Ready to make the world a better place? Starting a private foundation could be your avenue towards doing so. If you have a lot of money, are committed to helping others & want more tax benefits, here’s how you can start a private foundation
Private foundations can be a great way to give back and make an impact in the world. If you want to take one step ahead of other corporations and you have the financial means to do it, you can start a nonprofit to provide much needed funds for charitable causes. Plus, it comes with attractive tax breaks for donors.
However, it takes rigorous commitment to set up a private foundation that complies with the law. It can be a painstaking process for anyone who isn’t dedicated and isn’t familiar with the legal requirements. But not to worry, this guide will summarize everything you need to know about starting a private foundation.
What is a Private Foundation?
A private foundation is similar to public charities or other nonprofit organizations which are dedicated to helping philanthropic/charitable causes. Both public foundations and public charities are defined under the tax-exempt status under the 501(C)(3) of the Internal Revenue Code (IRC).
Public foundations are legal organizations established to provide charitable activities, as well as provide their donors with tax deductions for what they contributed.
When Should You Set Up a Private Foundation?
There’s no exact time that you should start a private foundation. You can start anywhere in your life, whether it be while you’re young or after you die. However, there are certain times when starting a foundation may be at your advantage.
Here’s when you should consider setting up a private foundation:
One of the most ideal times to set up a foundation is when there’s a liquidity event. A liquidity event is when you’re about to liquidate your investment shares in the company and exchange it for a liquid asset, which can qualify as cash or other tangible properties.
The benefit of starting a foundation at this stage is that it gives you the ability to reduce your tax liability. So, if you've received a large sum of money, such as an inheritance or even lottery winnings, you might want to give back while being tax-advantaged through a private foundation.
You can fund your private foundation by donating the following:
- Tangible property like art, yacht, cars, antiques, jewelry
- Real estate
- Stocks (whether privately, restrictively, or publicly held stock
- Intellectual property
Selling a Business
If you’re planning to sell your business, it might be a good time to donate some of its shares to a private foundation. This can reduce tax liabilities significantly. Moreover, you may also fund your private foundation through stocks (whether privately held and/or publicly held).
The great benefit of choosing to establish a private foundation instead of other charity vehicles (like donor-advised funds) is that you don’t need to liquidate contributions of privately held business stocks.
When the foundation does sell the stock, it will only need to pay a nominal tax of 1.39% of the net income.
When You’re About to Retire
If you’re about to retire and have a strong urge to start charitable work, starting a private foundation can be an excellent way for doing just that. With this, you’ll be able to put years of career experience towards solving problems in the community or around the world.
Private Foundation vs. Public Foundation
One thing that sets private and public foundations apart is where they get their financial support from. The majority of donations to private foundations usually come from a few individuals, corporations, or families.
Public charities may also receive money through taxes collected on behalf of the general population in addition to sponsorships/donations made specifically for this purpose.
In a nutshell, private foundations get their funding from private sources, which means you can be more specific about where your money goes.
Difference between a Private Foundation and Public Charity According to IRS:
When it comes to IRS regulations, there are 3 main differences between a private foundation and a public charity.
A private foundation:
- Must give away at least 5% of its investment assets annually.
- Must give the money to other non-profit organizations, or in some cases, individuals (like for scholarships).
- Must also pay a 1% to 2% excise tax on its net investment income.
Private Foundation Categories
Before you start a private foundation, you should know the difference between the types of private foundations. This is to ensure that you make an informed decision on how you would structure your foundation and what your merits and limitations would be.
There are 2 types of private foundations:
- Non-Operating Private Foundation
- Operating Private Foundation
Non-operating private foundations in general and by default are non-operating foundations. Unless they are able to host public programs they cannot be categorized as operating a private foundation.
Basically, a non-operating private foundation works to support public charities but does not hold public programs.
In contrast to private operating foundations, non-operating foundations need to pay out at least 5% of their investment assets in grants to non-profits each year. This is why it is also sometimes referred to as a “grant-making foundation.”
Operating private foundations, on the other hand, have a somewhat “hands-on” process in operating the foundation. This means they should actively conduct programs that provide benefits to charities.
The main benefit of a private pperating foundation over a non-operating one is that donors also get to enjoy higher tax deductions at a 50% rate. Whereas non-operating foundations can only deduct 30% from their donations. Moreover, operating foundations may not excise taxes from undistributed income. Non-operating private foundations, however, are subject to that.
Setting Up a Foundation: Preliminary Requirements
Now that you understand the basics of a private foundation, let’s dive deeper into the preliminary requirements of starting one.
There are 3 major stages in setting up a foundation:
- Planning the Structure
- IRS Registration
Next, we will expand on each stage.
Planning the Private Foundation Structure
What do you want the foundation to accomplish? What are its goals and how long do you want it to operate? This process is solely the planning stage – defining the mission, vision, funding, and management.
During this stage, you’ll want to answer the following guide questions:
- What’s the purpose of this foundation?
- What is our philanthropic objective?
- What is our mission?
- Where do we invest the funds?
- Who will lead? Who will be the board of directors?
- How are we going to fund the initial capital?
- How will it be sustained?
- What degree of control do you want over the funds?
- Am I able to handle the extra administrative work or how much work am I going to delegate?
At this stage, you need to comply and file the necessary legal requirements under state law. Here are some relevant sources to help in the filing process:
Here are some basic steps at this stage:
- Hiring financial advisors and a legal team to solidify the planning stage and help your organization with document compliance, records, and other admin work
- Appointing the board members
- Investing your time or hiring employees to manage
- Determining the lifespan of your foundation: Should it stop when you are deceased?
- Trust vs. Corporation
At this stage, your organization is now formed, and the next step requires you to apply it to the IRS for tax exemption.
IRS Requirements for Private Foundations include the following:
- Create grants worth a minimum of 5% of your organization’s investment assets each year
- Provide grants to nonprofits or for scholarships
- Pay 2% excise tax on your investment assets
How to qualify as a private operating foundation?
While there’s no difference in organizational requirements for operating and non-operating private foundations, there are regulatory laws that separate them apart.
According to the IRS, to qualify as a private operating foundation, it must:
- Pass income test – allot at least 85% of its minimum foundation investment return or its adjusted net income for public activities.
- Meet one other test from the following:
How to Start a Private Foundation: Step by Step Guide
This step-by-step guide will help you get off to a good start. Keep in mind that each state has its own set of rules when it comes to forming a private foundation.
With regards to specific requirements in your own state, you need to do your research ahead of time to ensure that you are compliant with all local filing requirements. This includes local business registration, charitable solicitation, state income tax exemption and sales tax exemption.
Once you have all of your ducks in a row, follow the steps below to get your private foundation up and running.
Define Your Organization Structure
The first step is defining your private foundation's purpose and guidelines. This definition guides the foundation's activities and is necessary to gain tax-exempt status.
One of the key benefits of a foundation is that you get to choose your board of directors and appoint your officers. The type of foundation desired dictates who should be chosen to sit on the board.
For example, If the foundation is a private family foundation, then family members should be appointed as officers and directors. If the foundation has a specific mission or focuses on a certain community, then people with expertise related to these objectives should be brought onto the board.
In some cases, the founder (or founders) of the private foundation may serve as its sole director. However, it is also possible to appoint a spouse, child, another family member, business associate, or anyone else as an officer or director.
Trust or Corporation
There are two ways to establish a foundation: as a charitable trust or as a nonprofit corporation.
A trust is easier to create and operate, but it does not offer the same legal protections for the trustees as a corporation. If you decide to establish your foundation as a trust, you will need to appoint trustees.
A corporation is more difficult to establish, but it provides more flexibility in how funds can be used and limits personal liability for the directors and officers. If you decide to establish your private foundation as a corporation, you will need to follow the standard steps to creating a corporation, including writing bylaws, and articles of incorporation. You’d also need to appoint officers and directors, and file with the state.
Create a Mission Statement
Next is to create your foundation’s mission statement. The mission statement should include the foundation’s charitable purpose. A non-profit mission statement must include what your foundation is for, what will guide it, and what fuels its passions. It should also articulate the change you want to contribute to society. Many foundations choose to use the common statutory language that many nonprofits use when creating their mission statement.
Create a Philanthropic Objective
What are the outcomes you want to achieve that will eventually improve the lives of other people? Think about the group of people you want to focus on and articulate these goals with a clear set of objectives. Reflect on what is important to your foundation and what motivates you to give for a cause.
Don’t worry if you haven’t had a clear perspective on your philanthropic objective. To help you navigate your thoughts, you can start by making small grants to a variety of projects/causes to figure out which ones you like best.
Determine the Size of Your Foundation
Pay attention as this is important. What do you think is the total value of assets your foundation can invest?
Most financial advisors recommend only considering setting up a foundation if they at least fund $1 million to $5 million in assets – aside from the expenses of hiring staff and other managing costs.
However, it’s also surprising to know that over 87% of existing foundations have a total asset of less than $5 million and 67% are even below $1 million. In addition, 98% of all foundations are even under $50 million.
So, does this mean you can build a foundation even below $1 million? The answer is yes – but test the waters first. To make it more advantageous, put your investment near a liquidity event so that it could lead to a larger endowment.
In addition, partnering with a reputable management solution for private foundations such as Foundation Source can help you cautiously grow your new foundation.
Determine the Life of Your Foundation
While there are no legal requirements about the foundation’s lifetime, we recommend you determine this early on. This gives you clarity on your foundation’s future goals and keeps the level of commitment of its members, whether it’s an important family matter or other valuable cause. It helps carry on the foundation’s philanthropic objectives for the generations to come.
If you don't want to, you don't have to hire any staff. But in many cases, hiring staff is advisable especially if you’ve got a lot on your plate or you don’t benefit the services of foundation management solutions. If you do the latter, they can act as your “virtual staff” so there's no need to pay anyone to manage your foundation.
Private foundations are allowed to pay reasonable compensation for professional services to the foundation – even if they're members of the family. This includes things such as a volunteer board of directors, paid staff, consultants, attorneys, and bank trust departments. Community foundations can also be used.
Getting your private foundation incorporated takes a lot of work. That’s why it might be the time for you to find an attorney to help you or hire a foundation management company.
A private foundation needs to be legally registered in the state where it will be carrying out its business activities. The process for doing this can vary from state to state, so it's important to check with your Secretary of State's office to find out the specific requirements for the state you're in.
Basically, you’ll need to accomplish the following:
- Make sure that the name of your foundation is not already in use by another organization. You can do this by searching online.
- Create Articles of Incorporation – this is a legal document that outlines how the corporation will be run. If you're doing this yourself, look for templates online that fit incorporating a nonprofit organization in your state.
- Designate your board of directors. New corporations usually need at least three members serving on the board. Name the members in the Articles of Incorporation.
- Pay any filing fees required.
Get an Employer Identification Number (EIN)
Starting a foundation also requires you to apply for an Employer Identification Number (EIN). This is basically a social security number for your business, and it will be used by government agencies to identify your foundation. Even if you don't have any employees, it's still advisable to get an EIN for your foundation. The best part is that you don’t need to pay for an EIN.
Here are the steps to apply for an EIN:
- Fill out IRS Form SS-4 (Application for Employer Identification Number). You will receive your EIN through mail.
- Call the IRS Business & Specialty Tax Line at (800) 829-4933 and apply over the phone. You will be receiving your EIN before the call ends.
- You can also apply for an EIN online through the IRS website. At the end of the application process, you will receive your EIN electronically.
IRS Application for Tax Exemption
You will need to submit IRS Form 1023 which is “Application for Recognition of Exemption Under Section 501(C)(3) of the Internal Revenue Code” and can be found at www.irs.gov.
Upon receiving your accomplished Form 1023, IRS will determine
- If your organization qualifies under a Section 501(c)(3) organization (or qualifies for tax exemption),
- If it is considered a private foundation or public charity.
Cost to Start a Private Foundation
The cost of starting and operating a private foundation usually consists of the startup expense, operational expense, initial fund, and annual tax payment.
Below is a breakdown each cost:
|Start-up Cost||One-time Fee||$4,500 to $30,000|
|Operational Expenses||Annually||Minimum of $5,000|
|Initial Fund||Annually||No legal requirements but most third-party services require minimum initial funding of at least $500,000|
A private foundation typically starts off with a startup cost from legal expenses. You have 2 options, hire a professional private foundation management service, or hire a private attorney
Cost of a Third-Party Foundation Management Service:
Services that specialize in this area usually charge $4,500 to $5,000 to start a foundation. For example, Foundation Source, one of the most reputable foundation management services charges a one-time setup fee of $4,750.
Cost of Hiring a Private Attorney:
Private attorneys that specialize in non-profit corporations and trusts charge around $8,000 to $30,000 to process state and federal applications.
Hence, using foundation management services will still be cheaper than administering the foundation yourself.
Ongoing Operational Expense
If you opt for a third-party private foundation service, you’ll usually be paying a minimum of $5,000 each year for the operating expenses. The cost may go up depending on the size and structure of your foundation. Some factors include tax preparation, program analysis, administration, operation, excise tax, and many more.
The minimum amount of money required to start a private foundation is usually $500,000 if you plan on using a third-party administrator. If you intend to hire your own staff to handle administrative services, then it is advisable to have between $3 and $5 million in assets.
A private foundation must give away at least 5% of its total assets each year, no matter how well its investments do. Running a small private foundation can cost 2.5% to 4% of assets annually in overhead expenses.
FAQ About Starting a Private Foundation
Can a Private Foundation Solicit Donations from the Public?
A private foundation typically gets its funds from one or two individual donations who are freely contributing funds as an action of their generosity. It doesn’t solicit donations from the public. However, private foundations can accept donations. Once it gets enough donations, it may even qualify for public status.
Can a Private Foundation Accept Donations from Other People?
Yes, a private foundation may also accept donations from people who are not associated with the organization. This may include family, friends, businesses, and employees.
What are the Benefits of Foundation?
Philanthropy and family legacy are two benefits of forming a foundation. With Philanthropy, you’ll be able to extend help to others who need your help through making grants, giving, and charities. You will also most likely leave a tradition of philanthropy and giving across family generations. Future generations will have deeper intentionality, understanding, and empathy and care for others as a result of the older generations philanthropic objectives.
Another benefit that comes with forming a foundation is when you contribute assets to a private foundation, you can deduct them from your income taxes in the year they are given. This deduction applies even if the foundation does not use the assets for charitable purposes until later. In addition to reducing your income taxes in the year when the gift is provided, this can also help reduce or eliminate potential estate taxes and avoid paying capital gains taxes on assets that have increased in value.
Lastly, private foundations offer donors the greatest degree of control over how their charitable gifts are used. Donors can decide which charities to give support to, who serves on the foundation's board, and how the foundation's assets are invested. Private foundations also offer donors more flexibility in terms of the forms of assets that can be used to fund the foundation.
What are the Tax Benefits of a Private Foundation
- Potential estate taxes can be reduced or eliminated
- Appreciated assets can be avoided from capital gains taxes
- A private foundation can offer income tax liability reduction to its contributors
- The growth of investment assets given to the foundation can be tax-advantaged
How Long Does It Take to Start a New Private Foundation?
Third-party services can typically get you started on your new private foundation in three business days to a week. Starting a private foundation by yourself may take more time as it’s like starting a new business.
While there are so many benefits that come with starting a private foundation, the process can be laborious. There are laws, requirements, costs, and more management that go with it. You will need to set up a board, file a lot of papers, and set up meetings.
We hope this step-by-step guide has aided you in the process of starting a private foundation.
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