ew individuals would start a business without a business plan. Nevertheless, many set up private foundations or other philanthropic entities without considering other available options. Too often, donors focus on income or estate tax savings, missing the other benefits—or headaches—of their chosen philanthropic vehicle. Using examples drawn from real-life donors, this article examines the advantages and disadvantages of four methods for deferred charitable giving: private foundations, community foundations, supporting organizations and proprietary funds. It is intended to help CPAs guide clients in making appropriate decisions on establishing philanthropic entities.
Private foundations are the best-known entities for deferred giving. Although the federal tax laws defining private foundations didn’t come into being until 1969, many private foundations predate that law. Andrew Carnegie, John D. Rockefeller and Henry Ford were among early donors—motivated by social rather than financial concerns.
Advantages. Donors choose to establish private foundations because they:
Allow donors and their families maximum control over charitable giving.
Can be used to “fund” several years of normal charitable giving.
Solution. After selling a substantial portion of his company, Mr. A established a multimillion-dollar private foundation to help offset his taxable gain. Because he had not yet determined his philanthropic goals, a private foundation was an attractive option to control future grantmaking.
Can be used to give assets that are not easily divided, such as real property. Property can be transferred to the foundation and sold tax-free, with the foundation distributing or keeping the proceeds.
Solution. Ms. B owns 2,000 acres of timber property. Because the charities she supports could not manage the property, she donates it to her private foundation. The foundation owns the property and sells the timber as it matures, distributing the sales proceeds to various charities.
Provide a means to fund foreign charitable endeavors. (Many public charities do not engage in international grantmaking.)
Solution. Mr. and Mrs. C want to help educate people in a specific developing country. Grants from their private foundation help pay for secondary school construction in remote villages.
Provide an organized structure for a family’s charitable activities. A foundation—with a board composed of family members—is an excellent reason for relatives to meet regularly for a common purpose, renew family ties and pass on a sense of social responsibility to the next generation. It is, however, unlikely to mend broken ties. The IRS regularly issues “foundation division” rulings that allow the breakup of family foundations. In 1999, it permitted the $13.5 billion Packard Foundation to split—the Packard’s son established a new foundation with $1.5 billion from the existing entity, while the three Packard daughters continued to run the original foundation.
Disadvantages. Private foundations also have a downside. In general, income tax deductions are less favorable for donations to private foundations than to public charities. (See the exhibit on page 25 for a list of donation and deduction limits.) For example, when clients contribute assets other than publicly traded stock, the income tax deduction is limited to the donor’s basis, which may differ from the purchase price, depending on basis adjustments since the original purchase date. There are other disadvantages as well:
Overhead can be extensive. If the foundation holds a lot of assets, its recordkeeping and annual tax return preparation are time-consuming. It must obtain advance IRS approval for scholarship programs. It must make its tax returns available to the public and grantseekers. The foundation receives many grant requests and must disclose the names of substantial donors to the public.
The foundation must take care not to engage in “self-dealing”—transactions with certain individuals and entities related to, or controlled by, the donor—which can result in substantial financial penalties.
Each year, the foundation must distribute at least 5% of its assets. This may be difficult for a foundation with illiquid but valuable holdings, such as real estate.
The trust cannot hold a permanent, substantial ownership interest in any business—even a publicly traded company—unless the foundation’s and all related parties’ holdings amount to less than 20% of an operating business.
Investment income, including capital gains, is subject to a 1% or 2% excise tax, which can be a substantial tax liability if the donor transfers low-basis assets to the foundation, which then sells them. (To avoid the excise tax, donors should transfer the stock as grants. A 2% tax doesn’t sound like much until you write the check to the IRS.)
Unrelated business income tax, which Congress created to put charities and taxable corporations on an equal footing, applies to any income from an S corporation, including gain on the sale of the stock. (If a limited liability company [LLC] or partnership has business income, it will be taxable to the private foundation partner or member, but gain on the sale of an LLC or partnership interest is generally not subject to this tax.)
When to consider a private foundation. CPAs should recommend their clients consider establishing a private foundation if
Donor or family control is the driving factor.
The donor wants to perpetuate his or her family name, or avoid direct charitable solicitation by referring all requests to the foundation.
The donor has publicly traded stock, or is not concerned by the donation limits for other assets.
The foundation will be established through a bequest.
The donor should consider another alternative if he or she
Needs the higher tax deduction. (Consider a public charity, such as a community foundation. To find a community foundation near you, go to www.communityfoundationlocator.org .)
Is unwilling to live with paperwork and other restrictions. (Consider a supporting organization.)
Wants to avoid publicity. (Consider an anonymous donor-advised fund at a community foundation or a gift fund.)
Solution. Although Mr. D had served on the board of a friend’s foundation, he decided, when he made a substantial charitable donation, to use a supporting organization within a community foundation. In his words: “I hated telling people ‘no.’ The community foundation screens all grant applications and brings me the best ones. I enjoy saying, ‘Yes, let’s fund that one this year.’”
Community foundations receive donations from individuals, businesses, private foundations and other charities and make grants to community charities. Some of these entities define community very broadly and even make grants internationally. Others define the term in a strict geographic sense, focusing on local needs. Still others focus on demographic profiles, religions or other common grounds.
Although the names may vary, community foundations offer four basic types of funds, all of which can be named for donors.
Donor-advised funds let donors recommend how grants from their fund are given. The foundation usually follows donors’ recommendations, provided the prospective grantee is a valid 501(c)(3) organization. (Some foundations impose geographic restrictions.)
Field-of-interest funds allow donors to specify a general or specific area of interest, such as education or health care. The foundation selects grantees.
Designated funds support specific charities. If the named charity dissolves, the foundation selects a similar entity.
Unrestricted funds often carry the donor’s name (the Jane Smith Fund, the Smith Company Fund, the Steve Smith Memorial Fund), but the foundation selects the grantees.
Community foundations offer individuals and companies an efficient way to centralize charitable giving and recommend grants to not-for-profit organizations. They are also used to hold lawsuit settlement funds when the injured party is an entire community (such as water or air pollution settlements).
Advantages. A fund established within a community foundation provides the donor with a tax deduction for the fair market value of appreciated long-term capital gain property. In addition it
Is exempt from excise taxes and administrative burdens.
Can be established at a moment’s notice, making it perfect for yearend giving.
Gives donors access to knowledgeable professionals who can provide advice on programs and community needs.
Allows donors to involve family members as fund advisers—within limits. Family members can advise a donor-advised fund. Depending on foundation rules, the fund can exist for one or two generations and sometimes even in perpetuity.
Allows donors to give anonymously—the foundation’s tax return is public, but the donor list is not.
Disadvantages. There are disadvantages to establishing funds in a community foundation. Donors have less control than with private foundations or supporting organizations. And, depending on the community foundation, the donor’s family may be limited to one or two successor generations as advisers or may not be able to advise in perpetuity.
When to consider a community foundation. CPAs should consider recommending a community foundation if a donor wants to
Establish a private foundation but has assets to donate other than publicly traded stock. (Consider a supporting organization instead.)
Support specific community programs but needs more time to gather information about the programs and the work they do.
Solution. On December 31, at 2 p.m., Mrs. H decided to establish a charity to benefit public school teachers in her community. With the help of her accountant, attorney, broker and the local community foundation, the fund was established in time for Mrs. H to take a tax deduction and for all the participants to attend their New Year’s Eve parties.
Favor a charity with a large donation but limit the use of income to specific programs, or give to a charity that is not ready for a large endowment.
Expose children or grandchildren to the joys and responsibilities of philanthropy but the donor needs expert assistance.
Remain anonymous. Foundation staff must know who the donor is, but the ultimate recipient or the public need not.
There are times when CPAs should recommend
a client consider other alternatives, such as when the
assets to be donated—for instance, large blocks of closely
held stock, S corporation stock, real estate or timber
property—are inappropriate for a community foundation. CPAs
should also recommend other options when
The proposed fund is inappropriate for the proposed grantee’s needs. For example, an endowment-type fund may not meet the needs of a building fund drive. A charity may also be large enough to manage its own endowment.
The donor is not interested in continued involvement. A donor planning to establish a donor-advised fund should be willing to review grant recommendations from the community foundation. (If not, consider a field-of-interest-fund.)
A supporting organization must fund one or more specific operating charities. Examples include the ladies’ auxiliary of a hospital, a parents’ club at a private school or a university alumni association. Although supporting organizations are not limited in the number of charities they can support, the IRS has expressed concern about them and may closely scrutinize applications from groups that intend to support multiple charities.
One type of supporting organization names the community foundation as the supported charity. The foundation provides the administrative support, while the donor focuses on grantmaking. The donor can develop the grantmaking program or the community foundation can do the work. This structure is as close as possible to the look and feel of a private foundation, but is more flexible.
Advantages. Some donors choose supporting organizations because they are not subject to many of the restrictive tax rules that apply to private foundations. In addition, supporting organizations
Don’t have to distribute a specific percentage of assets each year.
Can own an unlimited amount of closely held stock.
Can engage in economic activity (such as fair market value rentals) with their donors—provided no private benefit accrues to the donor and the organization follows state fiduciary rules regarding the charities’ investments.
Offer donors the same level of tax deductions as other public charities. This makes a significant difference to donors with substantially appreciated assets.
Solution. Mrs. F owned appreciated real estate investment trust units and wanted to use several million dollars worth to establish a private foundation. Because the units were not publicly traded stock, her donation deduction would have been limited to cost. Instead, she established a supporting organization at her local community foundation. This allowed her to deduct the current value of the units and still be involved in disbursing the income to charity.
Disadvantages. The supporting organization alternative is not without disadvantages. As is the case with many tax code provisions, the freedom from the excess business holdings, self-dealing and minimum distribution rules this option brings comes at a price—supported charities control or closely supervise the supporting organization. Although the IRS prefers that the “supported” charity assert control by appointing a majority of the board, technically the supported charity can be limited to one board member if the organization is closely integrated with the supported charity. The supporting organization board cannot be controlled by anyone who would be a “disqualified person”—the donor, his or her close relatives and some employees—if the organization were a private foundation.
A supporting organization is a separate legal entity. As such, it must have board meetings, file tax returns that are subject to public inspection and apply for its own tax exemption.
When to consider a supporting organization. CPAs should recommend establishing a supporting organization if a client wants to establish a foundation but has assets other than publicly traded stock, has closely held stock that will not be sold in the near future or wishes to benefit a charity that may not be ready to handle a significant endowment.
Solution. Mrs. G wanted to support the opera in her hometown. Because the previous opera board had spent its endowment and went bankrupt, she established a supporting organization, affiliated with the community foundation, for the opera’s benefit. This technique prevents the new opera from spending the principal. If the opera dissolves again, even after her death, the community foundation can redirect the funds to a similar cultural enterprise.
Donors should consider a different alternative if
Control is more important than the tax advantages of a supporting organization. (Consider a private foundation.)
The assets to be donated do not justify a separate entity. (Consider a community foundation or a gift fund—a $500,000 donation may be the minimum for a supporting organization to a community foundation, although many require $1 million to $2 million.)
The donor wants no involvement in running the organization. (Consider a restricted donation directly to the charity or a field-of-interest fund at a community foundation.)
Proprietary funds (also known as gift funds) are essentially charitable mutual funds. For tax purposes, the law treats proprietary funds as public charities rather than private foundations. Once assets are donated, the sponsoring mutual fund manages them.
Advantages. Proprietary funds are an efficient way to centralize charitable giving and recommend grants to not-for-profit organizations. Grants are limited to U.S. charities but otherwise have no geographic restrictions. In addition
The fund handles all administration and recordkeeping.
The fund can be established at the last minute.
Donors receive all tax benefits associated with donations to public charities.
A donor may authorize another party to recommend grants from his or her account.
Gifts from the fund can be made anonymously.
The arrangement is convenient for a donor who wants to fund a particular program over a period of time but take the tax deduction early.
Disadvantages. Proprietary funds have some disadvantages. Terms are standardized by each fund, generally nonnegotiable and, because the fund controls the assets, investment options are limited to certain mutual funds. In addition
Although funds are donor advised, donors do not have total control over giving.
Grants cannot be used to fulfill an existing pledge, for private benefit or for lobbying/political contributions.
Certain assets may not be acceptable if the fund is designed to handle only marketable securities.
Some funds have agreements with the IRS that voluntarily impose certain private foundation rules.
A donor must do his or her own due diligence on donee charities.
Some proprietary funds are paid out to other charities upon the death of the donor or fund adviser.
When to consider a proprietary fund. CPAs and their clients should consider a proprietary fund if
The donor wants an immediate income tax deduction but has no time to consider contribution recipients before yearend.
Gift amounts are too small to justify other options.
They like the income tax attributes of a public charity.
They seek professional investment of principal.
The donor has a specific philanthropic vision that can be fulfilled without help from a professional adviser.
Steer clients away from this type of fund if
The donor’s desire for control or publicity outweighs the tax and administrative advantages of a proprietary fund. (Consider a private foundation.)
S corporation stock, closely held stock that will not be redeemed promptly, real estate, timber property or similar assets are involved.
The donor wants help learning how to be an effective philanthropist in his or her community. (Consider a community foundation.)
The donor is interested in a family foundation that will have a lasting impact on his or her family and community. (Consider a private foundation.)
WHICH IS BEST?
There are very few absolute answers when selecting a philanthropic entity. In some situations, only a private foundation will do. In others—on December 31, for example—a donor-advised fund at a community foundation or a proprietary gift fund are the only available choices. In the final analysis a CPA must work closely with a client to decide which entity is best for that donor, the family and the community. As with many important decisions, timing is important, so CPAs should encourage clients to make charitable giving decisions now before yearend pressures force them into making a less than desirable choice.