Creating a Foundation for Tax Purposes

A private foundation is a legal entity established by an individual, family, or corporation for charitable goals. As a non-profit organization managed by its own trustees or directors, its funds are dedicated to philanthropic activities. This structure provides a formal way to organize charitable giving and allows founders to create a lasting legacy. While they offer tax advantages, their purpose is to serve the public good through grantmaking or direct charitable operations.

Tax Implications of a Private Foundation

Creating a private foundation offers tax incentives centered on deductions for contributions, avoidance of capital gains taxes, and reduction of estate taxes.

A primary benefit is the immediate income tax deduction for contributions. For cash donations, an individual can deduct an amount up to 30% of their adjusted gross income (AGI). For donations of certain appreciated assets, such as publicly traded stocks held for more than one year, the AGI limit is 20%. If contributions exceed these limits, the excess deduction can be carried forward for up to five subsequent tax years.

Donating long-term, appreciated assets directly to a foundation helps avoid capital gains tax. By transferring the asset, the donor can claim a fair market value deduction without first selling it and paying tax on the appreciation. For example, donating stock worth $100,000 that was purchased for $20,000 allows for a potential $100,000 deduction while avoiding capital gains tax on the $80,000 gain.

Assets transferred into a private foundation are removed from the donor’s personal estate, which can reduce federal and state estate tax liabilities. By moving assets into the foundation during their lifetime, a donor decreases the value of their taxable estate. This ensures more wealth is directed toward charitable causes rather than being consumed by taxes.

Key Decisions and Information Required for Creation

Before a foundation can be established, founders must make several key decisions and gather specific information. These steps define the foundation’s structure, leadership, and purpose, and create the documents required by state and federal authorities.

Founders must first choose a legal structure, which is either a charitable trust or a nonprofit corporation. A nonprofit corporation is managed by a board of directors under corporate bylaws, offering operational flexibility. A charitable trust is governed by a trust agreement and managed by trustees, which can offer a simpler framework. The choice depends on the founder’s goals regarding governance, perpetuity, and the specific legal requirements of the state.

Founders must select a name that complies with state regulations, which prohibit names that are misleading or too similar to existing entities. They must also appoint the initial governance body, such as a board of directors or trustees. These individuals are fiduciaries responsible for overseeing assets, adhering to the charitable mission, and complying with legal and tax obligations.

Drafting the governing documents formalizes the foundation’s existence. For a corporation, these are the Articles of Incorporation and Bylaws; for a trust, it is the Trust Agreement. These instruments must contain IRS-mandated language to qualify for tax-exemption, including a stated charitable purpose, operational rules, and a dissolution clause.

Obtaining Tax-Exempt Status from the IRS

To become a recognized private foundation, an organization must secure tax-exempt status from the IRS. This requires filing Form 1023, Application for Recognition of Exemption Under Section 501(c)(3). A determination letter from the IRS formally grants this status.

Form 1023 requires extensive details about the foundation’s purpose and planned operations. Applicants must submit a narrative of future activities, multi-year financial projections, and information about the foundation’s officers, directors, or trustees. This information must align with the governing documents.

The completed application and supporting documents are filed electronically via the Pay.gov portal, which requires a user fee. The IRS review process can take several months. Upon successful review, the IRS issues a formal determination letter, which is the official proof of the foundation’s tax-exempt status.

Ongoing Compliance and Operational Rules

To maintain its tax-exempt status and avoid penalties, a private foundation must adhere to ongoing compliance and operational rules. These regulations ensure the foundation operates for its charitable purpose and does not improperly benefit insiders.

Every private foundation must file Form 990-PF, Return of Private Foundation, with the IRS each year. This public document provides transparency into the foundation’s finances and activities. It includes details on assets, grants awarded, expenses, and the names of its officers and directors.

The IRS mandates a minimum distribution requirement to ensure foundations actively pursue their mission. Annually, a foundation must pay out grants and qualifying administrative expenses totaling about 5% of the average fair market value of its net investment assets from the prior year. Failure to meet this payout requirement can result in excise taxes on the undistributed amount.

Private foundations are subject to an excise tax on net investment income, including interest, dividends, and net capital gains, which is currently a flat 1.39%. Proposed changes could create a tiered system based on asset value. If enacted, the rate would remain 1.39% for assets under $50 million but rise to 2.78% for assets up to $250 million, 5% up to $5 billion, and 10% for assets over $5 billion. This tax is paid with the Form 990-PF and distinguishes private foundations from public charities.

Regulations strictly prohibit self-dealing, which refers to financial transactions between the foundation and its “disqualified persons.” This group includes substantial contributors, foundation managers, and their family members. Prohibited transactions include selling or leasing property, lending money, or furnishing goods or services between the foundation and a disqualified person. Engaging in such acts can lead to penalty taxes for the individuals involved.

Foundations must also abide by other restrictions to avoid penalties. These include rules against making jeopardizing investments that could risk charitable assets through speculative strategies. There are also limitations on excess business holdings, which restrict a foundation’s ownership in a for-profit enterprise. Finally, foundations are prohibited from making taxable expenditures, such as payments for lobbying or political activities.