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Charitable Relief Efforts & Private Foundations In Context
mergency relief for families impacted by the September 11 disaster has rapidly pulled together more than $1 billion for a variety of funds. Practical consideration and tax consequences apply to contributions. Donors should understand the difference between nondeductible contributions to help a local family and deductible contributions to a qualified charitable organization. A second wave of private foundations may follow among the families of victims. The use of private foundations offers great family control over funds but comes with additional administrative wrinkles. Here, we review two approaches for providing for the families of victims as well as honoring the memory of those we have lost.
Honoring Fallen Friends
On September 11, 2001, two brand new fathers left the northern New Jersey township of West Milford for the last time. Jeremy Glick boarded Flight 93 bound for Los Angeles, the flight that crashed in Pennsylvania when he and other passengers stormed hijackers in the cockpit. Michael Zinzi commuted 30 miles to the World Trade Center, where he worked as a CPA for Marsh and McLennan on the 100th floor of Tower 1.
Soon after the disaster, friends, families, and communities such as West Milford had to sort through the financial issues of directing funds to victims' families. Although bank accounts are an effective way to collect funds, contributions to a family's "memorial fund" do not qualify as a charitable contribution so no tax deduction applies to the donor. Nor is such aid taxable as income to the donee. Rather, transfers to a family's bank account are gifts.
Gift tax consequences are only a remote possibility in this context, however, since the contributions tend to be modest and the annual gift tax exclusion of $10,000 would apply. Even though a good Samaritan collected $60,000 to be turned over to Jeremy Glick's surviving family, the IRS is likely to treat the Samaritan as a custodian or trustee for the funds and not as a sole donor so long as the funds have not been commingled or misapplied.
But donors may be reluctant to give larger sums of money without obtaining a charitable deduction. As donations reach $5,000 and $10,000, donors do care about getting a charitable tax deduction. Since these disaster relief efforts typically look to the public for contributions, it may be prudent to respect the IRS preference to have public fundraising done through a public charitable organization as opposed to a private foundation. As indicated in the discussion that follows, private foundations have their appropriate uses, but they are not for every situation.
Groups incorporating charitable organizations and applying for 501(c)(3) status quickly learn that a charitable fund cannot single out specific families of known victims; a general class of beneficiaries is required. As a practical matter, the amount in a fund must suit its intended purpose. For example, a fund of less than $100,000 that is intended to provide scholarships in memory of a victim may not produce sufficient annual income and could soon be depleted. Having an exit strategy for when emergency relief efforts are concluded is also critical. The document establishing the charitable group must provide for funds to be used for some other charitable purpose in the event the fund is terminated or the organizer runs the risk of being held accountable.
While most of the initial fundraising is being conducted by public charities, a wave of private foundations may follow among the families of victims who receive outpourings of financial support from their community as well as insurance payments, legal settlements, and perhaps even book rights, publicity rights, and photography royalties in some instances. Families of victims may want to honor a loved one with an enduring scholarship, an endowed chair at a university, or a private foundation. The most flexible arrangement that enables a family to have control of the future uses of the funds is the private foundation. However, that arrangement also comes with the most strings attached.
Private Foundations
The private foundation is a useful way of making a lasting charitable gift in a manner that is personally gratifying. Donors considering these arrangements must be aware of the specialized tax rules that apply and the choices they will be expected to make. Although private foundations do have tax advantages, they are subject to various restrictions that do not apply to other charitable gifting techniques. However, what is sacrificed in terms of tax benefits and administrative rules is gained in terms of allowing a donor to have maximum control over the future disposition of funds. Here, we review the basic requirements of private foundations and current developments affecting their use.
A Retrospective
Private foundations have a long history that dates back to ancient times. In this nation, they are associated with periods of prosperity such as the end of the 19th century. A modern wave of private foundations arose during the prosperity of the 1950s. By the 1960s, promoters had found ways to exploit tax aspects of private foundations and Congress began to scrutinize foundations.
The Tax Reform Act of 1969 cracked down on foundation abuses by prohibiting certain transactions with Internal Revenue Code (IRC) Sections 4941 through 4945. That Act also imposed a 4% excise tax on investment income, limits on deductions, and limits on the deductibility of appreciated property.
As a result, normal behavior could trigger technical violations and severe penalties would then apply with strict liability. Tax penalties apply for self-dealing by disqualified persons such as trustees, directors, or certain contributors (§4941), failing to distribute 5% of income (§4942), and holding more than 5% of a business (§4943). Other sanctions apply to risky investments which jeopardize the charitable purposes of the foundation (§4944) and making taxable expenditures such as for propaganda, legislative lobbying, and political activities. §4945.
Few private foundations braved these new conditions in the early 1970s. Congress recognized that these restrictions were too onerous and in 1976, reduced the 4% excise tax on a private foundation's investments to 2% (§4940(a)). In 1984, Congress made it possible to reduce the tax to 1% if distribution requirements were met. §4940(e). Congress also allowed deductions to be carried over and further relaxed rules. Though not on a completely equal footing with public charities, private foundations were made competitive once again. And, considering the accumulation of wealth during the 1990s, the stage had been set for a new generation of clients to consider private foundations as an option.
What is a Private Foundation?
Private charitable foundations are best defined in the negative, by what they are not. Under §509(a)(2)(A), they are not "organizations under §170(b)(1)(A)(other than clauses vii and viii)". In other words, they are not churches, schools, hospitals, or government units. They are a §501(c)(3) organization that does not qualify as a public charity. Nor do they rely on the public for a significant portion of annual contributions. Nor do they receive more than one-third of their annual support from gifts, grants, fees, or sales. Nor do they receive less than one-third of income from investments (plus unrelated business income, less taxes). Although some private foundations are "operational," i.e., maintaining a facility such as a museum, the discussion of "private foundations" here refers to non-operating, grant-making entities.
Income Requirements: Tax savings are a relevant consideration in any charitable transfer. Some donors see each dollar of unnecessary taxation as another potential dollar for charity. For income tax purposes, gifts of cash or unappreciated assets to a public charity are deductible up to 50% of the donor's adjusted gross income (AGI). §170(b)(1)(A)(vii). By comparison, gifts of cash or unappreciated assets to a private foundation had been limited to 20% of the donor's AGI and were increased to 30% of AGI by the Tax Reform Act of 1984. Thus, with an adjusted gross income of $500,000, a donor could claim an income tax deduction for donating $250,000 to a public charity, but only $150,000 to a private foundation.
Mechanics: Although private foundations are defined under federal law, separate state laws govern their establishment. After selecting trust or corporate form, the foundation is set up to comply with both state and federal requirements. Trust-based foundations are fairly straightforward. They involve the selection of the trustees and successor trustees, a statement of the foundation's charitable purpose, and guidelines for the administration and distribution of assets. Long-term issues involve the duration of the trust and its ultimate disposition of assets.
To incorporate a private charitable foundation, articles of incorporation, bylaws, and all of the other trappings of establishing a corporation under state law must be provided. There must also be guidelines to define charitable purposes and set forth procedures to be followed by directors. At an organizational meeting, officers are elected, bylaws are adopted, resolutions to conduct business are passed, and minutes are taken. Both trusts and corporations must comply with §§4941 through 4945.
Once an entity has been set up, tax-exempt status is sought from the IRS. The approval process can take six months or more. Among the information to be submitted is an estimated budget for the coming two years. An employer ID number must be obtained, and, if wages are paid, income tax and Social Security must be withheld, deposited, and reported in the usual manner. Annual tax returns must be filed. Certain state forms may be required as well.
Tax Consequences: Once assets are donated to any charity, they appreciate without income tax and are not included in the donor's gross estate. These tax advantages are the same for public charities as well as private foundations. However, public charities have a slight edge with regard to the income tax deduction claimed by donors. The deduction that a donor, who files itemized tax returns, may claim on assets donated to a public charity is limited to 50% of the donor's adjusted gross income (AGI) for cash contributions and 30% of AGI for appreciated assets.
By comparison, contributions to private foundations are somewhat more restricted, with the limits set at 30% of AGI for contributions of cash (§170(b)(1)(D)(i)(I)) and 20% of AGI for appreciated property. §170(b)(1)(D)(i)(II). Corporations may deduct up to 10% of their income for contributions to any §501(c)(3) organization, including private foundations.
Private foundations also must contend with specialized treatment of capital gains. While charitable donations generally qualify for an income tax deduction for the property's fair market value, donations to a private foundation have only been deductible at their cost basis. An exception to this has been provided for qualified appreciated stock on a temporary basis in the past. As a result, qualified appreciated stock that is given to a private foundation is valued at fair market value if the gift was made prior to 1995 or after June 30, 1996. After expiring or being extended a number of times, this exception became permanent and was enacted retroactively to the last time it expired, June 30, 1998. An appreciated stock is qualified if it is corporate stock, held for at least 12 months, and can be valued using readily available market quotations on an established securities market. §170 (e)(5).
Excess gifts may be carried over for up to five years. §170(b)(1)(D)(ii). Pre-1995 gifts qualify for a carryover of the fair market value (FMV) of the gift rather than the cost basis. PLRs 9424040 and 947031. Gifts made from January 1, 1995, through June 30, 1996, were deducted at a cost basis, and the carryover for such gifts would presumably continue to be based on cost basis.
Current Developments and Strategies
A gift to a private foundation of an appreciated security is only deductible under §170(e)(5) if there are market quotations that are readily available. For example, A contributed Class B shares of Company X to a private foundation. Because Class B shares were not listed by an established securities market, only the cost basis of the shares could be deducted. This was true even though the Class B shares were convertible to Class A shares which were listed on the Nasdaq National Market. PLR 199915053.
By contrast, mutual fund shares that were transferred to a private foundation were considered qualified appreciated stock since market quotations are available-mutual funds are treated as corporations that must redeem the shares at net asset value and those values are published daily in newspapers with general circulation throughout the United States. Thus, the appreciated value of the mutual fund shares could be deducted. PLR 199925029.
A private foundation had the purpose of promoting educational organizations that were being supported by a public charity. To work in conjunction with charity without as many administrative and financial burdens, the private foundation reorganized, terminated its private foundation status, and became a supporting organization under §509(a)(3). Following termination, Reg. §1.507-2(b)(3) provides for a 60-month period before the former foundation qualifies as a supporting organization. The IRS ruled that the private foundation would not be subject to the private foundation terminations tax under §507(c), nor the net investment income tax under §4940(a) during the 60 month period. PLR 200016025.
Alternatives
What does a private foundation have that other planned-giving arrangements do not? Control. Once a donor releases an outright charitable gift or bequest, it can be used by the recipient with broad discretion. A pooled income fund has guidelines for the distribution of assets, but those guidelines aren't specifically determined by one donor and the assets are not associated with a single donor but with the entire pool. A donor's gift to a charitable trust offers some control over the use of the assets insofar as it can include many mandatory guidelines for the asset's future use.
Another alternative is an "advised fund." This approach is growing in popularity and can be very convenient. Such an entity enables a donor to retain a lifetime right to make recommendations on how the donated funds are used. The full charitable tax deduction is secured yet the administrative expenses of having a separate foundation are avoided. Some "community foundations" allow donors to establish a fund in their own name. This type of approach is useful when smaller amounts of money are involved; a community foundation can be funded with as little as $5,000.
By comparison, a private foundation with less than $250,000 may find that administrative expenses defeat the intended purposes of the foundation. In addition, a community foundation can be funded with any type of appreciated assets without affecting available tax deductions. By comparison, private foundations must be funded with publicly traded stock if a deduction for current market value is to be obtained.
Beyond Taxes
When is a private foundation right for a given client? It is not every individual who has the means to make a significant gift to charity, but for those that do, a private foundation allows the donor and the donor's family to finely tune the charitable grants offered by a private foundation. It can be gratifying to have the family name associated with an enduring source of good work and to involve family members in a worthy project. Notwithstanding tax changes or tax consequences, private foundations have continued to have an important role, both for donors and society. With a private foundation, an individual donor can make a difference, and do so on his or her own terms.
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Sponsored by James J. Eccleston, an attorney representing stockbrokers, financial planners and
investors nationwide in arbitration, litigation and regulatory matters, and a shareholder with the law firm
Shaheen, Novoselsky, Staat, Filipowski & Eccleston
P.C.(www.snsfe-law.com). This Web site contains material
of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment advisor when building and protecting your wealth.
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