What Is a Private Foundation?
Like public charities, private foundations are defined under section 501(c)(3) of the Internal Revenue Code (IRC), which grants tax-exempt status. In fact, “private foundation” is the default status given to organizations granted 501(c)(3) status.
To qualify for the tax exemption, the foundation’s purpose must be “charitable, religious, educational, scientific, literary, testing for public safety, foster national or international amateur sports, or prevent cruelty to children or animals.” The foundation may assist the poor, advance education, or maintain a public building.
- “Private foundation” is the default status given to organizations granted tax-exempt 501(c)(3) nonprofit status.
- Unlike a public charity, a private foundation typically makes donations, called “grants,” to other charities.
- A public foundation can consistently fund a select cause and provide cumulative benefits to the recipients over many years of donations.
- Starting a private foundation is much like starting any business and requires defining your purpose, applying for tax-exempt status and licensing, filing federal and state tax documents, and defining your organizational structure.
What Does a Private Foundation Do?
Unlike a public charity, a private foundation typically makes donations, called “grants,” to other charities. It usually does not conduct its own charitable operations. Private foundations make grants either to fund an organization’s general operating expenses or a specific program. They can also make grants to individuals if they follow Internal Revenue Service (IRS) rules.
The activities of a private foundation, like those of a public charity, must benefit the public in order for the foundation to maintain its tax-exempt status. The IRS defines three key differences between a public charity and a private foundation. Private foundations must:
- Make grants worth at least 5% of the foundation’s investment assets each year
- Provide grants only to other nonprofits (though under some circumstances it is possible to make grants to individuals, such as for educational scholarships)
- Pay a 1% to 2% excise tax on the organization’s net investment income
How To Start Your Own Private Foundation
Should You Start a Private Foundation?
If you regularly donate large sums of money, you might be wondering whether you should start your own private foundation. Perhaps you see a social need that hasn’t been met, or perhaps the prestige associated with running a charitable foundation in your own name intrigues you.
The most common type of foundation is the grant-making foundation. This is a not-for-profit organization primarily funded by an individual, a married couple, a family, or a corporation. The private foundation’s assets are called an endowment, which is invested to generate income for the foundation. The endowment is used to fund its operations and make grants.
While private foundations can be time-consuming and expensive, the thousands of individuals, families, and corporations who have established them believe these sacrifices are worthwhile.
How to Start a Foundation, Step by Step
1. Define your purpose
First, define your private foundation’s purpose and the guidelines it will follow in making its grants. This definition will guide your organization’s activities and is necessary to gain tax-exempt status.
2. Decide between trust and nonprofit
Next, decide whether to structure your foundation as a charitable trust or a nonprofit corporation. A charitable trust can be easier to establish and operate, but it may not provide the trustees with as much legal protection as a nonprofit corporation, which has stricter operating requirements. Despite being harder to create, nonprofit corporations are more common than charitable trusts, because they limit personal liability and have more flexibility in how they may use their funds.
If you organize as a trust, appoint trustees. If you organize as a corporation, follow the usual steps for establishing a corporation, including writing your articles of incorporation and bylaws, naming officers and directors, and filing with the state.
3. Apply for an employer identification number (EIN)
Regardless of how you decide to structure your private foundation, you must apply for an employer identification number (EIN). The IRS requires that you have an EIN even if you don’t anticipate hiring employees. The number will act as a tax identification number (TIN) for your foundation, just as a Social Security number (SSN) does for an individual.
4. File for tax-exempt status with the IRS
The next step is to file organizing documents with the IRS. Fill out Form 1023 (Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code) and prepare all of its required supporting documentation. This form asks for the basic identifying information about your foundation and how it will be organized and operated. It also requires applicants to pay a fee. It can only be completed and filed online at the IRS website.
5. File for tax-exempt status with your state
Finally, once the IRS approves your tax-exempt status, file any additional required paperwork to obtain tax-exempt status from your state.
Benefits of Having a Private Foundation
If you want to contribute to a good cause, the easiest way to do it is to write a check. So why were there at least 118,724 private foundations in the U.S. as of December 2019, according to IRS figures?
- Permanence—For one, a foundation can consistently fund a select cause and provide cumulative benefits to the recipients over many years of donations. Its permanence is part of the attraction.
- Legacy—Some families start foundations to create a legacy. A foundation established in a loved one’s name can honor that individual even after they have died. Establishing a foundation in a family name can also encourage other family members to participate in a common—and often bonding—cause.
- Tax-exempt status—Tax benefits are another reason for starting a private foundation. When organized as a 501(c)(3), private foundations are tax exempt. They can collect contributions of cash and appreciated property without paying taxes on those contributions. In addition, the contributors can claim their donations as tax deductions (with some restrictions).
How to Maintain Your Private Foundation
Setting up your private foundation is a lot of work, as is maintaining it, which entails following IRS rules.
Regulations and penalties
Your foundation must avoid prohibited activities, which the IRS defines as:
- Allowing more than an insubstantial accrual of benefits, including nonmonetary benefits, to individuals or organizations
- Allowing income or assets to accrue to insiders (for example, paying an unreasonable salary to an officer, director, or key employee)
- Participating in any political campaign on behalf of (or in opposition to) a candidate for public office, including making campaign contributions and issuing official public statements
Your foundation also must limit restricted activities, which the IRS defines as:
- Self-dealing with disqualified persons (defined as substantial contributors, foundation managers, and certain other related persons)
- Investment activity that might jeopardize the carrying out of exempt purposes
- Lobbying or attempting to influence legislation through actions or spending
Both the foundation and any entity that improperly benefits from a prohibited or restricted activity may face taxes and penalties for violating these rules. The foundation could even lose its tax-exempt status.
Running a private foundation also entails many of the same responsibilities and expenses as running a business. You must keep records, file annual tax returns using Form 990-PF (a detailed, 13-page document), and hire and manage employees (who may be your family members).
It’s a good idea to hire legal and accounting professionals to handle startup and ongoing regulatory and compliance matters such as bookkeeping, tax preparation, and corporate filings. Many aspects of starting and running a private foundation are governed by complex rules and/or require specialized knowledge.
How much money do you need to donate for it to be worth the effort to start and maintain a foundation? There is no hard-and-fast rule here, but most family foundations have assets of at least a few hundred thousand dollars, according to the Council on Foundations.
The Bottom Line
Establishing a private foundation can be a very good thing if you have sufficient cash to fund it. You can tailor your donations to the charitable mission you want to support, and because it is funded by investment income derived from an inviolable endowment, it can become a legacy for you and your family that continues to do good long after you and they are no longer alive.
However, if you’re not sure whether a private foundation is the most effective way to meet your philanthropic goals, you can always engage in simpler charitable alternatives, such as writing a check to your favorite nonprofit, donating your time, or contributing to a donor-advised fund.
Do All Private Foundations Have Tax-Exempt Status?
Yes, they do, as they must be created for one of the following express purposes enumerated by the IRS to qualify as a 501(c)(3) organization: charitable, religious, educational, scientific, literary, testing for public safety, foster national or international amateur sports, or prevent cruelty to children or animals.
How Much Money Do You Need to Start a Private Foundation?
While there is no set amount required by law, you need enough money to set up an endowment fund that can generate sufficient investment income to fund your charitable grants. The Council on Foundations says that most family foundations in the U.S. have an endowment of at least several hundred thousand dollars.
Is There a Requirement as to How Much Money a Private Foundation Must Pay Out?
Yes. The IRS requires that private foundations should pay out in charitable grants at least 5% of the foundation’s assets annually. If it fails to do so, it can lose its tax-exempt status.