose Section 501(c)(3) of the Internal Revenue Code exempts from Federal income tax organizations organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes or prevention of cruelty to children or animals or testing for public safety. The organization must engage primarily in activities which accomplish one or more of such exempt purposes. An organization will not qualify for exemption if more than an insubstantial part of its activities is not in furtherance of an exempt purpose. The presence of profit-making activities will not by itself disqualify an organization if the principal purpose of the profit-making activities is to further or accomplish an exempt purpose. In the usual case the nature and size of the trade or business must be compared with the nature and extent of the activities for which the organization is granted exemption in order to determine whether the principal purpose of such trade or business is to further (other than through the production of income) the purpose for which the organization is granted exemption. Court cases denying exempt status have involved large profits, substantial accumulations of income, and relatively small amounts of actual exempt activity. D. Prohibition Against Private Benefit No part of an exempt organization's net earnings may inure to the benefit of a private person. Insiders may not receive funds in excess of the fair market value of the goods or services they have furnished to the organization. Although reasonable salaries and director's fees may be paid, the payment of excessive salaries and fees constitutes inurement to the benefit of a private person. The IRS is very critical of insider transactions. An insider may not receive some special benefit which is unreasonable under the circumstances because of his relationship to the organization. However, adequately secured loans to controlling directors at current commercial rates do not preclude tax-exempt status. Nor does contingent compensation based on a percentage of contributions raised. An exempt organization must serve a public rather than a private interest. Thus, the organization may not be organized or operated for the benefit of private interests such as designated individuals, the founder or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests. The organization also cannot benefit such a narrow class of persons that the organization does not serve the public interest. For example, you cannot obtain an exemption for a foundation to provide scholarships for your family members. Nor will a neighborhood block association qualify as a 501(c)(3) organization. The restricted nature of its membership indicates that the organization is organized and operated to serve the private interests of its members rather than the public. E. Private Operating Foundations A private operating foundation is an organization that actively conducts its tax-exempt purpose, rather than merely making grants to other organizations. An operating foundation must meet an income test and one of three other tests--an assets test, an endowment test, or a support test.
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