Depending on your goals, a family foundation may be the right vehicle for your charitable giving. Family foundations are private foundations and must adhere to the Tax Code’s rules for private foundations. Having a picture of some of the restrictions on private foundations may help you in making the decision about whether a family foundation is the right choice for you.
Below is an overview of some of the major tax rules for family foundations. When establishing a family foundation, consulting with experienced legal counsel is invaluable to ensuring a complete understanding of the rules for private foundations from the start.
Self-Dealing: Limits on Financial Relationships with Related Parties
One of the main rules a family foundation must consider as it plans and conducts its activities is the Tax Code’s prohibition against most financial relationships with related parties. This is the prohibition against “self-dealing.” Simply stated, with few exceptions, a family foundation may not enter into any financial transaction with certain related parties, defined in the law as “disqualified persons.”
A disqualified person is any foundation officer, director, trustee or employee with the authority to act on behalf of the foundation and substantial contributors to the foundation. The term disqualified person also includes certain relatives of the persons listed above as well as entities controlled by these persons.
The list of prohibited transactions between a private foundation and a disqualified person includes:
- Sale, exchange or leasing of property (such as purchasing stationery, supplies, printing, graphic design or insurance) from a disqualified person.
- Lending of money or extension of credit by a private foundation to a disqualified person.
- Furnishing of goods, services or facilities by a private foundation to a disqualified person.
- Transferring the income or assets of the family foundation to or for the use of the a disqualified person.
- The payment of money or property to a government official.
- Satisfying the enforceable pledge of a disqualified person.
Examples of potential self-dealing
Personal family pledges – A legally binding pledge (personal pledge to charity, etc.) is a personal debt, and if a disqualified person makes such a pledge, it’s an act of self-dealing for a foundation to pay that debt.
Attending fundraisers – If the foundation buys a ticket to a fundraising event, and the ticket price includes payment for goods and services (e.g., dinner and entertainment) the ticket cannot be used by a disqualified person except if it is part of that individual’s oversight responsibility. Use of such tickets by spouses of foundation personnel who do not have a role with the foundation is an area of particular concern.
Hiring family members as staff or service providers – You can hire a family member as staff and pay them a salary or fee, but the compensation must be reasonable, the services necessary and personal (legal, accounting, banking, investment, etc), and charitable. The definition of personal services is narrow. For this reason, consulting with legal counsel when considering hiring family members as staff or service providers is particularly important.
Board compensation – Most foundations do not compensate board members. However, there is no prohibition against it, assuming fees are reasonable. The rule is essentially the same rule that applies to hiring family members as staff.
Providing Scholarships – Scholarships or grants to benefit disqualified persons are prohibited by the self-dealing rules. For example, a family foundation cannot provide a scholarship for the grandchildren of the foundation’s substantial donor.
Paying travel expenses for family
– The assets of a family foundation generally cannot be used to finance the travel (or any other expense) of spouses and children who have no role in the foundation. However, board members may be reimbursed for expenses incurred while engaged in legitimate and meaningful duties of the foundation.
Renting space from a family member – The payment of rent to any disqualified person by the foundation is self-dealing even if the rent charged is significantly below market rate and benefits the foundation. However, if the foundation leases space from a disqualified person and the rent is zero, there is no self-dealing.
Taxable Expenditures: Rules for Grantmaking
While a family foundation is permitted to make a wide range of grants to further its mission, attention to the rules for grantmaking is essential. As a baseline, foundations must make grants for charitable purposes. Making grants to public charities is often the simplest way to ensure a grant is for a charitable purpose. However, a family foundation may choose to further its mission by making grants to individuals for scholarships or other purposes, grants to non-U.S. based organizations or grants to other non-charities. These are all permissible types of grants as long as the foundation follows the appropriate rules to ensure that the grant is intended and used for charitable purposes. A family foundation should consider what types of grants it wants to make and learn the rules for making such grants to ensure continued compliance with the law.
Minimum Distribution: The Payout Requirement
A family foundation must make charitable expenditures that equal or exceed approximately 5 percent of the value of its endowment each year. These charitable expenditures can include grants and necessary and reasonable administrative expenses. Costs related to managing investments do not count toward fulfilling the 5 percent distribution.
Excise Tax and Investment Rules
While a family foundation does not generally pay income tax, as a private foundation it must pay an annual excise tax of 2 percent (or in certain cases 1%) of its net investment income. Additionally, a private foundation should be attentive to the rules affecting its investments. In particular, the private foundation rules dictate that a private foundation should not make imprudent and risky investments. The rules also regulate how much of a business enterprise a foundation may hold.
If you’ve decided that starting a family foundation would not fulfill your goals, consider other philanthropic options.