A family foundation is a private charitable organization, tax-exempt under Section 501(c)(3), that is funded by one family and controlled by that family’s chosen board. It gives donors a federal income tax deduction for their contributions and lets them decide, year after year, which charities receive grants. In return, the IRS imposes a set of rules that public charities do not face: a mandatory annual payout, a near-total ban on financial dealings with insiders, caps on business ownership, and an annual excise tax on investment income.
Private Foundation Status Under the IRS
The IRS grants tax-exempt status to family foundations under Section 501(c)(3), the same code section that covers public charities, churches, and schools.1Office of the Law Revision Counsel. 26 USC 501 – Exemption From Tax on Corporations, Certain Trusts, Etc What separates a family foundation from a public charity is where the money comes from. Under Section 509(a), any 501(c)(3) is treated as a private foundation by default unless it draws broad support from the public or from government sources.2Office of the Law Revision Counsel. 26 USC 509 – Private Foundation Defined Because one family is doing the funding, private foundation status is nearly automatic.
Within that category, the IRS separates operating from non-operating foundations. A private operating foundation spends at least 85 percent of its income on charitable activities it runs itself, such as a museum or a scholarship program.3Internal Revenue Service. Definition of Private Operating Foundation Most family foundations are non-operating: they invest an endowment and make grants to other charities. The distribution rules, tax rates, and deduction limits differ between the two.
Tax Deductions for Contributors
Money and property that go into a family foundation are deductible on the donor’s federal income tax return, but at lower ceilings than gifts to public charities. Cash contributions to a private non-operating foundation are deductible up to 30 percent of the donor’s adjusted gross income for the year.4Internal Revenue Service. Charitable Contribution Deductions Gifts of appreciated property such as stock or real estate are capped at 20 percent of AGI. Anything above the ceiling in a given year can be carried forward for up to five more tax years.
By comparison, cash gifts to public charities are generally deductible up to 50 percent of AGI, or 60 percent when that higher rate is in effect. The lower ceilings for a family foundation are the cost of the control it offers: the donor picks the causes, the timing, and the grant sizes rather than turning that authority over to an outside organization.
The 5 Percent Annual Payout
A non-operating private foundation has to distribute money for charitable purposes every year to keep its exempt status. The required amount is at least 5 percent of the average fair market value of the foundation’s non-charitable-use assets—essentially its investment portfolio—reduced by any acquisition debt on those assets.5Office of the Law Revision Counsel. 26 USC 4942 – Taxes on Failure to Distribute Income A foundation with $5 million in investments would need to distribute roughly $250,000 in a given year.
Qualifying distributions include grants to public charities, direct charitable spending, and the share of reasonable administrative expenses attributable to charitable work, such as staff time spent reviewing grant applications or conducting site visits.6Internal Revenue Service. Private Foundations – Treatment of Qualifying Distributions IRC 4942(h) Costs tied to managing the investment portfolio do not count. Foundations have to split their expenses between investment and charitable activities when they calculate whether they cleared the 5 percent bar.
A foundation that pays out more than the minimum can carry the excess forward for up to five years and apply it against future years’ requirements.7Internal Revenue Service. Refreshing Expiring Distribution Carryovers of Private Foundations After that five-year window the carryover disappears. A shortfall triggers a 30 percent excise tax on the undistributed amount.8Internal Revenue Service. Taxes on Failure to Distribute Income – Private Foundations If the foundation still hasn’t fixed the shortfall within 90 days of an IRS notice, a second tax of 100 percent hits whatever remains undistributed.
The Self-Dealing Ban
Federal law prohibits almost every financial transaction between a private foundation and its “disqualified persons.” That group includes substantial contributors, board members (called foundation managers), owners of more than 20 percent of any entity that is itself a substantial contributor, and the family members of all of them. Corporations, partnerships, and trusts controlled by those individuals are covered too.9Office of the Law Revision Counsel. 26 USC 4941 – Taxes on Self-Dealing
Prohibited transactions include:
- Buying or selling property between the foundation and an insider, even at fair market value.
- Lending money in either direction.
- Furnishing goods, services, or facilities to a disqualified person, with narrow exceptions.
- Paying compensation that is excessive or that is for services not reasonable and necessary to the foundation’s mission.
The initial excise tax for a self-dealing violation is 10 percent of the amount involved, imposed on the disqualified person for each year the transaction stays uncorrected.9Office of the Law Revision Counsel. 26 USC 4941 – Taxes on Self-Dealing If the transaction isn’t unwound within the correction period, the penalty jumps to 200 percent. A foundation manager who knowingly approves a self-dealing transaction faces a separate tax.
Compensation is the one common exception. A family member who serves as a foundation manager can be paid, but only for services reasonable and necessary to the exempt purpose, and only in an amount comparable to what an unrelated person with similar qualifications would earn for the same work.10Internal Revenue Service. Paying Compensation
Investment and Business Ownership Limits
Two more sets of rules govern what the foundation can hold. First, a foundation cannot invest in a way that jeopardizes its ability to carry out its charitable purposes. The standard is whether the managers used ordinary business care and prudence given the foundation’s short- and long-term needs, judged on the facts at the time of the investment rather than with hindsight.11Internal Revenue Service. IRC Section 4944(c) – Taxes on Investments Which Jeopardize Charitable Purpose A speculative bet with a large share of the endowment can trigger a 10 percent excise tax on the amount invested, plus another 25 percent if the investment is not removed from jeopardy.12Office of the Law Revision Counsel. 26 USC 4944 – Taxes on Investments Which Jeopardize Charitable Purpose
Second, the foundation together with its disqualified persons generally cannot own more than 20 percent of the voting stock of any business enterprise. That ceiling can go up to 35 percent if the foundation shows that unrelated parties keep effective control.13eCFR. 26 CFR 53.4943-3 – Determination of Excess Business Holdings Holdings above the cap draw a 10 percent excise tax on the excess, rising to 200 percent if the excess is not divested within the correction period.14Office of the Law Revision Counsel. 26 USC 4943 – Taxes on Excess Business Holdings
Excise Tax on Investment Income
Private foundations owe a flat 1.39 percent excise tax each year on their net investment income, which covers interest, dividends, rents, royalties, and capital gains from selling assets.15Office of the Law Revision Counsel. 26 USC 4940 – Excise Tax Based on Investment Income The tax applies no matter how much the foundation distributes. A foundation with a $10 million endowment earning $400,000 in investment income would owe about $5,560. The amount is reported and paid on Form 990-PF.
Setting One Up
Creating a family foundation is a multi-month process with state and federal steps.
Choose a Structure and Draft Governing Documents
The foundation can be organized as a nonprofit corporation or as a charitable trust. Families usually pick the corporate form because it gives board members clearer liability protection. Either way, the organizing document—articles of incorporation for a corporation, a trust agreement for a trust—has to include language limiting activities to exempt purposes and committing the foundation to follow the rules on distributions, self-dealing, excess business holdings, and jeopardizing investments.16Internal Revenue Service. Private Foundations – Required Provisions for Organizing Documents The IRS publishes sample provisions for both formats. A nonprofit corporation is formed by filing articles of incorporation with the state’s Secretary of State and paying a filing fee that varies by state.
Get an EIN and File Form 1023
The foundation needs an Employer Identification Number, which is free from the IRS website.17Internal Revenue Service. Get an Employer Identification Number With the EIN, you file Form 1023 electronically through Pay.gov.18Internal Revenue Service. About Form 1023 – Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code The form asks for a description of planned activities, how grants will be selected and monitored, and three years of projected financial data. The organizing document and bylaws have to be uploaded with it.
The user fee is $600.19Internal Revenue Service. Form 1023 and 1023-EZ – Amount of User Fee The IRS currently processes about 80 percent of applications within 191 days; complex cases run longer.20Internal Revenue Service. Where’s My Application for Tax-Exempt Status Approval comes as a determination letter confirming exempt status.
Register With the State
After the IRS approves the application, the foundation may need to register with the state attorney general or a designated agency before making grants or accepting contributions. Many states also require periodic financial reporting from charitable organizations holding trust assets.21Internal Revenue Service. Charitable Solicitation – State Requirements Fees and requirements vary by state.
Form 990-PF and Public Disclosure
Every private foundation files Form 990-PF each year regardless of income. It is due on the 15th day of the fifth month after the fiscal year closes—May 15 for a calendar-year foundation—with an automatic six-month extension available on Form 8868.22Internal Revenue Service. Annual Exempt Organization Return – Due Date The return reports income, expenses, grants, investments, officer compensation, and compliance with the 5 percent distribution rule, and it calculates the 1.39 percent investment income tax.
A late filer owes $20 per day up to the lesser of $10,500 or 5 percent of the foundation’s gross receipts for the year.23Internal Revenue Service. Annual Exempt Organization Return – Penalties for Failure to File Larger organizations face higher daily penalties and caps.
The Form 990-PF and the foundation’s original exemption application also have to be available for public inspection at the principal office during business hours. Anyone who asks in writing must be sent copies within 30 days, with charges limited to the actual cost of copying and postage.24eCFR. 26 CFR 301.6104(d)-1 – Public Inspection and Distribution of Applications for Tax Exemption and Annual Information Returns Each year’s return has to remain available for three years after its filing deadline or actual filing date, whichever is later.
Winding a Foundation Down
A family that decides to close its foundation has two clean paths. The simplest is to distribute all remaining net assets to one or more public charities that have existed for at least 60 consecutive months, which avoids the termination tax entirely.25Office of the Law Revision Counsel. 26 USC 507 – Termination of Private Foundation Status The other is to convert the foundation into a public charity by operating as one for a continuous 60-month period, provided the IRS is notified in advance and the public support tests are met throughout.
A foundation that terminates without following one of those paths owes a termination tax equal to the lower of the foundation’s total historical tax benefit from exempt status or the current value of its net assets.25Office of the Law Revision Counsel. 26 USC 507 – Termination of Private Foundation Status That tax can eat most or all of what is left, so any wind-down plan should be built around one of the two allowed routes.