Getting the tax aspects of your foundation right

It involves everything from how you fund it to how much money you distribute to grant recipients. The rules are tricky.

30 Jun 2016

A private foundation can be a wonderful vehicle for charitable giving, adding focus and impact to a family’s philanthropy and often perpetuating it in future generations. But a maze of tax rules complicates matters. Some regulations cover foundation basics—how tax deductions are calculated and what proportion of assets must go to charity each year. Others, however, are more obscure.

Not only are there rules about almost every aspect of running a foundation, but, according to David Leibell, senior wealth strategist for UBS Financial Services, Inc., “When you’re administering a foundation, you have to be aware of all of these rules.” It’s essential to know what’s required—and what’s not allowed.

Limits on tax deductions for donations

Private foundations are set up as tax-exempt organizations, and you receive an income tax deduction for your contributions that fund it. But there are limits on how much you can deduct each year.

If you contribute cash, you’re allowed to write off a maximum of 30% of your adjusted gross income for the tax year when you make the donation. If you earned $300,000, the most you could deduct would be $90,000. But you can also deduct another 30% of your adjusted gross income the following year, and you have five years to write off as much of your donation as possible.

Key takeaways

  • Private foundations are subject to a maze of complex tax regulations.
  • You can receive income tax deductions for your contributions to your foundation, but the amount you can deduct has a yearly limit.
  • Rules are even more restrictive when you’re contributing assets other than cash to a foundation.
  • Foundations require that you distribute 5% of the foundation’s assets each year—or face a tax penalty.
  • Always run any of your foundation’s proposed transactions by your legal counsel to be sure they won’t run afoul of technical tax rules.

If you fund your private foundation with assets other than cash, the rules are more restrictive. There’s a limit of 20% of adjusted gross income on your annual deductions, though you still have an additional five years to deduct excess amounts. For most of these types of gifts, such as private real estate or an interest in a family business, you’re allowed to deduct only what you paid for the asset—your cost basis—rather than its appreciated value when it goes into the foundation.

The one exception involves shares of publicly traded stock that you’ve owned for more than a year. The 20% rule still applies, but you can deduct the donation’s fair market value, not its cost basis. Compared with selling assets to raise cash and donating the after-tax proceeds to the foundation, contributing appreciated securities—and avoiding capital gains taxes—provides more value. (See “When not to give cash to charity.”) Nor will the foundation owe capital gains tax if it sells the investment. There is, however, a separate levy, known as excise tax, that does apply to a foundation’s investment profits. The rate is 2%, or 1% if the foundation consistently increases its charitable payouts. Take some time to discuss which assets you want to use to fund your foundation with your Financial Advisor, so you can make thoughtful choices that are in line with your overall wealth management plans.

Other tax rules you need to know

Many of the tax rules for private foundations aren’t about deductions. Instead, they involve things a foundation must do—and assess tax penalties for falling short. One of the most important of these is the 5% rule, which calls for private foundations to distribute 5% of foundation assets annually to other charitable organizations. The cost of administering your foundation can be part of the 5%, but investment management expenses don’t count. The IRS tax penalty for distributing too little is 30% of the shortfall.

There is also a long, complicated list of things your foundation isn’t supposed to do, and breaking those rules also results in tax penalties. “Self dealing,” in which a transaction you make with the foundation is deemed out of bounds—for example, leasing the foundation office space in a building you own—could incur a penalty tax as high as $20,000. “Unrelated business taxable income,” generated by a range of activities considered unrelated to the foundation’s charitable purpose, may be taxed at corporate or trust rates as high as 35%.

“The best advice is that when you’re interacting with your foundation, always run any proposed transaction by your legal counsel,” says Emily Brunner, wealth strategist for UBS Financial Services, Inc. “There are things that you can do that are of clear benefit to the foundation that may still run afoul of very technical tax rules.” Leibell notes that many of those rules, put in place because of past abuses, “are not necessarily commonsensical. You may find yourself trying to do good but in the process you inadvertently harm the foundation.”