A private family foundation can be one of the most important ways to formalize charitable giving. It can involve multiple generations in a shared philanthropic mission, and create a lasting structure for the causes your family cares about. It is also one of the more heavily regulated entities in the nonprofit sector, subject to a distinct set of excise taxes that do not apply to public charities.
At Abelaj Law, PC, we guide donors and families in New York and New Jersey through each stage of establishing a private foundation, from the initial decision through the governance structure that will guide it for years to come.
Decide Whether a Private Foundation Is the Right Vehicle
Before forming a private foundation, a family should evaluate whether the structure fits its charitable goals. A private foundation offers advantages that alternatives do not, including direct control over investments and grantmaking, the ability to employ family members in certain circumstances, and a permanent, visible institution that can carry a family name across generations. A donor-advised fund, by comparison, involves less administrative burden and lower cost, but offers less control and no separate legal identity.
Choose the Legal Structure and Draft Governing Documents
A private foundation may be organized as a nonprofit corporation or as a charitable trust. A nonprofit corporation is typically governed by a board of directors under bylaws, offers liability protection consistent with other corporate forms, and can be more adaptable over time. A charitable trust is governed by trustees under a trust instrument and offers more limited flexibility once established, though some families prefer it for reasons tied to control or existing estate documents.
Whichever structure is chosen, the foundation needs formal organizational documents, a certificate of incorporation and bylaws for a corporation, or a trust agreement for a trust, addressing charitable purpose, selection of the board or trustees, decision-making procedures, and a conflict-of-interest policy governing transactions involving insiders. Because private foundations are frequently governed by family members, this policy is not a formality. It is a practical safeguard against the self-dealing issues discussed below.
Apply for Tax-Exempt Status
To operate as a tax-exempt organization, the foundation must apply for recognition of exemption from the Internal Revenue Service, generally by filing Form 1023. Most newly formed charitable organizations are presumed to be private foundations under Internal Revenue Code Section 509(a) unless they qualify for public charity status, and an organization funded primarily by one family or a small group of related donors will typically be classified as a private foundation from the outset.
The application requires a detailed description of the foundation’s proposed activities, governance structure, and projected finances, and its accuracy forms the basis for the exemption granted.
Fund the Foundation
A private foundation can be funded during the founder’s lifetime, through a will or trust at death, or a combination of both, and funding decisions should be coordinated with the family’s estate plan. Cash and publicly traded securities are the most common funding assets, though closely held business interests or other illiquid assets raise additional valuation and compliance considerations that should be reviewed before the transfer.
Understand the Excise Tax Rules Under Chapter 42
Private foundations are subject to a distinct set of excise taxes under Chapter 42 of the Internal Revenue Code.
- Self-dealing. Section 4941 prohibits most financial transactions between the foundation and “disqualified persons,” including substantial contributors, foundation managers, and certain family members. Even a transaction that seems fair, such as a below-market lease, can be treated as prohibited self-dealing.
- Minimum distribution requirement. Section 4942 generally requires distribution of approximately five percent of average investment assets each year, with an excise tax on any shortfall.
- Excess business holdings. Section 4943 limits the extent to which a foundation and its disqualified persons may hold interests in a business enterprise, a particular concern where a foundation is funded with closely held business interests.
- Jeopardizing investments. Section 4944 imposes an excise tax on investments that jeopardize the foundation’s charitable purposes, requiring managers to exercise ordinary business care and prudence.
- Taxable expenditures. Section 4945 restricts certain expenditures, including grants to individuals or to non-public-charity organizations, unless the foundation follows procedures such as expenditure responsibility.
- Net investment income excise tax. Section 4940 imposes a tax on net investment income, currently 1.39 percent for most domestic tax-exempt private foundations.
Establish Ongoing Compliance Practices
A private foundation’s obligations do not end once it is formed and funded. It must file Form 990-PF annually, regardless of size, which requires detailed financial reporting and is subject to public disclosure. Ongoing attention to recordkeeping, board minutes documenting grant decisions, and consistent application of the conflict-of-interest policy all help demonstrate compliance.
Frequently Asked Questions
How long does it typically take to receive tax-exempt status after filing Form 1023?
Processing times vary with the complexity of the application and the Internal Revenue Service’s current workload. Straightforward applications are sometimes approved within a few months, while others take considerably longer.
Can a family member be paid for working at the foundation?
Yes, in certain circumstances. Reasonable compensation for services rendered is generally permitted and is not treated as self-dealing, but the amount must be reasonable and documented, and the arrangement should be reviewed against the disqualified person rules.
Can a private foundation make grants to individuals rather than only to other charities?
Yes, but grants to individuals for travel or study generally require the foundation to follow a specific, IRS-approved procedure. Making such grants without that procedure can result in the grants being treated as taxable expenditures.
Coordinate the Foundation With the Family’s Estate Plan
For many families, a private foundation is one component of a broader legacy plan that also includes wills, trusts, and lifetime gifting strategies, and coordinating the foundation’s governing documents with the estate plan helps ensure that funding commitments, succession of board or trustee roles, and the family’s charitable intent are documented consistently.
Because the excise tax rules leave little room for informal or after-the-fact correction, families are well served by involving experienced counsel before the foundation is formed rather than after a compliance issue arises.
At Abelaj Law, PC, our practice is led by attorney and CPA Jennifer V. Abelaj, whose combined legal and tax background allows her to advise families on both governance structure and tax posture from day one.
If your family is considering establishing a private foundation, we invite you to contact Abelaj Law, PC to discuss your charitable goals and how a foundation might fit within your broader estate plan.