Demystifying the Private Operating Foundation

Demystifying the Private Operating Foundation

Spotlighting an overlooked tool of personal philanthropy
Article posted in Foundations on 21 August 2018| comments
audience: National Publication, Dennis Walsh, CPA | last updated: 23 August 2018
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Summary

Private operating foundations are a little understood and under utilized planning tool. Dennis Walsh provides great insight and useful information.

 

By Dennis Walsh, CPA

Because of technical features and costs to set up and operate, the private foundation has been traditionally viewed as a vehicle suitable for high net worth philanthropy.  And its less known and more obscure cousin, the private operating foundation, has received little attention from planners.

Illustrating this point, according to IRS statistics there are approximately 97,500 U.S. private foundations and 8,600 of these, less than 9%, are private operating foundations.  Nearly three-fourths of these have assets of less than $1 million.  And upon review of these small operating foundations, it is apparent that a majority consist of community nonprofits lacking the broad public support needed to be classified as a public charity by the IRS.  Thus, there are relatively few operating foundations organized for personal philanthropy.

This article seeks to demonstrate how a private operating foundation can afford added flexibility and control in the conduct of philanthropy and fulfillment of legacy objectives, while also providing greater tax efficiency when compared to a donor advised fund or private foundation.  A review of these other two choices is a good starting point.

All section references are to the Internal Revenue Code and Regulations.

Donor advised fund

The donor advised fund (DAF) has exploded in popularity over the last two decades.  The number of funds has grown to more than 300,000, while distributing more than $15 billion annually to designated charities.

DAFs are sponsored by Section 501(c)(3) charitable organizations, and commonly found at investment firms, community foundations, and individual charities.  In addition to cash, DAF sponsors typically accept gifts of appreciated securities.  Some accept other types of non-cash gifts such as real estate, business interests, and intangible property, while also facilitating the liquidation of such assets. 

Especially popular with those under 50, donors are able to plan their year to year giving to maximize tax savings, such as giving in a high income year, while conveniently directing gifts to their favored charities in a time and manner that meets their giving goals.  Funds may be invested indefinitely until distributed at the donor/advisor’s request.

A DAF is easy to set up and account fees are modest, usually not exceeding 1% of account assets per year, plus mutual fund fees.  And donors may appoint successor advisors such as children to carry on a family giving legacy.

A major DAF advantage is the convenience of making gifts to multiple charities without the burden of substantiating each separate gift for tax purposes.  And many donors like the option to keep their gifts anonymous.

Because of the large increase to the standard deduction under the Tax Cuts and Jobs Act of 2017 (TCJA), far fewer individuals are able to itemize deductions.  Many who can still itemize need to bunch payment of their charitable gifts and other itemized deductions within alternating years in order to exceed the standard deduction otherwise available.  A DAF is ideally suited for this strategy.

Private foundation

A Charitable organization that does not receive at least one-third of its income from publicly-supported nonprofits, units of government, or the general public usually does not qualify as a public charity and is classified as a private foundation (PF) by the IRS.  This may include an organization choosing not to seek public support, such as a family foundation, as well as other nonprofits unable to diversify their funding sources or that receive most of their support from major donors.

With less public oversight of such organizations, Congress recognizes that the IRS cannot by itself adequately monitor their activities, and has put in place special safeguards to enhance transparency and to help deter impermissible private benefit that might be derived through tax-exempt status.

A PF is required to annually distribute for charitable purposes an amount equal to a deemed “minimum investment return.”  This is 5% of the value of foundation assets not used directly in carrying out exempt activities, after reduction for any related acquisition indebtedness.

A PF that makes grants to individuals for travel, study, or similar items must obtain advance approval of its grant making procedures from the IRS. And a PF generally may not grant funds to an organization other than a publicly-supported charity unless it complies with the expenditure responsibility rules of Section 4945(h).

For gifts and grants made by a PF, unlike a public charity, grantee names and addresses must be disclosed on Form 990-PF, the annual IRS information return for a private foundation.  IRS 990 series forms are open to the public.

The names and addresses of major donors to a public charity are removed from Form 990 for public inspection, including gifts to a donor advised fund.  However, for a private foundation such information must remain present on Form 990-PF for gifts exceeding the greater of $5,000 or 2% of annual foundation income.

A PF must also pay an annual excise tax equal to either 2% or 1% of its net investment income.  A foundation whose current year charitable distributions exceed what its distributions would be based on its average rate of payout over the last 4 years, plus 1%, qualifies for the lower rate for such year.

Gift deduction limits

For gifts to a public charity, including a DAF, individuals may deduct total annual contributions of cash and long-term capital gain property in an amount that does not exceed 60% and 30% of the donor’s adjusted gross income (AGI), respectively.  The limit for gifts of cash was increased from 50% to 60% by the TCJA.

For the same types of gifts to a PF, the annual percentage limitations are 30% and 20%, respectively. 

In addition, a deduction for a gift of non-cash property to a PF must be reduced by any long-term capital gain that would have resulted if the property had been sold at its fair market value at the time of the gift.  This generally limits a deduction to the donor’s cost or other basis of the property, eliminating tax savings from any appreciation in value during the donor’s period of ownership.

An exception exists for qualified appreciated stock.  This is stock for which a market quotation is readily available on an established securities market.  But this exception does not apply to the extent that the donor and family members contribute more than 10% of the value of the outstanding stock in the corporation.

Private operating foundation

A PF that makes sufficient expenditures in the active conduct of charitable activities may qualify as a private operating foundation (POF) and enjoy some of the benefits of public charity status.

A POF is not subject to the 5% minimum distribution requirement.  Instead, it has special distribution tests that afford some flexibility in the timing and amount of charitable expenditures, instead of applying a flat annual payout rate.  In addition, donations to a POF are tax deductible under the same rules as donations to a public charity without regard to the PF limitations discussed earlier.

POF qualification

To qualify as a POF for a particular year, the foundation must meet an income test:

The foundation must spend for the active conduct of exempt activities at least 85% of the smaller of:

  • Adjusted net income (as defined in Section 4942(f), or
  • Minimum investment return (as defined earlier)

It must also meet one of three alternative tests:

  • Assets test - 65% or more of foundation assets are devoted to the direct conduct of exempt activities
  • Endowment test - The foundation normally makes distributions in the active conduct of its exempt activities in an amount that is two-thirds or more of its minimum investment return
  • Support test - The foundation normally receives 85% or more of its support from the public and from 5 or more publicly supported organizations

“Adjusted net income” does not include charitable support received or long-term capital gain realized by the foundation.

It is not necessary to qualify under the same alternative test each year.  In addition, the foundation may satisfy the income and alternative tests by combining any 3 years within the most recent 4 year period, or may aggregate all 4 years.

Active conduct

Whether an expenditure is in the “active conduct” of exempt purposes is primarily a qualitative assessment that depends on facts and circumstances.  In addition to the direct delivery of program services, the payment of grants and the making of program related investments may qualify as active conduct expenditures, depending on whether the foundation maintains significant involvement in carrying out the supported activity.

For example, making grants to other charitable organizations for specific purposes is indirect and usually not in the active conduct of exempt purposes.  Nor is direct grant making if the foundations only involvement is screening and selecting applicants.  But a grant made as a component of an active foundation program, or a direct grant made in conjunction with ongoing foundation supervision and grantee reporting may qualify as active conduct expenditures.

Amounts paid to acquire or maintain assets used directly in the foundation's exempt activities are treated as active conduct expenditures.  In addition, administrative expenses such as salaries, travel expenses, and other operating costs necessary to conduct the foundation's exempt activities, regardless of whether they are directly in the active conduct of such activities, are treated as active conduct expenditures if reasonable in amount.

Thus, in cases where the sum of reasonable compensation and operating expenses properly allocable to exempt activities satisfies the income test and the foundation can also meet one of the alternative tests, a private foundation may qualify as a POF even where gifts and grants are not considered as made in the direct conduct of exempt activities.

See Treas. Reg. Sec. 53.4942(b)-1 for more details and examples.

Qualified intellectual property

Unlike a PF, a POF is eligible to receive a qualified intellectual property (QIP) contribution under Section 170(m).  This presents an attractive opportunity to gift valuable intellectual property (IP) rights to a POF and subsequently license use of such IP to provide a tax-free income stream to the foundation.

Charitable gifts of IP cannot exceed the donor’s adjusted basis, resulting in little or no deduction in most cases.  To compensate for this, a donor may receive annual charitable deductions based on income produced by the IP for up to 10 years, computed on a sliding scale of percentages.

IRA rollover

The IRA charitable rollover, technically termed a “qualified charitable distribution” (QCD) has grown in popularity since being made permanent under the 2015 PATH Act.  The QCD provision permits an owner of a traditional individual retirement account (IRA) who has reached age 70 ½ to make an annual contribution of up to $100,000 directly from the IRA to a qualified charity.

As a result of bypassing the donor’s tax return, this giving alternative may encourage larger charitable gifts as a result of not being subject to the annual percentage of AGI limits for charitable deductions, while also being applied to a donor’s annual required minimum distribution.  And because of certain exclusions and deductions that are sensitive to changes in AGI, it can result in added overall tax savings.

Although charitable gifts limited by the annual AGI percentages may be carried forward for up to 5 years, a donor’s current marginal tax rate may be higher than the tax rate in a carryover year.  Even where marginal rates are the same, however, the time value of any tax paid in the interim is permanently lost.  And given a donor’s advanced age, there is a greater risk the donor may die before realizing full benefit from the suspended deduction, with any remaining carryover available only to a surviving spouse.

A QCD may also be preferable in states that do not provide for a charitable deduction or credit against state income tax. 

Qualified recipient

An eligible QCD recipient is an entity recognized under Section 170(b)(1)(A).  Except as listed below, this includes an organization recognized under Section 501(c) (3), including a POF or conduit foundation as defined in Section 170(b)(1)(F).

Disqualified recipients include a:

  • Private foundation
  • donor advised fund
  • supporting organization (Section 509(a)(3))
  • split-interest trust, e.g. charitable remainder or lead trust

Case example

The following case compares tax effects of several options for accumulation of an endowment using a POF along with a QCD.

John and Mary Smith, each age 72, wish to establish a $1 million endowment for family philanthropy.  The Smith family has enjoyed a multi-generation interest in reducing hunger.

Instead of setting up a DAF and making grants to address such need, they have decided to take a more direct role by financing startup and financially distressed food relief agencies along with mentoring their management personnel.  In addition to making grants to such agencies, they will make low and no-interest loans as program related   investments.  The Smiths believe that a POF is the best vehicle to accomplish their goals.

John and Mary own traditional IRAs of $1.2 million each, along with marketable securities valued at $1.6 million.  They have income streams from pensions, annuities, and Social Security along with cash reserves sufficient to assure their retirement income security.  Their annual adjusted gross income is $200,000 and they have a federal marginal tax rate of 22%. 

If the Smiths fund the foundation by transfer of $1 million from their securities portfolio, they can claim a fair market value deduction that includes untaxed appreciation and avoid capital gain tax.  But their allowable annual deduction for gifts of capital gain property is capped at 30% of AGI, or $60,000 ($200,000 x30%), with a carryover of any unused portion limited to 5 years.

Thus, assuming their AGI remains constant, the maximum charitable deduction the Smiths can receive for their $1 million gift is $360,000, i.e. their current year deduction plus 5 carryover years.  Under this alternative the foundation would be immediately funded, but the Smiths would sacrifice tax savings of $140,800 {1,000,000 – 360,000) x .22}.

Alternatively, if John and Mary each apply their annual $100,000 QCD exclusions along with a gift of $200,000 of securities they can fully fund the foundation within 4 years, and will receive maximum tax benefit from the gift of securities within the carryover period.  By using a QCD, taxes deferred from past IRA contributions and related investment growth that John and Mary thought would eventually be taxed are now made permanent tax savings.

What if John and Mary fund the endowment from their IRAs without a QCD? 

A $1 distribution from an IRA will increase an individual’s currently allowable cash charitable deduction by 60 cents.  The remaining 40 cents will be carried to the next year.  In essence, 40 cents will be subject to immediate tax, likely at a higher marginal rate as a result of the spike in income.  And as mentioned earlier, if the donor returns to a lower tax bracket in a carryover year when tax benefit for the deduction is realized, there will be a permanent tax paid based on the spread between the marginal rates.

Accordingly, tax-efficient funding of the foundation under this alternative would need to occur over a much longer period of time, in order to assure that the currently taxable portion of amounts distributed from the IRA do not exceed the amount that fills the unused portion of the donor’s typical marginal rate bracket, while also managing the rolling 5-year carryover period.

With future uncertainties regarding income, deductions, and donor life expectancy, such arduous year to year tax management may not be practical.  And this approach would likely result in relatively small increments of endowment funding spread over a substantial period of time, possibly inadequate to meet the foundation’s capital needs.

Family payroll

A POF also provides a mechanism for the transfer of modest amounts of generational wealth to family members through reasonable compensation, with favorable tax outcomes to foundation employees.

Similar to family business tax planning, reasonable wages not exceeding the standard deduction paid to family members including minor children able to perform legitimate services may in turn be used to fund a Roth IRA and a Section 529 college savings plan with pre-tax dollars.  Employees may also be eligible for tax-favored employee benefits such as health insurance and qualified retirement plans.

Wages paid are subject to Social Security and Medicare taxes of 15.3% (combined employer and employee shares).  Net taxes saved will of course vary directly with marginal rates.  And state income tax savings should be considered as well.

The following table compares key planning features of a DAF, PF, and POF.

Summary

Advisors play a vital role in helping charitably minded clients identify and achieve their philanthropic goals. They should be adept at recognizing when a private operating foundation is a viable alternative to consider alongside the private foundation and donor advised fund as a vehicle for current giving, active philanthropy, and fulfillment of legacy objectives.

Donors to a private operating foundation may realize larger and more immediate tax savings for charitable gifts of cash and capital gain property than for similar gifts made to a private foundation.  And these more generous deduction limits along with eligibility to receive a qualified charitable distribution , not possible with a donor advised fund or private foundation, may together provide the most tax-favored and expeditious strategy for funding personal philanthropy.

But even where use of a private operating foundation is technically favorable, it’s not for everyone.  Clients should consider the recurring administrative costs and responsibilities of a separate entity, and become familiar with the self-dealing prohibitions of Section 4941 and the draconian excise tax penalties that may be imposed on both the foundation entity and insiders for violations.  The flexibility and control afforded by a foundation is accompanied by added risks that must be recognized and managed.

Accordingly, advisors need to assess client personality and the likelihood that compliance responsibilities will be adhered to and whether the client is likely to respect a separate foundation entity or is more inclined to use it as a personal checkbook.  For the latter client type, the independently-administered donor advised fund may be a better choice.

Finally, the use of a foundation vehicle may become preferable at a future time.  Clients should be cautioned that while it is permissible for a donor advised fund sponsor to grant assets to a private operating foundation without exercising expenditure responsibility, this is not true for a grant to a private foundation.  Sponsor policies regarding such transfers should be considered in advance of funding a particular donor advised account.

Helpful resources

For additional background on private foundations along with an overview of the self-dealing and expenditure responsibility rules, see “Public Charity or Private Foundation – Why Does it Matter?”  For more on reasonable compensation in the exempt organization context, see “Reasonable Compensation – A Section 4958 Primer.”  And for a comprehensive overview of the QIP provision, see “Donation of Intellectual Property: What Does it Look Like?”

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