A private foundation is a form of tax exempt nonprofit organization recognized by the IRS under section 501c3 501(c)(3) of the Internal Revenue Code. Starting a private foundation is not like starting a public charity, a private foundation is basically a family run business, it's extremely autocratic in nature, and more often than not is set up for tax evasion by the head of a wealthy family.
Unlike public charities, private foundations are started by people of means, and benefiting the public or being charitable is not their first mission, it's rather a secondary burden imposed upon them by the IRS.
To be clear: not all private foundations are setup by thieves, there're many responsible and well meaning private foundations that do many good, but the reality stays the same.
Starting a Private Foundation Table of Contents
- Private Foundations Have Some Advantages & Benefits
- Private Foundations Have a Few Disadvantageous Such as:
- Starting a Private Operating Foundation
- Private Operating Foundation Assets Test
- Private Operating Foundation Endowment Test
- Private Operating Foundation Support Test
- How to Start a Private Foundation
- Private Foundations Required Provisions
Private Foundations Have Some Advantages & Benefits
Unlike public charity organizations which are owned by the people, private foundations have owners, not donors, because the donors are the owners in the first place. Sounds complicated? Maybe it does if you're an honest person, but to majority of those who opt for a private foundation it's business as usual.
Private foundations can, and do:
- reduce the taxable income of their owners
- they avoid capital gain tax on properties of their owners,
- and potentially can eliminate estate taxes.
Not only that, private foundations can award scholarships and SELECT the recipient. They can also invest their funds, have business holdings, hire friends and family, pay expenses, and compensate their own family members.
If that wasn't enough, they can, and do, hoard 95% of their funds and spend only 5% of their investment income on the so-called "good deeds" they claimed in their application.
Public charities cannot do any of these.
Private Foundations Have a Few Disadvantageous Such as:
A private foundation is more strictly regulated by the IRS, and is subject to a number of anti-abuse rules and excise taxes that don't apply to public charities, because the IRS knows that they're not very charitable.
For example, private foundations are subject to tax on their net investment income and other excise taxes. The Internal Revenue Code imposes other requirements on private foundations as well, including strict restrictions on self-dealing, annual income distribution requirements, limits on holdings in business, and restrictions on certain investments.
The only consolation, if any, is that private foundation violations do result in IRS slapping them with heavy taxes, not only on the foundation itself, but also on foundation directors and certain related parties.
The biggest disadvantage of private foundations is that there's a cap on the amount of a contribution that a donor can deduct as a charitable deduction. For donations to a public charity, that limit is 50% of the donor's adjusted gross income. For contributions to a private foundation, the limit is 30%. In addition, contributors can deduct a higher percentage for contributions of capital gain property to public charities.
This makes private foundations almost ineligible for grants and big contributions, as most big donors are looking for tax write-off for their charitable donations to begin with. This usually is not a problem for most private foundations as they're self funding and don't rely on charitable donations, but for the honest foundations that actually spend their money by being "Charitable", it's a very big deal.
Starting a Private Operating Foundation
There's one more type of a nonprofit private foundation which is called a Private Operating Foundation. A private operating foundation is basically a "somewhat charitable" nonprofit foundation that spends at least 85% of its revenue on its exempt activities. A private operating foundation as its name suggests is any private foundation with the major difference that it has some sort of programs other than grant making.
Under Section 4942(j)(3), a private operating foundation must make qualifying distributions directly in furtherance of its exempt purposes. This generally means that private operating foundations engage directly in the active conduct of activities accomplishing their exempt purposes rather than passively distributing funds to individuals or organizations that accomplish those purposes.
To start a private operating foundation you have to meet one of the following tests:
- Private foundations assets test
- Private foundations endowment test
- Private foundations support test
Private Operating Foundation Assets Test
A private operating foundation will meet the assets test if 65% or more of its assets:
- Are devoted directly to the active conduct of its exempt activity, a functionally related business, or a combination of the two,
- Consist of stock of a corporation that's controlled by the foundation (by ownership of at least 80% of the total voting power of all classes of stock entitled to vote and at least 80% of the total shares of all other classes of stock) and at least 85% of the assets of which are so devoted, or
- Are any combination of (1) and (2).
Private Operating Foundation Endowment Test
A private operating foundation will meet the endowment test if it normally makes qualifying distributions directly for the active conduct of its exempt activities of at least two-thirds of its minimum investment return.
In determining whether the amount of qualifying distributions is at least two-thirds of the organization's minimum investment return, the organization is not required to trace the source of the expenditures to determine whether they were received from investment income or from contributions.
Private Operating Foundation Support Test
A private operating foundation will meet the support test if:
- At least 85 percent of the private foundation support (other than gross investment income) is normally received from the general public and 5 or more unrelated exempt organizations,
- Not more than 25 percent of the private foundation support (other than gross investment income) is normally received from any one exempt organization, and
- Not more than 50 percent of the private foundation support is normally received from gross investment income.
Here the term support means gifts, grants, contributions, membership fees, the value of services or facilities furnished by a governmental unit without charge, net income from unrelated business activities, and gross receipts from admissions, sales of merchandise, performance of services, or providing facilities in any activity that if not an unrelated trade or business.
Private Operating Foundations are not very common as most people either choose a private foundation or a start public charity.
How to Start a Private Foundation
Knowing these facts, you may still want to start a private foundation for an honest reason rather than making tax-free jobs for your family business, and you don't qualify as a 501c3 501(c)(3) public charity because of the source of the organization's income. The process of starting a private foundation is exactly the same as a public charity.
If you're torn between choosing a private foundation and private operating foundation as the type of your organizations, you most likely qualify as a public charity and you should organize as such.
There are multitude of pages on how to form a nonprofit, and you can use all of them as your guide. You still need the nonprofit bylaws, conflict of interest policy and the rest.
Private Foundations Required Provisions
One major difference between a public charity and a private foundation formation that you should know is this:
At the time of the State incorporation, the IRS required provisions for a private foundation to be included in the Articles of Incorporation have more clauses than public charities. Here are the required clauses for private foundations that IRS wants you to include with your state articles of incorporation in addition to the purpose and dissolution clause:
- The corporation will distribute its income for each tax year at a time and in a manner as not to become subject to the tax on undistributed income imposed by section 4942 of the Internal Revenue Code, or the corresponding section of any future federal tax code.
- The corporation will not engage in any act of self-dealing as defined in section 4941(d) of the Internal Revenue Code, or the corresponding section of any future federal tax code.
- The corporation will not retain any excess business holdings as defined in section 4943(c) of the Internal Revenue Code, or the corresponding section of any future federal tax code.
- The corporation will not make any investments in a manner as to subject it to tax under section 4944 of the Internal Revenue Code, or the corresponding section of any future federal tax code.
- The corporation will not make any taxable expenditures as defined in section 4945 of the Internal Revenue Code, or the corresponding section of any future federal tax code.
For the rest of the private foundation startup process, you should follow the nonprofit formation guide and you can successfully form a nonprofit private foundation.
Further Reading & References
- Unrelated Business Income Tax (UBIT) for 501c3 501(c)(3) Nonprofits – Learn when side income becomes taxable under IRS rules.
- IRS Manual for Determination of Public Charity Status – How the IRS decides if your nonprofit qualifies as a public charity.
- § 501. Internal Revenue Code of 1986 Section 501c3 501(c)(3) – The legal backbone defining tax-exempt organizations.
Private Foundations Questions
What are the differences between private foundations vs. public charities?
- Are churches, hospitals, qualified medical research organizations affiliated with hospitals, schools, colleges, and universities,
- Have an active program of fundraising and receive contributions from many sources, including the general public, governmental agencies, corporations, private foundations, or other public charities,
- Receive income from the conduct of activities in furtherance of the organization's exempt purposes, or
- Actively function in a supporting relationship to one or more existing public charities. Private foundations, typically have a single major source of funding (usually gifts from one family or corporation rather than funding from many sources) and most have as their primary activity the making of grants to other charitable organizations and to individuals, rather than the direct operation of charitable programs.