Friday March 29, 2024

7.2.1 Classification as a Private Foundation

Classification as a Private Foundation

Procedure for Public Charity Classification:  All Sec. 501(c)(3) charities are classified either as private foundations or as public charities.

Public Charity and Private Foundation Differences:  The distinction between a private foundation and a public charity is significant.

Private Foundation Excise Taxes:  Excise taxes are levied on a variety of improper transactions involving private foundations and public charities.

Types of Foundations:  Charities that do not qualify as public charities are all classified as private foundations.
All Sec. 501(c)(3) charities are classified either as private foundations or as public charities. Public charities tend to be the traditional "charitable" organizations such as schools, hospitals, churches, museums and organizations that work with broad segments of the public. Typically, a single wealthy family forms a private foundation as a charity that invests money and uses it to make grants to other charities.

Procedure for Public Charity Classification


All Sec. 501(c)(3) charities are classified by default as private foundations unless they specifically apply for public charity status and receive recognition from the IRS that they are public charities. A charity that wants to be classified as a public charity requests this classification as part of Form 1023. However, churches, public charities with gross receipts of $5,000 or less in each taxable year and charities covered by group tax exemptions may be classified as public charities without filing Form 1023.

Churches, schools, hospitals, medical research organizations and governmental units are "traditional" public charities. Various tests are applied to determine whether an organization meets the requirements of one of these traditional public charities. For example, a charity may be organized for educational purposes, but unless it meets specific requirements it will not qualify as a "school" to receive classification as a traditional public charity.

Public Charity and Private Foundation Differences


The distinction between a private foundation and a public charity is significant. Private foundations are subject to greater oversight and stricter operational constraints. In part, this is due to a presumption that it is easier to circumvent the rules that apply to charitable activity when a charity is controlled by a family or small group of people (because no one pays attention to what they are doing with their charitable money) as opposed to those charities that are in the public light and/or funded by a broad group of public donors who may keep the charity accountable for its activity and use of money. Of foremost importance to donors, donations to private foundations are subject to greater income tax deduction limitations than are donations to public charities. See GiftLaw Pro 1.1.3.

DEDUCTIBILITY OF GIFTSPrivate FoundationPublic Charity
Cash and Ordinary Income PropertyUp to 30% of AGIUp to 60% of AGI
Capital Gain Property Up to 20% of AGIUp to 30% of AGI
Value for Deduction Purposes Deduction limited to donor's basis in the donated asset. Fair market value deduction still available for gifts of cash and publicly held stock.Donor may deduct fair market value of donated asset.

Private Foundation Excise Taxes


Excise taxes are levied on a variety of improper transactions involving private foundations and public charities. Private foundation taxes are levied on self-dealing between the private foundation and a prohibited party, failure to distribute income as required, excess business holdings, investments that jeopardize the charitable purpose and taxable expenditures.

Self-dealing Taxes

Excise taxes are imposed on acts of self-dealing. These acts include direct or indirect sale, lease, loan, payments or provision of goods or services by a private foundation to a disqualified person. Sec. 4941(d)(1).

An initial tax of 10% of the amount involved with respect to an act of self-dealing is imposed on a disqualified person involved in self-dealing. If a self-dealing tax is imposed, a 5% tax (up to $20,000) may be levied on a foundation manager who knowingly participated in the act of self-dealing. Sec. 4941(c)(2).

If the act of self-dealing is not corrected, a tax of 200% is imposed on the disqualified person and a tax of 50% (up to $20,000 per act) is imposed on a foundation manager who refused to correct the act of self-dealing. These additional taxes are subject to abatement.

Tax on Failure to Distribute Income

A private nonoperating foundation must pay out a minimum amount each year to accomplish its exempt purposes. This amount may include reasonable administrative expenses. Sec. 4942(g)(1)(A). Failure to pay out the minimum may subject the foundation to a 30% tax. If the required payout is not made by the applicable tax period, an added tax of 100% is applicable. Sec. 4942(a) and (b). The distribution may include salaries, rent, travel costs, exempt purpose asset costs and other reasonable administrative expenses. Secs. 4942(g)(1)(B) and 4942(g)(2). Private operating foundations are not subject to the payout requirements.

Tax on Excess Business Holdings

Private foundations are subject to tax on excess business holdings. Sec. 4943. A private foundation is permitted to hold 20% (or 35% if there is outsider control) of corporate voting stock, reduced by the voting stock held by Sec. 4946 disqualified persons. There also is an exception permitting a private foundation to hold up to 2% of voting stock and total stock. For a partnership or LLC, the beneficial interests shall be measured rather than the voting stock.

Foundations generally have a five-year period to dispose of excess business holdings from a gift or bequest. Sec. 4943(c)(6) This five-year period may be extended an additional five years in limited circumstances. Sec. 4943(c)(7). Exceptions apply for holdings in a functionally related business or a business with at least 95% passive income. Sec. 4943(d)(3). The initial tax is equal to 10% of the value of the excess business holdings. If the foundation at the end of the applicable period continues to have excess business holdings, an added tax of 200% is applicable.

Tax on Jeopardizing Investments

Private foundations and foundation managers are subject to tax on investments that jeopardize the foundations' charitable purposes. Sec. 4944. The initial tax is 10% on the foundation and foundation managers ($10,000 maximum for managers) who knowingly made the jeopardizing investment.

If the investment is not sold, an additional tax of 25% on the foundation and 10% (up to $20,000) on a foundation manager applies. Investments primarily to fulfill charitable purposes and not for production of income are excluded from this tax. Sec. 4944(c).

Tax on Taxable Expenditures

Private foundation taxable expenditures include expenses for lobbying; certain voter registration drives, student study or travel grants, unless following Treasury procedures. Taxable expenditures also include private grants without following expenditure responsibility procedures under Sec. 4945(h) or payments for a noncharitable purpose.

Tax on a taxable expenditure for a foundation is 20%, and an additional tax of 100% is imposed if the expenditure is not corrected. A tax of 5% of the expenditure (up to $10,000) also is imposed on a foundation manager who knowingly makes a taxable expenditure. An additional tax of 50% of the amount of the expenditure (up to $20,000) is imposed on a foundation manager who does not correct the taxable expenditure.

Private Foundation Net Investment Income Excise Tax

Under Sec. 4940(a) of the Code, private foundations are subject to a 2% excise tax on net investment income. The 2% rate of tax is reduced to 1% if certain requirements are met. Sec. 4940(e). Unlike certain other excise taxes imposed on private foundations, the tax based on investment income does not result from a violation of substantive law by the private foundation. It is solely an excise tax.

Net investment income is the amount by which the sum of gross investment income and capital gain net income exceeds the deductions relating to the production of gross investment income. Sec. 4940(c)(1). Gross investment income is the gross amount of income from interest, dividends, rents, payments with respect to securities loans and royalties. Gross investment income does not include any income that is included in computing a foundation's unrelated business taxable income. Sec. 4940(c)(2) Capital gain net income takes into account only gains and losses from the sale or other disposition of property used for the production of interest, dividends, rents, and royalties and property used for the production of income included in computing the unrelated business income tax (except to the extent the gain or loss is taken into account for purposes of such tax). Losses from sales or other dispositions of property are allowed only to the extent of gains from such sales or other dispositions, and no capital loss carryovers are allowed.

Gross investment income (including for purposes of capital gain net income) includes items of income such as notional principal contracts, annuities and other substantially similar income from ordinary and routine investments, and with respect to capital gain net income, capital gains from appreciation, including capital gains and losses from the sale or other disposition of assets used to further an exempt purpose. Gains and losses on property used for a period of not less than one year for an exempt purpose are excluded if the entire property is exchanged immediately following such period solely for property of like kind that is to be used primarily for an exempt purpose. There are no carrybacks of losses from sales or other dispositions of property.

Charitable Organization Tax Shelter Disclosure

Under Sec. 4956 there are potential excise taxes on charitable organizations that are involved in tax shelter transactions. If a charity is party to a "listed transaction" that has been identified by the IRS as a tax avoidance strategy, taxes could be levied on both the charity and the charitable manager.

The tax on the organization is the greater of the top income tax rate times the tax shelter net income, or 75% of the proceeds received from the tax shelter. However, if the organization knew or had reason to know that the transaction involved a prohibited tax shelter, then the tax is the greater of 100% times the tax shelter net income, or 75% of the proceeds received from the tax shelter.

If a manager knows or has reason to know that the transaction involves a tax shelter, he or she is subject to a tax of $20,000. An organization that is party to a tax shelter is also required to disclose that participation to the IRS.

Types of Foundations


Charities that do not qualify as public charities are all classified as private foundations. There are three broad types of private foundations. They are the family foundation, corporate foundation and operating foundation. Other types of foundations typically fall within one of these three categories, or, like community foundations, are actually public charities and not private foundations.

Family Foundation

The first and largest type of private foundation is the family foundation. A family foundation receives most of its money from an individual or family and then invests and distributes that money for charitable purposes. Family foundations are sometimes also referred to as traditional or grantmaking foundations because they do not conduct charitable activities directly but instead support the charitable activities of others.

Corporate Foundation

The second type of private foundation is the corporate foundation. Corporate foundations are established by businesses as a means of carrying out a systematic program of giving.

Operating Foundation

Operating foundations are the third type of private foundation. Operating foundations actually conduct their own charitable activities rather than serve as conduits that simply distribute funds to other charities. Reg. 53.4942(b)-1. Operating foundations are treated like traditional private foundations in most respects. Significantly, private operating foundations are exempt from the minimum distribution requirement, and donations to private operating foundations receive more favorable tax treatment than those to traditional private foundations. They are subject to the same contribution deduction limitations as public charities. Perhaps the best-known example of a private operating foundation is the J. Paul Getty Museum in Los Angeles.

Conduit Foundation

A conduit foundation is a traditional private foundation that distributes 100% of the contributions it receives in a particular year. Under certain circumstances, contributions to a conduit foundation may be treated the same as those to a public charity for charitable deduction purposes. Sec. 170(b)(1)(E)(ii).

Community Foundation

Many people believe that community foundations are another type of private foundation. Community foundations, however, have broad public support and are therefore classified as public charities. Community foundations typically manage funds given to them and distribute those funds for charitable purposes, often in a specific locale or region or for specific causes.

Case Studies on Classification as a Private Foundation

Not All Tax-Exempt Organizations Are Treated Equally [Under the Code], Part 3 - Bank President Finds Little Return in Stock Gift to Foundation:   PetCare is a private foundation (PF) whose primary purpose is the prevention of cruelty to animals. PetCare was organized in 1980 and is exempt from federal income taxes under Sec. 501(c)(3) of the Code. PetCare receives most of its financial support from its founders; however, it does do some public fundraising. Specifically, PetCare raises awareness during local social functions by setting up booths and displays. The booths and displays educate and motivate citizens to support PetCare.

S Corporation Gifts - Strategies and Hurdles Every Advisor Should Know, Part 12 - Family Foundation Gets Behind the Wheel:   Tommy Ely, 58, owns and operates eight car dealerships spread throughout the city and surrounding areas. Tommy is the sole shareholder of Ely Motorsports, Inc., an S corporation founded in 1977. The eight car dealerships represent mainly high-end, luxury car lines.

Lucky Lucy Lindstrom's "Ultimate Control" Charity :   Lucy Lindstrom finished college and headed west. She started as a financial analyst with a large company in Seattle. After just four years, she became a Registered Investment Advisor (RIA) and began advising clients. Lucy also managed her own investments. With her keen insight into financial markets, Lucy soon began to move from traditional stocks and bonds into futures and commodities markets. Lucy was so successful in these markets that she now only manages her own large personal portfolio.

Somewhat late in life, Lucy discovered the wonderful world of philanthropy. She volunteered at her favorite charity and learned that giving someone in need a helping hand is even more gratifying than making another million in the futures market. Lucy invested $1,000,000 in a "penny stock" company. Recently, the stock rose from the $1 per share that she paid to over $5 per share. Lucy was delighted with her gain and decided to give the $5,000,000 in stock to a charitable foundation to help those in need.

Lucy discussed several options with her attorney and her favorite charity. She could create a private foundation (PF), or she could set up a supporting organization (SO) with her favorite charity. If the supporting organization were created, her favorite charity wants to elect three of the five directors, and Lucy would elect two directors. Since the SO would be controlled by her favorite charity, it would also qualify as a public charity. Lucy could give the stock and take a deduction up to 30% of her adjusted gross income, with a five-year carry-forward for the excess value.

Lucy thought about the SO but was also very interested in a private foundation (PF). She asked her attorney for reasons to select one or the other. Her attorney noted that private foundations are usually more expensive to operate, appreciated gifts are deductible only to 20% of AGI, deductions for gifts of real estate to a PF are limited to basis, there is usually a 2% excise tax on investment income and the PF is subject to various rules on self-dealing, minimum distributions and excess business holdings. "Wow!" said Lucy, "there are a lot of negatives about private foundations. So why do some of my friends set up private foundations?"

Private Letter Rulings

PLR 200116007 Transfer of Restricted Land to Private Foundation Still Qualifies Estate for Deduction:   Taxpayer owned a land estate and other substantial assets. Taxpayer desired that at his death the land estate be used as a public museum and garden operating exclusively for charitable and educational purposes. He thus during his lifetime created a private foundation (PF) whose exempt purpose was to preserve and maintain the land for future public use.

PLR 200120002 Transfer of Land to Private Foundation Qualifies Estate for Charitable Deduction:   Taxpayer owned a land estate and other substantial assets. Taxpayer desired that at his death the land estate be used as a public museum and garden operating exclusively for charitable and educational purposes. He thus during his lifetime created a private foundation (PF) whose exempt purpose was to preserve and maintain the land for future public use.

PLR 200420031 Corporate Foundation Grant Procedures Approved:   Widget Foundation is a private foundation created and funded by Widget, Inc. The Foundation started a program to provide scholarships to the children of Widget, Inc., employees. Widget Foundation seeks a ruling that the scholarships it awards will not constitute taxable expenditures.

PLR 200513030 PF Converts to Community Foundation:   Donors Alfred and Bertha created a private foundation. The private foundation was primarily designed to enhance the "physical, cultural and spiritual environment of the people of the State of M and the United States of America, and primarily of N and the area comprising O."

PLR 200607023 Private Foundation Settlement Agreement:   C died on Date 1. C's estate contained various rental properties worth X dollars in Trust D. Trust D's terms directed the executor of C's estate to make a full distribution of C's assets to B, a Sec. 501(c)(3) tax exempt private foundation under Sec. 509(a).

PLR 200709065 Subsidiary is a Functionally Related Business:   S, a private foundation, was formed to make grants to support organizations that help low-income individuals. In addition, S is a leading provider of program-related investments and investments in entities that not only produce an investment return but also serve to enhance communities and populations that are underserved.

PLR 200843041 Private Foundation's Tax-Exempt Status Survives Merger:   Y is a private operative foundation under Secs. 501(c)(3) and 509(a), while X is a private non-operating foundation under the same authority.

PLR 200916033 Scholarships Will Not Affect Exempt Status:   Foundation is a tax exempt charity under Secs. 501(c)(3), 509(a)(1) and 170(b)(1)(A)(vi). Its mission is to promote sports among the disabled, inner-city youth, the disadvantaged and women.

PLR 201302043 Sale of Conservation Easement Will Not Jeopardize Club's Exemption:   Club is classified as an exempt organization under Sec. 501(c)(7) of the Code. Club has operated continuously as a social club for over a decade. Club's purpose is to own and operate a private club for golf and other leisure activities for the recreation of its members.
PLR 201309018 IRS Revokes Foundation's Exempt Status:   ORG operates as a private foundation under Sections 501(c)(3) and 509(a) of the Code. ORG's purpose is to make grants to one or more charitable organizations. ORG's trustee quitclaimed a residential piece of real estate to the foundation but did not transfer the mortgage on the property.

PLR 201315031 Ranch Furthers Trust's Exempt Purpose:   Trust was established to support certain religious organizations and for general charitable purposes. Trust was later converted to a private foundation. Trust acquired the Ranch property to facilitate charitable programs. The Ranch is used to carry out two activities: the Retreat and the Program.
PLR 201335026 ORG's Exempt Status is Revoked:   ORG is a tax-exempt private non-operating foundation. ORG's purpose is to make grants to organizations classified as public charities under Section 501(c)(3).

PLR 201351026 IRS Rules Foundation Not Tax Exempt:   ORG is a private foundation under Sec. 501(c)(3) of the Code. ORG's purpose is to donate funds to different charitable organizations and government entities in order to further education, human culture and history, research of human diseases and protection of the natural environment.


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