What Is a Private Foundation?
Private foundations are defined under section 501(c)(3) of the Internal Revenue Code (IRC) like public charities. This grants them tax-exempt status. “Private foundation” is the default status given to organizations granted 501(c)(3) status.
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" to qualify for the tax exemption. The foundation can assist the poor, advance education, or maintain a public building.
Key Takeaways
- “Private foundation” is the default status given to organizations that are granted tax-exempt 501(c)(3) nonprofit status.
- A private foundation typically makes donations called “grants” to other charities, unlike a public charity.
- 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?
A private foundation typically makes donations called “grants” to other charities, unlike a public charity. It usually doesn't conduct its own charitable operations.Private foundations make grants to fund either 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 must benefit the public for the foundation to maintain its tax-exempt status, just like those of a public charity. 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 although it's possible to make grants to individuals under some circ*mstances such as for educational scholarships
- Pay a 1% to 2% excise tax on the organization’s net investment income
Should You Start a Private Foundation?
You might be wondering if you should start your own private foundation if you regularly donate large sums of money. Perhaps you see a social need that hasn’t been met or perhaps the prestige associated with running a charitable foundation in your 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. This is invested to generate income for the foundation. The endowment is used to fund its operations and make grants.
Private foundations can be time-consuming and expensive but 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 it's necessary to gain tax-exempt status.
#2 Decide Between a Trust or Nonprofit
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 its trustees with as much legal protection as a nonprofit corporation that has stricter operating requirements.Nonprofit corporations are more common than charitable trusts despite being harder to create because they limit personal liability and have more flexibility in how they can use their funds.
Appoint trustees if you organize as a trust. Follow the usual steps for establishing a corporation if you organize as 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)
You must apply for an employer identification number (EIN) regardless of how you decide to structure your private foundation. 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
The next step is to file organizing documents with the IRS. Fill out Form 1023, the Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, and prepare all 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 that applicants pay a fee. It can only be completed and filed online at the IRS website.
File any additional required paperwork to obtain tax-exempt status from your state after the IRS approves your tax-exempt status.
Benefits of Having a Private Foundation
The easiest way to do it is to write a check if you want to contribute to a good cause. So why were there at least 1,881,867 private foundations in the U.S. as of June 2024, according to IRS figures?
- Permanence: 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. They're tax-exempt when they're organized as a 501(c)(3). They can collect contributions of cash and appreciated property without paying taxes on those contributions. The contributors can also 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. The IRS defines these as:
- Allowing more than an insubstantial accrual of benefits to individuals or organizations, including nonmonetary benefits
- Allowing income or assets to accrue to insiders such as by 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 must also limit restricted activities. The IRS defines these as:
- Self-dealing with disqualified persons, defined as substantial contributors, foundation managers, and certain other related persons
- Investment activity that might jeopardize carrying out 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 can face taxes and penalties for violating these rules. The foundation could even lose its tax-exempt status.
Expenses
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 which is 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 have to donate for it to be worth the effort to start and maintain a foundation? There's 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.
Do All Private Foundations Have Tax-Exempt Status?
Yes, they do because they must be created for one of the following express purposes set 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 to prevent cruelty to children or animals.
How Much Money Do I Need to Start a Private Foundation?
There's no set amount required by law but you'll 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 at least 5% of the foundation’s assets annually in charitable grants. It can lose its tax-exempt status if it fails to do so.
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 it can become a legacy for you and your family that continues to do good long after you and they are no longer alive because it's funded by investment income derived from an inviolable endowment.
You can always engage in simpler charitable alternatives if you’re not sure whether a private foundation is the most effective way to meet your philanthropic goals, however. These can include writing a check to your favorite nonprofit, donating your time, or contributing to a donor-advised fund.
